On February 9, 2022, the US Securities and Exchange Commission (the "SEC") voted to propose a suite of new rules and amendments (the "Proposal") under the Investment Advisers Act of 1940, as amended (the "Advisers Act").1 If adopted, the Proposal would significantly increase the compliance obligations of advisers to "private funds" and would fundamentally reorder the relative rights, liabilities and bargaining leverage between advisers and their private fund investors. The Proposal creates a more prescriptive advisory relationship, which, among other changes, would prohibit common private fund practices, such as providing exculpation and indemnification for simple negligence and net-of-tax general partner clawbacks, and would reshape side-letter practices across the private funds industry.
This Legal Update provides a more detailed analysis of the Proposal briefly summarized in our earlier Legal Update.2
The Proposal focuses on advisers with respect to their "private funds" (i.e., funds that would be an "investment company" but for the exceptions provided in Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, as amended (the "Investment Company Act")). Although the Proposal specifically refers to private equity and hedge fund sponsors, the definition of a private fund (as was the case under the Volcker Rule with the definition of "covered fund") has the broader potential to include funds that focus on infrastructure, real estate and certain securitizations (such as collateralized loan obligations ("CLOs")).
The SEC stated that the Proposal is intended to address activities harmful to private fund investors, which persist despite the SEC's examination and enforcement efforts. Specifically, the Proposal is intended to provide investors with enhanced and standardized information about fund performance, costs and preferred terms, which the SEC believes would help investors better understand marketplace dynamics, increase competition and potentially bring greater efficiencies to this sector of the capital markets. Furthermore, the Proposal aims to curb the ability of private fund advisers to act on conflicts of interests that are not transparent to investors in a manner that ultimately benefits the adviser at the expense of investors. The SEC repeatedly noted that regulation was necessary because, in the SEC's view, private funds typically lack governance mechanisms that would check adviser overreach. In the SEC's view, the common practice of delegating certain investor determinations to limited partner advisory committees and similar conflict approval mechanisms do not go far enough to protect the interests of investors, even with informed consent.
While discrete portions of the Proposal codify current market practices, when taken as a whole, the Proposal appears to represent a departure from a regulatory approach that historically has been based on "full and fair" disclosure, informed consent and negotiations among sophisticated parties- typically high-net-worth individuals and institutional investors-toward a more protective and prescriptive regulatory framework that has some similarities to the one currently in place for registered investment funds targeted at retail investors. It also appears to be a pivot from the SEC's interpretation regarding the standard of conduct for investment advisers, which was published less than three years ago and largely memorialized the concept that an investment adviser's duty, as a fiduciary to its clients, is to "eliminate or make full and fair disclosure of all conflicts of interest which might incline an investment adviser . . . to render advice which is not disinterested such that a client can provide informed consent to the conflict."3 The Proposal, in large part, instead flatly prohibits certain conflicts of interest. For example, the proposed new requirement to share broken-deal expenses pro rata across all participating (or potentially participating) funds and accounts stands in contrast to longstanding practice permitting a flagship fund to bear the totality of such expenses as long as proper disclosure of that practice has been provided in advance to fund investors.
If the Proposal is adopted and reshapes certain contours of the private fund industry, we expect that adviser operational costs will increase. This could lead to upward management fee pressure, thus impacting returns. The general effect of such increased costs would also make it harder for smaller firms to compete and survive, perhaps driving further consolidation in the market.
The Proposal articulates a goal of protecting those who directly or indirectly invest in private funds, noting that some of the largest groups of private fund investors include state and municipal pension plans, college and university endowments and non-profit organizations, with SEC Chair Gary Gensler indicating that the Proposal is intended to protect the "teachers, firefighters, municipal workers, students, and professors" that benefit from investments made by those institutional investors4 and whom the SEC has recently identified as exam priorities.5 While we expect many aspects of the Proposal may be welcomed by investors, we note that the preferential terms that the Proposal seeks to curtail are typically sought by these same institutional investors that the Proposal seeks to protect.
Practice Notes:
Which Advisers Are Affected?
Much of the Proposal is targeted solely at SEC-registered investment advisers ("RIAs") to private funds, but some aspects apply to all advisers to private funds, including exempt reporting advisers ("ERAs") and other advisers exempt from registration (e.g., foreign private advisers).
Competitive Advantage for Non-US Advisers?
Moreover, certain aspects of the Proposal will not apply to non-US-based advisers' arrangements with non-US funds. The Proposal reiterates the long-standing SEC position that the substantive provisions of the Advisers Act do not apply with respect to the non-US clients of non-US-based advisers-even if those non-US clients are funds that have US person investors.
As a result, the specific prohibitions discussed in Section B, as well as Section C below, would not apply to the non-US funds of such advisers, even if the adviser is an RIA and even if the non-US were limited solely to US investors. In contrast, the prohibitions would apply to the use of US feeder or parallel funds by a non-US adviser, or the use of an affiliated US-based adviser as a subadviser.
This difference in treatment could provide non-US-based private fund managers a significant competitive advantage relative to their US counterparts, with lower costs and with greater liability protection, depending on the jurisdiction they select.
What Types of Funds Fall within the Proposal's Scope?
The Proposal primarily focuses on advisers' relationships with private funds, as defined. However, the Proposal doesn't include any carve-outs for-or directly acknowledge the impact on-CLOs, which frequently rely on Section 3(c)(7) under the Investment Company Act, and therefore are considered private funds.
What about Existing Funds?
The Proposal does not provide for grandfathering of existing contracts or advisory relationships.
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Footnotes
1. Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Advisers Act Release No. 5955 (Feb. 9, 2022) (Release), available at https://www.sec.gov/rules/proposed/2022/ia-5955.pdf.
2. SEC Proposals Would Significantly Impact Private Fund Advisers and Impose New Cybersecurity Requirements on Registered Advisers and Funds, including BDCs (February 14, 2022), available at https://www.mayerbrown.com/en/perspectives-events/publications/2022/02/sec-proposals-would-significantly-impact-private-fund-advisers-and-impose-new-cybersecurity-requirements-on-registered-advisers-and-funds-including-bdcs
3. Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Release No. 1A-5248, at n. 24 and accompanying text, (July 12, 2019) (Release), available at https://www.sec.gov/rules/interp/2019/ia-5248.pdf. According to the SEC, the Fiduciary Interpretation was intended to "reaffirm-and in some cases clarify-certain aspects of the fiduciary duty," affirming that this disclosure-based posture reflected long-standing practices and guidance. Id. at n.7 and accompanying text.
4. Statement on Private Fund Advisers Proposal, (February 9, 2022), available at https://www.sec.gov/news/statement/gensler-statement-private-fund-advisers-proposal-020922.
5. See, e.g., 2021 SEC Examination Priorities, available at https://www.sec.gov/files/2021-exam-priorities.pdf.
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