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The comment period ended Wednesday for the Securities and Exchange Commission’s proposed rules to regulate hedge funds — a period that saw the industry make a last-ditch effort to persuade the SEC not to enter their financial sector, which has been largely unregulated for decades. In an unusual move, SEC commissioners Cynthia Glassman and Paul Atkins filed a public dissent to the proposal. Alan Greenspan, chairman of the Federal Reserve Board, has also questioned the efficacy of the proposed regulations. If put into effect, they will require investment advisers working in hedge funds to register with the SEC, allowing the regulator to inspect the internal operations of hedge funds and call for other changes. Although considerably less comprehensive than the oversight imposed on companies listed on stock exchanges and mutual funds, the regulations reflect a dramatic change for an industry used to minimal scrutiny by regulators. Despite the industry’s opposition, the consensus among observers on both sides of the issue is that the rules are likely to go into effect by the middle of next year. SEC’S MOTIVES The growth of the industry, along with a series of scandals, prompted the SEC to propose the regulations. When hedge funds first became available, they were offered to exceptionally wealthy clients as tools to diversify portfolios and achieve higher returns than traditional investments. A once-tiny enclave of the investment world, it has ballooned fifteen-fold since 1993 into a $795 billion industry. Some estimate its assets reach $1 trillion in 7,000 funds. Hedge funds began to take large positions in stocks, bonds and commodity markets, often in the form of alternative investments like derivatives or futures contracts. With this growth came the scandals. Long Term Capital Management, a bellwether of the industry, collapsed in 1998, nearly causing a crisis equalling the one infecting Asian economies at the time. Greenspan, the Fed chairman, orchestrated a bailout of the fund to avoid a larger impact. More recently, state and federal regulators cited Canary Capital, also a flagship of the industry, for fraudulently participating in market-timing schemes with several well-known mutual funds. In all, the SEC alone has brought at least 46 cases against hedge funds in the past five years. The estimated cost of these frauds is $1 billion, according to the SEC. Investments in hedge funds by universities, charities, and even average investors — what the SEC calls “retailization” — heighten the fears that hedge-fund-induced losses could hurt not just sophisticated investors who understand the risks of the industry but less savvy investors. The SEC is not alone in holding this opinion. Consumer groups and the mutual fund industry, which is heavily regulated, have joined the call for greater government oversight of hedge funds. But Robert Leonard, head of the hedge fund team at Bryan Cave, said mutual funds took this position when they started to lose market share to hedge funds. “No one else is beating the drum on this,” he said, while acknowledging that it is difficult to argue against oversight of a trillion-dollar industry. Since the SEC began to deliberate the regulation hedge funds, it met resistance. Like many industries fending off government oversight, hedge funds said that self-regulation will be more effective and less costly than the SEC’s proposal. Managed Funds Association, the umbrella trade organization of 700 hedge funds, asked the SEC for more time to respond to the proposed rules. Last year, after the SEC conducted a study on the growth of hedge funds in which it explored many of the recommendations it is now considering, the association criticized nearly every facet of the SEC’s plans for additional oversight. It argued that mandatory registration of hedge fund investment advisers would not prevent fraud. Instead, the regulations would give investors a false sense of security, causing them to conclude that because hedge funds have registered with the SEC, they are free of fraud, the association said in a letter to SEC Chairman William Donaldson. The SEC’s anti-fraud powers do apply to the industry. These powers, when combined with sound self-regulation, could effectively curb fraud without the need for costly compliance measures, the association argues. Two SEC commissioners, Cynthia Glassman and Paul Atkins, filed a dissent to the proposal. They questioned many of the assertions made by the majority of the commissioners to support the regulations. They saw little “retailization” of the industry and no alarming increase in fraud, they said. The regulations would contribute little valuable information to regulators but cost hedge fund advisers a great deal, the dissenters said. Greenspan said that the regulations would encumber hedge funds’ participation in transactions that are essential for the smooth operation of financial markets and would do little to reduce fraud. The new rules are “window dressing,” said Leonard, concerned more with “political needs than reality.” Nothing the SEC does will prevent fraud by those intent on wrongdoing, he said. Sophisticated investors like pension funds are more apt to find frauds than the SEC, he said. Investment managers conduct months of due diligence before investing in a hedge fund, he said, a process that includes interviews with hedge fund managers, checks with references and validation of the fund’s performance. An SEC agent would review a hedge fund once every four to five years under the current plan, he said. “Who would rather have looking at a hedge fund manager? A professional investor or the SEC,” he asked. The SEC disagrees, saying the registration of hedge funds will allow it to inspect records without any suspicion of fraud. Under the current regime, the SEC can act only after finding fraud rather than taking preventative measures. “Unregistered hedge fund advisers operate largely in the shadows, with little oversight,” the SEC in its July report. According to the SEC, the threat of an examination will deter against fraud and keep out unfit individuals who were previously connected to financial crimes from working in the industry. The SEC’s proposal also would require hedge funds to implement compliance measures. Filings made by hedge funds would educate potential investors of the type of risks and investments associated with them. BOTTOM LINE “People in the hedge fund industry are saying this is Armageddon,” said Jay Baris of Kramer Levin Naftalis & Frankel, who is helping to write a comment letter to the SEC on behalf of the American Bar Association. Others claim the new regulations are not overly burdensome, he noted. “The answer is somewhere in between,” he said. The regulations would leave hedge funds with far less oversight and reporting requirements than others operating in financial markets. Many hedge funds are already registered with the SEC. Most of these, among the larger players in the industry, will need not have to make significant changes. The biggest impact will likely fall on smaller hedge funds that will have to bear significantly higher compliance costs, say industry experts. One letter sent to the SEC by a small hedge fund said compliance measures would absorb 15 to 20 percent of its revenues, essentially putting it out of business. Baris said he expects the proposed regulations to pass with few changes. In several months, he said, the regulations will kick in after the rule-making process is completed.

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