(The news featured below is a selection from the news covered in SEC Today, which is distributed to subscribers of SEC Today.)

Cox Outlines SEC's Response to Invalidated Hedge Fund Adviser Rule

Chairman Christopher Cox, in testimony before the Senate Banking Committee, outlined the steps he plans to take in response to the U.S. Court of Appeals decision that invalidated the SEC's hedge fund adviser rule. Among his plans is to recommend for Commission consideration rules to limit the marketing and availability of hedge funds to unsophisticated retail investors. Cox also plans to recommend what he characterized as emergency rulemakings and actions to address the side-effects of the court's decision.

Cox advised that immediately after the court's ruling, he instructed the staff to promptly evaluate the decision and provide him with a set of alternative actions that could be pursued without legislation. He cautioned the committee that his recommendations are subject to a consensus by the other commissioners.

He plans to recommend a new antifraud rule under the Investment Advisers Act that would "look through" a hedge fund to its investors to reverse the impact of the Goldstein decision. The court held that the antifraud provisions of sections 206(1) and (2) apply only to clients and not to investors in the hedge fund. Cox pointed out that the court itself said that section 206(4) is not limited to fraud against clients, so he believes the proposed rule would withstand judicial scrutiny. The rule would make clear that hedge fund advisers owe obligations to investors in hedge funds.

Cox also directed the staff to take emergency action to ensure that the transitional and exemptive rules contained in the SEC's hedge fund adviser rule are restored so that hedge fund advisers who were relying on the invalidated rules are not in violation of the SEC's regulatory requirements when the court issues its final mandate in mid-August, such as the provisions relating to performance fees. He also ordered emergency action to restore to newly registered hedge fund advisers their qualified exemption from the recordkeeping requirement for performance data prior to their registration. Without this action, Cox explained that the advisers that remain registered, but did not create records for the periods prior to their registrations, would be unable to use their performance track record. The result may be to discourage advisers from remaining registered voluntarily, he said.

Cox has also directed the staff to restore the extension of time for advisers to funds-of-hedge funds to provide their audited financial statements. Since underlying hedge funds typically provide audited financials to the fund-of-hedge funds managers after 120 days, the fund-of-fund managers need time to complete their audit work to send out the reports. The relief was invalidated by the Goldstein decision, according to Cox, so he plans to restore the extension of time from 120 days to 180.

Another impact of the Goldstein decision that must be undone relates to offshore advisers to offshore hedge funds. The court's decision created doubt as to whether registered offshore advisers will be subject to all of the provisions of the Investment Advisers Act and has created a disincentive for offshore advisers to remain voluntarily registered, Cox said. He has asked the staff to address this disincentive to registration.

Cox has also asked the staff to analyze and report on whether the current definition of "accredited investor" as applied to retail investment in hedge funds should be amended. Cox said the current definition is out of date and wholly inadequate to protect unsophisticated investors from the risks inherent in most hedge fund investments. Cox proposes to increase the suitability threshold from $1 million to $1.5 million of net worth with respect to investments in any hedge fund that charges a performance fee.

Randal Quarles, the Treasury Department's Under Secretary for Domestic Finance, and Reuben Jeffery III, chairman of the CFTC, also testified before the Committee. Quarles reported that Treasury has begun of series of meetings on the role of hedge funds in the securities markets. Treasury will work with the SEC and the President's Working Group on issues relating to hedge funds, he said. Quarles believes the hedge fund industry today poses less risk than in the past, during the crisis involving Long Term Capital Management. No individual fund is as large as LTCM, he explained, and funds are now more diversified.

Quarles said the hedge fund industry is now better situated to respond to shocks in the aftermath of LTCM because there is more focus on counter-party risk management. Cox added that broker-dealers have become more sophisticated at managing risk exposure. 

Senator Wayne Allard (R-CO) asked about offshore activities and the competitive environment for hedge funds. Cox said the SEC is working closely with the UK Financial Services Authority with respect to hedge fund activity and related risks. The UK and the U.S. markets account for the vast majority of hedge fund and prime brokerage activity, he explained. Cox added that both regulators are interested in acquiring basic census data on hedge funds. 

Cox reported that only 10 hedge funds have deregistered since the Goldstein decision, and most of those were for reasons unrelated to the court's decision. He said that more hedge fund advisers have become newly registered than have deregistered, so the SEC has experienced a net increase in hedge fund registrations since the decision.

Senator Chuck Hagel (R-NE) asked about the type of legislation that Congress should be considering with respect to hedge funds. Cox said he is focused on maximizing the SEC's existing statutory authority. He believes his proposed emergency measures, both in the form of rulemaking and perhaps no-action letters, will restore what existed pre-Goldstein, but said he does not have all of the answers yet.

Quarles said it was premature to recommend legislation until Treasury's comprehensive review is completed. There is no deadline for its completion, but the review is proceeding in a timely fashion, he said.