Goldstein v. Securities & Exchange Commission

United States Court of Appeals
FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued December 9, 2005 Decided June 23, 2006

No. 04-1434

PHILLIP GOLDSTEIN, ET AL.,
PETITIONERS

v.

SECURITIES AND EXCHANGE COMMISSION,
RESPONDENT

On Petition for Review of an Order of the
Securities and Exchange Commission

Philip D. Bartz argued the cause for petitioners. With
him on the briefs were Cameron Cohick and Gregory E. Keller.

Jacob H. Stillman, Solicitor, Securities & Exchange
Commission, argued the cause for respondent. With him on the
brief were Giovanni P. Prezioso, General Counsel, Randall W.
Quinn, Assistant General Counsel, and Dominick V. Freda,
Senior Counsel.

Before: RANDOLPH and GRIFFITH, Circuit Judges, and
EDWARDS, Senior Circuit Judge.

Opinion for the Court filed by Circuit Judge RANDOLPH.
 2

RANDOLPH, Circuit Judge: This is a petition for review
of the Securities and Exchange Commission’s regulation of
“hedge funds” under the Investment Advisers Act of 1940, 15
U.S.C. § 80b-1 et seq. See Registration Under the Advisers Act
of Certain Hedge Fund Advisers, 69 Fed. Reg. 72,054 (Dec. 10,
2004) (codified at 17 C.F.R. pts. 275, 279) (“Hedge Fund
Rule”). Previously exempt because they had “fewer than fifteen
clients,” 15 U.S.C. § 80b-3(b)(3), most advisers to hedge funds
must now register with the Commission if the funds they advise
have fifteen or more “shareholders, limited partners, members,
or beneficiaries.” 17 C.F.R. § 275.203(b)(3)-2(a). Petitioners
Philip Goldstein, an investment advisory firm Goldstein co-
owns (Kimball & Winthrop), and Opportunity Partners L.P., a
hedge fund in which Kimball & Winthrop is the general partner
and investment adviser (collectively “Goldstein”) challenge the
regulation’s equation of “client” with “investor.”

I.

“Hedge funds” are notoriously difficult to define. The
term appears nowhere in the federal securities laws, and even
industry participants do not agree upon a single definition. See,
e.g., SEC Roundtable on Hedge Funds (May 13, 2003)
(comments of David A. Vaughan), available at
http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.htm
(citing fourteen different definitions found in government and
industry publications). The term is commonly used as a catch-
all for “any pooled investment vehicle that is privately
organized, administered by professional investment managers,
and not widely available to the public.” PRESIDENT’S WORKING
GROUP ON FINANCIAL MARKETS, HEDGE FUNDS, LEVERAGE,
AND THE LESSONS OF LONG-TERM CAPITAL MANAGEMENT 1
(1999) (“Working Group Report”); see also IMPLICATIONS OF
THE GROWTH OF HEDGE FUNDS: STAFF REPORT TO THE UNITED
STATES SECURITIES AND EXCHANGE COMMISSION 3 (2003)
 3

(“Staff Report”) (defining “hedge fund” as “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”).

Hedge funds may be defined more precisely by reference
to what they are not. The Investment Company Act of 1940, 15
U.S.C. § 80a-1 et seq., directs the Commission to regulate any
issuer of securities that “is or holds itself out as being engaged
primarily . . . in the business of investing, reinvesting, or trading
in securities.” Id. § 80a-3(a)(1)(A). Although this definition
nominally describes hedge funds, most are exempt from the
Investment Company Act’s coverage because they have one
hundred or fewer beneficial owners and do not offer their
securities to the public, id. § 80a-3(c)(1), or because their
investors are all “qualified” high net-worth individuals or
institutions, id. § 80a-3(c)(7).1 Investment vehicles that remain
private and available only to highly sophisticated investors have
historically been understood not to present the same dangers to
public markets as more widely available investment companies,
like mutual funds.2 See Staff Report, supra, at 11-12, 13.

