Insight Analytical Note

Read

5th Circuit Overturns PFAR and Creates Significant Regulatory Uncertainty

Background:

  • On June 5th, 2024, a three-judge panel at the 5th U.S. Circuit Court of Appeals in New Orleans issued an opinion (“Opinion) which vacated a Securities and Exchange Commission (“SEC”) rule package, the Private Fund Adviser Rules (“PFAR”) that required increased disclosure from private fund advisers and prohibited certain fee arrangements.
  • While the SEC retains appeal options, it does not seem likely to prevail and the path would be long. Our view is that PFAR is dead.
  • The 5th Circuit’s opinion goes beyond just overturning PFAR and calls into question the basis of the legal theories used by the SEC for private equity and private fund enforcement.

Implications Beyond PFAR:

  • Violations Of Limited Partnership Agreements: The Opinion stated that …complying with the “fund’s governing agreements” is not fraud, nor is disagreement over “discretionary violations.”
    • Analysis:
      • Failure to comply with a fund’s governing agreements underpins almost every major private equity enforcement case including how management fees are calculated, broken deal expenses are allocated, investments are allocated, and related party service providers are hired and utilized. This one-line calls into question whether those types of cases will continue to be brought and whether examinations will be able to cite anti-fraud provisions.
      • The Opinion did not define “discretionary violations”. However, this could refer to managers utilizing their discretion to engage in conduct that is not specifically disclosed. Specificity of disclosure has been a key tenant of the SEC’s approach to private equity enforcement and this could complicate the SEC’s current approach.
  • Need for Investor Disclosure Called Into Question: The Opinion stated that the duty to disclose material facts extends to the client alone, which is the fund, not the investors in the fund.
    • Analysis:
      • The Investment Advisers Act requires disclosure of conflicts of interest and material facts to clients. For private fund advisers, the client is the fund itself, which is controlled, in turn, by the adviser. With the growth of the private funds industry over the past 20 years, the SEC has tried to extend the disclosure requirements to investors, who are the only ones able to evaluate such disclosure, by adopting certain rules under authority granted under Section 206(4) of the Investment Advisers Act. Removal of this authority will severely limit the SEC’s ability to conduct its investor protection activities in the private funds space.

Takeaways:

  1. Near Term Uncertainty: This decision strikes at the heart of the legal theories behind most private equity cases. Enforcement cases where the legal theories rely on formation document noncompliance will significantly slow. Likewise, exams focused on these issues may grind to a halt. More broadly, matters relying on Rule 206(4)-8 or other disclosure-based rules promulgated under 206(4) may similarly slow or be suspended.
  2. Less Private Equity Enforcement Cases: Firms under investigation for improper investor disclosures, noncompliance with fund documents or other 206(4) rules, including the pay-to-play rule, may now refuse to settle with the SEC and the SEC is unlikely to take the litigation risk. Accordingly, we will see significantly less private fund enforcement in the near future.
  3. Compliance Programs Will Be Largely Unchanged: Lessons from Goldstein: In 2006, the Appeals Court for the District of Columbia unanimously invalidated the SEC’s Hedge Fund Rule in a decision called Goldstein vs. the SEC. The Hedge Fund Rule required hedge funds to register as RIAs even though they did not meet the registration requirements at the time. The Hedge Fund Rule had already been implemented and hedge fund advisers were already registered. After the decision was enacted, only a small number of hedge funds deregistered because the advisers and their investors saw a benefit from regulation. While parts of the PFAR opinion throw some components of private equity regulation into question, the ultimate regulatory scheme and private equity managers’ approach to compliance is unlikely to change because investors see a benefit from robust compliance programs.