As regulators move toward more data-intensive investigations, the relationship between funds and their broker-dealers will get increased scrutiny - especially when hedge funds are involved, says Linda Chatman Thomsen, the director of the Securities and Exchange Commission's enforcement division.
"The regulated entities are our window into hedge funds," Ms. Thomsen said at a recent seminar of the Practising Law Institute.
Broker-dealers may be the regulated entity with the best view, she said, adding, "Everybody does business with them."
They can prepare for this scrutiny by having a clear set of procedures that govern their interactions with funds and ensuring that these policies are strictly and uniformly enforced. Preparation includes being able to show regulators that no trade violated an in-house rule.
"Remember that [in-house policy] will always be judged," Ms. Thomsen said, "and it will always be judged after the fact."
Hedge funds have been a particular thorn in the SEC's side in recent years. Though the commission adopted a rule requiring the famously secretive hedge fund advisers to register in certain circumstances, the rule failed to stand up to a court challenge. In June, a U.S. appellate court found the rule "arbitrary" and deemed it invalid.
SEC Chairman Christopher Cox responded by promising vigilance of the $1.5 trillion industry.
"There is a ton of money in these nontransparent vehicles, which is a recipe for disaster," said Ms. Thomsen. She quickly added that, though most hedge funds are well run and safe, the potential for wrongdoing is problematic.
Though hedge funds are designed to allow only "sophisticated" investors capable of large investments to participate, the sheer volume of trades these funds process has the potential to move markets, thereby affecting average investors.
A danger is that the brokers who execute these large trades may bend the rules to give their wealthy clients a market advantage.
"There is an incentive within broker-dealers to bend the rules, or even bend over backward to accommodate these clients," said Susan L. Merrill, the executive vice president of enforcement at the New York Stock Exchange.
And though brokers seem not to think twice about reporting people who game the system for gains of $25,000 or so, accommodating an ethical breach becomes a business advantage when it comes to a hedge fund manager who wants to make a late trade on a multimillion-dollar order, regulators said.
"Business managers are so intent on keeping the business," Ms. Merrill said, that "they keep these close-to-the-line cases to themselves."
In the most egregious examples, as the market-timing scandals showed, she said, a business infrastructure develops to help certain high-powered, revenue-boosting clients. Companies' in-house "legal and compliance [departments] were usually not aware of the practices," she said, "and when they were, they gave some very shady analyses."
This is when companies got in trouble, she added, because regulators often found the firms either had no clear policy proscribing the behavior or lacked the oversight to enforce it.
But a lawyer argues that it is unreasonable to expect broker-dealers to monitor their clients, let alone be held liable for the latter's business practices.
"If they did not see the red flags, they do not have the obligation to police clients, and it's hard to hold them responsible," said Harry J. Weiss, a partner in the Washington office of Wilmer Cutler Pickering Hale and Dorr. A faculty member at the institute, Mr. Weiss also is a veteran of the SEC.
But Ms. Thomsen said she believes broker-dealers do frequently see the red flags. "In a lot of cases, it goes beyond a blind eye," she said. "It's aiding and abetting, it's collusion, it's assistance." It is also punishable.
Regulators will take into account how many red flags were ignored, she said, and whether the broker-dealer would have been less tolerant of a transgression by a less favored client.
When it comes to producing evidence, Mr. Weiss said, it is hard for the SEC to prove a case beyond a reasonable doubt.
Robert Romano, an institute faculty member and partner specializing in litigation at the Morgan Lewis firm in New York, warned against challenging too vehemently the technical casework behind SEC complaints.
"Materiality and legal niceties find an impatient audience on the other side of the table," he said. "If you slice the issue too finely, the SEC will find something inappropriate."
Ms. Thomsen added that the SEC is committed to "beefing up" its capacity to parse and analyze large blocks of data. Mr. Cox has made it a priority to ensure the agency has the tools and resources to do so, she added.
"We're looking at the activities of hedge funds," she said. "If you're doing business with hedge funds, we're going to focus on you, and you need to know that going in." Broker-dealers that want to look good coming out of an investigation will ensure that their compliance policies keep up with their business plans.
As in dealing with any third-party adviser, Ms. Merrill said, broker-dealers must assume responsibility as fiduciaries. This means making sure all necessary letters are in; notices sent out; and most importantly that the firm's procedures are outlined, circulated, and enforced.
