Quantcast
Channel: The Capital Commitment

SEC Adopts Private Fund Adviser Rules

0
0

SEC Emblem

Yesterday, the five SEC commissioners voted 3-2, along party lines, to approve the Private Fund Adviser Rules. The final Rules scale back from what was initially proposed 18 months ago, in ways that are likely to be a relief to many private fund advisers. (For a summary of the initial proposal, please see our previous Alert.) Even in their current form, however, the Rules still impose many new obligations and introduce new prohibitions that are likely to significantly alter business practices, and impose new administrative burdens and costs, across many registered and exempt private fund advisers. All private fund advisers should therefore review their practices in light of the new Rules in order to assess whether and how their practices and documentation will need to change before the Rules’ compliance dates.

A summary of the Rules along with preliminary highlights appears below (to be followed by a more detailed summary in a forthcoming publication).  Readers may also wish to refer to the SEC’s Fact Sheet regarding the final Rules, as well as the Adopting Release.

Rule Which Advisers Are Covered? Transition Period Summary of Final Rule Certain Changes from the Proposal
Quarterly Statement Rule RIAs Only 18 months

Requires RIAs to provide quarterly statements to private fund investors with detailed information on:

· private fund fees and expenses;

· compensation received by the RIA and its affiliates and personnel from the fund and from portfolio investments, and any related fee offsets; and

· standardized fund performance.

Statements must be delivered within 45 days (Q1-Q3) or 90 days (Q4) of quarter-end.  For funds of funds, the deadlines are 75 days (Q1-Q3) and 120 days (Q4).

Expenses to be reported now include expenses allocated to the fund, in addition to expenses paid by the fund.

Statement no longer needs to list the fund’s ownership percentage of any portfolio investment.

Illiquid funds must now report investment performance with and without (as opposed to just without) the effect of fund-level subscription facilities.

Liquid funds are now not required to report investment returns since inception if inception is more than 10 years ago.

Advisers now provided with additional time to distribute Q4 reports, and advisers to funds of funds now provided with additional time to distribute all reports.

Timing of reporting now keyed off of the fund’s fiscal year, not calendar year.

Private Fund Audit Rule RIAs Only 18 months RIAs must ensure that each fund undergoes an annual financial statement audit.

Audit must now adhere to the same standards as the Custody Rule’s audit requirements.

If adviser is not in a control relationship with the fund (e.g., because it is an unaffiliated sub‑adviser to the fund), the adviser must now maintain records documenting its attempts to undergo an annual audit.

Auditors will not be required to notify the SEC in connection with issues arising under audits.

Adviser-Led Secondaries Rule RIAs Only

12 months for “larger” private fund advisers ($1.5BN or more in private fund AUM)

18 months for “smaller” private fund advisers (less than $1.5BN in private fund AUM)

RIAs causing a fund to undergo an adviser-led secondaries transaction must (i) obtain a fairness opinion or a valuation opinion and (ii) disclose any material business relationships the adviser has, or has had within the prior two years, with the opinion provider.

Advisers will have the option to obtain a fairness opinion or a valuation opinion.

Opinion and summary of material business relationships must now be delivered prior to the due date of the investors’ election form (instead of prior to closing).

Definition of “adviser-led secondary transaction” now revised to exclude tender offers.

Compliance Rule Amendments RIAs Only 60 days Amends the existing Compliance Rule to require all RIAs, including those that do not advise private funds, to document in writing the required annual review of their compliance policies and procedures. No changes.
Restricted Activities Rule All Advisers, Whether Registered or Not

12 months for “larger” private fund advisers ($1.5BN or more in private fund AUM)

18 months for “smaller” private fund advisers (less than $1.5BN in private fund AUM)

Restricts all private fund advisers from the following activities unless, in certain cases, disclosed to or, in other cases, disclosed to and consented by, the fund investors.

Disclosure is required before the fact in some cases, and after the fact in others.

“Consent” means approval by a majority in interest of fund investors that are not related persons of the adviser.  The Adopting Release specifies that LPAC approval is not sufficient.

Permitted With Disclosure:

· Causing fund to bear regulatory or compliance fees/expenses (must be disclosed after the fact, quarterly, which can be done through the Quarterly Reports).

