Hedgies Gone Wild: Global Authorities Seek To Regulate The Industry

by: Michael Panzner

After years of spectacular and largely unregulated growth, the hedge fund industry is increasingly in the sights of government overseers around the globe. As Reuters notes:

The battle over whether more oversight is needed for the $1.5 trillion global hedge fund industry heated up this week as more top officials clashed, underscoring a lack of consensus for radical change.

The European Central Bank waded into the debate again on Thursday evening, calling for more transparency in the sector.

Juergen Stark, an Executive Board member of the euro zone central bank, said opacity contributed to unease over risk.

“In this context, initiatives are highly welcome that aim at fostering a dialogue between public and private sectors on the best ways to contain possible risk posed by hedge funds,” Stark told a gathering in Brussels.

“Particular attention has to be given to counterparty risk management, risk monitoring and enhanced transparency and disclosure,” Stark said.

Amaranth Advisors, the U.S.-based hedge fund that imploded after $6.4 billion in energy losses last September, highlighted the risks of lightly regulated hedge funds.

The European Union's top financial regulator sees no need for more rules, however.

“For the present time we don't see what additional measures would be needed at European level,” EU Internal Market Commissioner Charlie McCreevy told Reuters on Thursday.

“There is a lot of disinformation. It's not correct to say that there is no regulation of hedge funds in Europe. It's a bit of a myth,” McCreevy said.

Not all would agree. German authorities, in particular, seem to be one of the more vocal antagonists, notes Over the Counter.

Over in Davos, the searchlight has been cast once again on hedge funds. German antipathy to the industry is well known - it was vice-chancellor Franz Muntefering who referred to foreign investors as "locusts" in April 2005, and events such as the TCI/Deutsche Borse conflict haven't helped.

The latest to take a stand is the chancellor herself - Angela Merkel, in a keynote speech (in German) at the World Economic Forum yesterday, picked hedge funds as one of the priorities for German presidency of the G8 group of advanced industrial economies.

"We want to minimize the systemic risks of the international capital markets and increase their transparency. This is particularly necessary for hedge funds," she told the audience.

Indeed, it is evident that heightened concerns about the industry are cropping up in a number of places, including the U.S., which has historically had something of a hands-off approach to an industry that caters for the needs of so-called sophisticated investors. A report from Hedgeweek provides some insight.

Jay Gould and Michael Wu of law firm Pillsbury Winthrop Shaw Pittman analyse the proposed fiduciary rule and increased accredited investor standard published by the US regulator at the end of last year.

On December 27, the Securities and Exchange Commission published two new rule proposals, a broad anti-fraud rule, and a substantial increase in the net worth standard for individuals who can invest in certain types of private funds that issue securities in reliance on the Regulation D private placement exemption under the Securities Act of 1933.

The SEC proposed the new anti-fraud rule as a result of the D.C. Court of Appeals decision in Goldstein v. SEC, which vacated the SEC's hedge fund adviser registration rule. The Goldstein decision left unclear the extent to which an adviser owes a duty to investors in a fund, as opposed to the fund itself. Also, in order to stem the 'retailisation' of hedge funds, the SEC proposed to limit the availability of private funds relying on Section 3(c)(1) of the Investment Company Act of 1940 to unsophisticated retail investors.

Proposed Rule 206(4)-8

The proposed anti-fraud rule, Rule 206(4)-8 under the Investment Advisers Act of 1940, would apply to all investment advisers, whether registered or unregistered. Under proposed Rule 206(4)-8(a)(1), it would constitute a fraudulent, deceptive or manipulative act, practice or course of business with the meaning of Section 206(4) of the Advisers Act for any adviser to a 'pooled investment vehicle' to make any untrue statement of a material fact to any investor or prospective investor in the pooled vehicle, or to omit to state a material fact necessary in order to make the statements, in light of the circumstances under which they were made not misleading.

This is the general standard contained in Rule 10b-5 under the Securities Exchange Act of 1934. Rule 10b-5 and other anti-fraud rules require that the actionable conduct occur 'in connection with the purchase and sale of a security.' Rule 206(4)-8(a)(1) applies 'regardless of whether the pool is offering, selling or redeeming securities' and therefore has much broader potential application.

The rule would apply to any 'pooled investment vehicle,' defined to include any issuer that is an investment company or a fund that relies on either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940 for its exemption from registration. Accordingly, the proposed rule would apply to domestic and foreign advisers to hedge funds, venture capital funds, buyout funds, other private equity funds, managed CDOs and registered investment companies, but not to funds relying on other exceptions from registration under the Investment Company Act, such as real estate investment trusts and business development companies.

Investment advisers should note that and although the proposed rule does not require knowledge by the adviser that a statement was false or misleading or that an act defrauded an investor or prospective investor in order to have liability under the rule, advisory clients would not be able to bring an action against an adviser. Only the SEC would be able to bring an action pursuant to this rule.

