SEC Goes Back to the Drawing Board Following Invalidation of Hedge Fund Rule
By Gareth T. Evans

In testimony before Congress last month, Securities and Exchange Commission Chairman Christopher Cox said that the SEC has been “forced back to the drawing board” following the D.C. Circuit’s invalidation of the SEC’s hedge fund rule in Goldstein v. SEC.¹ Cox now seeks new rules restricting the sale of hedge funds to retail investors and imposing additional anti-fraud provisions on hedge fund advisers. Whether such rules are really necessary should be the subject of considerable debate, however. In addition, Cox will need to proceed carefully to avoid the rulemaking mistakes that doomed the hedge fund rule and, just weeks earlier, the mutual fund independent director rule.

In the immediate future, Cox must clean up the mess that invalidation of the hedge fund rule has left for advisers who registered under the rule. The court’s decision not only invalidated the requirement that hedge fund advisers register with the SEC, but it also had the side-effect of invalidating exemptions from various regulatory requirements that would otherwise apply to registered investment advisers. Hoping to prevent a tide of deregistrations, Cox has directed the SEC staff to take “emergency action” to restore the exemptions and transitional provisions that were included in the hedge fund rule.² Without such action, many of the approximately 2,500 hedge fund advisers who registered with the SEC before the Goldstein decision could find themselves in violation of those requirements when the court issues its final mandate in mid-August.

The Hedge Fund Rule

Through the hedge fund rule, adopted in December 2004, the SEC sought to bring hedge fund advisers within the requirements of the Investment Advisers Act. The Advisers Act requires non-exempt investment advisers to register with the SEC and prohibits them from engaging in fraudulent and deceptive activities.³ Hedge fund advisers generally meet the Advisers Act’s definition of “investment adviser.”⁴ But they are usually exempt from registration under the private adviser exemption, which applies to advisers with fewer than fifteen “clients.”⁵ The Advisers Act does not define “client,” but before enacting the hedge fund rule the SEC had interpreted it to mean the funds themselves, rather than individual investors in the funds.⁶ Because most hedge fund advisers managed fewer than fifteen funds, they were exempt. The hedge fund rule changed that by requiring advisers to count the shareholders in their funds as clients for purposes of the private adviser exemption.⁷ The rule had the effect of requiring most hedge fund advisers to be registered by February 1.

In addition to providing the SEC with basic information about hedge fund advisers, registration brought advisers within the SEC’s compliance regime. Registration required advisers to implement compliance programs to prevent, detect and correct compliance violations and to appoint a chief compliance officer. It also required registered investment advisers to open their records to the SEC upon request and provided the SEC’s Office of Compliance Inspections and Examinations with the authority to conduct on-site compliance examinations.⁸ Furthermore, registration had the “salutary effect,” according to the SEC, of limiting the types of investors to whom hedge funds are sold. Most hedge fund advisers charge both an advisory fee based on assets under management and a performance fee based on the fund’s performance. The Advisers Act, however, prohibits advisers from charging a performance fee unless each investor in the fund is a “qualified client,” i.e., it has a net worth of at least $1.5 million or $750,000 in assets under management with the adviser.⁹ Registration, therefore, would have the effect of deterring hedge fund sales to retail investors. These requirements will continue to apply to hedge fund advisers even after the Goldstein decision, so long as they remain registered.

The hedge fund rule contained a number of transitional and exemptive provisions, meant to ensure fairness and ease the burden of regulatory requirements otherwise applicable to registered advisers. For example, it included “grandfathering” provisions allowing newly registered hedge fund advisers to continue charging performance fees pursuant to advisory contracts negotiated before the rule went into effect.¹⁰ In the absence of such relief, the adviser would have to either force non-qualified buyers out of funds or restructure its funds so that non-qualified buyers would not pay a performance fee.

The rule also included a qualified exemption from recordkeeping requirements, allowing advisers to market performance from periods before registration even if they had not retained records that the rules under the Advisers Act otherwise would require.¹¹ The rule extended the time from 120 to 180 days for “funds of hedge funds”—funds whose assets consist of investments in other hedge funds—to provide audited financial statements to investors, because often it is not possible to obtain the underlying funds’ audited financial statements within the 120-day period.¹² Finally, the rule limited the extraterritorial application of the Advisers Act by allowing offshore advisers to offshore funds to count the funds rather than investors as “clients” for most purposes under the Advisers Act.¹³ Among the “side-effects” of the hedge fund rule’s invalidation under Goldstein, however, is that these transitional and exemptive provisions are no longer available, creating a disincentive for hedge fund advisers to remain registered.

