On February 5, 2024, a three-judge panel of the US Court of Appeals for the Fifth Circuit heard oral arguments on the challenge to the “Private Funds Rules”1 issued by the Securities and Exchange Commission (the “SEC”). The panel consisted of Judges Leslie H. Southwick (a G.W. Bush appointee), Kurt D. Engelhardt (a Trump appointee), and Cory T. Wilson (a Trump appointee) (the “Panel”). A breakdown of the most significant arguments is provided below.
Highlights
- During argument by counsel for the SEC, much of the questioning focused on the SEC’s statutory authority under Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) (which added Section 211(h) of the Investment Advisers Act of 1940 [the “Advisers Act”]), particularly given Section 913’s primary focus on “retail customers” and the existence of a separate title of the Dodd-Frank Act focused on the regulation of private fund advisers.
- The Panel raised questions concerning the historically different treatment between registered funds and private funds under the Investment Company Act of 1940 (the “Investment Company Act”) and the extent to which the Private Funds Rules depart from that distinction.
- Some members of the Panel raised concerns regarding whether the SEC enforcement settlements cited in the adopting release were sufficient to justify a rulemaking that would have a significant impact on an industry as large as the private fund industry.
- Some members of the Panel also expressed concerns with vacating all of the parts of the Private Funds Rules, particularly the Private Fund Audit Rule and the Adviser-Led Secondaries Rule, which the Petitioners did not focus on in their briefs.
Takeaways
- The questioning during the oral argument suggests that some members of the Panel are skeptical of the SEC’s reliance on the rulemaking authority in Dodd-Frank Act Section 913/Section 211(h) of the Advisers Act.
- The questioning also suggests that some members of the Panel may find that there is insufficient factual basis to rely on the anti-fraud rulemaking authority under Section 206(4) of the Advisers Act. However, such a finding could either (i) call for the SEC to produce more evidence supporting the rules beyond the “few dozen” settlements of SEC enforcement actions (which may open the door for the SEC to cure the issues) or (ii) determine that evidence presented should not be considered “fraudulent conduct” (which may be more fatal to the rulemaking).
- The Panel may be reluctant to vacate the Private Funds Rules in their entirety, particularly the Private Fund Audit Rule and the Adviser-Led Secondaries Rule. If these are the only two Rules to survive, then exempt reporting advisers and other investment advisers that are not registered with the SEC would avoid the Private Funds Rules (since the Private Fund Audit Rule and Adviser-Led Secondaries Rule only apply to SEC-registered investment advisers).
- The Court’s opinion, when it is issued, should be analyzed not just for its direct effect on the Private Funds Rules but also for whether it raises questions about (i) prior SEC rulemakings under Advisers Act Section 206(4) that affected private fund advisers and their relationships with private fund investors and (ii) current SEC proposals under either or both of Section 211 or Section 206(4).
Next Steps
- The parties have requested a decision from the Court by May 31, 2024, but the Panel will determine the ultimate timing.
- A non-prevailing party can ask the Fifth Circuit to rehear the case “en banc” and/or can petition the Supreme Court to consider the case. Those decisions by the Fifth Circuit (whether to rehear en banc) and by the Supreme Court (whether to accept a petition to review the decision by the Panel or the en banc Fifth Circuit) are discretionary. Therefore, the timing of a resolution of the action remains highly uncertain.
- If the timing of ultimate decision stretches beyond the first compliance date in September 2024, the industry groups may request or the SEC may decide to stay the Private Funds Rules.
Full Summary of the Arguments in the Private Funds Rules Litigation
Speculation on Potential Shape of the Panel’s Decision
While one should not read too far into the Panel’s questioning, it does suggest that the Panel may be more likely to find that the SEC lacks the statutory authority under Dodd-Frank Act Section 913/Advisers Act Section 211 to promulgate rules governing the relationships between private fund advises and private fund investors.
It may also find that the Private Funds Rules cannot be promulgated under the anti-fraud rulemaking authority in Advisers Act Section 206(4). This finding could be based on a few different arguments. It could find that the “few dozen” SEC enforcement actions are not sufficient to support a rulemaking of this size (e.g., the prophylactic rulemaking cannot support sweeping up mostly conduct that is not violative of the Section 206 anti-fraud provisions, where the violative conduct is so rare). It could also find that the evidence cited by the SEC is not itself violative of Section 206(4) because it is not fraudulent, deceptive, and manipulative conduct (e.g., an imbalance of negotiating power between the private fund adviser and private fund investors or between private fund investors of different sizes and sophistication is not itself evidence of fraudulent conduct).
