Private Fund Rule Series | Part 3
Main Contributor: Samuel Carralejo, Compliance Manager
Background
This article analyzes the Restricted Activities Rule, adopted on August 23, 2023, as part of the Securities and Exchange Commission’s (“SEC”) new Private Fund Rule. This is the third of our series breaking down the Private Fund Rule. If you have not already done so, we encourage you to first read Parts 1 and 2. In Part 1, we overviewed the Private Fund Rule and detailed the Quarterly Statement and Written Annual Review Rules. In Part 2, we examined the Financial Audit and Adviser-Led Secondaries Rules.
Applicability
Unlike most other rules adopted under the Private Fund Rule, the Restricted Activities Rule applies to all private fund advisers, not just SEC-registered advisers. This means exempt reporting advisers, state-regulated advisers, and foreign private fund advisers must also comply. Note, however, advisers need not comply with the Private Fund Rule with respect to securitized asset funds.
Compliance Date
Smaller advisers—those with less than $1.5 billion in private fund assets under management, calculated as of the last day of the adviser’s most recently completed fiscal year—must comply with the Restricted Activities Rule by March 14, 2025, while larger advisers must comply by September 14, 2024.
Restricted Activities – Rule 211(h)(2)-1
Broadly, the Restricted Activities Rule prohibits private fund advisers from engaging in certain expense allocation practices, reducing adviser clawback for taxes, and borrowing from the fund. But contrary to the rule’s name, advisers are not flatly prohibited from engaging in these “restricted” activities as the rule provides certain disclosure and consent-based exceptions. Additionally, advisers are broadly exempt from complying with the restricted activities rules when complying would require the adviser to amend a pre-existing contract. Below, we outline the five (5) restricted activities, the pre-existing contract exception, and the associated books and records requirements.
Restricted Activities with Disclosure-Based Exceptions
(1) Charging regulatory, compliance, and examination fees to the private fund
Rule: Private fund advisers may not, directly or indirectly, charge or allocate to the private fund any regulatory or compliance fees or expenses, or fees or expenses associated with an examination of the adviser or its related persons, unless the adviser:
(i) Distributes a written notice of any such fees or expenses, including the specific dollar amount, to the private fund investors within 45 days after the fiscal quarter in which the charge occurs.
Indeed, an adviser must disclose all regulatory and compliance fees it allocates to the fund, not just those associated with an examination. This includes filing fees (e.g., Form ADV, Form PF, and other SEC or state filing fees) and fees paid to third-party compliance consultants. The SEC did not offer additional guidance as to the extent to which certain legal or other fees would be categorized as a regulatory or compliance expense. But in its reasoning, the SEC explained that the adviser’s management fee customarily factors in various integral “costs of doing business.” And since compliance is an integral part of managing a private fund, it is assumed advisers factor these fees into their management fee. As a result, the SEC believes charging compliance-related fees separately is a form of additional compensation that advisers must adequately disclose to investors. Therefore, in assessing whether it must disclose certain fees as a regulatory or compliance expense, the adviser should consider whether the fee is a fundamental cost.
To an extent, this rule overlaps with the quarterly statement rule as the quarterly statement rule requires advisers to breakdown all fees they allocate to the fund, which would include regulatory, compliance, and examination fees. As such, SEC-registered advisers must still disclose these fees in their quarterly statements, even if they distribute the written notices required under this rule separately.
(2) Reducing adviser clawback for taxes
Rule: Private fund advisers may not, directly or indirectly, reduce the amount of an adviser clawback by actual, potential, or hypothetical taxes applicable to the adviser, its related persons, or their respective owners or interest holders, unless the adviser:
(i) Distributes a written notice to the private fund investors setting forth the aggregate dollar amount of the adviser clawback before and after any reduction for actual, potential, or hypothetical taxes, within 45 days after the fiscal quarter in which the clawback occurs.
What is adviser clawback? The SEC defines adviser clawback as “any obligation of the adviser, its related persons, or their respective owners or interest holders to restore or otherwise return performance-based compensation to the private fund pursuant to the private fund’s governing agreements.”
For example, a fund’s governing documents may entitle the adviser to a periodic performance-based fee, provided it achieves a specified minimum return (i.e., hurdle rate). But if the fund’s performance fluctuates over time, the adviser may ultimately receive more than its rightful share of performance-based compensation by the time the fund liquidates. This receipt of excess compensation can trigger a clawback provision, requiring the adviser to return the excess compensation received. When returning the excess compensation to the fund, the adviser might subtract the taxes it paid on that excess compensation from the total amount it returns to the fund.
