What We Learned from the Failed Private Fund Rules

July 30, 2024

The SEC did not appeal the landmark decision of the Fifth Circuit that vacated the Private Fund Rules. The SEC could still appeal to the Supreme Court, though success there is looking less and less likely for the commission. Assuming the rules are gone for good, the private fund industry just avoided the time and expense of creating new compliance procedures. However, private fund managers would be wise to use this attempted rulemaking to predict priorities for the SEC and private fund investors.

Enforcement rather than Rulemaking

In the adopting release of the Private Fund Rules, the SEC declined to adopt two rules from the original proposal, and the reasons for leaving these out could be a picture of things to come. The rules on Fees for Unperformed Services and Adviser Limitations on Liability were both proposed but not adopted. The SEC staff stated that advisers have a fiduciary duty to private fund clients and the antifraud provisions apply to an adviser’s dealings with clients and fund investors. Rather than make the rules, the SEC will simply litigate such behavior under existing law. The SEC is tipping its hand. In the absence of new rules the SEC may bring more enforcements against private fund advisers to reach the same goals.

Contrary to the Public Interest 

In the adopting release of the vacated rules, the SEC cited public interest over 30 times to argue the need for the rulemaking. The goal of policing the activity of private fund advisers can still be reached under existing rules for advisers. The SEC takes issue with the lack of transparency, conflicts of interest and lack of governance mechanisms for private fund investors. Private fund advisers often act on behalf of the fund with little to no input or consent from fund investors. This source of conflict was the foundation for the Private Fund Rules. Even though the rules were vacated, expect the SEC to lean on existing requirements for registered investment advisers to regulate these risks.

Here is a quick break down of the risks each rule targeted:

The Preferential Treatment Rule – Preferential treatment of one private fund investor or group of private fund investors over another is contrary to the public interest and fraught with conflicts of interest. Review side-letters and firm practice around information sharing on fund exposures, the granting of preferential redemption rights and any other treatment not given to all investors. The rule would have brought the “death of side-letters” according to many commentators. Expect questions on these conflicts of interest and be ready to defend preferential arrangements with fund investors. For each conflict be ready to explain how any risks are mitigated.

The Restricted Activities Rule – Recall that this rule started as the “Prohibited Activities Rule.” The SEC feels that all of the activities are against the public interest and harmful to investors. Expect SEC Examiners to scrutinize the following:

• Investigation Fees and Expenses – The SEC sought a consent requirement for charging funds for the costs of a regulatory investigation and prohibited charging for any investigation that resulted in a sanction. If you charge a fund for these costs, consider what is disclosed to your investors and expect the SEC to look closely at the arrangement.
• Compliance and Examination Expenses – The SEC thought written notice should be delivered to investors when funds are charged for these expenses. Additionally, the idea of “investor” was broadened to all similar pools of assets. If you charge these expenses, SEC Examiners may ask whether investors in all similar pools of assets are notified or even aware of the charges. Your investors might ask about these costs during their due diligence too since it was highlighted by the attempted rule-making.
• Non-Pro Rata Expense Allocations – Here the SEC wanted prior written notice and for the allocation to be fair and equitable under the circumstances. Agreements that are unfair or inequitable can still be argued in federal court without the new rule. If you have non-pro rata allocations, are you comfortable that they are truly fair and equitable given the circumstances? Are you comfortable facing SEC Examiners that may scrutinize these allocations?
• Reducing Advisor Clawbacks for Taxes – Again, the SEC thought written notice should be delivered to investors. This would allow them to evaluate the tax impact by showing amounts before and after reductions for taxes. Expect more questions on the information shared regarding any clawbacks.
• Adviser Borrowing – When the adviser is on both sides of a transaction, there will be questions around conflicts of interest. The SEC tried to prohibit this practice entirely. If your firm borrows from a fund, expect scrutiny. The SEC has settled enforcement actions against private fund advisers in the past under existing rules for lack of disclosure to investors, failure to seek investor approval, and deceptive or manipulative practices.

The Quarterly Statement Rule – The SEC was probably overreaching its authority the most with this rule. While it cannot force advisers to deliver quarterly statements, you may already have institutional investors requesting such statements. Likewise, the Institutional Limited Partners Association (ILPA) has announced that they are continuing their work on the Quarterly Reporting Standards Initiative to create a common-sense reporting standard for fund investors. If this trend continues, you may need to have similar metrics available to court prospective investors.

The Adviser-Led Secondaries Rule – Conflicts of interest, especially around valuation, will still be an issue for adviser-led secondary transactions. The SEC sought to require a third-party opinion on fairness and valuation for such transactions. If you aren’t mitigating these inherent conflicts with independent, third-party input, expect questions around the transaction in your next exam.

The Mandatory Fund Financial Statement Audit Rule – Private fund audits, their timely delivery, and updates to Section 7.B of the ADV Part 1 indicating reports have been received are perennially reviewed by the SEC. While the rule would have expanded existing audit requirements, audits will still draw the attention of the SEC in an examination of a private fund adviser.

Private fund managers are thrilled that the Private Fund Rules, and all of their burdensome requirements, are not law. We may still see the SEC lean on existing requirements for registered investment advisers to regulate the same private fund activities. Time spent on the conflicts of interest these rules targeted will still strengthen compliance programs against regulatory risks and could help managers address investor concerns.

We will continue to monitor legal challenges, proposed rules, and agency actions that impact compliance programs. If you have any questions, or if you would like to speak with one of our regulatory experts, let us know.