The Goldstein Decision

In Goldstein, the D.C. Circuit strongly rebuked the SEC for its about-face in interpreting the meaning of “client” for purposes of the private adviser exemption. The court rejected the SEC’s argument that it was empowered to impose any meaning on the term “client” to which it is susceptible. The court stated that by not including a statutory definition in the Advisers Act, “it scarcely follows that Congress has authorized an agency to choose any one of those meanings.”¹⁴

The D.C. Circuit cited legislative history and other provisions of the Advisers Act indicating that Congress intended “client” to refer to the fund entities rather than their individual investors. The court also emphasized that under the Advisers Act and elsewhere the adviser’s fiduciary duties run to the fund and not to individual investors.¹⁵ Agreeing with SEC Commissioners Paul Atkins and Cynthia Glassman, who had dissented from the SEC’s adoption of the hedge fund rule, the court found that the SEC enacted it without any evidence that the role of fund advisers with respect to investors had changed to justify its action. The court concluded that absent such a justification, the SEC’s departure from prior agency policy “appears completely arbitrary.”¹⁶

The D.C. Circuit thus ordered the hedge fund rule vacated, which will become effective when the court’s mandate issues in mid-August.

Back to the Drawing Board: Implications for Hedge Funds and the SEC

On August 7, the SEC announced that it will not seek further review of Goldstein and that it will allow the decision to stand.¹⁷ Now, the SEC must revisit the hedge fund rule to at a minimum clean up the collateral damage caused by the invalidation of the rule’s transitional and exemptive provisions.In his recent congressional testimony, Cox announced that he was directing the SEC staff to take “emergency action” to restore these provisions for hedge fund advisors who complied with the rule and registered.¹⁸

Cox obviously wishes to prevent a tide of deregistrations. Without the emergency measures, many hedge fund managers will have a strong incentive to deregister as they could otherwise find themselves in violation of various rules under the Advisers Act. Cox also likely seeks to encourage voluntary registration—approximately half of all registrations before the Goldstein decision were voluntary and not in response to the hedge fund rule.¹⁹ If hedge funds deregister or choose not to register voluntarily, the SEC will lose a valuable source of information about the hedge fund industry for future rulemaking efforts. It also will lose its ability to require compliance with regulatory requirements under the Advisers Act and to conduct examinations to evaluate hedge fund compliance programs and detect violations of the securities laws.

There almost certainly will be increasing efforts to regulate hedge funds and their advisers. Hedge funds as we know them were unknown in 1940, when Congress enacted the Advisers Act. Today, they are estimated to have approximately $1.2 trillion in assets under management. In justifying its hedge fund rule, the SEC pointed to the near financial crisis caused by the collapse of hedge fund Long-Term Capital Management in late 1998, the trend towards “retailization” of hedge funds that has been increasing the exposure of ordinary investors to such funds, and increased investment in hedge funds by pension funds, universities, endowments, foundations and other organizations.²⁰ Indeed, Cox cited these factors in announcing that he will recommend that the SEC promulgate a new anti-fraud rule applicable to hedge fund advisers and that he is having the agency consider amending the current definition of “accredited investor” to raise the suitability threshold for investors in unregistered hedge funds.²¹ Legislation also may be forthcoming, as Congress has held several hearings this year regarding the hedge fund industry.

Cox must tread carefully to avoid the mistakes of his predecessor. The court’s decision in Goldstein again demonstrates that challenges to SEC rulemaking efforts can be successful. This is the second time in recent months that the D.C. Circuit has invalidated an SEC rule. In April, the court invalidated for the second time a rule in which the SEC tried to regulate the governance of mutual funds by mandating the number of independent directors and an independent chair.²² The court vacated the independent director rule because the agency had failed adequately to consider the costs of the rule on mutual funds. Taken together, the hedge fund and mutual fund decisions show that the D.C. Circuit continues to take seriously both the procedural constraints on agency action and the substantive limits of agency power under our government of separated powers, where Congress is ultimately charged with making policy decisions such as what industries should be subject to federal regulation, and to what extent.

