Post by kranker on Jul 10, 2006 21:22:39 GMT -4
JULY 17, 2006
NEWS: ANALYSIS & COMMENTARY
The SEC Isn't Finished With Hedge Funds
It's closing in on shady practices despite a setback from a federal court
The hedge fund cops may be down, but they're hardly out. In late June a federal court nixed the Securities & Exchange Commission's new hedge fund registration rule, which required funds to provide the SEC with basic information and subject themselves to random audits. The U.S. Court of Appeals for the District of Columbia Circuit called the rule "arbitrary" and, with a thump of the gavel, returned regulation to its pre-Feb. 1 state, when funds weren't required to open up the books for the SEC unless asked formally.
But don't throw a party for the hedgies just yet. During the nearly five months when registrations were taking place, SEC examiners found enough shady practices to keep investigators busy. "The SEC is still very much hot on the trail and will pursue the industry with whatever legal tools it already has," says Mitchell E. Nichter, a partner with Paul, Hastings, Janofsky & Walker in San Francisco.
The SEC is looking into a raft of abuses. Tops on the list: secret agreements, known as side letters, that give choice investors privileged information about holdings or special redemption terms. Funds are also under scrutiny for improperly valuing investments to hide losses or trump up returns to protect management fees. And SEC examiners say some funds are invested so heavily in exotic instruments that they couldn't come up with cash quickly if investors were to stampede for the exits.
Regulators are taking a hard look at side letters and evaluating whether disclosure alone will suffice. But legal experts say the SEC or Britain's Financial Services Authority will soon wipe out the practice. "We're going to see an expressed prohibition of side letters," says attorney James C. McCarroll of Reed Smith in New York.
Valuation is a hot topic, too. Many funds own thinly traded securities and complex derivatives whose values are subjective. The convergence of hedge funds and private-equity funds, which invest in private companies that aren't easy to value, makes matters more difficult. Says McCarroll: "Month-to-month valuations often are handled internally, creating potential for tension between a fund manager's drive to maximize performance-based fees and the need for honest, conservative valuations." Christopher E. Kundro, managing director and consultant at BearingPoint Inc. (BE ), calls valuation "a ticking time bomb."
Hedge fund losses can lead to particularly unsavory valuation practices. Susan Ferris Wyderko, acting director of the SEC's Investment Management Division, said in recent congressional testimony that many past enforcement cases against hedge funds have involved the "valuation of fund assets in order to hide losses or to artificially boost performance" -- and that this has become a big part of the examination process in the past few months. Funds, claiming certain investments are difficult to value, often put 10% to 15% of their portfolios in so-called side pockets, sequestered from the overall package. But some of the quarantined assets are merely poor performers.
After shelling out what Chairman Christopher Cox calls "significant resources" for policing hedge funds, it's unlikely the SEC will turn down the heat now. Under federal antifraud law, the SEC is already investigating hedge funds' role in bankruptcy cases as well as their access to insider information.
At the same time, the marketplace is demanding higher standards. "In effect, the SEC has achieved its objective," says Don Putnam, a managing partner at Boston's Grail Partners, an advisory merchant banking firm. "There is de facto regulation; the industry is learning that clients want safer hands." Michael G. Tannenbaum, a partner at Tannenbaum Helpern Syracuse & Hirschtritt in New York, predicts a combination of self-policing and government intervention. "If the SEC gets knocked out, Congress picks it up. And I think everyone would rather avoid oversight by a bunch of politicians."
By Mara Der Hovanesian
yahoo.businessweek.com/magazine/content/06_29/b3993055.htm
NEWS: ANALYSIS & COMMENTARY
The SEC Isn't Finished With Hedge Funds
It's closing in on shady practices despite a setback from a federal court
The hedge fund cops may be down, but they're hardly out. In late June a federal court nixed the Securities & Exchange Commission's new hedge fund registration rule, which required funds to provide the SEC with basic information and subject themselves to random audits. The U.S. Court of Appeals for the District of Columbia Circuit called the rule "arbitrary" and, with a thump of the gavel, returned regulation to its pre-Feb. 1 state, when funds weren't required to open up the books for the SEC unless asked formally.
But don't throw a party for the hedgies just yet. During the nearly five months when registrations were taking place, SEC examiners found enough shady practices to keep investigators busy. "The SEC is still very much hot on the trail and will pursue the industry with whatever legal tools it already has," says Mitchell E. Nichter, a partner with Paul, Hastings, Janofsky & Walker in San Francisco.
The SEC is looking into a raft of abuses. Tops on the list: secret agreements, known as side letters, that give choice investors privileged information about holdings or special redemption terms. Funds are also under scrutiny for improperly valuing investments to hide losses or trump up returns to protect management fees. And SEC examiners say some funds are invested so heavily in exotic instruments that they couldn't come up with cash quickly if investors were to stampede for the exits.
Regulators are taking a hard look at side letters and evaluating whether disclosure alone will suffice. But legal experts say the SEC or Britain's Financial Services Authority will soon wipe out the practice. "We're going to see an expressed prohibition of side letters," says attorney James C. McCarroll of Reed Smith in New York.
Valuation is a hot topic, too. Many funds own thinly traded securities and complex derivatives whose values are subjective. The convergence of hedge funds and private-equity funds, which invest in private companies that aren't easy to value, makes matters more difficult. Says McCarroll: "Month-to-month valuations often are handled internally, creating potential for tension between a fund manager's drive to maximize performance-based fees and the need for honest, conservative valuations." Christopher E. Kundro, managing director and consultant at BearingPoint Inc. (BE ), calls valuation "a ticking time bomb."
Hedge fund losses can lead to particularly unsavory valuation practices. Susan Ferris Wyderko, acting director of the SEC's Investment Management Division, said in recent congressional testimony that many past enforcement cases against hedge funds have involved the "valuation of fund assets in order to hide losses or to artificially boost performance" -- and that this has become a big part of the examination process in the past few months. Funds, claiming certain investments are difficult to value, often put 10% to 15% of their portfolios in so-called side pockets, sequestered from the overall package. But some of the quarantined assets are merely poor performers.
After shelling out what Chairman Christopher Cox calls "significant resources" for policing hedge funds, it's unlikely the SEC will turn down the heat now. Under federal antifraud law, the SEC is already investigating hedge funds' role in bankruptcy cases as well as their access to insider information.
At the same time, the marketplace is demanding higher standards. "In effect, the SEC has achieved its objective," says Don Putnam, a managing partner at Boston's Grail Partners, an advisory merchant banking firm. "There is de facto regulation; the industry is learning that clients want safer hands." Michael G. Tannenbaum, a partner at Tannenbaum Helpern Syracuse & Hirschtritt in New York, predicts a combination of self-policing and government intervention. "If the SEC gets knocked out, Congress picks it up. And I think everyone would rather avoid oversight by a bunch of politicians."
By Mara Der Hovanesian
yahoo.businessweek.com/magazine/content/06_29/b3993055.htm