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A number of members of the Senate Banking Committee believe that Congress needs to examine whether hedge funds should come under expanded SEC regulation. At a recent hearing on hedge fund developments, Richard Shelby, chairman of the committee, said that the growth of an indirect retail market and other recent trends in the industry pose a number of investor protection concerns. While praising hedge funds for providing liquidity allowing capital to seek higher rewards regardless of the overall market environment, Chairman Shelby cautioned that investor protection concerns have arisen as these funds are made available to less sophisticated investors. Hedge funds are loosely regulated, and fall within several exemptions from the federal securities laws. Recently, however, regulators have become more interested in hedge funds. For example, the SEC has advised investors that hedge funds, unlike mutual funds, are not registered with the Commission and are generally subject to very few regulatory controls. Further, the SEC has cautioned that hedge funds seek to profit in all kinds of markets by pursuing leveraging and other speculative investment practices that may increase the risk of loss. Similarly, the NASD recently reminded broker-dealers of their suitability obligations when selling hedge funds to investors. “We may have to close the door on some of these exemptions,” said Sen. Paul S. Sarbanes during an appearance by SEC Chairman William H. Donaldson before the committee. The SEC is in the midst of a study on hedge funds, and plans to hold public hearings on the issue in May 2003. While other committee members echoed Sarbanes’ comments, the consensus is to wait for the SEC to issue a report before beginning any possible legislative proposals. Congress is concerned that more investors are becoming exposed to hedge fund risk because it has become less expensive to invest in these vehicles and because some SEC-registered mutual funds are in turn investing in hedge funds, creating the risk that more investments will be out of the SEC’s range. Chairman Donaldson noted that there is no universal definition of a hedge fund, adding that many of these funds do not hedge at all, with some involved in fairly traditional equity investment. Hedge funds, however, do have risks beyond those of most SEC-registered investments, he continued. Many hedge funds require that investors keep their money in the fund for an extended period of time, and require notice prior to redemption. In addition, unlike traditional mutual funds, some hedge funds only allow redemptions once or twice per year. These funds usually do not have boards of directors, and do not have to file standardized reports. The managers often receive compensation based on both asset size and performance. Hedge funds are also not subject to the borrowing and leverage restrictions of registered investment companies. Since they are not registered with the SEC, they are out of range of the SEC’s examination and inspection process. Despite no clear definition, Donaldson cited estimates that there are close to 5,700 hedge funds operating within the United States, with about $600 billion in assets. He compared this amount with the $6.3 trillion managed through mutual funds. Committee members are concerned about the “retailization” of hedge funds, which means that these previously exotic investments, once accessible only to the wealthy, are now available to more ordinary investors. There is also concern about funds of funds, where regular mutual funds invest in hedge funds, thus exposing their shareholders to risk, partly because hedge funds tend to be less diversified than other mutual funds. Chairman Shelby emphasized that these funds of funds must provide sufficient transparency and protection for their customers. Sen. John E. Sununu noted that there is little guarantee that mutual funds and other institutional investors will have the investment acumen to avoid hedge fund risk, since many Wall Street firms, which he said are among the most sophisticated investors, placed huge amounts of money with Long Term Capital Management, which collapsed in 1998. LTCM then received a large bailout endorsed by the Federal Reserve Board. Sophisticated investors can also fail to receive information, Donaldson noted, stating that when registered investment funds invest in hedge funds, the hedge fund usually receives less information than does an individual who invests in a registered investment fund. The first “fund of hedge funds” began operations in 2002 and there are currently a total of 18 such funds, according to the SEC chairman. These are registered investment companies that invest in hedge funds. While all of these funds currently have a $25,000 minimum investment, there is no federal requirement for a minimum. Minimum investments could be lowered by the funds, therefore, in the absence of legislation or regulation. Most hedge funds are operated as limited partnerships and receive their funds from private placements. Under current rules, the funds may not generally advertise. In order to avoid SEC registration, they have limits on how many investors they can have, although these limits vary based on classification of the investors, which vary by the worth and income of the investors. While hedge funds do have to follow Exchange Act reporting if they own large equity shares, Donaldson emphasized that this reporting does not provide significant insight. Furthermore, hedge funds do not have to report short or debt positions. Sarbanes worries that some hedge funds have an inherent conflict of interest since they are part of a family that also includes regular investment companies. Donaldson said that this issue is on the SEC’s “checklist” of areas to explore. Sen. Sarbanes also pointed out the danger that a hedge fund will take a short position, and that an affiliated mutual fund will sell the same stock, thus reducing the price, and therefore benefiting the hedge fund’s short position. Chairman Donaldson stated that conflicts between long and short positions within hedge funds and related funds are the same possible conflicts that exist for any investment adviser that manages both SEC-registered, and non-registered, investments. � 2003, CCH INCORPORATED. All Rights Reserved.

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