Blogs from June, 2024


5th Circuit Court of Appeals

Balancing Freedom and Regulation: Implications of the Fifth Circuit's Ruling on SEC Authority and Investor Protection in Financial Markets

R Tamara de Silva

In the context of financial markets, the tension between the freedom to contract and the need for regulatory protection against fraud is particularly pronounced. Financial markets require a delicate balance between allowing free contractual arrangements and ensuring that such freedom does not lead to fraudulent practices that can undermine market integrity and public trust.

This tension was recently highlighted in a decision by the Fifth Circuit, which vacated U.S. Securities and Exchange Commission (SEC) regulations that would have required private fund advisers to provide detailed disclosures to investors.(i)   The SEC rule, adopted in August, aimed to bolster transparency in the $26.6 trillion market by mandating private fund managers to disclose information about performance fees and conflicts of interest. The overturned rule mandated that fund managers perform annual audits, issue quarterly performance reports, and not give some investors preference in redemptions or special access to holdings. (ii)

The U.S. Fifth Circuit Court of Appeals vacated the SEC's final rule, stating that the SEC overstepped its statutory authority. The court determined that sections 211(h) and 206(4) of the Investment Advisers Act, as amended by the Dodd-Frank Act, did not grant the SEC the authority to impose these rules on private funds. The ruling emphasized that private funds, including hedge funds and private equity funds, are designed for sophisticated investors and are not subject to the same regulatory framework as public investment vehicles. As a result, the SEC's attempt to regulate the internal governance of private funds through these disclosures was deemed unauthorized. The court found that Congress did not give the SEC explicit oversight of the governance structure of private funds, even with the expanded authority under the Dodd-Frank Act. The three-judge panel concluded that the SEC had exceeded its statutory authority, rendering the rule unsalvageable.

Private funds, including hedge funds, private equity funds, and venture capital funds, are subject to less stringent regulation compared to publicly traded investment vehicles like mutual funds. Nevertheless, due to revisions from the Dodd-Frank Act, certain fund advisers must register with the SEC under the Investment Advisers Act.

The Dodd-Frank Act also introduced Section 211(h) to the Advisers Act, requiring the SEC to ensure that "simple and clear disclosures" are provided to investors about their relationships with brokers, dealers, and investment advisers.

The Fifth Circuit interpreted "investors" to mean "retail customers" within the context of the statute. Since private funds are not available to retail investors, the court concluded that this provision does not pertain to private fund managers. It is worth noting, though, that retail investors, i.e. the public,  does invest in private funds through pension funds and retirement funds.

The court ruled that the SEC overstepped its authority and that such rules were unnecessary for the "highly sophisticated" investors that pour money into private funds. Judge Kurt D. Engelhardt, writing for the panel, asserted that the SEC “exceeded its statutory authority” by adopting the rule. Engelhardt noted that while the Dodd-Frank Act expanded the SEC's oversight, it did not authorize the level of intervention seen in the challenged rule. The court also rejected the SEC’s argument that the rule was necessary to prevent fraud, finding the agency's claims too vague and unsupported by evidence of widespread misconduct.

Some Historical Perspective

The primary purpose of the Securities and Exchange Commission (SEC) is to protect the public and investors. The SEC was established in 1934 in response to the Great Depression as part of the New Deal reforms. Its goals include ensuring investors have access to essential information, maintaining fair and efficient markets, and facilitating capital formation. The SEC enforces securities laws, requires public companies to disclose important information, and regulates securities markets and participants to restore and maintain investor confidence.

Was the Court Correct?

Was the court correct in inferring that Dodd-Frank’s reference to investors needing protection referred to retail investors?

In point of fact, retail investors have historically suffered from opacity and financial malfeasance of private funds because they are, through pension funds and retirement funds, investors in private funds. They have also suffered due to the financial contagion of financial crises. Moreover, they have been subjected to risks that they could not have agreed to, unlike their sophisticated counterparts.

financial malfeasance

Even a cursory knowledge of the history of financial markets may have informed the court that public pension funds have faced substantial losses due to financial malfeasance and contagion at times by the actions of what are deemed the best and brightest on Wall Street, including private fund managers. During the 2008 financial crisis, the collapse of Lehman Brothers resulted in more than $1 billion in losses for Florida’s public employee pension funds, exposing the bank's severe mismanagement and risky practices. More recently, the 2023 collapse of Silicon Valley Bank impacted the pension funds of public school employees across various states, demonstrating the fragility of these funds in the face of financial instability. The 2001 Enron scandal, one of the most notorious in U.S. history, led to enormous losses for public pensions like those of the Florida Retirement System and the University of California due to fraudulent accounting practices. Similarly, the 2002 WorldCom collapse, driven by extensive accounting fraud, inflicted substantial damage on public pension funds, including CalPERS. Orange County's 1994 bankruptcy, caused by high-risk investments in derivatives, severely affected public employee retirement systems, resulting in significant financial shortfalls and legal disputes. These instances highlight the recurring risks that public pension funds face from financial misconduct and what is at times a lack of transparency.

The decision underscores the challenges regulators face in balancing the need to protect investors and ensure market transparency while respecting the freedom of contract. While industry associations argued that the regulations would harm investors by increasing compliance costs and reducing competition, others, like Better Markets, viewed the ruling as a setback for investor protection, particularly for those relying on pension funds. (iii) It bears repetition that the public, including unsophisticated retail investors, make up pension funds.

This case illustrates the tension between the sometimes-competing interests of protecting investors/the public and allowing free-market principles to operate. While the SEC’s mandate includes protecting investors and maintaining fair, orderly, and efficient markets, it must do so within the boundaries set by Congress. Proponents of the court’s decision would claim that it underscores the importance of clearly defined statutory limits and the need for regulatory agencies to operate within those limits to avoid overreach and ensure that their actions are legally sound.

Regulations often infringe upon the freedom to contract by imposing conditions and requirements on market participants. However, such measures are necessary to protect investors from fraudulent activities and ensure fair trading practices. For instance, regulatory frameworks often require detailed disclosures and adherence to specific protocols during public offerings to prevent misinformation and protect investors.

This ruling is not likely to be the last word on the matter. For questions about this ruling, please contact R Tamara de Silva.


[i] The case is National Association of Fund Managers v. Securities and Exchange Commission, 23-60471, US Fifth Circuit Court of Appeals (New Orleans)



NB This information is provided as a service to clients and friends for educational purposes. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Readers should not act upon this information without seeking advice from a legal professional.

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