The Securities and Exchange Commission’s rule regulating private equity and hedge funds threatens to significantly harm investment in small businesses and reduce American workers’ nest eggs. The private fund industry is suing the agency over its burdensome and arbitrary rule that ignores congressional intent and misrepresents provisions of statute.
In New Orleans, a federal appellate court heard oral arguments from private fund advisers and the SEC. The SEC is claiming it wants to prevent fraudulent activity, but the rule is designed to intervene in privately negotiated contracts. The agency has admitted that systemic fraud does not exist. In fact, “investigations of advisers by governmental authorities are uncommon.” There is also no “record of abuse” that justifies the rule. The SEC only argues that there is a “potential for abuse.” This argument does not hold water.
The SEC wrongly claims there is a lack of competition among the private fund industry. On the contrary, the market for private equity (PE) fund advisers is highly competitive. According to a report published by the Committee on Capital Markets Regulation (CCMR), from the first quarter of 2013 to the first quarter of 2021, PE funds more than doubled to 18,925 while the number of PE advisers doubled to 1,628. Over the same nine-year period, the number of new PE funds “has grown, by a factor of over three,” from 466 to 1,402.
Criticisms that terms in private fund contracts are opaque fall flat because pension funds employ sophisticated financial professionals who understand the terms of their investments—these investors are not individuals who need protection from the SEC. Notably, section 913 of the Dodd-Frank Act hands power to the SEC to protect individual investors, but private fund investors are large institutions, such as pension funds and endowment funds. A modicum of discretion is necessary so private fund advisers, and their investors can agree on certain preferential terms that could increase returns to the ultimate beneficiaries—police officers, teachers, firefighters.
Regulating how terms of a contract, such as the applicability of side letter agreements, is outside the SEC’s statutory authority. Section 406 of Dodd-Frank amended the Investment Advisers Act of 1940 to make clear that it regulates the relationship between private fund advisers and their clients. The SEC dismisses Congress’s intent and instead pursues regulations that add burdensome requirements between the advisers and their investors. The SEC also ignores the fact that side letters allow some pension fund investors to receive preferential redemption rights, which is important to increase liquidity and comply with their fiduciary duty and “ERISA obligations.”
Investment company advisers maintain limitations on liability for negligence, but the SEC wants to remove these limitations for private fund advisers. Considering that mutual funds are offered to individual investors and private funds are not, the SEC fails to make a compelling argument for why it is necessary to restrict this limitation for private fund advisers. This could significantly impact small businesses, which according to an EY report, in 2022, made up about 85% of all PE-backed businesses.
Investors consummate agreements with private fund advisers under state law—where the SEC has no authority. Delaware law gives LLCs and LPs significant authority to write up contracts. LLC agreements “may not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing.” Moreover, if LLCs, LPs, or their directors or managers are grossly negligent, under Smith v. Van Gorkom and Aronson v. Lewis, corporate directors and officers are liable for breaching their fiduciary duty of care. USACafes held that directors of LLCs and LPs owe fiduciary duties to investors. By limiting terms in contracts, the SEC is making it harder for private fund advisers to comply with their fiduciary duties under state law.
The rule amounts to a major question because the private fund industry manages trillions of dollars in assets. Congress, however, never authorized the SEC to issue new rules to regulate contracts between advisers and investors. Moreover, the SEC’s mission is to protect individual investors, not institutions. The rule represents the SEC’s desire to “divert resources from the protection of retail investors.”
The rule’s lack of economic analysis and failure to identify and analyze the aggregate effects of other rules contravenes the Administrative Procedure Act and is arbitrary and capricious. The SEC’s rule should be vacated because the agency has not proven it has the statutory authority to intervene in private contracts between advisers and their investors. The SEC also provides no substantive economic analysis highlighting any market failures. The rule admits that “it is difficult to quantify the benefits of these restrictions, because there is a lack of data.”
The SEC’s rule is not about fraud prevention, it is about the government dictating terms of privately negotiated contracts. This goes far beyond the SEC’s statutory authority and is grounds for the rule’s nullification.