Divided SEC Proposes More Oversight of Hedge Funds

July 14 (Bloomberg) -- A divided U.S. Securities and Exchange Commission proposed that hedge fund managers be required to register with the agency, giving Chairman William Donaldson a victory in his campaign to open the $850 billion industry to greater scrutiny.

The plan, approved by a 3-2 vote over the opposition of most hedge funds, would give SEC inspectors power to examine the books of the private partnerships that are meant for wealthy investors. Managers of many of the largest hedge funds, including Tudor Investment Corp., Caxton Associates and Citadel Investment Group, would be forced to sign up with the SEC under the proposal.

"The commission's traditional approach to hedge funds has been to sit back and see what happens,'' Donaldson said at the SEC meeting in Washington. "In view of the changes in this industry and the trajectory it appears to be on, I believe this course is no longer responsible.''

Donaldson, a Republican, has led the drive for increased oversight, arguing that the SEC needs to learn more about the growing industry. He voted in favor of the measure along with Democratic appointees Roel Campos and Harvey Goldschmid. Two Republicans, Paul Atkins and Cynthia Glassman, opposed the plan.

`Form Over Substance'

Glassman, calling the plan an "example of form over substance,'' said the SEC inspectors, who missed detecting problems in mutual fund trading last year, might not be up to the task of evaluating such complicated investment partnerships.

"Registration implies inspection,'' Glassman said. "If we do it right, it costs serious resources and expertise that I don't think we have.''

The Managed Funds Association, the hedge fund industry's main trade group in Washington, said its 800 members will continue to fight the proposal.

"The case for mandatory investment adviser 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,'' John Gaine, the group's president, said in a statement.

The SEC plan would require managers that run hedge funds with at least 15 U.S. clients and $25 million in assets to register as an investment adviser with the SEC. Advisers must give the agency such information as their names, addresses and how much money they manage.

Inspections, Safeguards

Registration also lets the SEC conduct periodic inspections of the investment advisers. Under the proposal, hedge funds would be required to name a chief compliance officer and develop safeguards to uncover fraud, SEC officials said.

"These hedge fund advisers manage tens of millions of dollars of other people's money under arrangements that are potentially fraught with conflicts, but, in many cases, with almost no oversight of their activity,'' said Paul Roye, head of the SEC's investment management division. "It is important that the hedge fund adviser have a compliance officer who is there day in and day out.''

Donaldson and Roye said that the SEC wouldn't conduct regular inspections of hedge funds and instead would look for troubling trends and then launch targeted examinations.

Attorneys for hedge funds were split on whether the registration plan would be a burden for managers.

"Registration as an investment adviser is really not all that onerous if you are maintaining a good, clean operation,'' said Joseph Del Raso, a partner at Pepper Hamilton in Philadelphia who represents both registered and unregistered investment companies.

Regulation Concerns

Robert Leonard, a partner in the New York office of Bryan Cave, said hedge funds are more worried about what the SEC will do once the agency has its new oversight power. "Donaldson has said that he doesn't want to fully regulate the industry, that he just wants to understand it, but I'm concerned in the end this could lead to more regulation,'' he said.

Hedge funds, which require investors to have a net worth of at least $1 million or to earn $200,000 in income for at least two years, have been exempt from SEC oversight. The funds can bet on securities that rise or fall and often use leverage to boost their returns.

The rule proposed today would effectively raise the minimum investment requirement for hedge funds to $1.5 million in net worth, SEC officials said.

Assets Swell

SEC officials estimated that about 40 percent of hedge fund managers already register with the agency. Most of those funds chose to come under the agency's oversight because they are hoping to attract pension funds and other institutional investors that require their investment funds to be registered.

Those registered funds include Renaissance Technologies Corp., Andor Capital Management LLC and Maverick Capital Ltd.

Hedge fund assets have risen from $39 billion in 1990 to $865 billion in the first quarter of this year, according to Hedge Fund Research in Chicago.

The move to regulate hedge funds has grown since New York Attorney General Eliot Spitzer alleged last year that "illegal trading schemes'' enabled some hedge funds to buy mutual fund shares at prices not available to most investors.

Canary Capital Partners LLC and its managing principal, Edward Stern, agreed on Sept. 3 to return $30 million in profits and pay a $10 million fine. Since then, regulators have imposed more than $2.3 billion in sanctions against about a dozen companies including Bank of America Corp. and Alliance Capital Management Holding LP.

Today's SEC vote authorizes 60 days of public comment before the commissioners must vote again to make the rule final.

The Senate Banking Committee is scheduled to hold hearings tomorrow on the SEC's plan. Donaldson and representatives of the hedge fund industry, including Adam Cooper of Citadel and James Chanos of Kynikos Associates, have been called to testify.

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