Brief Fact Summary. A hedge fund manager, Goldstein (Plaintiff), argued that the SEC (Defendant) acted arbitrarily by issuing a rule (“Hedge Fund Rule”) as per the Advisers Act stating that hedge fund managers need to register with the SEC if the funds they oversaw had over 14 “shareholders, limited partners, members, or beneficiaries,” and were in opposition of equating “client” with “investorâ€, as the regulation does.
Synopsis of Rule of Law. The SEC creating a rule under the Advisers Act requiring a hedge fund manager to register with the SEC if the manager has over 15 â€œclientsâ€ (where â€œclientâ€ is equal with â€œinvestorâ€) is arbitrary.
The court noted that hedge funds are usually structured as limited partnerships to achieve maximum separation between ownership and management and that the general partner manages the fund for a fixed fee and a percentage of the gross profits from the fund while the limited partners are passive investors and generally take no part in management activities.View Full Point of Law
Issue. Is a rule created by the SEC under the Advisers Act requiring a hedge fund manager to register with the SEC if the manager has over 15 â€œclientsâ€ (where â€œclientâ€ is equal with â€œinvestorâ€) arbitrary?
Held. (Randolph, J.) Yes.The SEC creating a rule under the Advisers Act requiring a hedge fund manager to register with the SEC if the manager has over 15 â€œclientsâ€ (where â€œclientâ€ is equal with â€œinvestorâ€) is arbitrary. Due to the term â€œclientâ€ not being defined in the statute, the SEC asserts that the statute is “ambiguous as to a method for counting clients.” Just because Congress uses a word that can be taken multiple ways does not mean that an agency is allowed to just choose any of those meanings, rather the word’s meaning needs to be determined from the issue Congress wanted to solve and from that statutory context. The SEC feels that Congress proved they were cognizant of the ambiguity of â€œclientâ€ due to an amendment to Â§ 203(b)(3) that seeks to clarify that a â€œclientâ€ was not a partner, shareholder, or beneficial owner of a business development company for reasons of deciding how many clients an investment adviser has. Also, a previous amendment shows Congress’ comprehension that investment company entities, rather than their interest holders, were the adviser’s clients with another portion of the Advisers Act suggesting that “shareholders, limited partners, members, or beneficiaries” of a hedge fund to be considered “clientsâ€ by Congress. An â€œinvestment adviserâ€ is defined by the Advisers Act as an individual that advises others through publications or directly and as a result of hedge fund managers not receiving direct advice they cannot be an â€œinvestment adviserâ€ to each investor and so each investor cannot be the manager’s â€œclient.â€ The SEC also took this position until conception of the Hedge Fund Rule, writing “an adviser to an investment pool manages the assets of the pool on the basis of the investment objectives of the participants as a group, it appears appropriate to view the pool-rather than each participant-as a client of the adviser.” The Supreme Court of the United States also took this stance, stating that for an adviser-client relationship to exist there must be custom-made advice tailored to a client’s concerns provided, finding that person-to-person fiduciary relationships were the main characteristic of the adviser-client relationship. It is of note that although the Court was not interpreting the term â€œclientâ€ when it took this position, that the language and configuration of the Advisers Act fails to exclude the SEC’s construction (which was deemed unreasonable and surpasses its authority.) The interpretation by the SEC nears violating the plain language of the statute because in the hedge fund context the fiduciary duties owed by the adviser are only to the fund but under the interpretation of the SEC, the adviser would have fiduciary duties to both the investors and the fund, causing a conflict of interest for the adviser. This cannot happen. The Hedge Fund Rule amends the technique for counting clients under Â§ 203(b)(3) only, and, the SEC continued, it does not “alter the duties or obligations owed by an investment adviser to its clients.” Statutory interpretation assumes the same words utilized in varying portions of the same statute have the same meaning while the SEC failed to give a reason as to why that was not true with the term â€œclientâ€ under the Adviser’s Act. The SEC is not permitted to impose additional complex regulation of hedge funds via a manipulation of meaning. If some investor-adviser relationships present specific characteristics that signal a â€œclientâ€ relationship, the SEC was to have identified those characteristics and created its rule fittingly, but it did not do so and so it also did not satisfactorily validate dropping its own construction of Â§ 203(b)(3). The expanded safe harbor that the SEC adopted, now includes corporations, business trusts and limited liability companies and is still a part of the SEC’s rules.Â The exception from this safe harbor for investment entities that have less than 101 but more than 14 investors, is created by the Hedge Fund Rule and is not validated by the SEC. Without validation, the SEC’s rule appears totally unreasonable and arbitrary, it also fails to back the Advisers Act policy of regulating investment advisory activities that influence the national economy and national securities exchanges. Due to hedge funds becoming national, the Commission states that treating the entity as a single client as a result of the exemption would hinder Congress’ policy. The scope and scale of a hedge fund’s activities are not reflected in the number of investors it has, so even if Congress meant for Â§ 203(b)(3) to exempt the â€˜small time’ advisers from the registration requirements, the SEC’s rule fails to have a reasonable relationship to achieve that goal. A fund’s impact on national markets is determined by the volume of assets or the degree of its indebtedness. A situation is created by the SEC’s rule where funds with less than 101 investors are exempt from the ICA, however, those with over 14 are subject to registration as per the Advisers Act. The rule is arbitrary. The petition for review is granted and the Hedge Fund Rule is vacated and remanded.
Discussion. â€œInvestment advisersâ€ who are non-exempt are required to register with the SEC, 15 U.S.C. Â§ 80b-3, and under Â§ 80b-6, all advisers are forbidden from engaging in fraudulent or deceptivepractices. Through a census, the SEC is better equipped to respond to, start, and take remedial action regarding complaints against fraudulent advisers. Mostly an anti-fraud statute and registration, the Advisers Act was originally passed to “substitute a philosophy of full disclosure for the philosophy of caveat emptor” in the profession of investment advisers.