Commentary: Don't Bother Calling the Hedge-Fund Cops

By Mara Der Hovanesian

If the Securities & Exchange Commission had any doubts about what it faces in taking on the $500 billion hedge-fund industry, it need look no further than New York. In June, industry lobbyists deftly carved an exemption from a new state law on investment advisers that could have forced some hedge funds to disclose their inner workings, such as trading strategies. The threat to up and leave the state from which the bulk of hedge-fund managers operate was the clincher.

It's not the first time would-be regulators have buckled under pressure. After the 1998 blowup of Long-Term Capital Management, Washington railed against hedge funds' reckless use of borrowing against assets and their secretive nature. Designed to rein in hedge funds, the Derivatives Market Reform Act and The Hedge Fund Disclosure Act were bandied about in 1999, but died in Congressional committees the next year.

Now, the SEC is on the prowl again. In late May, Chairman Harvey L. Pitt announced the agency would investigate managers who pump up their performance, double as mutual-fund managers creating potential conflicts of interest, and use questionable tactics to market to unsophisticated investors. Until recently, most investors had to pony up at least $1 million to buy into a hedge fund. These days, the minimums are much lower, and that has regulators worried about the welfare of small investors. Pitt is worried about a "seismic boom" in assets: Hedge funds attracted a record $31 billion in 2001, and analysts expect the industry will top $1 trillion by 2004.

Investment pros such as William H. Gross, managing director of institutional money manager Pacific Investment Management Co., have joined the chorus of reprobation. On July 9, the respected bond guru slammed hedge funds for roiling markets by their "willingness to play fast and loose with the solvency of struggling companies."

Hedge funds--unregistered, private limited partnerships--are subject to the antifraud provisions of federal securities laws, but they aren't regulated by the Investment Company Act of 1940. Mutual funds, on the other hand, must register with the SEC and are subject to rigorous inspection. That means the SEC must rely on disgruntled investors and whistle-blowers for information about hedge-fund shenanigans. "It's not as if the SEC is asleep at the switch," says Margaret Sheehan, partner at Washington (D.C.)'s Alston & Bird LLP, which specializes in securities law. "They don't have a switch, or at least not much of one."

Nor are they likely to get one any time soon. Observers say the SEC is operating with a so-called private order of investigation. This rarely-used device is designed to facilitate fact-finding missions to help shape policy recommendations, rather than to catch rogues. However, the SEC is allowed to subpoena documents and witnesses--a big plus in the secretive world of hedge funds--though officials have to know where to look and whom to ask.

So far, the investigation amounts to a fishing expedition in a pool of some 6,000 funds. "The SEC's approach is scattershot; they have to be told about potential problems first," says Sheehan. "They don't get to just march in and look around." The SEC won't comment on its probe.

Billion-dollar funds are the likely first targets. But the most egregious problems tend to be among startup funds run by inexperienced managers. Taxed for resources, the SEC's success in turning up small-time scams doesn't look good. "The SEC spends most of its time reacting to complaints, let alone trying to stop scams before or as they're happening," says Thomas Fedorek, senior managing director of Citigate Global Intelligence & Security, an investigative firm.

For now, simple background checks of managers--which often turn up prior felony convictions or run-ins with securities regulators--offer investors who are willing to pay for them more protection than the SEC can. That won't change until Congress legislates tough rules governing hedge funds or brings them within the scope of the 1940 law--both distant prospects for now. In the meantime, it's buyer beware.

Der Hovanesian covers markets.

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