G Investment Management Group Alert June 2006 Court Vacates SEC Rule Requiring Hedge Funds to Register In its second surprise move in the past week, the The Rule Prior to October 2004 United States Court of Appeals for the District of Prior to October 2004, Section 203(b)(3) of Columbia Circuit has, on its own initiative, issued the Advisers Act specifically exempted from an order that delays the effectiveness of its June 23, registration any investment adviser that, among 2006 decision in Goldstein v. Securities and other things, had fewer than 15 “clients” during Exchange Commission . the preceding 12 months. Rule 203(b)(3)-1 generally permitted an adviser to count as a single In Goldstein , the Court vacated the rule recently client any pooled investment fund that it advised, enacted by the Securities and Exchange regardless of how many underlying investors were Commission (the “SEC”) that required most hedge invested in such fund. Thus, a private manager fund managers to register as investment advisers with fewer than 15 funds was usually exempt from pursuant to the Investment Advisers Act of 1940, federal registration. This so-called “ de minimis as amended (the “Advisers Act”). The Court’s June exemption” had allowed most hedge fund 27, 2006 order withholds the issuance of a mandate to managers to remain unregistered. As the hedge the SEC, which would make its June 23 decision fund industry’s assets approached one trillion effective, until seven days after the earlier of (i) the dollars, the SEC expressed growing concern over expiration of the period within which the SEC may its inability to examine the advisers to those funds. file a petition for a rehearing en banc by the D.C. Circuit or may appeal the Goldstein decision to the The Look-Through Rule United States Supreme Court; and (ii) the On October 26, 2004, the SEC voted, in a 3-2 disposition of such rehearing or appeal. decision, to adopt Rule 203(b)(3)-2 (the “Look- The Court’s most recent action means that, unless Through Rule”). The Look-Through Rule changed the SEC announces affirmatively that it will not the method of calculating the number of an appeal the Goldstein decision (in which case the adviser’s “clients.” The Look-Through Rule requires Court likely would issue the mandate), the hedge that a manager “look through” each of its funds fund registration rule adopted by the SEC will remain and managed accounts, and count as a client each in effect at least until early August. The paragraphs individual underlying investor (rather than each below are designed to provide you with background fund). Thus, if a manager has at least 15 individual and a summary of the most recent events. investors across all of its funds and managed This document is published by Lowenstein Sandler PC to keep clients and friends informed about current issues. It is intended to provide general information only. L Roseland, New Jersey Telephone 973.597.2500 65 Livingston Avenue www.lowenstein.com 07068-1791 Fax 973.597.2400
G accounts, that manager is required to register as an decision. Consequently, as of this writing, the investment adviser under the Look-Through Rule, Look-Through Rule remains legally in effect. The unless an exclusion or exemption applies (such as, next move is the SEC’s. for example, the exemption for venture capital, What the Court’s Decision Means private equity, and other funds with limited The SEC has yet to announce its intentions in liquidity). Accordingly, many previously exempt response to the Court’s decision. The SEC could managers registered with the SEC prior to the appeal the decision to the United States Supreme Look-Through Rule’s February 1, 2006 effective Court, attempt to modify the Look-Through Rule, date. In addition to filing a Form ADV, managers ask Congress to legislate, or altogether halt its were required, among other things, to adopt written efforts to regulate hedge funds at this time. A compliance policies and procedures, appoint a number of changes since the Look-Through Rule chief compliance officer, adhere to restrictions on was adopted in 2004 make it especially difficult to charging performance fees, maintain certain books predict what will happen next. and records, and prepare for surprise inspections by the SEC. The Look-Through Rule was controversial within the SEC even at the time of its adoption, The Goldstein Decision and the current SEC Chairman was not the In last week’s Goldstein decision, the Court of Chairman when the Look-Through Rule was Appeals held that the SEC had overstepped its adopted. The Court’s ruling, in essence, forecloses authority in adopting the Look-Through Rule. the possibility of re-defining the word “client” or While courts typically provide federal agencies, such employing any similar method to retrofit the existing as the SEC, wide latitude in enacting regulations, statute to a fundamentally expanded purpose. In the Court, while leaving as an open regulatory issue addition, two years have passed since the corporate the need for registration of hedge fund managers, governance headlines that fueled broad support for determined that the manner in which the SEC increased regulation of the financial services had required registration—by defining clients on industry. These factors point toward the SEC a look-through basis—was arbitrary and improper. abandoning its regulatory attempt. On the other The Court vacated the Look-Through Rule and hand, the SEC has hired and trained hundreds of sent it back to the SEC for reconsideration. Indeed, new inspectors to implement the Look-Through the Court seemed to suggest that if registration of Rule, the hedge fund industry has continued to fund managers is necessary due to the size of the grow at an accelerated rate since 2004, and some of industry and its impact on the capital markets, the trends about which the SEC was most the proper way to accomplish it is through worried—such as the retailization of hedge funds— legislative action. have continued unabated. These factors point Ultimately, the Court delayed issuing the toward the SEC pursuing its regulatory attempt. mandate that would have implemented its
G Depending on the SEC’s response, it may be appropriate for fund managers to reevaluate the need to remain registered, their compliance policies and procedures, and their fund offering terms. At this time, however, there is nothing to be done in advance of an initial substantive response from the SEC. * * * * * If you have any questions regarding these matters, please do not hesitate to contact a member of Lowenstein Sandler’s Investment Management Group. We will, of course, keep you apprised of further developments. The Investment Management Group Lowenstein Sandler PC Co-Chairs: Allen B. Levithan Robert G. Minion Partners: John L. Berger Andrew E. Graw Marie T. DeFalco Peter D. Greene Michael N. Gooen Counsel: Michael J.Caffrey Maureen E. Montague Paul W. Hartzel Sharon M. Mousserie John J. Herbst Brian A. Silikovitz Elaine M. Hughes Associates: Richard Bernstein Diana Ingallinera Faillace Susan M. Cohen Erik W. Johnson Javier Cuebas Steven P. Kirberger Brock M.Cusick Ryan S. Melcher Michael J. Dickey Michele L. Misher Brooke A. Gillar Scott H. Moss Mario V. Hernandez Keith T. O'Brien Steven N. Papera
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