Goldstein v. SEC: Could He Actually Win?
When Phillip Goldstein launched his legal fight against the SECís hedge fund manager registration rule back in December 2004, few in the investment management industry seemed to think heíd have a shot at winning. Perhaps they dismissed the suit as merely a further extension of Goldsteinís infamous Bumpty Dumpty comment letter (worth a read if you havenít already). Or perhaps they presumed that the SEC would be given judicial deference in interpreting the term "client," as used in the Advisers Act.
But looking closely at the arguments asserted in Goldsteinís April 13 opening brief, his June 3 reply brief, and the SECís May 18 opposition brief, you get to thinking that Goldstein just might be on to something. Based on the four squares of the briefs, itís possible that the D.C. Circuit actually might throw out the SECís hedge fund rule ó or at least scale it back quite a bit by requiring advisers to provide hedge fund information in code and striking the provision in the Advisers Act books and records rule that deems the records of the hedge fund to be records of the fundís adviser.
Of course, itíll be months and months before we actually find out what the three-judge panel thinks. According to McKenna Long & Aldridge partner Philip Bartz, part of Goldsteinís legal team, oral arguments in the case "almost certainly wonít happen until the fall."
Until then, hereís a look at some of the more interesting arguments in the briefs:
What did Congress mean, and when did they mean it? When Congress used the phrase "fewer than fifteen clients" in Section 203(b)(3), was it thinking that a hedge fund should be counted as one client? Or was it thinking that advisers should look through their hedge funds to count each fundís underlying investors toward the 14 client limit?
Of course, thatís a trick question ó hedge funds didnít exist when Congress first used the "fewer than fifteen clients" language back in 1940 (the earliest hedge funds popped up about a decade later).
Goldstein, however, based his case on the premise that Congress meant what it said when it used the term "clients" in 203(b)(3) ó it did not intend hedge funds to be looked through. In contrast, the SEC argued that 203(b)(3) isnít clear at all and that the agency was well within its rights to clarify that ambiguity.
Both Goldstein and the SEC used other statutory examples to support their views. Goldstein seized on the fact that, as originally enacted, the Advisers Act exempted advisers to investment companies and insurance companies from registration if they had no other clients other than the investment companies and insurance companies themselves. If "security holders of an investment entity are also Ďclients,í" he said, "an adviser could never have advised Ďonlyí an investment company because all of its security holders would have been considered clients as well."
Thatís a pretty good point, and the SECís response seemed a bit weak: Although the language in the exemption "may suggest that Congress intended that, with respect to investment companies, the legal entity be counted as the client, it does not mean that Congress must have intended that, with respect to private funds (which are excepted from the definition of Ďinvestment companyí under the [ICA]), the legal entity be counted as a client" (emphasis in the original). Congress, added the SEC, "may have" exempted advisers to investment companies given the fact that they are extensively regulated under the ICA. However, the SEC didnít cite any legislative history supporting that notion.
Score one for Goldstein.
The SEC countered by pointing to Congressís 1980 business development company-related amendment to 203(b)(3), where Congress was crystal-clear about its intent regarding looking through. Congress amended the section to clarify that when counting clients towards the 14 client limit, no shareholder, partner, or beneficial owner of a BDC should be deemed to be a client of the adviser for purposes of 203(b)(3) "unless such person is a client of such investment adviser separate and apart from his status as a shareholder, partner, or beneficial owner." That language, said the SEC, "would have been superfluous if . . . Congress intended that a shareholder, partner, or beneficial owner of a legal entity could never be counted to determine whether the exemption applied." In other words, Congress had to clarify how to treat BDC holders, since they realized that 203(b)(3) on its face was ambiguous.
Goldstein, anticipating the SECís BDC argument, had called reliance on that section "just wrong" and "disingenuous," citing legislative history that stated that the BDC language in 203(b)(3) shouldnít be used to determine whether non-BDC advisersí pools should, or should not be, looked through.
But that didnít seem to really be the SECís point: The BDC amendments were simply proof that 203(b)(3), on its face, was ambiguous. "That Congress felt it necessary to indicate who is an adviserís Ďclientí for counting purposes demonstrates, regardless of the specific entity at issue, the ambiguity inherent in applying the exemption," said the SEC.
Score one for the SEC.
Goldstein also pointed to ICA Section 3(c)(1), which explicitly refers to issuers whose outstanding securities are "beneficially owned by not more than one hundred persons." When Congress wanted to base an exemption on the number of security holders, rather than clients, said Goldstein, "it has explicitly done so."
The SEC responded by pointing out what it called the "fatal flaw" in this argument: that Goldstein assumed that when Congress exempted hedge funds in 3(c)(1), Congress also intended to exempt hedge fund advisers in 203(b)(3).
Goldstein expanded on his 3(c)(1) argument in his reply brief, noting that the section also demonstrates that Congress knew how to draft a look-through provision when it wanted to. Section 3(c)(1) states that when determining whether a pool has 100 owners, if a company owns 10 percent or more of the poolís outstanding voting securities, the companyís shareholders must be counted toward the 100 person limit. "[W]hile Congress knew how to, and in fact did, create a statutory Ďlook throughí in Section 3(c)," said Goldstein, "it did not provide any such Ďlook throughí in the parallel exemption for advisers" in 203(b)(3).
Whatís so ambiguous about the word "client?" At the end of the day, argued Goldstein, 203(b)(3) is not based on the number of security holders in a pool. Itís based on who is a client. And the term "client," said Goldstein, "requires no interpretation."
