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Financial R&R: SEC’s Adoption of Major Rule Changes for Private Fund Advisers

By Alliant Specialty

On August 23, 2023, the SEC implemented significant changes to private fund adviser regulations. Ron Borys, Ryan Farnsworth, Tim McAndrew and Steve Shappell join in a roundtable discussion covering the new expectations and requirements following the amendments to the Investment Advisers Act of 1940. While the final rules are less stringent than initially proposed, there is anticipation for considerable costly administration and compliance challenges facing private fund advisers as they conform and become compliant. For more information visit the Alliant Q&A.

Intro (00:01):
Welcome to Financial R&R, a show dedicated to financial insurance and risk management solutions and trends shaping the market today. Here are your hosts, Ron Borys and Ryan Farnsworth.

Ron Borys (00:13):
Welcome everyone. I'm Ron Borys. I'm here with Ryan Farnsworth, and this is the Financial R&R. Today we're here to talk about the new SEC rule and information that came out last week regarding private fund advisor rules and some new expectations and requirements on those folks. With me, we have Tim McAndrew, who leads our private equity practice within our financial institutions vertical, and Steve Shappell, who leads our legal and claims group. Both Steve and Tim have been frequent guests on the Financial R&R. Thanks again for joining us today. Tim, can you provide a high-level synopsis of what this new rule potentially means and break it down a little for our listeners?

Tim McAndrew (00:53):
Yeah, sure, at a high level, what was adopted by the SEC last week was some new rules and amendments under the Investment Advisors Act of 1940, that represent the most significant changes I've seen to the private fund and advisor regulation since probably the Dodd-Frank Reform Act from 2010. I think there was a lot of anticipation for what would be passed here. One of the big things that folks were eager to see was where they would end up on the proposed rule that was going to prohibit an advisor from seeking reimbursement, indemnification or limited liability involving common advisor activities. And I think there was a big sigh of relief that ultimately the recommendation was to not adopt that rule that would've prohibited an advisor from seeking reimbursement and the final rulemaking of their views on how an advisor's fiduciary duty already applies to its private fund clients. I do think there are some other things between the requirement on the audited fund financials, which a lot of registered fund advisors are already doing, but certainly some additional requirements on the quarterly statements around fees and expenses that portfolio companies are paying to the fund as well as to relevant persons as well as fund performance in general.

Ryan Farnsworth (02:12):
We could spend hours talking about all the rules that still were part of the final rules. I think the overarching theme, Ron, is that it could have been a lot worse for private fund advisors, and we always knew with the current administration that the SEC was going to continue to stay very close to the private fund industry, even in instances like Tim said, where they didn't formally adopt the proposed rule regarding reimbursement, indemnification, exculpation, etc. They still were very clear that they expect all private fund advisors, registered investment advisors, to perform at the utmost fiduciary duty that's been outlined for them previously. So, even without making formal rules, they still were very clear that they are right behind them in terms of regulation, etc., which I think is one thing that everyone in the industry has felt. And that's one thing that insurance underwriters continue to focus on. The thing that we continue to focus on as risk advisors and insurance brokers is maximizing coverage with respect to regulatory investigations. And Tim, I know there was formal guidance, or a formal rule implemented in speaking about allocating or charging fees and expenses to the private fund with respect to investigations specifically. Let's discuss that for a minute because that does have some pretty significant policy implications along those lines.

Tim McAndrew (03:40):
Absolutely. I think to your point about the recommendation that the commission prohibit without exception an advisor from charging or allocating fees of an advisor that has resulted in a court or authority imposing a sanction for a violation of the advisor's act. I think what that tells us is at what point the breadth of coverage afforded under the investigation definition in these policies and the moment in time from when investigation starts to when the sanction is imposed on the fund, that has some impact or influence on the negotiation of that investigation definition in a policy.

Ron Borys (04:16):
Right. And we already know from example, working with our existing clients that even prior to this new rule, many of our clients have been very sensitive to how expenses are allocated to the fund. So, hopefully this won't be that big of a change for a lot of those firms, but certainly it's going to add a layer of compliance, expense, for some firms it's certainly going to change the way in which some firms communicate with their investors. I know that was another big part. The regulators seem very focused on transparency and setting out some minimum requirements with regards to how private equity firms and hedge fund firms and alternative managers who fall under this rule are providing updates and communications. Again, some of the really big firms that have been doing this for the last 20, 30, 40 years, this has already been a best practice. But for some of the newer firms that are just getting started who may not have the same resources or tolerance for certain aspects of their business, this is going to be a big change for them.

