Goldstein v. Securities And Exchange Commission

451 F.3d 873 (D.C. Cir. 2006)

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Nature of the Case

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Facts

D believes that an amendment to § 203(b)(3) suggests the possibility that an investor in a hedge fund could be counted as a client of the fund's adviser. D defines 'hedge fund' as 'an entity that holds a pool of securities and perhaps other assets, whose interests are not sold in a registered public offering and which is not registered as an investment company under the Investment Company Act' The Investment Company Act of 1940 directs D to regulate any issuer of securities that 'is or holds itself out as being engaged primarily . . . in the business of investing, reinvesting, or trading in securities.' Most hedge funds are exempt from the Investment Company Act's coverage because they have one hundred or fewer beneficial owners and do not offer their securities to the public, or because their investors are all 'qualified' high net-worth individuals or institutions. Investment vehicles that remain private and available only to highly sophisticated investors have historically been understood not to present the same dangers to public markets as more widely available investment companies, like mutual funds. Hedge funds typically remain secretive about their positions and strategies, even to their own investors. The Investment Company Act places significant restrictions on the types of transactions registered investment companies may undertake. Such companies are, for example, foreclosed from trading on margin or engaging in short sales, and must secure shareholder approval to take on significant debt or invest in certain types of assets, such as real estate or commodities. These transactions are all core elements of most hedge funds' trading strategies. 'Hedging' transactions, from which the term 'hedge fund' developed, involve taking both long and short positions on debt and equity securities to reduce risk. This is still the most frequently used hedge fund strategy, though there are many others. Hedge funds trade in all sorts of assets, from traditional stocks, bonds, and currencies to more exotic financial derivatives and even non-financial assets. Hedge funds often use leverage to increase their returns. Domestic hedge funds are usually structured as limited partnerships to achieve maximum separation of ownership and management. The general partner manages the fund (or several funds) for a fixed fee and a percentage of the gross profits from the fund. The limited partners are passive investors and generally take no part in management activities. Hedge fund advisers also had been exempt from regulation under the Investment Advisers Act of 1940. Hedge fund general partners meet the definition of 'investment adviser' in the Advisers Act. But they usually satisfy the 'private adviser exemption' from registration in §203(b)(3) of the Act. That section exempts 'any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to any investment company registered under [the Investment Company Act].' As applied to limited partnerships and other entities, D had interpreted this provision to refer to the partnership or entity itself as the adviser's 'client.' Even the largest hedge fund managers usually ran fewer than fifteen hedge funds and were therefore exempt. The failure of Long-Term Capital Management, a Greenwich, Connecticut-based fund that had more than $125 billion in assets under management at its peak and when the fund collapsed almost all of the country's major financial institutions were put at risk due to their credit exposure to Long-Term. D issued the rule under review in December 2004 after notice and comment. D cited three main issues for increased regulation. Hedge fund assets grew by 260 percent from 1999 to 2004. By various new organizations, the 'retailization' of hedge funds increased the exposure of ordinary investors to such funds. This included the birth of 'funds of hedge funds' that offered shares to the public, and increased investment in hedge funds by pension funds, universities, endowments, foundations, and other charitable organizations. There was a substantial increase in the number of fraud actions brought against hedge funds. D moved to require hedge fund advisers to register under the Advisers Act so that it could gather 'basic information about hedge fund advisers and the hedge fund industry,' 'oversee hedge fund advisers,' and 'deter or detect fraud by unregistered hedge fund advisers.' The Hedge Fund Rule first defines a 'private fund' as an investment company that (a) is exempt from registration under the Investment Company Act by virtue of having fewer than one hundred investors or only qualified investors, (b) permits its investors to redeem their interests within two years of investing; and (c) markets itself on the basis of the 'skills, ability or expertise of the investment adviser.' It then specifies that 'for purposes of section 203(b)(3) you must count as clients the shareholders, limited partners, members, or beneficiaries . . . of [the] fund.' This would require most hedge fund advisers to register and as registered advisors, they must open their records to D upon request, and cannot charge their clients a performance fee unless such clients have a net worth of at least $ 1.5 million or at least $750,000 under management with the adviser. Ps petitioned for review. Ps claim that D misinterpreted § 203(b)(3) of the Advisers Act, a charge the D dissenters also leveled. This provision exempts from registration 'any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients.' The Act does not define 'client.' D believes that because the Act does not define client, this renders the statute 'ambiguous as to a method for counting clients' and therefore invokes Chevron.