Legal Analysis Highlights Need for Clarity in SEC's Hedge Fund Rule

NEW YORK (HedgeWorld.com)--Attorneys with the American Bar Association and officials at the Managed Funds Association have challenged key provisions of the SEC's proposal to regulate the hedge fund industry and have argued that some of the proposed rules would actually contradict the SEC's own current interpretation of existing regulations.

"The SEC Memorandum (to Sen. Jon Corzine (D., N.J.)) [a review of SEC regulatory actions] does not provide statutory authority, either explicit or implicit, for the rulemaking it now proposes," wrote John Gaine, president of the MFA, based in Washington, in an Oct. 12 follow-up commentary to the SEC's proposed rule.

At issue is the SEC's position that hedge funds present inherent dangers for investors and the argument that the public and regulators need to know exactly what managers in this emerging asset class are doing. Arguing that fraud is common to hedge funds, regulators are seeking to place greater restraints on managers by enhancing existing securities laws.

According to critics, the problem is that the SEC's interpretation of safe harbor rules adopted in 1985 that allow an adviser to count as a single client a corporation, a general partnership or other legal entity. In its proposed rule on hedge funds, the SEC has left it up in the air as to whether it plans on counting individual beneficiaries of a pension funds as clients rather than the entity itself as a single client, attorneys write.

If the agency decides to count individual pension fund beneficiaries, it would be a contradiction to the SEC's current interpretation of the Investment Advisers Act of 1940, according to the MFA and the American Bar Association's Task Force on Hedge Fund Regulation.

According to the current SEC proposal, if a hedge fund has less than US$30 million in assets under management but more than 14 clients, its manager still is subject to hedge fund registration.

Besides the issue of counting clients, the ABA's task force and the MFA don't believe the SEC has fully made its case for registration.

"Adviser registration is an important requirement that should only be invoked when there is clear and compelling evidence that it will fulfill explicit and state objectives," representatives of the American Bar Association, Chicago, wrote in a letter to the SEC.

Besides asking for clarity on the counting of clients, the ABA task force asked for the SEC to change its wording within the registration proposal and within the Form ADV questionnaire that registered hedge fund firms are required to fill out.

Recommending that any proposed rule not become effective until Jan. 1, 2006, the task force asked that the commission provide more specific wording regarding offshore hedge fund advisers and their registration compliance.

The group proposes that, for offshore funds, registration should only be required of funds to which U.S. investors contribute 25% or more capital and only if that level is reached on an aggregate basis. Such a rule would be similar to the ERISA rules now governing U.S. corporate pension fund investing in limited partnerships.

More important, ABA task force members are proposing that the SEC require private fund advisers to file a form with the commission providing information for a private fund registry.

Such a registry would be filed within 45 days after the end of the year and would include the name of the investment adviser, mailing address, jurisdiction, legal structure, number of employees and name and address of the fund's managing member. The ABA included a sample copy of such a document in its comments to the SEC filed at the end of September.

The commission is expected to meet regarding hedge fund registration in the coming weeks. Reuters reported that the commission would vote on the issue on Oct. 26. According to the SEC web site, all five commissioners are available for a vote on that day and are free from any scheduled speaking engagements.

SBarreto@HedgeWorld.com

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

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