The SEC’s New Private Fund Adviser Rule Comes Under Early Attack

The U.S. Securities and Exchange Commission (SEC) is engaged in new litigation following the introduction of the Private Fund Adviser (PFA) Rule. Designed to bolster transparency and competition within the private funds industry, the PFA has garnered both support and opposition (and, in any event, significant discussion from both sides). The private funds sector, responsible for managing an estimated $20 trillion in assets, has been under the microscope for its practices for some time. The PFA Rule was crafted to address these concerns, mandating quarterly reports on fee and performance metrics, annual audits for private funds, and the disclosure of specific fee structures. Additionally, the rule prohibits offering select investors preferential treatments and requires funds to provide quarterly statements on performance, fees, and expenses. It also necessitates either a fairness or valuation opinion for adviser-led secondary transactions.

Several trade associations, led by the Managed Funds Association (“MFA”), have initiated legal proceedings against the SEC, filing their lawsuit on September 1. Their grievances primarily revolve around the SEC's perceived overreach, concerns about escalating operational costs, potential curtailment of competition, and the limitation of investment opportunities. They also highlight the potential for the rule to unduly restrict private fund advisers in their dealings with investors and criticize the rule's perceived overreach in its prohibitions and disclosure mandates.  The lawsuit is highly critical and takes the position that the SEC's proposal was ill-considered, citing a report from the Commission's own Inspector General, which states that the SEC relied on inexperienced personnel and rushed an aggressive agenda without adequate research and analysis. Despite receiving feedback that the proposal had legal issues and reflected misunderstandings of the market, the SEC proceeded with its final rule.

Across the “v”, Gary Gensler, the SEC Chair, has been a vocal proponent of the rule. He emphasizes its potential to foster greater transparency and competition within the private funds sector. The SEC, for its part, maintains its belief that the rule aligns seamlessly with the existing laws, rules, and regulations applicable to the industry.  The rule's introduction has elicited a spectrum of responses from various stakeholders. Industry lobbyists, for instance, engaged in extensive dialogue with the SEC before the rule's finalization. While the SEC made some concessions as compared to the initial proposal (including, e.g., (i) providing for the general partner’s clawback to be before, rather than net of, taxes and (ii) providing for an ordinary negligence (rather than gross negligence) standard of care), from the adviser perspective, several contentious points remain unresolved. Legal experts have voiced concerns that the rule might not offer more protection to investors, especially given certain omissions. Prominent Republicans have also expressed reservations about the SEC's authority to introduce such regulations. In contrast, labor unions and Wall Street watchdogs have largely championed the new rules, viewing them as a significant step towards establishing equity between private equity firms and their investors.

As the legal challenges to the PFA Rule unfold, the outcomes will certainly impact the future trajectory of the private funds industry.