Fifth Circuit Court Of Appeals Invalidates The SEC's Private Fund Rules

On August 23, 2023, the U.S. Securities and Exchange Commission (SEC) narrowly adopted new final rules and amendments¹ under the Investment Advisers Act of 1940 that notably expanded the compliance requirements for registered and nonregistered private fund advisers, exempt reporting advisers (ERAs),² state-regulated advisers, foreign private advisers³ and all other registered advisers. The final rules were on track to significantly affect the way fund managers operate in the market by imposing new and at times convoluted requirements related to fundraising (the Preferential Treatment Rule), fees and expenses (the Restricted Activities Rule), presenting information to investors (the Quarterly Statement Rule), auditing fund vehicles (the Audit Rule) and conducting secondary transactions (the Adviser-Led Secondaries Rule).⁴

Fifth Circuit Challenge

On September 1, 2023, shortly after the final rules were adopted, several industry groups, including the National Association of Private Fund Managers and the Managed Funds Association, filed a petition with the Fifth Circuit Court of Appeals challenging the legality of the final rules. The fundamental argument was whether the SEC overstepped its statutory authority when it adopted the final rules and the extent to which the SEC could regulate private fund advisers under Sections 211(h) and 206(4) of the Adviser's Act.

On June 5, 2024, the Fifth Circuit, in a landmark decision,⁵ vacated the final rules. The three-judge panel unanimously decided that no part of final rules would survive because the SEC lacked the authority to provide oversight of the governance structure of private funds. The Fifth Circuit also stated that even when Congress expanded regulation over the private fund industry under the Dodd-Frank Act, it did not expand the SEC's oversight of the private fund industry and that the SEC had overreached its statutory mandate. The court found that the term "investors" under the Dodd Frank Act essentially refers to "retail customers" and not to investors of private funds. Additionally, the Fifth Circuit concluded that the SEC would not be able to use the anti-fraud provisions under Section 206(4) of the Advisers Act to bring enforcement against private fund managers because the SEC failed to state a "rational connection" between fraudulent acts and the final rules.

Finally, the Fifth Circuit's decision may prevent the SEC from reworking the final rules at all. Specifically, the Fifth Circuit stated that the final rules are not "reasonably designed" because they are not within the statutory authority of the SEC under (i) the Advisers Act, (ii) the Investment Company Act or (iii) the Dodd-Frank Act. The Fifth Circuit further stated that Section 206(4) of the Advisers Act does not authorize the SEC to require disclosure or reporting while other sections of the Advisers Act expressly require reporting and disclosure; private funds are specifically exempted in the Investment Company Act and, as noted above, the term "investors" in the Dodd-Frank Act refers to "retail customers" only and does not extend to investors of private funds. Without explicit authority to regulate private funds, it is likely any attempt by the SEC to regulate private funds may face legal challenges.

What's Next?

The SEC will need to rethink the way it moves forward in its rulemaking efforts if it intends to continue to try to increase its regulatory oversight of private funds. While the SEC has not provided any comments about the Fifth Circuit decision, its options are limited. The decision leaves very little leeway for restructuring the private fund adviser rules in a manner that could survive judicial scrutiny prior to consideration by the Supreme Court of the United States. And while the SEC could appeal the decision to the Supreme Court, the danger is that an affirmance could limit SEC rulemaking abilities in this area even further. This means that congressional action may be the only avenue for the SEC to address this ruling.

Although the final rules have been struck down, many private fund advisers have already put in place certain rules' provisions. For example, many private funds are now conducting annual audits that are compliant with the final rules and considering expanded reporting to their investors. Additionally, the SEC has noted in its 2024 Examination Priorities Report, that the SEC "will continue to focus on advisers to private funds and prioritize specific topics," including but not limited to:

1. Portfolio management risks;
2. Adherence to contractual requirements;
3. Accurate calculation and allocation of private fund fees and expenses, including adequacy of disclosures; and
4. Due diligence practices for consistency with policies, procedures and disclosures.

Fund managers and private fund advisers should continue to anticipate that SEC examination information requests and enforcement investigations will focus on the Examination Priorities Report and the topics addressed in the final rules, e.g., disclosure of preferential treatment or preferential information that has a material, negative effect on other investors; whether fees and expenses are allocated on a non pro rata basis; and whether expenses related to investigations or regulatory/compliance services are expensed to the fund.

We encourage you to continue to work with outside counsel to understand if and to what extent some provisions of the final rules may be beneficial to your private funds and investors. See our previous Alert analyzing the final rules for additional guidance.

Footnotes

1. The full text of the final rules was published in Release No. IA-6383, Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews (September 14, 2023).

2. In 2008, the Dodd-Frank Wall Street Reform and Consumer Protection Act created a new class of investment advisers commonly referred to as ERAs. ERAs generally rely on either the venture capital fund adviser exemption (Section 203(l) of the Advisers Act) or the private fund adviser exemption (Section 203(m) of the Advisers Act) to avoid registration with the SEC and the states.

3. The final rules would apply to foreign private fund advisers only in certain circumstances. For example, if a foreign private fund adviser manages a U.S.-domiciled fund, the foreign private fund adviser would be within the scope of the final rules with respect to that fund and would have to comply with the prohibitions contained in the restricted activities rule and the preferential treatment rule. Additionally, to the extent the foreign private fund adviser is registered with the SEC (as opposed to, for example, being only an exempt reporting adviser), the foreign private fund adviser would have to comply with the Quarterly Statement Rule, the mandatory private fund audit rule and the adviser-led secondary rule.

4. The Quarterly Statement Rule, Audit Rule and Adviser-Led Secondaries Rule applied to registered investment advisers only.

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

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.