Private Funds CFO Washington DC correspondent Bill Myers takes a closer look in a four-part series on what the striking down of the SEC’s private funds rule by a US Court of Appeals means for the market.

Here we present part one.

A federal appeals court has put a cap on the Securities and Exchange Commission’s reform ambitions, but fund managers may still find the compliance threshold rising below that.

The U.S. Court of Appeals for the Fifth Circuit on June 5 struck down the commission’s sweeping private fund rules. A three-judge panel ruled that regulators exceeded their powers in two ways. Firstly, by invoking art. 913 of the Dodd-Frank Act (which in turn amended Sec. 211(h) of the Investment Advisers Act). The judges ruled that Sec. 913/211(h) only applies to retail investors. Many experts expected the court to rule that way—the Fifth Circuit has historically been hostile to government regulation and the plain text of Sec. 913/211(h) clearly refers to private investors.

What surprised many experts was the second part of the ruling, when the court went even further by ruling that the SEC had violated the anti-fraud provisions of the Advisers Act, Sec. 206(4), to the rules. The Committee’s reliance on Sec. 206(4), Judge Kurt Engelhardt wrote for his colleagues, was “pretextual” – that is, regulators were looking for an easy excuse to impose the new rules. Not only had regulators failed to demonstrate that there was widespread fraud, Englehardt and the panel ruled, but regulators also cannot compel disclosures under Sec. 206(4). A fund advisor’s fiduciary duty is to the fund, not to the fund’s investors.

“By Congress’s design, private funds are exempt from federal regulation of their internal ‘governance structure,’” Engelhardt wrote in the 25-page decision. “The commission cannot make rules under the guise of section 206(4) that affect this internal governance structure.”

Adam Aderton, Willkie Farr and Gallagher
Adam Aderton, Willkie Farr and Gallagher

A ‘sledgehammer’

The June 5 decision is a coup for private fund managers and their proponents. Not only does it cap a rules package that, by the commission’s own estimate, would have cost the industry $5.4 billion to implement. It also jeopardizes pending and even current rules, such as the SEC’s proposed anti-takeover rules, the proposed outsourcing rules and the proposed predictive data analytics rules, and possibly the marketing rule. They all rely on Sec. 913/211(h) or Sec. 206(4) in whole or in part.

It’s a “sledgehammer” of a decision, says Adam Aderton, former co-chief of the SEC Enforcement Division’s asset management group, now a partner at Willkie Farr & Gallagher.

“We anticipate that any future rule will be challenged in the Fifth Circuit”

Neal Prunier, ILPA

“The committee has regularly used Sec. 206(4) to promulgate rules to regulate investment advisers,” he said. “Questions arising from this decision are a) are the adopted rules sufficiently related to anti-fraud protections to withstand judicial scrutiny, and b) what should we do about the rules under 206(4) that focus on disclosure and reporting, rather than on fraud? ? What about the other rules that seem to focus on disclosure? The marketing rule? Or the rules of the proxy advisor? Are those anti-fraud rules? Are they valid under this decision?”

‘Playbook’ to Challenge Future Fifth Court Cases

It is possible that Engelhardt and his colleagues intended to interpret their decision strictly.

Marc Ponchione, Debevoise & Plimpton

“It can be read as a fairly broad base for the industry,” says Marc Ponchione, partner at Debevoise & Plimpton. “Obviously other courts, if given the opportunity, might look at it differently. I think people are thinking very hard now about that aspect of that decision.

However narrowly Engelhardt’s decision is interpreted, it at least gives private funds and their advocates room to argue against regulations, or at least against individual enforcement actions.

“It can be read as a pretty wide berth for the industry”

Marc Ponchione, Debevoise & Plimpton

The Fifth Circuit has made such challenges easier. To block the private fund rules in the Fifth Circuit, industry advocates formed a new group, the National Association of Private Fund Managers, headquartered in Austin, and named it lead petitioner in the case. The SEC challenged the association’s position, essentially arguing that it was a Trojan horse that allowed the industry to forum shop in friendlier circuits. In the June 5 decision, Engelhardt and his colleagues omitted these arguments.

“Every filer is affected by the final rule because the final rule regulates private fund advisors, and every filer represents private fund advisors,” Engelhardt wrote.

Neal Prunier, ILPA

That means the path of any future rules affecting private funds could go through the Fifth Circuit, said Neal Prunier, director of industrial affairs for ILPA, a trade association that represents some of the largest managers of sovereign wealth, endowment and pension funds. represents the world. group filed an amicus brief in support of its interpretation of Sec. 913/211 (u).

“We anticipate that any future rule will be challenged in the Fifth Circuit,” he said. “There is a playbook for challenging the Fifth Circuit. That is something we think about a lot.”