Government catches up with hedge funds
As of today, hedge funds have to register with the SEC; some say that provides a false sense of security to less sophisticated investors.
By Amanda Cantrell, CNN/Money staff writer

NEW YORK (CNNMoney.com) - After two years of scrutiny, debate and even lawsuits, hedge funds are finally required to register as investment advisers with the Securities and Exchange Commission as of today.

The change marks the first time fund managers in the roughly $1 trillion industry have to register with the SEC as investment advisors, though many managers have already done so voluntarily. Hedge funds will not have to register their individual funds. Rather, they have to provide the SEC with basic information about the firm and also have to hire a chief compliance officer. As part of the rule, hedge fund firms are now subject to random SEC inspections.

The new rule carries some notable exceptions, however: As the rule is written, funds with less than $30 million under management will not have to register, though funds with $25 million or more are eligible for registration.

And funds who "lock up" their investors' money for two or more years or refuse to take new money can also avoid registration. The two-year loophole was meant to protect private equity and venture capital funds from getting caught up in the rule, but some managers invoked the exception to avoid registration.

Harry Davis, a partner with law firm Schulte Roth & Zabel, which represents many large hedge funds, said he doubts that funds would close to new investment just to avoid registration, but it may have been a deciding factor for managers deciding whether to close their funds.

"For funds that were thinking about whether they should close that might have tipped them in favor," he said of the rule. "But someone who still wants to grow their business isn't going to close just to avoid registration."

SEC spokesman John Nestor said the SEC is not restricting hedge funds from invoking these exceptions, but he feels that some firms who have tried to invoke it have faced resistance from investors.

"What hedge funds are finding is that big, institutional clients don't want to have their money restricted that way, so if a hedge fund says they want to go to a two-year lockup period, some funds are saying 'Not with my money you won't,'" he said.

A maturing industry

The hedge fund industry began as a maverick, entrepreneurial corner of the high-finance world in which managers could place big, unconventional and risky bets on non-traditional strategies. The most successful of these managers made their investors typically high-net-worth individuals very rich.

But as the industry has grown up, so has its investor base. Returns have come down from the stratosphere, and managers now heavily emphasize risk management. Those changes have made institutional investors more comfortable leading institutional investors like university endowments and lately, public and private pension plans to leap aboard. Because these types of investors often take comfort in registration, a number of hedge fund mangers registered voluntarily to attract institutional money.

People opposed to the registration rule say hedge funds are for sophisticated investors who don't need protecting, and that SEC registration status will give less sophisticated investors a false sense of security about funds, leading to sloppy due diligence.

They also say requiring funds to register would make starting a new hedge fund onerously expensive, because of the costs associated with registration including legal fees, staffing costs and other related expenses. Opponents to the rule argue that it is important to the growth of the hedge fund industry that new, successful funds are allowed to form without being unduly burdened with high costs from the outset.

Opponents also question whether SEC registration will help protect investors against fraudulent managers, especially since some of the SEC's hedge fund enforcement actions were levied at firms that were already registered with the SEC.

Randy Shain, executive vice president of investigative due diligence firm First Advantage CoreFacts, which publishes BackTrack Reports, said that while he doesn't think hedge fund registration is a terrible idea, he doesn't feel it will ferret out fraud.

"When I look at industries that are heavily regulated, I see no correlation between them and the prevention of fraud," he said. "Look at broker/dealers they're heavily regulated and yet they've given us the biggest boiler rooms. Why would this be different?"

One manager, Phil Goldstein, is so strongly opposed to the rule that he filed a lawsuit against the SEC, charging that the agency exceeded its regulatory authority. Goldstein, a shareholder activist who runs Bulldog Investors, a hedge fund firm that manages about $200 million, through his firm Opportunity Partners L.P.

One of the three judges hearing arguments in the suit, U.S. appeals court judge Harry Edwards, appeared to side with Goldstein, telling an SEC attorney the agency stretched the definition of "hedge fund clients" to make the registration proposal work, according to news reports. The panel is expected to issue a verdict soon.

"What you really have is a rogue agency. So many people give the SEC such wide latitude, but they have exceeded (their) legal authority," Goldstein told CNN/Money last year. He added that he feels a ruling forcing hedge funds to register with regulators should have come from Congress -- not the regulators themselves.

Donaldson's legacy

The SEC began investigating the hedge fund industry under former chairman William Donaldson, who led the charge during his 2-1/2-year tenure to make hedge funds register with the SEC under the Investment Advisers Act of 1940. The commission, sharply divided on the issue, voted to approve the controversial rule by a slim 3-2 majority.

Donaldson' cited the industry's spectacular growth it now stands at an estimated 8,000 funds and has doubled in size in the last four years as well as a rise in fraud cases in the lightly regulated industry.

Despite published reports of a bottleneck at the agency in processing registration applications, SEC spokesman Nestor said the commission anticipated a last-minute rush to registrations and staffed accordingly, which enabled it to cut the application processing time typically 45 days in half. He said the SEC only has 71 outstanding applications left to process.

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Hedge funds post gains in January: Click here.

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