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News August 14, 2006 Issue

It's Official: Cox Says SEC Will Not Appeal Goldstein Decision

The SEC has decided to hang up its gloves in the legal fight over its hedge fund manager registration rule.

In an August 7 statement, Chairman Christopher Cox announced that the Commission would not seek a review of the decision of the U.S. Court of Appeals in the Goldstein v. SEC case. Moreover, he said that the SEC would not petition the U.S. Supreme Court for a writ of certiorari. "The Commissionís solicitor and general counsel have concluded that, since the appellate courtís decision was based on multiple grounds and was unanimous, further appeal would be futile and would simply delay and distract from our goal of advancing investor protection," he said. "Instead, the Commission is moving aggressively on an agenda of rulemaking and staff guidance . . . to address the legal consequences from the invalidation of the rule."

Already, the new guidance is flowing, with the Division of Investment Management issuing a no-action letter to the American Bar Association subcommittee on private investment entities last week. In a separate action, the SEC is expected to propose a new rule that would "look through" a hedge fund to apply the Advisers Actís anti-fraud provisions to the fundís investors. That, noted Cox, "would reverse the side-effect of the Goldstein decision that the anti-fraud provisions of the [Advisers] Act apply only to Ďclientsí as the court interpreted that term, and not to investors in the hedge fund."

The SEC staff also is considering whether to raise the thresholds in the "accredited investor" definition, effectively increasing the minimum asset and income requirements for individuals who invest in hedge funds organized as 3(c)(1) funds. Currently, the definition of "accredited investor" includes individuals whose annual income exceeds $200,000, or whose net worth (or joint net worth with a spouse) exceeds $1 million. While those thresholds may have been steep when first set in 1982, there are substantially more investors today who meet those tests.

During his testimony last month before the Senate Banking Committee, Cox called the current accredited investor standards "out of date" and "wholly inadequate to protect unsophisticated investors from the complex risks of investment in most hedge funds." Noting that an investorís residence is not excluded from the net worth calculation, he pointed out that the median home price in California "is well over one-half million dollars."

The question, of course, is how high to raise the income and net worth tests. During his testimony, Cox noted that the SECís fund rule would have effectively required new hedge fund investors to meet a $1.5 million net worth test (registered advisers are subject to the Advisers Act performance fee rule, which effectively requires clients that are charged a performance fee to meet a $1.5 million net worth test). "This was an important change," said Cox, "and I would like to see it restored."

It is even possible that the thresholds could be raised higher. In past Congressional testimony, the Managed Funds Association has supported doubling the current levels, raising the net worth level to $2 million and the annual individual income level to $400,000.

Of course, the accredited investor definition is used for more than simply determining who can invest in a hedge fund. In his April 2003 testimony before the Senate Banking Committee, then-Chairman William Donaldson warned that a "global change" to the accredited investor standard could significantly impact the availability of securities registration exemptions to other types of companies. "In particular," he said, "we would carefully consider the effect of any adjustment to the standard on the opportunities for small business capital formation before proposing any change."

Meanwhile, hedge fund managers that registered because of the SECís rule are deciding whether to stay or go. Some advisers, on principal, may want to quickly deregister. Other advisers may feel that the bulk of the compliance work already has been done and that registration may be viewed favorably by prospective investors.

A few tips in this regard: First, before making a decision to deregister, consider whether youíll be subject to state regulation.

Second, if you arenít 100 percent certain about what to do, you may want to live life as an SEC-registered firm for a few more months. Thereís no rush to make a decision: Under the Advisers Act, a firm that is not required to be registered (because the fifteen client de minimis exception in Rule 203(b)(3)-1 is available) but that chooses to be registered, can decide down the line to withdraw if it chooses.

Of course, if youíve been operating outside the fifteen client de minimum exemption while registered, things get sticky. Under the new relief provided by the staff, you can still deregister, but to obtain the no-action comfort, youíll need to make that decision before February 1, 2007. Hedge fund managers that have launched advertising campaigns while registered, or that have implemented structural changes to their funds (such as adding special tranches), should discuss the impact of those changes and the application of the new relief with their favorite lawyer.

Meanwhile, Cox has promised all hedge fund managers, registered or not, that they will remain subject to SEC scrutiny. Notwithstanding the Goldstein decision, he said, "hedge funds today remain subject to SEC regulations and enforcement under the antifraud, civil liability, and other provisions of the federal securities laws." He promised that the SEC would continue to vigorously enforce the federal securities laws against hedge funds and advisers who violate those laws.

"Hedge funds," he said, "are not, should not be, and will not be unregulated."