The US Securities and Exchange Commission (SEC) is holding an open meeting on Wednesday, August 23, to consider whether to adopt proposed rules under the Investment Advisers Act of 1940 that, if adopted as proposed, would subject private fund advisers to a host of new and highly controversial requirements. The proposal also included an amendment to existing Rule 206(4)-7 under the Advisers Act that would require all registered investment advisers to document the results of currently required annual compliance reviews in writing.

In anticipation of the open meeting, here are six things the Eversheds Sutherland team will be looking out for: 

1. Prohibited Activities. Proposed new Advisers Act Rule 211(h)(2)-1 (Prohibited Activities Rule) would prohibit a registered 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). The SEC wrote that it believes these practices “must be prohibited in order to prevent certain activities that could result in fraud and investor harm. We believe these activities incentivize advisers to place their interests ahead of their clients’ (and, by extension, their investors’) ....” In proposing the Prohibited Activities Rule, the SEC asked whether it should take a different approach and not prohibit these activities outright but prohibit them only if the adviser fails to satisfy certain governance and other conditions (e.g., disclosure to investors in all relevant funds/vehicles or approval by the limited partners). We will be looking to see whether the final Prohibited Activities Rule (if adopted) prohibits private fund advisers from charging these fees and expenses outright or whether the SEC provides an alternative path for such fees and expenses to be assessed.

   One of the most controversial aspects of the proposed Prohibited Activities Rule is a provision that would prohibit a private fund adviser from seeking reimbursement, indemnification, exculpation from or limitation of 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. Many private funds and their investors have entered into agreements containing such contractual terms. The proposal would prohibit long-standing contractual provisions in the private fund industry. Many industry participants believe the SEC should not interfere with the contractual arrangements reached between private funds and investors. These participants are concerned that by prohibiting such provisions, the SEC is inappropriately inserting itself into the private dealings of sophisticated parties and thus distorting the market for the provision of such services. The SEC’s prohibition would raise the risks to private fund advisers and increase the costs of such services for investors. We will be looking to see whether the SEC sticks with the proposed broad prohibitions in any final Prohibited Activities Rule. 

2. Preferential Treatment. Proposed new Advisers Act Rule 211(h)(2)-3 (Preferential Treatment Rule) would prohibit a registered private fund adviser from providing preferential terms to certain investors regarding redemption or information about portfolio holdings or exposures. Like some of the other proposed rules in the rule set, this proposed rule would prohibit long-standing practices in the industry that have been privately negotiated between private fund advisers and investors. The SEC proposed to prohibit such practices on the basis that such preferential terms “can have a material, negative effect on other investors.” The SEC believes such terms present a conflict of interest between the adviser and the private fund client that is contrary to the public interest and the protection of investors. We will be looking to see whether the SEC adopts a final Preferential Treatment Rule that contains outright prohibitions or softens its position.

   The Preferential Treatment Rule would also 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 in the private fund regarding any other preferential treatment the adviser or its related persons provide to other investors in the same fund. Under the proposed rule, an adviser would need to describe specifically the preferential treatment to convey its relevance. For a prospective investor, the notice needs to be provided in writing prior to the investor’s investment. For an existing investor, the adviser would have to distribute the notice annually if any preferential treatment was provided to an investor since the last notice. We will be looking to see whether the SEC relaxes these disclosure obligations in the final rule. 

3. Adviser-led Secondaries. Proposed new Advisers Act Rule 211(h)(2)-2 (Adviser-led Secondaries Rule) would require fairness opinions to be issued by independent opinion providers and for the independent opinion providers to disclose any material business relationships with advisers. We will be looking to see whether and final Adviser-led Secondaries Rule instead prohibits the use of opinion providers with business relationships above a certain threshold (whether a certain dollar amount, percentage of revenue or otherwise).

   The SEC solicited comment regarding whether there were other transactions for which it should require a private fund adviser to obtain a fairness opinion – for example, before certain cross transactions take place between private funds it manages. Now that the SEC has deemed most securities valued using Level 2 inputs not to be securities for which market quotations are readily available for purposes of the Investment Company Act of 1940’s cross trade rule, we will be looking to see whether the SEC will require private fund advisers to obtain a fairness opinion before engaging in cross transactions involving securities valued using Level 2 or Level 3 inputs.

4. Audits. Proposed new Advisers Act Rule 206(4)-10 (Audit Rule) would require a registered private fund adviser to obtain an annual audit of the financial statements of any private fund it manages and to distribute them to investors in the private fund promptly after completion of the audit. The audit would need to be performed in accordance with US generally accepted accounting standards and by an independent accountant registered with and subject to inspection by the Public Company Accounting Oversight Board. Additionally, each fund’s audited financial statements would need to be prepared in accordance with US generally accepted accounting principles. Finally, the Audit Rule would require there to be a written agreement between the adviser or the private fund and the auditor, pursuant to which the auditor would be required to notify the SEC’s Division of Examinations upon the auditor’s termination or issuance of a modified opinion (Auditor Notification Requirement). 

   Aside from the Auditor Notification Requirement, these requirements are not dissimilar from existing private fund annual audit requirements under Advisers Act Rule 206(4)-2 (Custody Rule). Furthermore, in February 2023 (about one year after it issued the private fund adviser rule proposals), the SEC proposed new Advisers Act Rule 223-1 (Safeguarding Rule), which would take the place of the existing Custody Rule if adopted. The proposed Safeguarding Rule maintains the Custody Rule’s private fund annual audit requirement and includes a requirement that is substantially similar to the Audit Rule’s Auditor Notification Requirement. Given the potential redundancy of the Audit Rule and the proposed Safeguarding Rule’s private fund annual audit requirement, we will be looking to see whether the SEC defers action on the Audit Rule so that it can fold it into the final Safeguarding Rule it plans to adopt later this year.

5. Statements. Proposed new Advisers Act Rule 211(h)(1)-2 (Quarterly Statement Rule) would 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 within 45 days after each calendar quarter end. A number of commenters on the proposal expressed concern regarding the inflexibility of these standardized reporting requirements, particularly given the variability across funds and strategies regarding types of fees and expenses and methods of performance calculation. Given these concerns, we will be looking to see whether the SEC adopts a more principles-based and flexible approach to these reporting requirements that acknowledges this variability but still provides investors with transparency and information that is useful for purposes of comparing private fund investments. 

6. Compliance Procedures and Practices. The proposed changes to Advisers Act Rule 206(4)-7 did not specify any particular elements to be included in the written documentation of the annual review. However, it did solicit comment regarding whether the final rule should do so. We will be looking to see whether the final rule includes specific elements that must be included in any written documentation required by the final rule.

   We also will be looking to see whether the SEC expresses 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. 

Wednesday figures to be a highly consequential day for the private fund industry. Our team at Eversheds Sutherland will be reviewing the SEC’s final rules once they are released to the public. We plan to follow up with our quick reactions to these questions in a separate legal alert after the final rules are adopted. Stay tuned. 

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