Taking Stock Of The Private Funds Rules Litigation After Oral Arguments At The Fifth Circuit - Dodd-Frank, Consumer Protection Act

On February 5, 2024, a three-judge panel of the US Court of Appeals for the Fifth Circuit heard oral arguments on the challenge to the “Private Funds Rules”¹ issued by the Securities and Exchange Commission (the “SEC”). The panel consisted of Judges Leslie H. Southwick (a G.W. Bush appointee), Kurt D. Engelhardt (a Trump appointee), and Cory T. Wilson (a Trump appointee) (the “Panel”). A breakdown of the most significant arguments is provided below.

Highlights

During argument by counsel for the SEC, much of the questioning focused on the SEC's statutory authority under Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) (which added Section 211(h) of the Investment Advisers Act of 1940 [the “Advisers Act”]), particularly given Section 913's primary focus on “retail customers” and the existence of a separate title of the Dodd-Frank Act focused on the regulation of private fund advisers.
The Panel raised questions concerning the historically different treatment between registered funds and private funds under the Investment Company Act of 1940 (the “Investment Company Act”) and the extent to which the Private Funds Rules depart from that distinction.
Some members of the Panel raised concerns regarding whether the SEC enforcement settlements cited in the adopting release were sufficient to justify a rulemaking that would have a significant impact on an industry as large as the private fund industry.
Some members of the Panel also expressed concerns with vacating all of the parts of the Private Funds Rules, particularly the Private Fund Audit Rule and the Adviser-Led Secondaries Rule, which the Petitioners did not focus on in their briefs.

Takeaways

The questioning during the oral argument suggests that some members of the Panel are skeptical of the SEC's reliance on the rulemaking authority in Dodd-Frank Act Section 913/Section 211(h) of the Advisers Act.
The questioning also suggests that some members of the Panel may find that there is insufficient factual basis to rely on the anti-fraud rulemaking authority under Section 206(4) of the Advisers Act. However, such a finding could either (i) call for the SEC to produce more evidence supporting the rules beyond the “few dozen” settlements of SEC enforcement actions (which may open the door for the SEC to cure the issues) or (ii) determine that evidence presented should not be considered “fraudulent conduct” (which may be more fatal to the rulemaking).
The Panel may be reluctant to vacate the Private Funds Rules in their entirety, particularly the Private Fund Audit Rule and the Adviser-Led Secondaries Rule. If these are the only two Rules to survive, then exempt reporting advisers and other investment advisers that are not registered with the SEC would avoid the Private Funds Rules (since the Private Fund Audit Rule and Adviser-Led Secondaries Rule only apply to SEC-registered investment advisers).
The Court's opinion, when it is issued, should be analyzed not just for its direct effect on the Private Funds Rules but also for whether it raises questions about (i) prior SEC rulemakings under Advisers Act Section 206(4) that affected private fund advisers and their relationships with private fund investors and (ii) current SEC proposals under either or both of Section 211 or Section 206(4).

Next Steps

The parties have requested a decision from the Court by May 31, 2024, but the Panel will determine the ultimate timing.
A non-prevailing party can ask the Fifth Circuit to rehear the case “en banc” and/or can petition the Supreme Court to consider the case. Those decisions by the Fifth Circuit (whether to rehear en banc) and by the Supreme Court (whether to accept a petition to review the decision by the Panel or the en banc Fifth Circuit) are discretionary. Therefore, the timing of a resolution of the action remains highly uncertain.
If the timing of ultimate decision stretches beyond the first compliance date in September 2024, the industry groups may request or the SEC may decide to stay the Private Funds Rules.

Full Summary of the Arguments in the Private Funds Rules Litigation

Standing of Petitioners - National Association of Private Fund Managers (NAPFM) is the only petitioner based in the Fifth Circuit (otherwise the challenge would have had to be filed in a different circuit). NAPFM is a new organization for which there is little publicly available information.
Industry Groups' Briefs: Standing is “self-evident” because NAPFM is a non-profit headquartered in Texas and represents private fund advisers with more than $600 billion in AUM. In addition, the Secretary of NPAFM is also an officer of a private fund adviser that is headquartered in Texas.	SEC's Brief: NAPFM's “terse” claim of standing is insufficient, and without NAPFM, the appropriate circuit would be the D.C. Circuit.
Oral Argument: Not directly raised by the Panel.

