with U.S. GAAP, material differences with U.S. GAAP are reconciled, and
the reconciliation is distributed to investors along with the financial
statements? If so, should we specify what ``substantially similar''
means?
     Would there be unique challenges to complying with the
rule for auditors and advisers to private funds in foreign
jurisdictions? For example, might certain advisers or auditors face
challenges in complying with the proposed rule's Commission
notification requirement, including because of applicable privacy and
other local laws? If so, what would alleviate these challenges and
still achieve the policy goals of the proposed audit rule?
     Do commenters agree that the proposed rule's requirement
to distribute the audited financial statements promptly would provide
appropriate flexibility regarding the timing of the distribution of
audited financial statements? Should there nevertheless be an outer
limit on the number of days an investment adviser has from its fiscal
year end for the distribution of audited financial statements? If so,
what should that limit be? Would it be more appropriate for
distribution to be required within 120 days of the end of the fund's
fiscal year, as under the custody rule? Alternatively, would a longer
or shorter period be appropriate in most circumstances? Should the
timeline for distributing audited financial statements align with the
timeline for distributing quarterly statements under the proposed
quarterly statement rule? Why or why not? We understand that funds of
funds or certain funds in master-feeder structures (including those
advised by related persons) have difficulty satisfying the 120-day
requirement and that our staff has indicated they would not recommend
enforcement if certain of these funds satisfy the distribution
requirement within 180 or 260 days of the fund's fiscal year end,
depending on a variety of circumstances.\134\ If the rule contained a
specific distribution deadline, would these types of funds need a
separate deadline or other special treatment?
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    \134\ See generally Staff Responses to Questions About the
Custody Rule, available at https://www.sec.gov/divisions/investment/custody_faq_030510.htm.
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     Instead of requiring prompt distribution of the audited
financial statement to investors, should we require the statement to be
distributed or made available to investors upon request?
     Should the rule provide additional flexibility, such as
for situations in which the adviser can demonstrate that it reasonably
believed that it would be able to comply with the rule but failed due
to certain unforeseeable circumstances?
     Should the rule require annual audits, as proposed? Should
the rule require an audit upon a private fund's liquidation, as
proposed? Should we modify either or both of these requirements? If so,
how should we modify these requirements, and why?
     Advisers would be required to comply with the proposed
audit rule beginning with their first fiscal year after the compliance
date and any liquidation that occurs after the compliance date.
Advisers would also be required to obtain an audit annually. We
understand that newly formed and liquidating funds may face unique
challenges. For instance, the value provided by an audit of a very
short period of time, such as a period of less than three-months (a
``stub period''), may be diminished because there is a lack of
comparability in the information provided. In addition, we understand
that the cost of obtaining an audit covering a few months can be
similar to the cost of an audit covering an entire fiscal year. We
further understand that when newly formed entities have few financial
transactions and/or investments, obtaining an audit, relative to the
investor protections ultimately offered by obtaining the audit, may be
burdensome. Should the rule allow newly formed or liquidating entities
to obtain an audit less frequently than annually to avoid stub period
audits? Should the rule permit advisers to satisfy the audit
requirement by relying on an audit on an interval other than annually
when a fund is liquidating? For example, should we allow advisers

to rely on an audit of a fund every two years during the liquidation
process?
     If the rule were to permit audits less frequently than on
an annual basis, should it also include additional restrictions or
requirements? If so, what restrictions or requirements, and why? For
instance, should it require investment advisers to create and
distribute alternative financial reporting for the fund to investors
(e.g., cash-flow audit or asset verification)? Alternatively, or in
addition to alternative financial reporting, should the rule require
advisers to obtain a third-party examination? If so, what should the
examination consist of, and why? For example, would allowing advisers
to obtain an audit less frequently than annually during a liquidation
raise investor protection concerns that additional requirements could
address given the potential for a liquidation to last for an extended
period? If so, what additional requirements, and why? For example,
should advisers be required to provide notice to investors of their
intent to liquidate an entity in these circumstances? Should advisers
be required to obtain investor consent prior to satisfying the audit
requirement by relying on audits on a less than annual basis? Should we
set an outer limit for the period such an audit could cover (e.g., 15
months)?
     Should the rule define ``liquidation'' for purposes of the
liquidation audit requirement? If so, how? For example, should we base
such a definition on a certain percentage of assets under management of
the entity from or over previous fiscal period(s) or a stated threshold
based on an absolute dollar amount of the entity's assets under
management? Should we base the definition on a calculation of the ratio
of the management fees assessed on assets under management of the
entity or some other basis, for example, to detect whether an adviser
is charging management fees on a very small amount of assets?
     Are there risks posed to investors when an entity is
liquidating that the proposed rule does not address? If so, please
describe those risks. How should we modify the rule to address such
risks?
     Are there some types of investments that pose a greater
risk of misappropriation or loss to investors during a liquidation that
the rule should specifically address to provide greater investor
protection? If so, please describe the investment type; the particular
risk the investment type poses to investors during liquidation; and how
to modify the proposed rule to address such investor risk.
     We are not proposing the filing of a copy of the audit
report or a copy of the audited financial statements with the
Commission; should the rule contain such a requirement? Why or why not?
     Would the requirement for an accountant to comply with the
notification requirement change the approach that an accountant would
take with respect to audits that normally are performed for purposes of
satisfying the custody rule? If so, how?
     Should we, as proposed, require advisers to enter into, or
cause a private fund to enter into, a written agreement with the
independent public accountant completing the audit to notify the
Commission in connection with a modified opinion or termination?
     Do commenters agree that the professional engagement
period of an audit performed under the rule should begin and end as
indicated in Regulation S-X rule 2-01(f)(5), as proposed? If not, why
not?
     As noted above, the proposed Commission notification
provision bears some similarities to, and is drawn from our experience
with, a similar custody rule requirement in the surprise examination
context with which we believe advisers may likely already have some
familiarity. The regulations in 17 CFR 240.17a-5 (rule 17a-5) require a
broker or dealer's self-report to the Commission within one business
day and to provide a copy to the accountant. The accountant must report
to the Commission about any aspects of the broker or dealer's report
with which the accountant does not agree. If the broker or dealer fails
to self-report, the accountant must report to the Commission to
describe any material weaknesses or any instances of non-compliance
that triggered the notification requirement. Should the audit rule
contain similar requirements? Why or why not? Are private fund advisers
and the accountants that perform private fund financial statement
audits more familiar with Rule 17a-5's notification requirement than
the custody rule's notification requirement?
     Do commenters agree that the related proposed amendments
to the books and records rule would facilitate compliance with the
proposed audit rule? What additional or alternative amendments should
the rule include, if any?

C. Adviser-Led Secondaries

    We propose to require an adviser to obtain a fairness opinion in
connection with certain adviser-led secondary transactions where an
adviser offers fund investors the option to sell their interests in the
private fund, or to exchange them for new interests in another vehicle
advised by the adviser. This would provide an important check against
an adviser's conflicts of interest in structuring and leading a
transaction from which it may stand to profit at the expense of private
fund investors. The proposed adviser-led secondaries rule would
prohibit an adviser from completing an adviser-led secondary
transaction with respect to any private fund, unless the adviser
distributes to investors in the private fund, prior to the closing of
the transaction, a fairness opinion from an independent opinion
provider and a summary of any material business relationships the
adviser or any of its related persons has, or has had within the past
two years, with the independent opinion provider.\135\
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    \135\ Proposed rule 211(h)(2)-2. The proposed rule would not
apply to advisers that are not required to register as investment
advisers with the Commission, such as state-registered advisers and
exempt reporting advisers.
---------------------------------------------------------------------------

    Investments in closed-end private funds are typically illiquid and
require a long-term investor commitment of capital. Such funds
generally do not permit investors to withdraw or redeem their fund
interests prior to the end of the term. Open-end private funds may also
limit or restrict an investor's ability to withdraw or redeem its
interest, for example, with side pockets or illiquid sleeves. Without
the ability to cash out all or a portion of their interest from the
fund, investors have historically sought liquidity by selling their
interests on the secondary market to third parties. Advisers typically
have a relatively minor role in such ``investor-led'' transactions, as
investors engage in the transaction directly with the prospective
purchaser.
    In recent years, advisers have become increasingly active in the
secondary market. The number of ``adviser-led'' transactions has
increased, with the deal value of such transactions representing a
meaningful portion of the secondary market, particularly for closed-end
private funds.\136\ Adviser-led transactions are similar to investor-
led transactions in that they typically provide a mechanism for
investors to obtain liquidity; however, they also

have the potential to provide additional benefits to advisers and
investors. For example, an adviser-led transaction may seek to secure
additional capital and/or time to maximize the value of fund assets. An
adviser may accomplish this by permitting investors to ``roll'' their
interests into a new vehicle that has a longer term and/or additional
capital to invest.\137\
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    \136\ See, e.g., Private Equity International, GP-Led
Secondaries Report (Feb. 28, 2021), available at https://www.privateequityinternational.com/gp-led-secondaries-report-2021/
(noting one industry participant estimated that adviser-led
secondary transactions accounted for $26 billion (or 44% of the
secondary market) in 2020, while another estimated that they
accounted for more than $30 billion (or more than 50% of the
secondary market)).
    \137\ An investor would typically obtain liquidity in the event
it elects to sell--rather than roll--its fund interest.
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    Adviser-led secondaries often are highly bespoke transactions that
can take many forms. For purposes of the rule, we propose to define
them as transactions initiated by the investment adviser or any of its
related persons that offer the private fund's investors the choice to:
(i) Sell all or a portion of their interests in the private fund; or
(ii) convert or exchange all or a portion of their interests in the
private fund for interests in another vehicle advised by the adviser or
any of its related persons.\138\ We generally would consider a
transaction to be initiated by the adviser if the adviser commences a
process, or causes one or more other persons to commence a process,
that is designed to offer private fund investors the option to obtain
liquidity for their private fund interests. However, whether the
adviser or its related person initiates a secondary transaction
requires a facts and circumstances analysis. We would generally not
view a transaction as initiated by the adviser if the adviser, at the
unsolicited request of the investor, assists in the secondary sale of
such investor's fund interest.
---------------------------------------------------------------------------

    \138\ Proposed rule 211(h)(1)-1.
---------------------------------------------------------------------------

    This definition generally would include secondary transactions
where a fund is selling one or more assets to another vehicle managed
by the adviser, if investors have the option either to obtain liquidity
or to roll all or a portion of their interests into the other vehicle.
Examples of such transactions may include single asset transactions
(such as the fund selling a single asset to a new vehicle managed by
the adviser), strip sale transactions (such as the fund selling a
portion of multiple assets to a new vehicle managed by the adviser),
and full fund restructurings (such as the fund selling all of its
assets to a new vehicle managed by the adviser). The proposed
definition also would capture secondary transactions that may not
involve a cross sale between two vehicles managed by the same
adviser.\139\ For example, an adviser may arrange for one or more new
investors to purchase fund interests directly from the existing
investors as part of a ``tender offer'' or similar transaction.
---------------------------------------------------------------------------

