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Portfolio > Alternative Investments > Hedge Funds

Democrats and Hedge Funds

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Now that the Democrats have seized both houses of Congress, some hedge fund officials are anticipating tighter controls on the industry. Granted, Republicans, too, heightened their scrutiny of hedge funds of late, but Lisa McGreevy, executive VP and chief operating officer at the Managed Funds Association (MFA) in Washington

opines that “issues related to hedge funds are not partisan issues.” Prior to the November 7 midterm election, she says, “both Republicans and Democrats were working very closely with each other on the issue of where do we go from here” in monitoring hedge funds. Michael Tannenbaum, a partner at New York law firm Tannenbaum Helpern Syracuse & Hirschtritt LLP, argues, however, that hedge funds should indeed brace for more regulation. “Philosophically,” he argues, “it’s more likely that Democrats will regulate [hedge funds] than Republicans.”

Before the midterm elections, bipartisan efforts to scrutinize hedge funds were taken up by Rep. Richard Baker (R-Louisiana) and Rep. Barney Frank (D-Massachusetts) along with Rep. Mike Castle (R-Delaware) and Senator Richard Shelby (R-Alabama), McGreevy points out. Examining hedge funds “was non-partisan then and I think it’s still non-partisan,” she says.

In June, Congressman Frank–who becomes chairman of the House Financial Services Committee–introduced the Securities and Exchange Commission Authority Restoration Act of 2006 (H.R. 5712), which would give the SEC the go-ahead to reinstate its hedge fund manager registration rule. That rule was struck down by a June 23 ruling by the U.S. Court of Appeals for the District of Columbia Circuit, which focused its opposition on the SEC’s use of the term “client” in the hedge fund registration rule the securities regulator passed in December 2004. Tannenbaum, for one, believes that Frank will use his position as chair of the House Financial Services Committee to push his bill through.

Of Presidents and Pensions

Rep. Castle introduced a bill in mid-September, the Hedge Fund Study Act (H.R. 6079), which would require the President’s Working Group on Financial Markets to conduct a study of the hedge fund industry. In particular, the bill requests that the working group examine the changing nature of hedge funds and their definition; the growth of hedge funds; the growth of pension funds investing in hedge funds; whether investors can adequately protect themselves from risks associated with hedge funds; whether hedge fund leverage is effectively constrained; and the risks hedge funds pose to the overall financial markets and investors. Tannenbaum says the bill is a roadmap for what he expects will be “the hot buttons for the next year or two.” Going forward, he expects “tighter regulation and more precise regulation focused on particular segments of the industry as opposed to some major omnibus bill.” Congress should not take a “Sarbanes-Oxley, broad-brush approach to some of these perceived issues,” he said, rather it should “take a scalpel to some of these issues and regulate items on a case-by-case basis.”

The Pension Protection Act of 2006 modified the Department of Labor’s (DOL) plan asset regulation by allowing hedge fund advisors to accept more money from pension programs. But some members of Congress appear to be questioning whether that’s such a prudent move. McGreevy of MFA says the hedge fund issue that will get the most attention from the 110th Congress will be pension funds’ investment in hedge funds. “There will be a lot of discussion on whether or not hedge funds are an appropriate vehicle for pension fund assets,” she says. But Tannenbaum argues that Department of Labor rules as well as fiduciary liability standards under ERISA are “ample rules” to govern pension investments in hedge funds.

About the SEC . . .

There are others who believe that tighter hedge fund controls via legislation are not necessarily imminent, and that Congress is just trying to get a better handle on an industry that it doesn’t fully understand. It could be argued that the Government Accountability Office’s (GAO) broad review of two of the Securities and Exchange Commission’s divisions–the Office of Compliance, Inspection, and Examination (OCIE), and its enforcement unit–is one such fact-finding mission. GAO is performing the study at the behest of Senator Charles Grassley (R-Iowa), former chairman of the Senate Finance Committee. That post has now been secured by Senator Max Baucus (D-Montana). Grassley asked the GAO to examine these SEC divisions because of the regulator’s handling of an insider trading investigation involving Pequot Capital Management, a $7 billion hedge fund.

While it’s been said that the GAO’s priorities will be to zero in on whether the SEC properly monitors self-regulatory organizations like the New York Stock Exchange and NASD, Paul Anderson, a GAO spokesman, says it is “still in the design stage” of determining the study’s “scope, methodology, etc., in consultation with Sen. Grassley’s office.” When asked if the GAO will continue working with Grassley’s office now that Baucus has taken his place as Senate Finance chair, Anderson says that GAO is now “evaluating all of our pending requested work and, if the job has only GOP requesters, we are going to be determining the interest of the incoming majority in having it continue at its current priority.” Baucus is actually “looking forward to seeing the GAO study,” says Carol Guthrie, Baucus’s press secretary. Baucus is “in favor of transparency and certainly wants to make sure investors have the information they need to make smart decisions,” she says. The GAO study “will receive attention in the 110th Congress.”

While the GAO investigation is still ongoing, Brian Rubin, a lawyer with Sutherland Asbill & Brennan LLP in Washington, believes that whatever the outcome, “the SEC would be open to suggestions on how to do a better job…I think if the [GAO] comments are reasonable, then the SEC is likely to implement them even if there’s no mandate from Congress.”

The SEC itself has gotten more vigilant and expanded its enforcement activities against hedge funds, Tannenbaum notes. However, the SEC brought 574 enforcement actions in 2006, which is an 8.9% drop from the number of actions taken in 2005. The SEC’s enforcement director, Linda Thomsen, expects to file more lawsuits accusing hedge funds of illegal trading and violations of clients’ trust, according to a published report by Bloomberg. In its first case against a hedge fund manager, the NASD in October levied a $2.25 million fine against Paul Saunders for market timing through variable annuities, notes Rubin. According to NASD, Saunders is chairman and CEO of James River Capital, which is the general partner and trading manager of the Jazzman Fund. SEC chairman Christopher Cox, meanwhile, said recently that the SEC will propose increasing the amount of money an investor must have to participate in a hedge fund from $1 million to $1.5 million. That decision could come this month, and Tannenbaum says he expects Cox to “try to raise the net worth hurdle for accredited investors to nothing less than $1.5 million, possibly closer to $2 million.”


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