Oh yes it does, countered the SEC. As noted above, the agency asserted that the BDC amendment clearly demonstrates that Congress recognized that entities could be looked through (thatís why they decided to clear up the matter with respect to BDCs). And, of course, thereís the 1977 case of Abrahamson v. Fleschner, where the Second Circuit, in a footnote, described limited partners as clients of the adviser. Although the final opinion in the case did not contain that description, the footnote raised doubts in the industry that perhaps, for purposes of 203(b)(3), hedge funds should be looked through. The SEC noted that following Abrahamson, it received "numerous requests for guidance" and ultimately "resolved the uncertainty" by adopting the old Rule 203(b)(3)-1, which treated each hedge fund as a client (when the SEC adopted the rule, it noted that there might be other ways to count clients). Abrahamson, said the SEC, demonstrates that the scope of 203(b)(3) "is open to interpretation."
In his reply brief, Goldstein whipped out the W.J. Howey case, which describes a security holder as one who invests in a common enterprise in the hopes of earning a profit from the efforts of others. That, said Goldstein, is exactly what hedge fund investors do, just as investors invest in Microsoft in the hopes that Bill Gates knows what heís doing.
To describe the client relationship, Goldstein also continued to rely on the case of Lowe v. SEC, despite the SECís attempt to distinguish it based on the facts. Goldstein noted that the Supreme Court in Lowe said that Congress intended the Advisers Act to reach the Ďfiduciary, person-to-person relationships . . . that are characteristic of investment adviser-client relationships." Hedge fund investors, said Goldstein, simply donít receive personalized advice.
The SEC attempted to distinguish Lowe, rightly pointing out that the case dealt with a newsletter publisher, not a hedge fund manager. Nonetheless, the D.C. Circuit still might be inclined to refer to Lowe: itís not often that the Supreme Court talks about what types of relationships Congress intended the Advisers Act to cover.
Ironically, one of Goldsteinís strongest arguments that hedge fund investors are not clients comes from the SEC itself: ICA Rule 3a-4. In that rule, which provides guidance to wrap fee program sponsors seeking to avoid having their program being deemed a mutual fund, the SEC listed the factors that distinguish an investor in a pool, on one hand, from an individual client, on the other. (Rule 3a-4 is the rule that says a wrap fee program clientís account must be managed on the basis of the clientís financial situation and investment objectives, the client must be allowed to impose reasonable restrictions on the management of the account and retain indicia of ownership of the securities in the account, etc.).
Since Goldstein waited until his reply brief to raise the Rule 3a-4 argument, the SEC didnít get a chance to respond to it in writing. Itís likely, however, that the agency will make much of the fact that Rule 3a-4 is a non-exclusive safe harbor, rather than an interpretative rule. Moreover, Rule 3a-4 on its face states that it was not to create any presumption about an advisory program organized and operated outside of the ruleís parameters.
Still, itís an interesting argument.
Under my thumb . . . or not? In authorizing the SEC to issue rules under the Advisers Act, Congress, in Section 211(a), said that the SEC "may classify persons and matters within its jurisdiction" and "may prescribe different requirements for different classes of persons or matters." In other words, the SEC can slice up different categories of advisers "within its jurisdiction" and impose certain requirements on some but not on others.
By treating hedge fund investors as clients, said Goldstein, the SEC is not classifying people "within its jurisdiction." The hedge fund manager rule, he said, "operates by classifying persons who concededly are not within the SECís jurisdiction ó security holders of hedge funds."
Again, an interesting argument.
"In response to your inquiry about Hedge Fund #3493A7B . . ." Goldstein asserted that the hedge fund rule runs afoul of Advisers Act Section 210(c), which states that the SEC is not authorized to require any adviser to "disclose the identity, investments, or affairs of any client," except as part of a formal enforcement proceeding. (Incidentally, the SEC gets around Section 210(c) by allowing advisers to code client-specific information provided to examiners, so as to obscure their clientsí identity. Very few advisers go this route.)
Goldstein noted that one of the SECís rationales for requiring hedge fund advisers to register was that it would provide the SEC with "important information about this growing segment of the U.S. financial system." In Goldsteinís view, however, Section 210(c) prohibits the SEC from obtaining exactly the type of information itís hoping to get, since a hedge fund is a client of the adviser. While the 210(c) problem could be addressed by providing information on hedge funds in code, said Goldstein, "the information the Commission would be gathering would be utterly devoid of meaningful content in light of the SECís stated objectives."
The SEC asserted that Goldstein waived this claim because no one raised the 210(c) argument in any comment letter on the rulemaking. Goldstein countered that the argument wasnít waived because he (and the public) didnít have adequate notice of the SECís intention to obtain information on hedge funds. Section 210(c), he said, wasnít even mentioned in the rulemaking.
Odds and ends . . . Goldstein made a variety of other arguments, including asserting that hedge fund investors do not receive "direct" advice, that the SEC didnít have sufficient justification for adopting the rule, and that the rulemaking process was flawed. In his reply brief, he made much of the fact that the SEC didnít directly argue that hedge fund investors are, in fact, clients.
And yes, both the SEC and Goldstein resorted to cracking out the dictionary, citing various definitions of what, exactly, a client is. The SEC noted that an investor in a hedge fund "submits his cause" (namely, his money) to the management of the hedge fund adviser, and therefore "depends on" the adviserís services "as a customer."
Investors in a hedge fund, retorted Goldstein, arenít "customers."