Fordham Law School FLASH: The Fordham Law Archive of Scholarship and History SJD Dissertations Academics 2016 Private Equity Regulation in The Aftermath of The 2008 Financial Crisis: Is Title IV of The Dodd-Frank Act The Right Answer? The Political Economy of Dodd-Frank and The Case Against the Regulation of Private Equity Funds Under Title IV Gal Golod Fordham University School of Law Follow this and additional works at: https://ir.lawnet.fordham.edu/sjd Recommended Citation Golod, Gal, "Private Equity Regulation in The Aftermath of The 2008 Financial Crisis: Is Title IV of The Dodd-Frank Act The Right Answer? The Political Economy of Dodd-Frank and The Case Against the Regulation of Private Equity Funds Under Title IV" (2016). SJD Dissertations. 18. https://ir.lawnet.fordham.edu/sjd/18 This Dissertation is brought to you for free and open access by the Academics at FLASH: The Fordham Law Archive of Scholarship and History. It has been accepted for inclusion in SJD Dissertations by an authorized administrator of FLASH: The Fordham Law Archive of Scholarship and History. For more information, please contact [email protected]. PRIVATE EQUITY REGULATION IN THE AFTERMATH OF THE 2008 FINANCIAL CRISIS: IS TITLE IV OF THE DODD-FRANK ACT THE RIGHT ANSWER? THE POLITICAL ECONOMY OF DODD-FRANK AND THE CASE AGAINST THE REGULATION OF PRIVATE EQUITY FUNDS UNDER TITLE IV Gal Golod ABSTRACT Title IV of the Dodd-Frank Act and its implementing rules set out a major reform of the private investment fund industry and establish a new framework for regulatory and supervisory oversight of private investment funds. Title IV eliminated the private adviser exemption previously available under the Investment Advisers Act of 1940 and required the SEC to establish rules and regulations requiring advisers to "private investment funds", including private equity funds, to register with the SEC under the Investment Advisers Act of 1940. Through the elimination of the private adviser exemption, Title IV and its implementing rules now require that investment advisers to private equity funds, hedge funds and certain other funds with assets under management of $150 million or more register with the SEC, comply with certain SEC books, records, disclosure and reporting requirements, and be subject to extensive periodic SEC examination, unless they qualify for specific exemptions. This new regulatory regime is designed to bring transparency and oversight to the activities of private investment funds, control the build-up of systemic risk in the financial system and address the market and regulatory failures that led to the 2008 financial crisis. In this paper, I will i) analyze the political economy of the Dodd-Frank Act and its impact on the regulation of the private equity sector; ii) critically assess and challenge the Dodd-Frank and its implementing rules approach to the regulation of private equity funds; iii) evaluate the underlying economic theory of regulation and its relevance to the private equity sector; iv) challenge Title IV’s reliance on disclosure as the primary method of reducing systemic risk and protecting fund investors; v) examine the relationship between private equity funds and systemic risk; vi) analyze the use of leverage by private equity funds and the risk of excessive leverage; and vii) offer an alternative approach to the regulation of the private equity industry and the risks associated with leveraged lending to private equity funds. Additionally, this paper will specifically explore the political economy of financial regulation following the D.C. Circuit’s decision in Business Roundtable v. SEC and the importance, role and application of cost benefit analysis in financial regulation and particularly private equity regulation under Title IV and its implementing rules. Choosing whether and how to regulate is generally a question of regulators and the implementing agency evaluating tradeoffs and whether society, the financial system and the economy gain enough from the regulation to justify its costs. The goal is for regulators to ensure they adequately consider the effectiveness and consequences of their regulatory actions. In other words, the benefits must justify and exceed the costs of the proposed legislative action. This paper will further examine the costs and benefits of Title IV and its implementing rules, in light of the decision in Business Roundtable, and demonstrate how cost benefit analysis, when used properly, provides a fundamental decision making tool that helps regulators to ensure that regulatory efforts produce a net positive effect on society and the economy as a whole. 