Now What For The Hedge Fund Rule?

It’s too soon to know what the Securities and Exchange Commission will do now that its hedge fund registration rule has been tossed out. The U.S. Court of Appeals for the District of Columbia on Friday handed a major victory to Philip Goldstein of Opportunity Partners, the poster hedge fund which fought the law and won. The court ruling Friday seemed to indicate that it was the arbitrary numbers game that did in the measure. The D.C. Circuit Court noted that HFs were “notoriously difficult to define,” especially since the term doesn’t appear in federal securities laws and even industry players can’t agree on a definition. The court also took the SEC to task for using different definitions of “client.”

“The Commission cannot explain why ‘client’ should mean one thing when determining who fiduciary duties are owed... and something else entirely when determining whether an investment adviser must register” under the Investment Company Act of 1940.

The SEC tried to justify the rule by pointing out the increased number of HF investors, particularly those of the institutional variety, and a resulting jump in fraud actions. But the court said the agency failed to bring “any evidence that the role of fund advisers with respect to investors had undergone a transformation,” and therefore, “there was a disconnect between the factors the Commission cited and the rule it promulgated.” What’s more, the court found the filing requirement for advisers with more than 14 clients arbitrary.

It’s too soon to say what will happen next. The agency can appeal the ruling to an even higher authority – the U.S. Supreme Court – or perhaps go back to the drawing board and come up with legislation that answers the court’s objections. The SEC could also ask Congress to work on it, or just abandon the rule altogether. "It is premature to determine whether the SEC will rewrite the rule, with or without public comment, or allow it to fade into history or take this further" by appealing to the Supreme Court, said Ron Geffner, a partner in New York-based law firm Sadis & Goldberg's financial services group, told MARHedge.

In response to the ruling, SEC Chairman Christopher Cox says the agency will “use the court’s decision as a spur to improvement in both our rulemaking process and the effectiveness of our programs,” but did not provide specific details other than to say he has ordered his professional staff to evaluate the decision.