Key Takeaway:
- In August 2023 the Securities and Exchange Commission adopted final rules that sought to implement sweeping changes to the private funds industry. The Fifth Circuit Court of Appeals issued a decision today vacating the rule on the grounds that it exceeded the SEC's statutory rulemaking authority.
In a 3-0 decision issued today, June 5, 2024, the Fifth Circuit Court of Appeals (the “Court”) vacated the new private funds rule adopted by the Securities and Exchange Commission (the “SEC”) on August 23, 2023 (the “Rule”). The Court held that the SEC exceeded its statutory authority in adopting the Rule. Prior to the Court's decision, the compliance dates for the primary substantive provisions of the Rule (including quarterly reporting requirements for private funds, prohibited activities restrictions relating to permissible fund terms, private fund audit requirements and provisions relating to adviser-led secondaries) were September 14, 2024, for larger private fund advisers (with assets under management of $1.5 billion or greater) and March 14, 2025, for all other private fund advisers.
The SEC had based its rulemaking authority on Sections 206(4) and 211(h) of the Advisers Act.
As to Section 206(4), the Advisers Act's general anti-fraud provision, the Court found the SEC had not articulated a rational connection between fraud and the Rule, noting that (i) the Rule did not define the fraud it addressed; (ii) the SEC had observed misconduct by only 0.05% of investment advisers; and (iii) a failure to disclose information to private fund investors, such as required by the Rule, could not be fraud in absence of a duty to disclose and the Adviser Act's disclosure requirements flow to the fund itself, not its investors. Further, the Court found the Rule was not reasonably designed to address fraud because it did not sensibly fit within the statutory framework of the “sister” Investment Company Act and Advisers Act: the former expressly exempting private funds from its provisions addressing internal governance structures and a fund's relationship with outside investors; the latter not regulating these structures and relationships because the client of the adviser is the private fund itself, not its investors, leaving private fund advisers and the investors in their funds free to negotiate the terms of their relationship.
The Court also rejected the SEC's claim that Section 211(h) of the Advisers Act, adopted as part of the Dodd-Frank Wall Street Reform Act, expanded the SEC's rulemaking authority to cover the relationship generally between private fund advisers and investors in their private funds. The Court found that “investor” in Section 211(h) means “retail customer” and thus does not apply to a generic private fund investor because Section 211(h) was added to the Advisers Act pursuant to Title IX, which applies exclusively “retail customers,” and not by Title IV, the only section of Dodd Frank expressly addressing private fund advisers. More generally, the Court found that, in respect of investment funds, Dodd Frank intended only to regulate the relationship between a private fund adviser and its fund, leaving to the Investment Company Act the market-driven relationship between a private fund adviser, its fund, and the fund's outside investors.
The SEC has not commented as of the time of this alert as to whether it intends to seek further review, either through a request for an en banc rehearing by the full court of the Fifth Circuit or by petitioning the Supreme Court.
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