On August 23, 2023, the Securities and Exchange Commission (the SEC) released final rules under the Investment Advisers Act of 1940 (the Advisers Act), focused on private fund disclosures and sponsor practices (the Final Rules). Previously on February 9, 2022, the SEC had issued proposed rules on those issues (the Proposed Rules) and subsequently received significant industry interest and substantial feedback.
We highlight the key changes in the Final Rules from the Proposed Rules. Notably, the SEC did not adopt the controversial proposed rule that would have prohibited advisers from limiting their liability or seeking indemnification from a private fund or its investors for simple negligence (versus gross negligence). Our previous insight on the Proposed Rules is available here.
To whom (and when) do the Final Rules apply?
There are certain portions of the Final Rules that apply solely to registered investment advisers under the Advisers Act. These include the rules regarding Quarterly Statements, Mandatory Private Fund Adviser Audits and Adviser Secondaries (see Rules #1 through #3 below). On the other hand, the Restricted Activities Rule and Preferential Treatment Rule apply to all private fund advisers (regardless of whether they are registered or not) (see Rules #4 and #5 below)1.
The Final Rules are set to become effective 60 days after being published in the Federal Register. We note that a significant change from the Proposed Rules relates to the implementation of the Final Rules. The Final Rules make clear that the SEC will provide legacy status to (and therefore not impact) aspects of the Preferential Treatment Rule (with the exception of the disclosure portions of the rule) and the Restricted Activities Rule (with the exception that investment advisers cannot charge their fund clients for fees or expenses relating to an investigation that has resulted in the imposition of a sanction). More generally, the SEC will not require amendments to existing agreements be made as a result of the Final Rules. We discuss the implementation timeline with respect to compliance for new funds further below.
Key rules in the Final Rules
1. Quarterly reports and standardized performance disclosure
In short, the Final Rules provide that registered investment advisers must provide investors with a quarterly statement (within 45 days of the end of the first three quarters and 90 days of the end of the fourth quarter)2 that includes fees, expenses and performance for any private fund that it advises.
The SEC adopted the Proposed Rules that will require registered investment advisers to provide a quarterly statement relative to each private fund, with certain modifications. Consistent with the Proposed Rules, the Final Rules require the quarterly statements to be in a table format and include certain fund-level information and portfolio-level information. At the fund level, the Final Rules remain largely unchanged from the Proposed Rules and require the quarterly statements to provide detailed accounting of (a) compensation to the adviser and its related persons3 (i.e., management, advisory, sub-advisory and other similar fees and performance-based compensation); (b) fund-level (as the Final Rules clarify, including those both allocated to or paid by a private fund) fees and expenses (i.e., accounting, organizational, legal, audit, administration, tax, due diligence and travel, as well as expenses paid to related persons); and (c) the amount of offset or rebate carried forward to subsequent quarterly periods to reduce future payments or allocations to the adviser or its related persons. At the portfolio level, consistent with the Proposed Rules, the Final Rules require the quarterly statements to include a separate table in respect of covered portfolio investments4 showing the compensation allocated or paid by the fund’s underlying portfolio investments, with imputed costs to the fund calculated based on its ownership percentage in respect of the relevant portfolio investment.
As a change from the Proposed Rules, the Final Rules will no longer require disclosure of a private fund’s ownership percentage of each covered portfolio investment—the SEC agreed with certain comments that asserted that such percentage can be misleading to investors as it may not accurately represent the extent of control and influence a private fund adviser has over a portfolio company. The SEC also emphasized that each item of reported fees and expenses must be listed on separate lines even if for a de minimis amount and must include cross-references to the relevant sections of the private fund’s organizational and offering documents that set forth the calculation methodology—from the SEC’s perspective, itemized reporting is critical for the quarterly reporting to achieve its intended effect of improved transparency.
