SEC Proposes New Hedge Fund Rules

WASHINGTON —  A deeply divided Securities and Exchange Commission on Wednesday proposed stronger oversight of hedge funds, a fast-growing, $850-billion industry that regulators say poses unknown risks to investors and the economy.

Under the proposal, most hedge funds -- investment pools that embrace sophisticated and potentially risky strategies -- would have to register with the SEC, opening the door to greater scrutiny of their activities.

Such investments have traditionally been for the rich, but in recent years they also have become an ingredient in some retirement funds and other investment vehicles for ordinary investors.

Abusive trading practices by hedge funds also played a central role in the trading scandals that have roiled the mutual fund industry since September.

“For many years, it has been acceptable, if not satisfactory, for this agency to take a ‘sit back and see what happens’ approach to hedge funds,” SEC Chairman William H. Donaldson said before the 3-2 vote. “I believe this course is no longer responsible.”

Donaldson noted that the estimated assets of hedge funds have grown fifteen-fold since 1993 and are expected to soon top $1 trillion. He said the agency had brought 46 fraud cases against hedge funds in the last five years.

In its current investigation of the mutual fund industry, Donaldson added, SEC regulators have determined that 46 hedge funds engaged in abusive trading of mutual funds.

The proposed rules, which will be published for a 60-day public comment period, would enable regulators to better monitor hedge funds for these kinds of abuses, the chairman said.

Opponents, including much of the hedge-fund industry and two of the SEC’s Republican commissioners, assailed the proposal as unneeded and poorly developed.

“I fear that we are setting off at a frenetic pace down the road of a regulatory action without figuring out where we want to go,” said SEC Commissioner Paul S. Atkins, one of the two Republican dissenters.

Atkins contended the SEC should allocate more of its limited resources to keeping tabs on mutual funds, where far more Americans invest their money.

The proposal would require hedge funds with more than $25 million in assets to register with the agency, detailing the amount of their assets, the names of their advisors and other information. Currently, such registration is voluntary and fewer than half of the nation’s estimated 8,000 hedge funds comply, according to the SEC.

Funds also would have to employ a chief compliance officer and impose anti-fraud controls.

Cynthia A. Glassman, the other GOP dissenter, derided the proposal as “another example of form over substance.” Last month, the SEC had an identical 3-2 split on a measure that would require mutual fund boards to be headed by independent directors.

The esoteric world of hedge funds first barreled into public consciousness in 1998 with the spectacular collapse of Long-Term Capital Management, a fund that had achieved success using the strategies of Nobel Prize-winning economists. Ultimately, officials of the Federal Reserve Bank of New York helped organize a $3.6-billion bailout.

Then, in September, New York Atty. Gen. Eliot Spitzer filed charges against the hedge fund Canary Capital Partners for improper trading of mutual funds, bringing a new burst of negative publicity to the private investment vehicles.

Hedge funds employ a range of strategies that differ from mutual funds, such as making risky bets on future values of stocks and bonds. The minimum investment traditionally has been $1 million, explaining the lack of public clamor for tough oversight. But standards have eased, and individuals with a $200,000 income for two consecutive years may invest in hedge funds.

One of the issues driving the regulatory debate is the extent of middle-class participation in hedge funds through vehicles such as retirement plans.

Brian McQuade, a principal with the Hedge Fund Center -- a Web-based group that provides independent information about hedge funds to investors -- said that it was increasingly possible to find pension funds that allocate 20% of their assets to “alternative investments,” including hedge funds and real estate.

But he said authoritative numbers on hedge-fund investors were hard to come by, given the industry’s traditional privacy and lack of regulation.

McQuade described Wednesday’s SEC action as a “mixed bag,” with the potential to improve investor protections but also posing steeper regulatory costs for the funds. “Eventually hedge funds will be regulated like mutual funds,” he predicted. “This is just one step.”

Others described the SEC approach as inappropriate, given hedge funds’ historical clientele of savvy investors who understand they are taking greater risks in hopes of greater returns.

“If you start bridling hedge funds, it will take away the benefit that they offer to sophisticated, high-net-worth individuals,” said Perrie M. Weiner, a lawyer who is chair of the securities litigation group at Piper Rudnick in Los Angeles.

The industry is prepared to push hard to stave off a new rule. Its allies include Federal Reserve Chairman Alan Greenspan, who has expressed firm opposition to added regulation, contending that hedge funds infuse helpful capital flows into the financial system.

The public comment period ends Sept. 15, after which the SEC is expected to schedule a vote on the measure. The commission may modify the proposal, or drop it altogether, as opponents hope.

“The case for mandatory investment advisor registration of hedge fund managers has not been made, and we expect that, once all the facts are in, the proposal will not be adopted,” said John G. Gaine, president of the Managed Funds Assn., the hedge fund trade group.