Advisers that reduce clawback for taxes can allocate the risk of tax liability to the fund when it would otherwise be attributable to and borne by the adviser. Not only does this create a conflict of interest, but it also reduces the fund’s returns. Additionally, the SEC believes investors often lack detailed information regarding the extent of adviser clawback reductions and their impact on fund profits. Accordingly, the SEC now restricts advisers from reducing clawback for taxes unless advisers disclose the specific clawback amount before and after tax reductions.
45-Day Timeline: The 45-day quarter-end disclosure timeline generally matches the timeline for distributing quarterly statements under the new quarterly statement rule, so advisers can often disclose regulatory, compliance, and examination fees and clawback reductions in their quarterly statements. However, advisers have 90 days to deliver the fiscal year-end quarterly statement. Also, fund-of-fund advisers have 75 days to deliver quarterly statements (and 120 days to deliver the fiscal year-end quarterly statement). In these instances, the adviser cannot rely on the quarterly statement to deliver the disclosures.
(3) Charging portfolio investment-related expenses on a non-pro rata basis among private funds
Rule: Private fund advisers may not, directly or indirectly, charge or allocate fees or expenses related to a portfolio investment (or potential portfolio investment) on a non-pro rata basis when multiple private funds and other clients advised by the adviser or its related persons have invested (or propose to invest) in the same portfolio investment, unless:
(i) The non-pro rata charge or allocation is fair and equitable under the circumstances; and
(ii) Before charging or allocating such fees or expenses to a private fund client, the adviser distributes to each private fund investor a written notice of the non-pro rata charge or allocation, including a description of how such non-pro rata charge is fair and equitable under the circumstances.
Private fund advisers often manage multiple funds, each with unique compensation and ownership structures. This presents a conflict of interest when multiple private funds invest in the same company, or “portfolio investment,” as advisers are incentivized to allocate portfolio investment expenses among the funds to maximize the adviser’s interests rather than each private fund’s interest. For example, an adviser is incentivized to minimize allocating portfolio investment expenses to higher fee-paying funds—at the lower fee-paying fund’s expense—to increase its compensation. Advisers may also be inclined to allocate expenses away from the fund in which they or their related persons have a larger ownership interest. Accordingly, in order to allocate portfolio investment-related expenses on a non-pro-rata basis, advisers must treat their funds fairly and equitably and notify investors in advance.
What is fair and equitable? In typical SEC fashion, what constitutes “fair and equitable” treatment will be based on the specific facts and circumstances. But this does not necessarily mean advisers must treat their funds identically. While the SEC does not explicitly define the fair and equitable standard, it notes that relevant factors may include whether the expense:
(i) Relates to a specific type of security that one private fund client holds;
(ii) Relates to a bespoke structuring arrangement for one private fund client to participate in the portfolio investment; or
(iii) Benefits one private fund more than others, such as the potential benefit of certain insurance policies.
The SEC also declined to define “pro rata,” allowing advisers flexibility in their methodology to determine their pro rata allocations.
What should the advance notice include? The SEC did not prescribe specific information the notice must include, but stated that relevant factors the adviser should consider addressing include:
(i) The adviser’s allocation approach; and
(ii) The reasons why the adviser believes its non-pro rata allocation is fair and equitable under the circumstances.
Remember, unlike the compliance-related fee and adviser clawback notices discussed above, the adviser must deliver the non-pro-rata allocation notice to private fund investors before it allocates the expense.
“Distribute”: Under the rule’s “distribute” definition, when the private fund client is a pooled investment vehicle that is controlling, controlled by, or under common control with the adviser or its related persons, the adviser must look through that pool and send the applicable notice to the underlying investors. Also, advisers may not use layers of pooled investment vehicles to avoid meaningfully distributing the notices.
Restricted Activities with Consent-Based Exceptions
(4) Charging investigation-related expenses to the private fund
Rule: Private fund advisers may not, directly or indirectly, charge or allocate to the private fund fees or expenses associated with an investigation of the adviser or its related persons by any governmental or regulatory authority, unless the adviser:
(i) Requests that each private fund investor consent to such charge or allocation; and
(ii) Obtains written consent from a majority in interest of the private fund’s investors that are not related persons of the adviser.
But in no case shall the adviser charge or allocate to the private fund fees or expenses related to an investigation that results in a court or governmental authority imposing a sanction for violating the Investment Advisers Act of 1940 (“Advisers Act”).