Exemption from regulation under the Investment
Company Act allows hedge funds to engage in very different

1
Hedge funds are usually differentiated from other exempted
investment vehicles like private equity or venture capital funds by
their investing and governance behavior. See Hedge Fund Rule, 69
Fed. Reg. at 72,073 nn.224-225.
2
Mutual funds make up the vast majority of registered
investment companies, with about $6.4 trillion under management in
December 2002. See Staff Report, supra, at 1 n.4. Although precise
data are unavailable, some estimates of the size of the hedge fund
industry range from about $600 billion, id., to close to $900 billion,
Hedge Fund Rule, 69 Fed. Reg. at 72,055 & n.20.
 4

investing behavior than their mutual fund counterparts. While
mutual funds, for example, must register with the Commission
and disclose their investment positions and financial condition,
id. §§ 80a-8, 80a-29, hedge funds typically remain secretive
about their positions and strategies, even to their own investors.
See Staff Report, supra, at 46-47. The Investment Company Act
places significant restrictions on the types of transactions
registered investment companies may undertake. Such
companies are, for example, foreclosed from trading on margin
or engaging in short sales, 15 U.S.C. § 80a-12(a)(1), (3), and
must secure shareholder approval to take on significant debt or
invest in certain types of assets, such as real estate or
commodities, id. § 80a-13(a)(2). These transactions are all core
elements of most hedge funds’ trading strategies. See Staff
Report, supra, at 33-43. “Hedging” transactions, from which
the term “hedge fund” developed, see Willa E. Gibson, Is Hedge
Fund Regulation Necessary?, 73 TEMP. L. REV. 681, 684-85 &
n.18 (2000), involve taking both long and short positions on debt
and equity securities to reduce risk. This is still the most
frequently used hedge fund strategy, see Staff Report, supra, at
35, though there are many others. Hedge funds trade in all sorts
of assets, from traditional stocks, bonds, and currencies to more
exotic financial derivatives and even non-financial assets. See,
e.g., Kate Kelly, Creative Financing: Defying the Odds, Hedge
Funds Bet Billions on Movies, WALL ST. J., Apr. 29, 2006, at
A1. Hedge funds often use leverage to increase their returns.

Another distinctive feature of hedge funds is their
management structure. Unlike mutual funds, which must
comply with detailed requirements for independent boards of
directors, 15 U.S.C. § 80a-10, and whose shareholders must
explicitly approve of certain actions, id. § 80a-13, domestic
hedge funds are usually structured as limited partnerships to
achieve maximum separation of ownership and management. In
the typical arrangement, the general partner manages the fund
 5

(or several funds) for a fixed fee and a percentage of the gross
profits from the fund. The limited partners are passive investors
and generally take no part in management activities. See Staff
Report, supra, at 9-10, 61.

Hedge fund advisers also had been exempt from
regulation under the Investment Advisers Act of 1940, 15 U.S.C.
§ 80b-1 et seq. (“Advisers Act”), a companion statute to the
Investment Company Act, and the statute which primarily
concerns us in this case. Enacted by Congress to “substitute a
philosophy of full disclosure for the philosophy of caveat
emptor” in the investment advisory profession, SEC v. Capital
Gains Research Bureau, Inc., 375 U.S. 180, 186 (1963), the
Advisers Act is mainly a registration and anti-fraud statute.
Non-exempt “investment advisers” must register with the
Commission, 15 U.S.C. § 80b-3, and all advisers are prohibited
from engaging in fraudulent or deceptive practices, id. § 80b-6.
By keeping a census of advisers, the Commission can better
respond to, initiate, and take remedial action on complaints
against fraudulent advisers. See id. § 80b-4 (authorizing the
Commission to examine registered advisers’ records).

Hedge fund general partners meet the definition of
“investment adviser” in the Advisers Act. See 15 U.S.C. § 80b-
2(11) (defining “investment adviser” as one 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”); Abrahamson v. Fleschner, 568 F.2d 862,
869-71 (2d Cir. 1977) (holding that hedge fund general partners
are “investment advisers”), overruled in part on other grounds
by Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11
(1979). But they usually satisfy the “private adviser exemption”
from registration in § 203(b)(3) of the Act, 15 U.S.C. § 80b-
3(b)(3). That section exempts “any investment adviser who
 6

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 registered under [the
Investment Company Act].” Id. As applied to limited
partnerships and other entities, the Commission had interpreted
this provision to refer to the partnership or entity itself as the
adviser’s “client.” See 17 C.F.R. § 275.203(b)(3)-1. Even the
largest hedge fund managers usually ran fewer than fifteen
hedge funds and were therefore exempt.

