October 21, 2002

Roye: Funds of Hedge Funds Require Careful Scrutin

WASHINGTON (HedgeWorld.com)--Paul Roye, director of the division of investment management of the Securities and Exchange Commission, speaking to an audience of lawyers Thursday, dropped several hints about the direction of the SEC's ongoing inquiry into the hedge fund industry.

There has been much speculation in recent weeks that the SEC is ready to draft a report by the end of the year recommending increased regulation for hedge funds, perhaps requiring hedge fund managers to register as investment advisers.

Mr. Roye's remarks, the keynote address to the eighth annual advanced American Law Institute--American Bar Association Course of Study, Investment Management Regulation, were of course accompanied with the usual disclaimer that the views he expressed were his own and not those of the SEC or his colleagues on the staff thereof. Still, he cannot but have stoked the flames of speculation.

Mr. Roye said that the inquiry has focused especially upon "incidents of fraud with these funds, conflicts associated with managing these funds alongside mutual funds, and the increasing retailization of these funds." He said nothing about the timing of a staff report to the commissioners, but he did promise that it would present them with a "comprehensive record."

On a closely related matter, he discussed the custody rule at some length. This is the rule that mandates the separation and identification of client funds and securities left in the custody of an adviser under the Investment Advisers Act. He said that it has not been substantively revised since 1962. To dust it off for the new century and because "our examiners have on occasion discovered an adviser keeping certificates in an office file" where they might easily be lost or destroyed, the SEC has now proposed amendments requiring advisers with custody to maintain the funds and securities with a broker-dealer, bank or other qualified custodian.

The proposed amendments to the custody rule would effectively exempt from its requirements "advisers to limited partnerships and other pooled investment vehicles" because those vehicles have contractual means to protect themselves from the misuse of their assets. In much of his speech, Mr. Roye may have been building a case for a revision of those amendments that would abolish that exemption, subjecting hedge funds to the custody rule. He said that many comments have addressed the meaning of the term "qualified custodian" and other "issues of scope," and that the staff was taking these comments very seriously as it moved toward a recommendation to the commissioners on the final rule.

On another closely related issue, Mr. Roye said that his division is looking closely at hedge funds of funds. These types of funds are suitable, he said, only for sophisticated investors. It is worrisome, he thought, that they have become available to a wider range of investor than has historically been the case, because smaller investors are pooled together to meet the higher minimum investments that the underlying hedge funds require.

"We have been carefully scrutinizing these funds for appropriate disclosure and we are particularly interested in how these funds value their investments in the underlying hedge funds in determining their own net asset values."

A Tour of the Horizon

The speech as a whole was a comprehensive review of issues in investment management, traditional as well as alternative, today.

The SEC continues to address the issues inherent in the corporate governance reform legislation of this summer, such as the rules protecting the independence of auditors from pressure that may be put upon them by officers or directors of an issuer.

It is also at work implementing the provisions of the USA PATRIOT Act, assisting the Treasury Department and the Federal Reserve in common anti-money laundering efforts.

This May, the SEC proposed amendments that would improve mutual fund advertising disclosure and increase transparency as to mutual find proxy vote policies and practices.

Mr. Roye also said that exchange traded funds continue to evolve, and the SEC wants to keep up with that evolution, allowing for innovation so long as necessary protections are not compromised. "Last year we requested comment on the regulatory issues raised by actively managed ETFs in a concept release. The comments that we received on the release are helping to inform our review of specific applications for these new products."

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