Because investigations are focused on the adviser’s potential or actual wrongdoing, the SEC believes advisers should rightfully bear investigation costs. Investors may also generally assume the adviser must pay expenses associated with its own malfeasance. Without obtaining explicit consent, the SEC fears advisers are incentivized to engage in questionable conduct because advisers know they can simply forward potential investigation fees to investors who are not adequately informed of this practice. Accordingly, advisers are now prohibited from passing investigation fees (e.g., lawyers’ fees) to the fund unless they obtain prior investor consent.
The SEC acknowledged that governmental or regulatory bodies do not always formally notify an adviser that it is under investigation. In these instances, the adviser must assess whether it is under investigation based on the information available at the time.
Nevertheless, regardless of investor consent, an adviser may not allocate any investigation-related expenses when the adviser is sanctioned, as the SEC views this as the adviser waiving its liability and requiring its clients to acquiesce to the adviser’s violation. Therefore, if the adviser previously obtained investor consent and allocated the pending investigation expenses to the fund, then, upon sanction, the adviser must reimburse the fund.
More on consent: Advisers are generally free to prescribe the manner and process by which they obtain investor consent. Advisers may not, however, obtain blanket consent from investors, such as obtaining consent at the onset of the engagement through the fund’s governing documents. Rather, advisers must obtain investor consent for each specific investigation or borrowing. But while the adviser must request consent from each investor, it needs only obtain consent from a majority in interest of investors (that are not related persons of the adviser). In any case, advisers and fund investors may agree to a higher consent threshold.
(5) Borrowing from the private fund
Rule: Private fund advisers may not, directly or indirectly, borrow money, securities, or other private fund assets, or receive a loan or an extension of credit, from a private fund client, unless the adviser:
(i) Distributes to each private fund investor a written description of the material terms of, and requests each investor consent to, such borrowing, loan, or extension of credit; and
(ii) Obtains written consent from a majority in interest of the private fund’s investors that are not related persons of the adviser.
Private fund advisers that obtain loans from their managed funds, in essence, have the power to dictate their own loan terms. But the adviser’s interests are not necessarily aligned with the fund’s interests. For example, the adviser is interested in paying a low interest rate, while the fund is interested in maximizing profits. A loan to the adviser also prevents the fund from employing that capital to further its investment strategy. Accordingly, the SEC now requires advisers to obtain investor consent before borrowing to allow investors to evaluate whether the borrowing would be favorable for the fund and potentially negotiate the borrowing terms.
The SEC clarified that this restriction does not apply to fund loans to third parties or an adviser borrowing from individual investors outside the fund relationship. Tax advances and management fee offsets are also generally outside the rule’s purview.
What terms are material? Materiality will be based on—you guessed it—facts and circumstances. Though it does mandate specific loan terms to include, the SEC offered a few examples, including the:
(i) Loan amount;
(ii) Interest rate; and
(iii) Repayment schedule.
Pre-Existing Contract Exception
In addition to the case-by-case exceptions within each of the rules above, a broad exception applies to pre-existing contracts governing a private fund, borrowing, loan, or extension of credit entered by a private fund, as applicable. Specifically, an adviser need not comply with the restricted activities rules if three (3) conditions are met:
(i) The private fund has commenced operations as of the compliance date (March 14, 2025, or September 14, 2024, as applicable);
(ii) The agreement was entered into in writing before the compliance date; and
(iii) Complying with the rule would require the parties to amend such governing agreements.
Nevertheless, private fund advisers still may not charge or allocate to the private fund fees or expenses related to an investigation that results in a court or governmental authority sanctioning the adviser for violating the Advisers Act.
Books and Records
SEC-registered advisers must maintain the following books and records in connection with the Restricted Activities rules:
(i) A copy of any notification, consent, or other document distributed under the Restricted Activities rules; and
(ii) A record of each addressee and the corresponding date(s) sent.
Though not required, non-SEC-registered advisers should also consider maintaining these records, as it would allow them to demonstrate compliance, if needed.
Conclusion
Aimed at enhancing transparency, the Restricted Activities Rule represents a significant development in private fund regulation. It will take time for advisers to implement policies and procedures addressing these changes. Fortunately, advisers have time to prepare. Smaller advisers—those with less than $1.5 billion in private fund assets under management—have until March 14, 2025, to comply, while larger advisers have until September 14, 2024. In any case, advisers would be prudent to begin strategizing now. Of course, feel free to reach out to SCS to help with implementation and compliance!
Keep posted for the final installment of our Private Fund Rule Series, where we will explore the Preferential Treatment Rule.