CHALLENGE: What to do about the vacated private fund rule?

The regulatory uncertainty means that most will/should follow the rule anyway.

The United State Court of Appeals for the Fifth Circuit recently vacated the SEC’s expanded private fund rule that imposed both substantive prescriptions and proscriptions on both hedge funds and private equity funds.  The private fund rule, adopted last year in a contentious 3-2 SEC vote, would have imposed several new requirements on private fund managers registered with the SEC as investment advisers, initially required by the Dodd-Frank Act back in 2012.  The 2023 rule would have significantly limited private fund advisers from using side letter arrangements to benefit certain investors and charging regulatory and compliance expenses to the fund.  The 2023 rule would have also required private fund managers to deliver quarterly unlevered performance reports, obtain third party audits for funds managed, and deliver fairness opinions when selling in the secondary market. 

The Fifth Circuit vacated the 2023 private fund rule primarily because the Court determined that the SEC exceeded its authority in adopting the rule.  The Court determined that a private fund manager’s client is the fund and not the fund’s investors and that the Dodd-Frank Act did not intend for the SEC to regulate the market-driven relationship between private investors and the funds in which they invest.  The Court also argued that Congress did not intend to allow the SEC to impose further substantive regulation on the private funds industry because Congress recognized the different regulatory regime for public funds (i.e. mutual funds).  The Court also faulted the SEC for failing to establish a nexus between the rule and the fraud that the rule intends to remedy. 

What now?  Legally, the rule is a dead letter, and the SEC can no longer enforce its requirements.  Practically, we’re nowhere near the end of this debate.  The SEC will most likely appeal the decision to the Supreme Court, a process that could take many months.  In that process, expect everybody and their regulatory siblings to file amicus briefs supporting both sides.  The big issue for the Supremes is how much deference to give to regulatory agencies.  This particular Supreme Court has been suspicious of the expanding regulatory state.  However, any appellate litigator will tell you that it’s often difficult to determine how the star chamber will ultimately decide. 

In the meantime, the industry must face an unhappy SEC that it knows doesn’t like side letters and wants more financial disclosure. 

MY TAKE:  For most players in the private fund industry, whether the 2023 private fund rule ultimately becomes law probably doesn’t matter because regulatory uncertainty becomes de facto regulation.  The SEC has been scrutinizing side letters for years.  While not strictly prohibited by rule, the examinations staff often raises deficiencies about whether the fund manager provided enough side letter disclosure.  These deficiencies have resulted in enforcement cases.  The SEC therefore uses its biggest weapon – disclosure – to limit the use of side letters.   All the staff needs to do is turn up the disclosure dial so much that no disclosure will be enough, thereby regulating through disclosure.  The staff can use the same tactic with regulatory and compliance fees. 

Having a rule that requires quarterly statements and audits may not matter.  Most large funds already provide quarterly performance reports and deliver audited financial statements to comply with the custody rule.  The SEC can again use disclosure as a club to limit the presentation of levered performance results.

Requiring fairness opinions seems redundant when a fund is already audited and the fund manager already has a fiduciary duty.  Regardless, why require a fairness opinion if the sale is to a third party; presumably, the market determines fairness?

I think there’s a decent chance that the 5^th Circuit’s decision is overturned.  Despite the Supreme Court’s recent bias about the expanding administrative state, the SEC was created to regulate a technical industry that Congress doesn’t understand.  The 5^th Circuit’s tortured statutory intent and strict construction arguments seem dubious.  Also, the 5^th Circuit has a reputation and history of oddball decisions that seem out of step with the rest of the judiciary.

In the end, though, it probably doesn’t matter.  The regulatory uncertainty will force most firms to comply whether or not the rule has the force of law.  Perhaps, that was the SEC’s goal: Regulate or get caught trying.