During these unprecedented times, we are addressing a variety of questions and issues from fund managers relating to their investment vehicles. In this FAQ, we have focused on questions from investment advisers with respect to their unregistered funds and other alternative investment products.
Q1: What disclosure obligations do I have to my LPs, given the COVID-19 pandemic? How does this differ between prospective investors vs existing investors and closed-end fund vs open-end funds?
A: The SEC addressed the importance of disclosure with respect to public companies in its public statement on April 8, 2020 and, through its Investor Advisory Committee on May 4, 2020, and the same principles generally apply to investment managers. While historical information is still relevant, it “may be relatively less significant,” and the SEC encouraged companies to “respond to investor interest in: (1) where the company stands today, operationally and financially, (2) how the company’s COVID-19 response, including its efforts to protect the health and well-being of its workforce and its customers, is progressing, and (3) how its operations and financial condition may change as all our efforts to fight COVID‑19 progress”. By and large, surveys show that companies are generally already communicating frequently with clients and customers (among others), and we are seeing investment managers doing the same thing.
As a starting point, we recommend that you check the governing documents of your funds, as well as all side letters, for specific disclosure obligations (and potentially other obligations) with respect to (i) key person events, in the event of the incapacity of key personnel caused by COVID-19; (ii) certain key service providers; (iii) changes in liquidity (including the imposition of suspensions or other limitations on withdrawals in open-ended funds); (iv) changes with respect to, or a termination of, credit facilities; and (v) valuation issues.
Regardless of whether managers have an express obligation to do so, managers are generally trying to disclose the current and anticipated impact of COVID-19 on their operations and financial condition as well as on the investments, investment strategy, targeted returns, and investment limitations and restrictions of their funds. Note that a Preqin survey of managers from April 2020 (https://go.preqin.com/covid-19) showed 62% of fund managers say they are not changing their targeted returns as a result of COVID-19. These disclosures can be made in an updated private placement memorandum or (for efficiency) in a supplement to the private placement memorandum or, to the extent that the fund is closed to additional commitments, in investor communications.
The information should generally be provided as soon as practicable, in particular where it is actionable (including, where voluntary withdrawals are permissible, in an open-ended fund). Although the focus of this FAQ is unregistered funds, it should be noted that the SEC is not recommending enforcement action if a registered fund does not deliver an updated prospectus to current investors in the registered fund where the prospectus is not able to be timely delivered because of circumstances related to COVID‑19.
The annual update to many advisers’ Form ADV was due on March 30th, although the SEC provided temporary exemptive relief from certain filing deadlines and related delivery obligations. Advisers should consider if their response to COVID-19 requires any changes to Form ADV Part 1 or to Form ADV Part 2 brochures. See also the answer to Q5 below on filing and delivery obligations, as well as our related client alert.
All disclosures should be accurate. For example, disclosures that were originally hypothetical should be revised if the risk is no longer hypothetical.
Because managers may not have the necessary information from their counterparties, service providers, and/or underlying portfolio companies, managers should also be mindful of deadlines for reporting and disclosures in the governing documents and side letters of their funds and whether they can meet such deadlines. If they cannot meet the deadlines, and the terms of the governing documents or side letters offer no flexibility, managers should seek extensions of such deadlines.
Q2: An investor has submitted a signed subscription agreement, but the manager has not yet accepted it. If the investor asks for a return of its subscription agreement, what rights or obligations apply?
A: It will be important to consult the subscription agreement of the investor. Some subscription agreements provide that a subscription agreement is irrevocable once submitted. In such circumstances, the fund has no obligation to return the subscription agreement.
If such a provision is not included in the subscription agreement, then the manager may be required to return the subscription agreement, unless it can demonstrate any detrimental reliance. Under contracts law, a submitted subscription agreement constitutes an offer. Without any consideration to keep such an offer open (also known as an option contract), the offer may be rescinded if not yet accepted by the counterparty. Therefore, the fund would have an obligation to return the subscription agreement, and no legal remedies would attach to the fund.
Q3: How should I use the limited partners’ advisory committee to help navigate the COVID-19 pandemic?
A: Managers should consult their funds’ governing documents for any advisory committee provisions requiring consent, consultation, or notice of certain events. Some fund documents permit managers and fund GPs to consult the advisory committee and/or obtain their approval on specific matters, including review and approval of conflict of interest (in the case of certain open-ended funds) with respect to a breach of an investment limitation and (in the case of certain closed-end funds) to extend the offering period, the investment period, and/or the term of the fund. It is unlikely that the existence of the COVID-19 pandemic, alone, would trigger an obligation to consult the advisory committee and/or obtain their approval on specific matters, but such obligations may be triggered by certain circumstances that arise out of the pandemic, including, for example, where conflicts of interest are arising among client and/or proprietary accounts holding interests in the same issuer but at different levels of the capital structure or where the manager is required to notify the advisory committee of certain events that may materially affect the fund. In any event, most managers are engaging in active dialogue with the advisory committee as well as investors.
