Fifth Circuit Court of Appeals decision to overturn SECs Private Fund Adviser Rules, including the requirement for strict quarterly reporting, was met with criticism from some parts of the financial services industry. If passed, the rules would have required registered advisers offering private funds to clients to provide greater transparency on their fee structures and practices. In handing down the court's opinion, the three presiding judges noted that a private fund adviser's client is the fund itself, not the underlying investors. As a result, as long as advisers follow the rules governing the fund, they are not breaking any laws.
However, with the Fifth Circuit questioning the SEC's authority to enforce these rules, it's unlikely the agency will be able to prevail even if it appeals the court's decision, according to Igor Rozenblit, managing partner at consulting firm Iron Road Partners.
In one Posting on LinkedIn in the wake of the court's ruling, Rosenblit wrote that the SEC's rules were “clumsy” and expensive to enforce, which is largely what led to their challenge.
“However, the Fifth Circuit's overly broad decision may not be as positive as it seems, at least not for private equity,” he wrote. “Sophisticated investors believe they lack sufficient transparency in the operations of private equity advisors and have relied on SEC oversight for safety. Now, some of that oversight can be removed, increasing the perceived riskiness of the asset class.”
Anya Coverman, president and CEO of the Institute for Portfolio Alternatives, said that while transparency is essential to building investor confidence in private funds, the SEC's rules would make it challenging to close new funds, change the co-investment market and add unnecessary costs and process disruptions for both fund managers and investors. As a result, the IPA sees the court's decision as a victory for the industry.
“We believe the rules would have increased costs for investors, so we see the decision as a win for competition, lower costs and efficiency,” Coverman wrote in an emailed response to WealthManagement.com. “But we recognize that some investors will see the decision as a setback, and we want to work with those investors to try to find more tailored, favorable solutions to address their concerns.”
Coverman added that the IPA recognizes that the SEC currently has a “very active rulemaking agenda” and wants to engage in an active dialogue with the agency to find solutions that benefit everyone involved.
Meanwhile, Rozenblit said the legal ruling could have a limited impact if advisers choose to comply with the SEC's guidelines. He brought up a legal case from 2006 when the Court of Appeals struck down a rule that required hedge funds to register as RIAs. Despite the ruling, few hedge fund advisers relinquished their registration. Since both advisers and investors saw benefits from following the SEC's hedge fund rule, advisers continued to comply with it. Rosenblit expects to see a similar model with the Private Fund Adviser Rules.
This view is supported by the fact that the Association of Institutional Limited Partners, which represents limited partner investors in private equity, reiterated its commitment to create its own updated quarterly reporting standards. ILPA promised to provide an update on its efforts in the coming days.
In an official statement, the organization expressed its disappointment that the Fifth Circuit's decision removes any meaningful requirements for transparency, disclosure of potential advisor conflicts of interest and fund performance information related to private funds.
“With today's decision and the absence of mandated minimum standards, private funds will have no obligation to provide critical information about fees and expenses charged to fund investors and meaningful performance information, leaving LPs to negotiate terms that must be reasonable.” said ILPA CEO Jennifer Choi. “We are also disappointed that the Fifth Circuit did not recognize the SEC's longstanding authority to protect private market investors.”
On the other hand, Lindsay Burckett-St. Laurent, US managing director with global fund manager IQ-EQ, praised the Fifth Circuit Court's decision as fulfilling existing laws.
She agreed that individual investors would benefit from greater transparency when evaluating whether to invest in private funds. However, she argued that the burden should be placed primarily on retail client advisers to fulfill their fiduciary duties.
“We were all worried about what the decision would be, but the fact that the court agreed that the SEC exceeded its authority under Dodd-Frank and the authority given to it by the US Congress is a good victory for industry,” Burckett-St. Laurent said. “I think the SEC's focus on private equity advisers has distorted what they are mandated to do, which is protect retail investors. And I would argue that they would be better served to turn their focus back to retail advisers and making sure that their (clients') money is properly managed.”