On 23 August 2023, the SEC adopted final rules under the U.S. Investment Advisers Act of 1940 (the Advisers Act). Whilst the final rules are significantly less onerous than originally proposed, they do establish new requirements and obligations that will impact all private fund advisers, including both registered investment advisers (RIAs) and, in some cases, exempt reporting advisers (ERAs).
In particular, whilst the SEC had earlier proposed to ban outright certain categories of prohibited activities, the final rule adopts a disclosure (and in some cases investor consent) approach and also "grandfathers" most existing funds from the prohibited activities provisions. The new rules generally take effect 18 months after publication in the U.S. Federal Register, with certain of the prohibited activities rules subject to an effective date of 12 months after publication for fund groups with assets under management of US$1.5 billion or more.
The new rules
The final rules impose five new requirements on private fund advisers, along with two related rule amendments to facilitate the reforms:
Restricted Activities Rule. All private fund advisers (RIAs and ERAs alike) will be required to provide disclosures – and in some cases obtain investor consent – for a set of five "restricted activities" that involve conflicts of interest, charging certain regulatory-related fees and expenses, charging non-pro rata fees and expenses, returning only after-tax amounts of GP clawback and borrowing from private fund clients.
Quarterly Statement Rule. All SEC-registered private fund advisers must provide information about each private fund's fees, expenses and portfolio performance, with different standards for "liquid funds" and "illiquid funds" each as defined in the final rule. Statements will generally be due within 45 days after quarter-end and 90 days after year-end; funds of funds will have 75 and 120 days, respectively.
Audit Rule. All SEC-registered private fund advisers must procure for each private fund they advise to undergo an annual audit financial statement audit, which the final rule requires to be prepared in accordance with the provisions of Rule 206(4)-2, popularly known as the "Custody Rule."
Adviser-Led Secondaries Rule. SEC-registered private fund advisers conducting an adviser-led secondary transactions must satisfy certain requirements, one of which shall be either (i) a fairness opinion or (ii) a valuation opinion, along with enhanced disclosures about conflicts of interest with the opinion provider. The option to utilize a valuation opinion rather than a fairness opinion reflects the sharp criticism of this proposal from the private funds industry.
Preferential Treatment Rule. All private fund advisers (RIAs and ERAs alike) will be prohibited from providing preferential treatment to large investors with respect to redemption rights or access to information that could reasonably be expected to have a material, negative effect on other investors. In addition, advisers will be required to disclose all other types of preferential treatment (such as many side letter provisions), both to potential investors, to some degree, and to all other fund investors.
In addition to the five major reforms described above, the SEC is adopting proposed amendments to the Advisers Act compliance rule to require all SEC-registered advisers to document the annual review of their compliance policies and procedures in writing. Note that this change, unlike the other rules, takes effect within 60 days of publication in the Federal Register.
The SEC is amending Rule 204-2 (the Books and Records Rule) under the Advisers Act to incorporate recordkeeping related to the five new major rules. While the Books and Records Rule applies only to RIAs, ERAs should be mindful of the recordkeeping standards, both as a 'best practices' approach and in the event that an ERA might one day be required to register with the SEC.
The new rules will take effect in a staggered manner of up to 18 months after the final rule is published in the Federal Register, depending on the rule and the amount of assets under management of the relevant adviser:
- The Quarterly Statement Rule and Audit Rule take effect 18 months after publication in the Federal Register.
- The Adviser-Led Secondaries Rule, Restricted Activities Rule and Preferential Treatment Rule take effect.
- For advisers with less than US$1.5 billion in private fund assets under management, 12 months after publication in the Federal Register.
- For advisers with more than US$1.5 billion in private fund assets under management, 18 months after publication in the Federal Register.
- Revisions to the annual compliance review requirements take effect within 60 days of publication in the Federal Register.
Certain funds in operation prior to the effective date otherwise subject to the prohibition of the Preferential Treatment Rule and consent-based requirements of the Restricted Activities Rule will be "grandfathered" in as legacy funds to the extent compliance would require the adviser and investors to amend the fund's governing documents.
What this means for APAC investors
Taken together, the new rules represent one of the most significant regulatory impacts on private funds since the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Noting that the assets under management by private fund advisers rose from US$9.8 trillion in 2012 to US$26.6 trillion in 2022, the SEC highlighted the increasing exposure of many retirement plans to private funds, as well as rising retail investor interest in private funds.
The SEC believes that three primary factors contribute to investor protection risks and harms: lack of transparency, conflicts of interest, and lack of robust fund governing mechanisms. The SEC justified adoption of the final package of private fund rules, as modified to be less restrictive and more flexible than initially proposed, to provide investors with protections designed to meet these concerns.
The question remains as to how far the reforms will affect non-U.S. investor advisers. The rules contain only limited information on this point at present and it remains to be seen if the SEC confirms whether the substantive provisions will apply to relationships between a non-U.S. based investment adviser and its non-U.S. clients.
The final private funds rule is available in full here.
Please see our alert SEC adopts final rule implementing private fund reforms for more on the reforms.
Authored by James Wood, Adam Brown, Henry D. Kahn, Kevin Lees, and Nigel Sharman.