Advisories June 5, 2024

Investment Funds Advisory: Fifth Circuit Overturns SEC Private Funds Rules

Executive Summary
Minute Read

Our Investment Funds Team reviews the implications of the Fifth Circuit’s decision to vacate the Securities and Exchange Commission’s Private Funds Rules.

  • The rules would have expanded regulatory compliance requirements for private fund advisers
  • The court rejected the SEC’s argument that it had the statutory authority to issue the rules
  • Private funds sponsors can expect to keep business as usual, but the SEC is likely to appeal

The private funds industry received welcome news early today when the U.S. Court of Appeals for the Fifth Circuit overturned the Securities and Exchange Commission’s (SEC) Private Funds Rules, a sweeping set of proposed reforms designed to protect private fund investors by expanding the regulatory compliance requirements for private fund advisers, defined as investment advisers that advise entities that would be investment companies but for Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, commonly known as “private funds.”

The Private Funds Rules were one of many ambitious rule proposals by the SEC in recent years, affecting not just retail and individual investors, but increasingly sophisticated and institutional investors. The SEC stated its decision to adopt the Private Funds Rules was aimed at protecting the interests of Americans who have “indirect exposure to private funds through their participation in public and private pension plans, endowments, foundations, and certain other retirement plans” and at curtailing certain practices, including those arising out of conflicts of interest, that “have the potential to lead to investor harm.”

U.S. asset managers, financial services companies, and trade groups, including the American Investment Council, Managed Funds Association, and the National Association of Private Fund Managers, swiftly objected to the Private Funds Rules, claiming they “exceed the Commission’s statutory authority, were adopted without compliance with notice-and-comment requirements, and are otherwise arbitrary, capricious, an abuse of discretion, and contrary to law” and petitioned for the Fifth Circuit to vacate the SEC’s rules.

Today, the Fifth Circuit sided with the industry participants, agreeing that the SEC overstepped its authority.

Private Funds Rules

On August 23, 2023, the SEC voted 3–2 to adopt the Private Funds Rules under the Investment Advisers Act of 1940 as part of SEC Release No. IA-6383. The Private Funds Rules would have increased the regulation of private fund advisers and intensified the existing compliance rules for private fund investment advisers. It primarily affected SEC-registered advisers and exempt reporting advisers.

Promptly following the Private Funds Rules’ release, six trade associations filed a petition for review with the Fifth Circuit challenging the SEC’s statutory authority to adopt and enforce the rules.

Fifth Circuit Ruling

The petitioners representing six trade associations argued that, in promulgating the Private Funds Rules, the SEC exceeded its statutory authority provided by Congress. In response, the SEC asserted that it had authority to issue the Private Funds Rules pursuant to Sections 211(h) and 206(4) of the Advisers Act, but the Fifth Circuit rejected the SEC’s arguments. The Fifth Circuit vacated the SEC’s Private Funds Rules in their entirety, agreeing with the six trade associations that the SEC lacked authority to issue the Private Funds Rules.

Congress has vested the SEC with regulatory power under Section 206 of the Advisers Act and the Dodd–Frank Wall Street Reform and Consumer Protection Act. Section 206 of the Advisers Act provides that investment advisers cannot “employ any device, scheme, or artifice to defraud any client or prospective client,” nor can they “engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.” In Section 913 of the Dodd–Frank Act, Congress further provided the SEC with authority to require disclosures from investment advisers, granting the agency broad power to protect “retail investors,” nonprofessional investors who typically buy and sell securities through brokerage firms or retirement accounts like 401(k)s. The SEC attempted to use this broad authority under Dodd–Frank to impose the requirements under the Private Funds Rules, unsuccessfully arguing it properly promulgated the Private Funds Rules pursuant to its authority under Section 206(4) because the rules were reasonably designed to prevent fraud. The Fifth Circuit rejected this argument, finding that the SEC failed to explain how the Private Funds Rules would prevent fraud or whether it acted with the proper enabling authority under Dodd–Frank.

Dodd–Frank also gave the SEC Section 211(h) of the Advisers Act, which directs the SEC to “facilitate the provision of simple and clear disclosures to investors regarding the terms of their relationships with … investment advisers, including any material conflicts of interest,” and “where appropriate,” to “promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that the Commission deems contrary to the public interest and the protection of investors.” The SEC additionally argued that Section 211(h)’s use of the word “investors” included investors in private funds. The Fifth Circuit again disagreed with SEC because the provision of Dodd–Frank that added Section 211(h) to the Advisers Act solely concerned retail investors, and private funds are almost exclusively sold to “accredited investors.” Accordingly, the Fifth Circuit held that Section 211(h) did not provide the SEC with authority to issue the Private Funds Rules.

What’s Next?

We expect the SEC will petition the full Fifth Circuit to review the case during an en banc hearing, in which all judges of the Fifth Circuit participate in the decision. If the Fifth Circuit declines to hear the case en banc, the SEC will likely file a cert petition at the U.S. Supreme Court and ask the U.S. Supreme Court to review the Fifth Circuit’s decision.

As of now, and in the absence of the Fifth Circuit’s decision being overturned, private funds sponsors that have braced themselves in preparation for these sweeping reforms can return to business as usual. It remains to be seen whether investors will push for any of the changes the SEC had proposed during future negotiations with fund sponsors or whether the industry will largely remain unchanged. The Alston & Bird Private Funds Group will remain on top of the trends and prepared to guide clients in navigating the market’s response to the Fifth Circuit’s decision. 

You can subscribe to future advisories and other Alston & Bird publications by completing our publications subscription form. If you have any questions, or would like additional information, please contact one of the attorneys on our Investment Funds Team.

Media Contact
Alex Wolfe
Communications Director

This website uses cookies to improve functionality and performance. For more information, see our Privacy Statement. Additional details for California consumers can be found here.