· Reducing GP clawback for taxes (pre-tax and post-tax clawback amounts must be disclosed after the fact).

· Non-pro rata allocations of investment-related expenses across different funds investing in the same investment (fee/expense amounts must be disclosed before the fact, with accompanying explanation as to why the fund’s allocation is fair and equitable).

Permitted With Disclosure And Consent:

· Causing a fund to bear fees/expenses relating to government or regulatory investigations (other than in cases where the adviser is sanctioned for violating the Advisers Act or the Rules thereunder (“sanctioned matters”), which is never permitted, even with disclosure and consent).

· Adviser borrowing from a fund.

· Grandfathering applies (i.e., no need for consent) for all “legacy” agreements in-place as of the Compliance Date, other than agreements permitting a fund to bear expenses relating to “sanctioned matters”, as described above, which are not grandfathered (see below).

Initially proposed as outright prohibitions, most of these activities are now permitted if disclosed to, or if disclosed to and consented by, the fund investors (as described herein).

The SEC also added the grandfathering provision described herein.

Preferential Treatment Rule All Advisers, Whether Registered or Not

12 months for “larger” private fund advisers ($1.5BN or more in private fund AUM)

18 months for “smaller” private fund advisers (less than $1.5BN in private fund AUM)

Prohibits all advisers from providing preferential redemption or information rights that would have a material negative effect on other investors in the fund or in other funds with similar portfolios, except for (i) preferential redemption rights that are required by applicable law or (ii) preferential redemption rights or information rights that are offered to all other investors in the fund (and in all funds with similar portfolios).  Grandfathering applies for all “legacy” preferential redemption and information rights agreements in-place as of the Compliance Date (see below).

Requires all advisers to (i) disclose other preferential material economic terms prior to each other investor’s investment in the fund (or in any other fund with a similar portfolio) and (ii) all preferential terms of any kind (even grandfathered preferential terms) to all investors in the fund (and in all funds with similar portfolios) either (x) after the end of fundraising (for illiquid funds) or (y) after the relevant investor has been admitted (for liquid funds).

Also requires annual notices of any preferential terms granted since the most recent prior notice.

Initially proposed as outright prohibitions, preferential redemption and information rights are now permitted if required by applicable law (redemption rights only) or offered to all other investors (redemption and information rights). The SEC also added the grandfathering provision described herein.

Timing of notice delivery has also been changed, providing for post-closing delivery of notice regarding preferential rights that are not than material economic rights (as described herein).

Carve-Out For Advisers To Securitized Asset Funds As adopted, none of the Rules (other than the amended Compliance Rule) will apply to any advisers to the extent that they advise securitized asset funds (i.e., similarly to the definition appearing in Form PF and Form ADV, securitization vehicles or vehicles that issue asset-backed securities and whose investors are primarily debt holders). This carve-out would apply whether the adviser is registered or exempt. However, the carve-out would not extend to an adviser’s activities in advising other types of funds that are not securitized asset funds, in which case the Rules would apply to any non-securitized asset fund activities. In addition, such advisers (if RIAs) would remain subject to the amended Compliance Rule.
Carve-Out For “Offshore Advisers” Advising Non-U.S. Domiciled Funds Confirming and clarifying a carve-out initially proposed in the Proposing Release, the SEC notes that none of the Rules (other than the amended Compliance Rule) will apply to advisers that have their principal office and place of business outside the United States (“offshore advisers”) to the extent that they advise non-U.S. domiciled funds. This carve-out would apply whether the adviser is registered or exempt (e.g., as a non-U.S. ERA, or by relying on the foreign private adviser exemption). However, the carve-out would not extend to an offshore adviser’s activities in advising any U.S. domiciled funds (e.g., a Delaware limited partnership), in which case the Rules would apply to any U.S. domiciled fund activities.  In addition, offshore advisers (if RIAs) would remain subject to the amended Compliance Rule.
Grandfathering for Certain “Legacy” Agreements The Restricted Activities Rule and the Preferential Treatment Rule provide for grandfathering with respect to certain of the Rules’ provisions for any “legacy” contractual agreements that govern the fund (e.g., fund limited partnership agreement, subscription agreements and side letters) or that govern any borrowing, loan, or extension of credit entered into by a fund, if the agreements were entered into prior to the Compliance Date.  Specifically:
  • Legacy agreements relating to a fund bearing investigation-related expenses, or to the adviser lending to or borrowing from a fund, will be grandfathered without the need to obtain investor consent, other than agreements permitting a fund to bear expenses relating to “sanctioned matters”, as described above, which are not grandfathered.
  • Legacy preferential redemption or information rights are grandfathered without a need to offer them to other investors. However, grandfathered terms must still be disclosed pursuant to the notice provisions described above.
Proposed Provisions That Were Not Adopted

