SEC and Staff Response to Goldstein Decision

An update in the wake of the WEC decision not to appeal the Goldstein decision

David A. Vaughan and Michael L. Sherman
Originally published in the September 2006 issue

In the last issue we discussed the recent Goldstein decision which vacated the "Hedge Fund Rule," subject to potential appeal by the SEC. Since that time: (i) the SEC determined not to appeal Goldstein, allowing the Hedge Fund Rule to be vacated; (ii) the SEC Staff issued guidance, tempering some of the "side-effects" of Goldstein; and (iii) Chairman Cox, in testimony before Congress and other public statements, indicated that additional rules that will affect hedge funds and their managers may be imminent.

SEC's failure to appeal Goldstein means the hedge fund rule is vacated – but not that the SEC will no longer regulate hedge funds and their managers
No longer will hedge fund managers be compelled to look through the vehicle when counting clients for registration purposes, nor are they required to treat investors as clients for other purposes under the Advisers Act ("Act") – at least for now.

However, pending legislation would grant the SEC authority to enact a "look-through" rule. Moreover, as discussed below, the SEC and its Staff are considering "a new anti-fraud rule . . . that would have the effect of 'looking through' a hedge fund to its investors . . . [and] revers[ing] the side-effect of the Goldstein decision that the anti-fraud provisions of the Act apply only to 'clients' as the court interpreted that term [(i.e., the fund)], and not to investors in the hedge fund." Although it appears that this new rule would not mandate registration, it could extend the protection and reach of existing anti-fraud rules and considerations to the hedge fund adviser's relationship with investors.

Staff provides guidance for a post-Goldstein world

A primary concern in the wake of Goldstein was whether certain rule amendments and transition provisions were thrown out with the proverbial bathwater. The Goldstein opinion vacated all of the rules, amendments and transitional provisions that were adopted at the same time as the "look-through" registration rule which was the focus of the case ("Ancillary Provisions"). Without further action, advisers who chose to remain registered would have been unable to rely on certain Ancillary Provisions which were seen as beneficial to the orderly operation of funds and eased some of the burdens of beingnewly registered.

For example, an amendment to the Act's Custody Rule which allowed additional time for funds-of-funds to complete their annual audit was adopted with the Hedge Fund Rule. Additionally, the "lite regime" was a creature of the Hedge Fund Rule.

Both before Congress and in announcing the SEC's decision not to appeal Goldstein, Chairman Cox indicated that the staff would take action "to address the grandfathering, transition and other miscellaneous relief necessitated by the vacating of the rule [which] will help to eliminate disincentives for voluntary registration, and enable hedge fund advisers who are already registered . . . to remain registered."

Even before the SEC's decision was known, the ABA requested no-action guidance from the Staff on certain matters affecting hedge fund managers ("ABA Letter"), including those that are registered investment advisers ("RIAs"). Shortly after the SEC's decision not to appeal, the Staff issued its response to the ABA Letter ("Response").

The Response provided a forum for the Staff to clarify its position on the Ancillary Provisions and provides important information for those who wish to remain registered as well as for those who may choose to withdraw their registration.


Continued viability of reg lite

The Response confirmed that, as under the Hedge Fund Rule, RIAs (i) whose principal office and place of business is outside the United States ("offshore advisers") and (ii) who advise private funds organized and incorporated outside the United States ("offshore funds") but (iii) who have no direct U.S. clients ("offshore advisers") could choose not to be subject to certain substantive provisions of the Act (i.e., by electing the so-called "Reg. Lite Regime"). An offshore adviser who relies on Reg Lite is required to file and maintain its Form ADV, must keep certain (but not all) records required by the Act's Recordkeeping Rule, remains subject to the anti-fraud provisions of the Act (but not all of the anti-fraud rules thereunder) and may be inspected by SEC examiners. However, such an offshore adviser would not be subject to the full panoply of obligations and requirements of the Act and rules thereunder, with respect to non-U.S. clients (including offshore funds). An offshore adviser would be subject to all relevant provisions of and rules under the Act to the extent it services or solicits U.S. clients.

Records supporting performance information

The Response also confirmed that the Staff would not recommend enforcement action against RIAs who wished to advertise the performance of client accounts during periods prior to registration but did not maintain certain required supporting documentation relating to periods prior to the earlier of the date the RIA registered or February 10, 2005. Of course, such RIAs would be expected to retain whatever records they have in possession that pertain to the performance for such period and, in any event, must have sufficient support for any performance claims made. This Ancillary Provision had been adopted alongside the Hedge Fund Rule to protect new RIAs from any competitive disadvantage which would result from their inability to advertise performance relating to periods during which they were not required to keep the same types of records required of RIAs.

Performance-based compensation arrangements

Another Ancillary Provision acted to "grandfather" compensation provisions negotiated with existing investors and clients with respect to which the RIA would otherwise be unable to receive performance compensation that is permissible for unregistered advisers – provided that the relationship existed on or before February 10, 2005, and was legal at that time. This Ancillary Provision was necessary because RIAs are subject to the Act's general prohibition on performance fees or allocations, subject to certain exceptions, including (as relevant here) where such fees are charged to a "qualified client." Because many advisers who registered in the wake of the Hedge Fund Rule applied performance fees or allocations to all investors, regardless of "qualified client" status, the absence of a "grandfathering" provision would have required that those RIAs survey each investor to verify "qualified" status and either expel non-qualified investors from their funds or negotiate alternative charges.

The Response confirmed that the Staff would not recommend enforcement action against an RIA who receives performance fees or allocations if, and to the extent that, the RIA would have qualified for the "grandfathering" provision.

