The Securities and Exchange Commission headquarters in Washington.
Attorneys representing the Securities and Exchange Commission and private fund trade groups exchanged arguments Feb. 5 in federal court over the agency's new rule that requires increased disclosure from private fund advisers and prohibits certain fee arrangements.
At the heart of the matter, the three-judge panel at the 5th U.S. Circuit Court of Appeals in New Orleans is considering whether the SEC has the statutory authority to issue such a rule.
The rule, which was finalized in August, requires private fund advisers to supply investors with quarterly statements, including information about 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.
In a lawsuit filed in September, six industry groups — the National Association of Private Fund Managers, Alternative Investment Management Association, American Investment Council, Loan Syndications and Trading Association, Managed Funds Association, and National Venture Capital Association — argued that the SEC has no such authority and the rule unlawfully restricts the long-standing, widely used business arrangements of private funds and their investors.
Eugene Scalia, partner at Gibson, Dunn & Crutcher, who represented the trade groups during the Feb. 5 arguments, told the judges that Congress never gave the SEC authority to regulate private funds in this manner.
"For no good reason, the SEC here is attempting to subvert the statutory exemption provided to private funds and to conduct a hostile takeover of private funds," Scalia said. "It seizes upon a provision in the Dodd-Frank Act that concerns retail customers and uses that as a backdoor way of bypassing the exemption from the Investment Company Act."
The Investment Company Act, Scalia said, exempted private funds, which are intended only for sophisticated investors.
The SEC attorney, Jeffrey Berger, argued that more transparency is needed in the private funds space and that all investors need protection.
"Simply because an investor is sophisticated because they have a lot of wealth does not mean they don't enjoy the protection of the securities laws," he said.
Berger also referenced an amicus brief filed by the Institutional Limited Partners Association, Council of Institutional Investors and 11 public pension funds in support of the rule. He said institutional investors, particularly smaller pension funds, struggle to get pertinent information from private fund managers.
On the whole, the judges' questions to Berger revealed a "clear skepticism over the sweeping reach of the rule," said Julius Chen, a partner at law firm Akin Gump Strauss Hauer & Feld LLP, in an email.
"The panel even suggested that it would not be reasonable for the SEC to justify regulation of an industry of this size based on a smattering of examples of alleged wrongdoing, especially when economic reality indicates that the existing regime has been a market success," Chen added. "In the end, the main question for the petitioners' counsel seemed to be how far the court might go in vacating the rule, which is a promising sign for the private funds industry."
Jeremiah Williams, a partner in Ropes & Gray's litigation and enforcement practice group, said in an interview that the judges were less receptive to the SEC's argument.
"Based on arguments I think there's a high likelihood that they strike down part of this rule, at least," Williams said. "I think it's a closer call whether they'll strike down the whole rule."
Berger, the SEC attorney, said the entire rule package should not be vacated if the court takes issue with individual provisions. Scalia, the trade groups attorney, argued that the entire rule should be vacated because it was "flawed from root to branch."