Prohibition on Limiting or Eliminating Liability:  The SEC had initially proposed to prohibit an adviser to a private fund, directly or indirectly, from seeking reimbursement, indemnification, exculpation, or limitation of its liability by the private fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness in providing services to the private fund. Instead, the SEC took the opportunity in the Adopting Release to “reaffirm and clarify” its views on how an adviser’s fiduciary duty applies to its private fund clients and how the antifraud provisions apply to the adviser’s dealings with clients and fund investors. The SEC’s statements largely repeat its earlier guidance from its 2019 Interpretive Release on investment adviser fiduciary duties, and highlight certain related observations by the staff of the Examination Division as well as a recent instance in which the SEC applied those principles in a settled enforcement action. However, in closing on the topic of waivers of liability in fund governing agreements, the SEC noted that “to the extent that a waiver clause is unclear as to whether it applies to the Federal fiduciary duty, State fiduciary duties, or both, we will interpret the clause as waiving the Federal fiduciary duty”, and therefore as a breach of the Advisers Act.

Prohibition on Fees for Services Not Performed: The SEC had initially proposed to prohibit an adviser from charging fees to a fund or to a portfolio investment without providing corresponding services (e.g., prepaid fund management fees where advisory services are performed for only part of the relevant period or accelerated monitoring fees payable to a private equity fund adviser). In the Adopting Release, the SEC noted that it had determined that it was unnecessary to include such a prohibition by Rule “because such activity already is inconsistent with the adviser’s fiduciary duty”. The SEC is therefore likely to treat this as a de facto prohibited practice even absent a specific Rule.

“Illiquid Funds” vs. “Liquid Funds”

The definition of “illiquid fund”, as used throughout these Rules, was simplified to a two-factor test from the initially proposed six-factor test. It is now defined to mean any private fund in which investors (i) do not have the right to request redemptions and (ii) have limited opportunities to withdraw before the fund’s termination (formerly factors (iii) and (v) from the proposed version).

As under the initially proposed version, the final definition of “liquid fund” means any private fund that is not an illiquid fund.

Transition Periods The transition periods noted above will be measured from the date of the Rules’ publication in the Federal Register. While there is no set timeframe in which an Adopting Release’s publication must occur, it has historically ranged from several weeks to 30 days or more from the date of adoption.

 


Second Circuit Holds That the Syndicated Term Loans in Kirschner Are Not Securities

0
0

On August 24, 2023, the Second Circuit Court of Appeals issued its much-anticipated decision in Kirschner v. JP Morgan Chase Bank, holding that the syndicate term loans at issue were not securities. As noted in our earlier blog post, the SEC declined the court’s request to file an amicus brief, forgoing the opportunity to provide its views on the issue and influence the outcome of the appeal.[1]

In affirming the district court’s dismissal of the plaintiff’s state-law securities claims, the court applied the four-factor “family resemblance” test previously established by the Second Circuit and later adopted by the U.S. Supreme Court in Reves v. Ernst & Young. While the court recognized that the lenders’ motivation was investment given their expectation of profit from their purchase of the notes (a factor weighing in favor of the notes being a securities), the court was persuaded by the other three factors under Reves that weighed against concluding that the notes were securities.

  • First, in examining the plan of distribution, the court found that the notes were not offered and sold to a broad segment of the public. While there was a secondary market, the notes were generally unavailable to the general public by virtue of restrictions on assignments of the notes.
  • Second, in assessing the reasonable expectations of the public, the court found that the lenders were sophisticated and experienced institutional entities with ample notice that the notes were not securities.
  • Finally, in evaluating the presence of other risk-reducing factors, the court concluded that the protection afforded by the application of the securities laws was unnecessary. The court relied on the notes being secured by collateral and the bank regulators’ issuance of specific policy guidance addressing syndicated loans.

