On August 23, 2023, the Securities and Exchange Commission (SEC) adopted new rules and rule amendments (the “Private Fund Adviser Rules”) to enhance the regulation of private fund advisers. These rules and amendments were designed to protect private fund investors by increasing transparency, competition, and efficiency in the private funds market.

The rules required SEC-registered investment advisers (“RIAs”) to provide investors with quarterly statements detailing certain information regarding fund fees, expenses, and performance. In addition, RIAs were required to obtain and distribute to investors an annual financial statement audit of each private fund it advises and, in connection with an adviser-led secondary transaction, a fairness or valuation opinion.

All private fund advisers were prohibited from providing investors with preferential treatment regarding redemptions and information if such treatment would have a material, negative effect on other investors. In addition, the rules restricted private fund adviser activity that involved conflicts of interest and compensation schemes that the SEC determined to be contrary to the public interest and the protection of investors. Certain other activities were restricted without appropriate disclosures and, in some cases, investor consent. Lastly, all advisers were required to document the annual review of their compliance policies and procedures in writing. The rules were designed to take effect over a 12 to 18-month period. See Marcum’s article “Adoption of New Rules for Private Fund Advisers” for a more detailed look at the Private Fund Adviser Rules.

Shortly after the SEC announced the adoption of the Private Fund Adviser Rules, several private fund industry groups filed a lawsuit against the SEC in the United States Court of Appeals for the Fifth Circuit. These industry groups included the American Investment Council, National Association of Private Fund Managers, National Venture Capital Association, Managed Funds Association, Alternative Investment Management Association, and the Loan Syndications and Trading Association. These industry groups believed that the SEC had overstepped its statutory authority and that adopting the rules would increase fees, create less competition, and decrease choice for institutional investors, including pensions, foundations, and endowments. Some of the negative effects noted in the lawsuit were limiting the right of private fund advisers and their investors to tailor their relationships and interactions, enacting overreaching prohibitions and restrictions on certain private fund adviser activities, and imposing onerous, costly disclosure requirements and administrative obligations upon private fund advisers.

On June 5, 2024, the United States Court of Appeals for the Fifth Circuit unanimously vacated the Private Fund Adviser Rules in a 3-0 decision. The SEC had cited statutory authority under sections 211(h) and 206(4) of the Investment Advisers Act of 1940 (the “Advisers Act”) to support their right to enact the Private Fund Adviser Rules. Section 211(h) authorized the SEC to promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers. However, the Court concluded that the SEC could not rely on Section 211(h) because that section applies solely to retail customers. This is important because it will likely prevent the SEC from citing this section as grounds to enact rules and regulations concerning private funds going forward. Section 206(4) authorizes the SEC to define and prescribe means reasonably designed to prevent such acts, practices, and courses of business as fraudulent, deceptive, or manipulative with respect to investment advisers. The Court concluded that the SEC failed to establish a rational relationship between the Private Fund Adviser Rules and fraud. The Court considered other issues argued by the parties but ultimately only cited these two sections on the basis for its appeal.

The SEC has 90 days from the ruling date (September 5, 2024) to petition the United States Supreme Court. However, a favorable outcome may be unlikely. Just a few weeks after the ruling to vacate the Private Fund Adviser Rules, two landmark Supreme Court decisions regarding the scope of government agency rulemaking authority came down, one of which directly involved the SEC.

On June 27, 2024, the Supreme Court ruled on the SEC v. Jarkesy. This case began as an administrative enforcement action for violating antifraud provisions of the Securities Act, the Securities Exchange Act, and the Investment Advisers Act against George Jarkesy Jr. and Patriot28, LLC, an investment adviser. The SEC imposed a civil penalty, disgorgement, a cease-and-desist order, and industry and officer-and-director bars against Jarkesy through an administrative proceeding ruled on by an SEC administrative law judge. Jarkesy appealed, and the case eventually reached the Supreme Court. In a 6-3 ruling, the Supreme Court ultimately concluded that when the SEC alleges a defendant has violated an antifraud provision of the federal securities law and seeks civil penalties in an administrative proceeding, the Seventh Amendment of the United States Constitution entitles the defendant to a jury trial. This decision will prevent the SEC from using its own in-house courts in many cases. The Supreme Court’s opinion focused on actions alleging violations of antifraud provisions, but there are now questions as to whether the ruling could be more far-reaching, both at the SEC and other government agencies with administrative enforcement powers.

The following day, June 28, 2024, the Supreme Court ruled on Loper Bright Enterprises v. Raimondo. A 6-3 vote overturned the Chevron deference, which was established in a 1984 case titled Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc. The Chevron deference stood for the idea that judges should defer to government agency interpretations if there are gaps and ambiguities in law, so long as the interpretations are reasonable. The rationale underlying the Chevron deference was that agencies have more experience and expertise in their domain and are better suited than courts to make the policy judgements necessary to implement a statute and fill in the gaps.

Congress typically legislates in broad terms and can’t possibly anticipate every issue that will arise, so the Chevron deference presumed that Congress implicitly delegated authority to the agencies. Since being handed down in 1984, Chevron has become among the most frequently cited cases in American administrative law. Over 17,000 lower federal court decisions and 70 by the Supreme Court itself cited Chevron. In the decision reached in this case, the Supreme Court cited the Administrative Procedures Act of 1946, which governs how agencies of the federal government of the United States may propose and establish regulations and grants United States federal courts oversight over all agency actions. The Supreme Court held that the Administrative Procedures Act requires courts to exercise their independent judgement in deciding whether an agency has acted within its statutory authority, and courts may not defer to an agency’s interpretation of the law simply because a statute is ambiguous. This decision will likely result in a flood of lawsuits challenging old decisions that relied on Chevron and will significantly weaken the rulemaking authority of agencies like the SEC.

The SEC’s rulemaking agenda has been ambitious and aggressive since Chair Gary Gensler took office in 2021, but it will need to be reviewed and reconsidered in light of these recent developments.  The SEC has until September 2024 to petition the Supreme Court to review the Private Fund Adviser rules. If a new presidential administration takes office in January 2025, obtaining a favorable outcome through a Supreme Court petition could become even more difficult. The SEC could also try to propose new rules, but given the recent federal court decisions, any proposed rules would likely need to be much narrower in scope. It is unclear at this time how the SEC will proceed, but it is clear that the SEC’s power has been impaired.

Although the Private Fund Adviser Rules were fully vacated, the SEC still has the statutory tools to challenge some of the conduct it tried to legislate through rulemaking, particularly regarding disclosures concerning preferential treatment and restricted activities as defined in its proposed rules. As a result, the SEC will likely try to find opportunities to achieve its objectives through examination and enforcement. Private fund advisers should review disclosures, especially those related to these topics, and ensure no deviations or inconsistencies. Advisers should also be mindful of certain conflicts of interest and the calculation and reporting of fees and expenses. This will put advisers in the best position to deal with potential heightened SEC scrutiny.

Although the decision to fully vacate the Private Fund Adviser Rules was a big win for private fund advisers and industry groups, the rules had support from certain sectors of the investor community. Investors may seek certain rights that would have been afforded them under the rules. As a result, the Private Fund Adviser Rules could still prove to result in a meaningful shift in market practices. Advisers should be prepared to discuss the topics detailed in the rules during investor negotiations.

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