COURT INVALIDATES SEC RULES REQUIRING REGISTRATION OF HEDGE FUND ADVISERS

         In a serious blow to the SEC, the U.S. Court of Appeals for the D.C. Circuit recently invalidated Advisers Act Rule 203(b)(3)-2, requiring most hedge fund advisers to register with the Commission.  Goldstein v. SEC, No. 04-1434 (June 23, 2006). This ruling calls into question the SEC’s ability to regulate the entire hedge fund industry. 

            Adopted on December 2, 2004, and effective on February 1, 2006, the Rule required investment advisers to “count as clients the shareholders, limited partners, members, or beneficiaries” of a “private fund.”  Rule 203(b)(3)-2(a).   The term “private fund” was in turn defined to include most vehicles commonly regarded as hedge funds.[1]  This interpretation of the term “clients” made it impossible for many most hedge fund advisers to avail themselves of the “private adviser” exemption, which applies to advisers that: (1) have no more than fourteen clients; (2) do not hold themselves out generally to the public as investment advisers; and (3) do not act as investment advisers to any registered investment company or any business development company.   See Investment Advisers Act § 203(b)(3). Prior to the Rule, satisfying these conditions was relatively easy, since most advisers provided services to only a few funds, few advisers advertised their services to the investing public, and the hedge funds themselves typically could avoid registration.  Promulgation of the Rule represented a reversal of the SEC’s previous longstanding position that hedge funds themselves, rather than investors in such funds, were “clients” of  advisers. 

              In adopting the Rule, the SEC had argued that the term “client” was ambiguous “as a method for counting clients,” since it was undefined by the Advisers Act.  The D.C. Circuit, however, disagreed, citing case law indicating that “[t]he lack of a statutory definition of a word does not necessarily render the

meaning of a word ambiguous, just as the presence of a definition does not necessarily make the meaning clear.” Goldstein, slip op. at 9.   The court further stated that in defining the term “investment adviser,” the Advisers Act included those who provide “direct” advice and those who provide advice “through publications or writing,” i.e., through newsletters.   See Advisers Act § 202(11).   Applying this definition, the court observed that hedge fund investors cannot be considered recipients of “direct” advice from advisers, and concluded that: “[i]f the person or entity controlling the fund is not an “investment adviser” to each individual investor, then a fortiori each investor cannot be a “client” of that person or entity.  Id. at 12.  The court further opined that the SEC’s definition of “client” was inconsistent with the policy goals underlying the Advisers Act, According to the Court, for these and other reasons, the definition of “client” was unreasonable.  Therefore, the Court vacated and remanded the rule.  Id. at 19.

            The court’s decision is wide-reaching in its implications.  The immediate effect is to allow entities considering advising hedge funds to engage in this activity without needing to be registered with the SEC.  In addition, advisers of hedge funds may now legally deregister, although the form designated for this purpose, ADV-W, seems ill-suited for this unusual situation.  Deregistration would allow such advisers to avoid various legal requirements, including its regulation of advertising, the use of solicitors, disclosures to clients, management of client accounts, and designation of a chief compliance officer.” 

            Because SEC Chairman Cox is widely viewed as being more pro-business than his predecessor, it will be interesting to see whether he will encourage the agency to appeal the D.C. Circuit’s decision to the U.S. Supreme Court, and whether he will seek to rewrite the rule.  In this election year, many political constituencies will seek to influence his opinion about this important issue.

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[1] See Advisers Act Rule 203(b)(3)-2 (defining “private fund” as a company that would be an investment company under § 3(a) of the Investment Company Act “but for” the exception provided by that definition by either §§ 3(c)(1) or 3(c)(7) therein; (2) that permits its owners to redeem their interests within two years; and (3) such interests are offered based on the advisory skills, ability or expertise of the adviser). 

Comments

[Jack Doueck, Stillwater Capital]

We at Stillwater Capital feel strongly that all hedge fund managers with more than $25,000,000 under management or more than 14 clients should register with the S.E.C. We have been registered with the S.E.C. and have been through a very thorough but appropriate audit last summer. The S.E.C. Auditors checked all our books and records. They reviewed our checks and balances, trying to discover any conflicts of interest, any inconsistencies between what we promise our clients and what we actualy deliver. They checked the books and records of our funds and our management company. When I saw the level of detail that they paid attention to, I was very excited about the possibility that EVERY hedge fund that we invest in would be subject to these periodic audits without a lot of notice. That is a good check for the industry in general. Our Stillwater Asset Backed Lending business invests money with other asset backed hedge funds which are complex and difficult to do the due diligence work on. If every one of these funds were audited by the S.E.C., we would feel much safer and more certain that these managers would be operating in accordance not only with GAAP, but with the rules of the S.E.C., that they are delivering what they are promising and that there is less of a chance of foul play.
That being said, the best way to regulate the Hedge Fund Industry is for S.E.C. to require that every manager publish or make public their assets (in general, without specifics) via independent administrators and brokers on a monthly basis. That would further deter greedy and reckless managers from fraud. Our decision to register with the S.E.C. was a good one and we hope managers follow our lead.