NATIONAL ASSOCIATION OF PRIVATE FUND MANAGERS; ALTERNATIVE INVESTMENT MANAGEMENT ASSOCIATION, LIMITED; AMERICAN INVESTMENT COUNCIL; LOAN SYNDICATIONS AND TRADING ASSOCIATION; MANAGED FUNDS ASSOCIATION; NATIONAL VENTURE CAPITAL ASSOCIATION v. SECURITIES AND EXCHANGE COMMISSION
No. 23-60471
United States Court of Appeals for the Fifth Circuit
June 5, 2024
Kurt D. Engelhardt, Circuit Judge
Before
KURT D. ENGELHARDT, Circuit Judge:
The Securities and Exchange Commission (“Commission“) adopted a rule to enhance the regulation of private fund advisers, designed to protect investors who invest in private funds and to prevent fraud, deception, or manipulation by the investment advisers to those funds. Private Fund Advisors; Documentation of Registered Investment Adviser Compliance Reviews, 88 Fed. Reg. 63206 (Aug. 23, 2023) (to be codified at 17 C.F.R. pt. 275) [hereinafter “Final Rule“]. We consider a challenge to the Final Rule by petitioners National Association of Private Fund Managers, Alternative Investment Management Association, Ltd., American Investment Council, Loan Syndications and Trading Association, Managed Funds Association, and the National Venture Capital Association (collectively “Private Fund Managers“). For the following reasons, we VACATE the Final Rule.
I.
A.1
Private funds are pooled investment vehicles that are (as implied) private, not part of the public securities market. See Final Rule at 63207-08. Unlike familiar public pooled investment vehicles, like mutual funds, private funds are generally not accessible to non-professional investors, known as retail customers. Instead, they are generally open to some of the most sophisticated and wealthiest investors—e.g., Abu Dhabi Investment Authority, Yale University endowment, Hong Kong Monetary Authority, Stanford Management Company, and Harvard Management Company. Smaller investors, including state and local pension funds, have also helped the growth of the private fund sector. Id. Individuals—such as firefighters, public school educators, and law enforcement officers—have indirect exposure to private funds through their particiрation in public and private pension plans, which invest directly in private funds. Id. at 63208. There are many types of private funds, including private-equity funds, hedge funds, private credit funds, real estate funds, venture-capital funds, and collateralized loan obligations.
Over the past decade, the number of private funds has increased from 32,717 to 100,947, and the value has grown from $9.8 trillion in 2012 to $26.6 trillion in 2022. Final Rule at 63207. Amongst pension funds, the median allocation to private equity has risen from less than 1 percent in 2001 to approximately 9 percent in 2020. AR.145:2. And over the past 20 years, pension funds have earned returns of 9.25% per year in private equity, as opposed to only 5.4% per year in the public markets. AR.145:1 n.6.
B.
Investment companies, such as mutual funds and other publicly pooled investment vehicles, are subject to extensive regulation under the
Advisers to private funds, however, may be regulated in specific, limited respects through the
The Advisers Act recognizes a fiduciary duty between an investment adviser and his client.
C.
In this case, in promulgating the Final Rule, the Commission relies on preexisting antifraud rulemaking authority found in section 206 of the Advisors Act, as amended,
1.
Under the Advisers Act, “[i]nvestment adviser[s],” include “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.”
Section 80b-4(b) specifically addresses “[r]ecords and reports of private funds.” That section states that “[t]he Commission may require any investment adviser registered under this subchapter . . . to maintain such records of, and file with the Commission such reports regarding, private funds advised by the investment adviser, as necessary and appropriate in the public interest and for the protection of investors.” Id.
The Commission relies in part on section 206(4) of the Advisors Act, as amended,
It shall be unlawful for any investment advisor by use of the mails or any means of instrumentality of interstate commerce, directly or indirectly—
* * *
(4) to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative. The Commission shall, for the purposes of this paragraph (4) by rules and regulations define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative.
