The Securities and Exchange Commission (SEC) in July voted unanimously to adopt a new anti-fraud rule under the Investment Advisers Act it claims will clarify its ability to bring enforcement actions under the Advisers Act.
“This rule applies to investment advisers not only of hedge funds, but also of private equity funds, venture capital funds, and mutual funds. Collectively, these funds hold trillions of dollars of investors’ assets and play an important and growing role in our capital markets,” said SEC Chairman Christopher Cox in a press release.
While the majority of concern from the hedge fund industry regarding the December rule proposal had to do with raising the accredited investor threshold, which has not been acted on yet, several hedge fund professionals also were concerned with these anti-fraud rules. First, legal experts believed that the SEC already had the authority to go after fraud and more importantly the rule applies to all communication between a fund and a possible customer and does not include a “proof of scienter” (intent to defraud) provision, meaning that unintentional misstatements in offering material could result in an enforcement action. “The application [of this rule] is very broad,” says David Matteson partner at Drinker Biddle Gardner Carton.
In August, the SEC proposed additional revisions to Regulation D. Citadel’s distressed strategy Sowood Capital Management announced in late July that it has sold its portfolio to hedge fund giant Citadel Investment group after experiencing what it described as “severe declines in the value of our credit positions and non performance of offsetting hedges.”
In just one example of turbulence caused by widening credit spreads due to the subprime shake-up, Sowood lost more than $1.5 billion after experiencing drawdowns of 57% and 53% respectively in the Sowood Alpha Fund Ltd. and Sowood Alpha Fund LP in July.
Sowood Managing Partner Jeff Larson, in a call with investors on Aug. 3, noted that the fund had earned 16% in the 12-month period ending in June despite a 5% loss that month and those profits came substantially from credit-related positions, mostly credit vs. equity. Larson attributed the June losses primarily to sharply wider senior corporate credit spreads unaccompanied by the expected move in equities or subordinated credit.
He noted that despite the losses, Sowood did not view this as the beginning of a massive across-the-board widening of credit spreads that would have little regard for the fundamentals of individual companies or for relative values within the capital structure of those companies.
Because Sowood viewed June as an anomaly, it decided against unwinding positions. Larson acknowledged that that view was wrong as, “Credit spreads continued to widen dramatically,” he said.
