No Satisfaction: Dissenters Rip SEC Hedge Fund Rule

Likewise, the case for mandatory registration based on a premise that fraud is rampant in the hedge fund industry doesn't fly either, the commissioners wrote. The SEC staff's own 2003 report on hedge funds found no "disproportionate involvement of hedge funds or their advisers in fraud," they wrote. Over the past five years, cited cases of hedge fund fraud constituted roughly 2% of all SEC cases. Only 3% of combined SEC and CFTC fraud cases over the last five years involved hedge funds or their advisers.

In most of the 51 cases cited by rule supporters, mandatory registration would have had little effect because the funds were too small to be registered, were already registered or should have been registered, Commissioners Glassman and Atkins wrote. "Many were garden-variety fraudsters who could as easily have called their schemes something other than 'hedge funds.'" People intent on committing fraud probably won't bother to register with the SEC before opening up shop, thus making one of registration's goals–to weed out those convicted of felonies or with other kinds of disciplinary histories before they can start–moot, they wrote.

Twisting the knife a little, Commissioners Glassman and Atkins noted that although mutual funds are required to register, doing so did not help the SEC uncover the market-timing and late-trading abuses that have rocked that industry for the past year.

To enforce the new rule the SEC will have to divert resources from policing mutual funds, which have some 90 million investors. By contrast, hedge funds have an estimated 200,000 individual and institutional investors. "This seems unwise so soon after we made the case that we did not have enough staff to oversee the existing pool of registered advisers and funds," the two commissioners wrote. "In fact just two days after the majority adopted this rulemaking, [Paul F. Roye] the Director of the Division of Investment Management reportedly said that an option that the Commission has in its 'back pocket' is raising the threshold to registration level to US$40 million."

The costs of registration, which have been downplayed by SEC staff, are likely to hit smaller advisers hardest, they wrote.

And ironically, hedge fund registration may actually promote further retailization of the industry by conferring a kind of "seal of approval" on hedge funds.

The commissioners also offer a preview of possible legal challenges to the new rule, pointing out that in adopting the new rule the Commission staff and majority change the definition of "client" so as to look through the fund itself to the underlying investors. "Not only does the majority's action awkwardly depart from the established approach for identifying and adviser's clients," Commissioners Glassman and Atkins wrote, "but the majority rejected compelling challenges to the Commission's statutory authority for this action."

Essentially, they wrote, the SEC staff reinterpreted what Congress meant by "clients" when it passed the original Investment Advisers Act in 1940, and then amended it in 1970 and 1996. The effect of this reinterpretation is to assume that advisers overseeing large pools of capital had to register. This is a mistake, the duo wrote.

"?? 1/2 [T]he legislative history of that section [3(c)(1) of the Investment Company Act] suggests that Congress understood that there would be asset pools, some of them large, that were not reached by that statute. The fact that many advisers to such pools were not registered under the Advisers Act was certainly known to Congress and allowing them to continue in their unregistered state was entirely consistent with Congress' objective of minimizing regulatory restrictions on such pools of assets."

In conclusion, Commissioners Glassman and Atkins wrote, "Questions about the wisdom of the majority's approach are compounded by questions about the propriety of this approach in light of legislative and regulatory precedent. We hoped that the Commission would accord serious consideration to objections to their proposal. Today's rulemaking, which is the wrong solution to an undefined problem, disappoints those hopes and leaves better solutions unexplored."

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Contact Bob Keane with questions or comments at: [email protected].