US Appeals Court Junks SEC Hedge Fund Registration

by Glen Shapiro, LawAndTax-News.com, New York

27 June 2006

The US Court of Appeals last Friday threw out the SEC's vexed hedge fund registration rule, leaving in limbo the 1,200 or so funds which have registered since last year.

The court had previously sent back the rule for re-consideration by the SEC in 2005, but outgoing Chairman William Donaldson contentiously had it re-affirmed by his 3-2 partisan majority on the Commission, just days before leaving, and new Chairman Christopher Cox, a Republican, has chosen to enforce the rule although with his two Republican colleagues, William Atkins and Cynthia Glassman, he could have withdrawn it.

The registration rule achieves its goal by classifying the investors in a hedge fund as clients of the fund's adviser (manager), thereby causing many more fund managers to fall within existing fund registration rules which apply when there are more than 14 clients.

The Court made much of the fact that the SEC's general stance is to treat the general partners of limited partnerships as making up a single 'client'. 'As we have discussed,' said the judgement, 'in 1985 the Commission adopted a “safe
harbor” for general partners of limited partnerships, enabling them to count the partnership as a single “client” for the
purposes of § 203 so long as they provided advice to a “collective investment vehicle” based on the investment
objectives of the limited partners as a group. This “safe harbor” remains part of the Commission’s rules and has since been expanded to include corporations, limited liability companies, and business trusts (hedge funds sometimes take these less common forms).

'The Hedge Fund Rule therefore appears to carve out an exception from this safe harbor solely for investment entities that have fewer than one hundred-one but more than fourteen investors. . . . As discussed above, the Commission does not justify this exception by reference to any change in the nature of investment adviser-client relationships since the safe harbor was adopted. Absent such a justification, its choice appears completely arbitrary.'

Said the judgement: 'The Commission’s interpretation of the word “client” comes close to violating the plain language of the statute. At best it is counterintuitive to characterize the investors in a hedge fund as the “clients” of the adviser.'

Dissenting Commissioners Paul Atkins and Cynthia Glassman have continued to criticize the registration rule in recent months. Speaking before the IA Compliance Best Practices Summit 2006, Atkins said the addition of hedge fund advisers to the registration rule "could greatly impair our ability to oversee other investment advisers, whose activities are much greater consequence to the investing public, based on sheer numbers alone."

Atkins thinks that hedge fund fraud, when it happens, is not likely to be committed among the funds that register, and says that the SEC already has "broad authority under the securities laws" to go after such offenders. "Would it not be ironic if the hedge fund rule increased the regulatory burden on non-hedge fund advisors, as well?" asked Atkins.

Last year, speaking at a meeting of the Managed Funds Association, Mr Atkins predicted that the SEC will struggle to cope when new hedge fund registration rules came into force, explaining to MFA members that:

"Just as some of you are working hard to prepare to deal with us, we at the SEC are struggling to get ready to deal with you. We have neither the resources nor the expertise to oversee all of the potential new registrants."

The administration has also told Congress that further regulation of the hedge fund sector is not required. Testifying in May before the Senate Banking Committee in a hearing on hedge funds, Randal K. Quarles, Treasury Under Secretary for Domestic Finance stated that while the Treasury will continue to gather information on the fast growing hedge fund universe, he believed the need for further regulation now was unnecessary.

"I think, at this point, I wouldn't see evidence that would suggest that there should be greater regulation of hedge funds," Quarles told the committee.

Federal Reserve chief Ben Bernanke also rejects the need for more stringent government oversight of hedge funds. According to Bernanke, a system whereby the major regulatory role was assumed by government could create a "moral hazard" lulling private investors into thinking that they would be bailed out in the event of loss.

"Would counterparties relax their vigilance if they thought the authorities were monitoring and constraining hedge funds' risk-taking?" Bernanke asked in a speech to a conference on hedge fund risk sponsored by the Atlanta Fed in Sea Island, Georgia.

Bernanke argues that the best people to keep an eye on the activities of hedge funds are the banks. "A focus on counterparty risk management places the responsibility for monitoring risk squarely on the private market participants with the best incentives and capacity to do so," he stated.

While Congress is more split on the issue of hedge funds, with some lawmakers from both sides of the aisle calling for tougher regulation, others, including Mike Crapo (R - Idaho) argue that the SEC overstepped its jurisdictional mark by changing the definition of the Investment Act 1940 to force the vast majority of hedge funds to register as investment advisors, thus throwing them open to more scrutiny.

"While the SEC is an independent agency, it seems to me that it shouldn't be permitted to take the term 'independent' to an extreme," Crapo told the banking committee.

Sen. John Sununu (R - NH), concurred. "We have to ask very basically whether or not the SEC really is the appropriate agency to be undertaking that sort of regulatory requirement," he told the committee.

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