The Lesson of Goldstein v. SEC: If at First You do Not Succeed, Regulate Again?

• Author: Jeffrey M. Sneeringer
• Position: D., May 2008
• Pages: 1173-1223

Page 1173

THE LESSON OF GOLDSTEIN v. SEC :

IF AT FIRST YOU DO NOT SUCCEED, REGULATE AGAIN? JEFFREY M. SNEERINGER^*

I. INTRODUCTION

Tucked away at the end of almost every project plan is a line item for lessons learned—a time when all of the successes and setbacks can be viewed through the prism of hindsight. It is both an awkward and enlightening process during which events (both planned and unexpected), past decisions, and subsequent outcomes are analyzed and placed into context. As the first ten years of active regulation of hedge funds comes to a close, this is as good a time as any for investors, hedge fund managers, regulators, and legislators to reflect and consider possible next steps.

Hedge funds have evolved into an increasingly popular investment vehicle since their introduction the late 1940s.¹While once considered an investment option for the affluent, market forces and various legislative enactments over the last two decades have led to an unprecedented influx of investment capital. There are an estimated 8,800 hedge funds in existence with a total of $1.2 trillion in assets under management.²Even more interesting is that the Securities and Exchange Commission (SEC or Commission) estimates that hedge fund activity accounts for thirty percent of all U.S. equity trading volume even though hedge funds represent approximately just five percent of all U.S. assets under management.³

Copyright © 2008, Jeffrey M. Sneeringer.

* J.D., May 2008. I am indebted beyond words to my wife, Jessica, for her loving support and humor throughout the long three-year journey of law school. Thanks to Professor Regina Burch for all the guidance and encouragement. Finally, the staff of the Capital University Law Review provided many thoughtful comments during the editing process, and for that I am greatly appreciative. All mistakes are my own.

¹U.S. Securities and Exchange Commission, Implications of the Growth of Hedge Funds, Staff Report to the United States Securities and Exchange Commission 1 (Sept. 29, 2003), [hereinafter SEC Staff Report] http://www.sec.gov/ news/studies/hedgefunds0903.pdf.

² Regulation of Hedge Funds Before the U.S. Senate Committee on Banking, Housing and Urban Affairs, 109th Cong. (July 25, 2006) [hereinafter Regulation of Hedge Funds] (statement of SEC Chairman Christopher Cox), available at http://www.sec.gov/news/ testimony/2006/ts072506cc.htm.

³Id. See also infra note 104 and accompanying text.

Page 1174

1174 CAPITAL UNIVERSITY LAW REVIEW [36:1173

The SEC’s Hedge Fund Rule⁴was an attempt to provide a comprehensive regulatory scheme for domestic and off-shore hedge funds by closing loopholes in existing securities laws.⁵In Goldstein v. SEC,⁶the United States Court of Appeals for the District of Columbia rejected the Hedge Fund Rule holding that it was an arbitrary and unlawful extension of agency authority.⁷The petitioner, Phillip Goldstein, a general partner and adviser to a hedge fund, sought to enjoin the SEC from enforcing the Hedge Fund Rule.⁸The Commission presented evidence that indicated a possible ambiguity in the definition of the term, “client” under the Adviser’s Act section 203(b)(3).⁹However, the court held that the rule was unreasonable because it required advisers to owe fiduciary duties to both the fund and the individual security holders and because the rule contravened years of past SEC practices.¹⁰

The Goldstein decision was a setback for the SEC, but it was not altogether a surprise. Much of the United States Court of Appeals for the District of Columbia’s reasoning for throwing out the Hedge Fund Rule can be found in the dissenting opinions of the two Commissioners who voted against adopting the regulation in 2004.¹¹It is fair to say that the Commission’s attempt to solve a multi-variable problem with a one-size-fits-all rule was doomed to fail because it was based on assertions rather than facts and because the Commission ignored its own precedent.

Overall, the Goldstein decision would seem to cast doubt on SEC efforts to pass and enforce oversight rules for private investment funds. However, the case, while significant, is only one chapter in the ongoing saga of hedge fund regulation. The Commission responded in late 2006 with proposed regulations addressing fraud prosecutions (“Antifraud Rule”)¹²and modifications to the definition of accredited investor

⁴Registration Under the Advisers Act of Certain Hedge Fund Advisers, 69 Fed. Reg. 72054 (Dec. 10, 2004) [hereinafter Adopted Hedge Fund Rule].

⁵See Hedge Fund Rule discussion infra Part III.B.

⁶451 F.3d 873 (D.C. Cir. 2006).

⁷Id. at 884.

⁸See infra Part IV.A.

⁹See infra Part IV.C.1.

¹⁰See infra Part IV.C.2.

¹¹See infra Part III.B.

¹²Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles; Accredited Investors in Certain Private Investment Vehicles, 72 Fed. Reg. 400, 400–03 (proposed Jan. 4, 2007) [hereinafter 2007 Proposed Rules]. See also infra Part V.C.1.

