[co-author: Elizabeth Poole]

On August 23, the United States Securities and Exchange Commission (the “SEC” or “Commission”) adopted rules and rule amendments (the “PFA Rules”) under the Investment Advisers Act of 1940 (the “Advisers Act”) that impose new requirements and obligations on investment advisers to private funds. In a series of blog posts on the PFA Rules, we summarized the most notable regulatory changes, analyzed the SEC’s new quarterly reporting requirements and reviewed the PFA Rules’ impact on adviser-led secondary transactions. This post addresses the “Restricted Activities Rule,” which restricts private advisers from engaging in the following activities absent satisfaction of certain disclosure and consent requirements: (i) charging clients for regulatory, compliance and examination fees and expenses; (ii) reducing the adviser’s clawback obligations for taxes; (iii) allocating portfolio (or prospective portfolio) investment-related fees and expenses in a non-pro rata manner; (iv) charging clients for governmental or regulatory investigation-related fees; and (v) borrowing from clients (collectively, the “Restricted Activities”). Notably, the Restricted Activities Rule applies to all private fund advisers, not just those registered with the SEC.

As described in the SEC’s adopting release, the Commission’s chief aim in adopting the Restricted Activities Rule is to confront the conflicts of interest created by the Restricted Activities, thereby protecting investors from adviser fraud and deception. The PFA Rules release placed particular emphasis on adviser transparency, noting investment advisers’ alleged failure to provide sufficiently detailed information to investors on a consistent basis. In a significant departure from the Commission’s initial proposal to completely prohibit the Restricted Activities (the “Proposed Rule”), the final Restricted Activities Rule generally provides either a disclosure- or consent-based exception for each Restricted Activity. The Restricted Activities are grouped below based on whether disclosure-based or consent-based exceptions apply, and the post concludes with a summary of certain activities addressed by the Proposed Rule that the SEC ultimately did not restrict under the Restricted Activities Rule because it determined they are already sufficiently addressed by advisers’ fiduciary duties.

Restricted Activities with Disclosure-Based Exceptions

Regulatory, Compliance and Examination Fees and Expenses. The Restricted Activities Rule prohibits private fund advisers from charging their clients for regulatory or compliance fees and expenses of the adviser or its related persons and fees and expenses associated with any governmental or regulatory examination of the adviser or its related persons unless the adviser distributes a quarterly written notice of such fees or expenses, including the dollar amounts thereof, to private fund investors within 45 days after the end of the fiscal quarter in which the charge occurs. The “distribution” requirement, as used throughout the Restricted Activities Rule, contemplates delivery of a document to all investors in the private fund. A notification is not “distributed” pursuant to the Restricted Activities Rule when it is sent only to an investor in a pooled vehicle in a control relationship with the adviser or its related persons. Rather, the Restricted Activities Rule requires an adviser to “look through” any pool(s) and send the relevant notice to the underlying investors; however, since a control relationship is not present in the context of investors in a fund of funds, advisers are not required to look through to underlying investors in that context.

The Restricted Activities Rule’s disclosure exception attempts to quell commenters’ concerns that a per se prohibition ignores the market reality that such fee arrangements are heavily negotiated by investors. Moreover, in light of the positive correlation between compliance costs and portfolio diversification, one commenter feared an outright prohibition on charging regulatory and compliance fees and expenses to clients would deprive investors of the option to pay higher compliance costs to achieve greater diversification. Others warned that the prohibited fees and expenses would just be passed on to investors through higher management fees. Ultimately, the SEC defended its disclosure requirement as a mechanism to increase transparency around current market practice and protect investor expectations.

After-Tax Reduction of Adviser Clawbacks. The Restricted Activities Rule prohibits advisers from reducing the amount of any adviser clawback by actual, potential or hypothetical taxes unless the adviser provides written notice of the aggregate dollar amounts of the adviser clawback before and after the tax reduction to investors within 45 days of the end of the fiscal quarter in which it occurs. The SEC’s initial proposal to prohibit such reductions was met with assertions that advisers could end up in a worse after-tax position if clawbacks were prohibited from being net of taxes because taxes remitted for excess performance-based compensation generally cannot be recouped by amending prior tax returns, and any potential tax benefits from realizing subsequent losses are rarely realized in practice.

