U.S. hedge funds may slip past SEC, research shows

October 3, 2005
By Svea Herbst-Bayliss
Reuters

Hundreds of U.S. hedge funds may slip through the crack when they register with regulators, new research shows, causing a humiliating if not harmful situation as authorities begin to scrutinize the industry more closely. Life will change for thousands of loosely regulated hedge funds in February, when they must follow a new rule designed to reduce fraud in the hugely popular and often secretive $1 trillion industry. Funds that manage $30 million or more for 15 or more clients must register with the Securities and Exchange Commission and let the agency's inspectors review the hedge fund's books at any time.

With less than four months to go before the new rule takes effect, however, independent researchers, lawyers and even SEC officials said the agency's limited resources will be stretched dramatically, and some funds will not face the extra scrutiny -- at least not immediately. "We expect that some 1,900 hedge funds will plan to register with the SEC before February and that the agency will get bottlenecked, which means that a lot of hedge funds will be registered by default," Brian Shapiro, president of Carbon360, the research arm of CarbonBased Consulting, told Reuters.

Traditionally, the SEC has 45 days to accept or reject an advisor's package. But because so many hedge funds are waiting until the last minute to apply, the agency may not eye all the documents in time, lawyers said, agreeing with the research. "I think this is going to cause a traffic jam," said Paul Roth, partner at law firm Schulte Roth & Zabel, explaining some funds' applications may become effective without review. More problematic, however, could be what happens after the fund is registered, the researchers said.

Usually, the SEC conducts an audit within the first year of registration, which Carbon360 has calculated means the agency will have to review an additional 158 funds per month, tying up two examiners for four weeks on each one. SEC Commissioner Paul Atkins said last week that the agency may not be able to keep up. "We have neither the resources nor the expertise to oversee all of the potential new registrants," he told the hedge fund industry's lobby group MFA in a speech. Carbon360 based its research on public SEC documents and released it during the same week when the founders of collapsed hedge fund Bayou Group pleaded guilty to fraud, marking the latest industry blow-up. Federal and state investigators are still probing how the pair cheated investors out of an estimated $300 million.

For the SEC, admitting to staff shortages may be especially embarrassing after it worked for years to put the fast-growing industry on a tighter leash as pension funds, endowments and charities pour billions into hedge funds every year. If fund managers know the SEC's resources are stretched, the researchers said the agency's ability to protect the public may be watered down because managers will have less fear of being caught if they commit fraud. "Essentially, the SEC could fall flat in its defense of the public interest if the agency is as overwhelmed as we suspect it may be," Shapiro said. The SEC acknowledged the problem, but warned it will be vigilant nonetheless.

"Resource contraints don't allow us to have a cop on every corner," SEC spokesman John Nester said. "We must therefore use our existing resources as efficiently and effectively as possible, and identify the highest risk areas that warrant scrutiny by SEC examiners." Industry lawyers, meanwhile, said that letting a few funds slip through the cracks during the registration process will not be very harmful. "The registration form isn't where you catch bad people. The examination process is where you catch bad people," said Elizabeth Fries, partner at law firm Goodwin Procter. Schulte Roth & Zabel's Roth agreed. "If some funds become effective without being reviewed, they will be reviewed later. It does not seem to be a particular problem," Paul Roth said.

The original article appears here.

-- MDT

Labels: Bayou Group