Don’t wait for courts on PF rules, experts warn

Industry groups have challenged the SEC’s new private fund rules, but fund managers who wait for the courts to rescue them are taking a big risk, compliance experts warn.

Six trade associations representing private fund and loan syndication firms sued the commission in the US Court of Appeals for the Fifth Circuit on September 1. The suit claims the commission “exceeded its statutory authority and violated the requirements for agency rulemaking in multiple ways.” It asks the appellate judges to hold the sweeping new rules unlawful and to “vacate, and set aside the rules and grant such additional relief as may be necessary and appropriate.”

What the suit does not do is ask the appellate judges for an injunction. That could change, but administrative law is complicated. Any relief is months away at best. At the beginning of fiscal 2023, petitioners could expect to wait an average of 9.4 months from filing to judgment, according to the Fifth Circuit’s own data. Whomever loses is likely to appeal to the Supreme Court, which has itself been dealing with one of its biggest case backlogs since the 1950s.

The first deadline in the commission’s sweeping new rules – the requirement that registered private fund advisers conduct annual compliance reviews – takes effect 60 days after the rules appear in the Federal Register. Large, registered funds have 12 months to implement most of the new disclosure rules. Time, in other words, is not on the side of fund managers.

“It goes without saying that private equity, hedge, and other private fund managers will be paying close attention to this matter, but it is worth noting that this petition, in and of itself, does not have any tolling effect on the rule itself,” says Brian Daly, a partner with Akin Gump Strauss Hauer & Feld. “I have been suggesting that managers do initial planning but hold off on large-scale commitments of resources or money until early October. That will give them a chance to understand the litigation landscape, and to let the industry start to coalesce around common implementation questions.”

‘Arbitrary, capricious, an abuse’

Legal experts are also divided on whether any court can prune the new rules’ thorniest element – the “guidance” in the adopting release where the SEC claims that accelerated monitoring fees and indemnification clauses breach an advisers’ fiduciary duty. An industry victory against these regulations may still leave funds exposed to regulation by enforcement, experts say.

“It’s easier to pursue an action when you have prescriptive rules. Things become more open to interpretation otherwise,” says H Gregory Baker, a former SEC enforcement lawyer who now chairs Patterson, Belknap’s securities litigation group. “The SEC still has a lot of enforcement powers, regardless of whether these rules stand. I would never advise anyone to wait to see how this plays out in court, because you never know. The clock is still ticking.”

David Slovick is a veteran of the CFTC’s and SEC’s enforcement divisions. Now a partner with Barnes & Thornburg, he says the litigation may take years to resolve. “All industry has to lose is money,” he says. “They’ll pay their lawyers for a decade.”

In the meantime, government lawyers will have every incentive to go after fund managers for violations of the new rules – and the bigger the funds are, the more tempting a target they’ll be, Slovick says.

“Once the enforcement staff gets this rule, the genie’s out of the bottle,” he says. “Once you turn the rule over to the enforcement people, they’re going to say, ‘It says what I say it says.’ They’re going to want to sue the biggest firms. If I’m an enforcement attorney, I don’t want to go after Moe, Larry and Curly. I’d rather sue one of the big guys, because it’ll get my name in the news release.”

The industry suit is filed on behalf of the National Association of Private Fund Managers, the Alternative Investment Management Association, the American Investment Council, the Loan Syndications and Trading Association, the Managed Funds Association and the National Venture Capital Association.

“The new rules would fundamentally change the way private funds are regulated in America,” Gibson, Dunn & Crutcher partner Eugene Scalia writes in the 13-page complaint. “Among other things, the rules would effectively bar many of the bespoke contractual terms investors negotiate to meet their specific needs, would effectively bar advisers from charging for certain expenses, and would require costly reporting that is wholly unnecessary. The rules exceed the commission’s statutory authority, were adopted without compliance with notice-and-comment requirements, and are otherwise arbitrary, capricious, an abuse of discretion, and contrary to law, all in violation of the Administrative Procedure Act… and of the commission’s heightened obligation to consider its rules’ effects on ‘efficiency, competition, and capital formation.’”

An SEC spokeswoman said in an email that the agency “undertakes rulemaking consistent with its authorities and laws governing the administrative process, and we will vigorously defend the challenged rule in court.”

‘Table stakes’

Some compliance experts wonder if the litigation is “about” the new rules at all. Igor Rozenblit is a former SEC examiner who is now a partner with compliance consulting firm Iron Road Partners. He says it’s curious that the LSTA signed on as a plaintiff, because the new rules left the leveraged loan industry alone.

“At least a part of the motivation behind the litigation appears to be to challenge the SEC’s authority under Sec. 211(h) of the Investment Advisers Act, which was added by Dodd Frank,” he says. “The fear may be that in the future, the SEC could leverage Sec. 211(h) to prohibit or restrict certain practices where today those practices are deemed acceptable if there is proper disclosure.”

In an email statement, LSTA’s head of advocacy Elliot Ganz said many of his group’s member’s were “gratified” to have been left out of the new rules, but “managers of billions of dollars of loan funds are still covered by the rule.”

“Moreover,” Ganz added, “Moreover, the SEC’s expansive and misguided assertion of statutory authority under Section 211… is very concerning, not only in connection with this rule but also as applied to other rules such as the outsourcing rule and the predictive data analytics rule.”

Not everyone in industry supports the litigation.

“The audit requirements are going to raise the costs, especially for small GPs,” says Chris Hjelm, senior vice-president for investments at Covington, Kentucky-based Connetic Ventures, an exempt adviser currently registering with the commission. “But the use of an audit is to make sure that no one is messing with valuations or overstating earnings. To me, this is table stakes for managing money at scale. I think it’s time for this industry to mature.”

Hjelm worked in retail funds in his younger days. He says shrinking public markets are putting pressure on institutional investors and high-net-worth investors. Beyond the (relatively) orderly markets in Silicon Valley, Boston and New York, there are legions of small businesses looking for capital, and state money is pouring in. “It’s almost like a gold rush,” he says.

The problem is, there isn’t any uniformity in valuations. “It’s like the Wild West out there,” he says. The new private funds rules, he says, are “a good first step” at taming the frontiers.