August 31, 2023 - “Ahistorical, unjustified, unlawful, impractical, confusing, and harmful” is how Commissioner Hester Pierce described the Private Fund Disclosure Final Rules in her dissenting statement. “[T]hese rules are arbitrary and capricious” stated Commissioner Mark Uyeda. The SEC’s Final Rules, which have drawn industry scrutiny and ire since they were proposed, generally provide that private funds – funds formed in reliance on the 3(c)(1) and (7) exemptions in the Investment Company Act – 1) must prepare and deliver quarterly statements (“Quarterly Statement Rule”); 2) must have annual financial statement audits (“Audit Rule”); 3) are prohibited from entering into specified arrangements, including certain fee arrangements, unless certain conditions are met (“Restricted Activities Rule”); 4) are prohibited from engaging in adviser-led secondary transactions unless they obtain a fairness or valuation opinion (“Adviser-led Secondaries Rule”); 5) may not enter into tailored arrangements with investors regarding redemption and portfolio rights unless those same arrangement are offered to all other investors; and 6) may not enter into any other tailored arrangements unless all other investors receive written notice (together, the “Preferential Treatment Rule”).
In addition, all registered advisers must at least annually review and document compliance reviews in writing (“Compliance Review Rule”). Despite the substantial modifications described below, the Final Rules “impose significant new requirements on investment advisers…[and] represent a significant expansion of the SEC’s regulation of private fund advisers and will considerably alter how private fund advisers and investors in private funds—typically institutional investors, pension plans, and high-net-worth individuals—structure their relationships.” (Sullivan & Cromwell alert).
The LSTA continues to analyze the Final Rules and their impact and will be sharing further commentary over the next several weeks. Here, we focus on the exemption for CLOs and the statutory authority the SEC cites in promulgating the Final Rules. For a comprehensive review of the modifications made to the Proposed Rules, Sullivan & Cromwell provides a blackline of the Final Rules’ statutory text against that of the Proposed Rules and Debevoise & Plimpton and Mayer Brown offer rule by rule comparison charts.
CLOs are exempt from the Final Rules.
The Final Rules adopted the LSTA’s recommendation that CLOs be exempt from the Final Rules. None of the rules defined above other than the Compliance Review Rule will apply to investment advisers with respect to the securitized asset funds that they advise. Securitized asset funds (“SAFs”) are defined in the Final Rules as “any private fund whose primary purpose is to issue asset-backed securities and whose investors are primarily debt holders,” which is based on the corresponding definition for “securitized asset fund” in Form PF and Form ADV. (Schulte Roth & Zabel alert).
The SEC acknowledged that, as emphasized by the LSTA in its comments, “certain fundamental structural and operational differences together sufficiently distinguish them from other types of private funds to warrant carving them out of the final rules. These fundamental differences, when considered in combination with the existing governance and transparency requirements of SAFs, would cause much of the rules to be generally inapplicable and/or ineffective with respect to achieving the rulemaking’s goals.” Release at p. 56. It is a good and wholly appropriate result that the majority of the Final Rules will not apply to private advisers with respect to CLOs (and SAFs); however, members must keep their eyes open. In footnote 154, the SEC added that they will “continue to consider whether any additional regulatory action may be necessary with respect to SAF advisers in the future.”
The SEC’s statutory authority to adopt the Final Rules appears lacking.
Commenters on the Proposed Rules and Commissioners Peirce and Uyeda themselves have raised the alarm on the statutory authority cited by the SEC in its adopting release. The SEC relies primarily on two provisions of the Investment Advisers Act: Section 206(4) with respect to the Audit Rule and Section 211(h) with respect to the Quarterly Reporting, Restricted Activities, Adviser-led Secondary and Preferential Treatment Rules. Section 206(4) is an antifraud provision which empowers the SEC to “prescribe means reasonably designed to prevent, such acts, practices and courses of business that are fraudulent, deceptive or manipulative.”
It is not readily apparent how an ordinary compliance requirement like the Audit Rule fits the bill. More concerning, however, is the SEC’s reliance on Section 211(h). Section 211(h) was added by the Dodd-Frank Act – not in Title IV which directly addresses private fund advisers, but in Section 913 titled “Authority to Establish a Fiduciary Duty for Brokers and Dealers.” Section 913 is part of a section of Dodd-Frank that addresses retail investment advisers and broker dealers. Clearly private fund advisers are neither of these. Nowhere in Section 211(h) are private fund advisers clearly identified. Neither explicitly nor intuitively could Section 211(h) be seen as applying to private fund advisers.
Putting that aside, looking at the text of Section 211(h)(2), Congress authorizes the SEC to promulgate rules “prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that the Commission deems contrary to the public interest and the protection of investors.” This statutory provision is the basis for the Restricted Activities, Adviser-led Secondary and Preferential Treatment Rules. Even if private fund advisers were subject to this provision, none of the Final Rules address “sales practices, conflicts of interest or compensation schemes.” Both Commissioners Uyeda and Peirce call the SEC to task on their inappropriate reliance on Section 211(h). (Commenters on the Proposed Rules, including Citadel and Committees of the New York City Bar Association (see Section 3), also expressed deep skepticism over the SEC’s purported authority.)
Furthermore, the SEC’s interpretation of Rule 211(h) flies in the face of clear Congressional intent. Congress exempted private funds from the Investment Company Act, the rationale for this exemption being that the large, highly sophisticated investors who invest in private funds do not require the same protections as retail investors and, presumably, such investors are best placed to negotiate freely for the terms of their investments. The belief that Congress enacted Section 211(h), a subsection titled “Other Matters” in a part of the Dodd-Frank Act focused on advisers to retail investors and broker dealers, to upend the alternative statutory regime it designed for advisers to private funds lacks credibility(?).
Despite the positive result for CLOs, the Final Rules will greatly impact private credit funds and represent a sea-change in the regulation of private funds. The traditional distinction between retail investors and institutional investors is deeply blurred, which is at odds with Congressional intent. In light of Congress’s clear approach to the treatment of advisers to private funds, the SEC’s statutory authority for adopting the Final Rules seems non-existent. The LSTA is closely monitoring members’ reactions and concerns with the Final Rules and further detailed analysis is forthcoming.