SEC Stops Short of Hedge Fund Crackdown

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.''