The SEC adopted numerous private fund reforms on August 23, 2023. Here’s a closer look at the new Restricted Activities Rule and how the Legacy Status Rule applies to it.
The Restricted Activities Rule (Rule 211(h)(2)-1)
The rule at a glance: The Restricted Activities Rule applies to certain activities that advisers are restricted from engaging in, or may only engage in after disclosure to investors or receiving investors’ consent. Most restricted activities relate to borrowing from funds, adviser clawbacks, and how advisers can charge and allocate expenses.
Who does it apply to? All private fund advisers (registered or not).
When the rule goes into effect: 12 months after publication in the Federal Register for advisers with $1.5 billion or more in private fund AUM, and 18 months after publication in the Federal Register for all other advisers — September 14, 2024, and March 14, 2025, respectively.
Why the reform matters: Leading private fund managers may not perceive the Restricted Activities Rule as imposing entirely new restrictions on how they conduct business. These GPs either do not engage in these underlying restricted activities, or have policies and procedures in place to mitigate conflicts of interest. Smaller and newer fund advisers, though, may be looking at a bigger lift to comply with the new rule, especially as it relates to developing policies and procedures and documenting compliance.
For all funds, though, the focus is on implementing and revisiting best practices with regard to the new rule, as well as establishing a system to proactively comply with the rule, reduce risk, and be able to audit that compliance efficiently.
What advisers need: Many private fund advisers will need to enhance compliance policies and procedures. If they engage in restricted activities, they will likely need to provide additional notice or disclosures to investors or seek consent from investors, and they will need to document these activities. To do this, they need a tech-enabled obligation management program and best practices in place before the upcoming compliance date.
An in-depth look at the new rule: Private fund advisers may not engage in certain activities that are contrary to the public interest and the protection of investors unless they provide certain disclosures to investors and, in some cases, receive investor consent.
Restricted activities include, but are not limited to:
- Charging or allocating to the private fund fees or expenses associated with an investigation of the adviser without disclosure to all private fund investors and written consent from a majority in interest of the private fund investors.
- Charging or allocating fees or expenses related to an investigation that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Advisers Act or the rules thereunder.
- Charging or allocating to the private fund regulatory, examination, or compliance fees or expenses of the adviser, unless such fees and expenses are disclosed to investors within 45 days of the quarter in which the charge occurs.
- Reducing the amount of an adviser clawback by the amount of certain taxes, unless the adviser discloses the pre-tax and post-tax amount of the clawback to investors within 45 days of the quarter in which the clawback occurs.
- Charging or allocating fees or expenses related to a portfolio investment on a non-pro rata basis, unless the allocation approach is fair and equitable and the adviser distributes advance written notice of the non-pro rata charge and a description of how the allocation approach is fair and equitable under the circumstances.
- Borrowing or receiving an extension of credit from a private fund client without disclosure to all private fund investors and written consent from a majority in interest of the private fund investors.
How the final rule differs from the proposal: The SEC’s initial proposal referred to a “Prohibited Activities Rule,” which would have prohibited advisers from engaging in certain activities. The SEC did not adopt the prohibition on fees for unperformed services or the indemnification prohibition outlined in the proposal.
How Insight by Ontra can help advisers with their new compliance obligations
- Reference precedent: Review historical LPAs when crafting new language for future funds.
- Conduct compliance checks: Create quarterly sign-offs to confirm that if any restricted activity took place, the fund followed the designated workflow for providing notice and/or disclosures or receiving consent and marked actions as complete for audit trail purposes.
The Legacy Status Rule
The rule at a glance: The SEC is providing legacy status for the prohibition aspects of the Restricted Activities Rule that require investor consent.
Why this rule matters: The rule “grandfathers” private fund governing documents that were already in place before the compliance date. This relieves advisers and their investors from having to renegotiate and amend pre-existing governing documents.
An in-depth look at the new rule: The Legacy Status Rule clarifies that portions of the Restricted Activities Rule do not apply to contractual agreements advisers entered into in writing prior to the compliance date, which commenced operations as of the compliance date, if the restrictions would require the parties to amend the governing agreements of the private fund.
- The Legacy Status rule does not apply to the prohibition against charging or allocating fees or expenses related to an investigation that results or has resulted in a court or governmental authority imposing a sanction for a violation of the Advisers Act or the rules thereunder.
- Private fund governing agreements include the fund’s operating or organizational agreements, subscription agreements, and side letters.
- A private fund has commenced operations if it has engaged in bona fide investment, fundraising, or operational activity.
Key resources
How is your firm preparing?
Depending on your firm’s private fund AUM, you have until September 14, 2024, or March 14, 2025, to comply with the SEC reforms. Use this time wisely. Implement best practices and adopt an efficient and tech-enabled system to support your compliance efforts.
Stay tuned
Stay tuned for more in-depth information on the new SEC rules and how Insight, Ontra’s AI-backed obligation management platform, can help private fund managers comply with investor and regulatory obligations.
