US SEC Adopts Final Private Fund Adviser Rules - Implications for Non-US Investment Advisers
22 min read
On August 23, 2023, the US Securities and Exchange Commission ("SEC") voted 3 – 2 to approve the adoption of significant new rules applicable to advisers of private funds (the "Private Fund Adviser Rules"). With these sweeping changes to the regulatory landscape of the private funds industry, non-US managers will need to review their current policies and operational practices to determine whether changes need to be implemented, either as a direct requirement of the Private Fund Adviser Rules or as an industry best practice. The final rules are expected to have a substantial impact on industry-wide business practices and greatly increase regulatory burden.
Executive Summary
- The Private Fund Adviser Rules, set out in a 660-page Adopting Release,1 consist of five sets of regulations and prohibitions referred to as the Restricted Activities Rule, Preferential Treatment Rule, Quarterly Statement Rule, Audit Rule and Adviser-Led Secondary Rule.
- The final rules apply to investment advisers differently depending on their SEC-registration status, their location and the type and location of the private funds they advise.
- The Private Fund Adviser Rules do not apply to non-US investment advisers with respect to their non-US private funds.2 This interpretation applies regardless of whether such non-US private funds have US investors. Non-US investment advisers generally refers to advisers whose principal office and place of business is outside of the United States, and non-US private funds refers to private funds domiciled outside of the United States.
- The Private Fund Adviser Rules additionally do not apply to investment advisers with respect to securitized asset funds ("SAF advisers"). These advisers will not be required to comply with the final rules solely with respect to the securitized asset funds ("SAFs")3 they advise.
- The Adopting Release also requires all SEC-registered investment advisers (including those that do not manage private funds) to document their annual compliance reviews (the "Written Annual Review Rule"). This rule only applies to non-US advisers to the extent that they are registered with the SEC.
Below is a brief background of the history of the final rules followed by tables breaking down the Restricted Activities Rule and the Preferential Treatment Rule. Given that both rules are applicable to any US investment adviser (whether or not required to be registered) in addition to non-US advisers with respect to their US private fund clients, they are anticipated to have the greatest potential for international cross-pollination. A more high-level summary of the other final rules specific to SEC-registered advisers follows.
Background
The initial form of the adopted rules was proposed by the SEC in a split 3 – 1 vote on February 9, 2022 (the "Proposed Rules").4 The Proposed Rules prompted vigorous debate with more than 300 public comments submitted by various industry participants and stakeholders over two rounds of comment periods.5 A number of investment managers, investors and related industry groups strongly pushed back against the Proposed Rules, citing their departure from long-standing practices and the SEC's historical disclosure-based and principles-based approaches to regulation of the private funds industry. Other commentators raised concerns about the negative unintended consequences of such proposals, noting the potential suppression of capital formation, interference with sophisticated parties' freedom to contract, reduction of investment choices available to US investors, significant operational and compliance costs for covered advisers and the outsized, anticompetitive impact on smaller and newly formed managers. Various commentators also challenged the SEC's statutory authority for certain of the proposed changes and called into question the SEC's analysis of the proposals' economic impact on the private funds industry at large.
Although some aspects of the final rules were eased from the sweeping provisions of the Proposed Rules, various industry participants have reiterated some of their concerns given the substantial anticipated impact on long-standing business practices of the private funds industry. The final rules, some commentators argue, are also expected to significantly increase the regulatory compliance burden on private fund managers irrespective of the SEC modifying or eliminating some of the more controversial elements of the SEC's prior proposals.
Barring potential litigation challenges, the final rules are scheduled to go into effect 60 days from publication in the Federal Register,6 with staggered compliance transition dates depending on the type of rule and the level of an adviser's private fund assets under management.7 Generally, private fund advisers covered by the rule will have either a 12- or a 18-month compliance transition window following the effective date, while compliance with the Written Annual Review Rule is required 60 days after Federal Register publication.
The approved rules also include limited legacy status provisions (i.e., "grandfathering clauses") that disapply certain portions of the Restricted Activities Rule and Preferential Treatment Rule with respect to preexisting contractual arrangements. Such grandfathering provisions only apply (i) if the relevant private fund has commenced operations as of the rule compliance date (i.e., the end date of the applicable 12- or 18-month compliance transition window), (ii) with respect to a private fund's applicable governing agreements that were entered into prior to the relevant compliance date, and (iii) to the extent the relevant portion of the Restricted Activities Rule and the Preferential Treatment Rule would require amendments to such contractual agreements.
