Broker-Dealer and Investment Adviser Counseling Archives

There has been a dearth of Commission enforcement actions relating to Reg BI since the rule became effective in June 2020. This action for ordinary conflict of interest concerns, and another from February, may signal a more active Reg BI enforcement regime moving forward.

On May 21, 2024, the Securities and Exchange Commission (the “SEC” or the “Commission”) entered an administrative cease and desist order (the “Order”)[1] against a dually-registered broker-dealer and investment adviser (the “BD/RIA” or “Firm”) concerning “failures . . . to address conflicts of interest in compliance with Regulation Best Interest (“Reg BI”) and the [Investment Advisers Act of 1940 (“Advisers Act”)].” In particular, the Firm’s representatives recommended that clients “transfer securities . . . to new investment accounts” at the Firm’s affiliated private bank without disclosing that the representatives would be compensated for the recommendations and resulting transfers.

There has been a dearth of Commission enforcement actions relating to Reg BI since the rule became effective in June 2020. The Commission thus far has seemed content to leave enforcement to FINRA, which has settled approximately 30 Reg BI enforcement matters since 2020. This action for ordinary conflict of interest concerns, and another from February[2], are indicative of a more active SEC Reg BI enforcement regime moving forward.

The Order states that the Firm, through its representatives, “recommended that certain of its brokerage customers and advisory clients transfer securities . . . to new investment accounts” with an affiliated “wealth management firm that is part of the same parent organization.” The BD/RIA paid a “finders’ fee” to representatives that made “three or more customer referrals” in a quarter, and an “additional annual fee based on the value of any securities and other assets that were transferred.” The SEC found that the BD/RIA “did not disclose in writing that the representatives were acting as associated persons of [BD/RIA] when they made the transfer recommendations, or that the representatives would receive compensation . . . for making the recommendations, or the conflict of interest associated with the transfer recommendation.”

The Firm’s written broker-dealer Reg BI policies required the Firm to periodically review and evaluate conflicts, disclose all conflicts, and review and update disclosures. But, according to the Order, the policies failed to specify how registered representatives (“RR”) and supervisors could “identify, review, or address conflicts of interest related to the receipt of finders’ fees and annual fees,” or (2) “provide a mechanism for the [F]irm to identify and disclose . . . to retail customers that [RRs] . . . would receive finders’ fees and annual fees.”

Similarly, the SEC found that the Firm’s investment adviser “had written policies and procedures that required disclosure of all conflicts of interest to its advisory clients, however, this policy did not require any disclosure of compensation related to the account referrals and securities transfers.”

The Enforcement action apparently followed from a referral from the Division of Examinations (“Examinations”). The Order states that Examinations issued a deficiency letter “concerning the [F]irm’s lack of compliance with Regulation BI” and that the Firm quickly “addressed the deficiencies . . . by adopting new written policies and procedures related to the disclosure of conflicts of interest concerning . . . recommendations of securities transfers to its affiliates.” Nonetheless, it also resulted in a settled order, in which the Firm agreed to (1) pay a civil penalty of $223,228 and (2) neither admit nor deny findings that it (a) “failed to satisfy the General Obligation of Regulation BI by failing to comply with the Disclosure Obligation, Conflict of Interest Obligation, and Compliance Obligation,” in violation of Rule 15l-1(a) under the Exchange Act, and (b) “violated” Sections 206(2) and 206(4) of the Advisers Act and Rule 206(4)-7 thereunder, the latter of which requires that investment advisers “adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules.”

Analysis & Takeaways

This action is likely only the beginning of enforcement actions following from the SEC’s increased Reg BI enforcement focus, particularly on the conflicts and duty of care elements of the Rule.

The Order reflects an SEC expectation that Reg BI policies:
- Explain “how” to identify and address conflicts of interest related to compensation for product recommendations, and
- Provide a “mechanism” to identify and disclose conflicts of interest related to compensation for product recommendations.
Dual registrants may be particularly compelling targets for Reg BI enforcement so that the SEC can make side-by-side findings, one under the Advisers Act and the other under the Exchange Act (Reg BI), with respect to the same conduct by dual-hatted representatives implicating both regulatory regimes. This will enable the Commission to add settled enforcement actions as “precedent” to support the Staff’s FAQs on Reg BI, which arguably seek to substantially expand the scope of the Rule, in part by conflating the distinct roles of financial advisors when acting on behalf of the investment adviser versus the broker-dealer.

__________

[1] Order Instituting Administrative and Cease-and-Desist Proceedings, Pursuant to Sections 15(b) and 21C of the Securities Exchange Act of 1934 and sections 203(e) and 203(k) of the Investment Advisers Act of 1940, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order, Release No. 100186 (May 21, 2024), available at https://www.sec.gov/files/litigation/admin/2024/34-100186.pdf.

[2] On February 16, 2024, the SEC entered an administrative cease and desist order against a dually-registered broker-dealer and investment adviser for Reg BI disclosure, care, and compliance violations for recommending to retail clients its “core menu funds” that “earned higher fees” without disclosing “substantially equivalent, lower-cost share classes of affiliated funds.” See https://www.sec.gov/news/press-release/2024-22.

The following Gibson Dunn lawyers assisted in preparing this update: Lauren Jackson, Tina Samanta, Jon Seibald, Mark Schonfeld, David Woodcock, Tim Zimmerman, and Bryan Clegg.

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding the issues and considerations discussed above. Please contact the Gibson Dunn lawyer with whom you usually work, any leader or member of the firm’s Securities Enforcement practice group, or the authors:

Lauren Jackson – Washington, D.C. (+1 202.955.8293, ljackson@gibsondunn.com)
Tina Samanta – New York (+1 212.351.2469, tsamanta@gibsondunn.com)
Jon Seibald – New York (+1 212.351.3916, mseibald@gibsondunn.com)
Mark K. Schonfeld – Co-Chair, New York (+1 212.351.2433, mschonfeld@gibsondunn.com)
David Woodcock – Co-Chair, Dallas (+1 214.698.3211, dwoodcock@gibsondunn.com)
Timothy M. Zimmerman – Denver (+1 303.298.5721, tzimmerman@gibsondunn.com)
Bryan Clegg – Dallas (+1 214.698.3365, bclegg@gibsondunn.com)

Attorney Advertising: These materials were prepared for general informational purposes only based on information available at the time of publication and are not intended as, do not constitute, and should not be relied upon as, legal advice or a legal opinion on any specific facts or circumstances. Gibson Dunn (and its affiliates, attorneys, and employees) shall not have any liability in connection with any use of these materials. The sharing of these materials does not establish an attorney-client relationship with the recipient and should not be relied upon as an alternative for advice from qualified counsel. Please note that facts and circumstances may vary, and prior results do not guarantee a similar outcome.

On October 16, 2023, the U.S. Securities and Exchange Commission’s (the “SEC”) Division of Examinations released its 2024 examination priorities for the upcoming year (the “2024 Priorities”).[1] The publication of the 2024 Priorities comes at an important time in light of the final rules that the SEC adopted under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), in August of this year, which modify the inner workings of private funds and their sponsors by, among other things, restricting or requiring extensive disclosure of preferential treatment granted to investors, as well as imposing numerous additional reporting and other compliance requirements (the “New Private Funds Rules”).[2]

As anticipated, the 2024 Priorities further emphasize the SEC’s stated mission to increase “transparency into the examination program.” While the 2024 Priorities cover other important topics, we have highlighted the following key priorities that impact our private fund adviser clients and provided our analysis alongside them. We note that the following is not an exhaustive list of key priorities and is subject to change.

SEC Priority	GDC Analysis
The portfolio management risks present when there is exposure to recent market volatility and higher interest rates. This may include private funds experiencing poor performance, significant withdrawals and valuation issues, and private funds with more leverage and illiquid assets (such as real estate funds).	This priority seems largely focused on open-end funds that may experience liquidity shortfalls during periods of increased market volatility. For closed-end funds, this priority signals that in a difficult financial environment the SEC staff will be watching that sponsors are fairly valuing their funds’ assets and calculating their fees and performance accurately. Sponsors should continue to implement internal checks to ensure that their valuation policies are being followed and that positions are reassessed as conditions warrant. This priority also suggests a continued focus on advisers’ overall approach to portfolio risk and leverage management, including any policies and procedures adopted in that regard.
Adherence to contractual requirements regarding limited partner advisory committees or similar structures (e.g., advisory boards), including adhering to any contractual notification and consent processes.	Sponsors should periodically review their obligations related to limited partner advisory committee/board notices and consents to confirm that these obligations are being met and that such compliance is appropriately documented.
Conflicts, controls, and disclosures and use of affiliated service providers to ensure that such decisions are made, and processes are implemented, in the funds’ best interest and to allow investors to provide informed consent when needed. For example, such disclosure may include, but is not limited to, (i) disclosing processes for making initial and ongoing suitability determinations when allocating investments across investment vehicles managed by the same adviser or an affiliate, (ii) providing disclosure about how an adviser intends to mitigate or eliminate the conflicts of interest and (iii) disclosing economic incentives, such as the use of an affiliated firm to perform certain services.	Unless overturned or modified,[3] the New Private Funds Rules also will require sponsors to disclose fees to paid to the adviser and its affiliates on a quarterly basis. Given the SEC’s historic and continued focus on this area, sponsors would be wise to continue to approach affiliate transactions with special care, and strive to make a determination (documented by the sponsor’s conflicts committee where applicable) that any affiliate transactions have been effected in accordance with the fund’s governing documents, including any disclosure or informed consent requirements contained therein. Allocations of investment opportunities across multiple funds and other clients also will continue to be a focus of the SEC examination staff, and sponsors should ensure that appropriate documentation of allocation determinations is maintained.
Accurate calculation and allocation of private fund fees and expenses (both fund-level and investment-level), including valuation of illiquid assets (including adjustments to reflect write-downs or write-offs), calculation of post commitment period management fees (including whether a fund has the ability to recycle or reinvest proceeds after the commitment period), adequacy of disclosures, and potential offsetting of such fees and expenses.	The New Private Funds Rules set forth extensive reporting requirements related to fees and expenses, and the 2024 Priorities make clear that the SEC intends to spend significant time verifying calculations. We have seen the SEC pay increased attention to the calculation of fees at the end of a fund’s commitment period, particularly situations where the sponsor has a conflict of interest (such as the sponsor’s determination not to write off a permanently impaired investment such that management fees continue to be charged with respect to such investment).[4]
Due diligence practices for consistency with policies, procedures, and disclosures, particularly with respect to private equity and venture capital fund assessments of prospective portfolio companies.	It appears that the SEC intends to double check that sponsors are conducting due diligence in the manner they have communicated, both externally and internally. Sponsors would be wise to review marketing materials and internal policies for descriptions related to the due diligence that is undertaken when selecting investments. Sponsors should then confirm with the deal team whether the process has been followed and documented for all investments over the relevant period, and whether adjustments to disclosure or policy are needed or, alternatively, adjustments to the investment diligence process itself.
Compliance with Advisers Act requirements regarding custody, including accurate Form ADV reporting, timely completion of private fund audits by a qualified auditor and the distribution of private fund audited financial statements.	A continued focus on custody requirements does not come as a surprise as this has been a major point of emphasis of the SEC examination staff. Continued care and attention should be taken to ensure compliance with all aspects of the Advisers Act custody rule, which is highly technical, and that documentation of such compliance (for example, records of timely delivery of audited financial statements to investors) is maintained.
Policies and procedures for reporting on Form PF, including upon the occurrence of certain reporting events.	Please see our client alert, which can be found here, summarizing the SEC’s significant amendments to Form PF. Form PF amendments will go into effect on December 11, 2023 (i.e., “trigger” based filing requirements) and June 11, 2024 (i.e., additional reporting requirements as part of routine Form PF filings).

