Paul Roye, director of the division of investment management at the Securities and Exchange Commission (SEC), has conceded that some of the Commission’s staff will “get it wrong” during visits to hedge funds. “We are going to have situations where examiners look at something, don’t understand [it], and they will be off base,” said Roye. “We want to get it right, but we recognise we will not always get it right.”
The frank admission was made during last month’s Managed Funds Association (MFA) seminar – an event where the ominous tone of the content matched the gathering storm clouds above the venue in New York. During his address, Roye sought to reassure the scores of managers present at the Washington DC-based hedge funds lobby group’s seminar that the SEC’s ultimate objective was not to regulate funds’ investment strategies. “Five of the 10 largest, and presumably most successful [hedge funds] are currently registered with the SEC,” said Roye. “Your investment flexibility will not be hindered by your registration,” he added, pointing to the fact that research suggests there is no significant difference between registered and unregistered investment advisers’ performance.
Despite Roye’s emollient words, the concern among managers in the audience was palpable. The MFA, and its chairman, John Gaine, has been one of the most outspoken critics of the SEC’s move towards mandatory hedge funds registration. Last year, the SEC estimated the upfront cost to individual hedge funds of registration and associated compliance requirements to be $50,000. Panellist Paul Roth, a partner at law firm Sculte, Roth and Zabel in New York, is among those challenging the accuracy of this figure. He says the estimate might be accurate for a fund manager with a simple equity-based strategy, but for more complex strategies Roth said the cost could run into hundreds of thousands of dollars.
Several managers present at the MFA seminar told Risk that they and colleagues had discussed whether or not it would be preferable to shut up shop, rather than build the required infrastructure necessary to satisfy the SEC. “I wouldn’t be surprised if lots of funds with a small head count are having the same conversations now,” said one US equity fund manager who spoke to Risk.
One hedge fund manager, at least, is taking a more combative approach to the SEC’s new regulation requirements, due to become effective on February 1, 2006. At the end of December 2004, Phillip Goldstein filed a complaint against the SEC, alleging that the regulators’ actions had gone beyond those allowed by Congress. Goldstein is a portfolio manager at Opportunity Partners, a hedge fund in New Jersey with around $75 million worth of assets under management. He told Risk that the consensus among experts seems to be that though the lawsuit is meritorious, there is “little chance a court will rule against the mighty SEC”. The US Chamber of Commerce shares Goldstein’s view. The Washington DC-based lobby group claims the SEC has “overreached” its authority and formulated a “rule for a problem that does not exist”.
For most managers wanting to avoid registration with the SEC, the one approach that is most widely discussed with lawyers currently relates to lock-up periods, which specify over what time frame investors are forbidden from withdrawing capital from a fund. Under the SEC’s rule, private funds with a lock-up period of two years or more may not be required to register. This loophole is apparently a consequence of the difficulty of defining a hedge fund, and the SEC’s desire not to impinge on private equity funds, which tend to have relatively long lock-up periods.
One New York lawyer who spoke to Risk said managers who believe that imposing a two-year lock-up, while offering some investors so-called side letters that permit earlier redemptions, are heading for a fall. “They need to read the rule more carefully. If they try to assuage an unsettled investor like this, the SEC will require registration, despite the fund’s extended lock-up,” she says.
The SEC’s Roye also used his address as an opportunity to broach the subject of the regulator’s chief compliance officer (CCO) requirements. He said the SEC was not mandating that funds should hire a CCO, and that a person dedicated full-time to compliance may not be necessary, depending on a firm’s size. “We are thinking about [establishing] a CCO conference where we invite investment advisers in once a year,” said Roye, adding that the SEC’s chairman, William Donaldson, wants to be proactive, and that the regulator views CCOs as “partners” in its process. Regional SEC offices are considering hosting more frequent gatherings of CCOs.
Since 2000, the SEC has brought more than 50 enforcement actions against hedge funds, encompassing more than $1 billion in losses. “While some of you may not invite regulation, I do believe that there can be positive outcomes for the industry as a result of the SEC’s new registration rule,” Roye said. The SEC director has vigorously defended registration as a necessary step to allow the regulator to collect information that protects smaller investors, and punishes and prevents improper activity. From the polite but unenthusiastic applause that followed Roye’s closing comments, it appears that many hedge funds managers remain unconvinced about the benefits of registration.