Summary

On June 5, 2024, a three-judge panel of the U.S. Court of Appeals for the Fifth Circuit (the “Fifth Circuit”) unanimously vacated the “Private Fund Adviser Rules,”[1] which the U.S. Securities and Exchange Commission (the SEC) adopted in August 2023, with compliance dates beginning September 14, 2024.[2] The Fifth Circuit found that in adopting the rules, the SEC exceeded its statutory authority under Section 206(4) and Section 211(h) of the Investment Advisers Act of 1940 (the “Advisers Act”) and vacated them in their entirety.

Background

In adopting the Private Fund Adviser Rules, the SEC had highlighted the increasing importance of private funds and their advisers to investors, observing that, from 2012 to 2022, the number of private funds grew from 32,717 to 100,947, and the value of these funds increased from $9.8 trillion to $26.2 trillion. The SEC adopted the additional substantive requirements for audit, reporting, and fee and disclosure matters, within the “Private Funds Rules” in the belief these requirements would “protect private fund investors by increasing transparency, competition, and efficiency in the private funds market.”[3]

Overview of Vacated Rules

In its decision to vacate the Private Fund Adviser Rules, the Fifth Circuit determined that the “promulgation of the [Rule] was unauthorized . . . [such that] no part of it can stand.” The Private Fund Adviser Rules, which are now vacated, consist of the following:

• The “Audit Rule” (Rule 206(4)-10) required SEC-registered private fund advisers to obtain financial statement audits for every private fund they advise (other than securitized asset funds) consistent with existing practice under the Advisers Act custody rule.
• The “Quarterly Statements Rule” (Rule 211(h)(1)-2) required SEC-registered private fund advisers to distribute quarterly statements to fund investors detailing the fees and expenses, and including standardized performance reporting.
• The “Adviser-Led Secondary Rule” (Rule 211(h)(2)-2) required SEC-registered private fund advisers to obtain either a fairness or a valuation opinion in connection with any GP-led secondary transaction with disclosure of material business connections with the entity providing the opinion.
• The “Written Annual Compliance Review Rule” (Rule 206(4)-7(b)) required all SEC-registered advisers (whether or not they advise private funds) to memorialize the annual review of its compliance program in a written report that would be available to the SEC’s examination staff; this requirement was effective November 13, 2023.
• The “Restricted Activities Rule” (Rule 211(h)(2)-1) prohibited all advisers to private funds (other than securitized asset funds (including exempt reporting advisers)) from engaging in certain fund fee and expense practices such as: (i) allocating expenses to investors on a non-pro rata basis without providing proper notice; (ii) charging regulatory, compliance, and examination fees and expenses to fund investors without proper disclosure or consent; and (iii) reducing the adviser’s clawback by the adviser’s potential, actual, or hypothetical tax amounts without proper disclosure or consent.
• The “Preferential Treatment Rule” (Rule 211(h)(2)-3) prohibited all advisers to private funds (other than advisers of securitized asset funds and including exempt reporting advisers) from entering into side letter-type arrangements that result in preferential redemption rights or portfolio holdings disclosures and also mandated various disclosure requirements.

The Fifth Circuit’s Decision

As noted above, the Fifth Circuit held that the “promulgation of the [Rule] was unauthorized . . . [such that] no part of it can stand.” In other words, the Fifth Circuit determined that the SEC exceeded its statutory authority on the following bases.

• The Firth Circuit observed that the SEC had enacted the Private Fund Adviser Rules citing to Sections 206(4) and 211(h) of the Advisers Act as its rulemaking authority. With regard to Section 211(h), the Fifth Circuit concluded that Congress purposely limited the SEC’s rulemaking authority, granted under Title IX of the Dodd-Frank Act,[4] to relationships between investment advisers and “retail customers.” Because private fund investors are not “retail investors” due their heightened level of sophistication, the Fifth Circuit found that Section 211(h) of the Advisers Act does not apply to private fund investors. The Fifth Circuit stated that Section 211(h) “has nothing to do with private funds,” therefore the SEC could not rely on it to regulate private fund advisers.
• As to Section 206(4), the general anti-fraud provision of the Advisers Act, the Fifth Circuit concluded that the SEC failed to adequately state a connection between the Private Fund Adviser Rules and fraud. Specifically, the Fifth Circuit determined that: (i) the new rules failed to define the fraud that they supposedly addressed; (ii) the SEC was aware of misconduct by only 0.05% of investment advisers; and (iii) a failure to provide the disclosures required by the new rules could not be fraud without an associated duty to disclose, which extends only to a fund and not to investors in a fund. Further, the Fifth Circuit reasoned that the new rules were not “reasonably designed” because they failed to fit within the statutory design of the Advisers Act and the Investment Company Act of 1940, because “by congressional design, private funds are exempt from federal regulation of their internal ‘governance structure.’”

Next Steps in the Legal Process

The SEC must now determine its next steps. Though an unlikely path, the SEC has the option to seek rehearing en banc before the entire Fifth Circuit. Further, the SEC can file a petition for certiorari seeking review before the United States Supreme Court, which would generally be filed within 90 days. Alternatively, the SEC can pursue a new rulemaking initiative altogether. Due to its constrained resources, however, the SEC will have to be very strategic in determining what its response will be.

Only time will tell whether the challenge to the SEC’s rulemaking power by the Fifth Circuit in this instance will cause the SEC to reconsider other rules being proposed pursuant to Section IX of Dodd-Frank and whether it will materially pare back those proposals or proceed and face challenges in court.

Practical Guidance

Prior to this ruling, many private fund advisers had already begun implementing measures to ensure compliance with the Private Fund Adviser Rules. Private fund advisers may now reassess the substance and timeline for their current compliance initiatives pending certainty on any SEC action. Through the prior rulemaking process, the SEC has outlined many of its views regarding the inappropriateness of certain industry practices that it has deemed to be aggressive or contrary to private fund investors’ interests. As a result, advisers to private funds that may face future SEC staff examinations, SEC enforcement activity, and investor negotiation processes, should carefully assess the current state of the law and the direction in which the SEC has signaled it believes the industry should be headed.

[1] National Association of Private Fund Managers v. Securities and Exchange Commission, 5th Cir. No. 23-60471.

[2] Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, SEC Release No. IA-6383 (Aug. 23, 2023).

[3] Press Release, U.S. Securities and Exchange Commission, SEC Enhances the Regulation of Private Fund Advisers (Aug. 23, 2023.

[4] Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No. 111-203, 124 Stat. 1376 (2010).

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