Survival Guide to VC Regulations

Key Takeaways: On August 23, 2023, the SEC enacted comprehensive new rules for private fund advisers, including venture capital (VC) firms. There are 7 new rules. VCs need to comply with 2 of them and they’ll have 18 months to do it. Most sub-rules can be waived with disclosure; some require majority LP consent. No audits, quarterly reports or fairness opinions are required for VCs. Your regulatory compliance costs will go up.

New VC Regs Just Dropped

Last week, the SEC dropped 660-pages of new, “robust” VC regulations. With an estimated price tag of $5.6 billion in annual compliance costs, the SEC gave a wink and a nod to the Paperwork Reduction Act.

There’s no shortage of new rule summaries floating around from law firms and regulatory compliance shops, but none of them focus on emerging fund managers. This article fixes that gap by addressing it to emerging fund managers.

■ Here are the official SEC links to the new rules and materials:

• fact sheet (3 pages)
• press release
• proposed rules (342 pages)
• public comments
• final rules* (660 pages)

■ Estimated annual costs under new SEC private fund rules:

? Audits: $4B (71%)

? Restricted Activities: $593M (11%)

? Quarterly Statements: $490M (9%)

? Preferential Treatment (Side Letters): $407M (7%)

? Recordkeeping/Other: $124M (2%)

TOTAL: $5.6 Billion (per year, across the private funds industry)

Source: Paperwork Reduction Act Analysis by the SEC, p. 590-660 .

What’s Changed for VCs?

Here’s a summary of the major differences from the proposed rules published last year :

The final rules have been described as “watered down” versions from the original proposal. The proposed rules were framed as PROHIBITIVE, but these rules are RESTRICTIVE. But is that a good or bad thing for emerging managers?

Many praised the SEC for laying down sensible legislation. But not everyone.

One major consequence of shifting prohibited activities to merely restrictive activities is that there are now more steps to take to remain in compliance, mainly in terms of disclosures to LPs. This will have more of an impact on emerging managers than it will on larger funds because the compliance costs will be proportionally greater for the emerging fund managers.

What We All Got Wrong

Legal experts and the media got three things wrong about the final rules.

1. Most of the Rules Don’t Apply to VCs

First, many mistakenly assumed that all or most of the rules apply to VCs.

For example, a leading news source for the venture capital industry mistakenly wrote:

“VC firms will have to provide their LPs quarterly financial statements, which remarkably isn’t standard for all firms. They’ll also have to perform annual audits for each fund they manage.”

However, those two rules don’t apply to VCs and neither do any of the following five rules—they apply only to registered investment advisers (RIAs):

• ? Quarterly Statement Rule
• ? Audit Rule
• ? Adviser-Led Secondaries Rule
• ? Annual Review Rule
• ? Recordkeeping Rule
• ? No Waiver of GP Indemnification (Proposed Rule only)

Only two of the broad rules are generally applicable to VCs:

• ? Restricted Activities Rule (including 7 sub-rules).
• ? Preferential Treatment Rule (including 2 of the 3 sub-rules)

2. The SEC Finds that Waiving Fiduciary Duties is Illegal Per Se

The second issue is the SEC did not dodge the matter of waiving fiduciary duties:

Under the proposed rules, GPs would have been prohibited from seeking any limitation of liability (or indemnification) for breach of their fiduciary duties, bad faith, recklessness or even negligence.

Under the final rules, however, the SEC did not adopt the indemnification prohibition because it asserted that federal fiduciary duty and antifraud provisions already cover much of the prohibited activity—even if GPs are merely negligent:

“We are also not adopting the indemnification prohibition that we proposed because much of the activity that it would have prohibited is already prohibited by the Federal fiduciary duty and antifraud provisions.” —SEC’s Final Rule Release, at page 26 of 660 .

Section 206 of the Advisers Act generally makes it unlawful for any investment adviser, including VCs, to engage in “fraudulent, deceptive, or manipulative conduct.” Section 206 is broader than the antifraud provisions in the federal securities laws, and that is the bedrock principle the SEC is relying upon to bring about these new rules. In addition, the SEC is leveraging a new rule under the Dodd-Frank Act (Rule 211(h)), and it is unclear now if the SEC has the legal authority to apply that authority to adopt new rules to VCs.

3. There is No Private Right to Sue Under the Advisers Act

Third, many claimed that had the proposed rule on GP indemnification passed, it would have made it easier for LPs to sue the fund manager. However, LPs can’t sue fund managers for violations of the Advisers Act—other than as a rescission right to receive their funds back. That’s because there is generally no private right of action under the Advisers Act. An SEC rule wouldn't change this fact.

