Private Fund Adviser Rule Q&A: Spotlight On Restricted Activities

• Regulatory/Compliance Fees: Regulatory/compliance fees may be charged to a private fund when these fees are disclosed in writing to existing investors, within 45 days following the end of the relevant fiscal quarter.
• Investigation Fees: Investigation fees may be charged to a private fund when there is an investigation of the adviser or its related persons by any governmental or regulatory authority, provided that the adviser seeks consent from each investor and obtains written consent from at least a majority in interest of investors that are not related persons of the adviser. However, if the result of the investigation is a sanction under the Advisers Act (even without admitting/denying), the adviser is in all cases prohibited from charging such fees to the fund (regardless of consent). 
• Non-pro rata fees: Charging non pro-rata fees related to portfolio investments is permitted where the allocation approach is “fair and equitable” and the adviser provides advanced, written notice to all investors of the charge and also describes how the allocation approach is fair/equitable under the circumstances.
• Adviser clawbacks: Reducing adviser clawbacks for taxes is permitted where the adviser discloses the aggregate (gross) amount of adviser clawback before and after a reduction for taxes, within 45 days following the end of the relevant fiscal quarter.
• Borrowings: Borrowing from clients is permitted where the adviser distributes to each investor a written description of the material terms of the borrowing and requests from each investor and obtains written consent from a majority in interest of investors that are not related persons of the adviser.

Q: Disclosure is a key component of an adviser’s ability to engage in these specific restricted activities. How detailed must the disclosure be?

A: The standard is “informed consent.” The SEC stated that informed consent requires clear and detailed disclosure sufficient such that the investor understands the material facts and potential conflicts of interest.

Q: The restricted activities provisions apply to an adviser’s direct or indirect actions as it relates to certain actions taken with respect to any private fund, or any investors in a private fund – is there an implication to consider here?

A: This language is not uncommon in the SEC’s rulebook, but when used, can be viewed as, among other things, broadening the SEC’s ability and/or likelihood that it more readily challenges what it perceives as overly narrow interpretations to be an adviser doing something indirectly that it is prohibited from doing directly.

Q: The SEC proposed to prohibit an adviser from charging a private fund for certain fees in advance (e.g., prepaid monitoring/consulting/servicing fees), but chose not to adopt or otherwise modify the prohibition and include it in the restricted activities rule.  Are there any risks if I charge this type of fee in advance of earning it?

A: While the provision was technically dropped from the adopted rule, the SEC made clear that it was doing so because it viewed such conduct as already prohibited under the Advisers Act antifraud provisions. The SEC also made clear that where an adviser charges such fees, it must have a “reasonable belief” that it expects to provide the service and return such fees to the fund/fund investors if the services are not performed or otherwise earned.

Q: What are examples of “regulatory/compliance expenses?”

A: The overarching theme in determining what types of fees are “regulatory/compliance expenses” is to capture expenses that an investor reasonably believes would be part of an adviser’s overhead and, therefore, part of the adviser’s management fee separately charged. Typically, these expenses include registration/Form ADV costs, compliance reviews, use of compliance consultants/law firms, costs associated with preparing regulatory filings (e.g., Form D, Form PF), and costs to comply with new rules (e.g., these private fund adviser rules).

Q: An adviser charges regulatory/compliance expenses to a private fund and adds language permitting this in its PPM.  Beyond this disclosure, is it sufficient to add the amount of such fees (once charged) to the fund table that is part of the new quarterly report requirement? 

A: Yes, for quarters where the report is delivered within 45 days of quarter-end. The SEC purposefully set the timeline for disclosing regulatory expenses to align with the 45-day quarterly statement requirement (for 3 of the 4 quarters, at least). Accordingly, the quarterly statement can be used as the means of distribution and notice, except for the last quarter of the year (if the adviser uses the extra 45 days allowed). However, the adviser must still evaluate what level of detail to present in terms of “regulatory/compliance” expenses. 

Q: What level of detail is required in these disclosures?

A: The Adopting Release is unclear on how granular the disclosures must be to comply with the rule. We know a few things for sure: The adviser must use descriptive categories with associated dollar amounts – and, on one end of the spectrum, using a general category of “compliance fees” with an aggregate dollar amount is not sufficient. On the other end of the spectrum, disclosing “charges incurred to file Form PF” is likely too detailed. Somewhere in the middle may yield an acceptable result (e.g., “costs related to SEC examination,” “the cost of regulatory filings,” “the cost of compliance with proposed or new rules,” “registration costs,” or “regulatory costs for investment activity”). 

Q: What is the takeaway/practice point?

A: Advisers may continue to charge private fund clients the adviser's costs associated with regulatory and compliance obligations. However, advisers should contemplate the types of fees to be charged to the private fund and create a categorization framework – which types of expenses are related to the adviser’s business and which types of expenses are related to fund operations (with the former being subject to this rule). It is also critical to ensure that a private fund’s offering documents identify (with specificity) and authorize such fees to be charged through to the fund. In the event of an examination, SEC examiners will likely focus on any material expenses charged through to a fund that seem to fall within the compliance/regulatory area but are not sufficiently identified in the governing documents. Thus, the more clear and detailed the PPM disclosure/authorization, the better the likelihood that it provides a reasonable level of aggregation/categorization of the fee disclosures, particularly if, in the quarterly statement, there are cross-references to the corresponding offering document disclosure.

Q: What qualifies as an “investigation?” How are examination-related expenses different from expenses associated with an investigation?

