Legacy Status Under the New SEC Investment Adviser Rules
On Aug. 23, the U.S. Securities and Exchange Commission adopted the PFA Rules, rules and rule amendments under the Investment Advisers Act of 1940 that impose new requirements and obligations on private fund advisers. In previous blog posts, we provided a brief summary of the PFA Rules, discussed the new quarterly reporting requirements, analyzed the impact upon adviser-led secondaries, examined the new restricted activities rule and considered the new preferential treatment rules. This post focuses on the application of the PFA Rules to existing private funds’ contractual arrangements, including the question of whether such existing contractual arrangements receive “legacy status.” Where applicable, legacy status permits an existing fund to be “grandfathered in” and operate under the pre-PFA Rules amendments to the Advisers Act.
Although commentators urged the SEC to provide legacy status for the entirety of the PFA Rules, only two aspects of the PFA Rules received legacy status:
(1) Preferential redemption rights of one or more investors in favor of others.
(2) Restricted activities requiring investor consent.
Fund Eligibility for Legacy Status
A fund must first meet two criteria for the legacy status provisions to apply. First, it must be the case that the fund would be required to amend its existing contractual arrangements governing the fund in order to comply with the PFA Rules. The PFA Rules require an adviser to amend the fund’s contractual arrangements where such arrangements contain provisions in conflict with the PFA Rules. Contractual arrangements within the scope of this requirement include operating agreements, subscription agreements and side letters. In addition, contractual arrangements governing an extension of credit, such as promissory notes and credit agreements, are included within the scope of this requirement.
Second, the fund must have commenced operations as of the compliance date. On page 313 of the adopting release, the SEC defines commencement of a fund as “any bona fide activity directed towards operating a private fund.” These bona fide activities include investment, fundraising or operational activities, such as capital calls, setting up a subscription facility, holding a fund closing or conducting due diligence on potential fund investments.
The PFA Rules adopted staggered compliance dates based upon the value of an adviser’s assets under management. For “larger private fund advisers” – advisers with $1.5 billion or more in private fund assets under management – there is a 12-month transition period starting Sept. 14, 2023, and ending Sept. 14, 2024. For “smaller private fund advisers” – advisers with less than $1.5 billion in private funds assets under management – there is an 18-month transition period starting Sept. 14, 2024, and ending March 14, 2025.
Legacy Status of Preferential Redemption Rights
Prior to the promulgation of the PFA Rules, fund advisers sometimes utilized preferential redemption rights, such as more favorable liquidity rights, to entice preferred or influential investors to commit capital to the fund. Under new Rule 211(h)(2)-3(a)(1), fund advisers are now prohibited from providing preferential redemption rights to one investor that the adviser would “reasonably expect to have a material, negative effect on other investors.” Therefore, unless an exception applies, future funds cannot provide preferential redemption rights to investors.1
However, existing fund agreements containing provisions granting investors preferential redemption rights receive legacy status under Rule 211(h)(2)-3(d). Thus, if (i) a private fund contains preferential redemption rights in a governing agreement that conflict with the PFA Rules and (ii) the fund commenced operations as of the compliance date, then the fund receives legacy status. The receipt of legacy status preserves preexisting preferential arrangements and protects the adviser from violating the preferential treatment rule.
Restricted Activities Requiring Investor Consent
Under the PFA Rules, advisers are prohibited from performing two previously permissible activities unless the adviser receives investor consent. However, both of these new prohibitions receive legacy status. If the fund meets the legacy status eligibility requirements, the adviser may continue to perform these activities in pre-PFA Rules fashion.
Investigative Fees and Expenses. New Rule 211(h)(2)-1(a)(1) restricts advisers from charging the fund fees and expenses associated with an investigation of the adviser or its related person by any governmental or regulatory authority. However, the adviser may charge these fees to the fund if (i) the adviser seeks consent from all investors of the fund and (ii) a majority of the investors unrelated to the adviser provide their written consent to charge such fees and expenses to the fund.2 Previously, it was common industry practice for governing documents to grant advisers advance consent to charge investigative fees and expenses to the fund in some circumstances. Given that the rule specifies that an adviser must “request each investor … to consent to … such charge or allocation,” the new rules seem to require advisers to gain consent contemporaneously with each charge.
Borrowing. New Rule 211(h)(2)-1(a)(5) prohibits private fund advisers from borrowing money, securities or other private fund assets, or receiving a loan or an extension of credit from a client. However, the PFA Rules contain an exception to this borrowing prohibition that permits an adviser to borrow from the fund or a fund client if (i) the adviser distributes a written notice and description of the material terms of such borrowing to the investors, (ii) the adviser seeks their consent and (iii) a majority-in-interest of the investors unrelated to the adviser provide their written consent to the transaction. Similar to the above, industry practice involved advisers sometimes receiving advance investor consent in governing agreements to borrow assets from the fund; but the rule language requiring that “material terms” be disclosed to investors suggests that advisers need to acquire consent on each occasion they seek to borrow such funds.
