SEC’s private fund rules: a tax-related provision addresses adviser clawback amounts

The Securities and Exchange Commission (SEC)’s new final rules and amendments to the Investment Advisers Act of 1940 (the Advisers Act), set forth in Release No. IA-6383, Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, are designed to increase protections for private fund investors (the Final Rules).

Among other provisions, the Final Rules contain a tax-related provision wherein adviser clawback amounts may not be reduced for taxes paid unless certain disclosures are provided to investors. Specifically, the Final Rules prohibit an adviser from reducing a clawback amount by taxes paid by the adviser, related persons, or owners or interest holders, unless the adviser distributes a written notice to the affected investors setting forth the amount of the proposed clawback both before and after a reduction for taxes. Such notice must take into account the reduction for all actual, potential, or hypothetical taxes and must be provided within 45 days after the end of the fiscal quarter in which the clawback is proposed.

The Final Rules state that the purpose of this rule is to protect investors by “ensuring that they receive their share of fund profits, without any reduction for tax obligations of the adviser or its related persons.” In essence, the SEC believes that the new rule is fair because if clawbacks are received on a post-tax basis, advisers may put their interests ahead of their investors’ interests by allocating the risk of a tax liability to investors, thereby reducing the investors’ returns.

The Final Rule represents a concession from the SEC’s originally proposed clawback rule that would have prohibited any reduction of clawbacks for taxes. The SEC states that the Final Rules allow for a post-tax clawback with disclosure, given that a complete prohibition on post-tax clawbacks could have unintended consequences. Such consequences could include more advisers drafting agreements without any clawback provision and higher overall management fees.