A Landmark Reversal: Fifth Circuit Overturns Controversial SEC Private Funds Rule

On June 5, 2024, the U.S. Court of Appeals for the Fifth Circuit delivered a landmark opinion, overturning the SEC’s controversial Private Fund Adviser Rules, which were adopted in August 2023. This ruling has deemed the SEC to have overreached its statutory authority and declared the rules entirely unauthorized and invalid. The opinion vacating the final rules comes three months before the first compliance date, which was set for September 14, 2024. Industry stakeholders have welcomed the ruling as a victory, seeing it as a check on regulatory overreach. Arootah Advisor Michelle McGurk highlights the key implications of this case and its implications for the private funds industry.

Key Points from the Decision

The SEC’s Private Fund Adviser Rules are aimed at enhancing transparency and accountability within private investment funds. They would result in sweeping changes to the business operations and practices of private fund advisers. The rules, which we highlighted in our August 2023 regulatory roundup, include stringent disclosure obligations and compliance frameworks aimed to protect investors and ensure fair practices. The final rules, which were set to bring major changes to the private funds industry in the coming years, were challenged by petitioners who argued it disrupted established practices well beyond the SEC’s legal limits. As the court noted, in total, the final rules would have cost $5.4 billion and required millions of hours of employee time.

The Fifth Circuit ruled that Section 211(h) of the Advisers Act, amended following the 2008 financial crisis, was intended for retail investors, not private fund investors. Section 206(4) prohibits fraudulent, deceptive, or manipulative acts, but the court found that the SEC failed to establish a direct connection between this section and the final Private Fund Adviser Rules. They highlighted that a lack of disclosure does not equate to fraud or deception, and advisers’ duties are to the fund, not its investors. The court stressed the need for regulatory measures to balance investor protection with industry feasibility.

The Fifth Circuit’s Ruling: Reinforcing Regulatory Distinctions

Although the Fifth Circuit’s ruling was somewhat unexpected, it wasn’t entirely unforeseeable. Historically, a clear distinction has existed between regulation governing private funds (including hedge funds) and registered investment companies (such as mutual funds). Registered investment companies have been subject to stringent rules under the Investment Company Act, while private funds have been exempt from these regulations, as highlighted by:

• Sections 3(c)(1), for funds that do not make a public offering of securities and do not have more than 100 beneficial owners
• 3(c)(7), for funds whose securities are owned exclusively by “qualified purchasers.”

The court emphasized these distinctions, reinforcing that private funds were not meant to be governed by the same restrictive rules as registered investment companies. It reiterated that sophisticated and institutional investors are better positioned to protect their interests.

Furthermore, the Fifth Circuit clarified that the Dodd-Frank Act was primarily focused on the relationship between advisers and the private funds they manage, with private funds being governed by broader prohibitions against “fraudulent, deceptive, or manipulative” practices. The SEC’s move to impose specific rules on private funds through the 2021 Marketing Rule and the new Private Fund Adviser Rules marked a significant departure from the previous regulatory environment.

Next Steps and Future Outlook

The SEC could choose to challenge the Fifth Circuit ruling by petitioning the U.S. Supreme Court for a “writ of certiorari,” though there’s no assurance the Supreme Court would agree to hear the case. The SEC has not yet confirmed whether it will appeal the decision but given the unanimous decision and emphatic nature of the ruling, it may discourage the SEC from pursuing an appeal. If they do, they have two potential routes: asking the Fifth Circuit for an en banc rehearing within 45 days, where all the judges in the circuit would review the case—a rare and resource-intensive process; or petitioning the Supreme Court within 90 days, though the odds of the Supreme Court taking up the case or ruling differently are low. For now, the SEC’s Final Rules are suspended and won’t take effect on the planned compliance date. Given the time it takes for the Supreme Court to reconsider and act on any potential petition for review, it is estimated the final rules will be vacated for at least 12 months.

This decision fits into a broader trend of judicial scrutiny over SEC regulations, potentially inspiring more legal challenges and creating a fragmented regulatory environment. The ruling could also inspire further challenges to other SEC rules, such as the Safeguarding Rule, Cybersecurity Rule, and the Outsourcing Rule, all of which rely on similar regulatory authority and limit the SEC’s regulatory scope over the private funds industry. Fund managers need to be prepared for dynamic regulatory shifts.

For investors, this ruling presents mixed implications. Reduced regulatory burdens might lead to lower operational costs and higher returns, but also raise concerns about transparency and the risk of misconduct, so enhanced due diligence will be crucial. The Private Fund Adviser Rules had garnered significant support from certain institutional investor groups, including state pension funds, who may now pursue concessions that were intended to be provided by these rules during their negotiations with fund advisers.

Next Steps for Private Fund Advisers

Despite the ruling vacating the Private Fund Adviser Rules, the SEC can still pursue its regulatory goals through examinations and enforcement actions as an alternative means to achieve their objections. As such, private fund advisers can expect the SEC to scrutinize private fund managers’ practices, particularly around disclosures, preferential treatment, fees, and expenses. In preparation for this, advisers should perform internal reviews to assess if fees and expenses are allocated fairly, confirm if any loans or securities borrowed from private fund clients are appropriately documented, and ensure clawbacks are not reduced improperly for taxes. Also, since the SEC has flagged selective disclosure as a significant concern and has announced multiple enforcement actions related to improper disclosure of conflicts of interest, advisers should ensure they have updated conflict disclosures in fund documentation and Form ADV Part 2A as deemed necessary and evaluate whether investor consent or notice may be required.

Additionally, advisers should also closely examine whether they have given certain investors preferential access to liquidity or specific portfolio holdings information, which could reasonably be expected to negatively impact other investors in the same or related investment pools.

For private fund advisers who have already begun implementing these regulations it is important to reassess their commitment to retaining these changes. Further, advisers must also review any contractual obligations, such as side letters, that may bind them to comply with these rules or their principles. Notably, amendments to the compliance rule requiring a written annual review remain unaffected by this decision.

Despite the Fifth Circuit’s ruling, the SEC will still pursue enforcement where fees, preferential treatment, or other practices deviate from disclosed terms or where policies are inadequate to prevent misconduct. Maintaining accurate records and the ability to quickly produce documentation during examinations will be critical for advisers in this ever-changing regulatory environment.

The Bottom Line

The Fifth Circuit’s decision to overturn the SEC’s Private Fund Adviser Rules marks a pivotal moment in regulatory oversight of the private funds industry. While this ruling provides temporary relief from anticipated compliance burdens, private fund managers should remain vigilant. They must continue to uphold transparency and fair practices, anticipating ongoing scrutiny through SEC examinations and enforcement actions. As the landscape evolves, adapting internal practices and ensuring robust compliance frameworks will be crucial for navigating future regulatory challenges. This decision underscores the importance of staying informed and proactive in safeguarding investor interests while maintaining operational integrity within the dynamic regulatory environment. Our team of experts can help ensure you are compliant. Take the first step and find out how Arootah’s Hedge Fund Advisory can support you.