Private Fund Rules Cancelled, Survey Says Marketing Rule is a Lot of Work and the Intersection of Regulation BI and Investment Adviser’s Fiduciary Duty
Welcome to our June Regulatory Roundup, where we provide you with a quick look at the latest regulatory developments. In this edition, we discuss the implications of the Fifth Circuit’s striking down the Private Fund Rules, a survey on how much time advisers are spending on compliance with the Marketing Rule, a case study on how not to show fund performance and an SEC settlement where the obligations of Reg BI and fiduciary duty are blurred. Enjoy!
Court Strikes Down Private Adviser Fund Rules
The Fifth Circuit Court of Appeals vacated the SEC’s private fund adviser rules on June 5, 2024. A three-judge panel of the Fifth Circuit unanimously agreed and vacated the rules enacted under Section 206(4) and Section 211(h) of the Advisers Act (the “Private Fund Rules”), stating that the SEC exceeded its statutory authority in enacting these rules. Several industry trade groups, including the National Association of Private Fund Managers, Alternative Investment Management Association Ltd. (“AIMA”), American Investment Council, Loan Syndications and Trading Association, Managed Funds Association (“MFA”) and the National Venture Capital Association, brought suit to challenge the rules. The lawsuit was filed on September 1, 2003, shortly after the Private Fund Rules were adopted on August 23, 2023.
Here’s a summary of the vacated Rules:
- Rule 211(h)(1)-2, the Quarterly Statements Rule, which required private fund managers to provide investors with statements reflecting funds fees, expenses, performance, and compensation paid by portfolio companies to the adviser or its related persons.
- Rule 211(h)(2)-1, Restricted Activities Rule, which limited certain private fund practices, such as allocation of compliance fees, reduction in performance fee clawbacks from taxes, non-pro-rata expense allocations, and borrowing from private funds.
- Rule 211(h)(2)-2, Adviser-Led Secondaries Rule, which required SEC-registered investment advisers conducting adviser-led secondary transactions to obtain either a fairness or a valuation opinion and disclose any material business relationships between the adviser or its related persons and the independent opinion provider.
- Rule 211(h)(2)-2, the Preferential Treatment Rule, which prohibited advisers from giving preferential treatment for redemption rights and portfolio holdings or exposure information to certain investors where the adviser reasonably expects such treatment would have a material, negative effect on other investors.
- Rule 206(4)(7)(b), which required all SEC-registered investment advisers to memorialize the annual review of its compliance program in writing.
- Rule 206(4)-10, which required SEC-registered investment advisers to obtain an independent financial statements audit that met the requirements of the Advisers Act Custody Rule (Rule 206(4)-2.
What happens now?
The SEC has two options. First, it can seek an en banc review within 45 days of the decision. According to an Alert Memorandum published by Cleary Gottlieb, this review would be considered by the full roster of the Fifth Circuit’s active judges and “is generally considered to be an extraordinary measure given the expenditure of judicial resources, and a petitioner for re-hearing may be penalized if the Court views the petition to have insufficient merit.” The second option is to petition the U.S. Supreme Court within 90 days to review the decision. According to the Cleary Gottlieb Alert Memorandum, “[t]he likelihood that the Supreme Court would grant review – combined with the likelihood that it would reach a different decision than the Fifth Circuit did—seems sufficiently low that the SEC may not expend further time and resources on a petition.”[footnotes omitted] The SEC has not issued any statements on its plans.
The SEC could also go back to the drawing board to draft new regulations requiring greater transparency for private fund managers. No matter what course the Commission takes, it will be many months before any similar regulations can be imposed on private fund managers.
What does this mean for private fund advisers?
Although the SEC cannot enforce the Private Fund Rules, it can still use its examination and enforcement powers to restrict certain private fund practices that it believes violate private fund investors’ interests. The SEC has been laser-focused on conflicts of interest during private fund examinations and will continue to closely examine the practices discussed in the Proposing Release for the Private Fund Rules. SEC exam and enforcement staff are likely to closely review the disclosures and procedures used by firms when granting preferential redemption rights, allocating fees and expenses across funds and investors, and engaging in adviser-led secondary transactions. The Staff still has broad latitude to bring cases for breach of fiduciary duty and fraud.
Marketing Rule Survey Shows Advisers Devoting Significant Resources toward Compliance
To find out advisers’ biggest pain points during the first year of compliance with the Marketing Rule (Advisers Act Rule 206(4)-1), Seward & Kissel, a nationally recognized law firm, surveyed more than 120 investment advisers to assess the Rule’s impact. Unsurprisingly, 70% of respondents reported their presentation of performance in advertisements has been most affected by the new rule.
Within the performance presentation category, 74% of firms cited the requirement to show gross and net performance as a continuing challenge, followed by 46% of respondents citing extracted performance and 40% citing hypothetical performance. Advisers noted a “particular challenge in showing performance of a single investment, given an SEC staff FAQ providing that an adviser may not show gross performance of a single investment without also showing the net performance of that single investment.”
The report also found that compliance with the Marketing Rule resulted in reduced access by investors to certain information, with 7% of respondents indicating they removed prior investors from public access, 5% redacted portions of past letters, and 40% added disclosures to conform to the rule’s requirements.
The survey also found that private credit managers face more challenges in complying with the performance advertising requirements than firms that manage private equity funds, hedge funds, mutual funds, and separately managed accounts.
