SEC chief seeks 'emergency' rules for hedge funds
Chairman Cox asks staff to enact part of the rule tossed by an appeals court.
NEW YORK (CNNMoney.com) -- SEC Chairman Christopher Cox called Tuesday for "emergency" steps to reinstate parts of a rule that required hedge funds to register with the agency after an appeals court threw out the rule last month.
Cox, testifying before the Senate Banking Committee, said that in light of the court's decision to overturn the rule, he feels the current regulatory regime for hedge funds is "inadequate."
"We must move quickly to address the hole that the [court's decision] has left," he said. "Some improvements will be possible through administrative action. Others, however, may require legislation."
The SEC chairman said after the hearing that he has not ruled out a possible Supreme Court appeal of the court's decision, according to Reuters. Cox said the SEC has until Aug. 7 to decide whether to appeal and added that he is weighing "potential reputational damage to the SEC" if the Court rules against the SEC, according to the report.
Last month the U.S. Court of Appeals for the D.C. circuit threw out the SEC rule, which took effect in February and required hedge funds to register with the commission as investment advisers and submit to occasional inspections of their books and records. Since the appellate ruling, 10 hedge funds have filed paperwork to de-register from the SEC.
Whether or not they are registered, hedge funds are still subject to the SEC's anti-fraud provisions.
Hedge funds are private investment partnerships limited to institutional investors and wealthy individuals. Hedge funds use a variety of strategies, from betting on or against stocks, currencies or commodities to more esoteric strategies involving "derivative" investments or turning around distressed companies.
Estimates of the size of the hedge fund industry vary, but one widely used figure is $1.225 trillion, based on research from Chicago-based hedge fund tracker Hedge Fund Research. Hedge funds attracted $42 billion of new money in the second quarter, the largest quarterly spike in new assets since 2003, according to HFR.
Cox and some senators noted that the industry has grown explosively in recent years - some 3,000 percent in the last three years, Cox testified - and that hedge funds now account for roughly 30 percent of the trading volume on U.S. exchanges.
That growth has prompted regulators to raise questions about whether hedge funds pose "systemic" risks and whether the collapse of a hedge fund or group of hedge funds could roil the nation's financial markets.
Cox said he had instructed his staff to undertake "emergency" steps that would restore some tenets of the SEC's original rule, including a new anti-fraud rule that would refer to individual investors in a hedge fund as "clients" of the fund adviser, rather than referring to the fund itself as a "client."
The SEC's rule had required funds with 15 or more "clients," which it defined as individual investors, to register with the SEC, a reversal of the previous practice of referring to a single pool of capital as the fund adviser's client.
In its ruling, the D.C. court said the SEC's decision to "look through" a fund's investors and count them as clients was arbitrary, since fund managers do not directly provide personalized advice to a fund's investors but rather make investment decisions using a collective pool of capital.
Chairman Cox said he also recommends that the SEC pass emergency actions that would raise the minimum wealth requirement for an individual to invest in a hedge fund from $1 million to $1.5 million, which he said was part of the SEC's original rule and which the court ruling overturned.
The pros and cons
Opponents of additional regulation for hedge funds say the SEC's limited resources would be better spent protecting individual investors with less than $1 million in assets, who have less to lose and who are not allowed to invest directly in hedge funds.
Proponents say regulators need to know more about the investment activities of the funds, which they believe could pose "systemic" risks to the capital markets.
A handful of senators on the committee said during the hearing that they believe hedge funds play a valuable role in the capital markets by improving liquidity and pricing but that they want to learn more about their potential risks.
Treasury Undersecretary Randal Quarles testified that hedge funds as well as the brokers that execute trades and provide other services to hedge funds have taken big steps since the collapse of the giant, heavily leveraged Long Term Capital Management hedge fund in 1998 to reduce systemic risk.
Quarles said he believes hedge funds pose less risk to financial markets today than they have in the past, noting they use less leverage and are generally smaller than LTCM.
He said he is working with the President's Working Group, convened after the collapse of LTCM, and regulators including the New York Federal Reserve to meet with hedge funds and investment banks to learn more about the risks brokers and other parties face from their exposure to the funds. But he declined to speculate on what the outcome of the meetings might be.
"It would be premature to say we need regulation until we complete our review," he said.
But Sen. Paul Sarbanes, the ranking member of the committee and co-author of the Sarbanes-Oxley legislation, wondered whether a massive move by investors to pull cash out of hedge funds following a market collapse would trigger a "run on the bank" that could destabilize financial markets.
In response to the question, Cox echoed Quarles' view that the industry has changed since LTCM and that the big brokers that service hedge funds have "dramatically improved" their ability to monitor the funds and liquidate positions quickly.
Cox said the SEC is concerned about the effects that hedge funds have on "retail" investors.
While so-called mom and pop investors who aren't wealthy can't invest directly in hedge funds, they are being increasingly exposed to these funds through private and public pension plans, which more frequently do invest. But Cox acknowledged that hedge funds do not allow unqualified investors to participate.
"The commission staff are not aware of significant numbers of truly 'retail' investors investing in hedge funds," he said.
Commodity Futures Trading Commission chairman Reuben Jeffery also testified at the hearing.