ADMINISTRATIVE LAW -- JUDICIAL REVIEW OF AGENCY RULEMAKING -- DISTRICT OF COLUMBIA CIRCUIT VACATES SECURITIES AND EXCHANGE COMMISSION'S "HEDGE FUND RULE." -- Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).
Even the worst-run companies can take years to lose six billion dollars. In September 2006, the hedge fund Amaranth Advisors lost that sum in one week. (1) The evident susceptibility of hedge funds to losses of such scope and suddenness, beginning with the 1998 collapse of Long-Term Capital Management (2) (LTCM), has increasingly drawn the attention of the SEC. Responding in part to the LTCM crisis, the SEC promulgated a new regulation in 2004 that required hedge fund managers to register pursuant to the Investment Advisers Act of 1940 (3) (IAA). As part of this new "Hedge Fund Rule," (4) the SEC also narrowed the reach of a key IAA exemption. The Act exempts fund managers from registration if they have fewer than fifteen "clients," (5) a term the Hedge Fund Rule interpreted to include not only the funds themselves but also individuals. As a result, previously exempt managers suddenly found themselves above the fifteen-client threshold. (6) Under longstanding administrative law doctrine, this change should have survived legal challenge: reviewing courts cannot substitute their own construction of a statute for an agency's reasonable interpretation (7) and must defer to reasoned policy changes. (8) Recently, in Goldstein v. SEC, (9) the D.C. Circuit invalidated the Hedge Fund Rule as an instance of arbitrary rulemaking by the SEC. (10) In so holding, the court not only departed from its tradition of deferring to agency expertise, but also failed to advance the purposes underlying the IAA. Further, the court missed an opportunity to allow agencies greater substantive rulemaking flexibility in areas in which parties have the ability and incentives to escape regulation.
In 1985, the SEC promulgated a "Safe Harbor Rule" (11) that effectively excused from registration hedge fund managers under the IAA's fifteen-client limit by counting a hedge fund, and not each individual investor, as one client. (12) Almost two decades later, citing several changes in the economy--such as the growth in the number and importance of hedge funds, an increase in fraud cases involving fund managers, and a greater exposure of retail investors to the risks of hedge fund investing (13)--the SEC revisited the issue in a new round of notice-and-comment rulemaking. With two members dissenting, the SEC promulgated the final Hedge Fund Rule in December 2004. (14) An investment adviser named Phillip Goldstein (15) immediately challenged the rule in the D.C. Circuit. (16)
The D.C. Circuit vacated the Hedge Fund Rule and remanded. Writing for a unanimous panel, Judge Randolph (17) held that the SEC's departure from its earlier Safe Harbor Rule was invalid as an arbitrary action that conflicted with the purposes of the IAA. (18) Judge Randolph began his opinion by providing an overview of hedge funds, noting the difficulty of even defining what a hedge fund is. (19) Because of their structure, hedge funds historically have been subject to minimal oversight. Most can engage in investing behavior, such as trading on margin and short selling, to which traditional entities, such as mutual funds, have limited access. (20) Moreover, unlike traditional funds, hedge funds can "remain secretive about their positions and strategies, even to their own investors." (21)
The court considered whether, under the Administrative Procedure Act (22) (APA), the SEC's redefinition of "client" was "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with the law." (23) The petitioners argued primarily that the new rule misinterpreted "client" as used in section 203(b)(3) of the IAA. (24) The Commission responded that the statute's use of the term was ambiguous, (25) triggering the deferential standard outlined by the Supreme Court in Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc. (26)
The court rejected the SEC's argument. Although the IAA does not define "client," (27) this fact alone, the court held, did not render the term ambiguous, and even if the …