Taking Stock of the Private Funds Rules Litigation After Oral Arguments at the Fifth Circuit

Industry Groups’ Briefs: Standing is “self-evident” because NAPFM is a non-profit headquartered in Texas and represents private fund advisers with more than $600 billion in AUM. In addition, the Secretary of NPAFM is also an officer of a private fund adviser that is headquartered in Texas.

SEC’s Brief: NAPFM’s “terse” claim of standing is insufficient, and without NAPFM, the appropriate circuit would be the D.C. Circuit.

Oral Argument: Not directly raised by the Panel.

Industry Groups’ Briefs: It’s a single Rule (because Commissioner Crenshaw referred to it as a single Rule). (Note: The other Commissioners swap between “rule” and “rules” in their statements on the adopting of the Rule/Rules, except Commissioner Uyeda who uses “rules.”)

SEC’s Brief: There are five separate Rules, and the petitioners only address three of the Rules. The court should sever and not vacate all of the Rules, since each is distinct and vacating one does not affect the others.

Oral Argument: The Panel raised questions to the Petitioners that—since their Briefs focused only on three parts of the Rule/Rules, why should the Panel should vacate the other two parts of the Rule/Rules (i.e., the Private Fund Audit Rule and the Adviser-Led Secondaries Rule)? The Panel raised concerns about vacating parts of the Rule/Rules that are not specifically being challenged.

The Petitioners argue that the statutory authority argument (see below) applies to all of the parts of the Rule/Rules. However, the Petitioners concede that if not vacated based on statutory authority (and instead relying on rulemaking being arbitrary and capricious), then the Panel should only vacate certain provisions.

Industry Groups’ Briefs: The Investment Company Act is clearly designed to exclude private funds from regulation like registered funds. The SEC is attempting to regulate private funds through private fund advisers.

SEC’s Brief: The SEC is regulating private fund advisers (not private funds), which it is authorized to do under the Dodd-Frank Act and the Advisers Act generally.

Oral Argument: The Panel raised questions to the SEC on the history of the Investment Company Act, distinguishing between the regulation of registered funds and the absence of regulation of private funds. The Panel stated that there appeared to be a “bright” dividing line between registered funds and private funds. The Panel also seemed to believe that the Rule/Rules are the SEC’s first attempt to regulate investment advisers to private funds.

The SEC argued that private funds would continue to be regulated very differently from registered funds (e.g., re: public filings, independent board directors, etc.). The SEC also noted that it is seeking to regulate private fund advisers and not private funds.

Industry Groups’ Briefs: Goldstein prevents treating private fund investors as “clients” and subjecting the relationship between the private fund adviser and the private fund investors to the protections of the Advisers Act.

The Rule/Rules impose de facto duties between the adviser and investors and there are not such duties under federal law.

SEC’s Brief: The SEC is not relying on a statute that uses the term “client” nor converting “clients” into “investors,” and Goldstein is no longer relevant since Congress abolished the statute to which it was related (i.e., old Section 203(b)(3)).

Oral Argument: Not directly raised by the Panel.

Industry Groups’ Briefs: Congress sought to regulate private fund advisers in Title IV of the Dodd-Frank Act but the Rule/Rules are based on Title IX (Section 913).

Section 913 of the Dodd-Frank Act (which adopted Section 211(g) and (h) of the Advisers Act) applies only to (i) “retail customers” and not private funds (statutory intent) and (ii) advisory relationships and not relationships between private fund advisers and private fund investors (plain language).

“Customer” to “investor” switch because it was moving to stage of the relationship prior to the investor becoming a customer.

SEC’s Brief: Section 211(h) uses the word “investors” without limitation (plain language).

Other sections of Section 913 carefully use the word “retail customers,” and Section 913(g)(2) switched to the word “investors” (which typically is not limited to retail investors).

Section 211(h) is applicable to all investment advisers, so it would not make sense to include in Title IV (which was only applicable to private fund advisers).

Oral Argument: The Panel raised questions as to why rule making on private fund advisers was not in Title concerning private fund advisers and whether context of the rest of Title IX related to private fund advisers. The Panel also asked if Section 913 provided the SEC with new rulemaking authority that it did not have before (that go beyond Section 206(4)). The Panel also asked if the reference to this “subsection” in the Section 913 rulemaking authority grant should be read in context of the other provisions of Section 913 that focused on retail customers. The Panel finally asked if the SEC is seeking to rely on both Section 913 and Section 206(4).

The SEC argued that the context should be the Advisers Act (i.e., Section 211) to which the rulemaking authority was granted and not the other provisions in Section 913 (which were amendments to other federal securities laws). To this point, it noted that the rulemaking authority was referencing the subsection of the Advisers Act and not Section 913 of the Dodd-Frank Act. The SEC noted that the fact that the other sections use the term “retail customers” but only 913(g)(2) uses “investor” suggests that the change in terminology was intentional. The SEC confirmed that it believes it also has authority under Section 206(4) (discussed below).

Industry Groups’ Briefs: The SEC cannot rely on Section 206(4) as the statutory basis for the rules because (i) the SEC failed to define the allegedly fraudulent acts or explain how the rules would prevent those undefined acts and (ii) the rules are not reasonably designed to prevent fraud, deception or manipulation.

The SEC does not explain why Congress would adopt Section 211(h) if the SEC already had the authority under Section 206(4).

An investment adviser’s duty to disclose under Section 206(4) is only to its “clients” and not to investors in private funds.

The SEC fails to explain how the Rule/Rules prevent fraud, and the cited examples are very small when considering the breadth of the rulemaking effects.

