SEC Proposes New Rule on Investment Advisors’ Disclosures and Compliance

In a November 2021 speech at the Institutional Limited Partners Association Summit, SEC Chair, Gary Gensler, outlined areas of particular concern to the SEC with respect to investment advisors.² Gensler discussed:

• Fees and Expenses —­ Gensler stated that the SEC “can promote additional transparency around fees and expenses to fund investors.”³
• Side Letters —­ Gensler stated that the SEC needs “to consider recommendations regarding how we can level the playing field and strengthen transparency, or whether certain side letter provisions should not be permitted.”⁴
• Performance Metrics —­ Gensler said that the SEC needs to consider what it can do to enhance transparency regarding fund performance so that investors can understand whether private fund investments are “outperform[ing] the public markets net of fees, or taking into account leverage and liquidity.”⁵
• Fiduciary Duties —­ Gensler reiterated that private funds have federal fiduciary duties under the Investment Advisors Act, which cannot be waived, even if advisors secure waivers of state level fiduciary duties. He also stated that the SEC is examining ways to “mitigate the effects of conflicts of interest between general partners, their affiliates, and investors” —­ such as “prohibitions on certain conflicts and practices.”⁶
• Form PF Disclosures —­ Gensler stated that, while the SEC has “learned a lot” about financial markets from investment advisor Form PF disclosures, the SEC is considering “enhancing reporting and disclosure through Form PF or other reforms” to gain “more granular or timelier information.”⁷

And now the SEC has proposed a new rule to tackle many of the areas addressed in Gensler’s speech.

The new rule, which the SEC proposed under the Investment Advisors Act on February 9, 2022, would impose significant new requirements and limitations on private fund advisors.⁸ Some of the key provisions include:

• Quarterly Statement Rule —­ The SEC will require private fund advisers to provide investors quarterly statements describing, among other things, fund-level fees and expenses, including fees and expenses paid by underlying portfolio investments to the adviser or its related persons.⁹ The quarterly statements must also detail standardized gross and net performance information for all advised private funds.¹⁰
• Private Fund Audit Rule —­ The SEC will require private fund advisors to obtain a financial statement audit of each advised private fund annually and upon liquidation.¹¹
• Advisor-Led Secondaries Rule —­ The SEC will require private fund advisers to obtain a fairness opinion in connection with adviser-led secondary transactions when the adviser offers fund investors the option to sell their fund interests or exchange them for new interests in another of the advisor’s managed vehicles.¹²
• Prohibited Activities Rule —­ The SEC will prohibit all private fund advisers (including those that are not registered with the SEC) from engaging in certain activities because they are “contrary to the public interest and the protection of investors,” even if they are consented to following disclosure in fund documents. These activities include:
  • Seeking reimbursement, indemnification, exculpation or limitation of an adviser’s liability by the private fund or its investors for a breach of fiduciary duty (regardless of whether state or other law would permit an adviser to waive its fiduciary duty), willful misfeasance, bad faith, negligence, or recklessness in providing services to the private fund;¹³
  • Reducing the amount of an “adviser clawback” by actual, potential, or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders;¹⁴
  • Charging certain fees and expenses to a private fund or portfolio investment, including accelerated monitoring fees and costs of regulatory examinations/investigations of the adviser;
  • Charging fees or expenses related to a portfolio investment on a non-pro rata basis when multiple private funds and other clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment; and
  • Borrowing money, securities or other fund assets, or receiving an extension of credit, from a private fund client.
• Preferential Treatment Rule —­ The SEC will prohibit all private fund advisers (including those that are not registered with the SEC) from providing preferential treatment (such as through side letters) to certain fund investors regarding redemptions or information about portfolio holdings or exposures. The SEC will also prevent any other type of preferential treatment unless the adviser discloses such treatment to other current and prospective investors.
• Books and Records Rule —­ the SEC will require advisors to retain records regarding all of the above requirements, and to document the annual review of the adequacy of their compliance procedures in writing.

The SEC is proposing a one-year transition period for advisors to come into compliance with the Proposed Rule. Given the significant new compliance costs and business limitations the Proposed Rule will place on private fund advisors, as well as the SEC’s continued focus on investment advisors and investment companies, impacted Vinson & Elkins clients may wish to comment on the Proposed Rule or discuss its potential implications.

Please contact Vinson & Elkins attorneys should you wish to discuss the Proposed Rule.

¹ See Kenneth Corbin, Investment Advisors Are Most Targeted by SEC Enforcement in 2021, Barron’s (Nov. 22, 2021), https://www.barrons.com/advisor/articles/investment-advisors-sec-enforcement-2021-51637587930.

² See Chair Gary Gensler, SEC, Prepared Remarks At the Institutional Limited Partners Association Summit (Nov. 10, 2021), https://www.sec.gov/news/speech/gensler-ilpa-20211110.

³ Id.

⁴ Id.

⁵ Id.

⁶ Id.

⁷ Id.

⁸ See Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Review, 17 C.F.R. § 275 (proposed Feb. 9, 2002), https://www.sec.gov/rules/proposed/2022/ia-5955.pdf; Fact Sheet, Private Fund Proposed Reforms, SEC (Feb. 9, 2022), https://www.sec.gov/files/ia-5955-fact-sheet.pdf (the “Fact Sheet”). The SEC also released a proposed rule on cybersecurity, which is not addressed in this update.   

⁹ See Fact Sheet at 1.

¹⁰ See id.

¹¹ See id.

¹² See id. at 2.

¹³ See Proposed Rule at 133.

¹⁴ See id. at 144.