Rule or Rules? Vacate v. Sever - The issue is whether the Private Funds Rules should be treated as a single Rule or five separate Rules.² This affects whether, if the Panel finds a lack of statutory authority, economic basis, etc., it should vacate all of the Rule/Rules or should sever and vacate only the portion without statutory authority, sufficient economic analysis, etc.
Industry Groups' Briefs: It's a single Rule (because Commissioner Crenshaw referred to it as a single Rule). (Note: The other Commissioners swap between “rule” and “rules” in their statements on the adopting of the Rule/Rules, except Commissioner Uyeda who uses “rules.”)	SEC's Brief: There are five separate Rules, and the petitioners only address three of the Rules. The court should sever and not vacate all of the Rules, since each is distinct and vacating one does not affect the others.
Oral Argument: The Panel raised questions to the Petitioners that—since their Briefs focused only on three parts of the Rule/Rules, why should the Panel should vacate the other two parts of the Rule/Rules (i.e., the Private Fund Audit Rule and the Adviser-Led Secondaries Rule)? The Panel raised concerns about vacating parts of the Rule/Rules that are not specifically being challenged. The Petitioners argue that the statutory authority argument (see below) applies to all of the parts of the Rule/Rules. However, the Petitioners concede that if not vacated based on statutory authority (and instead relying on rulemaking being arbitrary and capricious), then the Panel should only vacate certain provisions.

Rule or Rules? Vacate v. Sever - The issue is whether the Private Funds Rules should be treated as a single Rule or five separate Rules.² This affects whether, if the Panel finds a lack of statutory authority, economic basis, etc., it should vacate all of the Rule/Rules or should sever and vacate only the portion without statutory authority, sufficient economic analysis, etc.

Industry Groups' Briefs: It's a single Rule (because Commissioner Crenshaw referred to it as a single Rule). (Note: The other Commissioners swap between “rule” and “rules” in their statements on the adopting of the Rule/Rules, except Commissioner Uyeda who uses “rules.”)

SEC's Brief: There are five separate Rules, and the petitioners only address three of the Rules. The court should sever and not vacate all of the Rules, since each is distinct and vacating one does not affect the others.

Oral Argument: The Panel raised questions to the Petitioners that—since their Briefs focused only on three parts of the Rule/Rules, why should the Panel should vacate the other two parts of the Rule/Rules (i.e., the Private Fund Audit Rule and the Adviser-Led Secondaries Rule)? The Panel raised concerns about vacating parts of the Rule/Rules that are not specifically being challenged.

The Petitioners argue that the statutory authority argument (see below) applies to all of the parts of the Rule/Rules. However, the Petitioners concede that if not vacated based on statutory authority (and instead relying on rulemaking being arbitrary and capricious), then the Panel should only vacate certain provisions.

Statutory Intent of Private Fund Exemptions in the Investment Company Act - Section 3(c)(1) and 3(c)(7) of the Investment Company Act were adopted to exclude these vehicles (including private funds) from the same regulation as registered funds.
Industry Groups' Briefs: The Investment Company Act is clearly designed to exclude private funds from regulation like registered funds. The SEC is attempting to regulate private funds through private fund advisers.	SEC's Brief: The SEC is regulating private fund advisers (not private funds), which it is authorized to do under the Dodd-Frank Act and the Advisers Act generally.
Oral Argument: The Panel raised questions to the SEC on the history of the Investment Company Act, distinguishing between the regulation of registered funds and the absence of regulation of private funds. The Panel stated that there appeared to be a “bright” dividing line between registered funds and private funds. The Panel also seemed to believe that the Rule/Rules are the SEC's first attempt to regulate investment advisers to private funds. The SEC argued that private funds would continue to be regulated very differently from registered funds (e.g., re: public filings, independent board directors, etc.). The SEC also noted that it is seeking to regulate private fund advisers and not private funds.

Statutory Intent of Private Fund Exemptions in the Investment Company Act - Section 3(c)(1) and 3(c)(7) of the Investment Company Act were adopted to exclude these vehicles (including private funds) from the same regulation as registered funds.

Industry Groups' Briefs: The Investment Company Act is clearly designed to exclude private funds from regulation like registered funds. The SEC is attempting to regulate private funds through private fund advisers.

SEC's Brief: The SEC is regulating private fund advisers (not private funds), which it is authorized to do under the Dodd-Frank Act and the Advisers Act generally.

Oral Argument: The Panel raised questions to the SEC on the history of the Investment Company Act, distinguishing between the regulation of registered funds and the absence of regulation of private funds. The Panel stated that there appeared to be a “bright” dividing line between registered funds and private funds. The Panel also seemed to believe that the Rule/Rules are the SEC's first attempt to regulate investment advisers to private funds.

