NEW YORK - The registration of hedge funds brings with it regulations that can affect the way in which portfolio managers get, and do, business.

Adapting to these Federal rules may mean it's time for hedge fund companies to take another look at their internal operational guidelines, said panelists at The National Investment Company Service Association Hedge Fund Conference held here last month.

"Side letters, special treatment of certain customers - it's just the old way of doing business," said Barry J. Cohen, senior managing director in charge of alternative investments at Bear, Stearns Securities in New York.

And it's no longer allowed, or at least not to the same degree.

In fact, registered hedge funds are now subject to a whole slew of regulations that affect how they advertise their products, publicize their performance and disclose their holdings, creating a compliance atmosphere that many managers simply aren't used to.

"What we look for are policies, procedures and controls to be in place," said William J. Delmage, assistant regional director for the Securities and Exchange Commission.

Hedge fund managers - now more than ever - must be careful about marketing. Managers should be absolutely certain that potential investors are pre-qualified before making any solicitations for investments. Pre-qualified investors must have at least $1 million to invest and annual incomes of $200,000 for individuals or $300,000 for married couples.

"You must have a reasonable belief that anyone you send to is accredited," warned Nora M. Jordan, a partner with New York law firm Davis Polk & Wardell. To do that, hedge fund managers must also have a pre-existing relationship with any prospective clients they may approach. "No cold calls, no mailings, and you can't initiate press coverage."

Although hedge fund investors are traditionally considered savvier than mutual fund investors, the SEC argues such pre-screening is in the interest of investor protection.

Once pre-qualified investors have been identified, hedge fund managers must be watchful of what they include in their marketing materials.

Testimonials are taboo, and suggesting that a manager has a "black box" formula for success is likewise banned. Reporting past performance is permissible, provided managers include how that performance compared to the overall market for the same period, and sales literature discloses these gains net of fees.

"Someone has to be able to make a clear decision based on the right facts," Delmage said. "You can't cherry pick facts and circumstances."

To ensure investors have all the information they might need, Jordan recommended including all the footnotes that can fit on offerings, which, according to NASD rules, must be relegated to two pages. Delmage said footnotes are good, but noted that hedge fund managers must be able to produce the back-up documents to prove them to SEC examiners, if asked.

Such stringent rules make it increasingly hard for hedge fund managers to make their products stand out among the 5,000 or so registered competitors, causing some hedge fund managers to bend the rules.

"It doesn't mean it's right, it doesn't mean it's legal, and it doesn't mean you should do it," Jordan said.

But hedge funds do sometimes bend the advertising and marketing rules, and when they do, principals must be prepared. "The common refrain is policies, procedures, controls," Delmage said. "Who is involved and what controls are in place?"

If a hedge fund accidentally sends materials to an investor who is not accredited, it may not be a problem, Jordan said. "But if it's more than one, that's a problem," she said. And if a money manager is quoted in the press mid-offer, that's a problem, too.

"The SEC does monitor this," said Jordan, who advised hedge funds to initiate a self-imposed cooling off period of at least 30 days, and as much as three months.

"This can really wreck an offer," she said. But the alternative can be even worse.

Even if the SEC does not catch the quote, it could haunt the manager. For example, if the fund falters, and an investor loses a large sum of money, he or she may point out the indiscretion to regulators, who may then initiate an investigation, even though the quote may be completely unrelated to the circumstances that caused the fund's value to drop.

"There is no bright-line test," Jordan said.

Once a manager has identified what they can tell and to whom they can tell it, they must determine how much they are willing to disclose, because the days of secret recipe portfolios are over.

"[The SEC] staff seems to be focused on the quality of disclosures," said Robert A. Nisi, a corporate risk officer for Cyrus Capital Partners in New York. Marketing materials, proxies, and prospectuses - they all must outline any special agreements a fund manager may have with one or several shareholders.

"Policies should specify how the allocations are placed," Delmage said. "Hierarchy is something we look for."

Fund managers must not only tell investors what they've invested in, but also with whom they've cut deals.

In the days before regulation, it was not uncommon for hedge fund shops to make special deals with certain high-net-worth clients. For example, they might have given an investor who plunked down $1 million a greater share of initial public offerings or an options agreement not available to all shareholders.

Such so-called side letters are not explicitly illegal, as long as everyone knows about them.

"You've got to make sure all your investors are treated fairly," Delmage said. The same goes for advisor agreements and fees.

"We're going to look for trading during the day, systematic patterns, an advisor favoring one client over another," Delmage said. "Sometimes there are legitimate reasons, and you've really got to document that. There should be procedures in place to track what's going on."

The SEC has conducted several sweeps, he said, and investigators are particularly looking for soft-dollar abuses to ensure gifts are reported, and that each fund's code of ethics is comprehensive and up to date, he said.

"In order to protect your fund and yourself in this environment, it's critical that management does a conflict-of-interest assessment," said Thomas A. Bilosi, managing director for PricewaterhouseCoopers in New York.

Hedge funds must be certain to tell investors whether the firm's executives have invested in their own products and, if so, how much they have on the line. While it's common for hedge funds to invest in one another, or in funds-of-funds, if managers don't make it public, regulators could slap them with charges of manipulating the marketplace.

"For a firm to identify conflicts of interest themselves is not a bad thing," Delmage assured conference-goers. "We're looking not only at conflicts of interest, but the potential for conflicts."

That means careful review and disclosure of all business relationships, including those with service providers.

"You'd be amazed, when we ask, how many hedge funds trade with someone who they are related to through blood or through marriage," Bilosi said. That, too, must be made public.

"Disclose it everywhere," Jordan said - in offering materials with every new product, in newsletters and in annual reports.

"And it's got to be real disclosure," she added. That means telling investors how such potential conflicts of interest could affect the value of their fund. Traditional investors new to this non-traditional space may be surprised, she said, but that's a risk that managers must take.

"It could mean you make less," Jordan said. And it might even affect they way hedge fund managers run their businesses. "If you're thinking of doing something investors might not like, then you probably shouldn't be doing it," Jordan said.

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

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