The Ghost of Christmas Past seemed to float through the Securities and Exchange Commission's end-of-year meeting, with regulators re-visiting the haunting issues of hedge fund regulation and the composition of mutual fund boards.
Like Scrooge, who changed his ways after seeing the effect of his actions, the regulators voted unanimously last Wednesday for more moderate versions of previously passed, vocally challenged and ultimately overturned rules.
In the case of hedge funds, the SEC called for raising the standards for qualifying investors, months after an appellate court threw out a rule requiring the funds to register. Likewise, after having rules requiring mutual fund boards ensure 75% of directors, including the chairman, were independent tossed out twice by the courts, the agency re-opened the opportunity for public comment.
"The SEC has been slapped around a little bit by the courts, the most notable example being vacating the hedge funds rule," said Jacob Zamansky, a securities attorney and investor advocate with Zamansky & Associates in New York. "They're trying to meet the criticism that the courts have given them."
Hedge funds became a hot-button issue when regulators tried to require managers to register, citing a need to protect investors. The rule, which passed 3-2, was immediately challenged by industry representatives, and ultimately overturned through Goldstein v. the U.S. Securities and Exchange Commission after a protracted battle that ended in the U.S. Court of Appeals.
In last week's meeting, the SEC adopted a more moderate position, adding to the minimum investor accreditation standards, set in 1982. Those guidelines required individuals to have a net worth of at least $1 million, a figure that could include the value of their homes, or annual income of $200,000 for at least two consecutive years.
"That definition is inadequate," Chairman Christopher Cox, a Republican, said. At the time the guidelines were set, only 1.87% of American households qualified, but inflation, a dynamic economy and an explosion of real estate values have combined to mean that 8.5% of households can now participate.
Now, investors will have to have at least $2.5 million in investments, excluding the value of their homes. This should reduce the proportion of eligible individuals to 1.29% of households. Furthermore, the Commission agreed to revisit the standard every five years.
"This type of line-drawing makes me uncomfortable," said Commissioner Paul S. Atkins, who voted against the registration rule. Atkins lauded the hedge fund industry as critical to maintaining capital liquidity in the economy, and questioned whether protecting individual investors from gambling more than they should in the marketplace should be the responsibility of the government.
Still, the Republican commissioner said the new standards are a far better approach than requiring registration.
The SEC also voted to tighten anti-fraud rules regarding hedge funds, ensuring that those that try to dupe investors through failing to disclose conflicts of interest, or so-called special "side-letter" agreements, can be prosecuted.
"This is a good step, but I would have gone further," said Commissioner Roel C. Campos, a Democrat and supporter of the overturned registration rule. Campos expressed his continued concern about the industry, which has grown in size and power in recent years.
"In the end," he said, "I believe very moderate oversight will enter the picture." He advocated encouraging hedge funds to register by offering incentives.
"We're tabling concerns that may exist for a later date," said Commissioner Annette L. Nazareth. "Today's action is critical following the Goldstein decision, as our ability to bring action against fraud has been called into question," she said. Wednesday's rules provided tools to ensure the agency is able to carry out its investor protection function, she said. "It's as fundamental as it gets," said Nazareth.
When it came to the decision of reopening the opportunity for public comment on whether mutual fund boards should be required to have independent chairman, Commission members had little to say.
In fact, Commissioners sidestepped saying anything about the rule during the all-day-meeting, only announcing at the end a unanimous decision to re-open comment for 60 days.
The rule was adopted first in 2004, following the late-trading and market-timing scandals that shook investor confidence in the industry best known for managing millions' retirement savings.
The courts twice overturned the rule, most recently last April. The court ruled in favor of the U.S. Chamber of Commerce, which argued that the federal agency failed to fully examine alternative measures or consider the cost to fund companies.
Advocates of the shareholder-oriented rule disagree.
"We think that the benefits far outweigh the costs," said Christine Benz, director of fund analysis at Chicago-based researcher Morningstar. "We point to a database of funds that are overpriced and have held onto underperforming managers for far too long," she said. No matter what the cost per shareholder of hiring outside watchdogs for the board, she said, the absence of such arm's length-evaluation is far more costly in the long term.
As for the actual cost of hiring non-affiliated board members and directors, "Our data showed that the costs were astonishingly low," said Susan Ferris Wyderko, executive director of the Mutual Fund Director's Forum (MFDF), which represents independent directors, and former head of Investor Education at the SEC.
The industry group's August 2005 study was not the only one to look at the costs associated with the rule. The Investment Company Institute also studied the question and actually reported costs even lower than that of the MFDF.
Independent consulting company Management Practice pegged the price at $16 per $1 million in assets. "The only new piece of information since that is yet another mutual fund scandal," said C. Meyrick Payne, a senior partner at the Stamford, Conn.-based company, referring to what he termed the "BYSIS Crisis." In September, BYSIS agreed to pay $21.4 million to settle SEC charges that the company helped about 25 mutual fund companies hide side agreements that allowed misuse of investors' assets to cover marketing and other costs.
"It's more evidence of the need for strong governance," Payne said.
But the Chamber stands by its concern that the SEC is unfairly increasing the cost of doing business for 9,000 mutual fund companies. "The Chamber will continue to oppose any rule that imposes improper costs, including a rule that imposes second-class citizenship' on management-chaired funds," wrote Senior Vice President and Chief Legal Officer David C. Chavern in a letter last Tuesday.
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