In an open meeting on August 23, 2023, the U.S. Securities and Exchange Commission voted to adopt new rules for private fund managers under the Investment Advisers Act of 1940. The new Rules reflect the most substantial overhaul of private funds adviser regulation since Dodd-Frank in 2010. But they are significantly less restrictive than the version first presented for public comment in February of last year. The SEC adopted two new Rules for all private fund advisers: the “Restricted Activities Rule” and the “Preferential Treatment Rule.” For registered private fund advisers, the SEC adopted three additional new Rules: the “Quarterly Statement Rule,” the “Private Fund Audit Rule,” and the “Adviser-led Secondaries Rule,” as well as amendments to the Advisers Act Compliance Rule which is applicable to all SEC-registered investment advisers.
Restricted Activities Rule
Intended to protect investors from certain fee and expense practices and potential conflicts of interest, this new Rule prohibits certain actions for all advisers—but with notable exceptions. This is a change from the blanket prohibition in the SEC’s original proposal. Under the new Rule—unless disclosed—advisers may not: (1) charge investors for their regulatory or compliance fees or expenses; (2) net taxes against a clawback of their carried interest; or (3) allocate or charge portfolio-level fees or expenses on a non–pro-rata basis. And without consent from a majority in the interest of private funds investors (excluding advisers’ and related persons’ interests), advisers may not charge their clients for fees or expenses associated with governmental or regulatory investigations. Nor, without such investor consent, may advisers borrow assets from their private fund clients. The Rule as adopted does not—as originally proposed—prevent advisers from seeking reimbursement, indemnification, exculpation, or limitation of liability with respect to private funds or their investors for breaches of fiduciary duty, willful misfeasance, bad faith, or negligence in connection with their services. Nor does the new Rule—as originally proposed—prohibit advisers from collecting fees for services not performed. The SEC explained, in declining to adopt an express prohibition, that this practice constitutes a breach of fiduciary duty and is therefore already implicitly prohibited. This new Rule generated the most controversy during the comment period, and its implementation as adopted represents the most significant departure among the new Rules from those that the SEC originally proposed.
Preferential Treatment Rule
Meant to ensure a level playing field for investors, this new Rule prohibits certain practices that treat certain private fund investors preferentially—unless certain exceptions are met. The new Rule generally prevents private fund advisers from allowing any investor to redeem its interests on terms reasonably expected to materially harm other investors. As proposed, there were no exceptions. As adopted, such redemption is permitted if the adviser has offered and will continue to offer the same ability to all investors, or if other binding law mandates such a redemption right for the investor. It also generally prohibits advisers from disclosing information to any investor that they reasonably expect would materially harm other investors. As originally proposed, there were no exceptions. But as adopted, the practice is permitted if the adviser discloses the same information to all interested investors. The new Rule also prohibits any other preferential treatment—unless such treatment is detailed in annual written disclosures. For current investors, the disclosures must specifically describe all preferential treatment. For prospective investors, the disclosures need only specify preferential treatment relating to material economic terms.
Quarterly Statement Rule
Aimed at increasing transparency for investors, this new Rule requires registered advisers to make quarterly disclosures about fees, expenses, performance, and potential conflicts of interest—unless quarterly disclosures complying with the Rule are already prepared by another person. The requisite quarterly statements must prominently disclose how expenses and fee offsets are calculated, as well as performance results calculated with and without capital call lines, with cross-references to funds’ governing documents. The SEC also amended Rule 204-2 to require advisers to retain books and records in connection with the preparation and distribution of these quarterly statements. When originally proposed, the Quarterly Statement Rule required disclosure within 45 days of the end of each calendar quarter. As adopted, for “funds of funds,” disclosures must be made within 75 days of the end of the first three fiscal quarters and 120 days of the end of the fiscal year. Otherwise, funds must issue their quarterly statements within 45 days of the end of the first three fiscal quarters and 90 days of the end of the fiscal year.
Private Fund Audit Rule
Intended to prevent asset misappropriation and ensure accurate valuations, this new Rule requires an annual independent financial statement audit for each registered adviser's fund that complies with Rule 206(4)-2 (the Custody Rule). But the Rule does not, as originally proposed, impose any audit requirements on top of those in the Custody Rule. Nor does it require auditors to report any issues to the SEC.
Adviser-led Secondaries Rule
Similarly intended to prevent fraud and ensure accurate valuations, this new Rule requires either a fairness or a valuation opinion from an independent provider in connection with any secondary transaction led by a registered adviser. Advisers also must provide written disclosures summarizing any recent material business relationships with the independent provider. But the Rule does not, as originally proposed, require a fairness opinion; a valuation opinion can also suffice. Nor does it apply to tender offers. And the opinion must be distributed to investors before the due date of the election form—not, as originally proposed, before the transaction closes.
Advisers Act Compliance Rule
The SEC adopted the amendments to this Rule as originally proposed, requiring all registered advisers to document in writing the annual review of their compliance policies and procedures.
While the new Rules provide more transparency for private fund investors, advisers should take comfort in the fact that the Rules as adopted impose significantly less restraint than as originally proposed, and investors may likewise appreciate that the SEC incorporated feedback aimed at preventing the Rules from imposing potentially unnecessary costs on private funds.