Although the Commission has a history of interest in
hedge funds, see Staff Report, supra, at app.A, the current push
for regulation had its origins in the failure of Long-Term Capital
Management, a Greenwich, Connecticut-based fund that had
more than $125 billion in assets under management at its peak.
In late 1998, the fund nearly collapsed. Almost all of the
country’s major financial institutions were put at risk due to
their credit exposure to Long-Term, and the president of the
Federal Reserve Bank of New York personally intervened to
engineer a bailout of the fund in order to avoid a national
financial crisis. See generally ROGER LOWENSTEIN, WHEN
GENIUS FAILED: THE RISE AND FALL OF LONG-TERM CAPITAL
MANAGEMENT (2000).

A joint working group of the major federal financial
regulators produced a report recommending regulatory changes
to the regime governing hedge funds, and the Commission’s
staff followed with its own report about the state of hedge fund
regulation. Drawing on the conclusions in the Staff Report, the
Commission – over the dissent of two of its members – issued
the rule under review in December 2004 after notice and
comment. The Commission cited three recent shifts in the
hedge fund industry to justify the need for increased regulation.
First, despite the failure of Long-Term Capital Management,
 7

hedge fund assets grew by 260 percent from 1999 to 2004.
Hedge Fund Rule, 69 Fed. Reg. at 72,055. Second, the
Commission noticed a trend toward “retailization” of hedge
funds that increased the exposure of ordinary investors to such
funds. This retailization was driven by hedge funds loosening
their investment requirements, the birth of “funds of hedge
funds” that offered shares to the public, and increased
investment in hedge funds by pension funds, universities,
endowments, foundations and other charitable organizations.
See id. at 72,057-58. Third, the Commission was concerned
about an increase in the number of fraud actions brought against
hedge funds. See id. at 72,056-57. Concluding that its “current
regulatory program for hedge fund advisers [was] inadequate,”
id. at 72,059, the Commission moved to require hedge fund
advisers to register under the Advisers Act so that it could gather
“basic information about hedge fund advisers and the hedge
fund industry,” “oversee hedge fund advisers,” and “deter or
detect fraud by unregistered hedge fund advisers,” id.

The Hedge Fund Rule first defines a “private fund” as an
investment company that (a) is exempt from registration under
the Investment Company Act by virtue of having fewer than one
hundred investors or only qualified investors, see 15 U.S.C.
§ 80a-3(c)(1), (7); (b) permits its investors to redeem their
interests within two years of investing; and (c) markets itself on
the basis of the “skills, ability or expertise of the investment
adviser.” 17 C.F.R. § 275.203(b)(3)-1(d)(1). For these private
funds, the rule then specifies that “[f]or purposes of section
203(b)(3) of the [Advisers] Act (15 U.S.C. § 80b-3(b)(3)), you
must count as clients the shareholders, limited partners,
members, or beneficiaries . . . of [the] fund.” Id.
§ 275.203(b)(3)-2(a). The rule had the effect of requiring most
hedge fund advisers to register by February 1, 2006.3
3
Application of the rule also triggers certain regulations that
apply only to registered advisers. Most importantly, registered
 8

II.

The dissenting Commissioners disputed the factual
predicates for the new rule and its wisdom. Goldstein makes
some of the same points but the major thrust of his complaint is
that the Commission’s action misinterpreted § 203(b)(3) of the
Advisers Act, a charge the Commission dissenters also leveled.
This provision exempts from registration “any investment
adviser who during the course of the preceding twelve months
has had fewer than fifteen clients.” 15 U.S.C. § 80b-3(b)(3)
(emphasis added). The Act does not define “client.” Relying on
Chevron U.S.A. Inc. v. Natural Resources Defense Council, 467
U.S. 837, 842-43 (1984), the Commission believes this renders
the statute “ambiguous as to a method for counting clients.” Br.
for Resp. 21. There is no such rule of law. The lack of a
statutory definition of a word does not necessarily render the
meaning of a word ambiguous, just as the presence of a
definition does not necessarily make the meaning clear. A
definition only pushes the problem back to the meaning of the
defining terms. See Alarm Indus. Commc’ns Comm. v. FCC,
131 F.3d 1066, 1068-70 (D.C. Cir. 1997); Doris Day Animal
League v. Veneman, 315 F. 3d 297, 298-99 (D.C. Cir. 2003).

