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Reporter
MFA
Reporting on issues for investment professionals in futures,
August/September 2002 hedge funds and other alternative investments
SEC to Investigate Hedge Funds
By Michael P. Malloy, Drinker Biddle & Reath LLP
n May 24, 2002, in a speech before the general mainly from the difference in fee structures between
O membership of the Investment Company Institute,
Harvey Pitt, Chairman of the SEC, announced that the
Commission would conduct a formal fact finding investigation
mutual funds and their unregistered counterparts.
Advisory fees for hedge funds are generally significantly
higher than for mutual funds. Consequently, there is an
into the private fund industry. Responding to what Chairman incentive for an adviser managing both a hedge fund and
Pitt termed a “seismic boom” in the industry, he noted that a mutual fund to allocate better performing securities to
the SEC’s goal is to determine whether the current lack of the hedge fund because of the large fee discrepancy.
regulation is serving the public interest. Chairman Pitt Chairman Pitt noted the third area of focus of the SEC’s
highlighted three areas that the SEC’s investigation will focus investigation will be an investigation into the marketing of
on: incidents of fraud, conflicts associated with managing hedge funds to retail investors. Hedge funds themselves
hedge funds alongside mutual cannot be directly marketed to the
funds, and marketing hedge funds retail public. They are sold only to
to retail investors. Responding to what investors meeting certain high-net-
Of the three areas of focus, fraud is Chairman Pitt termed a worth requirements. However, there
the area that has had the most atten- has been an increasing number of
tion in the press. There have been “seismic boom” in the so-called registered funds of hedge
many articles highlighting instances industry, he noted that funds. (See Hot Legal & Business
of investors losing millions of dol- Topics for 2002: Registered Fund
lars to fraudulent hedge fund man-
the SEC’s goal is to of Funds – A New Frontier for
agers. Notably, investors in determine whether the Hedge Funds, by Michael P. Malloy,
Manhattan Investment Fund Ltd. current lack of regu- in the March 2002 edition of MFA
recently lost approximately $400 Reporter and Registered Funds of
million while the fund’s manager
lation is serving the Hedge Funds, by Michael P. Malloy
told them that the fund was making public interest. and Jim Stangroom, in the June/July
money, according to an SEC Litiga- 2002 edition of MFA Reporter for
tion Release. The concerns of more detailed discussions of these
investors as well as the SEC have increased as the amount of products.) These funds, which are organized as closed-end
assets being poured into hedge funds increases significantly investment companies registered with the SEC, invest directly
($31 billion last year according to TASS Research). in several underlying hedge funds. To date, these funds have
The second area of focus of the SEC’s investigation is the not been sold to the general public, but rather to the so-
conflict of interest that arises when hedge funds are called “mass affluent.” However, if appropriately structured,
managed alongside mutual funds. This conflict arises continued on page 2
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they could potentially be sold to the general public, without MFA has learned that the SEC has sent letters to major hedge
regard to the current financial requirements for investing in fund managers who are registered investment advisers,
hedge funds. purportedly seeking various detailed information, such as
One possible change resulting from the SEC’s investigation is fee structures, size, prime brokerage relationships as well
increased disclosure requirements. Mutual funds have to file as distribution and investment strategies. MFA suspects that
detailed registration statements with the SEC annually. They unregistered hedge fund managers will soon be added to
also have to file shareholder reports semi-annually. While it the list of those investment advisers to be contacted.
is unlikely that hedge funds will have as burdensome
It is too early to accurately tell the scope, course or likely
requirements as mutual funds, there may be some SEC
results of the SEC’s formal fact finding investigation.
disclosure required.
These may also be difficult to ascertain as the investigation
Another change that may result from the SEC investigation progresses because the investigation will likely be kept
is modification of the so-called “de largely private by the SEC, which is
minimis” exception to registration not required to disclose details
under the Investment Advisers Act except to those it subpoenas. Howev-
of 1940. Many hedge fund man- While it is unlikely that er, it is clear that the SEC is going to
agers avoid registration based on hedge funds will have become an increasing presence in
this exception for advisers that have the hedge fund industry. I
fewer than 15 clients and do not
as burdensome require-
hold themselves out to the public as ments as mutual funds, Michael P. Malloy (michael.
malloy@dbr.com) is the head of and
investment advisers. Currently, each there may be some SEC a partner in the Investment Manage-
hedge fund counts as one client for
purposes of the exception. There- disclosure required. ment Group at Drinker Biddle &
fore, a manager that does not hold Reath LLP. Joshua B. Deringer
itself out to the public as an invest- (joshua.deringer@dbr.com), an
associate in the Group, assisted with
ment adviser could advise up to 14 hedge funds without hav-
the preparation of this article. Drinker Biddle & Reath LLP, a
ing to register with the SEC. The SEC could cause many more
Pennsylvania Limited Liability Partnership, is a full service
hedge fund managers to have to register by imposing a “look
law firm of more than 425 attorneys. Its Investment Manage-
through” to the underlying investors for purposes of deter-
ment Group advises a broad array of investment manage-
mining the number of clients. This would subject these man-
ment clients on financial services, products and related
agers to various additional requirements, including matters, including alternative products such as registered
restrictions relating to performance fees. funds of hedge funds, hedge funds and private equity funds.
www.dbr.com
Reprinted with permission from the MFA Reporter August/September 2002 issue.
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