Go-To Guide:

• The 5th Circuit Court of Appeals determined that the SEC “exceeded its statutory authority” in adopting the rules and sided with the industry groups that argued the rules were not necessary for “highly sophisticated” private fund investors.
• In rejecting the SEC’s argument that it had the authority to adopt these rules under sections 206(4) and 211(h) of the Advisers Act, the court determined that section 211(h) only applies to retail customers, that the rules’ anti-fraud measures under section 206(4) were merely “pretextual,” and that the SEC failed to articulate a “rational connection” between fraud and any part of the final rules.

On June 5, 2024, the U.S. Court of Appeals for the Fifth Circuit unanimously vacated a rule the Securities and Exchange Commission (SEC) enacted in August 2023 that was intended to protect investors who invest in certain private funds (e.g., hedge funds, private equity funds, and venture capital funds advised by registered or exempt reporting advisers) (Private Funds) and prevent fraud by the investment advisers to Private Funds. The Private Funds rule significantly expanded regulation of Private Funds managed by such investment advisers and was estimated to cost $5.4 billion and require millions of hours of employee time. The Private Funds rule, which a group of associations representing the Private Funds industry promptly challenged, would have imposed extensive new restrictions and disclosure requirements on investment advisers to Private Funds regarding their fees, expenses, performance, conflicts of interest and preferential treatment of certain investors.

The industry associations argued that Congress drew a “sharp line” between Private Funds and funds that serve retail customers, given that the Investment Company Act of 1940 (ICA) already extensively regulates registered investment companies (e.g., mutual funds, ETFs, and other publicly available pooled investment vehicles) and is aimed at protecting retail investors rather than investors in Private Funds, which operate in a manner exempt from the ICA and typically only are available to sophisticated investors.

The court agreed with the industry associations, concluding that the SEC exceeded its statutory rulemaking authority under sections 206(4) and 211(h) of the Investment Advisers Act of 1940 (Advisers Act) and Title IX of the Dodd-Frank Act of 2010 (Dodd-Frank Act).

The court reasoned that the Advisers Act and the ICA are “sister statutes” and should be interpreted harmoniously. Given the ICA’s significant regulation of registered investment companies and its imposition of measures designed to protect investors, the court agreed that Congress “clearly chose not to impose the same prescriptive framework on private funds.” Additionally, the court concluded that the Private Funds rule’s “anti-fraud” measure was merely “pretextual,” and that the SEC failed to articulate a “rational connection” between fraud and any part of the Private Funds rule. The court also considered the statutory construction of Title IX of the Dodd-Frank Act and the context in which it was enacted to determine whether Congress intended to grant the SEC broad rulemaking authority over private investors. It found the industry associations’ interpretation persuasive, holding that section 211(h) applies only to retail customers and could not be relied upon to regulate Private Fund advisers and their investors.

The SEC stated that it is reviewing the decision and would determine the next appropriate steps.

Investment advisers to Private Funds, managing trillions in assets, including the assets and investments by pensions, endowments, and wealthy individuals, in many cases already are mandated to register with, or at least report to, the SEC, subjecting them to regulatory oversight and requirements. However, the industry objected to the additional costs and burdens of the Private Funds rule, which included quarterly disclosures about fees and expenses and more uniformity to the information provided to investors. While the ruling drew criticism from advocates of greater transparency in financial markets, it could pave the way for further legal challenges from the Private Funds industry, which has long believed that the SEC has sought to expand its authority beyond that intended by Congress. Notwithstanding the Fifth Circuit’s ruling, a question remains whether industry groups will be as successful challenging similar regulations in this or other courts.