Fifth Circuit Vacates Private Fund Adviser Rules

Yesterday, a three-judge panel of the United States Court of Appeals for the Fifth Circuit unanimously vacated the Private Fund Adviser Rules adopted by the Securities and Exchange Commission (which we previously summarized) in their entirety, holding that the SEC exceeded its statutory authority in adopting the PFA Rules in August of 2023. The case was brought against the SEC by a group of industry associations that represent the interests of fund managers and investment sponsors. It is possible that the SEC will seek rehearing en banc by the Fifth Circuit or petition the Supreme Court to review the decision, since the Fifth Circuit’s analysis appears to have implications on SEC rulemaking authority beyond the PFA Rules. Alternatively the SEC could seek emergency relief to delay implementations of the Fifth Circuit’s decision or abandon the PFA Rules and engage in new rulemaking in areas previously addressed by them (or otherwise); however, such new rules could be challenged, particularly if the SEC fails to provide an alternative theory for its rulemaking authority. The Commission may also choose to promulgate a new set of rules aimed at increasing transparency and fairness in the private fund markets, though given the Fifth Circuit’s rationale in the decision, any such re-proposed rules would likely be narrower in scope to assure more solid footing in the SEC’s statutory authority. Absent the grant of some form of emergency relief, once the Fifth Circuit’s decision formally takes effect, which is expected to occur before the first PFA Rules compliance date in September 2024, the PFA Rules and all compliance dates thereunder will have no force or effect.

We previously analyzed the now-vacated PFA Rules, including requirements addressing quarterly reporting, adviser-led secondaries, preferential treatment and restricted activities; and we previewed the annual audit requirement. If the Fifth Circuit decision takes effect, these compliance obligations will not come into force for private fund advisers, although some, such as an annual audit, are best practice and market expectations even though they will not be legally mandated for all investment advisors.

The SEC relied on section 206(4) of the Investment Advisers Act and section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, codified at section 211(h) of the Advisers Act, in adopting the PFA Rules. The Fifth Circuit examined whether Dodd-Frank expanded the SEC’s rulemaking authority to cover private fund advisers and investors under section 211(h) of the Advisers Act and whether section 206(4) authorized the SEC to adopt the PFA Rules, ultimately holding that neither granted the SEC such authority. The Fifth Circuit cited and considered other issues argued by the industry groups and the SEC, but ultimately did not use any of these grounds in making its final determination.

The Fifth Circuit’s decision emphasized the interplay between the Advisers Act and the Investment Company Act of 1940. By limiting the Investment Company Act’s coverage to registered investment companies, the Fifth Circuit concluded that Congress intentionally designed a statutory scheme to allow private funds to negotiate their own governance structures with investors, which preserved the “market-driven relationship between a private fund adviser, the fund, and outside investors.” Unlike registered investment companies, the Fifth Circuit reasoned, Congress intended for private funds to freely negotiate fund agreements with investors, including provisions regarding preferential terms for certain investors, access to financial reports and adviser fees.

In considering the SEC’s reliance on section 913 of Dodd-Frank and its argument that Congress deliberately used the word “investors” rather than “retail customers” in section 211(h) of the Advisers Act to capture private fund investors, the Fifth Circuit noted that the entirety of section 913 applies to “retail investors.” It then concluded that section 211(h) of the Advisers Act similarly covers only “retail customers” that invest in registered investment companies, and not private fund investors. Accordingly, the Fifth Circuit held that the SEC could not rely on section 211(h) of the Advisers Act as authorizing its adoption of the PFA Rules stating that section 211(h) has “nothing to do with private funds.”

The Fifth Circuit also rejected the SEC’s assertion that section 206(4) of the Advisers Act, which grants it authority to enact rules designed to prevent fraudulent acts, provided it with authority to adopt the PFA Rules, stating that the SEC failed (i) to identify with specificity the allegedly fraudulent acts or conduct that it was targeting and (ii) to articulate how the PFA Rules would address such fraud, each of which is required for the SEC to promulgate a rule based on section 206(4) of the Advisors Act. The Fifth Circuit further opined that Congress explicitly provided for certain disclosure and reporting requirements throughout the Advisers Act but it chose not to do so in section 206(4); therefore, section 206(4) does not authorize the SEC to adopt rules regarding disclosure and reporting. The Fifth Circuit also found the PFA Rules inconsistent with the frameworks Congress designed under the Investment Company Act and the Advisers Act, inasmuch as it intentionally excluded private funds from the strict restrictions on registered investment companies and allowed private funds to negotiate their internal governance structures with their investors under those laws.

The Fifth Circuit’s decision has been positively received by many in the industry who point to the over $592 billion in projected compliance costs associated with the PFA Rules mentioned in the Fifth Circuit’s decision as a drag on investor returns and potentially crippling for small investment advisers. Several institutional investor commentators have expressed concern that certain private fund markets, such as private equity and venture capital, lack sufficient transparency, and the Fifth Circuit’s decision may lead to an increase in perceived riskiness of those asset classes, particularly in a high interest rate environment that has seen a slowdown in exits and pressure on valuations. Additionally, the Fifth Circuit’s questioning of the legal basis used by the SEC in private fund enforcement, such as the opinion’s language regarding violations of limited partnership agreements by fund managers and the relation of those violations (or lack thereof) to the antifraud provisions of securities laws, may have ramifications on the SEC’s ability to bring enforcement actions in the future.

As of today, the SEC has not signaled how it intends to proceed in light of the Fifth Circuit’s decision, and stakeholders are watching for the agency’s next steps. Notwithstanding the Fifth Circuit’s holding that the SEC lacks authority to enact the PFA Rules, it is clear from the SEC’s arguments that its remains focused on providing private fund investors with transparency about their investments, and it is likely that the SEC will continue to emphasize disclosure adequacy in its actions and investigations. While many private fund advisers are expected to put comprehensive PFA Rules compliance efforts on hold, pending developments in the appeals process or other SEC rulemaking, it is possible that many aspects of the PFA Rules will continue to exist in the form of investor requests and negotiation points in the formation of private funds going forward. Private fund advisers or investors with questions or concerns about the Fifth Circuit’s decision should contact an attorney in our Fund Formation and Investment Management group.