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Donaldson Says Commission's Hedge Fund Knowledge 'Woefully Inadequate'

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PALM BEACH, Fla. (–Securities and Exchange Commission Chairman William H. Donaldson told an audience of registered investment advisers that the commission’s knowledge of hedge funds was “woefully inadequate” and suggested mandatory hedge fund manager registration with the SEC was the best way to counter that.

Mr. Donaldson also answered critics’ contentions that having hedge fund managers register as investment advisers would not improve the SEC’s policing of the industry and would do little to protect retail investors, most of whom currently cannot access hedge funds. He said such criticism smacked of a double standard.

“Critics of our focus on hedge funds cannot, in my view, have it both ways–on one hand, to demand that the Commission be proactive and prevent and detect emerging but as of yet unforeseen harms and abuses, but on the other hand, to handicap our abilities to obtain simple, fundamental information that facilitates our identification of such abuses,” Mr. Donaldson said.

Mr. Donaldson has said he favors requiring hedge fund managers to register with the SEC, and in recent months has said the Commission is preparing proposed rules to achieve that Previous HedgeWorld Story. He has the support of commissioners Harvey Goldschmid and Roel Campos, however commissioners Cynthia Glassman and Paul Atkins have publicly criticized the registration initiative Previous HedgeWorld Story.

That leaves the commission divided 3-2 in favor of requiring some kind of manager registration.

An April 20 General Accounting Office report on SEC operations indicated staff with the commission’s Office of Compliance Inspections and Examinations and the Investment Management Division said their workload had increased in recent months due to the SEC’s stepped-up policing of mutual fund managers, among other initiatives. According to the GAO report, requiring hedge funds to register as investment advisers would mean monitoring an additional 600 to 1,100 advisers, placing further demands on the staff’s time and threatening goals to increase the frequency of manager examinations.

But as more investors have focused in recent years on risk over return, Mr. Donaldson has zeroed in on risk factors as drivers of SEC policy. Burned by the mutual fund market timing and late-trading scandal, which critics say has spotlighted the SEC’s inadequate oversight of financial markets, the commission has now committed to a proactive course of identifying risks ahead of time and moving to address them sooner rather than later.

Mr. Donaldson is leading the charge.

“Since becoming Chairman [in February 2003], I have become convinced by events … that the Commission needs to devote more time and energy to anticipating potential problems across the investment industry,” Mr. Donaldson told ICAA members.

At the top of Mr. Donaldson’s list is a new Office of Risk Assessment and Strategic Planning. The groundwork for the new office is being laid, with each major program area organizing internal risk teams. Mr. Donaldson said this would allow for a “bottom-up” approach to assessing risk within the various SEC divisions.

“When fully operational, the new Office of Risk Assessment will work in coordination with these internal risk teams to push the entire agency to proactively anticipate potential problem areas across the securities industry, focusing on early identification of new or resurgent forms of fraud and illegal or questionable activities,” Mr. Donaldson said.

Mr. Donaldson said the argument that hedge funds serve only wealthy investors who are supposed to be aware of potential risks does not work anymore, now that pension funds are investing in such strategies. Additionally, the growth of the hedge fund industry means hedge fund managers are having an increasingly significant impact on securities markets at large. Indeed, he said, hedge funds’ involvement in mutual fund timing and late trading shows they have entered the investing mainstream to the extent that greater regulatory scrutiny is required.

Acknowledging concerns that hedge funds may not be suitable for the same kind of regulation as other long-only investment advisers, Mr. Donaldson told the ICAA that the commission was looking at tailoring a different kind of registration and oversight regime for hedge funds.

“We could thus better target our inquiries to those hedge fund managers where there is some reasonable concern that they may be violating the federal securities laws,” Mr. Donaldson said.

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