(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.)

SEC Official Views Hedge Fund Registration; Discusses Complementary CFTC Regime

An SEC proposal requiring hedge fund managers to register as investment advisers is a necessary tool to enable the Commission to prevent fraud in this booming industry, in the view of a senior SEC official. In remarks at a recent hedge fund best practices seminar, Deputy Director Cynthia Fornelli warned that the potential for securities fraud in the hedge fund industry is great and increasing. Lucrative performance-driven compensation arrangements provide powerful incentives for potentially unscrupulous managers to claim inflated performance, she said, by over-valuing their portfolios; engaging in market manipulation; or unfairly allocating hot IPOs to hedge funds. The official also detailed how SEC and CFTC regulation will work together harmoniously in this area.

The rule proposal is designed to confront the likelihood of increased fraud in a number of ways, said the official. For example, registration would provide the Commission with basic, census-like information about the hedge fund industry, such as the number of hedge funds, their managers, and their assets under management. It would also require hedge fund advisers to provide, in a uniform format, fundamental information to their investors, such as the disciplinary history of a hedge fund's principals and how the hedge fund manager identifies and resolves possible conflicts of interest.

Moreover, the rule would require hedge fund advisers to maintain auditable books and records and to appoint a compliance officer to administer the adviser's own policies and procedures designed to ensure compliance with the federal securities laws. Finally, registration allows the Commission to inspect hedge fund advisers in order to prevent fraud or at least achieve early detection.

Importantly, the deputy director assured that the proposal would allow the SEC to better oversee hedge fund managers without impeding the way that hedge funds go about trading. In addition, the proposed approach would not limit the amount of leverage hedge funds use, force them to alter or disclose their legitimate proprietary trading strategies, or impede their contributions to the formation of capital.

This is because the Commission is seeking to regulate hedge fund managers under the Investment Advisers Act, explained the official, which is primarily a disclosure and antifraud law, and not under the Investment Company Act, which authorizes the SEC to restrict or prohibit certain investments and transactions.

Noting that even hedge funds that market to investors with a minimum $1 million investment can commit fraud, the official emphasized the SEC’s belief that all investors deserve the protections provided under the Advisers Act. Moreover, hedge funds are no longer the province of only the wealthy and sophisticated, she observed, since many employees participate in public pension funds that in turn invest in hedge funds. Similarly, registered funds of hedge funds have exposed investors to hedge fund investing for minimums as low as $25,000.

Finally, the senior official pointed out that the SEC’s efforts to bolster oversight of hedge fund advisers would complement CFTC and NFA oversight and examination of commodity pool operators and commodity trading advisors. Indeed, the SEC's program for overseeing investment advisers and the CFTC's program for overseeing CPOs and CTAs are statutorily designed to be complementary.

With the passage of the Commodity Futures Modernization Act, Congress took a significant step to avoid duplicative regulation in this area. Under the current statutory framework established by the Act, the CFTC would register and oversee hedge fund managers primarily engaged in the business of acting as commodity trading advisors.

In this context, the deputy director clarified that the SEC is not seeking to require registration of hedge fund advisers whose business consists primarily of advising others with respect to investments in futures. Under the Advisers Act, hedge fund advisers registered as CTAs with the CFTC can qualify for an exemption from SEC registration if their business does not consist primarily of acting as an investment adviser.

In addition, the CFTC has restructured its oversight of certain hedge fund advisers. The CFTC recently adopted rules allowing many hedge fund advisers to avoid registering as CPOs or CTAs. Thus, continued the official, new entrants to the industry have an opportunity to structure their activities so as to avoid CFTC registration, and existing hedge fund advisers may deregister with the CFTC.