On September 1, 2023, the Managed Funds Association and a group of private equity and hedge fund trade groups sued the U.S. Securities and Exchange Commission (SEC) in the United States Court of Appeals for the Fifth Circuit, arguing that the SEC overstepped its statutory authority in adopting new private fund adviser rules.  The lawsuit was filed under 5 U.S.C. §§ 702–704, 706, 15 U.S.C. § 80b–13(a) and Federal Rule of Appellate Procedure 15(a) as a petition for review of the new rules. The new rules were adopted on August 23, 2023, by a Commission vote of 3-2.

Under the new rules, all registered private fund advisers are required to issue enhanced disclosures, perform annual audits, and obtain a fairness opinion in adviser-led secondary transactions. Private fund advisers are also now restricted from engaging in certain activities without disclosure and consent from investors, and are prohibited from providing preferential treatment to some investors.[1]

The lawsuit alleges that the rules exceeded the SEC’s statutory authority, were arbitrary and contrary to the law, and were adopted in violation of the Administrative Procedure Act. The trade groups contend that these new rules would “fundamentally change the way private funds are regulated in America,” and asked the court to hold unlawful, vacate, and set aside the rules, and grant additional relief as necessary and appropriate.[1]

First, the trade groups argued that the SEC violated the notice-and-comment requirements of the Administrative Procedure Act. The SEC first proposed the new rules for public comments on February 9, 2022. The final adopted rules are different from the proposed rules in several aspects. The trade group argued that the SEC adopted the new rules that diverged sharply from the proposed rules without further notice to the public or opportunity to comment, in violation of the notice-and-comment requirements.

Second, the trade groups alleged that the new rules will curb the entrepreneurialism, flexibility, and investment returns of the private funds. The trade groups pointed out that private fund investors are often highly sophisticated investors advised by leading law firms. Investors have worked with the private fund advisers to develop mutually beneficial contractual terms for many years. The new rules will harm the thriving private funds business by restricting bespoke contractual terms and imposing onerous requirements.

Third, the trade groups claimed that the SEC exceeded its statutory authority. The trade groups argued that Congress has long recognized that private funds do not require exhaustive regulatory requirements given the size and sophistication of the investors. The general anti-fraud provision 206(4) of the Advisers Act or section 913 of the Dodd-Frank Act that focuses on retail investors do not provide a basis for SEC’s new sweeping regulatory power over private funds.

The SEC has yet to file a response to the suit, but it denied the trade groups’ claims stating that it “undertakes rulemaking consistent with its authorities and laws governing the administrative process, and [ ] will vigorously defend the challenged rule in court.”[2] Regarding their statutory authority, in the rules release, the SEC claimed that the new rules are within its statutory authorities under sections 206(4) and 211(h) of the Advisers Act as a means to prevent fraudulent acts, facilitate disclosures, and restrict certain sales practices, conflicts of interest, and compensation schemes in the private funds market.[3] The SEC also adopted a broader reading of section 913(g) of the Dodd-Frank Act, arguing that Congress did not cabin the Dodd-Frank reforms only to retail investors.[4] To support the adoption of the new rules, the SEC emphasized three major factors of risks in the private funds market that require enhanced regulation: lack of transparency, potential conflicts of interests, and lack of governance mechanisms.[5] SEC Chair Gary Gensler stated that the new rules can promote transparency, competition, and efficiency in the private funds market by enhancing advisers’ transparency and integrity.[6]

The outcome of the case is going to have significant implications for the SEC’s statutory authorities. Private funds groups and their supporters have argued that Congress has deliberately applied different regulatory regimes for private funds and that the SEC “encroaches on a major question that remains the domain of Congress.”[7] Labor unions, investors-focused organizations, and their supporters have argued that the new rules “fall squarely within the SEC’s legal authority” and “will help protect workers’ pensions and create a more transparent and accountable private funds market.”[8] A favorable outcome for the trade groups will hinder the SEC’s regulatory power under the anti-fraud provision in the Advisers Act and call into questions of many SEC’s existing regulations. If the court rules for the SEC, we will likely see more expansive regulations from the SEC.

This blog will continue to monitor the case. Meanwhile, the trade groups’ petition does not have a tolling effect on the new rules. The compliance dates of the new rules range from 60 days to 18 months after publication in the Federal Register. Private funds should start to take steps to conform to the new rules, which would likely require significant changes in the systems, disclosure processes, and other internal policies.