In a judgment announced on Friday, the D.C. Circuit Court decided that a Securities and Exchange Commission regulation tightening hedge fund oversight doesn't pass muster. That leaves us -- for the time being, anyway -- with the so-called "hedge fund rule" not ruling hedge funds.
The rule at issue, passed in a close vote under previous SEC chairman William Donaldson, required hedge-find advisors with at least 15 clients to register and to undergo routine inspections. The regulation took effect in February and formed a cornerstone for a potential foundation of increased regulatory scrutiny.
The rule reshaped the SEC's approach to defining a hedge fund client. The rule counted each hedge fund investor as a client, as opposed to the agency's former approach of viewing each hedge fund as an advisor's single client. Given that most hedge fund investors don't have a direct relationship with the advisor, the court criticized the definition and vacated the rule. "That the commission wanted a hook on which to hang more comprehensive regulation of hedge funds may be understandable," the court stated in its opinion. "But the commission may not accomplish its objective by a manipulation of meaning."
The spotlight now shines on the current SEC chairman, Christopher Cox. He inherited this contentious issue from his predecessor, and he faces divided opinion among the other commissioners on the subject. His options include appealing the decision to the Supreme Court (which is unlikely), revising the regulation, or dropping the whole foray into hedge fund regulation. Cox, too, issued a statement on Friday, essentially promising nothing other than a reevaluation of the SEC's approach to hedge fund activity.
Hedge funds oversee more than $1 trillion in assets, and the 1998 demise of Long-Term Capital Management made it clear how their activities can ripple through our financial system. The court may have called the SEC's bluff on attempting to hang its regulatory authority on a flimsy definition, but it's time for Chairman Cox to show his cards.
For related Foolishness:
- 7 Reasons to Bid Donaldson a Fond Adieu
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- Will the SEC Trim the Hedges?
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Fool contributor S.J. Caplan engaged in negotiations and projects involving Long-Term Capital during her tenure as a former vice president and assistant general counsel of Goldman Sachs and former vice president and derivative finance specialist at Lehman Brothers. The Motley Fool has a disclosure policy.