In an effort to make the burgeoning hedge fund industry more transparent and to reduce the chances of fraud, the SEC has changed the definition of a "client" under the Investment Act of 1940 so that hedge funds managing more than $30 million in assets with more than 15 clients will be obliged to register as investment advisers. Previously, hedge funds could skirt the registration rule because they counted each fund under their management as a single client, rather than each fund's individual investors.

However, in the first appellate hearing challenging the SEC's authority to change the rule, Circuit Judge Harry Edwards of the US Court of Appeals for the District of Columbia told SEC lawyer Jacob Stillman last Friday that the argument "doesn't hold up".

"You can't just come in here and say we're going to make 'client' mean whatever we want because we're the agency. We have to test your thesis and your thesis doesn't stand up," Judge Edwards remarked.

In response, Mr Stillman argued that the definition of a "client" under the legislation was too vague, and this made it "permissible" for the SEC to rewrite the rules.

For hedge funds, the new rules will mean the introduction of written compliance and ethics policies, the appointment of a chief compliance officer, and the keeping of more detailed records, to which the securities regulator must be allowed access.

The court is not expected to reach a decision in the case for another two or three months, and the verdict may come after the February 1 registration deadline for hedge funds.