SEC Hesitant About New Hedge Fund Regulation

by Glen Shapiro, LawAndTax-News.com, New York

28 July 2006

The Senate Banking Committee's hearing into hedge fund regulation continued on Wednesday, when Securities and Exchange Commission Chairman Christopher Cox held back from asking Congress to restore parts of the Commission's regulatory apparatus which were shot down by an Appeals Court decision last month.

Cox said that in any event he intended to recommend a number of steps to the full commission that the SEC can pursue without legislation. These would include a new anti-fraud rule to make it clear that hedge fund advisers owe serious obligations to investors in the hedge funds. He also proposed to restore transitional breaks and exemptions for certain hedge fund advisers that were protecting advisers from suddenly being in violation of SEC regulatory requirements in the event that the courts were to restore contentious registration ruling.

The Chairman also said he wanted to see clearer limits on the ability of hedge funds to marketing to unsophisticated small investors. However, he told the hearing that it was still an open question whether the SEC needed added legal authority to regulate hedge funds. The previous regime had been inadequate, he said, but he thought it possible that new rules he was bringing forward would be sufficient without primary legislation.

Committee Chairman Sen. Richard Shelby (R-Ala.) said: "There is a common misconception that hedge funds are completely unregulated and absolutely secretive investment vehicles. It is important to note that hedge funds are currently subject to the market manipulation and antifraud provisions of the federal securities laws."

Speaking on Tuesday, Randal Quarles, Under Secretary for Domestic Finance with the US Treasury, told the hearing that:

"In May, before a subcommittee of this panel, I presented testimony regarding the role that hedge funds play; that is, what hedge funds do for and in our financial markets. As I said then, if government addresses the question of regulation of any financial institution or activity without a clear understanding of the place it plays in our financial system, we run the risk of imposing unnecessary, excessive, or inappropriate legislation."

"As we consider the regulation of hedge funds, we should keep in mind that the role they fulfill in our financial markets is continuously evolving; and in recent years it has been evolving rapidly."

Speaking with regard to the SEC's amended hedge fund registration rule, he stated:

"In late 2004, the Securities and Exchange Commission (SEC) issued a final rule that required hedge fund advisers to register with the Commission, mainly out of a perceived need to address increasing instances of hedge fund fraud and a concern that less sophisticated investors were becoming increasingly exposed to hedge fund investments, either directly or indirectly through their pension plans. The rule went into effect on February 1, 2006, prompting more than 1,100 previously unregistered hedge fund advisers to register with the SEC."

"Neither Treasury nor the PWG (President's Working Group on Financial Markets) ever took a formal position on the rule. We did work with the SEC, however, both bilaterally and through the PWG, to make sure we understood the SEC's rationale for their rule, and what their goals and expectations were regarding its implementation. Although we did not formally comment on the SEC's proposed rule, we did ask the SEC to work with the Commodity Futures Trading Commission (CFTC) to avoid potential duplicative registration requirements for CFTC-registered commodity pool operators and commodity trading advisers."

"This past June, the U.S. Court of Appeals for the D.C. Circuit ruled that the SEC's hedge fund adviser registration rule was arbitrary in the way it redefined the term "client" so as to bring hedge fund advisers under the registration requirements of the Investment Advisers Act, and the court therefore vacated the rule. SEC Chairman Cox, in his statement on the Court's decision, expressed a very pragmatic approach to dealing with this decision. He noted that the SEC will continue to work with the PWG as it reevaluates its approach to hedge fund activity and as the SEC considers alternative courses of action. We look forward to working with Chairman Cox and the SEC staff on these issues."

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