June 26, 2006
The Court’s Decision
The Federal Court of Appeals for the D.C. Circuit has vacated the SEC’s rule regulating hedge funds under the Investment Advisers Act. See Goldstein v. Securities and Exchange Comm’n, No. 04-1434 (D.C. Cir. Jun. 23, 2006). Under the SEC’s "hedge fund rule," enacted in December 2004, most advisers to hedge funds were required to register with the SEC under the Advisers Act if the funds they advise have fifteen or more shareholders, limited partners or beneficiaries. By requiring registration under the Advisers Act, the SEC had sought to gain oversight of hedge funds and hedge fund advisers. The Court held that the SEC’s enactment of the hedge fund rule was "arbitrary" and exceeded the agency’s authority.
Before the SEC’s enactment of the hedge fund rule, hedge fund managers were usually exempt from registration under the Advisers Act’s "private adviser exemption." This exemption allows advisers with fewer than fifteen "clients" over the past twelve months not to register. Previously, the SEC had interpreted "client" to refer to the fund itself rather than to its investors. Even the largest hedge fund advisers usually manage fewer than fifteen hedge funds, so they fell within the exemption. In the hedge fund rule, however, the SEC did an about face, equating "client" with "investor," thereby requiring almost all hedge fund managers to register. Since the rule was passed in December 2004, more than 1,200 new hedge fund advisers registered with the SEC.
In vacating the hedge fund rule, the court strongly 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." The court 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 emphasized that under the Advisers Act and elsewhere the adviser’s fiduciary duties run to the fund and not to individual investors. Agreeing with the two dissenting Commissioners who opposed 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."
Implications for Hedge Fund Managers and the Investment Management Industry
The court’s decision 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. Recently, in a case brought on behalf of the United States Chamber of Commerce, for whom Gibson, Dunn & Crutcher LLP served as counsel, 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. 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 – not administrative agencies – is ultimately charged with making policy decisions such as what industries should be subject to federal regulation, and to what extent.
Importantly, industry involvement in creating a record at the rulemaking stage can be key in subsequent legal challenges. With the defeat of its hedge fund rule and fund governance rule, the SEC under its new Chairman appears determined to review and improve its rulemaking process, including its economic analysis. As the SEC moves toward a more exacting rulemaking process, issuers and other regulated entities interested in proposed SEC rules must give greater attention in rulemaking comments to cost and economic data and other relevant evidence they can present for the rulemaking record.
There almost certainly will be increasing efforts to regulate hedge funds and their advisers through rulemaking and enforcement actions, and possibly legislation, at both the federal and state levels. Hedge funds as we know them were unknown in 1940. 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. These factors may motivate federal and state regulatory and enforcement agencies to continue to attempt to regulate and investigate the hedge fund industry.
While the SEC has lost for now its ability to examine advisers to hedge funds through the registration and examination process, it retains its authority to investigate possible violations of the general antifraud provisions of the federal securities laws. Additionally, the plaintiffs class action securities bar is now realizing that hedge fund and mutual fund advisers represent a previously untapped source of potential judgments and settlements. The investment management industry should be prepared with appropriate legal representation so that it can predict the future challenges and help to mold its own future, rather than responding defensively to actions by regulators, Congress, and the courts.
Gibson, Dunn & Crutcher’s Investment Management, Securities Litigation, and Administrative Law and Regulatory Practice Groups represent members of the investment management industry and securities broker-dealers in connection with enforcement actions, governmental investigations, civil litigation, and rulemaking by federal and state regulatory agencies.
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© 2006 Gibson, Dunn & Crutcher LLP
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