SEC’s Brief: Section 206(4) grants prophylactic rulemaking authority (i.e., reasonably designed to prevent fraud from happening).

The SEC described problems to justify the prophylactic rule, including past enforcement actions, and provided detailed discussion of the fraudulent conduct targeted by the rules.

Rule/Rules are reasonably designed even if they capture legitimate practices, and sophisticated investors also need protection.

Oral Argument: The Panel seemed focused on factual basis for the alleged fraudulent conduct (discussed further below).

Industry Groups’ Briefs: The SEC lacks the authority under the Major-Questions Doctrine. The SEC is claiming “enormous” authority (which go beyond what the Rule/Rules are currently doing) and, even if the current Rule/Rules do not show it completely, the SEC’s claimed “plenary” authority would allow it to regulate private funds like registered funds.

The Rule/Rules impose de facto duties between the adviser and investors and there are not such duties under federal law.

SEC’s Brief: Dodd-Frank Act significant expanded the SEC’s authority in Sections 211(h) and 206(4).

Rule/Rules are consistent with existing SEC regulations for disclosures and regulation of conflicts of interest.

Oral Argument: Not directly raised by the Panel.

Industry Groups’ Briefs: The SEC failed to provide the public meaningful opportunity to comment because (i) the public did not have opportunity to comment on the new disclosure and consent exceptions in the Restricted Activities Rule (Rule 211(h)(2)-1) (which were not a “logical outgrowth of a prohibition regime”) and (ii) the public did not have opportunity to comment on an “illiquid fund” providing performance on levered basis (and not just unlevered basis) in the Quarterly Statements Rule (Rule 211(h)(1)-2). Asking a single “stray” question does not provide a meaningful opportunity to comment.

The Rule/Rules impose de facto duties between the adviser and investors and there are not such duties under federal law.

SEC’s Brief: The SEC provided meaningful opportunity to comment, received hundreds of comments and revised the proposed rules in response.

“Disclosure and consent” exemptions and quarterly-statement rule examples are “logical outgrowth” since raised as a question in the proposal.

Oral Argument: Not directly raised by the Panel, other than to note it would only support vacating certain parts of the Rule/Rules.

Industry Groups’ Briefs: There is no factual basis for the Rule/Rules because (i) there are too few examples of alleged wrongdoing, (ii) most examples of alleged wrongdoing were based on settlements of administrative proceedings (so they technically were still just allegations, and the proceeding may have been unconstitutional), (iii) one example seems to cite to a settlement that only indirectly supported the SEC’s claim, (iv) some of the rules that apply only to registered advisers discussed examples of actions taken by unregistered advisers, and (v) there is other evidence that shows that investors have more bargaining power than the SEC seems to think.

SEC’s Brief: The SEC based its rulemaking on (i) information collected from private fund advisers (e.g., Form PF), (ii) exams of private fund advisers, (iii) enforcement actions against private fund advisers, (iv) comments from private fund investors, (v) academic literature, and (vi) pension plan documents.

The “few dozen examples of alleged wrongdoing” cited by the petitioners is “significant evidence” but also only part of the evidentiary record. Settled actions are relevant because they set forth the SEC’s findings.

Focusing on only the largest and most sophisticated investors ignores the smaller investors investing in private funds.

Oral Argument: The Panel raised a question of how to consider a few dozen examples of wrongdoing when considering the regulation of a very large industry and asked what analogous cases they consider. The Panel also asked if all of the examples were settlements. The Panel raised a question of whether there was any market failure given the success of the private fund industry and a question of what evidence there is of a problem.

The SEC first argued against a hard and fast number that would be required to substantiate a rulemaking. However, it re-iterated that while the SEC enforcement settlements are a part of the evidentiary record (and are valid evidence since they set forth the SEC’s findings), the SEC also relied on a wider range of evidence, including Form PF and other filings, information from SEC examinations, and input and comment letters from private fund investors. The SEC cited cases in the Pay-to-Play space, including Wagner v. FEC and Blunt v. SEC. The SEC also argued that the success in the private fund industry has not been “equal” among all participants and that a “rising tide doesn’t lift all boats equally.” The SEC also argued that the Panel should consider the circumstances of a smaller pension plan investor who has its own fiduciary obligations but is operating without clear information on fees and expenses and on performance and is being disadvantaged with respect to information and redemption rights for larger institutional investors.

Industry Groups’ Briefs: The following provisions are unnecessary and unduly burdensome: (i) restrictions on side arrangements and “preferential treatment” in the Preferential Treatment Rule, (ii) restrictions on passing through expenses (e.g., investigation expenses and regulatory and compliance expenses) in the Restricted Activities Rule, and (iii) a one-size-fits-all requirement of the Quarterly Statements Rule.

SEC’s Brief: The SEC reasonably designed its decisions to adopt each of the preferential treatment rule, the disclosure and consent requirements for expenses, and quarterly reporting requirements.

Oral Argument: Not directly raised by the Panel.

Industry Groups’ Briefs: The SEC failed to adequately consider the impact on efficiency, competition, and capital formation and failed to make the required finding on its impact.

The Rule/Rules impose de facto duties between the adviser and investors and there are not such duties under federal law.

SEC’s Brief: The SEC reasonably considered the Rule’s/Rules’ likely economic effects.

Oral Argument: Not directly raised by the Panel.

Industry Groups’ Briefs: Discussion in Adopting Release on limitations of liability (and disclosure relating to hedge clauses) and charging fees for “unperformed services” is arbitrary and capricious.

SEC’s Brief: The SEC is allowed to provide interpretations of the federal fiduciary duty (not talking about state duties).

Oral Argument: Not directly raised by the Panel.