The noise surrounding hedge fund registration grew to a thunderous clap last week, as Congress heard testimony from several industry professionals and government officials on the merits of such a groundbreaking move.
The series of hearings on Capitol Hill comes on the heels of a Securities and Exchange Commission vote to approve a proposal to require hedge fund managers to open their books to its examiners. In a 3-2 decision, SEC commissioners put out for comment a rule requiring hedge fund advisors with at least 15 clients and $25 million or more under management to register with the Commission.
The increased scrutiny of hedge funds is a product of their rapid growth in the last decade, not to mention high-profile scandals involving the likes of Long Term Capital Management and Canary Capital. Currently, the industry has roughly $850 billion in assets spread across roughly 6,000 hedge funds operating in the U.S. The SEC estimates that 40% of those hedge funds are voluntarily registered
The rule, if passed, would permit the SEC to tally the number of hedge funds operating within the United States, the amount of assets under management and the identity of their advisors. The new rule would allow the SEC access to traditionally well-guarded information such as portfolio holdings, executives' employment history, accounting records and oversight of compliance policies. Registering as an investment advisor would also require hedge funds to appoint a chief compliance officer. A 60-day comment period has been set for the proposal once it has been posted to the federal register.
SEC Chairman William Donaldson, who voted in favor of the rule along with the Commission's two Democrats, argues that these steps will deter fraud and help identify problems before they become harmful to investors. Fueling his call for reform is the growing popularity of hedge funds among public and private pension funds, a trend he believes puts smaller investors at risk.
In testimony delivered before the Senate Banking Committee, Donaldson expressed concerns that hedge funds can have a disproportionate impact on investors given their use of leverage and rapid trading strategies. Supporting that claim, he cited a recent BusinessWeek article noting that at times a single hedge fund manager has been responsible for an average of 5% of the daily trading volume on the New York Stock Exchange. He went on to say that regulation of hedge funds would provide a more complete picture of the key players in the securities markets. "It would be irresponsible for the Commission not to consider appropriate regulatory oversight of the hedge fund industry," Donaldson testified.
Republican Commissioners Cynthia Glassman and Paul Atkins opposed the proposal, saying it would not help prevent instances of fraud and that hedge funds do not pose a serious threat to small investors. Glassman noted that of the $6 trillion in retirement plan assets held in the U.S., only 1.5% is invested in hedge funds.
"The staff's recommendation is premature and another example of form over substance," she said at the SEC's open meeting on July 14.
Despite Donaldson's dogged determination, hedge funds have a very powerful figure in their corner in Federal Reserve Chairman Alan Greenspan. He remains unconvinced that the new rule would successfully detect fraud and market manipulation. "Fraud is almost always uncovered through complaints of counterparties, or by accidents," Greenspan told members of the Banking Committee. He also expressed concerns that further regulation will drive funds out of business and have an adverse effect on capital markets. "Hedge fund arbitrageurs are required to move flexibly and expeditiously if they are to succeed. If placed under increasing restrictions, many will leave the industry, to the significant detriment of our economy," he said.
Greenspan's criticism of the proposal provides a strong counterpunch to what many in the industry have referred to as "regulatory creep." The proposed rule has caused quite a bit of consternation among constituents of the Managed Funds Association, who argued that much of the information needed to examine hedge funds is already available through their prime brokers. Adam Cooper, MFA's senior managing director and general counsel, told Congress that the rule would stretch the SEC's resources too thin to protect a small group of investors that presumably have the wherewithal to look out for themselves.
A spokeswoman for the industry's trade group characterized the provision as "duplicative" and "burdensome." She further argued that increased regulation would handcuff hedge fund managers' ability to react nimbly to changing market conditions. With respect to catching crooks, she said that simply stamping a guarantee on something doesn't really guarantee much. In fact, she noted that CalPERs, the nation's biggest pension fund and shareholder advocate, invests in nine unregistered hedge funds.
"I think a terrible case has been made for [registration]," said Perrie Weiner, partner and chair of the securities litigation group at national law firm Piper Rudnick. "You don't want to eliminate incentives for different funds and traders to invest. The more you regulate them, the less able they will be to react to a fluid market." William Tueting, a securities attorney specializing in private equity and hedge funds and a partner at Chapman and Cutler, believes that this will only lead to more stringent restrictions being imposed on hedge funds. "The dynamic of Washington regulation is that they'll start telling them how to run their business once they have them under their jurisdiction."
But the issue is so divisive and hotly contested that opinions on the matter depend on "which church you go to," as one industry insider explained. Nancy Van Sant, a former regional trial attorney at the SEC's Atlanta office and now a partner at law firm Sacher, Zelman, Van Sant, pointed out that while no industry is in favor of increasing regulatory constraints, the rule may have very real benefits for investors. "If you know an examiner could walk in the door at any time, you're more likely to tow the line," she said.
Ultimately, the decision will come down to who has the most clout in Washington. Many hedge fund firms, including Cerebrus Capital Management of New York, have reportedly made significant efforts to persuade the House Appropriations Committee to thwart Donaldson's crusade. Cerebrus is also trying to woo Senate Banking Committee Chairman Richard Shelby (R-Ala.), who remains on the fence on the issue. MFA President Jack Gaine, known to have very strong ties in Washington, predicted, "Once all the facts are in, the proposal will not be adopted." The SEC has landed the first punch. but hedge funds are far from being down for the count.
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