    \139\ We would not consider the proposed rule to apply to cross
sales where the adviser does not offer the private fund's investors
the choice to sell, convert, or exchange their fund interest.
---------------------------------------------------------------------------

    While adviser-led transactions can provide liquidity for investors
and secure additional time and capital to maximize the value of fund
assets, they also raise certain conflicts of interest. The adviser and
its related persons typically are involved on both sides of the
transaction and have interests in the transaction that are different
than, or in addition to, the interests of the private fund investors.
For example, because the adviser may have the opportunity to earn
economic and other benefits conditioned upon the closing of the
secondary transaction, such as additional management fees or carried
interest, the adviser generally has a conflict of interest in setting
and negotiating the transaction terms.
    Ensuring that the private fund and the investors that participate
in the secondary transaction are offered a fair price is a critical
component of preventing the type of harm that might result from the
adviser's conflict of interest in leading the transaction.\140\
Accordingly, prior to the closing of the transaction, the proposed rule
would require advisers to obtain a written opinion stating that the
price being offered to the private fund for any assets being sold as
part of an adviser-led secondary transaction is fair.\141\ This process
would provide an important market check for private fund investors by
providing some assurance that the price being offered is based on an
underlying valuation that falls within a range of reasonableness. We
understand that certain advisers obtain fairness opinions as a matter
of best practice because investors often lack access to sufficient
information, or may not have the capabilities or resources, to conduct
their own analysis of the price. However, to the extent that this
practice is not universal, the proposed rule would mandate it in
connection with all adviser-led secondary transactions.
---------------------------------------------------------------------------

    \140\ As a fiduciary, the adviser is obligated to act in the
fund's best interest and to make full and fair disclosure to the
fund of all conflicts and material facts associated with the
adviser-led transaction. See, e.g., Commission Interpretation
Regarding Standard of Conduct for Investment Advisers, Investment
Advisers Act Release No. 5248 (June 5, 2019) [84 FR 33669 (July 12,
2019)], at 24-25 (``2019 IA Fiduciary Duty Interpretation''). See
also EXAMS Private Funds Risk Alert 2020, supra footnote 9.
    \141\ Proposed rule 211(h)(1)-1 (defining ``fairness opinion'').
---------------------------------------------------------------------------

    To mitigate the potential influence of the adviser's conflict of
interest further, the rule would require these opinions to be issued
only by an ``independent opinion provider,'' which is one that (i)
provides fairness opinions in the ordinary course of its business and
(ii) is not a related person of the adviser.\142\ The ordinary course
of business requirement would largely correspond to persons with the
expertise to value illiquid and esoteric assets based on relevant
criteria. The requirement that the opinion provider not be a related
person of the adviser would reduce the risk that certain affiliations
could result in a biased opinion.\143\
---------------------------------------------------------------------------

    \142\ Proposed rule 211(h)(1)-1.
    \143\ See supra section II.A for a discussion of the definition
of ``related person.''
---------------------------------------------------------------------------

    We recognize, however, that other business relationships may have
the potential to result, or appear to result, in a biased opinion,
particularly if such relationships are not disclosed to private fund
investors. For example, an opinion provider that receives an income
stream from an adviser for performing services unrelated to the
issuance of the opinion might not want to jeopardize its business
relationship with the adviser by alerting the private fund investors
that the price being offered is unfair (or by otherwise refusing to
issue the fairness opinion). By requiring disclosure of such material
relationships, the proposed rule would put private fund investors in a
position to evaluate whether any conflicts associated with such
relationships may cause the opinion provider to deliver a biased
opinion. Thus, the proposed rule would require the adviser to prepare
and distribute to private fund investors a summary of any material
business relationships the adviser or any of its related persons has,
or has had within the past two years, with the independent opinion
provider. Whether a business relationship would be material under the
proposed rule would require a facts and circumstances analysis;
however, for purposes of the proposed rule, we believe that audit,
consulting, capital raising, investment banking, and other similar
services would typically meet this standard.
    The proposed rule would require an adviser to distribute the
opinion and the material business relationship summary to
investors.\144\ We believe that this proposed requirement would ensure
that investors receive the benefit of an independent price assessment,
which we believe will improve their decision-making ability and their
overall confidence in the transaction.
---------------------------------------------------------------------------

    \144\ Proposed rule 211(h)(2)-2.
---------------------------------------------------------------------------

    We request comment on all aspects of the proposed rule, including
the following items:

     Do commenters agree that adviser-led secondary
transactions can be of some benefit to a private fund and its
investors?
     Do commenters agree with the scope of the proposed rule?
Should the rule apply to all investment advisers? Why or why not? What
are the factors that weigh in favor of expanding the scope of the
proposed rule to apply to a broader scope of advisers than proposed?
Are there particular types of advisers that should or should not be
subject to the rule? Should the rule only apply when the adviser or its
related person is general partner (or equivalent) of a fund that is
party to the transaction?
     Should certain adviser-led transactions be exempt from the
proposed rule? For example, if the adviser conducts a competitive sale
process for the assets being sold, which ultimately leads to the price,
should advisers still be required to obtain a fairness opinion? Do
competitive bids typically represent net asset value? Do prospective
purchasers typically bid at a discount to net asset value? Does net
asset value always correspond to the current value of the assets being
sold? Why or why not? Are there other price discovery processes that we
should require to protect investors?
     Should certain adviser-led transactions be exempt from the
rule, such as adviser-led transactions involving liquid funds? For
example, if the underlying assets being sold in the transaction are
predominantly publicly traded securities, should advisers still be
required to obtain a fairness opinion? Do such transactions present the
same concerns as adviser-led secondary transactions involving illiquid
funds where the underlying assets are typically illiquid and not listed
or quoted on a securities exchange? Are there other hedge fund
transactions that we should exempt from the rule, such as hedge fund
restructurings where an adviser may be merging the portfolios of two
different hedge funds and gives all affected investors the option to
redeem or convert/exchange their interests into the new fund? Should
the exemption depend on whether the price of the transaction is based
on net asset value? Why or why not?
     Are there other transactions for which we should require
private fund advisers to obtain a fairness opinion? For example, should
we require advisers to obtain a fairness opinion before certain cross
transactions between private funds it manages? If so, which
transactions? Should we provide certain cross transaction exemptions,
such as exemptions for bridge financings or syndications where the
selling fund transfers the investments within a short period at a price
equal to cost plus interest?
     Should the scope of the fairness opinion be limited to the
price, as proposed? Alternatively, should we require the fairness
opinion to cover all, or certain other, terms of the transaction? For
example, should we revise the definition of ``fairness opinion'' to a
written opinion stating that the terms of the adviser-led secondary
transaction are fair to the private fund? Why or why not?
     Should the rule give investment advisers the option to
obtain either a fairness opinion or a third-party valuation? Why or why
not? What are the advantages and disadvantages of a third-party
valuation as compared to a fairness opinion, and vice versa?
     We request comment on the proposed use of ``related
person.'' Do commenters agree that the fairness opinion should be
issued by a person that is not a related person of the adviser? Should
we adopt a different definition of ``related person'' than the one
proposed?
     The proposed rule would require an ``independent opinion
provider'' to provide fairness opinions ``in the ordinary course of its
business.'' Do commenters agree with this approach?
     Instead of requiring disclosure of any material business
relationships between the adviser (or its related persons) and the
independent opinion provider, should the rule prohibit firms with
certain business relationships with the adviser, its related persons,
or the private fund from providing the fairness opinion? For example,
if a firm has provided consulting, prime broker, audit, capital
raising, or investment banking services to the private fund or the
adviser or its related persons within a certain time period--such as
two or three years--should the rule prohibit the firm from providing
the opinion? If so, should the rule include a threshold of materiality,
regularity, or frequency for some or all of such services to trigger
such a prohibition?
     Should we require the independent opinion provider to have
any specific qualifications, licenses, or registrations?
     Should we define the term ``transaction'' in the
definition of ``adviser-led secondary transaction''? If so, how should
the rule define ``transaction''? Should we reference the various types
of adviser-led secondary transactions in the definition? For example,
should ``transaction'' include only single asset transactions, strip
sale transactions, and other similar secondary transactions? Should we
include in the definition of ``adviser-led secondary transaction''
transactions initiated by the adviser's related persons?
     Should we define, or provide additional guidance
regarding, the phrase ``initiated by the investment adviser or any of
its related persons''? Should we define, or provide additional guidance
regarding, the role the adviser would have to play in a secondary
transaction for it to be considered an adviser-led transaction subject
to the proposed rule?
     Should the rule require the fairness opinion to state that
the private fund and/or its investors may rely on the opinion? Why or
why not?
     Should we require the fairness opinion to be obtained on
behalf of the private fund as proposed? Alternatively, should we
require the fairness opinion to be obtained on behalf of the private
fund investors? Are there characteristics of certain types of adviser-
led transactions, such as tender offers, that would require the
fairness opinion to be obtained on behalf of the private fund investors
rather than the private fund?
     Should the adviser be required to distribute a summary of
any material business relationships the adviser or its related persons
has, or has had within the past two years, with the independent opinion
provider as proposed? Should we provide guidance or impose requirements
regarding the level of detail advisers should include in the summary?
For example, should we require advisers to disclose the total amount
paid to the independent opinion provider by the adviser or its related
persons, if applicable? Why or why not? Is two years the appropriate
look-back period? Are there any other conflict disclosures we should
require in the fairness opinion or otherwise require to be made
available to investors?
     Should we define ``material business relationship'' for
purposes of the proposed rule? Should the rule include a threshold of
regularity or frequency (in addition to or in lieu of the materiality
threshold) for some or all of such relationships or services to trigger
a disclosure requirement?
     Should we require advisers to distribute the fairness
opinion to investors as proposed? Alternatively, should we require
advisers to only distribute or make the fairness opinion available to
investors upon request?
     We recognize that certain adviser-led transactions may not
involve investors rolling their interests into a new vehicle managed by
the adviser. For example, an adviser may arrange for a new investor to
offer to purchase fund interests directly from existing

investors, such as a tender offer. Do commenters agree that the first
prong of the definition would cover such transactions? Should the rule
treat such transactions differently?
     Should the rule apply to adviser-led transactions
initiated by the adviser or its related persons as proposed? Is the
definition of ``related person'' too broad in this context such that it
would capture secondary transactions initiated by third parties
unrelated to the adviser? Should we revise the definition of ``related
person'' to include an investment discretion requirement? Similarly, is
the definition of ``control'' too broad in this context?
     We recognize that, for certain adviser-led transactions,
the closing of the underlying deal may not occur simultaneously with
the closing of the new vehicle managed by the adviser. How should the
rule take this into account, if at all? For example, should we clarify
that, for purposes of the rule, an adviser would not be deemed to have
completed an adviser-led secondary transaction until the underlying
deal has closed (if applicable)? Alternatively, should we prohibit an
adviser from calling investor capital prior to obtaining and
distributing the fairness opinion?
1. Recordkeeping for Adviser-Led Secondaries
    We propose amending rule 204-2 under the Advisers Act to require
advisers to retain books and records to support their compliance with
the proposed adviser-led secondaries rule, which would help facilitate
the Commission's inspection and enforcement capabilities. We propose to
require advisers to retain a copy of the fairness opinion and material
business relationship summary distributed to investors, as well as a
record of each addressee, the date(s) the opinion was sent,
address(es), and delivery method(s).\145\ These proposed requirements
would facilitate our staff's ability to assess an adviser's compliance
with the proposed rule and would similarly enhance an adviser's
compliance efforts.
---------------------------------------------------------------------------

    \145\ See supra footnote 106 (describing the record retention
requirements under the books and records rule).
---------------------------------------------------------------------------

    We request comment on this aspect of the proposed rule:
     Should we require advisers to maintain the proposed
records or would these requirements be overly burdensome for advisers?
Are there alternative or additional recordkeeping requirements we
should impose?
     Should we require advisers to retain a record of each
addressee, the date(s) the statement was sent, address(es), and
delivery method(s) as proposed? Why or why not?

