Institutional investors seeking more transparency from private funds are dismayed with a federal appeals court’s decision to strike down a Securities and Exchange Commission rule that required increased disclosure from private fund advisers and prohibited certain fee arrangements.
“We are disappointed in the decision, which sets back efforts to increase private fund transparency and comparability to fund investors on fees, expenses and performance,” Amy Borrus, executive director of the Council of Institutional Investors (CII), said in an email.
CII, the Institutional Limited Partners Association and 11 public pension funds, including the $325.9 billion California State Teachers' Retirement System, filed an amicus brief in December defending the SEC rule against a private fund industry challenge, arguing that private fund advisers hold outsized control of information and influence over the fund formation process, to the detriment of investors. The alternatives market does not require the type of regular information disclosure that investors receive in public markets, investor groups noted.
But the private fund industry groups that challenged the rule are thrilled. The court's decision is the latest in some high-profile legal setbacks the SEC has dealt with in recent months, including the same court in December tossing out a rule that required companies to provide timelier disclosures on stock buybacks and the SEC in April electing to halt implementation of its public company climate disclosure rule while a different federal court considers multiple legal challenges on a consolidated basis.
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 — filed a lawsuit in the 5th U.S. Circuit Court of Appeals in New Orleans challenging the SEC's private fund adviser rule.
The rule, finalized in August, required private fund advisers to supply investors quarterly statements, including information about fees, expenses and performance; obtain an annual audit for each fund they manage; and acquire a fairness opinion in connection with an adviser-led secondary transaction.
The industry groups argued that the rule unlawfully restricted the long-standing, widely used business arrangements of private funds and their investors and exceeded the SEC's statutory authority. They also said the agency failed to provide the public a meaningful opportunity to comment on the final rule and that it did not perform an adequate cost-benefit analysis. Moreover, they said, the rule was arbitrary, capricious and otherwise unlawful.
On June 5, a three-judge panel at the 5th Circuit sided with the plaintiffs and ruled that the SEC exceeded its statutory authority in adopting the rule.
Specifically, the judges dismissed the SEC’s argument that Congress granted the agency authority to promulgate such a rule in the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The judges wrote that the SEC could not rely on Section 913 of the Dodd-Frank Act nor Section 211(h) of the Investment Advisers Act of 1940 to regulate private funds because those sections are limited to “retail customers.” Section 913, the judges held, “has nothing to do with private funds.”
It also called the rule’s anti-fraud measures under Section 206(4) of the Advisers Act “pretextual” and said the SEC did not articulate a “rational connection” between fraud and any part of the rule it adopted.
“In rejecting the SEC’s unfounded legal theory, the court has sent Washington regulators a strong message that they cannot bypass Congress when pushing their extreme agenda,” said a statement from Drew Maloney, president and CEO at the American Investment Council, a private equity trade group. Maloney touted the ruling as a victory for businesses across the U.S.
Following the June 5 decision, an SEC spokesperson said in an email that, “We’re reviewing the decision and will determine next steps as appropriate.”
The agency has the option to appeal the case before the entire 5th Circuit or file a petition for certiorari seeking review before the U.S. Supreme Court.
Jason Mulvihill, founder and president of the policy advisory firm Capitol Asset Strategies and former COO and general counsel at the American Investment Council, said the rule was extreme, unnecessary and ultimately would’ve cost limited partners and general partners a lot of time and money.
“I’m glad that the court recognized the SEC lacked statutory authority to pursue this rule,” Mulvihill said.
The level of detail that private funds would have been required to disclose under the rule was burdensome, said Jessica Mead, regional executive for North America at Alter Domus, a fund administrator with over $770 billion in private equity assets under administration.
Nevertheless, Alter Domus and its private fund clients are continuing their work to bolster transparency, Mead said, though now without an SEC compliance deadline looming. The rule had rolling compliance dates depending on the asset size of the fund adviser, with the first such date slated for Sept. 14.
The reason? Mead said investors want more information from private funds.
“I wouldn’t be surprised if investors start to demand more granular information from their fund managers,” she said. “And you never know, it may be a way for fund managers to attract investors as well, to say, ‘Hey, we can give you this level of information that you’ve been asking for.’ ”
INSTITUTIONS DISMAYED
Jennifer Choi, CEO of the ILPA, one of the groups that supported the SEC rule in a court filing, said in a statement following the decision: “Private funds will be under no obligation to provide critical information related to the fees and expenses charged to fund investors and meaningful performance information, leaving LPs to negotiate for terms that should be common sense.”
Benjamin Schiffrin, director of securities policy for Better Markets, a nonprofit investor advocacy group, who previously worked at SEC as an associate general counsel, said the court’s decision will hurt investors.
“We think that providing investors in private funds with the transparency that the rule would’ve provided is really important, and we’re very dismayed that the 5th Circuit is now not going to allow investors to receive those important disclosures,” he said.
Schiffrin said the private funds industry strategically filed the case in the 5th Circuit, given the court’s conservative track record. Twelve of the court’s 17 judges were appointed by Republican presidents, including the three that made the June 5 decision.
“In the current environment with a conservative Supreme Court and given that the 5th Circuit is always very skeptical of federal agency authority, I think you were sort of expecting that outcome, which is why the litigation was designed to be delivered there,” said Chris Hayes, managing partner at Capitol Asset Strategies and former senior policy counsel with the ILPA.
Another court could look at the same rule and legislative text and reach a different conclusion, Hayes said.
Now, it’s unlikely that government action will occur anytime soon addressing limited-partner challenges in fund agreements, Hayes said, unless a financial crisis erupts in the coming years and leads to another major legislative package like Dodd-Frank.
But Alter Domus’ Mead thinks the SEC at some point may issue a similar rule-making that’s less expansive and more narrowly tailored.
While the option for an appeal is still on the table, Mulvihill doesn’t expect the SEC to challenge the June 5 decision.
“Both the full 5th Circuit and the Supreme Court would be as skeptical as the three-judge panel was of the tenuous authority that the SEC claimed it had to write this rule,” he said. “If the SEC appeals and loses again, it would simply raise the profile of the case and put another exclamation point on what the SEC already cannot do."