Wilmer Hale Lawyers Fire Shot Across SEC’s Bow
There must be something in the water.
Once again, the SECís rulemaking authority is being challenged, this time by three partners of prominent law firm Wilmer Cutler Pickering Hale and Dorr. In a September 8 comment letter on the SECís hedge fund proposal, the lawyers asserted that the agency does not have the authority to require hedge fund managers to look through their funds to count underlying investors as "clients" for purposes of the Advisers Actís fifteen or fewer client de minimis exemption. (By amending Rule 203(b)(3)-1 to require such a look-through, the SEC effectively would require most hedge fund managers to register with the SEC as advisers.)
Although Wilmer Hale represents hedge fund managers, the comments do not appear to be submitted on behalf of any client, named or anonymous.
The letter makes for an interesting read. Going all the way back to 1940, the lawyers argued that Congress, when enacting the fifteen client de minimis exemption, "plainly understood" the term "client" to mean "an entity to which advice is given, not passive investors in such an entity who are not being advised individually." The lawyers noted that in 1939, an executive of Scudder, Stevens and Clark (now Scudder Investments) testified before Congress that advisers give "advice in connection with the specific condition of a particular individual," whereas investment companies provide services based on "what would be best for a cross-section of the American public," but not with respect to a particular individual.
A historical aside: Although the first "hedge fund" wasnít created until 1949, there were private investment pools kicking around back in the 1930s and 1940s. They just werenít called "hedge funds" at the time.
Jumping ahead a few decades, the lawyers parsed through the 1985 Supreme Court case of SEC v. Lowe, in which a newsletter publisher was deemed not to be an investment adviser since he did not offer individualized advice "attuned to any specific portfolio or any clientís particular needs."
In perhaps their cleverest argument, the lawyers pointed out that since the Advisers Act originally exempted advisers whose only clients were investment companies, an investor in a fund, logically speaking, could not be deemed to be a client of the adviser. As the lawyers put it, if the term "client" included fund investors, "there would be no such thing as an adviser whose only client is an investment company" (think about it for a moment). Along the same lines, the lawyers noted that if investment company shareholders were deemed clients of the adviser, almost all fund advisers would have failed the fewer than fifteen client de minimis test. (Congress got rid of the "only clients are investment companies" exemption in 1966 and added language clarifying that advisers to registered funds are not entitled to rely on the fewer than fifteen de minimis exemption.)
So why is the letter being perceived as a shot across the bow? Look at the signature line.
Not only was the letter signed by Marianne Smythe, a former director of the SECís Division of Investment Management, and her fellow investment management partner James Anderson, it also was signed by Louis Cohen, who just so happens to be a star appellate litigator. An excerpt from Cohenís official firm bio: "Mr. Cohenís appellate practice has included more than fifty cases on the merits in the U.S. Supreme Court and a large number of cases in the courts of appeals. He has argued sixteen cases in the Supreme Court, winning fifteen."
Might the case of Wilmer v. SEC be Cohenís next win?
Probably not. First, itís not clear whether the law firm would be able to show the concrete and particularized injury necessary to have standing to sue (although the firm certainly could help one of its hedge fund clients bring a case).
Second, the firm could sue, and lose. Exhibit A for the defense: the 1977 case of Abrahamson v. Fleschner, in which the Second Circuit held that general partners have a fiduciary duty to their limited partners. Although hedge fund lawyers have argued for years that Abrahamson was "wrongly decided" (as Skadden Arps partner Richard Prins told the SEC in a 2000 comment letter, more on that below), its holding re: fiduciary status is still on the books and bolsters the SECís investor-as-client argument.
Third, just because a law firm files a pretty stiff comment letter doesnít necessarily mean itís gearing up to sue. Despite the heavily-cited footnotes and language that occasionally sounds like the draft of an opening argument ("We show in these comments . . . . "), at the end of the day, the letter is simply one of many public comment letters opposing the hedge fund proposal.
Also, keep in mind that itís not the first time Wilmer has taken issue with the SECís authority to do things. Back in February 2003, the law firm published a client memorandum that characterized the SECís authority to adopt the then-pending compliance program rules for funds and advisers as "debatable."
One thingís clear: the SEC certainly believes it has appropriate authority. In 1997, when the SEC broadened Rule 203(b)(3)-1 to apply to other types of organizations in addition to limited partnerships, the agency made a point of emphasizing that the rule defines the term client "only for purposes of counting clients." It added that "persons that are grouped together for purposes of those sections may be required to be treated as separate clients for other purposes under the Advisers Act (and state investment adviser statutes)."
Moreover, in 2000, the SEC proposed to require advisers that are general partners of a limited partnership to treat each of the partnershipís limited partners as a "client" for purposes of the Form ADV brochure delivery requirement (advisers that are managers of LLCs or trustees of a trust similarly would be required to treat members or beneficial owners the same way.) At the time, the agency received a number of comments opposing this. Skadden Arpsís Prins argued that such an interpretation would have "numerous inappropriate corollary effects." One example: A fund would not be able to engage in agency cross transactions "without getting the approval of each and every investor in the fund." Moreover, noted Prins, "revocation of approval by a single investor would void the approval granted by all other investors."
Interestingly, Commissioners Cynthia Glassman and Paul Atkins, in their written dissent to the hedge fund proposal, did not raise concerns about the agencyís authority to amend the look-through provisions. They did, however, note that "hedge fund advisers provide advice to hedge fund investors as a group, not individually, and, therefore, they should not be deemed to be managing the assets of more than 14 persons . . . ."
Comments on the hedge fund proposal are due September 15. Despite several requests from commenters, the agency seems unlikely to postpone the due date for comments.
Aside from the Wilmer letter, the comment letter making the most waves is one submitted by Bryan Cave, which offers up an expanded Form D as an alternative to hedge fund registration. There also are a number of rather poignant letters filed by small hedge fund managers, explaining that the cost of adviser registration would destroy their livelihoods.
And then thereís the letter solicited by SEC associate director Robert Plaze, in which an
SEC-registered hedge fund manager reports that registration has been a benefit, not a burden. Costs for his firm have been "relatively benign," he said. Moreover, the manager noted that SEC examiners actually were "helpful and constructive in explaining the application" of recent regulatory changes to his firm and "helped us develop policies and procedures to comply with them."
Some predictions about two comment letters weíve yet to see:
First, the Investment Company Institute is likely to disagree with the Wilmer trioís assertions. In an April 2003 statement filed for the SECís hedge fund roundtable, the group, which supports hedge fund registration, noted that the SEC adopted Rule 203(b)(3)-1 in 1985 in light of ambiguity about who was a "client" under the Advisers Act following the Abrahamson case. "We believe the Commission has broad authority through the rulemaking process to interpret the Advisers Act and that it may change its interpretation after due consideration and administrative process," said the ICI.
Second, the Managed Funds Association is likely to raise the authority argument in its comment letter, but will not make that its primary focus.
And lastly: The SEC staff has prepared a written memorandum explaining its authority to adopt the hedge fund amendments. The three-page memo from SEC general counsel Giovanni Prezioso to Chairman William Donaldson on "The Commission's Authority to Regulate Hedge Fund Advisers" was sent to Senator Jon Corzine (D-NJ) on June 29.