Investment Board (June 22, 2022) (``Canada Pension Comment Letter'')
(suggesting that the SEC require disclosure of certain activities
rather than prohibiting them outright); SBAI Comment Letter; MFA
Comment Letter I.
    \615\ See, e.g., Schulte Comment Letter; ILPA Comment Letter I.
    \616\ See MFA Comment Letter I.
    \617\ See Convergence Comment Letter; Invest Europe Comment
Letter.
---------------------------------------------------------------------------

    We continue to believe that these activities involve conflicts of
interest (e.g., borrowing directly from a private fund client may
benefit the adviser while not being in the best interest of the fund)
and compensation schemes (e.g., passing certain expenses \618\ on to
funds, which increases the adviser's revenue and decreases the fund's
profits) that are contrary to the public interest and the protection of
investors. In addition, adopting protective restrictions on these
activities is reasonably designed to prevent fraud and deception.
---------------------------------------------------------------------------

    \618\ See supra section I (discussing ``reimbursements'' as a
form of ``compensation'').
---------------------------------------------------------------------------

    Many of our concerns with these activities have persisted despite
our related enforcement actions, and we believe therefore that further
regulation is required. Investors often lack sufficient insight into
the nature, scope, and impact of these activities, given that advisers
do not frequently or consistently provide investors with sufficiently
detailed information about them. In this regard, some commenters stated
that many advisers do not provide disclosure of the activities covered
by the restrictions and, when disclosure is provided about those
activities, it is often incomplete or includes unhelpful
information.\619\ In addition, the limitations of private fund
governance structures, discussed in detail above, warrant enhanced
investor protection with respect to these activities.\620\ For example,
current private fund governance mechanisms, such as the LPAC, may not
have sufficient independence, authority, or accountability to
effectively oversee and consent to conflicts or other harmful
practices.
---------------------------------------------------------------------------

    \619\ See Healthy Markets Comment Letter I (stating that
information is often unavailable or incomplete regarding these
activities that may simply serve to enrich persons related to their
investment advisers); ILPA Comment Letter I (stating that itemized
disclosure of compliance costs is currently insufficient); NEBF
Comment Letter (stating that it is difficult for investors to
observe, track, and evaluate the costs and expenses that advisers
shift to private funds); IFT Comment Letter (stating that some fund
advisers have ignored requests for baseline information about fees
and expenses).
    \620\ See supra section I.A.
---------------------------------------------------------------------------

    After considering comments, and for the reasons discussed below in

connection with each restricted activity, we have determined that
investors will be better informed and receive enhanced protection,
while still potentially benefiting from these activities when they are
carried out in the best interests of the fund, if investors are
provided with disclosures and, in some cases, consent rights regarding
these activities. Accordingly, the final rule generally will provide
either a disclosure-based exception or a disclosure- and consent-based
exception for each restricted activity. The non-pro rata restriction
will be subject to a before-the-fact disclosure-based exception (in
addition to the requirement that the allocation be fair and
reasonable), while the certain fees and expenses restrictions and the
post-tax clawback restriction will be subject to after-the-fact
disclosure-based exceptions. The borrowing restriction and the
investigation restriction will be subject to a consent-based exception,
which will require an adviser to receive advance consent from at least
a majority in interest of a fund's investors in order to engage in
these activities.\621\ Specifically, each consent-based exception will
require an adviser to seek consent for the restricted activity from all
of the fund's investors and obtain consent from at least a majority in
interest of investors that are not related persons of the adviser.\622\
A fund's governing documents may establish that a higher threshold of
investor consent is necessary in order for the adviser to engage in
these restricted activities and may generally prescribe the manner and
process by which the applicable threshold of investor consent is
obtained.\623\ However, in light of the limitations posed by fund
governance bodies, such as LPACs, advisory boards, or boards of
directors, which do not generally have a fiduciary obligation to the
private fund investors, as discussed above,\624\ the consent-based
exceptions will require that the relevant consent be sought and
obtained specifically from fund investors.
---------------------------------------------------------------------------

    \621\ However, the exception for the investigation restriction
does not apply to fees and expenses related to an investigation that
results or has resulted in a court or governmental authority
imposing a sanction for a violation of the Act or the rules
promulgated thereunder.
    \622\ With respect to a private fund whose investors are solely
related persons of the fund's adviser, such as an internal fund
whose investors are limited to the adviser's employees, the
requirement in the consent-based exceptions to seek and obtain
consent from non-related person investors will not apply.
    \623\ For instance, the terms of a fund's governing documents
may provide for the issuance of both voting and non-voting
interests, where the non-voting interests are generally excluded for
purposes of constituting a majority in interest (or a higher
threshold) of investors. The fund's governing documents may also
provide for the exclusion of defaulting investors for voting
purposes.
    \624\ See supra section I.A.
---------------------------------------------------------------------------

    In light of this change from the proposal to allow an adviser to
satisfy disclosure and, in some cases, consent requirements, as
applicable, instead of being prohibited from certain activities, we are
amending rule 204-2 under the Advisers Act to require SEC-registered
investment advisers to retain books and records to document their
compliance with the disclosure and consent aspects, as applicable of
the restricted activities rule. This will help facilitate the
Commission's inspection and enforcement capabilities. Accordingly, we
are requiring SEC-registered investment advisers to retain a copy of
any notification, consent, or other document distributed to or received
from private fund investors pursuant to this rule, along with a record
of each addressee and the corresponding date(s) sent for each such
document distributed by the adviser.\625\ Similarly, in a change from
the proposal, we are not requiring private fund advisers to make and
retain records of the addresses or delivery methods used to disseminate
any such notifications or other documents distributed to private fund
investors pursuant to this rule.\626\
---------------------------------------------------------------------------

    \625\ See final amended rule 204-2(a)(24).
    \626\ See the discussion of recordkeeping requirements above in
section II.B.6.
---------------------------------------------------------------------------

    The exceptions require advisers to ``distribute'' certain written
notices or consent requests to investors.\627\ An adviser generally
will satisfy the requirement to ``distribute'' a written notice or
consent request when it has been sent to all investors in the private
fund. However, the definition of ``distribute,'' ``distributes,'' and
``distributed'' precludes advisers from using layers of pooled
investment vehicles in a control relationship with the adviser to avoid
meaningful application of the distribution requirement.\628\ In
circumstances where an investor is itself a pooled vehicle that is
controlling, controlled by, or under common control (a ``control
relationship'') with the adviser or its related persons, the adviser
must look through that pool (and any pools in a control relationship
with the adviser or its related persons, such as in a master-feeder
fund structure) and send the written notice or consent request to
investors in those pools. Outside of a control relationship, such as if
the private fund investor is an unaffiliated fund of funds, this same
concern is not present, and the adviser would not need to look through
the structure to make delivery that satisfies the definition of
``distribute.'' This approach will lead to meaningful distribution of
the written notices and consent requests to the private fund's
investors.
---------------------------------------------------------------------------

    \627\ See supra footnote 435 (discussing electronic delivery).
    \628\ See final rule 211(h)(1)-1. See supra section II.B.3
(``Preparation and Distribution of Quarterly Statements'') for a
discussion of the ``distribution'' requirement generally.
---------------------------------------------------------------------------

    In addition, the disclosure-based exceptions to the restrictions on
certain regulatory, compliance, and examination fees and expenses and
post-tax clawbacks require advisers to distribute written notices to
investors within 45 days after the end of the fiscal quarter in which
the relevant activity occurs. This disclosure timeline is appropriate
because it emphasizes the need for the notices to be distributed to
investors within a reasonable period of time to help ensure their
timeliness, while affording advisers a limited degree of flexibility.
The 45-day timeline generally matches the timeline required for
advisers to distribute quarterly statements under the quarterly
statement rule, except for quarterly statements distributed at fiscal
year-end or quarterly statements prepared for a fund of funds. This
will allow advisers that are subject to the quarterly statement rule to
include disclosures related to the restricted activities rule in their
quarterly reports, subject to those exceptions.
1. Restricted Activities With Disclosure-Based Exceptions
(a) Regulatory, Compliance, and Examination Expenses
    We proposed to prohibit advisers from charging their private fund
clients for (i) regulatory or compliance fees and expenses of the
adviser or its related persons and (ii) fees and expenses associated
with an examination of the adviser or its related persons by any
governmental or regulatory authority. We are adopting these provisions
\629\ but, after considering comments, are providing an exception from
the proposed prohibitions if an adviser distributes a written notice of
any such fees or expenses, and the dollar amount thereof,\630\ to
investors in a private fund

in writing on at least a quarterly basis.\631\
---------------------------------------------------------------------------

    \629\ In a change from the proposal, we are revising this
requirement to capture not only amounts ``charged'' to the private
fund but also fees and expenses ``allocated to'' the private fund.
We believe that this clarification is necessary in light of the
various ways that a private fund may be caused to bear fees and
expenses.
    \630\ Such a written notice should generally include a detailed
accounting of each category of such fees and expenses. Advisers
should generally list each specific category of fee or expense as a
separate line item and the dollar amount thereof, rather than group
such fees and expenses into broad categories such as ``compliance
expenses.''
    \631\ Final rule 211(h)(2)-1(a)(2). We are also reiterating that
charging these expenses without authority in the governing documents
is inconsistent with an adviser's fiduciary duty. See the
introduction of this section II.E above for a discussion of the
distribution requirement. Advisers may, but are not required to,
provide such disclosure in the statements they must deliver to
investors under the quarterly statement rule, if they are subject to
that rule. Although we generally do not consider information in the
quarterly statement required by the rule to be an ``advertisement''
under the marketing rule, an adviser that offers new or additional
investment advisory services with regard to securities in the
quarterly statement would need to consider whether such information
is subject to the marketing rule. A communication to a current
investor is an ``advertisement'' when it offers new or additional
investment advisory services with regard to securities. See rule
206(4)-1.
---------------------------------------------------------------------------

    Some commenters supported the proposed prohibition, stating that
advisers should not be charging examination, regulatory, and compliance
fees and expenses to the fund.\632\ Other commenters stated that this
prohibition is unnecessary, at least in part because investors already
negotiate what fees may or may not be charged to funds.\633\ A number
of commenters suggested that we should require disclosure of these
expenses instead of prohibiting these practices.\634\ In particular, as
an alternative to the proposed prohibition, one commenter recommended
that any such expenses should be fully disclosed to investors as
separate line items \635\ while another commenter recommended that we
should require clear empirical disclosure of such expenses.\636\ Some
commenters argued that the proposed prohibition would harm investors
because it would disincentivize advisers from investing in
compliance.\637\ Another commenter argued that compliance costs
increase with diversification of an adviser's portfolio, and that
requiring advisers to bear costs of compliance would therefore
discourage portfolio diversification (and remove the ability for
investors to decide for themselves whether they are willing to pay
extra compliance costs to achieve better diversification).\638\ Others
predicted that advisers would assess higher management fees if they
could not allocate these fees and expenses to funds.\639\
---------------------------------------------------------------------------

    \632\ See, e.g., AFR Comment Letter I; OPERS Comment Letter; NY
State Comptroller Comment Letter.
    \633\ See, e.g., Sullivan and Cromwell LLP Comment Letter (Apr.
25, 2022) (``Sullivan & Cromwell Comment Letter''); NYC Bar Comment
Letter II; ASA Comment Letter. One commenter stated that this
prohibition is unnecessary because there is strong alignment of
interests between advisers and investors with respect to regulatory,
compliance, and examination-related expenses. This commenter noted
that investments from principals and employees of its adviser
account for over 20% of total assets under management and that these
principals and employees pay the same fees and expenses as third-
party investors. See Citadel Comment Letter. However, this is just
one example and we understand that different private fund advisers
have different alignments of interests with their investors
depending on the amount of proprietary capital invested in the
funds, fee arrangements, and other factors. Moreover, this
commenter's argument does not address whether the private fund
should be charged for the fees and expenses in the first place;
rather, it focuses on the fact that certain advisers, especially
advisers with significant investments in their private funds, have
an incentive to limit such fees and expenses because they have the
potential to reduce the adviser's returns alongside the investors'
returns.
    \634\ See, e.g., Schulte Comment Letter; AIMA/ACC Comment
Letter; SBAI Comment Letter. One commenter suggested that, to the
extent no management fees are charged, disclosure and approval by
the governing body for that private fund may be a more appropriate
avenue in ensuring the expenses passed on are appropriate. See
Albourne Comment Letter. We believe it is more appropriate to
require disclosure to investors as private fund governing bodies can
vary considerably in structure, representation and legal
responsibility.
    \635\ See SBAI Comment Letter.
    \636\ See NYC Bar Comment Letter II.
    \637\ See, e.g., NVCA Comment Letter; Chamber of Commerce
Comment Letter; Comment Letter of Andrew M. Weiss, Professor
Emeritus, Boston University, Chief Executive Officer, Weiss Asset
Management (Apr. 23, 2022) (``Weiss Comment Letter'').
    \638\ Comment Letter of Eric S. Maskin, Professor of Economics,
Harvard University (Apr. 21, 2022) (``Maskin Comment Letter'').
    \639\ See, e.g., Dechert Comment Letter; Haynes & Boone Comment
Letter; Chamber of Commerce Comment Letter.
---------------------------------------------------------------------------

