Softened SEC rules still have a bite

The commission's new rules are softer than the original proposal, but still impose rigid disclosures on exempt advisers.

The Securities and Exchange Commission has adopted the most sweeping new rules for the private fund industry since Dodd-Frank.

Private fund managers will be forbidden from passing along the costs from investigations unless they obtain informed consent from their investors, and they’ll have to disclose any fees or expenses for the costs of exams, enforcement or other compliance matters under new rules adopted by a divided SEC on August 23.

The new rules are lighter-touch in some areas than the original proposals, though they still contain many of their controversial prohibitions. But by introducing rigid disclosure requirements for activities the proposals would have banned, they provide some wiggle room, and other activities are protected with grandfather clauses.

For example, where the SEC’s proposal banned charging fees and expenses non-pro-rata among LPs, doing so will be exempt if “the allocation approach is fair and equitable and the adviser distributes advance written notice,” including a description of “how the allocation approach is fair and equitable.”

Funds can also use their tax bills to reduce clawbacks only if “the adviser discloses the pre-tax and post-tax amount of the clawback to investors.”

And they can borrow or receive credit extensions from private fund clients if they provide “disclosure to, and consent from, fund investors.”

The prohibitions apply to all private funds, registered or not. All registered investment advisers – whether they advise private funds or not – must “document in writing” a newly required annual review of their compliance policies and procedures, and any of their program’s failures. Registered private fund managers will now have to give their investors quarterly statements explaining fund performance, fees and expenses, audit each fund every year and obtain a fairness or valuation opinion on any secondaries GP-led continuation fund deal they carry out.

Even with the concessions, the new rules, totaling 660 pages, are the most dramatic changes to private fund regulation since Dodd-Frank passed.

Prohibited activities become ‘restricted activities’

Other differences between the proposals and the final rules include restrictions on offering “preferential terms” to investors in redemptions, “unless the ability to redeem is required by applicable law or the adviser offers the preferential redemption rights to all other investors without qualification.” They also can’t give only some investors details about portfolio holdings or exposures. The rules state that “such preferential information [must be] offered to all investors.”

“In addition,” regulators add in a new fact sheet, “this rule prohibits all private fund advisers from providing preferential treatment to investors, unless certain terms are disclosed in advance of an investor’s investment… and all terms are disclosed after the investment.”

The new rules do offer “legacy status” for its prohibited activities/preferential treatment regulations, “if the applicable rule would require the parties to amend the agreements.” That, too, is a (minor) concession to industry: more than one private fund advocate warned the commission its proposal was dangerously close to violating the Constitution’s ban on ex post facto laws because it would require funds to tear up existing agreements.

‘Ahistorical, unjustified, harmful’

SEC Commissioner Peirce
Hester Peirce

Supporters say the new rules will bring some much-needed daylight into a $25 trillion industry that has become too big to fail. Given the millions of ordinary Americans who find their pensions tied to private funds, supporters say, regulators need a closer look at the opaque business.

“Private funds and their advisers play a significant role for investors and issuers. They play an important role in nearly every sector of our capital markets,” SEC chairman Gary Gensler said in supporting the new rules. “Standing behind those entities are millions of investors like municipal workers — that’s the teachers, firefighters, professors, students, and more.”

Republican commissioners Hester Peirce and Mark Uyeda condemned the new rules. They were “ahistorical, unjustified, harmful” and uproot decades of Congressional and jurisprudential attitudes toward private funds, Peirce said in her dissent.

“We’re adopting a prescriptive regime that edges out contractually negotiated ground rules,” she said. “As long as investors understand the terms of what they’re investing, why should the government care what those terms are? In the name of fostering competition, we’re squashing it.”

Most of the new rules take effect 18 months after they appear in the Federal Register. In the same session as the vote to adopt the private fund regulations, the commission also reopened its proposed safeguarding rules for comment.

To sue or not to sue

Industry has fought the new rules tooth and nail. Beginning in late July, as word of the new rules made its way through Washington, representatives from the Managed Funds Association, the Investment Adviser Association and Goldman Sachs met with commissioners and their staff, SEC lobbying records show. Many groups brought in trial lawyers to write letters during the comment period, a subtle message that Gensler wouldn’t have missed. The question now is whether Gensler has softened his proposals enough to avoid a court challenge.

In an emailed statement, MFA president and CEO Bryan Corbett said his group is weighing “appropriate next steps.” The association “continues to have concerns that the final rule will increase costs, undermine competition, and reduce investment opportunities for pensions, foundations, and endowments,” Corbett said.

Anyone who wants to challenge these new rules in court got an immediate vote of confidence from US representative Patrick McHenry, who chairs the House Financial Services Committee and is a longtime Gensler critic. “Once again,” McHenry said in an email statement, “Chair Gensler’s SEC is exceeding its statutory authority to impose onerous and costly mandates – this time on private funds. By applying a framework designed for retail funds used by everyday investors to private funds, this rule fails to acknowledge the differences between these markets.”

The key constituency for Wednesday’s rules are the institutional investors. Gensler made one of his first speeches as chairman to the Institutional Limited Partners Association where he promised them changes were coming. He was caught off guard after some limited partners objected to the proposals’ ban on preferential terms. In an email statement, the Institutional Limited Partners Association said it was “heartened to see the rule take steps forward on fee and expense reporting and begin to address persistent conflicts of interest we’ve observed for some time, such as with GP-led secondaries transactions.”