By: Will Long
Volume IX – Issue II – Spring 2024
I. INTRODUCTION AND BACKGROUND
On June 5, 2024, a unanimous panel of the Fifth Circuit Court of Appeals (the Fifth Circuit) vacated the U.S. Securities and Exchange Commission’s (SEC) Private Fund Advisers; Documentation of Investment Advisor Compliance Reviews (the Final Rule). [1] The Final Rule threatened to expand reporting, disclosure, and prohibited certain types of preferential treatment of investors in private funds. [2] The Fifth Circuit’s decision to vacate the Final Rule, which would have cost $5.4 billion and required millions of hours of labor, [3] provides significant relief to private fund advisers.
In August 2023, the SEC adopted the Final Rule with the stated purpose of protecting investors by (i) increasing visibility into certain practices involving compensation schemes, sales practices, and conflicts of interest through disclosure; (ii) restricting adviser practices with the potential to lead to investor harm and are contrary to the public interest; (iii) restricting the ability of advisers to offer certain investors preferential treatment; (iv) requiring certain requirements with respect to adviser-led secondaries; and (v) requiring annual audits for private funds. [4]
In adopting the Final Rule, the SEC relied on two authorities: its general anti-fraud rulemaking authority under Section 206(4) of the Investment Advisers Act of 1940 (the Advisers Act) [5] and its authority to regulate private funds advisers under Section 913(h) of the Dodd-Frank Act. [6] In September 2023, NAPFM petitioners [7] pursued vacatur of the Final Rule under the Administrative Procedure Act (APA) and the Federal Rule of Appellate Procedure 15(a). [8] Petitioners asserted that the Final Rule exceeded its statutory authority and violated administrative procedure.
While the Fifth Circuit’s decision invalidates the SEC’s attempt to impose additional regulations on private funds and their advisors, it does not prevent the SEC from pursuing alternative methods of prioritizing the issues in the Final Rule. After examining and commenting on arguments from petitioners and respondents, this article will discuss new statutory constraints in the Advisers Act for future SEC rulemaking. It will also identify grounds on which future litigants could challenge SEC authority and other regulatory instruments the Commission might use to impose new compliance standards on private fund advisers.
II. RESPONDENT ARGUMENTS
In an opening brief filed on December 15th, 2023, the SEC stated that it adopted the Final Rule to address problematic practices by private fund advisers arising from conflicts of interest, insufficient transparency between private fund advisers and investors, and a lack of effective governance mechanisms. [9] The SEC argues these practices place private fund investors and stakeholders at risk. The Final Rule addresses these concerns by (i) requiring private-fund advisers to provide investors with more information about performance and fees, (ii) mitigating conflicts of interest, and (iii) obtaining investor consent for, or limiting certain activities that can harm investors. [10] The SEC raised multiple arguments in defense of its Final Rule. These arguments claim that the SEC has proper statutory authority to issue the Final Rule, that the SEC satisfied the APA’s procedural requirements, and that the SEC reasonably considered the rules’ likely economic effects. [11] This article will focus on the SEC’s claims to statutory authority under Section 913(h) of the Dodd-Frank Act (Section 211(h) of the Advisers Act) and Section 206(4) of the Advisers Act.
Dodd-Frank Section 913(h) authorizes the SEC to facilitate the provision of “disclosures to investors regarding the terms of their relationships” with advisers and “promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes” for investment advisers that the SEC deems contrary to “the protection of investors.” [12] The SEC claims it derives statutory authority to regulate private fund advisers because the statutory text uses the term “investors” without modification or limitation, therefore referring to all investors, including private-fund investors.
This reading is plausible, according to the SEC, because Congress does not define the term and its plain meaning, refers to someone who commits money “to earn a financial return.” [13] This argument is consistent with the ordinary use canon of statutory interpretation, which states that “words are to be understood in their ordinary, everyday meanings—unless the context indicates that they bear a technical sense.” [14] The SEC also cites statutory language in 15 U.S.C. 80b-2(a)(30) that defines “foreign private advisers” in terms of the number of “investors in the United States in private funds” (emphasis added) and later in the statute at 80b-2(b)(c) that authorizes the SEC to issue rules for the “protection of investors.” [15] The SEC cites these statutes to argue that Congress has previously used the term “investors” when enacting legislation that authorizes the SEC to engage in rulemaking that specifically concerns private- fund advisers.
