California is again taking a lead in public protection legislation by enacting Assembly Bill 2833, signed into law in September, on disclosures by public retirement funds. The new law requires that California public pension plans obtain and disclose information about private fund fees and expenses well beyond current norms. And whereas the recent fee-reporting template of the Institutional Limited Partnership Association affects only transparency in the private relationship between managers and investors, the California law bests them by requiring public disclosure.
The new law tackles the challenge of applying rules-based regulation in this arena. The law requires fiduciaries to seek specified disclosure on fees, expenses and carried interest. But under this rules-based approach, a fiduciary could comply with the law while still leaving out material disclosure because it doesn't fall into a specified category. In contrast, the recent Securities and Exchange Commission enforcement actions against abusive fee, expense and disclosure practices apply one of the few great principles-based provisions in our federal securities laws, Section 206 of the Investment Advisers Act. By dictating that investment advisers must not defraud, deceive or engage in any act, transaction, practice or course of business that is fraudulent, deceptive or manipulative, federal law places a burden on advisers to examine both the motives and results of their actions. It provides a flexible tool for the SEC to charge intentional and non-intentional conduct that harms investors. Under this broad standard, the SEC has successfully targeted a long list of activities, demonstrating the seemingly endless opportunities advisers have to act in self-interest, without adequate disclosure or consent, when managing other people's money. In comparison, rules-based regulation authorizes or prohibits specific conduct; but its very precision can inadvertently provide loopholes or be effective only against yesterday's perceived wrong.
The California law may cause a lot of handwringing.
First, there is the challenge of interpreting what the law actually requires. The law uses defined terms in ways that are not likely to be a good fit for every type of fund it seeks to cover. For example, the law treats carried interest as a type of fee paid by the fund, when carried interest is more frequently implemented as an allocation, which may or may not be distributed immediately. It also mandates disclosing the investor's “pro rata share of carried interest.” Pro-rating is not generally how carried interest is measured; it normally applies individually to each investor based on their own cash flows and the application of any customized terms.
Second, there is the worry that top fund managers will resist the law by shunning California's public pension systems as investors. It has been widely reported that the opacity of private fund economics can harm investors. It is also widely understood that private equity returns, in particular, bolstered pension plans in the post-2008 era when public market volatility, “sideways” growth and historically low interest rates threatened the achievability of pension systems' targeted rates of return. Private equity funds from that era are now in realization mode, and the clamor for capacity in new fund launches is high, despite worries about valuations in this phase of the economic cycle. To the extent California's public pension systems want to maintain allocations to private equity, they face increasing competition from sovereign wealth funds, endowments, family offices and the public plans of 49 other states.
Fund managers now face a choice: resist the law, either by avoiding California plans or by quibbling over some imperfectly tailored details, or embrace the spirit of the law, namely, the unarguable view that understanding costs of investment is a reasonable demand and a proper area of inquiry for public plan fiduciaries. I submit that fund managers who resist the law's underlying principle will find themselves at odds with the principles of Section 206 as well.
On the other hand, fund managers who embrace the challenges of implementing the California law also embrace the primacy of the fiduciary duty of loyalty — putting the investors' interests first. The public image of the private fund sector may be at stake, insofar as the media currently paints private fund advisers as investors' adversaries, driving ever more aggressively to squeeze revenue out of private fund assets.
In the complex landscape of laws applicable to private fund formation, many private fund managers found (in Delaware corporate law, for example) or forged (in clever contract provisions, for example) what appeared to be plausible paths to act in their self-interest. The SEC actions enforcing the Investment Advisers Act can be heard as a wake-up call. State corporate statutes and private contracts cannot override the duties investment advisers owe their clients under federal law. Understanding this, private fund managers that choose to work with California's public pension systems can claim the high road by finding a workable way to meet the new law's goals.
Alexandra Poe is a New York-based partner at Reed Smith LLP and the co-chair of its private fund formation and counseling practice.
