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News July 31, 2006 Issue

SEC Working to Fix Technical Issues Raised by Goldstein Decision, Says Cox

The August 7 deadline for the SEC to seek a rehearing on the Goldstein v. SEC case is rapidly approaching. As reported in a June 30 IM Insight breaking news e-mail alert, an informed source told IM Insight that he is "99.9 percent" certain that the SEC will not appeal the Goldstein decision.

Meanwhile, SEC Chairman Christopher Cox announced that the SEC is working on a series of emergency rulemakings and other actions to address various technical issues raised by the U.S. Court of Appealsí order, which broadly vacated all of the rulemaking in the SECís December 2004 hedge fund release.

During his July 25 testimony before the Senate Banking Committee, Cox said that he is planning to recommend that the Commission take action to "restore as much of the pre-Goldstein rule as possible." Cox, testifying on hedge fund regulation along with representatives from the Department of the Treasury and the Commodity Futures Trading Commission, told the Committee that in light of the courtís decision, the SECís program of hedge fund regulation was once again inadequate. "We must move quickly to address the hole that the Goldstein decision has left," he said. "Some improvements will be possible through administrative action. Others, however, may well require legislation."

Cox said that he has directed the SEC staff to insure that the various transitional and exemptive rules contained in the rulemaking "are restored to their full legal effect." Such action, he said, is necessary to insure that hedge fund advisers that have been relying on the SECís hedge fund rule "are not suddenly in violation of applicable regulatory requirements" when the court issues its mandate. The court is expected to issue its mandate in mid-August.

Assuming, of course, that the SEC does not appeal the case.

During his testimony, Cox touched on six specific projects:

ē Performance fee clients. The SEC is working on relief to allow newly-registered hedge fund managers to continue charging performance fees to investors who do not meet the definition of "qualified client" in Rule 205-3. The Goldstein decision invalidated a grandfathering provision allowing newly-registered hedge fund managers to maintain advisory contracts containing a performance fee provision with non-qualified clients. Cox explained that the provision had been designed to prevent a hedge fund adviser from having to renegotiate the terms of its existing advisory contracts or from having to expel pre-existing investors who are not qualified clients from its funds. The staff, said Cox, is working to reinstate that relief.

ē Performance back-up. Another emergency action would allow newly-registered hedge fund advisers to continue to rely on the exemption from the recordkeeping requirement for past performance records. Without this emergency action, explained Cox, newly-registered hedge fund advisers that remain registered will not be able to use their performance track record (unless, of course, they happen to have back-up records for that past performance). Cox noted that "rather perversely," the courtís vacation of this particular grandfathering provision would discourage firms from voluntarily remaining SEC-registered.

ē 180 days for fund of fundsí audited financials. Cox said that the staff is working on an action to restore the 180-day period that advisers to funds of hedge funds were given to deliver their audited financial statements. In a footnote in the hedge fund rulemaking, the 120-day period in the custody rule was extended to 180 days for funds of funds, in recognition of the fact that they typically do not receive their underlying hedge fundsí statements until the end of the 120-day deadline. The SEC had provided an additional 60 days so that fund of funds managers could complete their own audit work and send out their reports. The Goldstein decision, however, invalidated that 180 day provision.

ē Off-shore advisers. Off-shore advisers to off-shore hedge funds were required to register as advisers under the hedge fund rule if their funds had more than 14 U.S. investors. However, the hedge fund rulemaking allowed them to treat their fund as the "client" for all other purposes, providing them with a "hedge fund lite" scheme of regulation under the Advisers Act. The courtís decision eliminated this "hedge fund lite" relief and potentially would subject such newly-registered offshore advisers to all of the provisions of the Advisers Act with respect to their offshore hedge funds. Because that would create a disincentive for offshore advisers to remain voluntarily registered, said Cox, he has directed the staff to address this issue.

ē New anti-fraud rule. To the surprise of some, the Goldstein court flatly stated that a hedge fundís adviser "owes fiduciary duties only to the fund, not to the fundís investors," therefore implying that the anti-fraud provisions of Sections 206(1) and (2) of the Advisers Act do not apply to investors in the hedge fund. To address this, Cox reported that the staff is working on a new Advisers Act anti-fraud rule that would look through a hedge fund to its investors. The rule, he said, would reverse the statement in the Goldstein case by clearly stating that hedge fund advisers "owe serious obligations to investors in the hedge funds."

ē Accredited investor definition. To address concerns about "retailization" of hedge funds, Cox said that he has instructed the staff to analyze and report to the Commission on the possibility of amending the current "accredited investor" definition "as applied to retail investment in hedge funds without registration." Cox expressed concern that the current definition is "out of date" and "wholly inadequate" to protect unsophisticated investors from the complex risks of hedge fund investing.

During his testimony, Cox discussed broader hedge fund related issues. He urged Congress, which is considering the possibility of hedge fund legislation, to ensure that any such action is non-intrusive. "There should be no interference with the investment strategies or operations of hedge funds, including their use of derivatives trading, leverage, and short selling," he said. "Nor should the federal government trammel upon their creativity, their liquidity, or their flexibility." Cox emphasized that any legislation should not require portfolio disclosure and that a hedge fundís ability to keep its trading strategies and portfolio composition confidential be protected. And, he added, hedge funds should be able to continue to charge performance fees.

Cox said that he has directed the SEC staff to continue to conduct examinations of hedge fund advisers that remain SEC-registered. "Our continuing oversight of hedge fund advisers who remain registered with the SEC post-Goldstein will cover the majority of [the 2,500] hedge fund advisers of which we are aware," he said. "Because fully half of these advisers were registered with the SEC before the hedge fund rule required it, we anticipate that at least this number will voluntarily remain registered."

Cox acknowledged that some hedge fund advisers will de-register following the courtís decision. However, he noted that since the decision was issued, the number of hedge fund advisers that have registered has exceeded the number that have deregistered. "[W]e have actually experienced a net increase in hedge fund registrations since the Goldstein decision."

Cox said that the SEC also is working with other regulators, including the CFTC and the other members of the Presidentís Working Group, to coordinate the agencyís hedge fund oversight efforts. He also emphasized that the SEC is working closely with the U.K. Financial Services Authority. "As we move forward, it will be important that we view the whole picture as we work to evaluate both the systemic market risks and the retail investment issues associated with the growing presence of hedge funds in our capital markets," he said. As a result of the Goldstein decision, he noted, "we have been forced back to the drawing board to devise a workable means of acquiring even basic census data that would be necessary to monitor hedge fund activity in a way that could mitigate systemic risk." Hedge funds, he said, "are not, should not be, and will not be unregulated," he said. The question going forward, he indicated, is to "what extent" should the SEC and the Presidentís Working Group add new regulations.

During his testimony, Cox emphasized that he was expressing his own views as Chairman, and that his testimony did not represent the position of the five-member Commission.