Updated from 12:36 p.m. EDT

In a big blow to securities regulators, a federal appeals court has struck down a rule requiring large hedge funds to register with the

Securities and Exchange Commission

.

The appeals court ordered the SEC to reexamine the registration rule, saying that hedge funds are "notoriously difficult to define,'' according to a copy of the 19-page ruling.

The hedge fund registration rule, which went into effect in February, was a key reform instituted by former SEC Chairman William Donaldson. The regulation was enacted over the protest of the hedge fund industry and two dissenting members of the five-member commission.

Opponents had argued the rule would give regulators unfettered powers to audit the books of hedge funds.

The rule has forced more than 1,000 hedge funds with more than 15 investors, or "clients,'' to register with the SEC. But the court said the rule, which also exempts some hedge funds with less than $30 million in assets, was too vague and "arbitrary.''

The court specifically attacked the SEC's definition of the word "client,'' saying regulators did not provide a detailed enough explanation of what the word means in the context of a hedge fund.

"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,'' say U.S. Circuit Judge Raymond Randolph, writing for the three-judge panel of the Court of Appeals for the District of Columbia.

The court said the SEC offered no basis for its decision to make small hedge funds exempt from the rule. The court also noted that federal law suggests "Congress did not intend "shareholders, limited partners, members or beneficiaries'' of a hedge fund to be counted as "clients.'''

Legal experts say the court seems to be suggesting that it will be difficult for the SEC to formulate a rule that exempts certain hedge funds from registering.

In fact, the appellate court seems to a have a philosophical problem with the notion of requiring hedge funds to register. The opinion begins with the observation that hedge funds are not covered by the Investment Company Act, a federal law that governs the mutual fund industry.

"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,'' writes Judge Randolph, appointed to the bench in 1990 by the first President Bush.

SEC Commissioner Christopher Cox, in a prepared statement issued after the ruling, said nothing about the possibily of the SEC appealing the ruling. Instead, Cox says the decision "requires that going forward we reevaluate the agency's approach to hedge fund activity.''

The SEC has estimated that about 90% of large hedge funds have complied with the new rule. But a number of well-known hedge funds, SAC Capital, for instance, have avoided registration by taking advantages of a number of loopholes in the rule that render them exempt from the registration requirement.

The hedge fund advisers that have registered with the SEC manage about $2.4 trillion in assets. By comparison, the estimated 8,000 mutual fund advisers registered with the SEC manager $30 trillion in assets.

The ruling from the court was quick to draw criticism. Denise Valentine, senior analyst with Celent, a Boston-based financial research and consulting firm, says the decision is a "step back for the industry.''

The court ruling is the second major legal defeat for the SEC in its post-Enron reform era. Last year, a federal court ordered the SEC to reconsider a rule that requires mutual fund companies to hire independent directors. That rules was enacted in the wake of the mutual fund trading scandal

The legal challenge to the hedge fund rule was brought by Philip Goldstein, a manager of the Kimball & Winthrop investment advisory firm. Kimball & Winthrop is the adviser to the Opportunity Partners hedge fund.

It's too soon to say what will happen to the registration rule. The SEC presumably can appeal the ruling to the Supreme Court, or ask the appellate court to have another panel of judges review the ruling.

Cox is not believed to be a huge fan of the hedge fund registration rule. It's not clear if he would support any attempt to make the rule acceptable to the court by revising it.

"The political pressures have changed,'' says Ron Geffner, a partner with Sadis & Goldberg, who advises hedge funds. "It's not clear that with a new commissioner, the SEC will be back for another bite of the apple.''

But the court's ruling doesn't automatically overturn the SEC's power to conduct audits of hedge funds. Lawyers say until a hedge fund moves to deregister, the fund must comply with any request by the SEC to review its operations.

"If you're registered, you're registered. Period,'' says Robert Leonard, head of the New York hedge fund legal practice for Bingham McCutchen. "I'm advising my clients to wait some period of time to see how it's going to shake out.''