The decision itself is not all that surprising, especially given the precedent established by Second Circuit over thirty years ago in Banco Espanol de Credito v. Nat. Bank. But the decision does illustrate how the determination of whether a note will be deemed a security ultimately is a facts and circumstances test and that under different circumstances, a particular debt instrument could be held to be a security.

_____________________

[1] The Second Circuit noted in a footnote the SEC’s decision not to file a brief “[a]fter receiving several extensions of time to file its response to our invitation to provide its views on this question . . . .” Id. at 37 n. 117.

Lawsuit Challenges Private Fund Adviser Rules

0
0

On Friday, September 1, 2023, a lawsuit was filed with the federal Court of Appeals in the Fifth Circuit challenging the validity and enforceability of the recently adopted Private Fund Adviser Rules under the Investment Advisers Act of 1940 (the “Advisers Act”).  (Please see our prior alerts for a description of the Rules’ provisions and their applicability to non-U.S. investment advisers.)  The lawsuit was filed in the form of a Petition for Review pursuant to Section 213(a) of the Advisers Act, which authorizes such a petition for persons “aggrieved” by the actions of the Securities and Exchange Commission (the “Commission” or the “SEC”).

The Petition asserts that the new Rules “exceed the Commission’s statutory authority, were adopted without compliance with notice-and-comment requirements, and are otherwise arbitrary, capricious, an abuse of discretion, and contrary to law, all in violation of the Administrative Procedure Act…and of the Commission’s heightened obligation to consider its rules’ effects on ‘efficiency, competition, and capital formation’” in violation of requirements for SEC rulemaking under the Advisers Act.

The filing of such a lawsuit does not automatically pause the Rules’ transition periods or otherwise delay their compliance dates.  However, such a stay of the rules may be requested or granted, either by court order as part of the proceedings or as otherwise determined by the SEC.

The Petition was submitted jointly by six trade associations:

Each organization’s statement on the lawsuit is available at the above links.

Petitions for Review challenging other federal rules have on other occasions been filed in the D.C. Circuit, but that is not the exclusive venue in which such Petitions may be filed. Here, the Petition asserts that the basis for jurisdiction and venue are proper “because the petition challenges ‘an order issued by the Commission under [the Investment Advisers Act]’ and one or more petitioners ‘reside[ ] or’ have their ‘principal office or place of business’ in this Circuit” – which presumably is a reference to the National Association of Private Fund Managers, whose location in Texas permits the lawsuit to be heard by a federal appeals court that in recent years has been more friendly to challenges of federal regulations than has the D.C. Circuit.

The filing of the Petition is just the first step. The trade associations and the SEC will file briefs laying out their arguments later this fall. We, along with the rest of the private fund community, will be watching as the court considers the arguments.

The Countdown Starts: Compliance Dates Set for Private Fund Adviser Rules

0
0

Earlier today, the SEC’s Private Fund Adviser Rules were published in the Federal Register. As with all federal regulations, publication in the Federal Register begins the countdown to the Rules’ compliance dates. These dates are listed in the table below. Please see our prior alerts for an overview of the Rules’ provisions, a summary of their applicability to non-U.S. investment advisers and a discussion of a legal challenge to the Rules that was recently filed by six trade associations.

Rule Compliance Date
Compliance Rule Amendments [RIAs only] Monday, November 13, 2023
[60 days after publication]
“Larger” Private Fund Advisers ($1.5BN or more):

Adviser-Led Secondaries Rule [RIAs only]
Restricted Activities Rule [all advisers]
Preferential Treatment Rule [all advisers]

Saturday, September 14, 2024
[12 months after publication]
“Smaller” Private Fund Advisers (under $1.5BN):

Adviser-Led Secondaries Rule [RIAs only]
Restricted Activities Rule [all advisers]
Preferential Treatment Rule [all advisers]

Friday, March 14, 2025
[18 months after publication]
Quarterly Statement Rule [RIAs only]
Private Fund Audit Rule [RIAs only]
Friday, March 14, 2025
[18 months after publication]

 

Words Matter: Three Key Steps to Mitigate SEC Enforcement Risks Relating to Whistleblower Carveout Language