___________________________

[1] Available at: https://www.sec.gov/news/press-release/2023-222. See also https://www.sec.gov/files/2024-exam-priorities.pdf.

[2] For more information on the New Private Funds Rules, please see our client alert available here.

[3] The New Private Funds Rules are being challenged in court by an array of industry groups led by the National Association of Private Fund Managers, represented by Gibson Dunn. The U.S. Court of Appeals for the Fifth Circuit recently granted the challengers’ motion to expedite the case, which requested a decision by the end of May 2024. The challengers filed their opening brief on November 1, 2023.

[4] For more information on the recent SEC enforcement action against Insight Venture Management LLC (“Insight”) where the SEC found that Insight charged excess management fees to its investors through “inaccurate application of its permanent impairment policy” and failed to disclose a conflict of interest to investors concerning the same policy, please see our client alert available here.

The following Gibson Dunn attorneys assisted in preparing this client update: Tom Rossidis, Kevin Bettsteller, and Shannon Errico.

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding the issues and considerations discussed above. Please contact the Gibson Dunn lawyer with whom you usually work, the authors, or any of the following leaders and members of the firm’s Investment Funds practice group:

Investment Funds Group:
Jennifer Bellah Maguire – Los Angeles (+1 213-229-7986, jbellah@gibsondunn.com)
Kevin Bettsteller – Los Angeles (+1 310-552-8566, kbettsteller@gibsondunn.com)
Albert S. Cho – Hong Kong (+852 2214 3811, acho@gibsondunn.com)
Candice S. Choh – Los Angeles (+1 310-552-8658, cchoh@gibsondunn.com)
John Fadely – Singapore/Hong Kong (+65 6507 3688/+852 2214 3810, jfadely@gibsondunn.com)
A.J. Frey – Washington, D.C./New York (+1 202-887-3793, afrey@gibsondunn.com)
Shukie Grossman – New York (+1 212-351-2369, sgrossman@gibsondunn.com)
James M. Hays – Houston (+1 346-718-6642, jhays@gibsondunn.com)
Kira Idoko – New York (+1 212-351-3951, kidoko@gibsondunn.com)
Gregory Merz – Washington, D.C. (+1 202-887-3637, gmerz@gibsondunn.com)
Eve Mrozek – New York (+1 212-351-4053, emrozek@gibsondunn.com)
Roger D. Singer – New York (+1 212-351-3888, rsinger@gibsondunn.com)
Edward D. Sopher – New York (+1 212-351-3918, esopher@gibsondunn.com)
William Thomas, Jr. – Washington, D.C. (+1 202-887-3735, wthomas@gibsondunn.com)
Shannon Errico – New York (+1 212-351-2448, serrico@gibsondunn.com)
Tom Rossidis – New York (+1 212-351-4067, trossidis@gibsondunn.com)

The Securities and Exchange Commission (the “SEC” or the “Commission”) remains intensely focused on the regulation of the private investment funds industry. This roundup summarizes three recent enforcement and administrative items private fund advisers should be aware of.

1. Private Funds Rules Effective Dates Set

On August 23, 2023, the Commission adopted a package of new rules (the “Private Funds Rules”) for private fund advisers (“PFAs”) promulgated under the Investment Advisers Act of 1940 (the “Advisers Act”), which were summarized in our recent client alert here.[1] [2] The Private Funds Rules were published in the Federal Register on September 14, 2023, and will therefore become effective on the dates set forth below. Note, however, that the Private Funds Rules are being challenged in court by an array of industry groups led by the National Association of Private Fund Managers, represented by Gibson Dunn. The U.S. Court of Appeals for the Fifth Circuit recently granted the challengers’ motion to expedite the case, which requested a decision by the end of May 2024. The deadlines below are therefore subject to cancellation if this litigation succeeds in securing the vacatur of the Private Funds Rules altogether.

For purposes of the below table, private fund advisers with $1.5 billion or more in private fund assets under management are referred to as “Larger Advisers,” and private fund advisers with less than $1.5 billion in private fund assets are referred to as “Smaller Advisers.”

Date	Requirement
November 13, 2023	All registered investment advisers (including those without private fund clients) must keep a written record of their annual review of their compliance program (Rule 206(4)-7(b))
September 14, 2024	Subject to certain exceptions, both Larger Advisers and Smaller Advisers (registered or unregistered) with must comply with: the Preferential Treatment Rule (Rule 211(h)(2)-3) the Restricted Activities Rule (Rule 211(h)(2)-1) *Registered* Larger Advisers must comply with: the Adviser-Led Secondaries Rule (Rule 211(h)(2)-2)
March 14, 2025	*Registered* Larger Advisers and Smaller Advisers must comply with: The Audit Requirement (Rule 206(4)-10) Quarterly Statement Requirements (Rule 211(h)(1)-2) All Smaller Advisers (registered or unregistered) must comply with: the Restricted Activities Rule (Rule 211(h)(2)-1) the Preferential Treatment Rule (Rule 211(h)(2)-3 *Registered* Smaller Advisers must comply with: the Adviser-Led Secondaries Rule (Rule 211(h)(2)-2)

More details regarding the nuances related to each rule are summarized in the client alert linked above.

2. Nine Investment Advisers charged in breach of Marketing Rule[3]

On September 12, 2023 the SEC announced that it had conducted an enforcement sweep with respect to violations of the hypothetical performance requirements under Advisers Act Rule 206(4)-1 (the “Marketing Rule”). As a result, nine investment advisers were found to have violated the Marketing Rule for the alleged advertising of hypothetical performance to the general public on public websites without adequate policies and procedures in place “reasonably designed to ensure that the hypothetical performance was relevant to the likely financial situation and investment objectives of the intended audience.” This is consistent with the Marketing Rule’s Adopting Release, in which the Commission stated that this requirement meant that hypothetical performance would generally not be appropriate for general advertising to retail investors.[4]

We expect that the majority of our PFA clients are not in the practice of putting performance projections into the public sphere so as to avoid general solicitation and preserve their exemption from registration of their offerings under the Securities Act of 1933 (the “Securities Act”) and registration of their funds under the Investment Company Act of 1940 (the “Investment Company Act”). Any clients who engage in general solicitation in reliance on Rule 506(c) of Regulation D under the Securities Act should be aware that advertising materials containing hypothetical performance information should be tightly controlled, and should note that investors who only meet the “accredited investor” status are not likely to be deemed sophisticated enough to understand hypothetical performance solely by virtue of such status.

In addition, all advisers should take note that we expect the SEC will continue to focus on violations of the Marketing Rule in its routine examinations. We recommend ensuring that counsel has reviewed any marketing materials in pitchbooks and private placement memoranda ahead of providing those materials to prospective investors. In addition, it bears reminding that many sponsors have historically been in the habit of providing a previous fund’s annual or quarterly reports to prospective investors in a new fund, or inviting prospective new fund investors to annual meetings where existing fund performance is discussed. Any materials, including, but not limited to, investment committee memoranda, related to older funds that are discussed with or provided to prospective new investors in a forthcoming fund should be carefully reviewed to ensure compliance with the Marketing Rule.

3. In Rare Action, Investment Adviser Found to be Acting as an Illegal Broker-Dealer

On September 12, 2023, the Commission entered an Order Instituting Administrative and Cease-and-Desist Proceedings against a registered PFA, pursuant to Sections 15(b) and 21C of the Securities Exchange Act of 1934 (the “Exchange Act”) and Section 203(e) of the Advisers Act (the “Order”).[5] In the Order, the Commission found that the PFA had “willfully violated Section 15(a)(1) of the Exchange Act” which makes it unlawful to “effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security … unless such broker or dealer is registered in accordance with [the other relevant provisions of the Exchange Act].”[6] The PFA was ordered to pay disgorgement of $594,897, prejudgment interest of $76,896 and a civil monetary penalty of $150,000, totaling $821,793 in sanctions for operating as an unregistered broker-dealer when it received fees in exchange for placing its investment advisory clients into certain third party investment vehicles (that primarily held real estate) without being registered with the Commission as a broker-dealer. The Order does not allege or imply any other aggravating factor (e.g., fraud, unsuitability) with respect to the offerings, and describes the conduct as having occurred between 2012 and 2021.

This action is notable because we have historically seen staff of the SEC address this type of conduct by issuing deficiencies during the course of examinations of investment advisers instead of referring the matter for enforcement action in the absence of other aggregating factors, such as fraud in the underlying offering. Advisers who facilitate introductions of potential investors to issuers should ensure that they do not receive any sort of compensation or fees in exchange for such referrals, unless registered as a broker dealer.

Additional Enforcement Forecast for the Future

Congress recently allocated additional funds to the Commission for the current fiscal year which the Commission has indicated that it plans to use to hire 400 more staff members, including 125 new personnel for its Enforcement Division.[7] As a result, we believe broad ranging enforcement action against private fund managers will only become more frequent in the future.

We would welcome the opportunity to speak with you and provide guidance in light of the developments discussed above.

___________________________

[1] See A Guide to Understanding the New Private Funds Rules, Gibson, Dunn & Crutcher, LLP (Aug. 25, 2023), link.

[2] See Private Fund Advisers; Documentation of Registered Investment Adviser Compliance, Investment Advisers Act Release No. IA-6383 (Aug 23, 2023), link.

[3] A copy of the press release and the settlement orders may be found here: https://www.sec.gov/news/press-release/2023-173.

[4] See Investment Adviser Marketing, Investment Advisers Act Release No. IA-5653 (Dec. 22, 2020), link.

[5] Order Instituting Administrative and Cease-and Desist Proceedings, Pursuant to Sections 15(b) and 21C of the Securities Exchange Act of 1934 and Section 203(e) of the Investment Advisers Act of 1940, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order, Securities Exchange Act of 1934 Release No. 98354, Investment Advisers Act of 1940 Release No. 6415 (Sept. 12, 2023), link.

[6] Securities Exchange Act of 1934, 15 U.S.C.A. § 78o (West).

[7] See 2023 Mid-Year Securities Enforcement Update, Gibson, Dunn & Crutcher, LLP (Aug. 7, 2023), link.

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding the issues and considerations discussed above. Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Investment Funds practice group, or the following authors:

Kevin Bettsteller – Los Angeles (+1 310-552-8566, kbettsteller@gibsondunn.com)
Lauren Cook Jackson – Washington, D.C. (+1 202-955-8293, ljackson@gibsondunn.com)
Gregory Merz – Washington, D.C. (+1 202-887-3637, gmerz@gibsondunn.com)
Shannon Errico – New York (+1 212-351-2448, serrico@gibsondunn.com)
Zane E. Clark – Washington, D.C. (+1 202-955-8228 , zclark@gibsondunn.com)

On August 23, 2023, the U.S. Securities and Exchange Commission (the “SEC”) by a 3-2 vote adopted final rules (the “Final Rules”) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), which modify certain aspects of the rules initially proposed on February 9, 2022 (the “Proposed Rules”) and adopt others largely as proposed. The Final Rules reflect the SEC’s asserted goal of bringing “transparency” to the inner workings of private funds and their sponsors by restricting or requiring extensive disclosure of preferential treatment granted in side letters, as well as imposing numerous additional reporting and other compliance requirements.[1] While several of the Final Rules require further clarification, and industry practice will undoubtedly evolve as the Final Rules are further analyzed and, to the extent possible, implemented, the following table sets forth a high-level overview of key requirements and restrictions reflected in the Final Rules. Following the table is a Q&A addressing some of the most frequently asked questions sponsors and other industry participants have asked us. These materials are a general, initial summary and do not assess the legality of the Final Rules, which remain subject to potential challenge.

