Regulatory Creep and Venture Capital Risk Management (and Introducing the Financial Services Notebook)

Regulatory Creep and Venture Capital Risk Management

Since the 2008 financial crisis, the SEC has made repeated encroachments into the private funds industry. Registered investment advisers (RIAs) have borne the heaviest regulatory burden: routine examinations, frequent rulemaking, and aggressive enforcement activity. The harshest government gaze has always been reserved for retail-facing firms, but RIAs advising sophisticated accredited investors (e.g., private equity fund advisers) have also received a lot of attention from the Securities and Exchange Commission (SEC) over the past 15 years.

Venture capital fund advisers (VCs), most of whom are structured as exempt reporting advisers (ERAs), have traditionally had an easier time of it. ERAs are subject to fewer reporting obligations, a lighter compliance burden, and a lower likelihood of scrutiny by the SEC’s Division of Examinations and Division of Enforcement (Enforcement). This makes sense as applied to VCs: Limited partner investors (LPs) are typically highly sophisticated, drawn to and experienced in making high-risk investments in early-stage companies. According to traditional conventional wisdom, these LPs can protect themselves through careful contracting and, if things go south, private litigation, and they do not need the same degree of government protection as other investors.

Over time, however, the SEC has been slowly ratcheting up pressure on VCs. This campaign began in the initial wave of Dodd-Frank rulemaking in the early 2010s, as the SEC began to impose new requirements on ERAs that went (according to one former SEC Commissioner) “too far toward collapsing the distinction between what it means to be unregistered versus registered as an investment adviser.” But, despite predictions that increased SEC regulation would lead to stifled capital formation and innovation, the domestic VC industry managed to do okay in the 15 years since the financial crisis. In fact, it catalyzed one of the greatest cycles of innovation and wealth creation in history.

In recent years, the SEC has brought a consistent trickle of enforcement cases against VCs. This trickle seems to have broadened to a small stream in the last year or so, perhaps as the current SEC administration’s enforcement agenda has gained steam. On top of this, the SEC’s new private fund adviser rules, passed in August 2023, will create significant new compliance burdens and enforcement risks for VCs (unless they are struck down by the courts). For now, at least, the relatively gentle regulatory ride has become a bit bumpier.

Venture Capital Enforcement: The Temperature Rises (A Bit)

Let’s start with SEC Enforcement.

The SEC is allowed to cause problems for investment advisers largely thanks to Section 206 of the Investment Advisers Act of 1940. Section 206 applies to both RIAs and unregistered investment advisers (i.e., ERAs) alike.

The power of Section 206 comes from its simplicity. Distilled down to its essence, the law says, “Don’t do or say false or misleading stuff.” To paraphrase Gollum from The Lord of the Rings, the SEC doesn’t like it when investment advisers are “wicked, tricksy, false” or “hurt you, cheat you, lie.”

Since Dodd-Frank, ticky-tack cases against RIAs—including numerous private equity advisers—have been common. Many of these actions have focused on technical transgressions in management fee calculations, foot faults in private asset valuations, and expense allocation issues. The dollar amounts are often relatively low, and many of these cases do not involve any allegations of intentional or reckless conduct. By contrast, cases against VCs and other unregistered advisers have more frequently centered on egregious conduct (think blatant fraud or misappropriation).

In addition to the publicly reported cases, anecdotally, SEC Enforcement has opened numerous investigations into VCs in recent years. It has also brought a couple of relatively marginal cases—of the kind traditionally reserved for RIAs—against VC ERAs. A good example is Energy Innovation Capital Management. In a settled 2022 case, the SEC charged a VC with making errors in its management fee calculations.

• The errors included failing to account for valuation write-downs in management fee calculations, beginning one quarterly management fee calculation 15 days early, and including accrued (but not earned) interest in portfolio company securities valuations.
• The VC allegedly received about $675,000 over a two-year period that it had not properly earned. Once the SEC flagged the issues, Energy Innovation returned the funds to investors, with interest. The SEC still slapped the adviser with an additional $175,000 penalty.
• The SEC based its case on Sections 206(2) and 206(4) of the Advisers Act. Neither of these provisions requires the SEC to show bad faith or even recklessness. And the SEC’s order doesn’t include any allegations suggesting that there was any intent to mislead, misappropriate, or harm investors.