If Congress employs a term susceptible of several
meanings, as many terms are, it scarcely follows that Congress
has authorized an agency to choose any one of those meanings.
As always, the “words of the statute should be read in context,
the statute’s place in the overall statutory scheme should be

advisers must open their records to the Commission upon request, 15
U.S.C. § 80b-4, and cannot charge their clients a performance fee
unless such clients have a net worth of at least $1.5 million or at least
$750,000 under management with the adviser. Id. § 80b-5; 17 C.F.R.
§ 275.205-3; see also Hedge Fund Rule, 69 Fed. Reg. at 72,064 (citing
“salutary effect” of this rule to limit “retailization”).
 9

considered, and the problem Congress sought to solve should be
taken into account” to determine whether Congress has
foreclosed the agency’s interpretation. PDK Labs. Inc. v. DEA,
362 F.3d 786, 796 (D.C. Cir. 2004) (“PDK I”) (internal
quotation marks omitted).

“Client” may mean different things depending on
context. The client of a laundry occupies a very different
position than the client of a lawyer. Even for professional
representation, the specific indicia of a client relationship –
contracts, fees, duties, and the like – vary with the profession
and with the particulars of the situation. An attorney-client
relationship, for example, can be formed without any signs of
formal “employment.” See RESTATEMENT (THIRD) OF THE LAW
GOVERNING LAWYERS § 14 & cmt. c (2000) (“The client need
not necessarily pay or agree to pay the lawyer; and paying a
lawyer does not by itself create a client-lawyer relationship
. . ..”). Matters may be very different for the client of, say, an
architectural firm.

The Commission believes that an amendment to
§ 203(b)(3) suggests the possibility that an investor in a hedge
fund could be counted as a client of the fund’s adviser. In 1980,
Congress added to § 203(b)(3) the following language: “For
purposes of determining the number of clients of an investment
adviser under this paragraph, no shareholder, partner, or
beneficial owner of a business development company . . . shall
be deemed to be a client of such investment adviser unless such
person is a client of such investment adviser separate and apart
from his status as a shareholder, partner, or beneficial owner.”4

4
A “business development company” – commonly known as
a venture capital company – is defined in 15 U.S.C. §80a-2(a)(48) as
a “closed-end company which” operates for the purpose of making
investments in certain securities and making “available significant
managerial assistance with respect to the issuers of such securities.”
 10

Act of Oct. 21, 1980, Pub. L. No. 96-477, § 202, 94 Stat. 2275,
2290 (1980). This language was inserted against a backdrop of
uncertainty created by the Second Circuit’s decision in
Abrahamson v. Fleschner. The Abrahamson court held that
hedge fund general partners were “investment advisers” under
the Advisers Act, 568 F.2d at 869-71. In its original opinion, the
court specified that the general partners were advisers “to the
limited partners.” See Robert C. Hacker & Ronald D. Rotunda,
SEC Registration of Private Investment Partnerships After
Abrahamson v. Fleschner, 78 COLUM. L. REV. 1471, 1484 n.72
(1978). The final published opinion omits those four words, see
Abrahamson, 568 F.2d at 871 n.16, suggesting that the court
expressly declined to resolve any ambiguity in the term “client.”
If – as we generally assume – Congress was aware of this
judicial confusion, see, e.g., Beethoven.com LLC v. Librarian of
Congress, 394 F.3d 939, 945-46 (D.C. Cir. 2005), the 1980
amendment could be seen as Congress’s acknowledgment that
“client” is ambiguous in the context of § 203(b)(3). There are
statements in the legislative history that suggest as much. See,
e.g., H.R. REP. NO. 96-1341, at 62 (1980) (“[W]ith respect to
persons or firms which do not advise business development
companies, the . . . amendment . . . is not intended to suggest
that each shareholder, partner, or beneficial owner of a company
advised by such person or firm should or should not be regarded
as a client . . ..” (emphasis added)). Although “the views of a
subsequent Congress form a hazardous basis for inferring the
intent of an earlier one,” PDK I, 362 F.3d at 794-95 (quoting
United States v. Price, 361 U.S. 304, 313 (1960)), the 1980
amendment might be seen as introducing another definitional
possibility into the statute. See PDK Labs. Inc. v. DEA, 438
F.3d 1184, 1192-93 (D.C. Cir. 2006).5

