Fifth Circuit Invalidates SEC’s Private Funds Rule

While we await the end of the Supreme Court’s current term, with major decisions still to go on things like former President Trump’s claim to immunity from prosecution, and the Loper case which threatens the Chevron administrative law doctrine of deferring to the expertise of regulators, there is another appellate decision that has slid under the radar screen to some extent, concerning the authority of the SEC to enact rules under its original enabling statutes as well as under the Dodd-Frank Act passed after the 2008 financial crisis.  The decision deserves more attention than it has received.

Back about a year ago, the SEC adopted a rule governing private funds and their advisers, principally hedge and private equity funds.  These funds have long been subject to “regulation-lite,” on the rationale that their investors had to be highly qualified and super-sophisticated.  In my not-so-recent past I served as the Chief Legal Officer of such a fund adviser, so I know a little bit about the subject.

The new SEC private funds rule had several primary elements.  First, there was a “preferential treatment” rule, which prohibited advisers from giving certain preferential deals to some investors but not others, often without specific disclosure.  Second, the rule prohibited advisers from passing on to their funds certain compliance and investigatory expenses long thought to be covered by customary indemnification provisions.  Third, the rule required the delivery of quarterly financial statements to all investors.  Fourth, there were also provisions dealing with adviser-led secondaries, in which advisers offer to buy out investors looking to leave the fund who have limited liquidity options.  There were also provisions requiring annual audits and a few other related provisions.  You get the idea.

Several industry groups promptly sued, including the Managed Funds Association, or MFA, in which I actively participated back in the day.  The suit was filed in what they no doubt (and correctly) believed was the super-friendly, anti-regulation Fifth Circuit.  They were represented by Eugene Scalia and Gibson Dunn, which is also part of the anti-regulation playbook.  In a decision filed on June 5, the Fifth Circuit invalidated the SEC’s private funds rule.  No. 23-60471.

The core of the Fifth Circuit’s reasoning had two prongs.  The first was that the SEC’s new rule could not be justified under the general anti-fraud provisions of the Investment Companies or Investment Advisers Acts of 1940.  Really?  An element of the preferential treatment rule is that smaller investors aren’t necessarily being told that larger investors are getting a better deal, on things like fees and liquidity.  Yes, the private placement memoranda may say it could happen, but smaller investors may not know the specifics.  That sounds like a potentially material omission, which has long been held to be within the ambit of the anti-fraud provisions of the securities laws.  The other provisions could also be analogized as having elements of anti-fraud protection as well.  The ability to pass along investigatory expenses for example diminishes the incentive not to engage in fraud, and adviser-led secondaries can be accompanied by conflicts of interest and limited disclosures.  Yet, the Fifth Circuit concluded that the SEC’s reliance on general anti-fraud provisions of its basic enabling acts was “pretextual.”    

The SEC’s back-up was that the rule was justified under Section 913(h) of Dodd-Frank (at page 455 of the 849 page bill).  Section 913 authorized a number of SEC rulemakings, including for example the creation of a general fiduciary standard for broker-dealers and investment advisers dealing with “retail customers,” the term expressly used in sub-sections (a)-(g).  At the end of sub-section (g) there is even a definition of what constitutes a “retail customer.”  Then, in sub-section (h), Congress switched its language, using the term “investor,” without qualification, and authorizing the SEC to enact rules governing disclosure, compensation and conflicts by “advisers” to “investors.”  Even though the language is meaningfully different, the Fifth Circuit found it was “unlikely” that Congress intended to switch the scope and focus of the section by changing terminology in the middle.  Again, really?  Isn’t that a direct violation of every principle of textualism and statutory construction?

The direct consequence of the Fifth Circuit’s decision was to invalidate the SEC’s new private funds rule.  The longer-term consequence is that it will be all but impossible for the SEC to enact any new rules affecting private equity, hedge and venture funds unless Congress enacts additional enabling legislation, which just ain’t gonna happen.  Coupled with the various other challenges to SEC enforcement, including challenges to the appointment of administrative judges and the delegation of authority to them, means that the SEC’s overall regulatory and enforcement program will be greatly hampered, based in this instance on a highly questionable statutory interpretation.  

Mind you, I’m not saying I was fully in favor of the SEC’s proposed rule.  In fact, as it stands, or at least as it stood before it was invalidated, the rule was arguably unnecessary.  There is another industry organization, called the Institutional Limited Partners Association, or ILPA, which was not a plaintiff in the case but which has proposed form limited partnership and LLC fund provisions that covered most of the points addressed in the SEC’s rule.  ILPA has long been concerned about the very same issues which the SEC sought to address, and many of the larger fund complexes have acceded to their proposals, as part of the price of getting ILPA’s larger institutional investors into their funds.  Even before that many forms of side letters which institutional investors customarily requested prior to making an investment added additional terms to the forms of partnership and LLC agreements they were required to sign that also addressed many of the same issues.  Since the SEC’s rule arguably closed the barn door after the horses were already long gone, the rule’s invalidation may be of limited practical effect.

Still, general threats to regulatory authority should be of concern to us all.  It is a mark of the Red Team’s ongoing, long-term attack on the administrative state.

The views expressed here are those of the author, and do not necessarily represent or reflect the views of NYCLA, its affiliates, its officers, or its Board.

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