New VC Regs Just Dropped [Ed: But See Below, Rule Has Been Vacated] • What's Changed for VCs? • What We All Got Wrong • Summary of Final Rules • How Will This Impact LPA and Side Letter Negotiations?
Key Takeaways: On August 23, 2023, the SEC enacted comprehensive new rules for private fund advisers, including venture capital (VC) firms. There are seven new rules. VCs need to comply with two of them and they’ll have 18 months to do it. Most sub-rules can be waived with full disclosure, and some require majority LP consent. No audits, quarterly reports or fairness opinions are required for VCs. Expect regulatory compliance costs to go up.
[Ed. 6/21/2024: The Fifth Circuit Vacated the SEC’s Private Fund Adviser Rule on June 5, 2024. Chris Hayes has good key takeaways here. (Note: Caution, the PFA is no longer good law!]
New VC Regs Just Dropped
With a wink and a nod to the Paperwork Reduction Act, the SEC dropped 660-pages of “robust” VC regulations on August 23, 2023.1
While there’s no shortage of SEC rule summaries floating around from law firms and regulatory compliance shops,2 none of them specifically address emerging fund managers. This article aims to fix that gap by focusing on emerging fund managers.
■ Here are the officiallinks to the SEC’s rules and related materials:
The final rules have been described as “watered down” versions from the original proposal. The proposed rules were framed as prohibitive activities, but these new rules are merely restrictive activities. But is that a good or bad thing for emerging managers?
Many praised the SEC for laying down sensible legislation. But not everyone.
One major consequence of shifting prohibited activities to merely restrictive activities is that there are now more steps to take to remain in compliance, mainly in terms of disclosures to LPs. This will have more of an impact on emerging managers than it will on larger funds because the cost of doing business will be greater.
What We All Got Wrong
Legal experts and the media generally got three things wrong about the final rules.
1. Most of the Rules Don’t Apply to VCs
First, many mistakenly assumed that all or most of the rules apply to VCs.3
For example, a leading news source for the venture capital industry mistakenly wrote:
“VC firms will have to provide their LPs quarterly financial statements, which remarkably isn’t standard for all firms. They’ll also have to perform annual audits for each fund they manage.”4
However, those two rules don’t apply to VCs and neither do any of the following five rules—they apply only to registered investment advisers (RIAs):5
✅ Preferential TreatmentRule (including 2 of the 3 sub-rules)
2. The SEC Finds that Waiving Fiduciary Duties is Illegal Per Se
The second issue is the SEC did not dodge the matter of waiving fiduciary duties:7
Under the proposed rules, GPs would have been prohibited from seeking any limitation of liability (or indemnification) for breach of their fiduciary duties, bad faith, recklessness or even negligence.
Under the final rules, however, the SEC did not adopt the indemnification prohibition because it asserted that federal fiduciary duty and antifraud provisions already cover much of the prohibited activity—even if GPs are merely negligent:8
“We are also not adopting the indemnification prohibition that we proposed because much of the activity that it would have prohibited is already prohibited by the Federal fiduciary duty and antifraud provisions.” —SEC’s PFA Final Rule Release, at page 25 of 660.
Section 206 of the Advisers Act generally makes it unlawful for any investment adviser, including VCs, to engage in “fraudulent, deceptive, or manipulative conduct.” Section 206 is broader than the antifraud provisions in the federal securities laws, and that is the bedrock principle the SEC is relying upon to bring about these new rules. In addition, the SEC is leveraging a new rule under the Dodd-Frank Act (Rule 211(h)), and it is unclear now if the SEC has the legal authority to apply that authority to adopt new rules to VCs.9
3. There is No Private Right to Sue Under the Advisers Act
Third, many claimed that had the proposed rule on GP indemnification passed, it would have made it easier for LPs to sue the fund manager. However, LPs can’t sue fund managers for violations of the Advisers Act—other than perhaps as a rescission right to receive their funds back. That’s because there is no private right of action under the Advisers Act. An SEC rule would not have changed this fact.
