Significant court ruling against financial regulation by the US SEC

Securities and Exchange Commission Chairman Gary Gensler’s attempts to introduce some regulation covering the rapidly growing private equity market suffered a major blow last week when a federal court in New Orleans unanimously rejected the proposed measures.

This decision has far-reaching implications for the SEC’s continued efforts to regulate an area of the financial system that has been identified by the International Monetary Fund and others as a potential source of financial instability.

The U.S. Securities and Exchange Commission at the SEC headquarters in Washington (AP Photo/Andrew Harnik, File)

Over the past decade, in response to low interest rates, the private equity market has expanded rapidly as finance capital has sought new ways to accumulate profits and pension funds and others have sought to obtain better returns on their assets. The market size is estimated to have exceeded $2.1 trillion at the end of last year, up from $1.4 trillion at the end of 2022 and $875 billion in 2020, and is expected to reach $2.3 trillion in 2027.

The SEC’s new rules would require private equity firms and hedge funds to be more transparent by issuing quarterly financial reports detailing their performance and expenses, as well as undergoing annual audits.

These measures would put an end to the practice of offering preferential side deals to large investors at the expense of smaller ones.

The SEC’s attempted regulation immediately drew the ire of private funds, which have long enjoyed so-called “light regulation,” or virtually no oversight. After failing to push back against the changes, they initiated legal action last September and decided to move them to New Orleans, where they felt they had a better chance of success.

The case was further evidence of the incestuous nature of the American political, judicial and financial system.

Their legal brief was prepared by Eugene Scalia, who served as secretary of labor in the Trump administration and is the son of the late Supreme Court Justice Antonin Scalia. Scalia Sr., as the World Social Web Site explained in his obituary, was known for his rulings that took a predetermined outcome and then shaped the law. In his 5-4 ruling over the Supreme Court’s 2000 decision to halt vote counting in Florida, he declared there was “no universal suffrage.”

The son is not the father, of course, but as the saying goes, the apple doesn’t fall far from the tree, and Scalia Jr. built his legal career by challenging government attempts to regulate business.

The SEC based its legal position on the provisions of the Dodd-Frank Act, introduced after the 2008 financial crisis to impose new regulations on banks and finance. It needed to “facilitate the provision of simple and clear information to investors” and “publish rules prohibiting restrictions on certain sales practices, conflicts of interest and compensation systems.”

The SEC argued that private funds are now playing an increasingly important role for pension funds as they seek higher returns on their assets, which include the retirement funds of millions of Americans. Support for this argument was provided by some of these funds, which said in a lawsuit that they “simply do not have the resources to match those of the advisors with whom they invest.”

In its three-to-zero decision, the Fifth Circuit Court of Appeals not only rejected the SEC’s claims that the Dodd-Frank Act gave it the necessary powers to intervene, but also that it failed to tie the new regulations to its fraud prevention powers.

Representatives of private equity funds crowded from the rooftops in delight over the court’s ruling.

“Today’s ruling is a significant victory for markets, fund managers and investors,” Bryan Corbett, president of the Association of Managed Funds, said when the decision was announced last Wednesday. “Unfortunately, this is just one instance of overreach by the SEC to push through its most aggressive program in decades.”

Drew Maloney, president of the American Investment Council, sang from the same song.

“The court sent a strong message to Washington regulators that they cannot bypass Congress by pushing their extreme agenda.”

In fact, the proposed regulations were relatively mild and their main goal was to ensure greater transparency. When it comes to the rapidly growing private equity industry, such measures are “extreme.”

The decision, which the SEC can appeal to the Supreme Court with little chance of success, has far-reaching consequences. The regulator has already considered other rules, particularly on financial stability issues, but these have now been thrown into serious doubt.

In April last year in his Global Financial Stability ReportThe IMF has warned that there are significant risks in migrating large amounts of credit from regulated banks and more transparent public markets to less regulated markets and the more opaque world of private credit.

Summarizing the findings in a blog post, it said: “Appraisals are sparse, credit quality is not always clear or easy to assess, and it is difficult to understand how systemic risk may be building up given the not-so-clear links between private credit funds, private equity firms equity, commercial banks and investors.”

The IMF warned that while these vulnerabilities do not currently pose a threat to the financial system, the situation could change and “in the event of a severe economic downturn, credit quality could deteriorate rapidly.”

This assessment is based on experience, most notably during the 2008 crisis and again in March 2020, when the $26 trillion Treasury market froze. The Federal Reserve had to support the financial system with $4 trillion.

In its recommendations for action, the IMF said a “more vigilant regulatory and supervisory approach is needed” to private lending “focusing on risk monitoring and management, leverage, interconnectedness and exposure concentration.”

However, as the latest court ruling against the SEC makes clear, attempts to exercise even a modicum of control have been hampered by private ownership and a judicial system geared to defending its interests.