Fifth Circuit Strikes Down SEC Rule Regulating Private Investment Funds

On June 5, 2024, a three judge panel of the U.S. Fifth Circuit Court of Appeals unanimously struck down the Securities and Exchange Commission’s (“SEC”) final rule, which created onerous restrictions for managers of private equity pooled investments, hedge funds, and institutional investor funds (the “Rule”). The SEC issued the Rule on August 23, 2023, and the Rule has been subject to substantial commentary and criticism from the industry since its issuance. According to the SEC, the Rule would have cost an estimated $5.4 billion and would have required millions of hours of employee time for companies now required to comply. Vacating the Rule represents a huge win for the private equity fund industry.

As enacted, the Rule (i) enacted restrictions on certain terms that fund managers could include in side-letters for investors, (ii) prohibited fund managers from charging fees or expenses associated with certain activities, (iii) required fund managers to prepare and distribute additional reports to investors, (iv) required fund managers to provide independent fairness or valuation opinions and (v) required fund managers to undergo regular audits.

The Fifth Circuit stated that the Rule was fundamentally designed to “protect investors who invest in private investment funds and to prevent fraud, deception, or manipulation by the investment advisers to those funds.” Historically, only “retail customers” (nonprofessional investors) who invest publicly have been protected in this respect, while private investment funds have been largely exempt. In vacating the Rule, the Fifth Circuit concluded that the SEC exceeded statutory authority on two provisions under the Investment Advisers Act of 1940, as amended by the Dodd-Frank Act of 2010.

First, the Fifth Circuit concluded the provision of the Dodd Frank Act applies only to retail-oriented funds, and not to private investment funds. Private investment funds are exempt by way of their internal governance structure and are typically only available to accredited investors and qualified purchasers. Private funds are also free to negotiate fund arrangements and investments, which typically implicate many of the proposed limitations prescribed by the Rule.

Second, the Fifth Circuit opined that the SEC was too vague in defining the fraudulent or deceptive practices the Rule was designed to prevent. Both compliance with a fund’s governing documents or disagreement over “discretionary violations” are not inherently fraudulent or deceptive practices. The Fifth Circuit also stated that a failure to disclose cannot be deceptive without first having a duty to disclose.

The Fifth Circuit’s ruling immediately negates the Rule nationwide. As of June 10, 2024, the SEC has yet to comment on whether it will seek an en banc hearing of the full Fifth Circuit to entertain an appeal, or whether it will petition to the Supreme Court to reinstate the rule nationwide. Regardless of the SEC’s next actions, the Rule will remain vacated unless the Firth Circuit en banc or the Supreme Court over-turns the Fifth Circuit’s decision. Private fund investors and managers should stay apprised of any relevant updates on the SEC’s next steps.