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In June, 2009, the Obama administration proposed a comprehensive restructuring of the federal government’s supervision and regulation of the financial industry. Timothy Geithner announced several proposals that, if adopted, would affect not only public companies but also private equity funds, venture capital funds, and funds of funds.

The proposals are included in a white paper entitled “Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation.”

The white paper sets forth a number of specific proposals intended to achieve five key objectives:
1. Promote robust supervision and regulation of financial firms;
2. Establish comprehensive supervision of financial markets;
3. Protect consumers and investors from financial abuse;
4. Provide the government with the tools it needs to manage financial crises; and
5. Raise international regulatory standards and improve international cooperation.

Without acknowledging the distinction between hedge funds and other private investment pools, such as private equity funds and venture capital funds, the white paper proposes that “all advisers to hedge funds (and other private pools of capital, including private equity funds and venture capital funds) whose assets under management exceed some modest threshold should be required to register with the Securities Exchange Commission (“SEC”) under the Investment Advisers Act.” Requiring registration of fund managers, the white paper argues, will allow the SEC to collect data that would permit an informed assessment of whether such funds have become too large, leveraged, or interconnected to be allowed to function unregulated for financial stability purposes.

The white paper also proposes that any investment fund advised by an SEC-registered adviser (which, under the administration’s proposal, would include most private equity funds and venture capital funds) be subject to:
1. Recordkeeping requirements;
2. Requirements with respect to disclosures to investors, creditors, and counterparties; and
3. Regulatory reporting requirements.

Although some of the reporting requirements may vary depending on the type of investment fund, the white paper asserts that all funds should be required to report to the SEC, on a confidential basis, (a) the amount of assets under management, (b) borrowings, (c) off-balance sheet exposures, and (d) other information necessary to assess whether the fund or fund family is so large, highly leveraged, or interconnected that it poses a threat to financial stability. The white paper also proposes that the SEC should share the reports it receives from funds with the Federal Reserve, which would have the authority to designate a fund or a family of funds as a “Tier 1 Financial Holding Company” (i.e., a firm whose combination of size, leverage, and interconnectedness could pose a threat to financial stability were it to fail) and to subject such fund or family of funds to robust supervision and regulation. Under the proposal, funds would be subject to regular, periodic regulatory examinations by the SEC to monitor their compliance with the reporting and recordkeeping requirements.

The white paper also proposes that federal regulators should establish standards on compensation for “financial firms” that will be fully integrated into the supervisory process in order to align compensation incentives better with the interests of investors and the need to ensure safety and soundness in the financial sector

Although the proposals with respect to compensation appear to be directed primarily at the executives of banks and investment banks, the broad sweep of the term “financial firms” suggests that compensation standards may extend to hedge fund managers and the general partners of private equity funds, venture capital funds, and other private investment pools.

Although broad in scope, the proposal contains few specifics about implementation. Implementation will require comprehensive legislation and the subsequent adoption of a broad range of regulations by the Federal Reserve, the SEC, and other financial regulatory agencies. The white paper’s proposals with respect to hedge funds, private equity funds, venture capital funds, and other private investment funds are generally consistent with legislation introduced in Congress earlier this year.

Representative Barney Frank, chair of the House Financial Services Committee, has announced he plans to bring comprehensive financial services reform legislation to a vote in the House of Representatives before the end of 2009. The administration’s white paper will undoubtedly influence the legislation that emerges from Frank’s committee and will likely impose registration, reporting, and recordkeeping obligations on private equity funds, venture capital funds, and funds of funds and their general partners consistent with those recommended in the white paper.

Section 404 of the SOX Act has been extended for smaller companies-including small private equity firms. This section deals with internal control over financial reporting. The auditor has to generate a report on internal control. So far, the SEC has allowed a “management’s report” on internal control as a substitute. This report is the most expensive part of compliance.

Since SOX, not only have we seen a scarcity of initial public offerings, compliance costs have escalated, and it is doubtful that fraud has been reduced. The country is also in a recession, and SOX, whatever one thinks of it, increases costs and slows down activity at public companies. Were it to vanish instantly, we probably would see a corresponding stimulus to all companies who no longer have to comply.

On the other hand, Congress is in the mood for increased regulation with a President who claims to want to crack down on business abuses. Public opinion is probably in favor of keeping as much regulation as possible and protecting the small investor and business owners.

The purpose of SOX was to increase regulation of boards and management of publicly owned companies and the accounting firms that audit such companies. The act is also known as the Public Company Accounting Reform and Investor Protection Act, and created the Public Company Accounting Oversight Board (“PCAOB”).This act relates only to publicly-owned companies. It is attached as unconstitutional because its members are not appointed by the President.

The Petitioners in the case, The Free Enterprise Fund raises two constitutional questions: (1) whether the provisions of SOX creating PCAOB violate the Constitution’s separation of powers; and (2) whether it violates the Appointments Clause.

SOX has not done as much as was hoped. But it seems that SOX cannot be modified. PCAOB is a private-sector, nonprofit corporation, created to oversee the auditors of publicly-traded companies. It came into being in the wake of the accounting scandals at Enron, Wolrdcom, Adelphia, and other companies, which led to the passage of SOX. Under SOX, PCAOB has regulatory and enforcement authority over all accounting firms that audit public-traded companies. The five PCAOB members are appointed by a majority vote of the five Commissioners of the SEC.

If the Supreme Court rules in favor of the Petitioners in finding that PCAOB is unconstitutional, the ruling could mean the end of PCAOB. It could also means the end of SOX because SOX lacks a provision for severability. That means it cannot be hacked into pieces. It is either whole or it does not exist. Such a ruling would be a triumph for those who believe that in enacting the PCAOB-provision of SOX, Congress overstepped its authority by purportedly removing the President’s power and authority over PCAOB. If the Respondents prevail, PCAOB and SOX will remain intact. Either way, the ruling could have a significant impact on both administrative and securities law.

But much depends on how the case is argued and the justices who hear it. Sonia Sotomayor is new to the Supreme Court and we do not know how she will vote.This legislation is one threat facing private equity funds and I have no idea what will happen on the legal front.

If private equity firms are required to register with the SEC, which the current administration seems to favor, what will be the ramifications?

First: The smaller the firm, the larger will be the cost of compliance. Other than disclosure of financial information, we do not know what else this registration would imply. If a fund has benefit fund investors, there are restrictions. The problem is less the disclosure per se than the restrictions on what the fund is allowed to do. SEC registration merely means that the firm has to make information public. What is made public is what a firm has done; it does do not have to make its plans public. It may require that a firm make public the earnings of the top earners.

Let’s stay tuned to the news!

More on Supreme Court

Read more:
Leslie Pratch, Ph.D.: Financial Regulatory Reform’s Impact on Private Equity