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S.E.C. Proposes New Oversight on Hedge Funds

New York Times
July 14, 2004

The Securities and Exchange Commission today narrowly voted to propose new rules governing the lucrative and often risky world of hedge funds. If adopted, the rules would subject the growing industry to some of the same regulations that govern the more tightly-regulated mutual funds.

The action came in a split vote by the five-member commission, with the chairman, William H. Donaldson, siding with the two Democratic commissioners; the panel's two Republicans voting against the changes.

"The hedge fund industry is a one-trillion dollar corner along Wall Street with warning signs flashing at us," Mr. Donaldson said in prepared remarks before the commission voted today. "We simply can't afford to walk by and ignore it."

Paul Atkins, a Republican who voted against the measure, said it would unduly burden the high risk, high reward hedge funds, and could stifle economic growth. "I fear that we are setting off down the road of regulatory overreaction," he said.

Mr. Donaldson said the new rules were needed to help those investing in hedge funds make informed judgments, and because many ordinary investors are already indirectly exposed to the risks of hedge funds through their retirement plans and other investments that involve hedge funds.

Some 6,000 hedge funds in the United States control over $850 billion in assets, and the amount is rising. Many of America's largest financial institutions are major investors in hedge funds, and through their highly leveraged positions, the funds control even more money. Their interlocking holdings mean that if a large trade goes wrong, even major financial institutions can be dragged under.

"At a minimum, we want to have a handle on who's doing what inside hedge funds," said Andy Brooks, the head of equity trading at T. Rowe Price, a $200 billion group of mutual funds, based in Baltimore. "It does not have to constrict the markets," he added.

The proposed S.E.C. rule would oblige hedge funds to reveal certain basic information about their assets, their investment strategies and the past performance of their managers, information already required of ordinary mutual funds.

The proposed rules will be open for comment for two months, and will then be voted on again by the commission.

Meg Bode, a spokeswoman for the Managed Funds Association, a hedge fund industry trade group, said earlier problems with hedge funds had shown that there was "no need to inflict any additional oversight" on the industry.

"Just because hedge funds are not registered does not mean they are not regulated," Ms. Bode said. "It's a huge misconception outside the industry."

About two thirds of the country's largest hedge funds are already registered with the Commodity Futures Trading Commission, another government regulator, and others are in fact registered with the S.E.C. But it is the S.E.C. that is generally credited with the best enforcement efforts in the finance industry.

S.E.C. officials say the new rules would help prevent fraud at hedge funds. Paul Royce, head of the S.E.C.s investment fund division, said "in most of the hedge fund fraud cases we have seen," the S.E.C.'s involvement "began long after investors assets were gone."

Concern among regulators has increased as some hedge funds have recently begun to accept initial investments as low as $25,000, far below previous minimums that were generally around $1 million. Because they are meant to attract wealthier, and therefore supposedly more sophisticated investors, hedge funds are allowed to engage in riskier activities, such as investing in derivatives and shorting stocks, or betting that certain stocks will fall in price.

Hedge funds also traditionally take very large positions whose gains depend on minuscule swings in the prices of stocks, bonds and other financial instruments.

In 1998, the collapse of Long Term Capital Management, one of Wall Street's largest and — until that point, most profitable — hedge funds, sent ripples through the entire United States financial sector. L.T.C.M. had bet that the prices of certain financial instruments would ultimately converge, resulting in a massive profit for the firm and its clients. But before the prices eventually did converge, L.T.C.M. had run out of cash to fund its positions, and its clients, including some of Wall Street's largest banks, were faced with the prospect of losing billions of dollars overnight.

Only after William J. McDonough, the president of the Federal Reserve Bank of New York, called the country's leading bankers to his office for a marathon two-day bargaining session was a financial collapse averted, when the bankers agreed to pump $3.65 billion into L.T.C.M.



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