Fifth Circuit reverses SEC ruling on private fund advisers

The Private Fund Rules were the most comprehensive set of regulations for the private fund industry since the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”). On June 5, 2024, a unanimous three-judge panel of the United States Court of Appeals for the Fifth Circuit (“Fifth Circuit”) struck down the Private Fund Adviser Rules (“Private Fund Rules”).

While the Fifth Circuit’s decision is a significant event, the ruling does not overturn the impact of the regulations, which will continue to shape future review and enforcement actions, the relationship between private fund advisors and institutional investors, and industry best practices. These issues will continue to emerge in deficiency letters and enforcement proceedings. The Securities and Exchange Commission (“SEC”) will continue to regulate through a rigorous enforcement regime and may conduct reviews focused on the issues identified in the Private Fund Rules to support further rulemaking regarding private funds. The SEC may propose new rules, seek further industry comment, and possibly issue modified proposals for the Private Fund Rules.

Private Funds Policy Overview

The Private Funds Policy contains the following prescriptive rules:

• The principle of quarterly reporting: Requires quarterly investor statements detailing fees and expenses. Requires standardized reporting of fund performance based on net total return for “liquid” funds and internal rates of return (IRR) and multiples of invested capital (MOIC) for “illiquid” funds, along with reporting of contributions and distributions.
• Principle of auditing private funds: Requires private funds to be audited by a PCAOB-registered auditor that meets the independence standard set forth in Regulation SX and consistent with GAAP.
• Rule regarding secondary matters referred by counsel: Requires a fairness or valuation opinion for advisor-initiated transactions offering fund investors the option to sell all or part of their shares or convert or exchange them for new shares in another vehicle.
• Restricted Activities Policy:You are generally prohibited from: (i) charging or allocating fees or expenses related to an investigation of an adviser; (ii) charging fees or expenses related to an investigation that results in a penalty for a violation of the Advisers Act; (iii) charging or allocating regulatory, examination or compliance fees or expenses of the adviser; (iv) reducing the adviser’s returns for taxes; (v) disproportionate investment fees or expenses; and (vi) borrowing private funds from clients.
• The principle of preferential treatment:Prohibits redemption or liquidity terms that could reasonably be expected to have a material negative effect on other investors, with limited exceptions.
• Principle of preferential transparency:Prohibits disclosing portfolio holdings or risk exposures to any investor if doing so could have a material adverse effect on other investors.
• Annual Compliance Review Rule:Requires documentation of an annual review of compliance policies and procedures for all advisers, whether or not they advise private funds.

Applications for private fund advisors

To the extent that private fund advisers have changed existing practices, adjusted procedures or market approaches in anticipation of the Private Fund Rules, or provided certain notices or disclosures to current or prospective investors, they should evaluate whether and to what extent they should maintain and eliminate any such changes in accordance with applicable SEC rules and regulations. Private fund advisers should review their compliance programs, taking into account the historical context of the Private Fund Rules as well as the expectations of the SEC and investors, particularly in light of the Fifth Circuit ruling. Here are just a few areas to consider:

• Conflict of interest: Consider the various ways in which perceived or actual conflicts exist in the business of a private fund advisor, with particular emphasis on portfolio management conflicts, such as those present in the investment allocation and co-investment decision-making process. Private fund advisors should consider conflicts arising from strategic partnerships, such as relationships with lead investors and related service providers.
• Compliance Program Management: Conduct comprehensive risk assessments, compliance program reviews, and testing of compliance policies and procedures, with particular emphasis on the requirements of Rule 206(4)-7, using the Private Funds Rules as a source of interpretive guidance. Be prepared to discuss the results with the SEC and investors.
• Communication and reporting for investors: Review any changes made to investor report templates, notices, disclosures, marketing materials, and related investor documents, with particular attention to existing marketing materials, performance calculations, and disclosure practices, ensuring compliance with the SEC Marketing Rule. Consider the extent to which the private fund adviser may have contractually committed through side letters or other arrangements to comply with any aspect of the Private Fund Rules, including reviewing existing side letters and any Most Favored Nation (MFN) processes. Ensure timely completion of private fund audits and distribution of audited private fund financial statements to underlying investors.
• Fees and expenses: Carefully review the processes and procedures for fees and expenses, focusing on the allocation of specific expenses. It is important to ensure that there are no fee-related deficiencies, such as calculation errors or failures in manual processes. Advisors should also review the calculation and allocation of fees and expenses at both the fund and investment level.
• Regulatory reporting obligations: Private fund advisers should ensure they have a robust regulatory reporting framework in place to meet all reporting obligations in a timely and accurate manner. The SEC may take a more aggressive approach to errors and inaccuracies following the rescission of the private fund rules. Pay particular attention to Form ADV, Form PF and Form D, including any prior amendments. They should also expect the SEC to scrutinize ongoing regulatory filings, such as Forms 13F and 13H and Schedules 13D and 13G.
• Advisors on exemption reporting: Some of the Private Fund rules also apply to exempt advisers. This would expand SEC oversight of exempt advisers, which have been subject to limited SEC requirements to date, signaling a potential increase in SEC scrutiny and enforcement actions.

Private fund advisors should continue to proactively monitor the SEC’s actions in the private fund industry, despite the potential outcome of an appeal of the Fifth Circuit’s ruling. Private fund advisors are encouraged to contact Crowell & Moring LLP with any questions or to discuss this Client Alert.