In a ruling issued on Friday, June 23, 2006, the United States Court of Appeals for the District of Columbia Circuit vacated Rule 203(b)(3)(2) (the "Rule") promulgated under the Investment Advisers Act of 1940 (the "Act"), which had been adopted by the Securities and Exchange Commission (the "SEC") in December 2004 after prolonged heated debate. The Rule had modified the way advisers to certain "private funds," notably hedge funds, could count "clients" for purposes of determining whether they would be required to register with the SEC under the Act. Whereas under a prior SEC rule advisers to such funds could count the entire fund as one client, and thus generally avoid registration under provisions of the Act exempting advisers with 14 or fewer clients in any 12 month period (the "private adviser exemption"), the Rule required such advisers to count each investor in a "private fund" (generally any fund that allowed investors to redeem any portion of their interest within two years of their investment) towards the threshold of 14 clients for purposes of determining the availability of the Act’s private adviser exemption. As a result, an adviser to such a private fund was no longer able to rely on the private adviser exemption if the adviser, during the course of the preceding 12 months, has advised private funds that had more than 14 investors. It is estimated that over 1,000 additional hedge fund managers applied for registration with the SEC prior to the February 1, 2006 deadline, subjecting them to substantially increased recordkeeping, reporting, and compliance obligations that arise once an adviser is registered. The case, Phillip Goldstein, et al. v. Securities and Exchange Commission, was brought by Phillip Goldstein, a New York based adviser to Opportunity Partners, L.P., whose investment advisory firm, Kimball & Winthrop, had previously been exempt from registration under the Act by virtue of the private adviser exemption.

In its ruling, the Court held that the Rule was arbitrary in large measure because it resulted in a different definition of "client" for purposes of determining whether an adviser is required to register with the SEC than in all other contexts, thus violating the normal presumption that "the same words used in different parts of a statute have the same meaning." Moreover, the Court cited a long list of examples in which the SEC and even the courts agreed that a pooled investment vehicle, rather than its individual partners, members or shareholders, should be treated as the client of an investment adviser. Finally, the Court found that the premises underlying the SEC’s adoption of the Rule were misplaced. The Court noted that there is no evidence that the advisory relationship between hedge fund advisers and clients has changed, and further rejected the notion that the Rule is justified due to the enormous increase in importance hedge funds have on our national markets. On the latter point, the Court noted that the number of investors in a fund has no direct correlation to the actual size of the fund or its impact on the markets, and nothing in the Act indicates a Congressional policy to the contrary.

In a short statement responding to the Court’s decision, SEC Chairman Cox stated that the SEC "takes seriously its responsibility to make rules in accordance with our governing laws," and in that regard 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 our consideration." Chairman Cox further noted that the SEC will use the Court’s decision "as a spur to improvement in both our rulemaking process and the effectiveness of our programs to protect investors, maintain fair and orderly markets, and promote capital formation." Finally, Chairman Cox indicated that the SEC will continue to work with the President’s Working Group on Financial Markets to "evaluate both the systemic market risks and retail investment issues associated with the growing presence of hedge funds in the world’s capital markets." Chairman Cox did not indicate whether the SEC would appeal the Court’s ruling to the United States Supreme Court or seek Congressional involvement through an amendment to the Act, both difficult paths. Given the sweeping nature of the Court’s rejection of the Rule, and the fact that the SEC adopted it after extensive analysis of the growth of hedge funds and their impact on the markets, it is unclear how the SEC might attempt to revise the Rule or pursue other changes via the rulemaking process.

As a result of the Court’s decision, new hedge fund managers or managers whose assets under management are expected to grow beyond the Act’s threshold for SEC registration may now revert to the prior interpretation of the private adviser exemption, and may treat the fund itself as one client for purposes of determining whether they are required to register with the SEC. Fund managers who registered as of February 1, 2006 as a consequence of the Rule’s adoption now may decide to withdraw their registrations if they determine that the continuing costs of full compliance with the Act outweigh any incremental benefits of continued registration (e.g., certain investors as a matter of policy will only invest with registered advisers). Furthermore, fund managers who had elected to impose or were considering imposing two-year lockups on investors in order to avoid registration may wish to rethink that approach. The SEC does have the right to request a rehearing within 45 days of the Court decision, and the Court, on its own motion, has delayed the application of its decision during this time. If the SEC elects not to pursue a rehearing, then the Rule will be deemed vacated as of August 7, 2006.

We will continue to analyze the Court’s decision and will monitor the SEC’s actions going forward.

For your convenience, the Court’s decision is attached here.

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