News & Insights

Fifth Circuit Vacates Private Fund Reform Rules with Sweeping Opinion

What happened?

On June 5th, the Fifth U.S. Circuit Court of Appeals vacated the Private Fund Reform Rules, saying that the SEC exceeded its statutory authority in adopting them on August 23, 2023. The Private Fund Reform Rules were adopted by a narrow 3-2 vote with strong dissent from the conservative commissioners. This expansive set of rules sought to enhance regulation, not just of registered private fund advisers, but of all private fund managers. These rules included:

  • The Preferential Treatment Rule;
  • The Restricted Activities Rule;
  • The Quarterly Statement Rule;
  • The Adviser-Led Secondaries Rule; and
  • The Mandatory Fund Financial Statement Audit Rule.

Industry groups filed suit against this rulemaking in the Fifth Circuit, which has a contentious relationship with the SEC. The SEC presented two theories on how the SEC had the statutory authority to adopt these enhanced regulations of private fund managers. The court found that under both theories, the SEC exceeded its statutory authority.  For that reason, the court vacated the rules in a sweeping decision that may have implications for other SEC rulemaking.

Two Theories of SEC Authority

Antifraud Rulemaking Authority – First, the SEC cited preexisting antifraud rulemaking authority found in section 206 of the Advisers Act. This covers prevention of fraudulent, deceptive, or manipulative acts of any investment adviser. The court found that the SEC failed to explain how the rules would prevent fraud, stating that “complying with a ‘fund’s governing agreements’ is not fraud, nor is disagreement over ‘discretionary violations.’ And while some conduct could involve fraud, the [SEC] only has observed misconduct by about 0.05% of advisers.”  In short, the SEC failed to define the specific fraud that the rules would prevent.

The Dodd-Frank Act – The second authority cited by the SEC was the Dodd-Frank Act. Before the Dodd-Frank Act, most private fund advisers were exempt from SEC registration. The Act eliminated this “private adviser” exemption and most private fund advisers became subject to reporting, recordkeeping, and examination requirements, and other provisions, applicable to all investment advisers. However, the specific section of the Dodd-Frank Act that the SEC cited to go beyond these requirements of investment advisers applies only to “retail customers” and not to private fund investors. The court indicated that while the Dodd-Frank Act moved towards regulating the relationship between advisers and the private funds they advise, the section cited only applied to “retail customers” and could not apply to investors in private funds.

Both SEC arguments failed. They did not sufficiently define the fraud prevention the rules would achieve, and they could not rely on authority meant for the regulation of retail customers to enhance regulation of the relationship between advisers of private funds and private fund investors.  For these reasons, the court found the rules were unauthorized and vacated them.

What does this mean for me?

Currently, the rules appear unenforceable. In the absence of any comment from the SEC on the ruling, it is impossible to know what will happen next. There are a few possible scenarios. The SEC could petition the Fifth Circuit to re-hear the case or seek review by the Supreme Court. The SEC could also take what was learned from this case, revise the rules, and cite different authority in a new proposal that could survive a legal challenge.

Since the rules could come back with a successful appeal, we recommend ongoing attention to the case and review of your firm’s ability to come into compliance if needed. Likewise, any agreements negotiated with investors after August 23, 2023, might include some of the rule’s requirements by contract.  The terms of any such agreement are still valid.

For all registered investment advisers, the Private Fund Rules added the requirement to document a written annual review under 206(4)-7 of the Advisers Act. While the rule was vacated, annual reviews are still required, and documenting your annual review in writing is a best practice.

One take-away for advisers of private funds is that the vacated rules pointed to private fund activities the SEC views as “contrary to the public interest.” These are likely to stay priorities of the SEC. Preferential treatment and restricted activities can still be scrutinized in examinations and reviewed for potential fraudulent or manipulative practices under existing law.  The SEC is likely to look at the fairness of any adviser-led secondaries and the valuation method used, even though the rule that would require a third-party fairness opinion was vacated.  Similarly, the SEC could seek the disclosure goals of the vacated Quarterly Statement Rule and Audit Rule by applying its marketing rule powers to adviser communication or enhancing regulatory filing and reporting requirements.  The recent enhancement of Form PF is unchanged by this court decision.

There will be a lot of speculation about what this decision means for other SEC rule proposals and the SEC’s authority over the private fund industry generally.  Although these theories of statutory authority failed, all other laws on the books are still available for SEC enforcement and should remain part of your compliance program.

Fairview is monitoring this case closely. We will provide updates as they become available and will advise on next steps. If you have any initial questions or would like to speak with one of our regulatory experts, please contact us and we will be in touch soon.