Order Code RS22528
November 7, 2006
CRS Report for Congress
Received through the CRS Web
Hedge Funds: Goldstein v. Securities and
Exchange Commission
Michael V. Seitzinger
Legislative Attorney
American Law Division
Summary
In 2004 the Securities and Exchange Commission (SEC) issued a rule which
resulted in requiring many hedge fund advisers to register as investment advisers under
the Investment Advisers Act. Because hedge fund advisers had for the most part before
the rule been exempt from registration so long as they had fewer than fifteen clients,
hedge fund advisers, referred to collectively as Goldstein, brought suit to challenge the
rule. The District of Columbia Circuit, after examining an amendment to the Investment
Advisers Act, previous statements by the Securities and Exchange Commission, and the
Supreme Court case Lowe v. Securities and Exchange Commission, in a three-judge
panel unanimously held that the SEC’s hedge fund rule was arbitrary and vacated and
remanded the rule. On August 7, 2006, Chairman Cox stated that the SEC would not
seek en banc review of the Court of Appeals decision and would not petition the United
States Supreme Court for a writ of certiorari. This report will be updated as necessary.
The term “hedge fund” is difficult to define, since it does not appear anywhere in
federal securities laws. No single definition of the term appears to be used by industry
participants, but perhaps one of the most useful definitions of a hedge fund is that it is
“any pooled investment vehicle that is privately organized, administered by professional
investment managers, and not widely available to the public.”1
Hedge funds have received a great deal of media coverage in the past several years
because large sums of money have been gained or lost in a relatively short time by some
hedge funds. Some members of Congress believe that the SEC should be given specific
1 President’s Working Group on Financial Markets, HEDGE FUNDS, LEVERAGE, AND THE LESSONS
OF LONG-TERM CAPITAL MANAGEMENT 1 (1999). Another useful definition of the term is an
“entity that holds a pool of securities and perhaps other assets, whose interests are not sold in a
registered public offering and which is not registered as an investment company under the
Investment Company Act.” United States Securities and Exchange Commission, STAFF REPORT
TO THE UNITED STATES SECURITIES AND EXCHANGE COMMISSION ON THE IMPLICATIONS OF THE
GROWTH OF HEDGE FUNDS 3 (2003).
Congressional Research Service ˜ The Library of Congress

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statutory authority to require the registration of hedge funds or their advisers.2 Arguments
for other kinds of regulation or for no regulation have also been urged.3
In 2004 the SEC issued a rule4 which resulted in requiring many hedge fund advisers
to register with the SEC as investment advisers5 under the Investment Advisers Act.6 The
hedge fund rule first defines a “private fund” as an investment company that is exempt
from registration under the Investment Company Act7 because it has fewer than one
hundred investors or only qualified investors,8 allows its investors to redeem their
interests within two years of investing, and markets itself based upon the “skills, ability,
or expertise of the investment adviser.”9 The rule goes on to state that these private funds,
“[f]or purposes of section 203(b)(3) of the [Investment Advisers] Act (15 U.S.C. § 80b-
3(b)(3)),...must count as clients the shareholders, limited partners, members, or
2 See, e.g. H.R. 5712, 109th Cong.
3 See CRS Report 94-511, Hedge Funds: Should They Be Regulated?, by Mark Jickling.
4 69 FED. REG. 72,054 (Dec. 10, 2004), codified at 17 C.F.R. Parts 275 and 279.
5 An investment adviser is defined as:
any person who, for compensation, engages in the business of advising others, either
directly or through publications or writings, as to the value of securities or as to the
advisability of investing in, purchasing, or selling securities, or who, for compensation
and as part of a regular business, issues or promulgates analyses or reports concerning
securities; but does not include (A) a bank, or any bank holding company as defined
in the Bank Holding Company Act of 1956 [12 U.S.C.A. § 1841 et seq.] which is not
an investment company, except that the term “investment adviser” includes any bank
or bank holding company to the extent that such bank or bank holding company serves
or acts as an investment adviser to a registered investment company, but if, in the case
of a bank, such services or actions are performed through a separately identifiable
department or division, and not the bank itself, shall be deemed to be the investment
adviser; (B) any lawyer, accountant, engineer, or teacher whose performance of such
services is solely incidental to the practice of his profession; (C) any broker or dealer
whose performance of such services is solely incidental to the conduct of his business
as a broker or dealer and who receives no special compensation therefor; (D) the
publisher of any bona fide newspaper, news magazine or business or financial
publication of general and regular circulation; (E) any person whose advice, analyses,
or reports relate to no securities other than securities which are direct obligations of
or obligations guaranteed as to principal or interest by the United States, or securities
issued or guaranteed by corporations in which the United States has a direct or
indirect interest which shall have been designated by the Secretary of the Treasury,
pursuant to section 3(a)(12) of the Securities Exchange Act of 1934 [15 U.S.C.A. §
789c)(12)], as exempted securities for the purposes of that Act [15 U.S.C.A. § 78a et
seq.]; or (F) such other persons not within the intent of this paragraph, as the
Commission may designate by rules and regulations or order. 15 U.S.C. § 80b-2(11).
6 15 U.S.C. §§ 80b-1 et seq.
7 15 U.S.C. §§ 80a et seq.
8 15 U.S.C. § 80a-3(c)(1), (7).
9 17 C.F.R. § 275.203(b)(3)-1(d)(1).