0
0

Since 2015, the SEC has brought nearly two dozen enforcement actions for violations of the whistleblower protection rules under Rule 21F-17(a) against employers for actions taken to impede reporting to the SEC. The bulk of these actions have focused on language in employee-facing agreements that allegedly discouraged such reporting. The SEC shows no sign of slowing down; indeed, the Commission has brought five enforcement actions in this past fiscal year alone, and the penalties imposed for these violations appear to be increasing. The settlements – and the risk they represent – serve as a reminder for companies to review their existing employment documents and internal policies, including confidentiality policies, to ensure that restrictive language is removed and that appropriate whistleblower carveout language is included. Conducting this review, and making any appropriate changes, will help ensure compliance with Rule 21F-17(a).

  1. Identify Types of Agreements Subject to Rule

The majority of SEC actions alleging violations of Rule 21F-17(a) involve employee/employer relationships, and specifically focus on agreements that contain restrictive language deemed to impede SEC reporting. The types of agreements include employment agreements, severance agreements, non-disclosure agreements, release agreements, and other confidentiality agreements. Those are hardly the only sources of potentially restrictive – and sanctionable – language. The SEC has warned companies that improperly restrictive language may also be included in a company’s internal policies, procedures, and guidance, such as codes of conduct, compliance manuals, training materials, and other such documents.

Of course, employers are not the only ones who may run afoul of Rule 21F-17(a). The Rule is broader and not limited to employer/employee agreements and policies. For example, the SEC has brought actions involving agreements presented to customers and investors. The SEC has also brought actions against an employee who sought to impede a fellow employee’s reporting.

  1. Amend Restrictive Language that Could be Violative

In settlements to date, the SEC has focused on a variety of provisions that have been found to impede whistleblowers from reporting violations:

  • Release stating that the individual would not discuss the matter with FINRA, the SEC, or anyone else.
  • Language stating that the employee was “waiving your right to any monetary recovery or other individual relief” in connection with any charge or complaint filed with governmental agencies.
  • Separation agreement providing that reporting to administrative agencies was allowed, “but only if I notify the Company of a disclosure obligation or request within one business day after I learn of it and permit the Company to take all steps it deems to be appropriate to prevent or limit the required disclosure.”
  • Separation or similar agreements requiring the employee to certify that they had “not filed any complaint or charges against [the company], or any of its respective subsidiaries, affiliates, divisions, predecessors, successors, officers, directors, shareholders, employees, representatives or agents…with any state or federal court or local, state or federal agency.”
  • Separation agreements providing that employees would not “at any time in the future voluntarily contact or participate with any governmental agency in connection with any complaint or investigation pertaining to the Company, and [may] not be employed or otherwise act as an expert witness or consultant or in any similar paid capacity in any litigation, arbitration, regulatory or agency hearing or other adversarial or investigatory proceeding involving the Company.”
  • Compliance policy language stating that employees are “strictly prohibited from initiating contact with any Regulator without prior approval from the Legal or Compliance Department.”
  • Employee confidentiality agreements broadly defining “Confidential Information” to include all company financial information and financial reports and imposing a liquidated damages provision for violations, where the agreements did not also include “whistleblower carve-out” language.
  • A settlement agreement with investors that required confirmation that investors and their counsel have not contacted, and would not in the future contact, the SEC or other governmental agencies concerning matters in the agreement.

SEC settlements have also focused on contradictory language within a particular agreement itself or conflicts between different agreements or policies. For example, the SEC has alleged a Rule 21F-17(a) violation where a company’s compliance manual and compliance training material specifically prohibited employees from initiating contact with any regulator without prior approval from the legal or compliance department, even though the company’s code of conduct permitted employees to report to the government about possible violations of law.  The SEC has brought cases regardless of whether there was evidence that any employees had actually been impeded from reporting as a result of the restrictive language.

  1. Add Remedial Language that Has Been Cited with Approval

The SEC has also, by implication through its settlements, noted language that facially complies with Rule 21F-17. Examples of whistleblower carveout language that the SEC has cited with approval include the following:

  • Nothing in this Section shall be construed or deemed to interfere with any protected right to file a charge or complaint with any applicable federal, state or local governmental administrative agency charged with enforcement of any law, or with any protected right to participate in an investigation or proceeding conducted by such administrative agency, or to recover any award offered by such administrative agency associated with such charge or complaint.”
  • Nothing in this policy or any other Company policy or agreement is intended to prohibit you (with or without prior notice to the Company) from reporting to or participating in an investigation with a government agency or authority about a possible violation of law, or from making other disclosures protected by applicable whistleblower statutes.”
  • Where restrictive confidentiality provisions exist: “Employee can provide confidential information to Government Agencies without risk of being held liable for liquidated damages or other financial penalties.”

