This morning lawyers for the Securities and Exchange Commission will march into a federal circuit courthouse in Washington to try to defend yet another SEC regulation that may or may not run afoul of the law. In Goldstein v. SEC, a hedge fund and its adviser argue that the SEC has overstepped its bounds by requiring hedge fund advisers to register in the same way mutual fund advisers currently must. Back in 2004, in the wake of a mutual fund scandal, the SEC concluded that regulating hedge funds would be a logical solution, so the commission pushed through a rule reinterpreting existing laws. This lawsuit challenges the SEC’s authority to make law by redefinition.

Hedge funds are investment vehicles that cater to institutional investors and wealthy individuals. The funds achieve high returns through entrepreneurial strategies that take advantage of opportunities more traditional investors are too slow or risk-averse to exploit. Hedge fund investing isn’t for everyone, but the funds serve an important economic function, as the Federal Reserve chairman, Alan Greenspan, noted when he criticized the SEC’s attempt to bring such funds under the regulator’s aegis.

The funds escaped SEC scrutiny for most of the period after they were first developed in the late 1940s, in part because everyone correctly believed that the ultra rich investors to whom the funds cater would be smart enough to look after their own interests. Several other agencies, including the Treasury Department, would be on the lookout for any fraud.

That all changed recently. The spectacular collapse of one fund, Long-Term Capital Management, in 1998 propelled the funds into the headlines. Then a different hedge fund came up in an investigation of mutual fund market timing for exploiting the willingness of a mutual fund to engage in the practice. The SEC decided to recover from the embarrassment of its lax enforcement of mutual fund laws by also turning its eyes to hedge funds.

As a first step, the commission has required most hedge fund advisers to register, thus creating a list that would be useful should it opt to regulate them down the road. This rule is under the judicial microscope today. Congress has never told the SEC to regulate hedge funds, but it does require that any investment adviser with more than 15 clients register. Since hedge funds are typically set up as limited partnerships that then solicit the services of an adviser, everyone agrees that under the old interpretation of the law a fund would be a single client that would not trigger the registration requirement.

The SEC, however, has promulgated a new interpretation that looks to the number of partners in the hedge fund to determine whether the adviser must register. It is as if someone tried to argue that a corporate lawyer’s client was not the corporation but its thousands of shareholders as individuals, a lawyer for the petitioner in this case, Gregory Kellor, told us yesterday. What the SEC has done, Mr. Kellor says, is to “infinitely manipulate the term ‘client’ to achieve a regulatory end.”

This case is worth watching for several reasons. First, it is yet another threat to the credibility of an agency that has already been slapped down once by the courts for its slipshod attempt to regulate mutual funds; that case is due back in court next month, although the two cases hinge on different legal issues and the outcomes will not affect each other.

More importantly, the outcome could limit the scope of regulators to interpret congressional mandates creatively. The petitioners argue that although Congress has expanded the reach of current laws to cover new types of investments over the years, it has never expressed its intention to regulate hedge funds. Mr. Kellor notes that the issue is not whether or not hedge funds should be regulated, but who should pass the rules. Our vote is with duly elected representatives – as perilous as that can be – instead of pointy headed investocrats.

The SEC has been reeling for the better part of four years as Enron and WorldCom collapsed in heaps of fraud and especially in the wake of a mutual fund scandal that blossomed right under the agency’s nose. The instinct of the former chairman, William Donaldson, was to respond by expanding the agency’s regulator reach despite the fact that it already had too much on its plate. The new chairman, Christopher Cox, recently told the Wall Street Journal that he would stay the course on some of his predecessor’s policies, including the hedge fund rule. If we’re lucky, the court will use this case to spur him into reconsidering that approach.