Yesterday, the Fifth Circuit Court of Appeals vacated the SEC final rule titled Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews (“the Private Fund Rule”). The Court vacated the entire Private Fund Rule, which, at least for now, eliminates any obligation to comply with the rule in September.[1] The Court held that the SEC exceeded its statutory authority in enacting the Private Fund Rule to impose onerous requirements on hedge funds and private equity funds, including: (i) prohibiting preferential treatment of certain private-fund investors through “side arrangements,” (ii) prohibiting private-fund advisers from charging funds for fees or expenses related to regulatory compliance or certain investigations of the adviser, and (iii) requiring quarterly reporting statements on fund-level performance, adviser compensation, and other fees and expenses.[2]
The case was initiated by a number of private-fund industry trade groups (the “Trade Groups”). The Trade Groups viewed the Private Fund Rule as unnecessary regulatory overreach that would create billions of dollars of unnecessary compliance costs. They argued that the SEC did not have authority to promulgate the Private Fund Rule under federal statutes. Conversely, the SEC argued that it had such authority, and that the Private Fund Rule was necessary to help prevent fraud. The Court agreed with the Trade Groups.
First, the Court held that the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) did not expand the SEC’s rulemaking authority to cover private-fund advisers and investors under Section 211(h) of the Investment Advisers Act of 1940 (“Advisers Act”). The Court considered whether Section 211(h)’s reference to facilitating “clear disclosures to investors” reflected Congress’s intent to expand the SEC’s statutory authority to private funds, in light of other statutes that refer to an SEC mandate to act for “the protection of investors,” which have been held to apply to private funds. But the Court refused to interpret the mere word “investors” as extending the SEC’s mandate to regulate disclosures by private funds, because it could not be harmonized with the Investment Company Act of 1940 (“ICA”) – the Adviser Act’s “sister statute” – which expressly refrains from imposing a retail-customer regulatory framework on private funds.
The Dodd-Frank Act provision on which the SEC relied to reach private-fund advisers – Section 913(h) – applies, by its terms, to “retail customers” rather than private funds, and therefore, according to the Court, “has nothing to do with private funds.”[3] The fact that Section 211(h) of the Advisers Act[4] uses the undefined term “investors” instead of “retail customers” did not convince the Court that Congress meant to expand the reach of Section 211(h) to include private-fund investors. Rather, the Court found that Section 211(h) was devoted solely to the protection of retail customers.
Indeed, the Court noted that “by Congressional design” in the ICA (and by extension, the Adviser’s Act), federal regulation cannot intrude on a private fund’s internal “governance structure.” The Court drew on the ICA’s purpose of preserving the “market-driven relationship between a private fund adviser, the fund, and outside investors” – as opposed to regulating that relationship. It noted that “[u]nlike retail-oriented funds,” private funds can negotiate with investors on terms concerning access to financial reports, advisory fees chargeable to the fund, and preferential redemption terms. Consequently, the Private Fund Rule improperly intrudes on the statutory freedom of contract between private funds and their investors to vary the terms of disclosure obligations to address the goals of a specific private fund.
Second, the Court held that Section 206(4) of the Advisers Act – which permits the SEC to regulate “fraudulent, deceptive, or manipulative” acts regarding “any investment adviser” – does not authorize the Private Fund Rule. The Court rejected the SEC’s argument that the Private Fund Rule advances Section 206(4)’s purpose to prevent fraud or deception as “pretextual,” because the SEC gave no “rational connection” between the rule and potential fraud. The Court noted the SEC’s failure even to define the fraudulent practices that the Private Fund Rule would prevent. Nor, the Court reasoned, does the Private Fund Rule have a “close nexus” with the statutory aim of preventing fraud, because a failure to disclose cannot be deceptive without a specific duty to disclose. But an adviser’s duty to disclose extends to the fund itself, not the fund’s underlying investors. Therefore, the Court held that Section 206(4) does not give the SEC a mandate to impose the broad disclosure requirements under the Private Fund Rule.
The Court’s decision vacates every provision of the Private Fund Rule and, for now, eliminates any obligation to comply with the rule in September. The SEC’s options are limited to requesting a rehearing by the Panel or en banc by the Fifth Circuit (neither of which is likely to be successful), or requesting a stay of the order pending a further appeal to the Supreme Court. In addition, the Supreme Court may choose to hear an appeal on an expedited basis in an attempt to decide the issue before September 2024. However, it seems likely that, at a minimum, the September 2024 effective date will be pushed back given the Court’s decision.
Although private fund advisers are certainly pleased with the Court’s ruling, as the Court noted, private-fund investors can – and are expected to – negotiate with advisers for the very disclosures that the Private Fund Rule attempted to mandate. The Court’s observation may have planted the seed among investors themselves to demand the Private Fund Rule disclosures, and fund advisers should prepare for any “market-driven” effects of the Private Fund Rule. Further, while this decision significantly limits the rule-making authority of the SEC with respect to private-fund managers under the Dodd-Frank Act and the Advisers Act, interests in private funds remain securities. Sales of those interests, therefore, remain subject to the anti-fraud provisions of the Securities Act of 1933, as amended, and the rules and regulations promulgated thereunder. Full and fair disclosure of all the material terms of a private fund offering would still generally be required in connection with the sale of interests in private funds.
Sadis & Goldberg specializes in advising private funds and litigating on their behalf. We are available to discuss all matters related to private-fund formation, management, and litigation. If you have any questions about the Private Fund Rule, the decision vacating it, or any related issue, please contact Douglas Hirsch (dhirsch@sadis.com), Sam Lieberman (slieberman@sadis.com), Ron Geffner (rgeffner@sadis.com), Yehuda Braunstein (ybraunstein@sadis.com), David Fitzgerald (dfitzgerald@sadis.com), or Frank Restagno (frestagno@sadis.com).
[1]Nat’l Ass’n of Private Fund Managers, et al. v. SEC, No. 23-60471 (5th Cir. June 5, 2024).
[2] The Court quickly dispensed with the SEC’s threshold argument that the petitioners – each of which represents private fund advisers – lacked standing to challenge the Private Fund Rule.
[3] The Court repeatedly noted the SEC’s refusal to rely on Section IV of the Dodd-Frank Act – separated from Section 913 by “over 250 pages of statutory text,” and which imposed registration and “limited” reporting and record-keeping requirements on some private fund advisers – for the Private Fund Rule.
[4] Section 913(h) of the Dodd-Frank Act is codified in Section 211(h) of the Advisers Act.