Q4: Do I need to develop a business continuity plan? Has the SEC provided any guidance?
A: A rule requiring advisers to adopt business continuity and transition plans was proposed in 2016 but was never adopted. However, investment advisers have fiduciary duties (the duty of care and the duty of loyalty) to their clients, and having a business continuity plan arguably falls under the overarching principle of acting in the best interest of clients. Recently, we have seen SEC staff members asking about such plans during examinations, including, specifically, about how the business continuity plan has performed as firms have transitioned to remote work environments as a result of COVID-19. The business continuity plan will address the manager’s own procedures and operations,—including how oversight and surveillance of such operations must continue and should be memorialized,—as well as a review of the services provided by, and agreements with, third parties, including administrators, custodians, lenders, brokers, and technology platforms.
Q5: Do I need to mention the COVID-19 pandemic in my Form ADV? Do I need to file an other-than-annual amendment to my Form ADV as a result of COVID-19?
A: As noted in our answer to Q1 above, managers are generally trying to disclose the current and anticipated impact of COVID-19 on their operations and financial condition, as well as on the investments, investment strategy, targeted returns, and investment limitations and restrictions of their funds. This disclosure should include the potential risks the pandemic may pose to funds and client accounts. If, as a result of these new risks, an adviser’s existing disclosure in Form ADV Part 2 becomes materially inaccurate, this update should occur in an other-than-annual amendment to the adviser’s Form ADV Part 2.. However, not all COVID‑19 driven changes need to be disclosed. For example, pursuant to recently published SEC guidance, investment advisers are not required to include the temporary teleworking addresses of each employee in response to Item 1.F of Form ADV, Part 1A, so long as their temporary teleworking situation arises from a business continuity plan.
Additionally, by exemptive order dated March 13, 2020 (as amended and supplemented by exemptive order dated March 25, 2020), the SEC provided relief with respect to certain Form ADV filing and delivery obligations (and Form PF filing obligations) to advisers that are otherwise obligated to make their filings or deliver their brochure during the period beginning on March 13, 2020, and ending June 30, 2020. The updated order removes the requirements that an investment adviser relying on the relief must (1) disclose to the SEC or on the firm’s website why it cannot meet the normal deadline or (2) provide an estimate to the SEC or on the firm’s website when the firm intends to actually file its amendment. An adviser relying on the exemptive relief must file its Form ADV or Form PF, as applicable, and deliver its brochure (or summary of material changes) as soon as practicable—but no later than 45 days after the original due date.
Q6: What is the market practice regarding COVID-19 risk factors?
A: We have been seeing risk factors related to COVID-19 added to general macroeconomic risk factors, general market access risk factors, industry or sector specific risk factors (including, for example, risk factors relating to the travel, leisure and service industries), and liquidity risk factors—among many others. Please reach out to a member of the Private Funds Group for samples of risk factors. For more information on risk factors generally, please view our “SEC Update with Dave & Marty.”
Q7: Should I draw down on my subscription line during the COVID-19 pandemic?
A: If the purpose of drawing down on the subscription line is to have cash on hand, as opposed to funding a specific need, it is important to point out that a fund’s subscription-backed credit facility is fundamentally different than a line of credit that an operating business might have. Borrowing under a subscription-backed credit facility is a substitute for drawing down on capital commitments and tends to be for a limited duration for both practical reasons (the investors in the fund want to ensure that capital is drawdown and that the preferred return will start to “accrue”) and tax reasons (to mitigate UBTI and ECI risk for tax-exempt U.S. investors and non-U.S. investors, respectively).
Before borrowing under any credit facility, you should consider a number of issues, including the effect of borrowing (which could trigger a financial covenant default under other facilities, or, if you are holding excess cash, could trigger repayment obligations under other facilities). You should also consider whether there is any other alternative source of liquidity (including “recycling” rather than distributing amounts received by the fund, drawing down capital commitments, recalling investors capital under the giveback provisions, and/or having underlying portfolio companies (if any) tap into their credit facilities), taking into consideration the length of time that you want to hold such amounts and the rates available, among other things.
In any event, you should carefully review your loan documents as the current circumstances may constitute an MAE under the documents, even if neither the manager nor the fund are materially adversely affected. As MAE provisions tend to be highly negotiated, the impact of COVID-19 may not be evident, although case law in various states can help determine what types of circumstances may constitute an MAE.
Q8: If I called capital for an investment that has fallen through due to the pandemic, do I have to return the capital to LPs?
