Washington, D.C. (June 11, 2024) - On August 23, 2023, the Securities and Exchange Commission ("SEC") adopted a controversial new rule designed to enhance the regulation of private fund advisers. Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, 88 Fed. Reg. 63206 (Aug. 23, 2023). The rule, which passed by a narrow 3-2 vote, aimed to protect investors who directly or indirectly invest in private funds by increasing transparency, establishing requirements to address potentially harmful practices, and prohibiting certain activities deemed contrary to the public interest. Id. at 63209. However, on June 5, 2024, the U.S. Court of Appeals for the Fifth Circuit dealt a fatal blow to the SEC's efforts, vacating the rule in its entirety. See Nat'l Ass'n of Private Fund Managers v. SEC, No. 23-60471, slip op. at 25 (5th Cir. June 5, 2024) (Because the promulgation of the Final Rule was unauthorized, no part of it can stand.").
The Fifth Circuit's unanimous decision held that the SEC exceeded its statutory authority under the Investment Advisers Act of 1940 ("Advisers Act") in promulgating the rule. Id. at 17. The court focused on two provisions of the Advisers Act that the SEC relied upon: Section 211(h), which was added by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and the SEC's preexisting antifraud rulemaking authority under Section 206(4). Id. at 18-25.
Regarding Section 211(h), the court found that this provision applies only to "retail customers," not private fund investors. Id. at 22. The court emphasized that Section 913 of the Dodd-Frank Act, which added Section 211(h) to the Advisers Act, "has nothing to do with private funds" and instead focuses on the relationship between financial professionals and retail customers." Id. at 21. The court concluded that it was "unlikely that Congress meant to switch to 'investor'" in Section 211(h) to encompass private fund investors, given the context and structure of the Dodd-Frank Act." Id. at 21-22.
As for Section 206(4), the court held that the SEC's reliance on this antifraud provision was "pretextual." Id. at 23. The court found that the SEC failed to adequately explain how the rule would prevent fraud, as required by the specific language of Section 206(4). Id. Moreover, the court determined that the rule did not fit within the statutory design of the Investment Company Act of 1940 ("ICA"), which purposefully exempted private funds from the prescriptive regulatory framework applicable to public investment companies. Id. at 24.
The Fifth Circuit's ruling is a significant setback for the SEC's ambitious rulemaking agenda. In recent years, the SEC has adopted a series of far-reaching rules on various topics, including cybersecurity (Cybersecurity Risk Management for Investment Advisers, Registered Investment Companies, and Business Development Companies, 87 Fed. Reg. 72804 (Nov. 21, 2022)), artificial intelligence (Regulation of Artificial Intelligence in Asset Management, 88 Fed. Reg. 29960 (May 18, 2023)), and executive compensation clawbacks (Listing Standards for Recovery of Erroneously Awarded Compensation, 86 Fed. Reg. 41144 (July 30, 2021)). The decision in Nat'l Ass'n of Private Fund Managers v. SEC calls into question the agency's authority to promulgate these and other expansive regulations, particularly where the SEC relies on broad, general rulemaking provisions rather than specific congressional mandates.
The ruling may embolden industry groups and other interested parties seeking to challenge other of these recent rules in court, potentially leading to further judicial setbacks for the agency. Such challenges could delay the implementation of these rules or, as in the case of the private fund adviser rule, result in their complete vacatur. The decision may also prompt the SEC to reconsider its approach to rulemaking, focusing on more targeted, narrowly tailored regulations that are more likely to withstand judicial scrutiny.
The SEC has not yet announced whether it intends to seek rehearing en banc before the Fifth Circuit or petition for a writ of certiorari to the U.S. Supreme Court. In the meantime, private fund advisers, investors, and other industry participants should closely monitor developments in this area and consult with counsel to assess the implications of the Fifth Circuit's decision for their businesses and compliance obligations. The ruling may provide an opportunity for private fund advisers to reevaluate their current practices and disclosures in light of the vacated rule's requirements, while also underscoring the importance of engaging with the SEC and other regulators during the rulemaking process to ensure that industry perspectives are adequately considered.
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