These and other developments suggest a slow creep toward stricter SEC Enforcement practices toward VCs. Time to panic? Not at all. A good time to assess the robustness of your policies, procedures, and on-the-ground practices in areas like fee calculation, conflicts, expense allocation, and disclosure? Definitely.

New Risks: The 2023 Private Fund Adviser Rules

VCs are also now subject to many of the SEC’s new rules for private fund advisers (the Rules). There is a lengthy transition period before compliance is required, and existing funds are also grandfathered under many of the Rules. The Rules are also subject to legal challenge from industry groups before the Fifth Circuit Court of Appeals, which is often an energetic participant in assaults on the administrative state. The court is considering the case on an expedited basis, with a decision expected in mid-2024. But it’s impossible to predict the final outcome. To be prepared for compliance, private fund managers should begin planning now.

Some of the new Rules only apply to RIAs. But many of the most significant Rules apply to all investment advisers, including ERAs. The key Rules applicable to ERAs fall mostly into two buckets: preferential treatment and restricted activities. If you want a punchy explainer of where the rules landed, check out this Debevoise post. Here, I’m going to cover some of the high (low?) points relevant to VCs.

Preferential Treatment Rule

The Preferential Treatment Rule says that investment advisers can’t give better treatment to certain investors in a fund unless—depending on the context—the perks are either disclosed to all investors or offered to all investors. Key considerations for VCs include:

• The Rule addresses preferential redemption and information rights given to investors in the same fund or a “similar pool of assets,” meaning another fund “with substantially similar investment policies, objectives or strategies.” As an example, the SEC shared that an “adviser’s healthcare-focused private fund may be considered a ‘similar pool of assets’ to the adviser’s technology-focused private fund.” Work with outside counsel to ensure you’re taking reasonable and defensible positions about which vehicles in your family of funds constitute a “similar pool of assets” to one another.

• One part of the Rule focuses on preferential redemption and information rights. The SEC’s theory here is that favored investors should not be able to have a disproportionate inside view into performance factors and then weaponize that information by pursuing an early redemption at the expense of the remaining benighted investors who are stuck holding the bag. For closed-end funds like VCs, this shouldn’t generally be a big issue. LPs are locked up, so in theory, it shouldn’t matter if some investors get information that’s not available to others because they won’t be able to act on that information. The SEC acknowledged this context but still decided to make the rule applicable to illiquid funds.

  If you are considering granting extraordinary redemption rights to certain investors, think carefully and talk to your outside counsel about how to stay on the right side of this rule, including with respect to any preferential information that may have been provided to that investor. If the redemption right is expected to have a material negative effect on other investors, you will need to offer the same right to all investors. This is a mushy analysis that will be subject to hindsight second-guessing if the SEC later comes calling; tread carefully.

More broadly, under the Rule, you need to tell all investors about any preferential treatment granted to other investors via, for example, side letters. If these perks relate to “material economic terms”—which the SEC has said would include “cost of investing, liquidity rights, fee breaks, and co-investment rights”—they must be disclosed to all investors in advance. As a result, managers will need to determine workable mechanisms for providing less-advantaged LPs with detailed information—before they are admitted to the fund—about materially better terms offered to more-advantaged LPs. One helpful tidbit: The SEC explicitly agreed the rule does “not apply to preferential terms an adviser offers to investors and instead should apply only to preferential terms actually provided.”

Restricted Activities Rule

The Restricted Activities Rule says that investment advisers can’t engage in certain activities unless—depending on the context—the activities are either disclosed or consented to by investors.

