The Most Curious Rule Proposal in Securities and Exchange Commission History

Abstract

The Securities and Exchange Commission advertises itself as a disclosure-based agency that eschews merit regulation. It logically and historically provides greater investor protection to less sophisticated investors. The Commission’s proposed Private Equity Rules, however, reject both principles. They would transform the agency into a merit regulator that provides greater “investor protection” to more sophisticated than to less sophisticated investors.

The world’s most sophisticated investors dominate the market for venture capital, hedge, and private equity fund investing. They are represented by expert counsel. Yet, with no evidence of market failure, the Commission would prohibit these most sophisticated of all investors from entering into fully disclosed contractual provisions that they are free to reject but willingly accept. This is merit regulation in a market that least requires merit regulation.

This transition to merit regulation is fraught with peril. Once the agency merit regulates in the absence of market failure, it invites special interest pleading by other constituencies seeking to further parochial interests. It will be difficult for the Commission to articulate a principled basis for adopting some forms of merit regulation but not others. The inevitable result is a more politicized agency that can no longer credibly limit its mission to disclosure regulation.

Moreover, while the Commission would prohibit the world’s most sophisticated investors from agreeing to certain contractual provisions, it would allow the least sophisticated to be bound by precisely the same conditions. The Commission nowhere analyzes or defends this odd inversion which conflicts with large bodies of law and precedent.

If the Commission’s rationales for adopting the proposed rules are sufficient under the Administrative Procedures Act, then the Commission will have established a foundation for far more muscular intrusions into a broad range of contractual arrangements involving publicly traded instruments and private placements. Put another way, if the SEC can so aggressively regulate the substance of freely negotiated contracts involving the most sophisticated investors absent evidence of market failure, it follows, a fortiori, that it can regulate most other contractual arrangement involving less sophisticated investors subject to its jurisdiction. Much more is therefore at stake than a set of specialized rules impinging on freely negotiated contracts involving venture capital, hedge, and private equity funds. The proposed rules implicate foundational questions about the SEC’s role and authority in governing US capital markets that should not be minimized or ignored.

This draft is in the form of a comment letter submitted to the Commission, and is being converted to a law review article for future publication.

Keywords: SEC, securities regulation, merit regulation, private equity, investor protection, Administrative Procedures Act, sophisticated investors

JEL Classification: K22, K12, K23, G23, G24, G28, G38