D. Prohibited Activities

    We are also proposing to prohibit a private fund adviser from
engaging in certain sales practices, conflicts of interest, and
compensation schemes that are contrary to the public interest and the
protection of investors. We have observed certain industry practices
over the past decade that have persisted despite our enforcement
actions and that disclosure alone will not adequately address.\146\ As
discussed below, we believe that these sales practices, conflicts of
interest, and compensation schemes must be prohibited in order to
prevent certain activities that could result in fraud and investor
harm.\147\ We believe these activities incentivize advisers to place
their interests ahead of their clients' (and, by extension, their
investors'), and can result in private funds and their investors,
particularly smaller investors that are not able to negotiate
preferential deals with the adviser and its related persons, bearing an
unfair proportion of fees and expenses. The proposed rule would
prohibit these activities regardless of whether the private fund's
governing documents permit such activities or the adviser otherwise
discloses the practices and regardless of whether the private fund
investors (or governance mechanisms acting on their behalf, such as
limited partner advisory committees) have consented to the activities
either expressly or implicitly. Also, the proposed rule would prohibit
these activities even if they are performed indirectly, for example by
an adviser's related persons, because the activities have an equal
potential to harm the fund and its investors regardless of whether the
adviser engages in the activity directly or indirectly.\148\ As noted
above, we believe these prohibitions are necessary given the lack of
governance mechanisms that would help check overreaching by private
fund advisers.
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    \146\ See High-End Bargaining Problems, Vanderbilt Law Review
(forthcoming), Professor William Clayton (Jan. 8, 2022) at 9
(challenging ``the idea that sophisticated parties will demand
appropriate levels of disclosure and appropriate processes without
any intervention by policymakers . . .'').
    \147\ See sections 206 and 211(h)(2) of the Act.
    \148\ Any attempt to avoid any of the proposed rules'
restrictions, depending on the facts and circumstances, would
violate section 208(d) of the Act's general prohibitions against
doing anything indirectly which would be prohibited if done
directly. Section 208(d) of the Advisers Act.
---------------------------------------------------------------------------

    Proposed rule 211(h)(2)-1 would prohibit an investment adviser to a
private fund, directly or indirectly, from engaging in certain
activities with respect to the private fund or any investor in that
private fund, including:
    (i) Charging certain fees and expenses to a private fund or
portfolio investment, including accelerated monitoring fees; fees or
expenses associated with an examination or investigation of the adviser
or its related persons by governmental or regulatory authorities;
regulatory or compliance expenses or fees of the adviser or its related
persons; or 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;
    (ii) Reducing the amount of any adviser clawback by the amount of
certain taxes;
    (iii) 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; and
    (iv) Borrowing money, securities, or other fund assets, or
receiving an extension of credit, from a private fund client.
    This proposed rule would apply to all advisers to private funds,
regardless of whether they are registered with the Commission or one or
more states, exempt reporting advisers, or prohibited from
registration. We believe that this scope is appropriate since we
believe these activities are contrary to the public interest and the
protection of investors and have the potential to lead to fraud. We are
proposing this rule under sections 206 and 211 of the Advisers Act,
which sections apply to all investment advisers, regardless of SEC-
registration status.
    We request comment on the scope of the proposed rule, including the
following items:
     Should the rule apply to all advisers as proposed?
Alternatively, should the rule apply only to SEC-registered advisers?
If so, why?
     Should the rule only prohibit these activities with
respect to an adviser's private fund clients and the investors in those
private funds? Should the rule apply more broadly or more narrowly? For
example, should the rule apply to such activities with respect to all
clients of an adviser? Should the rule apply to such activities with
respect to persons to which the adviser offers co-

investment opportunities even if the adviser does not classify them as
its clients?
     We have historically taken the position that most of the
substantive provisions of the Advisers Act do not apply with respect to
the non-U.S. clients (including funds) of a registered offshore
adviser.\149\ In taking this approach, the Commission noted that U.S.
investors in an offshore fund generally would not expect the full
protection of the U.S. securities laws and that U.S. investors may be
precluded from an opportunity to invest in an offshore fund if their
participation would result in full application of the Advisers Act and
rules thereunder.\150\ Similarly, the proposed prohibited activities
rule would not apply to a registered offshore adviser's private funds
organized outside of the United States, regardless of whether the
private funds have U.S. investors. Do commenters agree that registered
offshore advisers should not be subject to this rule with respect to
their offshore private fund clients or offshore investors? Should other
rules in this rulemaking package take the same approach, or a different
approach, with respect to a registered offshore adviser's offshore
private fund clients? Please explain.
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    \149\ See, e.g., Exemptions for Advisers to Venture Capital
Funds, Private Fund Advisers With Less Than $150 Million in Assets
Under Management, and Foreign Private Advisers, Investment Advisers
Act Release No. 3222 (June 22, 2011) [76 FR 39645 (July 6, 2011)];
Marketing Release, supra footnote 61, at n.199.
    \150\ See Registration Under the Advisers Act of Certain Hedge
Fund Advisers, Investment Advisers Act Release No. 2333 (Dec. 2,
2004) [69 FR 72054, 72072 (Dec. 10, 2004)].
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     Instead of prohibiting these activities, should the rule
prohibit these activities unless the adviser satisfies certain
governance and other conditions (e.g., disclosure to investors in all
relevant funds/vehicles, approval by the limited partner advisory
committee (or other similar body) or directors)? Should the rule
prohibit these activities unless the adviser obtains approval for them
by a majority (by number and/or in interest) of investors? Should the
rule permit non pro-rata fee and expense allocations if such practice
is disclosed to, and consented by, co-investors?
     Should we amend the books and records rule to require
advisers to retain specific documentation evidencing compliance with
the prohibited activities rule? For example, records showing how fees
and expenses associated with an examination or investigation of the
adviser or its related persons by governmental or regulatory
authorities were paid or showing the allocations of fees and expenses
related to a portfolio investment on an investment by investment basis?
Would advisers be able to obtain or generate sufficient records to
demonstrate compliance with all aspects of the proposed rule? Should we
amend the books and records rule to require advisers to prepare a
memorandum on an annual basis attesting to their compliance with each
aspect of the proposed rule?
1. Fees for Unperformed Services
    First, the prohibited activities rule would prohibit an investment
adviser from 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.\151\ These payments sometimes are referred to as
``accelerated payments.''
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    \151\ Proposed rule 211(h)(2)-1(a)(1).
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    An adviser typically receives management fees and performance-based
compensation for providing advisory services to a fund. A fund's
portfolio investments may also make payments to the adviser and its
related persons. For example, some private fund advisers enter into
arrangements with a fund's portfolio investments to provide management,
consulting, financial, servicing, advisory, or other services. The
adviser and the applicable portfolio investment would enter into a
monitoring agreement or a management services agreement documenting the
payment terms and the services the adviser will provide.\152\ Such
agreements often include acceleration clauses, which permit the adviser
to accelerate the unpaid portion of the fee upon the occurrence of
certain triggering events, even though the adviser will never provide
the contracted for services.\153\ The accelerated payments reduce the
value of the portfolio investment upon the private fund's exit and thus
reduce returns to investors.
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    \152\ Monitoring fees frequently are based on a percentage of
EBITDA (earnings before income, taxes, depreciation, and
amortization). The agreements often renew automatically and
typically include periodic fee increases.
    \153\ Common triggering events include initial public offerings,
dispositions, and change of control events.
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    Because the private fund (and, by extension, its investors)
typically bears the costs of such payments indirectly and the adviser
typically receives the benefit, the receipt of such fees gives rise to
conflicts of interest between the fund (and, by extension, its
investors), on the one hand, and the adviser, on the other hand. For
example, the adviser receives the benefit of the accelerated fees
without incurring any costs associated with having to provide any
services. The private fund, however, may have a lower return on its
investment because the accelerated monitoring fees may reduce the
portfolio investment's available cash, in turn reducing the
investment's value in advance of a public offering or sale transaction.
An adviser also may have an incentive to cause the fund to exit a
portfolio investment earlier than anticipated, which may result in the
fund receiving a lesser return on its investment.\154\ Further, the
potential for the adviser to receive these economic benefits creates an
incentive for the adviser to seek portfolio investments for its own
benefit rather than for the fund's. We believe prohibiting this
practice, which distorts the economic relationship between the private
fund and the adviser, would help prevent the adviser from placing its
own interests ahead of the private fund.
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    \154\ Such incentive may be mitigated, in certain circumstances,
to the extent the adviser's performance-based compensation would
also be reduced in whole or part by the receipt of these payments.
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    In addition to these conflicts, we believe that charging a
portfolio investment for unperformed services creates a compensation
scheme that is contrary to the public interest and the protection of
investors because such practice unjustly enriches the adviser at the
expense of the private fund and its underlying investors who are not
receiving the benefit of any services. Accordingly, the proposed rule
would prohibit an adviser from charging these types of accelerated
payments.
    The prohibited activities rule would not prohibit an adviser from
receiving payment for services actually provided. The proposed rule
also would not prohibit an adviser from receiving payments in advance
for services that it reasonably expects to provide to the portfolio
investment in the future. For example, if an adviser expects to provide
monitoring services to a portfolio investment, the proposed rule would
not prohibit the adviser from charging for those services.\155\ Rather,
the proposed rule would prohibit compensation schemes where an

