One Step Too Far: Fifth Circuit Vacates SEC's Much-Anticipated Private Funds Rule

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How We Got Here

On June 30, 2020, the SEC first published a Risk Alert centered on regulatory issues in the private funds space. The Risk Alert advanced a list of concerns, including undisclosed conflicts of interest, side letters providing preferential liquidity rights to certain investors, miscalculation of fees and expenses, and inappropriate charges to private funds for compliance and regulatory expenses.

On April 19, 2021, Gary Gensler became Chair of the SEC. Six months later, he delivered a speech in which he highlighted a desire to regulate fees, side letters, and conflicts of interest in the private fund space.

These events foreshadowed a bold regulatory initiative to come. Especially when looking back over the past few years, it is easy to see how that chapter of the past became prologue.

The Die Is Cast

On August 23, 2023, after a lengthy notice and comment period that attracted over 300 public comments, the SEC announced the final Private Funds Rule. Most people reading this article are likely familiar with the Rule and its erstwhile requirements.  In summary, the Rule had five primary components:

• The Preferential Treatment Rule banned side letter agreements providing some kinds of preferential terms to fund investors, pertaining to information or redemption rights. It also implemented sweepingly broad obligations to disclose most other forms of side letter agreements to other private fund investors.
• The Restricted Activities Rule banned private fund advisors from charging some forms of regulatory and compliance expenses to their funds. It also prescribed methods to allocate fees and expenses among multiple clients of a private fund adviser.  It instituted a broad disclosure regime for certain types of expenses charged to funds, and some transactions with private funds.
• The Quarterly Statement Rule required private funds to provide a quarterly statement of performance, fees, and expenses to investors.
• The Audit Rule required annual audits for private fund financial statements.
• The Advisor-Led Secondaries Rule required a private fund adviser to obtain an independent fairness opinion for transactions in which private fund investors are given the option of selling their interests in a private fund, or exchanging them for new interests in another fund advised by the adviser.

The SEC estimated that compliance with the Rule would cost $5.4 billion and require “millions of employee hours.” Nevertheless, the agency stood by its concerns about misconduct in the private funds industry, and its ambitious agenda for reforms.

The Gauntlet Is Thrown Down

One week after the Private Funds Rule was finalized, several industry groups sued, seeking an injunction. Their announcements of the litigation centered on concerns regarding higher costs, fewer choices, and diminished competition in the private funds space.

In their court submissions, the plaintiffs advanced a variety of arguments, but the most pertinent one centered on the SEC’s authority to enact the Private Funds Rule. The plaintiffs contended that the Private Funds Rule “cannot operate independently of the laws that supposedly authorized it, but there is no way to reconcile the two.”  Pet. Br. at 25 (internal citation omitted). In other words, the plaintiffs argued that the Private Funds Rule was “in excess of statutory jurisdiction, authority, or limitations.”  Id. at 24 (citing 5 U.S.C. § 706(2)(A)).[1]

Specifically, the plaintiffs said that “retail-focused investment companies are subject to . . . detailed requirements governing almost every aspect of the funds’ operation.”  Pet. Br. at 25-26. However, suggested the plaintiffs, “Private funds are exempt from this regime . . . .  Congress concluded it should leave private-fund investors to structure their own investment terms . . . . [T]he Rule imposes precisely the sort of prescriptive regulations from which Congress freed private funds.”  Id. at 26. The plaintiffs further submitted that the Private Funds Rule, in attempting to impose fairly specific, detailed regulatory duties on private fund advisers to private fund investors, impermissibly turned private fund investors into advisory clients of private fund advisers – despite efforts by Congress “to expressly forbid the [SEC] from defining ‘client’ to include private-fund investors.”  Id. at 28.