Section 211, as amended, authorizes the Commission “to make, issue, amend, and rescind such rules and regulations and such orders as are necessary or appropriate to the exercise of the functions and powers conferred upon the Commission elsewhere in this subchapter.”
The next subsection, section 211(h) of the Advisers Act, as amended, states:
(h) Other matters
The Commission shall—
(1) facilitate the provision of simple and clear disclosures to investors regarding the terms of their relationships with brokers, dealers, and investment advisers, including any material conflicts of interest; and
(2) examine and, where appropriate, promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that the Commission deems contrary to the public interest and the protection of investors.
Id.
2.
At 849 pages, and spanning 16 different titles, the Dodd-Frank Act covered a multitude of topics relating to the financial system. Only Title IV explicitly dealt with private fund advisers, bearing the heading “Regulation of Advisers to Hedge Funds and Others” and the suggestion it be cited as the “Private Fund Investment Advisers Registration Act of 2010.” §§ 401, 404, 124 Stat. at 1570. Under Title IV, the Dodd-Frank Act imposed registration and carefully limited reporting and recordkeeping requirements on some private fund advisers, along with limited rulemaking authority. §§ 403-404, 124 Stat. at 1571-74 (found at
Section 913 starts off by defining the term “retail customer” and directs the Commission to “conduct a study to evaluate” the existing legal or regulatory standards of investment advisers “for providing investment advice and recommendations
D.
On February 9, 2022, the Commission proposed a new rule under the Advisers Act regarding private fund advisers. Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, 87 Fed. Reg. 16886 (proposed Mar. 24, 2022) (to be codified at 17 C.F.R. pt. 275) [hereinafter “Proposed Rule“]. The Commission determined that, after a decade of experience overseeing, regulating, and collecting data on private fund advisers, “there [was] a need to enhance the regulation of private fund advisers to protect investors, promote more efficient capital markets, and encourage capital formation.” Proposed Rule at 16889–90. The Proposed Rule was intended “to protect those who directly оr indirectly invest in private funds“—such as firefighters, law enforcement officials, and other public workers that participate in pension funds—“by increasing visibility into certain practices, establishing requirements to address certain practices that have the potential to lead to investor harm, and prohibiting advisor activity that [the Commission] believe[s] is contrary to the public interest and the protection of investors.” Id. at 16890.
The Commission received hundreds of comments on the Proposed Rule. The Commission moderated the Proposed Rule in response to comments and, on August 23, 2023, by a 3-2 vote, adopted the Final Rule. The Private Fund Managers describe three major changes to the regulation of private funds in the Final Rule: (1) the preferential treatment rule; (2) the restricted activities rule; and (3) the quarterly statеment rule. Final Rule at 63388–89. The Final Rule also includes the adviser-led secondaries rule, the audit rule, and two rule amendments. Id. at 63386–87, 63389.
First, the preferential treatment rule prohibits advisers from providing certain investors preferential redemption terms or access to information regarding a fund‘s portfolio holdings or exposures if the fund‘s adviser reasonably expects that doing so will have a material, negative effect on other fund investors, unless an exception applies. Final Rule at 63389–90. The
Second, the restricted activities rule prohibits, inter alia, private fund advisers from charging private funds for fees or expenses associated with investigations of the advisor, or for regulatory and compliance fees or expenses. Id. at 63389. In contrast to the Proposed Rule, the Commission omitted the proposed prohibition on fees for “unperformed services” and on advisers seeking reimbursement, indemnification, exculpation, or limitation of liability from the fund. Id. at 63212. The Commission added two exceptions: the disclosure-and-consent based exception and the disclosure-based exception. Id. at 63263. The disclosurе-and-consent based exception permits an adviser to charge for fees and expenses associated with an examination or investigation only if “the investment adviser requests each investor of the private fund to consent to, and obtains written consent from at least a majority in interest of the private fund‘s investors that are not related persons of the adviser for, such charge or allocation.” Id. at 63389. The Commission further added the disclosure-based exception to the prohibition of regulatory or compliance fees; advisers may charge such fees only if “the investment adviser distributes written notice of any such fees or expenses . . . within 45 days after the end of the fiscal quarter in which the charge occurs.” Id.
