From the September 01, 2006 issue of Futures Magazine • Subscribe!

Hedge fund regulation: what now?

The hedge fund industry fought tooth and nail against the Securities and Exchange Commission’s (SEC) plan to register hedge fund advisors. In the end they lost the fight, and since then the Managed Funds Association (MFA) has aggressively moved ahead into the new world of registration to ensure that new regulations do not become onerous. It seemed to arrive at a level of comfort and acceptance of the rule.

Now with the court ruling in the Goldstein case throwing out the Hedge Fund Registration rule and the SEC deciding not to appeal it, the industry is at a strange crossroads. Remember that despite energetic opposition to the SEC’s rule, when the issue was under consideration, many in the industry feared a much more intrusive rule and there was some sense of relief that the SEC didn’t go further by requiring that hedge funds themselves had to register. Now instead of disappearing the issue is back on the table and there is no guarantee that what comes next will be more amenable to the industry.

Judging from the response to the ruling, all those additional regulatory possibilities are back on the table, meaning this particular ruling may not be the victory it initially appeared to be. Rep. Barney Frank, D-Mass., has sponsored a bill in the House of Representatives that would grant the SEC authority to institute the rule in the first place, and the Senate Banking Committee recently held hearings on hedge fund regulation in lieu of the Goldstein decision. And the Treasury department has hearings planned.

At the time of his appointment, industry sources speculated that new SEC Chairman Christopher Cox would not fight to uphold a rule that former SEC Chairman William Donaldson pushed through on a split vote. But Cox, in testimony before the Banking committee, did not sound prepared to let the registration issue just slip away.

“The concerns about hedge funds that the SEC enunciated when we adopted our hedge fund registration rule in December 2004 remain the same today,” Cox stated. “The Commission stated that its then current program of hedge fund regulation was inadequate. With the rejection of the hedge fund rule by the Court of Appeals, I believe that is once again the case.”

If that did not make clear that he intended to follow through with additional measures, he added, “We must move quickly to address the gaping hole that the Goldstein decision left. Some improvements will be possible through administrative action. Others, however, may well require legislation.”

David Matteson, partner and head of the hedge fund practice group at Gardner Carton & Douglas LLP, says the result of the Goldstein decision opens up a wider range of possibilities for hedge fund regulation and moves the process into Congress. “In terms of what is going to happen, welcome to sausage making. The reality is, depending on how the process goes, the end result can be much more onerous. The results could be better or it could be worse.”

However, Lisa McGreevy, VP and chief operating officer of the MFA, sees Congress playing a back up role. “This is not a congressional issue at this point. It is very much a regulatory issue. That is the message that came through loud and clear at the Senate Banking Committee hearing.”

McGreevy also says that concern in Congress that U.S. markets remain competitive may favor a lighter touch. “Now with Treasury Secretary [Henry] Paulson at the helm, they are going to work very hard at making sure that we keep our capital markets attractive for investment. How you regulate market players is going to be a big piece of that.”

Industry professionals have called for cooperation between the SEC and other members of the Presidents Working Group (PWG), which includes the chairman of the Commodity Futures Trading Commission (CFTC), the Federal Reserve Board chairman and the secretary of the Treasury. When the hedge funds rule was enacted it was clear that other members of the PWG opposed it.

Then Fed Chairman Alan Greenspan warned of a “slippery slope” towards more restrictive regulation if the SEC passed its registration rule. In testimony before the Banking committee U.S. Treasury Undersecretary Randal Quarles pointed out that after its extensive examination of hedge funds following the collapse of Long-Term Capital Management, the PWG made a series of recommendations to enhance risk management. Quarles noted that one recommendation not made was for direct regulation of hedge funds, though that could change if leverage was not effectively constrained. Quarles concluded, “To date, the PWG has not observed evidence that indirect methods of constraining leverage are not working effectively.”

Jack Gaine, president of the MFA, was heartened that Cox stated that he would work with the PWG, which had been much more sympathetic with the MFA’s point of view.

“I see nothing coming out of there that would suggest [the SEC is] on a war path. Treasury and the Fed and the CFTC all should weigh in and I think they will with Chairman Cox.”

The sides appear to be the same, though the names have changed, and given Cox’s comments some form of added oversight seems inevitable. One change Cox suggested is increasing the accredited investor threshold. Investors are considered to be accredited — and eligible to invest in certain hedge funds that earn $200,000 annually or have a net worth of $1 million. This level has been the same for more than 20 years. This would not be controversial. The MFA had recommended the SEC increase the threshold three years ago when it was contemplating the new hedge funds rules.

“I don’t know what is going to come next,” says Paul Roth, partner in law firm Shulte Roth & Zabel LLP, “I am hoping the commission is going to do what Chairman Cox said in his testimony —increase the accredited investor test.”