adviser charges for services that it does not reasonably expect to
provide.
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    \155\ To the extent the adviser ultimately does not provide the
services, however, the proposed rule would require the adviser to
refund any prepaid amounts attributable to the unperformed services.
See proposed rule 211(h)(2)-1(a)(1) (prohibiting an adviser from
charging a portfolio investment for fees in respect of any services
that the investment adviser does not provide to the portfolio
investment).
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    We also do not intend to prohibit an arrangement where the adviser
shifts 100% of the economic benefit of any portfolio investment fee to
the private fund investors, whether through an offset, rebate, or
otherwise. We recognize that certain advisers offset management fees or
other amounts payable to the adviser at the fund level by the amount of
portfolio investment fees paid to the adviser. However, private funds
with a 100% management fee offset would not comply with the proposed
rule if there are excess fees retained by the adviser where no further
management fee offset can be applied and the private fund investors are
not offered a rebate or another economic benefit equal to their pro
rata share of any such excess fees.
    We request comment on this aspect of the prohibited activities
rule, including the following items:
     Are there any scenarios in which we should permit an
adviser to charge a fund's portfolio investment for unperformed
services? If so, please explain.
     Should we prohibit an adviser from being paid in advance
for services it reasonably expects to provide in the future? Why or why
not?
     As noted above, if an adviser is paid in advance, and
reasonably expects to perform services, but ultimately does not provide
the contracted for services, the proposed rule would require the
adviser to refund the prepaid amount attributable to the unperformed
services. Do commenters agree with this approach? Why or why not?
     The proposed rule specifically references ``monitoring,
servicing, consulting, or other fees.'' Do commenters agree with this
list? Should we eliminate any? Are there additional or alternative
types of remuneration that the rule should reference?
     Do commenters agree that if an adviser shifts 100% of the
economic benefit of any portfolio investment fee to the private fund
investors, whether through an offset, rebate, or otherwise, the adviser
would not violate the proposed rule? Why or why not? We recognize that
certain tax-sensitive investors often waive the right to receive their
share of any rebates of portfolio investment fees. How should the rule
take into account such waivers, if it all? For example, to the extent
one investor does not accept its share, should the rule require the
adviser to distribute such amount to the other investors in the fund?
Why or why not?
     Should the rule instead permit an adviser to engage in
this activity if the adviser satisfies certain disclosure, governance,
and/or other conditions (e.g., disclosure to investors in all relevant
funds/vehicles, approval by the LPAC (or other similar body) or
directors)?
     The proposed rule would prohibit compensation schemes
where an adviser charges for services that it does not reasonably
expect to provide. Is ``reasonably expect'' the appropriate standard?
Should we provide examples or guidance to assist advisers in complying
with this standard? Does this standard have the potential to reduce the
effectiveness of the rule? Are there other standards we should adopt?
2. Certain Fees and Expenses
    The second and third elements of the prohibited activities rule
would prevent an adviser from charging a private fund for fees or
expenses associated with an examination or investigation of the adviser
or its related persons by any governmental or regulatory authority, as
well as regulatory and compliance fees and expenses of the adviser or
its related persons.\156\
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    \156\ Proposed rules 211(h)(2)-1(a)(2) and (3). This prohibition
would include fees and expenses related to an examination or
investigation of the adviser by the Commission, including the amount
of any settlements or fines paid in connection therewith.
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    Advisers incur various fees and expenses in connection with the
establishment and ongoing operations of their advisory business.
Establishment fees and expenses often relate to the structuring and
organization of the adviser's business, including the adviser's
registration with financial regulators, such as the Commission. Ongoing
fees and expenses often relate to the adviser's overhead and
administrative expenses, such as salary, rent, and office supplies.
Ongoing expenses also may include those associated with an examination
or investigation of the adviser or its related persons.
    The proposed rule would prohibit an adviser from charging a private
fund for (i) fees and expenses associated with an examination or
investigation of the adviser or its related persons by any governmental
or regulatory authority, and (ii) regulatory or compliance fees and
expenses of the adviser or its related persons, even where such fees
and expenses are otherwise disclosed. We have seen an increase in
private fund advisers charging these expenses to private fund clients.
These types of expenses, which are a cost of being an investment
adviser, should not be passed on to private fund investors, whether as
a separate expense (in addition to a management fee) or as part of a
pass-through expense model.\157\ For example, we believe advisers
should bear the compliance expenses related to their registration with
the Commission, including fees and expenses related to preparing and
filing all items and corresponding schedules in Form ADV. Similarly, we
believe that an adviser should bear any expenses related to state
licensing and registration requirements applicable to the adviser and
its related persons, including expenses related to registration and
licensure of advisory personnel who contact or solicit investments from
state pension or similar plans.
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    \157\ 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. We recognize that
this aspect of the proposed rule would likely require advisers that
pass on the types of fees and expenses we propose to prohibit to re-
structure their fee and expense model.
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    We believe allocating these types of expenses to a private fund
client is contrary to the public interest and is harmful to investors
because they create an incentive for an adviser to place its own
interests ahead of the private fund's interests and unfairly allocate
expenses to the fund, even where fully disclosed. For example, in some
circumstances, an adviser may charge a fund significant fees and
expenses in connection with an investigation that may not be in the
fund's best interest. Further, as discussed above, we believe the
prohibited fees and expenses are related to forming and operating an
advisory business and thus should be borne by the adviser and its
owners rather than the private fund and its investors.
    We do not anticipate this aspect of the proposed prohibited
activities rule would cause a dramatic change in practice for most
private fund advisers, other than for certain advisers that utilize a
pass-through expense model as noted above. We recognize, however, that
advisers often charge private funds for regulatory, compliance, and
other similar fees and expenses directly related to the activities of
the private fund. The proposed rule would not change this practice. For
example, the proposed rule would not prohibit an adviser from charging
a private fund for all the costs associated with a regulatory filing of
the fund, such as Form D.\158\ In addition, we acknowledge that it may
not be clear whether certain fees and

expenses relate to the fund or the adviser, or it may not be clear
until after a significant amount of time has passed in certain cases.
In these circumstances, an adviser generally should allocate such fees
and expenses in a manner that it believes in good faith is fair and
equitable and is consistent with its fiduciary duty.
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    \158\ Advisers may be liable under the antifraud provisions of
the Federal securities laws if the private fund's offering and
organizational documents do not authorize such costs to be charged
to the private fund.
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    We request comment on this aspect of the prohibited activities
rule, including the following items:
     Are there circumstances in which it would be appropriate
in the public interest or for the protection of investors for a private
fund to bear (i) regulatory or compliance expenses of the adviser or
its related persons or (ii) expenses related to an examination or
investigation of the adviser or its related persons? If so, please
explain. Should we permit private funds to bear these fees and expenses
if fully disclosed and consented to by the private fund investors and/
or an LPAC (despite the limitations of private fund governance
mechanisms, as discussed above)? Should we place any conditions on
charging these fees and expenses, such as caps, management fee offsets,
or detailed reporting requirements in the proposed quarterly statement?
     The proposed rule would likely increase operating costs
for advisers that have historically charged private funds for the types
of fees and expenses covered by the proposed rules.
    Do commenters believe that advisers would increase management fees
to offset such increase in operating costs?
     Are there any additional types of fees or expenses that we
should prohibit an adviser from charging to a private fund?
Alternatively, are there fees and expenses that the rule should not
prohibit?
     Should we provide exceptions to the proposed rules for
certain types of private funds and/or certain types of advisers? For
example, should we permit a first-time fund adviser to charge
regulatory and compliance expenses to the fund? If so, why?
     Do commenters agree that many advisers do not currently
charge private funds for the types of fees and expenses covered by the
proposed rules and, as a result, the proposed rules would not cause a
dramatic change in industry practice? Why or why not? To the extent
commenters disagree, please provide supporting data.
     Will advisers have difficulty in determining whether fees
and expenses relate to the adviser's activities versus the fund's
activities? Should we provide guidance to assist advisers in making
such a determination? If so, what guidance should we provide? Should
the rule list certain types of fees and expenses that relate to the
adviser's activities versus the fund's activities?
     As discussed above, we recognize that certain private fund
advisers utilize a pass-through expense model. Should the rule provide
any full or partial exceptions for advisers utilizing such models,
particularly where the adviser does not charge any management,
advisory, or similar fees to the private fund?
3. Reducing Adviser Clawbacks for Taxes
    The fourth element of the prohibited activities rule would 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. We propose to
define ``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.\159\
We propose to define ``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.\160\
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    \159\ Proposed rule 211(h)(2)-1(a)(4). Because performance-based
compensation may be allocated or granted to individuals and entities
otherwise unaffiliated with the adviser, the proposed definition is
drafted broadly to capture any owner or interest holder of the
adviser or its related persons.
    \160\ Proposed rule 211(h)(1)-1. The proposed rule would not
apply to any clawbacks by an adviser of incentive compensation under
an arrangement subject to Section 956 of the Dodd-Frank Act and
regulations thereunder.
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    Investors typically seek to align their interests with the
adviser's interest by tying the adviser's compensation to the success
of the private fund. To accomplish this, many private funds provide the
adviser with a disproportionate share of profits generated by the fund,
often referred to as performance-based compensation.\161\ The adviser's
performance-based share of fund profits is often greater than the
adviser's ownership percentage in the fund.\162\ Although the
percentage can vary, a common performance-based compensation percentage
is 20%, meaning that, for each dollar of profit generated by the fund,
the adviser is generally entitled to 20 cents and the fund investors
are generally entitled to the remaining 80 cents.
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    \161\ Certain private funds refer to performance-based
compensation as carried interest, incentive fees, incentive
allocations, or profit allocations.
    \162\ For alignment of interest purposes, advisers often invest
their own capital in the fund alongside the third party capital.
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    Because the profitability of a private fund will fluctuate over
time, the amount of performance-based compensation to which the adviser
is entitled will also fluctuate. For example, a fund may initially
generate significant profits due to early realizations of successful
investments, resulting in distributions to the adviser. However, the
fund may subsequently dispose of unsuccessful investments, resulting in
losses to the fund. Certain private funds include ``clawback''
mechanisms in their governing agreements, which require the adviser (or
a related person of the adviser) \163\ to restore distributions or
allocations to the fund to the extent the adviser receives performance-
based compensation in excess of the amount to which it is otherwise
entitled under the fund's governing agreement. Typically, this means
that the adviser is required to return to the fund distributions or
allocations representing more than a specified percentage (e.g., 20%)
of the fund's aggregate profits. The clawback mechanism is intended to
ensure that the adviser and the investors ultimately receive the
appropriate split of cumulative profits generated over the life of the
fund or the applicable measurement period.
---------------------------------------------------------------------------

    \163\ For tax and other reasons, a related person of the
adviser, rather than the adviser, often receives the performance-
based compensation from the fund.
---------------------------------------------------------------------------