Third, the quarterly statement rule requires that private fund advisers preрare and distribute quarterly-reporting statements containing detailed information disclosing fund-level information about performance, adviser compensation, and other fund fees and expenses. Id. at 63388. The Commission added to this rule by expanding the requirements for “illiquid funds.” The Proposed Rule required advisers to disclose only “unlevered returns,” i.e., performance metrics “without the impact of fund-level subscription facilities.” Proposed Rule at 16903–04, 16972. Fund-level subscription facilities are loans that advisers use to make investments for the fund.7 The Commission commented that levered returns “often do not reflect the fund‘s actual performance and have the potential to mislead investors.” Id. at 16903. The Final Rule thus requires that advisers to illiquid funds disclose “levered returns” and “unlevered returns,” meaning “with and without the impact of fund-levеl subscription facilities.” Final Rule at 63388.
Last, the Commission adopted the adviser-led secondaries rule, the audit rule, and two rule amendments. Id. at 63386–89. The adviser-led secondaries rule requires registered private fund advisers to obtain and distribute to investors an independent fairness or valuation opinion and disclose any relationship with the opinion provider. Id. at 63389. The Commission claims that this rule “will help prevent investors from being defrauded, manipulated, and deceived
In total, the Commission estimated that the Final Rule will cost $5.4 billion and requirе millions of hours of employee time. Final Rule at 63330, 63336-37, 63348, 63352, 63370-79.8 The need for oversight, according to the Commission, stems from investor protection risks and harms, such as the lack of transparency, conflicts of interest, and lack of governance mechanisms. Id. at 63209. “[The Commission] has observed that these three factors contribute to significant investor harm, such as an adviser incorrectly, or improperly, charging fees and expenses to the private funds, contrary to the advisor‘s fiduciary duty, contractual obligations to the fund, or disclosures by the advisor.” Id.
On September 1, 2023, the Private Fund Managers filed a petition for review with this court seeking review of the Final Rule pursuant to the
II.
Under the APA, the court must uphold the Commission‘s decision unless it is in “excess of statutory jurisdiction, authority, or limitations” or “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.”
III.
As an initial matter, the Commission argues that (A.) the Private Fund Managers have not demonstrated Article III standing and have not shown that venue is
A.
The Commission raises standing, arguing that the Private Fund Managers have not borne their burden of establishing Article III associational standing. The Commission also claims that this circuit is not the appropriate venue because no other petitioner resides here.
For challenges of rules under the Advisers Act, “[a]ny person or party aggrieved by an order issued by the Commission . . . may obtain а review of such order in the United States court of appeals within any circuit wherein such person resides or has his principal office or place of business.”
Regarding standing, NAPFM need not identify particular members “when all the members of [an] organization are affected” because the challenged rule targets an entire “industry.” Alon Refin. Krotz Springs, Inc. v. EPA, 936 F.3d 628, 665 (D.C. Cir. 2019) (internal quotation marks omitted) (emphases removed). Each petitioner is affected by the Final Rule because the Final Rule regulates private fund advisers, and each petitioner represents private fund advisers. The Private Fund Managers also point out that the Commission admits each petitioner represents private fund advisers. Moreover, Article III is satisfied when “‘at least one’ petitioner . . . has standing.” R.J. Reynolds Vapor Co. v. Food & Drug Admin., 65 F.4th 182, 188 (5th Cir. 2023) (quoting Town of Chester v. Laroe Estates, Inc., 581 U.S. 433, 439 (2017)). Here, the Private Fund Managers have standing.
B.
The Commission relies on section 211(h) and section 206(4) of the Advisers Act for the authority to promulgate new rules. The Commission cites the changes made by the Dodd-Frank Act as filling a “serious statutory gap,” by augmenting the Commission‘s rulemaking power, “by authorizing the Commission to issue rules ‘for the protection of investors’ concerning certain disclosures, sales practices, conflicts of interest, and compensation schemes.”
