A federal appeals court struck down the US Securities and Exchange Commission’s rules requiring hedge funds and private equity firms to detail quarterly fees and expenses to investors — a significant setback in the regulator’s clampdown on the private-funds industry.
A three-judge panel of the US 5th Circuit Court of Appeals in New Orleans on Wednesday sided with industry groups, who argued that the agency overstepped its authority and that rules weren’t necessary for the “highly sophisticated” investors that pour money into private funds. Writing for the panel, Judge Kurt D. Engelhardt said the SEC “exceeded its statutory authority” by adopting the rule.
The SEC said the agency is reviewing the decision and “will determine next steps as appropriate.”
The regulations were just one of several rules that Wall Street’s main watchdog has been seeking to impose on hedge funds and private equity firms. SEC Chair Gary Gensler has prioritized clamping down on the $26 trillion market, which he says lacks transparency and can contribute to financial stability risks.
In addition to fee disclosures, the rule adopted by the SEC in August prohibited firms from allowing some favored investors to cash out more easily than others.
The industry groups, including the American Investment Council and the Managed Funds Association, argued in the lawsuit they filed a week after the rules were adopted that they would “fundamentally change the way private funds are regulated in America.” The groups said that private equity investors are among the most sophisticated in the world and would not be funneling their money into an industry if it was in need of a “government overhaul.”
In a statement on Wednesday, MFA, as the hedge fund trade group is known, hailed the decision as “significant victory for markets, fund managers, and investors, including pensions, foundations, and endowments.” In an apparent nod to other legal fights, Bryan Corbett, who leads the group, also said in a statement that the rulemaking was just one example “of SEC overreach.”
Drew Maloney, who leads the American Investment Council private equity industry trade group, dubbed the decision a “victory.” He also called the SEC’s legal theory “unfounded.”
“The court has sent Washington regulators a strong message that they cannot bypass Congress when pushing their extreme agenda,” he said.
The MFA and other trade groups separately have sued the SEC in March over rules requiring some firms to register as dealers in the US Treasuries market. That case was brought in federal court in Texas, which is also part of the Fifth Circuit. The appeals court has a reputation for conservative and pro-business rulings.
Ahead of Wednesday’s opinion, the SEC had argued that its fee disclosure rules are permitted under the 2010 Dodd-Frank Act. The agency has said in court filings that its regulations “are a flexible and measured approach to resolve problems affecting investors and their stakeholders.”
The appeals court was not convinced. Engelhardt said that, “by congressional design, private funds are exempt from federal regulation” of their internal structures. Plus, he said the 2010 law expanding government oversight of the US financial system is not as permissive as the SEC argued in defending the rule.
“While the Dodd-Frank Act expanded the Commission’s oversight in many respects, it did not do so to the extent the Commission argues here,” Engelhardt said.
The appeals court also rejected an argument from the SEC that the rule was necessary because it would weed out fraud, ruling that the SEC is conflating a lack of disclosure with deception. Plus, Engelhardt said the agency’s claims of fraud prevention were too vague to justify the rule.
“The Commission largely fails to define the fraudulent acts or practices that the Final Rule purportedly is designed to prevent,” he said. “And while some conduct could involve fraud, the Commission has only observed misconduct by about 0.05% of advisers.”
Two of the judges on the New Orleans-based court who issued the ruling were appointed by former President Donald Trump and one by George W. Bush.
The industry groups are represented by former Trump administration Labor Secretary Eugene Scalia, son of the late Supreme Court Justice Antonin Scalia.
The case is National Association of Fund Managers v. Securities and Exchange Commission, 23-60471, US Fifth Circuit Court of Appeals (New Orleans).
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