SEC Rule on Hedge Funds Is Invalidated

A federal appeals court on Friday struck down the Securities and Exchange Commission’s attempt to boost its oversight of hedge funds, calling a new SEC rule arbitrary and sending it back to the agency to be reworked.

The ruling was a blow to the SEC, which contends greater scrutiny is needed to ferret out fraud and head off risks to the global economy as hedge funds surge in popularity. There are more than 8,000 of the lightly regulated investment vehicles, with $1 trillion in assets, and they account for as much as one-fifth of U.S. stock-trading volume.

The decision by the Court of Appeals for the District of Columbia Circuit turned on a technical point. But it raised broader questions about whether federal regulators had the legal authority to patrol the hedge fund industry.

“It is a stunning setback for the SEC,” said Mitch Nichter, a hedge-fund lawyer at Paul, Hastings, Janofsky & Walker in San Francisco. “It’s unlikely the SEC is going to be able to fix this rule to withstand another legal challenge, and it’s unlikely that the SEC will be able to convince this Congress that hedge-fund regulation and registration is needed.”

Hedge funds typically pool money from wealthy individuals and institutional investors such as pension plans. They often pursue sophisticated and potentially risky investment strategies in hopes of outsized returns for their clients.

The rule struck down Friday was approved by a sharply divided SEC in 2004 and took effect Feb. 1. It required any hedge fund managing more than $25 million to register with the agency, provide extensive details about its operations and submit to periodic audits.

Phillip Goldstein, a hedge-fund manager in Pleasantville, N.Y., filed the legal challenge, arguing that the the rule imposed high compliance costs on small hedge funds while doing little to protect investors.

“I don’t want to sound gloating, but it was an incredible waste of time and resources, both for the hedge-fund industry and for the SEC,” Goldstein said.

In a statement, SEC Chairman Christopher Cox said the agency would “reevaluate” its approach to hedge-fund regulation.

“I have instructed the SEC’s professional staff to promptly evaluate the court’s decision, and to provide to the commission a set of alternatives for our consideration,” Cox said.

The legal challenge to the SEC rule revolved around the definition of the word “client.”

The SEC has the authority to regulate investment advisors, but in the past has exempted advisors with a small number of clients. For years, the SEC and the courts generally have considered each hedge fund itself, rather than the investors within a fund, to be a fund manager’s client.

The SEC altered that interpretation in adopting its hedge-fund regulation, designating each investor in the fund as a client. That effectively eliminated the exemption from regulation that many hedge funds firms had been allowed.

The court, however, disputed the SEC’s reasoning, saying its “interpretation of the word ‘client’ comes close to violating the plain language” of the law.

“That the commission wanted a hook on which to hang more comprehensive regulation of hedge funds may be understandable,” the court wrote. “But the commission may not accomplish its objective by a manipulation of meaning.”

Rich Goldman, an attorney who represents hedge funds for Bingham McCutchen, a law firm in Boston, predicted that the SEC would do an in-depth analysis to determine whether greater regulation is needed.

“More study of the hedge-fund industry needs to be done to decide if and how hedge-fund managers should be further regulated,” he said.

The commission approved the hedge-fund rule on a contentious 3-2 vote, with then-Chairman William Donaldson, a Republican, voting with two Democrats to impose oversight. Donaldson was excoriated by his two fellow Republicans, who argued that the need for regulation hadn’t been established.

Cox, a former Republican congressman from Newport Beach who succeeded Donaldson, surprised many on Wall Street by allowing the rule to stand.

Investor advocates have been split on the rule. Some argue that federal regulators should not spend limited resources scrutinizing funds that are intended for wealthy and presumably sophisticated investors.

But others point out that pension funds and other investment pools for middle-class Americans are increasingly putting money in hedge funds, and that the funds have become a potent force.

“Congress really needs to step into the debate,” said Tyson Slocum, director of energy research at Public Citizen. “Hedge funds have the potential to have a huge impact on the economy as a whole.”