In cоntrast, the crux of the Private Fund Managers’ argument is that Congress drew a “sharp line” between private funds and funds that serve retail customers. The ICA further details requirements governing almost every aspect of a fund‘s operations, and private funds are exempt from this regime. This is because “[i]nvestment vehicles that remain private and available only to highly sophisticated investors have historically been understood not
The question presented is whether the Commission has statutory authority under the Advisers Act to formulate the Final Rule to regulate private fund advisers and investors. The Commission relies on sections 206(4) and 211(h) of the Advisers Act in adopting the preferential treatment rule, restricted activities rule, quarterly statement rule, adviser-led secondaries rule, audit rule, and the amendment to compliance procedures and practices. Final Rule at 63386.
The central focus is thus on whether the Dodd-Frank Act expanded the Commission‘s rulemaking authority to cover private fund advisers and investors under section 211(h) of the Advisers Act, see Part III.B.1., and whether section 206(4) authorizes the Commission to adopt the Final Rule, see Part III.B.2. We hold neither section grants the Commission such authority.10
1.
It starts with the text. “[S]tatutory terms are generally interpreted in accordance with their ordinary meaning.” Sebelius v. Cloer, 569 U.S. 369, 376 (2013) (citation omitted). The ordinary-meaning canon is “the most fundamental semantic rule of interpretation.” ANTONIN SCALIA & BRYAN A. GARNER, READING LAW: THE INTERPRETATION OF LEGAL TEXTS § 6, at 69 (2012). The court‘s job “is to interpret thе words consistent with their ordinary meaning . . . at the time Congress enacted the statute,” Wis. Cent. Ltd. v. United States, 138 S. Ct. 2067, 2070 (2018) (internal quotation marks omitted), “unless the context in which the word[s] appear[]” suggests some other meaning, Taniguchi v. Kan Pac. Saipan, Ltd., 566 U.S. 560, 569 (2012).
Here, at first blush, section 211(h) seemingly grants the Commission the power to “facilitate the provision of simple and clear disclosures to [all] investors . . . including any material conflicts of interest” and “promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes” for any investment advisers that the Commission deems contrary to “the protection of investors.”
But statutory language “cannot be construed in a vacuum. It is a fundamental canon of statutory construction that the words of a statute must be read in their context and with a view to their place in the overall statutory scheme.” Roberts v. Sea-Land Servs., Inc., 566 U.S. 93, 101 (2012) (citation omitted); see also SCALIA & GARNER, supra, at 167-69 (applying the whole-text canon). And in cases where statutes are in pari materia (“in a like matter“), they should be interpreted harmoniously. SCALIA & GARNER, supra at 252.
The ICA and Advisers Act are “sister statutes” having been simultaneously enacted as Titles I and II. The ICA subjects investment companies to extensive regulations, replete with reporting and disclosure requirements, restrictions on expenses that may be charged to investors by the fund, restrictions on fund investments and fund capital structure, prohibitions against self-dealing, and prescriptive contractual governance requirements. See
Congress originally exempted private funds that do not make or propose to make a public offering of securities and do not have more than 100 beneficial owners.
