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Investment Management Group Alert

June 2006

Court Vacates SEC Rule Requiring Hedge Funds to Register

In its second surprise move in the past week, the United States Court of Appeals for the District of Columbia Circuit has, on its own initiative, issued an order that delays the effectiveness of its June 23, 2006 decision in Goldstein v. Securities and Exchange Commission. In Goldstein, the Court vacated the rule recently enacted by the Securities and Exchange Commission (the “SEC”) that required most hedge fund managers to register as investment advisers pursuant to the Investment Advisers Act of 1940, as amended (the “Advisers Act”). The Court’s June 27, 2006 order withholds the issuance of a mandate to the SEC, which would make its June 23 decision effective, until seven days after the earlier of (i) the expiration of the period within which the SEC may file a petition for a rehearing en banc by the D.C. Circuit or may appeal the Goldstein decision to the United States Supreme Court; and (ii) the disposition of such rehearing or appeal. The Court’s most recent action means that, unless the SEC announces affirmatively that it will not appeal the Goldstein decision (in which case the Court likely would issue the mandate), the hedge fund registration rule adopted by the SEC will remain in effect at least until early August. The paragraphs below are designed to provide you with background and a summary of the most recent events.

The Rule Prior to October 2004

Prior to October 2004, Section 203(b)(3) of the Advisers Act specifically exempted from registration any investment adviser that, among

• ther things, had fewer than 15 “clients” during

the preceding 12 months. Rule 203(b)(3)-1 generally permitted an adviser to count as a single client any pooled investment fund that it advised, regardless of how many underlying investors were invested in such fund. Thus, a private manager with fewer than 15 funds was usually exempt from federal registration. This so-called “de minimis exemption” had allowed most hedge fund managers to remain unregistered. As the hedge fund industry’s assets approached one trillion dollars, the SEC expressed growing concern over its inability to examine the advisers to those funds.

The Look-Through Rule

On October 26, 2004, the SEC voted, in a 3-2 decision, to adopt Rule 203(b)(3)-2 (the “Look- Through Rule”). The Look-Through Rule changed the method of calculating the number of an adviser’s “clients.” The Look-Through Rule requires that a manager “look through” each of its funds and managed accounts, and count as a client each individual underlying investor (rather than each fund). Thus, if a manager has at least 15 individual investors across all of its funds and managed

This document is published by Lowenstein Sandler PC to keep clients and friends informed about current issues. It is intended to provide general information only. 65 Livingston Avenue www.lowenstein.com Roseland, New Jersey 07068-1791 Telephone 973.597.2500 Fax 973.597.2400

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accounts, that manager is required to register as an investment adviser under the Look-Through Rule, unless an exclusion or exemption applies (such as, for example, the exemption for venture capital, private equity, and other funds with limited liquidity). Accordingly, many previously exempt managers registered with the SEC prior to the Look-Through Rule’s February 1, 2006 effective

• date. In addition to filing a Form ADV, managers

were required, among other things, to adopt written compliance policies and procedures, appoint a chief compliance officer, adhere to restrictions on charging performance fees, maintain certain books and records, and prepare for surprise inspections by the SEC.

The Goldstein Decision

In last week’s Goldstein decision, the Court of Appeals held that the SEC had overstepped its authority in adopting the Look-Through Rule. While courts typically provide federal agencies, such as the SEC, wide latitude in enacting regulations, the Court, while leaving as an open regulatory issue the need for registration of hedge fund managers, determined that the manner in which the SEC had required registration—by defining clients on a look-through basis—was arbitrary and improper. The Court vacated the Look-Through Rule and sent it back to the SEC for reconsideration. Indeed, the Court seemed to suggest that if registration of fund managers is necessary due to the size of the industry and its impact on the capital markets, the proper way to accomplish it is through legislative action. Ultimately, the Court delayed issuing the mandate that would have implemented its

• decision. Consequently, as of this writing, the

Look-Through Rule remains legally in effect. The next move is the SEC’s.

What the Court’s Decision Means

The SEC has yet to announce its intentions in response to the Court’s decision. The SEC could appeal the decision to the United States Supreme Court, attempt to modify the Look-Through Rule, ask Congress to legislate, or altogether halt its efforts to regulate hedge funds at this time. A number of changes since the Look-Through Rule was adopted in 2004 make it especially difficult to predict what will happen next. The Look-Through Rule was controversial within the SEC even at the time of its adoption, and the current SEC Chairman was not the Chairman when the Look-Through Rule was

• adopted. The Court’s ruling, in essence, forecloses

the possibility of re-defining the word “client” or employing any similar method to retrofit the existing statute to a fundamentally expanded purpose. In addition, two years have passed since the corporate governance headlines that fueled broad support for increased regulation of the financial services

• industry. These factors point toward the SEC

abandoning its regulatory attempt. On the other hand, the SEC has hired and trained hundreds of new inspectors to implement the Look-Through Rule, the hedge fund industry has continued to grow at an accelerated rate since 2004, and some of the trends about which the SEC was most worried—such as the retailization of hedge funds— have continued unabated. These factors point toward the SEC pursuing its regulatory attempt.

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Depending on the SEC’s response, it may be appropriate for fund managers to reevaluate the need to remain registered, their compliance policies and procedures, and their fund offering terms. At this time, however, there is nothing to be done in advance of an initial substantive response from the SEC. * * * * * If you have any questions regarding these matters, please do not hesitate to contact a member

• f Lowenstein Sandler’s Investment Management
• Group. We will, of course, keep you apprised of

further developments.

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The Investment Management Group Lowenstein Sandler PC

Co-Chairs: Allen B. Levithan Robert G. Minion Partners: John L. Berger Andrew E. Graw Marie T. DeFalco Peter D. Greene Michael N. Gooen Counsel: Michael J.Caffrey Maureen E. Montague Paul W. Hartzel Sharon M. Mousserie John J. Herbst Brian A. Silikovitz Elaine M. Hughes Associates: Richard Bernstein Diana Ingallinera Faillace Susan M. Cohen Erik W. Johnson Javier Cuebas Steven P. Kirberger Brock M.Cusick Ryan S. Melcher Michael J. Dickey Michele L. Misher Brooke A. Gillar Scott H. Moss Mario V. Hernandez Keith T. O'Brien Steven N. Papera