The US Securities and Exchange Commission’s sweeping private fund rules will cost the private fund industry $5.4 billion per year “for no good reason”, the lead attorney for six trade groups warned an appellate panel.
“The rule at issue here is a brazen attempt to exercise plenary authority over private funds,” Gibson, Dunn & Crutcher partner Eugene Scalia told a three-judge panel of the Fifth US Circuit Court of Appeals during oral arguments Monday, reminding the judges that private fund managers have been exempt from the Investment Company Act for generations. “Profits in private funds are substantially larger than the public markets. Fees have declined. Nonetheless, and for no good reason, the SEC is attempting to subvert the exemptions.”
Scalia, son of the late Supreme Court justice Antonin Scalia, urged the judges to scrap the new rules. He blasted the commission for a rushed rulemaking process with a weak economic analysis that ignored countless comments raising substantial concerns about the proposal. If allowed to stand, the rules will cost the industry $5.4 billion per year, and – by the commission’s own admission – will drive many smaller fund managers out of business, without a clear explanation for why the rules were necessary in the first place.
“There should be no mistaking the scope of what the SEC is trying to do,” Scalia said. “It’s saying it can regulate the terms for investing in private funds, how they’re governed, what private fund advisers are compensated for – it’s plenary authority. They’re doing it, moreover, in a vibrant sector of the economy. What harms have they identified?”
SEC assistant general counsel Jeff Berger argued for the commission. He rejected Scalia’s characterisation that the new rules rely solely on Title IX of the Dodd-Frank Act. He added that Congress used the phrase “investors” in Sec 211(h) of the Act, opening up a wider definition than merely “retail customers” used elsewhere in Dodd-Frank and giving the judges “a foothold” for supporting the new rules.
As to Scalia’s contention that private markets are raking in money, Berger said, “I wouldn’t assume that a rising tide lifts all boats.”
“Put yourself in the shoes of the small pension funds,” he urged the judges. “They are facing situations where they can’t get clear information about how much they’re paying on returns that they may or may not be getting.”
The new rules, he said, give smaller public pension funds such as the Louisiana Municipal Police Employees’ Retirement System – which signed an amicus brief in the case – “a chance to earn and enjoy the benefits of the private fund industry.”
Berger and the commission are facing an uphill battle. The Fifth Circuit is historically the most hostile to government regulation. The three judges at Monday’s panel – Leslie Southwick, Kurt Engelhardt and Cory Wilson – were all appointed by Republican presidents.
Indeed, multiple sources told affiliate title Private Funds CFO that private fund advocates formed the lead plaintiff in the case, the National Association of Private Fund Managers, nearly a year before the final rules were adopted and headquartered it in Texas so they could bring a challenge in the Fifth Circuit.
According to federal court statistics, it takes about six weeks for the Fifth Circuit to issue a final order in a case after oral arguments. Even a partial victory for the commission won’t leave fund managers with a lot of time: for funds with $1.5 billion or more in assets under management, many of the new requirements in the rules package take effect in September.
Among those listening to Monday’s arguments was Marc Elovitz, co-managing partner at Schulte, Roth & Zabel. He said the case was “extraordinary” because it illustrates just how far the industry’s worldview is from its regulator’s.
“There’s a real contrast in viewpoints about the fundamental premises here,” Elovitz said. “The SEC counsel articulated a market failure for the basis of this rulemaking. It’s an interesting response, because it suggests that the SEC’s view is that in order for a market to be successful, everyone must succeed. That’s in sharp contrast to the kind of a market-based, contractual approach that the private fund associations are talking about. It’s really two different viewpoints clashing.”
An SEC loss here may not spell the end of the argument, Elovitz said.
“One outcome of this could very well be that portions of the rule are vacated, and they’re vacated on the grounds that, under the Administrative Procedures Act, there wasn’t proper comment time for industry,” he said. “The SEC could say, ‘All right, well, we’ll re-propose.’ That’s why it’s so important how the court rules.”
On the other hand, if the judges rule against the commission on the grounds that it’s improperly relying on Dodd-Frank, “it would not only be relevant to what happens with these private funds rules, but a whole swath of SEC rulemaking. If that is the basis of any part of the rule being vacated, that would put a huge hole in a lot of the SEC’s arguments for other rules they’ve proposed.”