Relevance for Non-US Investment Advisers
The Private Fund Adviser Rules do not apply to non-US investment advisers (i.e., advisers whose principal office and place of business is outside of the United States) with respect to their non-US private funds (i.e., private funds domiciled outside of the United States).8 This interpretation applies regardless of whether such non-US private funds have US investors.9 The Written Annual Review Rule applies to any non-US investment adviser (including those that do not manage private funds) that is registered with the SEC. Non-US investment advisers that file with the SEC as exempt reporting advisers are not subject to the Written Annual Review Rule.
As detailed in the following table, however, the final rules affect non-US investment advisers differently, depending on their registration status and whether the manager advises US "clients" (i.e., private funds).10
| Non-US Advisers (SEC-Registered)11 | Non-US Advisers (Unregistered)12 | |
|---|---|---|
| Restricted Activities Rule | US private fund clients | US private fund clients |
| Preferential Treatment Rule | US private fund clients | US private fund clients |
| Quarterly Statement Rule | US private fund clients | N/A |
| Audit Rule | US private fund clients | N/A |
| Adviser-Led Secondary Rule | US private fund clients | N/A |
| Written Annual Review Rule | Generally applicable | N/A |
Although non-US managers advising only non-US private funds are not technically subject to the Private Fund Adviser Rules, the rules represent a substantial change to the regulatory landscape for the private funds industry and may very well have precedential value for other countries' regulatory regimes. It will also be important for non-US advisers, and particularly those contemplating a global fundraise, to become familiarized with the rules given that sophisticated, institutional investors may look to treat certain of such rules as best practices to be applied consistently across their fund investments.
Restricted Activities Rule — 211(h)(2)-1
- The Restricted Activities Rule generally prohibits an adviser from engaging in certain activities unless the adviser satisfies certain conditions, including, among others, certain disclosure and consent requirements.
- The following table sets out a detailed summary of each such restricted activity, the conditions that must be met for an adviser to be permitted to perform the activity and implementation guidance highlighted from the SEC's Adopting Release. Certain additional clarifications from the SEC are set out immediately following.
| Restricted Activity | Permitted | Implementation Guidance | |
|---|---|---|---|
| Regulatory, Compliance and Examination Expenses | Charging or allocating fees and expenses associated with any regulatory, compliance or examination fees or expenses of the adviser or its related persons | With subsequent disclosure |
The disclosure must include the total dollar amount of such fees and expenses and be provided to investors within 45 days after the end of the fiscal quarter in which the fees and expenses are charged Disclosure must also include sufficient detail to notify investors of their nature; i.e., that the fees and expenses are of a regulatory, compliance or investigative nature (as opposed to general references to legal expenses) Advisers are otherwise not required to specify whether such fees or expenses are related to the adviser's activities or a fund's activities |
| Investigation Expenses | Charging or allocating fees associated with an investigation of the adviser or its related persons by any governmental or regulatory authority | With informed consent | Each category of fee or expense must be disclosed as a separate line item, with a description as to how each such fee or expense is related to the relevant investigation |
| Post-Tax Clawback | Reducing the amount of any performance compensation clawback (e.g., clawback of carried interest, performance allocations, etc.) by actual, potential or hypothetical taxes applicable to the adviser, its related persons or their respective owners or interest holders | With subsequent disclosure | Disclosure must include the aggregate dollar amount of the adviser clawback both before and after the clawback reduction |
| Non-pro rata charge or allocation | Charging or allocating fees and expense related to a portfolio investment on a non-pro rata basis when more than one private fund or other client advised by the adviser or its related persons have invested in the same portfolio company |
With advance disclosure Any such charge or allocation must be fair and equitable |
Advance notice must be distributed to each investor in the relevant funds participating in the subject portfolio investment Disclosure must include a description of how the non-pro rata charge or allocation is fair and equitable under the circumstances. "Fair and equitable" is not defined in the Adopting Release but will be subject to a facts and circumstances analysis. Depending on the relevant facts and circumstances, the rationale for non-pro rata charges or allocations may include the need to structure investments differently for specific tax, regulatory, accounting or other reasons The timeline by when such advance notice must be performed is not specified "Pro rata" is not defined in the final rules. The Adopting Release provides that the appropriateness of a pro rata allocation method will depend on the facts and circumstances |
| Borrowings and extensions of credit | Borrowing money, securities, or other private fund assets, or receiving a loan or extension of credit, from a private fund client | With informed consent |
Consent must be accompanied by disclosure describing the material terms of the borrowing, such as the amount of money to be borrowed, interest rate and repayment schedule. Post-borrowing disclosures to reflect increases, decreases or other changes in the borrowing (to the extent relevant) are also recommended Ordinary course tax advances (i.e., funds provided to an adviser in advance of the adviser's actual or expected future share of the fund's assets) and management fee offsets will generally not be considered as borrowings or extensions of credit requiring informed consent |
Subsequent Disclosure
With respect to restricted activities permitted by way of subsequent, after-the-fact disclosure, any such disclosure must be made in writing within 45 days after the end of the fiscal quarter in which the relevant activity occurs.
