The ruling, passed in October 2004 as an adjunct to the Investment Advisers Act of 1940, was intended to address the SEC's contention that hedge funds have gone in recent years from being the off-shore, high-risk playground of the extremely rich to a more common area for less experienced investors to play in.
The regulation requires that hedge fund managers register as investment advisers with the SEC using "Form ADV," which calls for information including how many funds they manage, the amount of assets in the fund, their number of employees and what other types of clients they serve. Once the SEC knows who they are, it can begin auditing the firms, which so far have enjoyed relative obscurity.
Specifically the ruling states: "All records (as so defined) of such investment advisers are subject at any time, or from time to time, to such reasonable periodic, special, or other examinations by representatives of the Commission as the Commission deems necessary or appropriate in the public interest or for the protection of investors." (Translated, hedge funds need to keep all e-mail and produce it in a timely manner.)
Though most hedge funds remain anonymous to the SEC in the days before the deadline, some are registering with the SEC as requested; a few have even been voluntarily registered for years.
"We've been registered since 1994," said a COO of a hedge fund who requested anonymity because his company is prohibited from publicizing or advertising itself. "But we may be somewhat ahead of the curve in terms of getting registered and adopting technology."
The firm is using AdvisorMail, an outsourced e-mail archiving service developed and marketed by LiveOffice Corp., which the user said they preferred over some half dozen other products they evaluated because it encompasses e-mail, instant message and Bloomberg message archiving and indexing.
The user said his firm, like many hedge funds, employs only four or five people. The company has already outsourced its IT in general, and so outsourcing e-mail archiving for compliance was a natural fit for them. "We're not a big staff by any means," he said. "We certainly can't support a full-time IT person."
The staffing issue may also be a quandary affecting other hedge funds, the user said, but unlike his firm, others may not have decided on a technology for compliance.
"The costs add up pretty quickly," he said. He estimated hedge funds new to SEC registration will probably have to pay a consulting firm $40,000 to $60,000 just preparing to be registered, and that, since new SEC rules were put into place in 2000, compliance had cost him $50,000 to $100,000 a year.
Of an estimated 8,400 hedge funds in the U.S., LiveOffice said yesterday that about 75 are using its AdvisorMail product, by far the largest number of users among the companies SearchStorage.com surveyed. Symantec Corp. said that about 30 direct hedge fund customers are using its Veritas Enterprise Vault archiving software and another 20 outsourced customers through partner FivePoints Compliance Inc. Another outsourcing firm, IPR International LLC, reported five hedge funds for its e-mail archiving service.
An ongoing controversy: lawsuits and a two-year loophole
Cost and staffing are not the only issues preventing hedge funds from meeting the deadline. In fact, as of this week, many of the funds were still fighting to overturn the ruling rather than working to comply with it.
Opponents to the rule argue they are already heavily regulated, and have suggested that the SEC follow hedge funds using the documents they are already required to file. A lawsuit along these lines filed against the SEC by hedge fund advisers Phillip Goldstein and Opportunity Partners is still pending.
"They're subject to regulations like every other financial entity," said Greg Nowak, a securities lawyer and partner in the Philadelphia office of Pepper Hamilton LLP, who specializes in representing investment management companies and other clients on matters relating to the Investment Advisers Act of 1940. "But right now they're only subject to 'after-the-fact' regulations, not the proactive regulations the SEC is proposing."
Another part of the fight, Nowak added, was that the SEC has made harsh pronouncements about cracking down on hedge funds, but hasn't specified how exactly compliance can be achieved.
"They've told hedge funds they have to retain e-mails and IMs," Nowak said. "But they haven't told us what they'll be looking for, and in what format."
Nowak predicted that in the short term, most hedge funds would escape the regulation through what's referred to as "the two-year loophole," a clause in the rule excluding funds which lock investors in for two years or more.
The original intention of this part of the rule was to distinguish between private equities funds and hedge funds, but financial experts say it has had far from the intended effect -- of the 8,400 or so hedge funds in the U.S., only an estimated 1,000 to 1,500 were expected to fall under the SEC's rule as currently written. Of those, only 700 to 800 were expected to make the registration deadline of Feb. 1.
Moreover, Nowak said, the SEC would be loath to revise the ruling at this point.
"There was strong dissent when the initial ruling was passed," he said. "The vote was 3 to 2, and the chairmanship has since changed hands. I doubt they'll ever change the loophole at this point."
However, proponents of the registration requirements argue that there's no way the two-year loophole will last forever if the majority of hedge funds use it to evade SEC oversight.
"Hedge funds are a strong force that the SEC will want to contend with," said Mark Diamond, president and CEO of compliance consulting firm Contoural, Inc. "Sooner or later, regulation will be a fact of life for all of them."