SEC’s Private Fund Advisers Rule Vacated by the Fifth Circuit

The Private Fund Rules were the most comprehensive set of regulations for the private funds 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 U.S. Court of Appeals for the Fifth Circuit (“Fifth Circuit”) vacated the Private Fund Adviser Rules (“Private Fund Rules”).

While the Fifth Circuit's decision is a significant development, the ruling does not nullify the rules' influence, which will continue to shape future examination and enforcement activities, private fund adviser and institutional investor relationships, and industry best practices. These issues will continue appearing in deficiency letters and enforcement proceedings. The Securities and Exchange Commission (“SEC”) will continue to regulate through a rigorous enforcement regime and may perform sweeps focused on issues outlined in the Private Fund Rules to support further private fund rulemaking. The SEC may propose new rules, seek further industry comment, and possibly issue a modified Private Fund Rules proposal.

Private Fund Rules Overview

The Private Fund Rules provide for the following prescriptive rules:

• Quarterly Statements Rule: Requires quarterly investor statements with detailed fee and expense information. It requires standardized fund performance reporting 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 a statement of contributions and distributions.
• Private Fund Audit Rule: Requires private funds to be audited by a PCAOB-registered public accountant meeting the Regulation S-X independence standard, and in accordance with GAAP.
• Adviser-Led Secondaries Rule: Requires fairness or valuation opinions for adviser-initiated transactions offering fund investors the option between selling all or a portion of their interests and converting or exchanging them for new interests in another vehicle.
• Restricted Activities Rule: Generally prohibits: (i) charging or allocating fees or expenses associated with an investigation of the adviser; (ii) charging fees or expenses related to an investigation resulting in a sanction for violating the Advisers Act; (iii) charging or allocating regulatory, examination, or compliance fees or expenses of the adviser; (iv) reducing adviser clawbacks by taxes; (v) non-pro rata investment fees and expenses; and (vi) borrowing from private fund clients.
• Preferential Treatment Rule: Prohibits redemption or liquidity terms that would reasonably be expected to have a material, negative effect on other investors, with limited exceptions.
• Preferential Transparency Rule: Prohibits disclosing portfolio holdings or exposure information to any investor if doing so would have a material, negative effect on other investors.
• Annual Compliance Review Rule: Requires the documentation of the annual compliance policies and procedures review for all advisers, whether they advise private funds or not. 

Takeaways for Private Fund Advisers

To the extent 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 assess whether and to what extent they should retain and eliminate any such changes consistent with existing SEC rules and regulations. Private fund advisers should review their compliance programs considering the historical context of the Private Fund Rules, as well as SEC and investor expectations, especially in light of the Fifth Circuit's ruling. Outlined below are just a few areas for consideration:

• Conflicts of Interest: Consider the various ways in which perceived or actual conflicts exist within the private fund adviser’s business, with particular attention to portfolio management conflicts, such as those present in the investment and co-investment allocation decision-making process. Private fund advisers should consider conflicts arising from strategic partnerships, such as relationships with anchor investors and affiliated service providers.
• Compliance Program Management: Conduct extensive risk assessments, compliance program reviews, and testing of compliance policies and procedures, with a particular focus on the requirements of Rule 206(4)-7 using the Private Fund Rules as a source of interpretive guidance. Be prepared to discuss the outcomes with the SEC and investors.
• Investor Communications and Reporting: Review any revisions made to investor reporting templates, notices, disclosures, marketing collateral and related investor documents, with particular attention to existing marketing materials, performance calculations, and disclosure practices, ensuring compliance with the SEC’s Marketing Rule. Consider the extent to which a private fund adviser may have contractually obligated itself 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 Nations (MFN) processes. Ensure the timely completion of private fund audits and the distribution of private fund audited financial statements to underlying investors. 
• Fees and Expenses: Thoroughly review fee and expense processes and procedures, focusing on the allocation of certain expenses. It is important to ensure no fee-related deficiencies, such as calculation errors or failures in manual processes. Advisers should also review the calculation and allocation of fees and expenses at both the fund and investment levels.
• Regulatory Reporting Obligations: Private fund advisers should ensure they have a robust regulatory reporting framework to complete all reporting obligations timely and accurately. The SEC may take a more aggressive approach to errors and inaccuracies following the vacating 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.
• Exempt Reporting Advisers: Certain of the Private Fund Rules also apply to exempt reporting advisers. This would mean an expansion of SEC oversight with respect to exempt reporting advisers who, to date, have been subject to limited SEC requirements, signaling a potential increase in SEC examinations and enforcement actions.

Private fund advisers should continue to proactively monitor SEC action in the private funds industry, notwithstanding potential appeal outcomes from the Fifth Circuit’s ruling. Private fund advisers are encouraged to contact Crowell & Moring LLP with any questions or to discuss this Client Alert.