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No Satisfaction: Dissenters Rip SEC Hedge Fund Rule

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WASHINGTON (–Calling the Securities and Exchange Commission’s new rule to require registration of hedge fund managers as investment advisers “the wrong solution to an undefined problem,” Commissioners Cynthia A. Glassman and Paul S. Atkins vented months of frustration with the SEC’s rulemaking process and its result in a 30-page dissent included as part of the final rule.

SEC officials released the final hedge fund rule on Thursday [Dec. 2]. It will be published in the Federal Register in the coming weeks, but managers won’t be required to comply until Feb. 1, 2006. The rule essentially requires onshore hedge fund managers with more than 14 individual U.S. investors and more than US$25 million in U.S. investor assets to register as investment advisers with the SEC. Offshore managers are required to register if they have more than 14 U.S. investors, regardless of how much in assets they manage.

Commissioners Glassman and Atkins opposed mandatory registration from the beginning, saying there was no evidence hedge funds were attracting retail investors, that the SEC could better spend its limited resources policing much more widely available mutual funds and that the new rule as proposed would do little to prevent the kind of fraud and misconduct cited by those who supported it.

Following a brief summertime comment period, the Commission in October voted 3-2 to approve the new rule pretty much as originally proposed. In their dissent, Commissioners Glassman and Atkins said “the majority”–Chairman William H. Donaldson and Commissioners Roel C. Campos and Harvey J. Goldschmid–seemingly failed to consider any of the “credible concerns from diverse voices.”

“We continue to agree that we need more information on hedge funds, but we disagree with the majority’s solution,” Commissioners Glassman and Atkins wrote. “There are many viable alternatives to this rulemaking that should have been considered.”

Among those alternatives were working more closely with other regulators, such as the Commodities Futures Trading Commission, and with market participants such as prime brokers to gather more information about hedge funds. Consulting with the CFTC, they said, should have been a no-brainer given that a number of hedge fund managers are already registered with that body as commodity trading advisers or commodity pool operators.

CFTC staff, in fact, submitted a comment letter expressing concern about the potential for “duplicative regulation” were the SEC to pass its rule as proposed and not provide along with it a specific exemption for CFTC-registered managers.

According to Commissioners Glassman and Atkins, the failure to take the CFTC’s concerns into account was part of a broader pattern of either ignoring information that conflicted with the final rule or not actively seeking alternatives.

For instance, the Commission approved the final rule weeks before the President’s Working Group on Financial Markets could complete a data-sharing agreement requested by Rep. Richard H. Baker, R-La., chairman of the House Financial Services Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises. And it ignored a 1999 PWG report on the collapse of hedge fund Long-Term Capital Management that concluded mandatory registration of hedge fund managers as investment advisers was not the best way to monitor their activity.

“The majority contends that the report did not focus on the issues relevant to the Commission’s administration of the Advisers Act, but rather on the ‘stability of financial markets and the exposure of banks and other financial institutions to the counterparty risks of dealing with highly leveraged entities,’” Commissioners Glassman and Atkins wrote. “The Commission cannot protect the nation’s securities markets without considering the effect of its rules on the stability of financial markets.”

The two contend the SEC staff should have consulted more closely with other government agencies, such as the U.S. Treasury Department, to aggregate information already available. And they said the SEC didn’t consult at all with the Department of Labor, which oversees pension funds, despite the fact that one of the stated reasons for the new rule was increasing investment in hedge funds by pension plans, and by extension, pensioners and workers.

Along those same lines, Commissioners Glassman and Atkins wrote that the SEC staff ignored alternatives to registration offered in some of the more than 160 comment letters filed in connection with the proposed rule, alternatives such as requiring advisers who claim exemption under various sections of the Investment Company Act of 1940 to file “information statements” with the SEC and update them annually. These statements could include the names of all unregistered funds the managers advise, the names and qualifications of key owners and employees, assets under management, other types of accounts managed, lists of prime brokers used and performance data. SEC staff dismissed this and another suggestion–expanded Form D reporting–because they lacked an examination component, Commissioners Glassman and Atkins wrote.

But both commissioners said they believe SEC examinations of hedge funds will be a drain on resources and will not offer much in the way of the kind of deterrence SEC staff has promised.

Likewise, the case for mandatory registration based on a premise that fraud is rampant in the hedge fund industry doesn’t fly either, the commissioners wrote. The SEC staff’s own 2003 report on hedge funds found no “disproportionate involvement of hedge funds or their advisers in fraud,” they wrote. Over the past five years, cited cases of hedge fund fraud constituted roughly 2% of all SEC cases. Only 3% of combined SEC and CFTC fraud cases over the last five years involved hedge funds or their advisers.

In most of the 51 cases cited by rule supporters, mandatory registration would have had little effect because the funds were too small to be registered, were already registered or should have been registered, Commissioners Glassman and Atkins wrote. “Many were garden-variety fraudsters who could as easily have called their schemes something other than ‘hedge funds.’” People intent on committing fraud probably won’t bother to register with the SEC before opening up shop, thus making one of registration’s goals–to weed out those convicted of felonies or with other kinds of disciplinary histories before they can start–moot, they wrote.

Twisting the knife a little, Commissioners Glassman and Atkins noted that although mutual funds are required to register, doing so did not help the SEC uncover the market-timing and late-trading abuses that have rocked that industry for the past year.

To enforce the new rule the SEC will have to divert resources from policing mutual funds, which have some 90 million investors. By contrast, hedge funds have an estimated 200,000 individual and institutional investors. “This seems unwise so soon after we made the case that we did not have enough staff to oversee the existing pool of registered advisers and funds,” the two commissioners wrote. “In fact just two days after the majority adopted this rulemaking, [Paul F. Roye] the Director of the Division of Investment Management reportedly said that an option that the Commission has in its ‘back pocket’ is raising the threshold to registration level to US$40 million.”

The costs of registration, which have been downplayed by SEC staff, are likely to hit smaller advisers hardest, they wrote.

And ironically, hedge fund registration may actually promote further retailization of the industry by conferring a kind of “seal of approval” on hedge funds.

The commissioners also offer a preview of possible legal challenges to the new rule, pointing out that in adopting the new rule the Commission staff and majority change the definition of “client” so as to look through the fund itself to the underlying investors. “Not only does the majority’s action awkwardly depart from the established approach for identifying and adviser’s clients,” Commissioners Glassman and Atkins wrote, “but the majority rejected compelling challenges to the Commission’s statutory authority for this action.”

Essentially, they wrote, the SEC staff reinterpreted what Congress meant by “clients” when it passed the original Investment Advisers Act in 1940, and then amended it in 1970 and 1996. The effect of this reinterpretation is to assume that advisers overseeing large pools of capital had to register. This is a mistake, the duo wrote.

“?? 1/2 [T]he legislative history of that section [3(c)(1) of the Investment Company Act] suggests that Congress understood that there would be asset pools, some of them large, that were not reached by that statute. The fact that many advisers to such pools were not registered under the Advisers Act was certainly known to Congress and allowing them to continue in their unregistered state was entirely consistent with Congress’ objective of minimizing regulatory restrictions on such pools of assets.”

In conclusion, Commissioners Glassman and Atkins wrote, “Questions about the wisdom of the majority’s approach are compounded by questions about the propriety of this approach in light of legislative and regulatory precedent. We hoped that the Commission would accord serious consideration to objections to their proposal. Today’s rulemaking, which is the wrong solution to an undefined problem, disappoints those hopes and leaves better solutions unexplored.”

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