Private Funds Rules – Overview of Key Requirements and Restrictions

Requirement or Restriction	High-Level Observations	Compliance Date[2] / Grandfathering of existing funds[3]
Preferential Treatment Rule (Disclosure Requirements): An adviser may not admit an investor into a fund unless it has provided advance disclosure of material economic terms granted preferentially to other investors, and must disclose all other preferential treatment “as soon as reasonably practicable” after the end of the fundraising period (for illiquid funds) or the investor’s investment (for liquid funds) and at least annually thereafter (if new preferential terms are granted since the last notice).	As set forth below, this requirement fundamentally changes the rules of the game with respect to a fund’s typical MFN process and requires advance disclosure of material economic terms, including to those investors who are not entitled to elect them, and to those who would not typically see them (e.g., smaller investors who do not have side letters).Because the disclosure requirements apply to existing funds, older funds will need to disclose preferential treatment previously granted but not yet disclosed.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers) Existing funds grandfathered? No.
Quarterly Statement Rule: Registered advisers must issue quarterly statements detailing information regarding fund-level performance; the costs of investing in the fund, including itemized fund fees and expenses; the impact of any offsets or fee waivers; and an itemized accounting of all amounts paid to the adviser or its related persons by each portfolio company.	As set forth below, the requirement to show performance metrics for illiquid funds, both with and without the impact of fund-level subscription facilities, and to spell out clearly all fund-level and portfolio company-level special fees and expenses (e.g., monitoring fees) and provide a cross-reference to the section of the private fund’s organizational and offering documents setting forth the applicable calculation methodology with respect to each is extremely burdensome and could provide another basis for the SEC staff to review performance calculations and fee and expense allocations during exams. We also expect the timing deadlines for the quarter- and year-end statements to present significant operational challenges for sponsors.	Compliance Date: 18 months (Larger and Smaller Advisers) Existing funds grandfathered? No
Private Fund Audit Rule: Registered advisers must obtain an annual audit for each private fund that meets the requirements of the audit provision in the Advisers Act custody rule (Rule 206(4)-2), and will no longer be able to opt out of the requirement using surprise examinations.	Many private fund sponsors are already providing audited financial statements in compliance with the custody rule. Sponsors who opt out of this requirement in favor of surprise examinations will be affected. We note that the SEC has re-opened its comment period with respect to its proposal regarding safeguarding client assets to allow commenters to assess its interplay with the Private Fund Audit Rule.	Compliance Date: 18 months (Larger and Smaller Advisers) Existing funds grandfathered? No
Adviser-Led Secondaries Rule: Registered advisers must obtain and distribute an independent fairness opinion or valuation opinion in connection with an adviser-led secondary transaction, and disclose material business relationships the adviser has had in the last two years with the opinion provider.	We believe that a U.S. market norm has likely developed in recent years where many sponsors are already providing fairness opinions or valuation opinions as a best practice in GP-led secondaries. This requirement will, however, increase expenses for transactions that have not historically relied on such opinions (such as where a third-party bid establishes the price), and ultimately such expenses will be passed onto investors.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers Existing funds grandfathered? No
Books and Records Rule Amendments: Requirement to maintain certain books and records demonstrating compliance with the Final Rules.	We believe that the books and records amendments generally clarify that sponsors must maintain specific records of compliance with the new rules. We anticipate the SEC staff will focus on this requirement in considering possible deficiencies related to the new rules as part of routine exams.	Compliance Date: Based on the compliance date of the underlying rule for which records are required Existing funds grandfathered? No
Restricted Activities Rule (Investigation Costs): An adviser may not allocate to the private fund any fees or expenses associated with an investigation of the adviser without disclosing as much and receiving consent from a majority in interest of fund investors (excluding the adviser and its related persons), and is prohibited from charging the fund for fees and expenses for an investigation that results or has resulted in a sanction for a violation of the Advisers Act or the rules thereunder.	We believe this rule will adversely affect and burden sponsors.[4] Sponsors will no longer be able to allocate costs of an investigation to a fund unless a majority in interest of unaffiliated investors consent. The adopting release makes clear that the SEC intends that sponsors seek separate consents for each investigation, which would suggest that the practice of describing such costs with generality in the fund’s governing document would not be sufficient. Even if sponsors obtain consent to allocate costs related to an investigation to a fund, they will not be able to do so if the investigation results in sanctions for violations of the Advisers Act.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers Existing funds grandfathered? Yes, if disclosed.[5]
Restricted Activities Rule (Regulatory/Compliance Costs): Advisers may not charge or allocate to the private fund regulatory, examination, or compliance fees or expenses unless they are disclosed to investors within 45 days after the end of the fiscal quarter in which such charges occur.	The adopting release makes clear that the SEC continues to view advisers charging to the fund “manager-level” expenses that it feels should more appropriately be borne by the adviser as “contrary to the public interest and the protection of investors.” As is currently the case, an adviser that allocates its regulatory, compliance and examination costs to a fund should ensure that this practice is clearly permitted under the fund’s governing documents. However, even with such authority, the level of granular disclosure regarding such costs that the Final Rule seemingly requires could have a chilling effect on the practice (where applicable) and discourage investment in compliance.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers Existing funds grandfathered? Disclosure requirement generally applies
Restricted Activities Rule (After-tax Clawback): Advisers may not reduce the amount of a GP clawback by amounts due for certain taxes unless the pre-tax and post-tax amounts of the clawback are disclosed to investors within 45 days after the end of the fiscal quarter in which the clawback occurs.	Advisers who wish to reduce their GP clawback amount by their actual or hypothetical taxes (the latter being a common practice permitted by most fund governing documents) will need to provide investors with notice of having done so and disclosure of specific dollar amounts.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers Existing funds grandfathered? Yes, with disclosure
*Restricted Activities Rule (Non-pro rata* investment-level allocations):** Advisers may not charge or allocate fees or expenses related to a portfolio investment on a non-pro rata basis when multiple funds and other clients are invested, unless the allocation is “fair and equitable” and the adviser distributes advance notice describing the charge and justifying its fairness and equitability.	We believe that this requirement will put additional pressure on advisers to determine, at the outset of a fundraise, whether certain costs, such as those related to AIVs or feeder funds set up to accommodate particular investors’ unique tax or regulatory profiles, will be allocated across the fund or instead allocated exclusively to such investors. Increased disclosure will likely lead to more allocation of these costs across the fund. This rule also places additional pressure on the practice of disproportionately allocating broken deal expenses to the fund as opposed to investors who were proposed to have invested alongside the fund, which is a longstanding focus of the SEC.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers Existing funds grandfathered? Disclosure requirement generally applies
Restricted Activities Rule (Borrowing from the fund): Advisers may not borrow or receive an extension of credit from a private fund without disclosure to and consent from fund investors.	This rule does not apply to the more typical practice of sponsors lending money to the fund. In light of the clarification that disclosure and consent are required, a minority of sponsors may seek to include the ability to borrow from the fund on certain pre-defined terms in the fund’s governing documents.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers Existing funds grandfathered? Yes.[6]
Preferential Treatment Rule (Redemption Rights): An adviser may not offer preferential treatment to investors regarding their ability to redeem if the adviser reasonably expects such terms to have a material, negative effect on other investors, unless such ability is required by law or offered to all other investors in the fund without qualification.	State pension funds and sovereign wealth funds, in particular, often negotiate special redemption rights. Sponsors are being placed in the difficult position of determining whether such rights have a material, negative effect on other investors, when they are not driven by laws, rules or regulations applicable to the investor. The SEC has provided little guidance to assist in this determination, which must be examined on a case-by-case basis.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers Existing funds grandfathered? Yes.[7]
Preferential Treatment Rule (Portfolio Holdings Information): An adviser may not provide preferential information about portfolio holdings or exposures if the adviser reasonably expects that providing the information would have a material, negative effect on other investors, unless such preferential information is offered to all investors.	Attention should be given to information required by bespoke reporting templates to determine whether this provision applies.	Compliance Date: 12 months (Larger Advisers) 18 months (Smaller Advisers Existing funds grandfathered? Yes.[8]
Compliance Rule Amendment: All registered advisers (including those without private fund clients) must document in writing the required annual review of their compliance policies and procedures.	We believe this codifies an informal position that the SEC examinations staff has already imposed on advisers.	Compliance Date: 60 days after publication of the Final Rules in the Federal Register Existing funds grandfathered? N/A

Frequently Asked Questions:

The following Q&A sets forth our answers to questions to frequently asked questions:

Question: Which of the Final Rules apply to various types of sponsors?

- Registered investment advisers to private funds are subject to all of the rules and restrictions set forth in the table above.
- Exempt reporting advisers and other unregistered advisers are not affected by the Quarterly Statement Rule, the Private Fund Audit Rule, the Adviser-Led Secondaries Rule or the Compliance Rule Amendment.
- Offshore advisers whose principal place of business is outside the U.S., whether registered or unregistered, are technically subject to the Final Rules, but the SEC has indicated that it will not extend the requirements of these rules to the adviser’s activities with respect to their offshore private fund clients, even if the offshore funds have U.S. investors.
- The Final Rule states that Quarterly Statement Rule, Private Fund Audit Rule, Adviser-Led Secondaries Rule, Restricted Activities Rule and Preferential Treatment Rules do not apply to investment advisers with respect to securitized asset funds they advise; real estate funds relying on Section 3(c)(5)(C), and other collective investment vehicles that are not “private funds”[9] are also outside the technical scope of those rules.
- Real estate fund managers that are not registered with the SEC (or filing reports as an exempt reporting adviser) on the basis that they are not advising on “securities” are not subject to the Advisers Act or the Final Rules.

Question: What do sponsors have to disclose before and after admitting investors, and how will the current MFN process change?

Sponsors will now have to disclose (i) fee and carry breaks or other material economic arrangements preferentially granted to other investors ahead of admitting new investors into their private funds, and (ii) all preferential treatment as soon as reasonably practicable after the final closing of a closed end fund or the admission of the new investor in an open-end fund, and at least annually thereafter if preferential terms are provided that were not previously disclosed. This disclosure requirement applies to existing funds, even if they have held a final closing prior to the compliance date.

In a statement released concurrently with the release of the Final Rule, Commissioner Caroline A. Crenshaw stated that “collective action problems appear to prevent coordination among investors to bargain for uniform baseline terms.”[10] The SEC’s decision to require disclosure of material economic terms ahead of admitting investors to the fund and disclosure of all preferential treatment post-final closing takes aim at that purported collective action problem.

Notably, the SEC seemingly narrowed its original proposal by opting to require advance written disclosure of “any preferential treatment related to any material economic terms,” as opposed to advance disclosure of all preferential treatment, as originally proposed.[11] Notwithstanding that concession, all preferential treatment (notably, without the materiality qualifier) must invariably be disclosed as soon “as reasonably practicable” following the end of the private fund’s fundraising period (for illiquid funds) or the investor’s investment in the private fund (for liquid funds).[12]

The SEC notes that “as soon as reasonably practicable” will be a facts and circumstances analysis, but suggests that it believes that “it would generally be appropriate for advisers to distribute the notices within four weeks.”[13] We find this proposed timeline ambitious and, in the absence of a hard deadline, would predict that many sponsors will continue take additional time to complete their MFN process. The “as soon as reasonably practicable” requirement would, however, cut against conducting an MFN process an excessive number of months after the final closing, as sometimes happens at present.

