A question on everyone's mind these days is whether the Securities and Exchange Commission will appeal the recent federal appeals court ruling that overturned the SEC's controversial rule requiring most hedge fund advisors to register with the Commission under the Investment Advisers Act. While the majority of those in the investment industry opine that the SEC will not appeal–including SEC Commissioner Paul Atkins–some industry officials are encouraging the securities regulator to do so.
Until the SEC makes a decision, however, hedge fund advisors will remain in a state of regulatory limbo. "The notion of having the [hedge fund advisor registration] rules confused, as I think they are, isn't healthy for the U.S. markets," says Michael Tannenbaum, a partner at New York law firm Tannenbaum Helpern Syracuse & Hirschtritt LLP.
The June 23 ruling by the U.S. Court of Appeals for the District of Columbia Circuit focused its opposition on the SEC's use of the term "client" in the hedge fund registration rule the securities regulator passed in December 2004. As of January 1, 2005, 1,260 hedge fund advisors had registered; the total number, according to SEC spokesman John Heine, is now 2,533.
The rule included a new interpretation of a provision in the Investment Advisers Act exempting from registration advisors that had fewer than fifteen "clients" during the preceding year. Before the rule was adopted, the SEC had interpreted the registration exemption to count a hedge fund as a single client. The new rule reversed this position and required hedge fund advisors to count each investor–or limited partner–as a single client.
The federal appeals court ruling argued that the SEC's decision to treat each investor as a client was arbitrary, according to the Investment Adviser Association. The court ruling stated that "the Commission's interpretation of the word 'client' comes close to violating the plain language of the statute. At best it is counterintuitive to characterize the investors in a hedge fund as the 'clients' of the adviser. The adviser owes fiduciary duties only to the fund, not to the fund's investors."
Should Advisors Deregister?
Top Democrats acted quickly on June 29 by introducing a bill, the Securities and Exchange Commission Authority Restoration Act of 2006 (H.R. 5712), which would reverse the federal appeals court ruling by amending the Advisers Act to require hedge fund advisor registration.
The question now is whether advisors will start to deregister. Before deciding to deregister, Tannenbaum says advisors will wait for two things to occur: the allotted time the SEC has to appeal the ruling to lapse–which is 45 days after June 23 to file a petition with the federal appeals court, and 90 days after the ruling to appeal directly to the U.S. Supreme Court–and for Congressional action to be unlikely.
But Tannenbaum believes those hedge fund advisors that deregister do so at their own peril. Large institutional investors and pension investors who are subject to ERISA that are pouring money into the hedge fund marketplace "by the billions of dollars," he says, would prefer the hedge funds in which they invest to be registered. "The fiduciaries and trustees and investment committees at those institutional investors find great comfort in the fact that the manager to whom they are allocating money to invest is registered," he says. "From a legal standpoint, under ERISA, pension trustees who allocate money to nonregistered managers have a great deal more liability for the investment process than those trustees that allocate money to registered managers. The reason for that is it's a provision in ERISA and a DOL rule as well." The bottom line, he says, is if a hedge fund manager "wishes to address and get money from the institutional marketplace, they will find themselves needing to register."
