Regulatory Update: Part Two - Compliance Rule & Private Fund Advisers

REGULATORY CHANGES ARE IN THE AIR - PART TWO

On February 9, 2022 the SEC released proposed rules for investment advisers covering the areas of Annual Reviews, and Private Fund Advisers. The annual review rule (aka the "Compliance Rule") amendment proposes a mandatory requirement that all annual reviews must be documented in writing. Additionally, the SEC has proposed significant new rules for private fund advisers, below is a detailed summary of those proposed rules in order to provide some sense of their comprehensiveness. If adopted, the proposed rules would have a one-year transition period for advisers to come into compliance upon the final release date of the proposed rules.

Section A (Compliance Rule amendment) would apply only to SEC-registered investment advisers ("RIAs") while Section B would apply to all private fund advisers, including exempt reporting advisers as noted.

A. Compliance Rule (IAA 206(4)-7) Proposed Amendment (All SEC RIAs)

• Documentation of Annual Reviews of Compliance Programs

  • Mandatory requirement that all SEC RIAs document the annual review of their compliance program in writing

    • The SEC believes that requiring written documentation would focus renewed attention on the importance of the annual compliance review process and would result in records of annual compliance reviews that would allow our staff to assess whether an adviser has complied with the review requirement of the compliance rule.

  • Written documentation is intended to be flexible regarding the frequency

    • Annual review could include written quarterly reports

  • Written documentation is meant to be made available to the SEC

    • Attempts to shield from, or unnecessarily delay production of any non-privileged record is inconsistent with prompt production obligations and undermines the SEC's ability to conduct examinations.

B. Private Fund Advisers - New Proposed Rules

Note: Items 1 & 2 below would apply, if proposed rules are adopted in its current form, to any private fund adviser regardless of whether registered with the SEC, including exempt reporting advisers.

1. Prohibited Activities Rule (Applicable to all private fund advisers regardless of registration status) - proposed to address activities that the SEC believes to be contrary to the public interest and the protection of investors.

• Prohibited Activities:

  • Fees for unperformed services (e.g., accelerated payments)

  • Certain Fees and Expenses even where such fees or expenses may be disclosed in the fund documents -- Fees/expenses associated with an examination or investigation of the adviser or its related persons by governmental or regulatory agencies; and regulatory or compliance expenses or fees of the adviser or its related persons.

  • Certain Non-Pro Rata Fee and Expense Allocations -- Fees/expenses related to a potential or actual portfolio investment on a non-pro rata allocation basis when multiple private funds and other clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment.

  • Reducing Adviser Clawbacks for Taxes -- Reduction of clawback by actual, potential, or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders.

  • Limiting or Eliminating Liability for Adviser Misconduct -- Seeking reimbursement, indemnification, exculpation, or limitation of its liability by 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. Waiver of an adviser's compliance with the federal anti-fraud liability for breach of fiduciary duty to the private fund or with any other provision of the Advisers Act or rules is invalid under the Advisers Act. Offering documents that contain terms limiting or eliminating liability for adviser misconduct.

  • Borrowing from a Private Fund Client -- The adviser, directly or indirectly, borrowing money, securities, or other fund assets, or receiving a loan or an extension of credit, from a private fund client.

2. Preferential Treatment Rule (Applicable to all private fund advisers regardless of registration status) - proposed to address specific types of preferential treatment that the SEC believes to have a material negative effect on other fund investors.

• Prohibitions:

  • Preferential Liquidity Rights -- An adviser would be prohibited from granting an investor in the private fund ("PF") or in a substantially similar PF the ability to redeem its interest on terms that the adviser reasonably expects to have a material negative effect on other investors in that PF or substantially similar PF.

  • Preferential Transparency -- An adviser would be prohibited from providing information related to the holdings or exposures of the PF, or of a substantially similar PF, to any investor if the adviser reasonably expects that providing the information would have a material negative effect on other investors in that PF or in a substantially similar PF.

• Other Preferential Treatment:

  • Written Disclosures -- The provision of other preferential treatment to any investor in the PF would be prohibited unless the adviser provides written disclosures, specifically described, to prospective and current investors in a PF. Prospective investors must receive preferential treatment disclosures prior to the investments. Existing investors must receive disclosures annually if any preferential treatment is provided to an investor since the last notice.

3. Quarterly Statement Rule - proposed to allow an investor to monitor/assess the costs and performance of a fund over time. The following quarterly statement ("Statement") following requirements are proposed:

• Fees and Expenses Disclosures:

  • Private Fund-Level Disclosures -- A detailed accounting of all compensation, fees, and other amounts allocated or paid to the adviser or any of its related persons by the PF during the quarterly period ("Adviser Compensation"). A detailed accounting of all fees and expenses paid by the PF during the quarterly period other than Adviser Compensation ("Fund Expenses").

  • Portfolio Investment-Level Disclosures -- A detailed accounting of all portfolio investment compensation allocated or paid by each covered portfolio investment during the quarterly period. Portfolio investment is defined as any entity or issuer in which the private fund has invested directly or indirectly. The PF's ownership percentage of each covered portfolio investment as of the end of the quarterly period, or if the PF does not have an ownership interest in the covered portfolio investment, the adviser would be required to list 0% as the PF's ownership percentage. A brief description of the PF's investment in each covered portfolio investment.

  • Calculations and Cross References to Organizational and Offering Documents -- Prominent disclosures regarding the manner in which expenses, payments, allocations, rebates, waivers, and offsets are calculated. In addition, the Statement must include cross-references to the applicable section of the PF's organizational and offering documents that reflect the calculation methodology.

  • Performance Disclosures -- Standardized PF performance information in each investor Statement (certain prescribed requirements for liquid funds and illiquid funds).

  • Preparation and Distribution of Quarterly Statements -- Within 45 days after each calendar quarter-end. In situations where an investor is itself a pooled investment vehicle ("PIV") that is controlling, controlled by, or under common control with the adviser or its related persons, the adviser must look through that PIV (and any PIVs in a control relationship with the adviser or its related persons, such as in a master-feeder fund structure), in order to send to investors in those PIVs, unless the investor is an unaffiliated fund of funds.

  • Consolidated Reporting for Certain Fund Structures -- Substantially similar PIVs to the extent that doing so would provide more meaningful information to the PF's investors and would not be misleading.

4. Mandatory Private Fund Audit Rule - Proposed as a check on adviser's valuation of the private fund assets. Currently, the private fund adviser has a choice between a surprise exam (independent verification) or financial statements audit to comply with the custody rule. The proposed rule will make it mandatory for all RIAs with private funds to obtain a financial statement audit in order to comply with the custody rule.

• Private Fund Financial Statements Audit:

  • An adviser must obtain a financial statement audit of each advised private fund annually and on liquidation to comply with the custody rule.

5. Adviser-led Secondaries Rule (Fairness Opinion) - Proposed to provide a check against adviser's conflict of interest in structuring and leading a transaction by which it may profit at the expense of private fund investors.

• Fairness Opinion:

  • A fairness opinion would be required from an independent opinion provider and a summary of any material business relationships the adviser or any of its related persons has or has had within the past two years, with the independent opinion provider - prior to the closing of an adviser-led secondary transaction. The opinion must be documented and distributed to fund investors.

6. Books and Records Rule - The SEC will require advisers to retain records regarding compliance with all of the above proposed rules.