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The hedge fund industry is on edge. Securities regulators in New York have 30 hedge funds in their sights, while California regulators are moving to require registration of the unregulated funds � actions that may only be the beginning of a rocky 2008 for the secretive investment vehicles. With end-of-year withdrawals looming as wealthy clientele ponder pulling out more money as credit markets continue to be squeezed, much more litigation against hedge funds is predicted. “Anytime a hedge fund blows up, you are going to see class actions and a lot of cases are going to end up in [U.S. Securities and Exchange Commission] receivership and bankruptcies,” said Ross Intelisano of Rich & Intelisano in New York City, who represents a group of investors allegedly defrauded in the 2005 Bayou Group hedge fund case. “We see this as a growing area of our practice. Absolutely, in 2008, this will continue as more hedge funds sink,” he said. Morrison & Foerster announced earlier this year the creation of a hedge fund recovery team to address bankruptcy, restructuring and fund liquidation for the hedge fund failures it expects. Its area of concern focuses on funds betting on risky credit default swaps, which are bankruptcy insurance for creditors, and other distressed debt investments. Bear Stearns Suit Massachusetts regulators filed suit against Bear Stearns Cos. on Nov. 14 in a civil suit alleging fraud and improper trading in two mortgage-related hedge funds that collapsed. Bear Stearns provided $1.6 billion in financing in August to bolster the troubled funds, but both still fell into bankruptcy. In October, a regional enforcement official with the SEC in New York disclosed 30 investigations in the Northeast alone of hedge fund trading for potential conflicts of interest and asset-value manipulation. Compare that to the SEC average of roughly 20 cases a year nationally against hedge funds during the past five years. SEC spokesman John Heine in Washington confirmed the New York number, but declined to discuss any initiatives in other regions of the country, nor would any of the dozen regional offices contacted individually. The number of hedge funds has mushroomed in recent years. There are as many as 9,000 hedge funds investing as much as $1.2 trillion, according to private estimates and the California Department of Corporations. That’s up from a few hundred during the 1990s. As many as 2,000 of the 9,000 funds may be vulnerable to pressure from investor redemptions, according to Larry Engel, a bankruptcy specialist in Morrison & Foerster’s San Francisco office. Swap Trouble One area of hedge fund investment garnering plenty of publicity has been “credit default swaps,” a form of bankruptcy insurance for creditors who may be nervous about loan repayments. Hedge funds swap the debt back and forth in deals intended to spread the loan risk among many investors. “There is now a lot of [default swaps] betting that companies are going to fail,” said Engel. He said the default swaps are like buying term life insurance on five strangers. “If I buy the insurance and all five start dying, I get rich. Credit default swaps allow that,” Engel said. The problem arises in vulnerable hedge funds that made hard-to-value credit investments, such as mortgage-backed debt in a falling market, coupled with short lockup periods, meaning the fund’s investors may redeem their money more frequently. If investors demand their money and highly leveraged funds must make distress sales on hard-to-value assets to pay off, it can force their values even lower. He said he expects to see more troubled hedge funds go under in 2008. The Drexel Burnham junk bond collapse of the 1980s is an example of successive forced sales that created a downward spiral, he said. But there is almost no regulation of hedge funds. Last year the U.S. Circuit Court of Appeals for the District of Columbia overturned SEC rules requiring hedge funds to register with the SEC. There is not even a generally accepted definition of a hedge fund, and there is no requirement that they open their books to regulators, nor is there a requirement they disclose whether they have sufficient reserves to cover pledges made in the credit default swaps. Generally speaking, hedge funds are privately offered entities that hold a pool of securities or other assets, yet unlike mutual funds that hold securities traded on stock exchanges, they are not registered. The first was created in 1949 and intended, as the name suggests, to hedge against potential investment risk. Only investment-savvy, high net-worth investors can get in the door. Hedge funds frequently require an initial investment of at least $250,000, or sometimes as much as $5 million. In California, the state Department of Corporations is considering a proposal to require registration of an estimated 400 to 500 hedge funds in the state that have fewer than 15 clients and more than $25 million under management. Public hearings are slated for December, according to Mark Leyes, department spokesman. To justify the registration of hedge funds, California officials cited the rapid growth in the number of funds, the amount of assets at risk and increasingly frequent instances of market fraud. When funds blow up, they can lose jaw-dropping amounts. In August, Goldman Sachs Alpha Fund lost $2 billion of its $10 billion value, and Sowood Capital Management, a Boston hedge fund, lost half of its value, about $1.5 billion, in July. Both drops were related to the eroding debt market. Congress and state legislatures have not rushed to regulate, so expect to see disputes sorted out through class actions and individual lawsuits, said Intelisano, who also represents a group of the Bear Stearns hedge fund investors. Susan Ervin, head of the derivatives practice at Dechert from its Washington office, said that the function of credit default swaps is to transfer the risk of adverse credit events to someone better able to bear that risk. However, “the credit default swap market is opaque and largely unregulated, and there can be no assurance that credit risk ends up with parties capable of assuming it. “If a hedge fund or other [party on the other side of a deal] takes on more credit risk than it can manage and fails to meet its obligation, this could lead to a domino effect on other players,” said Ervin. An Investor Issue To be sure, many funds are reliable, and plenty of lawyers believe they do not need government regulation. “[Hedge funds] are sophisticated and, short of committing fraud, it should be an issue between them and their investors. The SEC should not protect the investors from themselves,” said Evan Flaschen of Houston-based Bracewell & Giuliani’s Hartford, Conn., office and an attorney advising hedge funds. “Good funds are doing the right things, including staying in communication with their investors,” he said. “We don’t think people need to be overly nervous about the state of hedge funds or their status in the marketplace,” said David Cushing of Crow & Associates in Princeton, N.J., which specializes in legal compliance in investing. “The concern in the credit market still requires a watchful eye over the next few months.” “I think that with the intense pressure on hedge funds to generate higher returns, they choose to take higher risks, using highly illiquid securities and then leveraging them up farther,” said Intelisano. “You’re going to see more funds getting caught up in the problems like Bear Stearns. I don’t think they understand that just because you slice up a mortgage and repackage it, that doesn’t take the risk out,” he said. This article originally appeared in theNational Law Journal , a publication of ALM. �

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