In a panel discussion during the Stout Summit: Investment Funds and Alternative Assets 2023, Joel Cohen, Managing Director in Stout’s Disputes, Claims, & Investigations group and New York Regional Leader, led a discussion on the current state of regulation, enforcement, and litigation as it relates to private funds.

This excerpt has been edited for length and clarity, and features the insights of Jaclyn Grodin, Counsel, Goulston & Storrs.

Jaclyn: As you’re likely aware, the SEC, particularly under Chair Gensler, has been very active in the private fund space. There were Form PF amendments. The private fund rules were adopted on August 23, and they will represent a significant change if they come to fruition. Some private fund trade associations filed a petition in the Fifth Circuit a few months ago to try and halt these rules, alleging that the SEC overstepped its authority with the rules’ broad scope. This was a topic discussed extensively during the public comment period.

The briefing on this matter is expedited, and it should conclude by the end of January, with a potential decision by May. Many have been following what’s happening in the Fifth Circuit, and it’s uncertain what could happen. It is quite possible to even end up in the Supreme Court, and the outcome very uncertain if that’s what happens.

Now, let’s delve into the private fund rules. The private fund rules that recently came into effect are extensive. There are five primary rules: the Quarterly Statement Rule, the Audit Rule, the Advisor-Led Secondaries Rule, the Restricted Activities Rule, and the Preferential Treatment rule. The first three apply only to SEC-registered advisors, while the Restricted Activities and Preferential Treatment rules apply to all advisors, regardless of their registration status.

Quarterly Statement Rule

The Quarterly Statements Rule requires registered investment advisors to distribute quarterly statements to fund investors. These statements must disclose substantial and detailed information about the fund’s investments and performance. Importantly, there are no exemptions for smaller emerging advisors, and this requirement cannot be waived in agreements.

The Audit Rule

Moving on to the Audit Rule, registered private fund advisors will be required to obtain a financial statement audit that satisfies the audit provision under the custody rule. This new rule effectively eliminates the surprise audit exam option under the Custody Rule.

Adviser-Led Secondaries Rule

Now, for the Advisor-Led Secondaries Rule, registered private fund advisors will be required to obtain either a fairness opinion or a valuation opinion from an independent opinion provider in connection with an adviser-led secondary. Fund advisors must also provide investors with a summary of any material business relationships the advisor has had within the last two years.

The Restricted Activity Rule and Preferential Treatment Rule

The Restricted Activity Rule covers five categories of activities, three of which have disclosure-based exceptions, and two of which have exceptions that require both disclosure and investor consent. Broadly speaking, these activity categories pertain to how the fund or advisor allocates expenses and fees related to routine exam and investigatory activities, as well as borrowing. Additionally, there will be legacy status, providing grandfathering for certain categories. This means that for older funds, there may be no need to amend their LP agreements in connection with these rules for restricted activity and preferential treatment. Keep in mind that the adopting release for these rules is a hefty 700 pages, so this discussion is just a starting point, and further and closer examination by advisers and compliance personnel is needed.

The compliance date for the Quarterly Statement and Audit Rules will come into effect 18 months after the publication of the Federal Register, on March 14, 2025. While this may seem distant, the extent of modifications required for your policies and procedures means that it’s not as far off as it appears. The compliance dates for the Adviser-Led Secondary’s, Preferential Treatment, and Restricted Activity Rules vary.

In conclusion, it’s crucial to recognize that even though there’s ongoing litigation in the Fifth Circuit, it has not affected the compliance dates. Your internal policies and procedures need to be updated in accordance with these rules very soon. While the outcome remains uncertain, it’s wise to take these rules seriously and collaborate with external providers to conduct internal audits to assess your current position and the necessary adjustments.