The Securities and Exchange Commission (the SEC) adopted new and somewhat controversial rules and rule amendments (the Final Rules) under the U.S. Investment Advisers Act of 1940 (the Act) in the fall of 2023 that impact the regulation of private fund advisers (Advisers). Under the Final Rules, Advisers registered under the Act will have increased compliance burdens and requirements regarding transparency to investors. The Final Rules also create additional prohibitions on all Advisers operating in the United States in relation to specified activities.
Since 2010, the SEC has established greater reporting and recordkeeping requirements for registered Advisers with a view to protect investors. The Final Rules expand on the existing regulatory regime and require Advisers to provide investors with more detailed information in the private funds context relating to investments, costs, and material economic terms including performance metrics and the preferential treatment of investors. Fortunately for Canadian asset managers, the SEC has clarified that the Final Rules will not impact its historical position that the rules do not apply substantively to offshore Advisers with respect to non-U.S. domiciled funds (whether or not the non-U.S. domiciled fund has U.S. investors).
|
SEC Final Rules |
|
|---|---|
|
Applies to all Advisers of Private Funds in the United States (including exempt reporting advisers and advisers relying on the foreign private adviser exemption) |
|
|
Restricted Activities Rule |
Prohibits Advisers from undertaking specified actions without providing notice to all investors of the fund and, in particular instances, unless consent is obtained from such fund's investors. |
|
Preferential Treatment Rule |
Prohibits Advisers from providing preferential treatment to some investors in the fund, as it relates to either redemption rights or access to information, if it would have a material negative effect on other investors. |
|
Applies only to Advisers Registered with the SEC |
|
|
Quarterly Statement Rule |
Advisers must provide quarterly statements to investors detailing fees, expenses, and performance of each private fund, as well as disclosure of portfolio-level compensation to the Adviser. |
|
Audit Rule |
Advisers must ensure private funds obtain audited financial statements, both annually and on liquidation. |
|
Adviser-Led Secondaries Rule |
Advisers must obtain an independent fairness opinion or valuation opinion prior to any continuation fund transaction. |
Canadian Exempt Reporting Advisers and the Final Rules
The SEC currently provides exemptions to Exempt Reporting Advisers (ERAs) from SEC registration requirements. Canadian private fund advisers may rely on §275.203(m)(b) of the Act, which exempts non-U.S. Advisers from the SEC registration requirement if the investment adviser (1) has no client that is a United States person except for qualifying private funds, and (2) all assets managed by the investment adviser at a place of business in the United States are solely attributed to private fund assets, the total value of which is less than $150 million. The SEC employes the ERA exemption to encourage the participation of non-U.S. Advisers in the U.S. market by limiting undue regulatory and operational requirements on non-U.S. Adviser business outside of the United States.
Two of the Final Rules will apply to Canadian ERAs: the Restricted Activities Rule and the Preferential Treatment Rule. These rules capture all Canadian Advisers with private funds domiciled in the United States, even if they are below the $150 million threshold. The additional three Final Rules, the Quarterly Statement Rule, the Audit Rule and the Adviser-Led Secondary Transaction Rule, apply only to registered Advisers. The Restricted Activities Rule and the Preferential Treatment Rule will come into effect for Canadian ERAs on March 14, 2025.
Final Rules Affecting Canadian Advisers
Restricted Activities Rule
The Restricted Activities Rule will restrict all Canadian Advisers with funds domiciled in the United States, including those that are exempt from registering under the Act, from engaging in specified activities unless they provide investors with adequate disclosure, and in some instances, receive the consent of all investors of the fund.
|
Restricted Activity |
Requires Notice to Investors |
Requires Investor Consent |
|---|---|---|
|
Charging or allocating to the fund any fees or expenses associated with an investigation into the Adviser (or related persons) by a governmental authority. |
Yes |
Yes |
|
Charging the fund for regulatory, examination, or compliance fees associated with an Adviser (or related persons). |
Yes |
No |
|
Reducing the amount of any Adviser clawback for taxes applicable to the Adviser, (or related persons) whether actual, potential, or hypothetical. |
Yes |
No |
|
Where an Adviser is the adviser for more than one fund invested in a single portfolio company, charging or allocating any fees or expenses related to such portfolio company on a non-pro rata basis. |
Yes |
No |
|
Borrowing money, securities, or other private fund assets, or receiving a loan or extension of credit, from a private fund client. |
Yes |
Yes |
Preferential Treatment Rule
The Preferential Treatment Rule will restrict all Canadian Advisers with funds domiciled in the United States, including those that are exempt from registering under the Act, from providing preferential treatment to certain investors of a private fund as it relates to either the redemption of interest or access to information on portfolio holdings.
Redemption: An Adviser may not grant any investor in a private fund (or in a similar pool of assets) the ability to redeem its interests on terms that the Adviser may reasonably expect to have a material negative effect on the other investors in such fund (or similar pool of assets). However, the Preferential Treatment Rule allows for two exceptions: (1) where the redemption is required by law, rule, regulation, or order of a specified government authority; or (2) if the Adviser has offered the same redemption ability to all existing investors and will continue to offer the same redemption ability to all future investors.
Access to Information: Advisers may not provide any one investor with information regarding portfolio holdings or exposures of a private fund (or of a similar pool of assets) if the Adviser may reasonably expect that providing such information would have a material negative effect on other investors in such fund (or similar pool of assets). The Preferential Treatment Rule allows for an exception where the Adviser offers such information to all other existing investors at the same time or substantially the same time.
The Preferential Treatment Rule also requires that the Adviser distribute to current investors a written notice of all preferential treatment the Adviser (or related persons) have provided to other investors in the same private fund. The timeline for providing such notice is based on the nature of the fund: for an illiquid fund, the notice is required as soon as reasonably practicable following the end of the fund's fundraising period; for a liquid fund, the notice is required as soon as reasonably practicably following an investor's investment in the private fund.
Challenges to the Final Rules
Following the SEC's publication of the Final Rules, a number of associations in the investment management industry have collaboratively challenged the Final Rules, referring to them as SEC overreach. These industry associations, including the Alternative Investment Management Association, the National Venture Capital Association, and the National Association of Private Fund Managers, filed suit in September 2023 in the U.S. Circuit Court for the Fifth Circuit requesting that the Final Rules be set aside. The industry groups have alleged that the SEC has exceeded its own statutory authority in adopting these rules that would be detrimental to the investment industry and prevent private fund managers from competitively offering custom solutions to fund investors.
Bennett Jones is following the litigation, and we are expecting the Fifth Circuit decision imminently before May 31, 2024. At this stage it is uncertain whether the matter will be resolved prior to the March 14, 2025 compliance date for Canadian ERAs with private funds located in the United States.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.