Only the SEC has the right to bring an enforcement action under the Advisers Act. And so, if you read between the lines of the proposed rules and the final rules, you’ll find that the SEC is effectively (1) prohibiting GPs from charging off any fees or expenses related to an investigation that results in sanctions by the SEC under the Advisers Act or “the rules promulgated thereunder” (i.e., these new PFA Rules), and (2) asserting its long-standing position that federal fiduciary duties are never waivable under the Advisers Act, thus keeping the general principles of the proposed rules in play.

This is a powerful move by the SEC because it both cements its rulemaking discretion under the Dodd-Frank Act and also clarifies its authority to hold GPs accountable for breaches of fiduciary duties and negligence without having to pass a new rule.

Summary of Final Rules for VCs

There are now two final SEC rules that apply to VCs, including several sub-categories:

1) Restricted Activities for VCs (11% of SEC's annual cost estimates)

§ 275.211(h)(2)-1(a) is a "restricted activities" rule that relates to fees, clawbacks and borrowing, among other things:

?? = prohibited; ?? = consent required; ?? = disclosure required

Prohibited Activities: Investigations that lead to Sanctions

• ?? Investigation fees. GPs are prohibited from charging any fees or expenses related to an investigation that results in sanctions by regulators.

Consent: Restricted Activities with Certain Investors

• ?? Investigation expenses. GPs are restricted from charging fees or expenses associated with investigations by any governmental or regulatory authority that does not result in sanctions UNLESS the GP seeks consent from all LPs and obtains written consent from at least a majority-in interest of LPs.
• ?? Borrowing Restrictions. GPs are restricted from borrowing money, securities, or other private fund assets, or receiving a loan or extension of credit from a private fund client UNLESS the GP (i) distributes to LPs a written notice and description of the material terms of the borrowing; and (ii) obtains written consent from at least a majority in interest of the LPs that are not related persons of the GP.

—Exception: Loans made directly to the GP by third parties (including LPs in the fund, such as a bank).

Restricted Activities with Disclosure-Based Exceptions

• ?? Regulatory, Compliance and Examination Expenses. GPs are restricted from charging fees or expenses associated with (i) regulatory or compliance matters, and (ii) fees and expenses from an examination by the SEC (or other governmental or regulatory authority) UNLESS GPs provide disclosure*
• ?? GPs are restricted from charging regulatory or compliance fees of the GP or related persons, UNLESS GPs provide disclosure*.

Non-Pro Rata Splits

• ?? GPs are restricted from 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, UNLESS GPs provide disclosure*.
• ?? GPs are restricted from reducing any GP clawback by applicable taxes UNLESS GPs disclose* pre-tax and post-tax clawback calculations.

(Edited: 9/8/2023—Here is a Cheat Sheet for Restricted Activities Rule ):

*All disclosure-based exceptions to the restrictions above (i.e., the blue circles—regulatory, compliance, and examination fees and expenses and post-tax clawbacks) require advisers to distribute written notices to LPs within 45 days after the end of the quarter after such fees or expenses were incurred by the fund.

2) Preferential Treatment (7% of SEC's annual cost estimates)

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

?? = prohibited; ?? = consent required; ?? = disclosure required

Redemption and 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.

(Edited: 9/8/2023—Here is a Cheat Sheet for Preferential Treatment Rule ):

Transition Period and Legacy Status:

• VCs with less than $1.5B AUM will have 18 months to comply with the new rules and the clock will start once the rules are published in the Federal Register (TBD).
• Also legacy status is available for Preferential Treatment Rule and the Restricted Activities Rule, provided the fund is operational organizational documents (side letters count) entered into prior to the compliance date. However, the consent rules will apply retroactively once the rules pass the compliance date (again, 18 months for all emerging fund VCs).

How Will This Impact LPA and Side Letter Negotiations?

There are three broad categories under the Preferential Treatment Rule:

1. Redemption rights, which are generally not applicable to VCs
2. Information rights, which apply in cases where LPs have negotiated info rights;
3. Side letters disclosures - it’s a matter of timing and specifics in the LP disclosures.

Preferential terms in a side letter that involve “material economic terms” have to be disclosed before a prospective LP invests if the GP “reasonably expects” that keeping the information would have a “material, negative effect” on other investors in that same private fund. Otherwise, GPs have to provide to LPs a comprehensive annual disclosure of all preferential treatment terms entered into by the GP or its related persons each year since the last annual notice disclosed it.

