Just because the Securities and Exchange Commission will not pursue the hedge fund registration rule struck down by the courts, does not mean Chairman Christopher Cox has abandoned efforts to increase oversight of hedge funds.
"The Commission is moving aggressively on an agenda of rulemaking and staff guidance to address the legal consequences from the invalidation of the rule," said Cox in a statement last week.
Washington-watchers say that means that the $1.5 trillion industry might look forward to higher accreditation limits, potential IRS involvement and even greater cooperation with foreign regulators.
But Bill Singer, a securities lawyer and partner with Grause, Kaplan, Bruno & Nusbaum in New York, sees last week's statement as "borderline inappropriate posturing," adding, "To some degree, it's a petulant, veiled threat."
Last Monday marked the deadline by which the SEC had to decide whether to let the U.S. Court of Appeals ruling stand, or to petition the nine robed members of the Supreme Court for an opportunity to continue the case.
Citing the unanimous ruling of the appellate court, Cox called attempts to prolong the battle a "futile" cause that would "simply delay and distract from our goal of advancing investor protection."
Phillip Goldstein, whose one-man legal stand against the SEC led to the June court ruling, called Cox's decision "sensible."
"He seems to be trying to get a consensus, not pushing an agenda down everyone's throats without thinking whether it's legal," said Goldstein, who manages Opportunity Partners, a hedge fund shop in Pleasantville, N.Y. He offered sharp criticism of Cox's predecessor William H. Donaldson. "Donaldson spent a lot of taxpayers' money on an illegal rule," said Goldstein. "Someone should send him a bill."
The courts agreed that the rule, which exempted funds with less than $25 million in assets, lock-up periods of two or more years or fewer than 15 investors, was arbitrary and discriminatory.
Goldstein called the rule a misguided attempt by a red-faced SEC to prove its relevance after missing the mutual fund market-timing and late-trading abuses exposed by New York Attorney General Eliot Spitzer. In the interest of establishing its credibility, the SEC made hedge funds its "scapegoat," according to Goldstein.
Registering hedge funds does little by way of stopping fraud, critics of the rule agree. In fact, most hedge fund fraud has been uncovered through investor complaints, not SEC oversight, said John Van, vice president of Van Hedge Fund Advisors in Nashville, Tenn.
What's more, the way the rule was written, it exempted those funds that were most fraud-prone, he said. Ponzi schemes and other frauds typically occur in small, fly-by-night funds with a fraction of the $25 million in assets required to trigger registration.
And the law already allows the SEC to pursue fraud in hedge funds.
"Many more truly retail customers lost money on the Enrons and Global Crossings. I think the SEC would [have to] admit, they can't do everything. To try to take on auditing hedge funds, some of which use some pretty esoteric strategies, is a huge task," Van said. Beyond huge, it's untenable, given the agency's resources.
Legislation introduced by U.S. Rep. Barney Frank (D-Mass.) calls for revising the law to give the SEC the authority to monitor hedge funds, as they do mutual funds and other securities pools, essentially circumventing the court ruling. How much support the bill has remains unclear this mid-term election year.
Van dismissed concerns that hedge funds, although fast-growing, have the real potential to move markets, a major reason for regulation cited by the SEC. Institutional investors only use hedge funds as a fraction of their portfolios, Van said. And in the vast volume of global investments, the $1.5 trillion industry, "is a tiny drop in the bucket," he said.
Still, there are some rules the SEC could pursue that make sense for the investors the agency is meant to protect, such as investor qualifications. Another impetus to the registration rule was the "retailization" of the space, especially with the advent of funds-of-funds. Right now, the minimum qualifications are $500,000 in annual income and $1 million net worth, although many funds have higher standards. The new standard most commonly bandied about is $5 million to invest.
"Here's the reality: those rules were set many years ago and haven't been indexed to inflation." said Phil Maisano, head of alternative investments at Mellon Financial in New York. "They probably need to be changed anyway."
In his statement, Cox also alluded to an anti-fraud rule that would "look though" hedge funds to their investors. Van called this a "back-strap measure" whereby the Internal Revenue Service would be involved under the USA PATRIOT Act anti-money laundering provisions. "Once the IRS is involved, will they look at other things?" Van posited. "Will investors want that?"
Van also speculated that the SEC may cooperate more with overseas regulators, a reversal of past policy. Sarah Davidoff, a partner at New York-based Strook, Strook & Lavan, has heard talk of "registration-light" by which non-U.S.-based funds might be required to register.
As for how funds may react, experts are taking a wait-and-see approach.
Those that lengthened their so-called lock-ups, or the period investors must wait to redeem their shares, to two years to dodge registration requirements may return to shorter-term commitments, Van said.
But industry insiders do not expect many of the 1,200 or so funds that have registered to revert their status. So far, only about 40 have taken such steps, Davidoff said.
"Registration doesn't help or hurt," Maisano agreed. Those funds courting institutional investors may even see it as a valuable sales point, especially in dealing with public beneficiaries, he said.
Goldstein maintains that whatever the SEC has in mind for new hedge fund regulations, they should be well planned, equitably enforced and have clear purpose. "Don't experiment on people," he said.
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