A federal court’s decision last month to vacate an SEC rule affecting private funds could force the SEC to reconsider its controversial rulemaking efforts in the registered fund space.
The Fifth Circuit Court of Appeals ruled June 5 that the SEC exceeded its statutory authority by creating a set of rules and amendments to the Investment Advisers Act of 1940 that would have imposed sweeping disclosure requirements and conflict-of-interest restrictions on hedge funds, private-equity funds, venture capital funds and other segments of the private-fund sector.
The ruling is unusual because it overturned the entire set of new SEC rules and amendments finalized in August 2023, rather than just a subset of those rules, and because the ruling reflects a unanimous decision by a three Fifth-Circuit judges who agreed that the SEC had attempted to regulate a market sector Congress had decided should be exempt from regulation by the SEC according to the decision in a lawsuit filed by half a dozen associations representing private-fund advisers.
Private-fund investors become limited partners with the fund adviser and have considerable influence in negotiating terms, unlike the mutual-fund market and retail investors cited in portions of the Advisers Act the SEC used to justify its rulemaking, the court ruled.
“By congressional design, private funds are exempt from federal regulation of their internal ‘governance structure’” and are excluded from the definition of “investment company” as it applies under terms of the Advisers Act, according to the court. To remain exempt, private funds have to satisfy specific statutory requirements, including a reliance on “qualified purchasers” rather than on public securities offerings to retail investors.
Private-fund advisers do have a fiduciary duty similar to those that apply to mutual-fund advisers, but the “client” for a private-fund adviser is the fund itself, not the individual investor, according to the court.
The decision to vacate the entire private-funds rule came on the heels of the SEC’s decision in April to stay implementation of its signature climate-disclosure rule for public companies until litigation challenging that rule could be resolved.
The Fifth Circuit’s decision makes it more challenging for the SEC to justify new regulations and vindicates the complaints of those in both the registered and unregistered funds industries who have spent much of the past three years vocally criticizing the SEC’s sweeping, breakneck approach to rulemaking under chair Gary Gensler.
“This case is extremely significant because it essentially threw out an SEC rule, it questioned the SEC’s authority pretty significantly, and appears to have cut back the SEC’s authority under the Advisers Act,” said Barry Barbash, an adjunct professor at the Georgetown University Law Center and a former director of the SEC’s Division of Investment Management. “The question is whether the same kind of theory applies to other contexts.”
The ruling was applauded throughout much of mutual fund industry, which has argued that the SEC’s rulemaking approach during the past three years has consistently been overly broad and aimed at problems that present a risk more theoretical than actual.
“[The SEC] comes up with what they think of as a public good, defined as they define it, and then they worry about the statutory authority as sort of an afterthought,” said Amy Doberman, a partner at WilmerHale and former assistant chief counsel at the Division of Investment Management. “The private funds rule is just an egregious example of, I think, the SEC getting in over its skis.”
“We echo the court’s concerns that the SEC acted outside of its mandate,” Investment Company Institute president Eric Pan said in a statement following the ruling. “As we await action on dozens of similarly overreaching proposals from the SEC, we hope the SEC takes the time to study this ruling and pay closer attention to the serious concerns expressed by the public and market participants on issues like liquidity risk management, safeguarding, and outsourcing.”
By explicitly defining limits on the SEC’s authority to regulate and specifically warning it away from aspects of the private-funds market, the Fifth Circuit’s decision reinforces the idea that the SEC may be overstepping its authority, echoing an accusation opponents have made against controversial and novel SEC rule proposals including the AI/predictive-analytics rule and the swing-pricing rule proposal, both of which the SEC has recently withdrawn for new analysis and revision.
Losses in court undercut the credibility of SEC rulemaking and add weight to the complaints of those pushing back on those rules, Barbash said.
“You have a federal court of significance essentially casting some real doubt on SEC rulemaking. That’s a significant, practical problem for the SEC,” Barbash said.
The court also specifically contradicted the SEC’s legal justification for the rule by deciding it had misinterpreted portions of Section 206(4) of the Investment Advisers Act, which allows the SEC to adopt regulations designed to prevent fraud.
“The Private Fund Managers claim that the Commission has not articulated a ‘rational connection’ between fraud and any part of the Final Rule the Commission adopted. We agree,” the court wrote in its decision. “The Commission fails to explain how the Final Rule would prevent fraud.”
That portion of the decision could undercut other pending regulations the SEC justified partially by invoking Section 206(4), including the fund cybersecurity risk management proposal, the AI/predictive analytics proposal and the outsourcing proposal.
So direct a refutation could encourage the SEC to be more cautious about moving forward with those and other rules in which it is breaking new legal ground as well, according to Doberman.
“I’m hopeful the commission will think long and hard about current proposals that may need to be re-proposed, as well as anything else that might be on the horizon,” Doberman said.
The Fifth Circuit’s decision will pave the way for future litigants to challenge SEC rulemaking, presenting new obstacles for controversial rules.
“Given that there’s now a recent question about SEC authority, it’s probably going to be the case that when parties who look to overturn or question SEC rulemaking, [they] probably will start to assert authority issues as well,” Barbash said. “I think the idea of questioning the SEC’s authority is going to be more prevalent.”
Even more limits to SEC rulemaking with Chevron deference struck down
Those limitations on SEC rulemaking will likely be compounded by the Supreme Court’s June 28 ruling in Loper Bright Enterprises v. Raimondo, according to Doberman. That landmark decision overturned the so-called “Chevron deference” doctrine that had required courts to defer to the expertise of federal agencies on matters that Congress had not explicitly addressed through legislation.
While the Fifth Circuit decision will have implications for SEC rulemaking, it may not change much about the rest of Gensler’s term, because it is already rare for rulemaking activity to take place in the second half of a presidential election year, according to Barbash, who spoke to Fund Directions prior to the Loper Bright decision.
“I think a lot of what happens with the SEC and how it responds to this would depend on what happens in the election,” Barbash said. “Based on how the SEC has operated over the last few years, I can’t see that the SEC is going to try to change very much about how it operates at least in the short term.”
For industry critics who have been aggravated by the Gensler SEC’s rulemaking agenda, the overturning of the private funds rule feels like justice being served.
“I hope that the court action will serve as a lesson and will rein in future administrations to think twice about considering their regulatory authority before they act,” Doberman said. “This is why we have checks and balances. This is a good thing. It gives me optimism about our institutions and about our system of government.”
