New Private Fund Adviser Regulations from the SEC

The Securities and Exchange Commission announced on August 23, 2023 that they have adopted new rules under the Investment Advisers Act of 1940 which call for greater transparency for investors who invest in private funds. While some of these rules will make investing with registered investment advisers clearer, others will make the world of venture capital a bit more challenging.

A slightly stricter version of the adopted rules was originally proposed by the SEC on February 9, 2022. The proposal garnered more than 300 public comments during its comment period, including comments from the Head of Policy and Regulatory Affairs at Carta, Inc. (Anthony Cimino), numerous international law and accounting firms, various state’s Attorneys Generals, presidential candidates and even an individual who went by “Silence Dogood” (a famous pen name used by Benjamin Franklin). Overall, most of the comments called for a scaling back of the proposals by the SEC, but in the end, barring any immediate litigation, the new rules will go into effect about 60 days from August 23 (60 days from the date they are published in the Federal Register, to be exact) with the period of compliance for existing funds beginning anywhere from 12 to 18 months from the effective date.

Perhaps most relevant to venture capitalists and those operating in the emerging company/startup sphere are what are referred to as the “Preferential Treatment Rules” set forth in Rule 211(h)(2)-3. Specifically, the barring of “preferential treatment” among investors is broken down into two categories: preferential treatment regarding redemption rights and preferential treatment regarding transparency rights. Taking first the barring of preferential redemption rights, the rule prohibits an investor in a private fund (or similar pool of assets) from being granted more favorable rights to redeem its interest if it is reasonably expected to have a material, negative impact on the other investors in the private fund (or similar pool of assets). Rights such as preferential redemption rights are often included in what is referred to as a “side letter” with an investor and will no longer be permitted even if a certain investor invests substantially more than others.

Similar to the new prohibition on preferential redemption is the prohibition on preferential transparency. Allowing certain investors information rights—which is often done via side letter as well—is no longer permitted unless the information is offered to all other investors at the same time or if the information would not be considered to be material or have a negative effect on the other investors.

One area in which the SEC seemingly departed from its original proposal is the fact that the adopted rule allows for “grandfathering” in preferential treatment set forth above. In other words, if, for example, a side letter currently allows an investor certain information rights and redemption rights, these will remain intact. Without this grandfathering status, side letters and other agreements encompassing preferential treatment would have had to be amended to conform with the rule.

Other forms of preferential treatment are still allowed going forward, but require various disclosures. For example, any material economic terms or preferential terms in general are permitted, but for the former, advance disclosure to the other investors is required and, for the latter, subsequent disclosure is required.

Another change from the proposal which will help the world of venture capitalists is the removal of indemnification prohibitions. In the original proposal, there would have been a blanket prohibition on advisers limiting or eliminating liability for any misconduct by the fund or its advisers. As the proposal would have included a bar on indemnification for negligence, it would have made it easier for partners or investors to sue funds. With this additional language removed, venture capitalists and private funds will have the option to remain relatively shielded behind robust indemnification provisions.

While this 650-page rule has numerous other new requirements and regulations, we chose to highlight those most pertinent to venture capitalists in this article. To the extent you are involved in what may be deemed a public fund and would like to either learn more on how to be protected or how these new regulations affect you, please contact Crowell & Moring LLP.