High-End Securities Regulation
The SEC has long taken a hands-off approach to private markets. Instead of direct regulation, the commission has used investor access restrictions to create high-end contracting environments where investors (in theory) have the resources necessary to fend for themselves. But in early 2022, this hands-off philosophy was turned on its head. In response to booming growth and concerns about harms to public pension plans and other institutional investors, the SEC proposed a sweeping set of regulatory interventions in the $18 trillion private fund industry (the ‘Private Fund Proposal’), a vast and important part of the private market ecosystem.
In a new paper, I analyze this new approach to private market securities regulation. Building on a comment letter that I filed with the SEC last spring, this paper seeks to address shortcomings in the SEC’s current private funds rule-making process and help to establish a more effective policy dialogue in private securities markets going forward. Over the summer, I presented the paper’s primary arguments and proposals in a presentation to members of the SEC’s Division of Investment Management and Division of Economic and Risk Analysis.
My paper argues that any effort to intervene in private securities markets should revolve around a basic question: What are the causes of bargaining failure? Because private market investors must satisfy minimum asset requirements, there is naturally a greater need to verify the existence of bargaining failure to legitimize intervening. If no collective action problems, principal-agent problems, market power problems, or other underlying issues are causing bargaining outcomes to fall short, the parties in private markets should be unusually well-positioned to use private ordering to find effective solutions to their problems. Investor sophistication also creates pressure to apply any interventions narrowly and calibrate them thoughtfully so they address these underlying causes without impinging more than necessary on freedom of contract.
This need to invest time and attention on the underlying causes of bargaining failure is magnified by another characteristic of private markets: the lack of publicly available information about how private markets operate. Because private funds are not subject to the traditional public disclosure requirements of the federal securities laws, it is much more difficult to demonstrate basic facts about how bargaining works in this area and cultivate thoughtful policy dialogues. This means that to satisfy the elevated burdens described above, it requires a more determined and creative approach to studying the underlying causes of bargaining failure.
Unfortunately, notwithstanding the factors described above, these issues were not a central focus of the SEC’s Private Fund Proposal or the comment letters submitted during the proposal’s comment period. Instead of asking industry participants to comment on the causes of bargaining failure in private funds, the 900+ questions in the Private Fund Proposal generally asked commenters to focus on practical issues of implementation without seeking input on whether the rule is addressing the right underlying causes in the first place.
To help fill this void in the policy dialogue, my paper presents the full results of the first empirical study asking institutional investors to identify the causes of bargaining failure in private equity funds. Institutional investors have substantial experience navigating the bargaining process in private funds. Many of them are serial investors in these funds, with in-house legal personnel focused on making investments in a range of private funds that are managed by a range of advisers. When asked what causes them to agree to problematic terms in private equity fund contracts, investors point most often to a lack of bargaining power and a related coordination problem, saying that they will lose access to fund managers or be allocated a smaller share of the fund if they push back against bad terms. Interestingly, however, when asked whether they would like to see regulatory responses to these issues, investors’ input was more mixed. A detailed discussion of these results—and the implications and limitations of the study—can be found in the paper.
One of the things that makes this polling data particularly interesting is the fact that the academic literature lacks a definitive theory of the causes of bargaining failure in private funds. The absence of an authoritative theory is not for lack of trying. Many scholars (including myself) have voiced serious concerns about questionable practices in private equity funds over the years and concluded that these practices are signs that things must not be functioning optimally. But the hardest question for scholars to answer has been why these problematic practices have taken hold in such a sophisticated bargaining environment. Scholars have offered various theories, but without access to publicly available information, these theories are very difficult to test. Likely because of this limitation, the policy recommendations in these studies have tended to be relatively cautious in their scope and substance.
The polling data presented in my paper provides a starting point for understanding where (from the investors’ perspective) the most problematic causes of bargaining failure exist in private funds. This is a useful reference point for those seeking to make the case for the existence of bargaining failure in private funds and the need for interventions. In like manner, however, to the extent that researchers can show that these claims are not supported by evidence, these survey results also provide a focal point for pushing back against claims of bargaining failure in private funds. Accordingly, my paper’s polling results should not (without more) be interpreted as providing a basis for aggressive regulatory interventions, but rather as a starting point for a more productive policy dialogue.
These issues have important policy implications, both immediately and in the longer-term. To guide the SEC, courts, and Congress, my paper sets forth a framework for thinking about the relationship between private market interventions and the SEC’s knowledge about the causes of bargaining failure. In short, I argue that the importance of verifying and understanding the relevant causes of bargaining failure in private funds (and private markets more broadly) increases as the aggressiveness of any proposed intervention increases. In the immediate future, this framework provides the SEC with a principled basis for deciding what interventions to include in the final private fund rule and encourages the SEC to embrace a longer-term perspective. In the medium-term, if the SEC ultimately decides to proceed with any interventions, this framework will also provide courts with a useful tool for evaluating whether the commission has gone too far.
As the expansion of private funds and private markets continues apace, I predict that the debate over high-end securities regulation in private markets has only just begun. My paper offers three suggestions for improving theory and policy in private securities markets going forward. First, I call for the SEC to work more deliberately with industry participants and scholars to study the causes of bargaining failure in private markets. Second, I encourage industry participants to do more to support research efforts in private markets—including by collaborating on academic interviews and surveys and providing anonymized documents for research purposes—and I argue that doing so will benefit market participants by contributing to better, more informed policy. Lastly, my paper calls on more corporate and securities law scholars to find thoughtful ways to contribute to private market securities research.
Importantly, even though my paper focuses primarily on private investment funds, many of the principles discussed in it are applicable to any private, high-end setting with sophisticated bargainers. As the private marketplace continues its meteoric growth, the principles set forth in this paper provide a necessary foundation to guide the future of securities law policy in private funds and across the spectrum of private markets.
William W. Clayton is Francis R. Kirkham Associate Professor of Law at Brigham Young University.
A version of this blog post first appeared on the CLS Blue Sky blog (here).
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