I. Vacating the Private Fund Rules

On August 23, 2023, the U.S. Securities and Exchange Commission (SEC) adopted the Private Fund Rules under the Investment Advisers Act of 1940 (Advisers Act). The Private Fund Rules were purportedly enacted to “protect private fund investors through increased transparency, competition, and marketplace efficiency.” The Rules made fundamental changes to the operation of private funds.  The enhanced regulation for private funds created 1) the preferential treatment rule, 2) the restricted activities rule, 3) the quarterly statement rule, 4) the adviser-led secondaries rule, and 5) the audit rule. These regulations alone would have cost $5.4 billion and required millions of hours of employee time. Yet, these regulations were significantly pared back from the SEC’s original Proposed Rules issued in February 2022. Private fund sponsors argued fiercely against the Proposed Rules during the comment periods, arguing that the Rules were an overstep of statutory authority, and unnecessarily raised compliance costs disproportionately affecting smaller funds. In September 2023, only one month following the publication of the Final Rules, a group of private fund managers filed a petition against the SEC asserting that very argument. 

On June 5, 2024, the Fifth Circuit decided in a unanimous three-judge panel to vacate the Private Fund Rules in their entirety. The court held that the SEC exceeded the bounds of its rulemaking authority when it adopted the rules—a welcome victory for private fund advisers. The court focused on the SEC’s cited authority for the regulations, determining that the SEC lacked authority under both Section 211(h) and 206(4) of the Advisers Act. Section 211(h) was added to the Advisers Act by the Dodd-Frank Act, allowing SEC regulation prohibiting certain sales practices and conflicts of interest. However, the Court found that the Dodd-Frank Act did not intend to allow specific regulations on private fund advisers, only “retail customers,” rebutting the SEC’s reliance on Section 211(h). Section 206(4) of the Advisers Act authorizes the SEC to enact regulations to prevent fraud, deception, and manipulation. Not only did the Court see no rational relationship between the Private Fund Rules and the prevention of fraud, but it also explained that Section 206(4) does not authorize the SEC to regulate private fund advisors generally. 

Rather than granting the SEC time to rewrite the rule, the decision to vacate leaves no question on the SEC’s lack of authority. Brian Daly, an investment management & private equity partner at Akin Gump, declared the Court’s approach “a pure, unabashed, full frontal assault on the very jurisdictional basis of the rulemaking,” that “could not have been more positive for the industry.” Without the ability to rewrite the rule, the SEC had two options: seek a rehearing en banc or file a petition for certiorari before the U.S. Supreme Court. On September 3, the deadline for seeking Supreme Court review passed, leaving the SEC with no remaining options absent a new rulemaking process. 

II. What Happens Next?

This falls on the heels of several recent decisions limiting SEC authority. Since 2022, the Fifth Circuit has held the SEC’s administrative proceedings unconstitutional, vacated the SEC’s share repurchase disclosure rules, and vacated the SEC’s changes to the notice-and-awareness requirements for proxy advisors. These public losses for the SEC beg the question, what are the next steps for Chairman Gary Gensler? As the Supreme Court deadline passed, the SEC issued a statement declaring that it had made “a strategic decision to focus resources on adopting and implementing other items on [its] rulemaking agenda.” 

Despite this statement and the Private Fund Rules no longer being in effect, the SEC is not backing down from its attempt to regulate private funds. The SEC’s Division of Examinations included private funds in their 2024 examination priorities. Further, the SEC has indicated that practices contained in the Private Fund Rules may be necessary to comply with an investment adviser’s fiduciary duties under the Advisers Act, regardless of authority under Section 211(h) or 204(6). With the SEC’s stated intentions to regulate private funds, we may see the judicial resistance to private fund regulation being met with increased oversight and policing efforts by the SEC Examination and Enforcement Divisions. Continued SEC aggression could result in private fund advisers maintaining a focus on compliance despite the rules being vacated. 

The vacated Private Fund Rules may also impact some of the SEC’s current Proposed Rules. Rules targeting AI, specifically the Predictive Data Analytics Proposal, the Outsourcing Proposal, and the Cybersecurity Proposal, face criticism in the wake of the Fifth Circuit’s ruling. In a comment to the SEC, the National Association of Private Fund Managers argues that because the Fifth Circuit recognized that “private funds are exempt from federal regulation of their internal governance structure,” the SEC must either withdraw the Proposed Rules or clarify that the Proposed Rules do not apply to investment advisers without “retail customers.” In contrast, Better Markets recently commented on the Proposed Rules, arguing that “any assertion that the rule proposals should be withdrawn in light of the Fifth Circuit’s holding . . . is erroneous.” Better Markets demonstrates additional reliance on the fiduciary duties required of all advisers under the Advisers Act as authority for enhanced oversight. 

The Fifth Circuit’s heightened focus on SEC authority makes these Proposed Rules targets for continued litigation. The SEC will ultimately have to decide whether the Commission is phased by the continued declarations of regulatory overstep. If not, enforcement of private fund regulation may prompt further judicial involvement. 

Cate Brewer is a second-year law student pursuing a JD/MBA at Wake Forest University. She holds a B.A. in Economics and Political Science with a minor in History from North Carolina State University. 

Reach Cate here:

LinkedIn: www.linkedin.com/in/cate-brewer-541a0422b

Email: [email protected]