U.S. Fifth Circuit Court of Appeals Vacates Private Funds Rules: What’s Next?

On June 5, 2024, the U.S. Fifth Circuit Court of Appeals (Fifth Circuit) issued an opinion that vacated the U.S. Securities and Exchange Commission (SEC) Private Fund Adviser Rules (the Rule), holding that the SEC exceeded its statutory authority in adopting the Rule. Specifically, the court held that the “promulgation of the [Rule] was unauthorized ... no part of it can stand.”

The Rule would have resulted in sweeping changes to private fund managers’ business relationships and practices. The petitioners who initially brought the lawsuit before the Fifth Circuit argued, among other things, that the Rule restricted or prohibited widely used and long-standing business practices of private funds and their investors in a manner that exceeded the SEC’s statutory authority. The Fifth Circuit’s decision is being applauded by many in the industry who viewed the Rule as an overextension of the SEC’s authority and harmful to the private funds industry.

The SEC has not yet indicated whether it will appeal the decision. Its options would include requesting rehearing, appealing to the Fifth Circuit en banc, or requesting that the U.S. Solicitor General approve a petition for a “writ of certiorari” with the U.S. Supreme Court. However, an appeal would likely take considerable additional time to resolve and require the SEC to devote additional resources that could distract from other initiatives.

In the meantime, the Rule has been vacated in its entirety, just short of 10 months after it was adopted and a little more than three months before what would have been the first compliance date, which raises the question: Now what should we do?

Our Take

Regardless of whether the SEC appeals the Fifth Circuit decision, the SEC still has statutory tools to challenge some of the conduct it sought to affirmatively legislate through rulemaking, particularly where practices are inconsistent with disclosures or undertakings, or policies and procedures are not reasonably designed to prevent violations of the federal securities laws. Thus, the SEC may find opportunities to achieve the objectives of the Rule through examination and enforcement initiatives. We anticipate that the SEC staff will be particularly focused on private fund managers’ policies, processes, and disclosures concerning preferential terms and activities that the staff deemed “restricted” under the Rule as well as fees and expenses. Below, we address steps that fund managers can consider taking notwithstanding the Fifth Circuit decision.

Next Steps

Examination information requests and enforcement investigations will continue to focus on the topics and issues addressed in the Rule. To best prepare for expected heightened scrutiny of private fund advisers by the SEC through its examination and enforcement programs, advisers should consider reviewing and assessing their compliance and disclosure practices related to the topics covered in the Rule, including whether

• fees and expenses are allocated on a non–pro rata basis and whether expenses related to the adviser’s investigations or regulatory/compliance services are expensed to the private fund
• any clawbacks are reduced for taxes applicable to the adviser and whether the adviser receives loans from or borrows securities/other assets from any private fund clients
• the adviser has granted preferential liquidity or preferential portfolio holdings information that the adviser reasonably expects to have a material, negative effect on other investors in that pool or parallel pools
  • With respect to preferential portfolio holdings information, the SEC said, “Selective disclosure to certain parties is a fundamental concern often prohibited or restricted under other Federal securities laws.” This view is helpful insight for advisers to consider how the SEC may approach a disclosure review during an adviser’s examination.
• any conflicts disclosures need updating in fund documentation and/or the adviser’s Form ADV Part 2A; depending on the circumstances, limited partner advisory committee or investor consent/notice may be required by the applicable private fund’s governing documents

While the Fifth Circuit decision means that the SEC will have a harder time bringing enforcement actions on certain categories of conduct, the SEC will not hesitate to bring enforcement actions where they conclude that fees, preferential treatment, and other practices deviate from disclosures and undertakings or where they deem policies and procedures to be inadequate to prevent misconduct. Thus, advisers can put themselves on the best possible footing by continuing to review these topics. Similarly, accurate recordkeeping and, in the context of an examination, the ability to quickly produce summaries of where preferential treatment may have been given or how fees and expenses are tested will remain important.

Other Observations

The statutory basis that the SEC identified as authority to promulgate the Rule is the same authority used as the basis for a number of proposed and recently adopted rules, including the Cybersecurity Rule, Safeguarding Rule, Predictive Data Analytics Rule, and the Outsourcing Rule. These rules may be susceptible to legal challenge based on the outcome of the Fifth Circuit’s ruling. More broadly, the Fifth Circuit labeled the Rule’s antifraud measure “pretextual,” which may cause further consideration of other antifraud rules where fraudulent acts or practices have not been adequately defined. We expect that the SEC rulemaking agenda will be newly reviewed and reconsidered in light of this ruling.

While the private funds industry is understandably relieved that the prescriptive Rule has been vacated, private fund advisers should continue to be mindful of certain conflicts of interest, preferential treatment offered to certain investors, calculation and reporting of fees and expenses, and other disclosures. Advisers may wish to reevaluate their policies and procedures and consider whether their fund documentation would benefit from updating in light of how investors and others in the industry may address some of the practices prescribed in the vacated Rule.

The full Fifth Circuit opinion can be found here.