Lastly, consistent with the Proposed Rules, the quarterly statement must provide applicable standardized fund performance information depending on whether such fund is a liquid or illiquid fund. The quarterly statements for illiquid funds (defined as any private fund that is not required to redeem interests upon an investor’s request and has limited opportunities, if any, for investors to withdraw before termination of the fund) must include certain performance measures calculated with and without the impact of any fund-level subscription facilities—the Proposed Rules had only required such performance metrics be computed without the impact of any amounts drawn-down on fund-level subscription facilities. The quarterly statements for liquid funds (defined as any other private fund that is not an illiquid fund) must include net total returns for each fiscal year over the shorter period of the past 10 fiscal years and since inception (the Proposed Rules would have required a liquid fund to disclose annual net total returns since inception). In addition, all disclosures of performance information must include a description of the criteria used and assumptions made in calculating performance-based compensation.
2. Mandatory fund audit
In short, the Final Rules provide that registered investment advisers will be required to undergo a financial statements audit, in accordance with U.S. Generally Accepted Accounting Principles (GAAP), by an independent public accountant (registered with and subject to inspection by the Public Company Accounting Oversight Board) for each advised private fund at least annually and promptly upon liquidation.
The SEC received many comments indicating that the difference between the custody rule and the Proposed Rules would cause confusion and undue administrative burdens; as such the SEC has revised the Final Rules to conform to the audit provision (and related requirements for delivery of audited financial statements) under the custody rule of the Advisers Act. Specifically, the Final Rules require that the audit be performed by an independent public accountant, the audited financial statements be prepared in accordance with GAAP and the annual audit of a private fund be completed within 120 days after its fiscal year-end and promptly upon liquidation. The financial statements must be prepared in accordance with either GAAP or some other comprehensive body of accounting standards, like the International Financial Reporting Standards, if the information is substantially similar to financial statements prepared in accordance with GAAP and contain a footnote reconciling any material differences. We note that as a change from the Proposed Rules, the Final Rules do not include an obligation to notify the SEC upon the issuance by the auditor of a modified opinion or following the resignation or dismissal from, or other termination of, the engagement or the removal of the auditor.
3. GP-led secondaries
In short, the Final Rules require registered investment advisers to provide either a fairness or valuation opinion in connection with GP-led secondaries.
The Final Rules provide that registered investment advisers will be required to deliver to investors, prior to the due date of their election forms, either (a) a fairness opinion stating that the price being offered to the private fund for any assets being sold by it as part of the GP-led transaction is fair, or (b) a written valuation opinion stating the value (as a single amount or a range) of any assets being sold in connection with any GP-led secondary transaction where the adviser offers fund investors the option to sell all or a portion of their interests in the private fund or exchange them for interests in another vehicle advised by the adviser. As a change from the Proposed Rules, advisers have the option to obtain and distribute to investors a valuation opinion in lieu of a fairness opinion.
In addition, advisers are required to provide a written summary of any material business relationships between the adviser or its related persons and the independent opinion provider for the two years prior to the date of the GP-led secondary. The Final Rules require advisers to obtain the opinion from an independent opinion provider, which reduces the risk of a biased opinion provided by related persons and further mitigates the potential influence of advisers’ conflicts of interest.
4. Restricted activities
In short, all advisers (whether registered or not) are prohibited from undertaking the following actions unless they provide disclosure of the same to investors: (a) charging the fund for fees or expenses relating to an investigation of the adviser or its related persons (but in no event can they charge any such amounts if they have been sanctioned as a result of such investigation); (b) charging the fund for any regulatory, examination or compliance fees or expenses of the adviser or its related persons; (c) reducing the amount of the adviser clawback by applicable taxes; (d) charging or allocating fees and expenses on a non-pro rata basis; or (e) borrowing money or assets from private fund clients.
