Federal Appeals Court Strikes Down SEC Private Fund Adviser Rule, Citing Overreach

A federal appeals court has struck down the Securities and Exchange Commission’s (SEC) private fund adviser rule, siding with industry advocates who argued that the agency exceeded its authority.

The U.S. Court of Appeals for the Fifth Circuit released a unanimous decision on Wednesday, vacating the rule based on the court’s interpretation of provisions meant to protect “retail” investors under the Investment Advisers Act and the Dodd-Frank Act.

The SEC contended that these provisions applied to all investors, thereby granting it the authority to regulate private funds. Traditionally, private funds owned by sophisticated investors have been exempt from the regulations that govern funds owned by retail investors. However, the court determined that Congress must explicitly grant the SEC the authority to regulate private funds.

“The private fund managers’ interpretation of the statute is persuasive. We therefore hold that Section 211(h) applies to ‘retail customers,’ and thus, the commission exceeded its statutory authority in relying on that section to adopt the final rule,” the court wrote, referring to the Investment Advisers Act.

The SEC had passed the rule in August by a 3-2 vote. The rule aimed to address several issues the agency identified within the private fund industry, such as perceived conflicts of interest by private fund advisers due to certain fees, expenses, and preferential treatment given to some investors via side letters. It also sought to require private fund advisers to provide quarterly statements on fund performance, fees, and expenses, audit all private funds annually, among other provisions.

The lawsuit against the rule was brought by several groups, including the National Association of Private Fund Managers, Alternative Investment Management Association (AIMA), American Investment Council (AIC), Loan Syndications and Trading Association, Managed Funds Association, and National Venture Capital Association.

AIMA Chief Executive Jack Inglis expressed satisfaction with the court’s decision, stating, “We are very pleased by the court’s ruling, which will spare the private funds industry and investors a lot of unnecessary costs and disruption as a result of the U.S. SEC’s unlawful action. Today’s ruling rewards our decision to file suit, which was taken to protect the interests of our members against regulatory overreach and improper rulemaking by the U.S. SEC that would have had severe and adverse impacts on a wide variety of market participants.”

AIC President and CEO Drew Maloney also welcomed the decision, saying, “In rejecting the SEC’s unfounded legal theory, the court has sent Washington regulators a strong message that they cannot bypass Congress when pushing their extreme agenda.”

Observers of the SEC’s rule and the subsequent lawsuit noted that the court emphasized Congress’s authority in regulating private fund advisers. David Slovick, a partner at Barnes & Thornburg, remarked, “The Fifth Circuit simply said, ‘Hey, SEC, if you want to make such sweeping changes, you need to have clear authorization from Congress first.’ The court didn’t say that private funds regulation is a bad idea, only that it’s Congress’s prerogative to impose regulations if it sees fit, not the SEC’s.”

Nixon Peabody Partner Benedict Kwon added, “The court chose to respect the demarcation that Congress made between registered investment companies and private investment funds and concluded that the SEC exceeded its authority in promulgating the new private fund rules.”

Christine Lombardo, a partner at Morgan Lewis, pointed out the significance of the court striking down the entire rule rather than allowing parts of it to stand. Despite the ruling, she advised private fund advisers to consider some of the SEC’s guidance on best practices, particularly regarding disclosures and expense allocations.

Brian Forman, a partner at Morrison Cohen, noted that much of the rule was unnecessary and could have been enforced under existing anti-fraud concepts, which the industry highlighted during the comment phase. He warned that many concepts from the rule still apply and advised clients to be cautious of increased enforcement under anti-fraud rules. “The text of the final rule still provides a lot of insight into what the SEC views as best practices, and we should still be mindful of it as an industry,” he said.

Lombardo mentioned that while the rule will not take effect, the SEC could propose a revised version or appeal the Fifth Circuit’s decision to the Supreme Court.

A spokesman for the SEC stated that the agency is “reviewing the decision and will determine next steps as appropriate.”

By fLEXI tEAM