Renewed Interest in Hedge Fund Regulation

There was a great flurry of activity last year when many hedge funds either sought to comply with new SEC registration requirements that applied to all but fairly small hedge funds, or reorganized themselves so as not to qualify (either by having long lock-ups, or by reorganizing themselves offshore). But it all came to naught when the SEC’s authority was challenged successfully in court (the ruling hinged on the definition of who the client is. The SEC had sought to invoke its authority under the Investment Company Act of 1940, which excludes advisers that have fewer than 15 clients in the preceding 12 month period. The court agreed with the plaintiff’s argument that the “client” is the fund the hedge fund manages, not the end investor. No hedge fund manages as many as 15 funds).

The SEC had said they would seek legislation to secure the needed supervisory powers, but with a Republican commissioner, and a hands-off posture at both Treasury and the Fed, this appeared to be more face-saving talk than a serious intention.

Support is coming from an unexpected quarter, as reported in CFO.com, “Sen. Grassley Seeks Hedge-Fund Rule:”

Breaking ranks with the Bush Administration and apparently with the Securities and Exchange Commission itself, Sen. Chuck Grassley has proposed legislation that would require most hedge funds to register with the SEC.

The amendment would narrow the exemption “that is currently used by large, private pooled investment vehicles to avoid registering with the Securities and Exchange Commission,” stated Grassley, the ranking Republican member of the Senate Finance Committee.

Grassley’s measure would amend the Investment Advisers Act of 1940, which exempts advisers from registering with the SEC if they have fewer than 15 clients in the preceding 12-month period and who don’t present themselves to the public as investment advisers.

Since last June, when the D.C. Circuit Court of Appeals overturned an SEC rule requiring most hedge fund advisers to register with the commission by Feb. 1, 2006, hedge fund advisers have been able to define the word “client” as the hedge fund itself, rather than the investors who own shares in it. Thus, an adviser serving two hedge funds is exempt from registration—even if the funds have many more than 15 investors.

Under the SEC’s rule, advisers had to count “shareholders, limited partners, members, or beneficiaries” as clients.

To date, 335 advisers have withdrawn in the wake of the Circuit Court decision, SEC spokesperson John Nester told CFO.com, while another 113 have withdrawn for assorted business. Seventy advisers have registered with the commission since the ruling. Nester said the SEC “declined immediate comment” on Grassley’s proposed amendment.

In the June Circuit Court ruling, Goldstein v. SEC the judges decided that the rule was “arbitrary.” While SEC Commissioner Christopher Cox said that the decision left a “gaping hole” in its ability to register and inspect hedge funds, the commission chose not to appeal the ruling.

Further, the SEC, as part of the President’s Working Group on Capital Market chaired by U.S. Treasury Secretary Henry Paulson, has agreed not to pursue more regulatory power over hedge funds.

Filed on Wednesday by Grassley, the amendment would empower the SEC to require all investment advisers to register except for those who:

• Have $50 million or less in assets under management;

• Have fewer than 25 clients;

• Don’t hold themselves out to the public as investment advisers;

•And manage the assets of fewer than 15 investors, regardless of whether the investors make use of the advisers’ services directly or through a pooled investment vehicle like a hedge fund.

Grassley filed the measure as an amendment to S.4, the 9/11 homeland security bill now being debated by the full Senate. The senator said the amendment is relevant to the larger bill because reports have shown that there are terrorist links to hedge funds.

What is interesting is that there appears to be growing support for hedge fund regulation. It is increasingly being recognized that pension funds and other large institutions invest in hedge funds, and therefore the little guy, and not just sophisticated investors, are exposed. Consider the suprisingly populist tone of this commentary from MarketWatch, “History lesson.” It overstates the problem of hedge fund fraud, but nevertheless highlights the need for more transparency:

There were a lot of dark days in 1929: Black Thursday, Black Friday, Black Monday and Black Tuesday, the last being the worst day for the stock market. But it wasn’t until four years later that any securities law was passed to protect investors.

The Securities Act of 1933 was the first law enacted by Congress to regulate the securities markets. It required securities registration and disclosure. Prior to 1933, the thinking was that other civil laws governed behavior, such as fraud and manipulation, and no specific laws were needed to address the securities industry.
I know, you ponder that and scratch your head. But it seems we haven’t learned a thing from history.

People are using that exact same rationale today to argue against hedge-fund regulations. Decades from now, people will be looking back on us, as we do on the Roaring ’20s, scratching their heads and wondering why rules weren’t in place to protect investors. The writing is on the wall, and it isn’t in invisible ink: a major hedge-fund-related meltdown is coming.

A major insider-trading case involving three hedge funds and several Wall Street firms came to light last week. Other cases of hedge-fund fraud have popped up in Denver, Greenwich, Conn., and a slew of other places around the country.
And the ripple effect is global: there are an estimated 9,000 hedge funds with more than $1.4 trillion in assets. That’s a pretty good number of funds — the mutual fund industry has about the same number — and a pretty significant amount of assets, about 20% of the total U.S. stock market value.

Yet, regulators are drumming their fingers on their desks: “What to do? What to do…?”

Registration is not enough
Sen. Charles Grassley, R-Iowa, announced an amendment this week that would require hedge-fund advisers to register with the Securities and Exchange Commission. Grassley said he’s offering the legislation because a federal appeals court last year overturned an SEC rule requiring advisers to register with the agency.

“My amendment gives Congress a good opportunity to say there should be greater transparency with hedge funds,” Grassley said. “Today the average Joe has a stake as pension funds are invested in hedge funds.”

That’s an understatement: Pension funds, banks and insurance companies are the backbone of the investment industry. These institutional investors have more assets invested in the capital markets than any one else. They also have more money invested in hedge funds than anyone else.

But registration of hedge funds isn’t enough. There is a duty for public officials to protect and serve the public; they’re not. Hedge funds managers are the most rogue group of people we’ve seen since the Robber Barons. Hedge funds can literally change the economic landscape of this country. And there is very little accountability for their actions….

Trust is a must
Trust must remain in the capital markets. When it’s breached, as we saw last week when confidence weakened on the heels of a decline in the Chinese stock market, investors flee. Even one of the financial industry’s own trade groups is concerned about investor trust being corrupted.

“Our organization is deeply troubled about the impact these ethics-related allegations have on investor trust,” said Jeff Diermeier, president and chief executive of the CFA Institute in Charlottesville, Va., about the insider-trading case brought to light last week. The CFA Institute is the home of chartered financial analysts who make up a big portion of the investment management industry.

To be sure, not all hedge funds are risk-oriented. Some have very staid investment management techniques. But, like they say, it only takes a few bad apples…
“We approach this with the knowledge that proper training and attention to ethics at an individual level, with continuous reinforcement, is part of the answer,” Diermeier said about solving the problem of investment schemes.

Unfortunately, a more heavy-handed approach is needed: the hedge fund industry needs to get slapped into shape. Regulators need to examine and understand exactly what hedge funds are — and provide oversight accordingly. Letting them remain in the shadows of Wall Street only threatens us investors with dark days ahead.