SEC re-evaluates hedge fund regulation
Commission acknowledges court ruling that exemption in registration rule is arbitrary.
By Amanda Cantrell, CNNMoney.com staff writer

NEW YORK (CNNMoney.com) - The Securities and Exchange Commission has acknowledged it will have to reconsider the rule it passed earlier this year requiring hedge funds to register as investment advisers in light of a federal appeals court's decision to toss out the rule.

The rule, aimed at regulating the $1.2 trillion hedge fund industry, took effect Feb. 1 after years of heated debate. It was tossed out Friday by the Appeals Court for the District of Columbia, which said the rule was arbitrary because it exempted hedge funds with fewer than 15 clients. The court has sent the rule back to the SEC to modify or reconsider.

Hedge funds are private investment pools limited to wealthy individuals and institutional investors, though more private and public pension plans are investing in these funds on behalf of regular people. The term "hedge fund" applies to many different types of investment funds, but most are limited to "accredited" investors who must meet a minimum standard of wealth, and all charge their investors fees based on the fund's performance.

The suit was filed by Philip Goldstein, founder of the $225 million Bulldog Investors, which runs the Opportunity Partners activist funds.

For his part, Goldstein, who filed the suit in December 2004, said the court's ruling vindicates his claim that the SEC overstepped its jurisdiction in passing the rule in the first place.

"It's a scary country in which unelected bureaucrats with no accountability are making up laws," said Goldstein. "The SEC has a function, but it's not to make laws, it's to enforce the laws."

The SEC said in a statement that the court's finding requires the agency to re-evaluate its approach to hedge fund activity.

"I have instructed the SEC's professional staff to promptly evaluate the court's decision, and to provide to the Commission a set of alternatives for our consideration," said SEC Chairman Christopher Cox in a statement. "The SEC will use the court's decision as a spur to improvement in both our rulemaking process and the effectiveness of our programs to protect investors, maintain fair and orderly markets, and promote capital formation."

Cox added that the SEC will continue to work with other agencies involved in the President's Working Group on Financial Markets, such as the Treasury, the CFTC and the Federal Reserve, "to evaluate both the systemic market risks and retail investment issues associated with the growing presence of hedge funds in the world's capital markets," according to the statement.

What's next for regulators

Hedge fund managers in favor of registration say it can help the industry ferret out instances of fraud at smaller funds, which they say give the industry a bad rap.

But people opposed to the registration rule say hedge funds are for sophisticated investors who don't need protecting. They 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.

The court argued in its 19-page ruling that the number of clients a fund has - the SEC defines a client as a single investor - does not reveal anything about the scale or scope of a fund's activities.

Instead, "It is the volume of assets under management or the extent of indebtedness of a hedge fund or other such financial metrics that determines a fund's importance to national markets," the ruling said, according to Reuters.

Jedd Wider, a partner in the business and finance practice of law firm Morgan Lewis, pointed out that the timing of the ruling is peculiar, given that the registration rule went into effect months ago and many hedge funds have already gone through the registration process.

"We may see Congress step in to the extent this is an avenue they are interested in moving down, and proposing registration that will carefully and more thoroughly define what is actually meant by the term 'client,'" said Wider.

Ron Geffner, a partner at law firm Sadis & Goldberg, said it is unclear whether the court's ruling will interfere with the work the SEC is currently doing to collect information on hedge funds. The rule gave the SEC the authority to conduct random examinations of hedge funds, and people in the business say the SEC wasted no time getting into the offices of hedge fund managers to conduct these exams.

"Given the change in the regime and the different focuses that the current commissioner may have from prior commissioners, it is unclear whether the staff is committed to re-writing the rule in an attempt to maintain or create additional regulatory scrutiny for managers of hedge funds, or whether this will just be a story I can tell my grandkids," he said.

A spokesman for the SEC said last month that the agency planned to examine about 10 to 15 percent of the roughly 1,000 newly registered hedge fund advisers in the coming year.

Many hedge funds had already registered voluntarily with the SEC before the rule went into effect. Many other funds skirted the issue altogether thanks to some exceptions written into the rule. 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.

Ben Bornstein, founder and portfolio manager of the Prospero Capital hedge funds, said his firm registered with the agency long before the rule went into effect and doesn't think Friday's ruling will deter the government from getting involved.

"I don't think it's a reversal of what the SEC is trying to do; if anything the obvious way to get around the issue is just to say that all hedge funds need to register as opposed to just the ones with more than 15 investors."

But Bornstein said that when it comes to regulation, the industry has gotten tougher on itself, without extra help from the government. Bornstein said many hedge fund prime brokers, who provide services including trade reconciliation, margin financing and securities lending, are getting much stricter in selecting hedge fund clients.

Bornstein said some prime brokers are now requiring funds to have as much as $25 million in assets before they will take a fund as a client.

"To raise that kind of capital right off the bad you have to have some contacts and strategy to raise real money," said Bornstein.

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Related: Court tosses hedge fund registration rule Top of page

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