Compliance June 5, 2024

SEC’s Private Fund Adviser Rule Struck Down by 5th Circuit Appeals Court

The 5th Circuit vacated the rule completely on Wednesday after being challenged by an association of private fund managers and other plaintiffs.

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The U.S. 5th Circuit Court of Appeals vacated the Securities and Exchange Commission’s Private Fund Adviser rule on Wednesday. The rule had been finalized in August and was challenged in court by the National Association of Private Fund Managers and other plaintiffs in September.

The rule regarding advisement of private investment funds had required advisers  to issue quarterly performance statements to investors in the fund as well as an annual audit. Advisers were also prohibited from giving preferential treatment to some investors regarding share redemption and access to information about the fund’s holdings if doing so would negatively affect other investors. Those advisers were also limited in their capacity to pass on enforcement related expenses to investors without their explicit consent.

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On Wednesday, a panel of the Court vacated the rule in its entirety by a 3-0 vote. The panel noted that the Dodd-Frank Act gave the SEC limited new authorities over private fund advisers, such as requiring them to register with the SEC and to issue rules to prevent fraud.

It did not, however, extend to the point where the SEC was seeking to regulate, according to the court, which wrote: “The Dodd-Frank Act only stepped towards regulating the relationship between the advisers and the private funds they advise,” and not the investors in said fund.

The Court added that the statutory language that the SEC cited in defense of the rule applies only to retail investors and not to investors in private funds, who are virtually never retail investors.

Private fund advisers normally consider the fund itself as their client, rather than the investors in the fund. Investors in private funds tend to be more sophisticated institutional or accredited investors, though some institutional investors such as pensions represent non-sophisticated investors.

Joshua Broaded, head of global regulatory compliance at ACA Group, says that private fund investors are often some of the most sophisticated and “can ask for the things that they want and need” in terms of additional disclosures, but that there is a “spectrum of power and sophistication” among them. Some, including smaller institutions or high net-worth individuals, are not nearly as sophisticated and do not have the negotiating power to request additional disclosures. Those were the types of investors the SEC was seeking to protect, but according to the 5th Circuit does not have the authority.

Broaded adds that the rule was mostly popular with institutional investors, who were broadly demanding more transparency, especially around fees and performance.

The SEC has not announced if they intend to appeal the ruling.

Broaded says that this rule represented many of the most “important and fundamental objectives for the SEC,” such as “fairness in how investors are treated” and disclosures that are “consistent from adviser to adviser.” The SEC will need some time “to digest this ruling,” Broaded says, but it has the options of appealing to the Supreme Court, appealing to the full Circuit (as opposed to a panel), or not appealing at all.

Broaded says that even though the rule was vacated, he expects investors to continue to ask for the key features in the rule and he anticipates “some of the intent of the rule will come into common practice.”

Compliance June 5, 2024

Showing Net Performance in Portfolio Subsets Is Hardest Part of Marketing Rule

The majority of investment advisers are changing marketing materials to try and comply with the rule, with frustrations, according to a Seward & Kissel survey.

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A majority of investment advisers are struggling to market the performance of subsets and breakouts of investment portfolios for fear of running afoul of the marketing rule, according to a recent survey by The Seward & Kissel LLP law firm of 120 advisers.

The Marketing Rule governs the advertising practices of advisers and came into effect in November 2022. The rule keeps many traditional requirements designed to prevent misleading investors, while adding that advisers may not use gross performance of investments before fees and costs in marketing materials unless net performance after fees are charged is also used–or they may use net and omit gross.– In addition, advisers can’t use hypothetical performance unless it is relevant to a specific audience.

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The survey, which sought to measure advisers’ feelings about the rule, found that 70% of advisers said that their marketing performance materials were the most affected by the rule; in comparison, just 25% said that their general communications with clients were most affected.

Among performance-related marketing materials, showing the gross versus net performance of investments was the most troublesome regulation to meet, and was cited by 76% of advisers as challenging.

Dan Bresler, a partner at Seward & Kissel and a co-author of the survey, says the key challenge here is with asset sub-sets: “the difficulty there is if you’re applying a fund level expense to a more narrow position.”

For example, a portfolio or pooled investment vehicle can be broken down by industry, region or other criteria for advertising purposes. The adviser would show the gross performance of the holdings in a portfolio and would then need to adjust for fees to show net performance. However, if those holdings are part of a product with many assets, and the fees are assessed to the product or portfolio as a whole, it can be difficult to calculate how much of those fees relate to that specific asset so the net performance can be calculated reasonably.

As for hypothetical performance, 46% of advisers answered that they never use hypotheticals in marketing and so are unaffected by the rule. Another 29% said there was no change in how they used hypothetical performance, 15% said they now do so less, 6% more and 4% stopped showing them completely once the rule was finalized.

The researchers found that private credit advisers struggled the most with hypothetical performance requirements, with 60% affirming that this provision was a challenge for them.

Bresler explains that private credit advisers often use target returns in their marketing as credit instruments are easier to predict. Since this is still, however, technically hypothetical performance, private credit advisers must be sure that the performance is well established and relevant to the audience receiving it.

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