Global Courant
Traders work on the floor of the New York Stock Exchange (NYSE) in New York City, July 6, 2023.
Brendan McDermid | Reuters
A sweeping change that the Securities and Exchange Commission is pushing for would push fund managers’ debt a step beyond current standards if they fail to deliver a higher standard of care.
The rule change means that the bar for indemnification of fund managers for “ordinary negligence” will be lowered from “gross negligence”. The latter, current standard, allows limited partners to sue only general partners for recklessness or ignoring obvious risk. But if that were changed to “common negligence,” LPs might be able to sue for simpler mistakes, making it easier for them to bring claims against GPs.
“It would dramatically change the relationship between fund managers and investors,” Marc Elovitz, partner and chair of the regulatory practice at Schulte Roth & Zabel, said in an interview for the Delivering Alpha newsletter.
“Fund managers’ ability to take risks and be protected for their simple day-to-day behavior is fundamental to having an investment strategy that has the potential for higher rewards,” said Schulte’s Elovitz, whose law firm represents investment funds. “If you’re going to have funds that potentially offer higher returns, there’s risk involved. And asset managers are going to have a hard time protecting themselves against those risks.”
Even the Institutional Limited Partners Association, which is a strong supporter of the rule changes, has expressed concern about the adverse effects that would result from a broad change to this standard.
“ILPA believes that an overarching application of the standard of ordinary negligence would have the unintended consequence of impacting a (general partner’s) risk tolerance and potentially damaging returns from private funds,” the group said in a recent analysis of the proposal.
However, ILPA said that “an ordinary standard of negligence, as applied to breach of contract, would ensure meaningful progress.”
SEC Chairman Gary Gensler has said in the past that this proposal would prohibit private fund advisers from “engaging in a number of activities contrary to the public interest and investor protection,” including indemnifying or limiting their liability for certain activities . The SEC has not responded to our request for comment for this newsletter.
The Private Fund Advisers (PFA) rule, initially proposed in February 2022, covers many areas, including quarterly fees and expense reports and preferential treatment of certain LPs over others. The change in remuneration is part of the reform. In a recent memo to clients, several law firms said they expect a final vote on the rule to take place this year.
If adopted in its current form, critics say the reforms would most certainly erode the risk tolerance of private funds, which should be much more cautious when making investment decisions.
It’s like taking your teen to the amusement park, but only riding the merry-go-round instead of the rollercoasters. And for many, that may not be worth the price of admission.
SEC is seeking rule changes that could lead fund managers to take less risk
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