    It is in investors' best interest for advisers to develop robust
regulatory and compliance programs that enable advisers to comply with
their legal and regulatory obligations. Regulatory, compliance, and
examination fees and expenses are customary costs of doing business
that enable advisers to operate and attract clients as well as
investors. For example, advisers may incur filing and other fees
associated with SEC filings, such as Form ADV and Form PF, as well as
certain state filings. Advisers may also pay fees and expenses for a
compliance consultant to help them with mock or real examinations. Most
private fund advisers charge management fees, in part, to pay for costs
incurred as a result of legal and regulatory obligations imposed on
them in connection with providing advisory services. These and other
costs of doing business are integral to managing a private fund and are
generally considered overhead payable by the adviser out of its own
resources. Charging investors separately for regulatory or compliance
fees and expenses of the adviser or its related persons, or fees and
expenses associated with an examination of the adviser or its related
persons by any governmental or regulatory authority, is therefore a
compensation scheme contrary to the public interest and protection of
investors because an investment adviser, despite the management fees,
is taking additional compensation for these fees and expenses.\640\
Moreover, such allocations create a conflict of interest because they
provide an incentive for an adviser to place its own interests ahead of
the private fund's interests and allocate expenses away from the
adviser to the fund.\641\ We also believe that allocation of these
types of fees and expenses to private fund clients can be deceptive in
current market practice. For example, investors may generally expect an
adviser to bear fees and expenses directly related to its advisory
business, similar to how investors typically bear fees and expenses
directly related to their own investment activity. Further, while
certain investors may contractually agree, with appropriate initial
disclosure, to bear an adviser's specified fees and expenses, they may
be deceived to the extent the adviser does not disclose the total
dollar amount of such fees and expenses after the fact. Investors may
also be deceived if advisers describe such fees and expenses so
generically as to conceal their true nature and extent.\642\
Restrictions on the charging of these fees and expenses are, therefore,
merited.
---------------------------------------------------------------------------

    \640\ See supra section I for a discussion of the definition of
``compensation scheme''.
    \641\ See, e.g., In the Matter of NB Alternatives Advisers,
supra footnote 29 (alleging private fund adviser allocated employee
compensation-related expenses to three private equity funds it
advised in violation of their organizational documents).
    \642\ For example, if an adviser charges a fund for fees and
expenses associated with the preparation and filing of the adviser's
Form ADV but only identifies such charges broadly as ``legal
expenses.''
---------------------------------------------------------------------------

    The requirement to disclose these charges for regulatory,
compliance, and examination fees and expenses within 45 days after the
end of the fiscal quarter is also appropriate. This timeline emphasizes
the need for the notices to be distributed to investors within a
reasonable period of time to help ensure their timeliness, while
affording advisers a limited degree of flexibility. The 45-day timeline
generally matches the timeline required for advisers to distribute
quarterly statements under the quarterly statement rule, except for
quarterly statements distributed at fiscal year-end or quarterly
statements prepared for a fund of funds. This structure will allow
advisers that are subject to the quarterly statement rule to generally
include disclosures related to the restricted

activities rule in their quarterly reports, subject to those
exceptions.
    After reviewing responses from commenters, we acknowledge that a
prohibition of certain of these charges without an exception for
instances in which the adviser provides effective disclosure could
result in unfavorable outcomes for investors. For example, as some
commenters also suggested,\643\ we anticipate that some advisers may be
disincentivized from diversifying their portfolios to the extent that
compliance costs (that will now be borne by the adviser) increase with
portfolio diversification. As other commenters also stated,\644\ some
advisers may attempt to increase management or other fees if they were
no longer able to charge such fees and expenses to fund clients, and
the increase in management fees may have been more than the increase in
any fees or expenses already being passed through to the private fund.
We also recognize that whether such fees and expenses can be charged to
the private fund can be highly negotiated by investors in certain
instances \645\ (e.g., investors may be more receptive to bearing
registration and other compliance expenses for a first-time
manager).\646\ As a result, we believe it is necessary to prohibit
these practices unless advisers distribute written notice of any such
fees or expenses, and the dollar amount thereof, to investors in any
such private funds in writing on at least a quarterly basis. In short,
advisers must notify investors of such actual allocation practices on a
regular, ongoing basis to help ensure that investors are able to
negotiate effectively for their own interests and avoid the
compensation schemes that are contrary to the public interest and the
protection of investors.
---------------------------------------------------------------------------

    \643\ See, e.g., Chamber of Commerce Comment Letter; Weiss
Comment Letter; Maskin Comment Letter.
    \644\ See, e.g., Dechert Comment Letter; Haynes & Boone Comment
Letter; Chamber of Commerce Comment Letter.
    \645\ However, even in such circumstances where fee and expense
allocation provisions are highly negotiated, we believe such
negotiation is only effective if investors are receiving timely and
detailed disclosure of any such allocations when they occur.
    \646\ Some commenters also stated that the proposed prohibition
would put underrepresented private fund advisers, such as those
advisers that are minority-owned, at a disadvantage when competing
with more established firms that can waive fees for services. See,
e.g., Blended Impact Comment Letter; CozDev LLC Comment Letter; BAM
Ventures Comment Letter.
---------------------------------------------------------------------------

    To illustrate, an adviser may charge a private fund client for fees
it pays to a compliance consultant to assess the adviser's compliance
program, provided the adviser discloses those fees pursuant to this
rule. An adviser may also charge a private fund client for fees and
expenses associated with an examination of the adviser or its related
persons, such as by staff from our Division of Examinations, provided
those fees and expenses are adequately disclosed pursuant to this rule.
    Some commenters expressed concerns about how the proposed
prohibition would adversely impact funds with ``pass-through'' expense
models.\647\ Since we are providing a disclosure-based exception from
this prohibition, we no longer anticipate that this aspect of the
proposed prohibited activities rule will cause a significant disruption
in practice for funds with pass-through expense models. We understand
that most pass-through funds already provide ongoing, regular
disclosure of the fees and expenses that are being ``passed through''
to investors.
---------------------------------------------------------------------------

    \647\ Certain private fund advisers utilize a pass-through
expense model where the private fund pays for most, if not all,
expenses, including the adviser's expenses, but the adviser does not
charge a management, advisory, or similar fee. See, e.g., BVCA
Comment Letter; Sullivan & Cromwell Comment Letter; SBAI Comment
Letter.
---------------------------------------------------------------------------

    Some commenters suggested that we should explicitly clarify which
compliance fees and expenses are related to the adviser's activities or
the fund's activities.\648\ As we are not flatly prohibiting advisers
from passing on compliance, regulatory, and examination expenses, we do
not believe it is necessary to describe which fees and expenses are
related to the adviser's activities or the fund's activities. Advisers
and investors may negotiate whether certain compliance, regulatory, or
examination fees and expenses are charged to a fund, provided that the
disclosure of such fees and expenses satisfies the requirements of the
rule.
---------------------------------------------------------------------------

    \648\ See, e.g., NSCP Comment Letter; NYC Bar Comment Letter II;
Ropes & Gray Comment Letter.
---------------------------------------------------------------------------

    (b) Reducing Adviser Clawbacks for Taxes
    We proposed to prohibit an adviser from reducing the amount of any
adviser clawback by actual, potential, or hypothetical taxes applicable
to the adviser, its related persons, or their respective owners or
interest holders.\649\ This proposed provision was designed to protect
investors by ensuring that they receive their share of fund profits,
without any reduction for tax obligations of the adviser or its related
persons.\650\ However, as discussed further below, the final rule will
not prohibit advisers from engaging in after-tax adviser clawback
reductions, if advisers satisfy certain disclosure requirements
designed to better inform private fund investors of the impact of
after-tax adviser clawback reductions.\651\
---------------------------------------------------------------------------

    \649\ The proposed rule defined: (i) ``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, and (ii) ``performance-based
compensation'' as allocations, payments, or distributions of capital
based on the private fund's (or its portfolio investments') capital
gains and/or capital appreciation. Commenters generally did not
provide comments with respect to the proposed definitions of
``adviser clawback'' and ``performance-based compensation.'' We are
adopting the definition of ``adviser clawback'' as proposed.
However, in a change from the proposed rule, we are making a
technical revision to the ``performance-based compensation''
definition to include allocations, payments, or distributions of
profit. See supra section II.B.1.a. See also final rule 211(h)(1)-1.
    \650\ See Proposing Release, supra footnote 3, at 146-147.
    \651\ For the avoidance of doubt, the rule does not change the
applicability to the adviser of any other applicable disclosure and
consent obligation, whether they exist under law, rule, regulation,
contract, or otherwise.
---------------------------------------------------------------------------

    Some commenters supported the proposal to prohibit advisers from
reducing the amount of any adviser clawback by actual, potential, or
hypothetical taxes.\652\ Some also encouraged the Commission to expand
the scope of the rule to require advisers to provide affirmatively,
whether in the governing agreement or otherwise, a clawback mechanism
to restore excess performance-based compensation, rather than only
prohibiting advisers from reducing clawbacks by taxes applicable to the
adviser.\653\
---------------------------------------------------------------------------

    \652\ See, e.g., AFL-CIO Comment Letter; Albourne Comment
Letter; Better Markets Comment Letter; Convergence Comment Letter;
NASAA Comment Letter; NYC Comptroller Comment Letter; OPERS Comment
Letter; Predistribution Initiative Comment Letter II; Comment Letter
of Reinhart Boerner Van Deuren (Apr. 12, 2022) (``Reinhart Comment
Letter''); RFG Comment Letter II. Because many entities that receive
performance-based compensation are fiscally transparent for U.S.
Federal income tax purposes and thus not subject to entity-level
taxes, determining the actual taxes paid on ``excess'' performance-
based compensation can be challenging, particularly for larger
advisers that have not only a significant number of participants
that receive such compensation but also have participants subject to
non-U.S. tax regimes. Moreover, investors may be in different U.S.
States as well, each with their State tax nuances. To address these
considerations, advisers typically use a ``hypothetical marginal tax
rate'' to determine the tax reduction amount, which is usually based
on the highest marginal U.S. Federal, State, and local tax rates.
    \653\ See NACUBO Comment Letter; Reinhart Comment Letter.
---------------------------------------------------------------------------

    The majority of commenters, however, opposed this aspect of the
proposal. Many commenters suggested that our proposal was unnecessary
to ensure that private fund investors receive their full share of fund
profits, because clawback mechanisms are structured to restore private
funds with

the full amount of any excess performance-based compensation received
by the adviser (or its related persons), except in the rare
circumstances where such excess amount is so significant as to be
greater than the total amount of performance-based compensation
retained by the adviser (or its related persons) on an after-tax
basis.\654\ These commenters suggested that post-tax clawbacks reflect
a widely accepted and negotiated position between advisers and their
private fund clients (and, indirectly, their private fund
investors).\655\ They stated that the prevailing market practice is to
allocate the economic risk of a post-tax clawback to private fund
clients, rather than to advisers, because if this economic risk were
allocated to advisers, it could leave them worse off than if they had
not received any performance-based compensation at all.\656\ These
commenters stated that advisers could be worse off because taxes paid
in respect of excess performance-based compensation generally cannot be
recouped by amending prior tax returns, and the ability to realize a
tax benefit from subsequent losses is in practice limited.
Additionally, these commenters indicated that both applicable tax rules
and portfolio management considerations (such as determining at what
time the disposal of a portfolio investment would be in a private fund
client's best economic interest) limit the actual discretion that
advisers otherwise might have to defer or delay payments of
performance-based compensation to prevent the need for a clawback.\657\
For example, because U.S. tax laws require a partner of a partnership
to pay annual tax based on the amount of partnership income allocated
to the partner, rather than based on the amount of actual partnership
distributions received by the partner in the applicable year, an
adviser may not necessarily be in a position to delay or defer payments
or allocations of performance-based compensation to prevent the need
for a clawback.
---------------------------------------------------------------------------