Implications for Employers and Others Subject to Rule

Employers and other companies subject to the requirements of Rule 21F-17 should take note of the SEC’s enforcement actions. These actions emphasize the SEC’s continued focus on identifying Rule violations and protecting potential whistleblowers, even in the absence of affirmative acts to impede reporting. As a result, companies should revisit and carefully examine policies and employment-related agreements that address confidentiality to ensure that restrictions and carveouts promote compliance with Rule 21F-17. Even a minor deviance from the SEC’s recommended verbiage could result in a costly enforcement action – scrutiny which may be avoided by closely hueing to language the SEC has previously approved in other enforcement actions.

2023 SEC Enforcement Results – Takeaways for Fund Managers

0
0

On November 14, 2023, the SEC’s Division of Enforcement announced its Enforcement Results for Fiscal Year 2023.  Below are some key takeaways for fund managers:

  • The Commission brought 760 total enforcement actions in FY 2023, which represents a 3% increase over FY 2022. The SEC also filed 501 new standalone enforcement actions, representing an 8% increase over the prior year.
  • The SEC obtained orders and judgments for over $4.9 billion in disgorgement and penalties, the second highest amount in its history. This number was second only to last year’s $6.4 billion (which notably included several sizable settlements against large broker-dealers in the SEC’s off-channel messaging sweep).
  • Overall, 18% of the SEC’s actions this year involved either investment advisers or investment companies, which is roughly in line with last year’s 23%. Over the past eight years, actions involving investment advisers/investment companies have consistently comprised the highest or next highest percentage of total SEC matters by category.
  • With respect to the SEC’s Whistleblower Program, the Commission set several noteworthy records this year. Namely, the SEC received a record number of whistleblower tips, awarded a record number of whistleblower awards, and awarded the largest ever award of nearly $279 million to a single whistleblower.  In addition, the SEC imposed a record-high $10 million penalty against a private fund manager for violations under Rule 21F-17, which prohibits impediments to whistleblowing.
  • The SEC highlighted its “initiative investigating noncompliance with the Marketing Rule,” which resulted in nine investment advisers being charged with violations relating to hypothetical performance.
  • The SEC emphasized several high-profile actions involving recordkeeping, reporting and other compliance related violations “targeting misconduct that undermines its effective oversight of the securities industry.” The SEC imposed significant civil penalties in these actions against regulated entities and issuers despite the absence of any allegations of investor harm.
  • The SEC further highlighted multiple enforcement actions addressing ESG issues, including cases involving misstatements made during the marketing of ESG-branded investment products.
  • The SEC came down especially hard on crypto-related matters this year, filing charges against a host of crypto exchanges, lending/staking products, and other intermediaries. The SEC brought several high-profile litigated matters that will challenge the scope of its regulatory authority in the crypto space.  This is part of a growing willingness on the part of the SEC to litigate matters when necessary. More than 40 percent of the standalone matters for FY 2023 were filed in whole or in part as litigated actions, against both entities and individuals.

Enforcement Actions Filed in Fiscal Years 2018 to 2023

  FY 2023 FY 2022 FY 2021 FY 2020 FY 2019 FY 2018
Disgorgement and Penalties Ordered (in billions) $4.949 $6.44 $3.80 $4.68 $4.35 $3.95
Total Actions 784 760 697 715 862 821
% of Total Actions Involving Investment Advisers / Investment Companies 18% 23% 23%

19%

 

29% 21%

These results demonstrate an SEC that has been active on the enforcement front.  The SEC’s Enforcement Director noted earlier this year that private funds were a “substantive priority area” for the division, specifically noting concerns about potential conflicts of interest and fee and expense issues.  Moreover, in over the past two years the SEC has pushed an aggressive slate of rulemaking affecting the private funds industry that impose new restrictions and arm regulators with additional tools to identify, exam and investigate market practices.  As 2024 begins, we expect to see more scrutiny of private fund managers, as the SEC takes steps to enforce the new rules and the principles it has espoused in its rulemaking—for example, focused on fiduciary obligations of private fund managers.