Informed Consent
With respect to restricted activities permitted by way of consent, the solicitation requests for such consent must be sent to all fund investors (looking through any investor that is itself a private fund controlling, controlled or under common control by the adviser or its related persons). Consent must be obtained from at least a majority in interest of investors unrelated to the adviser.
Approval from fund governance bodies such as LPACs, advisory boards or boards of directors are deemed insufficient to satisfy the consent requirements; however, the Adopting Release clarifies that the consent solicitation process can otherwise be subject to the manner and process by which fund investor consent would otherwise be obtained pursuant to a fund's governing documents. For example, where a fund's governing documents provide for issuance of voting and non-voting interests and non-voting interests are excluded for purposes of constituting a majority in interest (or higher threshold) of investor consent, such non-voting interests would similarly be excluded from the vote relating to the relevant restricted activity.
Legacy Status (for borrowings and charging investigation fees and expenses)
The approved rules provide limited legacy status. Only the portion of the Restricted Activities Rule that requires informed investor consent for the adviser to borrow from a private fund or to charge certain investigation fees and expenses will be disapplied with respect to prior contractual arrangements.
Additional SEC Clarifications
Although the final rules do not include the initially proposed provisions regarding the prohibitions on advisers charging fees for unperformed services or seeking to limit liability for breaches of fiduciary duty, willful misfeasance, bad faith, negligence or recklessness, the SEC included several reminders to managers regarding the way it intends to interpret certain such business practices. Notably, in the Adopting Release, the SEC confirmed that the following actions could be held to be contrary to an adviser's fiduciary duties and potentially expose an adviser to enforcement actions:
- Charging monitoring, servicing, consulting or other fees in respect of any services the investment adviser does not, or does not reasonably expect to, provide to a portfolio investment,
- Seeking, by way of a "waiver clause," "hedge clause" or other means, to obtain reimbursement, indemnification, exculpation or limitation of liability for a breach of an adviser's US federal fiduciary duties and legal obligations under the Advisers Act.
The SEC further notes that any such "waiver clause" or "hedge clause," unless accompanied by a "savings clause" that confirms a client's retention of certain non-waivable rights, would be considered a violation of the antifraud provisions of the Advisers Act, and if any such "waiver clause" or "hedge clause" is unclear as to whether it applies to an adviser's US federal fiduciary duties (as opposed to any other fiduciary duties to which the adviser may be subject), the SEC will interpret the clause as impermissibly intending to waive the adviser's US fiduciary duties.
Preferential Treatment Rule — 211(h)(2)-3
As detailed in the following tables, preferential treatment with respect to redemption and portfolio holding transparency rights are prohibited (subject to certain limited exceptions) to the extent such rights would reasonably be expected to have a material negative effect on other investors. Permitted preferential material economic terms must be disclosed to prospective investors prior to their investment. All preferential terms must otherwise be disclosed to existing investors on an after-the-fact basis.
Prohibited Preferential Treatment (with limited exceptions)
The following table sets out the types of Preferential Treatment which, subject to certain limited exceptions, are generally prohibited.
