In a victory for the private funds industry, the United States Court of Appeals for the Fifth Circuit vacated the SEC’s recently adopted Private Fund Adviser Rule on June 5, 2024. In other words, the controversial rule, which would have subjected the private funds industry to unprecedented levels of federal regulation, is—at least for now—gone.

As explained in our prior client alert, the Private Fund Adviser Rule would have, among other things: prohibited private fund advisers from engaging in certain restricted activities, such as using fund assets to pay for defense costs of government investigations of the adviser, without disclosure to and, in some circumstances, consent from investors; prohibited private fund advisers from offering preferential treatment and information to investors via side agreements; required private fund advisers to obtain fairness and valuation opinions before engaging in adviser-led secondary transactions; and required private fund advisers to issue new quarterly reports to investors on fees, expenses, and performance.

Takeaways

We think that firms can adopt a wait-and-see approach on compliance with the rule. We don’t suggest abandoning efforts towards compliance because the SEC likely will continue the legal fight to salvage the rule, and if successful, the rule or aspects of it could be back in force.

In the short term, private fund advisers shouldn’t be surprised if they feel aftershocks from the attempted rule. As explained below, the rule was vacated on statutory grounds, not because of a change in sentiment from the SEC. The SEC could pursue the aims of the rule through exams and enforcement, to the extent that the SEC already has its regulatory hooks into a private fund. In addition, investors may seek some of the benefits the rule would have provided through negotiations with private fund managers.

What happened?

A coalition of groups representing the private funds industry petitioned for review of the rule, claiming that the SEC exceeded its authority and did not follow appropriate procedural steps in promulgating the rule. The industry won. A three-judge panel of the Fifth Circuit held that the SEC, a federal regulatory agency whose power is prescribed by statute, lacked the statutory authority to adopt the rule. The SEC had invoked a section of the Dodd-Frank Act concerning protection of retail investors and the antifraud provisions of the Investment Advisers Act as authority to promulgate the rule. The Fifth Circuit disagreed that these statutory provisions authorized the SEC to undertake the rulemaking. With respect to the antifraud provisions, the court held that they did not justify the rule because the rule was not directed at preventing fraud, despite its general investor protection aims. And the court rejected the SEC’s reliance on a section of Dodd-Frank that prescribed protections for retail investors. In the court’s view, this section had “nothing to do with private funds.”

To many in the industry, the Fifth Circuit’s decision is not a surprise. The bases for the court’s ruling were known vulnerabilities of the rule (see here for SEC Commissioner Hester Pierce’s views) and perhaps reflected a calculated but ultimately unsuccessful risk the SEC was willing to take to extend its regulatory authority over the private funds industry.

What’s next?

The ball’s in the SEC’s court. The SEC immediately could seek rehearing by all of the judges on the Fifth Circuit and, depending on the outcome of that effort, could seek review in the United States Supreme Court. The SEC could choose to abandon the rule and focus resources elsewhere. Or the SEC could start over and pursue a modified version of the rule, relying on different statutory authority.