California has backed away from a controversial proposal to regulate hedge funds under strong opposition from its hedge fund industry.
The state's move comes as the Securities and Exchange Commission struggles with its own more limited initiative to raise investment thresholds for hedge fund participation. Many investors as well as hedge fund operators oppose an SEC proposal that would raise the required wealth level for hedge fund investors to $2.5 million in investible assets from the current level of $1 million in total net worth.
California withdrew its proposal this month after many hedge fund industry officials suggested the lightly regulated investment funds could move to another state if California started regulating them (InvestmentNews, Oct. 29). Only venture capital funds would have been exempt from the registration requirements under the proposed rule.
The proposal, issued in September, would have required hedge funds to register with the state if they are not already registered with the SEC. While the exact number of hedge funds operating in California is not available, the state has one of the largest number of the funds outside of New York, Connecticut and the Dallas area, according to industry officials.
State officials said that federal action on regulating hedge funds made it unnecessary to carry through with the proposal at this time.
"We are withdrawing the regulations due to an ongoing parallel process at the federal level which may pre-empt or obviate the need for state action at this time," Preston DuFauchard, commissioner of the state's Department of Corporations, said in a statement issued May 1.
"They've abandoned [the proposal] for now because they believe what is being done by the President's Working Group [on Financial Markets] satisfies their concerns with investment advisers" who operate hedge funds, said Alicia Lewis, legal counsel for the Managed Funds Association in Washington, which represents about 1,600 hedge funds. She represented the MFA in dealing with the California agency on the proposal.
Two private-sector committees set up by the Working Group in April recommended that hedge funds develop best practices for evaluating whether the funds are appropriate for particular portfolios, such as pension funds.
The fear that average investors are increasingly being exposed to hedge funds through pension funds has led to calls for government regulation of hedge funds.
However, according to David Friedland, president of the Miami-based Hedge Fund Association, "the pension fund has a professional investment committee, who are very sophisticated investors. They are responsible for overseeing the investments they make."
Furthermore, "the retail investor, if they're getting exposure [to hedge funds] through a pension, [is] getting a lot less risk than if they relied on a governmental agency to do that type of due diligence," he said.
Mr. Friedland is also president of Magnum U.S. Investments Inc. of Miami, which manages about $650 million.
The possibility that California hedge funds would leave the state if the registration proposal was finalized was stressed by Boston law firm Bingham McCutchen LLP.
"People take it as a given that California is like Connecticut, New York and a handful of other states" where there are concentrations of hedge funds, said Donald Davidson, a partner in the San Francisco office of Bingham McCutchen. "Most states, except for this handful, do require investment advisers to hedge funds and private equity funds to register with them."
"Those that do not require that have a competitive advantage to attracting and keeping advisers to hedge funds and private-equity funds within their borders because they don't impose this state regulatory regime on those advisers," Mr. Davidson said.
California, caught in a budget crunch, also faces limited resources.
"It was not a good time to take this on,"said Steven Insel, an attorney with Los Angeles law firm Jeffer Mangels Butler & Marmaro LLP, who lobbied against the proposal.
"They're pushing very hard on preventing elder abuse. How important is that, compared to protecting wealthy investors in hedge funds?" Mr. Insel said.
"I think what [California's action] translates into is all the comments were negative," said Phillip Goldstein, a principal with Bulldog Investors, a hedge fund group in Saddle Brook, N.J., that manages about $500 million.
The SEC lost an attempt to regulate hedge funds in 2006 when the federal appeals court in Washington declared the commission's rule to be illegal after he filed suit against the agency.
"They probably learned something from the SEC," Mr. Goldstein added.
California's action follows an initial attempt by Connecticut attorney general Richard Blumenthal to get his state to enact legislation that would give his agency power to oversee hedge funds (InvestmentNews, July 10, 2006). The state never passed such legislation.
E-mail Sara Hansard at email@example.com.