Regulatory Leviathans

Key Takeaways: The SEC is about to pass new regulations for private fund advisers, including venture capital (VC) firms. If adopted, these rules would be the first meaningful set of VC regulations since the Dodd-Frank Act came into effect after the Great Financial Crisis of 2008. These rules cover a wide range of issues under the Advisers Act and apply to both registered and unregistered investment advisers. A final vote is expected this week. Dear readers, if these rules pass as proposed—which seems likely now—brace yourselves. [Edit: 8/23/2023: The final rules have passed! One major win for VCs is the No GP Indemnification rule has been removed; the other rules passed primarily as proposed except they have been watered down by allowing GPs to waive them by obtain informed consent or, in some cases, providing full and fair disclosures]

Introduction

In my last article, we discussed three proposed legislative acts languishing around the halls of Congress, all aimed at improving conditions for raising VC funds, including:

1. Increasing the number of permitted LPs per fund from 100 to 200+ LPs;
2. Expanding VC “qualifying investments” to secondaries and fund-of-funds;
3. Granting?accredited investor?status to those who pass a knowledge-based test.

But today, we will look at the opposite and focus on proposed government restrictions. Here's a quick summary:

• The New PFA Rules
• Institutional Reactions
• VC Fund Regulatory Framework Context
• SEC's Priorities and Enforcement Actions
• VC Community's Response:
• Summary of the PFA Rules

The New PFA Rules

These?are the new VC rules?proposed by the SEC?for?Private Fund Advisers (PFA):

• Fiduciary Duties: GPs will be prohibited from seeking indemnification or exculpation for a breach of fiduciary duty, bad faith, negligence or recklessness.
• No Preferential Treatment Without Disclosure: GPs will be required to disclose, on a rolling basis and annually, to all current or prospective LPs any preferential treatment provided to an LP in a side letter or otherwise.
• No Preferential Treatment: GPs will not be able to redeem any LP or provide information to an LP if it would have a material, negative impact on other LPs.
• GP Clawbacks for Taxes: GPs will be prohibited from reducing the clawback by taxes paid by the GP and otherwise required to be paid back.
• Fees and Expenses: GPs will be prohibited from passing off registration fees, examinations or investigations, even where such fees and expenses are disclosed.
• Non-Pro Rata Fee Splits: GPs will be prohibited from charging fees and expenses related to a portfolio investment on a non-pro rata basis when multiple funds invest or have invested in the same investment (e.g., with SPVs/co-investments).
• Effective Date: Will these compliance rules take effective immediately? Over time? Or will emerging managers get a break as applied to new funds only?

Institutional Limited Partner Association's Take

Here are the key takeaways from the Institutional Limited Partner Association (ILPA)—generally, they support the new proposed rules, but with certain modifications:

[Ed: 8/23/2023]: Here's an updated chart of the final rules that passed today, August 23rd:

Before we get into the weeds of the proposed rules, it might be helpful to understand how these rules fit within the broader context of the VC regulatory framework.

VC Fund Regulatory Framework ??

A couple of years ago, I wrote on LinkedIn that:

“[T]here are?three main laws that govern 80% of venture capital fund law”: (1) the?Securities Act, (2) the?Investment Company Act, and (3) the?Advisers Act:

While this is directionally accurate, it’s a bit misleading since it implies all three laws hold equal weight. But that’s not the case. In reality, only one law matters:

90%+ of the most important fund laws and regulations come from one statute—the Advisers Act. ??

Why is the Advisers Act the Most Important Law???????

The Advisers Act serves as the backbone for VC fund law—but what about this law makes it so important or powerful?

It’s not because the Advisers Act is an obscure area of law that few people understand. Nor is it because the law is the newest or most specialized type of regulation for money managers—also called “investment advisers”?(with an ‘e’, for some reason).

The SEC’s Triad of Power

The reason why the Advisers Act is the most important law is because it grants the SEC the power to do three things.

