21 August 2006
On 23 June the Securities and Exchange Commission (SEC) suffered yet another judicial blow when the Washington DC Circuit Court of Appeals invalidated as "arbitrary" the SEC's new Investment Advisers Act Rule 203(b)(3)-1, which required many hedge fund managers to register as investment advisers.
The rule has had a very controversial history. A divided SEC adopted it as a means to combat a perceived increase in fraud in the hedge fund market in light of the tremendous growth of the sector and its increasing 'retailisation'. The rule requires that hedge fund managers should have no more than 14 investors, counted as 'clients', in their funds to qualify for an exemption from federal investment adviser registration.
A significant finding of the court in Phillip Goldstein v SEC was that the SEC failed to demonstrate that a hedge fund's investors should be treated as clients of the hedge fund's adviser for purposes of the registration exemption in Investment Advisers Act Section 203(b)(3). The court found that the SEC's interpretation of the term 'client' in the rule, as including hedge fund investors, "falls outside the bounds of reasonableness" and "comes close to violating the plain language of the statute".
The court also took issue with the SEC's differing definitions of the term 'client', noting that "the commission cannot explain why 'client' should mean one thing when determining to whom fiduciary duties are owed… and something else when determining whether an investment adviser must register under the act".
This may have broader implications for how the SEC has applied certain provisions of the act and its rules to hedge funds.
The SEC response
Shortly after the court's invalidation of the rule, SEC chairman Christopher Cox called for a re-examination of the organisation's approach to the regulation of hedge funds, and to review possible options regarding the rule. Following this the court issued a second order delaying its invalidation order until seven days after the disposition of any SEC petition for a rehearing. The SEC had until 7 August to file such a petition and has until 21 September to appeal directly to the US Supreme Court.
On 25 July, at a hearing on the operation and regulation of hedge funds before the Senate Committee on Banking, Housing and Urban Affairs, Cox presented his views on the appropriate regulation of hedge funds. He emphasised that, notwithstanding the Goldstein decision, hedge funds remain subject to SEC regulation and enforcement under federal securities laws. He also stated that, although the SEC was still evaluating its alternatives in light of Goldstein, he intended to recommend to the SEC that it take a number of urgent actions, including promulgation of a new anti-fraud rule under the Investment Advisers Act, which would apply explicitly to fraud committed by a hedge fund manager against investors in the hedge funds.
On 7 August Cox announced that the SEC would not seek a rehearing of Goldstein or appeal the decision, because the court's decision was "based on multiple grounds and was unanimous [and] further appeal would be futile and would simply delay and distract from the goal of advancing investor protection".
He stated that, instead, the SEC will move "aggressively" to promulgate new rules and guidance. Among those new initiatives will be the new anti-fraud rule, as well as consideration of whether to increase the minimum financial requirements for individuals who invest in hedge funds. Cox also stated that the SEC will take emergency action to ensure that the transitional and exemptive rules, also invalidated by Goldstein, are restored to full legal effect, so that any hedge fund managers relying on those rules are not suddenly in violation of the SEC's regulatory requirements when the court issues its final invalidation mandate in mid-August.
It is also far from clear as to whether the SEC has ruled out the option of seeking congressional authority to regulate hedge funds and/or hedge fund managers.
Democrat representatives Barney Frank, Paul Kanjorski and Michael Capuano have proposed legislation (the SEC Authority Restoration Act 2006) that would permit the SEC to regulate hedge fund managers, but Senator Richard Shelby, chairman of the Senate Banking Committee, has stated that he is not convinced that such regulation is needed at this time.
On 10 August the SEC's Division of Investment Management issued a no-action letter in response to a 31 July letter from the American Bar Association, which requested certain interpretive and no-action advice on issues affecting hedge fund managers that arose as a result of Goldstein. In that letter, the SEC announced that hedge fund advisers may rely on the private adviser exemption going forward, even if they had held themselves out as investment advisers or had more than 14 clients during the time they were registered, provided they withdraw their registrations by 1 February 2007. For the first 12 months following withdrawal from SEC registration, such advisers may, for purposes of assessing their eligibility for the 203(b)(3) exemption, determine the number of clients they have had by reference to a period of time beginning on the date of withdrawal. The letter also allows SEC-registered advisers to continue to rely upon a number of exemptive rules that were adopted at the same time as the hedge fund rule amendments.
What to do next?
So, what should advisers who registered with the SEC as a result of the rule do now? After 14 August those advisers can deregister with the SEC. Advisers who choose to deregister should consider the impact of such deregistration. They would need to disclose deregistration to investors and to amend hedge fund documentation and would possibly need to gain state investment adviser registration. In view of the uncertainty created by the possibility that pending legislation could effectively reverse Goldstein, the most prudent course of action might be to delay deregistration until prospects become more certain. n
Mitchell Nichter is a partner at Paul Hastings Janofsky & Walker