Advisers Act

Fiduciary Governance Group members to present on the impact of the SEC standards of conduct rulemaking on fund directors

Larry Stadulis and Sara Crovitz further expand their analysis of Regulation Best Interest, Form CRS and the IA Interpretive Release by hosting a webinar for the Mutual Fund Directors Forum. The webinar is called, “What Directors Need to Know about Regulation Best Interest and the Standards of Conduct Rulemaking Package,” and is scheduled for Thursday, September 12 from 2:00-3:00 pm. Further information, including registration, can be found here.

A Private Fund Manager’s Guide to the SEC’s ‘Standard of Conduct’ Release

The Securities and Exchange Commission recently adopted a package of new rules and interpretations, including Regulation Best Interest (Reg BI), the Form CRS Relationship Summary (Form CRS) and guidance1 on the Investment Advisers Act of 1940 (the Advisers Act Guidance or Release). This Client Alert will focus on the Advisers Act Guidance, which is applicable to both advisers fully registered with the SEC and exempt reporting advisers who manage only private funds.2 The following is a brief discussion of certain aspects that may be relevant to private fund managers.

More information on Reg BI, which is applicable only to broker-dealers, and Form CRS, which is applicable only to broker-dealers and investment advisers3 that enter into advisory contracts with “retail” investors, can be found in separate Client Alerts [Risk&Reward-June Edition and Risk&Reward-July Edition].

With the Advisers Act Guidance, the SEC aims to “reaffirm – and in some cases clarify – certain aspects of” an adviser’s fiduciary duty under the Advisers Act, namely the duty of care and duty of loyalty all advisers owe their clients. Of particular importance to private fund managers are the SEC’s general focus on the duty of loyalty as it relates to disclosure of material facts about conflicts of interest, and the SEC’s specific discussion of conflicts associated with allocation of investment opportunities among clients, including co-investments, each of which we cover below. In addition, we highlight a recent enforcement case involving a U.K.-based hedge fund manager that underscores certain of the themes from the Advisers Act Guidance.

Duty of Loyalty
The Release lays out the SEC’s view that “[u]nder its duty of loyalty, an investment adviser must eliminate or make full and fair disclosure of all conflicts of interest … such that a client can provide informed consent to the conflict.”

Disclosure and Informed Consent
The Release is not prescriptive with respect to how an adviser must disclose any conflicts and obtain informed consent from clients, but it does note that consent need not be in a written agreement. Rather, an adviser’s “client could implicitly consent by entering into or continuing the investment advisory relationship,” after receiving “a combination of Form ADV and other disclosure.” Although offering memoranda are not specifically referenced in the Advisers Act Guidance, SEC staff has suggested in the past4 that such disclosure may include a private fund’s offering memorandum.

Nor is the Release prescriptive in terms of the format and content of the disclosure, although the SEC clearly differentiated between an adviser’s obligations with respect to institutional clients (e.g., a private fund) and “retail” clients, noting that what constitutes full and fair disclosure “can differ, in some cases, significantly” between the two audiences.5 The key, however, is that “regardless of the nature of the client, the disclosure must be clear and detailed enough for the client to make an informed decision to consent to the conflict of interest or reject it.”

Specificity of Disclosure and Appropriateness of Use of ‘May’
The Release does, however, provide examples of disclosure practices that the SEC considers inadequate or inappropriate, with a particular focus on use of the word “may.” Citing past enforcement actions, the SEC points out that “disclosure that an adviser ‘may’ have a particular conflict, without more, is not adequate when the conflict actually exists…. In addition, the use of ‘may’ would be inappropriate if it simply precedes a list of all possible or potential conflicts regardless of likelihood and obfuscates actual conflicts to the point that a client cannot provide informed consent.” In terms of level of detail, the guidance notes that it would be insufficient simply to disclose that an adviser “has ‘other clients’ without describing how the adviser will manage conflicts between clients if and when they arise or to disclose that the adviser has ‘conflicts’ without further description.” Managers should take note of the above and review their firm’s disclosure for appropriate use of the word “may.”