We’ve all heard that:

The pen is mightier than the sword

But what if someone holds the power to wield both?the pen?and?the sword??And what if that someone also has the power to?probe?

The Advisers Act grants the SEC all three of these powers:

• By providing the SEC the power to create?rules and regulations?(the pen), the?power to investigate?(the probe) and the means to?enforce those rules?(the sword), the law ensures that investment advisers remain under the strict control of the SEC.

This triad of rulemaking, investigating, and enforcement authority constitutes the cornerstone of the SEC’s regulatory arsenal and why the Advisers Act is so powerful.

But true power comes not just from statutory authority, but also from court deference. Administrative agencies like the SEC receive the benefit-of-the-doubt when interpreting their own rules and laws because the Supreme Court ruled in 1982 that courts will generally defer to agencies for interpretations of statutory law (Chevron?deference).

Chevron?deference ensures that government agencies like the SEC receive broad authority without much in the way of checks-and-balances because they have little judicial scrutiny to override their decisions.

SEC Regulatory Priorities

After the boom years of 2020-2021, fund lawyers are bracing for a wave of U.S. regulatory enforcement actions that are unprecedented in scope and intensity.

Each year, the SEC unveils its list of enforcement priorities, and here are some of its stated priorities for the upcoming year 2023-2024:

1. Conflicts of interest*
2. Fees and expenses calculations*
3. Compliance with the Marketing and Custody Rules
4. Audited financial statements
5. Fiduciary duties*

*All of these five rules fall under the Advisers Act, although not all of them apply to VCs.

Here’s a brief overview of these rules:

• Conflicts of interest: The importance of transparency and fairness in dealings cannot be overstated. Where a conflict exists and can be waived (for example, a?principal transaction?in which warehoused assets are proposed to be transferred into the fund), informed written consent by LPs must be provided prior to transfer.
• Calculation and Allocation of Management Fees & Expenses: including the calculation of post-commitment period management fees and the impact of valuation practices at VC funds (See?SEC’s action against Alumni Ventures Group).
• Compliance with the Marketing and Custody Rules: While these rules generally only apply to registered advisers, performance advertising and compensated testimonials, endorsements, solicitations will receive extra scrutiny (See SEC settlements against celebrities such as Kim Kardashian, Lindsay Lohan, Jake Paul).
• Fiduciary Duties: This varies by jurisdiction and contract, but generally, all investment advisers (including VCs / ERAs) have “fiduciary duties.”

This means that you have a?duty to act in good faith?with the degree of care, skill, prudence and diligence under the circumstances that a prudent person acting in a fiduciary capacity would use, in providing investment advice and managing fund assets.

How can you meet your fiduciary duties? "Consult with your lawyer" and "follow the rules" are a given, but also:

• Encourage LPs to consult with THEIR lawyers and tax professionals. For example, LPs may not be aware that warehoused investments may affect their QSBS tax benefits (generally, these assets are ineligible for QSBS)
• Provide full and fair disclosure and seek informed consent on all conflicts. For example, with valuation concerns, get LPAC or majority LP consent
• Create and enforce internal written policies and procedures to ensure compliance with obligations. Have a code of ethics. Review annually.

SEC Enforcement Actions

This year, Gurbir Grewal, Director of the Division of Enforcement, announced that,

“While [the SEC] set a Commission record [in 2022] for total money ordered back at $6.4 billion, including a record $4.2 billion in penalties, we don’t expect to break these records and set new ones each year because we expect behaviors to change.?We expect compliance.”

What’s causing this unprecedented level of enforcement actions? Did the highs of the bull market suddenly cause a lack of scruples and a flagrant disregard for compliance?

Not likely. What’s happening here is the SEC is noticing something peculiar in markets. Capital is no longer flowing heaviest into the public markets, where regulation is much tighter.

