TheCorporateCounsel.net

While we do not cover developments with SEC fund rules that often here on TheCorporateCounsel.net, litigation over the SEC’s rules is on everyone’s mind these days, so the fate of the SEC’s controversial private funds rules in the courts is no doubt of interest. On Wednesday, a three-judge panel of the U.S. Court of Appeals for the Fifth Circuit vacated the private funds rules that the SEC adopted on August 23, 2023. This Goodwin alert notes:

Yesterday, a three-judge panel of the U.S. Court of Appeals for the Fifth Circuit vacated the “Private Funds Rules,” which the Securities and Exchange Commission (the “SEC”) adopted on August 23, 2023. The opinion of the Court (the “Opinion”) holds that the SEC lacked the rulemaking authority to issue these Rules under both Section 211(h) and Section 206(4) of the Investment Advisers Act of 1940 (the “Advisers Act”). As a result, the Opinion orders the Rules vacated. Once the Fifth Circuit decision formally takes effect—which should occur before the first compliance date, unless the SEC obtains some form of emergency relief or reconsideration—the Rules will be a nullity and all compliance dates will be moot. The SEC can seek further review of the Opinion, but review is not automatic: either the full Fifth Circuit or the Supreme Court would have to exercise discretion to hear the case.

As expected, the Fifth Circuit ruled that the SEC’s rulemaking authority under Section 211(h) of the Advisers Act is limited to “retail customers” and cannot be used in a rulemaking aimed at private funds and private fund investors. However, the Court also ruled that the SEC lacked rulemaking authority under Section 206(4) of the Advisers Act because (i) the SEC failed to define the “fraud” it was seeking to prevent and there were an insufficient number of enforcement actions to support the necessity of the rulemaking, (ii) Section 206(4) of the Advisers Act does not permit rulemaking concerning disclosures or reporting, (iii) Section 206(4) does not authorize the SEC to issue rulemakings that seeks to regulate the “internal corporate governance” of private funds (including with respect to investor reporting, fees and expenses, and redemption rights), and (iv) Section 206(4) only covers relationships with “clients” (e.g., the private funds) and not with the investors in private funds.

The SEC has a range of options in terms of next steps, none of which are likely to result in the Rules becoming effective in the near future. The SEC could theoretically propose new rules or re-open the existing rulemaking, which would likely be subject to a renewed challenge. The Opinion’s analysis, particularly with respect to Section 206(4), has potential ramifications beyond the Rules to a range of other current and future rulemaking. Thus, it appears more likely that the SEC would seek an “en banc” rehearing by the full Fifth Circuit (in a petition that would be due July 22, 2024) or skip that step and petition the Supreme Court to review the case.

The Fifth Circuit’s decision takes effect when the Fifth Circuit issues a formal order called a “mandate” to the SEC, which would ordinarily occur shortly after the time to seek rehearing expires (or shortly after rehearing is denied, if sought). Once that happens, the Private Fund Rules will be vacated, and all of the compliance dates from that point forward will no longer be effective. Although it is likely that the mandate will issue and the Rules will be vacated before the first compliance date, that is not guaranteed: for example, the SEC could seek emergency relief that delays the implementation of the Fifth Circuit’s decision and allows the Rules to take effect.

As you may recall, it was the Fifth Circuit that vacated the SEC’s share repurchase disclosure rules back in December 2023 on the grounds that the SEC acted arbitrarily and capriciously in adopting the final rules. And while the litigation over the climate disclosure rules has been consolidated in the U.S. Court of Appeals for the Eighth Circuit, that Court is notably comprised of conservative-leaning judges, similar to the Fifth Circuit.

One thing is for sure – the SEC’s recent rulemaking has been keeping the appellate group in the SEC General Counsel’s office very busy, and there are no signs of that slowing down.

– Dave Lynn