Hedge funds in the US should keep track of proposed changes to the regulatory framework and take proactive steps to comply with rules that may be introduced in the near future, according to Steven Nadel, a partner in the investment management group at law firm Seward & Kissel.

The hedge fund industry in the US is braced for a wave of fresh regulation in the wake of the market meltdown in 2008 and discovery of the Madoff fraud.

President Barack Obama and Treasury Secretary Tim Geithner have called for stricter supervision of hedge funds as part of a wider overhaul of the way financial markets are regulated.

Legislators at the federal and state level and regulators like the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission have put forward a plethora of proposals that could have a significant impact on the way hedge funds operate.

The headline development to date is the Private Fund Investment Advisers Registration Act proposed by the Obama administration in July 2009.

This would require all investment advisers with more than $30 million in assets to register with the SEC and provide the regulator with information about the funds they manage. Nadel believes the Act is "likely to be passed" although he does not expect this to happen until 2010.

However, registration is only one part of a much wider reform initiative, said Nadel. "The Obama administration has set the scene for a major overhaul of the regulatory framework. The president and his cabinet have prepared the ground. It now falls to individual regulators and legislators to come up with specific rules to regulate hedge funds," he said.

Nadel advises hedge funds to designate an individual within the company to keep track of proposed changes to the regulatory framework and liaise with external counsel about how to respond to potentially disruptive rule changes.

Compliance issues
"Regulatory changes take a long time to go from the drawing board to the rule books. There will usually be plenty of time for managers to figure out how they will comply with the rules. I would advise managers to take advantage of any opportunities to submit comments to regulators on proposals that will directly impact their business," said Nadel.

The SEC has already suggested potential rule changes that would impact hedge funds.

In April the regulator proposed reinstating the up-tick rule and other potential restrictions on short selling. A rule requiring fund managers to disclose short sales was allowed to expire in August. But the SEC has since said it will seek to increase public availability of short sale information through exchanges.

A temporary rule designed to curtail naked shorts was also made permanent at the end of July.

Custody rule
The SEC has also proposed a custody rule that would require fund managers to make additional disclosures about their custody arrangements. Advisers with custody of client assets will be subject to "surprise examinations" under the rules.

The custody rule is a direct response to the Madoff fraud, said Nadel. "The SEC clearly feels this will help avoid similar situations in the future." However, the rule will not have a significant impact on the majority of hedge funds that use external custodians and prime brokers to hold client assets, he added.

The threats facing the industry are not limited to regulation. Changes to the tax rules in the US could be particularly damaging to hedge funds.

The Obama administration's 2010 budget proposal includes measures to treat carried interest as ordinary income as opposed to capital gains for tax purposes. That would raise taxes on income earned from performance and incentive fees from the current rate of 15% applicable to capital gains to almost 40%.

There are also concerns that amendments to the tax rules at the state level could adversely impact hedge funds. For instance, in New York there have been calls for the incentive fees earned by hedge fund general partners to be subject to the city's unincorporated business tax.

Nadel said in the current environment it would be wise for managers to take some proactive steps to prepare for regulation. For instance, hedge fund managers not currently registered with the SEC should consider adopting a compliance manual, he said.

"Having existing compliance policies in place will help the transition to a registered environment. It is also good for business. The large investors prefer to deal with managers that have robust compliance procedures and policies in place," said Nadel.

Compliance policies should address issues like valuation, conflicts of interests and personal trading.

One area hedge funds ought to pay particular attention to is their relationships with external placement agents and finders.

Placement agents
The SEC has stepped up enforcement actions against companies that use intermediaries that are not registered as broker/dealers to source transactions. This includes placement agents and external marketers that raise assets for hedge funds.

The SEC has even proposed an outright ban on the use of placement agents to source investment from public institutions like pension funds.

"We advise hedge funds not to deal with people that promise to introduce them to potential investors unless they are registered broker/dealers," said Nadel.

Gaining access to investors through an unregistered intermediary could pose huge legal liabilities for the manager if the fund suffers losses further down the line, he added. "An investor that is introduced to a fund by an unlicensed broker can claim it was not a proper offering and seek the return of the invested capital," concluded Nadel.