    Advisers and investors often negotiate whether the clawback amount
should be reduced by taxes paid, or deemed paid, by the adviser or its
owners.\164\ For example, if an adviser received $10 of ``excess''
performance-based compensation, but the adviser or its owners paid $3
in taxes on such amount, investors often argue that the adviser should
be required to return the ``pre-tax'' amount ($10), while advisers
argue that they should only be required to return the ``post-tax''
amount ($7). To support the post-tax position, advisers often argue
that they should only be required to return the portion of excess

distributions they ultimately retain (and not the portion paid to any
taxing authority). Advisers also argue that, to the extent the clawback
occurs in any year subsequent to the year in which the performance-
based compensation was paid, it may be burdensome or impractical for
the adviser or its owners to amend tax returns from prior years or
otherwise take advantage of loss carryforwards for future tax
years.\165\
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    \164\ Fund agreements may require advisers to restore
performance-based compensation under other fact patterns as well.
For example, if an adviser has received performance-based
compensation, but the investors have not received the requisite
preferred return amount, the adviser may be subject to a clawback.
Any such requirement to restore or otherwise return performance-
based compensation under a private fund's governing agreement would
be covered by the proposed rule. See proposed rule 211(h)(1)-1
(defining ``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).
    \165\ When the clawback occurs in a subsequent tax year, the
``excess'' performance-based compensation will likely have already
been subject to tax in the year it was paid, even if the amount
subject to the clawback is determined on a pre-tax basis.
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    We believe that reducing the amount of any adviser clawback by
taxes applicable to the adviser puts the adviser's interests ahead of
the investors' interests and creates a compensation scheme that is
contrary to the public interest and the protection of investors, even
where such practice is disclosed. The interests of investors to receive
their share of fund profits--without any adviser tax reductions--
justifies the burdens on advisers, including the obligation to amend
tax returns. Advisers typically have control over the methodology used
to determine the timing of performance-based compensation distributions
or allocations, such as any waterfall arrangement.\166\ Advisers also
typically have control over whether the fund will make a distribution
or allocation of performance-based compensation. Advisers thus have
discretion to defer or otherwise delay payments, particularly if the
adviser is concerned about the possibility of a clawback.\167\ Even if
an adviser cannot defer or delay a payment, the adviser can escrow
performance-based compensation rather than making a payment to its
owners, which would allow the adviser to cover all or a portion of a
clawback obligation that may arise in the future. Accordingly, the
proposed rule would foster greater alignment of interest between
advisers and investors by prohibiting advisers from unfairly causing
investors to bear these tax costs associated with the payment,
distribution, or allocation of ``excess'' performance-based
compensation.
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    \166\ Private fund investors often seek to negotiate the
waterfall arrangement, and the timing of performance-based
compensation distributions, with the adviser. The issues relating to
clawbacks often arise in the context of a waterfall arrangement that
provides performance-based compensation to the adviser on a deal-by-
deal basis (or modified versions thereof), versus a waterfall
arrangement that is applied across the whole-fund with distributions
going to investors until the investors recoup 100% of their capital
contributions and receive a preferred return thereon. Both models
should generally result in the adviser and the investors receiving
the same split of fund profits over the life of the fund assuming
the fund documents have a clawback mechanism. The main distinction
between the two models is the timing of distributions or allocations
of performance-based compensation to the adviser. Whole-fund
waterfalls are often referred to in the private funds industry as
European waterfalls; deal-by-deal waterfalls are often referred to
as American waterfalls.
    \167\ We recognize that an adviser (and its personnel) may be
subject to a tax obligation whether or not the fund makes a
distribution, payment, or allocation of performance-based
compensation (e.g., tax allocations of income may precede or follow
cash payments of performance-based compensation), including if the
adviser places the performance-based compensation into escrow.
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    We request comment on this aspect of the proposed rule, including
the following items:
     Would this aspect of the proposed prohibited activities
rule have our intended effect of ensuring that investors receive their
full share of profits generated by the fund? Is there an alternative
approach that would better produce this intended effect? For example,
should we require advisers to return the entire amount of any adviser
clawback, rather than only prohibiting advisers from reducing the
clawback amount by actual, potential, or hypothetical taxes? Would this
approach ensure that investors receive their full share of fund
profits?
     Would the proposed clawback provision result in more
whole-fund waterfalls (commonly referred to as European waterfalls in
the private funds industry), which generally delay payments of
performance-based compensation until investors receive a return of all
capital contributions? What other effects would this aspect of the
proposed rule have on the industry, including with respect to adviser's
ability to attract, retain, and develop investment professionals?
     Instead of the proposed clawback provision, should we
prohibit deal-by-deal waterfall arrangements (commonly referred to as
American waterfalls)?
     We recognize that clawback mechanisms are more common for
closed-end funds and less common for open-end funds. Should the rule
separately address performance-based compensation for open-end private
funds? If so, how should we address those funds?
     Is the proposed definition of ``adviser clawback'' clear?
Are there ways in which the proposed definition is over- or under-
inclusive? For example, should the definition include ``all-partner''
givebacks or clawbacks (i.e., should advisers be prohibited from
reducing the portion of an all-partner giveback attributable to their
performance-based compensation by taxes paid or deemed paid)?\168\
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    \168\ An ``all-partner'' giveback is typically a requirement for
all investors to return or otherwise restore distributions to the
fund. An adviser may use this mechanism for the purpose of
satisfying fund obligations, liabilities, or expenses.
---------------------------------------------------------------------------

     Is the proposed definition of ``performance-based
compensation'' clear? Is it too narrow or too broad?
     What issues may advisers face in complying with this
aspect of the proposed prohibited activities rule? In particular, what
issues may result with respect to amending tax returns from prior
years?
     We recognize that this aspect of the proposed rule might
result in delayed payments of performance-based compensation. For
example, during the early stages of the fund, the adviser may be less
inclined to distribute performance-based compensation to investment
professionals that source or manage successful investments. How would
this aspect of the proposed prohibited activities rule affect the
intended incentive effects of performance-based compensation?
     We recognize that many fund agreements clawback
performance-based compensation on a post-tax basis. We considered, but
are not proposing, a rule that would generally allow this practice to
continue, but would prohibit advisers from using a hypothetical
marginal tax rate to determine the tax reduction amount.\169\ We
considered requiring advisers to use the actual marginal tax rates
applicable to the adviser or its owners, rather than a hypothetical
marginal tax rate. Our view is that this approach could be too
burdensome for advisers. Do commenters agree? If we were to adopt this
approach, how should we factor tax benefits realized by the adviser or
its owners into the tax reduction amount? What operational challenges
would advisers face under this alternative approach? For example, would
the amount of time it may take to determine

the actual tax amount, which may not be determined until a significant
amount of time has passed not justify the benefits? Do commenters
believe that the use of a hypothetical marginal tax rate is a
reasonable and cost-effective method for determining the tax reduction
amount, or do commenters believe that the hypothetical marginal tax
rate is too high? Why or why not? Please provide data.
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    \169\ 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. To
address this problem, 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. Advisers argue that this approach is a reasonable and
cost-effective method for determining the tax reduction amount;
investors argue that the hypothetical rate is too high and therefore
reduces the clawback amount to their detriment.
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4. Limiting or Eliminating Liability for Adviser Misconduct
    The fifth element of the proposed prohibited activities rule would
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.
    Currently, many private funds and/or their investors enter into
documents containing such contractual terms. Our staff has observed
private fund agreements with waiver and indemnification provisions that
have become more aggressive over time. For example, our staff recently
encountered many limited partnership agreements that state that the
adviser to the private fund or its related person, which is the general
partner to the fund, to the maximum extent permitted by applicable law,
will not be subject to any duties or standards (including fiduciary or
similar duties or standards) existing under the Advisers Act, Delaware
law, or Cayman Islands law or will not be liable to the fund or
investors for breaching its duties (including fiduciary duties) or
liabilities (that exist at law or in equity).\170\
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    \170\ See, e.g., EXAMS Private Funds Risk Alert 2022, supra
footnote 16 (discussing hedge clauses). See also Comment Letter of
the Institutional Limited Partners Association on the Proposed
Commission Interpretation Regarding Standard of Conduct for
Investment Advisers; Request for Comment on Enhancing Investment
Adviser Regulation (Aug. 6, 2018), File No. S7-09-18, at 6,
available athttps://ilpa.org/wp-content/uploads/2018/08/ILPA-Comment-Letter-on-SEC-Proposed-Fiduciary-Duty-Interpretation-August-6-2018.pdf. See also Protecting LLC Owners While Preserving LLC
Flexibility, University of California, Davis Law Review, 51 U.C.
Davis L. Rev. 2129, 2133, Professor Peter Molk (2018) (discussing
scenarios in which an investor is induced to ``sign away fundamental
protections'' without understanding the importance of those
protections, without understanding the meaning of certain legal
terms, and sometimes without reading the documents the investor
signs).
---------------------------------------------------------------------------

    While these contractual terms may be permissible under certain
state laws, a waiver of an adviser's compliance with its Federal
antifraud liability for breach of fiduciary duty to the private fund or
with any other provision of the Advisers Act or rules thereunder is
invalid under the Act.\171\ The prohibited activities rule would
specify the types of contractual provisions that would be invalid.\172\
For instance, it would prohibit an adviser from seeking indemnification
for breaching its fiduciary duty, regardless of whether state or other
law would permit an adviser to waive its fiduciary duty. The proposed
rule would also prohibit an adviser from seeking reimbursement for its
willful malfeasance. This scope of prohibitions is appropriate because
these activities harm investors by placing the adviser's interests
above those of its private fund clients (and investors in such
clients). By limiting an adviser's responsibility for breaching the
standard of conduct, the incentive to comply with the required standard
of conduct is eroded. We believe such contractual provisions are
neither in the public interest nor consistent with the protection of
investors, particularly where investors are led to believe the adviser
is contractually not obligated to comply with certain provisions of the
Act or rules thereunder, or where investors with less bargaining power
are forced to bear the brunt of such arrangements.\173\
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    \171\ See section 215(a) of the Advisers Act; 2019 IA Fiduciary
Duty Interpretation, supra footnote 140 (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.).
    \172\ See section 215(b) of the Advisers Act (stating that any
contract made in violation of the Act or rules thereunder is void).
    \173\ See Professor Clayton Article, supra footnote 7, at 309
(noting that ``LPAs have been criticized for waiving and otherwise
limiting managers' fiduciary duties to their investors under state
limited partnership law; for seeking to satisfy managers' fiduciary
duties under Federal law by providing generic and all-encompassing
disclosures . . . for requiring investors to indemnify managers for
liabilities resulting from an extremely broad array of conduct,
including criminal acts committed by managers''). See also The
Private Equity Negotiation Myth, Yale Journal on Regulation Vol.
37:67, Professor William Clayton (2020), at p. 70 (noting that
``large investors in private equity funds commonly use their
bargaining power to negotiate for individualized benefits outside of
fund agreements, where the benefit of the bargain is not shared with
other investors in the fund . . . an investor can use its bargaining
power to negotiate for individualized benefits before it negotiates
for things that will benefit all investors in the fund.''); ILPA
Model Limited Partnership Agreement (July 2020) (suggesting standard
of care, exculpation, and indemnification language in order to
reduce the cost, time and complexity of negotiating the terms of
investment).
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    We request comment on this aspect of the proposed rule, including
the following items:
     We have observed these types of contractual provisions
among private fund advisers and their related persons; do advisers to
clients other than private funds typically include these types of
contractual provisions?
     Are there other types of contractual provisions we should
prohibit as contrary to the public interest and the protection of
investors?
     Should this aspect of the final prohibited activities rule
prohibit limiting liability for ``gross negligence,'' or would
prohibiting limitations of liability for ordinary negligence, as
proposed, be more appropriate? Why?
     Should the proposed rule prohibit contractual provisions
that limit or purport to waive fiduciary duties and other liabilities
in situations where state law permits such waivers?
     Do commenters believe that the proposed rule would
increase operating expenses for advisers? For example, would the
proposed prohibition on receiving indemnification/exculpation for
negligence cause an adviser's insurance premium to increase?
5. Certain Non-Pro Rata Fee and Expense Allocations
    The sixth element of the prohibited activities rule would 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.\174\
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    \174\ Proposed rule 211(h)(2)-1(a)(6).
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    An adviser may cause a private fund and one or more other vehicles
to invest in an issuer or entity in which other related funds or
vehicles have, or are concurrently making, an investment. For example,
an adviser may form a parallel fund in a non-U.S. jurisdiction, such as
Luxembourg, to accommodate certain European or other non-U.S. investors
that invests alongside the adviser's main fund in all, or substantially
all, of its investments. An adviser also may form more bespoke
structures for large or strategic investors, such as separate accounts,
funds of one, and co-investment vehicles, that invest alongside other
funds managed by the adviser that have similar or overlapping
investment strategies.
    An adviser can face conflicts of interest where multiple clients
(and/or other persons advised by the adviser) invest, or propose to
invest, in the same portfolio investment, especially with respect to
allocating fees and expenses among those clients (or such other

