On February 5, 2024, a three-judge panel of the U.S. Court of Appeals for the Fifth Circuit heard oral arguments on the challenge to the “Private Funds Rules” 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.
Main 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.
Key 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.
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