SEC Hedge Fund Registration Rule Vacated by D.C. Circuit
On June 23, the U.S. Court of Appeals for the D.C. Circuit vacated the SEC’s rule requiring registration of certain hedge fund advisers, Rule 203(b)(3)-2 (Hedge Fund Rule) under the Investment Advisers Act of 1940 (Advisers Act). The SEC adopted the Hedge Fund Rule on December 2, 2004 under then-Chairman William Donaldson, and over the dissent of Commissioners Paul Atkins and Cynthia Glassman. The Hedge Fund Rule officially took effect on February 6, 2006.
The Hedge Fund Rule was based on an interpretation of Section 203(b)(3) of the Advisers Act, which provides an exemption from registration for advisers with fewer than 15 clients. Historically, hedge fund advisers had qualified for this exemption by counting each fund that it advised as a separate client, rather than each of the underlying investors. However, the Hedge Fund Rule required advisers to count each investor in a hedge fund as a client, effectively requiring most hedge fund advisers to register with the SEC.
In its opinion, the D.C. Circuit focused largely on the SEC’s interpretation of Section 203(b)(3). In adopting the Hedge Fund Rule, the SEC had concluded that, because the term "client" is not defined in the Advisers Act, the term is ambiguous and therefore subject to the SEC’s interpretation. The court disagreed, stating instead that the term had to be read in the context of the statute. In considering the Hedge Fund Rule, the court analyzed whether the term "client" was intended to include a fund’s investors. The court noted that investors in a private fund may benefit from the adviser’s advice, but they do not receive the advice directly. In addition, the court noted that the adviser has a direct relationship only with the fund, and that the adviser is concerned with the fund’s performance, not with each investor’s financial condition.
The court ultimately concluded that the SEC’s interpretation of Section 203(b)(3) was not reasonable. As a general matter, the court concluded that the SEC’s interpretation of the word client "comes close to violating the plain language of the statute." The court noted in particular that the adviser owes a fiduciary duty only to the fund, not to the fund’s investors. In addition, the court challenged the SEC’s argument that the Hedge Fund Rule amended only the method for counting clients under Section 203(b)(3), not the obligations owed by an investment adviser to its clients, stating that the SEC "cannot explain why client should mean one thing when determining to whom fiduciary duties are owed, and something else entirely when determining when an adviser must register under the [Advisers] Act."
In a public statement, SEC Chairman Christopher Cox stated that the D.C. Circuit’s finding "requires that going forward we reevaluate the agency’s approach to hedge fund activity." Chairman Cox stated further that he has instructed the SEC staff to evaluate the court’s decision, and to provide to the Commission a set of alternatives for its consideration. In addition, Chairman Cox stated that the SEC "will continue to work with the other members of the President’s Working Group on Financial Markets, including the Treasury, the CFTC, and the Federal Reserve, to evaluate both the systemic market risks and retail investment issues associated with the growing presence of hedge funds in the world’s capital markets."
View the D.C. Circuit’s opinion
View SEC Chairman Cox’s public statement
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