(The news featured below is a selection from the news covered in Federal Securities Law Reporter, which is distributed to subscribers of Federal Securities Law Reporter.)

SEC Defends Hedge Fund Rule Against Court Challenge

The SEC has filed a brief defending its rule requiring hedge fund advisers to register with the Commission against a petition arguing that the congressional intent underlying the Investment Advisers Act precludes such rulemaking. The petition was filed in the U.S. Circuit Court of Appeals for the District of Columbia . The SEC said that it has the authority to reasonably interpret a private exemption from the Investment Advisers Act in light of dramatic growth and exponential changes in the hedge fund industry and the entry of smaller investors into the hedge fund arena.

The case involves a statutory exemption from Investment Advisers Act registration available to any adviser that has had fewer than 15 clients during the past 12 months and does not hold itself out to the public as an investment adviser. The act does not specify how to count clients for purposes of this private adviser exemption.

The scope of the exemption is ambiguous when applied to advisers to pooled investment vehicles such as hedge funds since it can be argued that the adviser has only the single client when it effectively is advising 15 or more persons whose assets are managed through the pooled vehicle. In 1985, the Commission adopted a safe harbor that allowed advisers to count each pooled investment vehicle as a single client so long as the investment advice was provided based on the objectives of the vehicle rather than the objectives of its individual investors or owners.

In light of the changes in the hedge fund industry since 1985, and particularly in the past five years, the Commission has now withdrawn the 1985 safe harbor and adopted rules requiring advisers to look through a pooled investment vehicle and count each investor as a client. This new approach to the exemption effectively mandated Investment Advisers Act registration for advisers to hedge funds.

In its brief, the SEC defended the new rules by stating that the prior safe harbor had become inconsistent with the purpose behind the Investment Advisers Act exemption for a category of advisers whose activities were not sufficiently large or national in scope to justify federal regulation. The Commission said it was responding to a number of factors, including the dramatic growth in hedge funds, an increase in fraud involving hedge fund advisers and the broader exposure of smaller, non-traditional hedge fund investors to the risks of hedge fund investing. The Commission was concerned that the objectives of the Investment Advisers Act would be undermined if an adviser with more than 15 clients could evade its registration obligation by simply having those clients invest in a pooled fund vehicle.

The SEC, rejecting the petitioners' contention that the rulemaking creates conflicting fiduciary duties, said that this argument ignores the fact that the rules do not create or alter any duties. The rules do not require an adviser to follow or avoid any particular investment strategies. The SEC emphasized that the new rules do not impose any burdens on the legitimate investment activities of hedge funds. They do not regulate the trading or investment strategies of hedge funds themselves and are carefully tailored to require the registration of those advisers whose activities involving private funds most directly suggest the need for registration.

Registration of hedge fund advisers will give the Commission the ability to collect important information that it now lacks. Registration will allow the Commission to screen individuals associated with an adviser and to deny registration if they have been convicted of any felony or other crime bearing on their fitness to manage investors' funds, or have had a disciplinary event subjecting them to disqualification. The registration of hedge fund advisers also will help deter fraud by enabling the Commission to conduct examinations to identify compliance problems earlier and to identify practices that may be harmful to investors, as well as providing a deterrent to unlawful conduct. Registration under the Investment Advisers Act will carry the added benefit of subjecting hedge fund advisers to rules requiring them to adopt compliance controls and procedures designed to prevent violations of the act, according to the SEC, and to designate a chief compliance officer.