FAQs on SEC’s Private Fund Adviser Rules After Fifth Circuit Decision

As most fund managers have likely heard by now, on June 5, 2024, the US Court of Appeals for the Fifth Circuit vacated the private fund adviser rules that the Securities and Exchange Commission (SEC) adopted in summer 2023, which would have required compliance by fund managers as early as September 2024. In short, the court ruled that the SEC exceeded its statutory authority and that no part of the rules can stand.

Below, we address some frequently asked questions we’ve received since the ruling.

1. Which rules have been vacated?

The following rules under the Investment Advisers Act of 1940 have been vacated:

• Preferential Treatment Rule (Rule 211(h)(2)-3)
• Restricted Activities Rule (Rule 211(h)(2)-1)
• Quarterly Statement Rule (Rule 211(h)(1)-2)
• Adviser-Led Secondaries Rule (Rule 211(h)(2)-2)
• Private Fund Audit Rule (Rule 206(4)-10)

In addition, amendments to the Recordkeeping Rule (Rule 204-2) that were related to the above rules, as well as an amendment to the Compliance Rule (Rule 206(4)-7) that would have required written documentation of annual compliance reviews, have been vacated. (For a summary of these rules, refer to our Facing the SEC’s New Rules for Venture Capital and Other Private Fund Advisers blog post.)

2. Does vacatur mean the rules are dead, annulled, canceled, gone, etc.?

Sort of. A vacatur by the applicable highest court would mean those things. However, because the ruling was made by a panel of judges in the Fifth Circuit, it can be appealed for an en banc hearing by all the judges in the Fifth Circuit. Alternatively, it can be appealed to the US Supreme Court. The SEC has not announced whether it will appeal the decision. If the SEC were to appeal to the Supreme Court, the Supreme Court would still need to grant certiorari and agree to hear the case.

3. Should we view compliance with the rules as best practice?

Not necessarily. Fund managers are likely to face pressure from investors to implement some of the disclosure and reporting measures the rules would have required. But given how prescriptive the rules were, voluntary compliance with the rules would not seem to be a prerequisite for firms following a “best practice” standard in their business. For example, the Quarterly Statement Rule would have required dollar amount disclosure of every fund expense without exception for de minimis or miscellaneous items. And other aspects of the rules would have required fitting square pegs into round holes, expending resources (time and money) trying to fit under a two-sizes-fit-all approach. While it remains to be seen how the industry will ultimately trend, we note that the Institutional Limited Partners Association (ILPA), which had published reporting templates for public comment just days before the Fifth Circuit decision, announced that it is reorienting the templates and working to relaunch the comment period once it updates the scope of the templates.

All that said, firms should keep in mind that their fiduciary duty under the Investment Advisers Act has not changed. Investment advisers, whether registered or exempt, must act in their funds’ best interest, and not place their own interest ahead of the funds’ interest. This includes adequate disclosure of conflicts of interest, particularly where fees and expenses are involved. Many of the practices that the vacated rules sought to address have been the subject of SEC enforcement actions in the past, years before the rules were even proposed. The SEC’s exam staff will continue to probe – and the SEC’s enforcement staff will continue to investigate – fund managers’ practices and disclosures where conflicts of interest or fees and expenses are concerned.

4. Does this impact the requirements around showing levered and unlevered returns?

The short answer is no. The Quarterly Statement Rule would have required registered investment advisers (RIAs) to report levered and unlevered returns in their quarterly statements to investors. While this rule has been vacated, RIAs are separately subject to the Marketing Rule (Rule 206(4)-1), which has not been vacated.

The Marketing Rule requires gross performance in an advertisement to be accompanied by net performance with equal prominence. The net performance must be calculated over the same time period, using the same type of return and methodology, as the gross performance. In a marketing compliance FAQ, the SEC staff stated that it believes an adviser would not comply with this requirement if it showed a gross internal rate of return (IRR) that is calculated from the time an investment is made without reflecting fund borrowing or subscription facilities (i.e., an unlevered gross IRR) alongside a net IRR that is calculated from the time investor capital has been called to repay such borrowing (i.e., a levered net IRR). In the same FAQ, the staff stated its view that an adviser would violate the general prohibitions of the Marketing Rule if it showed only a levered net IRR without including an unlevered net IRR or disclosing the impact of subscription facilities on the net IRR shown.

Exempt reporting advisers (ERAs) are not subject to the Marketing Rule (nor would they have been subject to the Quarterly Statement Rule). RIAs, however, continue to be subject to the Marketing Rule, and the SEC staff’s FAQ described above remains applicable to their advertisements. (To learn more about the Marketing Rule, check out our previous blog posts: Venture Capital Fund Managers’ Guide to Applying the Latest Marketing Rule Risk Alert and Last-Minute Checklist for Private Fund Managers Complying With Marketing Rule.)