In a Legal Alert issued before yesterday’s SEC Open Meeting, we posed questions relating to six things that our Investment Services team would be looking for. We now have answers to some of those questions. 

***

On Wednesday, August 23, the SEC voted by a 3-2 margin to adopt new and amended rules under the Investment Advisers Act of 1940 that will impose a host of new regulatory requirements on private fund advisers. While the SEC did scale back some aspects of the proposal after receiving feedback from commenters, overall the rule set will impose substantial new prescriptive rules on private fund advisers. In addition, the SEC adopted as part of this rulemaking its proposal to amend existing Rule 206(4)-7 under the Advisers Act that will require all registered investment advisers to document in writing the results of currently required annual compliance reviews. 

Grandfathering

The SEC is grandfathering current contractual arrangements by providing “legacy status” for the prohibitions aspect of the Preferential Treatment Rule and those aspects of the Restricted Activities Rule that require investor consent. The legacy status provisions apply to governing agreements that were entered into prior to the compliance date if the applicable rule would require the parties to amend the agreements. Accordingly, agreements (e.g., limited partnership agreements) entered into before the relevant compliance date will not have to be amended as a result of these rules.

1. Restricted Activities. Proposed Advisers Act Rule 211(h)(2)-1 (Prohibited Activities Rule) would have prohibited a private fund adviser from charging certain fees and expenses (e.g., charging a portfolio investment for monitoring, servicing, consulting or other services the adviser does not provide or charging a private fund for fees or expenses associated with an examination or investigation of the adviser or for any regulatory or compliance fees or expenses of the adviser). We were looking to see if the final rule would prohibit private fund advisers from charging these fees and expenses outright or whether the SEC would provide an alternative path for such fees and expenses to be assessed (e.g., disclosure to investors in all relevant funds/vehicles or approval by the limited partners). In the final rule, the SEC took a nuanced approach by allowing private fund advisers to charge some of these fees and expenses if the private fund adviser provides certain disclosures and, for certain types of fees, also receives consent from investors. For instance, the new rule restricts private fund advisers from charging or allocating to a private fund fees or expenses associated with an investigation of the adviser without providing disclosure to, and obtaining consent from, fund investors. An adviser may not charge fees or expenses related to an investigation that results in a court or governmental authority imposing a sanction for a violation of the Advisers Act or the rules thereunder. The new rule, now termed the Restricted Activities Rule, also would restrict a private fund adviser from charging or allocating to a private fund regulatory, examination or compliance fees or expenses of the adviser, unless such fees and expenses are disclosed to investors. On the other hand, the SEC notes in the rule’s adopting release that it is unnecessary for the new rule to prohibit an adviser from charging fees without providing a corresponding service to a private fund because such activity already is inconsistent with the adviser’s fiduciary duty. 

   One of the most controversial aspects of the proposed Prohibited Activities Rule was a provision that would have prohibited a private fund adviser from seeking reimbursement, indemnification, exculpation or limitation with respect to its liability to the private fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence or recklessness in providing services to the private fund. Since many private funds and their investors have entered into agreements containing such contractual terms for many years, the proposal would have prohibited long-standing contractual provisions in the private fund industry. We were looking to see whether the SEC would stick with the proposed broad prohibitions in the final rule. The SEC decided not to adopt this prohibition and instead provided its views on how an adviser’s fiduciary duty applies to its private fund clients. The SEC noted that a waiver of an adviser’s federal antifraud liability for breach of its fiduciary duty to the private fund or of any other provision of the Advisers Act (or the rules thereunder) is invalid. Whether a contractual clause purporting to limit an adviser’s liability (also known as hedge clauses or waiver clauses) in an agreement with a private fund would violate the Advisers Act’s antifraud provisions will be determined based on the particular facts and circumstances. The SEC did note, however, that an adviser violates the antifraud provisions of the Advisers Act if there is a contract provision waiving its fiduciary duties (or the adviser’s federal fiduciary duty) and there is no language clarifying that the adviser is not waiving its fiduciary duty or that the client retains certain non-waivable rights. Finally, an adviser may not seek reimbursement, indemnification or exculpation for breaching its federal fiduciary duty (because such reimbursement, indemnification or exculpation would operate effectively as a waiver, which would be invalid under the Advisers Act).