A: The Adopting Release does not define an “investigation.” However, an investigation would likely include an allegation of wrongdoing (as compared with SEC examinations, sweep examinations, and responses to deficiency letters, which would be part of regulatory/compliance expenses as discussed above). Investigation fees are also different from examination-related expenses because charging a private fund for investigation-related costs requires specific investor consent before these expenses can be passed along, and if the investigation results in a sanction under the Advisers Act, then those expenses may not, in any event, be charged to a fund.

Q: How will an adviser know when an expense is (or becomes) an “investigation” expense?

A: The SEC acknowledges that it may not be clear when an investigation starts and/or the adviser may not know that an investigation is occurring. Nonetheless, the adviser will have to identify when the investigation starts, because that triggers the possibility of charging the fund for related costs, provided investor consent is obtained. One way to tell – if communications come from the SEC’s Division of Enforcement (rather than, for example, the Division of Examinations), it is likely that the subject-matter involved has become an “investigation.”

Q: My private fund’s offering documents already address charging for “litigation” expenses (or otherwise have an indemnification provision), but do not use the term “investigation.” Is investor consent still required?

A: Litigation expenses would likely be sufficient to cover “investigations.” If the fund’s offering documents (as they exist before the compliance date) are clear on the provision and, for example, include carveouts to prohibit the adviser from charging for fees related to an investigation that results in a sanction under the Advisers Act, the adviser can most likely rely on the rule’s legacy provision and avoid seeking and obtaining investor consent (though disclosure of the amounts will still be required). For funds formed after the compliance date, or language added to an existing fund's governing documents after the compliance date, an adviser would need to seek consent from investors and would not be able to rely on the legacy provisions. In any event, if the offering documents are not clear, then the adviser should clarify prior to the compliance date that litigation expenses include investigation expenses and revise any indemnity clause to include the required sanctions carveout. 

Q: If an adviser is undergoing an investigation, should the adviser charge these costs to the fund on an ongoing basis or wait until the investigation is closed?

A: Provided that the requisite consent has been obtained, the adviser has latitude to decide whether to charge the expense to the fund as incurred, or instead wait until the conclusion of the matter. As a general matter, whether to charge a private fund for costs related to an investigation requires a cost-benefit analysis. Doing so before the investigation has concluded may pose reputational issues; however, investigation-related costs may be very expensive and a cost not appropriately absorbed by the adviser. If the adviser obtains the required investor consent and chooses to charge expenses on an ongoing basis, and the adviser is ultimately sanctioned under the Advisers Act, the adviser has to refund any charges assessed/collected from the fund (which could raise further issues under the rule if the adviser does not have funds available to timely reimburse the fund). One option would be to consider if insurance policies may cover such costs.

Q: What is required for investor consent? Is negative consent permissible?  Can the consent be sought in advance through the offering documents?

A: The SEC did not address in the adopting release whether negative consent would be permissible, and it remains an open question. In addition, the SEC does not seem to approve of (or at least contemplate) that advance consent would be permissible (e.g., the rule’s cost-benefit analysis assumes separate costs to obtain such consents). The adviser may also consider prescribing the manner in which the “majority in interest” of unaffiliated private fund investors is determined (and also, for example, exclude non-voting interests or defaulting investors).

Q: What types of fees/expenses “are related to a portfolio investment” and therefore in scope with regard to charging such fees on a non-pro rata basis?

A: The Adopting Releases identifies as examples: asset-level due diligence; accounting; valuation; legal; research; travel; professional fees; deal sourcing; and broken-deal expenses. 

Q: Does the SEC define or otherwise provide guidance around what a “pro rata” allocation method means?

A: The Adopting Release does not define “pro rata.” The SEC acknowledges that pro rata calculations can be done in different ways, however. For example, an adviser could exclude non-participating investors from an otherwise pro rata allocation.

Q: The non-pro rata allocation must be “fair and equitable.” What qualifies as “fair and equitable?

A: The SEC provided a few examples of situations where a non-pro rata basis would meet the standard: (i) the expense relates to a specific type of security one private fund holds; (ii) the expense relates to a bespoke structuring arrangement for one private fund to participate in the portfolio investment; or (iii) one private fund stands to gain a particular benefit from the expense relative to other private funds that hold the same investment. However, if there is a conflict of interest, then the fair and equitable standard is unlikely to be met. An adviser that wants to avoid SEC scrutiny may choose to allocate fees equally/pro rata across all private funds to simplify the issue – advisers who take this approach should consider that doing so may result in disproportionate payment of fees by investors in funds with simpler structures – a potential result that should be disclosed in a fund’s offering documents.

Q: Although this provision does not require investor consent, it does (unlike other provisions), require disclosure to investors in advance of charging such fees through to the fund.  Does this raise any concerns?

A: The SEC is concerned with co-investments and these vehicles being set up by an adviser or its related persons and not taking on their share of related expenses. The advance notice requirement could potentially delay or derail a co-investment deal that typically moves at a fast pace. With regard to providing notice, advisers may consider distributing required notices early (both the amount of the charge and a description of how the non-pro-rata allocation is fair/equitable), which can be done before investors are admitted to the co-investment vehicle and during transaction review. In addition,  if a co-investment vehicle is never formed, the adviser should likely disclose to investors that it may be seen as a non-pro-rata allocation. Finally, advisers should beware of continuing to charge broken-deal expenses to a fund with no allocation to the co-investment vehicle.