The US Securities and Exchange Commission’s proposals prohibiting certain activities, with some essentially overriding negotiated fund terms, has sparked strong reactions from industry participants.
The area that is most concerning to many GPs, sources say, is where the SEC wants to get involved in indemnification and exculpation. According to some, this would change the very nature of how the private equity industry operates.
“GPs are, after all, making primarily illiquid control investments in portfolio companies in sometimes high-risk industries, and the indemnification and exculpation provisions are another version of [an] insurance policy that protects them so that they can take risk and generate the kinds of returns that they have promised to their investors,” Marco Masotti, a New York-based partner at Paul Weiss, tells Private Equity International.
“Once you change that standard of care, you’re changing how GPs function and the intended benefits of the business to investors,” he adds.
The proposed rules would prohibit all fund sponsors, including those that are not registered – ie. exempt reporting advisers – from engaging in certain practices, conflicts of interest and compensation arrangements that are, according to the SEC, “contrary to the public interest and the protection of investors”.
Proposed rule 211(h)(2)-1 would prohibit advisers from “seeking reimbursement, indemnification, exculpation or limitation of its liability by the private fund or its investors for a breach of fiduciary duty, wilful misfeasance, bad faith, negligence or recklessness in providing services to the private fund”.
The SEC also requests comment on whether the final prohibited activities rule should ban limiting liability for gross negligence, or whether prohibiting limitations of liability for “ordinary” negligence is more appropriate.
Why it is controversial
Exculpation and indemnification provisions are standard in private fund documentation. The former is the manager’s standard of care; it sets the standard for the conduct the manager will be held accountable to in the LP-GP relationship.
Indemnification mirrors the exculpation provision and allows the GP to protect itself from damages and lawsuits, so long as it is not found to have engaged in, for example, fraud, wilful misconduct or gross negligence in connection with its activities.
Most managers operate under a gross negligence standard of liability. The SEC’s proposal to prohibit gross negligence in the exculpation and indemnification standards and mandate a simple negligence standard of care may mean fund managers will not want to make riskier – and potentially higher reward – investments, Masotti notes.
“The nature of the [PE] business involves substantial risks, and the gross negligence standard protects the fund manager from routine second-guessing,” he adds.
“The standard of care is the most concerning because it fundamentally alters the agreement between GPs and LPs,” says Karl Paulson Egbert, a partner at Baker McKenzie.
LPs need GPs to take calculated risks, but those risks do not always pay off, Egbert notes. “The standard of care proposal would require GPs to bear execution risks themselves. That may make all but the largest GPs wary about offering investment strategies that inherently involve execution risks.”
By mandating an exception for any form of negligence, the proposed rules could, with the benefit of hindsight, open the door for claims by fund investors that investment decisions made by the manager were negligent, Egbert adds.
“The SEC staff has never before said that a gross negligence standard of care is per se illegal. I’d be very surprised if the SEC staff doesn’t relent on that,” he says.
Fines for non-compliance could range from the hundreds of thousands to multi-millions, the lawyer notes.
It is not, however, the dollar amount, but the moderation of behaviour that is concerning, Masotti says – the SEC is getting involved in an issue that is generally settled and provides a reasonable alignment of interests.