On April 23rd, Americans for Tax Reform led a coalition letter in opposition to the Securities and Exchange Commission’s proposed rule entitled, Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews. This rule, if adopted, would arbitrarily and unnecessarily expand the SEC’s regulatory authority over advisers to private equity funds, hedge funds, and venture capital funds. The rule imposes burdensome reporting requirements and interferes in private contracts negotiated between advisers and investors. The provisions drafted in the rule represent a severe overreach of governmental authority.
Americans for Tax Reform is joined by eleven other organizations in opposing this rule, including FreedomWorks, the Taxpayers Protection Alliance, Heritage Action, Citizens Against Government Waste, the Competitive Enterprise Institute, and the National Taxpayers Union.
The letter disputes the necessity of the rule, calling it a continuation of Chair Gary Gensler’s “paternalistic regulatory agenda that will only serve to increase costs and lower returns for institutional investors, bar retail investor participation in private capital markets, and restrict access to alternative investment options.” These critiques are especially salient when considering the benefits of private equity funds, which the letter lists in detail:
“The Chicago Booth Review found that leveraged buyouts increase productivity at target companies. According to the article, ‘[w]rit large, the study refutes the claim that private-equity profits rest entirely on financial engineering and zero-sum wealth transfers from other stakeholders. Buyouts also create social gains by raising productivity at acquired companies.’ Moreover, employment expands ‘by 11% in buyouts of privately held firms.’ There are also positive effects of private equity on county-level employment. One study found ‘a positive association between private equity investment and employment growth. Results indicate that for each $1 million in additional private equity investment, a little more than 1.3 new jobs are created.’ During the 2008 financial crisis, private equity firms saved failed banks and turned them around, avoiding any further systemic deterioration in the banking sector.”
Instead, Chair Gensler seeks to prohibit certain activities for private fund advisers, a gross overreach of SEC authority, as explained by the letter:
1. Prohibits after-tax clawbacks. This is unnecessary government intervention in private negotiations between advisers and investors on how to use clawbacks to pay taxes on performance-based compensation. There is no reason that the SEC needs to swoop in and “protect” institutional investors that have the wherewithal to understand the terms of the partnership agreements they are signing. The decisions about excess performance compensation are an agreement between private parties—it should remain that way.
2. Prohibits “an adviser to a private fund, directly or indirectly, from seeking reimbursement, indemnification, exculpation, or limitation of its liability by the private fund or its investors for a breach of fiduciary duty, willful misfeasance, bad faith, negligence, or recklessness in providing services to the private fund.” Investors conduct due diligence and voluntarily entered into partnership agreements with these certain provisions. There is no reason the SEC should be determining certain terms for an agreement between private parties.
Additionally, the Proposal conflicts with the Investment Company Act. Under current statute, a retail investor may not indemnify an investment adviser for gross negligence but may indemnify the investment adviser for ordinary negligence. Under the Proposal, sophisticated institutional investors, who have deep knowledge and wherewithal to understand and comprehend contractual agreements, are forbidden to indemnify private fund advisers for even ordinary negligence. This prohibition is clear overregulation that Congress has not instructed the SEC to pursue.
This prohibition would also lower returns for investors because sponsors would have less freedom to take greater investment risk. Pension funds, which rely on higher returns from private equity, would be particularly harmed by restricting limitation of liability.
The letter proceeds to catalog the excessive reporting mandates within the rule, including the distribution of quarterly reports, recording keeping requirements, submitting the identification of private fund investors to the SEC (which raises data privacy concerns), all–encompassing (and often retroactive) performance metrics, and other information disclosures that have no direct benefit to investors. Other mandates require obtaining a ‘fairness opinion’ prior to conducting adviser-led secondary transactions, and restricting side letter agreements for registered or non–registered private fund advisers, will further raise costs and reduce returns for investors.
Moreover, the letter discusses how short the comment period is for stakeholders to provide adequate input. Both Republicans and Democrats have expressed their concern with the SEC’s short comment period for this complex rule and other rules with Chair Gensler as the helm. The letter states that:
Lawmakers have vocalized their support for longer comment periods on the SEC’s new rules. In 2019, Democrats asked the SEC to provide at least 120 days to comment for any rules that amended the Community Reinvestment Act. House Democrats and Republicans have also asked the SEC to extend the comment period for the Proposal. Both sides of the aisle support comment period lengths that are commensurate with the complexity of the rule. The Proposal itself is highly complex and will largely transform the landscape of private funds. Accordingly, the comment period for the Proposal should be extended beyond its current deadline.
The letter closes with a resounding statement of disapproval:
The Proposal is an extensive regulatory shift that prioritizes government intervention over free market negotiations between private parties. Instead of sticking to its mission ‘to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation,’ the SEC has decided to give unneeded protection to only wealthy and institutional investors; introduce prohibitions that destabilize the financial landscape of private funds; and restrict capital formation by raising the cost of investing in private funds. If the SEC proceeds to a final rule with the same conclusions and analysis produced in the Proposal, it will violate the guidelines and procedures codified in the Administrative Procedure Act and be deemed arbitrary and capricious.
Click here to read the full letter.