Material economic terms that require prior disclosure include, without limitation, “the cost of investing, liquidity rights, fee breaks, and co-investment rights.”[14] The SEC cited excuse rights as an example of non-economic preferential terms which must be disclosed post-closing. Providing a summary of preferential treatment provisions with sufficient specificity to convey its relevance will satisfy this requirement, as will providing the actual provisions granted, and in each case this may be done on an anonymized basis.[15]

In our experience, most investors in private funds with commitments in excess of a certain threshold negotiate side letters with sponsors that contain a “most favored nations” (“MFN”) clause entitling them to view all or part of the side letters granted to other investors and, most frequently, to opt into those more favorable terms negotiated by other investors who make commitments that are equal to or lesser than their capital commitment (and are not otherwise inapplicable to them). This process (the “MFN Process”) typically happens after the fund’s final closing in the closed-end fund context. Accordingly, the Final Rules essentially require sponsors to conduct a portion of their MFN Process in piecemeal fashion, with part of the process conducted prior to the final closing and the rest conducted post final closing, and to do so with respect to each investor regardless of whether such investor negotiated a side letter with an MFN clause or is entitled to elect any of the disclosed provisions. This will curtail the common practice of only showing other investors’ side letter provisions to those investors with MFN provisions and of only showing investors those provisions which they are eligible to elect. Due to the ongoing disclosure requirements, those sponsors of closed-end funds which already held their final closings and ran a more limited MFN process will now be required to disclose any preferential treatment granted to other investors, regardless of size, that had not been previously disclosed. There is no requirement to offer the election of such provisions to the investors who receive the disclosure.

While, as a technical matter, only disclosure of the key terms is required (and not an opportunity to elect such terms), the natural consequence of disclosure is that investors may ask sponsors at the time they are informed of key terms (regardless of whether they have a side letter with an MFN provision) to be granted the same terms as other similarly situated investors.

We expect that these disclosure requirements will present a substantial logistical challenge and may affect previously negotiated commercial arrangements. The SEC has not prescribed a method of delivery for electronic notices, so sponsors will be able to choose whether to do so in the private placement memorandum (the “PPM”), as a standalone disclosure document in an electronic data room, via email or otherwise. PPM supplements may be a natural place to make this disclosure, since private funds typically accept investors across multiple closings over the course of a fundraising and already provide supplements to PPMs, although virtual data rooms may also be an attractive alternative delivery method.

Sponsors will face the issue of how to handle their first closing and how to handle disclosure of terms that are being negotiated concurrently in the final hours before a later closing. In a typical fund closing, multiple side letters are negotiated concurrently with investors in the days leading up to the closing date. Time will tell where the industry lands on this point, but one potential reading of the Final Rules suggests that a sponsor concerned about managing these closing dynamics could take the position that any preferential terms granted as of the same date and at a given closing can be deemed not to have been granted prior to the capital commitments made by any other investor in that closing, and therefore may be disclosed later. It remains to be seen, however, whether this approach is consistent with the intent of the Final Rules and whether, alternatively, the Final Rules would effectively obligate sponsors to communicate two dates to their prospective investors for their closings: one being the “drop dead” date when all side letter terms need to be agreed to, and the second being a later date when commitments will be accepted and the closing will occur. This approach would give the fund, and legal counsel, time to disclose any additional material economic terms to all investors and make any last-minute updates to their side letters in response to any requests to opt into those terms that they are eligible for. In any event, we expect that the Preferential Treatment Rule’s disclosure requirement, assuming it can be practically implemented, will increase organizational expense costs for sponsors. Many sponsors agree to organizational expense caps with their investors, and some are able to negotiate that the MFN Process falls outside of those caps. If at least a portion of the MFN Process, which can be lengthy and expensive, must take place ahead of closing investors, then sponsors are likely to seek increases to their organizational expense caps to accommodate these added costs. The Final Rules will also allow smaller investors, including those that did not themselves negotiate a “most favored nations” clause (or even have a side letter), to view the provisions negotiated by larger investors. This may result in more protracted negotiations with investors who are making capital commitments at sizes which, in the view of sponsors, do not typically entitle them to a side letter arrangement, or to propose in the fund’s PPM fee breakpoints and other means of giving preference based on size, timing and other pre-determined criteria instead of doing so through the side letter process.

Question: How will sponsors’ quarterly and annual reports be affected?

Under the Final Rules, registered investment advisers are required to prepare quarterly statements for each of their private funds that include (A) a table with a detailed accounting of all fees, compensation and other amounts paid to the adviser or any of its related persons by the fund as well as all other fees and expenses paid by the fund during the relevant reporting period, (B) a table with a detailed accounting of all fees and compensation paid to the adviser or any of its related persons by the fund’s covered portfolio investments and (C) performance measures of the fund for the relevant reporting period.[16] Advisers must comply with the quarterly statement requirement for a new fund once it has had two full fiscal quarters of operating results. The Final Rule goes into granular detail about what information needs to be clearly and prominently disclosed in the quarterly statements, including the methodologies used and assumptions relied upon in the quarterly statement, as further described below.

(A) Quarterly Statement: Fund-Level Fee, Compensation and Expense Disclosure

The Quarterly Statement Rule requires registered investment advisers to disclose on a quarterly basis (1) a detailed accounting of all compensation, fees, and other amounts allocated or paid to the adviser or any of its related persons by the private fund during the reporting period, including, but not limited to, management, advisory, sub-advisory, or similar fees or payments, and performance-based compensation (e.g., carried interest), (2) a detailed accounting of all fees and expenses allocated to or paid by the private fund during the reporting period other than those listed in (1), including, but not limited to, organizational, accounting, legal, administration, audit, tax, due diligence, and travel fees and expenses, and (3) the amount of any offsets or rebates carried forward during the reporting period to subsequent quarterly periods to reduce future payments or allocations to the adviser or its related persons.

The SEC emphasizes in several places throughout its commentary to the Final Rules that there should be separate line items for each category of compensation, fee or expense and that the exclusion of de minimis expenses, the grouping of smaller expenses into broad categories or the labeling of any expenses as miscellaneous is prohibited, which will require significant effort on the part of advisers. Additionally, they advise that to the extent a certain expense could be categorized as either adviser compensation or a fund expense, the Final Rule requires that such payment or allocation be categorized as adviser compensation. For example, if an adviser or its related persons provide consulting, legal or back-office services to a private fund as a permitted expense under the private fund’s governing documents, such amounts should be categorized as compensation as opposed to an expense. This highlights the technicalities that the Final Rule imposes upon advisers and the potential pitfalls that may arise in compliance.

The SEC also noted in its commentary that the definitions of “related person” and “control” adopted under the Final Rules are consistent with the definitions used on Form ADV and Form PF, which registered investment advisers are familiar with.

This set of disclosure must be done before and after the application of any offsets, rebates or waivers to fees or compensation received by the adviser, including, but not limited to, any fees an adviser or its related person receives for management services provided to a fund’s portfolio company.

(B) Quarterly Statement: Portfolio Investment-Level Fee and Compensation Disclosure

Similar to the above, the Quarterly Statement Rule requires registered investment advisers to disclose a detailed accounting of all portfolio investment compensation allocated or paid by each covered portfolio investment during the reporting period in a single, separate table from the disclosure table noted above.

The definition of a portfolio investment is broad and is intended to cover any entity through which a private fund holds an investment, including through holding vehicles, subsidiaries, acquisition vehicles, special purpose vehicles or the like. In its commentary to the Final Rules, the SEC recognizes that this may impose challenges specifically for funds of funds, as it may be difficult to determine portfolio investment compensation arrangements at the underlying fund level.

This prong of the Final Rule also similarly requires a detailed line-by-line itemization of all portfolio investment compensation. Additionally, the SEC also notes in its commentary to the Final Rules that advisers are required to list the portfolio investment compensation allocated or paid with respect to each covered portfolio investment both before and after the application of any offsets, rebates or waivers. However, it is not clear how this is intended to apply at this level, as such offsets are taken into account at the fund level, not the portfolio company level.

“Portfolio investment compensation” includes any compensation, fees, and other amounts allocated or paid to the adviser or any of its related persons by the portfolio investment attributable to the private fund’s interest in the portfolio investment, including, but not limited to, origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, directors, trustees or similar fees or payments. Notably, this requirement could cause some sponsors to consider transitioning in-house or affiliated operating groups to unaffiliated entities (e.g., owned by the operating advisors themselves).

(C) Quarterly Statement: Performance Disclosure

Under the Final Rule, registered investment advisers are required to provide standardized fund performance information in each quarterly statement. The performance metrics shown will depend on whether a private fund is classified as a liquid fund or an illiquid fund. An “illiquid fund” is defined as a private fund that does not have investor redemption mechanisms and that has limited opportunities for investor withdrawal other than in exceptional circumstances. A “liquid fund” is defined as a private fund that is not an illiquid fund.

(1) Liquid Funds

For liquid funds, registered investment advisers are required to show performance based on (A) annual net total return for each fiscal year for the 10 fiscal years prior to the quarterly statement or since inception (whichever is shorter), (B) average annual net total returns over one-, five-, and 10-fiscal year periods, and (C) cumulative net total return for the current fiscal year as of the end of the most recent fiscal quarter. It is anticipated that estimations may need to be made for liquid funds that have been operating for lengthy periods of time that did not keep adequate records of the earlier years.

(2) Illiquid Funds

For illiquid funds, registered investment advisers of illiquid funds are required to (i) show performance based on internal rates of return and multiples of invested capital (both gross and net metrics shown with equal prominence) (A) since inception and (B) for the realized and unrealized portions of the illiquid fund’s portfolio, with the realized and unrealized performance shown separately and (ii) present a statement of contributions and distributions. The Final Rule defines the terms “internal rate of return” and “multiple of invested capital”, on both a gross and net basis, and provides color on what is expected to be included in the statement of contributions and distributions.[17] This illustrates the granular and prescriptive nature of the Final Rule, which will require concerted effort on behalf of fund sponsors to ensure compliance.

Advisers are required to consider the impact of fund-level subscription facilities on returns and disclose such performance information for illiquid funds on both a levered and an unlevered basis. In its commentary to the Final Rules, the SEC is repeatedly focused on standardizing information across private funds as much as possible, and as such has provided no room for exclusions to this rule, such as possibly exempting advisers from providing unlevered returns on short-term subscription facilities or excluding subscription line fees and expenses from the calculation of net performance figures.

The SEC notes in its commentary to the Final Rules that to the extent that certain funds rely on information from portfolio investments to generate the required performance data and such information is not available prior to the distribution of the quarterly statement, an adviser would be expected to use the performance measures “through the most recent practicable date”, which is likely the end of the immediately preceding quarter.

An additional prong to the quarterly statement rule is to include clear and prominent disclosure of the methodologies and assumptions made in calculating performance information. This includes, but is not limited to, whether dividends were reinvested in a liquid fund, or whether any fee rates or fee discounts were assumed in the calculation of net performance measures.

This Final Rule also requires the quarterly statement to include cross-references to the sections of the private fund’s organizational and offering documents that set forth the applicable calculation methodology for all expenses, payments, allocations, rebates, waivers, and offsets. This will likely result in significant changes to how private placement memoranda and the operating agreements of private funds are drafted going forward. Furthermore, to the extent that the allocation and methodology provisions in existing operating agreements are not adequately detailed, this requirement under the Final Rule may prompt future LPA amendments that require limited partner consent.

