on the decision to regulate hedge funds - University of Illinois Law ...

PAREDES.DOC
9/8/2006 9:12:27 AM
988 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2006
dals that began with Enron in 2001, 54 the SEC evidently would no longer
tolerate a largely unregulated $1 trillion (and growing) hedge fund industry
about which it knew very little. The following briefly summarizes the
change in regulation.
Under Section 203(b)(3) of the Advisers Act, an investment adviser
55 who is otherwise subject to the registration requirements of the
Advisers Act does not have to register with the SEC if it: (1) has had
fewer than fifteen clients in the prior twelve-month period; (2) does not
hold itself out to the public as an investment adviser; and (3) does not
advise a registered investment company. Rule 203(b)(3)-1 of the Advisers
Act had allowed an investment adviser to count an investment fund,
such as a hedge fund, as a single client for purposes of Section 203(b)(3).
In other words, a hedge fund with, say, 100 investors counted as a single
client of an adviser for the fifteen-client threshold under Section
203(b)(3). Consequently, a hedge fund manager could manage up to
fourteen hedge funds, regardless of the number of hedge fund investors,
without triggering the obligation to register with the SEC as an investment
adviser under the Advisers Act.
In late 2004, the SEC, by a divisive and controversial three-to-two
vote, adopted new Rule 203(b)(3)-2 of the Advisers Act. Rule
203(b)(3)-2 requires an investment adviser of a “private fund” to look
through the fund to count each investor in the fund as a single client for
purposes of the registration requirement under the Advisers Act. Accordingly,
assuming the other requirements for registration are met, an
adviser of one or more private funds must register with the SEC if, in the
aggregate, there are fifteen or more investors in the fund or funds. A
“private fund” includes any company that (1) qualifies as an investment
company, except for the exclusions from registration under Section
3(c)(1) or Section 3(c)(7) of the Investment Company Act; (2) permits its
owners to redeem their ownership interests in the company within two
years of purchase (the “two-year lockup” provision); and (3) is offered
based on the investment advisory skills, ability, or expertise of the investment
adviser. In short, as a result of new Rule 203(b)(3)-2, hedge
fund managers had to start registering with the SEC as investment advisers
under the Advisers Act beginning February 1, 2006. This means,
among other things, that a hedge fund manager must (1) file a Form
ADV with the SEC, which requires disclosures regarding the fund’s
business practices and the manager’s background, although the manager
does not have to disclose details of the fund’s investment strategies or
trades; (2) deliver basic information to clients about the fund’s business
54. See generally William W. Bratton, Enron and the Dark Side of Shareholder Value, 76 TUL. L.
REV. 1275 (2002); Joel Seligman, No One Can Serve Two Masters: Corporate and Securities Law After
Enron, 80 WASH. U. L.Q. 449 (2002).
55. An “investment adviser” is generally defined as any natural person or company who, for
compensation, engages in the business of providing investment advice. 15 U.S.C. § 80b-2a(11).