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Talking Hedge Fund Registration With Nir Yarden

The Greenberg Traurig lawyer explains the two-year lock-up.

With a Feb. 1 deadline looming, hedge funds are getting ready to register as advisers under a new

Securities and Exchange Commission

rule. Most funds are complaining about the new burden of legal and operational obligations, but unless they get exemption, there is no alternative but to comply. Nir Yarden, an attorney at the New York firm of Greenberg Traurig, which specializes in hedge fund and private equity work, gave

insights on the impact of the controversial rule on the industry. What are the immediate implications of the registration rule for managers?

Nir Yarden:

All aspects of a manager's business will be subject to periodic SEC examination. Significant time and resources will be spent adopting and complying with various SEC-mandated procedures. Information will have to be submitted to the SEC on a regular basis and retention of business records will have to be maintained. For managers that avoid registration or are too small to register, constant diligence will have to be maintained to ensure that they do not trip over the registration rule.

Who are the hedge funds that are getting exemption?

A manager must register if it has 15 or more clients. Historically, a manager could count each hedge fund it advised as one client. The new rule now requires a manager to "look through" each private fund it manages and count each individual investor in a fund as a client for registration purposes. The 15-client registration threshold is thus considerably easier to trigger. However, the SEC created a loophole to the new rule: if a manager advises a fund that does not permit redemption within two years of purchase, the fund can still be counted as one client and the 15-client threshold is harder to attain.

The SEC intended the two-year lock-up provision to exclude private equity and venture capital funds. Its unintended consequence has been that certain hedge fund managers have changed the lock-up features of their funds to periods in excess of two years to avoid registration. Also, managers with assets of less than $25 million are exempt.

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What are some positive aspects of the rule?

Certain institutional investors now require managers to be SEC-registered before they are willing to invest in a manager's fund. A manager's registration has become an important factor for these investors. Also, many managers that don't register with the SEC are still required to register with state authorities. By making an SEC filing, a manager can usually submit that filing with state authorities and avoid having to make a separate filing.

Can we evaluate the cost of registration?

For large managers that have built up sizable back-office infrastructure to help administer their operations, the costs of registration are incremental. For small to midsized managers that lack this infrastructure, the costs are significant. Aside from the expense of implementing and monitoring ongoing SEC compliance procedures (including fees paid to attorneys, accountants and other back-office personnel), the real cost to a small manager may include the significant time he or she will have to invest to stay on top of the SEC's registration requirements.

Will the new rule address the issue of fraud?

To a certain extent, yes. For instance, a manager will have to disclose if its principals have ever been criminally convicted. To the extent a manager will have to undergo registration, there's an argument that certain bad guys may stay away since they'll now be monitored by the SEC. However, most hedge fund fraud has occurred largely in small funds (less than $25 million in assets) that are not even eligible to register with the SEC even if they wanted to. The managers of these funds prey on smaller individual investors who don't necessarily have the expertise or resources to do the necessary due diligence on what they're putting their money into.

Does the SEC have the staff and resources to oversee hedge funds?

Certain SEC commissioners have argued against the rule precisely because they felt that the SEC doesn't have the proper resources at this stage to actively monitor the hedge fund industry when its resources are stretched so thin currently monitoring other areas such as the mutual fund industry. In addition, some managers that have been the subject of SEC examination have complained that they are spending too much time educating SEC examiners on complicated trading strategies. In response, the SEC is beefing up its training of examiners.

How will the rule impact high net worth investors?

High net worth investors must perform thorough due diligence on a manager and understand the manager's investment style beyond simply relying on what's conveyed in a registration statement. While a manager's registration statement contains valuable information, it will not shed much light on a portfolio's risk or its risk relative to such factors as interest rate or market movement. Most managers lose money not because of fraud, but because of a bad bet -- nothing illegal in that, but investors should thoroughly understand which horse a manager is betting on.

Hedge fund manager Philip Goldstein has sued the agency over the rule. Does he have any chance to win in court?

It's very difficult to speculate on the outcome of any ongoing case based on limited oral arguments. Mr. Goldstein's case is still pending before federal court. For managers who have spent large resources becoming registered over the past year in anticipation of the new rule and have implemented extensive SEC-mandated procedures and policies, it's doubtful whether they would want to de-register simply because Mr. Goldstein wins his case.