SEC proposes rule change to potentially reduce risk-taking by fund managers

The Securities and Exchange Commission (SEC) is proposing a significant change that would raise the level of accountability for fund managers. If implemented, this change would require fund managers to adhere to a higher standard of care or face potential legal consequences.

The proposed rule change specifically involves the modification of the indemnification standards for fund managers. The current standard, “gross negligence,” limits legal action by limited partners (LPs) to cases of recklessness or disregard for obvious risks. However, the SEC is considering lowering this standard to “ordinary negligence,” which would empower LPs to sue for simpler mistakes. This change could make it easier for LPs to pursue legal claims against general partners (GPs).

Marc Elovitz, partner and chair of the regulatory practice at Schulte Roth & Zabel, believes that this change would fundamentally alter the relationship between fund managers and investors. According to Elovitz, the ability for fund managers to take risks and be protected from legal liability for their day-to-day activities is crucial for investment strategies with the potential for higher rewards. Implementing such a change could make it difficult for investment managers to safeguard themselves from the consequences of these risks.

Even the Institutional Limited Partners Association (ILPA), a proponent of the proposed rule changes, has expressed concerns about the potential negative impact of a broad application of the “ordinary negligence” standard. In an analysis of the proposal, ILPA stated that such a standard could affect a GP’s risk tolerance and potentially harm returns generated by private funds. However, ILPA acknowledged that applying the “ordinary negligence” standard to breaches of contract could lead to meaningful progress.

SEC Chair Gary Gensler has previously highlighted the importance of this proposal in preventing private fund advisors from engaging in activities that are contrary to the public interest and investor protection. The SEC has not provided a comment on this matter.

The Private Fund Advisers (PFA) rule, initially proposed in February 2022, encompasses various aspects, including quarterly reporting of fees and expenses and preferential treatment of certain LPs. The indemnity change is just one component of this broader reform. Several law firms expect the rule to be finalized this year. Critics argue that if the rule is implemented as currently proposed, it will undoubtedly influence the risk tolerance of private funds, forcing them to exercise greater caution in their investment decisions.

An analogy can be drawn to taking a teenager to an amusement park but only allowing them to ride the merry-go-round instead of the roller coasters. For many, this diminished experience may not justify the cost of admission.