Leasing computers to offshore companies is hardly the kind of transaction for which hedge funds are known. But court documents filed in April in New York State Supreme Court reveal that D.B. Zwirn Special Opportunities Fund did just that in November 2005 by financing part of a $29 million equipment lease for an Indian company purportedly setting up call center operations in Bangalore and New Jersey.

When the company defaulted on its first lease payment, it explained that fire had ravaged its call center in India. The explanation didn't hold water with the fund, which retained Schwartz Cooper, a Chicago firm known for its international asset recovery practice.

“We investigated the New Jersey operation and all we found were computer shells and gray-market goods,” says Roberto Anguizola, a principal with the firm. “Clearly, our clients had been the victims of a massive fraud.”

As their traditional markets get more competitive, hedge funds–which unlike mutual funds are exempt from the registration and disclosure requirement of federal securities laws–are branching out, taking risks that are beyond their historical ambit. Once the exclusive province of wealthy individuals, hedge funds today manage about $1.5 trillion in assets for a range of investors including pension funds, endowments and smaller investors. Hedge funds also are responsible for about 30 percent of trading volume on U.S. exchanges.

“Regulators will have an issue anytime they encounter a group with the power to control substantial amounts of trading activity,” says John Brunjes, partner at McCarter & English. “Anyone who's playing with that kind of money gets people hot.”

Hot enough, it appears, to spur the House Financial Services Committee to hold hearings in March that examined the need for new legislation to keep hedge funds in check. It's all part of a movement by legislators and regulators that are trying hard to draw in the fences around hedge funds–over strenuous industry objections.

SEC's Attack

As hedge funds grew, so did concerns about their potential risk to investors and the economy. The origins of the concerns lay in the $4.4 billion loss that Long-Term Capital Management suffered in 1998 as a result of a devaluation of the Russian ruble. The Federal Reserve Bank bailed out the fund for fear of the impact on the global economy.

Several years later, the SEC came up with a rule requiring certain hedge-fund advisers to register as a means of improving the funds' transparency. But in June 2006, the D.C. Circuit vacated the rule in Goldstein v. SEC. The court reasoned “investment vehicles that remain private and available only to highly sophisticated private investors have historically been understood not to present the same dangers to public markets as more widely available public investment companies.”

Just weeks later, SEC Chairman Christopher Cox told the Senate Banking Committee he might need legislative help with hedge fund regulation. In September 2006, Secretary of the Treasury Robert Rubin announced the President's Working Group on Financial Markets would undertake a study of hedge fund activities.

When new legislation wasn't forthcoming by year's end, the SEC proposed new rules to tighten up the definition of “accredited investors” eligible to invest in hedge funds.

“Under these rules, an 'accredited natural person' would have to own at least $2.5 million in investments, and that figure would be adjusted every five years for inflation,” explains Perrie Weiner, partner at DLA Piper.

The SEC also began investigating whether banks and securities firms set strict enough limits on loans to hedge funds. And it turned out that the legislative initiatives weren't dead.

Congressional Oversight

In February Sens. Carl Levin, Norm Coleman and Barack Obama introduced the Stop Tax Haven Abuse Act.

“The legislation is aimed primarily at tax shelter abuses and not specifically at hedge funds, but it would nonetheless require hedge funds to put in place anti-money-laundering policies that are similar to those applicable to other financial concerns,” explains Margaret Paradis, a partner at Baker & McKenzie.

But the President's Working Group report, released in late February, endorsed a hands-off approach. The group–which includes the chairs of the Treasury Department and the SEC–reasoned that market pressures were the best way to deal with hedge fund risks.

Just a few weeks later, however, Sen. Charles Grassley introduced legislation to revive the repealed rule requiring hedge funds to register with the SEC. On March 13 the House Financial Services Committee held the first of a series of hearings on the subject.

To nobody's surprise, the industry panelists at the hearing were virtually unanimous in opposition to legislation. Perhaps to their own surprise, however, they got some very influential support.

In April, Federal Reserve Chairman Ben Bernanke, speaking at a conference on global economics in New York, came out in favor of a “light regulatory touch” on hedge funds because they deal with highly sophisticated investors.

About the same time, Simon Johnson, the International Monetary Fund's chief economist, said his organization was not calling for more regulation of hedge funds. And in anticipation of the annual G7 meeting in late April, Canada's finance minister, Jim Flaherty, eschewed the need for global regulations of hedge funds.

Finally, the much-respected former Federal Reserve chief Alan Greenspan is on record as being wary of any direct regulation of hedge funds.

“Most regulators, apart from the enforcement agencies such as the SEC, came out against congressional action largely because of fears that it would drive capital offshore,” says Steve Howard, partner at Thacher Proffitt & Wood.

Before long, the pressure for legislation looked as if it was starting to abate.

Election Jitters

“There's not much appetite on Capitol Hill for increased legislation,” says Houman Shadab, a senior research fellow at George Mason University.

Howard's view is that nothing will happen for at least two years.

“In an election year, hedge fund legislation is not a topic any candidate wants to get near because it won't get him elected,” he says. “It might happen if we get a Democratic president, but that's too far off to predict.”

Which is not to say that hedge funds are free and clear.

“The SEC isn't going to go away, but then you're only dealing with change at the regulatory level,” Brunjes says.