Regulators see rise in homegrown hedge funds, vow crackdown

Small-fry investment advisers are increasingly turning to questionable investments to generate big-time returns, including a new twist – homegrown hedge funds.

State securities regulators have become alarmed by the trend and are vowing to step up oversight of advisers with less than $25 million under management.

“The biggest problem that we’re seeing now out in the hinterlands is some of these small investment advisers selling things they shouldn’t be selling,” says Deborah Bortner, the previous president of the North American Securities Administrators Association Inc. in Washington.

Alabama Securities Commission Director Joseph Borg, the new president, revealed its intention to crack down in a speech earlier this month at the Securities Industry Association’s Small Firms Conference in Fort Lauderdale, Fla.

“NASAA will be sending a message that we’re serious about overseeing investment advisers and their reps,” Mr. Borg said.

Risky business

In recent years, independent insurance agents have been the primary focus of regulatory action for selling high-risk promissory notes and viatical settlements that in many cases have cost investors their life savings.

Now advisers are following the trend, regulators say.

“They’re looking for products with high commission rates, and they have very little supervision over them,” says Ms. Bortner, who is director of securities for the state of Washington. “The small investment advisers have the same problem as insurance agents.”

Denise Crawford, securities commissioner of the Texas State Securities Board, says that in the last couple of years, hedge funds have become a hot area for much of that activity.

“Hedge funds used to be managed by highly experienced professionals. The problem now is with the rise of do-it-yourself trading. There are quite a few inexperienced investment advisers marketing their own investment pools, which they refer to as hedge funds.”

Texas currently has “multiple investigations” involving managed pooled accounts, Ms. Crawford says.

Many of the advisers who are being investigated or who have had cases brought against them in Texas have been charging above-normal fees, including performance fees.

risky investments

They also have poured their clients’ money into risky investments such as options and futures, as well as schemes involving the revenue from coin-operated telephones and automated teller machines.

The advisers in question have misrepresented the risk of the funds, the size of their fees and past performance, Ms. Crawford says.

The problem has also been compounded by an increase in the number of small investment advisers, says Mr. Borg.

“I think that that’s going to continue, especially after the March 2000 stock falloff. I suspect people have decided not every stock is going to go up.”

In 1996, Congress enacted legislation giving states sole jurisdiction over advisers managing less than $25 million in assets. The Securities and Exchange Commission has sole jurisdiction over advisory firms managing more than $25 million.

“This is a very fast-growing segment of the financial field,” says Patricia Struck, chairman of the NASAA’s investment adviser section. “Where abuses do take place, we are going to be the only people to address those. That’s the big concern,” adds Ms. Struck, who is securities administrator of Wisconsin’s Department of Financial Institutions.

In his speech at the SIA gathering, Mr. Borg also called for increasing cooperation with state insurance regulators, and state and federal banking regulators.

He also called for stepping up investment adviser examination programs.

The NASAA will push for the development of an electronic exam module that would make it possible for states to test investment advisers uniformly, he said.

Crucial to the NASAA’s effort to step up oversight of state-registered advisers is getting the advisers registered in the Investment Adviser Registration Depository.

The SEC recently opened that system to the public and now provides Internet access to federally registered advisers’ ADV forms, the disclosure forms that advisers must file with regulators.

State advisers should be on the system by late in the first quarter of 2002, says Melanie Senter Lubin, Maryland’s securities commissioner. Until recently, she headed the NASAA’s investment adviser section.

“Using that system is going to create a great tool for regulators, not only for registration responsibilities, but also for enforcement,” Ms. Lubin says.

“It will allow [us] to focus enforcement efforts. We can target enforcement sweeps when we do investment adviser exams.”