SEC Chairman Gary Gensler’s proposed compliance review rules won’t just keep private fund advisers from outsourcing their fiduciary duties or charging some fees and expenses—they’ll blow up existing agreements where those waivers, fees or expenses are in place, experts warn affiliate RCW.
Comments are still pouring in on the broad new proposal. Most advisers and adviser advocates are wary. Two elements have the industry the most worked up. The first would prevent advisers from using partnership agreements and the like to duck their fiduciary duties. The second would ban a host of fees and expenses. They range from so-called accelerated fees to exam, enforcement and litigation expenses (RCW, Feb. 11, 2022). They would apply to all advisers, registered or not.
Things are even worse than they look, say two veteran industry lobbyists who spoke to RCW on condition of anonymity because they’re not allowed to speak publicly for their client. In both cases, regulators say the new rules, if adopted, would make current agreements “invalid.”
“The prohibited activities rule would specify the types of contractual provisions that would be invalid,” the 341-page proposal states. “The proposed rule would prohibit these activities regardless of whether the private fund’s governing documents permit such activities, or the adviser otherwise discloses the practices and regardless of whether the private fund investors (or governance mechanisms acting on their behalf, such as limited partner advisory committees) have consented to the activities either expressly or implicitly.”
The Commission says it’s doing all this to protect private fund investors. Regulators “believe these prohibitions are necessary given the lack of governance mechanisms that would help check overreaching by private fund advisers,” the proposal states.
Some fund advisers have gotten better at disclosing their “sales practices, conflicts of interests, and compensation schemes to investors and the practices that are associated with them,” regulators say in the proposed rulemaking. But “we believe that it may be hard even for sophisticated investors with full and fair disclosure, to understand the future implications of terms and practices related to these practices at the time of investment and during the investment.”
Regulators usually adopt rules that use the future tense. After a given deadline, a practice will be banned. The plain language in the pending rules suggests existing contracts will have to be torn up.
Ex post facto?
This may give advocates a chance of overturning the rules in court, the two lobbyists say. Article I, Sec. 9 of the Constitution says, “No Bill of Attainder or ex post facto Law shall be passed.” A regulation that reaches back to invalidate currently valid contracts might be just the thing to test against that Constitutional prohibition, the lobbyists say.
That’s much further down the road. For now, the Commission says it has the authority to change the rules under the anti-fraud provisions of the Advisers Act and Sec. 913 of Dodd-Frank. Sec. 913 gives the SEC power “to address the legal or regulatory standards of care for brokers, dealers, investment advisers, persons associated with brokers or dealers, and persons associated with investment advisers” as “necessary or appropriate in the public interest and for the protection of retail customers.”
Part of Gensler’s argument is that private funds have grown too big to fail. Too many ordinary people, he says—especially pensioners—are behind those institutional investors. Private funds must sacrifice some of their privacy, Gensler says.
It’s not clear how widespread the practices are that disturb the SEC. ILPA has complained for years—each year more loudly—about advisers using partnership agreements or subcontracts to duck their fiduciary duties (RCW, Oct. 15, 2021).
‘How the market’s supposed to work’
Fees and expenses are a little trickier.
“Some of these points, it seems like they’re kind of prohibiting things that the market has already solved,” says Nick Miller, a partner in Seward & Kissel’s investment management practice. “The best example is the prohibition on accelerated payments. This was a fairly common practice five-to-10 years ago. Look, it’s a conflict, you’ve got to disclose it. But investors pushed back, and firms mostly shifted away from it. That’s how the market is supposed to work.”
Miller is one of many who think the rule proposal is a radical break from tradition (RCW, Feb. 24, 2022). “It looks like they’re moving from a disclosure to a rules-based system,” he says. Referring to the ban on reducing adviser claw backs by taxes, he said: “To me, the market has already kind of coalesced around it. The investors may not love it, but for the SEC to step in and prohibit that, strikes me as kind of a fundamental change in how they view private funds and their ability to negotiate commercial terms.”