U.S. Circuit Court of Appeals Overturns SEC's New Rules Targeting Private Funds
2024-09-24 22:20:06
On June 5, 2024, the U.S. Court of Appeals for the Fifth Circuit ruled to overturn the U.S. Securities and Exchange Commission's ("SEC") new rules ("the Rules") targeting private fund advisers. The Rules, adopted by the SEC on August 23, 2023, primarily required hedge funds and private equity firms to provide investors with detailed quarterly disclosures of fees and expenses. The Fifth Circuit's unanimous decision held that the SEC exceeded its authority in promulgating the Rules.
When adopting the Rules, the SEC stated that they aimed to increase transparency for investors regarding the conduct of private fund advisers managing third-party investments. In addition to mandating fee disclosures, the Rules imposed new obligations on private fund managers, such as requiring private fund audits, ensuring equal treatment for all investors regardless of investment size, and prohibiting firms from allowing certain preferred investors easier access to liquidity than others. The SEC argued that its goal was to standardize the information private funds provide to investors. Many private fund industry participants opposed the Rules, arguing that they unnecessarily and significantly increased compliance obligations and costs for private fund advisers.
The SEC based its authority to promulgate the Rules on Sections 206(4) and 211(h) of the Investment Advisers Act of 1940 ("Advisers Act"). The Fifth Circuit found that Section 211(h) of the Advisers Act did not expand the SEC's authority to regulate the relationship between private fund advisers, their private funds, and third-party investors to the extent the SEC claimed. Additionally, the Fifth Circuit ruled that the SEC's reliance on the anti-fraud provisions of Section 206(4) of the Advisers Act to adopt the Rules was a "pretext," and the SEC failed to articulate a "reasonable connection" between fraud and any part of the Rules adopted. The Fifth Circuit also rejected the SEC's argument that the Rules were necessary to prevent fraud, ruling that the SEC conflated a lack of disclosure with fraud. For these reasons, the Fifth Circuit concluded that the SEC "exceeded its statutory authority" in adopting the Rules, and because the entire rulemaking process was unauthorized, "no part of the Rules can stand." As a result, the Fifth Circuit vacated the Rules in their entirety.
The Fifth Circuit's decision is a significant victory for private fund advisers and the private fund industry. Furthermore, the Fifth Circuit's interpretation of the scope of Section 206(4) could impact other rules the SEC has previously adopted under Section 206(4) and may limit the SEC's ability to take certain regulatory actions in the future.
The SEC stated in a release that it is reviewing the decision and will "determine next steps as appropriate." It remains unclear whether the SEC will request a rehearing by the Fifth Circuit or appeal to the U.S. Supreme Court.