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News January 3, 2005 Issue

SEC's Hedge Fund Manager Rule Challenged in Court

As expected, the SEC has gotten itself sued over the hedge fund manager rule.

On December 21, hedge fund manager Phillip Goldstein filed suit in the U.S. District Court for the District of Columbia asking the court to declare that the SEC lacked the authority to adopt the rule. A parallel suit was filed in the U.S. Court of Appeals for the District of Columbia.

In many respects, Goldsteinís complaint resembles the complaint filed by the U.S. Chamber of Commerce challenging the SECís independent chair rule. Both suits allege that the SEC exceeded its statutory authority, failed to justify its exercise of rulemaking authority, and was arbitrary and capricious in adopting the rules. Goldstein's case is being headed by the team of Philip Bartz, of McKenna Long & Aldridge in Washington D.C., and Greg Keller of Harnes Keller in New York.

Will others join the legal fight? Goldstein told IM Insight that he didnít know if anyone else was planning to file a legal challenge to the rule, but that logistically it may make more sense for people to join his suit. "I donít know why anybody else would bring a case," said Goldstein. "If they were interested, why wouldnít they just join us?"

Donít look for the Managed Funds Association to join the party. Spokesperson Meg Bode noted that the MFA was on the record "even before the vote" as concurring with the views expressed in Wilmer Cutlerís comment letter questioning the SECís authority to adopt the rule. That being said, "I donít think MFA, as an industry association, actually sees itself as a plaintiff," Bode added. The MFA will monitor the litigation, "but in the meantime we are preparing our members for what we believe is inevitable at this point." She said that the MFA intends to work with the SEC to monitor implementation of the rule. (Incidentally, she noted that Goldstein is not an MFA member.)

In any event, if there are going to be additional cases, we should see them fairly soon. Under the Advisers Act, any person "aggrieved" by an SEC rule has 60 days after the rule is published in the Federal Register to file a petition in the U.S. Court of Appeals for the District of Columbia seeking judicial review. (If the aggrieved person misses the 60 day deadline, they still have six years to file a challenge under the Administrative Procedures Act, albeit in the lower U.S. District Court for the District of Columbia, we are told by a lawyer who knows such things.)

Goldstein, for one, thinks heís going to win. "Iím pretty determined," he said. "The only way we donít win this case is if the court says ĎWe defer to the SEC, donít bother us with the facts."

Other industry observers arenít as optimistic.

The likelihood of the suitís success is not dependent on who brings it, explained a senior mutual fund industry attorney. "Fundamentally, it comes down to the substance." When you strip everything away, he said, Goldsteinís lawsuit is about the quality of the SECís interpretation of a particular term in the statute (namely, what is a "client"). In contrast, said the lawyer, the issue at the heart of the U.S. Chamberís lawsuit is whether the SEC administratively increased the numerical standards set forth by Congress in the Investment Company Act. Goldsteinís case, he said, "is a weaker lawsuit because the challenge for the plaintiff in this case is to convince a court that the SEC misinterpreted a term that is used for purposes of the Advisers Act." The SEC "is going to have fairly broad powers of interpretation."

Nonetheless, he added, the SEC deserves to "get slapped around" over the hedge fund rulemaking. "I believe that their rulemaking process has been less than adequate. The fact that you have lawsuits on these rules suggests that the constituency of the ruled believes that the rulers are not listening to the ruled."

The lawyer noted that the process of federal rulemaking contemplates a dialog. When it comes to the independent chair and hedge fund rulemakings, he said, many in the industry "donít think thereís been a dialogue."