June 23 (Bloomberg) -- A federal appeals court struck down a controversial Securities and Exchange Commission rule that for the first time subjected the $1.1 trillion hedge-fund industry to stricter regulation and random inspections.

Saying the rule relied on an improper definition of ``client,'' a panel of the U.S. Court of Appeals in Washington rejected as arbitrary the SEC requirement that hedge-fund advisers with 15 or more clients register with the agency. Almost 1,000 previously unregistered hedge fund advisers submitted their paperwork to the regulator by the Feb. 1 deadline.

``It's a total loss for the SEC,'' said Barry Barbash, a former director of the SEC's investment management division, now a partner at Willkie Farr & Gallagher in Washington. ``The SEC was hammered by the court on all counts. I have not seen a decision in recent times in which the SEC had its position negated so completely.''

U.S. Circuit Judge A. Raymond Randolph, writing for a unanimous three-judge panel, said the SEC's effort to regulate hedge funds is hindered by the fact that the term doesn't appear in U.S. securities laws, and ``even industry participants do not agree upon a single definition.'' The SEC can appeal the court's decision to the full U.S. Court of Appeals in Washington or the U.S. Supreme Court.

SEC Chairman Christopher Cox said in a statement that he has asked his staff to provide the commission with a set of ``alternatives'' in reaction to the ruling.

`Arbitrary'

``The court's finding, that despite the commission's investor protection objective its rule is arbitrary and in violation of law, requires that going forward we reevaluate the agency's approach to hedge fund activity,'' Cox said.

In proposing the rule, the SEC said mandatory registration would stem fraud at hedge funds, whose assets have doubled since 2001. The rule was approved in October 2004 after hedge funds including Michael Lauer's Lancer Group collapsed. Under the regulation, advisers face criminal background checks and are required to document the assets they claim to manage.

SEC Commissioners Paul Atkins and Cynthia Glassman, who opposed the rule, applauded the court's decision.

``It's too bad that the SEC needs a court to tell us when we've gone too far,'' Atkins said.

Plaintiff Phillip Goldstein, manager of Pleasantville, New York-based Opportunity Partners LP, argued that the SEC lacked the authority to regulate hedge funds and failed to take into account compliance costs as high as $500,000. He said Congress would have to grant the agency the authority to extend its regulatory reach to hedge funds.

`Fudge It'

``They tried to fudge it,'' Goldstein said of the SEC rule in an interview. Today's decision ``was absolutely correct.''

The hedge fund rule was to be based upon the Investment Advisers Act of 1940. It applied to fund advisers with 15 or more clients and said each investor in a fund should be counted as a client. Advisers who had less than 15 clients in the preceding 12 months were exempt.

In one of his central arguments, Goldstein said a hedge fund should count as a single client of a fund adviser. The court said, under the law, clients receive investment advice directly from the adviser.

``Having bought into the fund, the investor fades into the background; his role is completely passive,'' the court said.

Deeming the individual investor a client would ``inevitably'' present conflicts of interest to the adviser, Randolph wrote in the ruling. ``Consider an investment adviser to a hedge fund that is about to go bankrupt,'' he wrote. ``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.''

Defining Client

The act didn't define what a client was, the court noted.

``Client may mean different things depending on context,'' Randolph wrote, adding ``the client of a laundry occupies a very different position than the client of a lawyer.''

Goldstein, whose business has been renamed Bulldog Investors and moved to Saddle Brook, New Jersey, said ``the SEC made a fundamentally dishonest determination'' in deciding to count each individual fund investor as a client. ``There's got to be a direct relationship,'' he added. ``A client has to know he's a client.''

Boston attorney Richard Goldman, co-chair of the hedge fund practice group at Bingham McCutchen and former general counsel to hedge fund Kobrick Capital, said prior to the new rule the SEC consistently defined funds, not people, as clients.

`Deep End'

Stephen Bokat, senior vice president and general counsel to the U.S. Chamber of Commerce, criticized the SEC for attempting through a rule what only Congress can do through legislation.

``The commission leaped off into the deep end without any justification for doing so,'' Bokat said.

David Becker, a former general counsel for the SEC, now a partner at Cleary Gottlieb Steen & Hamilton in Washington, said the ruling doesn't prevent the regulator from formulating a new rule that could withstand judicial scrutiny.

``I think it's not absolutely foreclosed but it'll be hard,'' Becker said. In the meantime, he added, ``the SEC will go back to having less readily available sources of information.''

Earlier today, Pequot Capital Management Inc., a $7 billion hedge fund run by Arthur Samberg, said it was probed by securities regulators for possible insider trading.

No Free Pass

Pequot, once the world's largest hedge-fund manager, didn't say which regulators were looking at its trading and denied any wrongdoing. The New York Times reported earlier today that the SEC is investigating whether the firm used insider tips to profit on trades.

``The SEC is somewhat under assault by the courts,'' said Steven Howard, a hedge fund attorney in the New York office of Thacher Proffitt & Wood LLP. ``This is really their second significant setback, the first being the independent chairman rule for mutual funds.''

Howard said that the agency will ``ultimately prevail'' and promulgate a hedge fund registration rule that will be upheld.

Cleary Gottlieb lawyer Becker said the court decision is only a temporary setback for the agency.

``I don't think any hedge fund manager should read this opinion as saying they've gotten a free pass from the D.C. Circuit,'' he said.

The case is Gardner v. SEC, 04-1434, in the U.S. Circuit Court of Appeals for the District of Columbia Circuit.

To contact the reporter on this story: Andrew Harris in Chicago aharris16@bloomberg.net.

Last Updated: June 23, 2006 17:51 EDT