Saturday, June 24, 2006

Strike Two on the SEC

Several years ago, when I was serving on the U.S. Advocacy committee of the CFA Institute (formerly called the Association for Investment Management and Research), we were invited to meet with staff members of the Securities and Exchange Commission to discuss some proposed regulations. At the time, the SEC staff had just finished an extensive paper on hedge funds. Largely because of the Long Term Capital Management blowup, there was pressure on the Commission to regulate these funds. Interestingly, the Commission's concern was not that these funds took too many risks, but that it was too easy for unaccredited investors to get into them.

An accredited investor is defined as one who has at least $200,000 in annual income ($300,000 if married) or $1 million in net assets. The SEC was concerned that some investors who didn't meet these thresholds were able to invest in hedge funds. There was also concern that perhaps the thresholds were too low.

It seemed to me that the solution was obvious. Instead of regulating hedge funds, the SEC could simply raise the thresholds that define an accredited investor. It could even peg the thresholds to inflation.

However, the SEC called for regulation. The commissioners voted along party lines. The two Democrats voted in favor of regulation; two Republicans voted against. Chairman William Donaldson, a Republican appointee, sided with the Democrats and hedge funds were required to register with the SEC and provide a minimal amount of information.

Well on Friday, an appeals court threw out the rule. While the court's reasoning may be complicated and hinge on legal nuances, it represents the second time that regulation introduced during Chairman Donaldson's tenure was set aside. The first had to do with the mutual fund independence rule that required that at least 75% of a fund's board, including the chair, be independent of the management of the fund. Mr. Donaldson sided with the Democrats on this issue as well.

At the time, I wrote in the Forbes Growth Investor that as an investor, I'd feel more comfortable knowing there was a critical mass on the board who was familiar with the management of the fund. While having some independent board members may be a good idea, 75% seemed ridiculously high.

I discussed both hedge fund regulation and the mutual fund independence rule just last week with former SEC Chairman Harvey Pitt. Interestingly, he said he didn't think we need more regulation of hedge funds. He felt we just need better regulation of the relationship between hedge funds and their investors. He also had some interesting things to say about mutual fund independence. This discussion took place on my MoneyMasters video program. I wish we could make it available to you sooner. Unfortunately, it won't be posted for viewing until Thursday, June 29. Please take a look at that time.