On August 23, 2023, the Securities and Exchange Commission (the SEC) released final rules under the Investment Advisers Act of 1940 (the Advisers Act), focused on private fund disclosures and sponsor practices (the Final Rules) as further detailed in this bulletin. According to the SEC, the Final Rules were designed to protect investors in private funds and prevent fraud, deception, or manipulation by investment advisers. Shortly following their adoption, the Final Rules were challenged by six associations representing private fund managers (the Private Fund Managers) in the United States Court of Appeals for the Fifth Circuit (the Fifth Circuit). On June 5, 2024, the Fifth Circuit vacated the Final Rules in their entirety based on the court's determination that the SEC did not have statutory authority under the Advisers Act to formulate the Final Rules.
The SEC relied on two sections of the Advisers Act for authority to promulgate the Final Rules. Section 211(h) gives the SEC the authority to "facilitate the provision of simple and clear disclosures to investors...including any material conflicts of interest" and "promulgate rules prohibiting or restricting certain sales practices, conflicts of interest and compensation schemes". The Private Fund Managers argued that Section 211(h) is housed in a larger set of provisions that are devoted to retail investment and the protection of retail investors and that the reference to "investors" in Section 211(h) should not be construed to have a broader application beyond retail investors. The Fifth Circuit ultimately agreed that Section 211(h) applies to retail investors only and that the Final Rules are therefore outside of the SEC's statutory authority.
Under Section 206(4), the SEC has the authority relative to any investment adviser to "define and prescribe means reasonably designed to prevent such acts, practices and courses of business as are fraudulent, deceptive or manipulative". According to the SEC, the Final Rules were designed to prevent fraud, and in response, the Private Fund Managers argued that there was no "rational connection" between fraud and any specific part of the Final Rules, including because the Advisers Act language specifically first requires that the SEC "define" the fraudulent act that requires it to prescribe rules, which they argued it had failed to do. Ultimately the Fifth Circuit ruled that the Final Rules did not fit within the statutory intention, basing its decision on the framework of the Advisers Act whereby Congress purposefully exempted private fund advisers from a prescriptive framework that registered advisers are otherwise subject to. They further stated that the Final Rules lack a "close nexus" to fraud given that a "failure to disclose" to investors cannot be deceptive or fraudulent without a duty to disclose, and the only statutory duty on private fund advisers to disclose is relative to their clients (i.e., the private funds they manage) and not the investors therein.
Accordingly, the Fifth Circuit held that the SEC lacked the statutory authority to formulate the Final Rules. Unless the SEC successfully appeals the Fifth Circuit's ruling, the Final Rules are of no force and effect.
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