In August 2023, the SEC adopted a new rule applicable to US-based private funds.  The rule included restrictions on the ability of the managers to favour particular investors and a requirement to provide quarterly reporting of fees and expenses. The rule was controversial, with institutional investors being concerned about the impact on side letter negotiations and sponsors expressing concerns about the cost of compliance.

A number of industry bodies brought a lawsuit in the US 5th Circuit Court of Appeals, arguing that the SEC had exceeded its authority.  On 5 June 2024, the Court ruled in favour of the plaintiffs and vacated the rule.  The SEC has yet to confirm how it intends to react to the judgement.

Side letters

The good news for institutional investors, which typically make sizeable commitments to US-based private funds, is that US-based private funds can continue agree bespoke terms with individual investors (at least for the time being).  US managers will not be able to cite the new rule as a justification for refusing requests for side letter terms.

The corollary of this is that institutional investors should continue to protect their own position by negotiating robust most-favoured nation provisions and requiring disclosure of side letter terms agreed to with other investors.

Reporting requirements

The SEC rule would have brought the regulatory environment in the US more into line with the regulatory environment in Europe under the Alternative Investment Fund Managers Directive (AIFMD).  

However, institutional investors have long been in the vanguard of the movement towards increased transparency.  Side letters commonly provide for reporting to comply with principles and templates published by organisations such as the Institutional Limited Partners Association and the Cost Transparency Initiative.  We anticipate that the trend towards increased transparency will continue, notwithstanding the reversal of the SEC rule.

Broader implications

The case affirms the general approach of common law courts around the world to upholding the principle of freedom of contract in the context of investment funds. The Court stated: "unlike investors in mutual funds, private fund investors have a significant hand in determining the terms on which they invest, often negotiating vigorously before making an investment. Private fund investors engage expert counselors, often including their own investment advisers, and typically conduct extensive diligence."  

The case also provides an illustration of how politicised investment law in the US has become.  All three of the SEC Democratic commissioners voted in favour of the rule, whereas both Republican commissioners voted against; the judges on the Court of Appeals which vacated the rule were all Republican nominees.  This trend may make the regulatory environment in the US less predictable, both for fund sponsors and investors.