Hedge Funds Under Fire: Is There Body Armor Out There?

Wednesday, June 1, 2005 - 01:00

In the last 18 months, the hedge fund industry with more than 8,000 hedge funds and nearly $1 trillion in assets has experienced unparalleled civil and criminal investigative scrutiny. No longer do we argue over the proprietary of hedge fund regulation. Instead, after late trading and market timing became household words, the debate ended, and the focus led to discussions of actual or proposed regulation.

Discussing the civil and criminal regulatory morass where the hedge fund industry finds itself is important but not practical. Prudence dictates that we examine the current hedge fund regulatory structure, and provide an approach to avoid civil and criminal sanctions in the future.

The Nuts And Bolts Of Hedge Fund Regulation

The term "hedge fund" is not defined or used in the statute books. In fact, hedge funds were created and tended to exist primarily outside the regulatory radarscope. Hedge funds are private investment vehicles managed by a professional investor that often engages in active trading in either a group of securities or commodities, including equities, government securities, municipal securities, futures, options and foreign currencies. Hedge funds usually employ sophisticated investment techniques, including arbitrage leveraging and hedging.

Hedge funds, however, face significant regulatory hurdles that must be overcome before entry into the hedge fund world. The apparent lack of explicit registration does not mean that the hedge fund business is regulation-less. There are numerous regulatory considerations when organizing and operating a domestic hedge fund. Many of these considerations arise from the interpretation and application of various statutes, including the Securities Act of 1933 ("Securities Act"), the Securities and Exchange Act of 1934 ("Exchange Act"), the Investment Advisers Act of 1940 ("Advisers Act"), and the Investment Company Act of 1940 ("Company Act"), as well as state blue sky laws and the Commodity Exchange Act.

Initially, most hedge funds market hedge fund interests solely to institutional investors or wealthy, sophisticated individuals. To be exempt from registration pursuant to the Company Act, a hedge fund may not be beneficially owned by more than 100 people. See Company Act § 3(c)(1). Further, securities registration exemption requires that hedge funds offered in the United States structure their offers and sales of hedge fund interests as private placements, pursuant to Securities Act Regulation D Rule 506, a non-exclusive safe harbor for issuers. Regulation D permits sales of hedge fund interests to an unlimited number of an "accredited investors," limits such sales to 35 non-accredited investors, and does not limit the dollar amount of securities that can be offered. Regulation D Rule 502(c), however, prohibits any offers or sales through general solicitation or general advertising.

Beginning in February 2006, amendments to the Advisers Act will require most hedge fund managers to register as an investment adviser. Hedge fund managers previously were exempt from registration because most did not have more than fifteen clients. The hedge fund was counted as one client despite the hedge fund having numerous investors, but the SEC now requires that the investment adviser must look through any entities like a hedge fund, and count the number of actual persons as clients and not the entity. Hedge fund managers covered by the Advisers Act will also have to adhere to many standards, including registration with either the SEC or in the state where its principal place of business is located. SEC or state registration depends upon the amount of client assets under management. The hedge fund manager will also have to provide business, financial, operational and investment disclosure information to their clients, not misuse non-public information, and disseminate all material information to their customers.

Hedge funds and their managers may, nonetheless, usually avoid broker registration, pursuant to the Exchange Act, because they are not "effecting transactions in securities for the account of others." See Exchange Act § 3(a)(4). Dealer registration will similarly not be required of the hedge fund or its manager because the hedge fund and its manager "buys or sells securities for such person's own account, either individually or in a fiduciary capacity, but not as a part of a regular business." See Exchange Act § 3(a)(5). Some hedge funds, however, execute transactions through an affiliated or "captured" broker-dealer. This broker-dealer is subject to all the provisions of the Exchange Act, including registration, association with a national securities exchange or association, and other financial requirements.

The Exchange Act also prohibits "soft dollar" arrangements that hedge fund managers previously entered into where a portion of the commissions generated in trading on behalf of the hedge fund were used to purchase goods and services for the benefit of the hedge fund manager. Such arrangements can raise questions of a conflict of interest when the hedge fund manager effectively pays higher commissions for received goods and services that may not be fully beneficial to the hedge fund on whose behalf the commissions were generated. The portion of commissions that exceeds the lowest available rate that is used to pay for such goods and services is referred to as "soft dollars." The Exchange Act also has several reporting requirements that maybe applicable to hedge funds. These requirements are similar for other investors. For example, if the hedge fund obtains a significant position in a company or the overall size of the fund's portfolio is substantial, reporting may be required.

The Commodity Exchange Act also requires registration for a hedge fund as a commodity pool operator, or, for a manager, as a commodity-trading adviser if the hedge fund trades on an organized futures exchange. Thus, hedge fund regulation is extensive and expansive over many compliance and operational functions.

Hedge Funds On The Hot Seat

All these hedge fund regulations have, unfortunately, not been unused.

Canary Capital Partners, LLC, PIMCO, Strong Capital Management, Inc. and Banc One International Advisers Corp. are a few of the entities that found themselves the subject of SEC and criminal investigations in the craze surrounding hedge funds and their trading. Further, the first person arrested in New York State Attorney General Eliot Spitzer's ongoing probe of the hedge fund industry is now on trial for alleged late trading where he faces 30 years in a New York prison.

