On June 5, 2024, a three-judge panel of the Fifth Circuit Court of Appeals (the "Fifth Circuit") unanimously vacated the rule1 adopted by the US Securities and Exchange Commission (the "SEC") to enhance the regulation of "private fund"2 advisers (the "Final Rule"). The Final Rule, adopted under the Investment Advisers Act of 1940, as amended ("Advisers Act"), on August 23, 2023, would have caused a significant change to the regulation and operation of private funds.
Industry participants have been closely monitoring the challenge to the Final Rule brought by several industry trade groups, speculating whether the Final Rule would be upheld, at least partially. Today's decision entirely vacates the Final Rule and may lay the groundwork for additional avenues to challenge SEC rules promulgated under Section 206(4) and Section 211(h) of the Advisers Act.
Below we provide a brief background on the Final Rule and the court's decision, the court's specific reasoning with respect to Sections 206(4) and 211(h) of the Advisers Act, potential implications for pending SEC rules, and potential next steps for the SEC in challenging the decision.
BACKGROUND
Initially proposed by the SEC in March 2022 and the subject of hundreds of comment letters, the Final Rule has several components, including:
- The preferential treatment rule
- The restricted activities rule
- The quarterly statement rule
- The adviser-led secondaries rule
- The audit rule
- Amendments to the compliance rule and the recordkeeping rule
Generally, the Final Rule would have (1) restricted certain activities by private fund advisers that the SEC believes involve conflicts of interest and compensation schemes that are contrary to the public interest; and (2) imposed a host of new disclosure requirements on advisers to private funds, similar in certain respects to the reporting requirements imposed on investment companies regulated under the Investment Company Act. The SEC estimated that compliance with the Final Rule would cost private fund managers $5.4 billion and require millions of hours of employee time.
The SEC adopted the Final Rule under on Section 913(h) of the Dodd-Frank Act,3 codified as Section 211(h) in the Advisers Act, and the antifraud rulemaking authority in Section 206 of the Advisers Act. The Fifth Circuit, after dispensing with questions of standing and venue, held on the merits that the SEC exceeded its statutory authority, concluding that:
- Section 211(h) of the Advisers Act applies to "retail customers" and not private fund investors.
- The SEC's reliance on the antifraud provision of Section 206(4) was "pretextual," and the SEC's "vague assertions" of misconduct that the Final Rule was purportedly designed to prevent lacked the "definitional specificity" required by Congress.
- Section 206(4) broadly "fails to authorize the Commission to require disclosure and reporting."
SECTION 211(H) ANALYSIS
The court held that Section 913 of the Dodd-Frank Act (and, thus, Section 211(h) of the Advisers Act) "has nothing to do with private funds" and that the SEC could not rely on this section of the statute to regulate private fund advisers and investors. Focusing on the statutory construction of the Dodd-Frank Act, the court noted that while Title IV of the statute includes provisions related to regulation of certain private fund advisers, the SEC sought to rely on Article IX and Section 913. Section 913(a)-(m) uses the term "retail customers" at least 30 times.4
The court was unpersuaded by the SEC's reasoning that Congress intentionally departed from the term "retail customer" in Section 211(h) of the Advisers Act (added by Section 913 of the Dodd-Frank Act) when it used the unmodified term "investor." The court found that "it is unlikely that Congress meant to switch to 'investor' 'in the middle of a provision otherwise devoted' to retail investment." Accordingly, the court found that the SEC's rulemaking authority under Section 211(h) could only relate to "retail customers" rather than private fund investors.
SECTION 206(4) ANALYSIS
Next, the court examined whether Section 206(4) authorizes the SEC to adopt the Final Rule. Section 206(4) authorizes the SEC to "define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative" by any investment adviser. The court reasoned that the SEC had failed to explain how the Final Rule would prevent fraud and had failed to "define" the fraud being prevented.
The court noted that Section 206(4) "fails to authorize the [SEC] to require disclosure and reporting," explaining that these obligations are instead embedded in other statutory requirements such as Section 203(c)(1) (the statutory provision related to the filing of Form ADV), Section 204(b)(3) (requiring maintenance of certain private fund records), and Section 211(h)(1) (requiring disclosure of material conflicts of interest to "investors").5 The court further reasoned that the Final Rule is not "reasonably designed" because it does not fit within the statutory design of the Advisers Act and its sister statute, the Investment Company Act, explaining that, by congressional design, funds not required to register under the Investment Company Act are "exempt from federal regulation of their internal governance structure."
Finally, and perhaps most interestingly, the court found that the SEC "conflates a lack of disclosure with fraud or deception." The court stated that "a failure to disclose cannot be deceptive without a duty to disclose" and that an adviser's duty to disclose extends to the client alone (i.e., the fund) and not to investors in such client. The court appears to suggest that Section 206(4) cannot provide a statutory basis to require any disclosure to investors in a pooled investment vehicle that are not otherwise clients of such vehicle's adviser.
IMPLICATIONS FOR PENDING SEC RULES
The court's decision could have significant implications for pending SEC rules. Currently, the SEC has proposed a number of rules which rely on statutory authority under Section 211(h) or Section 206(4), such as the outsourcing and predictive data analytics proposals in their current form (relying on both), and the "Safeguarding Rule" proposal to amend the Custody Rule (relying on the latter). It is unclear whether the court's decision could also call into question prior SEC rulemakings relying on Section 206(4), including, in particular, the application of the Marketing Rule (Rule 206(4)-1) to prospective investors in private funds and the pooled investment vehicle antifraud rule (Rule 206(4)-8).
WHAT COMES NEXT?
First, the SEC may seek rehearing en banc before the entire Fifth Circuit. Alternatively (or after such an en banc rehearing), the SEC could file a petition for certiorari seeking review before the Supreme Court of the United States. As of the date of this Legal Update, the SEC has only said it would "determine next steps as appropriate."
While the saga of the Final Rules isn't quite over, pending any such appeal process, the immediate takeaway for private fund advisers is clear: Any ongoing efforts to comply with the Final Rules ahead of the forthcoming September 14, 2024, compliance dates can be put on pause, perhaps permanently.
Footnotes
1. Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Investment Advisers Act Release No. 6383 (Aug. 23, 2023) [88 FR 63206 (Sept. 14, 2023)] (the "Adopting Release"), available at https://www.sec.gov/files/rules/final/2023/ia-6383.pdf. See also Mayer Brown's analysis of the Final Rule.
2. For purposes of the Final Rule, a "private fund" is an issuer that would be an "investment company act but for the exception provided in Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, as amended" ("Investment Company Act").
3. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No. 111-203, 124 Stat. 1376 (2010).
4. Under Advisers Act Section 211(g)(1), also added by the Dodd-Frank Act, the SEC is precluded from defining the term "customer" to include an investor in a private fund where the private fund has entered into an advisory contract with the adviser.
5. The court does not discuss this reasoning in light of SEC v Capital Gains, 375 U.S. 180 (1963), where the Supreme Court concluded that under Section 206(1) and 206(2) of the Advisers Act, a court has the authority to require disclosure of material facts as a prophylactic measure to prevent fraud ("To impose on the [SEC] the burden of showing deliberate dishonesty as a condition precedent to protecting investors through the prophylaxis of disclosure would effectively nullify the protective purposes of the statute. Reading the [Advisers] Act in light of its background we find no such requirement commanded.").
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