Hedge Funds Win in Court: Appeals Panel Strikes Down SEC Rule Try

By Becky Yerak, Chicago Tribune

Jun. 24–A 5-month-old rule subjecting often-secretive hedge funds to more oversight was dealt a blow Friday when a U.S. appeals court struck down efforts to regulate the rapidly growing industry.

On Feb. 1, the Securities and Exchange Commission began requiring hedge fund advisers to register with the regulator if they managed at least $30 million and had more than 14 clients. They also could be asked to undergo inspections.

But Friday, a federal appeals court in Washington found that hedge funds are “notoriously difficult to define,” handing the SEC its second major regulatory setback in recent months.

“The term appears nowhere in the federal securities laws and even industry participants do not agree upon a single definition” for hedge funds, Judge A. Raymond Randolph wrote in the three-judge panel’s unanimous 19-page opinion.

The SEC’s rule, he continued, “falls outside the bounds of reasonableness.”

The SEC proposed its new rules in July 2004. Since Jan. 1, 2005, more than 1,200 previously unregistered hedge-fund advisers have submitted paperwork to the SEC.

Although many hedge funds found loopholes to avoid registering, law firms held conferences to teach clients about the new rules. Firms that offered compliance products and services were in hot demand as the Feb. 1 deadline approached this year.

“I’m blown away by the court’s decision,” said Michael Gray, an attorney who represents hedge funds for Chicago-based law firm Schwartz Cooper. “It’s a significant decision because a lot of people went through a lot of effort and costs to comply with a law that has now been overturned.”

The ruling basically again relegates the SEC, at least where hedge funds are concerned, to the role of police officer, arriving on the scene largely after complaints are made or wrongdoing committed, rather than taking a more pro-active role in regulating and tracking the alternative investment class.

About 8,500 hedge funds manage more than $1 trillion in assets, according to Hedge Fund Research Inc. in Chicago. In 1990, there were 610 hedge funds with assets totaling $39 billion.

“It was clear that the SEC lacked the manpower to do much in the way of enforcement, but the rules allowed them to start gathering data and getting their arms around the hedge fund industry,” said Stuart Feffer, managing director of the investment management practice at consulting firm BearingPoint Inc.

“Now they’re back to where they were two years ago, still cops on the beat, but they need to wait for something to occur,” he said.

Critics of the SEC rules had argued that the regulations resulted in substantial costs of both money and manpower in areas such as recordkeeping, the monitoring of employees’ trading and the hiring of compliance officers. Foes also feared it would discourage new funds from starting up.

The plaintiff in the case, Phillip Goldstein of Pleasantville, N.Y.-based Opportunity Partners LP, argued that the SEC exceeded its authority to regulate hedge funds and that Congress should be the one with the power to initiate greater oversight.

“The court came down hard on the SEC,” said Barry Barbash, a former SEC lawyer and now a partner at Willkie Farr & Gallagher. “The court did not conclude that the SEC could not regulate hedge funds, but it did conclude this form of regulation was not going to” pass muster.

Earlier this month, the SEC said it would revisit a contentious rule requiring mutual funds to have independent chairmen.

The U.S. Chamber of Commerce had challenged the rule twice, and in a ruling this spring a U.S. appeals court agreed that the SEC violated federal procedures by failing to seek comment on the rule’s costs before reaffirming it in June 2005. The court said it would vacate the rule unless the SEC addressed that within 90 days.

As for Friday’s ruling over its hedge fund regulations, the SEC said it’s regrouping.

The court’s finding “requires that going forward we re-evaluate the agency’s approach to hedge fund activity,” SEC Chairman Christopher Cox said in a statement.

The SEC is studying the court’s decision and will consider its options, he said.

“The SEC will use the court’s decision as a spur to improvement in both our rulemaking process and the effectiveness of our programs to protect investors, maintain fair and orderly markets, and promote capital formation,” Cox said.

byerak@tribune.com

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Copyright (c) 2006, Chicago Tribune

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