Research

Hedge Funds, Crime and Regulation American-Style

Talk about ‘give a dog a bad name’. Anyone who gives their hedge fund a moniker like “High-grade structured credit strategies fund” or “High-grade structured credit strategies enhanced leverage fund” is asking for trouble, and trouble is what Bear Stearns, the manager of these products, may get.

Politicians in the US are riding their hobbyhorses in the wake of fallout from sub-prime mortgages and their role in CDOs, which ended up wreaking havoc in Bear hedge fund portfolios, ultimately leading to the Wall Street firm bailing out one of them.

Now the chairman of the Securities and Exchange Commission in Washington has announced an enquiry into Bear Stearns' two funds as well as another 12 that have invested in CDOs with sub-prime holdings.

America's hedge fund industry remains lightly regulated despite attempts by the SEC and the Treasury Department, thanks to a court case last year (the Goldstein decision) which did away with a mandatory requirement for certain funds to register with the SEC.

From the SEC's point of view, registration cloaks a hedge fund in legitimacy. Any Asia-based hedge fund registered with the SEC would not be subject to the full panoply of regulation and oversight that US onshore funds receive.

According to industry lawyers, however, regulators in Washington are proposing more anti-fraud provisions over matters such as insider trading, PIPES investments and naked short-selling. Post-Goldstein, the SEC may be seeking to re-define its jurisdiction over hedge funds and the tools that it can use to accomplish this.

“The SEC has proposed a rule that is intended to protect the investors in hedge funds against fraudulent conduct in the wake of the Goldstein decision,” says Gregory Gnall of law firm White and Case in New York. “The SEC is concerned about insider trading and other manipulative conduct and as a defensive measure wants to ensure its jurisdiction to protect underlying investors in hedge funds, since Goldstein held that only the funds are ‘clients’ under the US Investment Advisors Act.”

In the States, Gnall provides advice concerning regulatory examinations and represents clients in SEC, NYSE and NASD enforcement matters. He also handles broker/dealer compliance with the USA Patriot Act (just in case any of you hedge fund managers were contemplating terrorist acts).

He says the SEC is in something of a fight-back mode after the Goldstein case. So it is seeking other avenues in which it can retain a role.

Some hedge fund activities that American regulators are looking to address include ways in which hedge funds may potentially use relationships with other parties in an improper way. For example, their investors who may be in some way affiliated to the underlying investments.

Also being developed by US regulators is an expansion of what constitutes an accredited investor. For example, to undertake private placements to investors in a hedge fund, the latter have to be ‘accredited investors’. Previously, there was an income and net worth tests. Now, the SEC wants to expand this with a third qualifier, that the investor has a minimum level of investments amounting to US$2.5 million.

Last week the State of Massachusetts brought a case against UBS concerning its ‘hedge fund hotel’ programme, lest the funds are receiving some undisclosed benefit resulting in a conflict of interests. One might infer that regulatory scrutiny isn’t going away anytime soon.

If you are a hedge fund manager who has strayed from the path of righteousness, be aware that insider-trading penalties are three times the level of your profits. The SEC has no jurisdiction over criminal prosecutions, and that matter is left to the Department of Justice. For falsifying statements and overstating profits (which is basically theft), you could be staring up the wrong end of a 12-year jail sentence.

The US Congress will continue to rattle sabres at hedge funds at times when this is politically expedient. Fortunately no one in the US has resorted to calling investment managers 'locusts', and US officials helped see off a German attempt to regulate private equity and hedge funds at the last G8 powwow.

Candidates for the White House seem far more sanguine about the alternatives industry, given Republican candidate Mitt Romney was the co-founder of private equity firm Bain Capital and Democrat John Edwards worked in 2005-2006 as a part-time advisor to hedge fund Fortress Investments, making nearly US$500,000. (Plus, you have to think that Hillary Clinton would have made a tip-top prime broker).

Is envy the spur? Maybe those US Congressmen, feigning indignation with hedge funds, would also quite like a consultancy position one day.

 

This article first appeared in AsianInvestor on 4 July 2007.