The SEC argued that private funds would continue to be regulated very differently from registered funds (e.g., re: public filings, independent board directors, etc.). The SEC also noted that it is seeking to regulate private fund advisers and not private funds.

Goldstein Limitation on Clients for Advisers Act purposes - Goldstein was a Supreme Court decision that vacated a rule that would have required private fund advisers to register under the Advisers Act by interpreting “client” to include investors in private funds in (the now repealed) Section 203(b)(3).
Industry Groups' Briefs: Goldstein prevents treating private fund investors as “clients” and subjecting the relationship between the private fund adviser and the private fund investors to the protections of the Advisers Act. The Rule/Rules impose de facto duties between the adviser and investors and there are not such duties under federal law.	SEC's Brief: The SEC is not relying on a statute that uses the term “client” nor converting “clients” into “investors,” and Goldstein is no longer relevant since Congress abolished the statute to which it was related (i.e., old Section 203(b)(3)).
Oral Argument: Not directly raised by the Panel.

Goldstein Limitation on Clients for Advisers Act purposes - Goldstein was a Supreme Court decision that vacated a rule that would have required private fund advisers to register under the Advisers Act by interpreting “client” to include investors in private funds in (the now repealed) Section 203(b)(3).

Industry Groups' Briefs: Goldstein prevents treating private fund investors as “clients” and subjecting the relationship between the private fund adviser and the private fund investors to the protections of the Advisers Act.

The Rule/Rules impose de facto duties between the adviser and investors and there are not such duties under federal law.

SEC's Brief: The SEC is not relying on a statute that uses the term “client” nor converting “clients” into “investors,” and Goldstein is no longer relevant since Congress abolished the statute to which it was related (i.e., old Section 203(b)(3)).

Oral Argument: Not directly raised by the Panel.

Dodd-Frank Act Section 913/Advisers Act Section 211 Rulemaking Authority - The issue is whether the SEC correctly relied on Section 211(h), which was added to the Advisers Act by Section 913 of the Dodd-Frank Act, when Section 913 of the Dodd-Frank Act is mostly about “retail customers” and the new regulatory authority with respect to private fund advisers was primarily focused in Title IV of the Dodd-Frank Act.
Industry Groups' Briefs: Congress sought to regulate private fund advisers in Title IV of the Dodd-Frank Act but the Rule/Rules are based on Title IX (Section 913). Section 913 of the Dodd-Frank Act (which adopted Section 211(g) and (h) of the Advisers Act) applies only to (i) “retail customers” and not private funds (statutory intent) and (ii) advisory relationships and not relationships between private fund advisers and private fund investors (plain language). “Customer” to “investor” switch because it was moving to stage of the relationship prior to the investor becoming a customer.	SEC's Brief: Section 211(h) uses the word “investors” without limitation (plain language). Other sections of Section 913 carefully use the word “retail customers,” and Section 913(g)(2) switched to the word “investors” (which typically is not limited to retail investors). Section 211(h) is applicable to all investment advisers, so it would not make sense to include in Title IV (which was only applicable to private fund advisers).
Oral Argument: The Panel raised questions as to why rule making on private fund advisers was not in Title concerning private fund advisers and whether context of the rest of Title IX related to private fund advisers. The Panel also asked if Section 913 provided the SEC with new rulemaking authority that it did not have before (that go beyond Section 206(4)). The Panel also asked if the reference to this “subsection” in the Section 913 rulemaking authority grant should be read in context of the other provisions of Section 913 that focused on retail customers. The Panel finally asked if the SEC is seeking to rely on both Section 913 and Section 206(4). The SEC argued that the context should be the Advisers Act (i.e., Section 211) to which the rulemaking authority was granted and not the other provisions in Section 913 (which were amendments to other federal securities laws). To this point, it noted that the rulemaking authority was referencing the subsection of the Advisers Act and not Section 913 of the Dodd-Frank Act. The SEC noted that the fact that the other sections use the term “retail customers” but only 913(g)(2) uses “investor” suggests that the change in terminology was intentional. The SEC confirmed that it believes it also has authority under Section 206(4) (discussed below).