So, in summary:

• GPs must disclose the economic parts of the side letter concerning “material economic terms” to all prospective LPs before they join a fund.
• Annual disclosures of side letters with preferential treatment must be provided to all LPs.

“Preferential treatment is… contrary to the public interest and protection of investors” —SEC’s Final Rule Release, at page 268 of 660 .

How will the recent PFA rules impact current LPA and side letter negotiations?

Generally you can expect some temporary relief in the first 18 months of the rule passage for not disclosing side letters already entered into for prospective LPs. But after the 18 months is up, the annual notice will require you to disclose to all your investors any side letter with preferential terms that match the rule.

What matters is that (1) “information in side letters that existed before the compliance date will be disclosed to other investors that invest in the fund post compliance date” (through the annual disclosure notice), (2) “the legacy provisions apply with respect to contractual agreements that (i) govern the fund, which include, but are not limited to, the fund’s [LPA], the subscription agreements, and side letters,” and (3) “legacy status applies only to such agreements with respect to private funds that had commenced operations as of the compliance date.”

Can you withhold side letters in one parallel fund from another fund?

As for withholding side letters in one fund to another fund, the final rules only require disclosure within the “same private fund.” This could potentially create a loophole, allowing GPs to segregate their Section 3(c)(7) LPs, who may have specialized access needs, from their Section 3(c)(1) LPs.

Can you anonymize the identity of limited partners in the side letter?

Maybe—this comment suggests you might be able to withhold their identity:

“As a result, information in side letters that existed before the compliance date will be disclosed to other investors that invest in the fund post compliance date. Advisers are not required to disclose the identity of the specific investor that received a preferential term and can choose to anonymize that information.”

How much is this going to cost me?

Hard to say exactly. but the SEC has estimated that annual compliance costs for each private fund as a VC will be on average as follows:

• Preferential Treatment Rule = $4,288 per year per fund
• Restricted Activities Rule = $6,846 per year per fund
• Total for VCs: ~$11,134 per year (per fund)

This figure is likely low because it estimates the average hourly fee for lawyers at $353/hr.

What will the impact be?

Insurance carriers will likely be increasing their premiums on E&O insurance as the demand for policies outstrips the available supply. Coverage can be expensive, and based on quotes, getting a $3-5 million E&O policy for $100,000 to $125,000+ per year is not going to work for most emerging fund managers.

Regulatory compliance firms will also have a substantial increase in revenues as VC fund managers and other advisers look for alternative service providers to provide scalable regulatory compliance help. But the irony is these very same regulatory and compliance fees will need to be disclosed to LPs at the end of each quarter, and if they’re not submitted within a 45-day window, the GPs will be in violation of the rules.

Finally, emerging fund managers may need to have their LPAs, side letters and other fund documents reviewed and revised; not to mention the ongoing quarterly cost disclosures and annual LP disclosures, requiring substantial legal fees and costs. According to the SEC, this later work will involve “preparation of written notices and consents,” “provision, distribution, collection, retention, and tracking of written notices and consents,” and notices will be issued once annually to existing investors and once quarterly for prospective investors.

In summary, the new rules are poised to significantly increase the costs of negotiations, disclosures, and other compliance steps needed to fall in line with the new rules. The 18-month compliance window and legacy status offer some flexibility, but GPs will need to carefully navigate these changes to meet regulatory requirements and manage LP relationships effectively.

Final Takeaways

One crucial aspect that often gets overlooked here is the potential costs for complying with the new regulations falls on the emerging fund managers. With the SEC clarifying its stance on fiduciary duties and negligence, VCs are on notice: failure to comply could result in significant penalties.

But it’s not just a matter of paying significant penalties or fines—regulatory actions can result in (1) unrecoverable fees and sanctions, and (2) the loss of ability to continue operating as VC. We’re talking about people’s livelihoods here. In extreme cases, firms might even face compulsory dissolution or forced exit from the capital markets. Additionally, individuals within the firm could be barred from serving as officers or directors in SEC-regulated entities, depending on the severity of the violation.

All the more reason to treat these rules as a serious change in status.

Disclaimer: This article is intended to provide VCs with an overview of the key aspects of the new private fund adviser rules. However, it is not intended to be an exhaustive resource, and other factors may apply to your specific situation. You are strongly encouraged to seek guidance from experienced fund counsel to ensure compliance with the issues discussed above.

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