On June 5, 2024, the U.S. Court of Appeals for the Fifth Circuit (the “court”) vacated the private fund adviser rule (the “rule”) adopted by the Securities and Exchange Commission (SEC) in September 2023.
Notably, during the SEC’s August 23, 2023, public hearing adopting the rule, Commissioner Hester Peirce objected to the adoption on the grounds that private, sophisticated parties enter into arrangements that work for them, and as long as investors understand the terms, government interference is unnecessary. Additionally, Commissioner Peirce objected to a lack of statutory basis for the rule, noting that congressional authorization is required and that Rule 206(4) of the Investment Advisers Act of 1940 (“Advisers Act”) is an “uncomfortable home” for routine compliance issues. Ten months later, in a unanimous decision, the court agreed with Commissioner Peirce, ruling that Sections 211(h) and 206(4) of the Advisers Act – the provisions the SEC relied upon to justify its rulemaking – do not, in fact, authorize the SEC to regulate private funds and, as a result, the rule exceeded the authority granted by Congress.
Section 211(h) was added to the Advisers Act by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) following the 2008 financial crisis. It authorizes the SEC to "promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that the Commission deems contrary to the public interest and the protection of investors." During the public hearing adopting the rule, commissioners supporting the rule noted its importance in protecting “main street,” retail investors such as firefighters, teachers and police officers. This view was shared by various investor advocacy groups. In defense of the rule before the court, the SEC again noted the need to protect investors. However, the court found this justification without merit.
The court noted that the existing statutory scheme (including the Investment Company Act of 1940 and the Advisers Act) intentionally excludes private fund advisers from a highly proscriptive framework, like the rule. Had Congress wanted to include private market regulation within the existing statutory construct, it would have done so. Rather, the overall intent was to exclude private funds from a sweeping regulatory framework because they do not present the same dangers to the public market: the investors are qualified and highly sophisticated, possessing the ability to bargain and negotiate. Additionally, the court found that the statutory authority cited by the SEC – namely, Section 211(h) and Title IX of the Dodd-Frank Act – specifically applies to “retail customers” and cannot be extended to private fund investors.
In support of its rulemaking activities, the SEC cited its authority under Section 206(4) of the Advisers Act to “define, and prescribe means reasonably designed to prevent, such acts, practices and courses of business as are fraudulent, deceptive or manipulative," with respect to investment advisers. Arguing that the Advisers Act permits the SEC to “regulate acts that are ‘not themselves fraudulent’ if the restriction is ‘reasonably designed to prevent’ fraud or deception,”[1] the SEC noted that the rule is “designed to prevent fraudulent or deceptive acts, conduct, and/or courses of business.”[2] Again, the court disagreed, calling the rule’s anti-fraud measure “pretextual,” and concluding that the SEC had made no “rational connection” between fraud and any part of the rule.
Based on these overarching legal principles, the court found that the SEC exceeded its authority and vacated the rule.
The Future of Private Fund Regulation
The SEC’s next steps remain to be seen. Possible options include requesting a rehearing, appealing the decision or requesting a writ of certiorari with the U.S. Supreme Court. While the court’s decision is welcomed relief for private fund advisers, Warner Norcross + Judd LLP encourages continued diligence. The SEC has been releasing new rules at lightning speed, and the private fund space is expected to be a continued focus, as noted by the SEC in its 2024 Examination Priorities Report: “Advisers to private funds remain a significant portion of the SEC-registered investment adviser population. The Division will continue to focus on advisers to private funds and prioritize specific topics,” including but not limited to, portfolio management risks, adherence to contractual terms, calculation and allocation of fees and expenses, and compliance with the Advisers Act. Warner anticipates that the SEC will continue to address its concerns around private fund advisers’ activities through examination.
Additionally, with many pension and retirement organizations submitting briefs in support of the SEC and the rule, we anticipate heightened investor awareness around private fund governance and compliance. In an article titled, “The Lawsuit Against a New SEC Rule Could Harm Investor Protections,” the Center for American Progress stated that “if the 5th Circuit rules in favor of the plaintiffs bringing the case, the SEC could be prevented from delivering key—and badly needed—investment protections for everyday Americans ...” This main-street-meets-private-fund mentality and increased awareness and vigilance by investor advocacy groups could signal a shift in how private fund investors negotiate and engage with advisers.
We encourage private fund advisers to continue focusing on strong and robust compliance policies and procedures and to conduct thorough reviews and tests of the examination metrics identified in the Commission’s 2024 Examination Priorities Report. Warner’s Funds and Investments Industry Group will continue to monitor this issue and provide updates, as they become available.
For assistance with private fund adviser compliance or any other compliance needs, please contact Andrea McGrew or a member of Warner’s Funds and Investments Industry Group.