    \654\ See, e.g., AIC Comment Letter I; Dechert Comment Letter;
Ropes & Gray Comment Letter.
    \655\ See, e.g., AIC Comment Letter I; AIMA/ACC Comment Letter;
ASA Comment Letter; Comment Letter of Baird Capital (Apr. 25, 2022)
(``Baird Comment Letter''); Carta Comment Letter; IAA Comment Letter
II; Comment Letter of PROOF Management, LLC (May 25, 2022) (``Proof
Comment Letter''); Ropes & Gray Comment Letter.
    \656\ See, e.g., AIC Comment Letter I; Baird Comment Letter;
GPEVCA Comment Letter; IAA Comment Letter II; Invest Europe Comment
Letter; Comment Letter of National Association of Private Fund
Managers (Apr. 25, 2022); Proof Comment Letter; Ropes & Gray Comment
Letter.
    \657\ See, e.g., AIC Comment Letter I; GPEVCA Comment Letter;
Dechert Comment Letter; IAA Comment Letter II; Invest Europe Comment
Letter; Proof Comment Letter; Ropes & Gray Comment Letter; SIFMA-AMG
Comment Letter I.
---------------------------------------------------------------------------

    We believe that reducing the amount of any adviser clawback by
taxes applicable to the adviser presents an opportunity for an adviser
to put its own interests ahead of its clients' interests by allocating
to the client (and indirectly, to fund investors) the risk of a tax
liability otherwise attributable to and borne by the adviser, which
reduces its client's (and indirectly, fund investors') returns. We
therefore believe that, unless this practice is adequately disclosed to
investors, it creates a compensation scheme that is contrary to the
public interest and the protection of investors.\658\ Furthermore,
although investors may contractually agree, per a fund's governing
documents and with appropriate initial disclosure, to an adviser's
ability to reduce an adviser clawback by applicable taxes, investors
may be deceived to the extent that an adviser does not disclose
information relating to the total dollar amount of the adviser clawback
and its reduction after the fact.\659\ To the extent that their private
fund investments are opaque, investors can lack insight into this
potentially conflicted practice by advisers and its impact on the
returns of their private fund investments.
---------------------------------------------------------------------------

    \658\ The after-tax reduction of an adviser clawback constitutes
a compensation scheme within the meaning of section 211(h) of the
Advisers Act because it is a method by which an investment adviser
may take additional compensation indirectly that otherwise its
private fund clients would be entitled to as investment proceeds.
    \659\ Cf. Form PF; Event Reporting for Large Hedge Fund Advisers
and Private Equity Fund Advisers; Requirements for Large Private
Equity Fund Adviser Reporting, Investment Advisers Act Release No.
6279 (May 3, 2023) [88 FR 38146 (June 12, 2023)], at 73-74
(discussing conflicts of interest that may arise from general and
limited partner clawbacks and noting that ``clawbacks are negotiated
early on in a fund's life, long before the inciting event occurs'').
---------------------------------------------------------------------------

    We appreciate commenters' concerns that the proposed rule could
ultimately result in unintended consequences that would be inconsistent
with our proposal's purpose, such as, among others, the following:
fewer advisers choosing to offer clawback mechanisms in their private
funds when such mechanisms benefit investors; restructuring
performance-based compensation arrangements in a way that would be less
favorable for investors (e.g., adopting incentive fee structures that
reduce or eliminate the potential for a clawback but are less favorable
to certain investors from a tax treatment perspective, or implementing
higher carried interest rates); offsetting changes to other economic
terms applicable to investors (e.g., implementing higher management
fees); adjusting the timing of portfolio management decisions to avoid
potential clawback liabilities (i.e., potentially incentivizing
advisers to make portfolio management decisions for reasons other than
a private fund client's best interests); and disproportionate burdens
on smaller investment advisers that may be more reliant on the receipt
of performance-based compensation on a deal-by-deal basis to remunerate
their employees and fund their operations.\660\ In view of these
potential unintended consequences, several commenters suggested that
the Commission adopt disclosure requirements relating to the use of
after-tax adviser clawbacks rather than an outright prohibition of the
practice,\661\ and we agree, as described below.
---------------------------------------------------------------------------

    \660\ See, e.g., AIC Comment Letter I; AIC Comment Letter II;
AIMA/ACC Comment Letter; ATR Comment Letter; CCMR Comment Letter I;
Comment Letter of Correlation Ventures (June 13, 2022)
(``Correlation Ventures Comment Letter''); Comment Letter of
Canadian Venture Capital and Private Equity Association (Apr. 25,
2022) (``CVCA Comment Letter''); Comment Letter of Landspire Group
(Apr. 25, 2022); Lockstep Ventures Comment Letter; Comment Letter of
the National Association of Investment Companies (Apr. 25, 2022)
(``NAIC Comment Letter''); PIFF Comment Letter; Proof Comment
Letter; Ropes & Gray Comment Letter; SBAI Comment Letter; Schulte
Comment Letter; SIFMA-AMG Comment Letter I; Comment Letter of Top
Tier Capital Partners, LLC (June 13, 2022) (``Top Tier Comment
Letter'').
    \661\ See NVCA Comment Letter (stating that the Commission
should consider the alternative of using enhanced disclosures
instead of banning clawback reduction provisions); Comment Letter of
OPSEU Pension Plan Trust (Aug. 18, 2022) (stating that investment
terms are a negotiation between advisers and institutional investors
and that the final rules should generally focus on disclosure rather
than prohibitions); SIFMA-AMG Comment Letter I (stating that, if
adopted, the final rule should require advisers to include estimated
clawback calculations reflecting any adjustments for taxes as part
of the quarterly statement reporting requirements, which would
enable investors to assess a potential clawback situation and any
potential reductions for taxes, that may arise); AIC Comment Letter
I (stating that, if adopted, the final rule should require only
quarterly disclosures to private fund investors of the potential
clawback payable and the amount of carried interest distributions
that have been reserved against the potential clawback).
---------------------------------------------------------------------------

    Many investors lack information regarding adviser clawbacks and
their impact on fund profits. For example, many fund agreements only
require advisers to restore the excess performance-based compensation
(less taxes) to the fund, without requiring them to provide investors
with any information regarding the adviser's related determinations and
calculations, such as whether a clawback was triggered and the
aggregate amount of the clawback. Without adequate disclosure,
investors are unable to

understand and assess the magnitude and scope of the clawback, as well
as its impact on fund performance and investor returns. Further, not
all investors may be able to ask questions successfully or seek more
information about a clawback on a voluntary basis from their private
fund's adviser. We believe that disclosure will achieve the rule's
policy goal of protecting investors, while preventing unintended
consequences that may have resulted from a flat prohibition.
    Accordingly, the final rule will not prohibit advisers from
engaging in after-tax adviser clawback reductions, if advisers satisfy
certain disclosure requirements designed to better inform private fund
investors of the impact of after-tax adviser clawback reductions.\662\
Specifically, the final rule restricts advisers from reducing 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 distributes a
written notice to the investors of the impacted private fund client
that sets forth the aggregate dollar amounts of the adviser clawback
both before and after any such reduction of the clawback for actual,
potential, or hypothetical taxes within 45 days after the end of the
fiscal quarter in which the adviser clawback occurs.\663\
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    \662\ For the avoidance of doubt, this does not change the
applicability to the adviser of any other applicable disclosure and
consent obligations, whether they exist under law, rule, regulation,
contract, or otherwise.
    \663\ See final rule 211(h)(2)-1(a)(3).
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    In order to satisfy the disclosure requirement, within 45 days
after the end of the fiscal quarter in which the clawback occurs, an
adviser must distribute a written notice to the investors of the
affected private fund client that sets forth the aggregate dollar
amounts of the adviser clawback both before and after the application
of any tax reduction. These aggregate dollar amounts should reflect the
gross amount of excess compensation received by the adviser (or its
related persons) that is being clawed back. The aggregate dollar amount
of the clawback before the application of any tax reductions must not
be reduced by taxes paid, or deemed paid, by the recipients or other
persons on their behalf, whereas the aggregate dollar amount of the
clawback after the application of any tax reduction needs to be so
reduced. As an example of disclosure that an adviser can make to
satisfy this requirement, an adviser that is subject to a clawback
could at the end of a private fund's term include disclosure in the
fund's quarterly statement regarding the aggregate dollar amounts of
the adviser clawback before and after the application of any tax
reduction (if the adviser is subject to the quarterly statement
requirement and to the extent that the quarterly statement is delivered
within 45 days following the end of the relevant fiscal quarter). An
investor will be able to compare these reported aggregate dollar
amounts of the adviser clawback both before and after any tax reduction
to evaluate the actual impact of a tax reduction on the clawback.
    An investment adviser may wish to consider providing private fund
client investors with, and investors may request and negotiate for,
additional information that is not specifically required by the final
rule. For example, advisers that routinely monitor their potential
clawback liability could provide their private fund client investors
with information regarding their currently estimated clawback
amounts.\664\ Additionally, in situations where an adviser's tax
reduction serves to reduce the clawback amount received by a private
fund client, an adviser could consider providing investors in such fund
with information clarifying their respective shares of the reduction.
---------------------------------------------------------------------------

    \664\ One commenter stated that, if adopted, the final rule
should require advisers to include estimated clawback calculations
reflecting any adjustments for taxes as part of the quarterly
statement reporting requirements, which would enable investors to
assess a potential clawback situation, and any potential reductions
for taxes, that may arise. See SIFMA-AMG Comment Letter I. Including
such information in the quarterly statement is not necessary to
satisfy the specific disclosure requirements and transparency
objectives of the final restrictions rule.
---------------------------------------------------------------------------

(c) Certain Non-Pro Rata Fee and Expense Allocations
    We proposed to prohibit an adviser from directly or indirectly
charging or allocating fees and 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.\665\ Charging or allocating fees and 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 presents an opportunity for
an adviser to put its interests ahead of its clients' interests (and,
by extension, their investors'), and can result in private funds and
their investors, particularly smaller investors that may not have as
much influence with the adviser or its related persons, being misled,
deceived, or otherwise harmed. As discussed in greater detail below,
any such non-pro rata charge or allocation can create a conflict of
interest and operate as a compensation scheme, both of which we deem
contrary to the public interest and the protection of investors.\666\
This practice may also violate antifraud provisions if an adviser
contravenes representations within the fund governing documents, and
the adviser, faced with a conflict of interest, may seek to charge or
allocate fees and expenses to one fund client as opposed to another
client in a manner that benefits the adviser.\667\ Despite the number
of enforcement actions brought by the Commission, we believe that this
practice still exists among private fund advisers. Accordingly, we
believe it is appropriate to promulgate a rule that restricts it.\668\
The adopted rule therefore restricts this practice unless (i) the non-
pro rata charge or allocation is fair and equitable under the
circumstances and (ii) prior to charging or allocating such fees or
expenses to a private fund client, the investment adviser distributes
to each investor of the private fund a written notice of the non-pro
rata charge or allocation and a description of how it is fair and
equitable under the circumstances.\669\
---------------------------------------------------------------------------

    \665\ Proposed rule 211(h)(2)-1(a)(6).
    \666\ In the Matter of Energy Capital Partners, supra footnote
30; In the Matter of Rialto Capital Management, LLC, supra footnote
222; In the Matter of Lightyear Capital, LLC, Investment Advisers
Release No. 5096 (Dec. 26, 2018) (settled action); In the Matter of
WL Ross & Co. LLC, Investment Advisers Act Release No. 4494 (Aug.
24, 2016) (settled action); In the Matter of Kohlberg Kravis Roberts
& Co., supra footnote 28; In the Matter of Lincolnshire, supra
footnote 26; see In the Matter of Platinum Equity Advisors, LLC,
Investment Advisers Release No. 4772 (Sept. 21, 2017) (settled
action). Our staff has also observed instances of advisers charging
or allocating fees and expenses related to a 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 during
examinations. See EXAMS Private Funds Risk Alert 2020, supra
footnote 188.
    \667\ See, e.g., In the Matter of Platinum Equity Advisors, LLC,
supra footnote 666.
    \668\ See, e.g., In the Matter of Energy Capital Partners, supra
footnote 30; see also Healthy Markets Comment Letter I (stating that
investors are very unlikely to be willing or able to negotiate on
their own the end of these practices, such as charging certain non-
pro-rata fees and expenses).
    \669\ Final rule 211(h)(2)-1(a)(4). In a change from the
proposal, we are making a revision to the rule text to clarify that
the prohibition is against charging either fees, or expenses, or
both.
---------------------------------------------------------------------------