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beneficiaries...of [the] Fund.”10 Because hedge fund advisers had for the most part before
the rule been exempt from registration so long as they had “fewer than fifteen clients,”11
hedge fund advisers, referred to collectively as “Goldstein,” brought suit to challenge the
equation under the rule of “client” with “investor.”
Goldstein argued that the SEC misinterpreted section 203 of the Investment Advisers
Act, which exempts from registration “any investment adviser who during the course of
the preceding twelve months has had fewer than fifteen clients....”12 In response to
Goldstein’s argument, the SEC argued that, because the Investment Advisers Act does
not define “client,” the term is therefore ambiguous. The SEC in its argument for
authority to issue the hedge fund rule relied upon the discussion in Chevron, U.S.A., Inc.
v. Natural Resources Defense Council13 that “[i]f...the court determines Congress has not
directly addressed the precise question at issue, the court does not simply impose its own
construction on the statute, [footnote omitted] as would be necessary in the absence of an
administrative interpretation. Rather, if the statute is silent or ambiguous with respect to
the specific issue, the question for the court is whether the agency’s answer is based on
a permissible construction of the statute [footnote omitted].”14 The SEC argued in
Goldstein that, because the Investment Advisers Act does not define “client,” it was a
“permissible construction of the statute” for it to issue the hedge fund rule equating
“client” with “investor.”
The District of Columbia Circuit in a three-judge panel unanimously found that this
argument with respect to the SEC’s hedge fund rule did not mesh with an amendment by
Congress to section 203 and that it was counter to interpretations that the SEC itself had
made over the years about hedge fund advisers and investors.15
According to the court, a 1970 amendment, in which Congress eliminated a separate
exemption from registration under the Investment Advisers Act for advisers who advised
only investment companies and explicitly made the fewer than fifteen clients exemption
unavailable to such advisers,16 would have been unnecessary if the shareholders of
investment companies could be counted as “clients.” The court went on to state that
another section of the Investment Advisers Act suggests that Congress did not intend
“shareholders, limited partners, members, or beneficiaries” of a hedge fund to be
considered clients. In its definition of investment adviser as “any person who, for
compensation, engages in the business of advising others, either directly or through
publications or writings, as to the value of securities or as to the advisability of investing
10 17 C.F.R. § 275.203(b)(3)-2(a).
11 Exempted from registration is “any investment adviser who during the course of the preceding
twelve months has had fewer than fifteen clients and who neither holds himself out generally to
the public as an investment adviser nor acts as an investment adviser to any investment
company....” 15 U.S.C. § 80b-3(b)(3).
12 15 U.S.C. § 80b-3(b)(3).
13 467 U.S. 837, 842-843 (1984).
14 Id. at 843.
15 Goldstein v. Securities and Exchange Commission, 451 F.3d 873 (D.C. Cir. 2006).
16 P.L. 91-547, § 24, 84 Stat. 1413, 1430 (1970).

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in, purchasing, or selling securities,”17 the Investment Advisers Act does not cover a
hedge fund manager whose job is to control the disposition of the pool of money in the
fund and not to give investment advice. If, according to the court, the person controlling
the fund is not an investment adviser to each individual investor, each investor cannot be
a client of that person.
The SEC itself, before issuing the hedge fund rule, had apparently argued that an
investment adviser of an entity like a hedge fund does not directly advise others. In 1997
the SEC stated that a “client of an investment adviser typically is provided with
individualized advice that is based on the client’s financial situation and investment
objectives. In contrast, the investment adviser of an investment company need not
consider the individual needs of the company’s shareholders when making investment
decisions, and thus has no obligation to ensure that each security purchased for the
company’s portfolio is an appropriate investment for each shareholder.”18
The court then discussed a United States Supreme Court case to buttress further its
position. The case, Lowe v. Securities and Exchange Commission,19 held that certain
financial newsletters were not investment advisers. After looking at the legislative history
of the Investment Advisers Act, the Court held that the existence of an advisory
relationship depended primarily upon the character of the advice given. An investment
adviser “provide[s] personalized advice attuned to a client’s concerns.”20 According to
the court in Goldstein, the adviser/manager of a hedge fund is concerned with the fund’s
performance and not with the financial condition of each investor.
The District of Columbia Circuit concluded that “[t]he Commission has, in short, not
adequately explained how the relationship between hedge fund investors and advisers
justifies treating the former as clients of the latter”21 and held that the SEC’s hedge fund
rule was arbitrary and vacated and remanded the rule.
On August 6, 2006, Chairman Cox stated that the SEC would not seek en banc
review of the Court of Appeals decision and would not petition the United States Supreme
Court for a writ of certiorari.
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17 15 U.S.C. § 80b-2(11).
18 Status of Investment Advisory Programs Under the Investment Company Act of 1940, 62 FED.
REG. 15,098, 15,102 (Mar. 31, 1997).
19 472 U.S. 181 (1985).
20 Id. at 208.
21 Goldstein, at 882.

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