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Hedge Funds Suffer High Anxiety as Registration Nears

As the deadline for the Security and Exchange Commission's new hedge fund registration rule quickly approaches, many firms are scrambling to determine whether it might be better to take advantage of its loopholes and skirt the costly disclosure document altogether.

"People are waiting to the last minute," said Janaya Moscony, president of SEC Compliance Consultants in Philadelphia, which is helping hedge funds register. "It doesn't look like I'll be getting much sleep in the coming weeks."

The deadline to comply with the rule is Feb. 1, 2006, but with all the preliminary paperwork that requires the regulator's approval before the registration process can begin, hedge funds actually have just a couple of weeks remaining to be ready in time.

Like the SEC's controversial independent chairman rule for mutual funds, the registration rule has been a flashpoint between regulators and hedge funds since it was proposed in the wake of the market-timing and late-trading scandal. The SEC's beef with hedge funds, however, goes back much further in time. The regulator began paying closer attention to them in the early 1990s, and since 1999 it has imposed at least 51 enforcement actions against hedge funds that allegedly defrauded investors of $1.1 billion.

But by requiring that hedge funds register with them like any other investment advisor, the SEC has significantly expanded its police work in the sector. Registration means the SEC can conduct examinations and, as it says in final rule release, "identify compliance problems at an early stage and provide a deterrent to unlawful conduct." Registration would also force hedge funds to adopt compliance procedures and, the SEC said, keep convicted felons from running funds. The regulator is also hoping that registration will prevent the "retailization" of hedge funds by giving it the authority to enforce rules that say hedge fund investors must have a minimum net worth of $1.5 million.

Moscony thinks registration is a positive step, although it's no panacea.

"It would tighten up some of their processes, which is always a good thing," she said. "But registration itself isn't going to cure fraud."

Even the SEC is beginning to question the rule. In a recent speech deriding what he called an "undisciplined approach" to rulemaking at the SEC, Commissioner Paul Atkins said, "We are discovering that the benefits of registration might fall short of our expectations, since [the registration form] will not yield the type of information that would be needed for meaningful oversight." He also doesn't think the SEC has enough manpower to adequately police hedge funds.

As further testimony to Atkins' frustration, Moscony added that the operations of larger hedge funds are already under intense scrutiny by institutional investors, so registration would do little to improve compliance controls and procedures that are probably on par with mutual funds. Larger hedge funds also tend to have well-known managers at the helm, so whether they might have criminal records isn't usually an issue. Larger hedge funds also tend to be operating near their intended capacity, she added, so they're not afraid of losing new investors if they institute a two-year lock-up.

But for a hedge fund advisor that might be managing, say, $50 million, the costs of registration are way too high, Crow said. "It varies widely, and much of it depends on how you trade," he said. "Registration and compliance implementation costs in the first year could be $35,000 to $50,000, and for a larger firm it could be more than $1 million annually."

The SEC's cost/benefit analysis showed that registration would cost the average hedge fund about $20,000.

Hedge funds can also avoid registration by keeping their assets under management below $25 million, but that's not a realistic option, Crow said.

"It would be very difficult to run a business with less than $25 million," he said. It's been rumored that the SEC might raise that threshold, but "even if it were $50 million, it would be the same story," Crow said.

Adding further anxiety to hedge fund advisors is the prospect that powerful SEC examiners more accustomed to the straight-laced mutual fund world might soon be sniffing around their offices.

"These examiners see a little of everything," said Moscony, a former SEC accountant. "There is little bit of a learning curve at every firm they visit because every fund is structured differently, so I don't see it as a huge issue. They should be focused on what might appear on a request list from the SEC, what the potential risks are and the controls that they should have in place.

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