Understanding the SEC’s proposal to prohibit after-tax clawbacks for private fund sponsors

The SEC recently proposed to expand the regulation of private fund advisers to reduce potential conflicts of interest between advisers and sponsors, on the one hand, and fund entities and their investors, on the other.  This alert discusses one of the rules relating to after-tax clawbacks.

It is common for funds to align the financial interests of advisers and investors by basing advisor compensation (typically in the form of carried interest) on performance.  This can result in advisers receiving an outsize share of profits relative to their actual ownership in the fund. 

When fund profits vary over time, it is possible for prior compensation paid to advisers to be subject to a clawback, wherein the advisers return performance-based payments in a bid to put the investors and advisor on an equal footing financially.  As described below, the SEC’s rules package suggests that because advisers determine the timing and methodology of performance-based compensation, it is fair to make the advisers responsible for paying a more generous clawback.

On February 10, 2022, the SEC proposed new rules under the Investment Advisers Act of 1940.  If finalized, these Proposed Rules would regulate the contracts and governing documents of investment advisers, including private funds advisers, and even unregistered advisers.  The Proposed Rules would apply to agreements already in place as well as future agreements.  The SEC has proposed that the Proposed Rules have an effective date 60 days following the publication of the Proposed Rules as final and a compliance date that falls one year after the effective date, giving advisers some time to comply with the final rules. 

The Proposed Rules define a “clawback” to include any obligation of the adviser, its related persons, or owners to restore or return to the fund any performance-based compensation. Notably, for tax purposes, the Proposed Rules would fundamentally alter the ubiquitous private fund standard that allows for clawback amounts to be reduced for taxes paid or deemed paid by the General Partner on performance-based compensation. 

Specifically, the Proposed Rules would prohibit advisers from reducing the amount of their clawback obligations by actual, potential, or hypothetical taxes applicable to the adviser, its related person (eg, a GP), or their respective owners or interest holders.  The effect of this provision would be to increase the amount of clawback payments and thereby increase investor returns; it would also put advisers in a potentially worse after-tax position (owing to various limitations on tax losses to which advisors are subject).

Because they would apply to existing agreements following the one-year transition rule, the Proposed Rules would affect advisers who currently benefit from an after-tax clawback. 

The Proposed Rules do not, however, require that funds provide clawbacks at all, so it is possible that advisers will draft agreements allowing tax advances with no clawback option.

For a broader DLA Piper perspective on the Proposed Rules, please click here. To learn more about the Proposed Rules and clawbacks, please contact either of the authors or your usual DLA Piper relationship attorney.