On February 9, 2022, the Securities and Exchange Commission (the “SEC”) released proposed rules (the “Proposed Rules”) under the Investment Advisers Act of 1940 (the “Advisers Act”) that, if adopted as proposed, would significantly expand the regulatory landscape applicable to private fund advisers—including advisers that are not registered with the SEC.[1] In the accompanying press release, the SEC positioned the Proposed Rules as enhancing the regulation of private fund advisers “to protect private fund investors by increasing transparency, competition, and efficiency in the $18-trillion marketplace.”[2]

The Proposed Rules demonstrate the SEC’s recognition of the size and scope of private funds in the marketplace and signal a clear continuation of the SEC’s enhanced focus on private funds and their advisers. In a letter explaining her opposition to the Proposed Rules, Commissioner Hester Peirce expressed her belief that the “proposal represents a sea change” for private funds and fails to recognize that investors in private funds are well-represented investors that are able to fend for themselves.[3] Commissioner Peirce also predicts in her statement that, if the Proposed Rules are enacted, the SEC will devote examination and enforcement resources to ensure that private fund advisers adhere to the new requirements.[4]

A summary of some of the key elements of the Proposed Rules are described below:

Scope of Proposed Rules

As proposed, the Proposed Rules apply to investment advisers to “private funds”, which are issuers that would be an investment company under the Investment Company Act of 1940, as amended (the “Investment Company Act”), but for section 3(c)(1) or 3(c)(7) of that Investment Company Act.[5] Notably, certain parts of the Proposed Rules are applicable to all private fund advisers, not just registered investment advisers, including exempt reporting advisers, state-registered advisers, and other private fund advisers that are not subject to reporting or registration requirements.

Quarterly Statement Rule

The Proposed Rules would require SEC-registered investment advisers to private funds to prepare (or have a third party prepare) quarterly statements that include certain information regarding fees, expenses, payments to related persons, and performance for any private fund that the registered investment adviser advises, and distribute such reports to private fund investors within 45 days after each calendar quarter (beginning after a fund’s second calendar quarter of operating results).[6]

While many private fund advisers currently provide periodic reports to some or all private fund investors, the Proposed Rules, if adopted as proposed, would require standardized disclosures on, among other items, compensation paid to the adviser and its related persons, fund expenses, fund holdings that pay compensation to the adviser and its related persons, the cost of investing in the private fund, and the private fund’s performance.[7]

Private Fund Audit Rule

The Proposed Rules would require SEC-registered private fund advisers to cause the private funds they advise to obtain a financial statement audit at least annually and upon liquidation, and would require such audits to be delivered to private fund investors.[8]

Adviser-Led Secondaries Rule

The Proposed Rules would require an SEC-registered private fund adviser to obtain a fairness opinion in connection with any adviser-led secondary transaction[9] and to provide such fairness opinion to fund investors prior to the transaction in order to provide a check against an adviser’s conflicts of interest in such transaction.[10]

Prohibited Activities Rule

The Proposed Rules would prohibit private fund advisers from engaging in certain sales practices, conflicts of interests, and compensation schemes that the SEC believes are contrary to the public interest and the protection of investors.^[11] These prohibited activities include, among others: (i) charging certain fees and expenses to a private fund or its portfolio investments (such as fees for accelerated monitoring, unperformed services, or fees associated with the examination or the investigation of the adviser); (ii) seeking reimbursement, indemnification, exculpation, or limitation of certain adviser liabilities; (iii) reducing potential clawbacks for taxes applicable to the adviser or its related persons; (iv) charging fees or expenses related to portfolio investment on a non-pro rata basis; and (v) receiving an extension of credit from a private find client.

Notably, as proposed, this “Prohibited Activities Rule” would apply to all advisers to private funds, regardless of whether they are registered with the Commission or one or more states, exempt reporting advisers, unregistered advisers, foreign private advisers, or advisers that rely on the intrastate exemption from SEC registration and/or the de minimis exemption from SEC registration.[12]

Preferential Treatment Rule

The Proposed Rules would prohibit all private fund advisers from providing any preferential treatment to any investor in the private fund unless the adviser provides written disclosures to prospective and current investors[13] regarding all preferential treatment being provided to investors in the fund.[14] If adopted as proposed, the Proposed Rules would require that an adviser describe specifically the preferential treatment in order to convey its relevance to other investors (e.g., an adviser would need to specifically describe lower fee terms given to certain investor(s) rather than merely disclosing that some investors pay a lower fee).

Further, private fund advisers would be prohibited from granting preferential redemption rights or preferential transparency rights to any private fund investor.

As with the “Prohibited Activities Rule” above, the “Preferential Treatment Rule”, if adopted as proposed, would also apply to all advisers to private funds (including exempt reporting advisers, state registered advisers and other unregistered investment advisers).

Books and Records Rule Amendment

The Proposed Rules include amendments to the books and records rule under the Advisers Act, which, if adopted as proposed, would require SEC-registered investment advisers to retain records related to the Proposed Rules.[15] In the press release accompanying the Proposed Rules, the SEC indicated that it believes these amendments would facilitate the SEC’s ability to assess an adviser’s compliance with the Proposed Rules, including the adviser-led secondaries rule and preferential treatment rule.[16]

Compliance Rule Amendments.

Finally, the Proposed Rules would require all SEC-registered investment advisers to document their annual reviews. As proposed, the “Compliance Rule Amendments” would apply to all SEC-registered investment advisers, not just advisers to private funds.[17]

Comment Period

The public comment period for the Proposed Rules will remain open for at least sixty days following publication of the proposing release on the SEC’s website.

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If adopted as proposed, the Proposed Rules will significantly expand the regulatory obligations for advisers to private funds. As noted above, certain parts of the Proposed Rules apply to all private fund advisers, including exempt reporting advisers, state-registered investment advisers, and other unregistered investment advisers, and it is possible that the final rule (if adopted) could subject such advisers to even more portions of the Proposed Rules, greatly increasing regulatory burdens for such advisers.[18] Regardless, if adopted, the Proposed Rules will have broad implications and may change operational norms for all private fund advisers, even if the Proposed Rules ultimately only apply to SEC-registered investment advisers.