persons).\175\ We believe that any non-pro rata allocation of fees and
expenses under these circumstances is contrary to the protection of
investors because it would result in the adviser placing its own
interest ahead of another's, including in circumstances where the
adviser indirectly benefits by placing the interests of one or more
clients or investors ahead of another's.\176\ For example, 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). If the
adviser causes another fund to bear expenses attributable to such fund,
the fund bearing more than a pro rata share would be supporting the
value of the other fund's investment.\177\ Because compensation
structures in the funds may differ, an adviser may have an incentive to
allocate fees and expenses in a way that maximizes its compensation.
Further, an adviser's ownership may vary fund by fund and thus may
create an incentive to allocate fees and expenses away from the fund in
which the adviser holds a greater interest.\178\
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    \175\ See EXAMS Private Funds Risk Alert 2020, supra footnote 9.
See also, e.g., In the Matter of Rialto Capital Management, LLC,
Investment Advisers Act Release No. 5558 (Aug. 7, 2020) (settled
action) (alleging that adviser represented to the advisory
committee, which included private fund investors as committee
members, that it had data to support the adviser performing third-
party services in house and charging the funds certain rates; and
that the adviser misallocated fees for third-party services to the
private funds when such fees also should have been allocated to the
co-investment vehicles managed by the adviser).
    \176\ Because the proposed rule prohibits charging or allocating
fees and expenses related to a portfolio investment (or potential
portfolio investment) on a non-pro rata basis, advisers would not be
prohibited from charging vehicles that invest alongside each other
different advisory fees or other fund-level compensation. For
example, a co-investment vehicle may pay lower management fees than
the main fund.
    \177\ The proposed rule would 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 proposed rule would not prohibit an
adviser from diluting such fund's interest in the portfolio
investment in a manner that is economically equal to its pro rata
portion of such fee or expense.
    \178\ On a more granular level, to the extent the adviser's
personnel have varying ownership percentages in the funds, such
personnel may be subject to similar conflicts of interest in
determining how to allocate fees and expenses.
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    Moreover, we do not believe that fees and expenses attributable to
unconsummated--or potential--portfolio investments should be treated
differently than consummated investments, given that non-pro rata
allocations in respect of unconsummated investments generally present
the same concerns as discussed above with respect to consummated
investments. If more than one fund would have participated in an
investment that generated ``broken deal'' or other fees and expenses,
our view is that all such funds should bear their pro rata share of
such amount.
    We recognize that many advisers do not charge all their clients or
potential co-investors for fees and expenses relating to unconsummated
investments. For example, certain advisers offer existing investors,
related persons, or third parties the opportunity to co-invest
alongside the fund through one or more co-investment vehicles advised
by the adviser.\179\ Many advisers do not charge co-investment vehicles
or other co-investors for fees and expenses relating to unconsummated
investments. Instead, such fees and expenses are generally borne by the
adviser's main fund that would have participated in the transaction, in
which case the main fund would bear a disproportionate share of such
amount. Such practice, however, places the interests of the other
client and its underlying investors or of the other co-investors ahead
of the interests of the main fund and its underlying investors. Because
the other client would receive the benefit of any upside in the event
the transaction goes through, we believe that such client should also
generally bear the burden of any downside in the event the transaction
does not go through. Accordingly, the proposed rule does not include an
exception for these types of circumstances.\180\
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    \179\ In some cases, advisers use co-investment opportunities to
attract new investors and retain existing investors. Advisers may
offer these existing or prospective investors the opportunity to
invest in co-investment vehicles with materially different fee and
expense terms than the main fund (e.g., no fees or no obligation to
bear broken deal expenses). These co-investment opportunities may
raise conflicts of interest, particularly when the opportunity to
invest arises because of an existing investment and the fund itself
would otherwise be the sole investor.
    \180\ To the extent a potential co-investor has not executed a
binding agreement to participate in the transaction through a co-
investment vehicle (or another fund) managed by the adviser, the
proposed rule would not prohibit the adviser from allocating
``broken-deal'' or other fees and expenses attributable to such
potential co-investor to a fund that would have participated in the
transaction. Advisers may be liable under the antifraud provisions
of the Federal securities laws if the private fund's offering and
organizational documents do not authorize such costs to be charged
to the private fund.
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    We request comment on this aspect of the proposed prohibited
activities rule, including the following items:
     Should we prohibit non-pro rata fee and expense
allocations as proposed? If not, under what circumstances would non-pro
rata allocations be appropriate? For example, we recognize that
advisers often have policies and procedures in place that permit the
adviser to allocate fees and expenses in a fair and equitable manner
(or similar standard), rather than on a pro rata basis; would this
better achieve our policy goals? Why or why not? What specific
protections are included in such policies and procedures? Should such
protections be included in the rule? Why or why not? Should there be an
exception to the prohibition where an adviser determines that it is in
a private fund's best interest to bear more expenses than another
managed vehicle and the private fund's investors agree?
     Should the proposed rule apply to unconsummated--or
potential--portfolio investments, as proposed? Do commenters agree that
non-pro rata allocations of fees and expenses attributable to such
investments present the same concerns as the ones discussed above with
respect to consummated investments? Why or why not?
     We recognize that many co-investors do not agree to bear
their pro rata share of broken or dead deal expenses. Would the
proposed rule make it difficult for funds to consummate larger
investments where co-investment capital is needed? Would the proposed
rule cause funds to syndicate more deals post-closing once the adviser
is confident that the deal will not fall through?
     Should we include an exception for co-investment vehicles
(or certain other vehicles) that invest alongside another fund managed
by the adviser? If so, how should we define ``co-investment vehicle''?
Should the rule treat single-deal co-investment vehicles differently
than multi-deal co-investment vehicles? Why or why not?
     Should we define ``pro rata''? Should ``pro rata'' be
determined based on each client's ownership (or anticipated ownership)
of the portfolio investment? Will advisers interpret ``pro rata''
differently?
     Where multiple funds invest in the same portfolio
investment at different times, the first fund to invest may initially
bear a higher level of fees and expenses than later funds. Should the
proposed rule address fees and expense allocations among funds that
invest at different times, and if so, how? If a significant amount of
time has passed between the first fund's investment and the later
fund's investment, should the later fund pay interest on its portion of
fees and expenses? Should interest payments always apply when portfolio
investments are made at different times?

If not, how much time should lapse before interest applies?
     The proposed rule would prohibit advisers from 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 the scope of the phrase ``other clients advised by the
adviser or its related persons'' broad enough? Should we revise the
proposed rule to cover any other clients, vehicles, or other persons
advised by the adviser or its related persons? Alternatively, should we
revise the rule to cover all co-investment structures and arrangements?
     We recognize that a transaction counterparty may request
to only contract with one fund entity, which can result in one fund
being liable for its own share as well as another fund's share of any
transaction obligations, including fees and expenses. If one fund would
be responsible for the liability of another fund, those funds, in
certain cases, contractually agree to bear their pro rata share, often
times through a contribution or reimbursement agreement. Should we
prohibit this practice and thus require each fund entity to contract
directly with the counterparty? Alternatively, should we require
certain governance and other protections, such as contribution or
reimbursement agreements, if only one fund contracts directly with the
counterparty? Why or why not?
     As noted above, the proposed rule would not prohibit an
adviser from charging different fund-level compensation, such as
advisory fees, to vehicles that invest alongside each other in the same
underlying portfolio investment. For example, a co-investment vehicle
may pay lower management fees than the main fund. Is it sufficiently
clear that such arrangements would not be prohibited under the proposed
rule?
6. Borrowing
    The final element of the proposed prohibited activities rule would
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'').\181\ We have observed many forms of borrowing among
private fund advisers and their related persons, such as using fund
assets as collateral in order to obtain a loan from a party other than
the fund (i.e., borrowing against fund assets), accepting a loan
offered by a private fund client, and taking advantage of a continuous
line of credit extended by a private fund client. For example, the
Commission has brought enforcement actions alleging that private fund
advisers and their related persons have used fund assets to address
personal financial issues of one of the adviser's principals, to pay
for the advisory firm's expenses,\182\ or to bribe foreign government
officials.\183\ In these circumstances, the adviser's related person
that is the general partner of the fund sometimes, for example, causes
the fund to enter into the relationship with the adviser without the
knowledge or consent of the private fund investors.
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    \181\ Proposed rule 211(h)(2)-1(a)(7).
    \182\ See In the Matter of Monsoon Capital, LLC, Investment
Advisers Act Release No. 5490 (Apr. 30, 2020) (settled action)
(alleging that the owner of a private fund adviser borrowed $1
million from a private fund client in order to settle a personal
trade); Resilience Management, LLC, Investment Advisers Act Release
No. 4721 (June 29, 2017) (settled action) (alleging that a private
fund adviser borrowed money from funds in order to pay adviser's
expenses; and that the CEO of the adviser borrowed money to pay for
personal expenses); SEC v. Philip A. Falcone, [U.S. District Court
Southern District of New York, Consent] (Aug. 16, 2013) (hedge fund
adviser borrowed from hedge fund at low interest rate in order to
repay adviser's personal taxes. Adviser failed to disclose the loan
to investors for five months).
    \183\ See In the Matter of Och-Ziff Capital Management Group,
LLC, Investment Advisers Act Release No. 4540 (Sept. 29, 2016), at
para. 3 (settled action) (alleging that a private fund adviser
authorized the use of investor funds to pay bribes to foreign
government officials in order to obtain or retain business for its
parent company and its business partners).
---------------------------------------------------------------------------

    When an adviser borrows from a private fund client, 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). A private fund rarely has employees of its own. Its
officers, if any, are usually employed by the private fund's adviser.
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 authority to take actions
on behalf of the private fund without the 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 its duty to act in the best interests of the fund.
    Moreover, this practice may prevent the fund client from using
those assets to further the fund's investment strategy. Even where
disclosed (and potentially consented to by an advisory board, such as
an LPAC), this practice presents a conflict of interest that is 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) would potentially be in a
position to negotiate or discuss the terms of the borrowing with the
adviser, rather than all of the private fund's investors.
    The proposed rule would not prevent the adviser from borrowing from
a third party on the fund's behalf or from lending to the fund. Private
funds sometimes use subscription lines of credit, also known as credit
facilities, to address financing needs. For example, some private funds
use these facilities to address short-term financing needs when the
fund makes investments or participates in a co-investment. Other
private funds use such facilities for long-term financing purposes, for
example, when an infrastructure fund decides to use a long-term
facility during the development stage of a project before a capital
call. In these circumstances, the adviser is not borrowing from the
fund. Similarly, advisers sometimes lend money to a fund in order to
address start-up costs or to manage other expenses (for example, an
adviser may pay legal or operating expenses of several fund clients and
then seek reimbursement once the expenses have been allocated among the
advised private funds). Allowing advisers to continue this practice
would provide private funds access to capital, especially when they are
in the early stages of attracting investors. Advisers lending to
private funds they manage on terms that do not include excessive
interest rates or other abusive practices do not raise the same
concerns that advisers borrowing from private funds they manage raises
because there are fewer opportunities for abusive practices when the
adviser is providing money to, rather than taking money from, the
private fund.
    We request comment on this aspect of the proposed prohibitions
rule, including the following:
     Should we broaden the scope of the prohibition on
borrowings to prevent a private fund adviser from borrowing from co-
investment vehicles or other accounts that are not private funds?