Adding to antagonism towards the industry is the fact that some of their activities aren't necessarily seen as making the financial markets more efficient, but are rather a form of "money shuffling" that may do more harm than good. In "Borrowed Shares Swing Company Votes," the Wall Street Journal reports on a clever strategy that some operators have been using.

Private investment firms have found a simple way to profit from the workings of public companies: Borrow their shares, and then swing the outcomes of their votes.

In some cases, the strategy has allowed speculators to gamble that a company's stock will drop, and then vote for decisions that will ensure that it does -- without their ever having to own any stock themselves. Some outside interests have used the strategy to hide their voting power within a company until the last moment. Often, individual shareholders don't realize their own stocks, and their voting rights, have been borrowed from their brokerage accounts, until it's too late.

Fueling the practice -- dubbed "empty voting" in a study by two University of Texas professors -- is a booming business in lending shares. That business has nearly doubled in the past five years, according to one report, and now earns $8 billion a year for big brokerages and banks plus an unknown amount for institutional investors. Voting rights are lent along with the shares, and increasingly, that is leading to unintended consequences.

Reports this week of bad behavior at a few rogue firms won't help to bolster support, either. In "Bogus Audit Case Triggers Swoop by Regulators," the Financial Times reports on a case that will likely add to worries about what is really going on in some parts of the industry.

US regulators on Wednesday swooped on a US citizen and a hedge fund he operated after discovering that an audit of the fund's accounts claimed to have been done by accountants Grant Thornton had been completely fabricated.

The case raises questions about the extent to which hedge funds and other entities may be fraudulently passing off their financial statements as having been audited.

Regulators stumbled upon the case as part of an emergency inspection triggered by a tip-off from a would-be investor in the fund, Renaissance Asset Management, based in Georgia.

According to a lawsuit filed by the Commodity Futures Trading Commission (CFTC), the fund's chief operating officer, Anthony Ramunno, presented inspectors from the National Futures Association (NFA) with copies of what he claimed were audited annual reports for 2004 and 2005.

But Mr Ramunno contacted the Federal Bureau of Investigations shortly afterwards to admit that he had "committed fraud", a CFTC complaint said. The audit had never been carried out by Grant Thornton, or any other accounting firm.

Inspectors at the NFA, the self-regulatory body for the futures industry, also discovered a claim in financial statements that the fund had amassed $34m from would-be investors was also false. The fund's bank accounts held only $4m.

In "2 Hedge Funders Settle With SEC," the Associated Press details another instance of a hedgie gone wild.

Former hedge-fund trader Bret Grebow and former manager Robert Massimi have agreed to pay more than $4.5 million to settle charges that they took more than $5.2 million of investor money for their own personal use, the Securities and Exchange Commission said on Wednesday.

Grebow agreed to pay a $120,000 civil penalty and to give up almost $3 million in improperly earned money, including interest. Massimi agreed to pay a $120,000 civil penalty and to disgorge about $1.3 million. They were also barred from working for investment advisers, and settled without admitting or denying wrongdoing. An attorney for Massimi wasn't immediately available, and attorney for Grebow declined immediate comment.

"The commission vigorously pursues those who use hedge funds to carry out fraud," said Bruce Karpati, an assistant director in the SEC's enforcement division. "Through this settlement, Massimi and Grebow are effectively banned from the investment advisory business and have been ordered to pay full disgorgement and penalties."

Grebow was featured in a 2004 Wall Street Journal front-page article about how the rise in stock markets was leading Wall Street investors to live the high life again. In the article, Grebow described chartering planes to fly him and his girlfriend to his Florida home and to the Super Bowl, noting that the planes featured his favorite cereal, Cookie Crisp, and Jack Daniel's on ice.

Their hedge fund, HMC International LLC, was based in Montvale, N.J. Last July, Grebow was arrested and charged with operating a "Ponzi scheme," in which existing investors are repaid with money from new investors. The U.S. Attorney's Office in Manhattan wasn't immediately able to provide information about that case, and Grebow's attorney declined to comment.

Certain types of activities, like illegal tax avoidance, can really get regulators' juices flowing. History suggests this issue, in particular, is often a key impetus for stepped-up government intervention. A Bloomberg report details some concerns:

At the Deep End Bar, a poolside grill in St. Croix just steps from the Green Cay Marina, a handful of money managers and investors sip Cruzan rum from a local distillery and reach for complimentary bug repellent as dusk brings out the no-see-ums.

Warren Mosler, who opened a hedge fund firm in St. Croix five years ago, is having what's become the usual conversation with people who were lured to the U.S. Virgin Islands in 2001 by the prospect of legally cutting their tax bill by 90 percent. Almost half of the 49 funds that set up shop in the islands have fled in the past two years.

