Court Overturns SEC’s Enhanced Regulations for Private Equity, Hedge Funds

U.S. Securities and Exchange Commission (SEC) Chair Gary Gensler testifies before a Senate Banking, Housing, and Urban Affairs Committee oversight hearing on the SEC on Capitol Hill in Washington on Sept. 14, 2021. (Evelyn Hockstein/Reuters)

A federal appeals court has ruled that the Securities and Exchange Commission (SEC) overstepped its authority when it adopted enhanced regulations for hedge funds and private equity firms that industry groups denounced as regulatory overreach that would harm both fund managers and investors.

The Fifth U.S. Circuit Court of Appeals struck down the SEC’s rules in a decision filed on June 5, justifying its decision on the premise that the SEC exceeded its statutory authority.

“Because the promulgation of the Final Rule was unauthorized, no part of it can stand,” the judges wrote in the opinion. “Accordingly, we vacate the Final Rule.”

The ruling comes in response to a lawsuit filed by a coalition of industry groups, which argued that the rule was arbitrary, capricious, and unlawful; that the SEC failed to prove that the rules were addressing an actual problem; and that the commission failed to conduct an adequate cost-benefit analysis.

When adopting the rules, the SEC argued that they would increase transparency, competition, and efficiency in the private funds market.

Several of the plaintiffs issued statements on June 5 praising the court’s decision to void the enhanced regulations, with the Managed Funds Association (MFA) president and CEO calling it a “significant victory for markets, fund managers, and investors, including pensions, foundations, and endowments.”

A director and securities specialist at Wall Street watchdog Better Markets called the circuit court’s decision a “terrible setback” that would “deprive investors in private funds—including everyday Americans with pension funds—of the protections the rule would have provided against unfair and opaque practices.”

“We’re reviewing the decision and will determine next steps as appropriate,” an SEC spokesperson told The Epoch Times in an emailed statement.

The Rule

The SEC adopted the new rules in August 2023 in a 3–2 vote. The rules were rolled into one final rule that enhanced the regulation of private fund advisers in several key ways.

This included requiring private fund advisers registered with the SEC to detail quarterly fees and expenses to investors and barring favored investors from being able to redeem their investments more easily than others under certain circumstances.

The final rule also required private fund advisers to obtain an annual audit for each private fund and get a “fairness opinion” or valuation opinion with respect to an adviser-led secondary transaction.

The enhanced regulations also barred private fund advisers from engaging in certain activities deemed to be “contrary to the public interest” unless they provide certain disclosures to investors and obtain investor consent, in some cases.

Private fund advisers were also prohibited from providing certain types of preferential treatment that had a “material negative effect” on other investors while also barring other types of preferential treatment unless it was disclosed to both prospective and current investors.

The tougher rules also required all advisers registered with the SEC, including ones that don’t advise private funds, to compile written annual reports documenting their compliance policies and procedures.

“Private funds and their advisers play an important role in nearly every sector of the capital markets,” SEC Chair Gary Gensler said at the time the rule was promulgated. “By enhancing advisers’ transparency and integrity, we will help promote greater competition and thereby efficiency.”

Industry groups opposed the rules, taking legal action that sought to have them voided.

Allegations

The rules were challenged in a lawsuit brought by a coalition of industry groups comprising the MFA, the American Investment Council (AIC), the National Association of Private Fund Managers, the National Venture Capital Association, the Alternative Investment Management Association (AIMA), and the Loan Syndications and Trading Association.

The consortium argued for vacating the rule on several grounds.

First, they asserted that the new rule oversteps the SEC’s statutory authority by attempting to regulate the relationship terms between private funds and their investors, which are specifically exempt from such regulation. They also claimed that the SEC didn’t provide a meaningful opportunity for public comment on the final rule, which differed significantly from the proposed rule.

Furthermore, they argued that the rule is arbitrary, capricious, and unlawful, claiming that the SEC failed to present evidence of the industry problem it purportedly addresses.

Finally, the trade groups criticized the SEC for not conducting what they said was an adequate cost-benefit analysis, thereby neglecting its statutory obligation to consider whether the rule would promote efficiency, competition, and capital formation.

In its ruling, the appeals court sided with the groups, although Judge Kurt D. Engelhardt wrote in the decision that because the court found that the SEC exceeded its authority in setting the rule, the judges didn’t evaluate the remaining issues raised in the lawsuit.

Reactions

The industry groups behind the lawsuit praised the court’s decision.

Jack Inglis, CEO of AIMA, said in a statement reacting to the ruling that the court’s decision “will spare the private funds industry and investors a lot of unnecessary costs and disruption” and that it will “protect the interests of [AIMA] members against regulatory overreach and improper rulemaking by the U.S. SEC that would have had severe and adverse impacts on a wide variety of market participants.”

Bryan Corbett, president and CEO of MFA, said that the ruling is a major win for investors and fund managers alike, while applauding the court for affirming that “the SEC cannot expand its authority beyond what Congress intended.”

Drew Maloney, president and CEO of AIC, called the ruling “a victory for thousands of businesses across America that need capital to grow and millions of workers who depend on private equity and credit to strengthen their retirements.”

By contrast, Stephen Hall, legal director and security specialist at Wall Street watchdog Better Markets, called the decision “a terrible setback on many levels.”

“Regulations that arm investors such as pension funds with the information they need to invest in private funds are essential to protect the retirement savings of teachers, firefighters, and policemen,” Mr. Hall said.

He accused the Fifth Circuit of having a track record that’s “unduly sympathetic” to industry claims and alleged that the ruling would only encourage the industry to continue its practice of “forum shopping,” which is seeking out courts that are likely to side with them.

The ruling comes as the Biden administration has rolled out a number of new rules aimed at big business, including a Federal Trade Commission ban on noncompete agreements.