SEC Approves Exchange Listing Applications for Spot Bitcoin ETPs

0
0

The SEC issued an order approving the applications of 11 different spot Bitcoin exchange-traded products to each list and trade their shares on a national securities exchange. This order represents the first time that the SEC has permitted the listing of an exchange-traded product that invests directly in a cryptocurrency – here, Bitcoin.

Read the full client alert here.

SEC Settlement Highlights Risks for 13G Filers When Moving from Passive to Active Status

0
0

The SEC’s recent enforcement settlement involving a fund manager highlights the SEC’s focus on an investor’s “control purpose” triggering the requirement to file on a Schedule 13D as opposed to a short-form 13G. At issue was HG Vora Capital Management’s 5% interest in a public company, and whether it had complied with its obligations to supersede its existing filing with a long-form Schedule 13D filing within 10 days of no longer being “passive.”

Read the full post on the Regulatory & Compliance blog.


Top Ten Regulatory and Litigation Risks for Private Funds in 2024

0
0

To understand the litigation and regulatory risks that are coming in 2024 for private capital, it is helpful to look back briefly on recent events. Arguably, the single most important event over the last 18 months was the rapid increase in interest rates by the central banks in the United States, England, and Europe. From March 2022 to August 2023, the Federal Reserve increased interest rates at the fastest clip in more than 40 years, to break inflation that had reached the highest levels since the 1970s.

These actions had a profound impact on the private capital markets. Activity declined across the entire private capital landscape, with slowing capital formation and investment. The cryptocurrency market collapsed in the second half of 2022. Meanwhile, fundraising slowed dramatically in 2023. IPO activity also slowed to its slowest pace in over four years. M&A activity declined, resulting in fewer lending deals for private credit. Technology-focused funds and their portfolio companies, in particular, faced significant challenges, as operating costs increased, the cost of capital increased, and multiples declined. Meanwhile, default rates on loans started to increase, with fewer options for refinancings, as interest rates increased and business fundamentals weakened. In short, the entire private capital market was adjusting to the volatile shift from a low interest rate, high growth environment to a high interest rate, slower growth environment.

At the same time, there were positive signs in the broader economy, especially more recently, including strong employment indicators and declining inflation. The public release of ChatGPT4 in late 2022 fueled intense interest in AI, leading to a new technology investment cycle reminiscent of the early days of the internet following the release of Netscape Navigator in 1994. In addition, the stock market boomed – not only as a result of exuberance over AI, but also with the prospect of a soft-landing and interest rate cuts in 2024.

Higher interest rates and operating costs will put stress on certain portfolio companies, with controversies over layoffs and liquidations, putting pressure on boards and sponsor appointed directors (see our Portfolio Company Playbook). That said, there is a lot of dry powder to make new investments and geopolitical events have driven interest in defense tech and related sectors.

Alongside the macro-economic factors, asset managers must grapple with an ever-evolving regulatory landscape as new regulations over past years, and in development, will lead to increased enforcement activity.

With this backdrop, we are pleased to present the Top Ten Regulatory and Litigation Risks for Private Funds in 2024. We will be publishing a series of posts on each of these topics in the weeks ahead.

  1. Examining the SEC’s Slew of Recent Rules and Amendments
  2. Ongoing Capital Challenges Portend Continued Portfolio Company Litigation Risk in 2024
  3. ESG In 2024: Traps for The Unwary
  4. SEC and FCA Focus on Artificial Intelligence
  5. A Defensive Play? How Government Policy Hopes to Stimulate Private Investment In Defense Tech And The Security Ecosystem
  6. SEC Focus on Adviser-Led Secondaries Continues
  7. Not Off the Hook: The SEC Addresses its Position on Exculpation And Indemnification For Private Fund Advisers
  8. Cybersecurity Is A Focal Point For The SEC In 2024
  9. The Macro-Economic Environment: What It Means for VC Firms
  10. AI Investment: Is It a Bubble?