The Commission provides more support for this claim by arguing that Congress intentionally switched from using the term “retail customers” in Sections 913(b)-(f) to “investors” in 913(h). [16] The SEC claims this implies that Congress intended to specify a broad subset of investors in 913(h), rather than just retail customers. To support this interpretation, the SEC cites the majority opinion in Sebelius v. Cloer (2013) that states when “Congress includes particular language in one section of a statute but omits it in another section of the same [a]ct, it is generally presumed that Congress acts intentionally.” [17] Congress’s omission of the term “retail” as a modifier is purportedly evidence that it intended to authorize the SEC to regulate private fund advisers.
To extend the argument further, the SEC argues that the heading of Section 913(h) (“Other Matters”) confirms that Congress intended Dodd-Frank to cover more than retail customers. The Commission cites majority opinions in Fin. Planning Ass’n v. SEC (2007) and Travers v. Fed. Express Corp (2021) to claim that the use of the word “other” refers to content distinct and different from that already mentioned or implied. [18] This evidence is additional support for a broad reading of the term “investors” in 913(h).
Moving to the next claim of statutory authority, the SEC argues Section 206(4) of the Advisers Act grants the Commission authority to regulate private fund advisers. [19] Section 206(4) is a general antifraud rulemaking provision that authorizes the SEC to “prescribe means reasonably designed to prevent[] such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative.” [20] The SEC claims that Section 206(4) grants it “prophylactic rulemaking authority,” or in other words, authority to adopt rules to prevent certain private actions. [21] It supports this interpretation by citing the Supreme Court’s majority opinion in United States v. O'Hagan (1997) that states the SEC may regulate acts that are “not themselves fraudulent” if the restriction is “reasonably designed to prevent” fraud or deception. [22] To complete the argument, the SEC argues that each new rule is reasonably designed to prevent fraud or deception. As evidence, the SEC cites its various descriptions in the Federal Register of the problems that justified each rule. [23] Each description clarifies how the respective rule benefits investors by increasing transparency into private fund advisers’ sales practices and fees. For example, as to the adviser-led secondaries and audit rules, the SEC explains that investors are less likely to be deceived when they are aware of conflicts of interest between independent opinion advisers and private fund advisers. The SEC also argues that a similar rationale justifies the restricted activities and preferential treatment rule, which both restrict adviser action that results in investor harm.
III. PETITIONER ARGUMENTS
In an opening brief filed on November 1, 2023, petitioners emphasize that the Final Rule would fundamentally alter the way private fund advisers and private funds operate. [24] Under the existing market- oriented, contract-based approach (i.e., granting private funds and their advisors extensive autonomy), private funds have generated an average annual return of 14.1% before fees over the past three years, well ahead the 10.1% return posted by the S&P 500 during the same period. [25] Though gross private fund returns trailed public markets in 2023 by 5%, [26] future rate cuts and narrowing valuation gaps indicate a potential resurgence in private markets. [27] The SEC’s new disclosure and reporting requirements, however, could damper this growth by increasing AUM fees (Assets Under Management) from the existing 2-and- 20 fee structure, which harms investors by decreasing their return net of fees
Petitioners raise the following arguments for vacatur of the Final Rule. The arguments claim that the SEC has no statutory authority to adopt the Final Rule, the SEC deprived petitioners of a meaningful opportunity to comment on the proposed Final Rule, and the Final Rule is arbitrary and capricious under the APA. Again, this article focuses on the SEC’s statutory authority. [28]
Turning first to Dodd-Frank Section 913, petitioners contend the statute applies to “retail customers,” not private funds. [29] Petitioners cite the frequent usage of the term “retail customers” in Sections 913(b)-(f) (30 times) to frame Dodd-Frank as legislation intended to regulate retail investors, rather than private fund investors. As seen above, the SEC uses this evidence to advance their argument that Congress intended to give “investors” a broad meaning in Section 913(h), when it switched the terms. Petitioners respond to this argument by claiming that Congress switched to “investors” to refer to interactions between financial professionals and retail investors “before they become customers” (emphasis added). [30] Citing the Form CRS Relationships Summary, petitioners also claim that the SEC itself has recognized that switching from “customer” to "investor” in a statute indicates an intent to reach “an earlier stage” of the retail relationship. [31] This argument is intended to offer a competing explanation of the definition of “investor” in 913(h).