Roth expects the SEC to work with the other members of the PWG in fashioning whatever regulation comes next. Given the statements of members of the PWG, the SEC would need to change their approach from the last round of rule making. Roth also would like to see the rules regarding what information hedge funds are allowed to share with the public and press be loosened.

The boiler plate definition of hedge fund in the general business media includes terms like “loosely regulated” and “highly secretive.” What often is left out is that secrecy is mandated under the exemptions hedge funds receive from the Investment Advisors Act. In other words, if hedge funds wish to remain “loosely regulated” they have to keep their mouths’ shut, they can’t even hold themselves out to the public as investment advisors. These rules seem overly restrictive given that these hedge funds still are restricted to certain sophisticated investors.

Gaine says he expects some relief on the restrictions hedge fund managers face regarding what they can say and holding themselves out as investment advisors. “What we would like is some certainty and consistency in that whole area and that is something we might get. “People would get to know more about hedge funds and the regulators would get to know more about hedge funds and we wouldn’t have to pick up every single article every single day [and read] about the secretive shadowy hedge fund industry.”

Bad rule good result

The MFA, in 2000, published its Sound Practices for Hedge Fund Managers, in response to a recommendation by the PWG following its investigation of the Long-Term Capital Management failure. The MFA updated the document in 2003 and again in 2005 to address new issues including the prospect of increased regulation. The document is cited by many lawyers and chief compliance officers as a reference for hedge fund managers.

Robert Krause, chief risk officer at Event Capital Markets LLC, agrees that the MFA’s Sound Practices document is a positive for the industry. Krause, who performs due diligence on hedge funds for investors, says anything that improves the policies and procedures hedge funds have in place is good.

“Any kind of an operational oversight is a good thing. It standardizes the processes and procedures the funds should have in place. Right now it is kind of the wild, wild west; everybody just sets it up the way they want and they’re all different,” Krause says.

Numerous industry sources say while certain regulatory initiatives may have been unwarranted, the threat of regulation pushed managers to improve their processes. And while the the registration rule has been struck down, few in the industry believe it has had no impact. The SEC began a process of examining hedge funds several years ago and the Goldstein decision is seen as just one step in that process.

Roger Fenningdorf, principal of Rocaton Investment advisors, says institutional investors welcomed registration and much of the larger hedge funds had already moved to register to capture that market. He says institutional investors demanded greater transparency and have gotten it. “We have reached a middle ground where investors and hedge funds are comfortable with the level of transparency.”

Fenningdorf agrees the industry is better off for going through the process and the SEC also may have a better understanding of the industry as well.

“The SEC is more educated [regarding] the industry in preparing itself for registration,” Roth says.

What next

One of the biggest criticisms of the SEC rule is that it could give investors a false sense of security, leading them to let their guard down.

“You still need to do your own homework and not rely on the government or the registration to protect you,” Krause says. “But any kind of oversight, if it is thoughtful and reasonable and gives you a good standard to live up to, is a good thing. Regulation, if it is done right, it is a good thing. The jury is still out on whether it will be done right.”

That begs the question: What form should regulation take? Krause says it should be operational in nature. “It shouldn’t be regulating risk and it shouldn’t be regulating strategy or position. We need to have certain standards and rules in place.”

He says one of the most important rules to have in place is independent co-signatures on withdrawals from fund accounts. “It will make it harder for any fund manager or anybody in management to embezzle money. They would have to collude with an independent source.” The fund administrator would be the most likely independent source. “Having an institutional quality administrator independently co-signing is probably the most important piece the SEC could require, and as far as I know it is not being done.”

A rule requiring all prices come from an independent source would be another reform Krause would recommend. He acknowledges that this rule would not solve all the problems involved with pricing and valuation of exotic instruments, but adds, “in general independent pricing is another key component.”

The whole idea of applying incentive fees to exotic securities where even some managers acknowledge pricing is more of an art than a science may need to be reevaluated. “I have had administrators and auditors fooled with market quotes,” Krause says. “The manager was trading warrants but he owned all the warrants so he was essentially creating his own market price because nobody else was nearby. They would look on the screen and say ‘wow these warrants traded for $30, write it down.’ That is an independently priced [instrument]. Except the warrants were really worth about 3¢. Even though the auditor or administrator is looking up the price on Bloomberg, it isn’t necessarily a price that anybody can trade at.”

Jeff Blumberg, attorney with Gardner Carton & Douglas, suggests hedge funds stay registered for now and maintain procedures put in place because of the rule. “Regardless of whether you choose to deregister if and when this decision is finalized, the time and money that was spent developing policies and procedures to comply with the Advisers Act should not be discarded. These policies and procedures are valuable additions to your firm’s operations.”

He adds, “having an industry that largely, on a voluntary basis, maintains these types of policies and procedures may go a long way to convincing both the SEC and the investor population that further regulation is unnecessary.”

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