(The article featured below is a selection from Hedge Funds and Private Equity: Risk Management and Regulatory Update, which is available to subscribers of that publication.)

Hedge Fund Seminar Looks at Future Regulation of Industry

At a recent Practising Law Institute seminar in New York City, SEC officials and others viewed the landscape of possible future hedge fund regulation in the wake of the financial crisis. One possibility mentioned by panelists is mandatory federal hedge fund registration. When asked if all hedge funds should be required to register, SEC Director of Market Regulation Erik Sirri explained that the answer requires consideration of the purpose behind registration. In his view, any legislation requiring hedge fund registration will need to be clear about what abuses it aims to prevent and to which entities the mandate will apply.

The panelists agreed that stated principles behind such a mandate would be necessary and a narrow focus would make more sense than requiring registration for all hedge funds, as the funds vary greatly in size, activity and leverage. Panelists also noted that a shift from today's hedge fund governance to a future of regulatory requirements may not be so drastic since several regulations already apply to hedge funds and their advisers. Unregistered advisers should strongly consider maintaining compliance programs and providing employee training both to prevent unlawful behavior in the present and to prepare for the possibility of stricter regulation in the future, the panelists advised.

Recently, Senator Charles Grassley said that he would introduce a bill in the 111th Congress to require SEC registration of hedge fund advisers. The bill would require hedge fund advisers to register with the SEC, effectively providing a legislative override of the federal appeals courtGoldstein ruling. The Hedge Fund Registration Act, modeled on a bill the senator introduced in the 110th Congress, would authorize the SEC to require all investment advisers, including hedge fund managers, to register with the SEC. The bill would, however, exempt investment advisers who manage less than $50 million, have fewer than fifteen clients, do not hold themselves out to the public as investment advisers, and manage the assets for fewer than fifteen investors, regardless of whether investment is direct or through a pooled investment vehicle, such as a hedge fund.

According to Sen. Grassley, Congress needs to act because of the appeals court decision, which struck down as arbitrary an SEC rule that required registration of hedge fund advisers. The appeals panel rejected the SEC's suggestion of counting the investors in the hedge fund as clients of the fund's adviser within the statute's meaning of clients in order to get over the statutory client level. (Goldstein v. SEC, CA DofC 2006). That decision effectively ended all registration of hedge funds with the SEC, unless and until Congress acts.

Sen. Grassley has been making the case for greater transparency requirements for hedge funds since last year, following passage of the Pension Protection Act of 2006. He does not want the pension legislation undone by hedge fund secrecy. He observed that a lot of pension holders are in the dark about their exposure to hedge fund losses because transparency is so inadequate. Until recently, hedge funds were limited in how much pension plan equity they could receive, but the Pension Protection Act effectively eliminated such restrictions with regard to governmental pension assets, raising the prospect of even greater pension asset investment in such funds.

House Financial Services Chair Barney Frank is also interested in hedge fund regulation. He introduced legislation, H.R. 5712, to authorize the registration and monitoring of hedge funds, effectively reversing the federal appeals court decision declaring arbitrary an SEC rule requiring hedge funds to register with the SEC if they had more than fourteen clients and managed a specific amount of assets. The bill would give the SEC clear authority to require registration and monitoring. The Investment Advisers Act exempts from registration investment advisers with fewer than fifteen clients. Specifically, Frank's bill would authorize the SEC to interpret the term "client" to require the registration of advisers to funds that have more than 15 investors.