Allocation of Investment Opportunities Including Co-Investments
One specific area of potential conflicts of interest that the Release discussed is an adviser’s allocation policies and the obligation to describe “how the adviser will allocate investment opportunities, such that a client can provide informed consent.” In this way, the Release echoed in part the SEC’s Office of Compliance and Inspections (OCIE) 2019 Examination Priorities,6 which noted that OCIE plans to “review firms’ practices for … fairly allocating investment opportunities among clients,” and for “disclosing critical information to clients….”

For private fund managers, such allocation conflicts could arise in various contexts, for example, trade allocations among client accounts that have overlapping investment mandates, including a managed account run pari passu to a flagship fund, or a long-only fund that has been “carved out” from a flagship long/short fund. In addition, conflicts of interest could arise in the allocation of co-investment opportunities among clients, as suggested by the acting director of OCIE in a 2015 speech: “Co-investment opportunities have a very real and tangible economic value but also can be a source of various conflicts of interest,” and given that, “all investors deserve to know where they stand in the co-investment priority stack.”7 While on the enforcement front the SEC’s recent focus has primarily been on private equity managers’ practices with regard to allocation of fees and expenses associated with co-investments among clients,8 managers should take note of this increasing focus on co-investments more broadly, and should review their practices with respect to allocation of opportunities and relevant disclosure.

In terms of the content of allocation policies, the SEC clearly states that opportunities need not be allocated pro rata, noting further that “[a]n adviser and a client may even agree that certain investment opportunities or categories of investment opportunities will not be allocated or offered to a client” (emphasis added). The SEC’s use of the word “agree” in this context is a reminder of its expectation that an adviser’s “fiduciary duty follows the contours of the relationship … and the adviser and its client may shape that relationship by agreement, provided that there is full and fair disclosure and informed consent.”

In 2016, the SEC brought an enforcement proceeding9 against a U.K.-based hedge fund manager that highlights certain of the themes discussed above. In that case, the SEC alleged that the manager failed to inform investors in its existing flagship fund of the “significant overlap” in trade allocations between that flagship fund and a newer vehicle, which was marketed as having a divergent investment strategy. The SEC cited, among other things, the fact that the manager “never updated” the offering documents of the flagship fund, which disclosed that the manager “may manage additional funds in the future that may invest in the same markets as [the flagship fund] and certain conflicts of interest could result.” Further, the SEC alleged that the manager and its founder “should have, but did not, update the [due diligence questionnaire] response they provided to many existing and prospective [flagship fund] investors about [the new vehicle],” which continued to position the two funds as having separate strategies despite the “high degree of overlap” between their investments.

Duty of Care
In addition to its discussion of advisers’ duty of loyalty, the Release also describes advisers’ duty of care, including the duty to seek best execution and the newly described “duty to provide advice and monitoring.” With respect to best execution, the Release is consistent with prior SEC guidance and serves as a reminder of advisers’ obligations not only to seek best execution in selecting counterparties to execute trades on behalf of clients, but also to “periodically and systematically” evaluate such providers. Further, the Release lays out a newly described obligation to “monitor” client accounts, which should be “at a frequency that is in the best interest of the client, taking into account the scope of the agreed relationship.” While the SEC provides no specific guidance in terms of expectations with respect to private fund clients, all advisers may want to consider how best to document satisfaction of their duty to monitor client accounts. The Release further suggests that registered investment advisers “may consider whether written policies and procedures relating to monitoring would be appropriate.”

Given that the Release is immediately effective, below are certain questions that private fund managers may wish to consider in light of the SEC’s focus on these issues:

  • Have you reviewed the Conflicts of Interest disclosure in your fund offering documents and/or Form ADV, Part 2A, for appropriate use of the word “may”?
  • Do you have a written investment allocation policy, and are you following it and documenting any deviations therefrom?
  • Does your firm participate in co-investments, and if so, have you disclosed your policy (and any updates) to investors?
  • Do you have a process and documentation in place to substantiate your firm’s “duty to monitor” client accounts?