Ryan Farnsworth (05:12):
Yeah. And following the Dodd-Frank Act, the common phrase was, are you establishing a culture of compliance? Now, it's almost as if we look at this and we say, well, now compliance is going to become very costly because in a competitive environment where private fund advisors were already being challenged from a fee and advisory and overall compensation perspective, not to mention the day job of managing the markets and trying to maximize performance, it just made that job even more difficult for them and more costly and putting an insurance spin on it. You know, although we haven't had insurers coming to us saying that this coverage needs to change or this policy needs to change as a result of these rules that were finalized last week, you better believe that the level of underwriter scrutiny is going to only continue to increase to ensure that private fund advisors are complying with the rules that are being implemented.

That they are doing so with that culture of compliance in mind. Knowing that the SEC could call on at any minute, I think this will become super important that if firms haven't already done exercises such as mock exam audits or that type of practice from a compliance standpoint, that it should become an expectation from an underwriting perspective as they go through their annual renewal cycle. We have a lot of underwriter friends who were hoping that this would help turn the market as it potentially could have for private fund advisors if there was a limitation on liability or indemnification from the fund, where then the insurance policy would become even more important than it is today. We had a lot of clients that took that opportunity during the past 18 months while these rules were proposed to put insurance policy terms and insurance placement efforts and underwriting processes on a more prioritized effort with underwriters as they go through that process. And we would expect that unless firms do that going forward, they should expect to increase their insurance premium costs as well.

Tim McAndrew (07:22):
Yeah, and I think another interesting component to that, Ryan, is that it'll be interesting to see how the SEC staff applies certain aspects of the new rules and amendments during examinations. One thing that's recommended for adoption is the requirement that all registered fund advisors, including those that don't manage funds, document in writing the annual review of their compliance programs. Is their concern that that written document potentially serves as kind of a roadmap to an enforcement action? And how are these fund managers able to put this together without setting them up for possible enforcement action? I think that will be certainly interesting to see how that plays out over the next 18 months to a few years.

Ron Borys (08:02):
My take on it, Ryan and Tim, is that I don't think this will have a short-term impact on the market. I think most people will sit back and wait and see what this all means, how the regulators enforce the rules and the actions. It'll probably take, unfortunately, an example or somebody who may be made an example of that will get people's eyes and attention and it'll probably need to be a big name that will catch headlines. So, we'll see if that ultimately happens. But as we know, Tim, as a former underwriter, this has been a highly desired class, particularly the hedge fund class. I don't see that changing anytime soon.

Ryan Farnsworth (08:37):
Steve, from a legal and claims standpoint and recognizing that these firms will have a certain amount of time to become compliant with these final rules, what are some of the things that our asset management, investment advisor clients should be expecting in the short term as well as in the long term?

Steve Shappell (08:54):
Yeah, it's an interesting rule. And I think we've all rejoiced on the rule could have been worse, but facto could have been worse. I don't want to minimize the pain that we're going to have from this. There's an awful lot in this rule and in fact it could have been worse, and it could've been far more restrictive. It doesn't change the fact that we're going to have some exposures and I'll say the good news on a lot of the restricted activity component of the rule was it calmed down a little bit. It was less restrictive, but it's gone to a disclosure and consent and that's going to be an area of concern and an area of exposure of the quality of disclosure and consent. As we know, the SEC and the plaintiff's bar are pretty diligent and vigilant about disclosure and consent and the quality of disclosures and the quality of consent.

So that's an area that I will spend a lot of time thinking about in the coming weeks, months before this final rule kicks in. Because the devil is in the details and quality of disclosure and consent and the process of getting consent is going to be something that I can guarantee you, investors and SEC are going to have questions and they're going to challenge. So that's the first. And then the other good news is with regard to what was going to be a pretty militant rule on cost of investigations not being something that could be indemnified, that's changed, but to the point I was just making, it's changed to a disclosure and consent absent a government authority imposing sanctions for violating the Advisors Act, in which case then no fees or expenses can be charged back to a fund.

So, those are some areas that I think are going to be a challenge. The next area is the preferential treatment rule that has gotten a lot of attention and again it's largely a disclosure and quality of disclosure and consent format, structured approach here by the SEC. And I think there will continue to be challenges and continue to be people in the next 18 months trying to figure out what are some of the nuances here to make sure that advisors don't get caught up in preferential treatment, as far as disclosure.