“Private markets are the new public markets” —Matt Levine

The SEC’s 2023 Enforcement Priorities manual notes that there’s been an?80% surge in the gross assets of private funds over the last 5 years, largely driven by a zero interest rate policy and market exuberance. There are now ~50,000 private funds with around $25+ trillion in assets under management. Several years ago, private markets started outpacing public markets in terms of financing volume for private deals. Even with a down market in 2023, private markets still eclipse public markets in terms of total amount raised for equity financing. In fact, just the private funds industry alone has eclipsed the U.S. banking industry since 2021:

This is why Gary Gensler said the following about this change in market dynamics:

The VC Community’s Response

Ben Horowitz, co-founder of a16z, has labeled the current US regulatory environment as “existential” to American innovation. Even the former SEC Chair Jay Clayton has taken aim at the “regulation by enforcement” approach under the current administration. Although not naming any single agency or individual actor, Clayton said that it is a total abuse of power if “[the government thinks that if we’re not losing cases], we aren’t suing enough businesses.”

Regardless if that rhetoric is over-the-top or not, it highlights why some business leaders think the government has taken it a step too far.

But is that true for VCs? How bad can the regulations really be?

Registered Investment Advisers (RIAs)

Patrick O'Shaughnessy isn’t so sure why more VCs aren’t fully registered as RIAs:

There are apparently only?18 registered VC firms in the US:

• a16z, General Catalyst and Sequoia Capital have all become registered investment advisers (RIAs) in recent years in order to invest more of their funds into different assets outside of startup equity (including crypto, public stocks, and secondaries). That leaves the remaining 4,000+ VC firms who are not RIAs.

So why aren’t more VC advisers moving to register with the SEC?

• 1?? Costs: A 2017 survey revealed that exempt reporting advisers (ERAs) spend an average of $60,000 per year in compliance costs, whereas RIAs spend an average of $330,000 annually. The new PFA rules will now require VCs to eat these costs.

• 2?? Regulatory burdens: RIAs can only charge carry to “qualified clients,” must conduct audits, comply with a list of other SEC-adviser requirements, including the need to appoint a chief compliance officer. Audits will now be required by RIAs no matter what—no more relying on private fund exception to avoid audits.
• 3?? State regulations: For firms with less than $150 million in assets under management, it's often easier to comply with state laws. In states like California, maintaining exempt status requires 50% or more investments to be VC related, which is more lenient than the 80% federal law threshold.

Even though RIAs outnumber ERAs 10:1 across the regulatory investment landscape, in the venture capital industry, it's heavily skewed in the opposite direction (1:200+).

In early 2023, the SEC placed special emphasis on?registered investment advisers?(RIAs):

Currently, more than 5,500 RIAs, totaling over 35% of all RIAs, manage approximately 50,000 private funds with gross assets exceeding $21 trillion. Private fund assets continue to grow. In the past five years, there has been an 80% increase in the gross assets of private funds, with retirement plans steadily contributing to this growth.?[We] will continue to focus on RIAs to private funds.

If you want to avoid SEC adviser registration, each and every one of your funds has to fit into ONE of the two boxes in the graphic below below:

In other words, if only one of your funds is not considered a “venture capital fund,” then you lose your VC exempt status and must rely on a different exemption, such as the private fund adviser exemption, or else you must register with the SEC as an RIA:

Summary of Proposed PFA Rules for VCs

So where does that leave VCs? If you want to get ahead of where the regs are going, you should pay close attention to what happens with the SEC this Wednesday, August 23rd.

Will the PFA rules proposed by the SEC come to pass? Will VCs be impacted by those rules? What about emerging fund managers, will they be exempted for now? While we wait to see what the SEC is going to deliver, it would be a good idea to summarize the proposed PFA rules so we can compare what the final rules provide.

