SEC’s Private Fund Adviser Rule Struck Down by 5th Circuit Appeals Court

The U.S. 5th Circuit Court of Appeals vacated the Securities and Exchange Commission’s Private Fund Adviser rule on Wednesday. The rule had been finalized in August and was challenged in court by the National Association of Private Fund Managers and other plaintiffs in September.

The rule regarding advisement of private investment funds had required advisers  to issue quarterly performance statements to investors in the fund as well as an annual audit. Advisers were also prohibited from giving preferential treatment to some investors regarding share redemption and access to information about the fund’s holdings if doing so would negatively affect other investors. Those advisers were also limited in their capacity to pass on enforcement related expenses to investors without their explicit consent.

On Wednesday, a panel of the Court vacated the rule in its entirety by a 3-0 vote. 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 only to retail investors and not to investors in private funds, who are virtually never retail investors.

Private fund advisers normally consider the fund itself as their client, rather than the investors in the fund. Investors in private funds tend to be more sophisticated institutional or accredited investors, though some institutional investors such as pensions represent non-sophisticated investors.

Joshua Broaded, head of global regulatory compliance at ACA Group, says that private fund investors are often some of the most sophisticated and “can ask for the things that they want and need” in terms of additional disclosures, but that there is a “spectrum of power and sophistication” among them. Some, including smaller institutions or high net-worth individuals, are not nearly as sophisticated and do not have the negotiating power to request additional disclosures. Those were the types of investors the SEC was seeking to protect, but according to the 5^th Circuit does not have the authority.

Broaded adds that the rule was mostly popular with institutional investors, who were broadly demanding more transparency, especially around fees and performance.

The SEC has not announced if they intend to appeal the ruling.

Broaded says that this rule represented many of the most “important and fundamental objectives for the SEC,” such as “fairness in how investors are treated” and disclosures that are “consistent from adviser to adviser.” The SEC will need some time “to digest this ruling,” Broaded says, but it has the options of appealing to the Supreme Court, appealing to the full Circuit (as opposed to a panel), or not appealing at all.

Broaded says that even though the rule was vacated, he expects investors to continue to ask for the key features in the rule and he anticipates “some of the intent of the rule will come into common practice.”