November 8, 2023 - As we’ve previously noted, the LSTA in early September joined several trade associations in commencing a lawsuit against the SEC in connection with its Private Fund Advisers Rule (the “Rule”). Last week, Gibson Dunn submitted to the U.S. Court of Appeals for the Fifth Circuit (5^th Circuit) its opening brief. In an important related matter, the 5^th Circuit last week dealt the SEC a significant blow by ruling in a lawsuit brought by the U.S. Chamber of Commerce that the SEC violated the Administrative Procedure Act (“APA”) in implementing its Share Repurchase Disclosure Rule. That decision is likely to have a direct impact on our lawsuit.

Below we summarize the opening brief and describe the 5^th Circuit’s decision in the Chamber case and why it is so important.

The PFA Opening Brief. We ask the Court to vacate the Rule for lack of statutory authority to impose and for violating the APA on several grounds: (i) Congress exempted private funds from the prescriptive regime applicable to publicly available investment vehicles.  These investment vehicles, such as mutual funds, are closely regulated under the Investment Company Act of 1940; (ii) Congress deliberately carved out private funds from this regulatory framework, recognizing that investments in these vehicles are only available to highly sophisticated investors; (iii) private funds have flourished under this regulatory regime, growing in value from $9.8 trillion to $26.6 trillion in the past decade and providing investors with excellent returns; and (iv) despite the success of private funds, the SEC has imposed a radical overhaul of their business arrangements. 

The Rule would, among other things: (i) Sharply limit “side arrangements” thus limiting the ability of key investors to obtain additional information or favorable economic terms; (ii) ban advisers from charging investors for regulatory and compliance fees and for preparing regulatory filings; (iii) require advisers to prepare and distribute prescriptive, costly and burdensome quarterly reports rather than the tailored reports that are currently negotiated between advisers and investors (note that this requirement does not apply to CLO managers); and (iv) prohibit reimbursement indemnification, exculpation or limitation of liability by the fund, even in the case of simple negligence.

The brief then makes several arguments for vacating the Rule:(i) The Rule exceeds the SEC’s statutory authority. Congress purposely exempted private funds from the prescriptive regulation applicable to funds serving retail customers and the Rule turns that structure upside down. The SEC’s statutory argument relies on a random, ancillary provision entitled “Other Matters” from a section of the Dodd-Frank Act that has never been used in the context of private funds. Indeed, by its terms, that provision applies to retail customers who are not generally eligible to invest in private funds; (ii) the SEC denied the public a meaningful opportunity to comment. It made extensive revisions to the proposed rule but allowed no opportunity to comment on this retooling of the proposal; (iii) the Rule is arbitrary, capricious and otherwise unlawful. The SEC claimed that the Rule is needed to fix an industry problem but there is no factual basis for the Rule and the SEC offered no evidence of any problem. The Rule is also unworkable and unduly burdensome; and (iv) by imposing new multi-billion-dollar regulatory obligations, the SEC neglected its statutory duty to consider whether the Rule “will promote efficiency, competition and capital formation.”  They failed to adequately substantiate the Rule’s costs and benefits and failed to consider the cumulative effect of its numerous pending rules.

The 5^th Circuit’s Decision in U.S. Chamber of Commerce v. SEC. Early last week, a unanimous panel of the 5^th Circuit ruled that the SEC acted arbitrarily and capriciously in its enactment of its Share Repurchase Disclosure Modernization Rule (“Share Repurchase Rule”), in violation of the APA, when it “failed to respond to petitioners’ comments and failed to conduct a proper cost-benefit analysis.”

The Court found that the SEC completely ignored the petitioners’ comments about the proposed rule’s economic implications. In response to the SEC’s request for commenters to provide data to help it quantify the economic effects, the petitioners submitted three specific suggestions. The SEC admitted that they did not consider any of the suggestions, arguing that the data provided by the petitioners was already available to the SEC and, in any event, none of the points made by the petitioners would have resulted in a change to the Rule. The Court rejected the SEC’s explanations. Separately, the Court found that the SEC “failed adequately to substantiate the Rules’ benefits and costs.” Specifically, the SEC failed to establish the existence of any genuine problem with share buybacks; their arguments that the Share Repurchase Rule will reduce investor uncertainty and promote price discovery were theoretical and unsubstantiated. The court remanded the Rule for 30 days to give the SEC the opportunity to correct the defects in the Rule (i.e., substantiate the purported benefits).  Whether the SEC can do so is beyond the scope of this note. If it cannot, the Share Buyback Rule would presumably be vacated.

Takeaways from the 5^th Circuit decision vis-a-vis the PFA lawsuit. In addition to strong statutory claims, the joint-trades’ lawsuit on the Private Fund Advisers Rule asserts claims similar to those made by the Chamber. These include a failure by the SEC to substantiate its claims that private fund investors need the “protections” imposed by the Rule and that the SEC substantially changed the Rule (relative to the proposal) without giving the public the opportunity to comment. The fact that the Court was receptive to similar APA arguments in the share buyback case is encouraging. (Another notable aspect of the 5^th Circuit decision is that it was published only five months after the Share Repurchase Rule was finalized).

Next Steps. The SEC’s responsive brief is due December 15^th and the trade associations’ reply brief is due January 22^nd. Thereafter, the 5^th Circuit will set a date for oral arguments after which the assigned panel will decide the case. The case has been granted expedited treatment but it is still difficult to predict exactly when the Court will render its decision. Please reach out to Elliot Ganz if you have any questions.