In a unanimous decision published on June 5, 2024, the US Court of Appeals for the Fifth Circuit vacated the entire set of regulations, including amendments to existing rules (collectively, the Rules), adopted by the US Securities and Exchange Commission (SEC) in August 2023. The Rules, which were challenged by a group of private fund industry associations (petitioners), would have substantially overhauled the private investment fund industry.
The court’s ruling[1] is a welcome result for many private fund managers who have been preparing for months for the complex and burdensome set of requirements, with the compliance date for the most onerous provisions fast approaching in September 2024.
Although proponents of the Rules[2] argued that certain investors and investor groups expressed support for the wider availability of information relating to fund performance and investment terms under the Rules, the court’s ruling leaves open the possibility for investors to continue to freely negotiate for specialized terms. The proposing and adopting releases for the Rules also remain as expressions of the SEC’s examination and enforcement priorities.[3]
WHAT’S NEXT?
There are two avenues for the SEC to pursue further appellate review: First, the SEC can seek a rehearing en banc before the Fifth Circuit. If granted, all non-recused, active judges of the Fifth Circuit would consider the appeal. The SEC has 45 days from the date of the final ruling to request en banc rehearing. Second, the SEC could seek review by the US Supreme Court within 90 days of the final ruling (or denial of en banc rehearing), which would require the Solicitor General of the United States to petition for a writ of certiorari on the SEC’s behalf.
As an alternative to pursuing further appeals, the SEC could repropose some or all of the Rules under different legal authority, although that could be challenging in light of the court’s interpretation of the SEC’s authority under Section 206(4).
POTENTIAL FOR A LASTING IMPACT
Although vacated by the Fifth Circuit, the principles underlying the Rules may nonetheless continue to impact the private fund industry. For example, the Institutional Limited Partners Association (ILPA) has indicated that it plans to continue to develop a new investor reporting template based on the quarterly statement rule. In addition, because the Rules were adopted nearly one year ago, some investors have already negotiated to receive certain benefits and contractual rights based on the Rules in side letters and through other arrangements, and some private fund advisers have adjusted their procedures and market approaches in anticipation of the Rules. Thus, the Rules could have a lasting influence on market practices. In addition, certain aspects of the Rules and their proposing and adopting releases could serve as instructive guidelines as private fund managers navigate interpretive issues under the Investment Advisers Act of 1940 (Advisers Act), or—perhaps more likely—could presage attempts by the SEC to regulate through an aggressive approach to examination and enforcement.[4]
LOOKING FORWARD
The Fifth Circuit’s decision could also impact the SEC’s very active rulemaking agenda as well as embolden challenges to other final rules that are already in play. For example, the SEC’s Predictive Data Analytics proposal with respect to investment advisers is based on the same Section 211(h) authority that the court found to be invalid for regulating private funds.[5] In addition, the marketing rule was adopted based on Section 206(4) authority and explicitly applies to disclosures sent to private fund investors. It remains to be seen how the court’s ruling and discussion of Section 206(4) in its opinion could impact potential challenges to the marketing rule, including challenges to enforcement actions.
In light of the decision, private fund managers that have already begun implementing the Rules should assess whether they plan to retain any of the changes. They should also consider whether they have contractually obligated themselves, via side letters or otherwise, to comply with the Rules or the principles underlying the Rules. Notably, one part of the rulemaking package was already in place: amendments to the compliance rule requiring a written annual review.
Many registered investment advisers have memorialized such annual reviews already, and still more registered investment advisers had begun to comply with this requirement as of November 2023. It remains to be seen whether some advisers may now decide to adjust or relax their practices.
DETAILS OF THE RULING
In its opinion, the court first provides background on the private fund industry, noting the growth in private funds in recent years and stating that private funds generally are not directly accessible to retail customers, which the court equates with non-professional investors.
Next, the court describes registered funds and the Investment Company Act of 1940 (1940 Act), which is the separate statute that substantively regulates the structure and operations of investment companies, noting that the 1940 Act and the Advisers Act are “sister statutes” enacted as two parts of the same legislation.
The court then notes that in promulgating the Rules, the SEC relied on Sections 206 and 211(h) of the Advisers Act—the latter having been enacted in 2010 as part of the Dodd-Frank Act[6]—and then provides background on both statutory provisions and discusses a brief overview of the Rules.
In concluding its discussion of contextual background, the court points out that the SEC estimated that the Rules would “cost $5.4 billion and require millions of hours of employee time.”
