After much foreshadowing, the Securities and Exchange Commission recently released a series of proposed rule changes directed at the private funds industry. By far the most controversial aspect of the proposal is a series of restrictive rules that would change commercially negotiated terms— in particular the negotiated indemnification provision—and otherwise ban many practices by private fund sponsors.
The proposed rules also would prohibit investment advisers from offering preferential liquidity and fund portfolio information terms to certain fund investors. It further would require disclosure of the terms of individually negotiated side letter arrangements, the terms of which can be commercially sensitive, to all other investors in a private fund.
The proposal contains other terms that are perhaps less controversial but still impactful and burdensome. Among them are new standardized disclosures of private fund fees and expenses, and quarterly performance reports akin to disclosures by mutual funds and other retail funds.
The proposal would also require audited financial statements for all private funds and fair value opinions for so-called GP-led secondaries (sales of an investor’s interest in a private fund, where the sale is led by the fund’s adviser).
A companion proposalwould require additional confidential reporting to financial risk regulators with information about private funds. Some of the reporting would be required on a next-day basis, which could be challenging, especially when the reporting is made through an interface that is less than user-friendly or instinctive.
Taken together, the SEC’s proposals suggest that the regulator is seeking fundamental changes in the manner it regulates the private funds industry, or, as SEC Commissioner Hester M. Peirce characterized it in her announcement, a “sea change” in that regulation.
Fund Managers Have Ceased Some Practices Already
The SEC’s proposals cast a bleak view of the conduct and business practices of private fund managers, but that view is far from accurate. Over the 10 years since private fund managers became required by the Dodd-Frank Act to register with the SEC, those managers have significantly enhanced transparency practices and have ceased some of the practices that the SEC would now prohibit, such as the practice of taking fees for unperformed services, like accelerated monitoring fees.
Likewise, fund investors today, as a general matter, negotiate for and receive regular reporting of fee, expense, and performance information. General fiduciary principles already prohibit a wide array of self-dealing portrayed by the SEC as endemic in the industry. In this regard, many of today’s proposals are unlikely to meaningfully affect many private fund advisers who already follow fiduciary principles.
If the SEC’s proposals were merely redundant, perhaps they would spark less controversy. Regrettably, the SEC’s restrictive proposals that would change contractual terms, prohibit liquidity and informational side letters, and require disclosures of other side-letter terms are deeply problematic.
SEC Now Seeks to Alter Contractural Terms
That the SEC would seek to use regulation to alter commercially negotiated contractual terms is a troubling precedent, and should give all market participants concern that the SEC could do the same on other contractual arrangements.
Here, the SEC is looking to impose itself in commercial negotiations between a private fund sponsor and private fund investors, generally some of the most sophisticated and well-represented investors in the world. It is doubtful that such investors are not capable of protecting their commercial interests.
The SEC’s assertion of statutory authority for these proposed rules is unusual, to say the least. Without providing any analysis, the SEC asserts rulemaking authority provided under the Dodd-Frank Act.
However, that authority was provided to the SEC in the context of establishing conduct rules for broker-dealers. There is no mention of private fund managers in the authority the SEC asserts.
The SEC will also need to sharpen its pencil on the economic justifications underpinning the proposal. The SEC’s economic analysis regarding eliminating indemnification provisions is all of two paragraphs and does not take into account costs of the proposal to fund sponsors or the changes to private fund offering practices that would result from the proposal, if adopted.
By our estimation, the economic effects of that portion of the proposal could be very significant. Indeed, the economic analysis does not appear to pass muster with the SEC staff’s own guidance governing that analysis.
We anticipate a heavy volume of comments on the SEC’s proposals, which will be due around mid-April. We expect intense interest in, and scrutiny of, the SEC’s asserted authority and economic analysis for its proposals, including whether they rest solely on generalized assumptions that the rules will simply enhance market efficiency.
Should the rules eventually be enacted in their current form, significant litigation challenges could well follow.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
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David Blass is a partner in the Investment Funds practice and head of Asset Management Regulatory practice of Simpson Thacher & Bartlett LLP. He is a former senior officer of the SEC, and the former general counsel of the Investment Company Institute.