     Should we broaden the proposed prohibition to apply when
an adviser lends to the fund? \184\
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    \184\ See, e.g., In the Matter of Clean Energy Capital LLC,
Investment Advisers Act Release No. 3955 (Oct. 17, 2014) (settled
action) (alleging that a private equity fund adviser caused the
funds to borrow money from the adviser without providing notice to
investors and by pledging the private equity funds' assets as
collateral).
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     Should the proposed rule exclude certain activity from the
prohibition (e.g., scenarios where a private fund makes tax advances or
tax distributions to its general partner (or similar control person) to
ensure that the general partner and its investment professionals are
able to pay their personal taxes derived from the general partner's
interest in the fund)? If so, what activity should we exclude and why?
     Are there situations in which a fund would agree to lend a
start-up adviser money for initial costs and employee salaries? Are
there situations in which a private fund client should be able to make
a loan to a private fund adviser because the economic terms would be
favorable to the private fund? How would we determine that the terms
are favorable to the private fund?
     Should the proposed rule be expanded to prohibit an
adviser from borrowing against a private fund client's bank account or
other assets, where the lender may be a third party (rather than the
private fund)? Why or why not?
     Should we amend Form ADV and/or Form PF to require
advisers to report information about an adviser or its related person
lending to, or borrowing from, private funds or other clients? Why or
why not? For example, should we require advisers to report whether they
engage in this practice and to provide an aggregate amount or range of
such loans or borrowings?
     Recognizing the limitations of private fund governance
mechanisms, as discussed above, should we permit borrowing if it is
subject to specific governance and other protections (e.g., advance
disclosure to all investors, advance disclosure to an LPAC or similar
body, consent of a governing body such as an LPAC, and/or consent of a
majority or supermajority of investors)? Should we require private fund
advisers to make ongoing disclosures to investors and/or governing
bodies of the status of such borrowings? Why or why not?
     Should the rule include any full or partial exclusions for
certain transactions that may not involve conflicts of interest or that
may involve certain third parties that ameliorate the conflicts of
interest? For example, should we provide an exclusion if the terms of
the borrowing are set by an independent third party and such third
party has the authority to act on behalf of the fund in the event of a
default by the adviser? Why or why not?
     Do commenters envision unintended consequences of this
proposed prohibition, such as in circumstances where an adviser's
related person has its own commercial relationship with the fund?
     Should the rule prohibit (or otherwise restrict) advisers
from lending to private funds they manage on terms that include
excessive interest rates or other abusive practices? To what extent and
under what circumstances does this practice occur? Does it raise
similar concerns to borrowing?

E. Preferential Treatment

    In order to address specific types of preferential treatment that
have a material negative effect on other investors in the private fund
or in a substantially similar pool of assets, we also propose to
prohibit all private fund advisers, regardless of whether they are
registered with the Commission, from providing preferential terms to
certain investors regarding redemption or information about portfolio
holdings or exposures.\185\ We also propose to prohibit these advisers
from providing any other preferential treatment to any investor in the
private fund unless the adviser provides written disclosures to
prospective and current investors in a private fund regarding all
preferential treatment the adviser or its related persons are providing
to other investors in the same fund.\186\ Whether any terms are
``preferential'' would depend on the facts and circumstances.
---------------------------------------------------------------------------

    \185\ Proposed rule 211(h)(2)-3(a)(1) and (2).
    \186\ Proposed rule 211(h)(2)-3(b).
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    Side letters or side arrangements are generally agreements among
the investor, general partner, adviser, and/or the private fund that
provide the investor with different or preferential terms than those
set forth in the fund's governing documents.\187\ Side letters
generally grant more favorable rights and privileges to certain
preferred investors (e.g., seed investors, strategic investors, those
with large commitments, and employees, friends, and family) or to
investors subject to government regulation (e.g., the Employee
Retirement Income Security Act (``ERISA''), the Bank Holding Company
Act, or public records laws). Advisers often provide these terms for
strategic reasons that benefit the adviser. In some cases, these terms
can also benefit the fund, for example, if the adviser signs a side
letter with a large, early stage investor, then the fund will increase
its assets. Increased fund assets may enable the fund to make certain
investments, for example of a larger size, which ultimately benefits
all investors. However, preferential terms do not necessarily benefit
the fund or other investors that are not party to the side letter
agreement and, at times, we believe these terms can have a material,
negative effect on other investors.
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    \187\ The proposed rule would prohibit certain types of
preferential treatment and would require an adviser to disclose
other types of preferential treatment that the adviser or its
related persons (acting on their own behalf and/or on behalf of the
fund) provide to investors. Therefore, the proposed rule typically
would apply when the adviser's related person is the general partner
(or similar control person) and is a party (and/or caused the
private fund to be a party, directly or indirectly) to a side letter
or other arrangement with an investor, even if the adviser itself
(or any related person of the adviser) is not a party to the side
letter or other arrangement.
---------------------------------------------------------------------------

    We recognize that advisers provide a range of preferential
treatment, some of which does not necessarily disadvantage other fund
investors. In this case, we believe that disclosure is appropriate
because it would allow investors to make their own assessment. Other
types of preferential treatment, however, have a material, negative
effect on other fund investors or investors in a substantially similar
pool of assets. We propose to prohibit these types of preferential
treatment because they are sales practices that present a conflict of
interest between the adviser and the private fund client that are
contrary to the public interest and protection of investors. We have
tailored the proposed rule to address these different ends of the
spectrum.
Prohibited Preferential Redemptions
    We propose to prohibit a private fund adviser, including indirectly
through its related persons, from granting an investor in the private
fund or in a substantially similar pool of assets the ability to redeem
its interest on terms that the adviser reasonably expects to have a
material, negative effect on other investors in that private fund or in
a substantially similar pool of assets.\188\
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    \188\ Proposed rule 211(h)(2)-3(a)(1). For purposes of the
prohibitions in proposed rule 211(h)(2)-3(a)(1) or (2), whether an
adviser could have a reasonable expectation that the preferential
term would have a material, negative effect on other investors in
the same private fund or in a substantially similar pool of assets
would depend on the facts and circumstances.
---------------------------------------------------------------------------

    Different types of private funds and other pooled vehicles offer
different redemption opportunities, and an investor's ability to exit
or withdraw differs significantly depending on the fund's or pool's
liquidity profile. While open-end private funds typically allow

for periodic redemptions, closed-end private funds typically do not
permit investors to withdraw their investments without consent. We
understand that some private fund advisers grant one or more investors
more favorable redemption rights. For example, a large investor may
negotiate, through a side letter or other side arrangement, to be able
to redeem its interest in the fund before, or more frequently than,
other investors. Advisers enter into such arrangements in exchange for,
for example, a large investor agreeing to invest in the fund or a large
investor agreeing to participate in a future fundraising of an
investment vehicle that the adviser manages.\189\ Our staff also has
observed scenarios where an adviser establishes investment vehicles
that invest side-by-side along with the private fund that have better
liquidity terms than the terms provided to investors in the private
fund.\190\
---------------------------------------------------------------------------

    \189\ See supra section II.E. (Preferential Treatment)
(discussing side letters as a sales practice).
    \190\ See EXAMS Private Funds Risk Alert 2020, supra footnote 9.
---------------------------------------------------------------------------

    We believe that granting preferential liquidity terms on terms that
the adviser reasonably expects to have a material, negative effect on
other investors in the private fund or in a substantially similar pool
of assets is a sales practice that is harmful to the fund and its
investors. In granting preferential liquidity rights to a large
investor, the adviser stands to benefit because its fees increase as
fund assets under management increase. As noted above, the adviser
attracts preferred investors to invest in the fund by offering
preferential terms, such as more favorable liquidity rights. While the
fund also may experience some benefits, including the ability to
attract additional investors and to spread expenses over a broader
investor and asset base, there are scenarios where the preferential
liquidity terms harm the fund and other investors. For example, if an
adviser allows a preferred investor to exit the fund early and sells
liquid assets to accommodate the preferred investor's redemption, the
fund may be left with a less liquid pool of assets, which can inhibit
the fund's ability to carry out its investment strategy or promptly
satisfy other investors' redemption requests. This can dilute remaining
investors' interests in the fund and make it difficult for those
investors to mitigate their investment losses in a down market cycle.
These concerns can also apply when an adviser provides favorable
redemption rights to an investor in a substantially similar pool of
assets, such as another feeder fund investing in the same master fund.
The Commission believes that the potential harms to other investors
justify this restriction.
Prohibited Preferential Transparency
    We propose to prohibit an adviser and its related persons from
providing information regarding the portfolio holdings or exposures of
the private fund or of a substantially similar pool of assets to any
investor if the adviser reasonably expects that providing the
information would have a material, negative effect on other investors
in that private fund or in a substantially similar pool of assets.\191\
---------------------------------------------------------------------------

    \191\ Proposed rule 211(h)(2)-3(a)(2).
---------------------------------------------------------------------------

    Private fund advisers, in some cases, disclose information about
portfolio holdings or exposures to certain, but not all, investors in
the private fund or in a substantially similar pool of assets. For
example, an investor may request certain information about
characteristics of the fund's holdings to satisfy the investor's
internal reporting obligations. An investor can negotiate to receive
certain types of information that is not widely available to all
investors; however, an investor's success in obtaining such terms may
depend on factors including the size of its capital commitment.\192\
---------------------------------------------------------------------------

    \192\ See Professor Clayton Article, supra footnote 7, at 316
(noting that large investors can often negotiate fee discounts or
other side letter benefits that smaller investors would not
receive).
---------------------------------------------------------------------------

    Selective disclosure of portfolio holdings or exposures can result
in profits or avoidance of losses among those who were privy to the
information beforehand at the expense of investors who did not benefit
from such transparency. In addition, such information could enable an
investor to trade in portfolio holdings in a way that ``front-runs'' or
otherwise disadvantages the fund or other clients of the adviser.
Granting preferential transparency, for example through side letters,
presents a sales practice that is contrary to the public interest and
protection of investors because it preferences one investor at the
expense of another. An adviser may agree to provide preferential
information rights to a certain investor in exchange for something of
benefit to the adviser. The proposed rule is designed to neutralize the
potential for private fund advisers to treat portfolio holdings
information as a commodity to be used to gain or maintain favor with
particular investors.\193\ We believe that this proposed prohibition
would curtail activity that harms investors.
---------------------------------------------------------------------------

