Last week brought Securities and Exchange Commission (“SEC”) enforcement developments that, in our view, demonstrate the SEC’s interest in pursuing cases against investment advisers for conduct that would have been restricted under the Private Fund Adviser Rules (“PFAR”) and that the SEC stated in the PFAR adopting release was inconsistent with advisers’ fiduciary obligations.  As expected – and as previewed in our Client Alert on the Fifth Circuit’s decision in June – the SEC clearly still intends to act on the same concerns it raised in PFAR and will use its examination and enforcement tools to scrutinize the same adviser practices that drove the rulemaking.

Limitations of liability and indemnification.  In one case, the SEC announced settled charges against a registered investment adviser and fund manager, ClearPath Capital Partners, for inappropriate use of hedge clauses in fund documents.  The SEC charged ClearPath for violations of Section 206(2) of the Advisers Act (anti-fraud) because its private fund LPAs and other governing docs included “misleading” hedge clauses limiting the scope of its unwaivable fiduciary duty.  The SEC found that the hedge clauses “could lead a client to believe incorrectly that the client had waived a non-waivable cause of action against the adviser provided by state or federal law.” 

The final PFAR dropped the prohibition on these hedge clauses that had been included in the proposed version.  But the PFAR adopting release contained the SEC’s view that advisers may not waive their federal fiduciary obligations (or seek indemnification for breaches of such obligations)—even merely negligent conduct could amount to a breach of an adviser’s fiduciary duty, and advisers therefore should not ask clients to waive liability or provide indemnification for conduct in too broad of a fashion.  This case is a clear warning to the industry that the SEC will continue to aggressively enforce this view.  The ClearPath settlement order cited the SEC’s 2019 Fiduciary Duty Guidance (also cited in the PFAR adopting release) that had called hedge clauses “inconsistent with the Advisers Act,” regardless of client sophistication level.  The SEC found that the hedge clauses ClearPath had included in its LPAs were misleading, because they would lead investors to think they were waiving legal rights regarding claims beyond those for fraud, gross negligence, or willful misconduct. 

However, the ClearPath order went further in a concerning way.  At least some of the documents that the SEC found to be problematic and misleading did include some form of “savings” clauses – i.e., language stating that nothing in the hedge clause would limit the adviser’s liability to the extent it cannot be limited by law.  We believe what likely drove this outcome was the fact that ClearPath had retail clients, including ERISA clients.  The SEC has stated in numerous contexts and actions starting with the 2019 Fiduciary Duty Guidance that it will hold advisers with retail clients to higher standards.  We would be surprised if savings clauses were held insufficient where clients and funds advised by sponsors are limited to sophisticated and institutional clients (e.g., 3(c)(7) funds rather than 3(c)(1) funds). 

Preferential Treatment.  In another case, the SEC settled charges against a crypto-focused adviser, Galois Capital, that included Section 206(4) violations for allowing some private fund investors – including affiliated investors – to redeem on shorter notice than what was required under the fund’s LPA and what had been communicated to other investors.  The SEC found that Galois had violated both Section 206(4) (anti-fraud) and Rule 206(4)-8 (regarding disclosure practices) by providing preferential redemption rights when its disclosures and the fund LPA made no mention of such rights.  PFAR would have prohibited this fact pattern, and the case highlights the strict scrutiny that we expect the SEC enforcement division to bring to disclosures around preferential treatment targeted in the PFAR – whether prohibited or merely requiring explicit disclosure.

Taken together, the SEC has provided an early notice that it plans to use its pre-PFAR toolkit – fiduciary duty and anti-fraud provisions – to pursue conduct it believes is inappropriate and had tried to regulate and eliminate in PFAR.