The Watchdogs' Next Target: Hedge Funds

These freewheeling, high-risk investments have federal and state regulators alarmed. This time around, though, the SEC is in the lead

Now that federal and state securities regulators have cracked down on Wall Street analysts for their conflicts of interest, the watchdogs are training their sights on a new target: hedge funds. State authorities, alarmed by the explosive growth of these private investment pools and by a string of fraud cases, are pressing the Securities & Exchange Commission to bring the lightly regulated hedge-fund industry to heel. They're admonishing the SEC to act fast -- or risk being upstaged. "We're not going to stand around and wait for something to happen," says S. Anthony Taggart, director of the Securities Division of Utah's Commerce Dept.

Fighting words indeed. But so far, Round 2 in the tug-of-war between the states and the SEC isn't following the same contentious script as the slugfest over analysts. This time, states aren't pressing for broad structural reforms that would impinge upon the SEC's authority -- and the commission is faster off the mark.


  SEC Chairman William H. Donaldson has made hedge funds a top priority. Ratcheting up a yearlong staff review, the SEC is holding public hearings on hedge funds on May 14 and 15. "With the analyst issue, the federal government played catch-up," says David P. McCaffrey, professor of public administration and policy at the State University of New York at Albany. "But now that everyone's antennae are up, the chemistry [between the states and the feds] is different."

The watchdogs on both levels are alarmed that hedge funds are increasingly accessible to mainstream investors, expanding their market beyond institutions and wealthy individuals. While they look like mutual funds on steroids, hedge funds are far more freewheeling: They aren't subject to SEC audits or diversification rules, often trade on borrowed funds, and restrict investors' ability to withdraw their money.

Middle-income investors might not understand the resulting risks, so the SEC is mulling moves that would better protect them -- and give the agency a window into the funds' $600 billion in assets under management. The SEC may require hedge-fund managers to register with it as investment advisers. This would provide the agency with a glimpse of their holdings and trading strategies -- and a heads-up about risky investments.


  As registered investment advisers, hedge-fund managers would also be obliged to treat all the funds that they manage fairly. Now, critics charge, hedge-fund managers who also run mutual funds are free to channel hot stocks or initial public offerings to their private funds, depriving the mutual funds of juicy returns.

Donaldson may raise the thresholds for hedge-fund investment as well. Under a standard set in 1982, an investor needs $200,000 in annual income or a net worth of $1 million to buy in. Because of rapid increases in housing values, many upper-middle-class people now qualify.

And hedge funds are getting bolder about promoting themselves, overstepping an SEC ban on advertising of private offerings. "Are we seeing hedge funds being sold en masse to people who aren't [qualified]? Yep, we are," says Kristina L. Kneip, a senior examiner in Washington State's Securities Div.


  The National Association of Securities Dealers is doing its part by cracking down on brokers who sell hedge funds. Brokers have a duty to make sure such investments are suitable for their clients -- and that these investors understand the risks. In its ongoing sweep of firms that pitch hedge funds, the NASD in April censured and fined La Jolla (Calif.) broker Altegris Investments $175,000 for marketing hedge funds to investors without fully disclosing the risks.

States are trying to police hedge funds -- but they're leaving the heavy lifting to the feds. Many states do require fund managers to register with them, and they're cracking down on those who skirt the rules. In New York, Attorney General Eliot Spitzer is investigating allegations of fraud and stock-price manipulation by some hedge funds. But while Spitzer was determined to rewrite the rules for analysts, he told hedge-fund executives in March that their industry doesn't require fundamental change. Because hedge funds are geared to sophisticated investors, regulators "want to get a handle on the business, not a clamp," says Paul Schott Stevens, a partner at law firm Dechert LLP.

Still, regulators are likely to take a firmer stand than they did the last time hedge funds were in the headlines. After the near-collapse in 1998 of the mammoth Long Term Capital Management, the SEC and other financial-market overseers proposed reforms to curb highly leveraged trading. But when markets bounced back, the urge to regulate faded.


  That's less likely to happen now. Hedge funds are far bigger, and policymakers are much quicker post-Enron to spring to investors' defense. "It will be harder to conclude nothing needs to be done," says Barry Barbash, a former director of the SEC's investment-management division.

That shift is obvious on Capitol Hill. Senator Phil Gramm (R-Tex.) one of the hedge-fund industry's strongest defenders, has retired. His successor as banking committee chairman, populist Senator Richard C. Shelby (R-Ala.), has given Donaldson a green light to regulate. "It's going to happen. You'd have to have your head in the sand to think it won't," says John Kelly, CEO of Chicago-based Man Investments, the U.S. arm of London-based Man Group, a big hedge-fund operator.

And just in case the SEC does get cold feet, state regulators will be ready to light a fire.

By Amy Borrus in Washington

Edited by Paula Dwyer

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