Hedge Funds: Their Advisers Do Not Have to Register with the SEC, but More Information and Other Alternatives are Recommended

• Author: Sue Ann Mota
• Position: Professor of Legal Studies, Bowling Green State University
• Pages: 55-72

Page 55

Professor of Legal Studies, Bowling Green State University; J.D., University of Toledo College of Law, Order of the Coif; M.A. and B.A., Bowling Green State University.

I Introduction

Hedge funds have been defined in various ways,¹ but the term commonly means any pooled investment vehicle that is privately organized, professionally administered, and not widely available to the public.² Globally, hedge fund assets are estimated at over a trillion dollars.³

Because of the growing number and size of hedge funds, the broadening exposure of investors to hedge fund risk, and the growing number of instances of malfeasance of hedge fund advisers,⁴ the Securities and Exchange Commission ("SEC") promulgated the Registration Under the Advisers Act of Certain Page 56Hedge Fund Advisers ("Hedge Fund Rule")⁵ by amending and adding a rule under the Investment Advisers Act of 1940.⁶ The Investment Advisers Act of 1940 requires investment advisers to register with the SEC unless exempt.⁷ Hedge fund advisers were typically exempt from this requirement because they fell within the private adviser exemption of the Act.⁸ Under this exemption, if the investment adviser had fewer than fifteen clients over the last fifteen years, and neither held himself out generally to the public as an investment adviser nor acted as an investment adviser to any registered investment company, then he did not have to register with the SEC.⁹ Under the Hedge Fund Rule, private funds have to count the following investors as clients: shareholders, limited partners, members, or beneficiaries of the private fund.¹⁰

According to this new definition of "client," most hedge fund advisers had to register with the SEC by February 1, 2006.

However, the Hedge Fund Rule was vacated on June 23, 2006, by the Court of Appeals for the District of Columbia Circuit in Goldstein v. Securities and Exchange Commission.¹¹ The appeals court deemed the rule "arbitrary"¹² and found that the SEC inadequately explained why hedge fund investors were to be treated as clients of the fund under the rule.¹³

This article examines hedge fund regulation, as well as Goldstein and its impact. Part II discusses the Hedge Fund Rule, as well as the federal regulation of hedge funds prior to the implementation of the new rule. Part III discusses the Goldstein v. Page 57Securities and Exchange Commission case, which vacated the Hedge Fund Rule. Part IV examines what investors, hedge fund advisers, the SEC, and Congress could and should do concerning hedge funds. The SEC should adopt the recommendations of the two SEC Commissioners who dissented from the Hedge Fund Rule by not only obtaining information from other sources before imposing mandatory registration,¹⁴ but also by increasing oversight of advisers who are registered.¹⁵ If deemed necessary, Congress could also enact hedge fund regulation to close the gap left by Goldstein.¹⁶ Congress should also revisit the definition of a qualified purchaser, thus raising the bar to protect more investors. Part V concludes by noting that, although the Goldstein case correctly vacated the Hedge Fund Rule, the alternatives suggested in Part IV are a more appropriate means of regulating the hedge fund industry.

II Hedge Funds

The term "hedge fund" was reportedly first used to describe a fund managed by Alfred Winslow Jones in 1949.¹⁷ Mr. Jones's fund balanced long and short equity positions to "hedge" the portfolio's risks.¹⁸ Hedge fund advisers now use a wide variety of investment strategies to maximize returns for the investors.¹⁹

While many trade in securities,²⁰ bonds, and currencies, some also Page 58trade in derivatives and other assets, such as movies²¹ and even the rights to soccer players.²²

There is no statutory or regulatory definition of "hedge fund." However, hedge funds are typically organized by professional investment managers who frequently have a stake in the funds they manage and also receive a management fee that includes a share of the performance of the fund.²³

Before analyzing the development and application of the Hedge Fund Rule, it is important to consider the state of hedge fund regulation prior to the SEC's passage of the Hedge Fund Rule.

