The SEC has pared back some controversial aspects of its final rule overhauling the private fund industry — after the original proposal faced widespread pushback — but the rule will still bring significant changes to the industry, experts said.
There’s “a softening in some areas (of the rule), for sure,” said Kenneth Holston, a Boston-based partner in the asset management and investment funds practice group for law firm K&L Gates. “But the devil is going to be in the details.”
Despite the changes made, six industry groups filed a lawsuit against the SEC on Sept. 1, challenging the final rule in the 5th U.S. Circuit Court of Appeals in New Orleans.
The industry groups — the American Investment Council, the National Association of Private Fund Managers, National Venture Capital Association, Managed Funds Association, Alternative Investment Management Association, and the Loan Syndications and Trading Association — said the SEC exceeded its authority in issuing the rule, failed to prove a need for the rule and significantly altered the original proposal without subjecting the final rule to public comment.
On Aug. 23, the SEC voted to finalize the rule, which will increase disclosure requirements for private fund advisers and restrict certain fee arrangements.
The rule requires that advisers supply investors with quarterly statements that include information on fees, expenses and performance; obtain an annual audit for each fund it manages; and acquire a fairness opinion in connection with an adviser-led secondary transaction.
It also prohibits various activities and practices “that are contrary to the public interest and the protection of investors,” unless advisers disclose certain information to investors, or in some cases, receive their consent, according to an SEC fact sheet.
Similarly, the rule bars certain types of preferential treatment without disclosure of such treatment to current and prospective investors.
According to Mr. Holston, the final rule includes a “much smaller menu” of prohibited activities than the original proposal, as some were dropped altogether. One dropped provision would have prohibited fund advisers from seeking reimbursement, indemnification, exculpation, or limitation of liability by a private fund or its investors for certain activities, such as breach of fiduciary duty.
“After considering comments, we are not adopting this prohibition, in part, because we believe that it is not needed to address this problematic practice,” the SEC said in its final rule. “Rather, we are reaffirming and clarifying our views on how an adviser’s fiduciary duty applies to its private fund clients and how the antifraud provisions apply to the adviser’s dealings with clients and fund investors.”
The rule also “reframed” most prohibited practices as restricted, said Aaron Schlaphoff, meaning they are permitted but subject to disclosure and investor consent requirements. Mr. Schlaphoff is a New York-based partner in the corporate department and private funds group at law firm Paul, Weiss, Rifkind, Wharton & Garrison.
Notably, the final rule also includes the addition of what SEC Chairman Gary Gensler called a legacy provision for the restriction of certain activities and preferential treatment. This means advisers will “not need to renegotiate or, one might call, repaper limited partnership agreements” that were made before the rule takes effect, Mr. Gensler said during the Aug. 23 meeting.
The original proposal faced strong opposition from finance industry players, with the primary criticism being “these are negotiated transactions between accredited and institutional investors, and thus, they are able to protect themselves,” said Sean McKee, KPMG’s national practice leader for public investment management, who’s based in New York.
“In general, the institutional investment world, particularly the more liquid hedge fund universe, has done a decent job of regulating itself and has the ability to perform detailed due diligence on managers including all aspects of terms such as liquidity, fees, preferential treatment, etc.,” said James Neumann, Boston-based CIO of London-based Sussex Partners U.K. Ltd, a consulting firm with a focus on hedge funds and other alternative investment strategies, in a written comment. “Holding these sophisticated managers to a higher standard than retail-facing mutual funds therefore seems overly bureaucratic.”
Even Republicans on Capitol Hill have weighed in on the topic.
In an Aug. 23 news release, Reps. Bill Huizenga, R-Mich., and Steve Womack, R-Ark., criticized the final rule, following a July letter that the representatives sent to the SEC asking the agency to reconduct the economic analysis on the rule. The lawmakers chair the House Financial Services Subcommittee on Oversight and Investigations and the House Appropriations Subcommittee on Financial Services and General Government, respectively.
“While it is questionable at best that the SEC has the statutory authority to finalize this rule, the lack of transparency is even more concerning,” the lawmakers said in the news release. “We will continue to look for ways to hold Chair Gensler accountable as he pursues another bureaucratic mandate that lacks congressional approval.”
House Financial Services Committee Chairman Patrick McHenry, R-N.C., called on the SEC to rescind the new rule in his own Aug. 23 news release, adding, “Once again, Chair Gensler’s SEC is exceeding its statutory authority to impose onerous and costly mandates — this time on private funds.”
Just nine days after the SEC finalized the rule, six industry groups filed a lawsuit, calling on the court to “hold unlawful, vacate, and set aside the (SEC) rules, and grant such additional relief as may be necessary and appropriate,” the lawsuit states.
“The SEC has overstepped its statutory authority and core legislative mandate, leaving us no choice but to litigate,” Bryan Corbett, president and CEO of the Managed Funds Association, said in a Sept. 1 news release. “The private fund adviser rule will harm investors, fund managers and markets by increasing costs, undermining competition, and reducing investment opportunities for pensions, foundations and endowments.”
The six organizations are represented by Eugene Scalia and Helgi C. Walker of the law firm Gibson, Dunn & Crutcher. Mr. Scalia served as the U.S. secretary of labor during the last 16 months of the Trump administration.
In a separate Sept. 1 news release, Drew Maloney, president and CEO of the American Investment Council, said, “The SEC has exceeded its own authority, defied congressional design for private funds and advisers to those funds, and imposed significant new and unneeded burdens on private capital that fuels thousands of small businesses.”
While the SEC revised its final rule from the original proposal, the organizations said that such revisions should have been released for public comment, and the rule will still bring significant harm to the private fund industry.
“The decision to file suit is one we must take to protect the interests of our members against the severe and adverse impacts of the new rules,” Alternative Investment Management Association CEO Jack Inglis said in an AIMA news release Sept. 1. “AIMA agrees with the public statements made by SEC Commissioners Hester Peirce and Mark Uyeda that the adoption of the rules is both harmful and unlawful and lacks proper economic analysis of the effect on the private funds industry and the essential source of capital it provides.”
During the SEC meeting on Aug. 23, Republican Commissioners Ms. Peirce and Mr. Uyeda both conveyed their opposition to the rule, with Ms. Peirce calling it “a historical, unjustified, unlawful, impractical, confusing, and harmful.”
“The SEC has indicated its intention to operate akin to a self-appointed legislative body, aiming to impose far-reaching regulations on the realm of private funds without proper authorization from Congress,” said Bobby Franklin, president and CEO of the National Venture Capital Association, in a separate Sept. 1 news release.
However, not all financial organizations were supportive of the lawsuit. “The private funds industry lawsuit against the SEC rule requiring basic disclosures of the pervasive conflicts of interest and a vast array of unfair, predatory, and opaque anti-investor practices is baseless,” said Better Markets CEO Dennis Kelleher. “It makes the same cookie-cutter claims as other lawsuits seeking to protect financial industry profits at the expense of investors, including many teachers, firefighters, and police whose retirement funds are being ripped off.
Christine Williamson contributed to this story.