This consequence of the Final Rules is in tension with the legacy status (i.e. grandfathering) that the Final Rules afford governing agreements entered into prior to the date that the Final Rules take effect. The cross-reference requirement of the Quarterly Statement Rule may effectively eliminate the protections provided by the legacy status concept if sponsors will be required to amend their governing agreements to include sufficient allocation and methodology provisions according to the SEC’s new standards. Notwithstanding the fact that many sponsors may already disclose some of the information required under the Quarterly Statement Rule to their investors, it is anticipated that compliance with the Quarterly Statement Rule will result in significant increased cost to advisers and funds, especially at the outset in establishing compliant quarterly statement templates and disclosures.

Such disclosures must be included in the quarterly statement itself as opposed to in a separate document. The SEC noted that while advisers are not required to provide all supporting calculations in quarterly statements, such information should be made available to investors upon request.

With regards to timing, the Final Rule mandates that registered investment advisers must distribute the quarterly statements to the private fund’s investors within 45 days after the end of the first three fiscal quarters of each fiscal year and within 90 days after the end of each fiscal year, and in the case of fund of funds, within 75 days after the end of the first three fiscal quarters of each fiscal year and within 120 days after the end of each fiscal year.

Question: Which of the Proposed Rules were not adopted or were modified by the Final Rules?

While the Final Rules will require sponsors to provide investors with significantly more “transparency” regarding preferential economic arrangements granted in side letters (notably, with respect to material economic terms, before closing new investors into their funds) and fees received by the adviser and related persons, as well as providing new rules on quarterly statements, fund audits, adviser-led secondaries, books and records, annual compliance reviews and certain restricted activities, and some of the “disclose and consent” requirements may operate in practical effect as prohibitions on the relevant conduct, it is worth noting that the Final Rules do not specifically adopt the following items which had been set forth in the Proposed Rules.

In particular, the Final Rules do not:

(i) require all preferential rights granted by side letter to be disclosed prior to investment (only material economic terms must be disclosed prior, the rest must be disclosed later);

(ii) eliminate sponsors’ ability to be indemnified, or limit liability, for simple negligence (preserving the “gross negligence” standard for indemnification);

(iii) prohibit clawbacks of carried interest net of taxes (as noted above, this was replaced by a disclosure requirement);

(iv) expressly prohibit allocating portfolio investment fees and expenses to funds on a non-pro rata basis, subject to disclosure requirements; or

(v) prohibit borrowing from a fund (which may done with disclosure and consent).

Further, the Final Rules also do not provide the specific prohibition against charging accelerated monitoring fees that was noted in the Proposed Rules; although members of the SEC staff clarified during the open meeting held on the Final Rules on August 23, 2023 (the “Open Meeting”) that they did not feel specific language on accelerated monitoring fees was necessary because they believe such fees are already prohibited under applicable guidance. The Final Rules also do not expressly prohibit charging an adviser’s regulatory, compliance, examination and certain investigation costs to the fund (except, in some cases, with consent and disclosure and excluding those investigations that result from a violation of the Advisers Act). Our view, however, is that the SEC’s consistent messaging on the impropriety of such charges, combined with burdensome disclosure requirements, could function as a de-facto prohibition of such charges.

___________________________

[1] Resources:

– Link to the Final Rule and the Adopting Release (Release No. IA-6383; File No. S7-03-22 , RIN 3235-AN07, 17 CFR Part 275, Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews: Final Rule)

– Link to the SEC’s Fact Sheet concerning Final Rules

[2] For purposes of the compliance date, the SEC recognized that smaller advisers will require more time to implement certain rules and provided size-based deadlines for implementation, which will be staggered starting from the publication of the Final Rule in the Federal Register. “Larger Advisers” means advisers with assets under management attributable to private funds (“Private Funds AUM”) of $1.5 billion or more. “Smaller Advisers” means advisers with Private Funds AUM of less than $1.5 billion.

[3] The Final Rules grandfather in certain existing arrangements if the private fund has “commenced operations” and has made contractual arrangements related to the provision that were entered into prior to the compliance date, and if the Final Rules would require amending such agreements.

[4] Note that the term “investigation” does not appear to include examinations of the adviser, which are addressed in the row immediately below.

[5] Except that costs associated with investigations resulting in Advisers Act sanctions may not be allocated to new or existing funds even with disclosure and consent.

[6] For loan agreements entered into prior to the compliance date if compliance would require an amendment to such agreements

[7] With respect to contractual obligations entered into prior to the compliance date.

[8] With respect to contractual obligations entered into prior to the compliance date.

[9] Issuers that would be investment companies but for the exclusions contained in Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940.

[10] “Statement Regarding Private Fund Adviser Rulemaking”, Aug. 23, 2023, Commissioner Caroline A. Crenshaw (https://www.sec.gov/news/statement/crenshaw-statement-private-fund-advisers-082323?utm_medium=email&utm_source=govdelivery)

[11] Release, page 292.

[12] Release, page 294.

[13] Release, page 299.

[14] Id.

[15] Id at 297.

[16] 17 C.F.R. § 275.211(h)(1)-2(b)-(c).

[17] See 17 C.F.R. § 275.211(h)(1)-1. “Multiple of invested capital” means (i) the sum of: (A) the unrealized value of the illiquid fund; and (B) the value of distributions made by the illiquid fund; (ii) divided by the total capital contributed to the illiquid fund by its investors. “Internal rate of return” means the discount rate that causes the net present value of all cash flows throughout the life of the private fund to be equal to zero. Gross metrics are calculated gross of all fees, expenses and performance-based compensation borne by the private fund, whereas net metrics are calculated net of all fees, expenses and performance-based compensation borne by the private fund.

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding the issues and considerations discussed above, and we will continue to monitor developments in the coming months. Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Investment Funds practice group, or any of the individuals listed below:

Tax Group:
Pamela Lawrence Endreny – New York (+1 212-351-2474, pendreny@gibsondunn.com)
Brian W. Kniesly – New York (+1 212-351-2379, bkniesly@gibsondunn.com)
Daniel A. Zygielbaum – Washington, D.C. (+1 202-887-3768, dzygielbaum@gibsondunn.com)

The following Gibson Dunn attorneys assisted in preparing this client update: Kevin Bettsteller, Shannon Errico, Greg Merz, and Rachel Spinka.

In January 2021, the Corporate Transparency Act came into effect. The law, passed as part of the National Defense Authorization Act, requires millions of U.S. and non-U.S. companies to file information with the Financial Crimes Enforcement Network (“FinCEN”) regarding identity of the beneficial owner(s) of the company.[1] In September 2022, FinCEN promulgated a final rule laying out further details of which companies need to report, what information needs to be reported, and by when.[2]

In less than six months, millions of corporate entities in the United States will be required to file beneficial ownership information directly with FinCEN.[3] Specifically, FinCEN’s beneficial ownership regulation comes into effect on January 1, 2024. Companies that were in existence prior to that time have one year to comply (i.e., by January 1, 2025), and new companies formed after January 1, 2024 will have 30 days to comply with this new regulation.[4] Further, there are potential civil penalties of $500 per day and criminal penalties of up to $10,000 or 2 years in prison for failure to comply.[5]

While we expect that private investment funds and potentially their subsidiaries will generally be exempt from these reporting requirements pursuant to one of the exemptions set forth below, the existence of these new regulations means that each sponsor should undertake a thorough review of its entire structure, including upper tier parent company entities, special purpose vehicles, special accounts, and other entities which exist within the sponsor’s overall corporate structure to identify an applicable exemption for each (if available) or prepare to comply with the new regulation.

The breadth of companies covered by this regulation is quite broad. The regulation covers (a) any domestic corporation or LLC or entity which has filed a document with a Secretary of State (or similar office) and (b) any foreign corporation, LLC, or similar entity that has registered to business in a U.S. state or jurisdiction.[6] Companies that are required to report will have to provide for their “beneficial owners” (defined as those who exercise substantial control over, or own and control at least 25% of the company) information such as legal name, date of birth, address, and an image of a government identification document.[7] And companies created after January 1, 2024 will have to provide similar information for “company applicants,” meaning those directly involved in or primarily responsible for the filing that creates the company.[8]

Notably, however, the beneficial ownership regulation contains 23 exemptions for various types of entities. Some of the exemptions which may be most relevant to our investment funds clients include:

Certain SEC Registered Entities—The regulation exempts various entities that have registered with the SEC, including certain securities issuers, broker dealers, and entities registered under the ‘34 Act.[9]

Fund Advisers—The regulation also exempts an individual entity that meets the definition of an investment advisor or investment company, as well as venture capital fund advisers.[10]

Pooled Investment Vehicles (“PIVs”)—Another exemption covers PIVs operated by, among other entities, broker dealers, investment advisers, and venture capital fund advisers.[11]

Subsidiaries—Any entity “whose ownership interests are controlled or wholly owned, directly or indirectly,” by some—but critically not all—of the other entities that are exempt are also exempt.[12] Notably, for instance, subsidiaries of PIVs are not included as part of this exemption, although PIV subsidiaries may be exempt under other exemptions.

Large Operating Companies—Another important exemption is for “large operating companies,” which are defined as employing more than 20 full time employees in the United States, having an operating presence at a physical office within the United States, and having more than $5 million in gross receipts or sales from sources inside the United States.[13]

Determining whether the beneficial ownership regulation applies requires an entity-by-entity analysis, including for large and complicated corporate structures. For example, while many portfolio and operating companies of a fund may be exempt (e.g., as a large operating company), a holding company that sits above these companies may not qualify for any of the exemptions in the rule. Because this regulation comes into effect in less than six months, we recommend that our clients begin evaluating which of their entities are required to report and, for those entities, who qualifies as a beneficial owner.

* * *

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding the issues and considerations discussed above, including assisting your organization in conducting the entity-by-entity analysis required by the new rules. Gibson Dunn’s Anti-Money Laundering practice group provides legal and regulatory advice to all types of financial institutions and nonfinancial businesses with respect to compliance with federal and state anti-money laundering laws and regulations, including the U.S. Bank Secrecy Act as amended by the USA PATRIOT Act. The group’s members have experience as government lawyers with the Department of the Treasury, the U.S. Department of Justice (DOJ), the U.S. Securities and Exchange Commission (SEC), and the U.S. Attorneys’ Offices, as well as private practitioners.

____________________________

[1] William M. (Mac) Thornberry National Defense Authorization Act for Fiscal Year 2021, H.R. 6395, § 6403.

[2] 31 C.F.R. § 1010.380.

[3] 31 C.F.R. § 1010.380.

[4] 31 C.F.R. § 1010.380(a)(1).

[5] 31 U.S.C. § 5336(h).

[6] 31 C.F.R. § 1010.380(c)(1).

[7] 31 C.F.R. § 1010.380(b)(1).

[8] 31 C.F.R. § 1010.380(b)(1)(iv).

[9] 31 C.F.R. § 1010.380(c)(2)(i), (vii), (ix).

[10] 31 C.F.R. § 1010.380(c)(2)(x)-(xi).

[11] 31 C.F.R. § 1010.380(c)(2)(xviii).

[12] 31 C.F.R. § 1010.380(c)(2)(xxii).

[13] 31 C.F.R. § 1010.380(2)(xxi).

The following Gibson Dunn attorneys assisted in preparing this client update: A.J. Frey, Shannon Errico, Stephanie Brooker, M. Kendall Day, Linda Noonan, and Chris Jones.

Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Investment Funds or Anti-Money Laundering practice groups, or the following authors, practice leaders and members:

Investment Funds Group:
Jennifer Bellah Maguire – Los Angeles (+1 213-229-7986, jbellah@gibsondunn.com)
Kevin Bettsteller – Los Angeles (+1 310-552-8566, kbettsteller@gibsondunn.com)
Albert S. Cho – Hong Kong (+852 2214 3811, acho@gibsondunn.com)
Candice S. Choh – Los Angeles (+1 310-552-8658, cchoh@gibsondunn.com)
John Fadely – Singapore/Hong Kong (+65 6507 3688/+852 2214 3810, jfadely@gibsondunn.com)
A.J. Frey – Washington, D.C./New York (+1 202-887-3793, afrey@gibsondunn.com)
Shukie Grossman – New York (+1 212-351-2369, sgrossman@gibsondunn.com)
James M. Hays – Houston (+1 346-718-6642, jhays@gibsondunn.com)
Kira Idoko – New York (+1 212-351-3951, kidoko@gibsondunn.com)
Eve Mrozek – New York (+1 212-351-4053, emrozek@gibsondunn.com)
Roger D. Singer – New York (+1 212-351-3888, rsinger@gibsondunn.com)
Edward D. Sopher – New York (+1 212-351-3918, esopher@gibsondunn.com)
William Thomas, Jr. – Washington, D.C. (+1 202-887-3735, wthomas@gibsondunn.com)
Shannon Errico – New York (+1 212-351-2448, serrico@gibsondunn.com)

Anti-Money Laundering Group:
Stephanie Brooker – Washington, D.C.(+1 202-887-3502, sbrooker@gibsondunn.com)
M. Kendall Day – Washington, D.C. (+1 202-955-8220, kday@gibsondunn.com)
Linda Noonan – Washington, D.C. (+1 202-887-3595, lnoonan@gibsondunn.com)
Ella Capone – Washington, D.C. (+1 202-955-8220, ecapone@gibsondunn.com)
Chris Jones – Los Angeles (+1 213-229-7786, crjones@gibsondunn.com)

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice. Please note, prior results do not guarantee a similar outcome.

On June 20, 2023 the Securities and Exchange Commission (the “SEC” or the “Commission”) announced the settlement of an enforcement action against Insight Venture Management LLC (d/b/a Insight Partners) (“Insight”) and published an Order Instituting Administrative and Cease-and-Desist Proceedings, Pursuant to Sections 203(e) and 203(k) of the Investment Advisers Act of 1940 (the “Order”).[1] In the Order, the SEC found that Insight (1) charged excess management fees to its investors through “inaccurate application of its permanent impairment policy” and (2) failed to disclose a conflict of interest to investors concerning the same policy.[2] This action reflects a growing trend we continue to see in our representation of private fund managers in their routine examinations by the SEC–direct and explicit inquiry into the decision by a given fund manager to not permanently impair (i.e., “write-down”) a given fund asset when such impairment would reduce the basis on which management fees are calculated. We view this as a clear indication of the Commission’s focus on scrutinizing the calculation of management fees, in particular after the termination of the commitment period.

I. Calculation of Management Fees

Insight operated multiple funds (the “Funds”) whose respective limited partnership agreements (“LPAs”) required, like many do, that management fees be calculated during the “commitment period” (i.e., the period during which the Funds were permitted to make investments) on the basis of committed capital and during the “post-commitment period” (i.e., the period after the commitment period during which the Funds look to exit investments and realize returns)[3] based on invested capital (i.e., “the acquisition cost of portfolio investments held by the Funds”). Pursuant to the LPAs, when an asset had suffered a “permanent impairment in value” that basis was to be reduced commensurately.[4] The Commission took issue with Insight’s approach to determining whether a permanent impairment had occurred (and whether Insight resultantly calculated management fees on too large a basis).

Specifically, the Commission identified three of Insight’s practices as problematic:

Lack of written criteria in LPA. Insight did not include any language in the Funds’ LPAs indicating how a permanent impairment determination would be made.[5]
Subjective evaluation criteria. In practice, Insight employed a four pronged test to determine whether a permanent impairment was appropriate[6] which included whether: “(a) the valuation of the Fund’s aggregated investments in a portfolio company was currently written down in excess of 50% of the aggregate acquisition cost of the investments; (b) the valuation of the Fund’s aggregated investments in a portfolio company had been written down below its aggregate acquisition cost for six consecutive quarters; (c) the write-down was primarily due to the portfolio company’s weakening operating results, as opposed to market conditions or comparable transactions, or valuations of comparable public companies; and (d) the portfolio company would likely need to raise additional capital within the next twelve months.”[7]
Portfolio Company Level v. Portfolio Investment Level. The Funds’ LPAs included separate definitions for “portfolio company” (i.e., “an entity in which a [p]ortfolio [i]nvestment is made by the [p]artnership directly or through one or more intermediate entities of the [p]artnership”) and “portfolio investment” (i.e., “any debt or equity (or debt with equity) investment made by the [p]artnership”). Further, the LPA provision governing permanent impairments indicated that they were to be assessed on a portfolio investment level rather than a portfolio company level (emphasis added).[8] The Commission took the position that Insight’s aforementioned evaluation criteria failed to honor this distinction and instead only analyzed the need for a permanent impairment at the aggregate portfolio company level.[9]

Taken together, the Commission found that these practices caused Insight to fail to permanently impair certain of their Funds’ assets to the correct extent. As a result, the Commission determined that Insight failed to adequately reduce the basis upon which post-commitment period management fees were calculated, and overcharged their investors.

II. Conflicts of Interest

In addition to the miscalculation of management fees, the Commission also found that the subjective nature of the criteria Insight used to determine whether a permanent impairment had occurred created a conflict of interest between Insight and its investors. Put differently, because Insight was the party ultimately determining whether to find a permanent impairment had occurred, Insight had the right to reverse any permanent impairment it had previously applied, and finding a permanent impairment had occurred would result in Insight collecting fewer management fees, it should have, at the very least, disclosed the existence of this conflict to its investors.[10]

III. Violations and Penalties

As part of its settlement with the SEC, Insight was ordered to reimburse its investors upwards of $4.6 million, corresponding to excess management fees charged and interest thereon, and was required to pay a civil penalty of an additional $1.5 million. It is also notable that although the Commission acknowledged Insight’s prompt remedial efforts (which included mid-exam reimbursement) and cooperation during the course of the investigation, they still decided to proceed with enforcement.

IV. Analysis & Key Takeaways

When determining whether to find a permanent impairment, fund managers should consider listing the criteria they apply in the operative provisions of their LPA(s). Note also that if this practice is adopted, it will be imperative that fund managers adhere closely to the criteria included in the LPA.
Though we expect criteria for finding a permanent impairment will always involve some level of subjectivity, including objective factors to the extent possible and/or involving a third-party valuation professional in the process could provide a meaningful level of enforcement risk mitigation. However, while the Order indicates that Insight did, to the satisfaction of the Commission, subsequently apply more objective criteria when determining the amount of management fees it had overcharged its investors, the Order provides no clear guidance as to what criteria the Commission considers sufficiently objective.
In addition to common valuation related conflicts of interest disclosed in private placement memoranda and similar disclosure documents, fund managers should consider including explicit disclosure around the conflict of interest inherent in the fund manager deciding whether to permanently impair a fund’s assets when such decision would negatively impact the amount of management fees the fund manager would be owed.

V. Conclusion

The SEC’s recent settlement of its enforcement action against Insight reflects the overall trend towards increased scrutiny of the private funds industry generally, including pursuant to its increased rulemaking related to the same. More specifically, this emphasis on valuation and write-down practices is in harmony with the Commission’s 2023 Examination Priorities Report,[11] as well as other recently settled enforcement actions.[12] We expect this trend to continue.

__________________________

[1] Order Instituting Administrative and Cease-and-Desist Proceedings, Pursuant to Sections 203(e) and 203(k) of the Investment Advisers Act of 1940, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order, Release No. 6332 (June 20, 2023), link.

[2] Id., Paragraph 1

[3] Id., Paragraph 11

[4] Id., Paragraph 11

[5] Id., Paragraph 14

[6] We note that the Order did not make it clear whether this four-pronged test was maintained or recorded by Insight in any formal investment or valuation policy, but the Commission did note that “Insight did not adopt or implement written policies or procedures reasonably designed to prevent violations of the Advisers Act relating to the calculation of management fees…” See Id., Paragraph 18.

[7] Id., Paragraph 15

[8] Id., Paragraph 12

[9] Id., Paragraph 16

[10] Id., Paragraph 17

[11] Securities and Exchange Commission, Division of Examinations, 2023 Examination Priorities, link.

[12] See e.g., Order Instituting Administrative and Cease-and-Desist Proceedings, Pursuant to Sections 203(e) and 203(k) of the Investment Advisers Act of 1940, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order, Release No. 6104 (Sept. 2, 2022) (Finding that Energy Innovation Capital Management LLC, an exempt reporting adviser, improperly calculated management fees by failing to make adjustments for dispositions of its investments, which included any write-down in value of individual portfolio company securities, when the value of such securities provided the basis on which management fees were calculated, resulting in charging its investors excessive management fees), link; Order Instituting Administrative and Cease-and-Desist Proceedings, Pursuant to Sections 203(e) and 203(k) of the Investment Advisers Act of 1940, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order, Release No. 5617 (Oct. 22, 2020) (Finding that EDG Management Company, LLC failed to write-down the value of certain of its portfolio securities as required by the applicable LPA, which resulted in overcharging management fees to its investors which were calculated using the value of such portfolio securities as the basis), link.

Should you wish to review how your actual management fee calculations synch up with the mechanics set forth in your limited partnership agreement and disclosure set forth in your private placement memoranda, or if you have any questions about how best to prepare for examination scrutiny related to the same, please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Investment Funds practice group, or the following authors:

Kevin Bettsteller – Los Angeles (+1 310-552-8566, kbettsteller@gibsondunn.com)
Gregory Merz – Washington, D.C. (+1 202-887-3637, gmerz@gibsondunn.com)
Shannon Errico – New York (+1 212-351-2448, serrico@gibsondunn.com)
Zane E. Clark – Washington, D.C. (+1 202-955-8228 , zclark@gibsondunn.com)

Investment Funds Group Contacts:
Jennifer Bellah Maguire – Los Angeles (+1 213-229-7986, jbellah@gibsondunn.com)
Albert S. Cho – Hong Kong (+852 2214 3811, acho@gibsondunn.com)
Candice S. Choh – Los Angeles (+1 310-552-8658, cchoh@gibsondunn.com)
John Fadely – Singapore/Hong Kong (+65 6507 3688/+852 2214 3810, jfadely@gibsondunn.com)
A.J. Frey – Washington, D.C./New York (+1 202-887-3793, afrey@gibsondunn.com)
Shukie Grossman – New York (+1 212-351-2369, sgrossman@gibsondunn.com)
James M. Hays – Houston (+1 346-718-6642, jhays@gibsondunn.com)
Kira Idoko – New York (+1 212-351-3951, kidoko@gibsondunn.com)
Eve Mrozek – New York (+1 212-351-4053, emrozek@gibsondunn.com)
Roger D. Singer – New York (+1 212-351-3888, rsinger@gibsondunn.com)
Edward D. Sopher – New York (+1 212-351-3918, esopher@gibsondunn.com)
William Thomas, Jr. – Washington, D.C. (+1 202-887-3735, wthomas@gibsondunn.com)

I. Overview

On May 3, 2023, the U.S. Securities and Exchange Commission (the “SEC” or the “Commission”), by a three-to-two vote, adopted significant amendments (the “Amendments”) to Form PF, the confidential reporting form created in 2011 as part of the Dodd-Frank Act that is intended to provide the Commission and the Financial Stability Oversight Council (“FSOC”) with important data and information about private funds. The Commission, citing Form PF’s historical role in allowing both the Commission and FSOC to monitor systemic risk in the private funds industry, stated that the Amendments will provide regulators with “timely and critical information in times of market stress or volatility” as they attempt to “stem the tides on a potential crisis and help prevent investor harm.”[1]

Form PF is required to be completed and filed by entities which are (i) registered or required to register with the SEC as an investment adviser, (ii) manage one or more private funds, and (iii) together with their related persons, collectively, had at least $150 million in private fund assets under management as of the last day of the most recently completed fiscal year.[2] The Amendments, which introduce two new sections to Form PF, apply to three categories of advisers: (1) hedge fund advisers[3] with at least $1.5 billion in hedge fund assets under management (“Large Hedge Fund Advisers”), (2) investment advisers with at least $150 million in private fund assets under management (“Private Equity Advisers”), and (3) investment advisers with at least $2 billion in private equity fund assets under management (“Large Private Equity Advisers”)[4]. The first new section applies to all Private Equity Advisers, and requires that they make filings within 60 days following the end of any fiscal quarter in which a specified trigger event occurred (the “Quarterly Reporting Window”). The other new section applies only to Large Hedge Fund Advisers, and requires that they make filings as soon as practicable, but no later than 72 hours following certain “significant events that have the potential for broad impacts or investor loss” (the “72 hour Reporting Window”).[5] Finally, the Amendments require that Large Private Equity Advisers report additional data in their annual Form PF filings. The below table summarizes the applicable filing requirements, and each of these changes is described in greater detail below.