A Regulation of Hedge Funds

Hedge funds may be regulated by a number of federal laws, including the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940. However, hedge funds often escape regulation because they fall within the exemption provisions of these acts.²⁴

1. The Securities Act of 1933

The Securities Act of 1933²⁵ requires public securities offerings to be registered with the SEC²⁶ and also requires that a prospectus be provided to investors. Hedge fund offerings probably fall into the definition of securities under the 1933 Act, Page 59 which defines a security as any note, stock, treasury stock, security future, bond, debenture, or evidence of indebtedness, among other investment vehicles.²⁷ However, hedge fund securities offerings may avoid registration under the 1933 Act by relying on the "private offering" or "private placement" exemption located in Section 4(2) of the Act.²⁸ A private offering is defined as a transaction by an issuer which does not involve any public offering.²⁹ In the alternative, registration may also be avoided under the 1933 Act by relying on Rule 506 of Regulation D, which involves an offering only to accredited investors.³⁰ Most hedge fund securities offerings can probably take advantage of these exemptions.

2. The Securities Exchange Act of 1934

Some provisions of the Securities Exchange Act of 1934³¹ may also apply to hedge funds. Under the 1934 Act, dealers who are engaged in buying and selling securities for their own accounts must register with the SEC,³² whereas traders, who buy and sell securities that are not part of a regular business, do not.³³ The 1934 Act also has a registration and reporting provision which may apply to hedge funds. Section 12(g) of the 1934 Act³⁴ and Rule 12g-1³⁵ require that an issuer register equity security with the SEC when the issuer has 500 holders of record, who have a class of non-exempt securities and assets in excess of $10 million at the Page 60 conclusion of the most recently ended fiscal year. Registration of a class of equity security subjects the domestic registrant to periodic reporting requirements.³⁶ Most hedge funds, however, avoid registration under the 1934 Act by having fewer than 500 holders of record.³⁷

Though hedge funds may escape some regulation under the 1934 Act, there are some regulatory provisions of the Act which hedge funds may not escape. Hedge funds are subject to the 1934 Act's requirement of disclosure when an investor has direct or indirect beneficial ownership of more than five percent of any class of registered voting equity securities.³⁸ Insider reporting is triggered under the 1934 Act when hedge funds acquire more than ten percent of a class of registered voting securities.³⁹ Short swing profits provisions of the 1934 Act may also apply to hedge funds. They require insiders to disgorge any profits an insider earns from any purchase or sale of the issuer's security in a six month period.⁴⁰

3. The Investment Company Act of 1940

The Investment Company Act of 1940⁴¹ directs the SEC to regulate investment companies.⁴² While hedge funds could be classified as investment companies, they may avoid regulation under this Act by one of two statutory exemptions. First, the Investment Company Act excludes from the definition of investment companies those issuers whose outstanding securities are not owned by more than 100 investors and who do not Page 61 presently propose to make a public offering of their securities.⁴³

Second, the Investment Company Act excludes from the definition of investment company any issuer whose outstanding securities are owned exclusively by persons who, at the time of acquisition of the securities, are "qualified purchasers."⁴⁴ A qualified purchaser is any natural person or family-owned company owning more than $5 million in investments, or a trust of which the settler and trustee are qualified purchasers, or any person acting for his or her own account or the accounts of other qualified purchasers and who owns and invests more than $25 million in investments.⁴⁵

4. The Investment Advisers Act of 1940

The final federal regulation that may apply to hedge funds is the Investment Advisers Act of 1940.⁴⁶ Usually, hedge fund advisers also meet the definition of investment adviser under this Act. An investment adviser is defined as any person who, for compensation, engages in the business of advising others as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.⁴⁷ Unless exempt, investment advisers must register with the SEC.⁴⁸ There is exemption from registration for any investment adviser who had fewer than fifteen clients in the preceding twelve months and who neither generally holds himself or herself out to the public as an investment adviser, nor acts as an investment adviser to any registered investment company.⁴⁹ The Investment Advisers Act of 1940 does not specify Page 62 how to count clients for the purpose of the private adviser exception.⁵⁰ In 1985, the SEC adopted a rule allowing investment advisers to count each pooled investment vehicle as a single client.⁵¹ This exemption for fifteen or fewer clients was often used by hedge fund advisers to avoid registration. Registered...