The application of legacy status to these provisions is unclear. Specifically, it is unclear whether legacy status would mean that the adviser may in fact charge these fees without consent in cases where that is permitted but not required under an existing agreement. Critically, legacy status turns on whether compliance would require an amendment to existing governing agreements. A conservative interpretation of the PFA Rules would require advisers to seek consent for the charging of these fees to the funds they manage so long as they seek that consent without violating their existing agreements.
Side Letter Disclosure
Private fund advisers often enter into confidential side letters with certain investors in private funds pursuant to which the investors receive preferential treatment. Under new Rule 211(h)(2)-3(b), advisers now must disclose such preferential information and treatment to both prospective and current investors of the same fund.
Despite insistence from commentators, the SEC refused to provide legacy status to the disclosure requirements of the preferential treatment rule. On page 313 of the adopting release, in connection with explaining its decision that legacy status would not be available for the disclosure requirements, the SEC stated “. . … information in side letters that existed before the compliance date will be disclosed to other investors that invest in the fund post compliance date.” This language suggests the SEC does not believe disclosure is required to investors who invest in the fund before the compliance date. However, the meaning of the phrase “invest in” is not clear as it relates to private funds that call capital over time. For example, it remains to be seen whether the SEC would expect a fund that has ceased accepting capital commitments before the compliance date yet calls capital after the compliance date to disclose existing side letter provisions to all investors in the fund.
Turning to the language of the PFA Rules themselves, new Rule 211(h)(2)-3(b)(2) requires an adviser that provides preferential treatment to an investor of a fund to provide written notice of preferential treatment to current investors in the same fund. The timing of the written notice to investors differs for illiquid and liquid funds.3
Illiquid Funds. In an illiquid fund, the adviser must provide notice of preferential treatment “as soon as reasonably practicable following the fund’s fundraising period.” Thus, if the fund has completed its fundraising period (i.e., capital commitments), the rule language suggests that the adviser need not provide notice to current investors if the adviser later calls capital. As a result of this scenario, existing side letter provisions would potentially remain confidential, and it is possible that this is a scenario envisioned by the SEC in the discussion quoted above.
Liquid Funds. In a liquid fund, the adviser must provide notice of preferential treatment “as soon as reasonably practicable following the investor’s investment in the fund.” This language suggests that advisers need only provide notice of preferential treatment to investors making new subscriptions to the fund after the applicable compliance date.
Annual Disclosure. Finally, under new Rule 211(h)(2)-3(b)(2)(iii), advisers must provide an annual written notice to all investors detailing “any preferential treatment … to other investors in the same private fund since the last written notice provided in accordance with [Rule 211(2)-3(b)], if any.” The implications of this rule to existing private funds is unclear. One interpretation suggests that only “new” preferential treatment, such as a new or amended side letter, must be disclosed to investors. If this interpretation is correct, when a fund ceases accepting subscriptions before the compliance date and does not enter into any new side letters or amend existing side letters, the fund does not have to disclose any preferential treatment, past or present. An alternative reading suggests that complete disclosure of all existing preferential terms is required under this language since the adviser has yet to provide any written notice to current investors. This view would compel advisers to reveal pre-existing, confidential side letters to other investors in the same fund.
In sum, the PFA Rules may require disclosure of existing confidential side letters and other confidential arrangements providing preferential treatment to certain investors. At the moment, however, it is unclear whether the SEC will require disclosure of existing confidential arrangements in all cases.
1 There are two exceptions to the preferential redemption rights prohibition. First, advisers may provide preferential redemption rights if required under applicable U.S. or foreign law. Second, advisers may provide preferential redemption rights to one investor if the adviser offers the same redemption rights to all other existing investors of the fund and any future investors.
2 The PFA Rules explicitly prohibit and do not provide legacy status for any charges to the fund for fees or expenses related to an investigation that results or has resulted in an authority imposing a sanction for a violation of the Advisers Act. Therefore, the PFA Rules will prohibit the charging of these fees by advisers to the funds they manage regardless of what is provided in their existing agreements.
3 An illiquid fund is a private fund that (i) is not required to redeem interests upon an investor’s request and (ii) has limited opportunities for investors to withdraw before termination of the fund. A liquid fund is any private fund that is not illiquid. Informally, illiquid funds are often referred to as “private equity funds” or “venture capital funds,” while liquid funds are often referred to as “hedge funds.”