Appellate Court Pondering SEC Hedge Fund Registration Future

December 9, 2005 ( - A federal appellate court panel on Friday explored with lawyers what regulators meant by using the word "client" in a new hedge fund advisor rule currently under challenge.

Two of the three-judge panel hearing the appeal at the US Court of Appeals for the District of Columbia in Washington, DC, fired questions about the issue at attorney Jacob Stillman, who represented the US Securities and Exchange Commission (SEC), Reuters reported. The disputed rule requires the advisors to register with the SEC.

The meaning given the word “client” is a touchstone issue for the rule challenge since the SEC relied on the issue to close a major regulatory loophole that had existed in the rules. The existing regulation allowed hedge funds to avoid what they see as a costly and intrusive government process simply by defining each hedge fund they manage as a separate “client.”

As it stands, the new rule requires each investor to be counted as a client, forcing most large advisers to register with the SEC. The rule requires advisers to give the SEC basic information about themselves and submit to spot inspections. It was pushed through by a 3-2 vote under former SEC Chairman William Donaldson. 

Phillip Goldstein, manager of New York-based hedge fund group Opportunity Partners LP, sued to block the SEC rule, which was adopted in late 2004 amid concern at the SEC about explosive growth and fraud among hedge funds, the news report said (See  SEC Imposes Hedge Fund Registration ).

In defending the SEC, Stillman told the panel that in congressional legislation underlying the rule, “it is just not clear who the client is.” He said the SEC’s views on that point have shifted over the years. He said the agency’s latest view — that the client is the individual investor — is legally sound.

However, one member of the appellate panel apparently didn’t like what he was hearing. Argued Circuit Judge Harry Edwards, according to the news report: “You can’t just come in here and say we’re going to make ‘client’ mean whatever we want because we’re the agency. We have to test your thesis and your thesis doesn’t stand up.”