1 Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Investment Advisers Act Release No. IA-5248 (June 5, 2019).

2 The Advisers Act Guidance also applies to any managers relying on the “foreign private adviser” exemption of Section 202(a)(30) of the Advisers Act (Foreign Private Advisers), generally those with fewer than 15 U.S. clients and 15 U.S. investors in private funds as well as less than $25 million attributable to such U.S. clients and investors.

3 Note that Form CRS is also applicable to Foreign Private Advisers, but only to the extent of any advisory contracts with U.S. “retail” investors. A “retail” investor for purposes of Form CRS includes any natural person, without regard to net worth or sophistication. Note, however, that Form CRS does not “look through” to underlying investors in pooled investment vehicles such as hedge funds or mutual funds, such that it will not impact managers of only such vehicles, or those who advise institutional clients, such as separately managed accounts with endowments or pension funds.

4 Julie Riewe, co-chief, Asset Management Unit, Division of Enforcement, SEC, “Conflicts, Conflicts, Everywhere” (Feb. 26, 2015); see also In re James Caird Asset Management LLP and Timothy G. Leslie, Investment Advisers Act Release No. 4413 (June 2, 2016).

5 The Release notes that “institutional clients generally have a greater capacity and more resources than retail clients to analyze and understand complex conflicts and their ramifications.”

6 OCIE, SEC, Examination Priorities for 2019 (Dec. 20, 2018).

7 Marc Wyatt, acting director, Office of Compliance Inspections & Examinations, SEC, “Private Equity: A Look Back and a Glimpse Ahead” (May 13, 2015).

8 In re Lightyear Capital LLC, Investment Advisers Act Release No. 5096 (Dec. 26, 2018); and In re Kohlberg Kravis Roberts & Co. L.P., Investment Advisers Act Release No. 4131 (June 29, 2015).

9 In re Caird (June 2, 2016).

SEC Seeks Expanded Access to Private Fund Strategies

John P. Hamilton
Prufesh P. Modhera

On June 18, the Securities and Exchange Commission (SEC) issued a “Concept Release on Harmonization of Securities Offering Exemptions” (the Release). At over 200 pages, the Release seeks public comment on a wide variety of topics related to the current framework for private securities offerings.

This Client Alert will focus on two topics raised by the Release that are relevant to private fund managers: (i) potential changes to the definition of “accredited investors”1 and (ii) the potential for expanded access to private fund strategies, including private equity, venture capital and hedge fund strategies for retail investors who do not qualify as accredited investors. Public comments on the Release are due by Sept. 24.

Potential Changes to the Definition of Accredited Investor

Many private securities, including most private funds, are offered pursuant to an exemption from registration under Regulation D of the Securities Act of 1933, which generally requires that investors meet the qualifications of accredited investors.2 The Release seeks comment on whether to modify and/or expand the definition of that term.

In doing so, the Release revisits the SEC staff’s 2015 “Report on the Review of the Definition of Accredited Investor” (the 2015 Report),3 which recommended certain changes to the accredited investor definition, a summary of which can be found in a prior Client Alert. While the SEC declined to act on any of the changes recommended in the 2015 Report, this year’s Release seeks comment on largely the same list of recommendations as well as certain additional potential changes, two of which are highlighted below.

Similar to the 2015 Report, the Release again seeks comment on whether to maintain the current income and net worth tests and whether to index those amounts for inflation. Further, the Release asks whether to consider other measures of qualification, such as (i) a minimum investment test, rather than net worth; (ii) permitting individuals with certain professional credentials or prior experience investing in private offerings to qualify as accredited investors; or (iii) permitting individuals who pass an accredited investor exam to qualify as accredited investors. Two new suggestions from the Release not found in the 2015 Report are worth highlighting.