| Preferential Treatment | Permitted | Implementation Guidance | |
|---|---|---|---|
| Preferential Redemption | Granting an investor in the private fund or in a similar pool of assets (as described below) the ability to redeem its interest on terms that the adviser reasonably expects to have a material, negative effect on other investors in that private fund or in a similar pool of assets | If such redemption is required by the applicable laws, rules, regulations or orders of any relevant foreign or US governmental or political subdivision to which the investor, the private fund or any similar pool of assets is subject |
Differing redemption rights on account of an investor's policies, resolutions or other informal arrangements are not permitted Preferential treatment includes rights offered to certain investors in side letters, side arrangements and any more favorable liquidity terms provided in the fund's governing documents. Unless bespoke redemption terms are required on account of laws, regulations or orders, an adviser must offer the same redemption ability to all other existing investors and future investors without qualification (irrespective of an investor's commitment size, affiliation requirement or other limitations)13 |
| Preferential transparency | Providing information regarding the portfolio holdings or exposures of the private fund, or of a similar pool of assets, to any investor in the private fund if the adviser reasonably expects that providing the information would have a material, negative effect on other investors in that private fund or in a similar pool of assets | If the adviser offers such information to all other existing investors in the private fund and any similar pool of assets at the same time or substantially the same time |
The rule applies irrespective of whether such disclosure is provided in formal communications (e.g., side letters or other written communications) or informal communications (e.g., oral statements, such as phone conversations) "Material, negative effect" is not defined in the Adopting Release, but the SEC clarifies that an important factor will be an investor's ability to use preferential information to submit an earlier redemption request. Depending on the facts and circumstances, preferential transparency rights may accordingly be considered less material for investors in a closed-end fund which does not offer voluntary redemption rights |
Similar Pool of Assets
For purposes of the preferential treatment prohibitions, the term "similar pool of assets" is generally defined as a pooled investment vehicle (other than an investment company registered under the US Investment Company Act of 1940) with substantially similar investment policies, objectives or strategies to those of the private fund managed by the investment adviser or its related persons. The determination of whether a fund constitutes a "similar" pool of assets requires a facts and circumstances analysis. The SEC intentionally refrained from limiting the definition to funds that invest side by side or pari passu with the fund at issue and furthermore confirmed that a similar pool of assets could capture an adviser's proprietary fund, a co-investment fund and potentially even single investor funds that are ultimately intended to be commingled. The SEC clarifies, however, that a pool of assets with a materially different target return or sector focus would likely not have substantially similar investment policies, objectives or strategies to those of the subject private fund depending on the facts and circumstances.
Legacy Status
The approved rules provide limited legacy status with respect to the portion of the Preferential Treatment Rule which prohibits an adviser from providing certain preferential redemption rights and information about portfolio holdings.
Disclosure of Preferential Treatment (mandatory)
The following table sets out the mandatory disclosure obligations with respect to any preferential treatment provided to an investor in a private fund.
| Preferential Treatment | Disclosure Requirement | Implementation Guidance | |
|---|---|---|---|
| Material Economic Terms | Any preferential treatment related to any material economic terms that the adviser or its related persons provide to other investors in the same private fund | Advance disclosure |
Disclosure must be written and include specific information regarding the applicable material economic terms Disclosure must occur prior to a prospective investor's investment in the fund, although the rules do not specify a particular timeline for such advance disclosure Only preferential rights that are provided to other investors (as opposed to offered terms) are required to be disclosed "Material economic terms" is not defined in the Adopting Release but is broadly described as capturing any terms that would significantly impact a prospective investor's bargaining position. Examples include, but are not limited to, the cost of investing, liquidity rights, fee breaks and co-investment rights (irrespective of whether co-investment rights are offered on substantially similar fee and expense terms of those of the main fund) |
| Any Preferential Terms | Any preferential treatment that the adviser or its related persons provide to other investors in the same private fund |
Subsequent Disclosure: For liquid funds, disclosure must be provided as soon as reasonably practicable following the investor's investment in the private fund For illiquid funds, disclosure must be provided as soon as reasonably practicable following the end of the private fund's fundraising period For either fund type, specific information regarding any preferential treatment provided since the last written notice must be disclosed annually |
The Adopting Release does not specify a timeline for the requirement to disclose "as soon as reasonably practicable" but provides that it would be generally appropriate for such distribution to occur within four weeks of the relevant start date Disclosure of preferential treatment can be satisfied by providing a compendium of side letter terms (with identifying information redacted) or, alternatively, by way of a written summary to the extent that it specifically describes the preferential treatment14 |
Rules Specific to SEC-Registered Investment Advisers
SEC-registered private fund advisers whose principal office and/or place of business is within the United States and non-US registered private fund advisers with respect to their US private fund clients are subject to the Quarterly Statement Rule, Audit Rule and Adviser-Led Secondary Rule.15 Each US and non-US registered investment adviser is also subject to the Written Annual Review Rule. The following summaries are provided on a high-level basis only. Investment advisers that are registered with the SEC or are contemplating to so register should additionally consider the more extensive description of each such rule as set out in the Adopting Release.
Quarterly Statement Rule – 211(h)(1)-2
The Quarterly Statement Rule generally requires each covered adviser to prepare a quarterly statement that includes certain information regarding fees, expenses and performance for each private fund that the manager advises.
The rule requires such quarterly statements to be prepared and distributed to investors in private funds that are not funds of funds within 45 days after the first three fiscal quarter ends of each fiscal year and 90 days after the end of each fiscal year. If the private fund is a fund of funds, then the quarterly statement must be distributed to the private fund investors within 75 days after the first three fiscal quarter ends of each fiscal year and 120 days after the fiscal year end of the private fund. For a newly formed private fund, a quarterly statement must be prepared and distributed beginning after the fund's second full quarter of generating operating results. Consolidated reporting for similar pools of assets is required to the extent it would provide more meaningful information to the private fund's investors and is not misleading.
