More SEC Rules in Peril With Private Fund Rule Strikedown

Two of the Securities and Exchange Commission’s main rulemaking statutes hang in the balance after the U.S. Court of Appeals for the Fifth Circuit struck down on June 5 the agency’s Private Fund Adviser Rules.

The ruling “is a very broad Fifth Circuit decision,” Gail Bernstein, general counsel for the Investment Adviser Association in Washington, told me in a recent interview. The court “ended up treating all the rules as a package, including the [RIA] compliance program rule, which was under a different provision all together. It was sweeping.”

A three-judge panel found that the SEC lacked the rulemaking authority to issue the rules, which were adopted on Aug. 23, 2023, under both Section 211(h) and Section 206(4) of the Investment Advisers Act of 1940.

Section 211(h), added under the Dodd-Frank Act after the financial crisis, authorizes the SEC to restrict certain sales practices to protect investors. Section 206(4) is an antifraud statute.

Under 211(h), the court ruled “investors” includes only retail investors, not private fund investors, Bernstein explained. The court also ruled that the securities regulator had abused its antifraud authority under 206(4), which ”had been relied on by the SEC … for several of its rules for a very long time now.”

IAA would expect that the SEC is now mulling how the ruling will affect new and existing rules, according to Bernstein.

“Even more challenging for the SEC will be trying to figure out what [the court ruling] means for 206(4) because so many existing rules and proposed rules are based on it,” Bernstein relayed. “It’s been the go-to authority for virtually all of the SEC’s rules.”

Those rules include the proposed rules on advisor outsourcing, predictive data analytics and custody of assets, as well as the new Marketing Rule, Bernstein said.

With three and a half months remaining in the SEC fiscal year, the agency needs “to get busy working on the rulemaking agenda if they want to meet their goals,” added Amy Lynch, founder and president of FrontLine Compliance.

“However, changes within internal management may be affecting this,” Lynch said, as both the Investment Management and Examinations divisions “have undergone leadership changes this year and priorities have most likely changed because of it.”

The “most controversial” 2024 rulemakings remain as proposed rules, Lynch said:

• Safeguarding Advisory Client Assets
• Enhanced Disclosures by Certain Investment Advisers and Investment Companies about ESG Practices
• Conflicts of Interest Associated with the Use of Predictive Data Analytics by Broker-Dealers and Investment Advisers
• Outsourcing by Investment Advisers.

“Any finalized rules for advisers will be the responsibility of IM and previously the focus for IM was on funds, both private and public,” Lynch continued.

Bernstein expects to see final rules from the agency on cybersecurity, ESG and the outsourcing rule for advisors this summer “and certainly before the election” in November.

Reproposals of the SEC’s predictive data anlaytics and custody rules are also expected before the election, Bernstein said.

SEC Appeal?

While it’s “not clear whether the SEC will try to challenge the Fifth Circuit’s ruling” either by requesting en banc review by the court or a Supreme Court review, “as it stands, the decision could have broad implications for SEC rulemaking authority,” said Sara Crovitz, a partner at Stradley Ronon in Washington.

“Most SEC watchers have suggested the SEC won’t do either,” Bernstein said. The Fifth Circuit could either deny to rehear the case or “the court could take it and there’s a very high risk you then get instead of a three-judge panel decision … a full circuit panel decision; that could be even more damaging to the SEC.”