The Securities and Exchange Com- mission finally released its staff report on the hedge fund industry last month, and many hedge fund managers are breathing sighs of relief, as the SEC recommendations were less onerous than anticipated.
"What the SEC has done is fair," says Robert Schulman, co-CEO of Tremont Capital Management in Rye, New York. James Hedges, president of LJH Global Investments in Naples, Florida, says the report didn't contain any surprises. "The SEC has been consistent on the issues they've explored and found relevant," he says. Michael Tannenbaum, co-founder and partner of Tannenbaum, Halpern Syracuse & Hirschtritt LLP in New York, who leads the firm's Financial Services, Hedge Funds and Capital Markets Practice Group, says the only shocker was that SEC staff recommended allowing hedge funds that are marketed to qualified investors to advertise. "I'm happily surprised," he says.
But Tannenbaum does question whether the SEC has the authority to implement some of the proposed changes. The SEC operates within the framework of the Investment Advisers Act of 1940, "which has certain provisions built into it by legislation," he says. "The issue in my mind is to what degree, and to what extent, the Commission will be able to make changes, which could be seen to be changing the legislation." The SEC may have to go to Congress before it can proceed with some of its fixes, specifically its desire to have all hedge fund managers register as investment advisors under the Investment Advisers Act. We'll have to see how this plays out, since Section 203(b)3 of the Act exempts managers from registering if their funds have 14 or fewer clients and less than $25 million under management.
The Registration Question
Hedges predicts that requiring hedge funds to register will prompt "a few very large global hedge funds [to] return U.S. investors' capital and manage money for their 14 largest non-U.S. accounts so that they can remain unregistered." Jeff Joseph, managing director of Rydex Capital Partners, who also serves on the advisory board of hedge fund data collector HedgeWorld (and is a regular contributor to Investment Advisor's monthly hedge fund column, this month on page 117), says that it will likely be the larger hedge funds that move offshore to avoid registering. A lot of these larger funds, he says, have "never had to register for institutional business. They're not avoiding regulation [by not wanting to register], but they're avoiding the cost associated with it."
Joseph believes that hedge fund managers, in general, don't see registration as overly burdensome. "Some [hedge fund managers] that are forward thinking may be saying, 'If this is what it takes to reach a broader market, then we're for it.'" The real burden, Joseph says, is going to be on the SEC to regulate all of these hedge funds.
Schulman of Tremont says that requiring hedge fund managers to register "will be inconvenient," and may, indeed, drive some hedge funds offshore, but it's certainly not a rule that will "strangle" the industry. SEC Chairman William Donaldson "has been very clear in his desire not to stamp out [hedge funds'] investment opportunity," he says. Donaldson assured hedge fund officials during the two-day roundtable at SEC headquarters in May--in which Schulman participated along with 64 other hedge fund professionals--and in private discussions, Schulman says, that he "wants to regulate this industry, not strangle it."
Hedge fund registration would also subject hedge funds to the SEC's regular inspections and examinations program. Moreover, it would allow the SEC to glean information about conflicts in managing hedge funds side by side with other accounts and hedge funds' relationships with their prime brokers.
The SEC would also like to know how registered investment companies that invest their assets in hedge funds value their portfolio holdings. And the Commission would like to issue a "concept release" for examining wider use of hedge fund investment strategies in registered hedge funds, like increased use of leverage and short selling.
Advertising or Educating?
The proposed change perhaps most welcomed by the industry would be to allow hedge funds that are marketed to qualified investors--those with at least $5 million in investable assets--to advertise. Granted, this probably won't mean hedge funds will get to splash ads on CNBC and other television networks, Hedges of LJH says. A more likely scenario, he says, is that certain marketing materials will be approved "that will be useful in educating potential investors."
Schulman says SEC commissioners believe not enough qualified investors actually buy into hedge funds, which "are pretty good investments for the right segment of investor." So "allowing appropriate advertising" may be a good way to draw in those investors.