2. Preferential Treatment. Proposed Advisers Act Rule 211(h)(2)-3 (Preferential Treatment Rule) would have prohibited a private fund adviser from providing preferential terms to certain investors regarding redemption or information about portfolio holdings or exposures. We were looking to see whether the SEC would adopt a final rule retaining the outright prohibitions or whether the agency would soften its position. The SEC made some cosmetic changes to this aspect of the rule by prohibiting private fund advisers from providing preferential terms to investors regarding (a) redemptions from the fund, unless the ability to redeem is required by applicable law or the adviser offers the preferential redemption rights to all other investors without qualification, and (b) preferential information about portfolio holdings or exposures, unless such preferential information is offered to all investors. 

   The SEC also proposed to prohibit private fund advisers from providing any other preferential treatment to any investor in the private fund unless the adviser provides written disclosures to prospective and current investors about such preferential treatment. We were looking to see whether the SEC relaxed these disclosure obligations in the final rule. The SEC adopted this proposal largely as proposed. Under the adopted rule, if there is any preferential treatment related to any material economic terms, notice needs to be provided in writing prior to the investor’s investment. However, for all other instances of preferential treatment, advisers can provide disclosure in writing, to current investors, in accordance with the following timeline: for illiquid funds, as soon as reasonably practicable following the end of the private fund’s fundraising period, and for liquid funds, as soon as reasonably practicable following the investor’s investment in the private fund. In addition, an adviser will have to distribute a notice annually if any preferential treatment was provided to an investor since the last notice. Like the proposed rule, the final rule will require an adviser to describe specifically the preferential treatment to convey its relevance.

3. Adviser-led Secondaries. We were looking to see whether new Advisers Act Rule 211(h)(2)-2 (Adviser-led Secondaries Rule) would prohibit a private fund adviser from obtaining a fairness opinion from an opinion provider with business relationships above a certain threshold (whether a certain dollar amount, percentage of revenue or otherwise) with the adviser or its related persons if the adviser initiates a transaction that offers fund investors the choice between (a) selling all or a portion of their interests in the private fund and (b) converting or exchanging them for new interests in another vehicle advised by the adviser or any of its related persons (an adviser-led secondary transaction). The SEC chose not to do so and, in fact, allowed a private fund adviser to solicit either a fairness opinion or a written opinion stating the value (as a single amount or a range) of any assets being sold (a so-called valuation opinion) from the opinion provider. 

   We were also looking to see whether the SEC would require private fund advisers to obtain a fairness opinion before engaging in cross trades involving securities valued using Level 2 or Level 3 inputs. The SEC stated in the Adopting Release that it did not view “the rule to apply to cross trades (which, generally, include sales of assets from one fund managed by an adviser to another fund managed by the same adviser) where the adviser does not offer the private fund’s investors the choice to sell, convert, or exchange their fund interests.” In other words, an adviser will not need a fairness or valuation opinion before initiating private fund cross trades.

4. Audits. Given that there could have been redundancy between proposed new Advisers Act Rule 206(4)-10 (Audit Rule) and proposed new Advisers Act Rule 223-1 (Safeguarding Rule) with respect to their private fund annual audit requirements, we were looking to see whether the SEC would defer action on the Audit Rule so that it could be folded into the final Safeguarding Rule the SEC plans to adopt later this year. The SEC ended up taking an approach somewhat along these lines. The adopted Audit Rule will require a financial statement audit that meets the requirements of Advisers Act Rule 206(4)-2(b)(4) (Custody Rule) for each private fund that a private fund adviser manages, and it will further require delivery of such audited financial statements to private fund investors in accordance with Rule 206(4)-2(c). At the same time, the SEC re-opened the comment period for the proposed Safeguarding Rule so that commenters can reassess the proposed Safeguarding Rule’s amendments to the Custody Rule’s audit provision in light of the adoption of the Audit Rule.

