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Giving hedge fund investors a full accounting

Congress should require hedge funds, which are largely unregulated, to register with the Securities and Exchange Commission.

November 12, 2009

The federal jury that acquitted two Bear Stearns hedge-fund managers of securities fraud this week undermined the government's effort to find crimes in Wall Street's epic collapse. That's just half the story, though, and as far as investors are concerned, the less interesting half. Ralph Cioffi and Matthew Tannin, the men in charge of the two failed hedge funds, still face a lawsuit by the Securities and Exchange Commission. The SEC's filing demonstrates that agency's ability to pursue investment managers even when their funds are unregulated. It also shows what Congress should do to prevent investors from being victimized in the future.

A hedge fund collects money from wealthy individuals, pension funds and others with millions of dollars to invest and uses it to buy securities chosen by its manager. Unlike mutual funds, however, hedge funds aren't open to the public or required to register with the SEC. That means they don't have to disclose who's investing in them, where their money goes or how they're performing. Naturally, their investors expect to be kept informed, so funds typically provide audited information about their activities at least once a year. But those voluntary private disclosures aren't subject to regulators' real-time scrutiny.

The criminal case against Cioffi and Tannin, and the SEC's lawsuit, rely on similar allegations that the men deceived their investors by misrepresenting the funds' activities, withdrawals from the funds and their own stakes. The criminal case foundered because the jury wasn't convinced beyond a reasonable doubt that the men intended to violate the law. On the civil side, the SEC simply has to show by a preponderance of the evidence that the defendants deceived investors.

Nevertheless, it's worth remembering that investors lost $1.4 billion before the SEC looked at the men's actions and compared what they said with what they did. That's why Congress should bring hedge funds in from the cold and require the larger ones to register with the SEC, as bills pending in the House and Senate propose. At issue is a considerable amount of money and market activity -- according to the SEC, hedge funds held about 5% of all U.S. assets overseen by investment managers and made about 30% of the equity trades. Fund managers should be free to assemble their portfolios largely as they see fit, but it's reasonable to demand that they give investors a full accounting of the funds' health and the bets they're making. And in the case of the largest funds, it's only prudent to give regulators the information they need to detect and deter patterns of investments that put the financial system at risk.

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