Opting In to Accredited Investor Status

First, at the suggestion of three commenters on the 2015 Report and with little additional context, the Release asks whether individuals should be permitted, “after receiving disclosure about the risks of a private offering, to opt into being accredited investors.”

Non-Accredited Investors Advised by Registered Financial Professionals

In addition, the Release then explores in considerable detail another manner of qualifying as an accredited investor, which in some ways could be viewed as an expansion of the purchaser representative concept currently part of Rule 506(b) under Regulation D. As noted above, such offerings currently may choose to permit a limited number of non-accredited investors who, together with a purchaser representative, are able to meet the requirement of sufficient knowledge and experience to evaluate the prospective investment. Any such offerings are subject to greater disclosure obligations, however, and are less common, particularly among private fund issuers.

Based in part on the recommendation of a 2017 Report4 from the U.S. Department of the Treasury (the 2017 Treasury Report) to permit “otherwise non-accredited investors to retain professionals to advise them in order to qualify as accredited investors without limitation,” the Release asks whether the definition of accredited investor should be expanded to include those advised by registered financial professionals.

The Release asks a lengthy series of questions related to this concept, including whether any limitations or other investor protections would be appropriate for such new category of accredited investors to participate in private offerings (e.g., limitations on the type or amount of investments, or additional disclosure requirements). For example, the SEC seeks comment on whether it should allow such investors

to invest in pooled investment funds, such as private funds under Section 3(c)(1) under the Investment Company Act, if these investors are: (1) subject to limits on the amounts of investments in such pooled investment funds, such as a dollar amount or percentage of investments; and/or (2) limited to making the investment out of retirement or other similarly federally-regulated accounts? Would such a change substantially eliminate current distinctions between registered funds and private funds?

While the level of support for such an expansion of the definition of accredited investor is unclear, the three pages of detailed questions devoted to it suggest that the SEC is at least open to facilitating broader participation in private fund offerings by retail investors who are advised by registered financial professionals but otherwise unable to meet the relevant income or net worth tests.

Potential for Expanded Access to Private Fund Strategies for Non-Accredited Investors

Recognizing that private companies, particularly growth-stage companies, often see pooled investment funds as a valuable source of capital, the Release asks whether the SEC should take steps to expand such issuers’ ability to raise capital through pooled investment funds … .” In addition, citing the potential advantages to retail investors of portfolio diversification and return profiles that are less correlated to the public markets, the Release asks “whether retail investors should be allowed greater exposure to growth stage issuers through pooled investment funds … .

The Release goes on to highlight some of the challenges currently faced by retail investors seeking exposure to private offerings through pooled investment funds, noting that for non-accredited investors, their options are limited to seeking exposure through funds registered under the Investment Company Act of 1940 (the Investment Company Act) and business development companies5 (BDCs). Further, as the Release notes, such funds generally have limited, if any, exposure to privately offered securities.

To that end, the Release seeks comment on whether there are any regulatory provisions or SEC practices that discourage registered investment companies and BDCs from participating in private offerings.

Registered Funds of Funds

Specifically addressing the concept of a registered fund open to retail investors serving as a “feeder fund” into private funds such as private equity and hedge funds, the Release notes that historically such an approach has raised SEC staff concerns, in that such retail investors would not be eligible to invest directly in the underlying private funds. However, the Release suggests a willingness to consider other views on this topic.

What restrictions should there be, if any, on the ability of closed-end funds, including BDCs, to invest in private funds, including private equity funds and hedge funds, and to offer their shares to retail investors?

Interval Funds

In addition, the Release spends time exploring one such closed-end fund structure registered under the Investment Company Act, the interval fund, which provides liquidity to investors through periodic share repurchases. Suggesting that the SEC views such structures as underutilized, and also noting the recommendation of the 2017 Treasury Report,6 the Release seeks comment on a series of questions focused on, among other things, the liquidity mechanism of share repurchases and ways to decrease the compliance costs of these vehicles more broadly.