1 I will argue in this paper that the decision of regulators to regulate private equity funds and subject them to extensive SEC registration and reporting requirements (as reflected in Title IV of the Dodd-Frank Act) is inadequate, unnecessarily costly, inconsistent with the intended purpose of the Dodd-Frank Act and its underlying theory of regulation, too disclosure-focused, based on fundamental misconceptions as to the nature of private equity and does not properly address the risk of too much leverage. Furthermore, this paper will take the position that Title IV’s implementing rules do not meet the economic analysis and cost benefit justification standards set by the D.C. Circuit Court in the Business Roundtable decision. The SEC, in implementing Title IV, failed to perform an adequate cost benefit analysis and to consider the impact of this legislation on efficiency, competition and capital formation in the context of private equity funds. It failed to articulate a satisfactory and reasoned explanation for its regulatory actions, including a rational connection between the pre-crisis conduct and failures it was trying to address and the regulatory choices made. This paper will argue that Title IV and its implementing rules are not supported by i) the cost benefit analysis that would survive judicial scrutiny after the decision in Business Roundtable, and ii) any other compelling argument demonstrating that the benefits of Title IV are greater than its costs. Like any other post-crisis reform legislation, Title IV may have satisfied a political need, but it will not benefit the financial market or the economy as a whole, will not improve investor welfare and will not reduce the risks that private equity funds may pose to the financial system. I argue, instead, that since private equity funds are not a major source of systemic risk, they play a critical role as a driver of economic growth and their investors have the resources and sophistication to ‘fend for themselves’, these funds and their advisers should be subject to a reduced regulatory regime and exempt from the SEC registration, reporting and disclosure requirements under the Dodd-Frank Act and its implementing rules. The concerns associated with the use of leverage by private equity funds and the risk of excessive leverage should be addressed through more substantive rules like leveraged lending regulation and tighter underwriting practices, standards and policies. By setting new standards for underwriting of leveraged loans by banks and other lenders, regulators and policymakers can ensure that private equity funds will have to meet higher standards when seeking buyout loans, therefore, reducing the risk of high leverage and the remote probability of a systemic financial crisis. Also, this paper will conclude that overall financial regulators, and particularly the SEC should ground their rulemaking in rigorous cost benefit analysis and standards, consistent with the Business Roundtable decision, to arrive at more rational decision-making and efficient regulatory actions that advance the public interest. This legislative approach, unlike Title IV of the Dodd-Frank Act and its implementing rules, will avoid hasty regulation that fails to achieve its goals and imposes costs that exceed its benefits. It will ensure that society and the economy actually gain enough from the regulation to justify its costs. 2 TABLE OF CONTENTS I. INTRODUCTION II. BACKGROUND: PRIVATE INVESTMENT FUNDS OVERVIEW a. Private Equity Funds b. Hedge Funds c. Venture Capital Funds d. The Regulation of Private Investment Funds i. Pre-Dodd-Frank Regulatory Environment ii. Post-Dodd-Frank Regulatory Environment III. THE CASE AGAINST THE REGULATION OF PRIVATE EQUITY FUNDS UNDER TITLE IV OF THE DODD-FRANK ACT – IS TITLE IV THE RIGHT ANSWER? a. The Political Economy of The Dodd-Frank Act i. Title IV of the Dodd-Frank Act – The Same Legislative Pattern b. The Political Economy of Financial Rulemaking After Business Roundtable i. The History of Cost Benefit Analysis and Financial Regulation ii. Policy Considerations for Cost Benefit Analysis iii. D.C. Circuit Trilogy on SEC Cost Benefit Analysis iv. SEC Response: 2012 Cost Benefit Analysis Guidance Memorandum v. The Impact of the Business Roundtable Decision on the Political Economy of Financial Regulation vi. Title IV of the Dodd-Frank Act and Cost Benefit Analysis After Business Roundtable c. The Dodd-Frank Act and The Underlying Economic Theory of Regulation i. Title IV and The Market Failure Theory of Regulation d. Title IV and its Underlying Disclosure-Based Approach i. The Inconsistent Treatment of Private Equity Funds Under Title IV IV. THE RELATIONSHIP BETWEEN PRIVATE EQUITY AND SYSTEMIC RISK a. Private Equity and The 2008 Financial Crisis b. Private Equity Funds and Systemic Risk i. Systemic Risk ii. The Use of Leverage by Private Equity Funds iii. The Risks