A US appeals court rejected an SEC rule intended to compel private funds — like hedge funds and private equity firms — to give investors more transparency via disclosures into these investments. The New Orleans-based Fifth Circuit Court decided the SEC exceeded its authority by adopting the rule in August 2023. It ruled 3-0 in favor of six private equity and hedge fund groups that had challenged the regulations.

Private Fund rule

The SEC’s private fund rules were first proposed in January 2022 and were passed (a more streamlined version of them anyway) a full 18 months later with the two Republican Commissioners dissenting.

It required fund managers to issue quarterly performance and fee reports, perform annual audits, and stop giving some investors preferential treatment over redemptions and preferential information about portfolio holdings.

They were intended to increase transparency, fairness and accountability in an industry known for opacity, an argument having been put forward that such opacity can lead to fraud.

Six trade groups had sued to block these new rules and hailed the decision as a victory for markets and investors such as pensions, foundations and endowments.

The SEC had premised its ability to craft the rule on Section 913 of the Dodd-Frank Act, which grants the SEC authority under the Exchange Act and Advisers Act to adopt rules establishing a uniform fiduciary standard of conduct for broker-dealers and investment advisers when providing personalized investment advice about securities to retail customers.

Section 913 of Dodd-Frank

The author of the Fifth Circuit Court’s decision, Judge Kurt Engelhardt, said in the decision that Section 913 only applies to retail customers and has nothing to do with private funds. The judge said that actually the Dodd-Frank Act targets private funds under Title IV — and only with carefully limited reporting and recordkeeping requirements on some private fund advisers, along with providing only limited rulemaking authority.”

Furthermore, the judge said regulators failed “to explain how the final rule would prevent fraud.” He pointed out that the SEC largely fails to define the fraudulent acts or practices the final rule is purportedly designed to prevent, and that although some conduct by private funds could involve fraud, the Commission has observed misconduct by only about 0.05% of advisers.

Industry (mostly) rejoices

The decision drew praise from industry trade groups, which hailed it as one protecting capital in the form of private equity and credit that millions of workers depend on in America as components of their retirement investments.

The estimated compliance costs to affected businesses (which the SEC acknowledged in its rulemaking) was nearly $500m a year.

Six trade groups had sued the SEC to block these new rules — including the Managed Funds Association and the American Investment Council — and hailed the decision as a victory for markets and investors such as pensions, foundations and endowments.

The opinion requiring specific links to fraud could have implications for other SEC rules, such as the pending one regarding predictive data analytic tools.

The SEC told news outlets it was reviewing the decision and deciding whether it would appeal to the Supreme Court or ask the full five-member Fifth Circuit Court to review it (in an “en banc” hearing). As with the conservative Fifth Circuit Court, the conservative majority in the Supreme Court would make it a tough venue for an SEC challenge and an even tougher one for a victory.

Interesting, the core constituency that the rule targeted — the limited partners who invest in venture capital and private equity funds — were a bit less vehement in their opposition to the rule. In fact, 11 of them asked the judge to strike it down but preserve the SEC’s right to make future private fund rules under Section 913 — preferably less onerous and particularly not imposing restrictions on exempt private fund managers.

Implications

The SEC stripped of its private fund rule in its regulatory arsenal, is likely to use other, existing rules to manage what it sees as abuses by this industry sector. Its Marketing Rule is one that comes to mind. And the agency will likely continue to apply a heightened focus on investment managers’ disclosure practices with respect to expenses and conflicts also utilising existing rules.

It is worth noting that the Fifth Circuit opinion requiring specific links to fraud in SEC rulemaking could have implications for other rules, such as the pending one regarding predictive data analytic tools. And the SEC’s proposed climate rule has been challenged in court for exceeding the SEC’s rulemaking powers and lacking a specific material harm it is trying to prevent with new and costly disclosure obligations.

SEC Chair Gary Gensler’s rulemaking attempts have faced a string of lawsuits, and he has also had his hand forced in terms of approving spot bitcoin and ether ETFs. The litigation this year will continue to play out, underscoring the courts’ outsized role in the US regulatory landscape, absent Congressional intervention on any of these fronts.