Ryan Farnsworth (11:01):
I couldn't agree more in the near term, it could have been a lot worse, but we fully expect that this is going to become the next culture of compliance following Dodd-Frank, even in the rules that weren't finalized, with respect to the limitations on liability indemnification, etc., and other fees and expenses. It still has our clients and us as brokers, as we represent them for liability insurance, thinking about that Warren Buffet quote, which is, if a cop follows you for 500 miles, you're going to get a ticket, right? And it still feels like they're hot on the trails of private equity, asset management firms, investment advisors, even if some of these rules weren't completely finalized with the reforms.

Steve Shappell (11:43):
Yeah, you're spot on, Ryan. Just the quarterly statement rule alone, which hasn't got a whole lot of attention, it’s a lot. And the quality of that report is going to be scrutinized and challenged all the time. And I think the comment about if a cop follows you for 500 miles, that's a concern.

Ron Borys (12:02):
Yeah. I also think when you compare this round of regulatory work to Dodd-Frank, clearly the alternative asset management fund community had a little bit more leverage here to negotiate back and forth, whereas Dodd-Frank was coming off of the heels of probably one of the worst financial crises since the Great Depression, and there was a lot of change required as a result of business practices and patterns and wrongful acts and wrongdoing here. I think this was just the regulators feeling like there was some need for reform, as we know, right? The private investment fund world has historically held itself to a certain standard with regard to investors. And as people are quickly approaching that high-net-worth status, more people are now available, are able to invest in these funds than ever before, whether directly or through a fund-to-fund type platform. I think that, if I had to guess, was what the regulators were really focused in aiming at.

Steve Shappell (12:55):
Yeah, couldn't agree more Ron. Dodd-Frank stocks, though those come in to heal at massive amount of fraud, just not the situation we have here.

Ryan Farnsworth (13:03):
So, what we are expecting, Steve, more regulation, more active enforcement and other regulatory activity from a policy terms and perspective? We may not be expecting anything in the near term, but what are some of the high-level important coverage concepts that our clients should keep in mind?

Steve Shappell (13:22):
It really highlights the importance of looking carefully at the policies and making sure these policies trigger when everybody wants them triggered. When the SEC reaches out, because they have an informal inquiry about the quality of your quarterly statements, do we want the policy triggered then, or do we want it triggered when it's more advanced but yet not formal? Or do we want it to trigger when it's formal? That's a source of a lot of friction that I've dealt with for 25 years in this business, is when do we get into this policy? What's the agreement? At what point when the SEC starts asking questions can we trigger this policy? And I think this is just another great opportunity to make sure you sit with your broker, and you think about and understand when your policy's going to trigger, what situations will trigger it and how it will respond. Asking that question after the SEC has made the call is not the right time to be asking that question. This is a good opportunity between now and these regulations kicking in, these rules kicking in, to make sure everybody's on the same page about when this policy triggers.

Ron Borys (14:25):
Yeah, I would also expect the carriers to come forward and try to push for some language to try to reduce some of their exposure associated with this. Whether its allocation, discouragement fees has always been a big topic of discussion within insurance. So, I would encourage our listeners to be very leery of any new endorsements, any changes to the policy; make sure you're reviewing those carefully, make sure you're getting a second opinion. Obviously, Steve, we're very fortunate to have you and your team, where a bunch of lawyers work very closely with our brokers when it comes to policy language. Because again, I think that's probably one of my bigger concerns is that these managers, these funds could potentially have a different level of exposure, and how are the carriers going to react and respond to situations?

Steve Shappell (15:12):
Yeah. I think there's going to be a lot of discussion, dialogue, and analysis frankly, as to what's the exposure. For any carrier that's looking to pull back, there's going to be some work to explain to them that just doesn't work for our clients.

Ryan Farnsworth (15:26):
And the one thing we do know at least now is that these final rules, at least on their face, are not going to change the market like they perhaps could have if some of the other rules were formally adopted. But it will be something that will continue to be embedded within the underwriting and coverage negotiation process for many years to come.

Ron Borys (15:47):
Well, thanks again everyone for listening. Certainly, this was a great discussion. Again, just trying to keep our clients and prospects informed. We recently put out Q&A document with some frequently asked questions that we'll share amongst the social channels. But if anybody's interested in reviewing that document or learning more about our Financial Institutions practice, please visit our website at


Alliant note and disclaimer: This document is designed to provide general information and guidance. Please note that prior to implementation your legal counsel should review all details or policy information. Alliant Insurance Services does not provide legal advice or legal opinions. If a legal opinion is needed, please seek the services of your own legal advisor or ask Alliant Insurance Services for a referral. This document is provided on an “as is” basis without any warranty of any kind. Alliant Insurance Services disclaims any liability for any loss or damage from reliance on this document.