Where now for registration?
Four more years! Four more years! Four more years!
Friday’s appellate court decision that pried open the US Securities and Commission’s arthritic grip over hedge funds was hardly a surprise to anybody who paid attention to the argument in Dec. 2005. The judges’ questioning made it clear they had severe reservations about the SEC’s case, and it was likely a question of when, rather than if, another chunk of former chairman William H. Donaldson’s legacy would fall foul of the law.
While Phillip Goldstein – the manager who had the testicular fortitude to challenge the rushed, over-sold, flawed and ultimately futile regulatory maneuver – and his anonymous army of supporters (You go, Phil, just don’t use my name) rightly enjoys a famous victory, hedge funds now face a sustained period of regulatory uncertainty. With an equally uncertain outcome.
To invoke two much-beloved clichés: It is different this time. And be careful what you wish for.
What won’t happen No.I
The Cox commission will not, as the Donaldson commission did when its new mutual fund governance rules were first booted by the same court, merely pretend to address the objections before passing the same rule again. It didn’t work that time – the rule got kicked back, and is now actually being reviewed – and it is even less likely to succeed this time.
The mutual fund governance decision turned on a point of administrative process. The court found that the hedge fund rule was, as SEC chairman Christopher Cox conceded in a statement Friday, “in violation of law.” Period.
What needs to happen, but probably won’t
It would be nice if the SEC could offer at least some guidance to managers now considering their options. For example, hedge fund managers who choose to resign their registrations should not face regulatory retaliation. Having illegally induced those managers to register, it would add egregious insult to material injury if resignation had the effect of pushing a manager’s name up the inspection list.
[Almost 1300 hedge fund managers registered between Jan. 1 2005 and the Feb. 1, 2006 compliance deadline; while past performance would suggest that as many as half of those would eventually have registered, that still leaves 600-plus managers who are, effectively, victims of a regulatory fraud.]
Cox’s acknowledgement that the decision requires that “we reevaluate [our] approach to hedge fund activity,” and that he has instructed the “staff to…provide the commission a set of alternatives” is mere statement of the blindingly obvious and goes nowhere near far enough.
Why it is different this time
For one, many of the important players have changed, or at least changed seats.
Most significantly, the chief proponents of the hedge fund registration rule, approved by a 3-2 commission vote on Oct. 27, 2004, are long gone. Of the commissioners who supported the initiative, only Roel Campos remains, and some of his recent contributions on hedge fund-related questions leave the distinct impression that he has entirely lost the plot.
At the staff level, which is where the real power lies, most of the top layer of the division of investment management has turned over. Andrew ‘Buddy’ Donohue, the new director, has yet to express a substantive opinion on anything, let alone a controversial topic.
Putting aside any biases evident from his still officially unacknowledged history as a member of the Investment Company Institute’s board of governors, Donohue has recent practical experience of the uselessness of registration per se as a prophylactic against alleged securities fraud. As the former global general counsel of Merrill Lynch Investment Managers, Donohue will be intimately familiar with the circumstances of the failure of the MinusFunds-advised SPhinX funds; MinusFunds is an SEC-registered investment advisor (and, for that matter, a National Futures Association-regulated commodity trading advisor that is seriously delinquent in updating its records).
cited and the rule it promulgated. That the
Commission wanted a hook on which to hang more
comprehensive regulation of hedge funds may
be understandable. But the Commission may not
accomplish its objective by a manipulation of meaning…
US District Court of Appeals, District of Columbia Circuit
Goldstein et al vs Securities and Exchange Commission
Among the veterans of the last battle likely to have a hand in this one: commissioner Paul S. Atkins, who, with the soon-to-leave Cynthia Glassman, vigorously opposed the initiative; commissioner Annette Nazareth, formerly director of the division of market regulation, was not prominently involved, at least in public forums, the first time around; and Lori A. Richards, director of the office of compliance inspections and examinations, and the initiative’s chief beneficiary in terms of enhanced bureaucratic heft.
What won’t happen II
The SEC is not about to declare defeat and abandon the field. Hedge funds are simply too large, and too influential (although hardly as influential as they get credit for) to exist in a regulatory ionosphere where just a few – largely uncoordinated – agencies have some oversight of some aspects of some trading by some hedge funds.
