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SEC to Heighten Insider-Trading Scrutiny of Hedge Funds: Anti-Fraud, Accredited Investors Also High on List

NEW YORK-Hedge funds can't run or hide from regulators, and the accredited investor, anti-fraud and insider trading rules will be three of the key issues the Securities and Exchange Commission will focus on this year, Bruce Karpati, assistant regional director at the SEC told attendees at the National Investment Company Service Association's "Alternative Investments Conference" here last week.

The new proposed wealth standard would require investors to have minimum investable assets of $2.5 million, an increase from the $1 million current minimum, and would exclude real estate or closely held company stock. In addition, the SEC would increase the dollar amount every five years to adjust for inflation.

"It does help in making hedge funds more sophisticated type of investments," Karpati said, adding that he expects the proposal to get approved. Hedge funds are not required to check assets of clients, but it is a good-faith measure that they have the minimum monetary requirement, panelists noted.

Current hedge fund investors will be grandfathered in, noted Michael Tannenbaum, a partner with Tannenbaum Helpern Syracuse & Hirschtritt of New York.

The rule is not going to affect the industry that much, as the bulk of the money flowing into hedge funds is from large institutions, said Joel Press, managing director at Morgan Stanley Prime Brokerage, who was the keynote speaker at the conference.

However, smaller, start-up hedge funds will be affected by the new accreditation requirements, as they are already having trouble attracting assets, he said. And as a result, large hedge funds will continue to grow bigger, he noted.

Regulators will also examine insider trading at firms more closely this year. The SEC is going to look into making sure that traders do not have dual responsibilities of working on the trading desk and overseeing compliance rules, Karpati said.

Large companies such as Morgan Stanley and Goldman Sachs spend a lot of money on compliance and make sure there is no personal trading going on inside the firm, Press said. Although hedge funds do try to track insider trading to some degree, they should be more vigilant, as it is very easy to make an honest mistake, Press said.

If all the insider-trading cases against hedge funds were examined, and people looked at how many cases have been proven, they would see it's actually very little, Press countered.

Out of the insider-trading cases against hedge funds, only one or two hedge funds went out of business, and only a handful had to pay a fine, Press said. "Why do hedge funds get criticized for paying a fine, when the rest of the world pays fines all the time?" he questioned. "Hedge funds are the most pristine and least fraudulent firms in the financial industry," he said.

Contrary to popular belief, "this is a highly regulated industry, not a lightly regulated one," Press said. Virtually everything hedge funds do is in some way linked to regulations, he noted. He gave an example that prime brokerages are regulated, and when hedge funds do business with them, they are therefore regulated, as well.

Press warned against having side letters, stating "it is bad business." A side letter is separate from the offering memorandum that hedge funds give clients. It is an agreement between the advisor and select investors granting terms that are different than the standard offering document. It also states the fees the investor will pay for the services rendered by the fund manager. "All investors need to have the same rights and one investor can't receive more information than another," Press said.

"Side letters are really a detriment to other investors," Karpati agreed.

With respect to regulation and fund directors, more and more directors of hedge funds do not want to take on the responsibility and serve on boards, panelists noted.

Also, directors are increasingly requesting some type of insurance policy, and that is becoming expensive, Tannenbaum said. The insurance policy would not cover all losses, but would cover some of a director's defense cost, he said.

More and more directors are analyzing holdings in hedge fund portfolios, and are more experienced and qualified then before, said Craig Fulton, an associate at international offshore law firm Conyers Dill & Pearman of Bermuda.

As it stands now, directors who are uncomfortable with the nature of the fund they serve, consider resigning. That thinking is starting to shift, and now people are saying maybe they should consider firing the investment manager, instead of having the director leave, said Fulton.

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