A U.S. Securities and Exchange Commission rule tightening oversight of hedge-fund advisers is “arbitrary” and can’t stand, according to a ruling Friday by the U.S. Court of Appeals for the D.C. Circuit.

The rule, which took effect in February, requires most hedge fund advisers to register with the SEC and undergo routine inspections.

The appeal court today rejected the SEC’s approach, vacated the rule and sent it back to the agency for reconsideration.

The appeal focused on the SEC’s definition of a hedge fund “client”.

The SEC hedge fund rule overturned the agency’s former approach of viewing each hedge fund as a single client and instead counted each hedge fund investor as a client, requiring registration for hedge fund advisors with 15 or more clients.

The court said the SEC failed to justify its new approach.

Following delivery of the decision, SEC chairman Christopher Cox said, “The SEC takes seriously its responsibility to make rules in accordance with our governing laws. 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 added that he has instructed the SEC’s professional staff to promptly evaluate the court’s decision, and to provide to the commission a set of alternatives for consideration.

“The SEC will use the court’s decision as a spur to improvement in both our rulemaking process and the effectiveness of our programs to protect investors, maintain fair and orderly markets, and promote capital formation,” he said. “And we will continue to work with the other members of the President’s Working Group on Financial Markets, including the Treasury, the CFTC, and the Federal Reserve, to evaluate both the systemic market risks and retail investment issues associated with the growing presence of hedge funds in the world’s capital markets.”