Only the SEC has the right to bring an enforcement action under the Advisers Act. And so, if you read between the lines of the proposed rules and the final rules,10 you’ll find that the SEC is effectively (1) prohibiting GPs from charging off any fees or expenses related to an investigation that results in sanctions by the SEC under the Advisers Act or “the rules promulgated thereunder” (i.e., these new PFA Rules), and (2) asserting its long-standing position that federal fiduciary duties are never waivable under the Advisers Act, thus keeping the general principles of the proposed rules in play.11
This is a powerful move by the SEC because it both cements its rulemaking discretion under the Dodd-Frank Act and also clarifies its authority to hold GPs accountable for breaches of fiduciary duties and negligence without having to pass a new rule.
Summary of Final Rules for VCs
There are now two final SEC rules that apply to VCs with severalsub-categories:
1) Restricted Activities — Rule 211(h)(2)-1
§ 275.211(h)(2)-1(a)12is restricted activities relating to fees, clawbacks and borrowing that restricts advisers to a private fund from engaging in the following activities, unless they satisfy certain disclosure and, in some cases, consent requirements:
🛑 Investigation fees. GPs are prohibited from charging any fees or expenses related to an investigation that results in sanctions by regulators.13
Consent: Restricted Activities with Certain Investors
🟡 Investigation Expenses. GPs are restricted from charging fees or expenses associated with investigations by any governmental or regulatory authority that does not result in sanctions UNLESS the GP seeks consent from all LPs and obtains written consent from at least a majority-in interest of LPs.14
🟡 Borrowing Restrictions. GPs are restricted from borrowing money, securities, or other private fund assets, or receiving a loan or extension of credit from a private fund clientUNLESS the GP (i) distributes to LPs a written notice and description of the material terms of the borrowing; and (ii) obtains written consent from at least a majority in interest of the LPs that are not related persons of the GP.15
Exception: Loans made directly to the GP by third parties (including LPs in the fund, such as a bank).
Restricted Activities with Disclosure-Based Exceptions
🔵 Regulatory, Compliance andExamination Expenses. GPs are restricted from charging fees or expenses associated with (i) regulatory or compliance matters, and (ii) fees and expenses from an examination by the SEC (or other governmental or regulatory authority) UNLESS GPs provide disclosure*
🔵 GPs are restricted from charging regulatory or compliance fees of the GP or related persons, UNLESS GPs provide disclosure*.
🔵 Non-Pro Rata Splits. GPs are restricted from charging or allocating fees related to portfolio investments on a non-pro rata basis for multiple private funds managed by the GP or related persons UNLESS GPs provide disclosure*.
🔵 GPs are restricted from reducing any GP clawback by applicable taxes without fully disclosing* pre-tax and post-tax clawback calculations.
*All disclosure-based exceptions to the restrictions above (i.e., the blue circles—regulatory, compliance, and examination fees and expenses and post-tax clawbacks) require advisers to distribute written notices to LPs within 45 days after the end of the quarter after such fees or expenses were incurred by the fund.
VCs with less than $1.5B AUM will have 18 months to comply with the new rules and the clock will start once the rules are published in the Federal Register (TBD).
Also legacy status is available for Preferential Treatment Rule and the Restricted Activities Rule, provided the fund is operational organizational documents (side letters count) entered into prior to the compliance date. However, the consent rules will apply retroactively once the rules pass the compliance date (again, 18 months for all emerging fund VCs).
How Will This Impact LPA and Side Letter Negotiations?
What’s Sauce for the Goose is Sauce for the Duck.
There are three broad categories under the Preferential Treatment Rule:
Redemption rights, which are generally not applicable to VCs;16
Information rights, which apply in cases where LPs have negotiated info rights;
Side letters disclosures - it’s a matter of timing and specifics in the LP disclosures.
Preferential terms in a side letter that involve “material economic terms” have to be disclosed before a prospective LP invests if the GP “reasonably expects” that keeping the information would have a “material, negative effect” on other investors in that sameprivate fund. Otherwise, GPs have to provide to LPs a comprehensive annual disclosure of all preferential treatment terms entered into by the GP or its related persons each year since the last annual notice disclosed it.
So, in summary:
GPs must disclose the economic parts of the side letter concerning “material economic terms” to all prospective LPs before they join a fund.
