Securities and Exchange Committee Chairman William H. Donaldson said yesterday that he thinks the $600 billion hedge fund industry needs more oversight to protect investors from potential conflicts of interest that could lead to fraud.
"We need to have more sunlight in there," he said after a Senate Banking Committee hearing on hedge funds. Donaldson testified during a hearing on the SEC's investigation into hedge funds, which was launched in June in response to the rapid growth of the funds in recent years and an increasing numbers of fraud cases the agency is seeing.
Donaldson said it's his personal view that the industry needs more oversight, but the SEC has not yet reached a conclusion. However, his remarks provide the first hint since he took the helm eights weeks ago of what the agency will recommend to Congress when its investigation ends, industry and government officials said.
Donaldson, seeking to head off industry opposition to more oversight, emphasized that any supervision must be imposed carefully. He said the government should seek more disclosure rather than impose new compliance rules that might kill the ability of funds to offer the high-risk, potentially high-return investments that are their hallmark.
Hedge funds are unregulated investment pools that function like mutual funds for wealthy individuals or large investors. They have been exempted from most oversight, Donaldson said, because regulators and lawmakers have presumed investors in these funds were more sophisticated, and therefore in less need of consumer protections.
In recent years, hedge funds have proliferated -- growing from a few hundred in 1990 that managed $50 billion to more than 5,700 funds managing $600 billion.
As they've grown, hedge funds have solicited business from a much broader spectrum of consumers. And increasingly, Donaldson said, managers of regulated mutual funds also manage hedge funds. That has created a potential conflict of interests: Because fees from hedge investors are often more lucrative, managers might be tempted to favor hedge fund investors over mutual fund investors in how they trade securities.
Donaldson also said the SEC's inability to monitor hedge funds' day-to-day activities prevents it from policing against stock manipulation or other practices that could threaten the markets.
"The time has come," Donaldson said in his testimony, "for us . . . to review these risk-management, transparency and public-disclosure issues." Under current law, the SEC can probe a hedge fund only if the agency suspects fraud. More oversight would give regulators tools to prevent problems before they occur or get out of hand, not just to step in during a crisis, as is now the case, he said.
The hedge fund industry disagrees. "Our position is that the current regulatory structure that governs hedge funds is adequate," said Stephanie Pries, senior legal counsel for the Managed Funds Association, the industry's lobby group.
The industry has warned that if the SEC tries to impose new oversight, hedge funds might be pushed to relocate offshore, which would cost New York and other money centers in the country.
But congressional and other government sources said that if the SEC were to win greater oversight of hedge funds, Congress would likely give it the right to inspect any fund that has U.S. investors and invests in U.S. markets, regardless of where it is headquartered. So firms would gain little by going offshore, they said.
Congress and regulators have focused on hedge funds in the wake of several high-profile fraud cases, including the collapse of Long-Term Capital Management in the fall of 1998, which threatened to unravel financial markets.
Exemption from SEC oversight, said Sen. Paul S. Sarbanes (D-Md.), creates an "uneasy feeling there are ticking time bombs out there."
"Investor protection concerns arise that deserve careful consideration," said Senate Banking Committee Chairman Richard C. Shelby (R-Ala.).