Dodd-Frank Act Section 913/Advisers Act Section 211 Rulemaking Authority - The issue is whether the SEC correctly relied on Section 211(h), which was added to the Advisers Act by Section 913 of the Dodd-Frank Act, when Section 913 of the Dodd-Frank Act is mostly about “retail customers” and the new regulatory authority with respect to private fund advisers was primarily focused in Title IV of the Dodd-Frank Act.

Industry Groups' Briefs: Congress sought to regulate private fund advisers in Title IV of the Dodd-Frank Act but the Rule/Rules are based on Title IX (Section 913).

Section 913 of the Dodd-Frank Act (which adopted Section 211(g) and (h) of the Advisers Act) applies only to (i) “retail customers” and not private funds (statutory intent) and (ii) advisory relationships and not relationships between private fund advisers and private fund investors (plain language).

“Customer” to “investor” switch because it was moving to stage of the relationship prior to the investor becoming a customer.

SEC's Brief: Section 211(h) uses the word “investors” without limitation (plain language).

Other sections of Section 913 carefully use the word “retail customers,” and Section 913(g)(2) switched to the word “investors” (which typically is not limited to retail investors).

Section 211(h) is applicable to all investment advisers, so it would not make sense to include in Title IV (which was only applicable to private fund advisers).

Oral Argument: The Panel raised questions as to why rule making on private fund advisers was not in Title concerning private fund advisers and whether context of the rest of Title IX related to private fund advisers. The Panel also asked if Section 913 provided the SEC with new rulemaking authority that it did not have before (that go beyond Section 206(4)). The Panel also asked if the reference to this “subsection” in the Section 913 rulemaking authority grant should be read in context of the other provisions of Section 913 that focused on retail customers. The Panel finally asked if the SEC is seeking to rely on both Section 913 and Section 206(4).

The SEC argued that the context should be the Advisers Act (i.e., Section 211) to which the rulemaking authority was granted and not the other provisions in Section 913 (which were amendments to other federal securities laws). To this point, it noted that the rulemaking authority was referencing the subsection of the Advisers Act and not Section 913 of the Dodd-Frank Act. The SEC noted that the fact that the other sections use the term “retail customers” but only 913(g)(2) uses “investor” suggests that the change in terminology was intentional. The SEC confirmed that it believes it also has authority under Section 206(4) (discussed below).

Section 206(4) Rulemaking Authority - In addition to Section 211(h), the SEC also claimed statutory authority to adopt the Rule/Rules under Section 206(4) of the Advisers Act, which gives the SEC the authority to adopt rules reasonably designed to prevent “acts, practices and courses of business” that are “fraudulent, deceptive or manipulative.” The issue is the scope of the SEC's prophylactic rulemaking (i.e., its authority to adopt rules to prevent fraudulent, deceptive or manipulative conduct); what kind of conduct should be considered fraudulent, deceptive or manipulative; and whether that authority applies to the relationship between an investment adviser and a person who is not a “client” (e.g., a private fund investor).
Industry Groups' Briefs: The SEC cannot rely on Section 206(4) as the statutory basis for the rules because (i) the SEC failed to define the allegedly fraudulent acts or explain how the rules would prevent those undefined acts and (ii) the rules are not reasonably designed to prevent fraud, deception or manipulation. The SEC does not explain why Congress would adopt Section 211(h) if the SEC already had the authority under Section 206(4). An investment adviser's duty to disclose under Section 206(4) is only to its “clients” and not to investors in private funds. The SEC fails to explain how the Rule/Rules prevent fraud, and the cited examples are very small when considering the breadth of the rulemaking effects.	SEC's Brief: Section 206(4) grants prophylactic rulemaking authority (i.e., reasonably designed to prevent fraud from happening). The SEC described problems to justify the prophylactic rule, including past enforcement actions, and provided detailed discussion of the fraudulent conduct targeted by the rules. Rule/Rules are reasonably designed even if they capture legitimate practices, and sophisticated investors also need protection.
Oral Argument: The Panel seemed focused on factual basis for the alleged fraudulent conduct (discussed further below).

Section 206(4) Rulemaking Authority - In addition to Section 211(h), the SEC also claimed statutory authority to adopt the Rule/Rules under Section 206(4) of the Advisers Act, which gives the SEC the authority to adopt rules reasonably designed to prevent “acts, practices and courses of business” that are “fraudulent, deceptive or manipulative.” The issue is the scope of the SEC's prophylactic rulemaking (i.e., its authority to adopt rules to prevent fraudulent, deceptive or manipulative conduct); what kind of conduct should be considered fraudulent, deceptive or manipulative; and whether that authority applies to the relationship between an investment adviser and a person who is not a “client” (e.g., a private fund investor).

