On June 5, 2024, a three-judge panel of the U.S. Fifth Circuit Court of Appeals issued an opinion that vacated the Private Fund Adviser Rules (PFAR) proposed by the U.S. Securities and Exchange Commission (SEC) in August 2023.1 The Fifth Circuit ruled that the SEC’s rule violated section 706 of the Administrative Procedure Act (APA) and deemed that the SEC overstepped its statutory authority. Therefore, no part of the proposed rules could stand.2 

An overview of the Fifth Circuit’s ruling:3  

  • The SEC argued that Congress shifted its wording in section 211(h) of the Advisers Act to using the term “investor” rather than the proceeding use of “retail customer” to include private investors. According to the SEC, the heading “[o]ther matters” alludes to more than just “retail customers.” The Fifth Circuit held “…211(h) applies to retail customers,” and thus, the Commission “exceeded its statutory authority in relying on that section to adopt the Final Rule.” 
  • The SEC heavily relied on Section 206(4) of the Advisers Act for the right to prescribe “means reasonably designed to prevent” fraudulent acts. For this, the SEC must “define” a fraudulent activity, to which the Fifth Circuit described its definition as “vague.” The Fifth Circuit claimed that “the Commission fails to explain how the Final Rule would prevent fraud.”
  • The SEC relied on Section 206(4) of the Advisers Act to propose disclosure and reporting requirements that were more transparent than the standing Advisers Act. The Fifth Circuit holds that Congress ensured that there was regulation and disclosure through the existing act, and therefore the SEC cannot rely on Section 206(4).
  • The SEC blankets the terms “fraud” and “deception” with “lack of disclosure,” and PFAR lacks a “close nexus” with the statutory design for private funds. The Fifth Circuit responded that a failure to disclose “cannot be deceptive” without a “duty to disclose.” The Fifth Circuit pointed to the fiduciary duty of the advisor to the client, and this duty is the fund, not the investor. Further, the Fifth Circuit commented that the SEC has only observed misconduct by 0.05% of advisors over a seventeen-year period of enforcement activity. 
  • The SEC proposal would fundamentally alter the longstanding structure of private funds with increased visibility and regulations. The Fifth Circuit rejected this, as they “…agree that the Final Rule does not fit within the statutory design…. By congressional design, private funds are exempt from federal regulation of its internal ‘governance structure.’”

SEC Viewpoint on PFAR

The SEC’s proposed PFAR remained consistent with its focus on investor protection amidst the consistent growth of private funds. Instead of targeting private funds, the SEC focused the rule to advisors. The SEC’s stance is that increased regulation of private fund advisors and greater transparency in private transactions would protect direct and indirect investors alike. The proposed rules would specifically protect against advisers inappropriately charging fees or expenses to the fund, potential conflicts of interest, preferential treatment, and passthrough.  Beyond investor protection, the SEC believed these proposed rules would increase efficient capital markets and encourage greater competition.5 

Background on PFAR and the Advisers Act

On August 23, 2023, the SEC adopted PFAR, which were new rules and amendments under the Advisers Act and its compliance rules. The SEC estimated that, in total, these amendments would cost private funds $5.4 billion and require millions of hours of work from employees across the industry in the areas of compliance, restructuring, and auditing.6

A Brief Summary of Recent PFAR Activity:

2022: The SEC increased involvement with private investment funds.7

  • Significant proposal for rule amendments across the SEC 
  • Amendments to enhance information provided in Form PF8 
  • SEC enforcement matter on fees/expenses: SEC charges private equity adviser for failing to disclose disproportionate expense allocations to fund9

2023: The SEC proposed additional regulation and oversight across the private investment funds industry.

  • Amendments adopted and significant new rules proposed through PFAR, including:10

-  Applicable to SEC-registered advisers: Quarterly Statement Rule, Audit Rule, Adviser-Led Secondaries Rule

-  Apply to all advisers, regardless of registration status: Restricted Activities Rule, Preferential Treatment Rule

  • SEC Enforcement matter on fees/expenses: SEC charges private equity fund adviser for overcharging fees and failing to disclose fee calculation conflict11 
  • SEC Enforcement matter on individual liability/audit: SEC charges private fund auditor and audit engagement partner with improper professional conduct12 

By way of background, the Investment Company Act of 1940 (’40 Act), defined an investment company as one with more than 100 beneficial owners who made public offerings of securities.13 Under these terms, most private funds did not meet the statutory requirements and therefore were not considered “investment companies.”14 In 1996, Congress removed the 100-investor threshold for owned by “qualified purchasers,” greatly expanding the number of private funds considered “investment companies” and hence subject to regulation.15  

Further, the Advisers Act formulated a fiduciary duty between an investment adviser and its client, requiring private fund advisers to prioritize the funds’ performance over the individual investors’ financial conditions. A subsequent event impacting the private investment fund industry was the enactment of Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) in 2010.16 Pursuant to this act, most private fund advisers became subject to the same requirements as other investment advisers, such as reporting, recordkeeping, and examination requirements. 