The Commission claims that the Final Rule regulates private fund advisers and investors. But the makeup of the ICA preserves the market-driven relationship between a private fund adviser, the fund, and outside investors. The Dodd-Frank
The Commission claims that the word “investors” is used without modification or limitation, and the term includes private fund investors. The Commission argues that “retail customer” is defined in section 913(a), used throughout section 913(b)-(f), but the word “investor” does not appear in subsection (h). According to the Commission, Congress purposefully “switched” to “investors” —to include private investors—in section 211(h) and did not use “retail customers.” The Commission maintains that when Congress includes particular language in one section of a statute but omits it in another section of the same act, it is “generally presumed that Congress acts intentionally.” Sebelius, 569 U.S. at 378 (cleaned up)). It is unlikely that Congress meant to switch to “investor” “in the middle of a provision otherwise devoted” to retail investment. Schreiber v. Burlington N., Inc., 472 U.S. 1, 12 (1985). And the heading “[o]ther matters” confirms this point. The Commission claims that “[o]ther” indicates an intent to “cover more than retail customers,” but the subject covered must “have some resemblance to what preceded.” Thibodeaux v. Grasso Prod. Mgmt., Inc., 370 F.3d 486, 491 n.5 (5th Cir. 2004). A discussion of the interaction between financial professionals and “retail customers” is what preceded. “Othеr” encompasses “prospective” retail customers. See Form CRS Relationship Summary; Amendments to Form ADV, 84 Fed. Reg. 33492, 33542 (July 12, 2019) (to be codified at 17 C.F.R. pts. 200, 240, 249, 275, 279).
The Private Fund Managers’ interpretation of the statute is persuasive. We therefore hold that section 211(h) applies to “retail customers,” and thus, the Commission exceeded its statutory authority in relying on that section to adopt the Final Rule.
2.
Section 206(4), as amended, authorizes the Commission to “define, and prescribe means reasonably designed to prevent, such acts, practices, and courses of business as are fraudulent, deceptive, or manipulative” regarding “any investment adviser.”
The Final Rule‘s “anti-fraud” measure is pretextual. The Private Fund Managers claim that the Commission has not articulated a “rational connection” between fraud and any part of the Final Rule the Commission adopted. We agree. The Commission fails to explain how the Final Rule would prevent fraud. Section 206(4), as amended, specifically requires the Commission to “define” an act, practice, or course of business that is “fraudulent, deceptive, or manipulative” before the Commission can prescribe “means reasonably designed to prevent” “such” act, practice, or course of business.
Section 206(4) further fails to authorize the Commission to require disclosure and reporting. Other parts of the Advisers Act expressly provide for disclosure and reporting of certain information. See
The Private Fund Managers further maintain that the Final Rule is not “reasonably designed” per section 206(4) because to be “reasonably designed” requires a “sensible” fit within the “statutory text,” see Ascendium Educ. Sols., Inc. v. Cardona, 78 F.4th 470, 482 (D.C. Cir. 2023), and a “close nexus” with “statutory aims,” see O‘Hagan, 521 U.S. at 676 (citation omitted). We agree that the Final Rule does not fit within the statutory design. Mainly, the ICA purposefully exempted private funds from the prescriptive framework, permitting private
And the Final Rule lacks a “close nexus.” The Commission conflates a “lack of disclosure” with “fraud” or “deception,” see Final Rule at 63264, 63271, 63279, 63308, but a failure to disclose “cannot be deceptive” without a “duty to disclose.” See Regents of Univ. of Cal. v. Credit Suisse First Bos., 482 F.3d 372, 386 (5th Cir. 2007). The duty extends to the client alone, which is the fund, not the investors in the fund. SEC v. Washington Inv. Network, 475 F.3d 392, 404 (D.C. Cir. 2007) (“The Investment Advisers Act concerns itself with investment advisers, who, as fiduciaries, have a duty to disclose material information to clients.“); Goldstein, 451 F.3d at 880 (“If the person or entity controlling the fund is not an ‘investment adviser’ to each individual investor, then a fortiori each investor cannot be a ‘client’ of that person or entity.“). The Commission cannot rely on section 206(4) for the authority to adopt the Final Rule.
IV.
The Commission has exceeded its statutory authority in adopting the Final Rule. Under section 706 of the APA, when a court holds that an agency rule violates the APA, it “‘shall‘—not may—‘hold unlawful and set aside’ [the] agency action.” Sw. Elec. Power Co. v. EPA, 920 F.3d 999, 1022 (5th Cir. 2019) (citation omitted). Because the promulgation of the Final Rule was unauthorized, no part of it can stand. Accordingly, we VACATE the Final Rule.