Fund of funds compliance with custody rule

As a general matter, RIAs to hedge funds will be deemed to have custody of the hedge fund's 25assets to the extent that they (or an affiliate) acts as general partner/managing member to the fund or is permitted to automatically debit fees from the fund's account. RIAs who have custody of client assets must comply with the Advisers Act Custody Rule which requires, among other things, that the RIA cause the client's assets to be held in the care of a qualified custodian and that the qualified custodian provide quarterly account statements to the "client."

The Custody Rule specifically states that, where the RIA serves as general partner or managing member of a hedge fund, the required statements must be sent to each investor. This provision was not part of the Hedge Fund Rule and, thus, remains in effect. However, the Custody Rule provides an alternate means for compliance in the hedge fund context – annual distribution of audited financials, prepared in accordance with GAAP, to all investors, within 120 days following the end of the fund's fiscal year. Reliance on this annual audit method also allowed RIAs to avoid the qualified custodian requirement with respect to certain privately placed, uncertificated securities ("Private Security Exception").

An Ancillary Provision to the Hedge Fund Rule allowed RIAs to funds of funds to deliver the fund of fund's financials within 180 days, rather than the standard 120 day period. This represented significant relief as funds of funds often could not complete their audit until the underlying funds had completed theirs. For fund of funds managers, the extra sixty days often made the difference between being able to rely on the annual audit method and not. Because the interests in the underlying funds often qualified for the Private Security Exception (and were difficult and/or expensive to custody with a qualified custodian), funds of funds would suffer particularized hardship if this Ancillary Provision were not extended.

Fortunately, the Response confirmed that the Staff would not recommend enforcement action against a fund of funds RIA, provided that financials were distributed during the 180 day period following the fund of fund's fiscal year end.

Effect of goldstein on form adv amendments relating to private funds

Another Ancillary Provision amended Form ADV to require RIAs to provide certain information on the "private funds" they advise. Although Goldstein vacated these changes, Form ADV is currently maintained on, and filed through, IARD, an external, internet-based system maintained by the NASD. However, due to system and programming constraints, the IARD system has not yet been updated to revert to the prior version of the Form ADV, notwithstanding that the version now being used is no longer the "official" Form ADV. As promised in the Response, the Staff has posted further guidance (available at as to how RIAs should respond to Form ADV until the IARD system is updated.

Access to records

Another Ancillary Provision provided that therecords of a private fund are records of the RIA and thus subject to examination by the SEC staff if the RIA or any related person acts as the private fund's general partner, managing member, or in a comparable capacity. Although the Response did not directly address the question whether the books and records of the private fund would continue to be deemed to be records of the adviser following Goldstein, the Staff did note that an RIA "must make records available for examination in accordance with section 204 of the [Advisers] Act [and] may not evade this requirement by holding records by or through any other person, including a related person or private fund." This statement suggests that the examination staff may assert that the books and records held by any affiliate of the adviser or by its private fund would be subject to inspection by the Staff. RIAs who choose to remain registered should determine whether they can demonstrate full compliance with Section 204 without relying on records maintained by the funds they manage.

Access to records

Continued reliance on section 203(b)(3)

Goldstein did not expressly address its effect on RIAs who had already registered. An RIA cannot rely on Section 203(b)(3) if it "holds [it]self out generally to the public." Would RIAs who, being registered, took affirmative steps to market their advisory services and/or entered into advisory relationships with more than 14 clients (even without "look-through") be able to deregister? Assuming that the RIA reduced its client count below 15, would the RIA be required to maintain its registration (for at least a period of time), notwithstanding Goldstein?

The Response confirms that the Staff would permit an RIA that had registered because of the Hedge Fund Rule to withdraw registration without regard to whether the RIA, while registered (i) held itself out generally to the public while it was registered, and/or (ii) had more than fourteen clients while it was registered (counting each private fund as a single client). Thus, an RIA who engaged in general marketing and/or accepted clients beyond the registration threshold (again, counting each fund as a single client), could withdraw immediately upon (i) reducing its number of clients to 14 or fewer and (ii) ceasing any activity which constitutes a "holding out." Going forward, during the first 12 months following withdrawal, an adviser may determine its number of clients with reference to the date of withdrawal, rather than the statutory 12 month look-back. In order to rely on this relief, the RIA must withdraw its registration by February 1, 2007.

Submitting a balance sheet not required when filing form adv-w

RIAs withdraw from registration by filing Form ADV-W. Under certain circumstances (e.g., where the RIA or an affiliate had custody of client assets), such RIAs must provide an unaudited balance sheet on Schedule W2. RIAs who deregister by February 1, 2007 are not subject to the balance sheet requirement. However, such RIAs must:

  • answer "yes" to Item 3 of Form ADV-W
  • complete Schedule W2 but answer "0" to each item

Potential increase in "accredited investor" threshold

In Chairman Cox's testimony before the U.S. Senate Committee on Banking, Housing and Urban Affairs, he stated that he has asked the staff to analyze and report to the SEC on the possibility of amending the current definition of "accredited investor." Based on the Chairman's Congressional testimony, it is possible that the "accredited investor" threshold could increase to match the "qualified client" threshold and might exclude the investor's primary residence.

Inspections will continue

Chairman Cox has "directed the SEC staff to continue to conduct compliance examinations of investment advisers who remain registered with [the SEC] or register with [the SEC] in the future."

Mr. Vaughan is a partner and Mr. Sherman is an associate in the Washington, D.C., office of Dechert LLP. This document is a basic summary of legal issues. It should not be relied upon as an authoritative statement of the law. You should obtain detailed legal advice before taking action.