Key Takeaways
- • The SEC has proposed three categories of rules under the Investment Advisers Act of 1940: Disclosure Rules, Audit Rules, and Prohibited Activity Rules, with Stanford Law Professor Joseph A. Grundfest characterizing the Prohibited Activity Rules as "the most curious" in SEC history.
- • The Prohibited Activity Rules would ban investment advisers from charging private funds for accelerated monitoring fees, regulatory examination costs, compliance expenses, and non-pro rata portfolio investment fees when multiple clients have invested in the same opportunity.
- • Proposed rules would prohibit advisers from reducing clawback amounts by tax liabilities, seeking reimbursement or indemnification from private funds for breaches of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness, and borrowing money or securities from the funds they manage.
- • Grundfest's analysis raises foundational concerns about how these Prohibited Activity Rules operate within the existing framework of federal securities laws, suggesting the proposals warrant careful scrutiny beyond their specific technical provisions.
Summary
The SEC has released proposed rules under the Investment Advisers Act of 1940 that would substantially restrict the contractual terms and fee arrangements available to investment advisers managing private funds. According to Stanford Law Professor Joseph A. Grundfest, who has analyzed the proposal, the Prohibited Activity Rules represent an unusually aggressive regulatory intervention into adviser-fund relationships.
The Prohibited Activity Rules address four primary areas of adviser conduct. First, they would eliminate various fee arrangements, including accelerated monitoring fees, fees charged to private funds for regulatory examinations or investigations of the adviser, compliance and regulatory expenses of the adviser itself, and non-pro rata fees when multiple private funds or clients have invested in the same portfolio company. This represents a significant shift in cost allocation between advisers and their funds.
Second, the rules would prevent advisers from reducing clawback obligations—which require advisers to return previously distributed profits—by offsetting tax liabilities incurred by the adviser. Third, and perhaps most fundamentally, the rules would prohibit advisers from seeking any reimbursement, indemnification, exculpation, or liability limitation from private funds for breaches of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness in service provision. Fourth, advisers would be forbidden from borrowing money, securities, or other fund assets, or receiving credit extensions from the funds they manage.
Grundfest's characterization of these proposals as "the most curious in Securities and Exchange Commission history" signals that legal and industry experts view the Prohibited Activity Rules as raising substantial questions about regulatory scope and enforceability. His analysis focuses on foundational concerns regarding how these rules integrate with existing federal securities law frameworks, suggesting the proposals warrant examination at a structural level rather than merely on technical grounds.
The Prohibited Activity Rules address four primary areas of adviser conduct. First, they would eliminate various fee arrangements, including accelerated monitoring fees, fees charged to private funds for regulatory examinations or investigations of the adviser, compliance and regulatory expenses of the adviser itself, and non-pro rata fees when multiple private funds or clients have invested in the same portfolio company. This represents a significant shift in cost allocation between advisers and their funds.
Second, the rules would prevent advisers from reducing clawback obligations—which require advisers to return previously distributed profits—by offsetting tax liabilities incurred by the adviser. Third, and perhaps most fundamentally, the rules would prohibit advisers from seeking any reimbursement, indemnification, exculpation, or liability limitation from private funds for breaches of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness in service provision. Fourth, advisers would be forbidden from borrowing money, securities, or other fund assets, or receiving credit extensions from the funds they manage.
Grundfest's characterization of these proposals as "the most curious in Securities and Exchange Commission history" signals that legal and industry experts view the Prohibited Activity Rules as raising substantial questions about regulatory scope and enforceability. His analysis focuses on foundational concerns regarding how these rules integrate with existing federal securities law frameworks, suggesting the proposals warrant examination at a structural level rather than merely on technical grounds.
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