Cox appears to be taking these issues to heart. He has declared that regulatory actions and any legislation should not intrude upon hedge funds’ investment strategies or operations. According to Cox, hedge funds should be allowed to keep their trading strategies and portfolio compositions confidential; they should be able to continue to charge performance fees; and the costs of any regulation should be kept firmly in mind.²³

Nevertheless, whether the new rules that Cox has proposed are really necessary is debatable. Cox seeks the anti-fraud rule because the anti-fraud provisions of Sections 206(1) and 206(2) of the Advisers Act protect only “clients,” which the D.C. Circuit has now held does not include investors in hedge funds. Yet, Section 10(b) of the 1934 Act and SEC Rule 10b-5 already provide the same antifraud protection as those provisions, which have nearly identical language except for the limitation to “clients,” and Cox has acknowledged that the SEC’s ability to bring enforcement actions against hedge funds and their managers “remains intact.”²⁴ Furthermore, while looking into raising the threshold requirement for investing in hedge funds to curb “retailization,” Cox conceded that the agency’s staff members “are not aware of significant numbers of truly retail investors investing directly in hedge funds.”²⁵

Thus, while the emergency measures that Cox has proposed are indeed necessary to protect hedge fund advisers that choose to remain registered, the need for the anti-fraud and increased threshold investor requirements appears questionable.

Notes

1. Testimony of SEC Chairman Christopher Cox before U.S. Senate Committee on Banking, Housing and Urban Affairs (July 25, 2006) (hereinafter, “Cox Testimony”); see Goldstein v. Securities and Exchange Comm’n, 451 F.3d 873 (D.C. Cir. 2006); the hedge fund rule consisted of new rule 203(b)(3)-2 (17 C.F.R. § 275.203(b)(3)-2), and amendments to rules 203(b)(3)-1 (17 C.F.R. § 275.203(b)(3)-1), 203A-3 (17 C.F.R. § 275.203A-3), 204-2 (17 C.F.R. § 275.204-2), 205-3 (17 C.F.R. § 275.205-3), 206(4)-2 (17 C.F.R. § 275.206(4)-2), and 222-2 (17 C.F.R. § 275.222-2) under the Investment Advisers Act of 1940, 15 U.S.C. §§ 80b, et seq.

2. See Cox Testimony (July 25, 2006).

3. 15 U.S.C. § 80b-3 (registration requirement); 15 U.S.C. § 80b-6 (anti-fraud provisions).

4. See 15 U.S.C. § 80b-2(11).

5. See 15 U.S.C. § 80b-3(b)(3).

6. See 17 C.F.R. § 275.203(b)(3)-1.

7. See 17 C.F.R. § 275.203(b)(3)-2(a).

8. See Testimony of Susan Ferris Wyderko, Director, SEC Office of Investor Education and Assistance, before Subcommittee on Securities and Investment of the U.S. Senate Committee on Banking, Housing and Urban Affairs (May 16, 2006) (hereinafter “Wyderko Testimony”); see also Goldstein, 451 F.3d at 877 n.3.

9. See 69 Fed. Reg. at 72,064; see also Goldstein, 451 F.3d at 877 n.3.

10. See 17 C.F.R. § 275.205-3.

11. See 17 C.F.R. § 275.204-2 (e)(iii)(2).

12. See 17 C.F.R. § 275. 206(4)-2.

13. See 17 C.F.R. § 275. 203(b)(3)-2.

14. See Goldstein, 451 F.3d at 878.

15. Id. at 879-880.

16. Id. at 883.

17. See SEC Press Release (August 7, 2006).

18. See Cox Testimony (July 25, 2006).

19. See Wyderko Testimony (May 16, 2006).

20. See Goldstein, 451 F.3d at 877.

21. See Cox Testimony (July 25, 2006).

22. See Chamber of Commerce v. Securities and Exchange Comm’n, 443 F.3d 890 (D.C. Cir. 2006).

23. See Cox Testimony (July 25, 2006).

24. Compare 15 U.S.C. §§ 80b-6(1) and 80b-6(2) with 15 U.S.C. § 78j(b) and 17 C.F.R. § 240.10b-5.; see also Cox Testimony (July 25, 2006).

25. See Cox Testimony (July 25, 2006).

About the Author

Gareth T. Evans is a partner in the Los Angeles office of Gibson, Dunn & Crutcher LLP. Mr. Evans regularly represents and advises clients in the investment management industry. Contact: GEvans@gibsondunn.com.