On June 23 a three-judge panel of the U.S. Court of Appeals for the District of Columbia Circuit unanimously invalidated the U.S. Securities and Exchange Commission’s (SEC) hedge fund rules. The court acted on the grounds that the SEC’s redefinition of the term “client” to look through to fund investors (unless the fund adopted a two-year redemption lock-up) for purposes of determining a fund manager’s federal registration obligations “falls outside the bounds of reasonableness.” (Currently, a U.S. investment adviser must register if it has had more than 14 clients in the preceding 12 months and has at least $30 million under management; the dollar threshold does not apply to offshore managers, who need count only U.S. clients.)
The rules were vacated and remanded, with the court leaving open the possibility that the SEC might be able to define “certain characteristics present in some [fund] investor-adviser relationships that mark a ‘client’ relationship …” However, in a further order the court, in accordance with practice, withheld the issuance of its mandate until the expiration of the period within which the SEC can petition for a rehearing (either by the panel that issued the ruling or en banc). This means that, absent a statement by the SEC that it will not seek a rehearing, the earliest date upon which the rules will be deemed vacated is August 7. If the SEC petitions for a rehearing, that date would be extended pending the court’s action on the petition (which could take several months).
While SEC Chairman Christopher Cox left open all possibilities in his press release following the court’s decision, we think it unlikely that the SEC will seek either a rehearing or review by the Supreme Court, or that a rehearing or review would be granted if sought. We also think it unlikely that the SEC will take the court’s barely extended invitation to try to define particular investor arrangements (e.g., arising out of certain side-letter provisions) as client relationships. For practical purposes, therefore, we believe the SEC’s only viable option will be to seek explicit Congressional authority to regulate hedge fund managers.
Given the opposition of the Board of Governors of the Federal Reserve System, the U.S. Department of the Treasury, the U.S. Commodity Futures Trading Commission and the President’s Working Group on Financial Markets to the hedge fund rules, Congressional authorization likely will not be forthcoming, at least in the short run.
What should hedge fund managers do?
The court’s decision raises several questions: (1) whether managers who were on the verge of registration because of the hedge fund look-through are now free not to proceed, (2) whether managers should feel comfortable rescinding two-year lock-ups they had adopted to avoid the look-though and (3) whether managers that have registered solely because of the look-through should now consider withdrawal.
While it will be necessary to await a definitive SEC response, we suggest that managers on the verge of registration consider delaying their application pending SEC action. If the SEC abandons the process, many registered hedge fund managers will want to withdraw; however, business considerations may argue to the contrary. Some clients important to fund managers may prefer to invest in funds with registered managers, and Employee Retirement Income Security Act (ERISA) considerations may prompt managers with hedge funds deriving more than 25 percent of their assets from pension fund investors to maintain registration (although pending legislation may increase the ERISA threshold). The market permitting, we expect managers will generally want to retain lock-ups, even if they need to negotiate side-letter exceptions with particularly important investors.