The Securities and Exchange Commission’s loss in court over new restrictions on hedge funds and private equity firms casts a cloud over its other plans on artificial intelligence and climate change.
The SEC based its authority for the private fund disclosure rules, vacated this week by the US Court of Appeals for the Fifth Circuit, on a section of the Dodd-Frank Act. Congress passed that legislation in the wake of the 2008 financial crisis to protect ordinary investors.
The appeals court, which has a reputation for being business-friendly, said the SEC can’t rely on that section to dictate sales practices and compensation between private funds and institutional investors.
The decision makes it difficult for the SEC to “substantively regulate the relationship between sophisticated investors and fund managers,” said Akin Gump Strauss Hauer & Feld LLP partner Brian Daly, who advises private fund managers.
The SEC has in recent months pointed to the same section of Dodd-Frank to justify other proposed rules, including restrictions on money managers that use predictive data analytics to interact with clients.
The Fifth Circuit’s ruling, handing a win to the private fund industry plaintiffs—the American Investment Council, the National Association of Private Fund Managers, and MFA, formerly the Managed Funds Association—puts those restrictions on shaky ground.
The decision also raises questions about rules proposed under the SEC’s traditional anti-fraud powers.
Carving Out Funds
The SEC’s private fund disclosure rules, adopted by a 3-2 vote in August, were an aggressive bid by the agency under Chair Gary Gensler to tighten its grip on the fast-growing, $30 trillion-dollar industry. Gensler has said the popular industry needs more guardrails.
The rules would’ve required private funds to disclose more about their fees and expenses. Firms would’ve also been prohibited from giving sweetheart deals to some investors, making it easier for them to cash out.
The SEC couched the rules as transparency measures within its Dodd-Frank powers to prohibit or restrict advisers’ sales practices, conflicts of interest, and compensation.
But the Fifth Circuit said the Dodd-Frank provision applies only to “retail customers,” not the sophisticated and wealthy investors that have access to private funds, like the Harvard Management Company managing the university’s endowment or the Abu Dhabi Investment Authority.
“Congress created the private funds category to allow bespoke arrangements, to allow more customization, more negotiation between equals,” Daly said.
Industry groups howled at the rules, accusing the agency of a vast power grab. The SEC’s two Republican commissioners, both of whom voted against the measures, also foreshadowed parts of the Fifth Circuit’s decision. Commissioner Mark Uyeda said the agency was relying on a “tortured reading” of the law.
“We see a decision like this as maybe creating the potential for the SEC giving industry comment a bit more weight and thinking again before adopting rules like this, particularly under that provision of the Advisers Act,” said Nicole Krea, an asset management partner at Ropes & Gray LLP, referring to the 1940 law updated by Dodd-Frank.
The Fifth Circuit also said the SEC couldn’t rely on its traditional anti-fraud power in the Investment Advisers Act to “prescribe means reasonably designed to prevent” fraud by fund advisers. The court said the agency didn’t explain how the rule would prevent fraud.
The SEC could ask the full Fifth Circuit to review the case, or appeal to the US Supreme Court. The Fifth Circuit is already on track to review a record number of its own decisions this year.
AI, Climate Rules
The SEC has invoked the Dodd-Frank provision to support other recent rule proposals, including one last July that would require companies to assess whether their use of predictive data analytics or AI poses conflicts of interest.
Read More: Wall Street Braces for More SEC Scrutiny of AI, Private Funds
Proposals that would force investment funds to disclose their portfolio companies’ greenhouse gas emissions, restrict investment advisers when outsourcing certain services, and strengthen safe-keeping of investor assets also implicate either that section or the anti-fraud authority.
Gensler during a Thursday meeting of the SEC’s Investor Advisory Committee said he’s asked staff to consider re-proposing the predictive analytics rule after receiving “robust comments” from the public.
The Fifth Circuit’s decision will likely weigh heavily as the agency mulls its next steps on that and other proposals.
“There will be some internal discussion and strategizing about whether or not we believe that these rules as they’re currently drafted will withstand judicial scrutiny,” said Morrison & Foerster LLP partner and former SEC attorney Val Dahiya.
The Fifth Circuit’s comments about the SEC’s anti-fraud power could have particularly significant implications. The court said the SEC had to actually define the fraud.
“That sets a high standard,” said K&L Gates LLP partner Pablo Man, who works with investment advisers and private funds. “The broader implication is that it might affect additional rulemaking from the SEC.”
Multi-Front Attack
The ruling is a significant setback for the SEC. Within the agency, there are concerns about the potential for private funds to pose systemic risks to markets, given the power they wield.
Those concerns were amplified by the 2022 meltdown of Bill Hwang’s Archegos Capital Management, a family investment office that managed billions of dollars.
Read More: Bill Hwang Wants to Cite Morgan Stanley Leaks as Secrecy Defense
The Fifth Circuit’s opinion makes it difficult for the SEC to directly address concerns about a lack of transparency in the funds industry, attorneys said. But the agency has been “trying on multiple fronts to bring private funds under regulation,” Dahiya said.
Other recent measures include expanding the definition of “dealer” to sweep in some hedge funds. The SEC has also adopted rules forcing private funds to reveal more about short selling and stock lending. The private fund industry groups are also challenging those rules in court, including in cases that could go before the Fifth Circuit.
If the rules survive, they will shed more light on private funds and their activities.
“The SEC hasn’t taken a one-shot approach,” Dahiya said. “They are attacking this on multiple levels, with the understanding that some of these rules survive.”