    Charging or allocating fees and expenses related to a portfolio
investment (or potential portfolio investment) on a non-pro rata basis
presents a conflict of interest because advisers have economic and/or
other

business reasons to charge or allocate fees and expenses to one fund
client as opposed to another client (e.g., differences in a private
fund's fee structure, ownership structure, lifecycle, and investor
base).\670\ For example, when determining how to charge or allocate
fees and expenses related to a portfolio investment where multiple
private fund clients have invested (or propose to invest), the adviser
may choose to charge or allocate less fees and expenses to its higher
fee-paying client to the detriment of its lower fee-paying client
because the higher fee-paying client pays more to the adviser. Not only
would this decision to charge or allocate less fees and expenses to its
higher fee-paying client benefit the adviser but it could also
disadvantage the lower fee-paying client and its investors who bear
more than a pro rata share of expenses while supporting the value of
the higher fee-paying client's investment.\671\
---------------------------------------------------------------------------

    \670\ In some instances, a fund may not have the resources to
bear its pro rata share of expenses related to a portfolio
investment (whether due to insufficient reserves, the inability to
call capital to cover such expenses, or otherwise).
    \671\ The final rule does not prohibit an adviser from paying a
fund's pro rata portion of any fee or expense with its own capital.
In addition, to the extent a fund does not have resources to pay for
its share, the final rule does not prohibit an adviser from diluting
such fund's interest in the portfolio investment in a manner that is
fair and equitable, subject to applicable laws, rules, or
regulations and applicable provisions of the fund's governing
documents.
---------------------------------------------------------------------------

    We have observed these considerations leading advisers to favor one
private fund client (and its investors) over another private fund
client (and its investors) because of the fund's investor base. For
example, as part of their strategy, some advisers agree to perform
certain services, e.g., asset-level due diligence, accounting,
valuation, legal, either in-house or through a captive consulting firm,
for portfolio investments at costs that are at or below market rates
rather than hire a third party to perform these services.\672\ To
facilitate a portfolio investment, the adviser may set up a co-
investment vehicle that invests alongside the adviser's main fund.\673\
If the main fund and the co-investment vehicle have both invested (or
propose to invest) in the same portfolio investment that engages the
adviser for these services, the adviser may decide not to allocate the
costs of these services to the co-investment vehicle, which is often
made up of favored or larger investors and may have specific fee and
expense limits, and may instead allocate the costs of these services to
the main fund, causing the main fund to pay more in expenses than it
otherwise would under a pro-rata allocation.
---------------------------------------------------------------------------

    \672\ See, e.g., In the Matter of Rialto Capital Management,
LLC, supra footnote 222.
    \673\ Id.
---------------------------------------------------------------------------

    Charging or allocating fees and 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 is a conflict of interest for the adviser and can
also lead, and in our experience often does lead, to a compensation
scheme that we deem contrary to the public interest and protection of
investors, unless this practice is fair and equitable and is adequately
disclosed to investors in advance. It also may be fraudulent or
deceptive, and result in investor harm. For instance, if two funds
invest in the same portfolio investment but only one fund pays an
incentive allocation, the adviser may have an incentive to avoid
charging or allocating fees and expenses to the fund paying an
incentive allocation in an effort to increase the adviser's incentive
allocation. Similarly, if the adviser's ownership interests vary from
fund to fund, the adviser may have an incentive to charge or allocate
fees and expenses away from the fund in which the adviser holds a
greater interest.\674\ Because of these differences in ownership or
compensation structures, an adviser may have an incentive to charge or
allocate fees and expenses in a way that maximizes its economic
entitlements at the expense of its fund client's (and investors')
economic entitlements.
---------------------------------------------------------------------------

    \674\ Although the adviser's interest (or its affiliate's
interest, such as the general partner's interest) may not be charged
a management fee or an incentive allocation, they are often
allocated or charged fund expenses, directly or indirectly, in a
manner that is similar to a third party investor's interest in the
fund.
---------------------------------------------------------------------------

    Moreover, this practice can result in a conflict of interest and
compensation scheme contrary to the protection of investors by favoring
not only the adviser but also the adviser's related persons. For
example, an adviser may set up co-investment vehicles for related
persons, such as executives, family members, and certain consultants,
that invest alongside the adviser's main fund.\675\ These co-investment
vehicles may receive a set percentage of each portfolio investment made
by the adviser's main fund without having to share in any research
expenses, travel costs, professional fees, and other expenses incurred
in deal sourcing activities related to portfolio investments that never
materialize. For the adviser to allow its related persons, such as
executives, family, and certain consultants, to participate in
consummated portfolio investments without having to bear the cost of
these expenses may be an undisclosed form of compensation to the
adviser and its related persons. It also may defraud, deceive, or harm
the fund that bore the co-investment vehicle's share of expenses.
---------------------------------------------------------------------------

    \675\ See, e.g., In the Matter of Kohlberg Kravis Roberts & Co,
supra footnote 28.
---------------------------------------------------------------------------

    Some commenters supported the proposed prohibition and stated it
would protect investors, including those who do not benefit from co-
investment opportunities.\676\ In contrast, other commenters opposed
the proposed prohibition and stated that it could result in inequitable
outcomes \677\ and would be disruptive.\678\ Commenters stated that
allowing advisers to allocate expenses on a non-pro rata basis is
essential for the fair treatment of investors because it allows
advisers to allocate expenses appropriately to the relevant investors
that generated the additional cost.\679\ Commenters asserted that the
prescriptive nature of the proposed rule would result in unintended
consequences, indicating there may be circumstances, whether due to
tax, regulatory, accounting, or other reasons, where a pro rata expense
allocation would lead to inequitable results.\680\ For example, they
questioned whether the proposed rule would prevent an adviser from
fairly allocating tax liabilities that are attributable to a specific
investor in the private fund (e.g., withholding taxes and partnership-
level assessments resulting from a tax audit) and whether the adviser
absorbing certain expenses of a specific investor where that investor
is unable to pay for the expense in the private fund would be seen as
non-pro rata allocation under the proposed rule.\681\
---------------------------------------------------------------------------

    \676\ See Healthy Markets Comment Letter I; NY State Comptroller
Comment Letter; AFL-CIO Comment Letter; ILPA Comment Letter I; ICCR
Comment Letter; RFG Comment Letter II. See also IAA Comment Letter
II.
    \677\ See SBAI Comment Letter; IAA Comment Letter II; Ropes &
Gray Comment Letter.
    \678\ See Dechert Comment Letter; AIC Comment Letter I; MFA
Comment Letter I; NYC Bar Comment Letter II.
    \679\ See Dechert Comment Letter (discussing scenarios where a
particular investment structure, tax structure and/or regulatory
position or status for an investment exists solely to benefit one or
more particular investors); Ropes & Gray Comment Letter.
    \680\ See Dechert Comment Letter.
    \681\ See Dechert Comment Letter; OPERS Comment Letter.
---------------------------------------------------------------------------

    Many commenters suggested that we instead allow advisers to
allocate fees and expenses related to portfolio expenses in a fair and
equitable manner.

Some suggested that we refrain from rulemaking on this issue because
advisers are already required to allocate fees and expenses on a fair
and equitable basis,\682\ while others urged the Commission to adopt an
exception for non-pro rata fee and expense charges or allocations that
are appropriately disclosed and consented to by investors \683\ or an
alternative approach that involves disclosure to investors to avoid
unfair outcomes.\684\ For example, some commenters suggested that, as
an alternative to the proposed prohibition, advisers disclose their
policies and procedures regarding the allocation of fees and expenses
among private funds to each fund investor.\685\ In another example, a
commenter suggested that we should require disclosure only where fees
and expenses are not split on a pro-rata basis.\686\ One commenter
stated that advisers typically allocate expenses on a pro rata basis,
unless it would otherwise be fair and equitable to allocate non-pro
rata under the circumstances.\687\ This commenter suggested that a
disclosure-based approach would afford more flexibility and accommodate
the diversity of investment structures used by advisers for private
funds.
---------------------------------------------------------------------------

    \682\ See NYC Bar Comment Letter II; MFA Comment Letter I;
Comment Letter of the Managed Funds Association (June 13, 2022)
(``MFA Comment Letter II'').
    \683\ See Convergence Comment Letter; Invest Europe Comment
Letter.
    \684\ See Comment Letter of the Securities Industry and
Financial Markets Association Asset Management Group (June 13,
2022); GPEVCA Comment Letter; SIFMA-AMG Comment Letter I; SBAI
Comment Letter; Ropes & Gray Comment Letter; AIMA/ACC Comment
Letter.
    \685\ See IAA Comment Letter II; see generally NY State
Comptroller Comment Letter (suggesting the disclosure of written
expense allocation and control policies to investors).
    \686\ See SBAI Comment Letter.
    \687\ See GPEVCA Comment Letter.
---------------------------------------------------------------------------

    After considering comments, we are adopting a rule that focuses on
ensuring that clients are treated fairly and equitably, which we
recognize may not always mean clients must be treated identically.
Accordingly, in a change from the proposal, the final rule prohibits a
private fund adviser from charging or allocating fees and expenses
related to a portfolio investment (or potential portfolio investment)
on a non-pro rata basis, unless the adviser meets two
requirements.\688\
---------------------------------------------------------------------------

    \688\ Final rule 211(h)(2)-1(a)(4).
---------------------------------------------------------------------------

    First, the adviser's non-pro rata allocation must be fair and
equitable under the circumstances. Whether it is fair and equitable
will depend on factors relevant for the specific expense. For example,
it would be relevant whether the expense relates to a specific type of
security that one private fund client holds. In another example, a
factor could be whether the expense relates to a bespoke structuring
arrangement for one private fund client to participate in the portfolio
investment. As yet another example, another factor could be that one
private fund client may receive a greater benefit from the expense
relative to other private fund clients, such as the potential benefit
of certain insurance policies.
    Second, before charging or allocating such fees or expenses to a
private fund client, the adviser must distribute to each investor a
written notice of the non-pro rata charge or allocation and a
description of how it is fair and equitable under the circumstances.
The written notice will allow an investor to understand better how the
adviser is treating the private fund relative to other private funds or
clients advised by the adviser. For instance, the written notice may
help the investor understand whether the adviser's allocation approach
creates any conflicts of interest, results in any additional direct or
indirect compensation to the adviser or its related parties, creates
the risk of potential harms, or results in other disadvantages related
to such activity. In this notice, advisers should consider addressing
relevant factors, which might include the adviser's allocation approach
and the reason(s) why the adviser believes that its non-pro rata
allocation approach is fair and equitable under the circumstances. This
change is responsive to comments that we received suggesting that
adviser's allocations are or should be fair and equitable \689\ and
that a more disclosure-based approach in certain instances rather than
a strict requirement to charge or allocate fees and expenses solely on
a pro rata basis.\690\ This disclosure setting forth how the adviser's
allocation is fair and equitable must be distributed to all investors
in the private fund.
---------------------------------------------------------------------------

    \689\ GPEVCA Comment Letter; NYC Bar Comment Letter II; MFA
Comment Letter I; MFA Comment Letter II.
    \690\ See SIFMA-AMG Comment Letter I; GPEVCA Comment Letter;
SBAI Comment Letter. See generally IAA Comment Letter II (suggesting
the disclosure of written fee and expense allocation policies to
investors); NY State Comptroller Comment Letter (suggesting the
disclosure of written expense allocation and control policies to
investors).
---------------------------------------------------------------------------