Industry Groups' Briefs: The SEC cannot rely on Section 206(4) as the statutory basis for the rules because (i) the SEC failed to define the allegedly fraudulent acts or explain how the rules would prevent those undefined acts and (ii) the rules are not reasonably designed to prevent fraud, deception or manipulation.

The SEC does not explain why Congress would adopt Section 211(h) if the SEC already had the authority under Section 206(4).

An investment adviser's duty to disclose under Section 206(4) is only to its “clients” and not to investors in private funds.

The SEC fails to explain how the Rule/Rules prevent fraud, and the cited examples are very small when considering the breadth of the rulemaking effects.

SEC's Brief: Section 206(4) grants prophylactic rulemaking authority (i.e., reasonably designed to prevent fraud from happening).

The SEC described problems to justify the prophylactic rule, including past enforcement actions, and provided detailed discussion of the fraudulent conduct targeted by the rules.

Rule/Rules are reasonably designed even if they capture legitimate practices, and sophisticated investors also need protection.

Oral Argument: The Panel seemed focused on factual basis for the alleged fraudulent conduct (discussed further below).

Major Questions Doctrine - The issue is whether the SEC's claim of rulemaking authority violates the Major-Questions Doctrine (post West Virginia³ ) (i.e., there is no “clear congressional authorization” for “fundamentally and dramatically” altering the regulatory regime applicable to private funds).
Industry Groups' Briefs: The SEC lacks the authority under the Major-Questions Doctrine. The SEC is claiming “enormous” authority (which go beyond what the Rule/Rules are currently doing) and, even if the current Rule/Rules do not show it completely, the SEC's claimed “plenary” authority would allow it to regulate private funds like registered funds. The Rule/Rules impose de facto duties between the adviser and investors and there are not such duties under federal law.	SEC's Brief: Dodd-Frank Act significant expanded the SEC's authority in Sections 211(h) and 206(4). Rule/Rules are consistent with existing SEC regulations for disclosures and regulation of conflicts of interest.
Oral Argument: Not directly raised by the Panel.

Major Questions Doctrine - The issue is whether the SEC's claim of rulemaking authority violates the Major-Questions Doctrine (post West Virginia³ ) (i.e., there is no “clear congressional authorization” for “fundamentally and dramatically” altering the regulatory regime applicable to private funds).

Industry Groups' Briefs: The SEC lacks the authority under the Major-Questions Doctrine. The SEC is claiming “enormous” authority (which go beyond what the Rule/Rules are currently doing) and, even if the current Rule/Rules do not show it completely, the SEC's claimed “plenary” authority would allow it to regulate private funds like registered funds.

The Rule/Rules impose de facto duties between the adviser and investors and there are not such duties under federal law.

SEC's Brief: Dodd-Frank Act significant expanded the SEC's authority in Sections 211(h) and 206(4).

Rule/Rules are consistent with existing SEC regulations for disclosures and regulation of conflicts of interest.

Oral Argument: Not directly raised by the Panel.

Lack of Meaningful Opportunity to Comment - The SEC is obligated under Administrative Procedure Act (APA) to provide a meaningful opportunity to comment before adopting a final rule.
Industry Groups' Briefs: The SEC failed to provide the public meaningful opportunity to comment because (i) the public did not have opportunity to comment on the new disclosure and consent exceptions in the Restricted Activities Rule (Rule 211(h)(2)-1) (which were not a “logical outgrowth of a prohibition regime”) and (ii) the public did not have opportunity to comment on an “illiquid fund” providing performance on levered basis (and not just unlevered basis) in the Quarterly Statements Rule (Rule 211(h)(1)-2). Asking a single “stray” question does not provide a meaningful opportunity to comment. The Rule/Rules impose de facto duties between the adviser and investors and there are not such duties under federal law.	SEC's Brief: The SEC provided meaningful opportunity to comment, received hundreds of comments and revised the proposed rules in response. “Disclosure and consent” exemptions and quarterly-statement rule examples are “logical outgrowth” since raised as a question in the proposal.
Oral Argument: Not directly raised by the Panel, other than to note it would only support vacating certain parts of the Rule/Rules.

Lack of Meaningful Opportunity to Comment - The SEC is obligated under Administrative Procedure Act (APA) to provide a meaningful opportunity to comment before adopting a final rule.

