The hedge fund industry operates in a notorious shroud of secrecy. Investors and government regulators know little about hedge funds’ practices, activities and leadership, in stark contrast to the strict regulations and public scrutiny to which mutual funds and other investment vehicles are subject.

Since June 2004 the SEC has been trying to fix that disparity with an amendment to the 1940 Advisers Act that would require hedge fund managers who oversee more than $25 million to register with the commission and submit to the same compliance rules as other registered investment advisers. The amendment narrowly passed near the end of William Donaldson’s chairmanship in December 2004, and new chairman Christopher Cox has vowed to uphold it.

While transparency is generally seen as good for business, at least one hedge fund manager–Phillip Goldstein, manager of New York-based Opportunity Partners–isn’t happy about the rule change. He took his complaint to court, and in December 2005, the D.C. Circuit agreed to hear his challenge. Although his crusade has received significant attention and some support from the industry, few believe he will prevail.

“The Advisers Act does not define the term ‘client,’ and so the SEC has used its rulemaking authority to further define who, or what, counts as a client,” says Mark Braswell, partner at Thelen Reid & Priest. “To bring hedge fund managers within the Advisers Act, the SEC simply rewrote its own rule. I don’t see how the hedge fund manager registration rules will be overturned in court.”

The Price Of Compliance

Whether or not Goldstein’s challenge has a chance of succeeding, it’s not surprising that some hedge fund managers are balking at the new rule. Opponents of the rule change argue it will impose huge compliance costs on the hedge funds while providing few benefits to investors.

“The cost of complying with SEC regulations is not insignificant,” Braswell says. “All advisers must have a code of ethics, a chief compliance officer, a custom-tailored compliance policy and supervisory procedures.”

However, the SEC cites growing incidences of fraud involving hedge fund managers and the relative secrecy in which they operate as indications that registration is a needed step to protect investors. Ultimately, the SEC says, the costs of compliance pale in comparison to the losses an investor could sustain if fund managers engage in fraudulent activities.

“This is a trillion-dollar industry,” says Robert Plaze, associate director of the SEC’s investment management division. “The commission needs some tool to oversee it that will allow it to identify and deter problems before they occur.”

Despite those arguments, the case will likely be decided on narrow legal grounds. Goldstein’s argument hinges on the contention the SEC is overstepping its regulatory function into the realm of lawmaking. The SEC dismisses that argument.

“All investment advisers, including unregistered ones, were already subject to the statute,” Plaze says. “We are not expanding the commission’s authority by requiring registration. The hedge fund managers were already subject to SEC regulation.”

The Holdouts

Despite the vocal opposition to the new regulation, the tide of SEC oversight already seems to be turning. Prior to the rule’s passage, 40 percent of hedge fund managers had already voluntarily registered with the commission.

“Many investors want to put their money with funds and fund managers that don’t mind the transparency that SEC regulation brings,” Braswell says.

Funds that want to avoid registration with the SEC can still do so by restructuring to fit under the exceptions carved out in the SEC rule. For example, an exception meant to exclude venture capitalist firms from the registration requirement exempts any fund that requires investors to stay in for two years or longer. Some hedge funds are restructuring to fall under that exception. That activity, however, may be short-lived.

“Over time, competitive pressure will force many of the hedge funds that restructured to revert back and register with the commission, or lose investors,” Braswell predicts.