A: There is no obligation to return capital to LPs by law, but the governing documents of your fund or the side letters may impose a requirement to do so. Such amounts returned to LPs would generally be recallable. Additionally, the fund LPA may provide that, if unused capital is returned to the LPs within a certain time, it will not “accrue” any preferred return.
Q9: How is the decrease in the value of public equity portfolios affecting the amount of capital available for private funds?
A: Many investors (including endowments and institutional investors) impose certain investment limits with respect to their investment portfolios, such that only a fixed percentage of investments each year is allocated to alternative investments. In addition, a limited percentage is often allocated to public equities. With the recent drop in value of the public equities markets, depending on when and how the percentage limit is calculated, the value of an investor’s alternative investments may now exceed the fixed percentage allocated for such investor’s portfolio. As a result, investors subject to such quotas who already have interests in private funds may be required to liquidate (if they can) or transfer their interests in private funds to maintain compliance with such quotas. Any such withdrawals (if permitted) or transfers could result in an over-concentration of certain investors and could trigger other regulatory and tax issues, including under the BHCA, ERISA, CFC, and PTP rules—among others that have limits that may need to be monitored on an ongoing basis and not just at the time of the initial investment. You should also consult your financing agreements. Certain lenders may want notice of, or may want to approve, the transfer. Additionally, investors that are subject to such quotas may be prohibited from making any further private fund investments for the remainder of the fiscal year.
Q10: If I see an increase in transfer requests, what information should I take into consideration when deciding whether or not to consent to a transfer? Do I have to consent to transfers?
A: Whether or not a transfer requires approval of the general partner or manager of a fund is a negotiated point and is typically addressed in the fund’s governing documents and/or side letters. The concept of “transfer” is typically defined broadly to include pledging and other changes relating to ownership and may include indirect transfers of an entity’s beneficial owners. Generally speaking, most funds require the consent of the general partner or manager of the fund prior to an investor being permitted to transfer its interests. When considering whether to consent to a transfer, the general partner typically considers a variety of factors, including: (1) whether the transfer causes the fund’s benefit plan investor percentage to equal or exceed the 25% threshold and results in the fund’s assets being deemed “plan assets” within the meaning of ERISA; (2) whether the transfer causes the fund to be treated as a “publicly traded partnership” or taxed as a corporation; or (3) whether the transfer results in a violation of any law, rule, or regulation by the limited partner, the fund, the general partner, or any member of the general partner. Permitting investors to exercise their rights (within the parameters set in the fund’s governing documents and/or side letters) to transfer or (if permitted) withdraw from the fund will be important though. As noted in the keynote address of the SEC’s Co‑Director of the Division of Enforcement Steven Peikin at the Securities Enforcement Forum West 2020, the Coronavirus Steering Committee formed to coordinate the Division of Enforcement’s response to coronavirus-related enforcement issues is focused on protecting investors’ liquidity rights and will be monitoring, among other things, for “failures to honor redemption requests at […] private funds.”
Q11: An LP has signaled that they will default, or has actually defaulted, on their capital commitment. What are my next steps?
A: The governing documents and side letters of your fund will provide when an investor becomes a defaulting investor and what remedies can be exercised against such investor. In many funds, the general partner must send a formal notice to a defaulting investor and allow for a cure period before the GP can impose default penalties on the investor. In addition to the many other consequences of a default, in certain cases, the defaulting investor will lose side letter rights. You should also consider whether any defaults could trigger certain legal or regulatory issues including, for example, the fund’s assets being deemed “plan assets” within the meaning of ERISA (because the 25% ERISA test is not measured based on commitments but rather on drawn down capital). Additionally, you should consider what will be your alternative sources of funding in the event of a default. Over calling from other investors may be an option (subject to the concentration concerns we mentioned in Q9 but also subject to other limitations, including, for example, side letters with the non-defaulting investors) or drawing down under a credit facility.
Q12: Should I seek to suspend the offering period and/or investment period for a specified length of time (e.g., six months) given the uncertainty and in order to buy some time to regroup and get back to fundraising and investing after this period of uncertainty?
A: A Preqin survey of managers from April 2020 showed that the pandemic had slowed the fundraising process for 55% of managers surveyed. Although for some managers the fundraising process was accelerated, there will be challenges in fundraising, including in part (among many other reasons) because investor due diligence may be more limited and because of the difficulties around valuing assets (which could be a deterrent for subsequent closers). Even if managers are able to raise funds, an over-concentration of certain investors can trigger certain regulatory and tax concerns (including under the BHCA, ERISA, CFC, and PTP rules, among other rules that have limits that may need to be monitored on an ongoing basis and not just at the time of the initial investment (as discussed in Q9 above)), although it may be possible to address those concerns with ratcheting mechanisms. Depending on the governing documents of the fund, it is likely that you cannot “suspend” the offering and/or investment periods, but you may be able to extend both, with (or without) some support from investors or from the advisory committee.