Commenters described an array of potential consequences of a total prohibition, including: (i) disincentivizing clawback mechanisms (which benefit investors), (ii) increasing management fees, (iii) influencing the timing of portfolio management decisions to avoid clawback liabilities, and (iv) imposing a disproportionate burden on smaller advisers that heavily rely on performance-based compensation. To mitigate such unintended consequences, the SEC added a disclosure-based exception, which aims to increase adviser transparency, thereby empowering investors to analyze and assess each clawback and its implications for investor returns.

Portfolio Investment-Related, Non-Pro Rata Fee and Expense Allocations. The Restricted Activities Rule requires investment advisers to charge portfolio (or prospective portfolio) investment-related fees and expenses on a pro rata basis unless a non-pro rata allocation is (i) fair and equitable under the circumstances and (ii) the adviser distributes to each investor of the private fund advance written notice of the non-pro rata charge or allocation and an explanation of why it is fair and equitable under the circumstances. The Commission explained that fairness and equitability essentially depend on the facts and circumstances related to the applicable expense. While the “regulatory, compliance, and examination fees and expenses” and the “post-tax clawback” restrictions require subsequent disclosure, the non-pro rata fee allocation restriction requires advance disclosure to enable investors to engage in informed discussions with an adviser before being charged non-pro rata fees or expenses. The SEC chose not to define “pro rata” in order to afford advisers flexibility in selecting a method of pro rata allocation, noting that the term typically refers to ownership percentages.

The Proposed Rule would have prohibited advisers from charging portfolio (or prospective portfolio) investment-related fees and expenses on a non-pro rata basis in order to protect smaller investors with less bargaining power. The fairness and equitability prong of the Restricted Activities Rule recognizes the economic reality that pro rata expense allocation is not necessarily equitable, such as when tax liabilities are attributable to a single investor or when certain transaction structuring-related expenses are due to characteristics of a subset of investors. Additionally, some commenters voiced concern that the Proposed Rule would stifle co-investment activity given its time-sensitive nature and because advisers may lack sufficient leverage to require co-investors to bear their pro rata share of fees and expenses. Despite the shorter timeline for co-investments, the Commission noted that compliance can occur simultaneously with other co-investment pre-closing activities (such as review of fund agreements by investors and side letter negotiations), reiterating its belief that any incremental burden on co-investment deals is far outweighed by investor protection considerations.

Restricted Activities with Consent-Based Exceptions

Investigation Fees and Expenses. The Restricted Activities Rule prohibits an adviser from charging or allocating to a private fund fees or expenses associated with a governmental or regulatory investigation of the adviser or its related persons unless the adviser seeks consent from all of the fund’s investors and obtains written consent from at least a majority-in-interest of investors unrelated to the adviser for such charge or allocation. Notably, the consent-based exception does not apply to fees or expenses related to an investigation that results in court or governmental sanctions for a violation of the Advisers Act, which are never permitted to be allocated to clients.

The Proposed Rule would have banned advisers from charging clients for investigation-related fees, but commenters warned that a blanket prohibition would prevent investors from negotiating their own fee arrangements and result in higher management fees. The Commission settled on a consent-based restriction to address these concerns, noting that such an approach would encourage advisers to take precautions to avoid triggering an investigation and to limit investigation-related fees. Absent this requirement, the SEC asserted that investors would unjustly bear both the investigation expenses and any potential harm resulting from an adviser’s underlying misconduct. Moreover, according to the Commission, the outright prohibition on an adviser charging fees and expenses related to an investigation resulting in sanctions prevents the adviser from forcing its clients to acquiesce to the adviser’s wrongdoing.

Borrowing. The Restricted Activities Rule prohibits advisers from borrowing from a client unless the adviser distributes to all investors of the private fund a written notice, including a description of the material terms of the transaction, seeks their consent and obtains written consent from at least a majority-in-interest of the investors that are not related persons of the adviser. The restriction does not apply to borrowings from a third party on the fund’s behalf or to an adviser’s borrowings from individual investors outside the fund; rather, the restriction targets an adviser’s borrowings from its client’s assets for its own use.

