After the shocking revelation that Bernard Madoff’s hedge fund was really a huge Ponzi scheme, the call by legislators and media for hedge fund reform has been deafening. Although a few years ago the Securities and Exchange Commission attempted to do just that, by adopting a rule requiring many hedge fund advisers to register, the agency’s attempt was quashed by the courts. Now the Obama administration is trying to accomplish this same goal through the legislative process in a more sympathetic environment.

On Oct. 27, the House Financial Services Committee passed legislation requiring advisers of so-called “private funds” (which includes hedge funds and private equity funds) to register with the SEC. The bill, entitled the Private Fund Investment Advisers Registration Act of 2009 (the “Registration Act”), was submitted by the Treasury Department and introduced by Congressman Paul Kanjorski (D-Pa.)

If it is passed in its present form, the Registration Act will require most unregistered investment advisers managing private funds in excess of $150 million to register with the SEC. (The latest Senate bill, introduced by Christopher Dodd, D.-Conn., would require hedge fund firms with assets of more than $100 million to register.)

Hedge funds are privately organized investment vehicles that pool and administer assets. They are usually structured as limited partnerships whose general partner manages the fund, while the investors remain passive and take no part in the fund’s management and strategies. Historically, hedge funds had not been widely available to the ordinary investing public.

What the Registration Act does is eliminate an exemption that hedge funds and other private funds have used to avoid registration under the Investment Advisers Act of 1940 (the “Advisers Act”). Although hedge funds technically meet the SEC’s definition of an investment adviser, many have been able to avoid registration by claiming an exemption for advisers with fewer than 15 clients.

Because partnerships count as a single client, hedge funds can structure themselves in such a way that they officially serve less than 15 clients, despite the fact that they have many investors and exercise control over vast sums of investor monies.

By 2004, as a result of the incredible growth and proliferation of hedge funds, the increased exposure of ordinary investors to hedge funds, and the growing number of fraud actions brought against hedge funds, the SEC recognized that regulation was required. Therefore, it adopted a regulation known as the “Hedge Fund Rule” which eliminated the exemption to registration for private funds.

Shortly after it was issued, however, the Hedge Fund Rule was struck down by the courts. In Goldstein v. SEC, a case brought by a hedge fund manager challenging the regulation, the U.S. Court of Appeals for the D.C. Circuit concluded that the Hedge Fund Rule was an invalid interpretation of the Advisers Act. The problem, according to the court, was that the SEC defined the term “client” more broadly than Congress had intended.

The Registration Act would indirectly overrule the Goldstein decision. It would give the SEC authority to define the term “client” more expansively and reinstate the definition from its ill-fated Hedge Fund Rule.

Moreover, whether or not the SEC chooses to redefine the term “client,” the Registration Act would explicitly eliminate the exemption that hedge funds have relied upon. As a result, many advisers of private investment pools who had formerly been able to claim exempt status would now be required to register with the SEC.

Another major feature of the bill involves recordkeeping. The Registration Act would require the funds to publicly disclose information to the SEC such as the fund’s assets, use of leverage, trading practices, and other information considered necessary to protect the investing public.

These reporting requirements have some worried. Smaller hedge and private equity funds could find these new reporting requirements to be overly burdensome and costly. The draft legislation would give the SEC discretion as to the frequency and detail of the information required to be disclosed, so it is difficult to accurately estimate how burdensome this requirement will be in practice. What is certain is that the new reporting requirements will require private funds to incur both time and monetary expenses that they did not have to before.

Of course, given the economic climate and the recent frauds, Congress is less sympathetic to the private fund industry than it was before doesn’t seem to mind burdening private funds with the costs associated with the new reporting requirements. In fact, in addition to the Treasury Department’s bill, there are three other bills floating around Congress which would accomplish similar goals, two in the Senate and one in the House. It seems likely, therefore, that new oversight of private funds is on its way to becoming a reality.

Now that the bill is out of committee, the Registration Act seems likely to pass this year -- accomplishing through the legislative process what the SEC was unable to do when it attempted to implement the Hedge Fund Rule -- namely, greater oversight of hedge funds and other private funds. If President Obama signs the Registration Act into law this year, managers of hedge funds and private equity funds will have to thank Bernard Madoff for making them a popular target for reform.

Gregory Hindy, a partner in the Financial Services Litigation Practice Group at McCarter & English of Newark, regularly represent hedge funds and their principals in a wide array of matters. Daniel W. Beebe, a law clerk at the firm and law student at Seton Hall University School of Law, assisted with the research and drafting of this article.