Outlook for Private Funds

Although it is unclear what the SEC’s response may be to the Fifth Circuit ruling, the SEC may continue to pursue its objectives through heightened levels of examination and enforcement action. Likely areas of emphasis by the SEC are as follows (several of which were discussed at the Stout Summit in November 2023),17 and these may still apply given the Fifth Circuit ruling:

  • Portfolio management risks present when there is exposure to recent market volatility and higher interest rates
  • Adherence to contractual requirements regarding limited partnership advisory committees
  • Accurate calculation and allocation of private fund fees and expenses
  • Due diligence practices with specific focus on private equity and venture capital fund advisers’ assessment of prospective portfolio companies
  • Conflicts disclosure, including private funds managed alongside registered investment companies and use of affiliated service providers
  • Custody rule compliance
  • Form PF and related policies and procedures

Throughout 2022 and 2023, Stout issued various updates and guidance on the changing regulatory landscape for private funds.18 When PFAR was initially introduced, Stout emphasized the importance of private funds being proactive in ensuring its internal policies and procedures were updated in accordance with the new rules. Private funds could consider conducting internal audits through external providers and make the adjustments necessary in anticipation of any rule amendments.19

SEC Response

The SEC has yet to comment on its response to the Fifth Circuit decision to vacate the Private Fund Advisers Rules. However, there are two potential courses of action the SEC may take: (1) appealing to the Fifth Circuit en banc (to be reheard by the entire court) or (2) taking the case to the Supreme Court. To appeal to the Fifth Circuit en banc, the SEC must file within 45 days of the ruling.20 Due to the unanimous decision of the Fifth Circuit, the SEC may opt act in the Supreme Court. In the U.S. Supreme Court, the SEC would need four out of the nine justices to grant the hearing.21 While there is no guarantee that the court will hear the case, the petition must be submitted within 90 days of the ruling.22 

While there are no guarantees regarding the U.S. Supreme Court nor the Fifth Circuit en banc to hear the case, both a petition from the Solicitor General and the national and public importance of the case are significant, and the outcome would have industry-wide implications.

Anna Caplan and Peyton Murphy also contributed to this content. 

1. SEC Enhances the Regulation of Private Fund Advisers (August 23, 2023).

2. United States Court of Appeals for the Fifth Circuit: National Association of Private Fund Managers, et al. v. SEC, No. 23-60471 (June 5, 2024).

3. Ibid.

4. Final Rule: Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews

5. SEC Enhances the Regulation of Private Fund Advisers (August 23, 2023).

6. United States Court of Appeals for the Fifth Circuit: National Association of Private Fund Managers, et al. v. SEC, No. 23-60471 (June 5, 2024).

7. 5 Steps for Private Funds as SEC Ramps Up Oversight (February 17, 2022). Adapting to SEC’s Heightened Scrutiny of Private Funds (July 14, 2022).

8. Form PF; Event Reporting for Large Hedge Fund Advisers and Private Equity Fund Advisers; Requirements for Large Private Equity Fund Adviser Reporting – SEC Release No. IA-6297; File No. S7-01-22 (May 3, 2023).

9. SEC Charges Private Equity Adviser for Failing to Disclose Disproportionate Expense Allocations to Fund (June 14, 2022).

10. Overview of Proposed Private Fund Rules (December 26, 2023, a summary of panel discussions during the Stout Summit: Investment Funds and Alternative Assets 2023).

11. SEC Charges Private Equity Fund Adviser for Overcharging Fees and Failing To Disclose Fee Calculation Conflict (June 20, 2023).

12. SEC Charges Private Fund Auditor and Audit Engagement Partner with Improper Professional Conduct (March 29, 2023).

13. Ibid.

14. Ibid.

15. Ibid.

16. H.R.4173 - Dodd-Frank Wall Street Reform and Consumer Protection Act

17. Overview of Proposed Private Fund Rules (December 26, 2023, a summary of panel discussions during the Stout Summit: Investment Funds and Alternative Assets 2023).

18. 5 Steps for Private Funds as SEC Ramps Up Oversight (February 17, 2022). Adapting to SEC’s Heightened Scrutiny of Private Funds (July 14, 2022).

19. Overview of Proposed Private Fund Rules (December 26, 2023, a summary of panel discussions during the Stout Summit: Investment Funds and Alternative Assets 2023).

20. Practitioners’ Guide to The United States Court of Appeals for The Fifth Circuit (June 2024).

21. U.S. Courts Supreme Court Procedures.

22. Practitioners’ Guide to The United States Court of Appeals for The Fifth Circuit (June 2024).