The Panel did seem less inclined to vacate all of the Private Funds Rules, which may make it more likely that the Private Fund Audit Rule and Adviser-Led Secondaries Rule survive. These Rules apply only to SEC-registered investment advisers, so that would mean that exempt reporting advisers and other investment advisers that are not registered with the SEC would avoid the Private Funds Rules if the other three rules are the only ones struck down (particularly, the Restricted Activities Rule and the Preferential Treatment Rule). This may be viewed as an odd result since the lack of focus by the Petitioners on these two Rules in their briefs likely reflects their level of importance rather than the idea that there is more evidence of fraudulent conduct to support the Private Fund Audit Rule and the Adviser-Led Secondaries Rule.
It would also be interesting to see if the Panel does not vacate all of the Rules, whether they treat any of the Preferential Treatment Rule, the Restricted Activities Rule and the Quarterly Statements Rule differently. For example, the basis of the decision could differentiate between the prohibitions section of the Preferential Treatment Rule (with respect to preferential information and redemption rights) and the disclosure section of the Preferential Treatment Rule (which merely requires disclosure of the preferential treatment). It could also distinguish between the Preferential Treatment Rule (which is more focused on the relationship between private fund advisers and private fund investors) and the Restricted Activities Rule (which is more focused on the relationship between the private fund adviser and the private fund itself).
Possible Side Effects
An opinion of the Court that limits the ability of the SEC to promulgate rules under Section 211 of the Advisers Act could affect other currently proposed rulemakings that claim to rely in part on the statutory authority in Section 211, including (i) the proposed Cybersecurity Rules,4 (ii) the proposed Outsourcing Rule,5 (iii) the proposed Privacy Rule amendments,6 (iv) the proposed Predictive Analytics Rule,7 and (v) the proposed ESG Rule.8 While none of these are only focused on private fund advisers, all of these rules would affect private fund advisers. For example, the Predictive Analytics Rule applies with respect to private fund investors as well as the adviser’s clients and relies primarily on Section 211(h) with respect to investment advisers.9
In addition, an opinion of the Court that limits the rulemaking authority of the SEC under Section 206(4) of the Advisers Act with respect to the relationship between a private fund adviser and private fund investors could also affect existing rules under the Advisers Act that directly regulate the relationship between a private fund adviser and a private fund investor, including (i) Rule 206(4)-8, which prohibits an investment adviser from engaging in fraudulent, deceptive, and manipulative conduct with respect to private fund investors; (ii) Rule 206(4)-1 (the “Marketing Rule”), which regulates marketing communications by a private fund adviser to private fund investors (or prospective investors); and (iii) Rule 206(4)-5 (the “Pay-to-Play Rule”), which includes prohibitions on investment advisers (and certain of their employees) concerning political contributions and certain other political activity with respect to government officials of state or local government entities that are investors in private funds.
[1] National Association of Private Fund Managers v. Securities and Exchange Commission, 5th Cir. No. 23-60471. The “Private Funds Rules” are Rule 206(4)-10 (the “Private Fund Audit Rule”), Rule 211(h)(1)-2 (the “Quarterly Statements Rule”), Rule 211(h)(2)-1 (the “Restricted Activities Rule”), Rule 211(h)(2)-2 (the “Adviser-Led Secondaries Rule”) and Rule 211(h)(2)-3 (the “Preferential Treatment Rule”). Please see Client Alert: “SEC Adopts Expansive (Albeit Slightly Softened) Private Funds Rules”.
[2] For purposes of this Summary, we typically refer to the Private Funds Rules as “Rule/Rules” to reflect the dispute over whether it is a single rule or separate rules.
[3] West Virginia v. EPA, 142 S. Ct. 2587 (2022).
[4] Cybersecurity Risk Management for Investment Advisers, Registered Investment Companies, and Business Development Companies, SEC Release Nos. 33-11028; 34-94197; IA-5956; IC-34497 (Feb. 9, 2022).
[5] Outsourcing by Investment Advisers, SEC Release Nos. IA-6176 (Oct. 26, 2022).
[6] Regulation S-P: Privacy of Consumer Financial Information and Safeguarding Customer Information, SEC Release Nos. 34-97141; IA-6262 (March 15, 2023).
[7] Conflicts of Interest Associated with the Use of Predicative Data Analytics by Broker-Dealers and Investment Advisers, SEC Release Nos. 34-97990; IA-6353 (July 26, 2023).
[8] Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices, SEC Release No. 33-11068; 34-94985; IA-6034; IC-34594 (May 25, 2022).
[9] See Release No. IA-6353 at fn. 288.
[View source.]