Hedge funds will face regulation eventually

By Svea Herbst-Bayliss

NEW YORK (Reuters) - The loosely regulated hedge fund industry, which has escaped closer scrutiny following a federal judge's ruling in June, will ultimately face tighter oversight, a top New York law enforcement official said on Tuesday.

"I think hedge funds are going to be regulated," David Brown, chief of the investment protection unit in New York Attorney General Eliot Spitzer's office said. "The question is when and how."

Speaking at the Reuters Investment Banking Summit, Brown said there is more room for regulators to police the $1.3 trillion industry, where assets have doubled in the last three years and managers still promise out-sized returns.

But he said it might be difficult to find the most effective way for agencies like the U.S. Securities and Exchange Commission and possibly state regulators to flex their muscle.

Hedge funds, unlike mutual funds, do not have to let government auditors review their books and they are allowed to use trading techniques like selling stocks short and using borrowed money to try and boost returns.

A federal court in June struck down an SEC rule that allowed the agency to audit hedge funds, leaving the industry largely out of U.S. financial regulators' reach.

However several lawmakers have already signaled interest in putting the fast growing hedge fund industry on a tighter leash again, possibly through legislation. Brown said there are ways federal and state regulators can be more involved in the oversight.

"There may be three flavors of hedge fund problems," the Harvard-trained lawyer who oversaw New York attorney general Eliot Spitzer's investigation into improper and illegal trading practices in the mutual fund industry three years ago said.

There are hedge funds that rip off their own investors, those that trade illegally, or when the industry as a group does something "stupid that threatens to blow up the system," Brown explained.

"On the first two flavors of hedge fund problems, there certainly is room for all kinds of regulators," Brown said adding, "There are Ponzi schemes out there as we speak and there are certainly hedge funds out there trading on inside information."

Regulators have, for example, already cracked down on Kirk Wright, a former Atlanta, Georgia-based-hedge fund manager whose clients included professional football players and him with cheating them out of millions of dollars.

But regulators would be less effective in trying to watch over the already broad and fast growing types of trading strategies hedge funds employ, he said.

"I think it's very difficult to monitor effectively the trading strategies of hedge funds credibly in such a way as to get significant regulatory benefit out of it," Brown said, adding, over the long-run, "It may be helpful to get some charlatans out of the industry."