    We believe that it is important for all investors in the private
fund to receive this disclosure before the adviser charges or allocates
non-pro rata fees or expenses to a private fund client. Private fund
investors generally do not have insight into (and the quarterly
statement rule will not require advisers to disclose) the amounts of
joint fees or expenses that the adviser allocated to its other clients,
and investors are unable to compare amounts borne by their fund with
amounts borne by the adviser's other clients to assess whether the
adviser allocated joint costs consistently with the fund's terms and
other disclosures and representations made by the adviser. To make this
assessment, an investor would need access to information regarding the
terms of the adviser's relationships with its clients other than the
fund, as well as certain information (including potentially accounting
information) about those other clients. This advance disclosure
timeline therefore is appropriate because it provides investors with
access to important fee and expense information to enable investors to
discuss the non-pro rata allocation with the adviser before being
charged.
    As explained above, we believe it is important to restrict the
practice of charging or allocating fees and expenses related to a
portfolio investment (or potential portfolio investment) on a non-pro
rata basis because this practice presents a conflict of interest and
can result in a compensation scheme that is contrary to the public
interest and the protection of investors. We have not, however,
prohibited this practice where an adviser's non-pro rata allocation
would be fair and equitable under the circumstances. We recognize that
private fund advisers may structure investments for specific tax,
regulatory, accounting, or other reasons for the benefit of certain
investors, creating a diversity of investment structures. We believe
this framework offers investors additional protections while
simultaneously offering advisers the flexibility to execute investment
strategies and offer a diversity of investment structures in a way that
may benefit investors.
    This framework will also encourage advisers, as fiduciaries, to
review their approach to allocating fees and expenses to their clients,
particularly if advisers must disclose to investors why an allocation
is fair and equitable. This framework provides more comprehensive
information for investors so that investors can evaluate the adviser's
allocation approach.
    Several commenters, including a commenter that generally supported
this rule, expressed concern that the proposed rule could impair co-
investment opportunities.\691\ They

stated that co-investment opportunities benefit the fund and its
investors, and that such transactions are critical to enabling the fund
to execute its investment strategy.\692\ Commenters suggested that the
proposed rule would severely impact the availability of co-investment
opportunities because these are time-sensitive opportunities and
increasing the regulatory burden on advisers would only heighten the
chance that private funds would miss out on an opportunity to
participate.\693\ They also stated that the rule would interrupt the
commercial speed of co-investment transactions because potential co-
investors would wait until a transaction is certain before committing
to the transaction to avoid broken deal expenses.\694\ Also, these
commenters expressed concern that advisers could lack the leverage
necessary to require co-investors to share in fees and expenses on a
pro rata basis and that some co-investors may decline to participate in
the transaction rather than bear additional fees and expenses. These
commenters asserted that the rule would inhibit capital formation by
preventing funds from completing larger deals because they would not be
able to find co-investment capital to invest alongside the fund.
Because the final rule restricts (rather than prohibits) this practice
if the adviser makes certain disclosures, we believe the final rule
generally addresses these concerns. For example, although we
acknowledge that many co-investments are executed on short notice, co-
investors typically review and negotiate co-investment documentation,
such as fund agreements, side letters, and subscription agreements,
prior to the closing of the transaction. We believe that the final
rule's requirements can generally be completed during this period (and
prior to the adviser completing the non-pro rata charge or allocation).
We believe restricting this practice while requiring disclosure and
that it be fair and equitable balances the burdens on the adviser with
the interests of investors to be treated fairly and receive timely
access to important information about non-pro rata fee and expense
allocations. While we acknowledge that this approach imposes some
incremental burden on co-investment deals, we do not believe the
burdens created by these requirements will significantly deter investor
appetite for co-investments or inhibit capital formation.\695\
---------------------------------------------------------------------------

    \691\ See Schulte Comment Letter; OPERS Comment Letter; PIFF
Comment Letter; AIC Comment Letter I; Ropes & Gray Comment Letter;
BVCA Comment Letter; Invest Europe Comment Letter; Dechert Comment
Letter; GPEVCA Comment Letter. See also ILPA Comment Letter I.
    \692\ See Schulte Comment Letter; OPERS Comment Letter.
    \693\ See Schulte Comment Letter; PIFF Comment Letter.
    \694\ See AIC Comment Letter I; Ropes & Gray Comment Letter.
    \695\ See infra section VI.E.3 (where we discuss several factors
that may mitigate these potentially negative effects, including
reasons why the disclosure requirements could promote capital
formation).
---------------------------------------------------------------------------

    We requested comment on whether we should define ``pro rata.'' In
the past, we have generally observed that advisers implement pro rata
allocations based on ownership percentages.\696\ For example, one
adviser allocated a fund more than its pro rata share of bridge
facility commitment fees relative to its ownership of a portfolio
investment.\697\ In another example, a co-investment vehicle's
governing documents provided that the co-investment vehicle would pay
its pro rata share of expenses for any portfolio company investments
made by the co-investment vehicle.\698\ Although the co-investment
vehicle agreed to pay its pro rata share of expenses of any consummated
portfolio company investment and the co-investment vehicle invested on
a predetermined amount in each consummated portfolio company
investment, the adviser did not allocate broken deal expenses to the
co-investment vehicles.\699\ We have alleged in settled enforcement
actions that an adviser has allocated transaction fees in a way that
benefited the adviser rather than pro rata among the adviser's funds
and co-investors invested in the portfolio company investment.\700\
---------------------------------------------------------------------------

    \696\ See In the Matter of Energy Capital Partners, supra
footnote 30; In the Matter of Platinum Equity Advisors, LLC, supra
footnote 666; In the Matter of WL Ross & Co. LLC, supra footnote
666.
    \697\ See In the Matter of Energy Capital Partners, supra
footnote 30.
    \698\ See In the Matter of Platinum Equity Advisors, LLC, supra
footnote 666.
    \699\ See id.
    \700\ See In the Matter of WL Ross & Co. LLC, supra footnote 666
(the adviser retained for itself the portion of transaction fees
attributable to the co-investors' ownership of the portfolio
company, without subjecting such fees to any management fee
offsets).
---------------------------------------------------------------------------

    A commenter specifically suggested that we refrain from defining
``pro rata'' to allow advisers flexibility because there are multiple
methods that can be used to allocate pro rata.\701\ We agree that there
may be multiple methods to determine pro rata allocations, and we have
therefore declined to define ``pro rata.'' We recognize that the
framework we are adopting could result in some subjectivity regarding
how advisers calculate pro rata and when an allocation is fair and
equitable. Nonetheless, we believe that this framework offers
additional protection to investors in situations where an adviser may
have an incentive to favor one client (or a group of investors) over
another client (or another group of investors). This framework requires
an adviser to evaluate its conflicts of interest 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
and enhances protections and disclosures made to investors when an
adviser allocates or charges fees and expenses in a non-pro rata
manner.
---------------------------------------------------------------------------

    \701\ See IAA Comment Letter II; AIC Comment Letter I. But see
Ropes & Gray Comment Letter (suggesting that we define the concept
of ``pro rata'' to make the rule easier to apply in certain
circumstances).
---------------------------------------------------------------------------

2. Restricted Activities With Certain Investor Consent Exceptions
(a) Investigation Expenses
    We proposed to prohibit advisers from charging their private fund
clients for fees and expenses associated with an investigation of the
adviser or its related persons by any governmental or regulatory
authority. We are adopting this provision \702\ but, after considering
comments, we are providing an exception from the proposed prohibition
if an adviser seeks consent from all investors of a private fund, and
obtains written consent from at least a majority in interest of the
fund's investors that are not related persons of the adviser, for
charging the private fund for such investigation fees or expenses.\703\
However, the exception does not apply to fees or expenses related to an
investigation that results or has resulted in a court or governmental
authority imposing a sanction for a violation of the Act or the rules
promulgated thereunder.
---------------------------------------------------------------------------

    \702\ In a change from the proposal, we are revising this
requirement to capture not only amounts ``charged'' to the private
fund but also fees and expenses ``allocated to'' the private fund.
We believe that this clarification is necessary in light of the
various ways that a private fund may be caused to bear fees and
expenses.
    \703\ Final rule 211(h)(2)-1(a)(1). We are also reiterating that
charging these expenses without authority in the governing documents
is inconsistent with an adviser's fiduciary duty and may violate the
antifraud provisions of the Act. For purposes of requesting consent
under this rule, advisers generally should list each category of fee
or expense as a separate line item, rather than group fund expenses
into broad categories, and describe how each such fee or expense is
related to the relevant investigation.
---------------------------------------------------------------------------

    The heightened protection of investor consent is particularly
appropriate with respect to the investigation restriction because such
investigations are focused on the adviser's own potential or actual
wrongdoing. If an adviser is able to pass on expenses associated with
an investigation related to its own misfeasance, without providing

disclosure of the specific fees and expenses actually being passed
through to funds relating to a particular investigation and securing
consent from investors, such adviser has adverse incentives to engage
in conduct likely to trigger an investigation and may not be adequately
incentivized to limit the legal fees incurred on its own behalf.\704\
An adviser faces a conflict of interest when charging investors for
fees and expenses associated with an investigation of the adviser by
any governmental or regulatory authority because these fees and
expenses are related to the adviser's potential or actual wrongdoing.
---------------------------------------------------------------------------

    \704\ See infra sections VI.C.2 and VI.D.3.
---------------------------------------------------------------------------

    We recognize that governmental or regulatory bodies may not
formally notify an adviser that it is under investigation. In such a
circumstance, whether an adviser is under investigation would be
determined based on the information available.
    Some commenters supported the proposed prohibition, stating that
advisers should not be charging investigation fees and expenses to the
fund.\705\ Other commenters stated that this prohibition is
unnecessary, at least in part because investors are already able to
agree on what fees may or may not be charged to funds.\706\ Several
commenters suggested that we should require disclosure of these
expenses instead of prohibiting these practices.\707\ In particular, as
an alternative to the proposed prohibition, one commenter recommended
that any such expenses should be fully disclosed to investors as
separate line items \708\ while another commenter recommended that we
should require clear empirical disclosure of such expenses.\709\ Others
predicted that advisers would assess higher management fees if they
could not allocate these fees and expenses to funds.\710\ Some
commenters suggested that we should clarify that certain costs and
expenses resulting from settlements and judgments with governmental
authorities are not indemnifiable.\711\
---------------------------------------------------------------------------

    \705\ See, e.g., AFR Comment Letter I; United for Respect
Comment Letter I; NYC Comptroller Comment Letter.
    \706\ See, e.g., Sullivan & Cromwell Comment Letter; NYC Bar
Comment Letter II; ASA Comment Letter.
    \707\ See, e.g., AIMA/ACC Comment Letter; SBAI Comment Letter.
    \708\ See SBAI Comment Letter.
    \709\ See NYC Bar Comment Letter II.
    \710\ See, e.g., Dechert Comment Letter; Haynes & Boone Comment
Letter; Chamber of Commerce Comment Letter.
    \711\ See, e.g., CalPERS Comment Letter; NYC Comptroller Comment
Letter; ILPA Comment Letter I.
---------------------------------------------------------------------------

    Charging investors separately for fees and expenses associated with
an investigation of the adviser or its related persons by any
governmental or regulatory authority is a compensation scheme contrary
to the public interest, unless this practice is consented to, in
writing, by investors who are not related persons of the adviser. Such
fees and expenses are related to the adviser's potential or actual
wrongdoing and should be borne by the adviser unless investors consent
in writing to paying them for each specific investigation. Accordingly,
the allocation or charging of these types of expenses to private fund
clients constitutes a compensation scheme within the meaning of section
211(h) of the Advisers Act because it is a method by which an
investment adviser may take additional compensation in the form of
reimbursement for expenses that the adviser should bear.\712\ Moreover,
such allocations create a conflict of interest because they provide an
incentive for an adviser to place its own interests ahead of the
private fund's interests and allocate expenses away from the adviser to
the fund.\713\ In such a case where an adviser incurs expenses as a
result of an investigation into the adviser's conduct, then uses
investor assets to pay the expenses associated thereto, investors have
the potential to be doubly harmed if the adviser's alleged misconduct
harms investors.\714\ We also believe that allocation of these types of
fees and expenses to private fund clients can be deceptive in current
market practice. For example, investors may generally expect an adviser
to bear fees and expenses directly related to its own wrongdoing.
Regarding fees and expenses associated with investigation of the
adviser or its related persons, we do not believe it is appropriate for
an adviser to enrich itself by charging for investigation fees and
expenses related to its own actual or potential wrongdoing, unless
investors consent to such fees and expenses. Thus, we believe that,
unless this practice is consented to, in writing, by investors, it
creates a compensation scheme that is contrary to the public interest
and the protection of investors.
---------------------------------------------------------------------------