Here is a summary of the proposed PFA rules that apply to VCs:

Prohibited Activities for Private Fund Advisers

§ 275.211(h)(2)-1(a)?details the prohibited activities related to fees, expenses, liability, and borrowing:

Prohibited Fee and Expense Allocations:

• (1)?Charging?portfolio investments?for services the GP does not provide or is not reasonably expected to be provided.
• (2)?Charging private fund clients for examination or investigation fees of the GP or?related persons.
• (3)?Charging private fund clients for regulatory or compliance fees of the GP or?related persons.
• (6)?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.

Restrictions on GP Clawbacks

• (4)?Reducing the amount of any GP clawback by applicable taxes to the GP or?related persons.

Restrictions on Limitations of Liability:

• (5)?Seeking reimbursement, indemnification, or limitation of liability for breaches or negligence in providing services.

Borrowing Restrictions:

• (7)?Borrowing money, securities, or other private fund assets, or receiving a loan or extension of credit from a private fund client.

Rules on Preferential Treatment

§ 275.211(h)(2)-3?outlines the rules related to preferential treatment, including redemption, information sharing, and written notices:

No Redemptions or Information Sharing:

• Not granting an investor the ability to redeem interests on terms that negatively affect other investors.
• Not providing information on portfolio holdings or exposures if it would have a negative effect on other investors.

Disclosure of Preferential Treatment

• Providing advance written notice to prospective investors regarding specific preferential treatment provided to other investors.
• Distributing annual written notice to current investors regarding any preferential treatment provided since the last notice.

Final Takeaways

There's no doubt the PFA rules will have implications on the VC industry. It’s hard to say exactly how impactful they will be until (a) we know what the final rules provide, (b) when the rules will go into effect, and (c) how the industry and regulators use them.

But we will see some fundamental shifts on several things including:

• No Indemnification for Negligence. Without provisions for indemnification in cases of ordinary negligence, fund managers will be barred from pursuing reimbursement for lapses in judgement or adhering to the standard of care expected of a reasonable person in their position. Currently you can waive ordinary negligence but not gross negligence or intentional wrongdoing.

-- Ordinary negligence is like getting a parking ticket because you forgot to fill the parking meter.

-- Gross negligence is like running over the meter and parking on the sidewalk.

-- Intentional wrongdoing is like hitting a person or a pet with your car because you had road rage.

• Compliance Costs and Impact. The costs associated with compliance cannot be transferred to LPs, which means that the financial burden will be directly taken by GP’s bottom line, which can have an impact on management fees and budgets. This benefits service providers, including lawyers and specialized compliance experts, as well as insurance companies capable of underwriting the newly adjusted risks. This comes at the cost of new startups or continuing new funds.
• Disproportionate Impact on the Emerging Fund Managers. Large RIAs are in a much better position to accept the new PFA rules with relative ease. While these changes may increase their operational costs, the effect is manageable. On the other hand, emerging fund managers, with limited resources to meet complex compliance obligations, may face potentially existential challenges. The issue for these smaller advisers stems from a risk standpoint: they may either be unwilling to assume such a degree of risk or, if they do accept it, find themselves unable to fulfill their legal obligations should they be found in violation of the rules. This disproportionality in impact emphasizes the heightened vulnerability of emerging managers compared to their larger counterparts.

The adoption of the PFA rules by the SEC is a calculated move in line with the SEC’s more aggressive regulatory approach. While ostensibly to enhance transparency, protect investors, safeguard public interests, and address specific challenges prevalent in the private fund structure, the rules will have the effect of significantly increasing the costs of compliance, increasing insurance costs, and slowing down the formation of capital at a time when it has been one of the hardest periods to raise funds in over a decade.

There’s always a tension between investor protection and capital formation, which leads to innovation, but the question is whether the regulators will get the balance right?

We will have to wait and see until Wednesday and report back with the final rules. Stay tuned. [Ed: Please see this link to explain how the final rules will work: https://www.dhirubhai.net/posts/harveyesq_final-pfa-rules-passed-one-way-to-describe-activity-7100187109482758144-A5jw]

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Thanks,

Chris Harvey