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Lawsuit Challenges SEC's New Rules for Private Fund Advisers

A recent lawsuit, initiated by industry groups, has raised questions about the Securities and Exchange Commission's (SEC) authority to implement new regulations aimed at enhancing transparency and accountability in the private fund market, valued at over $26 trillion. The lawsuit, filed in the U.S. Court of Appeals for the Fifth Circuit, asserts that the SEC overstepped its statutory boundaries when introducing these rules.

Lawsuit Challenges SEC's New Rules for Private Fund Advisers

Several industry associations, including the National Association of Private Fund Managers, Alternative Investment Management Association, American Investment Council, Loan Syndications and Trading Association, Managed Funds Association (MFA), and National Venture Capital Association, are behind the legal action. The lawsuit's counsel is Eugene Scalia, a prominent lawyer known for challenging the federal government on matters of regulatory authority. The choice of the Fifth Circuit, a conservative appeals court, reflects the petitioners' strategic decision to challenge the SEC in a conservative-leaning jurisdiction.

MFA President and Chief Executive Bryan Corbett emphasized their opposition to the SEC's rules, stating that the private fund adviser rule would harm investors, fund managers, and markets by increasing costs, undermining competition, and reducing investment opportunities for various institutions such as pensions, foundations, and endowments.

However, legal experts closely following the lawsuit believe it is unlikely to halt the implementation of the SEC's rules. The rules are set to take effect in a year to 18 months, depending on the fund's size, and the lawsuit does not seek a delay in their implementation. David Slovick, a partner at the law firm Barnes & Thornburg and a former SEC regulator, expressed confidence that the SEC acted within its authority to establish these rules.

"In my opinion, the SEC had the authority to pass the rule," Slovick stated, suggesting that private fund advisers could delay significant expenditures on compliance until the lawsuit's outcome is determined.

Ed Winters, a partner at Eversheds Sutherland, who advises investment advisers on regulatory compliance, advises clients to continue preparing for compliance with the SEC's rules. He recommends beginning the compliance process gradually rather than rushing through it at the last minute, emphasizing the importance of dedicating resources to planning a response to the new regulations.

The lawsuit highlights the private fund industry's dissatisfaction with the pace and scope of SEC regulations. Kerry Potter McCormick, a partner at Barnes & Thornburg, noted that additional rules for private fund advisers are in the pipeline, further increasing the compliance burden on industry teams. Some industry insiders question whether these rules are addressing genuine problems or if the SEC is proposing solutions in search of a problem.

The rules, adopted by the SEC on August 23, target specific practices in the private fund industry that may pose risks and harm to investors and private funds. These practices include conflicts of interest related to certain fees and expenses, as well as preferential treatment afforded to select fund investors through the use of side letters. Instead of banning these practices outright, the SEC will require investment advisers to disclose these fees to investors and make preferential treatment arrangements available to all fund investors.

The new rules also mandate private fund advisers to provide investors with quarterly statements on fund performance, fees, and expenses, conduct annual audits of all private funds, obtain a fairness or valuation opinion for adviser-led secondary transactions, and implement new disclosure rules regarding material business relationships with independent opinion providers established within two years.

Compliance teams at private funds face substantial tasks in preparing to comply with these rules. Comprehensive analyses are required to determine how the mandates will impact a fund's business model and practices. Kerry Potter McCormick advises involving various internal stakeholders, including legal, finance, investor relations, and the C-suite, in this process. She highlights that finance teams need to be prepared for changes in quarterly reporting.

Additionally, private fund advisers should assess which tasks can be managed internally and which may necessitate the engagement of external counsel or compliance consultants. As funds continue to negotiate side letters, it is recommended to incorporate the new rules into these agreements to future-proof them, including policies for disclosing risks and conflicts of interest to investors.

While compliance with the new rules will incur costs, McCormick recommends that private fund advisers begin estimating these expenses and communicate them to internal stakeholders. This may include evaluating the need to hire additional compliance staff to manage the increased workload.

In summary, the lawsuit challenging the SEC's new rules for private fund advisers is unlikely to prevent their implementation, according to legal experts. Private fund industry participants are advised to continue preparing for compliance with these rules, which are set to enhance transparency and accountability in a rapidly growing sector. Despite industry concerns, the SEC appears to have a strong legal foundation for implementing these regulations, and compliance teams are encouraged to proactively plan their response.



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