The SEC (U.S. Securities and Exchange Commission) has provided notice that it is preparing to adopt the so-called “Private Funds Rules” under the Investment Advisers Act of 1940 (the “Advisers Act”) on August 23, 2023. Originally proposed on February 2022, these rules generated a lot of controversy from a range of industry participants. As we prepare for the adopted rules, we will be reviewing the final Private Funds Rules, with a focus on a few particular topics.
Is there a prohibition on a liability standard above a negligence standard?
Possibly the most controversial proposal was to restrict the ability of a private fund adviser to include a limitation of liability (or indemnification) at a standard above negligence, even though a gross negligence standard is common in the market (proposed rule 211(h)(2)-1(a)(5)). This proposal was also inconsistent with existing standards for registered funds under the Investment Company Act and would also notably not be applicable to advisory clients that are not “private funds.” We will be reviewing to see if the standard is adjusted to “gross negligence” or maintained at “negligence,” as well as whether the SEC is signaling that it may expand this position to other parts of the investment management industry. This was proposed to apply to both SEC-registered investment advisers and exempt reporting advisers.
Is there a prohibition on reductions of clawbacks to reflect taxes applicable to the adviser or other related persons?
Likely the second most controversial proposal was a restriction on the ability of a private fund adviser to reduce a clawback to reflect actual, potential, or hypothetical taxes applicable to the adviser and certain other related persons (proposed rule 211(h)(2)-1(a)(4)). This proposal appeared to not appreciate how both U.S. and non-U.S. tax laws apply to such clawback situations. We will be watching for whether the SEC scraps this prohibition given the complexity under US and non-US tax law or whether the SEC replaces this prohibition with a different prohibition or requirement that seeks to favor “European” fund waterfalls over “American” deal-by-deal waterfalls. This was proposed to apply to both SEC-registered investment advisers and exempt reporting advisers.
Does the SEC provide an exception for non-pro rata allocation of expenses for certain circumstances?
The proposed rules would also prohibit the non-pro rata allocation of certain expenses (proposed rule 211(h)(2)-1(a)(6)). However, there are a range of circumstances where a non-pro rata allocation would be a more fair and equitable allocation among the relevant funds and other clients. We will look for whether there are any exceptions provided for this prohibition for circumstances where a “fair and equitable” allocation may not be a pro rata allocation. This was proposed to apply to both SEC-registered investment advisers and exempt reporting advisers.
Are there prohibitions on some or all preferential treatment, or does it become mostly a disclosure requirement?
The SEC proposed prohibitions on preferential treatment with respect to redemptions and information on portfolio holdings or exposures, as well as disclosure requirements with respect to other preferential arrangements (proposed rule 211(h)(2)-3). Many large investors objected to both the prohibitions and the disclosure requirements, since many of the provisions offering preferential treatment were negotiated for by such investors in side letters. We will be monitoring to see if the preferential treatment prohibitions remain (or are turned into disclosure requirements) and also whether the disclosure requirements with respect to timing and level of detail are adjusted or clarified. This was proposed to apply to both SEC-registered investment advisers and exempt reporting advisers.
How does the performance reporting line up with the Marketing Rule requirements?
The proposed Private Funds Rules would create a new requirement to provide quarterly performance reporting with specific calculation requirements that differ based on whether the fund is a “liquid fund” or an “illiquid fund” (proposed rule 211(h)(1)-2(e)). The proposed specific calculation requirements represent a departure from the somewhat less prescriptive approach adopted by the Marketing Rule (Advisers Act Rule 206(4)-1), which itself has already introduced a range of new complications for registered investment advisers with respect to performance presentations. Given the difficulties of trying to comply with the Marketing Rule, we will be watching to see if the Private Funds Rules introduce even more complications (and potentially inconsistencies). This was proposed to apply only to SEC-registered investment advisers.
Is there greater clarity on the fee and expense disclosure requirements?
The proposed rules would also require quarterly reporting on fees and expenses associated with the private fund (proposed rule 211(h)(1)-2). While it seems likely that some form of fee and expense reporting will be adopted, the proposal provided little clarity as to how a private fund should approach such disclosures in practice, particularly on the level of granularity that will be required by such reports. We will be looking for more guidance on how the SEC expects the fee and expense disclosure to work as a practical matter, including the level of flexibility that private fund advisers will have in providing these reports and whether the SEC reduces the frequency of the reporting requirements given the practical challenges for private fund advisers who rely on an annual audit process. This was proposed to apply only to SEC-registered investment advisers.
Does the SEC require a fairness opinion for adviser-led secondary transactions?
The SEC has proposed that an investment adviser receive a fairness opinion for all adviser-led secondary transactions (proposed rule 211(h)(2)-2). It is notable that ILPA (The Institutional Limited Partners Association) did not consider a fairness opinion as necessary in all circumstances in its guidelines on continuation funds. Given that this does not seem to be considered necessary by investors in all circumstances, the SEC may consider other alternatives to fairness opinions to address the related conflicts of interest. However, the SEC does appear likely to include some requirements for adviser-led secondary transactions, since such transactions are now subject to certain quarterly reporting requirements on Form PF, with respect to private equity funds, and are one of the SEC’s examination priorities. This was proposed to apply only to SEC-registered investment advisers.
How do the annual audit requirements interact with the proposed Safeguarding Rule?
