A question on everyone’s mind these days is whether the Securities and Exchange Commission will appeal the recent federal appeals court ruling that overturned the SEC’s controversial rule requiring most hedge fund advisors to register with the Commission under the Investment Advisers Act. While the majority of those in the investment industry opine that the SEC will not appeal–including SEC Commissioner Paul Atkins–some industry officials are encouraging the securities regulator to do so.

Until the SEC makes a decision, however, hedge fund advisors will remain in a state of regulatory limbo. “The notion of having the [hedge fund advisor registration] rules confused, as I think they are, isn’t healthy for the U.S. markets,” says Michael Tannenbaum, a partner at New York law firm Tannenbaum Helpern Syracuse & Hirschtritt LLP.

The June 23 ruling by the U.S. Court of Appeals for the District of Columbia Circuit focused its opposition on the SEC’s use of the term “client” in the hedge fund registration rule the securities regulator passed in December 2004. As of January 1, 2005, 1,260 hedge fund advisors had registered; the total number, according to SEC spokesman John Heine, is now 2,533.

The rule included a new interpretation of a provision in the Investment Advisers Act exempting from registration advisors that had fewer than fifteen “clients” during the preceding year. Before the rule was adopted, the SEC had interpreted the registration exemption to count a hedge fund as a single client. The new rule reversed this position and required hedge fund advisors to count each investor–or limited partner–as a single client.

The federal appeals court ruling argued that the SEC’s decision to treat each investor as a client was arbitrary, according to the Investment Adviser Association. The court ruling stated that “the Commission’s interpretation of the word ‘client’ comes close to violating the plain language of the statute. At best it is counterintuitive to characterize the investors in a hedge fund as the ‘clients’ of the adviser. The adviser owes fiduciary duties only to the fund, not to the fund’s investors.”

Should Advisors Deregister?

Top Democrats acted quickly on June 29 by introducing a bill, the Securities and Exchange Commission Authority Restoration Act of 2006 (H.R. 5712), which would reverse the federal appeals court ruling by amending the Advisers Act to require hedge fund advisor registration.

The question now is whether advisors will start to deregister. Before deciding to deregister, Tannenbaum says advisors will wait for two things to occur: the allotted time the SEC has to appeal the ruling to lapse–which is 45 days after June 23 to file a petition with the federal appeals court, and 90 days after the ruling to appeal directly to the U.S. Supreme Court–and for Congressional action to be unlikely.

But Tannenbaum believes those hedge fund advisors that deregister do so at their own peril. Large institutional investors and pension investors who are subject to ERISA that are pouring money into the hedge fund marketplace “by the billions of dollars,” he says, would prefer the hedge funds in which they invest to be registered. “The fiduciaries and trustees and investment committees at those institutional investors find great comfort in the fact that the manager to whom they are allocating money to invest is registered,” he says. “From a legal standpoint, under ERISA, pension trustees who allocate money to nonregistered managers have a great deal more liability for the investment process than those trustees that allocate money to registered managers. The reason for that is it’s a provision in ERISA and a DOL rule as well.” The bottom line, he says, is if a hedge fund manager “wishes to address and get money from the institutional marketplace, they will find themselves needing to register.”

Jim Hedges, founder and president of LJH Global Investments, a hedge fund research and advisory firm in Naples, Florida, says that while he agrees that if the federal court’s judgment sticks, “a tremendous number of advisors will deregister,” he disagrees that the marketplace will force advisors to be registered. “If somebody wants to get ERISA money, that’s one thing,” he says, “but otherwise I don’t think they’ll be forced to register.” For his part, Hedges won’t be able to deregister because he “has too many clients and too many assets under management.”

Like other hedge fund advisors, Hedges says he’s “unconvinced that registration is going to prevent fraud” in the $1.1 trillion hedge fund industry. “A lot of time, money, investigation, and energy has been spent under the auspices of registration being used to prevent fraud, and I don’t think that’s a sufficient deterrent,” he says. “I think the SEC is already heavily burdened as an agency in terms of enforcement.”

An Overextended SEC?

During a conversation with Lori Richards, director of the SEC’s Office of Compliance Inspections and Examinations (OCIE), earlier this year, she admitted that the SEC’s exam staff is overextended. She said that over the last year, the number of registered investment advisors who’ve registered with the SEC jumped 20%–pushing the number of RIAs to more than 10,000. With only 400 examiners at her disposal, Richards said OCIE must “use our resources in the most effective way possible.” That’s going to be even more challenging, she said, now that OCIE has hedge fund advisors to examine. Taking on hedge fund examinations “has meant a more disciplined approach to identifying the investment advisors that pose the greatest compliance risk, as well as the activities by investment advisors that pose the greatest compliance risk,” Richards said.

Indeed, many in the industry say the recent appeals court ruling is a blessing in disguise for SEC Chairman Christopher Cox because it gives him an excuse to let the rule that was instituted by his predecessor just slip off the books. But Darren Sherman, CEO of Regulatory Advisory Services in New York and a former SEC official, begs to differ. Right after the appeals court ruling, Cox directed SEC staff to consider alternatives, and “the staff is now diligently at work trying to meet Cox’s request,” Sherman says. Plus, he says, don’t forget that it wasn’t just former SEC Chairman Bill Donaldson who was bent on getting hedge funds under the SEC’s aegis. “Senior staff at the SEC within the enforcement division as well as the investment management division were urging the Commission to require registration and regulation of hedge fund advisors.”

Some of the alternatives to keeping the hedge fund registration requirement, he says, “may be to focus not on the definition of client, but rather on the characteristics of the assets of the management within the unregistered investment pools.” Another alternative would be to require some type of light reporting on the part of hedge fund advisors, he says. For instance, the SEC would want to know the number of investment vehicles managed by a hedge fund, total assets under management, and the investment strategy utilized by the advisor, he says. “The SEC is looking for very high-level information because right now the SEC does not have a lot of information on hedge fund advisors.”

These alternatives, if agreed upon by Cox and the staff, would be put forth in a new proposed rule with a comment period, Sherman says, and it “would likely take years for the outcome to be determined.”

Hedge fund advisor registration has been an extremely contentious issue since Donaldson pushed the rule through, and Sherman, for one, believes “there will be grave consequences for the SEC and the investing public” should the House bill be shot down.

Washington Bureau Chief Melanie Waddell can be reached at mwaddell@investmentadvisor.com.