Page 1175

2008] GOLDSTEIN LESSONS 1175

(“Accredited Natural Person Proposal”).¹³Both rules, while minimal in scope when compared to the Hedge Fund Rule provisions, drew criticism from many circles.¹⁴The Antifraud Rule was adopted and became effective in August 2007.¹⁵

One constant throughout this ten-year story is the generally negative news coverage of the hedge fund industry during both prosperous times and the recent economic downturn. Coupled with political uncertainty, all of this raises the question: is it possible that that same regulation struck down in June 2006 could be revived? This Note argues that the next round of regulation must account for the lessons learned from the Hedge Fund Rule episode. The Note will present a history of the hedge fund regulation debate, discuss how the dissenting Commissioner’s arguments framed the Court’s analysis of the Goldstein case, and outline the events following the case. All of this leads to an evaluation of the rules proposed in 2007 and a look forward to how the current economic situation may influence the next steps the Commission and Congress take to regulate the hedge fund industry.

II. BACKGROUND: PRE-HEDGE FUND RULE REGULATIONS

A. What is a Hedge Fund?

“Hedge funds are notoriously difficult to define.”¹⁶Generally, hedge funds encompass privately organized pooled investment vehicles not necessarily available to the public.¹⁷The funds may employ many types of investment strategies including using leverage¹⁸to benefit from short-term movements in market prices.¹⁹Leverage may assume the form of trading various derivatives, taking short positions on stocks, or buying on the margin.²⁰

¹³2007 Proposed Rules, supra note 12, at 403–08. See also infra Part V.C.2.

¹⁴See infra Parts V.C.1 & V.C.2.

¹⁵See Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles, 72 Fed. Reg. 44756, 44756–57 (adopted Aug. 9, 2007) [hereinafter Adopted Antifraud Rule]. See also infra Part V.C.1.

¹⁶Goldstein v. SEC, 451 F.3d 873, 874 (D.C. Cir. 2006).

¹⁷See SEC Staff Report, supra note 1, at 3.

¹⁸Willa E. Gibson, Is Hedge Fund Regulation Necessary?, 73 TEMP. L. REV. 681, 685– 86 (2000).

¹⁹Id. at 686.

²⁰Id. at 688.

Page 1176

1176 CAPITAL UNIVERSITY LAW REVIEW [36:1173

Employing leverage shifts risk away from individual investors who desire stability in prices and performance.²¹In addition, leverage provides liquidity to capital markets through the form of negative feedback trading.²²This process entails buying and selling securities against prevailing market prices.²³For instance, it is common for hedge funds to buy a security during a period when it is generally being sold by most investors.²⁴

Another investment strategy employed by hedge funds relates to purchasing long-term positions in traditional stocks, bonds, or currencies.²⁵

The same strategic freedom is not shared by similar investment vehicles, like mutual funds, which are not permitted to trade on margins or participate in short sales of securities.²⁶Hedge funds may also engage in financing nontraditional and much riskier activities like movies²⁷and race horses.²⁸Regardless of strategy, hedge funds operate in a secretive manner in order to maximize gains.²⁹

Hedge funds are usually structured as limited partnerships with the general partner serving as the investment adviser.³⁰The funds may also be structured as limited liability companies or business trusts.³¹These business entities provide tax benefits and limited liability to fund investors.³²Fund manager compensation, in most cases, derives from a

²¹Daniel K. Liffmann, Note, Registration of Hedge Fund Advisers Under the Investment Advisers Act, 38 LOY. L.A. L. REV. 2147, 2158 (2005).

²²Id.

²³See SEC Staff Report, supra note 1, at 34.

²⁴Id. at 33.

²⁵Id.

²⁶15 U.S.C. § 80a-12(a)(1) (2000).

²⁷See Kate Kelly, Defying the Odds, Hedge Funds Bet Billions on Movies, WALL ST. J., Apr. 29, 2006, at A1.

²⁸Race-Horse Hedge Funds Begin to Gallop, DE A L BO O K BL O G —N.Y.

TIM E S , June 9, 2008, http://dealbook.blogs.nytimes.com/2008/06/09/ horse-focused-hedge-funds-go-to-the-races/.

²⁹Troy A. Paredes, On The Decision to Regulate Hedge Funds: The SEC’s Regulatory Philosophy, Style, and Mission, 2006 U. ILL. L. REV. 975, 986–87 (“The very nature of hedge funds requires that they operate in secrecy because hedge funds make money by exploiting market inefficiencies and by taking positions based on anticipated market moves. The opportunity to make money quickly vanishes when trading strategies or particular positions and trades are disclosed and others start to make the same investments.”).

³⁰See SEC Staff Report, supra note 1, at 9.

³¹Id. at 9 n.27.

³²Id.

Page 1177

2008] GOLDSTEIN LESSONS 1177

management fee, usually 1–2% of the assets under management, and a performance fee ranging from 10–30% of the fund’s total...