Wall Street fights back against new SEC reforms in scathing lawsuit

A cohort of trade associations has thrown the first punch in a brawl over new Securities and Exchange Commission (SEC) regulations governing how investors are protected when putting their money with private fund advisers.

The group said in a lawsuit filed Friday in the U.S. Court of Appeals for the Fifth Circuit that they were challenging the Private Fund Adviser rule adopted by the SEC last month because the agency has exceeded its mandate and introduced rules that will stymy investment.

“The SEC has overstepped its statutory authority and core legislative mandate, leaving us no choice but to litigate,” said MFA President and CEO Bryan Corbett statement. “The Private Fund Adviser rule will harm investors, fund managers, and markets by increasing costs, undermining competition, and reducing investment opportunities for pensions, foundations, and endowments.”

Lobbyists for the lucrative industry sparred with the SEC in the run up to the final vote on a 660-page package last month, and even modifications seen as industry “wins” remain flashpoints. 

Via that vote, the SEC adopted a slate of rules that apply only to SEC-registered funds, including the obligation to provide investors quarterly statements regarding performance, fees and expenses; undertake an annual audit of each private fund; and obtain either a fairness or valuation opinion through an adviser-led secondary transaction.

Under the new rule, all private fund advisers would also be subject to restrictions on certain sales practices, conflicts of interest and compensation schemes unless accompanied by appropriate disclosures and, in some cases, investor consent.

The original proposal prohibited these activities outright, with no exception for disclosures or consent. The SEC also pulled back language that would have made it easier for investors to sue fund managers.

“The failure to include standard of care language in the final rule really leaves investors with no greater protection than if the new rules had not been adopted,” Michael P. Calabrese, a partner at the law firm Foley & Lardner, told The Hill.

“In some ways, this runs counter to one of the principles that seemed to underlie the Commission’s efforts – discouraging preferential treatment. Larger investors, and those with statutory or policy mandates on this issue, will continue to get better results here than others.”

The Managed Funds Association (MFA), National Association of Private Fund Managers (NAPFM), National Venture Capital Association (NVCA), American Investment Council (AIC), Alternative Investment Management Association (AIMA) and Loan Syndications & Trading Association (LSTA) are all parties to the suit.

The SEC responded to the lawsuit Friday in a statement.

“The Commission undertakes rulemaking consistent with its authorities and laws governing the administrative process, and we will vigorously defend the challenged rule in court,” an SEC spokesperson told The Hill.

What does Wall Street want from the SEC?

In the lawsuit, the associations argue the rules limit the rights of advisers to tailor investor relations and interactions, enact overreaching prohibitions on certain activities and impose “onerous, costly” disclosure and consent requirements.

AIMA CEO Jack Inglis said “the adoption of the rules is both harmful and unlawful and lacks proper economic analysis of the effect on the private funds industry and the essential source of capital it provides.”

Gene Scalia and Helgi Walker of the law firm Gibson Dunn & Crutcher LLP jointly represent the associations in their case against the SEC.

The new rules are the latest move by the SEC, led by Chair Gary Gensler, to put in place some transparency into the booming trillion-dollar industry.

More than 47,000 SEC-registered funds topped $14 trillion in combined net assets at the end of last year, according to the SEC’s most recent private fund statistics. 

That’s up from 37,398 funds with more than $11.7 trillion in net assets at the start of 2021, and 20,573 funds totaling $5.3 trillion at the start of 2013.

Hedge funds and private equity chafe at new rules

Private funds have enjoyed looser regulation and disclosure requirements than their banking counterparts, and several years of low borrowing costs have contributed to the industry’s boom.

“We’ve had a long statutory framework which provided funds with specific exemptions from certain federal securities laws. And what this rulemaking is trying to do is pull those private funds back into sort of the public funds space,” Michael Piwowar, executive vice president of finance at the Milken Institute, told The Hill.

Piwowar, a former SEC commissioner and acting chairman and Republican chief economist for the Senate Banking Committee, called the private funds rule “unprecedented.”

Wall Street and trade associations including MFA, AIMA and AIC extensively lobbied the SEC and lawmakers in the leadup to the vote, according to federal lobbying disclosures and SEC meeting logs.

High-profile Republicans have also voiced concerns over the authority of the agency to enact these regulations.

Sens. Tim Scott (R-S.C.), ranking member on the Senate Banking Committee, and Bill Hagerty (R-Tenn.) wrote to the SEC in December 2022 to express concerns with the agency’s legal authority, the economic analysis of the regulation and the potential impact on small, minority- and women-owned funds in the original proposal. 

A spokesperson for Scott pointed The Hill to an excerpt from the 2022 letter criticizing the agency’s attempt to impose “stringent” regulation on private funds that “encroaches on a major question that remains the domain of Congress.”

“Congress has repeatedly and deliberately applied different regulatory regimes and requirements to private funds and their investors than those applicable to registered investment companies, retail investors and their brokers. This conscious choice exempts private funds from the more extensively regulated regime applicable to retail products,” Scott reasoned.

The Great Recession created a new climate for regulators

The SEC rests its case to expand oversight authority over private fund advisers on provisions in the 2010 Dodd-Frank Act to adopt rules “reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive or manipulative.”

“I feel very confident about the analysis, about the authorities,” Gensler told reporters after the open meeting last month.

“The SEC has long exempted private funds from the disclosures their investors need, so of course has the authority to amend that here in response to how much this industry has changed in the last decades. Arguing otherwise is like saying the SEC has the power to de-regulate, but not to re-regulate,” Americans for Financial Reform’s “private equity guy,” Senior Policy Analyst Andrew Park, told The Hill.

Labor unions and Wall Street watchdogs are among the rules’ supporters.

“The labor movement welcomes the SEC’s private funds rule that levels the playing field between the general partners of private equity firms and their investors including pension plans,” Brandon Rees, deputy director of corporations and capital markets at AFL-CIO, one of the signatories, told The Hill in a written statement.

“The transparency provided by the SEC’s new rule will help lower pension plan investment expenses, and thereby enhance the retirement security of working people.”

Park said the transparency and reporting standardization would enable pension funds to negotiate better fees and terms on behalf of those saving for retirement.

Wall Street’s political power reaches across the aisle

The growing power of private equity in the economy has attracted scrutiny from some Democratic lawmakers who welcomed the new regulations.

Senate Banking Committee Chairman Sherrod Brown (D-Ohio) applauded the SEC vote last month, saying the rules “will help protect workers’ pensions and create a more transparent and accountable private funds market.”

Brown was one of eight senators who penned a letter to Gensler in May urging him to finalize the rules.

“The new rules for private equity and hedge fund advisers fall squarely within the SEC’s legal authority and directly target the rampant abuses within the industry,” said Sen. Elizabeth Warren (D-Mass.) in a statement to The Hill. 

“Increasing transparency in an infamously opaque market will help protect and empower investors, but reining in the abuses by Wall Street firms will take much more significant reforms that I will keep fighting to enact.”

Representatives for Warren, Brown and Scott did not immediately respond to a request for comment on the lawsuit Friday.