Annual disclosures of side letters with preferential treatment must be provided to all LPs.
The SEC finds that:
“Preferential treatment is… contrary to the public interest and protection of investors”17
“Rising tide lifts all boats” or are we “opening the floodgates”?
How will the recent PFA rules impact current LPA and side letter negotiations?
Generally you can expect some temporary relief in the first 18 months of the rule passage for not disclosing side letters already entered into for prospective LPs. But after the 18 months is up, the annual notice will require you to disclose to all your investors any side letter with preferential terms that match the rule.
What matters is that (1) “information in side letters that existed before the compliance date will be disclosed to other investors that invest in the fund post compliance date” (through the annual disclosure notice), (2) “the legacy provisions apply with respect to contractual agreements that (i) govern the fund, which include, but are not limited to, the fund’s [LPA], the subscription agreements, and side letters,” and (3) “legacy status applies only to such agreements with respect to private funds that had commenced operations as of the compliance date.”18
Can you withhold side letters in one parallel fund from another fund?
As for withholding side letters in one fund to another fund, the final rules only require disclosure within the “same private fund.” This could potentially create a loophole, allowing GPs to segregate their Section 3(c)(7) LPs, who may have specialized access needs, from their Section 3(c)(1) LPs.
Can you anonymize the identity of limited partners in the side letter?
Maybe—this comment suggests you might be able to withhold their identity:
“As a result, information in side letters that existed before the compliance date will be disclosed to other investors that invest in the fund post compliance date. Advisers are not required to disclose the identity of the specific investor that received a preferential term and can choose to anonymize that information.”
What will the impact be?
Insurance brokers and carriers will likely be increasing their premiums on E&O insurance as the demand for policies outstrips the available supply. Coverage can be expensive, and based on some quotes, getting a $3-5 million E&O policy for $100,000 to $125,000+ per year is not going to work for most emerging fund managers.
Regulatory compliance firms will also have a substantial increase in revenues as VC fund managers and other advisers look for alternative service providers to provide scalable regulatory compliance help. But the irony is these very same regulatory and compliance fees will need to be disclosed to LPs at the end of each quarter, and if they’re not submitted within a 45-day window, the GPs will be in violation of the rules.
Finally, emerging fund managers may need to have their LPAs, side letters and other fund documents reviewed and revised; not to mention the ongoing quarterly cost disclosures and annual LP disclosures, requiring substantial legal fees and costs. According to the SEC, this later work will involve “preparation of written notices and consents,” “provision, distribution, collection, retention, and tracking of written notices and consents,” and notices will be issued once annually to existing investors and once quarterly for prospective investors.
■ The SEC has estimated that annual compliance costs will be on average as follows:
Preferential Treatment Rule = $4,288 per year per fund
Restricted Activities Rule = $6,846 per year per fund
In summary, the new rules are poised to significantly increase the costs of negotiations, disclosures, and other compliance steps needed to fall in line with the new rules. The 18-month compliance window and legacy status offer some flexibility, but GPs will need to carefully navigate these changes to meet regulatory requirements and manage LP relationships effectively.
Final Takeaways
One crucial aspect that often gets overlooked here is the potential costs for complying with the new regulations falls on the emerging fund managers. With the SEC clarifying its stance on fiduciary duties and negligence, VCs are on notice: failure to comply could result in significant penalties.
But it’s not just a matter of paying significant penalties or fines—regulatory actions can result in (1) unrecoverable fees and sanctions, and (2) the loss of ability to continue operating as VC. We’re talking about people’s livelihoods here. In extreme cases, firms might even face compulsory dissolution or forced exit from the capital markets. Additionally, individuals within the firm could be barred from serving as officers or directors in SEC-regulated entities, depending on the severity of the violation.
All the more reason to treat these rules as a serious change in status.
Disclaimer: This article is intended to provide VCs with an overview of the key aspects of the new private fund adviser rules. However, it is not intended to be an exhaustive resource, and other factors may apply to your specific situation. You are strongly encouraged to seek guidance from experienced fund counsel to ensure compliance with the issues discussed above.
