On July 25, 2006, Securities and Exchange Commission Chairman Christopher Cox announced in testimony before the US Senate Committee on Banking, Housing and Urban Affairs, that he would recommend several emergency actions following the invalidation of the SEC's hedge fund adviser registration rule, Rule 203(b)(3)-2, by the US Court of Appeals for the District of Columbia Circuit in Goldstein v. SEC, No. 04-1434. Chairman Cox indicated that the emergency actions would fall into three categories:
(1) Look-Through to Hedge Fund Investors for Purposes of Antifraud Rules
Chairman Cox said that a "side effect" of the Goldstein decision was that the anti-fraud provisions of Sections 206(1) and 206(2) of the Investment Advisers Act of 1940 apply only to clients--i.e., to hedge funds, not investors in hedge funds. Chairman Cox said that the SEC staff is analyzing whether the SEC could adopt a rule under Section 206(4) of the Advisers Act to proscribe fraud by advisers against investors in hedge funds. Given the Goldstein decision, however, adoption of such a rule may invite another court challenge. In addition, given that other anti-fraud rules, including Rule 10b-5 under the Securities Exchange Act of 1934 are applicable to issuers of securities and their control persons (such as hedge funds and their managers), it is not clear what additional protection would be available to investors in hedge funds by adopting such a rule.
(2) Reinstatement of Transitional and Exemptive Rules
Chairman Cox is directing the SEC staff to take action to restore the legal effect of the transitional and exemptive rules included in the hedge fund adviser registration rule. This action would affect:
- hedge fund advisers who were relying on grandfathering provisions in the rule that allow them to continue to have investors who are not "qualified clients" under Rule 205-3, which allows advisers to charge performance-based advisory fees, and advisory agreements which did not comply with the Advisers Act;
- hedge fund advisers who were relying on an exemption from recordkeeping requirements for performance data for periods before registration;
- hedge fund advisers who were relying on the special 180-day period in the custody rule for funds of hedge funds to provide audited financial statements; and
- offshore advisers to offshore hedge funds who otherwise would face uncertainty as to the scope of the applicability of the Advisers Act for their offshore hedge funds, as opposed to only those sections of the Act specified in the hedge fund adviser registration rule. Even with the adoption of such a rule, offshore advisers may still face considerable uncertainty as to the applicability of various provisions of the Advisers Act.
(3) Possible Limited Change to Definition of Accredited Investor
Although Chairman Cox stated that the SEC staff was not aware of retail investors investing directly in hedge funds to any significant degree, he indicated that any such development would be viewed with alarm. To address his concerns regarding "retailization," he has asked the SEC staff to report on the possibility of amending the definition of "accredited investor" as applied to retail investment in hedge funds without registration.
Chairman Cox also articulated the general principles he would apply to SEC action and legislation as to hedge fund activities:
- To the extent possible, governmental action should be non-intrusive. This principle applies to hedge fund investment strategies or operations, including derivatives trading, leverage and short-selling.
- Governmental action affecting hedge funds should not "trammel upon their creativity, their liquidity or their flexibility."
- "Costs of any regulation should be kept firmly in mind."
- Trading strategies and portfolio composition should remain confidential—i.e., there should be no required portfolio disclosure.
- Hedge fund advisers should continue to be able to charge performance fees.
Finally, it was reported that Chairman Cox advised reporters in remarks following his testimony that he had not ruled out an SEC appeal of the Goldstein decision to the US Supreme Court.