By Anne Sherry, J.D.
SEC Commissioner Hester Peirce said that she declined to support the agency’s new rulemaking on private fund advisers because it is “ahistorical, unjustified, unlawful, impractical, confusing, and harmful.” Contrasting the flourishing landscape for private funds with a historic oak tree recently felled in her neighborhood, Peirce was perplexed that the SEC “has chosen to haul out its chainsaw and start whacking away at the regulatory framework.” The commissioner closed her statement with a list of outstanding questions about the rules.
New rules. On Wednesday the SEC passed, by a 3-2 vote, final rules and amendments governing private funds under the Investment Advisors Act of 1940 (Advisers Act). The rules require private fund advisers who are registered with the Commission to provide investors with quarterly statements regarding private fund performance, fees and expenses. The advisers also will be required to have each private fund audited annually, and to solicit a fairness opinion in connection with an adviser-led secondary transaction.
Peirce’s concerns. In the statement, Peirce broke down why she sees this rulemaking as “ahistorical, unjustified, unlawful, impractical, confusing, and harmful.” Congress intended for private funds to develop outside the requirements governing registered investment companies. Imposing a retail framework on an institutional marketplace unnecessarily interferes in a private-ordering system that is working well in this space, Peirce posits.
In Peirce’s view, the fact that during some private fund investors have to make compromises when negotiating terms does not mean the market has failed. “Despite our concerns, the lack of homogeneity in the private market is to be expected in a world ordered by individual negotiation and contract,” she writes. Even if the SEC is correct that investors are helpless in this respect, the solution is not more regulation, but changing existing rules to encourage new advisers to enter the market and compete with incumbents.
Furthermore, Peirce takes issue with the statutory foundation for the rulemaking—or, in her view, the lack thereof. The commissioner objects to the use of the antifraud provision of the Advisers Act to mandate private fund audits because this turns a routine compliance issue into an antifraud violation remedied by enforcement action. The rest of the rulemaking relies on Dodd-Frank Section 211(h)(1), a provision that is “clearly aimed at retail investors’ relationships with their financial professionals.”
Even though the final rule improves on the proposal, Peirce still finds it impractical and confusing, presenting numerous challenges in implementation. The rulemaking also raises new questions that could even affect how fund advisers select and carry out investment strategies. And the rule will harm investors, advisers, and the economy by squelching competition from newer, smaller advisers. The rule also constrains negotiations; investors will not be able to waive the rule’s protections even if doing so would benefit them.
Remaining questions. Finally, Peirce raises a litany of outstanding questions—some concrete and some rhetorical—about the rulemaking. Why did the Commission propose to prohibit practices that it says were already illegal, and now that it is officially characterizing them as illegal, will advisers be given time to come into compliance? What is and is not grandfathered under the final rule? If an adviser has to offer the same preferential treatment to everyone, how is the treatment preferential? The commissioner directs some of her questions to DERA, asking whether they anticipate advisory fees will increase as a result of the rule and whether the rule will make it harder for smaller advisory firms to compete with larger advisers.