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Last month, the SEC proposed rules under the Advisor Act indicating a step change in how the SEC intends to reduce conflicts of interest involving private fund managers and their investors. As we noted earlier in the context of increased disclosure obligations, the SEC’s recent approach heralds a sea change redefining the relationship between private fund managers and their investors. For decades, the SEC has sought to resolve potential conflicts through a combination of disclosure and informed consent, given the sophisticated nature of private fund sponsors. However, the SEC’s proposal now builds on this approach, concluding that some fund manager practices are inherently conflicting and therefore in some cases require the fund manager to take specific actions, or in other cases need to be categorically prohibited. As the SEC said in its proposed release, “We have observed certain industry practices over the past decade that have persisted despite our enforcement actions and that disclosure alone will not be enough to address. adequately.”
The SEC’s focus on conflicts of interest is nothing new and is an ongoing focus of the Enforcement Division and the Examinations Division. Under the anti-fraud provisions of the Advisors Act and related fiduciary duties, investment advisors must “eliminate or at least expose by full and fair disclosure ‘all conflicts’ which might incline an investment advisor, knowingly or unknowingly , to give advice that is not disinterested”. For fund managers, any financial determination or allocation involving the manager and the client (that is to say fund) has the potential to be considered a conflict, requiring proper disclosure and consent. Now, however, the SEC is taking the position that there are certain conflicts that private equity investors cannot consent to, no matter how well disclosed.
For example, the proposed SEC rules contain requirements and prohibitions on the following:
- Mandatory: quarterly reports. The proposed rules would require all SEC-registered fund managers to provide quarterly reports to all investors on: (i) fund-level advisor compensation, fees/expenses, and compensation, itemized and referencing relevant sections of the governing documents; (ii) investment advisor compensation at the investment level, again broken down in detail by investment; and (iii) investment performance at the fund level, on a normalized basis. The SEC’s objective with this proposal is twofold: to provide sufficient transparency to enable investors to monitor and control the expenses they incur, and to provide a basis for comparison of investment performance for investors in different funds.
- Required: Fairness Opinions in Advisor-Led Secondary Transactions. The proposed rules would also require all SEC-registered fund managers to obtain a fairness opinion in all adviser-led secondary transactions (which would include most general partner-led fund restructurings, as well as takeover bids and other types of secondary transactions). The fund manager will also be required to provide all investors with a list of all material business relationships between the fund manager and the opinion provider (and their respective affiliates).
- Prohibited: expedited monitoring fees. The proposed rules would prohibit these and other fees for services that are not provided to a holding company. Historically, enforcement has focused on whether the manager has adequately disclosed that it could accelerate future monitoring fees.
- Prohibited: Charging the fund for regulatory or compliance expenses. The proposed rules would also prohibit the attribution to a fund of the regulatory or compliance costs of the adviser or its related persons. This prohibition is not limited to investigations or reviews by the SEC. It would also prohibit the awarding of start-up and registration compliance fees for new fund managers.
- Prohibited: seek exculpation or compensation for simple negligence (or worse). The proposed rules would also prohibit any fund manager from seeking exculpation or compensation for negligence, recklessness, breach of fiduciary duty, willful misconduct or bad faith, in the performance of services to a private fund.
- Prohibited: reduce the recovery of general practitioners for taxes. The Proposed Rules would also prohibit reducing the General Partner’s recoveries by the amount of any actual, potential or hypothetical taxes. This proposal runs counter to established and long-standing conventions in the private fund space.
- Prohibited: Extensions of credit to the fund manager: The proposed rules would also prohibit borrowing or receiving an extension of credit from a customer, although it is unclear how the prohibition would affect typical conditions for advancement/compensation of private funds that might be considered a credit extension.
- Prohibited: Disproportionate allocation of expenses related to the transaction. The proposed rules would also prohibit disproportionate allocations of transaction-related expenses and fees between funds and co-investment vehicles participating in the transaction. In particular, this proposal aims to ensure that the co-investors bear a proportionate share of the expenses related to the broken agreement. Significantly, the SEC recognizes that some co-investors may engage in a transaction but refuse to be contractually obligated to bear the broken transaction costs, which would leave the manager itself as the only remaining party to bear these expenses.
- Prohibited: certain preferential treatment: The proposed rules would also prohibit all instances of preferential treatment for private fund investors regarding: (i) redemptions or other liquidity rights and (ii) information rights relating to the fund’s portfolio, in each case in the extent that the rights could have a material adverse impact on other investors in the fund, and would prohibit other types of preferential treatment (for example. fee terms) unless fully and specifically disclosed to all prospective investors and with annual updates. These provisions are often found in side letters requested by some investors, which may be negotiated at the same time or even after other investors have already committed to the fund. Importantly, the SEC expects these disclosures to be made before investors invest in the fund, which could pose significant logistical challenges for fund managers before an initial close given the fluidity of negotiations with investors in the fund. this context.
As we have noted, many of the previous proposals deviate from past SEC practice, which historically focused on the clarity (or lack thereof) of information to be provided to investors prior to engagement. A number of these proposals also run counter to long-standing commercial norms, limiting freedom of contract between advisers and investors, however sophisticated or well-represented those investors may be. If adopted, they would lead to significant changes in the way private fund managers conduct their business and interact with their investors.
These proposals also serve as a clear indication of the SEC’s review and focus on enforcement going forward, regardless of what form the final rules take. The issues and practices addressed by these proposals have been the focus of the SEC’s Examination Division and Enforcement Division for the past decade. This proposal therefore serves as an indication of what they are likely to focus their attention on in the future.
Conflicts of Interest: How High Will the Bar Be Raised?
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