Fifth Circuit Vacates the Private Funds Rules And Constrains the SEC’s Rulemaking Authority

Yesterday, a three-judge panel of the U.S. Court of Appeals for the Fifth Circuit vacated the “Private Funds Rules,”¹ which the Securities and Exchange Commission (the “SEC”) adopted on August 23, 2023. The opinion of the Court (the “Opinion”) holds that the SEC lacked the rulemaking authority to issue these Rules under both Section 211(h) and Section 206(4) of the Investment Advisers Act of 1940 (the “Advisers Act”). As a result, the Opinion orders the Rules vacated. Once the Fifth Circuit decision formally takes effect—which should occur before the first compliance date, unless the SEC obtains some form of emergency relief or reconsideration—the Rules will be a nullity and all compliance dates will be moot. The SEC can seek further review of the Opinion, but review is not automatic: either the full Fifth Circuit or the Supreme Court would have to exercise discretion to hear the case.

As expected, the Fifth Circuit ruled that the SEC’s rulemaking authority under Section 211(h) of the Advisers Act is limited to “retail customers” and cannot be used in a rulemaking aimed at private funds and private fund investors. However, the Court also ruled that the SEC lacked rulemaking authority under Section 206(4) of the Advisers Act because (i) the SEC failed to define the “fraud” it was seeking to prevent and there were an insufficient number of enforcement actions to support the necessity of the rulemaking, (ii) Section 206(4) of the Advisers Act does not permit rulemaking concerning disclosures or reporting, (iii) Section 206(4) does not authorize the SEC to issue rulemakings that seeks to regulate the “internal corporate governance” of private funds (including with respect to investor reporting, fees and expenses, and redemption rights), and (iv) Section 206(4) only covers relationships with “clients” (e.g., the private funds) and not with the investors in private funds.

The SEC has a range of options in terms of next steps, none of which are likely to result in the Rules becoming effective in the near future. The SEC could theoretically propose new rules or re-open the existing rulemaking, which would likely be subject to a renewed challenge. The Opinion’s analysis, particularly with respect to Section 206(4), has potential ramifications beyond the Rules to a range of other current and future rulemaking. Thus, it appears more likely that the SEC would seek an “en banc” rehearing by the full Fifth Circuit (in a petition that would be due July 22, 2024) or skip that step and petition the Supreme Court to review the case.

The Fifth Circuit’s decision takes effect when the Fifth Circuit issues a formal order called a “mandate” to the SEC, which would ordinarily occur shortly after the time to seek rehearing expires (or shortly after rehearing is denied, if sought). Once that happens, the Private Fund Rules will be vacated, and all of the compliance dates from that point forward will no longer be effective. Although it is likely that the mandate will issue and the Rules will be vacated before the first compliance date, that is not guaranteed: for example, the SEC could seek emergency relief that delays the implementation of the Fifth Circuit’s decision and allows the Rules to take effect.

Analysis of the Opinion

First, the Opinion treats the “Private Funds Rules” as a single Rule, despite there being five separately numbered rules. This was a position taken by the Petitioners and disputed by the SEC; however, the Opinion does not elaborate on why the Court adopted the Petitioners’ position.²

Second, the Opinion finds that the SEC’s rulemaking authority under Section 211(h) of the Advisers Act (as added by Dodd-Frank Act Section 913) is limited to rulemaking with respect to “retail customers.” This position was based on the statutory context of Dodd-Frank Act Section 913, which is primarily focused on such “retail customers.” This limitation could have an impact on other rulemakings relying on Section 211(h) to cover investment advisers more broadly, including the controversial proposed rule regarding the use of artificial intelligence and predictive analytics by investment advisers, which already seemed likely to be re-proposed rather than adopted.³

Finally, and most importantly, the Opinion finds that the SEC also lacks the rulemaking authority under Section 206(4) of the Advisers Act, which is the anti-fraud rulemaking authority that is the basis for the majority of rules adopted under the Advisers Act.

