SEC's Aguilar urges tougher hedge fund regulation

NEW YORK (Reuters) - A Democratic member of the Securities and Exchange Commission called for stricter supervision of hedge funds, particularly large funds that have an impact on the broader financial markets.

Luis Aguilar said the market turmoil of the past year provides evidence that government oversight of hedge funds has not kept pace with the large role they play in stocks, debt and other assets. The fundamental bargain struck some 60 years ago -- that hedge funds should be left alone because they only transact privately with the very rich -- may no longer be valid, he added.

"These sophisticated investors may not have fully appreciated the risks they were taking prior to the recent crisis," Aguilar said at the HedgeWorld spring fund services conference on Thursday.

"Perhaps the definition of 'sophisticated' should be reconsidered. Maybe the criteria should focus on actual investment experience, not just net worth or income."

More broadly, he said the hands-off era appears to be over for hedge funds.

Many questions have been raised about the role hedge funds may have played in driving down the shares of Bear Stearns, or if they manipulated the credit default swap market, or if their collective fire-sales in the same assets contributed to last year's upheaval.

Meanwhile, investors are up in arms about fee structures and last year's hedge fund redemption bans.

"Because investors are not registered, we cannot adequately oversee how they are operated and if they are still qualified for the (regulatory) exclusion," Aguilar said.

The SEC has been under fire for not preventing last year's market meltdown and the demise of several large broker-dealers, as well as its failure to catch the $65 billion fraud by Wall Street veteran Bernie Madoff.

Still, Aguilar expects the SEC will play a key role in the regulation of markets going forward.

He said it was tough for the agency to determine the frequency of insider trading among hedge funds because of the funds' secretive ways.

"We have little credible information about what is out there and what they are doing," he said.

Aguilar reiterated his calls for Congress to make the SEC a self-funded organization, much like the Federal Deposit Insurance Corp, saying this would enable it to increase spending on enforcement and supervision.

A few years ago the SEC tried unsuccessfully to mandate hedge fund registration. But there is more political pressure to change U.S. regulation now. A draft proposal from the Obama administration calls for registration, and at least half a dozen bills have been introduced in the U.S. Congress calling for hedge fund regulation.

Investors are also demanding changes and challenging the practices of fund managers. Aguilar said record numbers of investors are filing complaints with the SEC. Complaints range from fraud and insider trading to falsely reporting asset values and not performing due diligence.

"The reason for their exclusion from regulation is on faulty ground; it seems certain regulation for hedge funds is coming," Aguilar said.

Registration may not be enough to give regulators a complete picture, he added, speaking to a room of hedge fund managers who later directed some angry comments his way during a question-and-answer session.

One solution, he said, is applying some provisions of the 1940 investment managers law to hedge funds. He also called for a tiered approach to regulation, with the largest funds subject to additional rules, such as leverage limits.

(Reporting by Joseph A. Giannone; editing by John Wallace)