The SEC has proposed a radical change to the Custody Rule (Advisers Act Rule 206(4)-2) into the new (and itself highly controversial) Safeguarding Rule. Among many other things, the Safeguarding Rule includes a proposal that would adjust annual audit requirements that currently exist under the Custody Rule. The proposed Private Funds Rules would introduce a new, separate requirement for private funds to be audited regardless of whether such funds are subject to an audit requirement under the Custody Rule (or the proposed Safeguarding Rule). We will be monitoring to see if this requirement is dropped from the adopted Private Funds Rules or is adjusted to ensure that there are no inconsistencies with the Custody Rule or proposed Safeguarding Rule requirements. This was proposed to apply only to SEC-registered investment advisers.
Will some or all of the requirement remain applicable to both registered investment advisers and exempt reporting advisers?The proposed rules on prohibited conflicted activities and restrictions on preferential treatment were proposed to apply both to registered investment advisers and exempt reporting advisers. This represents a significant departure with respect to exempt reporting advisers, who have only been subject to limited parts of the substantive provisions and rules of the Advisers Act. Applying a wider set of substantive requirements to exempt reporting advisers could signal a greater intent to regulate exempt reporting advisers. We will be looking out for whether the SEC appears to be taking an increased interest in regulating exempt reporting advisers, which could also indicate an increase in the frequency of SEC examinations and other oversight activities with respect to exempt reporting advisers.
Will the SEC provide clarity on the applicability to non-U.S. investment advisers?
Historically, the SEC has only applied a limited number of the Advisers Act substantive provisions to non-US investment advisers with respect to non-US clients. The proposal only provided limited clarity as to whether this approach would apply to the Private Funds Rules.
These extraterritoriality concerns apply both to SEC-registered investment advisers and exempt reporting advisers. In fact, the importance of this interpretative position is heightened if the Private Funds Rules apply to exempt reporting advisers, given the large number of non-US exempt reporting advisers with only limited connections to the United States.
We will be watching to see if the SEC confirms, expands, or restricts its positions on the applicability of the substantive provisions of the Advisers Act with respect to a relationship between a non-US investment adviser and its non-US clients. We will also be monitoring whether SEC-registered investment advisers and exempt reporting advisers are treated in the same or a different manner.
Is there grandfathering of existing contractual arrangements?
The proposed rules are intended to (and would) significantly alter the economic arrangements between private fund advisers and funds (and investors). However, the proposed rules did not include any grandfathering of existing agreements that are not compliant with the Private Funds Rules. In addition to thorny constitutional issues, there are wide range of practical issues relating to attempting to renegotiate and amend a wide range of existing contractual arrangements within the proposed one-year transition period. This topic also appears as one of the prime potential areas for litigation. We will be looking out for whether a grandfathering provision is added to the Private Funds Rules and, if so, what form such grandfathering provision takes, including whether it is temporary or permanent. These grandfathering concerns apply to proposed rules applicable to both SEC-registered investment advisers and exempt reporting advisers.
What does this say about the Gensler SEC more generally?
The SEC under Chair Gensler has stood out due to, among other things, the incredible number of new rule proposals and also the aggressiveness of those proposals. As one of the earlier proposals, we will be watching to see whether the Private Funds Rules are adopted substantially as proposed, tempered in minor ways, or revised in material ways. The SEC’s approach here could give an indication of what to expect with respect to the other rule proposals that are set to be adopted later. There are also a number of indications that various groups are considering litigation with respect to the Private Funds Rules, so the SEC may pull back certain parts of the rules that it feels are more vulnerable to litigation or, alternatively, push forward and risk the potential for litigation.
Is there a curveball?
Along the same lines, some of the recent rule adoptions have suggested that the Gensler SEC is willing to adopt rules that are different from those that were proposed. As recently expressed by Commissioner Uyeda, “I am concerned about the pattern of recent Commission proposals in which somewhat outlandish components were included, which drew the attention and focus of commenters. Subsequently, the Commission pivoted to a different approach at final rule adoption, the details of which had never been fully previewed to the public.” It may be that the Private Funds Rules are substantially different from those that were proposed and include elements that are not expected. Alternatively, the SEC may decide to adopt what it considers to be the less controversial elements (e.g., quarterly expense reporting) and defer the adoption of the more controversial elements (e.g., the indemnification standard) to a later date.
* * *
We will review the adopted Private Funds Rules and provide additional information and analysis soon thereafter.
 For additional information, please see our Client Alert: Ravi Chopra, Jacqueline Eaves, Robert C. Emerson, Gregory Larkin, and Brian O'Neill, “ILPA Publishes Guidance on Continuation Funds,” Goodwin, May 30, 2023.
 For additional information, please see our Client Alert: Gregory Larkin, Brynn D. Peltz, Cynthia Wells, Daniel Ji, Justin Kanter, and Grace Willingham, “New Form PF Current and Quarterly Event Reporting and Expanded Large Private Equity Fund Adviser Reporting Adopted by SEC,” Goodwin, May 4, 2023.
 For additional information, please see our Client Alert: Gregory Larkin, Brynn D. Peltz, Cynthia Wells, Daniel Ji, and Justin Kanter, “Private Fund Sponsors Remain in Spotlight of the SEC’s Examination Priorities” Goodwin, February 8, 2023.
 For additional information, please see our Client Alert: Gregory Larkin, Brynn D. Peltz, Cynthia Wells, Daniel Ji, and Justin Kanter, “SEC Proposes Radical Transformation of Custody Rule Into New Safeguarding Rule,” Goodwin, February 16, 2023.  Commissioner Mark T. Uyeda, Statement on the Proposals re: Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers (July 26, 2023), https://www.sec.gov/news/statement/uyeda-statement-predictive-data-analytics-072623 (citing recent rules regarding money market fund reforms).