As a result, hedge funds and their managers should never forget that hedge funds and their managers are subject to the anti-fraud provisions of the Securities, Exchange, Advisers, Company and Commodity Exchange Acts. Further, hedge funds and their managers are subject to the state securities laws in the states where they obtain investors as we have seen with Mr. Spitzer's investigations.

Market timing and late trading investigations are, however, only the beginning stages of the regulators' inquiries. Increased scrutiny will undoubtedly lead the regulators to investigate civil and criminal sales practice abuses as well as marketing and suitability violations. In fact, the NASD has already placed its membership on notice of perceived hedge fund sales problems. See NASD Notice to Members 03-07. Civil and criminal regulators are also employing all the investigative tools at their disposal on hedge funds and managers, including wiretaps, cooperators and search warrants. Such tactics are no longer used solely on organized crime. The hedge fund industry will undoubtedly see these tactics employed against its members shortly (if they have not already borne witness to their effect.)

In short, regulators are increasing hedge fund regulatory oversight because they perceive that hedge funds and their managers have an enormous impact on securities and commodities markets, and are not simply playthings for wealthy investors. Thus, regulators argue that their oversight protects both investors and the economy from unscrupulous hedge funds and their managers.

Is There A Light At The End Of The Tunnel?

Despite all the investigations and the increased scrutiny, all is not gloom and doom for hedge funds and their managers. However, the window of opportunity to embrace change and avoid "Canary-like" problems is rapidly shrinking.

We suggest, therefore, three guiding concepts to assist hedge funds and their managers in a positive way. These principles are not a talisman, but practical in nature, designed to uncover and detect past and future problems. We suggest hedge funds and their managers: (1) conduct an audit of past practices and investments; (2) implement the three "Cs"; and (3) periodically review their compliance and operations programs.

Initially, hedge funds and their managers must be confident that their past investments or strategy were compliant with previous laws and regulations. Hedge funds and their managers should, therefore, consider auditing their past investments and practices to ensure their conduct did not violate any statute or rule. Willful blindness to past problems is simply not a defense if regulators begin making inquiries. Self-examinations may also pay dividends if an investigation is begun by a regulator. The hedge funds and their managers may use this audit information to positively respond to subsequent investigations or even pre-empt a much broader civil or criminal investigation.

Hedge funds and their managers should also adopt and implement the three "Cs" as a way to detect and prohibit improper, illegal and unethical activities at the hedge fund. The three "Cs" are: compliance, internal controls and communication. Hedge funds should adopt strong compliance programs even if these are not now required by regulators. As stated above, Advisers Act Rules 206(4)-7(a)-(c) will require that the hedge fund manager have a chief compliance officer and compliance procedures. The hedge fund should also have them. Compliance officers should also be granted substantial authority within the hedge fund to effect and implement the written procedures. These compliance procedures must be complete, but adaptable to ensure the hedge fund will be able to handle novel issues.

Hedge funds must also adopt specific and written internal controls to standardize the manner hedge funds and their managers address various business and operational activities. These internal controls must lay out specific and detailed procedures to handle training, trading, financial and audit operations. All of these policies should be designed to prevent, detect and correct violations, and are the "front-line" defense against problematic transactions and operations possibly employed by hedge funds.

Communication between the various individuals that comprise hedge funds and their managers is also essential. Hedge funds and their managers should strive to create workplaces that foster communication where the entry level clerk would feel comfortable reporting trading irregularities to senior management (of course, through well-established parameters). Such reporting could save hedge funds and their managers from countless hours of future regulatory headaches.

The final suggestion to hedge funds and their managers would be to establish periodic reviews for the compliance, internal controls and communication programs instituted. For example, investment advisers are (and, most likely, the majority of hedge fund managers will be) required to annually review compliance and operational procedures. See Investment Advisers Release 2204. Hedge funds would do well to adopt this requirement to ensure that compliance and operations change as business lines develop and are re-focused.

These suggestions do not create a "one size-fits all" program, but are an initial step to develop the parameters for individualized plans for different hedge funds and their business operations.


In sum, hedge funds and their managers are under unprecedented scrutiny. A careful examination of their business operations and development of policies and procedures to ensure detection of illegal activity may be their only "body armor" from civil or criminal liability.

Ernest E. Badway is a Partner in the law firm of Saiber Schlesinger Satz & Goldstein, LLC, Newark, NJ. He previously served as an attorney with the Division of Enforcement, United States Securities and Exchange Commission. He represents broker-dealers, brokers, hedge funds, and investment advisors in securities regulatory, securities defense and white collar criminal defense in matters arising from trading and underwriting activities and in internal investigations, as well as defending enforcement actions by the SEC, NASD, NYSE, the New York Attorney General's Office, and the New Jersey Bureau of Securities. Mr. Badway can be reached at (973) 622-3333, ext. 4812.

Please email the author at eeb@saiber.com with questions about this article.