SEC seeks rule change that could cause fund managers to take less risk

A sweeping change sought by the Securities and Exchange Commission would take fund managers’ culpability a step further than current standards if they don’t effectuate a greater standard of care.  

The rule change involves lowering the bar for indemnification of fund managers to “ordinary negligence” from “gross negligence.” The latter, current standard, allows limited partners to sue general partners only for recklessness or disregard to obvious risk. But if that were changed to “ordinary negligence,” then LPs may be able to sue for simpler mistakes, making it easier for them to bring claims against GPs. 

“It would monumentally change the relationship between fund managers and investors,” said Marc Elovitz, partner and chair of the regulatory practice at Schulte Roth & Zabel, in an interview for the Delivering Alpha Newsletter. 

“The ability for fund managers to take risks and to be protected for their simple day to day conduct is fundamental to having an investment strategy that has potentially higher rewards, ” said Schulte’s Elovitz, whose law firm represents investment funds. “If you’re going to have funds that offer potentially higher returns, there are going to be risks associated with that. And investment managers are going to have a hard time protecting themselves from being on the hook for those risks.”  

Even the Institutional Limited Partners Association, which has been a broad proponent of the rule changes, has raised concerns about the adverse effects stemming from a broad change in this standard. 

“ILPA believes that an umbrella application of the ordinary negligence standard would have the unintended consequence of impacting a [general partner’s] risk tolerance and potentially damaging returns produced in private funds,” the group said in a recent analysis of the proposal. 

However, ILPA said that, “an ordinary negligence standard as applied to breach of contract would assure meaningful progress.” 

SEC Chair Gary Gensler has said in the past that this proposal prohibits private fund advisors from “engaging in a number of activities that are contrary to the public interest and the protection of investors,” including indemnification or limitation of its liability for certain activities. The SEC did not respond to our request to comment for this newsletter. 

The Private Fund Advisers (PFA) rule, which was initially proposed in February 2022, covers a lot of ground, including quarterly fee and expense reporting and preferential treatment of certain LPs over others. The indemnity change is one piece of the reform. In a recent memo to clients, several law firms have said they expect a final vote on the rule will take place this year. 

If it passes in its current form, critics say the reforms would most certainly affect the risk tolerance among private funds, who would need to tread much more carefully in making investment decisions. 

It’s kind of like taking your teenager 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.