Do the proposed new rules for private funds mean you will need to tear up existing LP agreements and rewrite them? That is just one of the extreme fears among VCs trying to get their heads around the SEC’s proposed changes.
To separate fact from fiction, I reached out to Igor Rozenblit, who served as co-head of the SEC’s Private Funds Unit for more than 11 years. Rozenblit opened up his own regulatory consulting shop, Iron Road Partners, last June. Its customers are primarily registered investment advisers, but it has one that is an exempt reporting adviser.
If the SEC adopts its proposed rules for private funds as is, will both registered and exempt VC funds have to rewrite their existing limited partnership agreements to make them compliant?
Exempt Reporting Advisers, including venture capital firms who have elected not to register because of the venture capital exemption, will have to comply with the prohibitions and rules around preferential treatment, which are contained in this rule. While they will not have to rewrite their limited partnership agreements, parts of their agreements may no longer be enforceable. For example, venture capital managers will no longer be able to seek indemnification from LPs for simple negligence, raising the possibility that GPs could get sued by investors for making bad investments or making honest mistakes in due diligence.
Additionally, venture capital managers will no longer be able to negotiate returning clawbacks to investors net of tax, meaning that they may have to fund the tax paid on their carried interest from their own pocket. There are also other prohibitions around fees, expenses and borrowings that will impact venture capital managers less but could nevertheless become problematic.
Can you elaborate on the proposal to change the liability standard in LP agreements from gross negligence to simple negligence and how that might play out for a venture fund? And would that change apply to both ERAs as well as registered advisers?
The new rule proposal would prohibit all investment advisers, not just registered investment advisers, from seeking reimbursement, indemnification, exculpation or limitation of the adviser’s (and its related persons’) liability to the private fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence or recklessness in providing services to the private fund.
This would prevent venture capital managers from waiving or limiting their fiduciary duty under federal or state law, even if a state expressly permits such a waiver. This will have the effect of lowering the liability standard from gross negligence — which is where it is today in most LPAs — to simple negligence. This will expose managers to more litigation risk and may eventually inhibit or elongate investment decision processes as the manager does more diligence before making any investments.
Which of the proposed changes do you think will have the biggest impact on venture capital firms, the majority of which are exempt advisers?
The biggest impacts for Exempt Reporting Advisers will be the changes in the clawback structures and liability standards, however there are fee and expense prohibitions that may also impact venture. For example, there is a prohibition against allocating expenses on a non-pro-rata basis when multiple funds are invested in the same portfolio company.
This could become problematic for firms that may have committed co-investment vehicles or which may have a carve-out for employee investments in their deals because they would now need to allocate all expenses such as broken-deal expenses and research expenses to co-investors and to individuals.
Given your experience as co-head of the SEC’s Private Funds Unit, what does your gut tell about which of the proposed rules stand the best chance of being adopted as is?
It is doubtful that any of the rules will be adopted “as is.” The Administrative Procedures Act (APA) requires that agencies involve the public in rulemaking by allowing comment. Those comments need to be considered in order for rulemakings to comply with the act. Nevertheless, I believe these rules will be adopted in some form.
Some provisions that are likely to survive in some form include the reporting provisions, which some view as critical, the requirements for an annual audit and requirements for written annual compliance reviews. None of those provisions are applicable to ERAs however.
What does your gut tell about which of the proposed rules are least likely to be adopted as is?
The provisions that are least likely to survive include some of the prohibitions. The SEC has historically regulated private funds via a regime focused on disclosure, and outright prohibitions are a departure from that approach. Industry participants are likely to argue that the SEC lacks legal authority to enact these prohibitions.
Additionally, some prohibitions may be impractical to implement or may be written too broadly, such as the prohibition against borrowing from the manager, which could inadvertently capture delayed distributions, or very common mechanics around funds funding organizational expenses. The commission may modify those after receiving comment.
Is there anything in the proposed rules that has been largely overlooked by exempt advisers that they should pay attention to?
Most Exempt Reporting advisers are not used to heavy regulation and typically do not stay abreast of regulatory developments. Those firms may be surprised that the prohibitions in this rule and the requirements around reporting side letters and preferential treatment apply to them. To comply, even ERAs will need to increase their compliance and legal spend.