The Proposed Rule would have prohibited such borrowings, which commenters feared would stifle investor-friendly borrowing arrangements (such as tax advances and certain affiliated service provider activities) and limit otherwise lawful transactions (such as securities purchases by an adviser from its client when accompanied by requisite disclosures and consents). Other commenters viewed the Proposed Rule as unnecessary because advisers rarely borrow from fund clients. The SEC ultimately adopted the consent-based restriction to protect investors from the conflict of interest intrinsic to borrowing transactions whereby the adviser benefits from the loan and manages the client lender (i.e., an adviser’s interest in a lower interest rate and a client’s interest in a higher interest rate), particularly because investment advisers typically have broad authority to act on behalf of the fund. According to the SEC, mere disclosure is insufficient because of the structure of private funds, which positions only certain investors to access relevant information and negotiate or monitor adviser borrowing. Despite comments suggesting the distribution of notice via regulatory filings, the Restricted Activities Rule reflects the Commission’s belief that direct disclosure to investors accompanied by an adviser’s consent request is necessary to timely resolve any conflicts related to adviser borrowings. Finally, the SEC clarified that certain ordinary course practices, such as tax advances and management fee offsets, are not borrowings subject to the Restricted Activities Rule because they constitute a reduction in an adviser’s future income rather than borrowings subject to repayment.

Activities Subject to Fiduciary Duty Obligations

Fees for Unperformed Services. The SEC did not adopt the Proposed Rule’s prohibition on charging fees for services that an investment adviser does not, or does not reasonably expect to, provide to the portfolio investment. The Commission viewed the Proposed Rule as redundant because such conduct almost always constitutes a breach of the adviser’s fiduciary duty, particularly in light of commenters’ statements that it is market practice for fund documents to prohibit advisers from charging fees for unperformed services.

The Waiver or Indemnification Prohibition. The Commission did not adopt the Proposed Rule’s prohibition on advisers seeking reimbursement, indemnification, exculpation or limitation of liability by the private fund or its investors for breach of fiduciary duty, willful misfeasance, bad faith, negligence or recklessness in providing services to the private fund (the “waiver or indemnification prohibition”). Many commenters expressed staunch opposition, citing higher costs for investors, increased risk of private litigation, lower adviser risk tolerance resulting in lower investor returns and a disproportionate burden on retail investors as compared to institutional investors. Because a waiver of an adviser’s antifraud liability for breach of fiduciary duty is invalid under the Advisers Act, the Commission characterized the Proposed Rule as unnecessary. The SEC thus emphasized and clarified the scope of adviser fiduciary duties and the application of antifraud provisions to an adviser’s dealings with clients and fund investors, providing two examples of antifraud violations: a contract provision (“hedge clause”) waiving (i) all of the adviser’s fiduciary duties or (ii) its federal fiduciary duty, in each case absent language clarifying the client’s retention of certain non-waivable rights (a “savings clause”).

Application to Existing Funds

Larger private fund advisers (with $1.5 billion or more in private funds assets under management) must achieve compliance within 12 months of the PFA Rules’ publication in the Federal Register (by September 14, 2024), while smaller private fund advisers (with less than $1.5 billion in private funds assets) have an 18-month transition period in which to comply (by March 14, 2025). The SEC is also amending rule 204-2 of the Advisers Act to require SEC-registered investment advisers to retain books and records to demonstrate their compliance with the disclosure and consent requirements of the Restricted Activities Rule.

Additionally, “legacy status” does not apply to the disclosure-based requirements, but it does apply to both of the consent-based requirements of the Restricted Activities Rule, namely the borrowing restriction and investigative fees restriction, subject to the complete prohibition on charging fees related to an investigation resulting in sanctions. Essentially, governing agreements executed prior to the compliance date will be grandfathered if the Restricted Activities Rule would otherwise require that they be amended.