Hedge funds must race the clock to check their dealer-rule status

As winter in the US recedes, some hedge funds know how they’ll spend the warmer months: trying to work out how to respond to the Securities and Exchange Commission’s (SEC) recent dealer registration rule. For funds to determine whether they count as dealers under the new rules may prove as difficult as pinning down the point at which spring becomes summer.

Firms must register by April 29 next year if they engage in what the SEC deems dealer-like activity. The determination hinges on whether a firm “regularly” offers prices on both sides of a market for the same security or earns its revenue “primarily” by capturing bid-ask spreads.

Because neither term is clearly defined, funds say they now face a task of analysis that makes the timeline for compliance unrealistic.

For a firm with diverse and complex strategies simply deciding whether the organisation is caught by the rule could take six months, industry participants reckon. After that, a firm would need time to act – reorganising units, divesting businesses or potentially registering with the SEC.

Hedge fund executives say reorganisation alone, given the need to secure investor consent and the possibility of triggering redemption rights, could take a year. Filing for registration, they say, might take nine to 12 months.

The analysis stage of the process will demand more work than might at first appear. Hedge funds are going to have to examine their activities over daily, weekly, or even monthly horizons, they say – looking back through multiple years of history – to determine whether trading by strategies of similar types might be construed as dealer activity.

Hedge fund executives say reorganisation alone, given the need to secure investor consent and the possibility of triggering redemption rights, could take a year

The job is complicated by different securities trading with different frequencies, making it hard for funds to know how far apart trades on different sides of a market need to be to avoid counting as dealing under the rule. What’s more, the liquidity profile of a security can change from month to month, or year to year.

Large multi-strategy hedge funds, often organised as autonomous pods, will be hardest hit. Parts of the rule could be interpreted as applying at an entity rather than strategy level, lawyers say. That means if one portfolio manager places an order on one side of a trade and another manager places an order on the other in the same day, a firm could be deemed to be engaging in dealer activity.

“It’s a big concern,” says William Barbera, partner at law firm SRZ. “If the SEC’s position is that the tests apply at the entity level, then internal surveillance and policing around these rules will be very difficult for funds with multiple strategies and portfolio managers.”

For hedge funds to come up with even an approximate answer on dealer designation, then, will take time. To be ready to present a credible picture to regulators if challenged will take still longer.

Many investors say funds will never achieve certainty on the matter, simply because of the rule’s breadth and ambiguity. Investment strategies are not static, they point out. Portfolio managers come and go. And every time that occurs, the exercise starts over.

A mistake could prove costly. An enforcement action for failing to register as a dealer might lead to fines and would likely force firms to disgorge any profits earned through trading activity in the period they were found to be non-compliant, up to five or possibly 10 years.

Is there a chance the rule will be delayed? On March 18, three industry groups filed a petition in the District Court of Texas to block the SEC’s rule change, saying the regulator lacks the authority to expand the definition of dealer in this way and failed to do a proper cost-benefit analysis.

The petitioners could ask for a temporary stay of the rule. But hedge funds will still have to proceed with their internal analysis lest the legal action should fail.

Firms say they will also have to prepare legal defences against potential enforcement actions.

In time, a few hedge funds might decide to register. That’s unlikely to be the case for a while, though, not least because of the work to determine whether they qualify first.

“I will only be able to sleep at night if the rule is fully vacated,” says one senior counsel at a large hedge fund. A long restless summer lies ahead.

Editing by Rob Mannix