    \712\ See supra section I for a discussion of the definition of
``compensation scheme''.
    \713\ See, e.g., See, e.g., In the Matter of Cherokee Investment
Partners, LLC and Cherokee Advisers, LLC, supra footnote 26
(alleging that the adviser improperly shifted expenses related to an
examination and an investigation away from itself).
    \714\ One commenter stated that the proposed prohibition on
advisers charging their private fund clients for these expenses is
unnecessary because the Commission has the authority, as a condition
of the settlement, to require advisers to bear the costs associated
with a settlement or penalty. See Citadel Comment Letter. We view
this authority as supporting the need for a broader rule in this
area rather than relying on invocations of this authority in each
separate instance. In addition, relying on imposing this condition
as a condition of settlement, by which point an adviser who has
committed fraud may have dissipated its money and be unable to
reimburse investors for the investigation expenses already charged,
provides inadequate and lesser protection to investors compared to
the rule's consent requirement.
---------------------------------------------------------------------------

    After reviewing responses from commenters, however, we acknowledge
that a prohibition of certain of these charges without an exception for
instances in which the adviser obtains investor consent could result in
unfavorable outcomes for investors. For example, as some commenters
suggested,\715\ some advisers may attempt to increase management or
other fees if they were no longer able to charge such fees and expenses
to fund clients, and the increase in management fees might have been
more than the increase in any fees or expenses already being passed
through to the private fund. We also recognize that whether such fees
and expenses can be charged to the private fund can be highly
negotiated by investors in certain instances.\716\ As a result, we
believe it is necessary to prohibit these practices unless advisers get
requisite written consent from investors.
---------------------------------------------------------------------------

    \715\ See, e.g., Dechert Comment Letter; Haynes & Boone Comment
Letter; Chamber of Commerce Comment Letter.
    \716\ However, even in such circumstances where investigation
fee and expense allocation provisions are highly negotiated, we
believe such negotiation is only effective if investors explicitly
consent to any such allocations in each specific instance.
---------------------------------------------------------------------------

    The final rule, however, does not contain a consent-based exception
for an adviser to charge a fund for fees or expenses related to an
investigation that results or has resulted in a court or governmental
authority imposing a sanction for a violation of the Act or the rules
promulgated thereunder. Such charges will be outright prohibited. If an
adviser were to charge a client for such fees and expenses, we would
view that adviser as requiring its client to acquiesce to the adviser's
violation of the Act. Advisers must comply with all applicable
provisions of the Act, and the SEC would view a waiver of any provision
of the Act as invalid under section 215(a) of the Act. Section 215(a)
of the Act provides that any condition, stipulation, or provision
binding any person to waive compliance with any provision of the Act
shall be void.\717\ An adviser that charges its private fund client for
fees and expenses related to the adviser's violation of the Act, or the

rules promulgated thereunder, would operate as a waiver of its
liability for such violation. While other types of investigations may
involve a great variety of potential or actual wrongdoing that may
differ in nature and severity, compliance with the Act is core to the
existence and activities of investment advisers. Accordingly, an
adviser charging its private fund client for fees and expenses related
to an investigation that results or has resulted in a court or
governmental authority imposing a sanction for a violation of the Act,
or the rules promulgated thereunder, is impermissible.\718\
---------------------------------------------------------------------------

    \717\ See section 215(a) of the Advisers Act. See also section
215(b) of the Advisers Act (stating that any contract made in
violation of the Act or rules thereunder is void).
    \718\ For example, if the Commission sanctioned an adviser
pursuant to a settled order finding that the adviser violated the
Act or the rules promulgated thereunder, including an order to which
the adviser consented without admitting or denying the Commission's
findings, the adviser would not be permitted to seek investor
consent to charge any fees and expenses related to the Commission's
investigation to the fund, including any penalties or disgorgement.
---------------------------------------------------------------------------

    To illustrate, an adviser may charge a private fund client for fees
and expenses associated with an investigation by the SEC of the adviser
or its related persons for a potential violation of Section 206 of the
Act or the rules thereunder, provided those fees and expenses are
consented to by investors pursuant to this rule. However, if the
investigation results in a court or governmental authority imposing a
sanction on the adviser for a violation of the Act or the rules
promulgated thereunder, then the adviser must refund the fund for the
fees and expenses associated with the investigation, such as lawyer's
fees.
    Some commenters also expressed concerns about how the proposed
prohibition related to investigation expenses would adversely impact
funds with ``pass-through'' expense models.\719\ First, investigations
of advisers by governmental authorities are uncommon, and thus we do
not expect expenses related to investigations to pose a threat to the
majority of advisers using pass-through expense models. Second, since
we are providing a consent-based exception from this prohibition,
advisers with pass-through expense models are still able to charge
investigation expenses to the funds they advise, provided they obtain
investor consent pursuant to this rule (subject to compliance with
other applicable disclosure and consent requirements). Thus, the final
rule generally does not prohibit advisers from continuing to utilize
such models. Such advisers, like any other private fund adviser, would
nonetheless be prohibited from allocating to such funds fees or
expenses related an investigation that results or has resulted in a
court or governmental authority imposing a sanction for a violation of
the Act, or the rules promulgated thereunder.\720\
---------------------------------------------------------------------------

    \719\ See, e.g., BVCA Comment Letter; Sullivan & Cromwell
Comment Letter; SBAI Comment Letter.
    \720\ The obligation of an adviser to a pass-through fund to pay
fees or expenses associated with a sanction under the Act is
attenuated to the extent such adviser has other assets (e.g.,
balance sheet capital), sources of revenue (e.g., performance-based
compensation), or access to capital (e.g., loans) to pay any such
fees or expenses. As the Commission may already require advisers to
pass-through funds to pay penalties associated with a sanction under
the Act, we anticipate that this rule will not cause a significant
disruption from current practice for advisers to pass-through funds.
---------------------------------------------------------------------------

(b) Borrowing
    We proposed to prohibit an adviser directly or indirectly from
borrowing money, securities, or other fund assets, or receiving a loan
or an extension of credit, from a private fund client (collectively, a
``borrowing'').\721\
---------------------------------------------------------------------------

    \721\ Proposed rule 211(h)(2)-1(a)(7).
---------------------------------------------------------------------------

    Some commenters opposed the prohibition,\722\ while others
supported it.\723\ One commenter encouraged the Commission to expand
the scope of the proposed prohibition by preventing an adviser from
borrowing from co-investment vehicles or other accounts.\724\ Another
commenter that opposed the proposed prohibition stated that the
prohibition was unnecessary because advisers and their related persons
rarely borrow from fund clients.\725\ These commenters asserted that
the proposed prohibition could inadvertently prohibit activity that
could benefit investors, such as tax advances,\726\ borrowing
arrangements outside of the fund structure,\727\ and the activity of
service providers that are affiliates of the adviser, especially with
large financial institutions that play many roles in a private fund
complex.\728\ Commenters also stated that the rule could prohibit
certain types of transactions that are permitted (e.g., an adviser
purchasing securities from a client), with appropriate disclosure and
consent, under section 206(3) of the Advisers Act.\729\ One commenter
stated that we should instead require disclosure of adviser borrowings
on Form PF and Form ADV,\730\ while other commenters stated that we
should provide exemptions for borrowings disclosed to investors or
LPACs to ensure that these arrangements are entered into on arm's
length terms.\731\
---------------------------------------------------------------------------

    \722\ See SIFMA-AMG Comment Letter I; NYC Bar Comment Letter II;
IAA Comment Letter II.
    \723\ See OPERS Comment Letter; Convergence Comment Letter; AFL-
CIO Comment Letter; ILPA Comment Letter I; RFG Comment Letter II;
American Association for Justice Comment Letter.
    \724\ See Convergence Comment Letter.
    \725\ See NYC Bar Comment Letter II.
    \726\ Tax advances occur when the private fund pays or
distributes amounts to the general partner to allow the general
partner to cover tax obligations.
    \727\ See SBAI Comment Letter; CFA Comment Letter I; AIC Comment
Letter I.
    \728\ See IAA Comment Letter II.
    \729\ See, e.g., SIFMA-AMG Comment Letter I (stating that
borrowing securities can be structured as a purchase subject to
section 206(3) of the Advisers Act); NYC Bar Comment Letter II. To
the extent that a borrowing under the final rule involves a purchase
under section 206(3) of the Advisers Act, the requirements of that
section will continue to apply to the adviser.
    \730\ See Convergence Comment Letter.
    \731\ See, e.g., IAA Comment Letter II; AIC Comment Letter I.
---------------------------------------------------------------------------

    Under section 211(h)(2) of the Advisers Act, the Commission has the
authority to promulgate rules to prohibit or restrict certain conflicts
of interest that the Commission deems contrary to the public interest
and the protection of investors. We believe it is important to restrict
the practice of borrowing from a private fund client because it
presents a conflict of interest that is contrary to the public interest
and the protection of investors. When an adviser borrows from a private
fund, that adviser has a conflict of interest because it is on both
sides of the transaction (i.e., the adviser benefits from the loan and
manages the client lender). As discussed above, a private fund rarely
has employees of its own. The fund typically relies on the investment
adviser (and, in certain cases, affiliated entities) to provide
management, investment, and other services, and such persons usually
have general authority to take actions on behalf of the private fund
without further consent or approval of any other person. This structure
causes a conflict of interest between the private fund (and, by
extension, its investors) and the investment adviser because the
interests of the fund are not necessarily aligned with the interests of
the adviser. For example, when determining the interest rate for the
borrowing, an investment adviser's interest in maximizing its own
profit by negotiating (or setting) a low rate may conflict with the
private fund's (and, by extension, its investors') interest in seeking
to maximize the profits of the fund. As another example, if the adviser
becomes insolvent or suffers financial distress, the interests of the
fund in seeking to protect its interests (whether through enforcing a
default against, or renegotiating the terms of the loan with, the
adviser) may conflict with the interests of the adviser in seeking to
discharge the liability or otherwise renegotiate more favorable terms
for itself.
    Additionally, this practice may prevent the fund client from using
those assets to further the fund's investment strategy. Even where
disclosed to

investors (or to an advisory board of the private fund, such as an
LPAC), this practice presents a conflict of interest that can be
harmful to investors because, as a result of the unique structure of
private funds, only certain investors with specific information or
governance rights (such as representation on the LPAC) may be in a
position to discuss, diligence, negotiate, consent to, or monitor the
borrowing with the adviser, rather than all of the private fund's
investors, depending on the facts and circumstances.
    Further, section 206(4) of the Advisers Act permits the Commission
to prescribe a means to prevent acts, practices, and courses of
business that are fraudulent, deceptive, or manipulative. Restricting
the ability of an adviser to borrow from a private fund client would
help prevent fraud, deception, and manipulation that can occur when an
adviser engages in this practice. The Commission has previously settled
enforcement actions against advisers that directly or indirectly
borrowed from private fund clients without providing appropriate
disclosure or obtaining approval.\732\ For example, the Commission
brought charges against a private fund adviser and its owner for, among
other things, improperly borrowing money from a private fund.\733\
Specifically, the Commission order alleged that the owner breached his
fiduciary duty when he borrowed from the fund to settle a personal
trade. In another example, the Commission found that an investment
adviser, through its owner, improperly borrowed money from private
funds to pay the adviser's expenses.\734\ In both instances, the
advisers did not timely disclose or obtain approval for the borrowings.
The advisers also defrauded the private funds and their investors by
illegally using the private funds' assets to serve their personal
interests. Despite the Commission's enforcement efforts, adviser
borrowing practices continue to pose harmful risks to private funds
(and, by extension, their investors) in light of the conflicts of
interests that arise between a fund and its adviser when the adviser
has a direct or indirect interest on both sides of a borrowing
arrangement.
---------------------------------------------------------------------------

