Appeals Court Vacates SEC Hedge-Fund Rule

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    Appeals Court Vacates
    SEC Hedge-Fund Rule

    June 23, 2006 10:51 a.m.

    A controversial Securities and Exchange Commission rule tightening oversight of hedge fund advisers is "arbitrary" and cannot stand, according to a ruling Friday by the U.S. Court of Appeals for the D.C. Circuit.

    The rule, which took effect in February, requires most hedge fund advisors to register with the SEC and undergo routine inspections. Former SEC Chairman William Donaldson pushed for the requirement, saying stricter oversight is needed given the dramatic growth of hedge funds, which are lightly regulated investment pools intended for wealthy investors.

    In a long-awaited decision, the appellate court rejected the SEC's approach, vacated the rule and sent it back to the agency for reconsideration.

    The opinion focused on an issue that dominated oral arguments in the case on Dec. 9, namely the SEC's definition of a hedge fund "client."

    The SEC rule overturned the agency's former approach of viewing each hedge fund as a single client and instead counted each hedge fund investor as a client, requiring registration for hedge fund advisors with 15 or more clients.

    A skeptical court said the SEC failed to justify the turnabout and that its new interpretation "falls outside the bounds of reasonableness" and comes close to violating "the plain language" of the 1940 Investment Advisers Act.

    According to the 19-page opinion, the SEC didn't show why the new rule was needed or adequately explain "how the relationship between hedge fund investors and advisers justifies treating the former as clients of the latter."

    Phillip Goldstein, a portfolio manager for Opportunity Partners LP, a Pleasantville, N.Y., hedge fund, challenged the rule and claimed it unreasonable for the SEC to define as a "client" someone who doesn't receive individual investment advice from the hedge fund advisor. Goldstein's attorney, Philip Bartz, argued that hedge fund managers provide investment advice to the fund, not each individual investor.

    SEC Solicitor Jacob Stillman, who argued on behalf of the agency, said U.S. laws don't clearly define who is a hedge fund client, giving the SEC leeway to make the call. He told the three-judge appellate court panel that the SEC was correct in treating hedge fund investors as clients.

    Write to Judith Burns at judith.burns@dowjones.com1

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