Move to register hedge funds could spur relocations

California weighs requiring registration by larger advisers

Oct 29, 2007 @ 12:20 pm

By Sara Hansard

California's proposal to register hedge funds could drive much of the industry out of the state, experts say. As proposed, hedge fund advisers that have fewer than 15 hedge fund clients and more than $25 million under management would be required to register with the state if they are not already registered with the Securities and Exchange Commission. Hedge fund registration with the SEC is voluntary. California hedge fund advisers that manage less than $25 million — there are 400 to 500 of them — already must register with the state. "Essentially, hedge funds are not captured by our current rules," said Preston DuFauchard, commissioner of the state's Department of Corporations. The proposal would bring all hedge fund advisers under closer state supervision. It "doesn't really change the rule for how they operate," said Mr. DuFauchard, who is a member of Gov. Arnold Schwarzenegger's administration. "It just [requires them] to register with us," and the cost of registration would be minimal, he said. A 2006 ruling by the U.S. Court of Appeals for the District of Columbia Circuit that overturned an SEC regulation requiring hedge fund advisers to register with the commission "throws a little bit of uncertainty" into the status of hedge fund regulation, Mr. DuFauchard said. It also is a source of concern for at least one attorney.

"At the end of the day, there's a parade of horribles that could easily happen arising from the Department of Corporations' looking into your books and records," said Donald Davidson, a partner in the San Francisco office of Bingham McCutchen LLP of Boston.

Hedge funds tend to set up shop in states that impose the fewest regulations on their activities, he contends.

"If you plotted the degree of regulatory oversight the states impose, it's no accident that hedge funds tend to be concentrated in states that do not impose heavy regulatory regimes," said Mr. Davidson, who represents hedge funds in his practice. If registration is required, he predicts, hedge funds will leave California.

That view is shared by Phillip Goldstein, the hedge fund operator who filed the successful suit against the SEC's hedge fund registration rule. The principal of Bulldog Investors in Saddle Brook, N.J., wrote in an e-mail that the California rule will "not go anywhere because hedge funds will threaten to move to a more friendly state, which is easy to do, and the politicians don't want to lose the tax revenue."

However, the state regulator is monitoring the situation, and if it gets "a sense that there will be a substantial exodus from the state, this will be part of what we consider when we go forward with this rule adoption," Mr. DuFauchard said. "I do believe the California economy and businesses and people in California create a strong source of hedge fund revenues."

Hedge funds, which are subject to securities antifraud rules, would be required to open their books and records to state oversight if the California proposal goes through. The funds are secretive about their investment philosophies, preferring not to share that information with anyone, Mr. Davidson said. The proposal also might affect private equity funds, though venture capital is outside its scope, he added.

The primary reasons for the proposal are "the growth of hedge funds, the increase in fraud related to hedge fund activities and the broadening market participation in hedge funds," according to the department.

These are the same reasons the SEC cited when it issued its 2004 rule requiring hedge fund advisers to register.

California's rationale for its proposed rule is "very weak," Mr. Goldstein wrote. "They should have to cite some evidence of actual hedge fund fraud suffered by California investors that would not have happened if the proposed rule were in effect," he said.

While no precise figures are available as to the size of the hedge fund industry in California, the state is probably home to the nation's third-largest concentration of hedge funds. Overall, hedge funds control about $1.8 trillion in assets in the United States, according to Jack Gaine, president of The Managed Funds Association in Washington, which represents the industry. The association has set up a working group to examine the California proposal, he said.

In a report last February, The President's Working Group on Financial Markets concluded that there was no need for further regulation of hedge funds, Mr. Gaine noted. Instead, the working group recommended that the industry come up with best practices, which the MFA is working on. The Treasury secretary is chairman of the group, which also includes the chairmen of the Federal Reserve Board, the Securities and Exchange Commission and the Commodity Futures Trading Commission.

"It is of fairly great concern that an individual state, the largest state, goes out and sets up a registration, regulatory scheme," Mr. Gaine said.

In some states, a similar move seems unlikely. Connecticut and New York, thought to be the top two states by hedge fund concentration, have considered imposing more regulations, but neither has acted, Mr. Gaine added.

"I know of nothing [contemplated] in Connecticut this session," said Howard Pitkin, commissioner of Connecticut's Department of Banking in Hartford. He opposes registration of hedge funds, and his office has no plans to submit legislation that would allow such rules.

Legislation was introduced in the New Jersey legislature in the spring to explicitly add hedge funds to the state's securities antifraud statute, but it wasn't enacted.

While the industry gears up to oppose the California proposal, the plaintiff's bar is expressing support for the plan. Alan Sparer, a plaintiff's attorney whose firm is based in San Francisco, said the proposed regulation is needed because hedge funds are increasingly being sold to investors who are less well off than in the past.

For instance, one of his clients invested most of his non-retirement savings of $300,000 in a municipal bond arbitrage hedge fund that was "sold as being a very safe income-producing investment," he said.

Instead, the fund lost 75% of its value in one month "because arbitrage of municipal bonds went crazy with the credit crunch in August," Mr. Sparer said. "That's the kind of person who needs this sort of protection."

Sara Hansard can be reached at shansard@crain.com.

"I THINK California is important for this industry."

Preston DuFauchard

Commissioner

California Department of Corporations

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