Industry Groups' Briefs: The SEC failed to provide the public meaningful opportunity to comment because (i) the public did not have opportunity to comment on the new disclosure and consent exceptions in the Restricted Activities Rule (Rule 211(h)(2)-1) (which were not a “logical outgrowth of a prohibition regime”) and (ii) the public did not have opportunity to comment on an “illiquid fund” providing performance on levered basis (and not just unlevered basis) in the Quarterly Statements Rule (Rule 211(h)(1)-2). Asking a single “stray” question does not provide a meaningful opportunity to comment.

The Rule/Rules impose de facto duties between the adviser and investors and there are not such duties under federal law.

SEC's Brief: The SEC provided meaningful opportunity to comment, received hundreds of comments and revised the proposed rules in response.

“Disclosure and consent” exemptions and quarterly-statement rule examples are “logical outgrowth” since raised as a question in the proposal.

Oral Argument: Not directly raised by the Panel, other than to note it would only support vacating certain parts of the Rule/Rules.

Absence of Factual Basis - The SEC is obligated under the APA to have a factual basis for adopting the Rule/Rules.
Industry Groups' Briefs: There is no factual basis for the Rule/Rules because (i) there are too few examples of alleged wrongdoing, (ii) most examples of alleged wrongdoing were based on settlements of administrative proceedings (so they technically were still just allegations, and the proceeding may have been unconstitutional), (iii) one example seems to cite to a settlement that only indirectly supported the SEC's claim, (iv) some of the rules that apply only to registered advisers discussed examples of actions taken by unregistered advisers, and (v) there is other evidence that shows that investors have more bargaining power than the SEC seems to think.	SEC's Brief: The SEC based its rulemaking on (i) information collected from private fund advisers (e.g., Form PF), (ii) exams of private fund advisers, (iii) enforcement actions against private fund advisers, (iv) comments from private fund investors, (v) academic literature, and (vi) pension plan documents. The “few dozen examples of alleged wrongdoing” cited by the petitioners is “significant evidence” but also only part of the evidentiary record. Settled actions are relevant because they set forth the SEC's findings. Focusing on only the largest and most sophisticated investors ignores the smaller investors investing in private funds.
Oral Argument: The Panel raised a question of how to consider a few dozen examples of wrongdoing when considering the regulation of a very large industry and asked what analogous cases they consider. The Panel also asked if all of the examples were settlements. The Panel raised a question of whether there was any market failure given the success of the private fund industry and a question of what evidence there is of a problem. The SEC first argued against a hard and fast number that would be required to substantiate a rulemaking. However, it re-iterated that while the SEC enforcement settlements are a part of the evidentiary record (and are valid evidence since they set forth the SEC's findings), the SEC also relied on a wider range of evidence, including Form PF and other filings, information from SEC examinations, and input and comment letters from private fund investors. The SEC cited cases in the Pay-to-Play space, including Wagner v. FEC and Blunt v. SEC. The SEC also argued that the success in the private fund industry has not been “equal” among all participants and that a “rising tide doesn't lift all boats equally.” The SEC also argued that the Panel should consider the circumstances of a smaller pension plan investor who has its own fiduciary obligations but is operating without clear information on fees and expenses and on performance and is being disadvantaged with respect to information and redemption rights for larger institutional investors.

Absence of Factual Basis - The SEC is obligated under the APA to have a factual basis for adopting the Rule/Rules.

Industry Groups' Briefs: There is no factual basis for the Rule/Rules because (i) there are too few examples of alleged wrongdoing, (ii) most examples of alleged wrongdoing were based on settlements of administrative proceedings (so they technically were still just allegations, and the proceeding may have been unconstitutional), (iii) one example seems to cite to a settlement that only indirectly supported the SEC's claim, (iv) some of the rules that apply only to registered advisers discussed examples of actions taken by unregistered advisers, and (v) there is other evidence that shows that investors have more bargaining power than the SEC seems to think.

SEC's Brief: The SEC based its rulemaking on (i) information collected from private fund advisers (e.g., Form PF), (ii) exams of private fund advisers, (iii) enforcement actions against private fund advisers, (iv) comments from private fund investors, (v) academic literature, and (vi) pension plan documents.

The “few dozen examples of alleged wrongdoing” cited by the petitioners is “significant evidence” but also only part of the evidentiary record. Settled actions are relevant because they set forth the SEC's findings.

Focusing on only the largest and most sophisticated investors ignores the smaller investors investing in private funds.