5
There is irony in the Commission’s reliance on this
amendment to demonstrate the ambiguity of “client.” As we discuss
below, the Commission in 1985 established a “safe harbor,” allowing
advisers to count certain limited partnerships as single clients
 11

On the other hand, a 1970 amendment to § 203 appears
to reflect Congress’s understanding at the time that investment
company entities, not their shareholders, were the advisers’
clients. In the amendment, Congress eliminated a separate
exemption from registration for advisers who advised only
investment companies and explicitly made the fewer-than-
fifteen-clients exemption unavailable to such advisers.
Investment Company Amendments Act of 1970, Pub. L. No. 91-
547, § 24, 84 Stat. 1413, 1430 (1970). This latter prohibition
would have been unnecessary if the shareholders of investment
companies could be counted as “clients.”

Another section of the Advisers Act strongly suggests
that Congress did not intend “shareholders, limited partners,
members, or beneficiaries” of a hedge fund to be counted as
“clients.” Although the statute does not define “client,” it does
define “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 in, purchasing, or
selling securities.” 15 U.S.C. § 80b-2(11) (emphasis added).
An investor in a private fund may benefit from the adviser’s
advice (or he may suffer from it) but he does not receive the
advice directly. He invests a portion of his assets in the fund.
The fund manager – the adviser – controls the disposition of the
pool of capital in the fund. The adviser does not tell the investor
how to spend his money; the investor made that decision when

specifically in order to provide “greater certainty” about the meaning
of the term. Definition of “Client” of Investment Adviser for Certain
Purposes Relating to Limited Partnerships, 50 Fed. Reg. 8740, 8740
(Mar. 5, 1985) (“Safe Harbor Proposed Rule”). In so doing, the
Commission declared that it “should [not] distinguish such a limited
partnership from a business development partnership,” and that it was
therefore “incorporat[ing] the approach of the 1980 Amendments into
a limited partnership rule.” Id. at 8741.
 12

he invested in the fund. Having bought into the fund, the
investor fades into the background; his role is completely
passive. If the person or entity controlling the fund is not an
“investment adviser” to each individual investor, then a fortiori
each investor cannot be a “client” of that person or entity. These
are just two sides of the same coin.

This had been the Commission’s view until it issued the
new rule. As recently as 1997, it explained 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.” Status of Investment Advisory Programs
Under the Investment Company Act of 1940, 62 Fed. Reg.
15,098, 15,102 (Mar. 31, 1997). The Commission said much the
same in 1985 when it promulgated a rule with respect to
investment companies set up as limited partnerships rather than
as corporations. The “client” for purposes of the fifteen-client
rule of § 203(b)(3) is the limited partnership not the individual
partners. See 17 C.F.R. § 275.203(b)(3)-1(a)(2). As the
Commission wrote in proposing the rule, when “an adviser to an
investment pool manages the assets of the pool on the basis of
the investment objectives of the participants as a group, it
appears appropriate to view the pool – rather than each
participant – as a client of the adviser.” Safe Harbor Proposed
Rule, 50 Fed. Reg. at 8741.

