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SEC Proposes Big Changes to ’40 Act Fund Advisers

The Securities and Exchange Commission has proposed new rules and amendments under the Investment Advisers Act of 1940 to further regulate private fund advisers.

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The Securities and Exchange Commission has proposed new rules and amendments under the Investment Advisers Act of 1940 to further regulate private fund advisers with the goal of “protecting private fund investors by increasing transparency, competition, and efficiency in the $18 trillion marketplace.”

The new rules continue the SEC’s recent focus on private fund advisers and address issues related to transparency regarding costs, performance, and preferential terms, as well as conflicts of interests.

“Private fund advisers, through the funds they manage, touch so much of our economy. Thus, it’s worth asking whether we can promote more efficiency, competition, and transparency in this field,” said SEC Chair Gary Gensler. “I support this proposal because, if adopted, it would help investors in private funds on the one hand, and companies raising capital from these funds on the other.”

The proposed rules would require registered private fund advisers to provide investors with quarterly statements detailing certain information related to fund fees, expenses, and performance. The SEC believes that such improvements to the quality of information will improve investors’ ability to assess their investments and monitor compliance with the fund’s governing documents.

The proposed changes would also create new requirements related to fund audits, books and records, and adviser-led secondary transactions. Specifically, the SEC would require a registered private fund adviser to obtain an annual financial statement audit in accordance with GAAP of each private fund it advises, and upon liquidation, by a registered independent public accountant, which would be required to notify the SEC if dismissed or when it issues a modified opinion.

Further, in connection with certain adviser-led secondary transactions (offering fund investors the option to sell or exchange interests in a private fund), a fairness opinion would be required from an independent opinion provider.

The proposals would also prohibit all advisers to private funds (whether registered with the SEC or one or more states, exempt reporting advisers, or prohibited from registration)

from engaging in several activities, including seeking reimbursement, indemnification, exculpation, or limitation of liability by the fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness.

Advisers would be prohibited from charging certain fees and expenses to a private fund or its portfolio investments, such as fees for unperformed services and fees associated with an examination or investigation of the adviser.

The proposals would prohibit reducing the amount of an adviser clawback by the amount of certain taxes; charging fees or expenses related to a portfolio investment on a non-pro rata basis when multiple private funds, other clients and related persons have invested; borrowing or receiving an extension of credit from a private fund client; and providing preferential redemption or portfolio holding information to certain investors.

Additionally, private fund advisers, including those that are not registered with the SEC, would be prohibited from providing certain types of preferential treatment to investors in their funds unless it is disclosed to current and prospective investors.

Brett Evans, an attorney at Evans Law PC, observed that “while the proposed extensive regulatory framework of private investment advisers is a shift from the SEC’s historical focus on protecting retail investors, the proposal is framed to look through the traditional pension and endowment private fund investors to their beneficiaries, the ‘teachers, firefighters, municipal workers and professors,’ in an attempt to protect them through further transparency and disclosure standardization.”

Finally, and of interest to all registered investment advisers, not just private fund advisers, within the 341-page release, the SEC proposed amendments to Advisers Act Rule 206(4)-7 (the compliance rule) that would establish a written documentation requirement of their current compliance rule obligations – a review, no less frequently than annually, of the adequacy of their compliance policies and procedures and the effectiveness of their implementation.

The public comment period will remain open for 60 days following publication of the proposal on the SEC’s website, or 30 days after its publication in the Federal Register, whichever period is longer.

Electronic comments can be submitted through the SEC’s comment form at http://www.sec.gov/rules/submitcomments.htm or via e-mail to rule-comments@sec.gov with file number S7-03-22 included in the subject line.

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