In recent years, the U.S. Securities and Exchange Commission (SEC) has taken an aggressive approach to regulating the private markets. Under the leadership of Chair Gary Gensler, the Commission has focused its scrutiny on private funds in particular.
While the Investment Company Act offers two pathways for private funds to remain exempt from SEC registration and related requirements—Section 3(c)(1) and Section 3(c)(7)—the Commission has authority over all investment advisers, including private fund advisers.
Lacking the ability to impose rules directly on funds that Congress exempted from SEC oversight, the Commission has instead crafted rules targeting private fund advisers. Some of these rules have been challenged in court, and the outcome of the case could have significant implications for private fund advisers—including exempt reporting advisers (ERAs) who aren’t required to register with the SEC.
SEC’s Private Fund Adviser rules
Among the most consequential new rules that will impact the private market landscape are the SEC’s Private Fund Adviser rules, which were proposed in February 2022 and adopted in August 2023. Engagement from Carta and the broader industry helped soften some of the more problematic aspects of the proposal. But as a whole and individually, these rules constitute a major change to the way business is done in the private fund sector and a shift in how the industry is regulated.
The Private Fund Adviser rules will disproportionately affect small and emerging managers. For example, the rules prohibit private fund advisers from engaging in certain activities, including common practices like side letters, unless disclosures are provided to investors—in some cases, before an investment is made. The rules also require registered investment advisers (RIAs) of private funds to deliver prescriptive quarterly statements to their investors on fund fees, expenses, and performance.
Pushback from industry
Despite some softening of the final rules, industry groups have pushed back against the SEC, suing to block the implementation of the new requirements.
In a court filing, industry groups led by the National Association of Fund Managers claim the Private Fund Adviser rules “exceed the Commission’s statutory authority, were adopted without compliance with notice-and-comment requirements, and are otherwise arbitrary, capricious, an abuse of discretion, and contrary to law.”
The petitioners have asked the Fifth Circuit to vacate the rules.
Stakes of the case
The petitioners’ lawsuit makes two separate arguments for vacating the Private Fund Adviser rules: first, that the SEC exceeded its authority in issuing the rules; and second, that the rules are capricious and arbitrary. If the court agrees with either assessment, it could vacate the rules or return them to the SEC with instructions for remedy.
The ruling will largely depend on how the Fifth Circuit interprets the SEC’s authority in two areas:
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SEC’s authority over private fund advisers: The Dodd-Frank Act gives the SEC the authority to impose disclosure requirements relating to advisory relationships and conflicts of interest. By citing Dodd-Frank as a source of authority for promulgating the PFA rules, the SEC presumes this authority applies not only to funds registered with the Commission as investment companies, but to all private funds—including those that aren’t open to retail investors. The lawsuit asks the Court to determine whether this is the case.
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SEC’s anti-fraud authority: The SEC also cited a general anti-fraud provision under Section 206(4) of the Investment Advisers Act of 1940 as a basis for some of its rules. The lawsuit suggests that the SEC has only recently made the “discovery of a sweeping new power over private funds,” through Section 206(4), that it represents an unreasonable expansion of agency authority, and that regulators are acting against the congressional intent to exempt certain kinds of funds from the type of extensive regulatory oversight it claims the SEC is attempting to impose.
The Court’s ruling could embolden or curb SEC rulemaking under one or both of these presumed authorities, depending on the outcome.
Why the Fifth Circuit?
The decision to bring suit in the Fifth Circuit was strategic. The petitioners could have sued the SEC in any jurisdiction where one or more of the petitioners resides or does business. Industry groups brought their suit to the Fifth Circuit because they perceived it to be the court most favorable to their desired outcome: vacating the rules.
Justices on the Fifth Circuit have demonstrated greater skepticism of the powers claimed by various federal agencies. In a recent but separate case against the SEC, the Fifth Circuit vacated an SEC rule requiring additional disclosures related to stock buybacks. The justices cited the Administrative Procedure Act, which asks that courts set aside rules found to be “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” Notably, the National Association of Fund Managers repeated this wording in their claim.
What’s next
The case could result in few potential outcomes. The court could either:
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uphold the rules in their entirety,
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strike down parts of the rules, or
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send the rules back to the SEC with instructions for remedy.
Our take: Given the Fifth Circuit’s skepticism of expansive regulatory authority, it seems more likely than not that the justices will find portions of the rule arbitrary or capricious, or that the SEC exceeded its authority in issuing them. After the ruling, either side could request that the Fifth Circuit rehear the case en banc (meaning all the justices will hear the case, rather than a three-judge panel), or appeal to the Supreme Court. Whether the case proceeds to the highest court will depend on the breadth of the FIfth Circuit’s decision.
Why it matters: An adverse court decision for the SEC—especially one that finds that it exceeded its statutory authority—would erect a significant obstacle for the SEC to regulate investment advisers. The SEC has relied on the same presumed authorities for other controversial proposals, including the outstanding rule proposals on predictive analytics and ESG investment.
How Carta is helping fund managers prepare for PFA compliance
The Policy, Product, and Fund Administration teams at Carta are working together to design the industry's first standardized template to meet the new quarterly statement reporting requirements that go into effect for registered investment advisers in March 2025.
Our standardized template will help fund managers comply with the new reporting requirements for quarterly statements, without additional outlay in time or resources. RIAs on Carta will be able to begin using the new standardized quarterly statement later this summer, well in advance of the March 2025 deadline.
>>Sign up below for the Carta Policy Team’s weekly private markets newsletter
Timeline for the SEC’s Private Fund Adviser rules
Here’s a timeline of how we got here—and what to expect next:
February 2022: The SEC issues its proposal for the new Private Fund Adviser rules and opens the 60-day public comment period.
April 2022: Carta joins other industry groups in urging the SEC to lengthen the public comment period and reconsider aspects of the rules, particularly those that would disproportionately affect emerging managers and ecosystem.
August 2023: The SEC adopts a modified set of Private Fund Adviser rules.
September 2023: Industry groups representing private fund advisers sue the SEC in federal court to block implementation of the rules.
February 2024: A three-judge panel on the Fifth Circuit Court of Appeals hears oral arguments in National Association of Fund Managers v. Securities and Exchange Commission.
Going forward
May 2024: Petitioners have asked the Fifth Circuit to hand down a ruling by May, which is the earliest the court is expected to rule. However, the court is not bound by the petitioners’ request and may rule at any time.
Summer 2024: RIAs on Carta will be able to begin using the new standardized, PFA-compliant quarterly statements.
September 2024: If the rules are upheld, compliance with certain prohibitions outlined in the PFA rules go into effect for funds with over $1.5 billion in assets under management. This includes the preferential treatment rule (i.e., prohibition of side letters), the restricted activities rule, and the advisor-led secondaries rule.
March 2025: If upheld, compliance with the quarterly statement and private fund audit rules begin to go into effect.
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