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Fifth Circuit Strikes Down SEC’s Private Fund Advisor Rules

Contributing Author, Lucy Oh, Summer Associate

On June 5, 2024, the United States Court of Appeals for the Fifth Circuit (“Fifth Circuit”) struck down the Securities and Exchange Commission’s (“SEC”) private fund adviser rules (“Rules”), which were originally adopted in August 2023 and would have been fully implemented by early 2025, as outlined in our LEGALcurrents, SEC Adopts Private Fund Adviser Reforms.

Background

The Rules would have required all private fund advisers to provide disclosure to or obtain consent from investors before engaging in restricted activities such as charging investors certain fees or expenses and providing preferential treatment, such as redemption terms, to some investors over others. Furthermore, the Rules would have required registered private fund advisers to provide substantial disclosures to investors, including annually audited financial statements; quarterly statements disclosing the fund’s performance, fees, and expenses; and fairness opinions before offering existing investors the choice between selling their interest in the fund or converting into a new vehicle led by the adviser.

Fifth Circuit’s Decision

The Fifth Circuit vacated the Rules in their entirety after holding that the SEC lacked authority to adopt the Rules under sections 211(h) and 206(4) of the Investment Advisers Act of 1940 (“Advisers Act”).

Congress added section 211(h) to the Advisers Act through section 913(h) of the Dodd-Frank Act. Section 211(h) authorized the SEC to make rules requiring disclosure to “investors” and to restrict activities that are contrary to the protection of investors. The Court reasoned that the word “investors” in this context meant a “retail customer” instead of a private fund or private fund investor, finding it unlikely that Congress intended to provide for the regulation of private funds in the middle of a section that is devoted to regulating retail investments. Under the Advisers Act, a retail customer is a natural person who receives advice from an investment adviser for personal, family or household purposes. In addition, the Court contrasted the Advisers Act provisions added in the Dodd-Frank Act with the Investment Company Act and reasoned that Congress could have added private funds to the Investment Company Act or imposed Investment Company Act-like disclosure requirements on private funds, but it did not. Thus, the Court found that the SEC did not have authority under section 211(h) to regulate private funds or private fund advisers.

Next, the SEC argued that the Rules are valid under section 206(4) of the Advisers Act, which authorized the SEC to make rules that are reasonably designed to prevent investment advisers from engaging in fraud or deception. The Court noted that SEC had not specifically defined the fraudulent or deceptive act it sought to prevent and did not provide a rational connection between the Rules and preventing fraud. In addition, the Court pointed to the absence of authority granted to the SEC under section 206(4) to make rules requiring disclosure from private funds as a means to prevent fraud. These points, together with the Court’s finding on section 211(h), formed the basis of the Court’s holding that the SEC did not have authority under Section 206(4) to make rules requiring disclosure from private fund advisers.

Because the Court held that the SEC did not have authority under the Advisers Act to propose and adopt the new Rules, the Court vacated the Rules.

In response to the decision, the SEC may request a rehearing before the entire Fifth Circuit, petition the U.S. Supreme Court to review the Fifth Circuit’s decision, or propose new rules. Without further action, however, the Rules will not come into effect as adopted.

Next Steps

The Fifth Circuit’s decision reflects a larger trend in federal court decisions curbing the regulatory authority of agencies. This decision, in combination with the Supreme Court’s recent decisions in Loper Bright (overruling the Chevron doctrine, which required courts to defer to federal agency expertise when rules are challenged) and Corner Post (expanding the statute of limitations for challenges to federal agency regulations), may lead to significant changes in how the SEC adopts new rules and will make existing rules more susceptible to legal challenges.

If you have any questions about the impact of the Fifth Circuit’s decision on your business’s current or future practices, please contact a member of Harter Secrest & Emery’s Securities and Capital Markets group.

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