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Fifth Circuit Strikes Down SEC Private Fund Adviser Rule

A panel of the U.S. Court of Appeals for the Fifth Circuit vacated the U.S. Securities and Exchange Commission’s Private Fund Adviser Rule in its entirety by a 3-0 vote. The rule had been finalized in August 2023 and was challenged in court by the National Association of Private Fund Managers, Alternative Investment Management Association Limited, American Investment Council, and other plaintiffs in September.

This highly anticipated decision curbs the SEC’s authority to regulate private funds. Absent a successful appeal of the decision to the Supreme Court, the rule will not come into effect in November.

Under the revised rule, private investment fund advisers were obligated to provide quarterly performance statements to investors and undergo an annual audit. Additionally, advisers were prohibited from granting preferential treatment to select investors in terms of share redemption or access to fund holdings if it adversely impacts other investors. Those advisers were also limited in their capacity to pass on enforcement related expenses to investors without their explicit consent.

The panel noted that the Dodd-Frank Act gave the SEC limited new authorities over private fund advisers, such as requiring them to register with the SEC and to issue rules to prevent fraud.

It did not, however, extend to the point where the SEC was seeking to regulate, according to the court, which wrote: “The Dodd-Frank Act only stepped towards regulating the relationship between the advisers and the private funds they advise,” and not the investors in said fund.

The Court added that the statutory language that the SEC cited in defense of the rule applies exclusively to retail investors and does not extend to investors in private funds.

Private fund advisers typically prioritize the fund itself as their client, rather than individual investors within the fund. These investors tend to be sophisticated institutional or accredited investors.

Advocacy groups like the Institute for Portfolio Alternatives welcomed the court’s decision as a positive development for markets, fund managers, and investors.

“Today’s ruling is a clear reminder to the SEC to operate within the agency’s statutory mandate,” said Anya Coverman, president and chief executive officer of IPA. “If implemented, this rule would have changed the closing process for private funds, prohibited common side letter terms, altered the co-investment market, and created unnecessary reporting requirements for private fund advisers.”

The SEC has not announced if they intend to appeal the ruling or re-propose the rule.

According to IPA, the court decision is the latest example of the federal judiciary reining in regulatory authority. The Fifth Circuit’s opinion could give rise to challenges to other SEC rules that rely on similar authority and may have implications for future rulemaking.