After a final thwarting of the SEC’s efforts to govern the private funds industry, the agency has moved to forgo rulemaking in favor of litigation.
It became clear this month that the SEC would not act to challenge the Supreme Court’s June decision to throw out proposed requirements for more transparency around fees and preferential treatment practices. The SEC’s inaction was seen as the nail in the coffin in its protracted efforts to invoke rule changes to regulate the industry.
Now, SEC chair Gary Gensler, whose time in the role may be coming to a close with a new presidential administration around the corner, is guiding an effort to effect change through enforcement actions and litigation instead. To add to his challenges, recent Supreme Court developments have chipped away at the power of federal agencies to introduce rule changes.
“We are already starting to see the SEC, in examinations, pressing more on the types of issues that the private fund adviser rule changes would have addressed, basically trying to build up a case that those rules were important,” said Aaron Schlaphoff, a former SEC regulator and a partner in the investment funds group at law firm Paul Weiss.
On Sept. 3, for example, the agency announced a settlement with Florida-based Galois Capital Management, a cryptocurrency-focused private fund charged with misleading investors about the notice period required for redemptions, a form of preferential treatment that the original rule changes would have addressed.
Rulemaking headwinds
The battle between Gensler and the private funds industry began in August 2023, when the SEC adopted a set of new rules and amendments to the Investment Advisers Act of 1940 that would, among other changes, restrict private fund managers’ ability to offer LPs preferential terms on redemptions and require GPs to provide them with detailed accounting of all fees and expenses paid by the fund during the reporting period.
The adoption of the rules and amendments raised swift backlash from industry advocacy groups, which argued that the SEC’s efforts would overwhelm GPs with fund reporting obligations. Trade groups, including the Managed Funds Association, the National Association of Private Fund Managers, the National Venture Capital Association filed a lawsuit, arguing that the adoption of the rules would harm investors and fund managers by increasing costs and undermining competition.
In June, a federal appeals court in New Orleans ruled in favor of the private fund coalition and threw out the SEC’s rule changes in a major win for the private funds industry. In its ruling, the court determined that the regulator overstepped its authority in its adoption of the material.
For Gensler and the SEC, the overturn set a murky precedent for the regulator’s rulemaking ability, particularly as the agency enters into the final month of its fiscal year, a period typically frenzied with regulatory activity. The agency still has several proposed rules on its docket, including a rule that would establish standards for funds submitting data to the SEC and Gensler’s reputation-defining regulations aiming to fight greenwashing and false ESG claims from investment funds.
“The SEC is almost assuredly taking a hard look at their prospects for rulemaking generally,” said Joel Wattenbarger, a partner at law firm Ropes & Gray and a co-head of the firm’s private funds regulatory practice.
A shift in focus
The clock is ticking for Gensler—whom President Joe Biden appointed in 2021—as November’s presidential election fast approaches, the results of which could eventually move him out of his position as chairman. In order to make material changes to the private funds industry, the agency is now focusing its attention on litigation.
It has taken this approach before, turning to the courts when attempted rule changes did not work out. In February 2023, the SEC proposed changes to the Investment Advisers Act of 1940 intended to enhance protections of assets managed by registered investment advisers. The proposal drew criticism from industry leaders and lawmakers, who argued that the requirements would disadvantage SEC-registered RIAs.
“Again, we’re seeing greater attention on that topic in SEC examinations, especially in the last month,” Schlaphoff said. “The SEC has made a habit of this in recent years.”
Another recent Supreme Court decision could further diminish the SEC’s rulemaking abilities. The court decided in June to overturn the “Chevron deference,” the practice of federal courts deferring to federal agencies’ interpretation of ambiguous language in statutes. The end of the Chevron deference could give federal courts new avenues to challenge the SEC’s proposed rules and increase uncertainty around the outcomes of the regulator’s rules and regulations.
The SEC, among other federal agencies, has historically relied on the Chevron deference to extend its power. With the Private Fund Adviser Rules, the SEC depended on its own interpretation of the Dodd-Frank Act to support its proposed rule changes.
Without the final word on the interpretation of laws, agencies now have less ground to stand on when proposing changes to these statutes.
If the SEC had decided to challenge the appellate court’s overturning of the private investment advisers act rules, the agency would either have had to return to the unsympathetic fifth circuit court or take the case to the Supreme Court.
“The risk of going to the Supreme Court,” Wattenbarger said, “is that the SEC might not only lose its appeal, but, in a worst-case scenario, it would wind up with a Supreme Court precedent that was even more harmful for the SEC’s institutional interests than merely losing this particular case in the fifth circuit.”
Featured image of SEC chair Gary Gensler by Drew Angerer/Getty Images
