Michael Klein
A coalition of six US trade bodies representing hedge funds and private markets firms is suing the US Securities and Exchange Commission, claiming the financial regulator’s new disclosure rules for private funds are unlawful and harmful to the industry.
The lawsuit, filed on 1 September in a federal appeals court, argues that the Private Fund Advisers Rules will “hamper the jobs, innovation, and other benefits private funds bring to the economy”.
The suit calls for the rules to be set aside as they exceed the commission’s statutory authority and are arbitrary, capricious, and otherwise unlawful.
The SEC passed the rules in a 3-2 vote on 23 August. They require private funds to provide investors with quarterly statements detailing certain information about fund fees, expenses, and performance.
They will also prohibit funds from providing investors with preferential treatment and curtail the use of side letters.
In addition, private fund advisers must obtain and distribute to investors an annual financial statement audit of each private fund they advise, as well as a fairness or valuation opinion.
Alleged regulatory overreach
“The SEC has overstepped its statutory authority and core legislative mandate, leaving us no choice but to litigate,” said Bryan Corbett, President and CEO Bryan Corbett of the Managed Funds Association (MFA).
“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 petitioners said the rules result in increased fees, less competition, and decreased choice for institutional investors, including pensions, foundations, and endowments.
Specifically, the rules would harm private fund advisers and their investors by needlessly limiting their right to tailor their relationship and interactions, the MFA said. They would impose onerous, costly disclosure requirements and administrative obligations upon private fund advisers.
Overall, the MFA said the prohibitions and restrictions represented a regulatory overreach by the SEC and the rules exceeded the commission’s authority under the Investment Advisers Act of 1940 and other applicable laws.
In addition, the association claimed they run counter to the SEC’s stated mission to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.
When the new rules were released SEC Chair Gary Gensler said: “Private funds and their advisers play an important role in nearly every sector of the capital markets. By enhancing advisers’ transparency and integrity, we will help promote greater competition and thereby efficiency. Consistent with our mission and Congressional mandate, we advance today’s rules on behalf of all investors — big or small, institutional or retail, sophisticated or not.”
The claim was filed by the Managed Funds Association, National Association of Private Fund Managers, National Venture Capital Association, American Investment Council, Alternative Investment Management Association and the Loan Syndications & Trading Association.
‘Ahistorical, unjustified, unlawful, impractical, confusing and harmful ’
AIMA, the global representative of the alternative investment industry, said it had chosen to form part of the coalition of associations after an extensive review of the final text of the PFAR proposal.
The lawsuit reflected the need to protect the association’s global membership from the negative consequences of the rules.
Private funds are a major driver of economic growth and provide significant benefits for investors, AIMA said, adding that the new rules are unambiguously harmful to the industry and the choices that are available to investors.
AIMA CEO Jack Inglis said, “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.”
Peirce and Uyeda, both Republican appointees, were the dissenting commissioners in the SEC’s August vote.
“The rulemaking is an historical, unjustified, unlawful, impractical, confusing and harmful . . . In the name of fostering competition, we are squelching it,” Peirce said, noting that “the market has not failed”. Her methodical dissent is believed to have laid some of the groundwork for the industry lawsuit, the Financial Times reported.
AIMA said the rules would set back the industry by several decades by making it nearly impossible for private fund managers to offer bespoke treatment to fund investors.
“Our research and investor feedback show that customisation is a growing trend that has been spearheaded by institutional investors moving away from uniform products to a partnership model. This model offers investors greater flexibility while still retaining the operational benefits of investing in pooled vehicles,” AIMA added.
Governance structures
In its Adopting Release the SEC explained that one intended effect of the rules was to address harms arising out of private funds governance structures.
It discussed private funds with limited partner advisory committees or boards of directors, expressing concern that “these types of bodies may not have sufficient independence, authority, or accountability to oversee and consent to these conflicts,” and that they “do not have a fiduciary obligation to the private fund investors.”
Some legal commentators have argued this scrutiny on a long-established industry standard, together with expanded information and consent rights granted to investors under the rules, could see the industry moving away from reliance on limited partner advisory committees or boards to fund-wide consents.
If the rules stand, they will likely lead to an industry-wide change how advisers charge funds for certain fees and expenses and how they report to investors.
This will increase administrative burdens and operational costs which are typically passed on to investors.