    \732\ See SEC v. Philip A. Falcone, et al., Civil Action 12-CV-
5027 (S.D.N.Y) (Aug. 16, 2013) (consent of defendants) (admitting
that a hedge fund adviser borrowed from a hedge fund client, at an
interest rate lower than the fund's borrowing rate, in order to
repay the adviser's personal taxes, and that the adviser failed to
disclose the loan to investors for five months); In the Matter of
Wave Equity Partners LLC, Investment Advisers Act Release No. 6146
(Sept. 23, 2022) (settled action) (alleging that the adviser (i)
borrowed money from a private equity fund that it managed in order
to pay placement agent fees to a third-party vendor; and (ii)
without adequate disclosure, failed promptly to repay the fund
through an offset of quarterly management fees as required by fund
documents); In the Matter of SparkLabs Global Ventures Management,
LLC, et al., Investment Advisers Act Release No. 6121 (Sept. 12,
2022) (settled action) (alleging that exempt reporting advisers and
their owner (i) directed certain funds they managed to make more
than 50 unauthorized loans totaling over $4.4 million, at below-
market interest rates, to other funds under their management and
certain affiliates of the adviser and/or its related persons; (ii)
failed to enforce the terms of the loans when they were due; and
(iii) failed to disclose to their clients or investors the conflicts
of interest associated with the loans and to seek approval for
them).
    \733\ See In the Matter of Monsoon Capital, LLC, Investment
Advisers Act Release No. 5490 (Apr. 30, 2020) (settled action).
    \734\ See In the Matter of Resilience Management, LLC, et al.,
Investment Advisers Act Release No. 4721 (June 29, 2017) (settled
action).
---------------------------------------------------------------------------

    After considering comments and in a change from the proposal, the
final rule prohibits advisers from engaging in borrowings from a
private fund client unless the adviser distributes a written notice and
description of the material terms of the borrowing to the investors of
the private fund, seeks their consent for the borrowing, and obtains
written consent from at least a majority in interest of the fund's
investors that are not related persons of the adviser (as described
above).\735\ The final rule does not enumerate specific terms of the
borrowing that must be disclosed in connection with an adviser's
consent request; rather, it requires advisers to disclose the
prospective borrowing and the material terms related thereto. This
could include, for example, the amount of money to be borrowed, the
interest rate, and the repayment schedule, depending on the facts and
circumstances. We believe that this approach will help prevent activity
that is potentially harmful unless accompanied by specific and timely
disclosure that can be meaningfully evaluated and acted upon by
investors. By not enumerating specific terms that must be disclosed and
instead incorporating a materiality standard, the final rule will also
afford investors and advisers the flexibility to negotiate for
disclosures and terms that are tailored to their unique needs and
relationships.\736\
---------------------------------------------------------------------------

    \735\ Final rule 211(h)(2)-1(a)(5). See supra section II.E.
(Restricted Activities) for discussions of the ``distribution''
requirement and of the type and manner of investor consent required
under the final rule.
    \736\ Advisers may also consider providing additional
information, including, to the extent relevant, updated post-
borrowing disclosure to reflect increases, decreases, or other
changes in the borrowing, to help investors understand the nature of
the conflict of interest and its potential influence on the adviser.
---------------------------------------------------------------------------

    The heightened protection of investor consent is particularly
appropriate with respect to the borrowing restriction. Borrowing from a
private fund creates a conflict of interest where the adviser is
incentivized to favor its own interest over the interest of the fund.
Additionally, there are other potential conflicts that arise in the
event that the adviser is unable to repay the borrowing, or it has to
choose whether to repay the borrowing among other uses of the capital
when funds are limited. This restriction will not apply to borrowings
from a third party on the fund's behalf or to the adviser's borrowings
from individual investors outside of the fund, such as a bank that is
invested in the fund; instead the restriction focuses on the types of
borrowings that, based on our experience, present the greatest
opportunities for an adviser to abuse its control over a client's
assets; namely, when an adviser borrows its client's assets, directly
or indirectly, for its own use. However, we recognize that, in certain
instances, such as in connection with enabling a smaller adviser to
satisfy a sponsor commitment to the fund, investors may under certain
terms be willing to accept a borrowing from the fund by the
adviser.\737\ Rather than prescribe these terms, the final rule will
require that advisers disclose and obtain advance written consent for
them from investors, as discussed above. In this way, the rule will
enable investors to have an opportunity to evaluate whether a proposed
borrowing would be favorable for the fund (as opposed to only for the
adviser) and, relatedly, to negotiate for changes to the terms of the
borrowing as appropriate.
---------------------------------------------------------------------------

    \737\ See, e.g., ILPA Comment Letter I.
---------------------------------------------------------------------------

    Because we are providing a consent-based exception from this
prohibition, the revised approach is responsive to commenters who
stated that the rule should be based on more express disclosure to, and
consent from, investors rather than prohibition-based. We were not
persuaded, however, by comments suggesting that the manner of
disclosure about adviser borrowings should be through Form ADV or Form
PF. We believe that disclosure directly to investors, in the format
contemplated by the final rule and in connection with an adviser's
consent request, will better ensure that existing investors have timely
access to information that will assist those investors in determining
the conflicts related to such borrowings and how they impact the
adviser's relationship with the private fund, whether the borrowing
would be in the fund's or the adviser's interest, and

whether to ultimately approve or disapprove of the borrowing.
Additionally, the related books and records requirement in final rule
204-2(a)(24) will require advisers to maintain this information in a
manner that permits easy location, access, and retrieval of any
particular record.
    Finally, in response to commenters, we are clarifying that we did
not intend for the proposed rule to prohibit certain practices that
have the potential to benefit investors, and we would not interpret
ordinary course tax advances and management fee offsets as borrowings
that are subject to this final rule, as discussed below.
    A tax advance occurs when a fund provides an adviser or its
affiliate an advance of money against the adviser's actual or expected
future share of the fund's assets (e.g., the adviser's accrued
performance fees or carried interest) to allow the adviser or its
affiliate to meet certain of its tax obligations (or its investment
professionals' tax obligations) as they are due. Such advances are used
to enable an adviser, its affiliates, and its investment professionals
to pay taxes derived from their interest in a fund (e.g., taxes
associated with performance fees or carried interest that have been
allocated to the affiliated general partner), because such tax
liabilities frequently arise and are due before these parties are
actually entitled to a cash distribution from the fund. This practice
can benefit investors because it allows advisers to pay their tax
liabilities while continuing to manage the fund and, accordingly, to
avoid the potential misalignment of interests that can occur if
advisers were instead to seek higher amounts of compensation from a
fund (or from fund portfolio investments) to create a reserve amount
covering their potential tax liabilities or to begin timing portfolio
investment transactions in consideration of the resulting tax impacts
on the adviser and its affiliates and their personnel (as opposed to
managing the fund with a focus solely on the best interests of the
fund).\738\ Some commenters suggested that such arrangements are widely
disclosed to and understood by investors.\739\ We do not interpret the
final rule to apply to tax advances as a type of restricted borrowing
because they are tax payments that are attributable to and made against
the unrealized income (or other amounts) allocated to in respect of the
private fund. As such, they are not structured to include the repayment
of advanced amounts to the fund, but rather only the reduction of the
future income to be received by the adviser. However, to the extent
that a tax advance is structured to contemplate amounts that will be
repaid to the fund, as opposed to amounts that only reduce an adviser's
future income, it would generally be a restricted borrowing under the
final rule, subject to the rule's consent requirement.
---------------------------------------------------------------------------

    \738\ Commenters state that prohibiting this practice would harm
smaller advisers and raise barriers to entry because such advisers
would not be able to fund such tax payments. See SBAI Comment
Letter; AIMA/ACC Comment Letter; AIC Comment Letter III.
    \739\ See, e.g., MFA Comment Letter II; SBAI Comment Letter;
AIMA/ACC Comment Letter; AIC Comment Letter I; AIC Comment Letter
II.
---------------------------------------------------------------------------

    Similarly, management fee offsets are not borrowings subject to the
final rule because they do not involve the adviser or its affiliates
taking fund assets and promising to repay such assets at a later date.
Management fee offsets typically occur when an adviser reduces the
management fee owed by the fund by other amounts that the fund has
already paid to, or on behalf of, the adviser, its affiliates, or
certain other persons. For example, fund governing documents may
require an adviser to reduce the management fee by any amounts the
adviser's affiliates receive for providing services to a portfolio
company that the fund invests in. Also, some private fund governing
documents limit organizational expenses and provide that any amount of
organizational expenses paid by the fund above the expense cap may be
offset against the adviser's management fee. Management fee offsets
benefit investors because they reduce the fees and expenses the fund
pays to the adviser and its affiliates, typically on a dollar-for-
dollar basis with the amount initially paid, directly or indirectly, by
the fund. We therefore consider a management fee offset to be a
calculation methodology that reduces the amount a fund pays the adviser
and its affiliates in the future.
    We also remind advisers of their fiduciary obligations when
engaging in transactions with private fund clients and of their
antifraud obligations when engaging with private fund investors. To
satisfy its fiduciary duty, an adviser must eliminate or at least
expose through full and fair disclosure all conflicts of interest which
might incline an investment adviser to provide advice that is not
disinterested.\740\ Full and fair disclosure should be sufficiently
specific so that a client is able to understand the material fact or
conflict of interest and make an informed decision whether to provide
consent.\741\ The disclosure must be clear and detailed enough for the
client to make an informed decision to consent to the conflict of
interest or reject it.\742\ When making disclosures to private fund
investors, advisers should also be mindful of their antifraud
responsibilities per rule 206(4)-8 under the Advisers Act.
---------------------------------------------------------------------------

    \740\ See 2019 IA Fiduciary Duty Interpretation, supra footnote
5, at 23.
    \741\ See id.
    \742\ See id., at 25-26.
---------------------------------------------------------------------------

F. Certain Adviser Misconduct

1. Fees for Unperformed Services
    We are not adopting the proposed prohibition on charging a
portfolio investment for monitoring, servicing, consulting, or other
fees in respect of any services the investment adviser does not, or
does not reasonably expect to, provide to the portfolio
investment.\743\ As discussed below, we believe that it is unnecessary
for the final rule to prohibit an adviser from charging fees without
providing a corresponding service to its private fund client because
such activity already is inconsistent with the adviser's fiduciary
duty.
---------------------------------------------------------------------------

    \743\ Proposing Release, supra footnote at 3, at 136.
---------------------------------------------------------------------------

    Some commenters supported this prohibition.\744\ Commenters
generally stated that charging fees for unperformed services to the
fund is against the public interest and inconsistent with the Advisers
Act by placing the interests of the advisers ahead of those of
investors.\745\ A commenter suggested that because of the substantial
conflicts of interest faced by advisers charging fees for unperformed
services no amount of disclosure should be enough to enable an investor
to provide informed consent to these practices.\746\ Another commenter
indicated that an adviser should refund prepaid amounts attributable to
unperformed services where an adviser is paid in advance for services
that it reasonably expects to perform but ultimately does not
provide.\747\ A commenter expressed concern that advisers have not
historically provided enough transparency into certain payments, such
as monitoring fees.\748\
---------------------------------------------------------------------------

    \744\ Comment Letter of Eileen Appelbaum and Jeffrey Hooke (Mar.
17, 2022); Comment Letter of Senators Sherrod Brown and Jack Reed
(Aug. 4, 2022) (``Senators Brown and Reed Comment Letter''); Trine
Comment Letter; AFREF Comment Letter I; OPERS Comment Letter;
Morningstar Comment Letter; ILPA Comment Letter I; For The Long Term
Comment Letter; Healthy Markets Comment Letter I; Predistribution
Initiative Comment Letter II; NYSIF Comment Letter.
    \745\ Morningstar Comment Letter; Healthy Markets Comment Letter
I.
    \746\ Senators Brown and Reed Comment Letter.
    \747\ ILPA Comment Letter I.
    \748\ See generally AFREF Comment Letter I.