Triggering Event	Large Hedge Fund Advisers with $1.5bn+ in hedge fund AUM	Private Equity Advisers with $150m+ in private fund AUM	Large Private Equity Advisers with $2bn+ private equity fund AUM
The investment adviser instigates a secondary transaction		File within 60 days of quarter end	File within 60 days of quarter end
Investors elect to remove the general partner (with or without cause)		File within 60 days of quarter end	File within 60 days of quarter end
Investors elect to terminate the fund (for any reason)		File within 60 days of quarter end	File within 60 days of quarter end
Investors elect to terminate the investment period (for any reason)		File within 60 days of quarter end	File within 60 days of quarter end
10-business day holding period return of fund is less than or equal to 20% of aggregate calculated value	File within 72 hours
10 business day change in posted margin, collateral, or equivalent is greater than or equal to 20% of average daily aggregate calculated value during same period	File within 72 hours
Fund is in default on a call for margin, collateral or an equivalent that it cannot cover, or adviser determines that fund will not be able to meet such call	File within 72 hours
A counterparty to a reporting fund (a) does not meet a call for margin, collateral or equivalent or fails to make any other payment on time and in the form contractually required and (b) the amount involved is greater than 5% of aggregate calculated value	File within 72 hours
Termination or material restriction of a reporting fund’s relationship with a prime broker	File within 72 hours
There is a “significant disruption or degradation of the reporting fund’s critical operations”	File within 72 hours
Fund receives cumulative requests for withdrawals or redemptions equal to at least 50% of the most recent net asset value	File within 72 hours
Fund is unable to pay redemption requests	File within 72 hours
Fund has suspended redemptions for at least 5 consecutive business days	File within 72 hours

II. Private Equity Advisers are required to file Form PF on a quarterly basis following the occurrence of certain “trigger” events

The Amendments require that all Private Equity Advisers file Form PF in the Quarterly Reporting Window after the end of a fiscal quarter in which either (1) an adviser-led secondary transaction occurred or (2) a fund’s investors elect to remove the general partner, terminate the fund, or terminate the fund’s investment period.[6] Accordingly, Private Equity Advisers are recommended to institute a process wherein they check on a quarterly basis whether a filing is required as a result of such activity.

A. Adviser-Led Secondary Transactions

Private Equity Advisers will be required to file Form PF within the Quarterly Reporting Window after an adviser-led secondary transaction, which the Amendments define as “any transaction initiated by the adviser or any of its related persons that offers private fund investors the choice to: (1) sell all or a portion of their interests in the private fund; or (2) convert or exchange all or a portion of their interests in the private fund for interests in another vehicle advised by the adviser or any of its related persons.”[7] A filing is only required if the transaction is “initiated” by a fund’s Private Equity Adviser (or a related person), which the Commission conceded will require an analysis of the relevant facts and circumstances and noted would generally not include a scenario where the adviser, at the unsolicited request of an investor, participates in a secondary sale of such investor’s fund interest.[8] Importantly, the requirement does not contain exceptions for ordinary-course transactions or situations where the fund’s investors or advisory committee have approved the transaction, as the Commission noted that such approvals, while helpful, “do not always ameliorate investor protection concerns.”[9]

B. Removal of General Partner, Termination of Fund or Termination of Investment Period

Private Equity Advisers will also be required to file Form PF within the Quarterly Reporting Window following: (1) the removal of the adviser or an affiliate thereof as the general partner (or similar control person) of a fund, (2) the election by the fund’s investors to terminate the fund, or (3) the election by the fund’s investors to terminate the fund’s investment period.[10] In each case, the Private Equity Adviser will be required to disclose the effective date of the removal or termination event, as applicable, and a description of such event, and each requirement is triggered upon the adviser receiving notification of the investors’ decision.[11] The Commission noted that only removals or terminations made by the election of the investors would require a filing, but stressed the filing requirement was not limited to “for cause” removals or terminations, noting that such instances are inherently “serious departures from ordinary course operations.”[12]

III. Large Hedge Fund Advisers are required to file Form PF within 72 hours of specified “trigger” events

Under the Amendments, Large Hedge Fund Advisers will be required to file Form PF within the 72 hour Reporting Window following certain triggering events, which are summarized below. As a practical matter, this means that Large Hedge Fund Advisers will need to add a significant number of items to the list of calculations that they run daily in order to determine whether a filing is required.

Extraordinary Investment Losses. Filing required if, as of any business day, the 10-business day holding period return of a reporting fund is less than or equal to 20% of the reporting fund aggregate calculated value.[13]
Significant Margin and Default Events. Filing required if (a) during any 10 business days, the change in a reporting fund’s posted margin, collateral, or equivalent is greater than or equal to 20% of such reporting fund’s average daily aggregate calculated value during the same period or (b) the adviser receives notice that a reporting fund is in default on a call for margin, collateral or an equivalent that it cannot cover with additional funds (or determines that such reporting fund will not be able to meet such call).[14]
Counterparty Default. Filing required if a counterparty to a reporting fund (a) does not meet a call for margin, collateral or equivalent or fails to make any other payment on time and in the form contractually required and (b) the amount involved is greater than 5% of the reporting fund aggregate calculated value.[15]
Prime Broker Relationship Terminated or Materially Restricted. Filing required following the termination or material restriction of a reporting fund’s relationship with a prime broker.[16]
Operations Events. Filing required following an “operations event,” which is defined as a “significant disruption or degradation of the reporting fund’s critical operations” (e.g., operations necessary for the investment, trading, valuation, reporting, and risk management of the reporting fund or the operation of the reporting fund in accordance with federal securities laws and regulations).[17]
Redemptions. Filing required if a reporting fund (a) receives cumulative requests for withdrawals or redemptions equal to at least 50% of the most recent net asset value (after netting against subscriptions or other contributions from investors received and contractually committed), (b) is unable to pay redemption requests, or (c) has suspended redemptions for at least 5 consecutive business days.[18]

The portion of the Amendments covered in sections II and III above will become effective six months after publication of the adopting release in the Federal Register.

IV. Large Private Equity Advisers are required to report additional data as part of their routine Form PF filings

Finally, the Amendments add and amend various questions to Section 4 of Form PF, which is only required to be completed by Large Private Equity Advisers. Most importantly, such advisers will now be required to report whether any reporting fund has effectuated (1) a limited partner clawback (or clawbacks) in excess of an aggregate amount equal to 10% of such fund’s aggregate capital commitments or (2) any general partner clawback, and must provide the reason for such clawback.[19]

The Amendments will also require Large Private Equity Advisers to answer new questions regarding investment strategies of their private equity funds and fund-level borrowing (including with regard to the value of the fund’s borrowings, the types of creditors, and whether the fund can borrow at the fund-level as an alternative or complement to financing of portfolio companies). Additionally, the Amendments will require more granular details regarding certain events of default, bridge financing arrangements (including identifying the institution that provides any bridge loan to a controlled portfolio company), and the geographical breakdown of a fund’s investments (based on a percentage of NAV).[20] Unlike the “trigger” based filing requirements outlined above, changes to Section 4 will become effective one year following publication, and thus should not be relevant for advisers with a December fiscal year end until their annual filings are due in 2025.[21]

V. Analysis

The Amendments will require Private Equity Advisers to add to their quarterly compliance checklists a question as to whether they need to make a filing as a result of a GP-initiated secondary transaction, or a vote of the limited partners to remove the general partner, terminate the fund, or end the investment period early. In addition to paying attention to the other filing requirements described above, Large Hedge Fund Advisers will now need to perform specified calculations on a daily basis (see section III.A. and B. above) and will need to closely monitor redemption requests to determine if they have exceeded 50% of the most recently calculated NAV.

It is not clear what the effect of making a filing under the new requirements will be, but as the Amendments are intended to allow the SEC to monitor systemic risk, such filings will presumably lead to additional questions from the staff, and raise the probability of an SEC inspection.

_____________________________

[1] Press Release, U.S. Securities and Exchange Commission, “Statement on Amendments to Form PF” (May 3, 2023), available at https://www.sec.gov/news/statement/crenshaw-statement-form-pf-050323.

[2] Form PF General Instructions, available at https://www.sec.gov/files/formpf.pdf.

[3] A “hedge fund” generally includes any private fund (other than a securitized asset fund):

(a) with respect to which one or more investment advisers (or related persons of investment advisers) may be paid a performance fee or allocation calculated by taking into account unrealized gains (other than a fee or allocation the calculation of which may take into account unrealized gains solely for the purpose of reducing such fee or allocation to reflect net unrealized losses);

(b) that may borrow an amount in excess of one-half of its net asset value (including any committed capital) or may have gross notional exposure in excess of twice its net asset value (including any committed capital); or

(c) that may sell securities or other assets short or enter into similar transactions (other than for the purpose of hedging currency exposure or managing duration).

Solely for purposes of Form PF, any commodity pool about which you are reporting or required to report on Form PF is categorized as a hedge fund.

For purposes of this definition, long and short positions should not be netted and any borrowings or notional exposure of another person that are guaranteed by the private fund or that the private fund may otherwise be obligated to satisfy should be included.

In general, advisers managing open-ended real asset funds are not considered to be “hedge funds” under Form PF and will not need to make the additional filings included in the Amendments for Large Hedge Fund Advisers. Should you have any questions about the proper filing status of one of your funds, please contact the Gibson Dunn lawyer with whom you usually work, or one of the authors listed herein.

[4] “Regulatory assets under management” corresponds to the same figure reported in the adviser’s Form ADV filing (“RAUM”). “Private fund assets under management” refers to the portion of an adviser’s RAUM attributable to private funds, “private equity fund assets under management” refers to the portion of an adviser’s RAUM attributable to private equity funds, and “hedge fund assets under management” refers to the portion of an adviser’s RAUM attributable to hedge funds.