Oral Argument: The Panel raised a question of how to consider a few dozen examples of wrongdoing when considering the regulation of a very large industry and asked what analogous cases they consider. The Panel also asked if all of the examples were settlements. The Panel raised a question of whether there was any market failure given the success of the private fund industry and a question of what evidence there is of a problem.

The SEC first argued against a hard and fast number that would be required to substantiate a rulemaking. However, it re-iterated that while the SEC enforcement settlements are a part of the evidentiary record (and are valid evidence since they set forth the SEC's findings), the SEC also relied on a wider range of evidence, including Form PF and other filings, information from SEC examinations, and input and comment letters from private fund investors. The SEC cited cases in the Pay-to-Play space, including Wagner v. FEC and Blunt v. SEC. The SEC also argued that the success in the private fund industry has not been “equal” among all participants and that a “rising tide doesn't lift all boats equally.” The SEC also argued that the Panel should consider the circumstances of a smaller pension plan investor who has its own fiduciary obligations but is operating without clear information on fees and expenses and on performance and is being disadvantaged with respect to information and redemption rights for larger institutional investors.

Certain Provisions Unnecessary and Unduly Burdensome - The SEC is prohibited from adopting rules that are unnecessary or unduly burdensome.
Industry Groups' Briefs: The following provisions are unnecessary and unduly burdensome: (i) restrictions on side arrangements and “preferential treatment” in the Preferential Treatment Rule, (ii) restrictions on passing through expenses (e.g., investigation expenses and regulatory and compliance expenses) in the Restricted Activities Rule, and (iii) a one-size-fits-all requirement of the Quarterly Statements Rule.	SEC's Brief: The SEC reasonably designed its decisions to adopt each of the preferential treatment rule, the disclosure and consent requirements for expenses, and quarterly reporting requirements.
Oral Argument: Not directly raised by the Panel.

Inadequate Economic Analysis - The SEC is obligated under the APA to engage in economic analysis sufficient to consider the impact on efficiency, competition, and capital formation.
Industry Groups' Briefs: The SEC failed to adequately consider the impact on efficiency, competition, and capital formation and failed to make the required finding on its impact. The Rule/Rules impose de facto duties between the adviser and investors and there are not such duties under federal law.	SEC's Brief: The SEC reasonably considered the Rule's/Rules' likely economic effects.
Oral Argument: Not directly raised by the Panel.

Inadequate Economic Analysis - The SEC is obligated under the APA to engage in economic analysis sufficient to consider the impact on efficiency, competition, and capital formation.

Industry Groups' Briefs: The SEC failed to adequately consider the impact on efficiency, competition, and capital formation and failed to make the required finding on its impact.

The Rule/Rules impose de facto duties between the adviser and investors and there are not such duties under federal law.

SEC's Brief: The SEC reasonably considered the Rule's/Rules' likely economic effects.

Oral Argument: Not directly raised by the Panel.

Discussion in Adopting Release is Arbitrary and Capricious - The SEC is prohibited from engaging in actions that are arbitrary and capricious.
Industry Groups' Briefs: Discussion in Adopting Release on limitations of liability (and disclosure relating to hedge clauses) and charging fees for “unperformed services” is arbitrary and capricious.	SEC's Brief: The SEC is allowed to provide interpretations of the federal fiduciary duty (not talking about state duties).
Oral Argument: Not directly raised by the Panel.

Speculation on Potential Shape of the Panel's Decision

While one should not read too far into the Panel's questioning, it does suggest that the Panel may be more likely to find that the SEC lacks the statutory authority under Dodd-Frank Act Section 913/Advisers Act Section 211 to promulgate rules governing the relationships between private fund advises and private fund investors.

It may also find that the Private Funds Rules cannot be promulgated under the anti-fraud rulemaking authority in Advisers Act Section 206(4). This finding could be based on a few different arguments. It could find that the “few dozen” SEC enforcement actions are not sufficient to support a rulemaking of this size (e.g., the prophylactic rulemaking cannot support sweeping up mostly conduct that is not violative of the Section 206 anti-fraud provisions, where the violative conduct is so rare). It could also find that the evidence cited by the SEC is not itself violative of Section 206(4) because it is not fraudulent, deceptive, and manipulative conduct (e.g., an imbalance of negotiating power between the private fund adviser and private fund investors or between private fund investors of different sizes and sophistication is not itself evidence of fraudulent conduct).

