Matthew Goldstein

Return to Article

SEC Stops Short of Hedge Fund Crackdown

Matthew Goldstein

Securities regulators are considering requiring hedge-fund managers to register as investment advisers, a move that could subject the $600 billion industry to periodic inspections for the first time.

The recommendation is contained in a long-awaited Securities and Exchange Commission report on the state of the hedge fund business. SEC officials released the report at a Monday morning press conference in Washington.

"The staff is concerned that the commission's inability to examine hedge fund advisers makes it difficult to uncover fraud and other misconduct," the report said. "The commission typically is able to take action with respect to fraud and other misconduct only after it receives relevant information from third parties."

But hedge fund managers will likely breathe a sigh of relief after reading the report because it does not call for many other sweeping reforms. In the wake of a number of recent hedge fund scandals, some had thought the SEC would want to crack down on these loosely regulated investment funds that are favored by the rich and famous.

"Can most managers live with this? Sure,'' said Ron Geffner, a New York attorney who advises hedge funds. "It's a sign the SEC is sensitive to the impact its actions will have on an industry.''

Most of the other recommendations are vague. For instance, the report said the SEC should "encourage the hedge fund industry to embrace and further develop best practices."

It's also worth noting the recommendation about registering hedge fund managers is a long way from becoming law. The SEC must first propose a regulation to register hedge fund managers and then seek public comments on it. It could be many months before such a regulation is adopted.

Still, the idea of registering hedge-fund managers is an important first step by regulators to bring some order to the Wild West environment that many hedge funds operate in.

By registering hedge fund managers, the SEC would gain the authority to periodically inspect and examine the funds and their books. Registration also would require hedge fund managers to disclose more information about themselves to investors, including potential conflicts of interests. It also would force hedge funds to raise the minimum amount needed to invest from $500,000 to $750,000.

The SEC report contends that registration will make it easier for regulators to detect potential fraudulent activity at a hedge fund. But it's not clear that is necessarily so.

The mutual fund industry is a highly regulated business and portfolio mangers long have long had to register as investment managers with the SEC. Yet it was New York Attorney General Eliot Spitzer who brought one of the most significant fraud cases involving the mutual fund industry and a hedge fund.

In August, Spitzer's office charged that Canary Capital Management, a New Jersey hedge fund, had engaged in illegal trading activity with four mutual fund families, including those offered by Bank of America(BAC Quote) and Janus(JNS Quote). The Spitzer investigation, which is continuing, has led to the filing of criminal charges against a former BofA official.

"We don't' view our examination program as eliminating all fraud,'' said Paul F. Roye, director of the SEC's Investment Management Division, who led the committee that drafted the report. "Right now it's a wait-and-see approach. But if we can go in affirmatively and look at books and records, we have a much better chance of picking up and identifying'' potential wrongdoing.

An SEC examination might give regulators an early warning about whether a hedge fund manager is inflating asset values in order to boost his performance and his management fees. Such allegations have sprung up in a number of high-profile hedge fund collapses, including Kenneth Lipper's Lipper Funds, Michael Lauer's Lancer Management Group and Beacon Hill Asset Management.

The SEC report, meanwhile, does not recommend any new rules for a Wall Street firm that serve as the "prime broker'' for a hedge fund. Even though hedge funds rely on prime brokers to execute trades, lend them money and sometimes provide office space, brokers are not expected to be on the lookout for suspicious hedge fund activity.

Regulators hope Wall Street firms will do their part to keep hedge fund manager honest, but Roye doesn't envision any new regulation forcing brokers to take action.

"We would hope when they see fraudulent or abusive behavior they would pick up the phone and give us call,'' said Roye. "That goes with being a responsible participant in our market.''