Whether average investors should have more or less access to hedge funds is a fundamental question facing the Securities and Exchange Commission, the agency's chairman, William Donaldson, told a House panel May 22.

"Hedge fund" is not legally defined, and has become a catch-all term for many unregistered, privately offered, managed pools of capital, excluding venture capital and private equity funds, Donaldson said in testimony before the House Financial Services Capital Markets Subcommittee.

It is important, he emphasized, that there is no universally accepted definition of hedge fund, because that means regulators must rely on self-reporting to determine the size of the industry. Currently, there are between 6,000 and 7,000 hedge funds managing some $600 billion, the SEC chairman reported. Hedge fund investors are generally institutions and high net worth individuals who are willing to accept greater risks in return for a greater return on their investment.

In the past year, the SEC staff has studied more than 650 hedge funds managing roughly $162 billion, he said. The agency also sponsored a roundtable of hedge fund experts May 14 and 15 to explore whether more regulation is required for the lightly regulated industry (35 SRLR 851, 5/19/03). Hedge funds are exempt from the 1940 Investment Company Act, but are subject to SEC antifraud regulation.

Until July 7, Donaldson related, the commission is accepting public comments on hedge funds and regulatory issues surrounding them. He told the panel that the SEC staff will issue a report "sometime in the early fall" with recommendations.

Exemptions.

As a general rule, hedge funds employ sophisticated hedging and arbitrage techniques using long and short positions, leverage, and derivatives, and investments in many markets. They are generally exempt from regulation under Sections 3(c)(1) and 3(c)(7) of the 1940 Act.

Only "qualified purchasers" can invest in 3(c)(7) funds. An individual with more than $5 million in investments, for instance, is a qualified purchaser, as is a "qualified institutional buyer" under 1933 Securities Act Rule 144A. These funds can have an unlimited number of investors, but usually are limited voluntarily to 499 investors to avoid 1934 Securities Exchange Act regulation.

Funds exempt under (3)(c)(1) may have 100 or fewer beneficial owners, who must be accredited investors. For example, accredited investors would include individual investors with at least $1 million in net worth or earning $200,000 or more per year ($300,000 for a couple).

Who Should Be There?

Subcommittee Chairman Richard Baker (R-La.) raised a thematic issue at the hearing, namely whether "retailization" of hedge funds "brings those [persons] into the market who really should not be there." Retailization is the sale of interests in hedge funds to retail investors, rather than high net worth individuals or institutions.

The SEC has said that the proliferation of funds of hedge funds--mutual funds that invest in hedge funds and that generally require a minimum investment of only $25,000--shows a trend towards retailization of the industry. While funds of hedge funds voluntarily require their investors to be accredited, Donaldson stressed, the law does not mandate that standard.

Donaldson told the subcommittee that the SEC is "mindful of two trends" of thought with regard to altering hedge fund regulation. These ideas hinge on the fact that 1940 Act exemptions for hedge funds are based on an investor's assets and/or earning power.

On the one hand, he said, people are asking, "Why should only wealthy people have access to investment vehicles such as this?" In remarks to reporters after the hearing, Paul Roye, director of the Division of Investment Management, repeated the question, observing that, after all, the 1940 Act permits funds of hedge funds to provide access to investors regardless of their level of income or investments.

On the other hand, Donaldson told the panel, some people ask whether the criteria for being an accredited investor should be even higher, to ensure that only "sophisticated" investors are in the hedge fund market. For example, one SEC official at the roundtable said he believed the threshold numbers should be at least doubled.

Possibility of Registration.

As to possible registration for funds, Baker queried, "Shouldn't hedge funds be registered so we know who they are?"

Citing the $600 billion under management, Donaldson replied, "It's too much money for us to know as little as we know now about what's going on." Saying that he did not want to prejudge any commission action, Donaldson remarked, "We need to, one way or another, know more."

Donaldson also explained to the committee that there are "all sorts of levels of registration." He said that the "simplest" approach is registration of the hedge fund manager as an investment adviser. That opens the door for regulators to examine books and records, for example, Donaldson noted.

Currently, according to Roye, about one-third of all hedge fund managers are registered with the SEC as investment advisers.

Donaldson acknowledged at one point that in light of the thousands of hedge funds that exist, the 26 enforcement actions that the SEC has taken against funds since 1998 are "not that much."

However, when Rep. Pat Toomey (R-Pa.), a former investment banker, asked "What's the harm being done that warrants new regulation?" Donaldson said his personal view is that in a cost-benefit analysis, "gaining the right to examine hedge funds is not that costly." The "benefit to society," he said, justifies registration at that level. "We just don't know what we don't know," Donaldson said of the industry with tremendous magnitude and market power.

Donaldson said that in his view, regulators need to look at hedge funds' books and records and how they value securities. This need is accentuated, he said, by the fact that, according to round table participants, influential hedge fund investors are unable to obtain the information they want from the funds.

The SEC chief carved out one area, at least, that he believes should remain hands-off for regulators--hedge funds' trading strategies. "Any attempt to try to make hedge funds display their proprietary investment techniques," he said, runs counter to the proprietary nature of those techniques. With regard to disclosure of short positions, Donaldson noted that the self-regulatory organizations already require the publication of short positions on a monthly basis.

In another vein, Committee Chairman Michael Oxley (R-Ohio) asked whether new research analyst conflict of interest rules reached in the global Wall Street settlement recently would govern a situation in which "an analyst is encouraged to downgrade a stock to curry favor with a hedge fund." That, Donaldson replied, would violate the new rules. He said at the hearing and afterward to reporters that the commission has not heard of this type of activity. Donaldson urged that any such incident be reported to the commission.

Working in Field.

In other matters, Donaldson related that the commission is now "working in the field to document the problem" of lack of disclosure to potential mutual fund investors regarding incentives and inducements given to the broker to sell a particular fund. Not enough of this information is currently disclosed, he told lawmakers.

On a second panel of witnesses, John Mauldin, president of Millennium Wave Investments, an investment adviser, argued in favor of extending to the middle class the "positive values the hedge funds offer to rich investors."

Paul Kamenar, senior executive counsel with Washington Legal Foundation (WLF), and Terry F. Lenzner, chairman of Investigative Group International, called for regulation to eliminate abusive trading practices, in particular, the alleged collusion between short sellers and class action plaintiff's attorneys that results in short selling attacks on companies. Lenzner suggested that there be more timely information on changes in short positions and the application of insider trading laws and Rule 13D strictures to short positions, as well as long investors. WLF has petitioned the SEC to adopt a disclosure rule requiring trial attorneys to give pre-notification to the SEC and the public of discussions with analysts, short sellers, and others about potential or pending lawsuits (35 SRLR 653, 4/21/03).

Meanwhile, Owen Lamont, associate professor of finance at the graduate school of business at the University of Chicago, and David Rocker, managing general partner at New Jersey-based Rocker Partners, called for "leveling the playing field" that they said is tilted against short sellers. Lamont said firms fight sometimes "extraordinarily acrimonious" battles to impede the short selling of their stocks. Rocker called for making the uptick rule less restrictive.

By Rachel McTague