SEC and NY AG Will Use Aggressive Tactics to Target Hedge Funds and Short Sellers

September 22, 2008

Too many fingers to point.  Not enough people to blame.  Enter hedge funds. False rumor mongering must have led to abusive short selling and market manipulation.

Such must be the thinking of the Enforcement Staff at the Securities & Exchange Commission.  The most recent “crisis on Wall Street” combined with the SEC’s ongoing and apparent disdain for hedge funds and their trading practices have once again placed hedge funds under the microscope.  After creating a “hedge fund task force” earlier this year to focus on insider trading allegations, the SEC is now attempting to blame current liquidity problems in the marketplace on the trading practices of hedge funds.

In an effort to launch investigations that assign blame for the recent Wall Street activity, the SEC has announced that it will require hedge fund managers to describe, under oath, their trades in certain financial stocks as well as certain other information.  Presumably, if a given hedge fund fails to comply with the request, SEC subpoenas will fly.  The New York Stock Exchange and the Financial Industry Regulatory Authority will also conduct probes, including on-site visits to firms. As if that's not enough, New York State Attorney General Andrew Cuomo intends to investigate whether short sellers engaged in a conspiracy to spread rumors and bad information to influence or drive down the stock price of various financial institutions.

These pseudo-investigations may drag out for months or years, as hedge fund managers and others try to explain the reasons behind trades made in the spur of the trading moment.  For example, it will be a Herculean task to set forth in a sworn affidavit the reasons behind each and every trade made by a hedge fund.  In requiring sworn “oaths” the SEC is raising the stakes.  It is a federal crime to lie under oath to the SEC.

These investigative initiatives take place within a paradigm shift in the nature and form of the U.S. regulatory apparatus affecting financial institutions and hedge funds. In the course of last week, the SEC first moved to suspend naked short-selling in all stocks, and then moved to suspend entirely for a 10-day period short-selling in the stocks of 799 US and foreign-based financial institutions.  Additionally, institutional money managers subject to Schedule 13F reporting for their equity holdings will be required, effective September 22, 2008 to file on new Form SH weekly reports beginning September 29, 2008 of their short positions.  Form SH must be filed electronically on the first business day of every calendar week immediately following a week in which a subject manager effected short sales.  Initial Form SH filings will be confidential, but thereafter will be released every two weeks once the filings are received.  Press Releases with links to the SEC's Emergency Orders may be found at  http://www.sec.gov/.  We expect these actions to be followed by permanent and sweeping regulation and legislation affecting financial institutions and hedge funds, including efforts to reinstate the SEC's "uptick rule" for short-selling and finalization of long-pending SEC regulations defining a new, more stringent category of "accredited natural persons" who may invest in hedge funds.

In our opinion, the upshot of these governmental actions, in tandem with sweeping reforms at the financial institutions holding company level being undertaken by the U.S. Treasury and Federal Reserve Board, will mean that short-selling and leverage -- two of the essential investment strategies of hedge funds -- will be severely curtailed under an anticipated new regulatory regime that will, in the end, completely redefine the nature of hedge funds as investment vehicles.   

Hedge funds must exercise great care in responding to inquiries from the SEC, the Attorney General’s office, and other regulatory agencies.  Bracewell & Giuliani’s White Collar Criminal and Regulatory Defense practice features former enforcement attorneys from the SEC in New York, Washington and Texas, former federal prosecutors from the U.S. Department of Justice, and former state district attorneys and assistant attorneys general.  We specialize in guiding hedge funds through government investigations of all kinds and understand how to respond to inquiries of the type that are coming.

Governmental Relations

The Bracewell Government Relations and Strategy group has several decades of experience in Washington, working at the highest levels in the legislative and executive branches. In the area of complex financial regulation, the group has been very active, representing major foreign and domestic financial institutions seeking regulatory approvals, oversight and legislative options. The group includes a former Assistant Secretary of Treasury for Legislative Affairs, former Senior Staffers to Chairs of the Senate Finance and Senate Banking Committees, as well as two former members of Congress.

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