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Hedge Fund Registration Narrowly Passes

It's official. In a highly anticipated move, the Securities and Exchange Commission voted 3-2 in favor of requiring hedge fund managers to register as investment advisors with the agency last week.

The mandate, which will take effect on Feb. 1, 2006, will enable the Commission to collect more information on the rapidly growing investment product and give the SEC staff the ability to conduct examinations of the funds. The new requirement will force hedge funds with more than $25 million in assets to implement several new recordkeeping procedures, which opponents to the rule say will be costly and are unnecessary.

However, the timeframe in which funds will have to come into compliance was a surprise, according to Joseph Sack, executive vice president of The Bond Market Association. "The SEC, in what appears to be a concession to the industry, wants to give enough time to the industry to be ready for the proposed regulation, wants to give enough time to the staff of the Commission itself to get its act in order, and is going to focus on risk analysis in terms of being ready to provide this regulation."

The new rules will also require funds to put in compliance controls as well as provide potential investors with more information. Currently, information about hedge funds is sketchy. Industry assets in the increasingly popular product are thought to be between $870 billion and $1 trillion. Furthermore, several at the Commission have expressed in recent months their concerns about the role hedge funds play in the capital markets and the little that is currently known about them.

"We know too little about this dramatically growing industry," Commissioner Harvey Goldschmid said at the meeting. "What little we do know, at least to me, has alarm bells ringing."

Chairman William Donaldson said in an open meeting of the SEC last week that with the product increasing in size and instances of fraud on the rise, it is difficult to deter or discover such activity before it happens due to the Commission's current lack of oversight and inspection authority. He said that hedge funds are playing an increased role in the market scandals of the last few years and that the SEC needs more power to not only punish fraud, but to help it prevent future meltdowns at some hedge funds.

"The growth in hedge funds has, unfortunately, been accompanied by troubling growth in the number of our hedge fund enforcement cases," said Paul Roye, the SEC's director of the division of investment management. Roye said that in the last five years, the SEC has brought 51 cases involving hedge fund fraud that resulted in losses of more than $1.1 billion. "These cases are more than 10% of the cases against investment advisors over the same period."

The highly publicized near-collapse of hedge fund Long Term Capital Management five years ago and the recent mutual fund trading scandals involving hedge funds such as Eddie Stern's Canary Capital Partners, have dramatically increased the profile of hedge funds and reinforced the negative stereotype that they are run by rogue managers and use shady investment tactics.

"We are seeing hedge funds used to defraud other market participants," Roye added, noting that the Commission has counted that nearly 400 hedge funds and 87 hedge fund advisors were involved in the mutual fund market-timing and late-trading scandals that have plagued that industry for the last 14 months. "They were most of the late traders and market timers," he said. "They picked the pockets of every-day mutual fund investors."

For its part, the Investment Company Institute came out in strong support of the move, saying that "in light of the record" of hedge funds, the initiative seems "altogether prudent."

Roye said the new regulations are necessary to help the agency gather census information on the industry. He also said that the Commission's ability to conduct examinations will serve as a deterrent to fraud. In addition to adding compliance controls, Roye said the move will help the Commission to keep fraudsters and other unfit individuals out of the hedge fund business. Other benefits of the rule include the limiting of the retailization of hedge funds and the closing of a loophole in the Advisers Act that was being used by hedge funds because it allowed an exception for any advisor providing advice to a small number of clients.