By Frederick M. Lehrer
Over the past twenty-five years hedge fund assets have grown from hundreds of millions of dollars to hundreds of billions. Now at over a trillion dollars, hedge fund assets are predicted to increase to $6 trillion by 2015. Despite this exploding growth, hedge funds have remained largely unregulated, which is largely attributed to hedge funds not being required to register with the SEC (i.e. under the Investment Company Act of 1940 that regulates mutual funds) (Investment Company Act of 1940 is hereafter referred to as the “Investment Company Act”). Now the SEC is being pressured to institute a hedge fund regulatory scheme, which appears to be motivated in part by the fear that the enormity, unregulated and risky nature of the hedge fund market (especially with a looming foreclosure mortgage crisis) poses potential fraud related losses of the same magnitude or exceeding that of Enron, WorldCom, and others.”
Hedge Fund Basics
(Structure) – Hedge funds are similar to mutual funds in that they both represent a pool of investors’ money that invest in various financial instruments; however, in many ways the similarities end there, most significantly that:
• Investments in hedge funds are infinitely more expansive then mutual funds and may Include common stock, bonds, oil and gas interests real estate, commodities, and a host of other investments, which may or not be liquid;
• Hedge funds may invest in illiquid securities that pose valuation difficulties or even defy the ability to fix true values;
• Hedge fund fees include not only asset management fees (for example, 1 % to 2% of assets), but also “performance fees” (for example, 20% of the hedge fund’s profits);
• Hedge funds are not subject to borrowing leveraging restrictions, whereas mutual fundsare required to adhere to such restrictions; and
• Mutual funds are directly subject to examination/inspection by SEC examiners, whereas properly exempted hedge funds are not required to register under the Investment Company Act of 1940, and thus are not subject to SEC examinations or inspections.
Exclusions or Exceptions to Registration
Hedge funds are similar to mutual funds in that they both represent a pool of investors’ money that invest in various financial instruments; however, in many ways the similarities end there, most significantly that:
- Investments in hedge funds are infinitely more expansive then mutual funds and may include, common stock, bonds, oil and gas interests, real estate, commodities, and a host of other investments, which mayor not be liquid;
- Hedge funds may invest in illiquid securities that pose valuation difficulties or even defy the ability to fix true values;
- Hedge fund fees include not only asset management fees (for example, 1% to 2% of assets), but also “performance fees” (for example, 20% of the hedge fund’s profits);
- Hedge fund are not subject to borrowing/leveraging restrictions, whereas mutual funds are required to adhere to such restrictions; and
- Mutual funds are directly subject to examination/inspection by SEC examiners, whereas properly exempted hedge funds are not required to register under the Investment Company Act of 1940, and thus are not subject to SEC examinations or inspections.
Absence of Required Disclosure
Hedge funds are subject to the anti-fraud provisions of the federal securities laws and hedge fund managers are subject to the fiduciary duties of investment advisors.
Current Hedge Fund Regulation
Hedge funds are subject to the anti-fraud provisions of the federal securities laws and hedge fund managers are subject to the fiduciary duties of investment advisors. Additionally, as discussed below, the SEC recently passed a new anti-fraud rule to the Investment Advisers Act of 1940, which subjects investment advisers of hedge funds to that rule.
Additionally, as discussed below, the SEC recently passed a new anti-fraud rule to the Investment Advisers Act of 1940, which subjects investment advisers of hedge funds to that rule.
SEC Enforcement of Hedge Funds
Significant cases that the SEC has filed in the hedge fund area have primarily involved fraud, false or misleading statements in hedge fund offering documents, market manipulation, performance misrepresentation, insider trading, illegal short selling, and fraudulent allocation of investment opportunities. The following represent just a few of such cases:
In the Matter of Millennium Partners, et al
Here, the SEC alleged that hedge fund managers generated profits of tens of millions of dollars for their hedge funds by employing deceptive and fraudulent market timing of mutual funds to the detriment of the mutual funds and mutual fund investors. It was further alleged that in order to carry out the fraudulent scheme, avoid detection and circumvent restrictions that the mutual funds imposed on market timing, the hedge fund managers: (a) created approximately 100 legal entities to hide that Millenium was behind the mutual fund trading; (b) used these entities to create in excess of 1000 accounts; (c) structured their trading to avoid detection by the mutual funds; and (d) used omnibus accounts and certain annuities to further hide Millenium’s identity.”
