Most financial market observers were surprised on Friday, June 23, 2006, when the United States Court of Appeals for the District of Columbia Circuit rendered a decision in Goldstein v. Securities and Exchange Commission that vacated the SEC's "Hedge Fund Rule" - Rule 203(b)(3)-2 of the Investment Advisers Act of 1940 (Advisers Act). The Hedge Fund Rule, enacted by a 3-2 decision of the SEC in 2004, had redefined the term "client" as used in the Advisers Act in such a way as to require most hedge fund managers to register as investment advisers by February 1, 2006. The dissenting commissioners had argued that the SEC's adoption of the Hedge Fund Rule, relying upon an interpretation of "client" that rejected the clear meaning of the term elsewhere in the Advisers Act and years of contrary SEC interpretation of the term, was outside the scope of the SEC's authority. Nonetheless, few expected Phillip Goldstein's challenge to the agency's rule-making to meet with any success. Consequently, the Court's decision caught almost everyone by surprise.
The decision was just the first of a number of surprises. The action the Court was expected to take following the decision was to issue a mandate to the SEC requiring the SEC to withdraw the Hedge Fund Rule. Instead, on June 27, 2006, the Court, on its own initiative, issued an order that delayed the effectiveness of its decision in Goldstein to give the SEC an opportunity to appeal the decision. As a result of this order, the Hedge Fund Rule has remained in force as written. The initial statements of Christopher Cox, Chairman of the SEC, sounded less than adamant about pursuing reinstatement of the Rule, leading many to believe that the regulatory initiative would be abandoned. However, just six days after the Court's decision, Congress lent a helping hand when Barney Frank (D-MA), the Ranking Member of the House Financial Services Committee, introduced H.R. 5712, with the telling short title: "Securities and Exchange Commission Authority Restoration Act of 2006." H.R. 5712, only two paragraphs long, does no more than extend to the SEC the authority to require hedge fund registration and the authority to redefine "client." On July 18, 2006, the Bill was referred to the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, where it remains as of this writing.
So much has happened in such a short period of time that many managers, particularly those who were just about to register when the Court ruled, are understandably confused and unsure as to how to proceed. The purpose of this article is to review how we got to where we are, to speculate on what is likely to happen next, and to offer some guidance on the best course of action for managers.
The Rule Prior To October 2004
Prior to October 2004, Section 203(b)(3) of the Advisers Act specifically exempted from registration any investment adviser that, among other things, had had fewer than 15 "clients" during the preceding 12 months. Rule 203(b)(3)-1 generally permitted an adviser to count any pooled investment fund that it advised as a single client, regardless of how many underlying investors were invested in such pooled fund. Thus, a private manager with fewer than 15 funds was usually exempt from federal registration. This exemption had allowed most hedge fund managers to remain unregistered.
The Hedge Fund Rule
The Hedge Fund Rule required that a manager "look through" each of its funds and managed accounts, and count as a client each underlying investor (rather than each fund). Thus, if a manager with sufficient assets under management had at least 15 individual investors across all of its funds and managed accounts, that manager was required to register as an investment adviser under the Hedge Fund Rule, unless an exclusion or exemption applied.
The Goldstein Decision
In Goldstein, the Court held that the SEC had overstepped its authority in adopting the Hedge Fund Rule. While courts typically provide federal agencies, such as the SEC, wide latitude in enacting regulations, the three-judge panel concluded unanimously that the manner in which the SEC had required registration - by defining clients on a look-through basis - was arbitrary and improper. Ultimately, the Court vacated the Hedge Fund Rule but, as mentioned above, it delayed issuing the order that would enforce its decision. The Court suggested that if registration of fund managers is necessary due to the size of the industry and its impact on the capital markets, the proper way to accomplish it is through legislation.
What Next?
The deadline by which the SEC could ask for a rehearing by the Court en banc - August 7, 2006 - passed without the SEC taking action. The SEC has additional time within which to file a petition for certiorari with the U.S. Supreme Court, but Cox announced on August 7 that because "the [C]ourt decision was based on multiple grounds and was unanimous, further appeal would be futile and would simply delay and distract from our goal of advancing investor protection." Given this message, the Court may issue its mandate to the SEC, rendering the Hedge Fund Rule void, at any time.
Chairman Cox's July 25, 2006 testimony before the Senate Committee on Banking, Housing and Urban Affairs clarified that the SEC is fully committed to hedge fund monitoring and regulation. The Chairman told the Senate Committee that "[h]edge funds are not, should not be, and will not be, unregulated." It appears that the SEC is taking a three-pronged approach: (1) it intends to use existing law to the maximum extent permissible to oversee hedge fund operations; (2) it intends to encourage Congress to support its hedge fund regulation efforts through legislation; and (3) it intends to institute several interim and "emergency" steps to keep the Goldstein decision from imposing unintended consequences on hedge fund managers that are currently registered.
