Just days after a federal appeals court

struck down the registration rule for hedge funds, politicians are reviving the regulation agenda. On Monday, Senator Chuck Hagel (R., Neb.) called for more hearings on the industry. On Wednesday, the Senate Judiciary Committee held a hearing on short-selling activities by hedge funds and the independence of stock analysts, chaired by Pennsylvania Senator Arlen Specter (R., Pa.)

"Now what?" is the main question for industry participants. The

Securities and Exchange Commission

may or may not appeal the court decision. Many believe that it might be time for Congress to step in and enact new legislation, but no one knows for sure what will happen.

"After the court of appeals decision

... last week, hedge funds are a regulatory black hole, lacking even minimal disclosure and accountability required of mutual funds and other similar institutions," says Richard Blumenthal, the attorney general of Connecticut.

Blumenthal suggests that Congress should provide incentives to encourage the SEC and the state banking regulation agencies to intensify enforcement actions. He urged the committee to extend the SEC, NASD and New York Stock Exchange stock analysts rules to independent research firms to prevent conflicts of interests between trading and research.

The relationship between hedge funds and analysts are at the center of the controversy.

Last year,

Overstock

(OSTK) - Get Report

filed a lawsuit alleging a wide-ranging conspiracy to manipulate the share price of the Internet retailer. Overstock alleges that research firm Gradient Analytics was in cahoots with short-sellers, including Rocker Partners, which owns a small stake in

TheStreet.com

(TSCM)

, publisher of this Web site. A similar action also involving Gradient was brought by Canadian pharmaceutical company

Biovail

against SAC Capital, an $8.5 billion hedge fund.

Both Rocker and Gradient have denied wrongdoing. Patrick Byrne, CEO of Overstock, was not on the witness list Thursday.

TheStreet.com and James J. Cramer, its co-founder and major shareholder, were subpoenaed in February in connection with an SEC investigation into Overstock's allegations. The SEC has agreed that it will not, at this time, seek to enforce the portions of the subpoenas issued to the company and other media firms, including

Dow Jones

(DJ)

, that concern communications between journalists and their sources.

Meanwhile, the debate continues to rage between those who want to regulate what the SEC estimates to be a $2.4 trillion industry and opponents of such regulation.

The Great Debate

Gary Aguirre, a former SEC investigator who in 2004 and 2005 conducted an investigation of suspected insider trading by $7 billion hedge fund Pequot Capital Management, is an advocate of greater scrutiny. In his testimony Wednesday, he said that federal law enforcement did not adequately protect the nation's capital markets from the risk of manipulation. The gravity of fraud varies depending on the type of victims.

When victims are hedge fund investors, repercussions are limited in scope because "fraud by hedge funds against their own investors is not disproportionably high," he said.

The greater threat is when hedge funds manipulate other market participants, such as cheating regular investors, as they did with the mutual fund timing scandals, for instance. In this area, "the SEC -- the 'cop on the street' -- does not spend much time walking this beat," said Aguirre, whose views on his former employer are certainly not neutral. He was terminated by the SEC last year, for what he claims were political reasons.

Aguirre testified that he wanted to subpoena "the former CEO of a large investment bank," and that the SEC blocked the issuance of the subpoena. The CEO was identified by

The New York Times

as John Mack, now head of

Morgan Stanley

(MS) - Get Report

, who briefly served as Pequot chairman last year. The SEC declined to comment on Aguirre's termination.

In his testimony, Aguirre criticized the commission for removing him from the Pequot case and terminating his employment. "No new legislation or regulation can protect market participants from hedge fund abuses unless the SEC does its job," he said. In particular, he pointed to the SEC's investigations of so-called PIPE deals, or private investments in public equity, saying that "the SEC again wore blinders."

Out of 27 PIPE cases the agency is investigating, it has only filed three, he says.

An SEC spokesman had "no immediate response."

Hedge funds were represented by Joseph McLaughlin, a representative of the Managed Fund Association, an industry trade group. In his testimony, McLaughlin, a lawyer at Sidley Austin, underlined the positive features of hedge funds, as expected. He stressed the fact that hedge funds provide public pensions with portfolio diversification, and also highlighted their noncorrelation to the traditional markets. He also stressed that hedge funds are a source of liquidity, adding depth to the markets. Finally, "the increase in hedge fund growth has coincided with a decrease in overall market volatility," he said. It may be because hedge fund investors have longer redemption horizons and that, because of that, hedge funds have fewer incentives to engage in momentum trading, he noted.

Even beyond the point of regulation, the SEC has room to scrutinize hedge fund managers in the future.

The commission recently took a new step in this direction by announcing that it will begin to address the issue of side letters. Side letters are contracts hedge fund managers enter into with some of their investors, granting them preferential treatment, such as lower fees, more liquidity or better access to portfolio information.

Last month, Susan Wyderko, then director of the SEC's office of investor education, testified before a subcommittee of the U.S. Senate Committee on Banking and announced that the SEC will review side-letter agreement and evaluate whether or not they harm the interests of other investors.

Some hedge funds argue that one of the best ways to address the problem of secrecy and fraud among hedge funds is to allow managers to market their funds, the way mutual fund managers do. As of now, the SEC prohibits hedge funds from advertising. That was reportedly the reasoning of Steven Kessler, chief compliance officer at SAC Capital, at a recent Securities Industry Association panel discussion. Hedge funds are notoriously secretive, and allowing them to communicate with the public may give investors more transparency and control.

Here again, hedge funds have a lot of lobbying and educating work to do. The industry must convince regulators to give them more freedom, while assuring investors that hedge funds are not the terrifying black holes they are often depicted to be.

As originally published, this column contained errors. Please see

Corrections and Clarifications.