Hedgies Brace for New Rules in Wake of Madoff Scandal

BOSTON/WASHINGTON (Reuters) – Investor Bernard Madoff’s alleged fraud was so enormous that it left hedge fund industry executives groping for words to describe it.

The only thing they are certain of is that his alleged Ponzi scheme — estimated at $50 billion — will prompt fresh calls for regulators to beef up enforcement and possibly adopt new rules for loosely supervised hedge funds.

“If this fraud is even a fraction of the magnitude that is alleged, there will be calls for regulation that will mandate some level of auditing, compliance and monitoring,” said Jacob Frenkel, a former Securities and Exchange Commission enforcement lawyer who is now in private practice.

For decades the $1.5 trillion hedge fund industry has avoided the strict rules that regulators impose on mutual funds where millions of Americans save for college and retirement.

Hedge funds, their managers argued successfully for years, were reserved for wealthy people who required less protection.

That argument may now be out the window, industry lawyers, hedge fund investors and analysts agreed, noting that Madoff’s offerings were sold to thousands of people who might not be considered super wealthy.

Even before this debacle, lawmakers including Rep Barney Frank, hinted that hedge funds would face new rules in the next year. They might be asked to have bigger capital reserves and reveal certain positions to the Federal Reserve so central bankers can monitor risk.

Madoff, a pioneer on Wall Street and former chairman of the Nasdaq Stock Market, told clients his name was on the door and that he worked hard to maintain an unblemished record of value, fair-dealing, and high ethical standards, his firm’s hallmark.

Investors with Tremont Capital, Kingate Global Fund, and BBVA Group whose money was ultimately handled by Madoff might balk at these claims right now, wondering why his scheme prospered for so long.

“What we really need is for all investment companies to have some kind of oversight,” said James Angel, associate professor of finance at Georgetown University.

“On the other side, you don’t want to turn it into an over regulated mutual fund. You need to make sure that (securities) police do stick their noses in the right away.”

Some people said this might include giving regulators the right to make spot checks at hedge funds to review auditing practices.

That might have shed some light on Madoff’s years of steady returns that many investors said looked too good to be true.

“If you look at his performance, it was a straight line up. That’s silly,” said a Wall Street professional who at one point worked with a firm that did business with Madoff feeder funds.

“He did not have a reputable auditor, which was another giant red flag. He wouldn’t talk to you about how he made money. He met with very few people, and if you did meet him, you got 20 minutes with him,” the person said, who requested anonymity because he was not authorized to speak to the media.

As more details of Madoff’s alleged fraud emerge, some people also wondered if the Securities and Exchange Commission, which has been harshly criticized for not having done enough to mitigate this year’s financial market meltdown, missed warning signs at Madoff.

“I’ve got to think that regulators will look at this and see that there might have been some way they could have headed this off at the pass,” said Peter Turecek, a managing director at Kroll Inc., a risk consultancy owned by Marsh & McLennan Cos. Inc.

But Lynn Turner, the SEC’s former chief accountant, said it was too early to tell whether the SEC missed crucial signs.

The scope of the alleged fraud is still unknown, Turner said. While Madoff has pointed to $50 billion, he was supposedly only managing $17 billion in assets.

Turner questioned whether the alleged fraud was committed in the portion of Madoff’s business that would be within the scope of a regular inspection.

“If it turns out that this occurred at a time when the SEC didn’t have the resources to do an inspection, then there may be calls for resources for the SEC to do its job,” he said.

By Svea Herbst-Bayliss and Rachelle Younglai
(Additional reporting by Caroline Humer and Dan Wilchins in New York; Editing by Bernard Orr)