On February 9, 2022, by a vote of 3-1, the Securities and Exchange Commission (“SEC”) proposed new rules that would dramatically and fundamentally alter the regulation of private fund advisers.¹ The proposed rules represent a significant expansion of the regulation of private fund advisers and would materially impact the operations and practices of both registered and unregistered private fund advisers (including exempt reporting advisers).

While the current rules applicable to private fund advisers are generally principles-based and grounded in disclosure, in light of the sophistication of private fund investors, the proposed rules are highly proscriptive and would vastly restrict, and in many cases expressly prohibit, a number of common practices. For example, the rules would expressly prohibit registered and unregistered private fund advisers from seeking indemnification for simple negligence. The rules would also prohibit registered and unregistered private fund advisers from providing preferential treatment to an investor (e.g., through side letters) absent explicit and highly detailed disclosure of such preferential terms in advance to all prospective investors and on an annual basis to all current investors.

Other areas of the proposed rules would apply only to registered advisers and would require such private fund advisers to:

• provide investors with quarterly statements detailing information regarding private fund performance, fees and expenses;
• obtain an annual audit for each private fund; and
• in connection with adviser-led secondary transactions, obtain a fairness opinion from an independent opinion provider regarding such transactions.

The proposed rules would also require registered advisers to maintain written documentation of their annual compliance review and amend the books and records rule to require advisers to retain records to facilitate the SEC’s assessment of an adviser’s compliance with these new rules.

Proposed Rules Applicable to Both Registered and Unregistered Advisers, Including ERAs

Prohibited Activities

The proposed rules would expressly prohibit all registered and unregistered private fund advisers from engaging in certain practices, including:

• charging certain fees and expenses to a private fund or its portfolio investments, such as fees for unperformed services (e.g., accelerated monitoring fees);
• charging expenses associated with an examination or investigation of the adviser or its related persons by any governmental or regulatory authority to a private fund;
• charging regulatory or compliance fees or expenses of the adviser or its related persons to a private fund;
• seeking reimbursement, indemnification, exculpation, or limitation of liability for its breach of fiduciary duty, willful misfeasance, bad faith, negligence or recklessness in providing services to a private fund;
• reducing the amount of any “adviser clawback”² by the amount of actual, potential, or hypothetical taxes;
• charging fees or expenses related to a portfolio investment on a non-pro rata 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; and
• borrowing money, securities, or other fund assets, or receiving an extension of credit from a private fund client.

Preferential Treatment (e.g., Side Letters)

The proposed rules would prohibit all registered and unregistered private fund advisers from directly or indirectly:

• granting an investor preferential redemption terms if the adviser reasonably expects that doing so would have a material, negative effect on other investors in the private fund;
• providing information regarding the portfolio holdings or exposures of a private fund, or of a substantially similar pool of assets, to any investor if the adviser reasonably expects that doing so would have a material, negative effect on other investors in that private fund or in a substantially similar pool of assets; or
• providing any other preferential treatment to an investor unless all such rights are disclosed in writing, with a high degree of specificity³
  • in advance to all prospective investors and
  • on an at least annual basis to all existing investors in the applicable private fund.

Proposed Rules Applicable to Registered Advisers

Quarterly Statements

• The proposed rules would require registered private fund advisers to distribute a quarterly statement to investors detailing all fees and expenses paid by the private fund during the reporting period, which statement also includes information regarding compensation or other amounts paid by the private fund’s portfolio investments to the adviser or any of its related persons.
• The proposed rules would impose different reporting for “liquid funds” and “illiquid funds”⁴:
  • liquid fund statements would be required to contain a report of annual net total returns since inception, average annual net total returns over prescribed time periods, and quarterly net total returns for the current calendar year; and
  • illiquid fund statements would be required to contain the gross and net internal rate of return and gross and net multiple of invested capital for the illiquid fund to capture performance from the fund’s inception through the end of the current calendar quarter.

Private Fund Audits

• The proposed rules would require that the financial statements of all private funds managed by registered advisers:
  • be audited by an independent public accountant at least annually and upon liquidation; and
  • be promptly delivered to investors following the audit’s completion.
• The fund auditors would also be required to report the following events directly to the SEC:
  • the issuance of an audit report that contains a modified opinion (with such notice to be received promptly); and
  • the resignation, dismissal or other termination of the engagement with the auditor, or upon the auditor removing itself or being removed from consideration for being reappointed (with such notice to be received within four business days).

Adviser-Led Secondaries

In order to provide a check against conflicts of interest the SEC has identified in connection with adviser-led secondary transactions⁵, the proposed rules would require registered private fund advisers to:

• obtain a fairness opinion from an independent opinion provider in connection with certain adviser-led secondary transactions;
• distribute the opinion to investors prior to the close of the applicable transaction; and
• provide investors with a summary of certain 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.

Written Annual Compliance Rule Requirement

The proposed rules would amend Rule 206(4)-7 under the Advisers Act (the compliance rule) to require that all registered advisers, including those that do not advise private funds, document their annual compliance review in writing and retain such documentation for at least five years.

The proposed rules would also amend Rule 204-2 under the Advisers Act (the books and records rule) to require advisers to retain records related to new requirements contained in the proposed rules.

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The public comment period for the proposed rules will remain open for the longer of 60 days following publication on the SEC’s website or 30 days following publication in the Federal Register.

We expect the proposed rules to attract significant industry attention. If you have any questions regarding the information discussed above, please contact your Investment Management Group attorney at Seward & Kissel LLP.