NEW YORK-As regulators move toward more data-intensive investigations, the relationship between hedge funds and their broker/dealers will receive increased scrutiny, said Linda Chatman Thomsen, director of the Securities and Exchange Commission's division of enforcement.

"The regulated entities are our window into hedge funds," Thomsen told attendee of the Practising Law Institute's "Coping with Broker/Dealer Regulation" seminar here last Wednesday.

And broker/dealers may be the regulated entity with the best view. "Everybody does business with them," she said.

For broker/dealers that want to be prepared, that means having a clear set of procedures that govern those interactions, and ensuring those policies, once set, are strictly and uniformly enforced. Most importantly, it means being able to prove no trades violated any in-house rule when regulators ask.

"Remember that [in-house policy] will always be judged, and it will always be judged after the fact," Thomson said.

Hedge funds have been a particular thorn in the SEC's side in recent years. Although the Federal regulator passed a rule requiring the famously furtive hedge fund advisors to register, it failed to stand up to challenges (see related story, page one). In June, after a series of protracted court battles, the U.S. Appeals Court called the rule "arbitrary" and deemed it invalid. SEC Chairman Christopher Cox responded by vowing continued vigilance over the $1.5 trillion industry.

"There is a ton of money in these non-transparent vehicles, which is a recipe for disaster," said Thomsen, who quickly added while the majority of hedge funds are well run and safe for investors, the potential for widespread wrongdoing is a problem.

Although hedge funds are designed to only allow "sophisticated" investors with a certain amount of money at their disposal to participate, the sheer volume of trades these funds process has the potential to move markets, thereby affecting the ingenue Average Joe.

The danger is that the brokers who execute these large trades may make exceptions to give their high-paying clients a market advantage.

"There is an incentive within broker/dealers to bend the rules, or even bend over backwards to accommodate these clients," said Susan L. Merrill, executive vice president of enforcement at the New York Stock Exchange.

And while brokers seem to not think twice about reporting individuals who game the system to net gains of $25,000, when it comes to a hedge fund manager who wants to make a late trade on a multi-million-dollar order, accommodating an ethical breach becomes a business decision, regulators said.

"Business managers are so intent on keeping the business, they keep these close-to-the-line cases to themselves, Merrill added.

In the most egregious examples, as the market-timing scandals showed, a business infrastructure develops to help certain high-power, revenue-boosting clients. "[Firms' in-house] legal and compliance [departments] were usually not aware of the practices, and when they were, they gave some very shady analyses," Merrill said.

That's when firms get in trouble, she added, because often regulators found they either had no clear policies proscribing the behavior, or they lacked the oversight to enforce them.

Others argue that it is unreasonable for the SEC to expect broker/dealers to monitor, let alone be held liable for, the business practices of their clients.

"If they did not see the red flags, they do not have the obligation to police clients, and it's hard to hold them responsible," said Harry J. Weiss, a partner with Wilmer Cutler Pickering Hale and Dorr's Washington office. Also a PLI faculty member, Weiss worked at the SEC for more than a decade.

But Thomsen believes broker/dealers see those red flags but ignore them. "In a lot of cases, it goes beyond a blind eye," Thomsen said. "It's aiding and abetting, it's collusion, it's assistance." It's also punishable.

Regulators will take into account how many red flags were ignored, and if broker/dealers would have been less tolerant of transgressions, had it been a less influential client, she said.

Still, when it comes to producing evidence, Weiss said, it's hard for the SEC to prove its case beyond a reasonable doubt.

Robert Romano, a PLI faculty member and partner who specializes in litigation at Morgan Lewis in New York, warned against challenging the technical casework behind SEC complaints too vehemently.

"Materiality and legal niceties find an impatient audience on the other side of the table," he said. "If you slice the issue too finely, the SEC will find something inappropriate."

Thomsen added that the SEC is committed to "beefing up" its capacity to parse and analyze large blocks of data, and that Chairman Cox has made it a priority to ensure the agency has the tools and resources to do so.

The bottom line, she said, is that hairsplitting SEC claims can be an effective defensive tactic, but as far as an offense, it's lousy.

"We're looking at the activities of hedge funds," she said. "If you're doing business with hedge funds, we're going to focus on you, and you need to know that going in," she said.

Broker/dealers that want to look good coming out will ensure that their compliance policies keep up with their business plans.

Like dealing with any third-party advisor, Merrill said, broker/dealers must assume responsibility as fiduciaries. That means making sure all necessary letters are in, notices sent out and, most importantly, that the firm's procedures are outlined, circulated and enforced.

"It's your business, and it's hundreds of millions of dollars per year," she said. "You have to make sure it's under control."

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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