private fund advisers

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In its final Private Fund Adviser Rules adopted last year, the SEC dropped one of the more controversial proposed rules—the proposal to prohibit contractual exculpation or indemnification provisions that would shield or indemnify the adviser in matters involving the adviser’s negligence or breach of fiduciary duty.  On its face, this was a concession to the fund management industry. However, the Rule’s Adopting Release asserted that the SEC believed the provision was not needed because the antifraud provisions of the Advisers Act already prohibited certain provisions that would be covered by the proposal. Because the SEC’s interpretation was based on current law (there is no grandfathering or “implementation date” in the future), we predict that contractual indemnification or exculpation provisions will remain firmly in the SEC’s sights for 2024. SEC exams and enforcement proceedings are likely to focus on these provisions, and they may be implicated in GP/LP disputes as well.

2023’s excitement for generative artificial intelligence (AI) prompted the SEC to respond on multiple fronts – stump speeches, rulemaking, new exam priorities and sweeps and previewing potential enforcement actions. SEC Chair Gary Gensler raised concerns regarding potential conflicts and investor harm resulting from the proliferation of AI and warned that an AI-caused financial crisis is nearly unavoidable absent regulation. The SEC adopted a number of initiatives in 2023 to respond to these perceived risks. 

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

Earlier today, the SEC’s Private Fund Adviser Rules were published in the Federal Register. As with all federal regulations, publication in the Federal Register begins the countdown to the Rules’ compliance dates. These dates are listed in the table below. Please see our prior alerts for an overview of…

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

SEC Emblem

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

As IPOs and other traditional paths to liquidity for private assets have become more challenging, GP-led secondary transactions have emerged as a powerful and popular tool across closed-end private funds, leading to explosive growth over the last five years. And while macro factors influence their prevalence year over year, these transactions remain broadly popular across the various stakeholders in these transactions, facilitating different goals for different parties: 

  • Existing Investors (LPs):  Near-term liquidity in a liquidity-constrained market, typically with an option to continue participation if desired
  • New Investors (Buyers):  Access to a mature portfolio with unrealized upside
  • Fund Adviser (GP):  Extended duration to capture future upside of well-performing assets, additional capital to support existing portfolio, and reset economics aligning with longer-term outlook

It’s a pattern we often see in boom-and-bust cycles—disputes rising in the period after a wave crests. SPAC deal volume hit an unprecedented high in 2021, but then slowed down in 2022 alongside IPOs. However, the fallout from the SPAC wave will continue to unfold this year, generating increased regulatory attention and a growing number of disputes.

The SEC’s Enforcement Division is conducting a sweep investigation of large investment advisers regarding their employees’ use of “off-channel” communications.  The sweep, which has been widely reported in the press, focuses on text messages from personal phones, personal email, WhatsApp and other platforms not typically captured or monitored by advisers.  The sweep is causing considerable industry concern, following the SEC’s announcement of settlements against a number of large broker-dealers for use of off-channel communications, that resulted in $1.235 billion of cumulative penalties. 

Implications of SEC attempt to curb indemnification for private fund managers

The SEC spent 2022 making multiple and sweeping proposals to amend rules under the Advisers Act, many of which have the ability to significantly re-shape market standards for private funds.  Here, we focus on the SEC’s proposal to undo a common protection for private fund advisers – the ability to rely, as against the private fund or its investors, on exculpatory and indemnification provisions for a breach of fiduciary duty, willful misfeasance, recklessness, or simple negligence in providing services to the private fund.  This prohibition would relate not just to liability under the Advisers Act, but to all causes of action.