Hedge Funds vs. the SEC

The industry has crushed previous regulatory attempts. Will it happen again?

Barely three years ago, the Commodity Futures Trading Commission floated a regulation that seemed both logical and necessary. Its proposed Rule 4.27 would have required operators of large commodities-trading "pools," including many hedge funds, to report periodically to regulators on their finances and risk. The aim was to prevent another Long Term Capital Management--a secretive, overleveraged fund whose demise in 1998 almost ripped apart the financial system.

But hedge funds didn't think Rule 4.27 was either logical or necessary. In fact, they hated it--and they weren't shy about saying so. In the months that followed, the funds, their lawyers, and their lobbyists--the little-known but potent Managed Funds Assn. (MFA), whose 600 members represent a cross-section of the hedge-fund industry--ferociously attacked the proposal. It was a familiar scenario. In 1999, a Hedge Fund Disclosure Act was proposed in Congress and met a similar reception.

The result of both attempts to rein in hedge funds: nothing. The legislation, after an initial flurry of highly publicized activity, quietly succumbed. The CFTC rule wasn't revised, withdrawn, or watered down--it simply didn't happen. Rule 4.27 was still on the CFTC's Semiannual Regulatory Agenda last Dec. 9, with the terse notation: "Next action undetermined." Says Tobey Kaczensky, a CFTC special counsel: "It's kind of a bureaucratic thing. We don't know what to do with it, so we just leave it there."

If history is any guide, the snuffing out of the Hedge Fund Disclosure Act and CFTC Rule 4.27 is likely to be repeated again and again in the months ahead. Regulators are taking aim at hedge funds, and these private investment partnerships--traditionally for the wealthy but being peddled to a wider audience--will need all their as-yet unvanquished lobbying prowess to keep the government at bay.

A ton of money is at stake. This is a $600 billion industry, and it's growing fast. The fundamental question: Will the government oversee and regulate its growth? Advocates of regulation are confident. "If there is a need for regulation, it will occur in spite of any efforts the industry may mount," insists Securities & Exchange Commissioner Roel C. Campos. "The mutual-fund industry has significant clout, very strong lobbying organizations, and they were not successful recently in stopping our proxy-disclosure rules, which they were very much against."

Facing down regulators are the funds themselves, an array of high-powered law firms, and, coordinating and overseeing the fund-industry response, the MFA. Founded in 1991, when hedge funds were still a cottage industry, its influence grew as the industry mushroomed. By the late 1990s, the MFA had the cash and the clout to hire powerhouse law firms such as Sullivan & Cromwell LLP. Through the traditional lobbying techniques of letter-writing, congressional testimony, and frequent meetings with legislators and regulators, the MFA became a force to be reckoned with. Its board of directors is top-heavy with execs from the most powerful Wall Street firms, such as Goldman Sachs (GS ), Merrill Lynch (MER ), and Morgan Stanley (MWD ). And, in the finest traditions of lobbyist-regulatory revolving doors, the MFA's general counsel, Patrick J. McCarty, moved to a similar position at the CFTC in March, 2002.

The MFA has done more than block regulations. It has also carved out concessions for the industry. One of the hedge-fund biz's earliest victories came in 1996, when the National Securities Markets Improvement Act of 1996 quintupled--from 99 to 499--the number of investors allowed into new hedge funds. The law resulted in huge growth in the industry--and, critics maintain, abuses.

Over the past two years, the SEC has brought 10 enforcement actions against hedge funds that sprouted up during the '90s hedge-fund boom. The allegations range from Ponzi schemes disguised as hedge funds to massive inflation of assets. The accused were mainly obscure fund managers. One hedge-fund notable--Kenneth Lipper--has been charged with misconduct, which he denies, by investors.

Another area of regulatory focus is the increasingly ubiquitous "funds of funds" that invest in other funds--often for a high fee. Concern that investors might be underestimating the risks of such funds led the NASD to issue an "investor alert" last August, warning against their dangers, including their "high fees and expenses." The MFA swiftly responded with a visit to the NASD by MFA President John G. Gaine and a Sullivan & Cromwell attorney. In a follow-up letter, later posted on the MFA Web site, the group suggested an edited version of the alert that watered down its negative content and eliminated reference to all those SEC enforcement actions. The NASD declined.

The NASD's rebuff was a minor irritant, but the strictures under discussion are anything but. For now, at least, the MFA is keeping a low public posture on the subject. MFA President Gaine declined to be interviewed on the record. This public reticence is understandable--after all, the SEC hasn't yet done anything publicly. According to Campos, the agency is awaiting the conclusion in a few weeks of a longstanding inquiry. The SEC's staff will then circulate the findings and make recommendations.

The marketing of funds to unsophisticated retail investors has a strong chance of being targeted. Although technically, an investor must be a millionaire to put cash into a hedge fund, regulators worry that the nouveau riche and retirees with large nest eggs may unwisely sink their entire fortunes into one without understanding the risks. At his congressional confirmation hearing on Feb. 5, incoming SEC Chairman William H. Donaldson cited a "distressing move toward what I would call the `retailization' of hedge funds."

In his testimony, Donaldson also expressed concern about what he described as "possible manipulative aspects to hedge-fund management." What does that mean? Donaldson didn't say. But the fact that he used such tough talk is hardly reassuring to fund lobbyists. One way of countering any move toward regulation might be for the fund industry to agree to the nice-sounding but essentially meaningless SEC registration of all hedge-fund managers as investment advisers.

That idea appeals, of course, to the many fund managers who are already registered with the SEC or CFTC. By agreeing to such a proviso, the fund industry may be able to shrug off tougher steps, such as limits on leverage or short-selling--the mother's milk of hedge funds that differentiates them from mutual funds. Hedge-fund managers maintain that short-selling is a perennial scapegoat for market woes. Charles J. Gradante, a consultant to fund investors and managing principal at Hennessee Group LLC, notes that New York Stock Exchange studies of short-selling, "as far back as the crash of '29," have failed to show a link between short-selling and market crashes. Other areas of possible regulatory interest include "transparency." That's Wall Street lingo for the willingness, if any, of hedge funds to tell their clients what they do. Traditionally, these funds are as opaque as lunar rocks.

The smart money is wagering that all these proposals will remain just that--theoretical concepts that quietly die. To prevail in the coming regulatory battle, the hedge-fund industry needs only to encourage Congress and the bureaucracy to do what they do best: nothing. It has worked before. Whether it works again pretty much depends on one man--the new chairman of the SEC. If Donaldson shows unanticipated mettle and actually puts action behind his tough talk, hedge funds will be face to face with their worst nightmare: regulators who give a damn.

By Gary Weiss in New York

    Before it's here, it's on the Bloomberg Terminal.