March 17, 2022 - In earlier missives and webcast, we have offered an overview of the SEC’s Private Fund Disclosure Rule (“proposed rule”) and its impact on CLOs, a review of the SEC’s cost-benefit analysis (and implications for quarterly reporting) and the impact of the annual audit rule on “securitized asset funds.” Today we sample the proposed rule’s plethora of prohibited activities that could affect CLOs. The rule outright prohibits i) an adviser from seeking exculpation or indemnification from a fund; ii) non-pro rata fee arrangements; iii) certain preferential treatment; iv) charging certain other fees (and requires extensive disclosure of other non-prohibited fees); v) reducing the amount of any adviser clawback by the amount of certain taxes; and vi) borrowings from private fund clients. In the interest of priority, space – and reader sanity – we cover the first four issues below.
Limiting Liability (p. 150, 244): The proposed rule would prohibit an adviser from seeking reimbursement, indemnification, exculpation or limitation of liability for a breach of fiduciary duty, willful malfeasance, bad faith, negligence or recklessness. Currently, many private funds enter into documents containing these contractual terms. In the cost benefit analysis, the SEC states that even when disclosed and permissible under state law, these practices may involve breaches of fiduciary duty and harms to investors. The SEC asserts that investors would benefit from elimination of fund expenses involved in reimbursing the adviser as well as costs involved in negotiating with or researching the adviser to avoid breaches. By prohibiting reimbursement, indemnification, etc., the proposal may make such activities incrementally less likely to occur. The SEC notes that costs might include advisers increasing other fees to compensate for the loss of indemnification.
Non-Pro Rata Fees (p. 152, 239): The proposed rule would prohibit an adviser from charging or allocating fees and expenses related to a portfolio investment on a non-pro rata basis when multiple private funds and other clients invest in the same portfolio investment (such as parallel funds in non-US jurisdictions to accommodate non-US investors or structures such as SMAs). In its cost-benefit analysis, the SEC suggests there may be a zero-sum aspect here. Investors that had received lower fees likely would face increased costs, while investors that had paid higher fees would face decreased costs. Meanwhile, advisers would face costs in updating their business practices and might find that overall fees may decline in a less-flexible fee environment.
Preferential Treatment (p. 162, 194, 244, 296): The proposed rule would prohibit private funds from providing certain preferential terms to some investors that would have material negative effects on other investors in that fund or in a substantially similar pool of assets. Specifically, there would be a prohibition on advisers providing preferential access to information to some investors, as well as some investors being able to preferentially redeem their interests. The SEC provides a case study of an adviser preferentially sharing potentially negative information about the funds’ assets and then permitting certain investors to redeem their interests, thus harming other investors in the fund (or a fund with substantially similar assets). Importantly, a “substantially similar pool of assets” is defined as a pooled investment vehicle with substantially similar investment policies, objectives, or strategies to those of the private fund managed by the adviser. It would also include pooled vehicles with different base currencies and pooled vehicles with embedded leverage that have substantially similar investment policies, objectives, or strategies. The SEC notes that the preferential treatment prohibition could i) benefit the non-preferred investors and ii) eliminate the research to avoid advisers that engage in preferential treatment, thus reducing costs. The prohibition’s costs include the preferred investors losing the excess return associated preferential terms. Advisers also would incur the costs of updating their processes for entering into agreements to eliminate preferential terms.
Other preferential terms are permitted if the adviser provides written disclosures to prospective and current investors regarding allpreferential treatment to other investors. Annual disclosure must be detailed, such as providing copies of side letters to all investors. The SEC notes that this would benefit investors that do not enjoy favoritism but would impose a cost on advisers as they bring their contracting and disclosure practices into compliance. The SEC anticipates that the cost of disclosure of preferential terms would be $161,452,375 annually; however, this cost could decline if advisers choose not to offer any other preferential treatment. These costs may be borne by the adviser or by the investor in the form of higher fund expenses. Investors that benefit from preferential terms are harmed by this provision.
Charging Certain Other Fees (p. 140, 234): The proposed rule prohibits a number of fees. First, the proposed rule prohibits an advisor from charging fees or expenses associated with an examination or investigation of the adviser by any governmental or regulatory authority, as well as regulatory and compliance fees and expenses. The SEC comments that this prohibition would lower the charges and costs that investors face and may discourage advisers from engaging in riskier behavior that might trigger examinations. However, advisers may face costs as they change their business practices and forgo fees that would otherwise be charged; moreover, they may increase management fees. Investors might bear the costs of foregone investments.
Advisers also may not charge monitoring, servicing, consulting, or other fees in respect of any services it does not provide. The SEC notes that these fees can create conflicts of interest and may cause the investor to receive a lower rate of return. The prohibition potentially would cost the adviser fees, but these might be mitigated through an increase in management fees.
This is a sampling of the prohibited activities; some clearly fly in the face of existing contractual obligations. The LSTA continues to painstakingly analyze the rule and respond (quickly!) on behalf of industry.