In a somewhat unexpected ruling this past Wednesday, a Louisiana U.S. appeals court overturned in its entirety an SEC finalized rule adopted in August 2023. The rule, which amended the Investment Advisers Act of 1940, was intended to provide more protection to investors and transparency into non-registered private funds. It also would have required advisers of private funds to spend additional, significant administrative time and resources to comply. While some in the industry may have expected the rule to be partially vacated, its compete reversal came as a surprise to many.
Historically, hedge funds, private equity funds, venture capital funds and commodity pools, which make up the roughly $30 trillion private fund industry, have enjoyed lower compliance requirements than mutual funds and exchange-traded funds in the registered funds space. This often results in lower operating costs and less burdensome disclosure requirements for private funds. The new August rule stood to change that balance. Learn more about the court’s decision and what it means for funds and advisers.
The three-judge panel of the U.S. Court of Appeals for the Fifth Circuit unanimously stated that no part of the private funds rule adopted by the SEC on August 23, 2023, can stand. As a refresher, the rule included:
The court stated the rule exceeded the SEC’s statutory authority because the laws on which it relied didn’t give the SEC such authority. "By congressional design, private funds are exempt from federal regulation of their internal governance structure,” wrote Judge Kurt Engelhardt.
The ruling was provided in response to a lawsuit brought last summer by a cohort of trade associations, including the Managed Funds Association, American Investment Council, National Association of Private Fund Managers, National Venture Capital Association, Alternative Investment Management Association, and the Loan Syndications and Trading Association. They argued the rules would fundamentally change the way private funds are regulated in the U.S. They claimed the rule would also effectively bar bespoke contractual terms investors negotiate to meet specific needs, and would prevent advisers from charging for certain expenses, ultimately requiring costly reporting they felt was unnecessary.
There are always two sides to any story. The appealing trade associations, and many others, are applauding the court’s decision as a significant victory for private fund advisers and investors alike. Investors will continue to be able to negotiate tailored terms with private fund advisers to meet their specific needs, and advisers will avoid the costly implementation of the rule. Those in favor of the ruling also believe it’s a victory for U.S. businesses that look to private funds for investments/capital to grow.
On the other hand, financial reform groups are disappointed, as they believe the rule would have provided investors with key protections and transparency, which has been the current SEC regime’s agenda over the past few years. Some of these investors include pension funds, which are essential to the retirement savings of policemen, firefighters and teachers.
From our perspective, we believe the SEC’s intent was to protect investors from practices that can often be viewed as opaque in the private fund world and to create more transparency. However, investors in such funds are typically high-net-worth individuals, trusts, accredited investors and sophisticated institutional clients that typically have the knowledge and resources to understand the complexities of the private funds in which they invest. This includes fund fee structures and expenses, which are currently shared and disclosed to investors through private placement memorandums, subscription agreements and other fund organizational agreements. These funds were not designed for the everyday retail investor, nor should they be, given the complexities and risks associated with these funds’ underlying investments. The SEC rule also would have ultimately resulted in higher costs to investors with additional compliance burden.
We expect the SEC will carefully review this court ruling in detail and weigh the concerns of market participants before taking next steps. In the meantime, we will continue to monitor the developments on this ruling and its impact to those in the industry.
Contact Syed Farooq or a member of your service team to discuss this topic further.
Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.