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The Secured Lender

TSL-NOV24-COVR 

SFNet's 80th Annual Convention Issue
 

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October 24, 2024

Source: SFNet

Private Funds Rule Update: Fifth Circuit Vacates SEC's Regulatory Framework

In a significant development for the private funds industry, the U.S. Court of Appeals for the Fifth Circuit has unanimously vacated the SEC's 2023 Private Funds Rule, marking a major setback for the Commission's efforts to enhance regulation of private fund advisers. The ruling, issued this summer, found that the SEC exceeded its statutory authority in implementing the sweeping regulatory framework that would have imposed substantial new disclosure requirements and restrictions on the $26 trillion private funds industry.

Background on the Private Funds Rule

The SEC's original rule, adopted in August 2023, sought to implement comprehensive reforms, including mandatory quarterly statements detailing fees and expenses, annual audits, fairness opinions for adviser-led secondary transactions, and restrictions on certain adviser practices. The rule would have required private fund advisers to provide detailed disclosures about fund performance, portfolio-level fees, and preferential treatment arrangements. These requirements were designed to increase transparency and protect investors in private funds, which typically include institutional investors, pension plans, and high-net-worth individuals.

The Fifth Circuit's Decision

The court's decision hinged on two key determinations regarding the SEC's regulatory authority:

  • Section 211(h) Authority: The court held that the SEC's rulemaking authority under Section 211(h) of the Investment Advisers Act is limited to "retail customers" and does not extend to sophisticated private fund investors. This interpretation significantly narrows the SEC's regulatory reach in the private funds space.
  • Anti-Fraud Authority: The court found that the SEC failed to establish a "rational connection" between the rule's requirements and the prevention of fraud under Section 206(4) of the Advisers Act. The ruling emphasizes that the SEC must specifically define fraudulent or manipulative practices before adopting preventive measures.

Implications for the Industry

The decision has far-reaching implications for both the private funds industry and the SEC's regulatory authority:

  • Private fund advisers are no longer required to implement the extensive disclosure and operational changes that would have been mandated by the rule.
  • The SEC's authority to regulate sophisticated investors has been significantly curtailed.
  • Future SEC rulemaking efforts may face heightened scrutiny, particularly regarding the Commission's anti-fraud authority.
  • The decision may provide grounds for challenging other SEC rules that rely on similar statutory provisions.

Next Steps

SEC Chair Gensler has indicated that the Commission is reviewing the decision and considering its next steps, while emphasizing that the original rule was intended to promote competition and efficiency through enhanced transparency. The industry should continue monitoring developments as the SEC determines its response to this significant limitation of its regulatory authority.