For example, the Release asks whether it should permit interval funds to mirror the five-year investment period of a typical private equity fund, with periodic repurchases following such period, rather than the current maximum period, generally 12 months. Further, the Release seeks comment on whether it should make changes to facilitate compliance with certain technical aspects of the Investment Company Act by interval funds, particularly those pursuing a private equity or venture capital strategy (e.g., by permitting a two-year ramp-up period for funds to meet the relevant diversification requirements or by providing relief from the restrictions on affiliated transactions for control investments made by interval funds).

Retirement Savers – Target Date Funds and Robo-Advisers

The SEC also highlights target date funds aimed at retirement savers, which are typically structured as open-end funds registered under the Investment Company Act (i.e., mutual funds), as potentially appropriate vehicles to seek exposure to private offerings. The Release suggests that relative to other mutual funds, such funds with target dates far into the future may have holding periods that are better aligned with the limited liquidity profile of privately issued securities.

Therefore, the Release asks whether it should take steps to enable certain target date funds to seek limited exposure to private offerings. The Release also seeks comment on a similar concept of facilitating limited exposure to private offerings in the portfolios recommended by robo-advisers to the extent their services are focused on retirement savings for retail investors.

Performance Fees

The Release also asks whether the SEC should consider changes to the restrictions on performance fees under the Investment Advisers Act of 1940 (the Advisers Act). Performance fees, typically charged by private fund managers, may generally be charged only to a fund vehicle managed by a registered investment adviser7 if all the fund’s investors meet the standard of “qualified client,”8 which is generally considered a higher bar to meet than the accredited investor test.

Although the Release provides little additional context, the request for comment below implies an awareness by the SEC of the effect of regulatory constraints on the market for financial product development.

How do the restrictions on performance fees under the Advisers Act affect the offering of venture strategies by registered investment companies and BDCs? Should we make changes to the restrictions on performance fees?

And while the question above relates to registered funds and BDCs offering venture strategies, a similar analysis of the restriction on performance fees would be relevant to expansion of access to private funds for retail investors more generally, whether by an expansion of the definition of accredited investor or by permitting broader participation by non-accredited investors in private funds, either directly or indirectly (e.g., through a registered feeder fund as outlined above).

1 To be an accredited investor, a natural person generally must either have an annual income that exceeds $200,000 in each of the two most recent years (or $300,000 joint income with spouse) or a net worth exceeding $1 million (individually or jointly with spouse), excluding the value of their primary residence.

2 Note that under Rule 506(b) of Regulation D (the exemption most commonly used by private funds), a private security may be offered to an unlimited number of accredited investors. In addition, the issuer may also choose to permit up to 35 non-accredited investors, provided that all non-accredited investors, either alone or together with a third party that meets the requirements of a “purchaser representative,” must be sophisticated, i.e., they must have sufficient knowledge and experience to evaluate the prospective investment. If any non-accredited investors are included, however, the offering will be subject to greater disclosure obligations, and as a result, this is part of the reason few private fund issuers make offers to any non-accredited investors. In fact, according to the Release, only 6% of all private offerings under Rule 506(b) between 2015 and 2018 permitted non-accredited investors.

3 Pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act, every four years the SEC is required to review the accredited investor definition as it relates to natural persons.

4 A Financial System That Creates Economic Opportunities, Capital Markets. U.S. Department of the Treasury (October 2017),

5 As described by the Release, “BDCs are a category of closed-end investment companies that do not register under the Investment Company Act, but rather elect to be subject to the provisions of sections 55 through 65 of that act.”

6 The Release notes that as of Dec. 31, 2018, there were 57 interval funds with about $29.7 billion in assets under management. In addition, as the Release states, “the 2017 Treasury Report recommended that the Commission review its rules regarding interval funds to determine whether more flexible provisions might encourage the creation of registered closed-end funds that invest in offerings of smaller public companies and private companies whose shares have limited or no liquidity.”