Q13: My fund is at the end of its term, and I was planning to wind down and dissolve this year. However, there are no longer any commercially viable options to sell the remaining assets due to the COVID-19 pandemic. What should I do next?
A: There will typically be no time limit under the governing documents of a fund to complete the wind-up and liquidation of the fund after dissolution. Additionally, if the governing documents of the fund allow for in-kind distributions, you could distribute the assets directly to the fund investors (although there may be restrictions under law, contract, and policy that limit your right to make distributions in kind). For example, the consent of the issuer of a security may be needed to transfer the security; an investor’s side letter may prohibit the distribution of assets in kind to such investor; laws (such as ERISA) may restrict distributions in kind to certain investors that such laws are intended to protect, and certain laws may require that the holders of the securities meet certain requirements (such as a 144A security needing to be held by a QIB). As an alternative to distributing the assets of the fund in kind, subject to the governing documents of the fund, you may consider distributing interests in a liquidating trust or other special purpose vehicle, or, if the fund has not been formally dissolved, ask for an extension of the fund’s term to continue managing the assets until a viable exit opportunity is available.
Q14: What if the fund or a portfolio company auditor cannot deliver a clean audit on time because of the COVID-19 pandemic?
A: The SEC’s Division of Corporate Finance has recently acknowledged in Disclosure Guidance that GAAP financial measures may not be timely available due to the impact of the COVID-19 pandemic and, in light of the current situation, the Division of Corporate Finance may allow public companies “to reconcile a non-GAAP financial measure to preliminary GAAP results that either include provisional amount(s) based on a reasonable estimate, or a range of reasonably estimable GAAP results.”
The SEC staff also updated its responses to its “frequently asked questions” to recognize that, in these circumstances, a fund that relies on the audit exception to the Custody Rule may not be able to deliver its audited financial statements within the prescribed 120 days (or 180 days in the case of a fund-of-funds) of fiscal year end. The SEC staff confirmed that it will not recommend enforcement action against an adviser for a violation of the Custody Rule if the adviser reasonably believed that its fund’s audited financial statements would be distributed within the required timeframes, but the adviser was unable to comply with this requirement due to unforeseeable circumstances. The staff also noted that it would not recommend enforcement against an adviser where the fund is subject to the surprise examination provisions of the Custody Rule, and the adviser reasonably believed that the independent auditor would complete the examination within the required time frame but failed to do so due to logistical disruptions caused by the response to COVID-19.
Q15: I have seen several scams related to COVID-19. Should I update my firm’s cybersecurity policy?
A: In light of recent scams and cybersecurity attacks, the Cybersecurity and Infrastructure Security Agency under the Department of Homeland Security has issued Risk Management Guidance, which we recommend you consult. While updating a firm’s cybersecurity policy is not specifically required, the agency has recommended that the workforce take a number of precautions, including avoiding clicking on links to an unsolicited email, adequately securing systems that enable remote access, and updating incident response plans to consider workforce changes in a distributed environment.
For more information on COVD-19 resources, please visit MoFo’s Coronavirus (COVID-19) Resource Center.
 As of May 19, 2020.
 “[A]n adviser’s fiduciary obligation to its clients includes the obligation to take steps to protect the clients’ interests from being placed at risk as the result of the adviser’s inability to provide advisory services after, for example, a natural disaster or, in the case of some smaller firms, the dealt of the owner or key personnel.” Compliance Programs of Investment Companies and Investment Advisers, SEC Rel. No. IA-2204 (Dec. 17, 2003) available at https://www.sec.gov/rules/final/ia-2204.htm#P102_22999.
 In particular in light of the SEC’s increased attention to risks that may arise out of the pandemic, as described in the keynote address of the SEC’s Co-Director of the Division of Enforcement Steven Peikin at the Securities Enforcement Forum West 2020 (https://www.sec.gov/news/speech/keynote-securities-enforcement-forum-west-2020). Among other things, the Coronavirus Steering Committee formed to coordinate the Division of Enforcement’s response to coronavirus-related enforcement issues has increased efforts to monitor for, and detect, insider trading and market manipulation under the current circumstances and are urging companies to “follow their disclosure controls and procedures to protect against the improper dissemination and use of [material nonpublic information].”
 See Division of Investment Management Coronavirus (COVID-19) Response FAQs available at https://www.sec.gov/investment/covid-19-response-faq.
 15%, according to the same Preqin survey.
 See Staff Responses to Questions About the Custody Rule available at https://www.sec.gov/divisions/investment/custody_faq_030510.htm.