Furthermore, petitioners cite the heading of 913(h) (“Other Matters”) to argue that the term “investor” must be read in line with the whole statute. [32] The SEC claims that the heading connotes new information than that already mentioned or implied, thus severing Section 913(h) from the preceding statutory text. Petitioners reject this view, citing a majority opinion in Thibodeaux v. Grasso Prod. Mgmt Inc. (2004) that the subject covered must “have some resemblance to what preceded.” [33] What preceded in Dodd-Frank was a discussion of legal protections for retail customers—not investors in private funds.
The SEC makes a futile attempt to isolate Section 913(h) from the preceding statutory text by citing the frequent usage of “retail customers” and its heading (“Other Matters”). If anything, both pieces of evidence support petitioners’ arguments that (i) Congress enacted the Dodd-Frank Act to regulate retail investors, not private fund investors and (ii) the term “investors” cannot be read outside its statutory context. This context is communicated at Section 913(b), which directs the SEC to study the “effectiveness” of legal protections for “retail customers” involving recommendations from brokers, dealers, or investment advisors. [34] In Section 913(c), Congress identifies thirteen specific considerations the SEC should consider in conducting the study required under 913(b). But there is no text in Section 913(b) or 913(c) that either mentions private funds or suggests anything related to private funds. The plain subject of each subsection is retail customers, not private fund investors.
Petitioners offer support for this argument by citing Beecham v. United States (1994) [35] and Roberts v. Sea-Land (2012) [36] —two cases that turned on the whole-text canon of constitutional interpretation (i.e., that statutory text must be considered as a whole, not in part). When considered as a whole, Dodd-Frank does not authorize the SEC to regulate private fund advisers and restructure private funds’ business models. The only text in Dodd-Frank that might imply this authorization is Section 913(h), but if Congress intended to grant this authority, it would have done so in the Dodd-Frank section titled “Regulation of Advisers to Hedge Funds and Others.” [37] It is unlikely that Congress intended to grant the SEC broad rulemaking authority to restructure private funds and create new reporting requirements for private fund advisers in a section five titles away that doesn’t mention private funds, and specifically in a final sub-section titled “Other Matters.”
The SEC argues it derives this broad authority to “restructure” private funds “business models” in Section 913(g), [38] which authorizes the SEC to establish fiduciary duties for brokers and dealers. [39] But like Section 913(c), this section targets retail customers, not investors in private funds. In fact, petitioners note that Section 913(g) states that the SEC “shall not” modify the term “customer” to “include an investor in a private fund managed by an investment adviser.” [40] Moving to the Advisers Act, petitioners argue that Section 206(4) also does not authorize the SEC to adopt the Final Rule. Section 206(4) of the Advisers Act authorizes the SEC to “define, and prescribe means reasonably designed to prevent,” “acts, practices, and courses of business” that are “fraudulent, deceptive, or manipulative.” [41] Petitioners contend the Final Rule is inconsistent with this authorizing statute because it (i) does not define the fraudulent acts the Final Rule prevents, (ii) explain how the Final Rule will prevent these acts, and (iii) show that the rule is reasonably designed. [42] As covered in the section above, the SEC cites their descriptions of each rule to argue that the Final Rule is designed to prevent deception and fraud. However, the SEC’s argument is futile because it lacks statutory authority to adopt the rules. Even if the SEC did have statutory authority, it would need to successfully defend against petitioners’ claims that the Final Rule is arbitrary and capricious under the APA. The SEC would struggle to defend against these claims against the backdrop of Loper Bright Enterprises v. Raimondo (2024) which applied higher scrutiny to final agency action. [43]
IV. FIFTH CIRCUIT RULING
On June 5th, 2024, the Fifth Circuit vacated the SEC’s Final Rule in a judgment that turned on the Commission’s statutory authority to adopt the Final Rule. The majority opinion opens with a discussion of statutory interpretation, establishing that statutory text “cannot be construed in a vacuum.” [44] Consistent with the whole-text canon of statutory interpretation, the 5th Circuit holds that a term’s context takes precedence over its ordinary use when establishing its meaning. [45] The context of Dodd-Frank, per the Court’s opinion, has “nothing to do with private funds.” [46] To support this claim, the opinion frames Dodd-Frank as a logical outgrowth of the Advisers Act and Investment Company Act of 1940 (i.e., the Adviser Act’s “sister statute”). Both statutes impose restrictions on the internal management of investment companies, but “preserve[] the market-driven relationship between a private fund adviser, the fund, and outside investors.” [47] Consistent with this rationale, the 5th Circuit holds that the SEC misreads Dodd-Frank when it claims statutory authority to regulate private-fund advisers.