• To properly charge compliance and exam fees to a fund, advisers need to provide written notice of the charges to investors quarterly. The SEC wants detailed disclosure here. Think carefully and consult with counsel about what qualifies as a compliance expense.
• To properly charge investigation fees to a fund, advisers need to get advance written consent from a majority in interest of the investors. Also, if an investigation ultimately results in charges and penalties, advisers will need to reimburse the fund for the fees. Read on below for insurance angles.

Prohibition Against Indemnification (Not Adopted)

Originally, the SEC proposed to prevent advisers from seeking indemnification for “breach of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness.” The private funds industry understandably freaked out. Acknowledging that “most commenters” opposed the prohibition against indemnification, the SEC backed down and removed the provision from the final rules. In doing so, however, the agency did a lot of ominous throat-clearing.

• In the adopting release for the Rules, the SEC made it very clear that it believes an adviser “may not seek reimbursement, indemnification, or exculpation for breaching its Federal fiduciary duty because such reimbursement, indemnification, or exculpation would operate effectively as a waiver, which would be invalid under the Act.” (emphasis added)
• What does this mean for contracts that indemnify investment managers? Note my emphasis above on “breaching” and “Federal.” In the SEC’s view, contracts must make clear that the indemnity does not extend to an adviser’s breach of fiduciary duty under the Advisers Act—and the SEC believes that you can “negligently” breach your fiduciary duty under Section 206. If an indemnification agreement would extend to those types of charges, the SEC will not be happy.
• If, on the other hand, an adviser is indemnified against certain conduct in a private action brought by non-retail investors, the SEC seems (maybe?) to have removed itself from that conversation. Also keep in mind that the SEC is talking about “indemnification” for “breaching” a fiduciary duty, and not necessarily about advancement of defense costs prior to any finding of liability. The SEC’s adopting release is about as clear as mud. Raise these issues with the wonkiest funds lawyers you can find and make sure your indemnification agreements pass muster.

Venture Capital Risk Management: Understand Your Insurance Coverage

As the SEC continues its steady regulatory campaign and as capital markets show tentative signs of unfreezing, it’s a good time to talk with your insurance advisor to make sure you are adequately armored against risk in the next market cycle. Here are a few things that are top of mind as we kick off 2024:

• Ensure you have appropriate insurance coverage for investigations. SEC exams and investigations can be very costly (in an extensive investigation that follows a lengthy exam, think eight figures). Routine exam costs are typically excluded from insurance coverage, but entity-level costs from regulatory investigations are increasingly covered under general partnership liability and/or errors and omissions policies. As discussed above, directly charging investigative expenses to a fund in the future will require a messy disclosure and consent process—and reimbursement to the fund if you settle with the SEC. It may be preferable to maintain broad entity investigation coverage that will kick in if SEC Enforcement comes calling. Remember, though, this coverage is just for defense costs. If you end up settling with the SEC, penalties will be excluded from coverage.
  
  With this in mind, how much coverage do you have for investigations? What’s the basis for that number? Can your insurance broker explain what kinds of situations would likely be covered under your policy and what situations may not be covered? For example, how does your policy define an informal investigation and a formal investigation, and what exactly triggers coverage under each type of claim? The SEC may use different investigative tools depending on whether an entity is registered. As a result, key coverage triggers for RIAs may be different from coverage triggers for ERAs. Be sure that you are working with an insurance broker who understands these nuances and can help you map these risks onto your insurance policies.
• Check on your coverage for partners who sit on portfolio company boards. The IPO market has recently shown a few green shoots. Public companies are at their most vulnerable to private securities class actions in the wake of IPOs. If your partners are on these boards, they have potential exposure. Maintaining appropriate firm-level coverage helps protect them against any gaps in coverage at the portfolio company level. (As an aside, this is one of the reasons why you also want the same insurance experts handling both programs.)

Finally, as the temperature rises a bit for VCs, it’s a good time to ask questions about the claim capabilities of your insurance team. If private litigants or the government come calling and you are incurring significant legal costs, the last thing you need is a coverage dispute with your carrier. There are two ways to de-risk this: make sure you have (1) robust policy language and (2) a well-resourced and highly experienced team who will negotiate effectively with carriers if disputes do arise.