By Jennifer Kalmanides

On February 9, 2022, the Securities and Exchange Commission (the “SEC”) unveiled a slate of newly proposed rules, which, if enacted, will significantly impact the way in which private fund managers conduct business.  While the proposed rules vary in their scope and substance, taken together they seem to reflect a meaningful shift in the way the SEC conceives of its regulatory role with respect to private funds, moving away from the disclosure-based regime historically considered appropriate for sophisticated investors in the private funds space to a series of prescriptive requirements of the sort previously determined to be more suited to financial products for retail investors. 

Though each proposed rule is consequential on its own, this alert will focus on the SEC’s proposed rule prohibiting certain preferential treatment for private fund investors (the “Preferential Treatment Rule”), which would have far-ranging implications for side letter negotiations.   

Overview

The Preferential Treatment Rule consists of two primary components: (i) a complete prohibition on certain types of preferential treatment that have a material, negative effect on other fund investors or investors in a substantially similar pool of assets (such as a parallel fund) and (ii) a broader prohibition on all other types of preferential treatment, unless disclosed in writing to current and prospective fund investors.  Both the determination of whether a term is “preferential” in the first instance and whether an adviser could reasonably expect a preferential term to have a material, negative effect on other investors in the same fund or substantially similar pool of assets would depend on the facts and circumstances.  

Notably, the Preferential Treatment Rule would apply to all private fund advisers (including those exempt from registration) and their related persons.  The SEC has also proposed amending rule 204-2 under the Investment Advisers Act of 1940 to require registered advisers to retain books and records to evidence their compliance with the Preferential Treatment Rule.

Complete Prohibition

Under the Preferential Treatment Rule, no private fund adviser may provide preferential terms regarding redemptions or information about portfolio holdings or exposures to a subset of fund investors or investors in a substantially similar pool of assets, if the adviser reasonably expects that the provision of such preferential liquidity terms or information rights would have a material, negative effect on those other investors.

For purposes of this Rule, a “substantially similar pool of assets” would be defined to mean any pooled investment vehicle (other than an investment company registered under the Investment Company Act of 1940 or a company that elects to be regulated as such) with substantially similar investment policies, objectives or strategies to those of the private fund managed by the adviser or its related persons.  As above, whether a pool of assets would be considered substantially similar to the private fund will depend on a facts and circumstances analysis. 

Permitted with Disclosure

Additionally, the Preferential Treatment Rule would deny private fund advisers the ability to offer any other type of preferential treatment to fund investors, unless such preferential terms are explicitly disclosed to other current and prospective fund investors.  It is important to note that there is no “material, negative effect” qualifier for this second category: its requirements apply to all terms that could be considered preferential based on a facts and circumstances analysis.  For instance, the SEC expressly mentioned excuse rights (i.e., the right to refrain from participating in certain investments the fund plans to make) as an example of a preferential term that would require disclosure in the release.

Specific, Detailed Disclosure

An adviser would be required to describe with specificity the preferential treatment provided in order to convey its relevance.  For instance, it would not be sufficient for an adviser to generically refer to a lower fee rate provided to certain investors, rather the adviser would need to detail the exact lower fee rate or range of rates offered in order to provide sufficient disclosure under the proposed Rule.  An adviser can therefore satisfy the disclosure requirement either by providing a written summary of the preferential terms provided to other investors in the fund, so long as the adviser describes the preferential treatment with sufficient specificity, or, alternatively, the adviser may provide copies of the relevant side letter(s) containing the preferential terms with the investor’s identifying information redacted. 

Timing for Disclosure

The timing of notice of preferential terms under the proposed Rule would depend on whether the recipient is a current or prospective investor in the fund: prospective investors would need to be provided written notice prior to closing on an investment in the fund, while an adviser would be required to notify existing investors annually of any new preferential terms granted to other investors since the prior notice.  

The SEC is accepting comments on the proposed rules contained in the release, including the Preferential Treatment Rule, until the later of April 11, 2022 or 30 days from the date that the proposal is published in the Federal Register.