For its part, the SEC emphasized a “need for oversight . . . stem[ming] from . . . lack of transparency, conflicts of interest, and lack of governance mechanisms.”  Id. at 14. The SEC asserted that the Private Funds Rule was supported by the following statutes:

• Section 206(4) of the Investment Advisers Act, which makes it illegal for any investment advisor “to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative.” Nat’l Ass’n of Private Fund Mgrs. v. SEC, No. 23-60471, Slip Op. at 7 (Jun. 5, 2024).
• Section 211(h) of the Advisers Act (created by Section 913 of the Dodd-Frank Act) which empowers the SEC to “promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for . . . investment advisers.” at 8.
• Section 211(h) of the Advisers Act, which authorizes the SEC to make regulations to “facilitate the provision of simple and clear disclosures to investors,” and restrict “certain sales practices, conflicts of interest, and compensation schemes.”

[1] “Agencies get their authority to issue regulations from laws (statutes) passed by Congress . . . .  An agency must not take action that goes beyond its statutory authority.” Office of the Federal Register, A Guide to the Rulemaking Process (last accessed Jun. 10, 2024).

The Line Is Drawn

The Fifth Circuit emphatically sided with the plaintiffs.

First, the Court concluded that Section 211 of the Investment Advisers Act, although it referred to “investment advisers” generally, did not authorize the regulatory scheme for private fund advisers set down through the Private Funds Rule. The Court ruled that the Investment Company Act “subjects investment companies to extensive regulations, replete with reporting and disclosure requirements [and] restrictions on expenses that may be charged to investors by the fund . . . .  Yet Congress clearly chose not to impose the same prescriptive framework on private funds.”  Id. at 19-20.  “Unlike retail-oriented funds, private funds are free to negotiate fund agreements concerning access to periodic financial reports, investor input on advisory fees charged to the fund, and terms – including redemption terms – available to particular investors.”  Id. at 20 (citing 15 U.S.C. §§ 80a-29(e), 80a-15(a)(1), 80a-22, 80a-18).

The Court concluded that the Investment Company Act “preserves the market-driven relationship between a private fund adviser, the fund, and outside investors. The Dodd-Frank Act only stepped towards regulating the relationship between the advisers and private funds they advise.”  Id. at 20.  “Most telling, section 913 of the Dodd-Frank Act – the section the [SEC] relies on – applies to ‘retail customers,’ not private fund investors.  It has nothing to do with private funds.”  Id. at 21.[1]

Second, the Court rejected the SEC’s argument that “it may regulate acts that are not themselves fraudulent if the restriction is reasonably designed to prevent fraud or deception” under the auspices of Section 206(4) of the Investment Advisers Act.  Id. at 21-22.  The Court determined that “[t]he [SEC] fails to explain how [the Private Funds Rule] would prevent fraud.  Section 206(4) . . . specifically requires the [SEC] to define an act, practice, or course of business that is fraudulent, deceptive, or manipulative before the [SEC] can” regulate it.  Id. at 23. The Court pointed out that most of the SEC’s stated justifications for the Private Funds Rule did not amount to fraud.  Id.

The Court went on to observe that “Section 206(4) further fails to authorize the [SEC] to require disclosure and reporting. Other parts of the Advisers Act expressly provide for disclosure and reporting of certain information. This shows where Congress wanted to provide for reporting and disclosure of certain information, it did so explicitly.”  Id. (internal citations omitted). The Court concluded that the Private Funds Rule’s focus on disclosure “lacks a close nexus” to the prevention of fraud because “a failure to disclose cannot be deceptive without a duty to disclose.”  Id. at 24.  In the Court’s view, this duty to disclose “extends to the client alone, which is the fund, not the investors in the fund.”  Id.

Bereft of a statutory foundation, the Private Funds Rule was vacated in its entirety.

[1] The Court included a statutory construction analysis of the use of the term “investor” in Section 913(h) of the Dodd-Frank Act. The Court acknowledged that the statute called for “the provision of simple and clear disclosures to investors,” but concluded that, given the focus on retail investors throughout other provisions of Section 913, that section “applies to retail customers” and did not support the Private Funds Rule.  Id. at 22.

What Happens Now

The SEC said “it is reviewing the decision and will determine next steps as appropriate.”  At bottom, the agency has three options, although none are easy.