Examining the SEC’s Slew of Recent Rules and Amendments

0
0

In a wave of SEC rulemaking this past year, representing a “new world order” event akin to Dodd-Frank, the SEC has provided itself with a fresh set of tools to increase regulatory and enforcement scrutiny on private funds. Among other things, certain of the rules could result in fundamental changes to market practices and greater disclosure to LPs. While ongoing litigation will determine the fates of the Private Fund Adviser Rules, the Short Sale Disclosure Rule, and the Securities Lending Rule, and while other rules are awaiting final adoption, the SEC concerns underlying the rulemaking will continue regardless.   

In fact, many of the new rules concern longstanding focus areas of Exams and Enforcement, including what the SEC has identified as problematic practices by private fund advisers arising from conflicts of interest, insufficient transparency, and a lack of effective governance mechanisms. The SEC’s Enforcement Director noted earlier in 2023 that private funds were a “substantive priority area” for the division, and last year the SEC brought a number of cases relating to these core issues. However, many of the rules give the SEC new requirements to examine and new devices with which to investigate them, and advisers face far more opportunities for “foot faults” in failing to comply with the new rules or to adopt reasonably designed compliance policies. The new rules impose many new obligations and introduce new restrictions that are likely to significantly alter business practices, and impose new administrative burdens and costs, across many registered and exempt private fund advisers.

While compliance dates stretch into the future, increased scrutiny in these areas is already happening (pre-compliance dates). Given the pending industry legal challenges to the scope of the new rules and claims of SEC overreach, the SEC staff is under pressure to look for examples of conduct that justify the rulemaking.  Even if the scope of the new rules is scaled back because of legal challenges, these areas will continue to be a focus of future examinations and investigations.

Many of the new rules require advisers to provide greater disclosure of market practices to the SEC.  These rule changes provide the SEC with enhanced tools to assess systemic risk and monitor market trends, and will inform future examinations, enforcement investigations and targeting of risk areas.

Certain notable rules that have been adopted to date, chronologically:

Adopted RuleCompliance Date
The Marketing RuleMandatory as of November 4, 2022.
Form PF Reporting RulesPartially effective and mandatory as of December 11, 2023, with certain compliance dates in 2024.
*Private Fund Adviser Rules  Effective as of November 13, 2023; compliance dates vary.
Amendments to Section 13(d) and 13(g) Reporting RuleAdopted October 10, 2023; compliance dates vary.
*Short Sale Disclosure RuleAdopted October 13, 2023; compliance dates vary.
*These rules are presently being challenged in the Fifth Circuit.

The key proposed Rules impacting private fund advisers that have not yet been adopted, chronologically:

Proposed RuleInitial Proposal Date
Cybersecurity RuleFebruary 9, 2022
ESG Reporting and Disclosure RequirementsMay 25, 2022
Outsourcing RuleOctober 26, 2022
Safeguarding RuleProposed February 15, 2023; comment period reopened August 23, 2023
Amendments to Regulation S-PMarch 15, 2023
Conflicts of Interest and Predictive Data Analytics RuleJuly 26, 2023

The SEC exam/enforcement approach is likely to mirror what we have already seen with respect to the new Marketing Rule, which went into effect in 2022:

  • Last year, SEC examinations focused on basic compliance with the rule, including: changes to policies and procedures and any new employee training in response to the rule, review and approval process for marketing materials, substantiation of material facts (and related back-up) and compliance with the rule’s requirements with respect to performance advertising, testimonials and endorsements and third-party ratings.
  • In September 2023, the SEC announced the results of an enforcement sweep focused on the Marketing Rule and its limitations on advertising hypothetical performance, leading to settled orders against nine registered investment advisers, all involving the use of hypothetical investment performance that was published on the advisers’ public websites rather than to a particular intended audience.

It remains to be seen what will happen with respect to the other rules, some of whose effective dates are quickly approaching. But based on SEC activity after the Marketing Rule’s compliance date, it seems likely that each of the new rules will bring about more regulatory enforcement actions. And due to the lack of precedent in applying certain aspects of the new rules, it may take time to iron out the interpretation of specific provisions. Fund manager practices and documentation will likely need to be examined before the rules’ varying compliance dates with this uncertainty in mind, changing practices as needed in response to the SEC’s application of these new rules in exams and enforcement.

Read more of our Top Ten Regulatory and Litigation Risks for Private Funds in 2024.





Latest Images