Hedge Funds Face Regulation & Oversight by SEC–Will There Be Another Compliance Tool in Addition to IRS Whistleblower Program?

When improprieties occur with hedge funds, the hedge funds’ lack of transparency and dearth of disclosure obligations make violations of the law difficult to uncover. Sometimes, persons in the hedge fund industry report those abuses through the IRS Whistleblower Program, as some of our IRS Whistleblower clients have done.

Nonetheless, the hedge fund industry remains cloaked in secrecy, frustrating experts who now seek to gauge the impact of hedge funds on the current financial crisis.

A new bill just introduced in the Senate, the “Hedge Fund Transparency Act,” would lift that cloak and create disclosure requirements for hedge funds and oversight of hedge funds by the SEC. This bipartisan bill sponsored by Senators Chuck Grassley and Carl Levin modifies a prior approach to hedge fund scrutiny pressed by Sen. Grassley, after a whistleblower complained that SEC supervisors were impeding an investigation into a major hedge fund.

According to Sen. Grassley, “The bill contains four basic requirements to make hedge funds subject to SEC regulation and oversight. It requires them to register with the SEC, to file an annual disclosure form with basic information that will be made publicly available, to maintain books and records required by the SEC, and to cooperate with any SEC information request or examination.”

Until the Bear Stearns debacle, there seemed little political will for any serious oversight of hedge funds. The SEC in 2004 had issued a rule requiring hedge funds to register under the Investment Advisers Act, to comply with related regulations, and to provide basic information through a public disclosure form. In June 2006, however, the U.S. Court of Appeals for the District of Columbia Circuit declared the rule invalid as incompatible with the Investment Advisers Act.

In hindsight, that absence of scrutiny may be seen as a grave error, one which may have helped create the current financial meltdown.

Since 1998, when the Federal Reserve acted to rescue Long-Term Capital Management (LTCM), a hedge fund with more than $125 billion in assets under management and a total market position of approximately $1.3 trillion, investments in hedge funds have grown dramatically.

According to the SEC, by 2006 hedge funds represented 5 percent of all U.S. assets under management, and 30 percent of all equity trading volume in the United States. More recently, approximately 10,000 hedge funds were managing about $1.8 trillion in assets, after losses over the past year of more than $1 trillion.

Pension plans have increasingly poured billions into hedge funds–from about $3.2 billion in 2000, to more than $50 billion in 2006. By September 2006, the Missouri State Employees Retirement System reportedly had invested over 30 percent of its assets in hedge funds.

As Senator Levin explained, “Universities and charities have also directed significant assets to hedge funds. The result is that hedge fund losses threaten every economic sector in America, from the wealthy to the working class relying on pensions to our institutions of higher learning to our non-profit charities.” Banks and securities firms also set up hedge funds.

According to Sen. Levin,

Because of their ownership, size and reach, their clientele, and the high-risk nature of their investments, the failure of a hedge fund today can imperil not only its direct investors, but also the financial institutions that own them, lent them money, or did business with them. From there, the effects can ripple through the markets and impact the entire economy.

Sen. Levin explained the role of hedge funds in the downfall of Bear Stearns, and how the ripple effects of those events in 2007 later affected Merrill Lynch and Bank of America:

Take, for example, the June 2007 collapse of two offshore hedge funds established by Bear Stearns. Those two hedge funds were not particularly large, but were heavily invested in complex financial instruments tied to subprime mortgages. When the housing market weakened and mortgage-backed securities lost value, it wasn’t just the hedge funds that suffered losses. It was also a number of large financial institutions which had lent them money or entered into business transactions with them, including its parent company, Bear Stearns.

As Bear Stearns began reporting losses and market confidence in the firm began dropping, the Federal Reserve and Treasury Department helped broker a deal allowing JPMorgan Chase to purchase the company. As part of that deal, the government agreed to take over $30 billion in troubled assets off the books of Bear Stearns, hiring an asset manager and putting taxpayers on the hook for them financially.

But the problems didn’t stop there. Another financial institution, Merrill Lynch, had invested in the Bear Stearns hedge funds and also suffered losses. Those losses, when added to others, so damaged the company’s bottom line that, despite a promise of $10 billion in new capital from the Troubled Asset Relief Program or TARP, Merrill Lynch was viewed by the market as teetering on the brink of collapse. With the government’s encouragement, Bank of America stepped in and bought the company. As the extent of the Merrill Lynch losses became apparent, Bank of America itself began to lose market confidence. To counteract the Merrill Lynch losses, Bank of America wound up taking billions more taxpayer dollars under the TARP Program.

In the meantime, two managers of the Bear Stearns hedge funds were arrested on charges of conspiracy, securities fraud, and wire fraud. Their cases have yet to go to trial. But prosecutors allege that as the hedge funds were losing value, their managers were telling investors a very different story. “[B]elieve it or not,” one of the financiers allegedly wrote in an e-mail to a colleague, “I’ve been able to convince people to add more money.”

The two Bear Stearns hedge funds offer a sobering set of facts, but they represent only a small part of the story. Other hedge funds are contracting or folding as clients demand their money back. To meet client demands, hedge funds are selling lots of assets, further weakening stock and bond prices. As one leading hedge fund owner, George Soros, testified before Congress in November: “It has to be recognized that hedge funds were . . . an integral part of the bubble which now has burst.”

We applaud Senators Grassley and Levin in working to bring needed transparency and disclosure requirements to the hedge fund industry.

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From the start of the new IRS Whistleblower Program, our whistleblower lawyers at Finch McCranie, LLP have represented whistleblowers in the new program. We have represented persons with IRS Whistleblower claims in the hedge fund industry, other financial services industries, real estate, manufacturing, and many other businesses, as tax fraud, tax evasion, and tax noncompliance are not limited to one area.

Our attorneys are available for a free consultation at 800-228-9159, or by clicking HERE to contact us by email.