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  • Laura Bewick Howitt, CFA, CIPM, MBA

SEC ADOPTS SIGNIFICANT RULE CHANGES FOR PRIVATE INVESTMENT ADVISERS

On August 23, 2023, the Securities and Exchange Commission (SEC) adopted new rules and rule amendments to the Investment Adviser’s Act. They involve significant changes to the rules governing Private Investment Advisers as well as updates to existing compliance rules applicable to all investment advisers. This article summarizes the changes and implications for private fund advisers, particularly Canadian private fund advisors operating in the US and subject to SEC rules. We have also found large value in looking to the SEC rules and guidance for implementing controls and standards for Canadian firms operating in the private/ exempt market.


Purpose of the Rule Changes

The rules are designed to protect investors who directly or indirectly invest in private funds by increasing visibility into certain practices involving compensation schemes, sales practices, and conflicts of interest through disclosure; establishing requirements to address such practices that have the potential to lead to investor harm; and restricting practices that are contrary to the public interest and the protection of investors. These rules are likewise designed to prevent fraud, deception, or manipulation by the investment advisers to those funds.


Summary of the Rule Changes


1. Restricted Activities Rule – 211(h)(2)-1 – Prohibits Private funds (other than securitized asset funds) from directly or indirectly charging or allocating to the fund:


  • investigation fees or expenses of the private fund advisor or its related persons, without the requesting written consent and obtaining it from a majority of investors. Additionally, these expenses may not be charged or allocated if the investigation results in a court or government agency-imposed sanction for a violation of the Advisers Act or related rules;

  • regulatory or compliance or examination fees or expenses, without distributing written notice including the dollar amount to all private fund investors within 45 days after the end of the fiscal quarter in which the charge occurs;

  • clawback of actual, potential or hypothetical taxes applicable to the private fund advisor, related persons or their respective owners or interest holders, without written notice of the dollar amounts of the clawback within 45 days after the end of the fiscal quarter in which the clawback occurs;

  • non-pro rata fees or expenses unless (i) the pro-rata charge or allocation is fair and equitable under the circumstances, and (ii) prior to charging a private fund client, the private fund advisor distributed written notice of the charge or allocation and described how it is fair and equitable under the circumstances.

Borrowing money, securities or private fund assets or borrowing from a private fund client is also prohibited unless the private fund advisor: (i) distributes a written description of the material terms of the borrowing and requests consent, and, (ii) obtains written consent from a majority of investors that are not related persons of the private fund adviser.



2. Preferential Treatment Rule – 211(h)(2)-3 – Prohibits Private Fund Advisers (registered or exempt) from directly or indirectly:

  • allowing redemptions on terms that the private fund advisor reasonably expect will have a material negative effect on other investors in the private fund or similar pool of assets unless: (i) the ability to redeem is required by applicable laws, rules, regulations, or orders; or (ii) the private fund adviser offers the same redemption ability to all other existing investors and will continue to offer it to all future investors in the private fund and any similar pool of assets.

  • providing information regarding the portfolio holdings or exposures of the private fund, or of a similar pool of assets, to any investor in the private fund if providing the information could reasonably be expected to have a material, negative effect on other investors in that private fund or in a similar pool of assets, except if the private fund adviser offers such information to all other existing investors in the private fund and any similar pool of assets at the same time or substantially the same time;

  • providing any preferential treatment to any investor in the private fund unless the private fund adviser provides written notice as follows:

For prospective investors in a private fund, the private fund adviser must provide each prospective investor with a written notice with specific information regarding any preferential treatment related to any material economic terms that the fund adviser or related persons provide to other investors in the same private fund.


For current investors in a private fund, the private fund adviser must provide the following:


  • Illiquid fund - as soon as reasonably practicable following the end of the fundraising period, written disclosure of all preferential treatment the private fund adviser or its related persons has provided to other investors in the same private fund;

  • Liquid fund - as soon as reasonably practicable following the investor’s investment, written disclosure of all preferential treatment the private fund adviser or its related persons has provided to other investors in the same private fund; and

  • On at least an annual basis, a written notice that provides specific information regarding any preferential treatment provided by the private fund adviser or its related persons to other investors in the same private fund since the last written notice.


3. Amended Books and Records Rule – 204-2 – Requires all SEC-Registered private fund advisers (and those requiring to be registered) to keep records relating to:

  • any notice required pursuant to the Preferential Tax Treatment Rule along with each addressee and the date sent;

  • a copy of any quarterly statement pursuant to the Quarterly Statements Rule along with each addressee and the date sent, and all records of the calculation method for all expenses, payments, allocations, rebates, offsets, waivers, and performance listed on any statement delivered pursuant to the rule;

  • for private fund clients: (i) a copy of any audited financial statements prepared pursuant to the Private Fund Audit Rule, along with each addressee and date sent, or (ii) a record of the steps taken to cause a private fund client not in a control relationship to undergo a financial statement audit pursuant to the Private Fund Audit Rule

  • documentation substantiating the private fund adviser’s determination that a private fund client is a liquid fund or an illiquid fund pursuant to the Quarterly Statements Rule;

  • a copy of any fairness opinion or valuation opinion and material business relationship summary distributed pursuant to the Adviser-Led Secondaries Rule, along with a record of each addressee and the date sent; and,

  • a copy of any notification, consent, or other document distributed or received pursuant to the Restricted Activities Rule, along with a record of each addressee and the date sent for each such document distributed.


4. Amended Compliance Rule 306(4)-7 (annual compliance review) - requires all SEC-registered advisers (including those that do not advise on private funds) to document in writing the required annual review of their compliance policies and procedures.


5. Legacy Status: The SEC is providing “legacy status” for the prohibitions in the Preferential Treatment Rule and consent requirements in the Restricted Activities Rule for agreements that were entered into prior to the compliance date if the rule would require the parties to amend the agreement.


Conclusion

For Canadian Private Investment Advisors operating in the United States under SEC regulations, these changes are quite significant. However, the final approved rule changes mostly soften the prohibitions originally proposed and instead requires, enhanced disclosures, written notices and/or written consent.



SGD Compliance Consulting is here to help with guidance on the rule changes; updates to policies and procedures; and, meeting written notification, disclosure and recordkeeping requirements.


© 2023 SGD Compliance Consulting Inc.


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