The Supreme Court embraced a similar conception of the
adviser-client relationship when it held in Lowe v. SEC, 472
U.S. 181 (1985), that publishers of certain financial newsletters
were not “investment advisers.” Id. at 211; see 15 U.S.C. § 80b-
 13

2(11)(D). After an extensive discussion of the legislative history
of the Advisers Act, the Court held that existence of an advisory
relationship depended largely on the character of the advice
rendered. Persons engaged in the investment advisory
profession “provide personalized advice attuned to a client’s
concerns.” Lowe, 472 U.S. at 208. “[F]iduciary, person-to-
person relationships” were “characteristic” of the “investment
adviser-client relationship[].” Id. at 210. The Court thought it
“significant” that the Advisers Act “repeatedly” referred to
“clients,” which signified to the Court “the kind of fiduciary
relationship the Act was designed to regulate.” Id. at 208 n.54,
201 n.45. This type of direct relationship exists between the
adviser and the fund, but not between the adviser and the
investors in the fund. The adviser is concerned with the fund’s
performance, not with each investor’s financial condition.

The Commission nevertheless is right to point out that
the Lowe Court was not rendering an interpretation of the word
“client.” See Hedge Fund Rule, 69 Fed. Reg. at 72,069 n.174.
Because it was construing an exception to the definition of
“investment adviser,” we do not read too much into the Court’s
understanding of the meaning of “client.” See Nat’l Cable &
Telecomms. Ass’n v. Brand X Internet Servs., 125 S. Ct. 2688,
2700 (2005).

As we have noted before, “[i]t may be that . . . the strict
dichotomy between clarity and ambiguity is artificial, that what
we have is a continuum, a probability of meaning.” PDK I, 362
F.3d at 797. Here, even if the Advisers Act does not foreclose
the Commission’s interpretation, the interpretation falls outside
the bounds of reasonableness. “An agency construction of a
statute cannot survive judicial review if a contested regulation
reflects an action that exceeds the agency’s authority. It does
not matter whether the unlawful action arises because the
disputed regulation defies the plain language of a statute or
 14

because the agency’s construction is utterly unreasonable and
thus impermissible.” Aid Ass’n for Lutherans v. United States
Postal Serv., 321 F.3d 1166, 1174 (D.C. Cir. 2003); see also id.
at 1177-78; Am. Library Ass’n v. FCC, 406 F.3d 689, 699 (D.C.
Cir. 2005).

“The ‘reasonableness’ of an agency’s construction
depends,” in part, “on the construction’s ‘fit’ with the statutory
language, as well as its conformity to statutory purposes.”
Abbott Labs. v. Young, 920 F.2d 984, 988 (D.C. Cir. 1990). As
described above, the Commission’s interpretation of the word
“client” comes close to violating the plain language of the
statute. At best it is counterintuitive to characterize the investors
in a hedge fund as the “clients” of the adviser. See Am. Bar
Ass’n v. FTC, 430 F.3d 457, 471 (D.C. Cir. 2005). The adviser
owes fiduciary duties only to the fund, not to the fund’s
investors. Section 206 of the Advisers Act, 15 U.S.C. § 80b-6,
makes it unlawful for any investment adviser – registered or not
– “to engage in any transaction, practice, or course of business
which operates as a fraud or deceit upon any client or
prospective client.” Id. § 80b-6(2). In SEC v. Capital Gains
Research Bureau, Inc., 375 U.S. 180 (1963), the Supreme Court
held that this provision created a fiduciary duty of loyalty
between an adviser and his client. See id. at 191-92; id. at 201
(“The statute, in recognition of the adviser’s fiduciary
relationship to his clients, requires that his advice be
disinterested.”); see also Hedge Fund Rule, 69 Fed. Reg. at
72,059 & n.57. In that case, the duty of loyalty required an
adviser to disclose self-interested transactions to his clients. The
Commission recognizes more generally that the duty of loyalty
“requires advisers to manage their clients’ portfolios in the best
interest of clients,” and imposes obligations to “fully disclose
any material conflicts the adviser has with its clients, to seek
best execution for client transactions, and to have a reasonable
basis for client recommendations.” Id. at 72,054.
 15