Under the Final Rules, all private fund advisers (including unregistered investment advisers such as exempt reporting advisers) or their related persons will be prohibited from conducting the following activities unless they meet the exceptions provided below. We note that the SEC did not adopt the Proposed Rules which would have prohibited advisers and their related persons from receiving compensation for monitoring, servicing, consulting, or other fees in respect of any services that the investment adviser did not, or did not reasonably expect to, provide, including accelerated monitoring fees. The SEC noted that such activities already run contrary to an adviser’s fiduciary duty to its clients under Federal law.
Investigation expenses: The SEC largely adopted the Proposed Rules that prohibit advisers and their related persons from charging a private fund for fees and expenses associated with the investigation of the adviser or its related persons by any governmental authority. As a change from the Proposed Rules, the SEC provided an exception that allows advisers to charge the investors for fees and expenses associated with such investigation if such advisers seek consent from all investors and obtain written consent from at least a majority in interest of the investors. However, such fees and expenses may not be charged (even with consent) if the adviser or its related persons have been sanctioned as a result of such investigation.
Compliance costs: With respect to regulatory, compliance and examination expenses, unless advisers provide quarterly disclosure of the same, they will be prohibited from charging regulatory or compliance fees and expenses incurred thereby. In the Final Rules, the SEC provided some examples of these fees and expenses, including filing and other fees associated with Form ADV, Form PF and other state filings. One change that is worth noting is the SEC revised this prohibition to capture not only amounts “charged” to the private fund, but also fees and expenses “allocated to” the private fund.
Clawback obligations: Unless advisers provide quarterly disclosure of the after-tax adviser clawback reductions, they will be prohibited from reducing their clawback obligations based upon actual, potential or hypothetical taxes applicable to the adviser, its related persons or their interest holders.
Non-pro rata allocation: When multiple private funds and other clients advised by an adviser or its related persons have invested in the same portfolio investment, the adviser will be prohibited from charging or allocating fees and expenses related to such portfolio investment on a non-pro rata basis, unless (a) the non-pro rata charge or allocation is fair and equitable under the circumstances, and (b) prior to charging or allocating such fees or expenses to a private fund client, the adviser distributes to each investor of the private fund a written notice of the non-pro rata charge or allocation and a description of how it is fair and equitable under the circumstances. The SEC indicated that their focus on non-pro rata expense allocations is intended to address how an adviser allocates to co-investment vehicles their pro rata share of broken deal expenses.
Borrowings: Unless an adviser provides notice to its investors (including a description of the material terms of a borrowing by such adviser or its related persons) and obtains the consent of a majority in interest of investors, the adviser will be prohibited from borrowing money, securities or other fund assets, or receiving a loan or an extension of credit from a private fund that it manages.
We note the SEC did not adopt the Proposed Rules that would have prohibited advisers and their related persons from seeking reimbursement, indemnification, exculpation or limitation of liability from a private fund or its investors for a breach of fiduciary duty, willful malfeasance, bad faith, negligence or recklessness in providing services to the private fund. The SEC took the position that it would not be necessary to address this in light of comments received in respect of the same and proposed to leave it to the parties to agree as to the appropriate standards to apply to the relevant adviser, subject to the adviser’s fiduciary duties under applicable Federal or state laws.
5. Preferential treatment
In short, the Final Rules prohibit all advisers (whether registered or not) from agreeing to provide preferential treatment to investors in respect of redemptions or portfolio-level information that, in each case, the adviser reasonably expects to have a material, negative effect on the other investors in that private fund or in a substantially similar pool of assets. With respect to all other preferential terms, (a) to the extent that such terms are material economic terms, then advisers must provide the other investors with advance written notice thereof and (b) such other terms must be disclosed but can be disclosed post-fundraising period.