The Panel did seem less inclined to vacate all of the Private Funds Rules, which may make it more likely that the Private Fund Audit Rule and Adviser-Led Secondaries Rule survive. These Rules apply only to SEC-registered investment advisers, so that would mean that exempt reporting advisers and other investment advisers that are not registered with the SEC would avoid the Private Funds Rules if the other three rules are the only ones struck down (particularly, the Restricted Activities Rule and the Preferential Treatment Rule). This may be viewed as an odd result since the lack of focus by the Petitioners on these two Rules in their briefs likely reflects their level of importance rather than the idea that there is more evidence of fraudulent conduct to support the Private Fund Audit Rule and the Adviser-Led Secondaries Rule.

It would also be interesting to see if the Panel does not vacate all of the Rules, whether they treat any of the Preferential Treatment Rule, the Restricted Activities Rule and the Quarterly Statements Rule differently. For example, the basis of the decision could differentiate between the prohibitions section of the Preferential Treatment Rule (with respect to preferential information and redemption rights) and the disclosure section of the Preferential Treatment Rule (which merely requires disclosure of the preferential treatment). It could also distinguish between the Preferential Treatment Rule (which is more focused on the relationship between private fund advisers and private fund investors) and the Restricted Activities Rule (which is more focused on the relationship between the private fund adviser and the private fund itself).

Possible Side Effects

An opinion of the Court that limits the ability of the SEC to promulgate rules under Section 211 of the Advisers Act could affect other currently proposed rulemakings that claim to rely in part on the statutory authority in Section 211, including (i) the proposed Cybersecurity Rules,⁴ (ii) the proposed Outsourcing Rule,⁵ (iii) the proposed Privacy Rule amendments,⁶ (iv) the proposed Predictive Analytics Rule,⁷ and (v) the proposed ESG Rule.⁸ While none of these are only focused on private fund advisers, all of these rules would affect private fund advisers. For example, the Predictive Analytics Rule applies with respect to private fund investors as well as the adviser's clients and relies primarily on Section 211(h) with respect to investment advisers.⁹

In addition, an opinion of the Court that limits the rulemaking authority of the SEC under Section 206(4) of the Advisers Act with respect to the relationship between a private fund adviser and private fund investors could also affect existing rules under the Advisers Act that directly regulate the relationship between a private fund adviser and a private fund investor, including (i) Rule 206(4)-8, which prohibits an investment adviser from engaging in fraudulent, deceptive, and manipulative conduct with respect to private fund investors; (ii) Rule 206(4)-1 (the “Marketing Rule”), which regulates marketing communications by a private fund adviser to private fund investors (or prospective investors); and (iii) Rule 206(4)-5 (the “Pay-to-Play Rule”), which includes prohibitions on investment advisers (and certain of their employees) concerning political contributions and certain other political activity with respect to government officials of state or local government entities that are investors in private funds.

Footnotes

1 National Association of Private Fund Managers v. Securities and Exchange Commission, 5th Cir. No. 23-60471. The “Private Funds Rules” are Rule 206(4)-10 (the “Private Fund Audit Rule”), Rule 211(h)(1)-2 (the “Quarterly Statements Rule”), Rule 211(h)(2)-1 (the “Restricted Activities Rule”), Rule 211(h)(2)-2 (the “Adviser-Led Secondaries Rule”) and Rule 211(h)(2)-3 (the “Preferential Treatment Rule”). Please see Client Alert: “ SEC Adopts Expansive (Albeit Slightly Softened) Private Funds Rules”.

2 For purposes of this Summary, we typically refer to the Private Funds Rules as “Rule/Rules” to reflect the dispute over whether it is a single rule or separate rules.

3 West Virginia v. EPA, 142 S. Ct. 2587 (2022).

4 Cybersecurity Risk Management for Investment Advisers, Registered Investment Companies, and Business Development Companies, SEC Release Nos. 33-11028; 34-94197; IA-5956; IC-34497 (Feb. 9, 2022).

5 Outsourcing by Investment Advisers, SEC Release Nos. IA-6176 (Oct. 26, 2022).

6 Regulation S-P: Privacy of Consumer Financial Information and Safeguarding Customer Information, SEC Release Nos. 34-97141; IA-6262 (March 15, 2023).

7 Conflicts of Interest Associated with the Use of Predicative Data Analytics by Broker-Dealers and Investment Advisers, SEC Release Nos. 34-97990; IA-6353 (July 26, 2023).

8 Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices, SEC Release No. 33-11068; 34-94985; IA-6034; IC-34594 (May 25, 2022).

9 See Release No. IA-6353 at fn. 288.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.