Fifth Circuit wipes out private fund adviser rules

Fifth Circuit wipes out private fund adviser rules

Author: The Carta Policy Team
Read time:  7 minutes
Published date:  7 June 2024
SEC is expected to appeal the decision


  • Fifth Circuit reverses private fund adviser rules

  • Financial services spending bill begins lengthy path to enactment

  • SEC panel discusses potential for AI regulation

  • Appeals court rules that VC must suspend grant program to Black women

Fifth Circuit strikes private fund adviser rules

In a huge win for the private funds industry, this week a three-judge panel of the Fifth Circuit struck down the SEC’s private fund adviser rules on the grounds the agency exceeded its authority in issuing the new requirements. These rules would have changed how venture capital and private equity operate and are regulated, imposing operational challenges and compliance costs on all fund managers—regardless of size or registration status.

The legal analysis

  • The court found the SEC did not have authority under Section 211(h) of the Investment Advisers Act, which was added by the Dodd-Frank Act. The court limited the SEC’s rulemaking authority to protections for retail customers, as opposed to sophisticated investors in private funds. 

  • More importantly, the court found the SEC lacked rulemaking authority under Section 206(4)—the SEC’s general anti-fraud authority that serves as the basis for most of the rules adopted under the Advisers Act. The court found the agency did not provide a factual basis to justify the rule and that the anti-fraud rules cannot be used as the basis for disclosure-based rulemaking.

What this decision means for funds: With the Fifth Circuit’s decision, new requirements that would have required VC and PE private fund advisers to prepare and distribute prescriptive quarterly statements and disclose side letter terms (among other requirements) will not become effective—at least in the near term. The SEC will likely appeal the decision, though the agency is still determining next steps. But even if an appeal is ultimately successful, that process would almost certainly extend beyond current compliance deadlines. So funds have some breathing room. 

Broader impacts: The Fifth Circuit’s ruling may impact other SEC initiatives that affect  private fund advisers—namely the proposed custody and predictive data analytics rules. Existing rules that impose disclosure requirements on private fund advisers, such as the Marketing Rule, could also come under fire. These proposals and rules were all promulgated using the same legal authority justification used for the private fund adviser rules.

What’s next: Given the potential ramifications of the decision, the SEC is expected to appeal, but any ultimate resolution will likely extend into next year. 

  • The SEC can petition for a rehearing of the case by the entire Fifth Circuit (an en banc hearing) or appeal directly to the U.S. Supreme Court, though review by either court is not automatic. A SCOTUS appeal is the most likely path forward given the conservative leaning of the Fifth Circuit.

Carta will continue to track developments on the private fund adviser rules and other rulemaking initiatives that will impact the private fund ecosystem. 

Financial services spending bill begins lengthy path to enactment

The House Appropriations Committee Subcommittee started the process to fund the financial regulators, though this will take time. FSGG Subcommittee started the process to fund the financial regulators, though this will take time. The bill proposes broad funding cuts for financial regulators and places a marker on several policy points: 

  • SEC. In addition to a significant budget cut, the bill would prohibit the SEC from using funding to advance or enforce using funding to advance or enforce a host of rules, including climate-related financial disclosures, custody arrangements, changes to Reg D and the accredited investor standard, and updates to the way “holders of record” are calculated under Section 12(g), which would force more private companies to go public. The bill would also significantly narrow the enforcement actions the agency can pursue for digital asset transactions.

  • Treasury/IRS. The proposed $2.3 billion cut to Treasury resources would be taken almost entirely from IRS funds, with the FSGG Chairman noting the bill would take steps to prevent agencies like the IRS from unfairly targeting taxpayers. A cut in IRS funds would likely impact new IRS modernization and large partnership examination efforts, and the bill would also prevent FinCEN from using fund to implement or enforce beneficial ownership reporting rules under the Corporate Transparency Act that have been found unconstitutional or do not reflect congressional intent

  • SBA. Paired with a $187 million cut to the Small Business Administration’s funding, the bill would also prevent the agency from further expanding its existing direct loan programs and bar the creation of new ones. This follow’s last year’s controversial expansion of the 7(a) program to include fintech lenders.

Why it matters: The FSGG bill released by the committee is a starting point for future appropriations negotiations.  It will not become law in its current form, but signals the Republican policy priorities they will push for in a final bill—and in the future. Existing government funding expires on Sept. 30, but that deadline will be extended until after the election or, more likely, into 2025.

SEC panel discusses potential for AI regulation

The SEC’s Investor Advisory Committee (IAC) hosted a panel on the agency’s role in regulating artificial intelligence (AI), particularly how AI adoption fits within the existing regulatory framework and where additional guidance and regulation may be needed.

  • Panelists discussed the foundations of AI, the core pillars of AI governance, the use of AI in auditing, and the risks of applying ill-fitting regulatory frameworks to AI models, among other areas.  

  • On the regulatory front, there was some consideration around whether the SEC should separate efforts to regulate AI technology from efforts to regulate AI use-case outcomes. The former focuses on elements like algorithmic transparency, testing and certification, and data governance, while the latter would apply frameworks based on sectors and/or level of risk involved.

A separate discussion focused on regulating social media as a means of providing investment advice, and the IAC reviewed a series of draft policy recommendations and subcommittee reports.

Why it matters: The SEC, like Congress and other financial regulators, is trying to decode the rapidly evolving universe of AI. Last summer, the SEC waded into AI regulation by proposing a controversial AI-related rule that sought to create guardrails around the use of predictive data analytics by broker-dealers and investment advisers. The rule received swift pushback from industry, with opponents claiming that the rule was too broad and would inhibit the development and innovation of new financial technology tools, and thus the rule is likely to be modified and reproposed. 

Discussions from the IAC and other industry engagement will help shape how the SEC approaches AI regulation. But ultimately, any recommendations from the IAC on how the SEC could best regulate AI would be nonbinding suggestions, not a mandate to the Commission. 

Appeals court rules that VC must suspend grant program to Black women

This week, an appeals court ruled to suspend a venture capital firm’s grant program for Black women business owners, ruling that a conservative group is likely to eventually prevail in its lawsuit claiming that the program is discriminatory. 

  • The challenge was brought against Fearless Fund by a conservative activist group who claimed that the VC’s grant program for Black women was discriminatory under the Civil Rights Act, which prohibits discrimination on the basis of race when enforcing contracts. .

  • The 2-1 injunction ruling found the challenger's argument to be legally sound (and therefore likely to eventually prevail in court) Anti-affirmative action activists have recently been leveraging these laws to challenge programs intended to benefit minority-owned businesses.

While the court's ruling was somewhat anticipated because of the court’s conservative leaning, there was intense pushback from the VC industry. Fearless Fund has reiterated its commitment to continue to fight the lawsuit.

Why it matters: Less than 1% of venture capital funding goes to businesses owned by Black and Hispanic women. Grant programs, such as the one run by the Fearless Fund, aim to lower the barriers to entry that minority- and women-owned businesses and funds face because they have historically had less access to capital than their peers. And research shows diverse founders create more value for investors. 

Carta supports policies that democratize access to capital, lower barriers to entry, and increase investment opportunities across the population to encourage a more diverse and inclusive economy. Some possible mechanisms for achieving these goals include:

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The Carta Policy Team
Carta’s Policy Team aims to connect the policymaking community and venture ecosystem to build an ownership economy and advance policies that support private companies, their employees, and their investors.
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