On June 5, the US Court of Appeals for the Fifth Circuit vacated a US Securities and Exchange Commission (SEC) Rule designed to provide investors in private funds — such as private equity, private credit, hedge funds, venture capital, and real estate — more information about fund fees and expenses, limit certain expenses that could be passed through to investors, and restrict preferential treatment of fund investors.

Compliance requirements were set to take effect in September 2024. However, now that the Rule has been struck down in federal court, private funds need not comply unless the Fifth Circuit decision is overturned. As of now, it is unclear what action, if any, the SEC will take following the Fifth Circuit’s ruling, an enormous win for private fund sponsors that would have otherwise expended significant resources preparing to comply with the obligations required by the Rule.

Overview of Vacated Rule

In August 2023, the SEC adopted the Rule by 3-2 vote. The Rule would have had significant effects on the private fund industry. Private Fund Advisors; Documentation of Registered Investment Adviser Compliance Reviews, 88 Fed. Reg. 63206 (Aug. 23, 2023). A group of trade associations challenged the Rule in the US Court of Appeals for the Fifth Circuit, arguing that, among other deficiencies, the SEC lacked statutory authority to promulgate the Rule and there was no factual basis for the key provision of the Rule, making the Rule arbitrary, capricious, and otherwise unlawful under the Administrative Procedure Act.

Fifth Circuit’s Decision

Last week, the Fifth Circuit agreed and vacated the Rule in a 3-0 decision. The SEC argued that it had authority to promulgate the Rule under Sections 211(h) and 206(4) of the Investment Advisers Act of 1940 . The Fifth Circuit determined that, in private funds, it is “the fund itself” that is the client, not the individual investors in the fund. Further, the Fifth Circuit held that the term “investor” as used in Section 211(h) of the Advisers Act is limited to “retail customers,” so Section 211(h) did not provide statutory authority for the Rule. Therefore, the Fifth Circuit held that Section 206(4) of the Advisers Act, which enables the SEC to define and prescribe means to prevent fraudulent, deceptive, or manipulative acts by investment advisors, did not provide statutory authority for the Rule because the SEC did not articulate a rational connection between the Rule and preventing fraud. The Fifth Circuit likewise held that the Advisers Act did not authorize the SEC to require the disclosures mandated by the Rule.

Industry Reactions

The Rule was highly criticized by industry groups before its enactment due to the significant expenditures required for private fund sponsors to comply with its obligations. In particular, the ongoing compliance requirements, including “quarterly statements” and “preferential treatment” disclosures, posed a substantial burden to operating a private fund efficiently.

Meanwhile, private fund investors are critical of the Fifth Circuit’s decision. In a statement from the Institutional Limited Partners Association, a professional organization representing nearly 600 institutions that hold more than $2 trillion private equity assets under management, its CEO stated that the decision to vacate the Rule poses “actual and meaningful risks” related to lack of transparency, conflicts of interest, and internal governance mechanisms designed to protect the capital of public employees often invested in such funds. The statement further expressed concern that the Fifth Circuit’s decision may jeopardize the SEC’s authority to regulate the private fund industry.

Implications

Indeed, the Fifth Circuit’s decision potentially provides industry groups ammunition to challenge other rules and proposed rules promulgated under Sections 206(4) and 211(h) of the Advisers Act.

The SEC has not yet indicated whether it will challenge the panel’s decision through a request for rehearing en banc before the Fifth Circuit and or whether it will file a petition for certiorari with the US Supreme Court. Meanwhile, the Rule’s compliance deadlines, which were set to begin in September 2024, have been vacated along with the rest of the Rule. 

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Gurpartap (Gio) Singh also contributed to this article.