[5] Press Release, U.S. Securities and Exchange Commission, “Statement on Amendments to Form PF” (May 3, 2023), available at https://www.sec.gov/news/statement/crenshaw-statement-form-pf-050323.

[6] Amendments to Form PF to Require Event Reporting for Large Hedge Fund Advisers and Private Equity Fund Advisers and to Amend Reporting Requirements for Large Private Equity Advisers, SEC Rel. No. IA-6297 (May 3, 2023). Available at https://www.sec.gov/news/press-release/2023-86?utm_medium=email&utm_source=govdelivery.

[7] Id. at 61.

[8] Id.

[9] Id. at 64.

[10] Id. at 64-65.

[11] Id. at 65.

[12] Id. at 67.

[13] Id. at 17. “Reporting fund aggregate calculated value” is defined as follows: Every position in the reporting fund’s portfolio, including cash and cash equivalents, short positions, and any fund-level borrowing, with the most recent price or value applied to the position for purposes of managing the investment portfolio. The reporting fund aggregate calculated value is a signed value calculated on a net basis and not on a gross basis. Where one or more portfolio positions are valued less frequently than daily, the last price used should be carried forward, though a current foreign exchange rate may be applied if the position is not valued in U.S. dollars. It is not necessary to adjust the reporting fund aggregate calculated value for accrued fees or expenses. Reporting fund aggregate calculated value does not need to be subjected to fair valuation procedures. The inclusion of income accruals is recommended but not required; however, the approach should be consistent over time. The reporting fund aggregate calculated value may be calculated using the adviser’s own internal methodologies and conventions of the adviser’s service providers, provided that these are consistent with the information reported internally. “Holding period return” is defined as the cumulative ‘daily rate of return’ over the holding period calculated by geometrically linking the daily rates of return.

[14] Id. at 22-31.

[15] Id. at 31-34.

[16] Id. at 35. Termination events that are set forth in the prime broker (or related) agreement that are isolated to the financial state, activities or other conditions solely of the prime broker do not require a filing.

[17] Id. at 41-48.

[18] Id. at 49-54. While “cumulative” isn’t defined, a filing will be required if, at any time, total withdrawal or redemption requests which have not been granted exceed 50% of NAV.

[19] Id. at 72-78. For purposes of the Amendments, a “limited partner clawback” is defined as “an obligation of a fund’s investors to return all or any portion of a distribution made by the fund to satisfy a liability, obligation, or expense of the fund pursuant to the fund’s governing agreements,” and a “general partner clawback” is defined as “any obligation of the general partner, its related persons, or their respective owners or interest holders to restore or otherwise return performance-based compensation to the fund pursuant to the fund’s governing agreements.”

[20] Id. at 79-83.

[21] Id. at 87-88.

Gibson Dunn’s lawyers are available to assist with any questions you may have regarding the issues and considerations discussed above. Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Investment Funds practice group, or the following authors:

Gregory Merz – Washington, D.C. (+1 202-887-3637, gmerz@gibsondunn.com)
Lauren Cook Jackson – Washington, D.C. (+1 202-955-8293, ljackson@gibsondunn.com)
Shannon Errico – New York (+1 212-351-2448, serrico@gibsondunn.com)
Robert Harrington – New York (+1 212-351-2608, rharrington@gibsondunn.com)

Click for PDF

What you need to know now.

On Wednesday, February 9, 2022, the SEC proposed changes to its rules for investment advisers to private funds. The proposal, if adopted, will be a seismic shift in the regulatory landscape for private fund advisers.

We plan to share a detailed analysis soon. For now, please find below a quick Q&A update.

Q1: What is in the proposal?

A1: New requirements and prohibitions.

New Requirements

The new rules, if adopted as proposed, will require a private fund adviser to:

Provide fund investors with quarterly statements that include standardized disclosures on fees and expenses (generated at the fund and portfolio investment levels) and investment performance (with distinct requirements for liquid and illiquid funds);

For purposes of calculating IRR and MOIC, performance must be presented on an unlevered basis;

Obtain annual audited financial statements for each fund advised by the adviser, and deliver the audited financial statements to each of the fund’s investors;

Obtain an independent, professional fairness opinion for all “adviser-led secondary transactions” and deliver copies of the opinion to investors participating in the transaction;

Prepare and retain a written report of the adviser’s annual compliance program review;

Disclose to all prospective investors in a fund, prior to investment, the details of any preferential rights granted to any of the fund’s investors;* and

Disclose annually to all fund investors the details of any preferential rights granted to any of the fund’s investors.*

*The last two bullets apply to all private fund advisers, including those that are not required to register.

New Prohibitions

The new rules, if adopted as proposed, will prohibit all registered and exempt-reporting advisers to private funds from:

Providing preferential treatment to one or more investors with respect to (i) redemption or other liquidity rights, or (ii) access to information regarding portfolio investments and exposures;

Accelerating the payment of portfolio company monitoring fees;

Allocating to a fund costs related to government examinations or investigations of the adviser;

Allocating to a fund adviser-level regulatory or compliance related costs;

Allocating costs related to portfolio investments held by multiple funds and co-investment vehicles on a non pro rata basis;

Returning clawbacks of carried interest net of taxes;

Benefiting from any indemnification or limitations of liability for breach of fiduciary duty, willful malfeasance, bad faith, recklessness or simple negligence; and

Borrowing from a fund.

Q2: I am an adviser that already prepares audited financial statements for our fund(s). How does the new audit requirement differ from the Custody Rule’s audit requirement?

A2: The proposed audit requirement differs from the Custody Rule’s audit requirement in a number of respects. For example, the proposed rules:

Require the adviser to take “all reasonable steps” to cause funds advised but not controlled by the adviser (e.g., sub-advised funds) to prepare and deliver audited financial statements;

Require advisers to “promptly” deliver statements after completion of the audit (instead of within 120 days of the fund’s fiscal year end);

Require the auditor to notify the SEC if (i) the auditor resigns or is terminated, or (ii) the auditor is unable to deliver a clean opinion.
If you do not already prepare audited financial statements for the fund(s) you manage: The new rules do not have a surprise audit alternative.

Q3: What is an “adviser-led secondary transaction” that requires a professional, independent fairness opinion?

A3: An adviser-led secondary transaction is defined as a transaction in fund interests initiated by the investment adviser that offers fund investors a choice to either:

sell all or a portion of their interests in the fund; or

convert or exchange all or a portion of their interests in the fund for interests in another vehicle advised by the adviser or its related persons.

Secondary transactions in which an adviser provides assistance on an LP’s request, but is not involved in setting the price for the transaction, would not be considered “adviser-led.”

Q4: What about my business would change under the proposed rules?

A4: It depends. Much of the proposal aligns with current industry best practices and is already part of business-as-usual for private fund advisers with sophisticated institutional clients. For example, many advisers already:

Provide quarterly statements (albeit the form and content of these statements may have to change to comply with the new proposed requirements);

Prepare and provide audited financial statements for their funds; and

Obtain fairness opinions in connection with fund restructurings, continuation funds and other secondary transactions;

Document the results of their annual compliance program reviews in writing.
However, other aspects of the proposal represent costly, time consuming and logistically challenging undertakings. For example:

The proposed new disclosure requirements with respect to preferential treatment will be burdensome and logistically challenging to implement as compared to current practices regarding side letters and fund closing processes; and

The prohibitions on returning clawbacks net of taxes and indemnification for simple negligence are inconsistent with market practice.

Q5: When will we know whether the rules will be adopted?

A5: We will not know for months, perhaps years. Market participants will have 30 days after the proposal is published in the Federal Register or until April 11, 2022, whichever is later, to submit comments on the proposal to the SEC. There is no proscribed timeline thereafter by which final rules must be completed and released.

Q6: If the proposed rules are not yet adopted, why should I care now?

A6: You should care for at least two reasons:

In a recent Risk Alert, the SEC’s Examination Division highlighted a number of the issues identified in the rules proposal. The SEC could regulate through examination and enforcement in advance of the Commission completing a final rulemaking.

The proposal has been a long time coming and many significant components of the proposal are likely to be adopted. Chair Gensler, Commissioners Lee and Crenshaw all issued similar, full-throated endorsements of the proposal. However, Commissioner Pierce issued a dissenting statement and voted against the proposal. The proposal has been met with nearly instantaneous and strenuous objections from the private fund industry. Accordingly, we expect a robust comment process that may lead to modifications before the final rules are adopted.

Q7: How did we get here?

A7: The SEC’s focus on the private fund industry has steadily grown since 2010 and has dramatically intensified over the last year.

In December 2020, the SEC replaced the advertising and solicitation rules for advisers, with the new Marketing Rule. The new rule significantly impacts communications between private fund advisers and investors in private funds. Compliance is required by November 2022.

In the SEC’s Spring 2021 regulatory agenda, the new SEC Chair included increased regulation of the private fund industry – alongside cryptocurrency, SPACs, and ESG disclosures – as one of his top regulatory priorities.

In November 2021, Chair Gensler told the ILPA Summit that the time has come to “take stock” and “bring sunshine and competition to the private fund space” because private funds – which manage $17 trillion – play an important role in the country’s capital markets.

On January 26, 2022, the SEC proposed updates to reporting requirements on Form PF.

On January 27, 2022, the Examination Division released the Risk Alert referenced above, entitled “Observations from Examinations of Private Fund Advisers.”

On February 9, 2022, the SEC issued its 341-page rules proposal for increased regulation of advisers to private funds.

On February 9, 2022, the SEC also proposed cybersecurity-related rules for investment advisers that would, among other things, require firms to (1) disclose cybersecurity risks and incidents on the Form ADV 2A and (2) report significant cybersecurity incidents on a new Form ADV-C. The comment period for the proposal is the same as described in A5 above.

Q8: Is there anything else I need to know?

A8: Yes. We will soon publish a more detailed analysis of the Feb. 9 proposals. In the meantime, we note that all investment advisers are required to comply with the new Marketing Rule by no later than November 5, 2022. We strongly recommend that you begin planning for this deadline now. As a practical matter, we suggest drafting any offering documents or marketing materials with new Rule’s disclosure standards in mind, especially if you anticipate using the materials after your firm converts over to compliance with the new Rule.

The following Gibson Dunn attorneys assisted in preparing this client update: Gregory Merz, Lauren Cook Jackson, and Crystal Becker.

Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Investment Funds practice group, or any of the following:

Jennifer Bellah Maguire – Los Angeles (+1 213-229-7986, jbellah@gibsondunn.com)
Albert S. Cho – Hong Kong (+852 2214 3811, acho@gibsondunn.com)
Candice S. Choh – Los Angeles (+1 310-552-8658, cchoh@gibsondunn.com)
John Fadely – Hong Kong (+852 2214 3810, jfadely@gibsondunn.com)
A.J. Frey – Washington, D.C. (+1 202-887-3793, afrey@gibsondunn.com)
Y. Shukie Grossman – New York (+1 212-351-2369, sgrossman@gibsondunn.com)
John Senior – New York (+1 212-351-2391, jsenior@gibsondunn.com)
Roger D. Singer – New York (+1 212-351-3888, rsinger@gibsondunn.com)
Edward D. Sopher – New York (+1 212-351-3918, esopher@gibsondunn.com)
C. William Thomas, Jr. – Washington, D.C. (+1 202-887-3735, wthomas@gibsondunn.com)
Gregory Merz – Washington, D.C. (+1 202-887-3637, gmerz@gibsondunn.com)
Lauren Cook Jackson – Washington, D.C. (+1 202-955-8293, ljackson@gibsondunn.com)
Crystal Becker – New York (+1 212-351-2679, cbecker@gibsondunn.com)

Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.