Hedge Funds

In the March/April 2006 issue, I addressed the new regulations and amendments to the Investment Advisers Act of 1940 ("Act" or "Hedge Fund Rule").¹ As of Feb. 1, 2006, the new regulation (Rule 203(b)(3)-2) required significantly more hedge fund advisers to: (1) register with the SEC; (2) implement new policies and procedures; (3) designate a chief compliance officer; and (4) comply with the Act and all applicable SEC rules.²   

As set forth in my previous column, hedge funds employ a range of speculative and aggressive strategies that frequently combine common investments with short sales, leveraging, and arbitrage strategies to maximize returns, and therefore require savvy investing by experienced backers. For the past 60 years, hedge funds have been able to sidestep requirements of the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Advisers Act of 1940. That was, until February 2006, when the requirements that certain hedge fund advisers register with the SEC commenced (though the actual rule was adopted in December 2004). The SEC fought hard for a few years to pass these new regulations and amendments, which were finally approved by the Commission with a mere majority vote of 3/2.

On Dec. 2, 2004, Phillip Goldstein of Kimball & Winthrop Inc., and Opportunity Partners LP, sued the SEC in district court to overturn provisions of the Act and its recent amendments. Although most advisers knew about Goldstein's fight against the new regulations, the "better safe than sorry" rule of thumb kicked in, and more than a thousand hedge funds were registered with the SEC by the February 2006 requirement date; almost half of that number filed late registrations within days after the deadline.

On June 23, 2006, the U.S. Court of Appeals for the District of Columbia invalidated the SEC's new rule and related amendments, most significantly which required hedge fund advisers to count each investor of a private fund" toward the 15-client exemption.³ The court found that the SEC's meaning of "client" was unfounded. Because the Act doesn't define "client," the SEC attempted to make the term more understandable.

The court rejected the SEC's stance that it had the authority to define "clients." Because there's not a statutory definition of the term, the court held that "it scarcely follows that Congress has authorized [the SEC] to choose any one of those meanings." The court also cited a 1970 amendment to the Act that suggests that Congress considered "investment company entities, not their shareholders" to be advisers" clients.⁴ Furthermore, the court referred to the hedge fund adviser as only owing fiduciary duties to the hedge fund, rather than the investors.⁵ Thus, the hedge fund rule was vacated and remanded.

Two months after the court's critical analysis of the SEC's regulatory actions, SEC Chairman Christopher Cox stated that the Commission wouldn't be seeking further review of the appeal court's decision. Rather, "the Commission is moving aggressively on agenda of rulemaking and staff guidance ... to address the legal consequences from invalidation of the rule."⁶ While waiting to see what will happen next, Chairman Cox has recommended that the SEC take the following remediation actions:

1. Propose a new anti-fraud rule under the Act, which would have the ability to "look through" a hedge fund to its investors, and could withstand judicial scrutiny

2. Allow an adviser to withdraw from registration in reliance of the private adviser exemption under the Act, without providing a balance sheet when filing a Form ADV-W (as long as registration is done before February 2007)

3. Restore transitional and exemptive rules in the 2004 hedge fund rule

4. Exempt newly registered advisers from the performance data recordkeeping requirement

5. Restore time requirement for providing audited financial statements

6. Eliminate registration requirements of offshore advisers of offshore funds.⁷  

The securities industry continues to emphasize that hedge funds have always been and will continue to be subject to anti-fraud provisions of states, self-regulatory organizations, the federal securities laws, and the Investment Advisers Act.⁸  

Though the SEC acknowledged, "[there] is no evidence indicating that hedge funds or their advisers engage disproportionately in fraudulent activity," it justified its reasons for tighter regulation of hedge funds in other ways.⁹  

So, for now, to understand the current state of hedge fund regulation, go back in time to 2004, to the days before the Hedge Fund Rule, and start from scratch.  

Juliana Morehead, J.D., CFE, is a legal writer and editor for the ACFE.  

The Association of Certified Fraud Examiners assumes sole copyright of any article published on www.Fraud-Magazine.com or ACFE.com. Permission of the publisher is required before an article can be copied or reproduced. 

¹Securities and Exchange Commission. Registration Under the Advisers Act of Certain Hedge Fund Advisers, Release No. IA-2333. www.sec.gov/rules/final/ia-2333.htm.

²Id.

³Goldstein v. Securities and Exchange Commission, 451 F3d 873 at 878 (D.C. Cir. 2006).

⁴Id. at 879.

⁵Id at 881.

⁶Securities and Exchange Commission. Statement of Chairman Cox Concerning the Decision of the U.S. Court of Appeals in Phillip Goldstein, et al. v. SEC. Aug. 2006. http://www.sec.gov/news/press/2006/2006-135.htm.

⁷Securities and Exchange Commission. Statement of Chairman Cox Before the U.S. Senate Committee on Banking, Housing and Urban Development. July 25, 2006. http://www.sec.gov/news/testimony/2006/ts072506cc.htm.

⁸Id.

⁹Securities and Exchange Commission. Staff Report: "Implications on the Growth of Hedge Funds." Sept. 2003. http://www.sec.gov/news/studies/hedgefunds0903.pdf. The SEC referred to the following reasons for justifying tighter regulation of hedge funds: (1) in four years (1999-2004) hedge fund assets grew by 260 percent; (2) no longer were hedge funds limited to sophisticated investors; and (3) due to the enormous growth of hedge funds in the industry, the SEC foresaw an increase in hedge fund fraud.