One data point that many compliance officers can appreciate is the amount of time spent on compliance with the Marketing Rule. According to the survey, “11% of respondents said they committed over 100 hours to complying with the Marketing Rule, 23% said 51-100 hours, 54% said 11-50 hours and 13% said 0-10 hours. Respondents with higher AUM generally committed more time:
- 74% of respondents with more than $5 billion AUM committed more than 50 hours
- 21% of respondents with $5 billion or less AUM committed more than 50 hours”
Let’s compare these numbers to the estimates provided by the SEC in the Marketing Rule’s Adopting Release. The SEC broke down the total annual hours and time costs for the various rule requirements, including the general prohibitions, testimonials and endorsements, third-party ratings and performance. Based on the SEC’s numbers, an investment adviser using performance data in its marketing materials would need to spend about 36 hours per year complying with the Marketing Rule. This number does not include advisers using hypothetical, predecessor or related performance, testimonials and endorsements or third-party ratings.
Here’s how I arrived at this number. The SEC estimated that advisers would spend approximately six hours per year complying with the Marketing Rule’s seven general prohibitions. For compliance with the performance requirements, the SEC estimated that advisers would need about five hours to prepare net performance. The SEC also estimated that firms would need about 11.76 hours to calculate performance results for the one-, five-, and ten-year periods required by the Marketing Rule. Finally, the SEC indicated that it would take about 10 hours a year to retain advertisements and an additional three hours to retain communications containing performance results to comply with Advisers Act Rule 204-2 recordkeeping requirements. The sum of these estimates is 35.75 hours. Keep in mind, however, that the SEC’s estimates are based on a bigger universe of investment advisers (13,038), while the Seward & Kissel survey is based on a much smaller sample (120).
It is no surprise that firms report spending dozens of hours complying with the Marketing Rule and continue to struggle with presenting performance data. Although some parts of the rule codified or clarified existing SEC positions, other parts created new and additional burdens in terms of disclosures, performance presentation and record-keeping. The results of the Seward & Kissel survey show that firms take the Marketing Rule seriously by devoting extensive time and attention to compliance.
Nothing New to See Here: SEC Brings Case Against Adviser for Misleading Performance Data
The SEC settled another case under the Marketing Rule (Advisers Act Rule 206(4)-1) with Twenty Acre Capital LP, an SEC-registered investment adviser based in Pennsylvania. Twenty Acre managed a private fund that invested in publicly traded equities, including initial public offerings. The firm used pitch decks and fact sheets with prospective investors that included performance returns.
Twenty Acre’s mistake was presenting the performance of one investor’s account as if it were the Fund’s returns. This particular investor invested at the fund’s inception and participated in some highly profitable IPO investments, boosting its returns. Not all investors could participate in IPOs because of investment restrictions under FINRA Rules 5130 and 5131. Consequently, this investor’s net performance of 44.8% was much better than the fund’s overall net performance of negative 5.7%.
Twenty Acres was fined $100,000 for violating Section 206(4) of the Advisers Act and Rules 206(4)-8 and 206(4)-1, the Marketing Rule, presumably receiving at least some credit for taking prompt action to fix the issue and cooperating with the Staff.
Although brought under the Marketing Rule, this case could have easily been bought by the Commission under the anti-fraud provisions of the Advisers Act Section 206. The facts are remarkably similar to the SEC’s proceeding against Van Kampen Investment Advisory Corp. and Alan Sachtleben from 1999. In that case, Van Kampen advertised a fund showing outsized returns without disclosing to investors or the SEC that the fund’s performance was largely attributable to investments in hot IPOs, and that it was unlikely to recreate such returns in the future as the fund grew larger. The SEC found that Van Kampen and Alan Sachtleben, its Chief Investment Officer, had violated Advisers Act Section 206(2)’s anti-fraud provisions.
So, the lesson learned here is that advisers must be careful to tell the whole story when communicating with potential investors. The SEC will be looking at your marketing materials with the benefit of hindsight, so include any information investors might want when making their investment decision.
The Intersection of Regulation BI and Adviser’s Fiduciary Duty
The SEC entered a settlement order with Key Investment Services, LLC (“KIS”), a dually registered broker-dealer and investment adviser, primarily for violating Regulation Best Interest (Reg BI). At the heart of the matter was a referral program, where KIS registered representatives and investment adviser representatives got paid initial referral and ongoing annual fees for recommending that customers with $1 million or more of investable assets move their accounts to Key Private Bank. KIS paid these fees to its representatives.
Unfortunately for KIS, the payment of these fees represented a conflict of interest, which should have been disclosed under Reg. BI. Moreover, the SEC concluded that in addition to failing to meet Reg BI’s Disclosure Obligation, KIS also failed to meet its Conflict of Interest and Compliance Obligations, “which require broker-dealers to, among other things, provide certain prescribed written disclosures to their customers; have policies and procedures reasonably designed to identify and address conflicts of interest; and establish, maintain and enforce written policies and procedures reasonably designed to achieve compliance with Regulation BI.”
The SEC did not stop there, however, finding that KIS had also violated its obligations under the Advisers Act. Specifically, the SEC held that KIS violated Advisers Act Section 206(2), the anti-fraud provision, as well as Advisers Act Section 206(4) and Rule 206(4)-7, which require investment advisers to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules. Ultimately, KIS had to pay a penalty of $223,228.
This case illustrates how closely the SEC views the relationship between Reg BI’s obligations and an adviser’s fiduciary duties. It also serves as a reminder that regulators see no difference between internal referral programs and third-party referral arrangements.
