SEC seeks stricter rule

By Marcy Gordon
Associated Press

WASHINGTON — Federal regulators yesterday proposed new oversight for hedge funds, investment pools traditionally for the wealthy that are growing and attracting small investors but have scant federal scrutiny.

The vote was 3-2, marking the second time in less than a month the Securities and Exchange Commission split over a significant regulatory move. In both instances, SEC Chairman William Donaldson and the two Democratic commissioners opted for stricter regulation while the two other Republican members opposed it.

On June 23, the panel voted in the same fashion to mandate that mutual fund boards have chairmen who are independent from the companies managing the funds — an action that will force an estimated 80 percent of U.S. mutual funds, or some 3,700 funds, to replace their chairmen.

This time, the SEC approved a proposed new rule ordering most hedge fund managers to register with the agency. If formally adopted after a 60-day public comment period, the rule would open the funds' books to SEC examiners and make them subject to an array of regulations including accounting and disclosure requirements.

The agency could, for example, conduct inspection "sweeps" of groups of hedge funds, something it now lacks legal authority to do.

The high-risk, potentially high-return funds have an estimated $750 billion to $1 trillion in assets and are growing, and oversight is needed to head off potential blowups that could hurt ordinary investors, SEC officials say.

"Small investors are increasingly being exposed to the risks of hedge fund investing," Paul Roye, head of the SEC's investment fund division, said before the vote at a public meeting. He said the agency "needs to detect and prevent fraud at an earlier stage, and prevent these fraudulent activities from damaging markets and harming average investors.

"In most of the hedge fund fraud cases we have seen, the (SEC's) involvement began long after investors' assets were gone," he said.

Donaldson said some 40 hedge funds are believed to have been involved in the scandal engulfing the $7 trillion mutual fund industry.

The two Republican commissioners, Paul Atkins and Cynthia Glassman, expressed opposition to the proposal. But the two Democrats on the panel supported it along with Donaldson.

"I fear that we are setting off down the road of regulatory overreaction," Atkins said at the meeting. "Fraud deterrence is a laudable goal, but so is avoiding regulatory overreach."

Tighter regulation of the funds also is strenuously opposed by other policymakers, notably Federal Reserve Chairman Alan Greenspan, who maintains that it would hinder the flexibility of financial markets.

Still, a number of hedge fund managers — representing some 40 percent of those in the United States — have voluntarily registered with the SEC, many of them in recent months since officials began discussing the issue.

SEC cracks down on false promotions of penny stocks

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Under-$5 trading off the market So-called "penny stocks" are securities of very small companies that trade for less than $5. They are not traded on national exchanges and can pose significant risk to investors. Evaluating the risk It may be difficult to learn more about companies that do not register with the SEC, but try to: • Get financial statements. • Verify claims, contracts. • Call the company's customers. Information is an investor's best tool, but misinformation can be easily spread on the Internet. Be wary of ... • Promises of quick profits and offers to share "inside" info. • Pressure to invest before you have a chance to investigate. • Words like "guarantee" and "limited offer" that might be a red flag. Source: Securities and Exchange Commission

The Securities and Exchange Commission is increasing its legal actions against individuals and companies that falsely promote penny stocks online. In a recent case involving Ives Health Co., the SEC reported a final judgment against the company's former president, M. Keith Ives, for disseminating misleading information on the Internet.

A federal court ordered Ives to compensate investors for a total of $1.25 million for, among other things, falsely claiming the effectiveness of T-factor, an HIV medication that the company developed.

Defined by the SEC as stocks that sell below $5 a share, penny stocks have always been considered speculative and easily manipulated. But stock market experts, seeing an increase in penny stock promotion online, say investors should be wary of swindlers — especially as the market continues its recovery.

"When markets are going up, people are more apt to dabble in stocks. So when you receive this information — no matter where it's coming from — if it's a bull market, you may be more willing to listen to it," said Peter Wysocki, assistant professor of accounting at the Massachusetts Institute of Technology Sloan School of Management.

Penny stocks generally trade on over-the-counter markets, such as the Pink Sheets or the OTC Bulletin Board, where they are not required to meet listing standards set by the SEC. In addition, many smaller companies do not have to file reports with the SEC, making it relatively simple for almost anyone to spread false information.

By influencing investors with misleading data on a company, fraudulent brokers or companies can hype up the price of a stock, then sell their own shares once the price reaches a certain level. This scam, known as "pump and dump," is practically as old as the stock market.

Experts say that since the early days of the Internet, promoters, phony research groups and unscrupulous brokerages have used spam mail, message boards, chat rooms, Web sites and newsletters to lure novice investors into believing a given penny stock was the next Microsoft.

Often, they do not explain why a company is so successful or what it actually does; they distract readers with fancy charts tracking their success, said J. Randall Woolridge, professor of finance at Smeal College of Business at Penn State University.

There are many truthful, legitimate companies that issue penny stock. But major increases in trading volume or sudden changes in a stock's price may indicate that some sort of fraud is taking place, said John C. Edmunds, professor of finance at Babson College in Wellesley, Mass.