If the investors are owed a fiduciary duty and the entity
is also owed a fiduciary duty, then the adviser will inevitably
face conflicts of interest. Consider an investment adviser to a
hedge fund that is about to go bankrupt. His advice to the fund
will likely include any and all measures to remain solvent. His
advice to an investor in the fund, however, would likely be to
sell. For the same reason, we do not ordinarily deem the
shareholders in a corporation the “clients” of the corporation’s
lawyers or accountants. See RESTATEMENT, supra, § 96 cmt.b
(“By representing the organization, a lawyer does not thereby
also form a client-lawyer relationship with all or any individuals
. . . who have an ownership or other beneficial interest in it, such
as its shareholders.”). While the shareholders may benefit from
the professionals’ counsel indirectly, their individual interests
easily can be drawn into conflict with the interests of the entity.
It simply cannot be the case that investment advisers are the
servants of two masters in this way.6
The Commission’s response to this argument is telling.
It argues that the Hedge Fund Rule amends only the method for
counting clients under § 203(b)(3), and that it does not “alter the
duties or obligations owed by an investment adviser to its
6
In the Hedge Fund Rule, 69 Fed. Reg. at 72,070 n.187, and
again at oral argument, Tr. of Oral Argument 16-17, the Commission
argued that the fiduciary duties created by the anti-fraud provisions of
the Advisers Act did in fact extend to the relationship between an
adviser and the limited partners of a hedge fund. The Commission
relies on Abrahamson v. Fleschner, in which the Second Circuit found
that limited partners of a hedge fund stated a cause of action against
the general partner for fraud under § 206. 568 F.2d at 877-78. The
anti-fraud provision also applies, however, to persons other than
clients. See 15 U.S.C. § 80b-6(4). In the absence of further
specification, Abrahamson can only be read for the proposition that
investors in a hedge fund may sustain an action for fraud against the
fund’s adviser. Cf. United States v. Elliott, 62 F.3d 1304, 1311-13
(11th Cir. 1995) (holding that adviser-client relationship was not
required for criminal fraud conviction under § 206).
 16

clients.” 69 Fed. Reg. at 72,070. We ordinarily presume that
the same words used in different parts of a statute have the same
meaning. See Sullivan v. Stroop, 496 U.S. 478, 484 (1990). The
Commission cannot explain why “client” should mean one thing
when determining to whom fiduciary duties are owed, 15 U.S.C.
§ 80b-6(1)-(3), and something else entirely when determining
whether an investment adviser must register under the Act, id.
§ 80b-3(b)(3). Cf. Mobil Oil Corp. v. EPA, 871 F.2d 149, 153
(D.C. Cir. 1989).

The Commission also argues that the organizational form
of most hedge funds is merely “legal artifice,” Br. for Resp. 41,
to shield advisers who want to advise more than fifteen clients
and remain exempt from registration. See Hedge Fund Rule, 69
Fed. Reg. at 72,068. But as the discussion above shows, form
matters in this area of the law because it dictates to whom
fiduciary duties are owed.

The Hedge Fund Rule might be more understandable if,
over the years, the advisory relationship between hedge fund
advisers and investors had changed. The Commission cited, as
justification for its rule, a rise in the amount of hedge fund
assets, indications that more pension funds and other institutions
were investing in hedge funds, and an increase in fraud actions
involving hedge funds. All of this may be true, although the
dissenting Commissioners doubted it. But without any evidence
that the role of fund advisers with respect to investors had
undergone a transformation, there is a disconnect between the
factors the Commission cited and the rule it promulgated. That
the Commission wanted a hook on which to hang more
comprehensive regulation of hedge funds may be
understandable. But the Commission may not accomplish its
objective by a manipulation of meaning.
 17

The 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. See Shays v.
FEC, 414 F.3d 76, 96-97 (D.C. Cir. 2005) (explaining that
agency interpretation is not “reasonable” if it is “arbitrary and
capricious”). The Commission points to its finding that a hedge
fund adviser sometimes “may not treat all of its hedge fund
investors the same.” Hedge Fund Rule, 69 Fed. Reg. at 72,069-
70 (citing different lock-up periods, greater access to
information, lower fees, and “side pocket” arrangements). From
this the Commission concludes that each account of a hedge
fund investor “may bear many of the characteristics of separate
investment accounts, which, of course, must be counted as
separate clients.” Id. at 72,070. But the Commission’s
conclusion does not follow from its premise. It may be that
different classes of investors have different rights or privileges
with respect to their investments.7 This reveals little, however,
about the relationship between the investor and the adviser.
Even if it did, the Commission has not justified treating all
investors in hedge funds as clients for the purpose of the rule.
If there are certain characteristics present in some investor-
adviser relationships that mark a “client” relationship, then the
Commission should have identified those characteristics and
tailored its rule accordingly.

