With mandatory SEC registration overturned, hedge funds face hard choices. Paul Schaeffer is head of strategy and innovation for SEI's Investment Manager Services unit. SEI is based in Oaks, Pa.

Now that the 7 August deadline has passed for the Securities and Exchange Commission(SEC) to appeal the June 2006 federal court decision overturning the SEC hedge fund advisor registration rule, the order vacating the rule is final.

Hedge-fund advisors that registered as a result of the rule now have a choice: Should they deregister, seizing an opportunity for less intrusive regulation? Or are there compelling reasons for them to remain registered even if it is no longer required? Each position has its pros and cons. The following is a brief overview of what experts and SEI's hedge-fund clients are thinking.

Backdrop of uncertainty

To say hedge-fund-advisor regulation is a moving target understates the situation. Initially, the SEC's reaction to the court decision suggested it would not appeal the court's decision. Remarks by Federal Reserve chairman Ben Bernanke seemed not to advocate further regulation beyond self-imposed financial discipline by creditors who provide hedge funds with leverage facilities.

However, since then, the waters have been further muddied. SEC chairman Christopher Cox has indicated that the SEC could explore new avenues for regulation of the hedge-fund industry. Congressional legislation to enact new hedge-fund regulatory mechanisms has also been introduced, presenting the risk that future regulation could go even further than the SEC's original rule.

A recent SEI "Knowledge Partnership" survey suggests that many registered hedge-fund advisors expect they will become subject to some form of new regulation within the next year. Responding to the survey in the first week of August, more than 50% of those queried believe new federal hedge-fund-advisor regulations are at least somewhat likely to be adopted within the next 12 months, with 72% of those same firms believing it is "very likely."

But as Yogi Berra famously said, "it ain't over till it's over."

David Tittsworth, executive director of the Investment Adviser Association(IAA), a Washington, D.C.-based association of registered investment advisors (RIAs) seems to take similar view. "While different people will make different predictions about the prospects for legislative action or the SEC's pursuit of new regulatory authority, no one can say hedge-fund regulation is dead," he says. "It will be very interesting to how the issue plays out in the coming weeks and months."

Scenario 1: Deregister now

Though it remains to be seen whether hedge-fund advisors will deregister in substantial numbers now that they have the opportunity, deregistering would appear, at first glance, to yield some immediate and longer-term payoffs.

Less intrusive regulation. For many advisors, the most compelling benefit would be to eliminate certain types of SEC scrutiny, most notably SEC routine exams and sweep exams and their attendant risks, distractions, and productivity drains.
No prescribed recordkeeping requirement. The advisors Act recordkeeping requirements would no longer apply, including those concerning e-mail retention, substantially reducing that administrative burden.
Greater flexibility to charge performance fees. advisor's Act limitations on performance-based fees would no longer apply. Registered advisors, including those that manage hedge funds, may only charge performance-based management fees to "qualified" clients that meet certain net worth requirements. Unregistered advisors can charge performance fees to qualified clients and accredited investors, although the SEC has indicated that it wants to revisit the definition of accredited investor. Additional limitations on performance fees also apply to accounts covered by the Employee Retirement Income Security Act of 1974 (ERISA).
Reduced compliance costs. Overall, the direct and indirect costs of compliance would likely be reduced. For boutique advisors who struggle to keep a handle on overhead and feel they simply can't afford to carry unnecessary costs, this may be the overriding factor.

Advisors need to consider, however, whether the fact that they have already put in the work to come into compliance with requirements for SEC registration diminishes the benefits of now deregistering. At some point, deregistration is of limited benefit if all you accomplish is the dismantling of some of your new compliance and recordkeeping infrastructure, which are now sunk costs.

Deregistration has other evident downsides, particularly for advisors who are still seeking to expand their assets and client rosters. In a climate of rising client expectations with respect to transparency and disclosure, prospective investors may be inclined to look less favorably on unregistered advisors.

Timothy Levin, a Philadelphia-based partner in the investment-management practice group of the law firm Morgan, Lewis & Bockius says that many institutional investors, especially ERISA investors, "have added SEC registration as a screening criteria to their hedge fund investment guidelines." This is particularly true given that a sizable minority of hedge-fund-advisors chose to register with the SEC before it was required, adds Levin. "If a majority of your competitors remain registered now or were previously registered, and you choose to deregister, that could be viewed as a potentially troubling signal by investors conducting due diligence."

SEI's corporate counsel Phil Masterson notes that a hedge-fund advisor's approach to deregulation may prove a function of its prior stance on the matter. "To a great extent, at least with respect to current investors, the perceptions associated with deregistering will be largely influenced by how a firm positioned registration with investors," he says. "Was it characterized as an unnecessary intrusion or simply as a formalization of the firm's existing compliance program?"

The "what if" factor is another important consideration, albeit one that is difficult to nail down. Should some new regulatory mechanism or authority be established, advisors who have deregistered may find themselves scrambling to re-institute compliance measures they have just dismantled.

"You have to ask yourself, 'If I deregister and then have to turn around in 90, 120 or 180 days and start a process all over again, is it worth it?'" says the IAA's Tittsworth. "There is also the possibility that those who remain registered will be treated differently under a new regulatory scheme."

And, of course, deregistering doesn't mean freedom from regulatory scrutiny entirely. Anti-fraud rules and insider-trading prohibitions remain in place, and the SEC may well use them to turn up the heat on business practices it deems questionable.

In addition, the prospect of deregistering with the SEC, only to once again have to navigate among the many variations of state regulation and registration requirements could still be daunting.

