Hedge funds, throughout their history, have not been subject to much scrutiny or regulations.¹ In February 2006, however, hedge funds must comply with the new Securities and Exchange Commission’s (SEC) regulations under the Investment Advisors Act (Act).² The hedge fund industry managers have long been secretive of their goings on, and the lack of any watchdog over them has enabled them to utilize various, often risky, strategies to deliver vast returns to their wealthy clientele. Today, hedge funds have become “the fastest-growing sector in financial services.”³ This has caused much alarm due to the increase in the number of hedge funds, which makes hedge fund investment available to less affluent investors.

The recent hedge fund scandals, such as the collapse of the Bayou Group of Stamford, Connecticut, highlights the importance of the new SEC rules. Samuel Israel III, the chief executive, and Daniel Marino, the former chief financial officer, founded Bayou in 1996 as a small, high-end money management firm. Over its nine years of existence, Bayou experienced regular losses, all the while, its investors were assured that they were earning significant gains.⁴ Bayou’s status as a hedge fund allowed its advisors activities to be “virtually unregulated” providing them with a “free hand over what…[to] disclose about [its]…trading activities.”⁵ This charade came to an end when, this summer, the Bayou group terminated its business and all of its checks bounced. Then came the panic, the investors searched for the founders who had seemingly disappeared. The two returned in late September and pled guilty to fraud charges, “essentially admitting that those investors’ millions were thrown away in a failed business.”⁶

Perhaps, if the Bayou Group of was subject to more intense regulations, the $450 million hedge fund may not have been infused with or enabled to perpetrate such fraud upon its investors. Or maybe it still would have due to the failings and conniving of its founders. Regardless, the new SEC rule and amendments signify the acknowledgement that hedge funds can no longer go on without being subject to some regulations.

The SEC summarizes it’s new rule as follows:

The Commission is adopting a new rule and rule amendments under the Investment Advisers Act of 1940. The new rule and amendments require advisers to certain private investment pools (“hedge funds”) to register with the Commission under the Advisers Act. The rule and rule amendments are designed to provide the protections afforded by the Advisers Act to investors in hedge funds, and to enhance the Commission’s ability to protect our nation’s securities markets.⁷

By February 1, 2006, most hedge fund advisers must be in compliance with the Act.8 These advisors will have to comply with most of the regulations that govern other investment advisors. This new rule requires the majority of hedge fund advisors⁹ to register with the SEC by filing a document called Form ADV. Hedge fund advisers will have to provide their address, professional history and any record of infractions.¹⁰ The hedge funds will also be subject to random audits by the SEC. Due to the possibility of an impending audit, advisers must maintain all their documents and emails.

Significantly the “Act does not require an adviser to follow or avoid any particular investment strategies, nor does it require or prohibit specific investments.”¹¹ Registration also does not require advisers to reveal their “trading strategies or disclose their portfolio holdings.”¹² Additionally, it would not impede advisers’ ability to “leverage their portfolio holdings and would not restrict the ability of hedge funds to provide liquidity to the markets.”¹³

To be in compliance with the Act, by February 1, 2006, hedge funds will be required to adopt policies and procedures in order to avoid any violations of the Act. In pursuit of this goal, the hedge funds will also have to name a chief compliance officer.¹⁴ While the Act does not specify how the hedge funds are to develop their policies and procedures, the funds must put into practice a compliance infrastructure.¹⁵ The SEC has admitted that its “examination staff resources are limited, and…[it] cannot be at the office of every adviser at all times. Compliance officers serve as the front line watch for violations of securities laws, and provide protection against conflicts of interests.”¹⁶

When the advisors registrations are effective, they must fully comply with the Advisors Act and all of the SEC rules. This encompasses the provisions that apply to registered advisors, including “limitations on performance fees, [SEC]…books and records requirements, and [the SEC]…rules governing advertising and cash solicitations.”¹⁷

Clearly, these requirements mark a new era for the hedge fund industry. For the first time they will be required to register with the SEC and be in compliance with the SEC rules.

