A federal appeals court has dealt a serious blow to the Securities and Exchange Commission's plans to more closely regulate hedge funds.

The three judges who sit on the U.S. Court of Appeals for the District of Columbia Circuit ruled unanimously last week that the SEC had overstepped its authority in defining hedge fund investors as "clients" of a fund manager, and subsequently ordering any hedge fund manager with 15 investors or more to register with the agency.

SEC Chairman Christopher Cox said that he hasn't yet decided whether or not the decision will be appealed. In a statement, he said that he already instructed SEC staff to evaluate the court's decision, as well as to provide a set of alternatives for the commission's consideration.

"The SEC takes seriously its responsibility to make rules in accordance with our governing laws," Cox said, in a statement. "The court's finding, that despite the commission's investor protection objective, its rule is arbitrary and in violation of law, requires that going forward we reevaluate the agency's approach to hedge fund activity."

Hedge funds are still treated like any other investor in determining whether they violated basic securities laws, like insider trading, but hedge fund managers have said that they have acted responsibly and should not be subjected to the regulatory burdens faced by mutual funds.

The SEC hedge fund rule was originally adopted in December 2004, in a close vote under Cox's predecessor, William Donaldson. Nearly 1,000 fund managers registered with the commissioned by the deadline of Feb. 1, 2006. Those managers could now choose to de-register. The rule had also allowed the SEC to periodically inspect the records of a hedge fund.

The SEC is currently seeking comment on another beleaguered rule passed under Donaldson in a narrow vote, which had required that at least 75 percent of directors, including the chairman, of mutual fund boards be independent from the fund sponsor.

Previously on WebCPA:

SEC Sends Mutual Fund Rule Out for Comment, Again (June 15, 2006)SEC: Tougher on Hedge Funds, Looser on Quiet Periods (Oct. 27, 2005)

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