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Regulatory Alert: Fifth Circuit Vacates the SEC’s Private Fund Advisers Rules

June 14, 2024

Last week, the Fifth Circuit Court of Appeals (the “Court”) struck down the “Private Fund Advisers Rules” (the “Rules”) that the Securities and Exchange Commission (“SEC”) adopted last August. In short, the Court held that (i) the SEC rulemaking authority under Section 211(h) of the Investment Advisers Act of 1940 (the “Advisers Act”) is limited to “retail customers”; and (ii) the SEC failed to identify the “fraud” that it seeks to prevent under its “anti-fraud” rulemaking authority under Section 206(4) of the Advisers Act.

The Rules would have, among other requirements, subjected SEC-registered private fund advisers to quarterly statement and annual audit requirements, as well as upended the use of side letter agreements by both registered and unregistered private fund advisers through new preferential treatment rules. The Court’s decision is a sharp rebuke of the SEC and a significant development for all industry participants.

Practical Implications

Quarterly Statement and Audit Requirements

Under the Rules, registered private fund advisers would have been required to present investors with quarterly statements detailing the fund’s performance, fees, expenses and other compensation paid to the adviser. However, it is customary for most private funds to provide at least quarterly reports to investors regardless. In other words, the practical impact of the requirement would likely have been minimal.

Similarly, under current SEC custody rules, registered private fund advisers are generally required to either distribute audited financial statements to investors or be subject to an annual surprise examination. The vast majority of registered private fund advisers typically opt to distribute audited financials to investors rather than be subject to an annual surprise examination; as such, the annual audit requirement under the Rules would have been largely redundant with current practices.

Preferential Treatment

As previously noted, we believe the preferential treatment portions of the Rules would have been the headliner. Under the Rules, registered and unregistered private fund advisers would have been prohibited from providing certain preferential treatment to investors with respect to both redemption and information rights. Additionally, the Rules would have required registered and unregistered private fund advisers to disclose other types of preferential treatment arrangements to current and potential investors, which would have upended longstanding practices regarding the use of side letter agreements in private funds.  

By vacating the Rules, the Court has given the green light to private fund advisers and investors to continue to negotiate confidential side letter agreements, including agreements that provide preferential redemption and/or information rights to certain investors.

Proponents of the Rules understandably view the Court’s decision as a loss for investors seeking more investor protection and transparency. Conversely, opponents of the Rules—including the trade associations that filed the lawsuit last year along with many private fund advisers and institutional investors—view the decision as a significant victory that will reduce costs and allow industry participants to continue to freely negotiate contract terms. Ultimately, the Court’s decision places more power back into the hands of private fund advisers.

What’s Next?

The SEC may seek an en banc review of the decision with the full Fifth Circuit or appeal the Court’s decision to the Supreme Court. Given the discretionary nature of these reviews, it is unclear when the matter will be fully resolved. In the meantime, we will continue to closely monitor the situation. Please feel free to reach out to us should you have any questions.