By Mark Heine and Gary Kocher – K&L Gates
On August 23, 2023, the U.S. Securities and Exchange Commission (the “SEC”) adopted a number of new rules (the “New Rules”) under the Investment Advisers Act of 1940 (the “Advisers Act”). The New Rules are designed by the SEC to increase investor visibility into adviser practices and to address certain practices that could lead to investor harm. The New Rules impact three categories of investment advisers: (i) all registered investment advisers, (ii) registered investment advisers (“RIAs”) that advise private funds, and (iii) advisers (both registered and non-registered) that advise private funds.
As a general matter, advisers that only provide investment advisory services to venture capital funds are not required to be registered with the SEC and are referred to as ‘exempt reporting advisers’ (or “ERAs”). Most , if not all, advisers to angel funds that are organized by or in connection with ACA member groups fall within this category. As such, the focus here is limited to the New Rules that apply to ERAs.
The two primary categories of the New Rules that apply to ERAs include (i) certain restricted activities, and (ii) the granting of preferential treatment to certain investors.
Restricted Activities
The New Rules include a number of new “restricted activities” that require advisers to comply with certain disclosure and consent requirements if they elect to engage in such restricted activities, as described below:
A private fund adviser may not charge a fund fees or expenses associated with an investigation of the adviser or its related persons by any governmental or regulatory authority unless the adviser requests and obtains the consent of a majority in interest of the private fund’s investors (other than GP-related persons); provided that no such investigation expenses may be charged in any event if that adviser is subject to a sanction for violating the Advisers Act or its rules as a result of the investigation.
- A private fund adviser may not charge the fund (i) fees or expenses associated with an examination of the adviser or its related persons by any governmental or regulatory authority and/or (ii) for the regulatory and compliance fees and expenses of the adviser or its related persons unless the adviser distributes a written notice of any such fees or expenses, and the dollar amount thereof, to investors in a private fund in writing within 45 days after the end of the fiscal quarter in which the charge occurs. Also, if an adviser desires to charge such fees and expenses to a fund, the operative legal documents of the fund must include language permitting such expenses to be paid by the fund.
- A private fund adviser will be restricted from reducing the amount of its clawback obligation by actual, potential, or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders, unless the adviser distributes a written notice to the investors of such private fund that sets forth the aggregate dollar amounts of the adviser clawback before and after any reduction for actual, potential, or hypothetical taxes within 45 days after the end of the fiscal quarter in which the adviser clawback occurs. Also, if an adviser desires to reduce its clawback obligation by the taxes described above, the operative legal documents of the fund must include language permitting such reductions.
- A private fund adviser may not allocate fees and expenses related to a portfolio investment on a non-pro rata basis when multiple private funds and other clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment unless (i) the allocation approach is fair and equitable under the circumstances, and (ii) prior to charging or allocating such fees or expenses to a private fund client, the investment adviser distributes to each investor of the private fund a written notice of the non-pro rata charge or allocation and a description of how it is fair and equitable under the circumstances.
- A private fund adviser may not borrow money, securities or other fund assets, or receive an extension of credit, from a private fund unless the private fund adviser (i) distributes to each investor a written description of the material terms of such transaction, and (ii) obtains advance written consent from at least a majority in interest of the fund’s investors who are not related persons of the adviser.
Preferential Treatment/Side Letters
The New Rules include limitations on an adviser’s ability to provide some (but not all) investors with preferential treatment (often contained in so-called “Side Letters”), as described below:
- Granting of preferred economic rights is prohibited unless prospective investors in the same private fund are provided written notice of such material economic terms prior to investing.
- Advisers of illiquid funds (venture funds) are required to provide investors with notice of all preferential terms granted to investors as soon as reasonably practicable after the end of the fundraising period (and annually thereafter, if any new preferential terms are granted).
- Although unlikely to impact angel funds, the New Rules also limits the granting of redemption rights and/or portfolio information rights where the adviser reasonably expects they would have a material, negative effect on the other investors (noting that there are exceptions to these general rules for (i) redemptions required by law/regulation, and (ii) situations where the redemptions and/or information rights are offered to all other investors).
While the New Rules impose several new obligations, the SEC chose not to adopt certain provisions contained in the proposed rule that had been subject to widespread comment in the industry and fear that adviser liability could be significantly expanded for failures of portfolio companies. Notably, the New Rules omitted the prohibitions from an adviser (i) seeking exculpation and/or indemnification for the adviser’s simple negligence, or (ii) receiving fees for unperformed services (as an example, if an adviser (or an affiliate) is engaged by a portfolio company to provide consulting or other services, the adviser would be prohibited from including a clause in the service contract that would “accelerate” the payment of all remaining (and unearned) fees if the portfolio company is sold prior to the end of the service contract term). Instead, with respect to the receipt of fees for any such unperformed services, the SEC reiterates its position that such conduct is inconsistent with an adviser’s fiduciary duty and therefore violate the Advisers Act antifraud provisions, even if disclosed and/or even with investor consent. The SEC’s position is a good reminder that ERAs, as investment advisers, are bound to federal fiduciary standards and subject to the antifraud provisions under the Advisers Act and the rules thereunder.
Finally, it has been widely reported that the New Rule imposes new audit requirements for private funds, but angel fund organizers can breathe easy because this requirement only applies to RIAs to private funds and would not impact the typical angel fund.
We will continue to monitor and report on the implementation of the New Rules and the specific implications for ERAs to angel funds.
K&L Gates has a large group of attorneys advising fund advisers for public and private funds, as well as investors in such funds. Please feel free to contact Mark Heine (Mark.Heine@klgates.com) or Gary Kocher (gary.kocher@klgates.com) if we can answer any questions.
UPDATE! Additional Information from the SEC Released:
The above analysis is for general informational purposes only and does not constitute legal advice.
