So What’s a Hedge Fund Manager To Do?
Judging from the courtís questions during the December 9 oral argument in the Goldstein v. SEC hedge fund case, thereís a good chance the SECís hedge fund rule is going to be tossed out.
According to Linda Lord, a legal analyst in UBSís U.S. Office of Public Policy, the U.S. Court of Appeals for the District of Columbia "is most likely to invalidate the hedge fund adviser registration rule." Based on the questions raised by the three-judge panel, she said, "it does not appear that the SEC was successful in presenting its case for defining the term Ďclientí to look through entities represented by investment advisers."
And, of course, oral argument aside, it does seem that Phillip Goldstein has built himself a pretty strong case (see "Goldstein v. SEC: Could He Actually Win?" IM Insight, June 13, 2005).
However, thereís also a good chance that the court will let the rule stand. McKenna Long & Aldridge partner Philip Bartz, who argued Goldsteinís case before the court, cautioned against reading too much into the courtís questions during the oral argument. "We just donít know what the panel is going to do," he said.
The uncertainty is placing some hedge fund managers in a real pickle: Do they go ahead and file their Form ADV by January 9 (the last day for fund managers to file and still have a good shot at being declared effective by the February 1 registration deadline), only to find out a few weeks later that the hedge fund rule has been struck down and registration is no longer required?
Or do they hold off, and risk violating the SECís registration requirement if the rule is upheld?
Neither option is ideal. Under the first approach, a firm might undergo the cost and hassle of registration and coming into compliance with a myriad array of SEC rules, only to find out that ultimately, it didnít have to. Under the second approach, the firm could end up violating an SEC rule if the agency wins. Not exactly a good way to start off a new relationship with oneís regulator.
While it's likely that the court will move quickly to issue an opinion, theyíd have to do so by January 8, at the latest, to solve the dilemma facing hedge fund managers. According to Bartz, "the court is completely aware of what the deadline is" for hedge fund manager registration. "Weíre hopeful that maybe theyíll do something before then." He noted that Goldstein had asked for an expedited hearing, and that the case so far has "moved along." However, in his remarks, Bartz was referring to the February deadline, not the more immediate January 9 deadline.
So whatís a hedge fund manager to do?
There may be a third option. Letís call it "freezing in place." A fund manager can simply stop accepting new money after January 31 and take a wait-and-see approach to the litigation, without registering or making any attempt to comply with SEC rules applicable to registered firms.
If the SEC wins, the fund manager would have to resign itself to its fate as a registered entity, and build a compliance program and file an ADV. Once the ADV is declared effective (at which point the manager must be SEC-compliant), the manager can begin accepting money again.
However, if Goldstein wins and the court invalidates the SECís rule, the frozen fund manager can simply "thaw out" and begin accepting new money the very day the courtís order is effective (although it might be prudent to check with your favorite lawyer to confirm that the rule truly has been struck down. You know how courts are with those pesky mandates. And then thereís that whole appeals process to consider).
The freeze-in-place approach would seem to work because the SEC and staff have made clear that pre-February 1 investments that are not subject to a two-year lockup will not cause a fund to be deemed a "private fund" triggering SEC registration, as long investments made on or after February 1 are subject to a two-year lockup. The flip side of that position, it seems, is that if a fund simply stops accepting investments on January 31, a manager can effectively "freeze" and wait out the litigation. However, there are two points to keep in mind: a firm taking the "freeze" approach canít accept any new money, period ó and that includes investments from existing investors.
Moreover, thereís the question of what those existing investors need to be told to effectively "freeze" the fund. Would a letter to investors suffice? Should it notify them that the fund is temporarily closed, pending the outcome of the Goldstein v. SEC case, the timing of which is uncertain, and that subsequent investments in the fund made after the resolution of the case may be subject to new limited partnership agreements with different terms and conditions?
All questions to ask your favorite lawyer.
Another possibility, of course, is that Goldstein or another third party could ask the court for an emergency stay, akin to what the U.S. Chamber of Commerce sought and obtained in its challenge of the SECís fund governance rules. An emergency stay "is actually a good thought," said Bartz. "So far we havenít gone that route." As the time gets closer to February 1 and the court still hasnít issued an order, he said, "we would consider all options available to us," he added. "Weíre not going to take anything off the table." Whether or not to file for an emergency stay, he said, "is a decision we would make as we got closer to deadline."
In Bartzís view, Goldstein would be the most likely candidate to file a motion for an emergency stay. However, he acknowledged that an outside party could file a motion for an emergency stay, but noted that the party would either have to file their own suit challenging the rule or ask the court to permit them to intervene in Goldsteinís case. A party requesting an emergency stay would need "some vehicle to sue the SEC," to fundamentally challenge the rulemaking, he said. "You canít just come in and start asking for stays."
As of press time, Bartz reported that "no one has said anything" about joining Goldsteinís case for the purpose of asking for an emergency stay.