Assessing CHOICE Act's PE Fund Deregistration Provision
The Dodd-Frank Act brought widespread change to the private equity industry with new registration and reporting requirements for the managers of private funds. A draft of the Financial Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs Act (Financial CHOICE Act), recently reported by the House Financial Services Committee, seeks to turn back the clock and undo some of these changes by, among other things, exempting managers of “private equity funds” from the registration requirements of the Investment Advisers Act of 1940.1
The bill is expected by many to pass in the House of Representatives during 2017, perhaps with further amendments. Once the House passes the bill, it will move to the Senate, which may not take action until 2018. If the Senate passes the bill, the exemption may be narrower than that contained in the House bill, with the differences left to be resolved in the conference committee stage.
It remains unclear whether and to what extent the proposed exemption from registration requirements for investment advisers of "private equity funds" in the Financial CHOICE Act would return the private equity landscape to the less regulated state that it experienced before Dodd-Frank. Many of the changes wrought by Dodd-Frank may prove to be fixtures even in a somewhat less regulated private equity fund industry.
What the Law Would Change
Proposed Section 858 of the Financial CHOICE Act (Section 858) exempts investment advisers from SEC registration and reporting requirements "with respect to the provisions of investment advice relating to a private equity fund." It also mandates that the U.S. Securities and Exchange Commission issue regulations requiring that exempted investment advisers keep records and report information to the SEC.
Assessing the potential impact of Section 858 remains difficult at this stage, and not merely because the relevant provisions of the Financial CHOICE Act may yet undergo further modifications. There is ambiguity in Section 858 as currently drafted, and wide discretion would be left to the SEC to determine the scope of its implementation. Although investment advisers that are required to register with the SEC are subject to many detailed requirements that exempted advisers are not, exempted advisers would remain subject to the anti-fraud provisions of the Investment Advisers Act. Thus, any advisers exempted under Section 858 would remain subject to those statutory anti-fraud provisions and, presumably, to anti-fraud rules adopted by the SEC, which underpin many of the enforcement actions taken against private equity fund managers since the adoption of Dodd-Frank.
The text of the proposed statute also leaves open many questions. Will exempted advisers be exempt only from mandatory registration, or are they to be precluded from discretionary registration as well? How will “private equity funds” be defined? How will the exemption interact with other exemptions, such as the so-called "private fund adviser" and "venture capital fund adviser" exemptions? What will the reporting and disclosure requirements be?
The Financial CHOICE Act defers to the SEC to establish a definition for the "private equity funds" whose investment advisers will be exempted from mandatory registration. A narrow definition of exempted "private equity funds" could mitigate much of the impact of Section 858 by narrowing the category of advisers who will qualify for the exemption. However the term is ultimately defined, investment advisers that manage other types of private funds or have other clients may be required to remain registered and Section 858 would have only a minimal (or no) impact on them.
Section 858 also continues to require record-keeping and reporting to the SEC for investment advisers exempted from registration for their advice to private equity funds. Section 858 leaves wide latitude to the SEC to determine the scope of these reporting requirements, as the SEC may adopt any reporting requirements "necessary and appropriate in the public interest and for the protection of investors" taking into account fund size, governance, investment strategy, risk and other factors. Maintenance of broad reporting requirements for otherwise unregistered advisers could counterbalance any changes deregistration might have on the industry.
Support for the Bill from Institutional Investors and State Securities Regulators
Opening the door to deregistration of private equity funds may be very attractive to investment advisers that find registration especially cumbersome. Many aspects of the investment adviser regulation regime remain oriented toward persons who advise as to publicly traded securities, and the evolving application of the regime to persons who exclusively advise as to private securities has at times been difficult. Further, the SEC's staff have had to go through a significant learning curve with regard to the industry in the Dodd-Frank era, and certain of the SEC's enforcement and examination priorities during this period have attacked practices that had developed over decades. However, given (1) the vast resources already expended in recent years by investment advisers seeking to comply with the expanded registration requirements that resulted from Dodd-Frank, (2) the potentially dubious benefits of deregistration given the remaining reporting requirements contemplated by the Financial CHOICE Act, and (3) the potential for lost investor confidence as a result of deregistration, many investment advisers that become exempted from registration may (if possible) choose to remain registered even once no longer required to do so. For example, when the so-called "hedge fund registration" rule was overturned by the Goldstein decision in 2006,2 many hedge fund managers that had registered as investment advisers under the rule chose to remain registered, in light of the investments they had made in creating compliance infrastructures and investor relations concerns.
Many investors will not welcome the loosening of regulatory requirements applicable to private equity fund advisers. For example, the Institutional Limited Partners Association opposes Section 858, which ILPA is concerned will "hurt limited partners ... and their beneficiaries by removing regulatory oversight that has successfully enforced transparency and ensured compliance with mandatory reporting procedures." ILPA cites increased disclosure of fees and expenses and increased compliance by managers with the terms of their fund documents as perceived benefits of registration.3 Generally echoing these concerns, the Council of Institutional Investors opposes Section 858 "because it would remove transparency in private equity."4 Likewise, state securities regulators have also come out in opposition to the decreased regulation and registration requirements proposed by the Financial CHOICE Act. The North American Securities Administrators Association reported to the House Financial Services Committee that "as recent SEC examinations have revealed, the scrutiny of advisers to private funds is important to the protection of investors in such funds ... The registration of private fund advisers has brought much needed transparency to a significant segment of the markets."5 Moreover, the information gleaned by the SEC from mandatory registration regarding unlawful fees and charges will not be "unlearned," and it is likely that this is an area of concern that will be ingrained into SEC enforcement practices for the long term.
Given the wide discretion left to the SEC to determine the scope of funds exempted under Section 858 and the fact that the bill's future progress through the House and Senate cannot be predicted with any certainty, the extent to which Section 858 will have a tangible impact on private equity fund adviser practices will remain unknown for some time. Even if the option of deregistration becomes available to private equity fund managers under Section 858, Dodd-Frank may have brought lasting changes to the industry that will outlive its particular operative provisions.
Ellen Fleishhacker and Robert Holton are partners at Arnold & Porter Kaye Scholer LLP. They co-head the firm's investment management practice.
Jacob Goldenberg, a student at Berkeley Law School, contributed to this article.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
See Section 858 of Financial CHOICE Act, https://www.congress.gov/115/bills/hr10/BILLS-115hr10rh.pdf. The bill was reported by the Financial Services Committee, discharged by various other committees and placed on the Union Calendar (No. 100) on May 25, 2017.
Institutional Limited Partners Association. “Repealing SEC Requirements Will Harm Critical Investor Protections and Flow of Information.” Ilpa.org. Apr. 27, 2017. (https://ilpa.org/wp-content/uploads/2017/04/ILPA-Opposes-Provisions-in-CHOICE-Act-of-2017.pdf)
Council of Institutional Investors. “Mark-up of H.R. 10, the Financial CHOICE Act of 2017.” Cii.org. Apr. 29, 2017. (http://www.cii.org/files/issues_and_advocacy/correspondence/2017/04_29_17_letter_cmte_fin_serv.pdf)
Testimony of Melanie Senter Lubin, Maryland Securities Commissioner on Behalf of North American Securities Administrators Association before the U.S. House Committee on Financial Services. Nasaa.org. April 28, 2017. (http://www.nasaa.org/41990/legislative-proposal-create-hope-opportunity-investors-consumers-entrepreneurs-2/)