Levin of Morgan, Lewis & Bockius says that "avoiding state advisor-registration requirements can be difficult, especially for SEC-registered advisors who took advantage of the opportunity to hold themselves out to the public as investment advisors. Going back to the state-by-state regulatory scheme could really be a case of jumping out of the frying pan and into the fire."

Scenario 2: Stay registered

For advisors who registered as a result of the now-vacated rule, there is a clear case to be made for the status quo -- or at least for taking a wait-and-see attitude until the prospects for new regulation are clearer.

Sunk costs. Advisors who have already gone to the trouble and expense of ramping up to meet registration requirements may find little advantage, and some risk, in backpedaling. As noted, cost factors may be secondary because a large portion of the total costs associated with registration can not be recovered through de-registration.
Cementing of Compliance Culture. In perception, if not in reality, removing compliance-related infrastructure or deregistering with the goal of relaxing compliance burdens could be viewed as equivalent to relaxing the firm's compliance culture—and that is a message advisors may not want to send their employees, investors or prospective investors.
Investor Expectations. Some investors may expect voluntary registration, which could be construed as a best practice and would likely be of some competitive advantage in attracting and retaining investors. Some registered advisors may also find that it is important to their marketing efforts to be able to hold themselves out to the public as investment advisors, a luxury that is available only to registered advisors.
Greater Access to ERISA Money. ERISA investors may expect managers of funds that hold ERISA plan assets (i.e., exceed the 25% plan-asset threshold) to be registered, because only an investment advisor that is registered can qualify as an "investment manager" under ERISA. Status as an investment manager is important to ERISA plan investors because it can provide them with certain protections from fiduciary liability. In addition, registration is important to the hedge-fund advisor that manages ERISA plan assets because registration is a requirement to qualify as a "qualified professional asset manager" (QPAM). Under applicable Department of Labor exemptions, QPAMs are permitted to engage in many common transactions that would otherwise violate ERISA-prohibited transaction rules. All in all, registration may be an important factor in attracting ERISA plan investors.
Staying Current. Continuous compliance with the registration requirements and the prescribed annual evaluation of the advisor's compliance program will facilitate advisors' readiness to comply with new regulations that may be adopted in the future.

Nevertheless, as discussed above, there are tradeoffs. Remaining registered entails incurring certain related costs, as well as administrative burdens, including annually updating the firm's ADV form. It also means remaining subject to SEC inspections and sweep exams, with all their related risks and costs in time and money.

Scenario 3: Find the Middle Ground

Some advisors may choose to hedge their bets by deregistering while keeping the key elements of their compliance infrastructure intact. This strategy allows them get out from under bureaucratic burden, intrusive regulation and regulatory exposure associated with registration yet preserve their compliance focus and capability. Being able to point to their voluntary systems and measures may help them mitigate any negative perceptions of deregistration.

On the other hand, hedge fund sponsors should be sensitive to prospective investors and consultants who may use registration as a cut-and-dried screening factor, regardless of the compliance program in place at the firm. There is also legitimate concern that, in the absence of a regulatory mandate, voluntary measures may succumb to entropy.

"Sustaining a sound compliance culture was already a significant challenge when registration was mandatory," says Jim Volk, chief compliance officer for SEI's Investment Manager Services unit. "It only becomes more difficult when compliance considerations are viewed only as best practices or discretionary." Given competing demands for resources and the ongoing business demands, deregistered advisors intending to maintain their compliance practices will need to resist gradual erosion.

What hedge-fund advisors say

Registered hedge-fund advisors are looking cautiously at the prospect of changing their SEC registration status, according to a survey by SEI. The findings below are based on responses from numerous hedge-fund advisory firms, all of which are registered.

Only 15% have already made the decision to deregister; 45% intend to remain registered; the remaining 40% are still undecided.
Most firms that are already planning to deregister say the costs of regulation and the drain on existing resources are the primary motivators in that decision.

A significant number of those planning to deregister intend to keep key elements of their compliance programs intact.

100% expect to keep in place a chief compliance officer responsible for overall compliance, although 40% of them intend to scale back their duties and responsibilities. 
100% also plan on keeping a formal, written compliance manual of key policies and procedures, with 80% intending to test and monitor those annually.
However, 60% plan on scaling back their annual formal review and assessment of their compliance program.

Among firms that are planning to remain registered, the most commonly cited reasons are because they believe their investors and prospects expect it and because being registered seems to be best practice.

While at least half expected some sort of new regulation to materialize within the next year, close to a third were still uncertain as to what the future would hold.

What the experts recommend

Caution and thorough deliberation seem to be the watchwords among knowledgeable observers who are following the unfolding developments concerning hedge fund regulation.

Acknowledging that deregistration could be a viable option for hedge funds that are not open to new investors or those that don't seek institutional assets, the IAA's Tittsworth concludes that there is no one right course of action. Each advisor must weigh all the factors to determine what response makes sense. "If I were a hedge-fund manager, I'd be thinking about what's best for my business," he says. "Who are my clients, and who do I want my clients to be? How do I want my firm to be perceived by clients and prospects? Most fundamentally, how am I going to make money? After assessing these basic business questions, you will be in a much better position to figure out if deregistration really makes sense for your firm."

In the minds of many advisors, marketplace perceptions are the primary concern, according to SEI's Volk. "Particularly if you are a hedge-fund advisor targeting the institutional market, client expectations are far more important than regulatory technicalities," he says. "Regardless of whether registration is required, clients will want to know that your practices are within their comfort zone and, furthermore, that you take compliance seriously."

The upshot is that hedge fund advisors should not rely on someone else to point them on a path through the changing regulatory environment. Outside experts can offer guidance and food for thought, but only the advisor knows what is best for its particular business. --FWR

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