Appellate Court Strikes Hedge Fund Registration Rule


Rule Determined to be Arbitrary, Sent Back to SEC

By Mark J. Astarita, Esq.

In a decision issued on June 23, 2006, the United States Court of Appeals for the DC Circuit has thrown out the SEC’s controversial rule requiring the registration of hedge funds.

The SEC’s rule, which became effective in February 2005, was actually the registration of hedge fund managers, not the funds themselves. The rule has become known as the Hedge Fund Rule, and was adopted under the Investment Advisers Act of 1940, 15 U.S.C. 80b-1.

The rule was adopted on questionable factual grounds, and there was a significant dissent to the adoption of the rule from two of the five SEC Commissioners. In a previous article, I discussed the rule and the potential problems with the enactment, and entire rationale for the rule. See, Registration of Hedge Fund Managers -Bureaucracy Without Benefit.

In short, hedge fund managers were previously exempt from registration under the Investment Advisers Act because they had “fewer than fifteen clients,” 15 U.S.C. § 80b-3(b)(3). Previous rules and interpretations of the Act counted a hedge fund as one “client” and therefore the manager of one hedge fund did not have to register as an advisor. Hedge funds also remained outside of the scope of the Investment Company Act of 1940, which exempts funds that have less than 100 investors.

The new Hedge Fund Rule changed the definition of “clients, in the Investment Advisers Act, to include “shareholders, limited partners, members, or beneficiaries.” 17 C.F.R. § 275.203(b)(3)-2(a), and the rule change applied to all advisers who had more than 30 million dollars under management. The net effect was that all managers of hedge funds with over 30 million dollars had to register with the SEC as investment advisors.

Philip Goldstein challenged the regulation, and the federal appellate court agreed with his view of the rule, striking the rule as being arbitrary. The Court provided an analysis of the relevant statutes and exceptions to registration for hedge fund managers, and found that the Hedge Fund Rule carved out an exception from the exceptions for investment entities that have fewer than one hundred-one but more than fourteen investors. The Court found that the SEC did not justify this exception, and that absent such justification, the new rule was “completely arbitrary.”

The Court also found that the Hedge Fund Rule “exacerbates whatever problems one might perceive in Congress’s method for determining who to regulate. The Commission’s rule creates a situation in which funds with one hundred or fewer investors are exempt from the more demanding Investment Company Act, but those with fifteen or more investors trigger registration under the Advisers Act. This is an arbitrary rule.”

It is now up to the SEC to determine the next step. With a new Chairman, we may see a complete revision, if not gutting, of the rule. Alternatively, Congressional action, by amending the Investment Advisers Act, could address the Court’s concerns, but it is doubtful that Congress will take up such an endeavor, which, for the reasons originally cited, would cause more controversy, more regulation, more bureaucracy, with little if any benefit.

And the decision itself adds to the controversy. Approximately 1,000 hedge fund managers registered with the SEC under the rule, and despite this decision, they remain registered with the SEC…you can’t simply “un-register” yourself. Investment Advisers will now have to re-examine whether they wish to remain registered as investment advisers. Those who choose to give up their registration will face the possibility that the SEC comes back with another version of the rule, causing such advisers to register again.

Nothing herein is intended as legal or financial advice. The law is different in different jurisdictions, and the facts of a particular matter can change the application of the law. Please consult an attorney or your financial advisor before acting upon the information contained in this article.



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Mark Astarita is a nationally recognized securities attorney, who represents investors, financial professionals and firms in securities litigation, arbitration and regulatory matters, including SEC and FINRA investigations and enforcement proceedings.

He is a partner in the national securities law firm Sallah Astarita & Cox, LLC, and the founder of The Securities Law Home Page -, which was one of the first legal topic sites on the Internet. It went online in 1995 and is updated daily with news, commentary and securities law related links.