Mosler complains that hedge funds were chased away by federal tax law changes and an Internal Revenue Service that says it suspects rampant fraud by those that signed up for the tax incentive.

A sure sign that the temperature is about to be turned up on an industry is when those who are potentially at risk start getting all lawyered up. A National Law Journal report suggests Washington legal firms see the regulatory winds blowing that way.

The recent Democratic takeover of Congress has led to a power shift among law firms jockeying for government relations talent and preparing for the expected deluge of congressional investigations and legislative proposals.

At least a dozen firms have announced key appointments of government relations attorneys since the elections last November, or revealed ongoing negotiations with potential hires. Mayer, Brown, Rowe & Maw of Chicago and Washington-based Venable formed new practice groups dedicated to congressional oversight and investigations work.

Firms known for their Washington power base, such as Kirkpatrick & Lockhart Preston Gates Ellis; Hunton & Williams of Richmond, Va.; and Washington-based Patton Boggs, also say they're poised for an upswing in legislative work.

The Democratic takeover of Congress during a Republican administration fosters a climate ripe for investigations as legislators seek to embarrass and outdo the administration, lawyers say. New House of Representatives ethics rules implemented in January to restrict gift-taking also added deposition powers to the House's main investigative body, the Committee on Oversight and Government Reform.

In the year ahead, Congress is expected to target a wide range of industries and subject areas, including the energy, financial services and pharmaceutical industries. Also, probes of government contracting, which will involve reviews of spending on reconstruction in Iraq, are in the offing....

Companies and individuals that find themselves under scrutiny by the Committee on Oversight and Government Reform may find the glare of the spotlight a little hotter, thanks to recent rule changes that give deposition and subpoena authority to committee members and their legal staffers.

Nick Allard, a Washington attorney who co-chairs Patton Boggs' public policy department, said that the Jan. 4 resolution was a "very, very early warning" sign of an increasing tide of subpoenas and investigations.

"That should be expected to expand greatly the depth and breadth of investigations in a broad number of sectors," Allard said.

Although the firm said the hire wasn't election-driven, Patton Boggs is ready for hedge fund investigations with the January addition of Fred Hatfield, a former commissioner of the Commodity Futures Trading Commission, the Washington-based regulatory body that monitors the futures and options markets.

A formal deposition process should also boost the committee's preparation for public hearings by giving members an official avenue to explore topics outside of the time constraints of the public hearing process, said Steven Ross, a public law and policy partner in Akin Gump Strauss Hauer & Feld's Washington office. "It's a way to test different theories and explore what the witness will say rather than having to do it with the lights on," Ross said....

The congressional power shift will transform the relatively quiet government relations scene of the last eight to 10 years, said Gary Slaiman, a partner in Bingham McCutchen's Washington office, who expects investigations from government oversight committees, the finance committees, the judiciary committees and the commerce committees in each house.

Interestingly, there is evidence that at least some of those who have been benefactors and beneficiaries of the booming hedge fund industry are scaling back their involvement, according to the Wall Street Journal. While it seems driven by future return prospects, it could mean the support of powerful interests is wavering, encouraging those in charge to go ahead and do their thing.

Americans of ultrahigh net worth -- those households with $5 million or more, not including their primary residence -- reduced their exposure to hedge funds in 2006, and the wealthiest subset trimmed its holdings the most, a survey found.

Hedge-fund exposure among ultrahigh net worth Americans fell to 14% last year from 17% in 2005, according to a mail and online survey of 526 qualified U.S. households conducted by strategic-consulting firm Spectrem Group of Chicago. Of the richest Americans -- those with more than $25 million, not including their primary residence -- 27% owned hedge funds last year, down from 38% in 2005, the survey found. Of that 27%, the mean hedge-fund balance was more than $1.6 million.

The results are consistent with the theme Spectrem has seen in its focus groups -- that individuals are being a bit more moderate in their investment perspective, said George Walper, president of Spectrem.

"In general, what we're seeing is that individuals are saying they want to be far more involved with their investments, but more importantly they're pausing and making sure they're comfortable with their overall allocation," he said.

The decline in holdings of hedge funds, investment pools for the wealthy and institutional investors, came in a year of several high-profile hedge-fund blowups, one in which many hedge funds failed to blast by some key equity indexes....

"This population of sophisticated investors is taking pause somewhat," he said. "The hedge-fund sector is something they're evaluating; they're considering how much exposure they want. We think they're always going to want some exposure."

While there is no doubt that there are a lot of honest, smart, and careful operators in the hedge fund industry, the size of the rewards involved has invariably attracted a number of dangerous gunslingers who have stepped over the line in terms of risky or otherwise unwelcome behavior. The question is, will the emergence of a hodgepodge global crackdown now, when the financial system appears poised on a knife edge, have unintended consequences?

We shall see.