Turning to its analysis, the court quickly dismisses the SEC’s challenges to the petitioners’ standing and the appropriateness of venue in the Fifth Circuit. The court then sets forth the standard of its review: “[u]nder the [Administrative Procedure Act], the court must uphold the [SEC’s] decision unless it is in ‘excess of statutory jurisdiction, authority or limitations’ or ‘arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.’” (citations omitted).
Next, the Court succinctly states the key issue: “whether the Dodd-Frank Act expanded the [SEC’s] rulemaking authority to cover private fund advisers and investors under section 211(h) of the Advisers Act . . . and whether section 206(4) authorizes the [SEC] to adopt the [Rules].” The court then proceeds to analyze the scope of regulatory authority conferred upon the SEC by Congress under those two Sections.
Applying established principles of statutory construction, the court determined that neither Section 206(4) nor Section 211(h) grants the SEC authority to adopt the Rules. The court stated that it, therefore, must—not may—determine the rulemaking to be unlawful and set aside the SEC’s action to adopt the Rules.
In addition to the court’s primary holding that vacates the Rules in full, the court’s opinion included notable additional areas of focus:
- The court focuses on the fact that Congress, in enacting the 1940 Act, clearly chose not to impose the same types of prescriptive requirements that apply to investment companies on private funds, noting that, as recently as 1996, Congress added Section 3(c)(7) to the 1940 Act to exclude a new type of private fund from the definition of “investment company” under the 1940 Act.
- The court focuses on the fact that the provision in Title IV of the Dodd-Frank Act clearly expressed Congress’ intent to regulate certain aspects, and only those aspects, of the private fund industry. In contrast, the court notes that Section 211(h) was enacted as part of Title IX of the Dodd-Frank Act—some 250 pages later in the 849-page statute—and, notwithstanding some drafting ambiguity, the court holds that, consistent with the balance of Title IX, Section 211(h) confers authority on the SEC only with respect to “retail customers.”
- Regarding Section 206(4), the court agrees with the petitioners that the SEC did not articulate a rational connection between purported fraud and the Rules, describing the stated claims of fraud as pretextual. The court also finds that the SEC failed to explain how the Rules would prevent the stated fraud. The court clearly lays out a two-step process for rulemaking under Section 206(4) whereby the SEC must “‘define’ an act, practice, or course of business that is ‘fraudulent, deceptive, or manipulative’ before the [SEC] can prescribe ‘means reasonably designed to prevent’ ‘such’ act, practice or course of business.” The court states that the SEC’s “vague assertions fall short of the definitional specificity that Congress has required.”
- The court, relying significantly on Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006), differentiates between an investment adviser’s duties to its clients under the Advisers Act, as contrasted with both regulation of internal operations of a fund and obligations to investors in a fund. The court states that in order for a failure to disclose to be deceptive, there must first be a duty to disclose and that, in the case of an investment adviser, such duty extends to the client alone, “which is the fund, not the investors in the fund.”
Law clerk Lacey Johnson contributed to this LawFlash.
[1] National Association of Private Fund Managers v. SEC, No. 23-60471 (5th Cir. 2024).
[2] Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Investment Advisers Act Rel. No. 6383 (August 23, 2023) (Adopting Release). The Rules included a set of five new rules: the preferential treatment rule (Rule 211(h)(2)-3 under the Advisers Act), the restricted activities rule (Rule 211(h)(2)-1), the quarterly statement rule (Rule 211(h)(1)-2), the adviser-led secondaries rule (Rule 211(h)(2)-2), and the audit rule (Rule 206(4)-10), as well as amendments to Rules 206(4)-7 (requiring annual compliance reviews to be in writing) and Rule 204-2 (imposing certain recordkeeping obligations).
[3] However, the Rules were adopted in a 3-2 vote under SEC Chair Gensler, and a future SEC could very well chart a different path on these issues.
[4] In the adopting release, the SEC noted that it did not adopt certain provisions from the initial proposal of the Rules (such as charging clients for services not yet performed or having clients contractually waive breach of fiduciary duty) but these would nonetheless still apply through general fiduciary duty principles.
[5] Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers, Investment Advisers Act Rel. No. 6353 (July 26, 2023) (Proposing Release). We note, however, that this proposal is more clearly tailored to retail investors than the Rules. Unrelatedly, the SEC has recently hinted that it may re-propose this rule as well as its broker-dealer analog.
[6] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).
[View source.]
