Credit: Securities and Exchange Commission
Hedge funds, private equity firms, and venture capital firms have been historically private industries. However, just a few weeks ago, the Securities and Exchange Commission (SEC) announced that it would pull the curtain back on these industries in an effort to protect private investors. The new rules and rule amendments are an effort to further regulate the private fund industry, which will see its most significant change since the regulations adopted in the wake of the 2008 financial crisis. The SEC’s concern arises from the lack of transparency, competition, and efficiency among private funds, which impacts their ability to protect investors.
How much will this compliance cost the industry? Billions. These expenses are directly incurred by maintaining legal teams and the advanced reporting technology required to follow the new regulations. As a result, a group of private equity and hedge fund groups are suing the SEC and have asked the United States Court of Appeals for the Fifth Circuit to vacate the new rules. In determining whether these regulations will stand up to judicial scrutiny, we must first explore the SEC’s structure and how it is expected to impact the private fund industry.
SEC Structure and Evolution
The SEC was created in 1934 pursuant to the Securities and Exchange Act. The five-member commission is appointed by the President and confirmed by the Senate. This five member panel has the power to vote on the new regulations before they are passed. In the case at hand, the SEC board voted three to two.
Credit: Flickr_Caption- SEC Chairman Gary Gensler
The SEC has broad authority to regulate and oversee industries in the public and private sectors. Its mission is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” To accomplish this mission, the SEC has a team of over 4,500 staff members who conduct market research, propose new rules, and enforce these rules and regulations to better maintain market behaviors and protect investors.
Over the course of the eighty-nine years that the SEC has been in existence, the markets have changed drastically. New markets have emerged, a mass of companies have failed, and many more have formed. A record 67 million U.S. families held direct or indirect holdings in 2019. With new aspects of business changing over time, rules and regulations must change as well. The SEC has the ability to introduce new regulations to evolve with the markets to give investors protection that they would not have had previously. As a result of this ability, the SEC passed the new Private Fund Adviser Rules, which affected hedge funds, private equity firms, and venture capital firms to help protect investors by requiring these funds to show more transparency to their “customers.”
Private Fund Adviser Rules
The Private Fund Adviser Rules are grouped into five sets of regulations or prohibitions and were adopted alongside other rules that apply to advisers differently depending on their SEC registration status, fund location, and types of assets under management. Notably, funds made up of securitized assets are excluded from the new set of regulations and prohibitions. Private Fund Adviser Rules include the:
Quarterly Statement Rule
Audit Rule
Adviser-led Secondaries Rule
Preferential Treatment Rule
Restricted Activities Rule
Private fund advisers who are registered with the SEC will be required to distribute quarterly statements and have their annual statements audited. When advising clients to switch vehicles into another investment managed by the adviser, they will need to obtain fairness or valuation opinions.
Additionally, all private fund advisers, registered or not, will be prohibited from providing preferential treatment to investors unless required to, or unless the preferential information is disclosed to all fund clients. Furthermore, a number of other activities will be prohibited unless properly disclosed to clients. For example, advisers will need to disclose any expenses charged to the fund that are associated with investigations into the adviser or that were incurred while meeting compliance. If the fund wants to borrow or receive credit from another private fund, the adviser must disclose the financing. And any non-pro rata fees, unless “fair and equitable,” must be disclosed in advance of the fee. Finally, all clawbacks must be disclosed and consented to by fund investors.
Private Equity and Hedge Fund Trade Groups Sue the SEC
Naturally, the expenses associated with these new rules, coupled with the transparency requirements, have left private funds dissatisfied. On September 1, 2023, a group of private funds filed suit against the SEC in order to vacate the rules adopted by the Commission. Six funds are seeking these rules to be repealed on behalf of the industry. An SEC spokesperson said the agency plans to defend the new rules in court.
Under the Administrative Procedure Act (APA), “a reviewing court may set aside an agency action only if the findings and conclusions are found to be arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with the law.”
In their filing, the six funds allege that the SEC exceeded its statutory authority because its new rules “were adopted without compliance with notice-and-comment requirements, and were otherwise arbitrary, capricious, an abuse of discretion, and contrary to law, all in violation” of the APA.
However, courts are highly deferential to agencies like the SEC. To combat this claim, the SEC only needs to show that the rules it imposes are within “the bounds of reasoned decision making,” as “a court may not substitute its own policy judgment for that of an agency.”
The group of private funds claims that the SEC may not meet this standard. In their suit, the private funds claim that the SEC “was relying on ‘detailees’ with ‘little or no experience,’ and trying to rush through an ‘aggressive agenda’ without adequate ‘research and analysis.’” They go on to say that the SEC’s “proposal suffered from serious legal problems, was unworkable, and related basic misunderstandings of the market the Commission sought to regulate.”
Conclusion
Whether or not the new rules and regulations are deemed to misunderstand the market by the SEC is a question to be answered by the reviewing court. In the meantime, investors will monitor the private fund market to see how these new rules affect an otherwise booming industry. At the time of writing this article, the private fund industry is worth $20 trillion. With investor transparency at stake for the SEC and billions of dollars in compliance on the line for private funds, this lawsuit will set a precedent for new rules and regulations to come for this otherwise elusive industry.
*The views expressed in this article do not represent the views of Santa Clara University.