One, it can accept the decision and go back to the drawing board and formulate a new plan for regulating private funds. However, the breadth of the decision – particularly its distinction between “retail investors” and private fund investors centered on the Investment Company Act – makes this a daunting prospect. Presumably the SEC came forward with what it believed to be the strongest statutory support for the Private Funds Rule it could provide. Having lost Section Sections 206(4) and 211(h) of the Investment Advisers Act, it’s not immediately clear which alternatives are available to support a thorough regulatory regime for private funds.

Two, it can petition for en banc review of the decision before the full Fifth Circuit. Some believe that the Court’s current composition of more than two-thirds Republican appointees makes this an even steeper uphill climb than the usual long odds. According to Fifth Circuit statistics, 94% of petitions for rehearing were denied last year.  Those denials are just for requests to be heard. On the merits, historical federal court statistics more broadly indicate that “[f]ewer than 9 percent of total appeals result[] in the reversal of lower court decisions.”

Three, it could petition for certiorari before the Supreme Court of the United States. However, the current Supreme Court has shown itself to be particularly inhospitable to what it sees as regulatory overreach. See, e.g., West Virginia v. EPA, 597 U.S. 697 (2022) (“Agencies have only those powers given to them by Congress, and enabling legislation is generally not an open book to which the agency may add pages and change the plot line.”); Politico, Supreme Court Move Could Spell Doom for Power of Federal Regulators (May 1, 2023). A loss before the Supreme Court could have much farther-reaching and more damaging consequences for the SEC than the current decision. Courts outside of Missouri, Louisiana, and Texas are not required to follow the Fifth Circuit’s decision and its embedded logic, including with respect to the role of the Investment Company Act in interpreting language in the Investment Advisers Act, and the concomitant distinction between “retail investors” and private fund investors. Other jurisdictions might interpret the operative terms in the Advisers Act differently, looking for interpretive cues within the Advisers Act itself rather than the accompanying Investment Company Act. However, every Federal court in the country is required to follow the decisions of the Supreme Court.

Where We Go From Here

Whatever path the SEC choses, the Fifth Circuit decision has profoundly altered the regulatory landscape for private funds, at least for the foreseeable future. However, given the growth of assets in the private funds space in recent years – $17 trillion between 2012 and 2022 – the Private Funds Rule is unlikely to be the last regulatory effort in this sphere.

A question left unanswered in the Fifth Circuit’s decision is whether there is any other potential basis on which the SEC might suggest a private fund adviser has an obligation to disclose conflicts of interest to private fund investors. In the Court’s view, the authorities submitted by the SEC did not establish a “duty to disclose” the matters addressed in the Private Funds Rule.

But given the agency’s recent focus on investment advisers and conflict disclosures, the agency may be back with new theories on which it could base a duty to disclose.  And in the private funds context, the question still looms – if the fund is the adviser’s client, to whom must conflicts (or any other items) be disclosed?  Typically fund management is affiliated with the adviser.  Not every private fund has a Limited Partner Advisory Committee. These circumstances may require another decision harmonizing the status of a private fund as the advisory client, versus a need for some mechanism for effective disclosure to private fund investors who stand to be affected.

Finally, a broader procedural conflict looms on the horizon, with potentially the most consequential implications of all.  The Fifth Circuit has attracted praise and criticism alike for its willingness to curtail the authority of regulatory agencies, making it an appealing forum for future industry litigants.  However, the typical forum for challenges to regulatory agencies has been the U.S. Court of Appeals for the D.C. Circuit, which includes a greater number of Democratic appointees and may be a more hospitable forum for federal regulatory agencies.  If other industries take notice of the fate of the Private Funds Rule and follow suit with their own challenges in the Fifth Circuit, a tug-of-war over the forum for these disputes may quickly come to the fore.  Given the limited number of certiorari petitions accepted by the Supreme Court each term, the difference in forum could have effects that reach far into the evolving interrelationship between industry and regulators.

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