Private Equity

On June 5, 2019, the Securities and Exchange Commission (SEC) adopted several new rules and interpretations designed to protect retail investors in their relationships with registered investment advisers and broker-dealers.  While private fund managers are not the primary focus of the rules, they should be aware of these developments.

SEC Interpretation Regarding Standard of Conduct for Investment Advisers

Most relevant for private fund managers is the SEC’s guidance regarding the fiduciary duty investment advisers owe to their clients.^[1]  The U.S. Supreme Court has found that the Investment Advisers Act of 1940 (Advisers Act) imposes a fiduciary obligation on an investment adviser, and therefore the adviser must always act in the best interest of its clients.^[2]  As a fiduciary, an adviser owes its clients a duty of care and a duty of loyalty, which duties are enforceable pursuant to the anti-fraud provisions of the Advisers Act, primarily Section 206 and the rules thereunder.

In its interpretation, the SEC stated that the duty of care includes, among other things, the duty to: (i) provide advice that is in the best interest of the client, (ii) seek best execution of a client’s transactions and (iii) provide advice and monitoring over the course of the relationship. The SEC also provided guidance regarding an investment adviser’s obligations in connection with its duty of care, including, among other things, the duty to: (i) make a reasonable inquiry into a client’s financial situation, level of financial sophistication, investment experience and investment objectives (collectively, a client’s investment profile), (ii) provide personalized advice that is suitable for and in the best interest of the client based on the client’s investment profile, (iii) update a client’s investment profile in order to adjust its advice to reflect any changed circumstances and (iv) take into account the costs of an investment strategy, including the cost of fees or compensation, when considering whether such investment strategy is in the best interest of the client.

The SEC stated that the duty of loyalty requires an investment adviser to: (i) put its client’s interests first, (ii) not favor its own interests over those of a client or unfairly favor one client over another, (iii) make full and fair disclosure to its clients of all material facts relating to the advisory relationship and (iv) seek to avoid conflicts of interest with its clients and make full and fair disclosure of all conflicts of interest that could affect the advisory relationship. The guidance emphasized that with respect to conflicts of interest, disclosure must be sufficiently specific and clear so that a client has sufficient facts to provide informed consent to a conflicted transaction or arrangement.^[3] 

Importantly, the SEC acknowledged that the duty owed to a client “… must be viewed in the context of the agreed-upon scope of the relationship between the adviser and the client…. For example, the obligations of an adviser providing comprehensive, discretionary advice in an ongoing relationship with a retail client… will be significantly different from the obligations of an adviser to a registered investment company or private fund where the contract defines the scope of the adviser’s services and limitations on its authority with substantial specificity….”  However, the fiduciary obligation always applies, and may not be waived or modified by contract.

Form CRS Relationship Summary and Related Disclosure Requirements

In an attempt to reduce what the SEC sees as confusion among retail investors regarding the nature of their relationships with registered investment advisers^[4] and broker-dealers, the SEC adopted a new disclosure document for those firms (Form CRS Relationship Summary).^[5]  This short (two pages maximum for advisers and broker-dealers and four pages for dual registrants) summary will inform retail investors about the relationships and services the investment adviser or broker-dealer offers, the standard of conduct and the fees and costs associated with those services, specified conflicts of interest, and whether the firm and its financial professionals currently have reportable legal or disciplinary events. Retail investors will receive a summary at the beginning of a relationship with a firm, and updated information following a material change. The relationship summary will be in addition to the existing obligation of a registered adviser to deliver a Form ADV Part 2A brochure and will be subject to SEC filing and recordkeeping requirements.  Advisers will have to file their initial relationship summary with the SEC between May 1, 2020 and June 30, 2020.

Of note to private fund sponsors, the relationship summary must only be delivered to a “retail investor,” which is defined as a natural person, or the legal representative of such natural person, who seeks to receive or receives services primarily for personal, family or household purposes. While this definition does not include an exemption based on net worth or investor sophistication, it does not seem to cover investors in private funds.  Therefore, it appears that a private fund sponsor will not be required to comply with the Form CRS requirement with respect to natural person limited partners in its funds.

Regulation Best Interest

After many years of study and internal debate, the SEC adopted Regulation Best Interest, which establishes a standard of conduct for broker-dealers when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer.^[6]  Under new Rule 15l-1 under the Securities Exchange Act of 1934, a broker-dealer must act in the best interest of the retail customer at the time a recommendation is made without placing the financial or other interest of the broker-dealer ahead of the interest of the retail customer. The SEC stated that this obligation would be satisfied if the broker-dealer, among other things: (i) before or at the time of such recommendation, reasonably discloses to the retail customer, in writing, the material facts relating to the scope and terms of the relationship, and all material conflicts of interest associated with the recommendation, (ii) exercises reasonable diligence, care and skill, (iii) establishes, maintains, and enforces written policies and procedures reasonably designed to identify and at a minimum disclose, or eliminate, all conflicts of interest that are associated with such recommendation and (iv) establishes, maintains, and enforces written policies and procedures reasonably designed to comply with Regulation Best Interest as a whole.  Broker-dealers must comply with Regulation Best Interest by June 30, 2020.

Regulation Best Interest will apply to all relevant transactions between a broker-dealer and a “retail customer.”  A retail customer is defined as a natural person, or the legal representative of such natural person, who (i) receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer, or a natural person who is an associated person of a broker or dealer and (ii) uses the recommendation primarily for personal, family, or household purposes.  Based on this definition, the sale of private fund interests by placement agents and other registered broker-dealers to institutional investors (such as corporations and pension plans) generally would not be covered by Regulation Best Interest.  However, sales to high net worth individuals and their estate planning and related vehicles generally would be covered.