US Court of Appeals vacates SEC private fund rules

31 July 2024 | Americas | Articles

The decision by the U.S. Court of Appeals for the Fifth Circuit to vacate the SEC’s Private Fund Adviser Rules has sent ripples through the investment advisory community. This ruling, issued in June 2024, has significant consequences for registered investment advisors and broker-dealers managing private funds.

The Fifth Circuit found that the SEC overstepped its statutory authority in implementing new rules aimed at regulating private funds. The rules, known collectively as the Private Fund Adviser Rules, were intended to enhance transparency and investor protection by imposing stringent reporting and compliance requirements on private fund advisers.

The court’s decision focused on Sections 211(h) and 206(4) of the Investment Advisers Act of 1940. According to the court, these sections don’t provide the SEC with the authority to regulate private funds in the manner proposed. The court also emphasized that the regulator’s interpretation was overly broad and that there was insufficient evidence of widespread misconduct to justify such extensive rulemaking.

The vacated rules included several critical components designed to increase oversight and accountability in private fund management:

1. Private Fund Audit Rule – Required annual audits for private funds.
2. Quarterly Statements Rule – Mandated quarterly statements detailing fees, expenses, and performance.
3. Restricted Activities Rule – Limited certain activities deemed risky or unfair.
4. Adviser-Led Secondaries Rule – Imposed conditions on secondary transactions led by advisers.
5. Preferential Treatment Rule – Restricted preferential terms for certain investors without disclosure to all investors.

The Fifth Circuit’s decision hinged on the interpretation of the SEC’s authority under the Investment Advisers Act, and ruled that:

• Section 211(h) applies to non-professional investors, i.e., retail customers, and not to private funds
• Section 206(4) allows the SEC to define and prevent fraudulent practices but does not grant the authority to impose broad regulatory requirements on private fund advisers without clear evidence of fraud.

The court also noted the lack of a close nexus between the Final Rule and the statutory goals, arguing that the regulator’s justification for the rules was based on vague assertions rather than concrete evidence of fraud.

Implications for RIAs and broker-dealers

• Compliance and reporting: With the vacatur of the rules, registered investment advisors (RIAs) and broker-dealers managing private funds are relieved from the burdensome compliance and reporting obligations. This allows for continued market-driven contractual relationships between sophisticated investors.
• Future SEC actions: The SEC might petition the Supreme Court for a review of the decision or propose new, narrower rules that align more closely with its statutory authority. Until then, private fund advisers should remain cautious.
• Market practices: Despite the vacatur, investor expectations for transparency and fairness are likely to persist. RIAs and broker-dealers should anticipate continued scrutiny from investors, and adapt their practices to maintain trust and competitive advantage.

The SEC has the option to seek arehearing in the Fifth Circuit or petition the Supreme Court . The decision to pursue these options may be influenced by the outcome of the upcoming presidential election, which could bring changes to the SEC’s leadership and regulatory priorities.

The Fifth Circuit’s ruling is a pivotal moment in the regulation of private funds, highlighting the limitations of the SEC’s rulemaking authority. While the decision vacates the new rules, it underscores the need for RIAs and broker-dealers to remain vigilant and responsive to the evolving regulatory landscape. Staying informed and prepared for potential new regulations or continued enforcement actions is essential for maintaining compliance and investor confidence.