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Who Is Watching the Watchdog?

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Who Is Watching the Watchdog?

Berlau Op Ed in The Wall Street Journal

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Today in the D.C. Circuit Court of Appeals, outspoken hedge fund manager Phillip Goldstein will have his chance to challenge the SEC's hedge fund registration rule. The rule's fine points will be debated, and the SEC will likely argue that the rule was narrowly tailored to put only minimal burden on hedge funds. But outside the courtroom, some are discovering that the SEC's hedge fund scheme is actually so broad it could likely ensnare two other investing segments crucial to dynamic growth: venture capital and private equity. Last year, for example, the National Venture Capital Association (NVCA) wrote to the SEC that the hedge fund regulations "create a risk of future burdensome regulation on venture capital."

Mr. Goldstein's case, arguing that the SEC has exceeded Congress's authority, is probably the last shot at defeating the rule before it goes into effect in February. It was pushed through by SEC Chairman William Donaldson and the commission's two Democratic commissioners over the objections of the two other Republican commissioners. But Mr. Donaldson's successor, the free-market former House member Chris Cox, surprised many when he told The Wall Street Journal that he also planned to implement the rule "exactly as adopted."

Yet, as adopted, the rule regulates more than meets the eye. Although the SEC has stressed its intention to require registration of hedge funds, the term most used in the rule is "private funds." In a brief filed in the Goldstein case, the SEC indicates that this term could cover more than just hedge funds. It describes "private funds" as "a category of pooled investment vehicles that encompasses most hedge funds." It also defines them as "entities that engage in securities transactions privately with each of their investors" and "that are marketed on the basis of the skill and expertise of the investment adviser."

These features do describe hedge funds, but they also apply to most venture capital and private equity funds. Business lore portrays venture capitalists as the white knights of the marketplace, whereas hedge funds are often portrayed unfairly as black hats. But the organizational structure of the two entities is actually very similar. As NVCA President Mark Hessen noted in comments to the SEC in 2004, venture capital and hedge funds both fit "into the same [regulatory] exclusions and generally [are] organized as limited partnerships."

This means the "hedge fund" rule and its possible extensions, already criticized by Alan Greenspan, could have an effect even more dramatic than anticipated. After all, venture capital has historically provided seed money to innovative companies from Intel to Google, and private equity is keeping the economy moving by restructuring slowing industries and purchasing public companies hobbled by Sarbanes-Oxley.

The SEC regulation distinguishes between hedge funds and other entities in just one way. It exempts "private funds" that make investors leave their funds in for more than a two-year period. This is "the only provision of the . . . rule that fulfills the Commission's stated intention to exclude venture capital and private equity," according to the NVCA, since these funds usually invest for the longer term. But since investors put in money at various times during the partnership's duration, some venture capital funds may still fall under the SEC's definition, says Brian Borders, outside counsel to NVCA.

More important, though, is that this rule could be what former SEC Chairman Donaldson called a "first step." Largely in response to the rule, many hedge funds have increased their "lock-up" period to three years instead of two, and probably not as many will be registering as anticipated. But if the SEC decides to extend the rule to cover hedge funds with three-, four-, and five-year redemption periods to force more to register, even more venture capital and private equity will be caught in the agency's net.

Registration, for venture capital as for hedge funds, would not be a modest imposition. It contains paperwork requirements, random inspections and even some limits on performance fees. And then there's the danger the SEC could go even further by performing "risk-based inspections" that indirectly regulate investment strategy.

This danger is one that Congress has repeatedly tried to avoid -- and why Mr. Goldstein's case is so important. The SEC played some elaborate games to claim legal authority for its rules. In the original Investment Company Act of 1940, Congress exempted companies with fewer than 100 investors from having to register with the SEC. In the 1990s, Congress extended this to entities with an unlimited number of "sophisticated" investors, meaning institutional investment managers or individuals with high income or net worth. The SEC can go after private equity, venture capital and hedge funds if fraud occurs. But there has been has been a widespread consensus that these investors don't need the additional protection of the registration process, and that it is essential for the capital markets that these entities be able to move quickly.

But the SEC brought these funds under the process anyway by regulating managers as "investment advisers" and broadening the definition of "clients." It reversed a 20-year agency policy saying that the client of a private fund manager was the fund, not the investors in the fund to whom no personal advice was offered. Thus, it magically found that the manager now suddenly had more than the 15 clients required for registration as an investment adviser.

In its brief, the SEC argues that Congress's "ambiguity" allows it to "count each investor as a client" if the vehicle is a "private fund." Mr. Goldstein's attorneys counter that the SEC's interpretation of the law "is not founded on any reasonable determination that an adviser-client relationship exists." What the Court decides will impact venture capital and private equity, and whatever happens, Congress should resolve this "ambiguity" with even more airtight language reining in the SEC.

In a sense, by exposing the SEC's slippery justifications for the rule, Mr. Goldstein is watching the watchdog. No matter what happens, investors owe a debt of gratitude to the hedge fund manager who, ironically, brought some transparency to the actions of the SEC.