Footnotes

1 Hedge funds are organized by professional investment managers who frequently have a significant stake in the funds they manage and receive a management fee that includes a substantial share of the performance of the fund. Advisers organize and operate hedge funds in a manner that avoids regulation as investment companies under the Investment Company Act of 1940, and hedge funds do not make public offerings of their securities.

Registration Under the Advisers Act of Certain Hedge Fund Advisers available at http://www.sec.gov/rules/final/ia-2333.htm#text (last visited Oct. 25, 2005).

2 The effective date of the amendments to rule 206(4)-2 and Form ADV is January 10, 2005. The effective date of new rule 203(b)(3)-2 and amendments to rules 203(b)(3)-1, 203A-3, 204-2, 205-3, and 222-2 is February 10, 2005. Hedge fund advisers may elect to begin complying with the new rule and the rule amendments as of their effective date, but have until February 1, 2006 to come into compliance with rule 203(b)(3)-2 and the amendments to rules 203(b)(3)-1, 203A-3, 204-2, 205-3, 206(4)-2, and 222-2. Id.

3 Jenny Anderson, A Modest Proposal to Prevent Hedge Fund Fraud, N.Y. TIMES (Oct. 7, 2005). See also Registration Under the Advisers Act of Certain Hedge Fund Advisers available at http://www.sec.gov/rules/final/ia-2333.htm#text (last visited Oct. 25, 2005) (explaining that “[i]t is estimated that there are now approximately $870 billion of assets in approximately 7000 funds. What is remarkable is the growth of the hedge funds. In the last five years alone, hedge fund assets have grown 260 percent, and in the last year, hedge fund assets have grown over 30 percent.”).

4 See Jenny Anderson, Two at Hedge Fund Emerge to Plead Guilty to Fraud, N.Y. TIMES (Sept. 30, 2005).

5 See Id.

6 Id.

7 Registration Under the Advisers Act of Certain Hedge Fund Advisers available at http://www.sec.gov/rules/final/ia-2333.htm#text (last visited Oct. 25, 2005).

8 See section 203A(a)(1)(A) [15 U.S.C. 80b-3a(a)(1)(A)].

The National Securities Markets Improvement Act of 1996 amended the Advisers Act to divide the responsibility for regulating investment advisers between the Commission and the state securities authorities. Section 203A of the Advisers Act [15 U.S.C. 80b-3a] effects this division by generally prohibiting investment advisers from registering with us [the SEC] unless they have at least $25 million of assets under management or advise a registered investment company, and preempting most state regulatory requirements with respect to SEC-registered advisers. See Pub. L. No. 104-290, 110 Stat. 3416 (1996) (codified in scattered sections of the United States Code).

Certain Broker-Dealers Deemed Not To Be Investment Advisers, Extension of Compliance Date, FN 188, at http://www.sec.gov/rules/final/34-52407.pdf (last visited Oct. 25, 2005).

9 See Certain Broker-Dealers Deemed Not To Be Investment Advisers, Extension of Compliance Date, http://www.sec.gov/rules/final/34-52407.pdf (last visited Oct. 25, 2005).

10 See David F. Swensen, Invest at Your Own Risk, N.Y. TIMES (Oct. 19, 2005); see also Jenny Anderson, A Modest Proposal to Prevent Hedge Fund Fraud, N.Y. TIMES (Oct. 7, 2005).

11 Registration Under the Advisers Act of Certain Hedge Fund Advisers available at http://www.sec.gov/rules/final/ia-2333.htm#text (last visited Oct. 25, 2005).

12 Id.

13 Id.

14 Rule 206(4)-7 [17 CFR 275.206(4)-7].

15 See Compliance Programs of Investment Companies and Investment Advisers, Investment Advisers Act Release No. 2204 (Dec. 17, 2003) [68 FR 74714 (Dec. 24, 2003)].

16 Registration Under the Advisers Act of Certain Hedge Fund Advisers available at http://www.sec.gov/rules/final/ia-2333.htm#text (last visited Oct. 25, 2005).

17 Id. (Section 205(a)(1) and rule 205-3 cover performance fees; Rule 204-2 cover books and record requirements; Rule 206(4)-1 cover advertising; andRule 206(4)-3 cover cash solicitations.