Lack of Factual Basis. In the Opinion, the Court found that the SEC reliance on its anti-fraud authority was “pretextual” and that the SEC failed to define the “fraud” that it seeks to prevent. The Opinion states that “[c]omplying with the ‘fund’s governing agreements’ is not fraud, nor is disagreement over ‘discretionary violations.’” The first part suggests that there cannot be fraud if the investment adviser is merely complying with an agreement negotiated between two sophisticated parties. The second part is harder to parse in our preliminary analysis since the Opinion does not provide a citation for the phrase “discretionary violations,” which does not appear in the briefs of either of the parties.
Section 206(4) Cannot Be Used for Disclosure and Reporting. The Court ruled that the SEC cannot use Section 206(4) to require disclosure and reporting and that such rulemaking authority only exists in certain sections of the Advisers Act, specifically, the sections the SEC has used to promulgate Form ADV and Form PF along with Section 211(h), which, as noted above, the Opinion would limit to disclosure and reporting with respect to “retail customers.” The Opinion does not address the fact that a number of existing rules impose disclosure and reporting requirements, including, among others, Rule 206(4)-1 (the Marketing Rule) and Rule 206(4)-8 (the Pooled Investment Vehicle Anti-Fraud Rule). It also represents an unexpected revision to the historical debate about whether Section 206(4) should only be used for disclosure-based rulemaking.
Congressional Intent to Not Regulate Private Fund Internal Governance. The Opinion states that the Private Funds Rules do not “fit within the statutory design,” which sought to exempt private funds from the requirements of the Investment Company Act of 1940, because of the statutory exemptions for private funds in Section 3(c)(1) and 3(c)(7) of the Investment Company Act. Specifically, the Court found that the SEC cannot issue rules that affect the “internal governance structure” of private funds, with a particular focus on terms concerning investor reporting, fees and expenses, and redemptions that are set forth in the private fund governing documents.
No Advisers Act Duty of Disclosure to Fund Investors. In the Opinion, the Court found that the SEC does not have the rulemaking authority with respect to disclosures to private fund investors because there can be no “fraud” where there is no duty to disclose. The Opinion states that such duty to disclose under the Advisers Act applies only to “clients” (e.g., the funds themselves) and not to investors in the funds. The Opinion does not reconcile this position with Rule 206(4)-8, which imposes a duty of disclosure (and anti-fraud provisions) on private fund advisers in communications with private fund investors, as well as other disclosure requirements under the federal securities laws (most notably, Rule 10b-5 under the Securities Exchange Act of 1934).

Next Steps

While the Opinion represents a significant point in the challenge of the Private Funds Rules, it is unlikely to be the end of the line. The SEC can ask the Fifth Circuit to rehear the case “en banc” and/or can ask the Solicitor General to 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.

The timing of a resolution of the action remains highly uncertain. As a practical matter, it seems much more likely that the SEC will seek to petition the Supreme Court (rather than first seek the Fifth Circuit’s en banc review) in order to resolve the issue in a more timely manner. If that is the course the SEC takes, any Supreme Court petition would be due in September of this year, and the Supreme Court would likely announce whether it would grant the petition to review the Opinion by the first quarter of 2025. If the Supreme Court did accept review, it would likely issue a decision by June 2025. If, however, the SEC petitions the full Fifth Circuit for rehearing in July, this entire timeline would move back. If a new Administration takes office in January 2025, it could potentially abandon any effort to seek Supreme Court review, at least if the Court has not already decided to hear the issue.

As noted above, once the Fifth Circuit formally issues its decision (the “mandate”), the Private Fund Rules will be vacated in their entirety and all of the compliance dates will no longer be effective. If the SEC does not petition the Fifth Circuit for rehearing and does not obtain some emergency relief from the Fifth Circuit or Supreme Court, then the Rules should be vacated well in advance of the September compliance dates—even if the SEC later asks the Supreme Court to reinstate them.

^[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,” available at https://www.goodwinlaw.com/en/insights/publications/2023/08/alerts-finance-pif-sec-adopts-private-funds-rules.
^[2] For additional information on the positions taken by the parties in this litigation, please our other Client Alerts on the litigation: Client Alert: Key Questions for the Upcoming Private Funds Rules Fifth Circuit Decision (May 21, 2024), Client Alert: Taking Stock of the Private Funds Rules Litigation After Oral Arguments at the Fifth Circuit (Feb. 7, 2024) and Client Alert: Reviewing the Industry Groups’ Opening Brief Challenging the Private Funds Rules (Nov. 6, 2023).”
^[3] Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers, SEC Release Nos. 34-97990; IA-6353 (July 26, 2023).

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