5. Statements. Advisers Act Rule 211(h)(1)-2 (Quarterly Statement Rule) was adopted largely as proposed. This rule will require a registered private fund adviser to prepare a quarterly statement that includes certain standardized information regarding fees, expenses and performance for any private fund that it advises and to distribute the quarterly statement to the private fund’s investors. We were looking to see whether the SEC would adopt a more principles-based and flexible approach to these reporting requirements that would have acknowledged the variability across funds and strategies regarding types of fees and expenses and methods of performance calculation, but the SEC did not do so. The SEC did, however, make a handful of other modest changes to this rule. While the quarterly statement for the private fund’s first three quarters of each fiscal year still must be delivered within 45 days after the end of the quarter, the fourth-quarter statement must be delivered within 90 days after the end of the quarter. In addition, statements of fund of funds must be delivered within 75 days after the end of the first three fiscal quarters and within 120 days after the end of the fourth quarter. And finally, annual net total returns are only required for the past 10 fiscal years or since inception, whichever is shorter, rather than for each calendar year since inception.

6. Compliance Procedures and Practices. We were looking to see whether the amendments to Advisers Act Rule 206(4)-7 (Compliance Rule) would specify elements that would be required to be included in any written documentation required pursuant to those amendments. The short answer is no. The amendments were adopted substantially as proposed. Instead, the SEC stated that “[t]he written documentation requirement is intended to be flexible to allow advisers to continue to use the review procedures they have developed and found most effective.”

   We were also looking to see whether the SEC would express any views in the Adopting Release regarding attempts to assert attorney-client privilege or other privilege claims against attempts by the SEC to obtain investment adviser records. It did. The Adopting Release states that “Commission staff has observed improper claims of the attorney-client privilege, the work-product doctrine, or other similar protections over required records, including any records documenting the annual review under the compliance rule, based on reliance on attorneys working for the adviser in-house or the engagement of law firms and other service providers (e.g., compliance consultants) through law firms.”  

Compliance Dates

All the new rules and amendments will take effect 60 days after publication in the Federal Register. All private fund advisers will need to comply with the Quarterly Statement Rule (Rule 211(h)(1)-2) and the Audit Rule (Rule 206(4)-10) not later than 18 months after publication in the Federal Register. Larger private fund advisers (those with $1.5 billion or more in private funds assets under management) will need to comply with the Restricted Activities Rule (Rule 211(h)(2)-1), the Adviser-led Secondaries Rule (Rule 211(h)(2)-2) and the Preferential Treatment Rule (Rule 211(h)(2)-3) not later than 12 months after publication in the Federal Register. All other private fund advisers will need to comply with the Restricted Activities Rule, the Adviser-led Secondaries Rule and the Preferential Treatment Rule not later than 18 months after publication in the Federal Register. All registered investment advisers will need to comply with the amended Compliance Rule not later than 60 days after publication in the Federal Register.

Exceptions for Securitized Asset Funds

In response to industry comments, the new private fund rules do not apply to investment advisers to securitized asset funds (SAFs), such as collateralized loan obligations. The final rule defines an SAF as “any private fund whose primary purpose is to issue asset backed securities and whose investors are primarily debt holders.” This definition, which is based on the definition for “securitized asset fund” in Form PF and Form ADV, is designed to capture vehicles established for the purpose of issuing asset backed securities. These vehicles securitize assets by pooling and converting them into securities that are offered and sold in the capital markets. Commenters noted that the structure and purpose of SAFs are distinct from those of other types of private funds, including that: (a) SAFs do not issue equity but rather issue notes at various seniorities that entitle holders to interest payments and repayment of principal; (b) SAFs do not have general partners affiliated with their advisers but rather have unaffiliated trustees as fiduciary agents of the SAF investors; and (c) their notes are held in street name and traded such that an adviser does not necessarily know the identity of the noteholders.

Our team at Eversheds Sutherland will be reviewing the SEC’s final rules in greater detail over the coming days. We plan to follow up with more detailed thoughts on the final rules soon. 

________

[View source.]