While Tannenbaum is pleasantly surprised that the SEC wants to relax the advertising rules on 3(c)(7) funds, which are those funds sold to qualified investors, he sees a bit of a conundrum afoot. "If the rules are relaxed with respect to 3(c)(7) funds so that there can be advertising of those funds and a freer discussion of those funds with reporters, the issue in my mind is: What effect, if any, does that have on the private placement exemption that covers a 3(c)(1) fund that might be standing side by side in the manager's stable with the 3(c)(7) fund?" Tannenbaum says. "Many times a typical hedge fund structure includes a 3(c)(1) fund, which is not qualified. There's a prohibition in the securities laws against conditioning the market. You can't condition the market before you sell into it. So the query there is: if you can talk about a 3(c)(7), is that a conditioning of the market, vis-?-vis a 3(c)(1)?" Tannenbaum says he's curious to see how the SEC sorts this out.
Wait Till Next Year
It will likely be the second quarter of 2004 before the SEC commissioners decide which staff recommendations become the regulatory law of the land, predicts Schulman and Tannenbaum. And even after the SEC decides its course of action, the public will be given an opportunity to weigh in. While most of the people I interviewed believe the proposed changes will make it into any final regulation, it should be interesting to watch the negotiations among Congress and the SEC, as well as among the SEC commissioners, to finalize the rules. Tannenbaum thinks the two Republican SEC commissioners, Paul Atkins and Cynthia Glassman, may put up a fuss over some issues, specifically hedge fund registration, which both are opposed to. "If those two folks are reflective of their Congressional colleagues, it's very possible that there is no appetite to change this" registration requirement, Tannenbaum says.
SEC Enters Mutual Fund Fray
Chairman Donaldson is also moving quickly to deter any further abuses of market timing and late trading by mutual funds and hedge funds. New York Attorney General Eliot Spitzer alleged in September that the hedge fund Canary Capital Partners LLC of Secaucus, New Jersey, engaged in shady trading with four mutual fund families. Canary's managing principal ended up shelling out a total of $40 million in fines. Donaldson quickly began investigating the late trading and market timing shenanigans, and in early October said the SEC is considering issuing new rules and amending others to thwart any future abuses. To prevent the circumvention of forward-pricing requirements for purchases and redemptions of mutual fund shares, Donaldson said in a prepared statement that SEC staff is considering whether to require funds, rather than an intermediary such as a broker/dealer or other unregulated third party, to receive the order prior to the time the fund prices its shares for an investor to receive that day's price. For most funds, he said, the fund would have to receive the order by 4:00 p.m.
As for market timing, Donaldson said the SEC is considering requiring funds firms to:
o Disclose in fund-offering documents market timing policies and procedures;
o Include procedures to comply with representations regarding market timing policies and procedures;
o Emphasize the obligation of funds to fair value their securities under certain circumstances to minimize market timing arbitrage opportunities; and
o Reinforce the obligation of fund directors to consider the adequacy and effectiveness of fund market timing practices and procedures.
Hedge Funds and Insurance
On a side note, Tremont Partners recently launched a new platform of single-manager and funds of funds for insurance companies to use in their private placement life and annuity and Corporate Owned Life Insurance (COLI) contracts. The platform, called LifeInvest, complies with a recent Internal Revenue Service ruling that states that "companies selling funds for private placement insurance products must employ funds that are available only to insurance providers," according to Tremont. Schulman says the IRS ruling clarifies "a murky area." There was uncertainty, he says, "as to whether or not investment vehicles had to be insurance dedicated. The [IRS] rules were pretty clear in how they related to annuities, but because hedge funds are already private investments, it was uncertain how the IRS would propose insurance companies invest in them."
The LifeInvest funds include three strategy-specific funds of funds specializing in long/short equity, convertible arbitrage, and event driven strategies. Tremont plans to add global macro and fixed-income arbitrage funds within several months.