If only the battle were over for hedge funds. The latest ruling from a federal appeals court in Washington striking down the Securities and Exchange Commission’s attempt to regulate the funds gives the funds, and the investing public that benefits from their existence, a reprieve. The court ruled, in effect, that any expanded regulation will have to come from the Capitol and not the SEC’s offices across the street. There is a growing threat that Congress might just do that, especially in the wake of a separate SEC investigation of Pequot Capital Management, first reported in the New York Times on the morning the court’s ruling came down.

The judges considered an SEC rule adopted in late 2004 that required all hedge fund managers to register with the commission by February 1 of this year. The Investment Advisers Act of 1940 requires financial advisers to register if they have more than 15 clients. Because hedge funds are typically set up as limited partnerships that then hire a manager, the managers legally have only one client, the partnership. To get around this rule, the SEC proposed to redefine the word “client” by counting, for the purposes of that one line in the statute only, each investor in a hedge fund as a separate client.

The riders of the United States Circuit for the District of Columbia were too smart to fall for it. Although one suspects, reading the ruling, the judges were sympathetic to the SEC’s desire to regulate hedge funds, the court was not willing to let the SEC invent its own law. “That the Commission wanted a hook on which to hang more comprehensive regulation of hedge funds may be understandable,” Judge A. Raymond Randolph, an appointee of President George H.W. Bush, wrote for the court. “But the Commissions may not accomplish its objective by a manipulation of meaning.”

Hedge funds remain at the mercy of Capitol Hill. Lawmakers may have resisted the temptation to regulate the funds at least three times before, but the last time was 26 years ago, when they inserted language in the 1940 law effectively exempting hedge funds. Since then, the funds have grown exponentially in number and in assets. By one count, there are now 8,500 hedge funds managing a total of $1 trillion, compared to 610 funds managing $39 billion in 1990. That may be small compared to the total size of the markets, but hedge funds now account for about a third of all trades. The funds were catapulted into the public consciousness by the collapse in 1998 of Long-Term Capital Management and have remained an object of public and regulatory fascination ever since.

The danger now is that the failure of the SEC’s effort to control the funds through regulation coupled with the growing public awareness and suspicion of the business will lead to a clamor for legislation. The funds, catering to wealthy individuals and institutions, generally specialize in developing trading strategies that work by finding new ways to iron out inefficiencies in the market, often by using strategies like short selling. It’s risky for the hedge fund investors and managers, which is why the pay-offs are so big. But it benefits the rest of us because in essence they only make money if they find ways to make sure the rest of us end up paying the right price for assets. Ironically, the very keys to their success – their secrecy and high returns – could spur Congress into killing the geese that are laying so many golden eggs.

As the court was preparing to hear this case in December, we wrote that “the outcome could limit the scope of regulators to interpret congressional mandates creatively.” The court has done just that. We also noted that one lawyer for the plaintiff suggested that the question in this case was not whether to regulate hedge funds but who should do the regulating. We cast our vote then with “elected representatives – as perilous as that may be – instead of pointy headed investocrats.” Well, the question is back to whether to regulate hedge funds. The answer is the entire economy will be hurt, for ordinary investors as well as partners in these funds, if Congress moves against the hedge funds.