Goldstein v. Securities and Exchange Commission

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.