Fresh off the heels of a January 27, 2022 Risk Alert, in which the U.S. SEC staff cautioned about common deficiencies and concerns observed in examinations of private fund advisers, on February 9, 2022 the SEC itself proposed significant rule changes. If adopted, the new rules will dramatically impact the fiduciary duty and disclosure obligations owed by private fund investment advisers to their clients—and potentially expose registrants and their management and certain employees to liability for non-compliance. On January 26, 2022, the SEC also released a proposal to amend Form PF, which includes the need for funds to report to the SEC within one business day significant valuation decreases.
Armed with almost 10 years of post-Dodd-Frank insights, gained from confidential and public filings, examinations and enforcement actions, the SEC unleashed a flurry of rule proposals that we believe will be on the active agenda and acted upon before the beginning of the 2022/2024 election cycle. If these rules are adopted, regulatory compliance burdens on advisers in the 18-trillion-dollar private fund sector will increase. We will also see increased transparency on familiar SEC private fund concerns relating to conflicts, fee and expense practices, adviser compensation, charges for in-house services to portfolio companies, valuations, cyber risk, and books and records.
In summary, the February 9 proposed changes in rules will require U.S. registered private fund advisers to:
- Provide to fund investors detailed, standardized and quarterly information on fees, expenses and performance, including data on portfolio investment compensation
- Obtain annual financial statement audits by a Public Company Accounting Oversight Board-registered auditor
- Document in writing the adviser’s annual compliance reviews
- Provide investors with an independent fairness opinion for any GP-led secondary transaction
- Increase the extent of cyber protections for managers and investors
The SEC is also proposing certain amendments to the books and records requirements that will facilitate the examination of private fund adviser’s compliance with these new regulations.
In addition, all private fund advisers, even those not registered with the SEC, would be prohibited from engaging in certain sales practices, conflicted transactions and practices, and compensation practices that have become common in the industry.
If adopted as drafted, the new rules would, for example, prohibit advisers from:
- Charging client funds, and therefore investors, for the costs associated with regulatory or compliance examinations or investigations of the adviser or its related persons
- Charging certain fees for services to client-owned portfolio companies, which are in addition to the typical management and performance fees
- The SEC’s staff’s January 27th Risk Alert and a recent settled enforcement action recently took aim at so-called “Hedge Clauses” that purport to limit the adviser’s liability via contract
In addition, advisers that have discretion to value illiquid client-fund owned assets and whose compensation is also based on the value of those illiquid investments would come under increased scrutiny as a result of mandated external audits to determine whether the adviser’s valuation practices are in accordance with accounting standards.
Other practices such as allocating certain fees and expenses in a non-pro rata fashion and providing certain types of preferential treatment would be axed by the rules, if adopted.
Regarding the SEC’s continued drumbeat on cyber security, advisers and funds would have to adopt and implement written cyber security policies and procedures, notify the SEC of certain types of cyber incidents within 48 hours and promptly notify clients and investors of such incidents. The proposed rule, while noble in its intent to improve transparency, could itself pose a risk. The proposal to publicly disclose cyber security risks and incidents that have previously occurred could provide a treasure trove of valuable information for bad actors, who are on the prowl for information that could inform the tactics and strategies they use to execute cyberattacks on the electronic financial infrastructure.
The SEC also recently proposed reducing the settlement cycle for most broker-dealer transactions from T+2 to T+1, which will require broker-dealers and registered investment advisers to shorten the cycle of trade confirmation and affirmation to trade date. Managers will be required to reimagine their middle office processes, controls and technology. The impact from the proposed changes could be felt in all areas of fund operations, including treasury and cash management, stock loan, counterparty selection and business continuity planning.
Regulatory obligations for private fund advisers, which are already complex, will likely intensify. Kroll’s compliance, valuation and cyber experts are closely monitoring developments with the rule proposals. We are helping clients evaluate what, if any, changes need to be made to client and investor disclosures, business practices and compliance policies and procedures in order to stay on the right side of regulatory expectations.
Stay tuned for an upcoming webinar series, where Kroll compliance, valuation and cyber experts discuss the SEC’s recent announcements and what it means for your firm.
Please contact Kroll directly if you are considering responding to the request for public comment on the proposals or have any questions about the new proposed rules and what it could mean for your business.