By painting with such a broad brush, the Commission
has failed adequately to justify departing from its own prior
interpretation of § 203(b)(3). See Mich. Pub. Power Agency v.
FERC, 405 F.3d 8, 12 (D.C. Cir. 2005) (citing Greater Boston
Television Corp. v. FCC, 444 F.2d 841, 852 (D.C. Cir. 1970)).

7
This is in fact a common arrangement throughout the law of
business organizations. Many corporations, for example, have
different classes of common or preferred stock. Although different
classes of stockholders have different rights or privileges, the basic
fiduciary duties of managers to shareholders remain uniform.
 18

As we have discussed, in 1985 the Commission adopted a “safe
harbor” for general partners of limited partnerships, enabling
them to count the partnership as a single “client” for the
purposes of § 203 so long as they provided advice to a
“collective investment vehicle” based on the investment
objectives of the limited partners as a group. Safe Harbor
Proposed Rule, 50 Fed. Reg. at 8741. This “safe harbor”
remains part of the Commission’s rules and has since been
expanded to include corporations, limited liability companies,
and business trusts (hedge funds sometimes take these less
common forms, see Staff Report, supra, at 9-10 & n.27). The
Hedge Fund Rule therefore appears to carve out an exception
from this safe harbor solely for investment entities that have
fewer than one hundred-one but more than fourteen investors.
Compare 17 C.F.R. § 275.203(b)(3)-1, with id. § 275.203(b)(3)-
2. As discussed above, the Commission does not justify this
exception by reference to any change in the nature of investment
adviser-client relationships since the safe harbor was adopted.
Absent such a justification, its choice appears completely
arbitrary. See Northpoint Technology, Ltd. v.FCC, 412 F.3d
145, 156 (D.C. Cir. 2005) (“A statutory interpretation . . . that
results from an unexplained departure from prior [agency]
policy and practice is not a reasonable one.”).

Nor is this choice any more rational when viewed in light
of the policy goals underlying the Advisers Act. See Abbott
Labs., 920 F.2d at 988. The Commission recites Congress’s
findings in § 201 that investment advisory activities
“substantially . . . affect . . . national securities exchanges . . .
and the national economy,” 15 U.S.C. § 80b-1(3), and concludes
that “[i]n enacting [section 203(b)(3)], Congress exempted from
the registration requirements a category of advisers whose
activities were not sufficiently large or national in scope.”
Hedge Fund Rule, 69 Fed. Reg. at 72,067. The Commission
reasons that because hedge funds are now national in scope,
 19

treating the entity as a single client for the purpose of the
exemption would frustrate Congress’s policy. If Congress did
intend the exemption to prevent regulation only of small-scale
operations – a policy goal that is clear from neither the statute’s
text nor its legislative history – the Commission’s rule bears no
rational relationship to achieving that goal. The number of
investors in a hedge fund – the “clients” according to the
Commission’s rule – reveals nothing about the scale or scope of
the fund’s activities. It is the volume of assets under
management or the extent of indebtedness of a hedge fund or
other such financial metrics that determines a fund’s importance
to national markets. One might say that if Congress meant to
exclude regulation of small operations, it chose a very odd way
of accomplishing its objective – by excluding investment
companies with one hundred or fewer investors and investment
advisers having fewer than fifteen clients. But the Hedge Fund
Rule only exacerbates whatever problems one might perceive in
Congress’s method for determining who to regulate. The
Commission’s rule creates a situation in which funds with one
hundred or fewer investors are exempt from the more
demanding Investment Company Act, but those with fifteen or
more investors trigger registration under the Advisers Act. This
is an arbitrary rule.

***

The petition for review is granted, and the Hedge Fund
Rule is vacated and remanded.

So ordered.