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Comment Period Ends: Leaving Something from Everybody

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WASHINGTON (–Despite calls for extension, the Securities and Exchange Commission has let the clock run out on the comment period for its proposed rule requiring most hedge funds to register as investment advisers.

A comment from the National Futures Association proposed that any final SEC rule exclude from its coverage commodity pool operators and commodity trading advisers registered with the Commodity Futures Trading Commission. By way of justifying this carve-out, the NFA calls into question one of the premises of the pro-registration case: the idea that the SEC needs more information about a burgeoning industry.

“NFA already collects a significant amount of information regarding CPOs and hedge funds through its audits…. We would be happy to talk to [SEC] staff about sharing this and any other information, which can be accomplished without requiring CPOs and CTAs to register as investment advisers.”

The Managed Funds Association’s comment is an elaboration of that theme. Existing rules and regulations covering futures trading, interaction with broker-dealers and with banks, etc., already establish an abundant base of data about the hedge fund industry. The MFA proposes in its comment that this existing information should be evaluated by the President’s Working Group on financial markets to ensure “that the appropriate regulatory agencies will have access to this information as necessary to carry out their regulatory responsibilities.”

Registration is not only unnecessary for information gathering purposes it is burdensome and inconsistent with the core objectives of the securities statutes, the MFA contends.

But if, “following further study and the above-referenced undertaking by the PWG, the SEC is able to demonstrate that certain of its objectives remain valid and unsatisfied, alternative proposals can be explored” by which the necessary missing information might be raised short of registration.

The comment suggests three possibilities. Requirements might be imposed upon those hedge funds that take advantage of the statutory exemption from registration that they: provide notification containing information the SEC demonstrates to be necessary or appropriate; agree to provide “on special call by the SEC under limited circumstances,” certain information relevant to enforcement of anti-fraud and anti-manipulation provisions of the law; or certify compliance with qualification standards.

The Range of Comments

From the terse to the loquacious, from the allegorical to the literal, from the advocates of registration to its opponents, from theory to practice–comments have lined themselves up along any of a number of axes.

One commenter identified himself only as Pablo. Pablo offered a single sentence to the effect that since Alan Greenspan is against the proposed rule, it must be a good idea.

Another comment commending the SEC on its proposal came from Robert M. Lam, chairman of the Pennsylvania Securities Commission. “The increase in enforcement actions brought against hedge funds by the SEC underscores the need for registration and oversight. The [PSC] applauds SEC efforts to protect investors from securities fraud.”

The Ohio Public Employees’ Retirement System weighed in to much the same effect. Laurie Fiori Hacking, its executive director, commented that hedge fund registration will “increase hedge fund transparency, particularly as it relates to adequate risk disclosure, by providing the SEC with valuable information about hedge funds and funds of hedge funds, another growing sector.” She also wrote that the OPERS agrees with the SEC that “offshore advisers to hedge funds should be treated similar to any other type of offshore adviser that provides advise to U.S. residents.”

Through the Looking Glass

Some of the rule’s opponents argued law; others argued facts. A comment from the law firm Wilmer Cutler Pickering Hale and Dorr, Washington, focused on the issue of statutory mandate and the manner in which the SEC proposes to count to 15. In 1940, Congress excepted from registration as investment adviser any adviser with “fewer than fifteen clients.” The new rule proposes to “look through” institutional clients to treat their individual members and owners as separate clients for purposes of this rule. Wilmer Cutler made the case that the SEC has no authority to look through, because the legislative history and the precedents surrounding the 1940 Act show that a “client” is a person directly receiving investment advice.

The Wilmer Cutler partners who compiled this comment (Marianne K. Smythe, Louis R. Cohen and James E. Anderson) relied in particular upon Lowe v. SEC, a 1985 Supreme Court decision holding that the publisher of a securities newsletter who doesn’t provide personalized investment advice isn’t an investment adviser in the sense of the act. The Court reasoned that readers of a newsletter aren’t clients of the publisher, i.e. publishers don’t have “the kind of fiduciary, person-to-person relationships that were discussed at length in the legislative history of the Act and that are characteristic of investment adviser-client relationships.” Likewise, the comment reasons, the close fiduciary relationship that exists between adviser and client doesn’t exist between an adviser and most of those who might be counted as “clients” under the read-through clause of the proposed rule. Many fund investors are “entirely passive and indistinguishable.”

A comment from Opportunity Partners LP, Pleasantville, N.Y., written by its principal, Phillip Goldstein, makes much the same point in humorous and allegorical terms. Mr. Goldstein begins by quoting Humpty Dumpty, as imagined by Lewis Carroll, to the effect that words mean what he, the big egg, wants them to mean. Mr. Goldstein then explains that he recently encountered a kin of Humpty, named Bumpty Dumpty, and that Bumpty (who now appears to be on the SEC staff) sought to explain why to him why the SEC proposal makes sense.

Here is a brief sample of the dialogue that follows that disclosure.

Mr. Goldstein: “The Supreme Court went into great detail about the legislative history of the Advisers Act and especially as to what an adviser is and a client. However, I didn’t see Lowe mentioned in the SEC’s release. How come?”

Bumpty: “We don’t put much credence in Lowe.

PG: “Why not?”

BD: “We lost that case.”

PG: “I think you have to follow it anyway.”

Remember the Costs

Other commenters focused not on the legal argument but upon the likely costs of such a rule. Alex Cook, a registered investment adviser himself, wrote that he has “no doubt that further oversight will bring some benefits,” but he is concerned that “those benefits would be dramatically overwhelmed by the costs, both direct costs to the SEC and funds, and also tangential costs in a variety of areas.”

Rodney C. Pitts, of Charlotte, N.C., wrote that he and his family have been investing in hedge funds since 1989. He is concerned that the SEC is proposing to tamper with an effective system.

“The cost of registration and regulation under the Investment Advisers Act of 1940 would be very costly for the advisors … and it would not protect very many investors.”

A similar cost-based caution came from overseas. The Alternative Investment Management Association, London, noted that almost all non-U.S. hedge fund managers have American investors in their funds, and warned of “the undesirability of, and difficulties inherent in, separate and possibly duplicative regulatory, examination, and enforcement regimes and requirements.” It asked that any rule adopted include exemptions for advisers who are already subject to efficient regulation in their home jurisdiction or where they operate.

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Contact Bob Keane with questions or comments at: [email protected].


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