Legislation seen as necessary to revive hedge fund registration

WASHINGTON — If the federal government decides to resurrect a regulation requiring hedge fund advisers to register with the Securities and Exchange Commission, Congress will have to pave the way with legislation — and it's unclear whether federal lawmakers will move on the issue.

That was the consensus among hedge fund attorneys in the wake of hearings the week of July 24 on hedge fund regulation before the Senate Banking Committee.

"At least today the sentiment appears to be to leave things as they are," said George Mazin, a hedge fund attorney with the law firm Dechert LLP, New York.

"There's going to be some momentum on the part of Congress, (but) I don't know where it's going to end up," added Nir Yarden, a hedge fund attorney with the law firm Greenberg Traurig, New York.

The feeling that the SEC would not resurrect the registration rule on its own was based on the committee testimony of SEC Chairman Christopher Cox.

Mr. Cox told lawmakers the SEC was taking steps to regulate hedge funds — but might need legislation to patch the "hole" created by a federal appeals court decision in June. That ruling threw out a requirement that hedge fund managers register with the SEC and be available for agency inspections.

"Some improvements will be possible through administrative action; others, however, may well require legislation," said Mr. Cox in his testimony.

Under questioning from committee lawmakers, Mr. Cox said it was still an open issue as to whether legislation would be needed. He said it would depend on SEC efforts to "put Humpty Dumpty back together again" by resurrecting much of the old registration requirement or even to forge a "more sturdy" series of hedge fund regulations under existing agency statutes.

"There doesn't look like there's going to be a significant push from the SEC for legislation," Mr. Mazin said.

Hedge fund attorneys said the steps Mr. Cox testified he wanted the SEC to take to close the registration gap — including adoption of a new agency anti-fraud rule that "would clearly state that hedge fund advisers owe serious obligations to investors in the hedge funds" — fell far short of a registration requirement.

"The bark is a lot bigger than the bite," said Mr. Yarden.

"He's pretty much deferring to Congress," said Lawrence Vincent, a hedge fund attorney with the law firm Bryan Cave LLP, New York.

Taking some sense of urgency out of the need for regulation, the SEC's Mr. Cox testified the number of hedge fund advisers registered at the agency had actually gone up since the appeals court threw out the registration rule.

(According to the SEC, 2,533 hedge fund advisers were registered at the agency as of June 23, the day the decision was handed down. Since the decision, 22 new advisers have registered, while 16 have indicated intentions to withdraw, with all but one of the withdrawals being for reasons unrelated to the court decision.)

That's the case, according to the hedge fund attorneys, because registration has become an accepted cost of business for many hedge funds — a layer of protection that is expected by many pension funds and other institutional investors.

"Managers are going to have a hard time explaining to investors why they are going to deregister even if they are legally able to do so," said Mr. Mazin.

"There is so much money coming in from the institutions that it is the institutional inflow causing the registration to take place," added Mike Tannenbaum, a hedge fund attorney with the law firm Tannenbaum Helpern Syracuse & Hirschtritt LLP, New York.

Of course, hedge fund attorneys warned that the relatively rosy regulatory climate for hedge funds could change fast if there's a major hedge fund scandal or collapse.

During the hearings, Mr. Cox complained that without a registration rule, the agency lacks the ability to acquire basic census data about the industry. The agency, according to Mr. Cox, estimates there are about 8,800 hedge funds with $1.2 trillion in assets.

In addition, Mr. Cox said that increasing investment in hedge funds by institutional investors, including public and private pension plans, carried "with it the potential for retail exposure to hedge-fund risk."

Even in the wake of the appeals court's decision, Mr. Cox said hedge funds remain subject to SEC regulations and enforcement actions on fraud, civil liability and other provisions of federal securities laws.

"We will continue to vigorously enforce the federal securities laws against hedge fund and hedge fund advisers who violate those laws," Mr. Cox said.

On a related note, Randal K. Quarles, Treasury Department undersecretary for domestic finance, testified at the hearing that his department and the Department of Labor supported a compromise provision in pending pension reform legislation that would allow hedge funds to tap billions of dollars of new money from pension funds by changing how pension assets are counted.

Under existing rules, hedge funds with more than 25% of their assets derived from employee benefit plans are consider a fiduciary under the Employee Retirement Income Security Act. That would expose a hedge fund manager to potential liability if an investment failed.

The proposed change, according to industry and congressional sources, would allow hedge funds and other financial enterprises to stop counting public and foreign pension assets toward the 25% cap.

"There is some scope for more flexibility," Mr. Quarles said.