7 Note that the restriction on performance fees does not apply to “exempt reporting advisers,” which include, among others, certain venture capital managers and private fund advisers who manage less than $150 million in assets from a place of business in the United States.

8 Pursuant to Rule 205-3 of the Advisers Act, a qualified client must generally have at least $1 million in assets under management with the adviser immediately after entering into an investment advisory contract, or the adviser must reasonably believe the investor has a net worth (together with assets held jointly with a spouse) of more than $2.1 million exclusive of the value of their primary residence.

SEC alleges breach of fiduciary duty over undisclosed conflicts of interest

Live Blogging: IA Interpretive Release – rollovers/low cost products

Sarah mentions that the fiduciary duty applies to advice re. rollovers and to prospective clients. In terms of satisfying the fiduciary standard of care, merely selecting the lowest cost product is not sufficient. With respect to the duty of loyalty, informed consent can be explicit or implicit and need not be in writing. However, such conflicts may be of such a nature that full and fair disclosure may not be enough.

Live Blogging: IA Interpretive Release – effective date

Sarah notes that the IA interpretive guidance applies now, and so firms can/should begin thinking about compliance presently for purposes of enforcement.

Live Blogging: Investment Adviser (IA) Interpretive Release

Sara Crovitz is now discussing the Investment Adviser Interpretive Release. She notes the IA release applies to all clients, both retail and institutional. The scope of the fiduciary relationship can be shaped by the agreement between the customer and adviser. She mentions that the adviser could not waive its fiduciary duties, regardless of sophistication of the customer.

Live Blogging – SEC standards of conduct rulemaking

Three members of Stradley’s Fiduciary Governance Group are currently presenting on the SEC’s significant rulemaking re. broker-dealer and investment adviser standards of conduct. Larry Stadulis is the first to speak and tackles Reg BI. The policy objectives of Reg BI are:

  • designed to improve consumer protection, particularly against conflicts of interest;
  • designed to help retail investors to better understand and compare investment options and clarity over standards of conduct.

Larry notes that Reg BI does not impose “full blown fiduciary status” on broker-dealers and that there is not a uniform fiduciary standard for investment advisers and broker-dealers.

Impact of New SEC Regulation Best Interest and Other Standards of Conduct Rules on Broker-Dealers, Investment Advisers and Investment Companies

As a reminder, Larry Stadulis, Sara Crovitz and John Baker will host an on-demand webinar via Strafford tomorrow at 1:00 pm EDT to discuss the recent adoption of Regulation Best Interest, Form CRS and other rules and interpretations, and their effect on registered investment advisers, registered broker-dealers and investment companies. Though this webinar has a fee, CLE is available. They will explain the practical implications for broker-dealers, investment advisers and investment companies on the Securities and Exchange Commission’s (SEC) new standard of conduct rules and guidance. Specifically, they will discuss:

  • Regulation Best Interest: How and why the SEC adopted, and the implications for firms of, a standard of conduct for broker-dealers and their associated natural persons when making a recommendation to a retail customer of any securities transaction or investment strategy involving securities.
  • Form CRS: How and why the SEC adopted, and the implications for firms of, a requirement for registered investment advisers and registered broker-dealers to provide a Form CRS relationship summary to retail investors.
  • Standard of Conduct for Investment Advisers: How and why the SEC adopted, and the implications for firms of, an interpretation of the standard of conduct for investment advisers.
  • “Solely Incidental”: How and why the SEC adopted, and the implications for firms of, an interpretation of the “solely incidental” prong of section 202(a)(11)(C) of the Investment Advisers Act of 1940, which provides that the term “investment adviser” does not include any broker or dealer whose performance of investment advisory services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor.

Registration for the webinar can be found here. The webinar will supplement our extensive analysis on the entire SEC rulemaking.

Alan Goldberg & Larry Stadulis quoted in AdvisorNews re. implementing the SEC’s standards of conduct package