July 31, 2006

The Road Ahead


When Securities and Exchange Commission Chairman Christopher Cox testified last week before the Senate Banking Committee about hedge fund regulation, industry observers waited to see what clues he might give to the agency's future direction. Depending on how Cox decides to proceed, he could tear apart the relative calm that has marked his first year at the helm after the divisive tenure of his predecessor, William Donaldson.

Clearly, the hard feelings from those divisions have not entirely gone away. Earlier this month, outgoing Commissioner Cynthia Glassman gave a speech to the National Economists Club in Washington, DC, lambasting the SEC the for passing new rules for hedge funds and mutual fund boards. She characterized the initiatives as wasted effort.

"Our time would have been better spent doing a more rigorous analysis of the many real issues we face and the most efficient and effective ways to resolve them," said Glassman, one of three Republicans on the five-member commission. She announced her resignation May 15.

On the same day, in a different venue, Glassman's fellow Republican commissioner, Paul Atkins, said the SEC is rethinking the mutual fund rule after the commission's "embarrassing defeat in court." He, too, publicly scolded the agency for overstepping its bounds. Both commissioners had vehemently opposed the SEC's rules involving hedge funds and mutual funds.

For now, both rules are dead. But the two issues have certainly not died.

In April, a federal appeals court vacated the mutual fund rule, which required that mutual funds have 75% independent directors and an independent chairman. The court said the SEC didn't follow proper procedures in passing the rule, which was part of a larger package of reforms meant to address abuses in the mutual fund industry. Two months later, a panel of the US Court of Appeals for the District of Columbia threw out the SEC's hedge fund rule, which required hedge funds to register with the agency. The court ruling, in response to a lawsuit by Phillip Goldstein, manager of Pleasantville, NY-based Opportunity Partners, stated that the SEC did not have the authority to make such a change.

Although SEC watchers say the unanimous hedge fund ruling by the appellate court didn't really leave grounds for an appeal, Cox last week, following his Senate testimony, told reporters he had not ruled it out. The SEC has until August 7 to ask the Supreme Court to take up the case.

Balancing Risks

But before doing so, say observers, Cox should weigh the consequences carefully-an appeal might cause an acrimonious split in the SEC. "I'm not sure that Cox will want to put the commission through that again," says Michael Missal, a partner at the law firm Kirkpatrick & Lockhart Nicholson Graham and a former senior counsel in the SEC's Division of Enforcement.

Missal is referring to the difficult times the commission went through during the Donaldson era, during which disagreements among commissioners--previously kept private and nonpartisan--became public, bitter and fully partisan. "I've been in the securities arena for close to 28 years, and I can't ever remember seeing the SEC commissioners so contentious at any time," says Barry Barbash, a partner at Willkie Farr & Gallagher in Washington, DC, and a former director of the SEC's Division of Investment Management. "I've not seen the rancor that there was in connection with the mutual fund rule and the hedge fund rule."

Missal agrees. "The SEC had always taken great efforts to be as nonpolitical as possible. And you didn't have Democrats and Republicans lined up against each other," he says, noting that things changed during Donaldson's tenure. "I think the number of commissioners involved and the public nature of their disagreements were really unprecedented."

Mark Perlow, a Kirkpatrick & Lockhart partner who served in the SEC's Office of the General Counsel as well as its Division of Enforcement, blames the politicization of the agency during Donaldson's tenure on the barrage of controversy surrounding corporate accounting frauds, the Wall Street research scandal and the mutual fund scandal.

"It raised the profile of the agency, both politically and in the media, to the point where partisan political points could be scored by both political parties," Perlow says. "As a political issue, it had legs."

And the zeal with which New York State Attorney General Eliot Spitzer pursued the Wall Street investment banks and mutual funds involved in the scandals put a great deal of political pressure on the SEC to be more activist, Perlow says. "In my opinion, these things pushed the agency farther than good public policy would have required," he says. However, he concedes, some quick action was probably needed. "One can argue whether Donaldson's particular policies were wrong, but I think his activism preserved the credibility of the agency," Perlow says.

Nonetheless, many in the industry believe the agency bungled its attempt to regulate hedge funds by trying to achieve too much. For one thing, many larger hedge funds were registered anyway, because some of their large investors wanted them to be. Instead of forcing all hedge funds to register, the SEC could have simply tried to get a census of all the funds out there, obtained some information about them, and then examined certain funds that warranted greater inspection, which would have been within its authority.

"This was a tremendously botched job. It's embarrassing," says one former SEC staffer, who preferred anonymity. "Sometimes you have to make a decision to get something rather than nothing."

Critics of Donaldson believe the agency also bungled the controversial mutual fund rule, which came in response to the mutual fund scandal, when it pushed the rule through 10 days before Donaldson was due to step down. They say the SEC could have gone with a less onerous alternative, such as requiring that 75% of a mutual fund's board of directors, but not its chairman, be independent, mandating simply disclosure of the chairman's independent status.

"Just because you're independent doesn't mean it will help fund governance," Kirkpatrick's Missal says, citing some of the larger fund complexes, like Vanguard, that are well run yet don't have an independent chairman sitting on the board. "So this rule would essentially knock out someone who is very experienced from being the chairman, and it could actually take away the effectiveness of what the board does."

Donaldson's supporters acknowledge that the commission may have been acting under political pressure, but point out that the court struck down the rule chiefly on technical, rather than jurisdictional, issues.

