Earlier today (June 23, 2006), the United States Court of Appeals for the District of Columbia Circuit vacated Rule 203(b)(3)-2 (the “Rule”) under the Investment Advisers Act of 1940 (the “Advisers Act”). The Rule, which was adopted by the Securities and Exchange Commission (the “Commission”) in 2004 and became effective in February of this year, had the effect of requiring many hedge fund managers to register as investment advisers under the Advisers Act.
In determining that the Rule is “arbitrary,” the Court found that “the Commission’s interpretation of the word ‘client’ comes close to violating the plain language of the statute” and ”[a]t best it is counterintuitive.” The Court based its conclusion, in part, on the ground that ”[t]he Commission cannot explain why ‘client’ should mean one thing when determining to whom fiduciary duties are owed [under Section 206 of the Advisers Act], and something else entirely when determining whether an investment adviser must register under the [Advisers] Act.” In addition, the Court pointed out that, when it adopted Rule 203(b)(3)-1 with respect to investment companies set up as limited partnerships, the Commission had stated that the client for purposes of the 15 client “de minimis” rule is the limited partnership not the individual partners, so that “without any evidence that the role of advisers with respect to investors had undergone a transformation, there is a disconnect between the factors the Commission cited and the rule it promulgated…the Commission has, in short, not adequately explained how the relationship between hedge fund investors and advisers justifies treating the former as clients of the latter.”
SEC Chairman Cox released a statement this afternoon in response to the Court’s decision, noting that he has “instructed the SEC’s professional staff to promptly evaluate the Court’s decision, and to provide to the Commission a set of alternatives for [the Commission’s] consideration.”
The Cleary Gottlieb alert memo regarding the adoption of the Rule and the Court’s opinion (Goldstein v. SEC, No. 04-1434) is available here.