Liquidity and portfolio holding information: The SEC adopted the Proposed Rules that will prohibit any private fund adviser (including unregistered advisers) from providing preferential treatment to investors in respect of redemptions to the extent it reasonably expects such preferential redemption rights to have a material, negative effect on other investors in the fund, subject to two new exceptions: (a) redemptions required by law, rule, regulation or order of certain governmental authorities and (b) if advisers have offered the same redemption ability to all existing investors and will continue to do so for all future investors. In addition, the SEC adopted the Proposed Rules that will prohibit all private fund advisers from providing information about portfolio holdings or exposures if there is a reasonable expectation of the adviser that such provisions could have a material, negative effect on other investors, subject to a new exception that permits such information to be disclosed to an investor if the same information is disclosed to all investors.
All other preferential terms: The SEC adopted the Proposed Rules that will prohibit any investment adviser (including unregistered advisers) from providing any other type of preferential treatment to investors unless the adviser discloses such treatment to other current and prospective investors. However, there are some changes worth noting: the SEC is (a) limiting the advance written notice requirement to material economic terms, as opposed to all preferential terms, and (b) requiring advisers to disclose in writing all other preferential terms to investors following a specified timeline, which can follow the end of the fundraising period. In addition, the Final Rules require advisers to describe the preferential terms with specificity.
The Final Rules require all registered advisers to document the annual review of their compliance policies and procedures in writing. To address comments opposing the written annual review requirement, the SEC asserted that the written records of the annual review could provide more transparency for the SEC staff’s review of the advisers and prompt more detailed, thorough compliance review by the advisers. The SEC also noted that the Final Rules on the written annual review are drafted in a manner to provide private fund advisers with flexibility to determine the scope of review (subject to minimum review requirements under existing guidance) and how to document such review, including when, if at all, and how to communicate with service providers or outside counsel.
The SEC has offered certain transition periods before private fund advisers will be required to comply with the applicable Final Rules. For the Quarterly Statement Rule and the Annual Audit Rule, the SEC adopted an 18-month transition period. For the GP-Led Secondaries Rule, Restricted Activities Rule and Preferential Treatment Rule, advisers with less than $1.5 billion in private funds assets under management will have an 18-month transition period, and advisers with at least $1.5 billion in private funds assets under management will have a 12-month transition period. Compliance with the requirements in respect of the written documentation of an adviser’s annual review will be required 60 days after the publication of the Final Rules.
We will continue monitoring the effect of the Final Rules and will keep you apprised of any further developments. If you have any questions regarding the Final Rules, please feel free to reach out to your Torys team.
We note that the Final Rules (other than the written documentation requirement) do not apply to securitized asset funds (SAFs, defined as any private fund whose primary purpose is to issue asset-backed securities and whose investors are primarily debt holders) on the basis that the SAFs do not issue equity but instead issue notes at various seniorities that entitle holders to interest payments and repayment of principal. Instead, most SAF investors rely on metrics such as a yield performance, cash distributions and characteristics and quality of the underlying assets used to pay the notes, which are often included in the underlying governing documents. Additionally, SAFs do not have general partners affiliated with their advisers but rather unaffiliated trustees as fiduciaries of the SAF investors.
Any fund of funds will have 75 days after the end of first three fiscal quarters and 120 days after the end of each fiscal year to deliver such quarterly statements to investors.
Consistent with the Proposed Rules, the Final Rules define “related person” as (i) all officers, partners or directors, including those performing similar functions, of the adviser; (ii) all persons directly or indirectly controlling or controlled by the adviser; (iii) all current employees (other than those performing only clerical, administrative, support or similar functions) of the adviser; and (iv) any person under common control of the adviser.
Consistent with the Proposed Rules, the Final Rules define “covered portfolio investment” as a portfolio investment that allocated or paid the investment adviser or its related persons portfolio investment compensation during the reporting period. Portfolio investment compensation means any compensation, fees and other amounts allocated or paid to the investment adviser or any of its related persons by the portfolio investment attributable to the private fund’s interest in such portfolio investment.
To discuss these issues, please contact the author(s).
This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.
For permission to republish this or any other publication, contact Janelle Weed.