The U.S. Securities and Exchange Commission has come under scrutiny again following the adoption of a recent rule regarding hedge funds. In a three-to-two vote on Oct. 26, the SEC decided to require hedge fund managers with assets in excess of $25 million to register under the Investment Advisors Act of 1940. The regulation goes into effect on Feb. 1, 2006. Although an estimated 40 percent of hedge fund managers are already registered under the SEC, the rule has spurred heated debates.
Hedge funds - and their managers - have not historically been regulated as vigorously as stocks, mutual funds and similar investment tools. Under the new rule, however, they will have to deal with many of the same requirements as their 40-Act cousins.
As registered investment advisers, hedge fund managers will need to adopt basic compliance controls, improve their disclosures to investors and open their doors to the SEC for periodic audits. The SEC will also be able to collect - and make public - basic information on hedge fund advisers in the U.S., including their assets, identities and disciplinary history. Although the rule was enacted to prevent fraud and acquire more reliable information on hedge funds, in an industry that values its informational privacy, the regulatory requirements are receiving an unwelcome response.
The Great Debate
At a recent Securities Industry Association hedge fund conference in New York City, speaker Senator John Sununu (R-New Hampshire) expressed concern that the high up-front cost of regulation and compliance - which industry sources believe was underestimated by the SEC at $50,000 per fund - will be a barrier to new market entrants. Hedge funds now have to equip themselves with the tools and technology to support the SEC requirements, like e-mail search and retrieval capabilities, and this may be only the first of many regulations to come. Also, since hedge funds often use aggressive strategies that are not available to mutual funds - like selling short, leverage and arbitrage - some believe the new rule will undermine the vitality of the industry.
The SEC claims that much of the worry is unwarranted. Robert Plaze, associated director of the division of investment management at the SEC, denies accusations that the Commission's rule would hinder business. "I think this [rule] is a fairly unintrusive form of oversight and regulation," he says. "We have one of the most dynamic money management industries in the world - most of it is subject to the Advisors Act, and it certainly has not impeded that business," he adds.
TowerGroup senior analyst Tim Lind notes that the science of trading hedge funds may in fact be a greater threat to the hedge fund industry than any regulation. "As hedge funds get bigger and bigger, whether or not they own the whole market, whether or not they can move as quickly and adeptly as they used to, is the more important question," he says.
Lind believes that because hedge funds, by virtue of their nature, are so focused on trading strategy, they've underinvested in the infrastructure around operations. "Although I hate to see the government dictating our technology priorities, a lot of the operational improvements [that will be made as a result of the rule] will certainly benefit the hedge funds' ability to collect and manage and disseminate information to their customers and, ultimately, improve their ability to attract greater investments into their funds," he says.
Lind's theory is supported by many in the hedge fund community. William Freilich, general counsel at Bear, Stearns Securities, said at the SIA hedge fund conference that a lot of institutions are currently using hedge funds to get nearly guaranteed, bond-like returns. According to Freilich, the rule will give credibility to hedge funds, enticing institutions to invest in them. Hedge fund managers who wish to gain marketing leverage might even be better off registering early to demonstrate to their clients that they're open and honest.
"We can debate all we want about the SEC's right to oversee this group," says Lind. "The bottom line is it's going to happen."
Regardless of whether hedge-fund managers are for or against the regulation, they still will have to evaluate their current processes and prepare for the coming deadline. The biggest concerns of most hedge funds will be hiring a compliance officer, establishing policies and procedures, and training a compliance staff. Hedge funds will have to begin investing in additional third-party software applications, specifically order management systems, where the trade capture process begins, and e-mail record and retention systems, which document any pertinent communications about those trades. Hedge-fund managers will also have to face many challenges around pricing.
Currently, there's no specific guidance that defines the fair value of many of the securities that are held in hedge fund portfolios, like credit default swaps, interest rate derivative products and high-yield convertible bonds. Hedge fund managers must be able to prove to regulators that they've engaged in a good-faith effort to value these holdings fairly. They must be able to demonstrate, through documented procedures, that they've done everything in their power to price things accurately. A hedge fund that isn't procedurally and operationally sound may be in jeopardy of an enforcement action. "Good faith and due diligence are two things you'll see very much in underpinning regulatory guidance," says Lind. "Hedge funds will have to show general transparency in how they do things."
Technology will play a key role in building that transparency. Although the many hedge funds WS&T contacted for this article were reluctant to share their compliance initiatives, Lind predicts that more and more funds will find a way to adapt systems that were traditionally sold to the sell-side for use by hedge funds. A lack of adequate infrastructure may also drive hedge funds into more outsourcing propositions with prime brokers for front-end administration systems, data warehouse technology and reconciliation systems traditionally found in mutual funds and institutional asset managers.
Lind says that, ultimately, hedge funds will now have to arm themselves with software that demonstrates three important attributes: "I have control over my environment; I know where my money is; and I know what my security positions are because I reconcile them all the time."
SEC Compliance Checklist
January 2005 to March 2005
- Draft written policies and procedures.
- Create repository for document retention.
- Determine personnel structure for compliance department.
April 2005 to June 2005
- Train chief compliance officer.
- Create exception reports and review logs.
- Create relevant compliance committees; review and document documentation procedures.
July 2005 to September 2005
- Revise written procedures and review procedures.
- Begin periodic employee training.
- Retain and review e-mail and instant messages.
October 2005 to December 2005
- Continue training, compliance committee meetings, review and documentation procedures.
- Conduct annual compliance review.
- Conduct annual employee interviews and obtain code of ethics certifications.
- Draft and file Form ADV by Dec. 15, 2005.
- Draft annual compliance report.
- Present annual compliance report to senior management.
COMPLIANCE DEADLINE: Feb. 1, 2006