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Hedge Funds Draw Concerns

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SEC Chairman Cox tells a Senate committee that the increasingly popular partnerships need further regulation.

July 26, 2006|From Reuters and Bloomberg News

Hedge fund regulation by the Securities and Exchange Commission is inadequate, SEC Chairman Christopher Cox told a Senate panel Tuesday, but he did not ask for specific legislation to help the agency.

Hedge funds -- generally secretive private investment partnerships that can use high-risk strategies in an effort to make extraordinary gains -- have doubled their assets in the last five years to about $1.3 trillion overall and have become a major Wall Street force.

"You have this uneasy feeling about a whole area here that we don't know very well," Sen. Paul S. Sarbanes (D-Md.) said at the Senate Banking Committee hearing.

Under Cox's predecessor, William H. Donaldson, the SEC voted last year to require most hedge fund advisors to register with the SEC to allow for greater oversight. But a U.S. appeals court threw out the rule June 23, saying the agency had overstepped its authority.

Cox told the committee that he had not ruled out appealing the decision to the Supreme Court. The SEC has until Aug. 7 to file an appeal.

In the meantime, Cox said the SEC was preparing alternatives aimed at restoring parts of the rule while ensuring they would stand up to litigation. The original proposal would have made clear that the SEC had the primary responsibility for regulating hedge funds, more than other federal agencies or the states.

In a move to protect investors, Cox said he intended to recommend that the SEC further limit marketing and availability of hedge funds to "unsophisticated retail investors."

Typical hedge fund clients are wealthy individuals and institutions such as pension plans, but some funds have opened to investors of lesser means.

Cox said he asked the SEC staff to study raising the net worth level an investor would be required to have to participate in an unregistered hedge fund to $1.5 million. It now is $1 million.

He also said he would recommend that the SEC adopt a new anti-fraud rule to protect hedge fund investors.

Amid concerns of another hedge fund meltdown such as the collapse of Long-Term Capital Management in 1998 -- which spread momentary panic in financial markets because of the fund's heavy use of borrowed money in its investment bets -- some in Congress want legislation that would require more hedge fund disclosure of basic information.

But Sen. John E. Sununu (R-N.H.) criticized the SEC's fund registration rule at the hearing.

Without a clear definition of a problem or evidence showing how the regulation would improve financial market efficiency, "no one should be surprised that a court decides that the way in which the regulations were put forward was arbitrary and unfair," Sununu said.

Treasury Undersecretary Randal Quarles, who also testified at the hearing, said hedge funds were less likely to trigger widespread harm to markets today than in previous years because major banks that lend to the funds had increased their scrutiny of the industry.

Quarles said it would be premature for Congress to introduce new legislation regulating hedge funds.

The President's Working Group on Financial Markets, which consists of banking, securities and commodities regulators, has not recommended direct regulation of hedge funds. But it has stated that if evidence emerged that indirect regulation wasn't working to constrain the amount of debt funds took on in pursuit of high returns, then direct regulation of hedge funds could be considered.

The biggest hedge fund managers include Goldman Sachs Group Inc. and D.E. Shaw Group in New York, San Francisco's Farallon Capital Management and Westport, Conn.-based Bridgewater Associates.

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