SEC Overburdening Itself?

The SEC narrowly succeeded in passing a final rule requiring hedge fund advisors to register under the Investment Adviser Act of 1940. The commission says the measure will benefit all involved parties, including investors, but many observers say the SEC is biting off more than it can chew.

Under the rule, hedge fund advisors with more than $30 million in assets under management must register with the SEC. Such registration gives registered reps and qualified retail investors access to more data about the advisors’ businesses, their disciplinary history and their disclosures about conflicts of interest, among other things.

“Currently no government or agency has reliable data on hedge funds,” says the SEC’s Paul Roye, speaking to an audience at the SIA’s hedge fund conference in the Marriott Marquis in New York. “At the commission we’ve been relying on third-party data.”

According to that data, assets in U.S. hedge funds have increased 15-fold since 1993 to nearly $1 trillion, and the number of hedge funds has increased fivefold to roughly 7,000.

But skeptics say the SEC, which failed to catch the scandals in the heavily regulated mutual fund industry, is piling additional straws onto an already overburdened camel’s back. Sen. John Sununu (R-N.H.), speaking at the conference, said the roughly 200,000 investors in hedge funds—most of whom are sophisticated people who understand hedge funds’ risk-reward proposition—do not warrant so much attention from the SEC. The public would be better served if the commission focused more of its dwindling resources on the 92 million less sophisticated mutual fund investors, he said.

The hedge fund registration measure is an exercise in “defensive posturing by the SEC,” Sununu said, adding that there is no empirical data or historical precedent to prove that advisor registration corresponds to better investment performance or to a reduced likelihood of shenanigans at a fund.

Roye nonetheless said be believes registration will help keep the most nefarious people from setting up shop in the hedge fund industry. “Hedge fund advisors were key participants in the past year’s mutual fund scandals,” he noted. Indeed, in the last five years the SEC has brought 51 enforcement cases involving 400 hedge funds and 87 advisors, resulting in more than $1 billion in investor losses.

However, SEC commissioners Cynthia Glassman and Paul Atkins, the two dissenting votes in October’s 3-to-2 decision to pass the new rule, say in their dissenting remarks that these frauds were primarily committed by advisors who were unlikely to have been caught by the new registration process. “Mandatory registration would not add to the commission’s ability to combat these types of fraud,” they write in the dissenting opinion.

The SEC has grown more concerned about hedge funds mainly because they have become more accessible to the average investor in recent years. This “retail-ization,” of hedge funds, through vehicles such as fund of funds, which now account for 20 percent of hedge fund capital, means that more pensions and small investors are putting money into them.

As the debate about the SEC rule continues, one thing is a near certainty, according to Sununu: Its passage means that the costs of compliance for advisors will likely discourage new entrants, stunt innovation and even push hedge funds offshore. “The burden is on the SEC to justify this action and show what value this regulation will bring.”

The compliance date for the new registration requirement is Feb.1, 2006. The rule can be viewed at the SEC’s Web site.

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