In a highly anticipated opinion, the Fifth Circuit announced on June 5, 2024 its decision1 to vacate rules adopted by the Securities and Exchange Commission (SEC or the Commission) in 2023 (collectively, the Rule) that would have imposed substantial new regulatory obligations on investment advisers to private funds. The Commission's Rule that was at stake in the case introduced significant changes to the regulation of private funds. Among other changes, the Rule prohibited investment advisers from providing investors with preferential treatment with respect to redemption rights and portfolio information and charging private funds for costs associated with governmental investigations without the consent of the private fund's investors. The Rule also required investment advisers to provide investors with quarterly reporting statements setting forth a variety of information, including fund performance and adviser compensation. In vacating the Rule, the court concluded that the SEC lacked the authority to promulgate such a rule under the Investment Advisers Act of 1940 (the Advisers Act). The court's decision indicates that the SEC's authority to protect investors through rulemaking does not encompass the ability to promulgate rules to protect the types of sophisticated investors who are permitted to invest in private funds.
The National Association of Private Fund Managers and other industry groups filed a claim challenging the Rule under the Administrative Procedure Act (APA) and Rule 15(a) of the Federal Rules of Appellate Procedure. They argued that in adopting the Rule the SEC exceeded its statutory authority, and that the Rule as adopted was not a logical outgrowth of the Commission's rule as proposed. The plaintiffs also argued that the Rule was arbitrary and capricious under the APA, and that the SEC "failed to adequately consider the [Rule's] impact on efficiency, competition, and capital formation." In response, the SEC claimed that it possessed the authority to promulgate rules proscribing investment adviser conduct to protect investors, including those who invest in private funds, under Sections 211(h) and 206(4) of the Advisers Act. The SEC also argued that the plaintiffs filed their claim in an improper venue and lacked standing under Article III of the Constitution.
Because the court rejected the SEC's arguments on standing and venue, the outcome of this case turned on the court's interpretation of Advisers Act Sections 211(h) and 206(4). In the court's view, the SEC overstated its authority under these statutory provisions and, accordingly, the Commission exceeded its statutory authority in promulgating the Rule.
First, the court disagreed with the SEC's interpretation of Section 211(h), which codified Section 913(h) of the Dodd-Frank Act (Dodd-Frank) into the Advisers Act. While the section contains broad language allowing the SEC to "facilitate the provision of simple and clear disclosures" to all investors and "'promulgate rules prohibiting or restricting certain sales practices ... for any investment advisers,'" the court found that this language does not cover investors in, and advisers of, private funds. When explaining its reasoning, the court referenced the Investment Company Act of 1940 (the Company Act), enacted at the same time as the Advisers Act. The court noted that the Company Act sought to preserve a "market driven relationship between a private fund adviser, the fund and outside investors[,]" and found that the Rule impermissibly altered this relationship. Next, the court held that, contrary to the SEC's position, Dodd-Frank Section 913 had "nothing to do with private funds." Instead, in the court's view, Section 913 only applied to "retail customers," less-sophisticated investors who generally are unable to participate in private funds. To justify this interpretation, the court noted that only Title IV of Dodd-Frank introduced explicit provisions to regulate private fund advisers, while Title IX of Dodd-Frank, in which Section 913 is located, addresses only retail customers. Nonetheless, the SEC claimed that Congress' decision to use "investor" in Section 913(h), instead of "retail customers," indicated its intention to "include private investors" in Section 913's coverage. But the court ultimately disagreed with this interpretation, writing that it was "unlikely that Congress meant to switch to 'investor' 'in the middle of a provision otherwise devoted' to retail investment."
The court also dismissed the SEC's claim that it sought to prevent fraud through the Rule as "pretextual." Section 206(4) authorizes the SEC to "prescribe means reasonably designed to prevent ... fraudulent, deceptive, or manipulative" behavior or practices among "any investment adviser." However, the court found that the Commission failed "to explain how the [Rule] would prevent fraud[,]" because the Rule did not "'define' the fraudulent acts or practices that the [Rule] purportedly is designed to prevent." Moreover, the court found that Section 206(4) does not "authorize the Commission to require disclosure and reporting." The court reached this conclusion after noting that where Congress intended to require investment advisers to disclose or require specific information, it articulated that intention expressly in the statute. In contrast, Section 206(4) does not include an explicit requirement for investment advisers to disclose certain information..
With this decision, the Fifth Circuit returns federal regulation of private fund advisers to the pre-Rule status quo, at least for now. However, the case provides a clearer picture of the SEC's interest in increasing federal oversight of private funds, and may portend the SEC taking an aggressive approach to audits and other enforcement actions relating to private fund advisers. In addition, the Commission may seek a rehearing on the Rule through an appeal. It could also restart the rulemaking process and craft a new version of the Rule that addresses the deficiencies the court observed.
Summer associate Priyanka Podugu assisted in the preparation of this alert.
Footnote
1. Nat'l Ass'n of Priv. Fund Managers v. Sec. Exch. Comm'n, No. 23-60471 (5th Circuit, June 5, 2024).
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