The Court also rejects the SEC’s argument that Congress switched to the term “investors” in Section 913(h) to expand the Commission’s rulemaking authority in a provision “otherwise devoted” to retail investment. The opinion also rejects the SEC’s argument that the heading (“Other Matters”) of 913(h) separates its content from the preceding statutory text. The Court cites the majority opinion in Thibodeaux that holds the subject covered must “have some resemblance to what preceded.” [48]
Turning to the SEC’s claim of authority in Section 206(4), the 5th Circuit affirms petitioners’ claim that each rule was not reasonably designed to prevent fraud or deception. It holds that the SEC fails to “define” the fraudulent acts or practices the Final Rule intends to prevent. [49] The Court also steps beyond this argument and holds that Section 206(4) fails to authorize the SEC to create disclosure and reporting requirements. [50] Under this holding, the SEC would not be able to claim statutory authority under Section 206(4) even if the Final Rule was reasonably designed to prevent fraud or deception. This holding could potentially limit the SEC’s scope of statutory authority in future rulemaking.
V. IMPLICATIONS FOR PRIVATE FUND ADVISERS
The SEC did not appeal the 5th Circuit’s decision—the deadline to seek a rehearing by the 5th Circuit panel or full court expired and the Commission did not petition the Supreme Court for certiorari. As mentioned above, the 5th Circuit’s decision is part of increasing court scrutiny of final agency actions. Three weeks later, on June 26th, the 5th Circuit vacated the SEC’s 2022 recission of its 2020 proxy firm disclosure rule in Nat’l Ass’n of Manufacturers v. SEC (2024). [51] On June 27th, the Supreme Court also decided SEC v. Jarkesy (2024), [52] entitling defendants who face civil penalties for securities fraud to jury trials and on June 28th, the Court overturned the 40-year-old Chevron doctrine in Loper Bright. [53]
With this trend of increasing scrutiny of final agency action—and SEC action specifically—the SEC will need to claim statutory authority pursuant to other provisions in the Advisers Act to target private funds advisers. Several of the SEC’s proposed regulations in June 2024, such as the Safeguarding Rule, rely on either Section 206(4) of the Advisers Act or Dodd-Frank Section 913(h) for statutory authority. Focusing on Section 206(4), SEC rulemakings relying on this statute, such as certain provisions of the Marketing Rule and investment adviser compliance rules, may face potential challenges under the 5th Circuit's ruling in NAPFM that Section 206(4) does not authorize the SEC to create disclosure and reporting requirements. Under this precedent, the SEC will now need to “define” fraudulent or deceptive acts before it is authorized to adopt rules “reasonably designed” to prevent such acts. The 5th Circuit’s narrow interpretation of Section 913(h) also provides ground for future litigants to challenge SEC rulemaking, such as the proposed predictive analytics, cybersecurity, and outsourcing rules.
While the 5th Circuit opinion benefits the private funds industry, the SEC can target private fund advisers by using examinations and enforcement proceedings (i.e., investigations into firms for potential violations of federal securities laws). This would involve numerous examinations conducted by the Division of Examinations and referrals to the Division of Enforcement. Private fund advisers still retain the benefits of limited SEC rulemaking authority, but risk reputational costs associated with potential SEC enforcement action. Though the SEC will continue to target private fund advisers, the 5th Circuit ruling in NAPFM is a significant win for the private funds sector.
Endnotes
[1] See National Association of Private Fund Managers et. al. v. Securities and Exchange Commission, (5th Cir. 2024) (No. 23-60471).