Politically, Cox can’t, however much he may want to, walk away from the issue. The Investment Company Institute, trade association for the mutual fund industry, has so far refrained from public comment on Friday’s court decision. But it has, since the onset of the mutual fund trading scandal in 2003, ramped up its lobbying activity and is even now likely calling down the heat.
[Noted with interest: Buddy Donohue contributed $5000 to the ICI Political Action Committee in Dec. 2005. Two months earlier, he gave $2000 to Rick Santorum, the third-ranked Republican senator who, based on current polls, is likely to lose his seat in this year’s election.]
The process of reevaluating “the agency’s approach to hedge fund activity” and coming up with “a set of alternatives” will not move quickly. Donaldson’s rush to regulate was driven by many factors, including the agency’s embarrassment in the post-Enron corporate crime era and, on Donaldson’s own watch, New York attorney general Eliot Spitzer’s Canary action, which exposed the ineffectiveness of the SEC’s mutual fund oversight regime.
As well, Donaldson, a Bush family friend yanked from retirement to replace the risible and reviled Harvey Pitt, was a man in a hurry. His “damn the torpedoes” attitude supported a view that his priorities were quick action and an early return to retirement, rather than losing too much sleep over whether the action actually addressed the problem or, for that matter, could survive a relatively simple legal challenge.
The hedge fund court ruling itself would seem to block rapid a rapid response. Having bent itself into a pretzel to come up with the now discredited “how-to-count-clients” method of establish its right to regulate hedge funds, the chances of the SEC quickly coming up with a clean, simple – and legal – alternative approach seem remote.
Four more years! Four more years!
Just how long will the new regulatory uncertainty last? It’s hard to imagine much being achieved within 12 months; it took the Donaldson commission 18 months to get from roundtable to a rule and that was regarded as quick work.
The SEC could, however, do at least a couple of things fairly quickly:
- Revisit its accredited and qualified investor standards, which have not changed since the early 1980s. That would take the retailization concerns, regularly cited as one of the justifications for a formal hedge fund regulatory process, off the table, even while perpetuating the securities laws’ canard that wealth is somehow correlated with investment acumen.
- Eliminate the effective gag-order on hedge fund managers’ participation in public debate created by the non-solicitation rules that apply to private offerings. The rules, usually enforced only when other, more material, wrong-doing has occurred, certainly inhibit managers’ bona fide media contacts, contributing substantially to the air of mystery that surrounds hedge funds and their activities.
The possibility of both these steps were, in some form or other, raised in the 2003 staff report Implications of the Growth of Hedge Funds. Neither was taken up as the Donaldson commission chose instead to bang the round peg of hedge funds into the square hole of an existing regulatory scheme.
Beyond that, a real solution requires sober consideration of some of the many alternative proposals made, and ignored by the “my way or the highway” crowd, in the first go-around. Whether or not that occurs, and Cox’s statement that the SEC would “use the court's decision as a spur to improvement in both our rulemaking process and the effectiveness of our programs to protect investors” is more than cant, will depend on numerous unknown factors.
What alternative proposals will emerge? Essentially, it depends on whether the new generation of senior staff decides to look at the issues objectively or, like its predecessors, use the process to cement a regulatory power-grab. Several good ideas were sprinkled among the form-letter dross of the public comments in the original rulemaking. Commissioners Atkins and Glassman got most headlines for their criticism of the registration initiative, while the positive suggestions they did make were largely ignored.
But even the best-intended process will likely have to confront the vagaries of the political winds. As the rapid-fire collapses of Enron, in late 2001, and then WorldCom resulted in the passage of Sarbanes-Oxley and its roll-call of unintended consequences, so might a serious hedge fund-related financial accident provide the stimulus for legislative action that is unlikely to work out well for either markets in general, or hedge funds in particular.
The SEC unquestionably has an important role in hedge fund regulation. But it needs to work much harder at matching its approach to the real, valid challenges rather than acting for the mere appearance of action. Something that isn’t “in violation of law” would be good, too.
US Court of Appeals, District of Colombia Circuit
Phillip Goldstein et al, Petitioners v. Securities and Exchange Commission, Respondent
Opinion for the Court filed by Circuit Judge Randolph
Statement of Chairman Cox
Concerning the Decision of the US Court of Appeals in
Phillip Goldstein et al. v. Securities and Exchange Commission
Washington DC, Jun. 23 2006
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