(The news featured below is a selection from the news covered in the Federal Securities Report Letter, which is distributed to subscribers of the Federal Securities Law Reports.)

Commission Proposes to Require Hedge Fund Adviser Registration

In a split decision, the SEC voted to release for comment a proposed rule that would require hedge fund advisers to register under the Investment Advisers Act. New Rule 203(b)(3)-2 is intended to enable the SEC to gather basic information about the hedge fund industry, which is expected to have $1 trillion of assets under management by the end of the year.

Registration of all hedge fund advisers would allow the SEC to calculate the number of hedge funds operating in the United States, the amount of assets in each fund and the identity of persons controlling those assets. It also would give the agency the authority to conduct examinations of hedge fund advisers.

Chairman William Donaldson said the examination authority is vital to the Commission's efforts to be proactive and aggressive in identifying problems before they occur. "There are warning signals coming from the hedge fund industry that the Commission cannot ignore," he said. "The truth is we don't know enough about what is going on in the hedge fund industry," said Commissioner Harvey Goldschmid. The commissioner concluded that "we simply cannot keep assets of this magnitude in the shadows."

Among the warning signs cited by the chairman was the increase in fraud cases involving hedge fund advisers. The staff has identified 46 hedge fund frauds resulting in more than $1 billion in investor losses over the past five years. Hedge funds were also involved in the late trading and market timing scandals involving mutual funds.

Commissioners Cynthia Glassman and Paul Atkins opposed the rule proposal and said that the increase in fraud needs to be kept in perspective. Commissioner Atkins suggested that the rate of increase in fraud is not dramatic, while Glassman noted that the 46 cases represent less than two percent of the agency's enforcement docket.

Mr. Goldschmid responded that it would make no sense for the Commission to turn a blind eye to what is happening in the hedge fund industry. "In a rational regulatory system, there is a need to respond to clear warning signals," he said.

Commissioner Atkins said that he believes that the SEC "is setting off at a frenetic pace down the road to regulatory overreaction. " He suggested that hedge fund advisers should consider whether this was only the first step toward more regulation, and how they would feel if they were soon subject to ad hoc, disruptive requests for information.

Commissioner Roel Campos said that Mr. Atkins' remarks amounted to a "scare tactic." According to Mr. Campos, "those questions add emotion to a rational argument, but are really beside the point." In his view, the underlying principle of the proposed rule is that there is no inherent right to solicit and manage the public's money in the dark.

Paul Roye, the director of the Division of Investment Management, said that examinations will begin to shed light on the huge amount that is not known about hedge funds. He said the staff, at the chairman's urging, will use a risk-based approach to examinations in order to conserve limited agency resources and to focus the staff's efforts on high risk advisers.

In addition to giving the staff examination authority, the proposed rule would require all hedge fund advisers to adopt basic compliance controls, improve disclosures made to investors and prevent felons or individuals with other serious disciplinary records from managing hedge funds.

The rule also would change the way that hedge funds count their clients, thereby impacting their eligibility for an exemption from the registration requirements. Under existing rules, an adviser that has 14 or fewer clients, and does not hold itself out to the public as an investment adviser, does not have to register.

The staff had noted that this rule allows an adviser to count each hedge fund, with up to 499 investors each, as a single client. Mr. Roye estimated that this allows an unregistered adviser to manage the assets, albeit indirectly, of nearly 7,000 clients. If the hedge fund has investors that are funds of hedge funds, that number would increase exponentially, he said. The proposed rule would require advisers to look through the funds and to count the number of investors when determining whether they are eligible for the exemption.

Finally, the proposed rule contains special provisions for advisers located outside the United States. These rules would limit the extraterritorial application of the Investment Advisers Act to offshore advisers that have U.S. investors.

Public comments on the rule proposal are due to the Commission by September 15.

¨ The proposing release will be published in a forthcoming REPORT