SEC v. Hillary Shane
Here, the SEC alleged insider trading involving a PIPE transaction in which the hedge fund adviser, in a private exempt offering, purchased shares of a public company and misused confidential information. The SEC also alleged that the hedge fund advisor had committed violations of the registration provisions of the federal securities laws by effecting short sales prior to the “PIPE Registration Statement” going effective, and then covering those short sales with those that she obtained in the private offering.
SEC v. Scott R. Sacane, et al
Here, the SEC alleged stock manipulation by hedge fund managers who allegedly created the allusion of greater demand in two stocks than actually had existed. Specifically, the SEC’s complaint alleges that the managers had manipulated the price of two biotechnology companies, Esperion Therapeutics, Inc. and Aksys Ltd., by making regular and substantial purchases of both stocks through the hedge funds they managed and concealing these purchases by, among other things, failing to file various required forms and schedules required by the SEC and making false SEC filinqs.
SEC v. John H. Whittier
Here, the SEC alleged that then hedge fund manager John H. Whittier repeatedly made material misrepresentations to investors regarding the oversight and diversification of two hedge funds that he managed. The SEC alleged that despite promising investors that the funds would be broadly diversified, Mr. Whittier instead amassed a position in a single small-cap stock, which far exceeded the 10% cap on individual long positions as disclosed in the hedge fund offering memoranda.”
New Hedge Fund Related Rule
On August 3, 2007, the SEC published its release regarding its adoption of Rule 206(4)-8 of the Investment Advisers Act of 1940, which specifically prohibits investment advisers from making false or misleading statements to, or engaging in other fraud on, investors or prospective investors in a pooled investment vehicle they manage. This new rule will increase the likelihood of increased SEC enforcement of actions involving hedge funds. There are important provisions of Rule 206(4)-8, which directly effect the regulation of hedge funds, as follows:
- This rule applies to both registered and unregistered investment advisers. The passage of this rule was partially in response to the SEC’s view that many of their enforcement cases against advisers to pooled investment vehicles have been brought against advisers that are not registered under the Advisers Act, and the SEC’s belief that it is critical that the SEC continue to be in a position to bring actions against unregistered advisers that manage pools and that defraud investors in those pools;
- This rule applies to investment advisers with respect to any “pooled investment vehicle” they advise. The rule defines a pooled investment vehicle as any investment company defined in section 3(a) of the Investment Company Act and any privately offered pooled investment vehicle that is excluded from the definition of Investment Company under the lnvestment Company Act. As a result, the rule applies to advisers of hedge funds, private equity funds, venture capital funds, and other types of privately offered pools that invest in securities;
- This rule prohibits any investment adviser to a pooled investment vehicle from: (a) making an untrue statement of a material fact to any investor or prospective investor in the pooled investment vehicle; or (b) omitting to state a material fact necessary in order to make the statements made to any investor or prospective investor in the pooled investment vehicle, in the light of the circumstances under which they were made, not misleading;
- This rule prohibits advisers to pooled investment vehicles from making any materially false or misleading statements to investors in the pool, regardless of whether the pool is offering, selling, or redeeming securities. By its operations, this new rule prohibits materially false or misleading statements regarding hedge fund investment strategies, the experience and credentials of the adviser (or its associated persons), the risks associated with an investment in a hedge fund, the performance of the hedge fund or other funds advised by the adviser, the valuation of the hedge fund or investor accounts in it, and practices the adviser follows in the operation of its advisory business such as how the adviser allocates investment opportunities; and
- This rule makes it a fraudulent, deceptive, or manipulative act, practice, or course of business for any investment adviser to a pooled investment vehicle to “otherwise engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor in the pooled investment vehicle.” This provision was designed to provide broader application to deceptive conduct, as opposed to affirmative [misleading or misrepresented] statements or material omissions.”
Conclusion
Due to the exponential growth in hedge funds, as well as regulatory and public perception that the investing public needs regulatory protection from fraud in the hedge fund arena, it is likely that the SEC will approve of additional new laws that will directly or indirectly effect the regulation of hedge funds.
The foregoing information is for informational purposes only and should not be construed as legal advice.