In his testimony, Chairman Cox pointed out that the Hedge Fund Rule had been accomplishing what the SEC intended. Of the 2,500 hedge fund advisers currently registered, half of them had registered since the promulgation of the Hedge Fund Rule.1 The Chairman also noted that the conditions that had led to calls for regulation still exist and have been increasing. The "remarkable growth" of hedge funds has continued unabated; the incidences of fraud in the industry have been growing; and the potential for harm to retail investors is rising.
The Chairman made clear that despite Goldstein, hedge funds are subject to SEC regulation and enforcement under anti-fraud, civil liability, and other provisions of the securities laws, a point noted by the Goldstein Court as well. Chairman Cox said that the SEC will introduce on an emergent basis an additional anti-fraud rule under the Advisers Act, specifically targeted at gaining more information on hedge fund investors and ensuring that all of the anti-fraud provisions of the Advisers Act apply to a manager's relationship with the underlying investors in any fund the manager advises as well as with the fund itself. In addition, Chairman Cox said that he will "recommend to the full Commission that the SEC take formal steps to further limit the marketing and availability of hedge funds to unsophisticated retail investors." He has said that one step the SEC is considering in this regard is to increase the minimum asset and income requirements necessary to qualify as an "accredited investor." The current $1 million net worth minimum or alternative $200,000 per year minimum salary (or $300,000 with a spouse) were high hurdles when they were set decades ago. Now, as the Chairman testified, those requirements are no longer screening out middle-income Americans who stand to lose their life savings in risky hedge fund investments. Any new rules introduced by the SEC will be subject to the usual notice and comment periods.
Although hedge funds are subject to some SEC regulation and oversight, what has been lost as a result of the Goldstein decision is the ability to force managers to register and submit to surprise SEC inspections. The Chairman testified that he would support legislation to regain that ability, but that any legislation should be "non-intrusive." He outlined limitations that any legislation (as well as any future SEC regulation) should observe, in order to preserve the creativity, liquidity, and flexibility that historically have contributed to the growth of hedge funds:
There should be no interference with the investment strategies or operations of hedge funds, including their use of derivatives trading, leverage, or short selling.
The costs of compliance must be considered and minimized.
There should be no portfolio disclosure provisions. A hedge fund's ability to keep its trading strategies and portfolio composition confidential should be protected.
Hedge fund managers should continue to be able to charge their investors performance fees.
The Chairman noted that the Hedge Fund Rule had done more than redefine the term "client." It had introduced certain exemptions and exclusions designed to provide specific benefits to hedge fund managers. When the Hedge Fund Rule is voided (as we expect it to be), those exemptions and exclusions also will expire, leaving fund managers who registered exposed to the full brunt of registration, which they will not have expected. For example, the Hedge Fund Rule minimized registration requirements for certain offshore managers (colloquially known as "registration light"). To the extent that those offshore managers have registered, they will no longer be subject to "registration light" when the Hedge Fund Rule is voided, but instead simply will be registered managers. In a response, dated August 10, 2006, to a letter from the American Bar Association, the SEC announced certain no-action positions that it will take to prevent those who registered in compliance with the Hedge Fund Rule from suffering such unintended consequences. In addition to effectively restoring "registration light" for qualified offshore managers, the SEC's position will accomplish the following:
Restore the "grandfathering" provision for collecting performance fees from investors who are not "qualified clients," but who invested with the registered adviser prior to February 10, 2005.
Restore the exemption from maintenance of performance data prior to registration.
Restore the extra time that the Hedge Fund Rule gave managers of fund of funds (180 days rather than 120 days) to supply audited financial statements in compliance with the custody rule.
Prevent enforcement against a registered investment adviser that de-registers after having "held itself out" as an adviser and advised more than 15 "clients" (using the pre-Hedge Fund Rule definition) while registered; provided that the adviser stops holding itself out as an adviser, advises fewer than 15 clients after withdrawal, and withdraws its registration by February 1, 2007.
News on this topic breaks nearly every day. All of us in the industry had 17 months to prepare ourselves for implementation of the Hedge Fund Rule, but have had only weeks to respond to its sudden and unexpected demise. Even the SEC is still feeling its way and planning its next moves. We expect that the Hedge Fund Rule, or at least parts thereof, will be reinstated legislatively, but it may take some time. Depending on further action by the SEC and/or Congress in the coming months, it may be appropriate for fund managers to reevaluate the need to remain registered, their compliance policies and procedures, and their fund offering terms. At present, it appears that it may be advantageous for those who wish to withdraw to do so by February 2007. At this time, however, the most prudent course of action is still to watch and wait.1Only a handful have de-registered post Goldstein .
Published September 1, 2006.
