In a rebuke to the U.S. Securities and Exchange Commission (the SEC), the U.S. Court of Appeals for the Fifth Circuit on Wednesday, June 5, 2024 vacated in full the set of new SEC rules for private funds adopted last August by the SEC.

The vacated rules were consolidated into a single private funds rule upon the adoption of five new rules plus ancillary amendments to existing rules under the U.S. Investment Advisers Act of 1940 (the Advisers Act). The private funds rule represented the most significant regulatory development for private fund advisers since the adoption of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act). While the final rule was less onerous than the one that the SEC proposed in February 2022, a number of sponsor-side industry players brought suit against the final rule, arguing that the SEC, among other things, exceeded its statutory authority under the Advisers Act. While many parts of the new rule were set to take effect in March 2025, some would have become effective as soon as September 2024 for advisers with over US$1.5 billion in assets under management.

The Fifth Circuit agreed with the claims, vacating the final rule by unanimous vote of the three-judge panel. In doing so, the Fifth Circuit found that the SEC exceeded its statutory authority under Section 211(h), a new provision of the Advisers Act added by Dodd-Frank Act, as well as under Section 206(4), one of several anti-fraud provisions of the Advisers Act and traditionally an anchor for the SEC’s investment advisory rulemaking authority.

The SEC has not indicated whether it will appeal the ruling, either to an en banc hearing before all the Fifth Circuit’s judges or to the U.S. Supreme Court; the SEC has 90 days from the ruling to petition the Supreme Court for certiorari. But the decision is the most notable setback to SEC rulemaking under the Advisers Act since 2006 when, in Goldstein v. SEC, the U.S. Court of Appeals for the D.C. Circuit invalidated the SEC’s hedge fund rule, a pre-Dodd Frank Act measure that would have provided the SEC with greater oversight of hedge funds in particular.

Background

The SEC had attempted to accomplish several things with the new private fund rule: (i) introduce a harmonized standard for quarterly reporting; (ii) mandate an annual audit requirement for fund financial statements; (iii) require either valuation or fairness opinions for adviser-led secondaries; (iv) mitigate several “prohibited activities” through additional consent or disclosure requirements; and (v) address preferential treatment of certain investors within funds by either outright prohibition and/or disclosure requirements. The rule also included ancillary books and records requirements, as well as an amendment providing that the annual review required under Rule 206(4)-7 for all registered investment advisers (RIAs) be in writing.

The reforms described in (iv) and (v) above would have applied broadly to all investment advisers, including exempt advisers, not just RIAs.

Fifth Circuit decision

In invalidating the rule, the Fifth Circuit ruled that the SEC had exceeded its authority under Section 211(h) of the Advisers Act, which gives the SEC authority to promulgate rules prohibiting or restricting sales practices, conflicts of interest and compensation schemes for broker-dealers and investment advisers that the SEC deems contrary to the public interest and the protection of investors. The Fifth Circuit held that Section 211, as a whole, applies only to “retail customers,” a term that specifically excludes private fund investors. Going back to the Goldstein case, and reinforced by the Dodd-Frank Act, courts have found that under the Advisers Act, private fund advisers are generally deemed to provide investment advice only to the private fund itself, and not to the fund’s investors, who are not considered advisory clients. The Fifth Circuit’s holding on Section 211(h) may impact the future of several recently proposed SEC rules that rely in whole or in part on Section 211, including (i) new rules in respect of environmental, social and governance (ESG) disclosure; (ii) a new ‘safeguarding rule’ designed to update and revise the existing custody rule; (iii) a new ‘outsourcing rule’ to mandate disclosure about certain third-party service providers; and (iv) rules governing the use of artificial intelligence and similar technology.

The Fifth Circuit also ruled that the SEC exceeded its authority under Section 206(4) of the Advisers Act. The Fifth Circuit held that the SEC had failed to provide a rationale of how the private funds rule would prevent fraud, stating that Section 206(4) requires the SEC to “define” an act, practice or course of business that is fraudulent or manipulative before it can adopt rules “reasonably designed to prevent” such act, practice or course of business. The Court emphasized the role of the Advisers Act in the regulatory scheme as a “sister statute” to the U.S. Investment Company Act of 1940 (the Company Act), noting that the Company Act subjects investment companies, including registered funds, to a prescriptive framework of regulatory requirements, while exempting from those requirements many private funds under Section 3(c)(1) and 3(c)(7) of the Company Act. The Fifth Circuit said that, in doing so, Congress intended to exempt private funds specifically from federal regulation of their internal “governance structure.”

The Fifth Circuit’s broad holding that Section 206(4) fails to authorize the SEC to require disclosure and reporting was perhaps more surprising than its holding limiting Section 211(h) to retail customers, and its reading of Section 206(4) may call into question the basis for existing rules. The SEC has enacted many of its key Advisers Act compliance requirements under its Section 206(4) authority, including requirements governing custody, political contributions, and compliance policies and procedures. Most recently, since November 2022, the marketing rule (Rule 206(4)-1) mandates a number of disclosure requirements as to RIA advertising, including through endorsements and testimonials.

Looking ahead

While the ruling is a victory for fund sponsors, the SEC’s Department of Examinations included private fund advisers as a continued focus of their examination program in fiscal year 2024. Accordingly, many of the principles of investor protection underlying the private funds rule may continue to be areas of focus of SEC review, including the pro rata sharing of fees and expenses, conflicts in adviser-led secondaries and presentation of performance information. By way of example, while the SEC dropped from its final rule proposed prohibitions on fees for unperformed services (such as accelerated monitoring fees) and certain limitations of liability for negligence, the SEC reiterated in its adopting release that it viewed both of those practices as contrary to an investment adviser’s fiduciary duty under the Advisers Act, which includes both a duty of care and a duty of loyalty to an adviser’s clients. Moreover, it is possible that institutional investors will seek some of the rule’s protections as part of ongoing and future negotiations regarding advisory arrangements.

We continue to monitor ongoing implications of this important ruling and other regulatory developments, and we will provide updates as additional developments emerge.

Authored by Adam Brown, Parikshit Dasgupta, Brian Diamond, Brayton Dresser, Richard Madris, Bryan Ricapito, David Winter, Henry Kahn, Kevin Lees, and Madelyn Healy Joseph.