Counting Clients under the Investment Advisers Act – The Demise of the Hedge Fund Rule

Section 203(b) lays out the exceptions to registration under the Investment Advisers Act. Section 203(b)(3) exempts you if during the previous 12 months (i) you have fewer than 15 clients and (ii) you do not hold yourself out as an investment adviser.

For private investment funds, the general partner is generally considered an investment adviser [See: Abrahamson v. Fleschner, 568 F.2d 862 (2d Cir. 1977) , overruled in part on other grounds by Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11 (1979)]

In the private investment world, as long as you had fewer than 15 funds and did not hold yourself out as an investment adviser you did not have to register.  The question is what was a fund/client for the purposes of the Investment Company Act?

With the demise of Long Term Capital, the SEC was interested in regulating hedge funds. In 2004 the SEC passed the Hedge Fund Rule which tried to expand the scope of the Investment Advisers Act by defining “client” under Section 203(b)(3). The rule specified that for “[f]or purposes of section 203(b)(3) of the [Advisers] Act (15 U.S.C. § 80b-3(b)(3)), you must count as clients the shareholders, limited partners, members, or beneficiaries . . . of [the] fund.” § 275.203(b)(3)-2(a). Effectively, the SEC tried to shift the definition from the fund up to the investors in the fund.

This Hedge Fund Rule was overturned by the United States Court of Appeals for the District of Columbia Circuit in the appelate case of Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).

“An investor in a private fund may benefit from the adviser’s advice (or he may suffer from it) but he does not receive the advice directly. He invests a portion of his assets in the fund. The fund manager – the adviser – controls the disposition of the pool of capital in the fund. The adviser does not tell the investor how to spend his money; the investor made that decision when he  invested in the fund. Having bought into the fund, the investor fades into the background; his role is completely passive. If the person or entity controlling the fund is not an “investment adviser” to each individual investor, then a fortiori each investor cannot be a “client” of that person or entity.”

, , , , ,

Trackbacks/Pingbacks

  1. Compliance Building · Anti-Fraud Provision of the Investment Advisers Act - March 25, 2009

    […] Although negligent conduct is proscribed, the SEC specifically stated that the rule does not create a fiduciary duty not otherwise imposed by law. This rule should not change the way an investment advisers perform their duties.  It merely removes the doubt regarding the scope of the SEC’s authority created by Goldstein. […]

  2. Compliance Building · Counting Clients under the Investment Advisers Act - March 25, 2009

    […] to feed ‹ Counting Clients under the Investment Advisers Act – The Demise of the Hedge Fund Rule  •  SAFETY Act […]

  3. More on the Private Fund Transparency Act of 2009 | Compliance Building - June 19, 2009

    […] I am not sure what this change would do. I suspect it is an attempt to address the demise of the Hedge Fund Rule and allow the SEC to define the investors in private investment funds as “clients” of […]

  4. Private Equity and the Custody Rule | Compliance Building - June 8, 2010

    […] the impending removal of the 15 Client Rule exemption from registration with the SEC, I was scratching my head trying to figure how to make the […]

  5. Fund Manager Fraud for Exceeding Lerverage Limits | Compliance Building - July 27, 2010

    […] legal team used the Goldstein v. SEC case to argue that the SEC is precluded form treating fund investors as clients. The Sixth Circuit Court […]