SEC Issues Proposed Rules to Enhance Private Fund Investor Protection

The SEC issued Release Number IA-5955 on February 9, 2022, which proposes new rules and amendments under the Investment Advisers Act of 1940 (Advisers Act).

The proposal contains five new rules and two amendments to existing rules in an effort to protect private fund investors and enhance regulation of private fund advisors.

Proposed New Rules and Amendments

Listed on the SEC website as of February, 9 2022, the proposed new rules and amendments are to be open for comments for 60 days following that publication or 30 days following publication in the Federal Register, whichever period is longer.

A total of five new rules and two amendments to existing rules are reviewed below.

Proposed New Rules

The proposed new rules pertain to the distribution of quarterly statements, private fund audits, advisor-led secondaries, prohibition on certain activities by private fund advisors, and preferential treatment of certain investors.

Quarterly Statement Rule

Registered private fund advisors would be required to distribute a quarterly statement to private fund investors with a detailed accounting of all fees and expenses paid by the private fund during the reporting period. This statement would disclose information regarding compensation or other amounts paid by the private fund’s portfolio investments to the advisor or any related persons.

Advisors would need to provide information about the private fund’s performance. For liquid funds, quarterly statements would list 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.

Statements of illiquid funds would need to provide the gross and net internal rate of return and gross and net multiple of invested capital to capture the illiquid fund’s performance from inception through the end of the current calendar quarter.

This proposal was designed to help improve the quality of information provided to fund investors, so that they can more easily monitor, assess, and compare their private fund investments.

Private Fund Audit Rule

The proposal would require registered private fund advisors to cause the private funds they advise to undergo a financial statement audit at least annually and upon liquidation. The audited financial statements would also be required to be distributed to investors promptly after the completion of the audits.

The objective of these audits is to provide an important check on advisors’ valuation of private fund assets, which often serve as the basis for the calculation of their fees, and to protect private fund investors against misappropriation of fund assets.

Advisor-Led Secondaries Rule

The proposal would require a registered private-fund advisor to obtain a fairness opinion for an advisor-led secondary transaction. In these transactions, advisors often offer existing fund investors the option to sell or exchange their interests in the private fund for interests in another vehicle advised by the advisor.

The independent opinion-provider would determine the fairness of the price being offered to the private fund for any assets being sold as part of the transaction.

The advisor would also need to prepare and distribute a summary of any material business relationships they or any related persons have had with the independent opinion-provider within the past two years.

This requirement would provide a check against an advisor’s potential conflicts of interest in structuring and leading transactions for its profit at the expense of private fund investors.

Prohibited Activities Rule

All private fund advisors would be prohibited from engaging in practices that are contrary to the public interest and the protection of investors.

These activities include:

  • Fees and expenses. Charging certain fees and expenses to a private fund or its portfolio investments, such as fees for unperformed services and fees associated with an examination or investigation of the advisor. In addition, charging fees or expenses on a non-pro rata basis related to a portfolio investment.
  • Limitation of liability. Seeking reimbursement, indemnification, exculpation, or limitation of liability for certain activity.
  • Reduction in advisor claw-back. Reducing the amount of an advisor claw-back by the amount of certain taxes.
  • Borrowing and Credit. Borrowing or receiving an extension of credit from a private fund client.

Prohibiting these practices is intended to address potential conflicts-of-interest that could reasonably lead to fraud and investor harm by preventing advisors from placing their own interests in front of the private fund’s interests.

Preferential Treatment Rule

New rules would be put in place to protect private fund investors from being negatively impacted by material preferential treatment given to others.

Private fund advisors would be prohibited from providing preferential terms to certain investors regarding redemptions from a fund or sharing information about portfolio holdings or exposures. Also, the private fund advisors would be prohibited from providing other preferential treatment unless disclosed to current and prospective investors.

Amendments to Existing Rules

In addition to the five new proposed rules, the proposal would amend two existing rules under the Advisers Act.

Amendments to Books and Records Rule

Advisors would be required to keep records related to any of these proposed rules to facilitate the SEC’s ability to assess an advisor’s compliance with these proposed rules.

Amendments to Compliance Rule

All registered advisors, including those that don’t advise private funds, would be required to document their annual review of their compliance policies and procedures in writing.

Transition Period and Compliance Date

Advisors would be granted a one-year transition period to provide necessary time to come into compliance with these new and amended rules if they are adopted.

Accordingly, the SEC is proposing that the compliance date of any adoption of this proposal would be one year following the rules’ effective dates, which would be 60 days after the date of publication of the rules in the Federal Register.

We’re Here to Help

For more information about how these proposed changes could affect your fund, please contact your Moss Adams professional.

You can find additional resources at our Financial Services Practice.

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