By a narrow margin, the Securities and Exchange Commission (SEC) on Tuesday voted out a final rule that will increase the agency’s ability to detect fraud and other wrongdoing in the hedge fund market, a rapidly growing segment of the financial market that has been increasing its presence in the energy markets but for the most part has been free of regulation over the years.

In a 3-2 vote, the Commission approved rule 203(b)(3)-2 that will require hedge fund advisers to register with the SEC under the Investment Advisers Act of 1940. The rule will take effect in February 2006, and current investors in hedge funds and other clients of hedge fund advisers will be grandfathered. Consequently, “no one is going to have to leave the hedge fund who perhaps wouldn’t be eligible to be in the hedge fund in the future as a result of the performance fee rules,” the SEC said.

Chairman William H. Donaldson, along with Commissioners Harvey Goldschmid and Roel Campos (both Democrats), voted in support of the initiative, while Republican Commissioners Paul Atkins and Cynthia Glassman opposed it.

Critics characterize the new rule as an “attack on the hedge fund industry, which it is most definitely not,” said Donaldson at the SEC’s meeting Tuesday. The agency just “wants[s] to be able to monitor this fast-growing industry.” And despite what opponents say, the SEC does have the “resources” to oversee the hedge fund market, whose involvement has been mostly restricted to wealthy individuals and institutions, he noted.

It’s estimated there are more than 8,000 hedge funds worldwide (mostly U.S.), valued at $870 billion and growing. The industry is expected to expand to $1 trillion by as early as the end of this year, Goldschmid said. Of the individual hedge funds, more than 200 have been identified as active in the energy industry, including the natural gas, crude oil and electricity markets.

Hedge funds trade crude oil on both the New York Mercantile Exchange (Nymex) and London’s International Petroleum Exchange (IPE) as well as the over-the-counter (OTC) energy derivatives markets. Similarly, they trade natural gas on both futures exchanges and the North American OTC markets. To round out their participation, they trade both gasoline and heating oil on Nymex and gasoil on the IPE.

The SEC’s staff estimates that 40-50% of all hedge fund advisers already are registered with the agency. The new rule would allow the Commission to:

With the meteoric growth of the hedge funds, “I do agree we need to know more about them,” said Glassman, but she disagreed that the rule was the correct approach to take. Instead, opponents recommended that a registry of hedge fund advisers be created, and that the SEC require audited financial information from the funds.

Glassman noted there were 55 cases of fraud involving hedge funds over the past five years. She said she didn’t believe the rule would have made any difference in preventing the fraud or ferreting it out sooner in these cases. Moreover, she warned that oversight of the hedge fund industry will divert significant agency resources from other investigative activities.

Atkins said he was “befuddled” as to why the SEC was charging ahead in the face of so much opposition to the rule. He questioned whether the SEC had the authorization to proceed without statutory approval from Congress. He noted the Commission would do well to keep an eye trained on mutual funds rather than hedge fund advisers.

“We know too little about this dramatically growing industry,” which has been sounding “alarm bells,” Goldschmid said. Given the substantial growth of the industry, the SEC “can no longer turn a blind eye.” The rule will act as a potential deterrent to “white-collar wrongdoers,” he noted.

Speaking to the hedge fund market, Goldschmid assured it that there would be no interference from the SEC with the investment strategies of hedge funds.

There is “[too] much troubling evidence of fraudulent activity” in the hedge fund industry, said Campos in casting a vote in favor of the rule. The Commission has made “significant accommodations” for the industry in the rule, such as delaying the effective day of the rule for a year and allowing the grandfathering of current investors in hedge funds.

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