    \193\ See Selective Disclosure and Insider Trading, Securities
Act of 1933 Release No. 33-7881 (Aug. 15, 2000) [65 FR 51715 (Aug.
24, 2000)].
---------------------------------------------------------------------------

Substantially Similar Pool of Assets
    The proposed rule would define the term ``substantially similar
pool of assets'' as a pooled investment vehicle (other than an
investment company registered under the Investment Company Act of 1940
or a company that elects to be regulated as such) with substantially
similar investment policies, objectives, or strategies to those of the
private fund managed by the adviser or its related persons.\194\
Whether a pool of assets managed by the adviser is ``substantially
similar'' to the private fund requires a facts and circumstances
analysis. A pool of assets with a materially different target return or
sector focus, for example, would likely not have substantially similar
investment policies, objectives, or strategies as the subject private
fund, depending on the facts and circumstances.
---------------------------------------------------------------------------

    \194\ Proposed rule 211(h)(1)-1.
---------------------------------------------------------------------------

    The types of asset pools that would be included in this term would
include a variety of pools, regardless of whether they are private
funds. For example, this term would include limited liability
companies, partnerships, and other organizational structures,
regardless of the number of investors; feeders to the same master fund;
and parallel fund structures and alternative investment vehicles. It
would also include pooled vehicles with different base currencies and
pooled vehicles with embedded leverage to the extent such pooled
vehicles have substantially similar investment policies, objectives, or
strategies as those of the subject private fund. In addition, an
adviser would be required to consider whether its proprietary accounts
meet the definition of ``substantially similar pool of assets.''
    This proposed definition is designed to capture most commonly used
fund structures and prevent advisers from structuring around the
prohibitions on preferential treatment. For example, in a master-feeder
structure, some advisers create custom feeder funds for favored
investors. Without a comprehensive definition of substantially similar
pool of assets, the proposed rule would not preclude such advisers from
providing preferential treatment to investors in these custom feeder
funds to the detriment of investors in standard commingled feeder funds
within the master-feeder structure. While similar concerns may exist
for separately managed accounts, this proposed rule is designed to
address the specific concerns that arise out of the lack of

transparency and governance mechanisms prevalent in the private fund
structure.
Other Preferential Treatment
    The proposed rule also would prohibit other preferential terms
unless the adviser provides certain written disclosures to prospective
and current investors.\195\ We believe that certain types of
preferential terms raise relatively minor concerns, if fully disclosed.
However, we are concerned that an adviser's current sales practices do
not provide all investors with sufficient detail regarding preferential
terms granted to other investors.\196\ For example, an adviser to a
private equity fund may provide ``excuse rights'' (i.e., the right to
refrain from participating in a specific investment the private fund
plans to make) to certain private fund investors. Advisers sometimes
grant excuse rights to accommodate an investor's unique investment
restrictions, such as a mandate to avoid investment in portfolio
companies that do not meet certain environmental, social, or governance
standards. This lack of transparency prevents investors from
understanding the scope of preferential terms granted. The proposed
rule would prohibit these terms unless the adviser provides information
about them in a written notice.
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    \195\ Proposed rule 211(h)(2)-3(b).
    \196\ See Juliane Begenau and Emil Siriwardane, How Do Private
Equity Fees Vary Across Public Pensions?, Harvard Business School
(2020), available at https://www.hbs.edu/faculty/Pages/item.aspx?num=57534.
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    Increased transparency would better inform investors regarding the
breadth of preferential treatment, the potential for those terms to
affect their investment in the private fund, and the potential costs
(including compliance costs) associated with these preferential
terms.\197\ This disclosure would help investors shape the terms of
their relationship with the adviser of the private fund. For example,
they might also learn of similarly situated investors who are receiving
a better deal with respect to fees or other terms. An investor also may
learn that the adviser provided fee discounts to a large, early stage
investor. Or, an investor may learn that the adviser granted a
strategic investor the right to increase its investment in the fund
even though the fund is closed to new investors or to additional
investments by other existing investors. This may lead the investor to
request additional information on other benefits that the adviser's
related persons or large investors receive, such as co-investment
rights. An investor may then be able to understand better certain
potential conflicts of interest and the risk of potential harms or
other disadvantages.
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    \197\ The Alternative Investment Fund Managers Directive (AIFMD)
includes transparency obligations requiring disclosure to all
investors of any preferential treatment received by a particular
investor, including by way of a side letter. See AIFMD Art. 23.
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    Under the proposed rule, an adviser would need to describe
specifically the preferential treatment to convey its relevance. For
example, if an adviser provides an investor with lower fee terms in
exchange for a significantly higher capital contribution than paid by
others, we do not believe that mere disclosure that some investors pay
a lower fee is specific enough. Instead, we believe an adviser must
describe the lower fee terms, including the applicable rate (or range
of rates if multiple investors pay such lower fees), in order to
provide specific information as required by the proposed rule. An
adviser could comply with the proposed disclosure requirements by
providing copies of side letters (with identifying information
regarding the other investors redacted).\198\ Alternatively, an adviser
could provide a written summary of the preferential terms provided to
other investors in the same private fund, provided the summary
specifically describes the preferential treatment.
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    \198\ We are not proposing to require the adviser to disclose
the names or even types of investors provided preferential terms as
part of this proposed disclosure requirement.
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    The timing of the proposed rule's delivery requirements would
differ depending on whether the recipient is a prospective or existing
investor in the private fund. For a prospective investor the notice
needs to be provided, in writing, prior to the investor's investment.
For an existing investor, the adviser would have to ``distribute'' the
notice annually if any preferential treatment is provided to an
investor since the last notice.\199\ An adviser would satisfy its
distribution requirement to current investors by sending the written
notice to all of the private fund's investors. If an investor is a
pooled investment vehicle that is in a control relationship with the
adviser, the adviser must look through that pool in order to send the
notice to investors in those pools.\200\ We believe this aspect of the
proposed rule would require advisers to reassess periodically the
preferential terms they provide to investors in the same fund, and
investors would benefit from receiving periodic updates on preferential
terms provided to other investors in the same fund. We also believe
that providing this information annually would not overwhelm investors
with disclosure.
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    \199\ As a practical matter, a private fund that does not admit
new investors or provide new terms to existing investors would not
need to deliver an annual notice. However, an adviser that enters
into a side letter after the closing date of the fund would need to
disclose any covered preferential terms in the side letter to
investors that are locked into the fund.
    \200\ See supra section II.A.3 (Preparation and Distribution of
Quarterly Statements).
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    We request comment on this aspect of the proposed rule, including
the following:
     Should the proposed rule apply only to SEC-registered
advisers and advisers that are required to be registered with the SEC
instead of all advisers, as proposed?
     Should we prohibit all preferential treatment instead of
the proposed approach, which is to prohibit certain types of
preferential treatment (i.e., liquidity and transparency terms that an
adviser reasonably expects to have a material, negative effect) and
prohibit all other types of preferential treatment unless disclosed?
Why or why not?
     Should the proposed prohibitions apply only to terms that
the adviser reasonably expects to have a material, negative effect, as
proposed? Alternatively, should the proposed prohibitions apply more
broadly to terms that the adviser reasonably expects could have a
material, negative effect? Why or why not?
     Should we prohibit all preferential liquidity terms,
rather than just those that the adviser reasonably expects to have a
material, negative effect on other investors in that fund or in a
substantially similar pool of assets? Why or why not?
     Are there certain investors who require different
liquidity terms (e.g., ERISA plans, government plans)? If so, which
types of investors and what liquidity terms do they require? How do
advisers currently accommodate such investors without disadvantaging
other investors in the private fund? Should the proposed rule permit
different liquidity terms for these investor types? If so, should the
proposed rule impose restrictions in order to protect other private
fund investors? If so, which types of restrictions?
     Are there practices related to liquidity and redemption
rights that the proposed rule should explicitly address (e.g., in-kind
distribution of securities in connection with a redemption, side-
pocketing of illiquid investments, discounting or eliminating the
management fee while a fund suspends

liquidity)? For example, should the proposed rule prohibit in-kind
distribution of securities in connection with a redemption, side-
pocketing illiquid investments, or discounting or eliminating the
management fee while a fund suspends liquidity? Alternatively, should
the proposed rule include an exception for these activities?
     Should we prohibit all preferential transparency regarding
holdings or exposures of the fund or pool, rather than just prohibiting
preferential transparency regarding holdings or exposures that the
adviser reasonably expects to have a material, negative effect on other
investors in that fund or in a substantially similar pool of assets?
Why or why not?
     Should we define, or provide guidance on, when
preferential redemption terms or preferential information rights would
have a material, negative effect on other investors? If so, what should
be some determining factors? Would it be relevant that the redemption
terms would cause another investor to reconsider its investment
decision? Please explain your answer. Should we clarify whether an
adviser could disclose information about holdings or exposures of the
fund or a substantially similar pool of assets on a delayed basis
without violating the proposed prohibition? Should the proposed rule
expressly require disclosure to investors after a specified period? If
so, what period?
     Are transparency concerns, especially with regard to
information that could have an impact on an investor's decision to
redeem, more prominent with certain fund types (e.g., hedge funds,
private equity funds)? If so, which types and why?
     Should we exempt certain types of private funds from the
written notice requirements of the proposed preferential treatment
rule? \201\ If so, which types of funds and why?
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    \201\ See proposed rule 211(h)(2)-3(b).
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     Should we restrict the use of side letters and side
arrangements so that they can only be used to address certain matters
such as, for example, legal, regulatory, or tax issues that are
specific to an investor?
     Should the rule's prohibitions on preferential terms
extend to a substantially similar pool of assets or apply only to each
private fund separately?
     The proposed definition of ``substantially similar pool of
assets'' would not include co-investments by a separately managed
account managed by the adviser or its related persons. Is this
definition too narrow? Why or why not? Would the proposed definition
appropriately capture similar funds? Should it, for example, include
circumstances where a private fund invests alongside a separately
managed account? Why or why not? Should the definition include a co-
investment vehicle that is structured as a pool of assets that invests
in a single entity and where the private fund invests in the same
entity?
     Should we limit ``substantially similar pool of assets''
to pools the adviser or its related persons manage, as proposed? Is the
proposed definition too broad or too narrow? The proposed definition
would require the pool of assets to have substantially similar (i)
investment policies, (ii) objectives, or (iii) strategies to those of
the private fund. Should we change ``or'' to ``and'' and instead
require that the pool satisfy all three requirements (i.e., have
substantially similar investment policies, objectives, and strategies)?
Should we instead require that the pool satisfy only two of the three
criteria? For example, should the definition only require the pool of
assets to have substantially similar objectives and strategies (and not
policies) to those of the private fund? Are there other unique
characteristics or factors, such as the target rate of return, the
proposed definition should address? Should the definition exclude
multi-share class private funds? If so, why?