The Securities and Exchange Commission moved Wednesday to increase its oversight of hedge funds, a sometimes volatile investment tool of the wealthy that now operates almost without regulation.
SEC Chairman William Donaldson, a Republican, joined two Democratic commissioners in voting to issue a proposal requiring that hedge funds register with the agency and disclose basic information about their management. Until recently, Donaldson had been in the Republican camp and opposed to increasing regulation.
“The commission’s traditional approach to hedge funds has been to sit back and see what happens,” Donaldson said. “I believe this course is no longer responsible.”
The proposal now goes through a 60-day public comment period before coming up for a final vote.
Hedge funds are capital pools put together by investment advisers that cater to the wealthy, though in recent years some have reduced the minimum investment required to broaden their pool of investors. They are free to use risky strategies that are prohibited for most mutual funds, such as trading in options, futures and other derivatives.
Hedge funds gained notoriety last year when it was disclosed that a New York fund, Canary Capital Partners LLC, had agreements to buy mutual fund shares at advantageous terms and prices not available to ordinary investors.
Some of the nation biggest financial houses–Bank of America, Janus Capital Group and Bank One–have paid a total of $2.3 billion in penalties after their participation in the scheme came to light.
The proposal issued Wednesday would require all but the smallest hedge funds to register as an investment adviser with the SEC, disclosing information such as their identity and the amount of money they manage. The SEC would gain greater ability to inspect their operations, making it easier to detect fraud. Hedge funds also would have to employ a compliance officer to ensure no securities laws are broken.
Many hedge funds have voluntarily registered with the SEC. This is typically done to attract pension funds or other institutions that otherwise will not invest with a hedge fund.
But the Managed Funds Association, a trade group that includes hedge funds, opposes mandatory registration.
“Any resort to governmental regulation has to be carefully considered to ensure that the benefits afforded outweigh the burdens created,” said John Gaine, president of the association. “The case for mandatory investment adviser registration of hedge fund managers has not been made.”
The sheer size of hedge funds, estimated to manage as much as $1 trillion in assets, unnerves some in the financial industry. In 1990, hedge funds managed only an estimated $50 billion.
Nor was Canary the first hedge fund to run into trouble.
In 1998, the Federal Reserve pushed major banks into funding a bailout for Long-Term Capital Management, a huge hedge fund that had badly misjudged the direction of interest rates. The Fed feared that if the fund collapsed, it would imperil international finance.
“Ever since Long-Term Capital Management nearly caused a worldwide financial meltdown, it’s been clear that hedge funds can have a huge impact,” said John Coffee, a professor at Columbia Law School.
He said more regulation is warranted because hedge funds, once the domain of the rich, are now being marketed to the upper middle class.
Hedge funds can accept money only from individuals who have assets of $1 million or more, or who have an annual income of at least $200,000.
When the industry adopted that rule, it was presumed that people in those brackets would be sophisticated investors able to understand the risks they were taking on.
But many more people now qualify to invest than in the past. And some hedge funds have reduced their minimum investment to increase their appeal to well-to-do, but not necessarily rich, clients.
Some who study hedge funds say the present system isn’t perfect, but it is better than imposing heavy-handed regulation.
Randall Kroszner, an economics professor at the University of Chicago Graduate School of Business, said the SEC hasn’t succeeded in halting wrongdoing among the mutual funds and stocks it already regulates.
“Frauds occur regardless of SEC registration,” Kroszner said. “The SEC doesn’t have the resources to prevent all fraud.”
That fact weighs on some on the SEC.
“We do not have unlimited resources,” said Republican Commissioner Cynthia Glassman, who opposes the new rules.
She said the public would “be better served if we devoted such resources to more effective regulation of mutual funds, the investment choice for over 90 million Americans.”
Donaldson’s break with his party is notable. Recently, he voted with the Democrats to require that mutual funds have independent chairmen.
One Washington observer said Donaldson’s new acceptance of regulation contains a message for investors.
“It’s a signal that the problems are probably more severe than we see on the surface,” said Richard Edelman, professor emeritus of finance at American University.
