Even Pared Back, SEC’s Private-Fund Rules Mean Hard Adjustment for Industry

U.S. regulators softened their proposed overhaul of private-fund rules, but even the toned-down measures approved Wednesday present a major challenge to the industry and could spur lawsuits, attorneys and regulatory experts say.

The Securities and Exchange Commission voted 3-2 to approve a new set of rules for private-equity firms and hedge funds, which Wall Street had been awaiting with apprehension for 18 months. 

Since February 2022, when the nation’s top financial-enforcement agency first floated its proposals for the $27 trillion industry, asset managers and their lobbyists have pushed back, questioning the agency’s legal standing to rewrite the rules and objecting to the added costs the regulations would impose.

The final form of the agency’s new rules scrapped some elements that fund managers objected to most loudly, and some that would be extremely hard to implement, attorneys and regulatory experts say.

But despite the revisions from what was originally proposed, the result is a very tough set of rules that the industry might choose to challenge in court, said Igor Rozenblit, founder and managing partner of consulting firm Iron Road Partners and a former head of private-fund examinations at the SEC.

The package of rule changes approved Wednesday “is as aggressive as it could have been,” said Rozenblit. He added that while some parts of the original proposal would have been unwieldy and would have invited legal challenges, the final version “is workable, and reflects the policy goals of the administration.”

Private-equity firms had focused their concerns on two elements of the original proposal, both of which were revised in the final version, say lawyers who advise fund managers on regulatory matters.

The SEC initially proposed making it easier to hold firms liable for negligence. That could have led to a flood of lawsuits by investors when funds lost money or deals went bad, lawyers say. The agency cut the provision from the final proposal.

Second, the SEC said Wednesday that the new rules wouldn’t apply retroactively, which had been a significant point of anxiety for firms.

But on a host of other issues the agency left its original proposal intact, or made only minor adjustments. The new rules take effect over time. 

The new regulations require firms to provide standardized quarterly reports of expenses and fees as well as fund performance, including the use of a form of debt that artificially inflates results. Firms had said this requirement—a longstanding demand of institutional investors—would be too heavy a burden on their back offices.

Fund managers will have to give investors third-party verification about prices paid in so-called adviser-led secondary transactions, a type of transaction the agency and investors have said is prone to conflicts of interest. Opponents of the change said it will make these deals more costly.

Firms will also be required to inform all investors about any preferential financial terms given to some investors, a change that drew objections from both asset managers and some large investors. And managers will be forbidden from getting reimbursement from investors for the costs of some government investigations or penalties, a longtime frustration of some institutions that invest in the asset class.

“I wouldn’t say [the final version] is a significant walk back because it is still a hefty compliance obligation,” said Marc Ponchione, a partner at law firm Debevoise & Plimpton who advises private-equity firms on regulatory and compliance issues.

Attorneys and industry representatives Wednesday afternoon were still digesting the 660-page final version of the rule changes. The possibility of legal challenges to the new rules remains quite alive despite the adjustments to the original proposal, lawyers say.

A spokeswoman for the American Investment Council, a private-equity lobbying group, said the organization is reviewing the changes, but that it had been concerned that as originally proposed they could reduce competition, limit choice and harm retirees. The Washington group in an Aug. 8 letter to the SEC said Congress hadn’t given the regulator legal authority to “fundamentally alter the regulatory ecosystem for private funds.”

The Managed Funds Association, a lobbying group for hedge funds, is reviewing the final version and assessing potential next steps, including possible court action, said Bryan Corbett, the group’s chief executive.

At a meeting Wednesday, SEC Chair Gary Gensler alluded to the possibility of a legal fight looming over the rules, stressing that the agency had been given “clear authority from Congress” and had ample legal rights for the regulatory push.

The two Republicans on the commission, Hester Peirce and Mark Uyeda, questioned those claims, with Uyeda saying the new rules are based on “questionable statutory authority.”

It is unusual for SEC commissioners to so extensively discuss legal authority, which suggests that “there clearly is a backdrop of litigation concern,” said David Blass, a partner at Simpson Thacher & Bartlett who advises firms on regulatory matters.

Nonetheless, the final rule changes indicate the SEC took into account many objections to the original proposal and adjusted its approach to some difficult and controversial issues, Blass said.

Write to Chris Cumming at [email protected]