[2] See Private Fund Advisers; Documentation of Investment Adviser Compliance Reviews, 88 FR 63296 (Aug. 2023).
[3] See NAPFM, at 21.
[4] Id. at 2.
[5] See 15 U.S.C. § 80b-6.
[6] See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010)
[7] National Association of Private Fund Managers, Alternative Investment Management Association, Ltd., American Investment Council, Loan Syndications and Trading Association, Managed Funds Association, and the National Venture Capital Association.
[8] See NAPFM at 14–15.
[9] See Brief of Respondent, NAPFM vs. SEC, (5th Cir. 2024) (No. 23-60471).
[10] Id. (21).
[11] Id. (v).
[12] See § 913(h)(1–2), 124 Stat. at 1829 (codified as amended at 15 U.S.C. § 80b-11(h)).
[13] See Merriam Webster’s Collegiate Dictionary (10th ed. 2002); See also Black’s Law Dictionary (11th ed. 2019) (“A buyer of a security or other property who seeks to profit from it without exhausting the principal.”).
[14] See Scalia, A. and Garner, B. Reading Law § 6, at 69 (2012).
[15] See 15 U.S.C. 80b-2(a)(30); See also 15 U.S.C. 80b-2(b)(c).
[16] Id. at 9 (19).
[17] See Sebelius v. Cloer, 569 U.S. 369 (2013).
[18] See Travers v. Fed. Express Corp., 8 F.4th 198 (3rd Cir. 2021); Fin. Planning Ass’n v. SEC, 482 F.3d 481 (D.C. Cir. 2007).
[19] Id. at 9 (28).
[20] See Section 206(4), 15 U.S.C. 80b-6(4).
[21] Id. at 9 (13).
[22] See United States v. O’Hagan, 521 U.S. 642 (1997).
[23] See R.63213-17, 63222–23, 63239, 63257, 63261, 63273, 63279, 63285.
[24] See NAPFM at 2.
[25] See C. Slotsky, D. Carneal, W. Yasinski, US PE/VC Benchmark Commentary: Calendar Year 2023, Cambridge Associates, Aug. 2024, https://www.cambridgeassociates.com/insight/us-pe-vc-benchmark-commentary-calendar-year-2023/?source=syndication.
[26] Id.
[27] See FS Investments, Private Market Outlook: Refilling the Glass, Fall 2024, https://fsinvestments.com/fs-insights/q4-2024-private-markets-outlook-refilling-the-glass/#:~:text=As%20we%20approach%20the%20end%20of%202024%2C%20sparks,hike%20cycle%20cast%20a%20shadow%20over%20private%20markets.
[28] See Reply Brief for Petitioners, NAPFM v. SEC, (5thCir. 2024) (No. 23-60471).
[29] Id. at 28 (10).
[30] Id. at 28.
[31] See Form CRS Relationship Summary, 84 Fed. Reg. 33,492, 33,542/2 (July 12, 2019).
[32] Id. at 28.
[33] See Thibodeaux v. Grasso Prod. Mgmt. Inc., 370 F.3d 486 (5th Cir. 2004).
[34] See § 913(b)(1), 124 Stat. at 1824–25.
[35] See Beecham v. United States, 511 U.S. 368, 372 (1994).
[36] Id. at 13, 167–69.
[37] See 124 Stat. at 1570.
[38] See 88 Fed. Reg. at 63,338/1.
[39] Id. at 9 (citing 124 Stat. at 1828–29).
[40] Id. at 9. (citing 124 Stat. at 1829).
[41] Id. at 5 (citing 6(4)).
[42] Id. at 28.
[43] See Loper Bright Enterprises v. Raimondo, 603 U.S. __ (2024).
[44] See NAPFM 18.
[45] See NAPFM at 20.
[46] Id.
[47] See NAPFM at 21.
[48] Id. at 33.
[49] See NAPFM at 23.
[50] See NAPFM at 43.
[51] See Nat’l Ass’n of Manufacturers v. SEC (2024), (5thCir. 2024) (No. 23-60471).
[52] See SEC v. Jarkesy, 603 U.S. __ (2024).
[53] Id. at 43.