Audit Rule – 206(4)-10
Investment advisers subject to the Audit Rule are required to obtain an annual financial statement audit of the covered private funds they advise. Any such audit must generally be performed (among other requirements) (i) by an independent public accountant that meets certain qualification requirements, (ii) in accordance with generally accepted accounting principles (or other comprehensive body of accounting standards that presents information substantially similar to US GAAP, with any material differences reconciled), and (iii) on an annual basis. The audited financial statements of a private fund must be delivered to its investors within 120 days of the private fund's fiscal year-end. The Adopting Release confirms that this audit requirement will be satisfied by an adviser's compliance with its annual audit requirements under the Custody Rule.16
Adviser-Led Secondary Rule – 211(h)(2)-2
In connection with any adviser-led secondary transaction, the Adviser-Led Secondary Rule requires covered investment advisers to distribute to investors prior to the due date of the election form for such transaction both (i) a fairness opinion or valuation opinion from an independent opinion provider and (ii) a written summary of any material business relationships between the adviser or its related persons and the independent opinion provider within the two-year period immediately prior to the issuance date of the fairness or valuation opinion. "Adviser-led secondary transaction" is broadly described in the Adopting Release as any transaction initiated by an adviser or its related persons that offers fund investors the option between selling all or a portion of their interests in the private fund and converting or exchanging them for new interests in another vehicle advised by the adviser or any of its related persons.
The Adopting Release clarifies that the SEC would not view a transaction as "initiated by the adviser" if the adviser, at the unsolicited request of the investor, assists in the secondary sale of such investor's fund interest. Further, tender offers will not be considered an adviser-led secondary transaction for the purposes of this rule if an investor is faced with the decision between (i) selling all or a portion of its interest and (ii) converting or exchanging all or a portion of its interest.
Written Annual Review Rule – 206(4)-7(b)
Each SEC-registered investment adviser is currently required to review annually the adequacy of its compliance policies and procedures. The Written Annual Review Rule imposes an additional requirement that any such adviser (and not just those advising private funds) must document this annual compliance review in writing.
1 Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Release No. IA-6368 (Aug. 23, 2023) (Adopting Release).
2 See our alert SEC Adopts Final Private Fund Adviser Rules for a discussion of the rules relevant for US-based investment advisers, including those exempt from registration.
3 As defined in Form PF and Form ADV.
4 Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Release No. IA-5955 (Feb. 9, 2022) (Proposed Rules).
5 Submitted Comments on Proposed Rules.
6 New legislation is often published in the Federal Register shortly after it is adopted.
7 Private fund advisers with US$1.5 billion or more in private funds assets under management will have a 12-month transition period with respect to the Adviser-Led Secondaries Rule, the Restricted Activities Rule, and the Preferential Treatment Rule, while advisers with less than US$1.5 billion in private funds assets under management will have an 18-month transition period with respect to such rules. Each SEC-registered private fund adviser will have an 18-month compliance transition period with respect to the Audit Rule and the Quarterly Statement Rule.
8 See our alert SEC Adopts Final Private Fund Adviser Rules for a discussion of the rules relevant for US-based investment advisers, including those exempt from registration.
9 See Adopting Release at pages 46-50.
10 The Private Fund Adviser Rules additionally do not apply to investment advisers with respect to securitized asset funds. These advisers will not be required to comply with these requirements of the final rules solely with respect to the securitized asset funds that they advise.
11 Or otherwise required to be registered.
12 Unregistered non-US private fund advisers generally includes any non-US adviser that is exempt from SEC registration pursuant to the foreign private fund adviser exemption or the exempt reporting adviser exemptions for private fund advisers and venture capital fund advisers as well as any other adviser that is not required to be registered.
13 Although the Adopting Release provides that an adviser can still offer multiple classes of interests with different liquidity options, the SEC also clarifies that an adviser cannot place restrictions on the availability of certain classes of interests if such restrictions preclude the possibility of certain investors from participating in the class with more favorable liquidity and where such liquidity rights could be reasonably expected to have a material, negative effect on other investors.
14 For example, with respect to fees, an adviser must disclose the applicable rate (or applicable range of rates) as opposed to just noting that certain investors may be subject to lower fees.
15 See the Executive Summary for applicability of these rules to SAF advisers.
16 17 CFR 275.206(4)-2 of the Advisers Act (Custody Rule).
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