Cox: Hedge Funds Must Be Regulated

Jul 28 2006 | 2:31pm ET

Hedge funds took center stage this week in a place they'd probably rather be forgotten: Capitol Hill.

"Hedge funds are not, should not be, and will not be unregulated," said Securities and Exchange Commission Chairman Christopher Cox in his first extensive public comment on the agency's plan to pick up the pieces following the federal court's decision last month to toss out the hedge fund registration rule.

In testimony before the Senate Banking Committee on Tuesday Cox said that he has directed SEC staff to take "emergency" measures to restore some of the rules lost in Goldstein vs. SEC, including reinstating some of the "safe harbor" exemptions for hedge fund managers. "We must move quickly to address the hole that the Goldstein decision has left," he said. How, exactly, that "hole" will be addressed is still up in the air, though Cox said he would leave that up to Congress.

"Some improvements will be possible through administrative action," Cox told the committee. "Others, however, may well require legislation."
 
"We are working as quickly as we can to try and, if not put Humpty Dumpty back together again, then to erect something more sturdy that will accomplish the same goals."

Cox also hedged on what the commission could do when committee chairman Sen. Richard Shelby (R-Ala.) asked whether the SEC has the statutory authority to regulate hedge funds. "I'm not prepared to say yes or no to the question today," Cox responded. "Right now, the regulatory regime implemented by the SEC is inadequate."

The chairman fell short, however, of recommending Congressional action. He also refused to rule out a Supreme Court appeal of the Goldstein decision, though he conceded, "The fact that the decision of the court of appeals was on multiple grounds and was unanimous weights heavy in that consideration." The SEC must makes its decision on an appeal by Aug. 7.

Cox did appeal to lawmakers to take care in passing hedge fund regulations, possibly in light of The Hill newspaper's report that Reps. Richard Baker (R-La.) and Barney Frank (D-Mass.) are collaborating on a revised version of Baker's 1999 hedge fund bill, which would have required hedge funds to make quarterly reports to the Fed on assets, liabilities and leverage. It is important not to "trammel upon their creativity, their liquidity, or their flexibility," Cox said, speaking of hedge funds. "The costs of any regulation should be kept firmly in mind."

One area Cox said he expects to substantially rewrite the rules involving hedge funds is limiting marketing and availability to smaller investors. Hedge funds "are generally risky ventures that simply don't make sense for most retail investors," he told the committee, and indicated he would like to raise the minimum net worth for hedge fund investors to $1.8 million, from $1 million. Cox said the current definition of "accredited investor" is "not only out of date, but wholly inadequate to protect unsophisticated investors from the complex risks of investment in most hedge funds." Increased retail investment in hedge funds "should be viewed with alarm," he said.

Also testifying at the hearing, U.S. Treasury Undersecretary Randal Quarles downplayed the risks hedge funds posed, and said Congressional action to regulate them would be "premature."

"The hedge fund industry is better situated today than it might have been in the past both to respond to shocks and for problems in the hedge fund industry not to metastasize," Quarles told the committee. "Many of these issues and concerns have been or are actively being addressed — outside of a formal scheme of direct regulation of hedge funds — both by policymakers and by private sector groups."

Pitt's Two Cents

In the wake of his successor's testimony, former Securities and Exchange Commission Chairman Harvey Pitt took the agency to task for being too quick to regulate. In a Wall Street Journal op-ed, Pitt wrote, "any time a problem arises, the solution is to toss another regulation or statute at it."

Pitt, who now heads Washington, D.C.-based consulting firm Kalorama Partners, chastised the SEC's hedge fund and mutual fund rulemaking efforts as "inherently uneconomic," charging that it implemented the hedge fund registration rule without "any empirical support for that conclusion and only presented lip-service justifications. The economic reality of hedge funds is that they cater to sophisticated investors, and the SEC never adequately addressed why it should stretch its limited resources to try and cover investors who can fend for themselves."

Instead, the agency should focus on "the atrophied state of the SEC's economic analysis capacity," Pitt said, rather than relying "too heavily on legal doctrinarism."


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