Over the summer the business boogey-man du jour was identity theft. Like many other blogs The Daily Caveat rode that wave in part because the giant data aggregators who were some of the prime offenders are the most prominent vendors in our industry. But the business pages have subsequently moved on and identity theft concerns have filtered down to local newscasts sandwiched between lost dog stories and local politics. Hedge fund shenanigans have now taken their turn in the finance pages as the monster in the closet.

Frankly, there is good reason to be wary of the hedge fund market place. As fund managers are wont to point out, the alternative investment strategies they employ are not for the average investor. Their clientele has traditionally been made up of financially sophisticated, wealthy individuals who were able - at least theoretically - understand and assess the strategies employed by their advisors. But the marketplace for hedge fund investors has been changing for several years and by all accounts will continue to do so, as more institutional investors such as pension funds get in on the game.

With this undeniable change comes a not unreasonable desire for hedge funds to work well for everyone. Part of that process is educational. As with any investment decision, caveat emptor must be the rule and fund managers are right to suggest that any investor who does not do their homework is asking for trouble. Consequently companies like Caveat Research are more and more often being asked to assist clients in vetting hedge fund investment opportunities in the same manner we have traditionally assisted other due diligence matters.

But what else can be done structurally to adapt funds to the changing marketplace for their services? Already funds have become more "domesticated" as larger institutions have gotten in on the game. But the occasional bad actor or business strategy gone awry has repeatedly forced the public flogging of hedge funds in the press. Unfortunately as in all areas of business, the bad actors often overshadow the good. The debate over what regulatory changes are necessary, desirable or undesirable continues. Even as the SEC readies itself to take on regulation of some funds early next year, at least one shareholder activist is seeking to block the enactment of the new rule:

Via the Financial Times:

SEC hedge funds rule is challenged

December 08, 2005
Financial Times (MSN Money)

A prominent shareholder activist will on Friday urge a court to strike down the chief US financial regulator's flagship rule to supervise the hedge fund industry. Lawyers for Phillip Goldstein, New York-based head of hedge fund Opportunity Partners, will ask a federal appeals court to declare invalid the hedge fund registration rule drawn up by the Securities and Exchange Commission.

It is the second legal challenge to SEC regulation masterminded by William Donaldson, the former chairman of the regulator, who stepped down in June. The US Chamber of Commerce is seeking to strike down the SEC rule that is supposed to improve mutual fund governance.

In a legal brief submitted to the court of appeals for the district of Columbia, lawyers for Mr Goldstein said the rule on hedge fund registration should be declared invalid "because the SEC does not have the statutory authority to extend its regulatory power to a hedge fund" under the 1940 investment advisers law.

The lawyers also claimed the SEC had acted in a "capricious and unreasonable" manner because it "vastly understated" the compliance costs stemming from the rule, which would be passed on to investors. The rule requires US-based hedge fund managers who control assets of more than $25m to register with the SEC by February 1 next year.

The 1940 law requires many investment advisers to register with the SEC, but it exempts those who have fewer than 15 clients and do not market themselves to the public. In 1985, the SEC said these private advisers could count each partnership into which investors put their money as a single client.

This decision enabled hedge funds, which typically operate as partnerships, to avoid registration even though they may have large numbers of clients. The new rule would require hedge funds to count each investor as a client and so most would have to register.

In its legal brief for the court case, the SEC said Mr Goldstein's challenge had "no merit". The SEC justified the rule by highlighting the rapid growth of hedge funds during the past five years, the rising interest of retail investors in them, and increasing instances of fraud in the industry. In its legal brief for the court case, the SEC said Mr Goldstein's legal challenge had "no merit".

The original article appears here.

Whether the SEC rule is adequate on its face is one thing. Whether they can muster the enforcement resources necessary to make it work is quite another. We shall see what the spring brings, or if these legal challenges gain traction enough to derail the new regulations before they start.

Meanwhile, if you were listening to drive-time NPR last night you probably heard a sympathetic piece on Marketplace, with fund managers decrying the overstated bad-rep their industry is getting. If you missed it, the story is worth a listen if only for a second opinion.

-- MDT

Labels: identity theft