5 MIN READ
Published 08/06/2024
As the U.S. Securities and Exchange Commission (SEC) continues to push for expanded transparency and tighter regulations, investment advisers (advisers) — and more specifically, private fund advisers — need to remain vigilant. Significant legal expense, costly fines, and hard-earned reputations are at stake.
“Routine SEC examinations may lead to litigation costs, fines, and penalties. It is essential for investment advisers to connect with their risk-management teams to ensure they are prepared with updated strategies,” says Jennifer Lohmann, financial lines claims officer. “There’s a lot on the line, but by working with the right team of professionals, advisers can protect themselves and move ahead with confidence.”
Tightening regulations continue.
Throughout 2023, the SEC filed 784 enforcement actions, 18 percent of which were brought against investment advisers and investment companies. The SEC obtained orders for nearly $5 billion in financial remedies, largely consisting of fines, penalties, and disgorgement. This culminated in November, whenthe SEC adopted the Final Rules and Amendments (“the Final Rules”) under the Investment Advisers Act of 1940, with a continued focus on transparency for investors.
With this move, the SEC sought to protect those invested in private funds, emphasizing indirect exposure to investors through their participation in public and private pension plans, endowments, foundations, and other retirement plans. The Final Rules were intended for registered private fund advisers — and in part for all private fund advisers — to increase transparency to investors in a variety of ways.
Following the adoption of the Final Rules, a group of private fund industry associations petitioned the Fifth Circuit, challenging the Final Rules. On June 5, 2024, the Fifth Circuit vacated the Final Rules, noting the SEC had overstepped its authority.
Following the June 5 ruling, the SEC has several options. The first was to seek rehearing en banc before the Fifth Circuit; however, the deadline to seek rehearing has passed, so the SEC may now opt to draft new rules that comply with the Fifth Circuit ruling or it may appeal to the Supreme Court. The SEC has 90 days from the June 5 order to appeal to the Supreme Court. As of June 13, a representative for the SEC advised that the Commission was still considering its next steps.
“It is unclear which direction the SEC will take. However, based on the SEC’s focus in 2023 and the 2024 Examination Priorities put out earlier this year, I believe it is unlikely that the SEC takes no further action,” says Lohmann. “We should know more in September, depending on which course of action the SEC takes, making this an important time for all advisers to take stock of risks and to review and understand their insurance coverage.”
What could new SEC rules mean for private fund advisers?
“It will be a significant internal undertaking for advisers if the rules are revamped,” says Lohmann. To get a sense of what could be coming, advisers should consider that while some of the rules recently blocked by the Fifth Circuit only apply to registered private fund advisers, some apply to all private fund advisers and all registered advisers. New requirements could include:
- Issuing quarterly statements to investors
- Documenting annual reviews in writing
- Obtaining annual audits of financial statements for all private funds they advise both directly and indirectly
- Obtaining fairness/valuation opinions and distributing summaries of relevant business relationships for adviser-led secondary transactions
- Ceasing certain activities that the SEC believes involve conflicts of interest and ceasing compensation schemes that go against public interest
- Prohibiting certain preferential redemption rights with certain exceptions.
Keep in mind that this is an abbreviated list. To see the SEC’s entire proposal, please review the SEC documentation or consult with an expert.
What role does insurance play?
If the Final Rules go into effect, it is critical that advisers are prepared to respond appropriately and implement new policies and procedures. Now is also the time for advisers to review their insurance coverage with a knowledgeable broker. Together, advisers and brokers can determine if additional adjustments are warranted to help mitigate risk. It is important to note that insurance coverage typically does not provide coverage for fines and penalties.
- SEC investigations and litigation often result in significant expenses, and insurance may provide coverage for defense costs incurred in connection with a regulatory investigation against an insured (but typically, only after such insured is identified by name as a subject of the investigation in a Wells Notice, target letter, or formal order of investigation), as well as subsequent litigation; however, routine inspections, examinations, audits, and industry sweeps are typically not subject to coverage. Advisers should assess specific insurance needs with their broker.
- Although the Advisers Act does not grant investors a private cause of action, investors could pursue a common law claim for breach of fiduciary duty under state law, pointing to fiduciary standards under the Advisers Act as relevant or persuasive. Management and professional liability insurance could help mitigate costs in such an event.
Working with a knowledgeable insurance partner can help you understand what exposures to expect, as well as which policies offer protection and exactly what that protection entails. This is critical to help advisers understand their coverage should they face the unpleasant surprise of an investigation or lawsuit.
How can private fund advisers prepare?
Whether these rules come into play or not, the SEC is focused on making changes. In May 2023, the SEC Enforcement Director listed private funds as a “substantive priority area,” highlighting concerns about possible conflicts of interest and “fee and expense” issues in the industry. Additionally, in the SEC’s 2024 Examination Priorities, the SEC again highlighted investment advisers and investment advisers to private funds as a focal point.
“Private fund managers should prepare for continued greater scrutiny regardless of what happens with the Final Rules,” Lohmann says. “Yes, there are costs associated with changes to policies and procedures. However, noncompliance could be costlier.”
- Work with a team of trusted and knowledgeable financial, legal, and risk-management professionals.
- Understand the Final Rules and the grace periods for implementing them while tracking the status of the Fifth Circuit ruling.
- Evaluate the firm’s ability to report financial and conflict of interest information.
- Review structures for fees, claw backs, and borrowing facilities to understand what might need to change to comply with new rules.
- Review the need for directors and officers insurance.
Finally, think bigger picture: consider revisiting other policies with an eye toward minimizing vulnerability from claims that fall outside this sphere.
You know regulations, we know risk.
Operating in a heavily regulated environment is nothing new for private fund advisers. But unique risks require specialized protection and knowledgeable professionals in your corner. That is why Liberty closely monitors industry regulations and offers a variety of insurance products with a comprehensive array of coverages, as well as a team of dedicated and experienced underwriters and claims professionals ready to partner with you.
Our underwriting team is ready to review your needs and explore solutions with you.
To learn more, please visit our financial institutions page.
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