---------------------------------------------------------------------------

    Other commenters opposed this prohibition for several reasons.
First, commenters stated that this prohibition may be unnecessary
because it is generally market practice for fund documents to prohibit
advisers from charging fees for unperformed services or, less commonly,
to disclose such practices.\749\ Second, a commenter indicated that
certain advisers may structure fee arrangements based on the value
expected to be created, rather than based on a time-worked model.\750\
Third, a commenter expressed concerns that the ``reasonably expect''
standard is inappropriate because of the risk that advisers would be
second-guessed afterwards.\751\
---------------------------------------------------------------------------

    \749\ See SIFMA-AMG Comment Letter I; Invest Europe Comment
Letter; see generally Dechert Comment Letter.
    \750\ AIC Comment Letter I.
    \751\ Dechert Comment Letter.
---------------------------------------------------------------------------

    Fees for unperformed services may incentivize an adviser to cause a
private fund to exit a portfolio investment earlier than anticipated.
We stated in the proposal that such fees may cause an adviser to seek
portfolio investments for its own benefit rather than for the private
fund's benefit.\752\ In addition, we noted that such fees have the
potential to distort the economic relationship between the private fund
and the adviser because the adviser receives the benefit of such fees,
at the expense of the fund, without incurring any costs associated with
having to provide any services.
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    \752\ See Proposing Release, supra footnote 3, at 137.
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    We believe that charging a client fees for unperformed services
(including indirectly by charging fees to a portfolio investment held
by the fund) where the adviser does not, or does not reasonably expect
to, provide such services is inconsistent with an adviser's fiduciary
duty.\753\ Typically by its nature charging a client fees for
unperformed services, directly or indirectly, involves a
misrepresentation or an omission of a material fact, whether in the
private fund's offering memorandum or otherwise, regarding the amount
being charged to the client, directly or indirectly, by the adviser or
the adviser's related person, the nature of the services being provided
by the adviser or the adviser's related person, or both. An adviser's
fiduciary duty under the Advisers Act comprises a duty of care and a
duty of loyalty. This fiduciary duty requires an adviser ``to adopt the
principal's goals, objectives, or ends.'' \754\ This means the adviser
must, at all times, serve the best interest of its client and not
subordinate its client's interest to its own.\755\ In other words, the
adviser cannot place its own interests ahead of its client's interests.
Because charging fees without providing or reasonably expecting to
provide a corresponding service to its private fund client, in our
view, would cause the adviser to place its own interests ahead of its
client's interests, as more fully described in the paragraph below, we
have determined that it is unnecessary to prohibit activity that is
already indirectly inconsistent with the adviser's fiduciary duty.\756\
Thus, we are not adopting the rule as originally proposed. Commenters'
statements that it is generally market practice for fund documents to
prohibit advisers from charging fees for unperformed services may
suggest that market participants are acting consistent with the
adviser's fiduciary duty and that private fund advisers do not engage
in these compensation practices.
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    \753\ We proposed to adopt this rule under sections 206 and 211
of the Advisers Act. Proposing Release, supra footnote 3, at 134.
See also 2019 IA Fiduciary Duty Interpretation, supra footnote 5, at
1 and n.2-3 (discussing an adviser's fiduciary duty under Federal
law).
    \754\ See 2019 IA Fiduciary Duty Interpretation, supra footnote
5, at 7-8.
    \755\ See 2019 IA Fiduciary Duty Interpretation, supra footnote
5, at n.58.
    \756\ Section 206(1) and section 206(2) of the Advisers Act.
Depending on the facts and circumstances, we believe that this
conduct may also violate other Federal securities laws, rules, and
regulations, such as rule 206(4)-8, which prohibits advisers to
pooled investment vehicles from, among other things, defrauding
investors or prospective investors.
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    Previously, we have charged advisers for violating section 206(2)
of the Advisers Act when improperly charging monitoring, servicing,
consulting, or other fees, which may accelerate upon the occurrence of
certain events, to a portfolio investment.\757\ These fees reduce the
value of the fund's portfolio investment, which, in turn, reduces the
amount available for distribution to the fund's investors. Because the
adviser or its related person receives these fees, it faces a
significant conflict of interest and cannot effectively consent on
behalf of the fund. The conflict of interest from these fee
arrangements can lead an adviser in other ways to act to serve its
interest over its client's interest, in breach of its fiduciary duty.
For example, fees for unperformed services may incentivize an adviser
to cause a private fund to exit a portfolio investment earlier than
anticipated or cause an adviser to seek portfolio investments for its
own benefit rather than for the private fund's benefit. If the adviser
reasonably expects to provide services to a portfolio investment, the
adviser may attempt to provide full and fair disclosure to all
investors or a group representing all investors, such as a fund board
or an LPAC.\758\ But, in some instances, disclosure may be
insufficient. We have long brought enforcement actions based on the
view that an adviser, as a fiduciary, may not keep prepaid advisory
fees for services that it does not, or does not reasonably expect to,
provide to a client.\759\ And an adviser cannot do indirectly what it
is not permitted to do directly.\760\ Thus, where the adviser does not,
or does not reasonably expect to, provide services to the portfolio
investment, the adviser would be violating its fiduciary duty by using
its position to extract payments indirectly from a fund, through a
portfolio investment.
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    \757\ See, e.g., In the Matter of THL Managers V, LLC and THL
Managers VI, LLC, Investment Advisers Act Release No. 4952 (June 29,
2018) (settled action); In the Matter of TPG Capital Advisors, LLC,
Investment Advisers Act Release No. 4830 (Dec. 21, 2017) (settled
action); In the Matter of Apollo Management V, L.P., et al.,
Investment Advisers Act Release No. 3392 (Aug. 23, 2016) (settled
action); In the Matter of Blackstone, supra footnote 26.
    \758\ Advisers that are subject to the quarterly statement rule
discussed above will also need to disclose these amounts in the
quarterly statement provided to investors, to the extent such
compensation meets the definition of portfolio-investment
compensation.
    \759\ See Jason Baker Tuttle, Sr., Initial Decision Release No.
13 (Jan. 8, 1990); Monitored Assets Corp., Investment Advisers Act
Release No. 1195 (Aug. 28, 1989) (settled order); In the Matter of
Beverly Hills Wealth Mgmt., LLC, Investment Advisers Act Release No.
4975 (July 20, 2018) (settled order).
    \760\ Section 208(d) of the Advisers Act.
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    Under our interpretation, an adviser could receive payment for
services actually provided. An adviser could also receive payments in
advance for services that it reasonably expects to provide to the
portfolio investment in the future, whether such arrangements are based
on a time-worked model (i.e., where fees are determined based on a
fixed dollar amount and the amount of time worked) or a value-add model
(i.e., where the fees are determined based on the value contributed by
the adviser's services).\761\ For example, if an adviser expects to
provide monitoring services to a portfolio investment, the adviser is
not prohibited from charging for those services. Rather, an adviser is
not permitted to charge for services that it does not reasonably expect
to provide. Further, to the extent that the adviser ultimately does not
provide the services, the adviser would need to refund any

prepaid amounts attributable to unperformed services.
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    \761\ See AIC Comment Letter I (stating that ``[i]f monitoring
fees are charged based on the deal size, periodic payments instead
of a lump sum payment can provide the portfolio company with
liquidity management by spreading the costs over time, even though
the services and resulting value creation may not correspond to the
same time period of payments.'').
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2. Limiting or Eliminating Liability
    We proposed to prohibit an adviser to a private fund, directly or
indirectly, from seeking reimbursement, indemnification, exculpation,
or limitation of its liability by the private fund or its investors for
a breach of fiduciary duty, willful misfeasance, bad faith, negligence,
or recklessness in providing services to the private fund (``waiver or
indemnification prohibition'').\762\ As discussed further below, we are
not adopting this prohibition, in part, because we believe that it is
not necessary to achieve our goal to address this problematic practice.
Rather, we discuss below our views on how an adviser's fiduciary duty
applies to its private fund clients and how the antifraud provisions
apply to the adviser's dealings with clients and fund investors.
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    \762\ Proposed rule 211(h)(2)-1(a)(5).
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    Some commenters supported this prohibition \763\ stating that the
prohibition is necessary to protect private fund investors, address the
increasing erosion of private fund advisers' fiduciary duties,\764\ and
save investors time and legal fees when negotiating fund
documents.\765\ One commenter that represents several limited partners
and historically advocated for increased protections regarding
fiduciary terms \766\ supported allowing indemnification for an
adviser's simple negligence but maintaining the proposed prohibition on
indemnification for simple negligence in scenarios where there is a
material breach of the limited partnership agreement and side
letters.\767\ Some commenters suggested narrowing this provision to
align with the Commission's statement in the 2019 IA Fiduciary Duty
Interpretation, instead of adopting a broader prohibition that,
according to commenters, would implicate State and local law.\768\
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    \763\ See, e.g., Comment Letter of Phil Thompson (Mar. 8, 2022)
(``Thompson Comment Letter''); OPERS Comment Letter; CalPERS Comment
Letter; Morningstar Comment Letter.
    \764\ See, e.g., NYC Comptroller Comment Letter; OPERS Comment
Letter; Thompson Comment Letter; Better Markets Comment Letter.
    \765\ See NACUBO Comment Letter.
    \766\ See ILPA Letter to Chairman Gensler (Apr. 21, 2021).
    \767\ See ILPA Comment Letter I.
    \768\ See Invest Europe Comment Letter; MFA Comment Letter I.
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    In contrast, most commenters opposed it.\769\ Some commenters
stated that the proposed prohibition would increase costs for investors
\770\ (including through insurance premiums, higher management fees,
and revising existing agreements),\771\ increase the threat of private
litigation,\772\ and cause advisers to take less risk, which could
result in lower investor returns and fewer available strategies.\773\
Many commenters stated that the proposed prohibition would result in
more onerous liability standards for sophisticated investors than for
retail investors and that such a difference would result in better
protection for institutional investors than for investors in retail
products.\774\
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    \769\ See, e.g., SBAI Comment Letter; Thin Line Capital Comment
Letter; ATR Comment Letter; ILPA Comment Letter I; Chamber of
Commerce Comment Letter; Comment Letter of Real Estate Roundtable
Comment Letter (Apr. 25, 2022); CVCA Comment Letter; AIMA/ACC
Comment Letter.
    \770\ See, e.g., Chamber of Commerce Comment Letter; MFA Comment
Letter I.
    \771\ See, e.g., Schulte Comment Letter; Comment Letter of Real
Estate Board of New York (Apr. 21, 2022) (``REBNY Comment Letter'');
CVCA Comment Letter.
    \772\ See, e.g., Invest Europe Comment Letter; Schulte Comment
Letter; MFA Comment Letter I.
    \773\ See, e.g., TIAA Comment Letter; SIFMA-AMG Comment Letter
I; ILPA Comment Letter I; AIC Comment Letter I; NYC Bar Comment
Letter II.
    \774\ See, e.g., Invest Europe Comment Letter; Schulte Comment
Letter; SBAI Comment Letter; SIFMA-AMG Comment Letter I; AIC Comment
Letter I; MFA Comment Letter I; AIMA/ACC Comment Letter.
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    After considering comments, we are not adopting this prohibition,
in part, because we believe that it is not needed to address this
problematic practice. Rather, we are reaffirming and clarifying our
views on how an adviser's fiduciary duty applies to its private fund
clients and how the antifraud provisions apply to the adviser's
dealings with clients and fund investors. We remind advisers of their
obligation to act consistently with their Federal fiduciary duty and
their legal obligations under the Advisers Act, including the antifraud
provisions.\775\ A waiver of an adviser's compliance with its Federal
antifraud liability for breach of its fiduciary duty to the private
fund or otherwise, or of any other provision of the Advisers Act, or
rules thereunder, is invalid under the Act.\776\
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    \775\ See 2019 IA Fiduciary Duty Interpretation, supra footnote
5; section 206 of the Advisers Act.
    \776\ See section 215(a) of the Advisers Act; 2019 IA Fiduciary
Duty Interpretation, supra footnote 5, at n.29 (stating that an
adviser's Federal fiduciary obligations are enforceable through
section 206 of the Advisers Act and that the SEC would view a waiver
of enforcement of section 206 as implicating section 215(a) of the
Advisers Act. Section 215(a) of the Advisers Act provides that any
condition, stipulation or provision binding any person to waive
compliance with any provision of the title shall be void.). See
section 215(b) of the Advisers Act (stating that any contract made
in violation of the Act or rules thereunder is void).
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    An adviser's Federal fiduciary duty is to its clients and the
obligations that flow from the adviser's fiduciary duty depend upon
what functions the adviser, as agent, has agreed to assume for the
client, its principal.\777\ In addition, full and fair disclosure for
an institutional client (including the specificity, level of detail,
and explanation of terminology) can differ, in some cases
significantly, from full and fair disclosure for a retail client
because institutional clients generally have a greater capacity and
more resources than retail clients to analyze and understand complex
conflicts and their ramifications.\778\ Regardless of the nature of the