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Technically, the SEC “was not required to perform a regulatory impact analysis but complied with the Regulatory Flexibility Act and the Paperwork Reduction Act and included a robust economic analysis in the Proposing Release”. Robust, indeed. These are the most significant rule changes to happen to venture capitalists since the Great Financial Crisis of 2008 resulted in the passage of the Dodd-Frank Act.
Of course, some VC firms can apply to become a registered investment adviser but this is a small number of VC firms who do, and typically they have large AUMs who can afford the regulatory burdens and costs associated with applying to become an RIA.
RIAs have to meet a certain threshold of Regulatory Assets Under Management (RAUM) to register with the SEC as opposed to a state regulatory agency. Generally, “advisers” (also referred to as GPs) with less than $150 million in RAUM are exempt from SEC registration but may still be subject to certain reporting and recordkeeping provisions as Exempt Reporting Advisers (ERAs). VCs and small private fund advisers are often ERAs.
To be fair to Del and everyone else, I initially missed this too - I didn’t pick it up until I read through the SEC Private Fund Adviser Rule Release over this past weekend.
“Section 211(h)(2) [of Dodd-Frank Act] authorizes the Commission to ‘examine and, where appropriate, promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that the Commission deems contrary to the public interest and the protection of investors.’ That provision cannot support the prohibited activities rule or the side letter rights rule for two reasons. First, those rules do not prohibit or restrict ‘certain sales practices, conflicts of interest, [or] compensation schemes.’ And second, the actions prohibited by those rules are not ‘contrary to the public interest and the protection of investors.’”
Are side letters a “sales practices, conflicts of interest or compensation schemes?” What about LPA negotiations? We may have to wait for the courts to answer those questions.
See 17 CFR § 275.211(h)(2)-1(a)(1) Private fund adviser restricted activities - investigation fees and expenses (provided, however, that the investment adviser may not charge or allocate to the private fund fees or expenses related to an investigation that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Investment Advisers Act of 1940 or the rules promulgated thereunder.”)
The waiver of liability and hedge clauses goes beyond the scope of this article, but in general, a hedge clause is a contract provision that attempts to waive liability for claims, often to the “the maximum extent permitted by law.” The SEC has highlighted these clauses violate the Advisers Act and this is an enforcement priority for them. Thus, for example, if you have a provision in your LPA that looks like this, it may be viewed with suspicion as a potential violation under the Advisers Act:
The SEC’s stance on hedge clauses implies a need for greater transparency and clarity in contract language. This is particularly important for LPAs that often have complex indemnification and liability clauses. The SEC’s focus on these issues means that both GPs and LPs should consult specialized counsel to ensure their agreements are in compliance with the latest SEC guidelines and enforcement priorities.
Redemptions are not permitted in a VC fund “unless extraordinary circumstances” exist. See the definition of a “venture capital fund” under Rule 203(l)-1: A “venture capital fund,” as defined in Section 203(l)-1 under the Advisers Act, is a private fund that relies on Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 that:
✅ “(4) does not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances;”
There are two exceptions to waiving the prohibition on redemption rights under the Preferential Treatment Rule: (1) when redemption is required by applicable law, rule, or regulation, or via an order of certain governmental authorities, and (2) if the GP has offered the same redemption rights to all existing investors.
“The ‘commencement of operations’ includes any bona fide activity directed towards operating a private fund, including investment, fundraising, or operational activity. Examples of activity that could indicate a private fund has commenced operations include issuing capital calls, setting up a subscription facility for the fund, holding an initial fund closing and conducting due diligence on potential fund investments, or making an investment on behalf of the fund.” SeeSEC’s PFA Final Rule Release, at p. 267.
Really useful distinction between what applies to VC funds and what was widely assumed to apply. The side letter section is especially practical for emerging managers, since the burden is not only knowing the rule but translating it into disclosure timing and repeatable LPA workflows. Regulatory summaries age quickly, so the vacatur note and date-stamped context are valuable.
Really useful distinction between what applies to VC funds and what was widely assumed to apply. The side letter section is especially practical for emerging managers, since the burden is not only knowing the rule but translating it into disclosure timing and repeatable LPA workflows. Regulatory summaries age quickly, so the vacatur note and date-stamped context are valuable.