On June 5, 2024, the Fifth Circuit struck down the SEC’s Private Fund Adviser Rules, adopted on August 23, 2023, and challenged shortly thereafter. These Rules had sought to establish fundamentally new and more extensive obligations for private fund advisers registered with the SEC. This included certain heightened reporting obligations as well as limitations on some common practices.

On the reporting side, the rules imposed an obligation to provide quarterly statements to investors detailing fund fees, expenses, and performance, and to provide yearly audited financial statements to each investor. Additionally, adviser-led secondary transactions would require either a fairness or valuation opinion.

The rules had further imposed restrictions on the use of side letters giving some investors preferential treatment, for example with respect to redemptions, or access to information. Finally, the rules had limited advisers from charging funds they managed for costs associated with investigations and other regulatory and compliance matters.

A core concern for the SEC was to reduce or eliminate potential conflicts between investors, and between investors and the adviser. This was the stated basis for the adviser-led secondaries rule, to ensure that when investors were offered the option of exchanging interests in a private fund into another advised by the adviser (or related persons), they were provided a fairness or valuation opinion. It was also behind the prohibitions against preferential terms for certain investors.

Fifth Circuit ruling

While the SEC argued that the 2010 Dodd-Frank Act authorized it to enact the rule pursuant to its authority to enact rules regarding fund governance, and to limit fraud by advisers, industry groups had challenged it as overstepping that authority. The Fifth Circuit agreed, holding that the SEC lacked the rule-making authority it claimed under the antifraud provisions of the Advisers Act, and other provisions as well.

The Court further held that the SEC’s rule-making authority only applied to vehicles involving retail customers. Notably, the Court began its discussion by pointing out that investors in private funds (which are not open to retail investors generally) are wealthy and sophisticated, and that even where the ultimate beneficiaries are public employees such as firefighters and teachers, that exposure is only through their participation in pension plans, which are professionally managed.

Are industry celebrations premature?

Why is this not the unalloyed victory that some might think it is? After all, a slew of rules ranging from slightly intrusive and bothersome to practice-altering were struck down. And, perhaps recognizing judicial hostility to agency rule-making, it appears the SEC is not seeking en banc review, although there is the possibility of Supreme Court review.

There are three reasons why viewing this as an unqualified win for the private fund industry might be premature.

First, the mere fact that the SEC cannot impose standards through rule-making does not mean that it cannot highlight them through examinations of private fund advisors. Thus, in its listing of 2024 Examination Priorities, conflicts of interest and due diligence practices for private funds were listed (and were listed near the beginning of the priorities listed).

The SEC’s exam staff can certainly stress the areas identified in the private funds rules through its examinations of private fund advisers. For example, even in the absence of rules requiring a fairness or valuation opinion in certain circumstances, or prohibitions against preferential treatment, the exam staff can request information regarding the adequacy of disclosure on these or related matters to investors.

Second, the SEC’s enforcement program can prosecute advisers for inadequate or misleading disclosures as well as examining those disclosures. When one of the authors served as a senior trial counsel at the SEC, there were significant concerns that many so-called sophisticated investors lacked understanding of how private deals and side letters were negotiated. There were also concerns that advisers were improperly charging fund clients for various expenses without adequate disclosures.

The Division of Enforcement can take up the cudgel to create behavioral norms. Even without rules requiring or forbidding certain practices, such as preferential treatment regarding redemptions or access to information about portfolio positions, the SEC can investigate and pursue claims of inadequate or misleading disclosures about those practices.

Finally, and perhaps most importantly,  the SEC may have changed expectations by market participants. Among other things, what the SEC does is express norms of behavior for regulated entities. It does this in several ways. Most obviously, it enacts regulations that govern behavior.

Even less sophisticated private fund investors might now ask for information regarding preferential treatment afforded to certain investors or side letters.

However, the SEC also creates expectations for conduct through publicizing issues it believes are concerns in an industry. Even though the private fund rules have been struck down, the SEC has raised expectations and awareness.

Multiple groups submitted amicus briefs to the Fifth Circuit defending the rule, including industry participants such as the Institutional Limited Partners Association, which represents many large institutional investors such as pensions and sovereign wealth funds, and multiple reform groups. These groups represent various constituencies that are now fully aware of the concerns raised by the SEC – and many had in fact submitted comment letters to the SEC when the original proposed rules were released supporting the programmatic goals the rules advanced.

Even less sophisticated private fund investors might now ask for information regarding preferential treatment afforded to certain investors or side letters. Even though the Fifth Circuit struck down the rule limiting the use of fund assets in connection with responding to government action, investors might seek either disclosure of such use or, if they have enough bargaining power, restrictions on advisers’ charging funds for examination or investigation expenses. Investors might seek carve-outs or limits on fund charges related to investigations that result in findings of violations.

Ultimately, while the SEC might have failed in forcing the private fund world to adopt certain standard practices, the simple fact of having raised investor expectations might force fund advisers to incorporate a large part of what the SEC was seeking by fiat. In this way, what regulators fail to impose by rule or regulation might end up incorporated within the standard terms and conditions sought by private fund investors.