The Fifth Circuit Court of Appeals (Fifth Circuit) today issued its ruling striking down the “Private Fund Advisers Rule” (the “PFA”). The proposed PFA was introduced on February 9, 2022 (“Proposed Rule”). The Securities and Exchange Commission (the “SEC”) worked with the institutional investor and private investment fund manager communities to finalize the rule over an extended comment period. While the final rule (“Final Rule”) scaled back the Proposed Rule, the Fifth Circuit ultimately struck down the Final Rule on the grounds that the SEC exceeded its statutory authority. The statutory authority on which the SEC relied on was contained in Section 211(h) and Section 206(4) of the Advisers Act.

Overview of the Final Rule that was Struck Down

The Final Rule consisted of a number of individual rules as outlined below:

1. Enhanced Reporting and Transparency
   • Quarterly Statements: Private fund advisers registered with the SEC would be required to distribute quarterly statements to their investors. These statements would detail the fund’s performance, fees, expenses, and certain payments made to the adviser.
   • Mandatory Annual Audits: Every private fund advised by registered advisors would be required to undergo a yearly financial statement audit aimed to ensure accurate valuation of private fund assets and safeguarding against misappropriation.
   • Adviser-led Secondaries: The Final Rule would have required advisers to obtain a fairness or valuation opinion in connection with such transactions. Furthermore, advisers would have needed to disclose any material business ties with the entity providing the opinion.
   • Restricted Activities: The Final Rule would have disallowed certain practices that may not align with public interest or investor protection. Examples include (i) charging investigation-related fees without disclosure or consent, (ii) tax adjusting the adviser’s carried interest clawback without reporting the clawback amount both with and without taxes, or (iii) allocating expenses to fund investors on a non-pro rata basis without proper notice.
   • Fair Play: The Final Rule sought to ban preferential treatment, such as giving certain investors exclusive redemption rights or exclusive insights into portfolio holdings, with limited exceptions that require disclosure to all investors.
2. Rigorous Compliance Requirements: Every registered adviser would have needed to document their annual review of compliance policies in writing.

Summary of the Fifth Circuit Decision

• Lack of Authority under Section 211(h):

With respect to Section 211(h), the SEC viewed the Dodd-Frank Act as expanding the SEC’s rulemaking authority to cover private fund advisers and investors under Section 211(h). In reaching its decision that the SEC exceeded its authority under Section 211(h), the Fifth Circuit relied on statutory construction that differentiates between the extensive regulation, reporting and disclosure requirements, restrictions and prohibitions of the Investment Company Act and the relative dearth of such extensive regulation on private funds under the Advisers Act. The Fifth Circuit also focused heavily on Section 913 of the Dodd-Frank Act, its stated application to “retail customers,” and the reliance of the SEC on Title IX of the Dodd-Frank Act to buttress its arguments that it did have appropriate rulemaking authority when (i) Title IV is the appropriate provision of the Dodd-Frank Act imposing regulatory requirements on private fund advisers and (ii) Title IX clearly applies to retail customers.

• Lack of Authority under Section 206(4):

With respect to Section 206(4), the Fifth Circuit concluded that the Final Rule did not articulate a rational connection between the anti-fraud authority granted under Section 206(4) and the focus of the Final Rule, noting that the SEC failed to define the fraudulent acts or practices the Final Rule was designed to prevent. On separate grounds, the Fifth Circuit also confirmed that Section 206(4) did not authorize rulemaking to require disclosure and reporting on the grounds that Congress did not explicitly state its intent to provide for reporting and disclosure in Section 206(4). Finally, the Fifth Circuit also concluded that the Final Rule was not reasonably designed to sensibly fit within the statutory text and did not have a close nexus with the statute’s statutory aims.

Next Steps

With the Final Rule vacated, the SEC has a number of options, which include abandoning the Final Rule, seeking en banc review with the full Fifth Circuit, or appealing the Fifth Circuit’s decision to the Supreme Court. Given the time required for the Supreme Court to consider and act (or not act) on any petition by the SEC for review, it is estimated that the Final Rule will remain vacated for at least 12 months. To the extent that the Fifth Circuit’s decision is not set aside by the full Circuit Court or overruled (or not accepted for review) by the Supreme Court, none of the elements of the Final Rule will be binding on private fund advisers.