SEC proposes enhanced disclosures for private equity and hedge funds

As a result, most of the agency’s examination and enforcement efforts have been spent protecting small investors. Wealthy and large institutional investors, considered more sophisticated by the SEC, have been largely allowed to fend for themselves; after all, they can afford to take losses when their risky bets do not pay off.

On Wednesday, the SEC voted to propose a rule that would require hedge funds and private equity funds—a corner of the market the agency estimates to be worth $18 trillion—to provide detailed information on fees, expenses, and performance on a quarterly basis. The information would be provided only to investors, although the SEC could access some of the information during examinations if it deems it necessary.

Private fund advisers would be prohibited under the new rules from engaging in certain activities the SEC deems “contrary to the public interest” and detrimental to investors, like charging fees to investors when the adviser’s activities are under review by regulators.

The proposed rule would also prohibit private fund advisers “from providing certain types of preferential treatment to investors in their funds and all other preferential treatment unless it is disclosed to current and prospective investors,” according to an SEC press release.

The proposal would require private funds be audited on an annual basis and that registered private fund advisers provide investors with an independent fairness opinion for any adviser-led secondary transaction.

Further, SEC-registered advisers, including those that do not manage private funds, would be required to document the annual review of their compliance policies and procedures in writing.

“I support this proposal because, if adopted, it would help investors in private funds on the one hand and companies raising capital from these funds on the other,” said SEC Chair Gary Gensler in the press release.

In the proposed rule, the SEC said many private funds “do not have comprehensive mechanisms for private fund investors to exercise effective governance” and do not document the annual review of their compliance policies and procedures in writing.

“We believe that requiring written documentation would focus renewed attention on the importance of the annual compliance review process and would result in records of annual compliance reviews that would allow our staff to assess whether an adviser has complied with the review requirement of the compliance rule,” the proposal said.

The proposal passed by a 3-1 vote. Gensler and Democratic Commissioners Allison Herren Lee and Caroline Crenshaw voted in favor, while Republican Commissioner Hester Peirce voted no.

The new rules and amendments might signal a shift in philosophy at the SEC, away from a principles-based regime to a rules-based one, said Kelley Howes, of counsel at Morrison & Foerster and vice chair of the firm’s investment management group.

“These investment advisers to private funds, like all advisers, are fiduciaries. There’s never been a question about that,” Howes said. “They have to act in the best interest of their clients.”

While the SEC had previously left private fund advisers and their wealthy investor clients to establish their own disclosure rules, now advisers will have to provide detailed, standardized information on fees, expenses, and performance on a quarterly basis.

Private fund advisers “may already be disclosing this information, maybe not every quarter and maybe not in the same way,” Howes said. These firms will have to implement new policies and procedures to meet these new reporting requirements “There is going to be a cost to comply with it,” she said.

Other requirements, like the mandate private funds undergo annual audits, are not as big a deal, Howes said. “The vast majority of private fund advisers already do that,” she said.

Peirce, the only commissioner to vote against the proposal, said in a statement, “These changes represent a meaningful recasting of the SEC’s mission.”

The proposal, she said, “embodies a belief that many sophisticated institutions and high net worth individuals are not competent or assertive enough to obtain and analyze the information they need to make good investment decisions or to structure appropriately their relationships with private funds. Therefore, the Commission judges it wise to divert resources from the protection of retail investors to safeguard these wealthy investors who are represented by sophisticated, experienced investment professionals. I disagree with both assessments.”

The SEC also proposed two other rules Wednesday.

One rule would require registered investment advisers, registered investment companies, and business development companies have written policies and procedures that address cybersecurity risk, as well as a new mandate for confidential reporting of significant cybersecurity incidents to the SEC.

The proposal would require advisers and funds to publicly disclose cybersecurity risks and significant cybersecurity incidents that occurred in the last two fiscal years in their brochures and registration statements. It would also include new recordkeeping requirements that would aid the SEC during examinations and investigations.

The second rule proposes to reduce the time required to settle securities trades from two days (T+2) to one day (T+1). Such a change was first teased by Gensler shortly after he took over as chair of the regulator in the aftermath of last year’s “meme stocks” craze.

“The proposed changes are designed to reduce the credit, market, and liquidity risks in securities transactions faced by market participants and U.S. investors,” the SEC said in a press release.