The New Orleans-based U.S. Court of Appeals for the Fifth Circuit (Court), on June 5, 2024, vacated the new private fund rules (Private Fund Rules) adopted by the SEC in August 2023, resulting in a significant victory for private fund advisers.1 The Private Fund Rules made fundamental changes to the business and operations of private fund advisers by creating 1) the preferential treatment rule, 2) the restricted activities rule, 3) the quarterly statement rule, 4) the adviser-led secondaries rule and 5) the audit rule.2 In September 2023, a group of private fund managers (Petitioners) filed a petition against the SEC asserting, among other things, that the SEC exceeded its statutory authority in formulating the Private Fund Rules to regulate private fund advisers and that the SEC is not authorized to adopt the Private Fund Rules.
The Court's Opinion
In a unanimous opinion authored by Judge Kurt D. Engelhardt, the three-judge panel of the Court agreed with the Petitioners' claims and fully vacated the Private Fund Rules. The Court's ruling relied on the interpretation of Sections 211(h) and 206(4) of the Investment Advisers Act of 1940 (Advisers Act) to determine that the SEC exceeded its authority in promulgating the Private Fund Rules.
The Court first considered whether the SEC had the authority under Section 211(h) to regulate private fund advisers. Section 211(h) was added to the Advisers Act by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) following the 2008 financial crisis. It authorized the SEC to "promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that the SEC deems contrary to the public interest and the protection of investors." The court distinguished Section 211(h) from other sections of the Dodd-Frank Act that amended the Advisers Act to expand the SEC regulatory authority over private fund advisers, including by requiring registration and imposing recordkeeping requirements. The Court found that the Dodd-Frank Act "only stepped towards regulating the relationship between the advisers and the private funds they advise" and that Congress decided not to impose specific regulations on private fund advisers like those imposed on funds that serve retail customers. The Court concluded that the SEC could not rely on Section 211(h) to promulgate the Private Fund Rules because that section applies only to "retail customers."
The Court also considered Section 206(4) of the Advisers Act, which 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" with respect to investment advisers. The Court found that the SEC's reliance on Section 206(4) was "pre-textual" and that it failed to establish a rational relationship between the Private Fund Rules and how they would prevent fraud. The Court explained that Section 206(4) does not authorize the SEC to impose disclosures and reporting obligations on private fund advisers, which were exempted from the "prescriptive framework." The Court reasoned that if Congress wanted to impose those regulations on private fund advisers, it would have done so in the statute. Rather, the Court broadly found that "by congressional design," private funds are exempt from regulation over their internal "governance structure."
What Happens Next?
This holding by the Court provided relief for private fund advisers who were racing to understand the practical implications of the Private Fund Rules and to implement policies to comply with the new rules. As the Court noted, the Private Fund Rules would have cost $5.4 billion and required millions of hours of employee time. A spokesperson for the SEC has stated that the SEC is reviewing the decision and will determine its next steps. The SEC may seek rehearing en banc before the entire Court. Or, the SEC could file a petition for certiorari before the U.S. Supreme Court.
Key Takeaways
Notwithstanding the Court's decision, the vacated Private Fund Rules may still have a meaningful impact on the operations of private fund advisers, for a couple of significant reasons:
- First, the Private Fund Rules had significant support from certain sectors of the investor community, including state pension plans and certain industry groups who filed an amicus brief in support of the rules. Certain investors may seek in their negotiations with private fund advisers to obtain rights that would otherwise have been afforded by the Private Fund Rules. As a result, the Private Fund Rules may still herald a meaningful shift in market practice in the industry.
- Further, private funds are expected to be a continued focus of the SEC. The SEC's Division of Examinations included private funds in their 2024 examination priorities. Although the Court's broad ruling may limit the tools available to the SEC to regulate certain market practices, the SEC indicated in the adopting release of the rules that certain practices contained in the Private Fund Rules may be necessary to comply with an investment adviser's fiduciary duties under the Advisers Act. For example, the SEC indicated that the quarterly statement rule was intended to prevent fraudulent, deceptive or manipulative practices observed by the SEC, including charging monitoring and other similar fees to portfolio companies without disclosing the fees to investors. Going forward, it may be prudent for private fund advisers to continue to examine their own policies and procedures in light of the principles reflected in the vacated Private Fund Rules.
Footnotes
1. Nat'l Assoc. of Private Fund Mgrs. v. SEC, No. 23-60471, 2024 WL 2836655 (5th Cir. June 5, 2024).
2. For a detailed summary of the Private Fund Rules, see "Summary and Early Analysis of New SEC Private Fund Rules," Holland & Knight alert, Sept. 18, 2023.
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