"The view of many was that it may have been that the court was looking for a reason to send this back to the agency," says another former SEC official, who spoke on condition of anonymity. "It was a very charged, highly controversial rule-making that was very much opposed not only by a large part of the industry but also by two commissioners, and the court may have been thinking that the SEC overstepped a bit."

Testing the Power of Consensus

Cox, a former Republican congressman, has so far largely been the business-friendly chairman many had expected, swinging the pendulum back from the greater enforcement of Donaldson's reign. "Each leader has a different style, and Cox is experienced at developing consensus, from his leadership days on the Hill," says Allan Mostoff, president of the Mutual Fund Directors Forum. He did surprise the industry in January, when the commission issued standards for fining companies that commit financial fraud. In issuing those standards, Cox rejected the conservative line that corporate penalties do more harm than good. But in typical Cox style, he was able to bring the agency's two other Republican commissioners, Glassman and Atkins, into line so that the SEC could show a unified position.

"Chairman Cox seems to have made a lot of effort to have the commission function better. And it appears he's been successful to date," says Wilkie Farr's Barbash.

Arthur Laby, an associate professor at Rutgers University in Camden, NJ, and a former assistant general counsel at the SEC, is less flattering. He agrees the public squabbling has died down under Cox, but he says it's not so much about the new chairman's prowess as a consensus builder. Rather, Laby says Cox isn't raising the highly charged issues that fractured the agency in the past. "The more difficult issues are more likely to bring out differences among commissioners than the less contentious issues," Laby says.

That may well change, as Cox may not have much choice about wading in. The commission has republished its original proposal for the mutual fund rule with an explicit request for comments on the rule's costs and regulatory alternatives, which were the procedural points the appeals court took issue with. Most of those interviewed say they really don't know where Cox stands on the mutual fund rule, but if the commissioners divide again along party lines, Cox, like Donaldson, could be called upon to cast the deciding vote.

Meanwhile, the SEC is by no means done with the hedge funds. During his testimony to the Senate last Tuesday, Cox made it clear he won't sit on his hands. "Notwithstanding the Goldstein decision, hedge funds today remain subject to SEC regulations and enforcement under the antifraud, civil liability and other provisions of the federal securities laws," he said. "We will continue to vigorously enforce the federal securities laws against hedge funds and hedge fund advisers who violate those laws. Hedge funds are not, should not be and will not be unregulated."

Cox pointed to the more than 60 enforcement cases the agency has brought against hedge fund managers, including cases addressing misappropriation of fund assets, insider trading, misrepresentation of portfolio performance, market manipulation, improper valuation of assets, illegal short selling and the like.

"But while our ability to bring enforcement actions against hedge funds and their managers remains intact following the Goldstein decision, the same cannot be said for the commission's ability to require hedge fund advisers to register and submit to inspections," he said, adding that the commission "must move quickly to address the hole that the Goldstein decision has left."

Cox said the commission might be able to make some changes through administrative action, although others may require legislation. He mentioned several emergency rules the SEC is planning to implement in order to reverse some "side effects" of the court decision, which invalidated the antifraud protection included in the 2004 rule for individual investors in hedge funds, as well as a number of exemptions for hedge funds from regulation as registered investment advisers. This could potentially harm hedge funds that have already registered, which may push them to deregister. So far, however, not many have. "Although these are early returns and may not be indicative of the final outcome, we have actually experienced a net increase in hedge fund registrations since the Goldstein decision," Cox told the committee.

He also said the SEC would seek to raise the net-worth threshold for "accredited" investors in hedge funds to $1.5 million from $1 million, pointing to the rise in real estate values that has pushed many middle-income people into the accredited category.

But in a sign that he may tread lightly when it comes to hedge fund regulation, Cox told Congress that any actions taken by his agency or the legislature should be "nonintrusive."

"There should be no interference with the investment strategies or operations of hedge funds, including their use of derivatives trading, leverage, and short selling," he said. He argued that regulators should not require portfolio disclosure or interfere with performance fees.

Perlow of Kirkpatrick says that despite Cox's tough stance during his testimony, the chairman said nothing dramatic, important or new. And while the commission says it has not yet decided whether to appeal the hedge fund rule, Perlow argued that Cox spoke as if the rule were dead. "He was trying to preserve the largely uncontroversial portions of the rule," Perlow said. "A Washington cynic would say he's waiting until after the election so that politicians cannot use this as political fodder."

The only new point Cox really made, Perlow said, was that the agency was considering proposing a rule that would expressly extend the antifraud responsibilities that advisers have to their investors. While not exactly groundbreaking, if the SEC starts getting specific on what those duties are, you could see some substantive rule-making, Perlow said.

"But he didn't give details," Perlow said. "That will be the interesting inside baseball story as it unfolds over the next six months."

While not directly correlated to fund regulation, observers might glean some insight from the SEC's vote last Wednesday to amend the rules around disclosure of executive compensation.

The rule changes address a host of issues, but most prominently impact grants of stock options to executives. Disclosure of executive and director compensation will now require narrative disclosure in addition to the current tables, and the release detailing the changes explained the new process of option grant disclosure in painstaking detail.

But even if Cox's own views counsel caution, the political zeitgeist may well force him, like Donaldson before him, to act. Stephanie Monaco, a partner at Mayer, Brown, Rowe & Maw in Washington, DC, and a former lawyer in the SEC's Division of Investment Management, says the SEC is likely to have an uphill battle no matter which way it goes with the hedge fund issue.

"You're going to have lines drawn and sides taken, not necessarily along political party lines--though that will certainly have an impact," she says.

In that event, Cox's famous consensus-building skills may not be enough.


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