Hedge Funds Fear New SEC Regulations
Managers Can Run, But Not Hide From Best Practices, Culture of Compliance
June 30, 2008
NEW YORK - The freewheeling days for hedge funds may be numbered.
Depending on who gets elected to the White House in November, the next Securities and Exchange Commission may push to impose additional regulations on hedge funds that, many critics say, could strangle managers' ability to generate exceptional returns.
Ironically, hedge fund experts say the best way for the industry to prepare for the new regulations may also be the best way to prevent the new regulations from happening.
"The SEC has it out for hedge funds," said Jeffrey Cobb, a partner in the Stamford, Conn., law offices of Edwards Angell Palmer & Dodge LLP, speaking recently during a two-day "Hedge Funds 101 & 102" conference at the Helmsley hotel sponsored by Financial Research Associates.
For years, the SEC has been mulling changes to Regulation D of the Securities Act of 1933 that would increase the minimum hedge fund buy-in from $1 million to $2.5 million, Cobb said.
"With a little more provocation, the SEC could enact this rule," he said. "It could seriously impair the ability of small funds to gain capital."
Hedge funds are already regulated in a variety of ways, including restrictions on advertising and offers to the public, restrictions on investment advisor registration exemptions, anti-fraud provisions, anti-money laundering regulations and customer identification requirements, among others.
Generally, hedge funds managers are banned from advertising or holding themselves out to the public as investment advisors. Private placement exemptions require hedge funds to file notices with the SEC and state securities regulators and to limit their offerings to sophisticated investors.
Because hedge funds involve risky, complex, illiquid or opaque investments and strategies, regulators think these private pools of capital should only be available to sophisticated investors who understand the risks-and can swallow losses.
Hedge fund managers with more than 14 clients are required to register as investment advisors with the SEC under the Investment Advisors Act of 1940. To be exempt from regulations under the Investment Company Act of 1940, hedge funds must restrict their clientele to "qualified purchasers" with investments of at least $5 million, or have no more than 100 investors.
"The majority of hedge funds do not register as advisors under the advisors act," Cobb said. "It is highly onerous and expensive to be registered. I am seeing more investment companies behaving like hedge funds, using short selling and derivatives."
Some loopholes remain, such as the prominent use of hedge funds by institutional investors and pension plans, held by investors that would not qualify independently. The theory is that the plan administrator is more sophisticated than the average investor.
President's Working Group
In April, the President's Working Group on Financial Markets (PWG) released a pair of reports on industry best practices that cover hedge fund disclosure, asset valuation, risk management, business operations, compliance and conflicts of interest. These best practices have seen support from hedge fund organizations including the Managed Funds Association and the Alternative Investment Management Association.
"I very strongly urge the industry to adopt these best practices," said Richard Marshall, a partner with the New York law firm Ropes & Gray. "Everyone is telling you to look at these. It's not even questionable that ignoring this is highly risky. Next year, this stuff may be mandated. What does not following an industry custom mean? Negligence."
Marshall said there should be some flexibility for small advisors and managers with limited resources.
"When this question was raised to the SEC, they said tough,'" Marshall noted. "We are not going to give a break to the little guy.' Essentially, the SEC said, Maybe there shouldn't be small advisors.' I think smaller firms should be allowed to make practical decisions."
The hedge fund industry has grown so fast and so large, it is critical to establish a compliance and business practices framework, say consultants to the President's Working Group.
"Over the past three decades, the hedge fund industry has evolved from a niche business consisting primarily of single-strategy, single-geography firms serving high-net-worth individuals, into an important participant in global markets, consisting primarily of global multi-strategy firms serving a wide variety of institutional investors," writes the Asset Managers Committee's report to the PWG. "The industry has grown to 8,000 firms and $2 trillion in assets under management and has become an increasingly important participant in the financial markets. With this growth comes increased responsibility."
The purpose of the best practices report is to establish a comprehensive compliance framework to serve as guidance to a hedge fund manager, with respect to ethical, regulatory compliance and conflict of interest situations.
The framework should include a written code of ethics, a written compliance manual, the establishment of a committee to review conflicts, regular training of personnel in compliance issues and the creation of a chief compliance officer to monitor and maintain the program.
Senior leaders of the firm should foster this culture of compliance throughout their organization, the report said, setting an example through high ethical behavior to employees and encouraging personnel to communicate their concerns to senior management or the chief compliance officer.
A corresponding report by the Investors Committee to the PWG spells out specific best practices recommendations.
"Addressing the dissimilar needs of such a broad range of participants is challenging," said the report. "No single set of best practices applies uniformly to every hedge fund investment, and the burden of applying the practices set forth in this document falls upon the institutions and individuals who are considering or engaged in making such investments."
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