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News July 19, 2004 Issue

Hedge Fund Manager Registration: The Politics

Last week, SEC Chairman William Donaldson won the battle. It remains to see if he will win the war.

During the SECís July 14 meeting, Donaldson described the hedge fund industry as a "one-trillion-dollar corner along Wall Street, with Ďwarning signsí flashing at us." The SEC, he said, "simply canít afford to continue to walk by and ignore it."

Moving the imagery from Manhattan to Montana, Commissioner Harvey Goldschmid described hedge funds as operating in a "Wild West atmosphere." Despite the fact that theyíve "grown like topsy," the SEC doesnít know how many hedge funds there are or how much they manage, he said. "We know too little about whatís going on. And what we do know sets off alarm bells in reasonable people," he added.

Donaldson, Goldschmid and others portrayed the requirement to register as an adviser as involving only minimal costs, an observation that might be of interest to advisers struggling to develop their compliance programs or grappling with e-mails. "Adviser registration imposes few regulatory burdens on registrants," said Donaldson. "There are almost no costs to whatís being proposed," said Goldschmid, adding that registration would impose "only modest costs" on hedge fund managers. Commissioner Roel Campos described hedge fund manager registration as "a modest proposal."

Goldschmid also noted that investors with only $200,000 of earnings can now invest $25,000 in fund of hedge funds. Moreover, he added, because pension funds can invest in hedge funds, "there is danger to American working families."

Hmmm.

To serve as an "investment manager" under ERISA, a manager must be either a SEC or state-registered adviser, or a bank or insurance company. Based on that, it would seem that to the extent pension funds invest in hedge funds, they already are investing in hedge funds managed by SEC-registered advisers.

That point wasnít lost on Commissioner Cynthia Glassman. She pointed out that a registration requirement would expand the universe of hedge funds managed by SEC-registered advisers and therefore encourage even more pension fund investment in hedge funds. "Is this really the outcome we want?" she asked.

The highlight (or lowlight, depending on your perspective) of the meeting was when Commissioner Paul Atkins pulled out a piechart that examined how the 46 managers involved in the SECís hedge fund enforcement cases brought in the past five years would have been affected by the proposed rule. Of the 46 managers charged, he said, 8 were already SEC registered, 5 should have been registered, 20 would not be subject to SEC registration under the rule because they were too small, 3 were fraudsters that would not have been deterred by registration anyway, and 2 were principals of registered entities. The remaining 8, he said, would be slapped with the SECís "Good Housekeeping" seal of approval (at which point he slapped an SEC seal on the piechart for effect).

"I fear that we are setting off in a frenetic pace down the road of regulatory overreaction without pausing to consider where we want to go," said Atkins. "A close reading of this proposal suggests to me that the Commissionís debate about compulsory registration of hedge fund advisers might be finished and that this discussion and the comment process are merely an administrative formality to be endured in order to get the rule in place."

He criticized "the less-than-candid suggestion that this is simply an inexpensive, non-burdensome rule." Registration, he said, "is just the camelís nose under the tent." He acknowledged that some hedge fund managers might not view SEC registration as a burden, but recommended that they consider how they would view the proposal if it were merely the first step in the process of more substantive regulation of hedge fund business models and business practices. He dangled the threat of e-mail requests over their head: "Would you be concerned if you knew that you could be subjected to disruptive, ad hoc requests for information, including all e-mails in a prescribed format?" he asked.

Atkins said that the proposing release "makes it abundantly clear" that the SEC does not know what information it wants or need (an argument also made by Commissioner Glassman). "Until we have a better idea of what we are looking for," said Atkins, "I will not ask taxpayers to foot the bill for a fishing expedition carried out to protect institutions or the very rich from investment losses."

Atkins asked the Division of Investment Management staff just one question, but it was a doozy: "What kind of information could you receive in the comment process that would persuade you that this approach is inadvisable?"

After a long pause, Division director Paul Roye responded, "Thatís a difficult question to answer." But he went on to explain that the staff had identified a number of concerns with hedge funds. "We saw the adviser registration as really a comprehensive way of addressing the concerns," said Roye. "Our job is to protect investors and to suppress fraud. We saw this as an effective way to do it. If somebody can give us ideas about comprehensive ways to address it in a more effective way, we are certainly all ears."

The themes were repeated the next day at the Senate Banking Committee hearing, where Chairman Donaldson was the star witness. Chairman Richard Shelby (R-AL) outed himself as opposing the hedge fund registration requirement, joined by several other fellow Republican Senators. However, Democratic Senators Paul Sarbanes (D-MD) and Jon Corzine
(D-NJ) indicated that they supported registration. Senator Charles Schumer (D-NY) said he hadnít made up his mind.

Predictably, the hedge fund industry witnesses comprising the second panel argued against the proposal.

Of interest to all advisers: the Senators seemed to be quite interested in what, exactly, it means to be an SEC-registered adviser. At one point, Senator Corzine asked Donaldson: "What is Form ADV?" A copy of the form was entered into the record.