Are the SEC’s Private Fund Advisers Rules Now Dead? No, but they are on Life Support

The U.S. Court of Appeals for the Fifth Circuit (the “Fifth Circuit”) has thrown a wrench into the gears of the U.S. Securities and Exchange Commission (the “SEC”) in its attempt to regulate those investment advisers that manage collective investment funds offered only to sophisticated investors, that is, private funds, under the Investment Advisers Act of 1940 (the “Advisers Act”).[1] As described in our August 28, 2023 Client Alert, the SEC had adopted sweeping new rules and rule amendments affecting investment advisers that manage private funds (collectively, the “Private Fund Advisers Rules”).[2] Shortly thereafter, the National Association of Private Fund Managers and other organizations filed a petition with the Fifth Circuit to review the Private Fund Advisers Rules under the Administrative Procedures Act (the “APA”). On June 5, 2024, the Fifth Circuit determined that the SEC had exceeded its authority under the APA when it adopted the Private Fund Advisers Rules, and the Fifth Circuit vacated the Private Fund Advisers Rules in their entirety.[3]

Brief Summary of the Fifth Circuit’s Opinion

In the Private Fund Advisers Rules’ adopting release and before the Fifth Circuit, the SEC claimed that it had the authority to adopt the Private Fund Advisers Rules and to regulate private fund advisers and investors pursuant to two anti-fraud provisions under the Advisers Act: Section 211(h) and Section 206(4).

Section 211(h) grants the SEC the power to facilitate simple and clear disclosures to “investors,” including material conflicts of interests, as well as promulgate rules prohibiting or restricting certain sales practices, conflicts of interest and compensation schemes by investment advisers that the SEC deems contrary for the protection of investors. The SEC claimed that investors, as used in Section 211(h), included investors in private funds. The Fifth Circuit concluded, however, that Section 211(h)’s reference to “investors” only applies to “retail customers,” not to private funds or the sophisticated investors who are eligible to invest in private funds. Among other things, the Fifth Circuit noted that Congress had intended to impose a prescriptive regulatory framework – the Investment Company Act of 1940 (the “1940 Act”) – on retail funds, such as, mutual funds, exchange-traded funds, and exchange-listed closed-end funds. However, the Fifth Circuit also observed that Congress chose not to impose the same or another prescriptive framework on private funds, and instead, preserve a market-driven relationship among the private fund adviser, the private fund and the private fund’s investors. The Fifth Circuit also noted that the Advisers Act only recognizes a fiduciary duty between an investment adviser and its client, and in the context of private funds, following Goldstein v. SEC,[4] the client of the investment adviser is the private fund, not the fund’s investors.

Section 206(4) authorizes the SEC to adopt rules that define an act, practice, or course of business by an investment adviser that is fraudulent, deceptive or manipulative, and then prescribe a means that is reasonably designed to prevent such an act, practice or course of business. The SEC argued that it could regulate acts that are not themselves fraudulent if the restriction is reasonably designed to prevent fraud or deception. The Fifth Circuit disagreed, stating, among other things, that Section 206(4) requires the SEC to define an act or practice that is fraudulent, deceptive or manipulative, and then a means that is reasonably designed to prevent that act or practice. The Fifth Circuit concluded that the SEC had failed to define an act, practice or course of business that was itself fraudulent, noting that the acts and practices addressed by the Private Fund Advisers Rules were not themselves fraudulent.

Potential Next Steps by the SEC

Going forward, the SEC can take any of four possible steps: (1) request a rehearing before the entire Fifth Circuit (i.e., en banc); (2) appeal the Fifth Circuit’s decision to the U.S. Supreme Court; (3) begin the process of drafting new rules that would comply with the Fifth Circuit’s decision; or (4) do nothing and let the Fifth Circuit’s decision stand. As of the date of this Client Alert, the SEC has not stated publicly which step it intends to take. The SEC has until late July 2024 to determine whether it intends to ask the Fifth Circuit for a rehearing en banc, and until early September 2024 to determine whether it will appeal the Fifth Circuit’s decision to the U.S. Supreme Court. We will keep you informed when the SEC states how it intends to proceed.

Going Forward

Even if the Fifth Circuit’s decision to vacate the Private Fund Advisers Rules becomes final, we expect that some institutional investors will look to negotiate terms with private fund sponsors that are reasonably consistent with some terms of the Private Fund Advisers Rules, especially terms related to the Private Fund Advisers Rules disclosure and restricted activities provisions. We also expect that the SEC Staff will continue to push for more disclosure and transparency in private fund operations, using among other things examination and enforcement initiatives. Finally, we anticipate some of the objectives behind the Private Fund Advisers Rules will be, at some point, adopted by non-U.S. regulators, thus affecting those U.S. private funds used in parallel, master-feeder and other multi-fund/multi-jurisdiction structures.