Goldstein v. Securities and Exchange Commission

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 “clients†(where “client†is equal with “investorâ€) is arbitrary.

Facts. A rule was promulgated under § 203(b)(3) of the Investment Advisers Act of 1940 (Advisers Act) by the SEC that required hedge fund managers to register with the SEC if their managed funds had over fourteen “shareholders, limited partners, members, or beneficiaries,†which the rule forced the adviser to treat as “clients†under this Act, and funds that were exempt from registration as per the Investment  Company Act (ICA).  The SEC had previously created a safe harbor exemption for managers that described a “client†as the hedge fund limited partnership or entity and since even the leading fund managers rarely oversee more than 15 funds, most managers fall under the safe harbor exemption. Due to most hedge funds having one hundred beneficial owners or less and fail to provide securities to the public or due to their investors all being “qualified†high net-worth persons or institutions, they are also exempt from the ICA’s coverage. Unlike mutual funds that must comply with comprehensive requirements for independent boards of directors, whose activities must be expressly authorized by shareholders, as a result of usually being exempt from the requirements of ICA hedge funds partake in transactions that mutual funds cannot and domestic hedge funds typically are structured as limited partnerships to glean ultimate separation of management and ownership. The general partner usually manages the fund(s) for a fixed fee and percentage of the fund’s gross profits, and the partners are passive investors.  Under the Advisers Act, hedge fund general partners are defined as “investment advisers†even though they typically satisfy the “private adviser exemption” for advisers with less than fifteen clients who are not publically known as investment advisers nor act as such to any investment company registered with the ICA. The interest of the SEC in upping regulation of the hedge fund industry was reignited by Long-Term Capital Management’s (Long-Term) failure, with nearly all of the country’s primary financial institutions being put at risk because their credit exposure to Long-Term’s breakdown. Three shifts in the hedge fund industry were mentioned by the SEC to justify the need for amplified regulation. The first shift was that in spite of the breakdown of Long-Term, the assets of the hedge fund continue to expand, the second was the inclination towards “retailization†of hedge funds that expanded the exposure of ordinary investors to like funds and the third was the fraud actions brought against hedge funds was on the rise. Requiring hedge fund advisers to register under the Advisers Act was the Hedge Fund Rule’s purpose and so that the SEC would be able to obtain information about the hedge fund industry and hedge fund advisers, supervise advisers and deter/detect fraud by unregistered advisers. The factual predicates for the new rule was doubted by the dissenters and they also thought that § 203(b)(3) of the Advisers Act  was misinterpreted by the SEC. A hedge fund manager, Goldstein, petitioned for review of the Hedge Fund Rule, likewise alleging that the Advisers Act was misinterpreted by the SEC. The regulation’s equation of “client†with “investor†was contended by Goldstein. The court of appeals granted review.

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 “clients†(where “client†is equal with “investorâ€) 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 “clients†(where “client†is equal with “investorâ€) is arbitrary. Due to the term “client†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 “client†due to an amendment to § 203(b)(3) that seeks to clarify that a “client†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 “clients†by Congress. An “investment adviser†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 “investment adviser†to each investor and so each investor cannot be the manager’s “client.†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 “client†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 § 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 “client†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 “client†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 § 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.  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 § 203(b)(3) to exempt the ‘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. “Investment advisers†who are non-exempt are required to register with the SEC, 15 U.S.C. § 80b-3, and under § 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.