The New Regulatory Regime for Hedge Funds: Has the Sec Gone Down the Wrong Path?
Preiserowicz, Jacob, Fordham Journal of Corporate & Financial Law
Hedge funds, by and large unregulated up to this point, became subject to securities and Exchange Commission ("SEC") regulation as of February 2006. This same body regulates foreign funds with U.S. investors. Theoretically, the new amendments to the Investment Advisers Act of 1940 (the "Advisers Act") eliminate a registration loophole. This requires most fund managers to register with the sec, thereby placing them under its watchful eye. Regulation of the industry was not an unexpected and isolated decision; rather it can be viewed as the culmination of a period of industry turmoil and corporate fraud. Some examples of the more notable collapses and frauds during this period were the collapse of the hedge fund Long-Term Capital Management (LTCM),1 analyst conflicts of interest, market timing, Enron, Worldcom, Tyco, Adelphia, and Healthsouth. Ultimately, these incidents resulted in the enactment of Sarbanes Oxley ("SOX").2 The period of debate that led to the implementation of the additional regulation was filled with sharp criticism of the SEC's proposals from the hedge fund industry and from within the SEC.3 In fact, the amendments were only narrowly approved by a 3-2 vote of the SEC commissioners.4
Is regulation a good idea? This paper's analysis generates two alternatives. At its best, the SEC will be able to adequately protect the general investing public from an industry that is allegedly rapidly entering an era of "retailization" and that can greatly influence market movements due to the sheer scope and size of the industry. At its worst, regulation is a purely political move that plays off the public's fear of another "Enron" and threatens to obstruct a useful investment tool of the wealthy, as well as damage a useful market efficiency tool. While I am in favor of some form of regulation, primarily due to the influence that hedge funds have on the market, I do believe that political factors have contributed to a less than optimal regulatory structure. I believe that regulation should proceed as planned for the lower tier of hedge fund clients, while the upper tier should be able to participate in an industry free of regulation.
Part I is an overview of the hedge fund industry. This will address the current legal structure: how funds are structured so as to evade regulation. Part II addresses the sec's concerns and the subsequent regulations that were put in place to combat these concerns. Part III analyzes the justifications for sec regulation of hedge funds and whether these justifications are warranted. Part IV addresses the deficiencies in the new regulatory regime by proposing a modified regulatory structure.
I. OVERVIEW OF HEDGE FUNDS
A. Hedge Fund Basics
While almost universally referred to as hedge funds, a more fitting description of these investment vehicles would be "private investment partnerships."5 These partnerships are "relatively unregulated pooled investment vehicles in the form of limited partnerships or limited liability companies that have the flexibility to invest in a broad range of securities and commodities using a broad range of trading techniques."6 The funds generally cater to institutional investors, endowment funds and wealthy individuals. In fact, they are generally restricted to this group by law.7 Fund managers will often invest a significant portion of their own wealth into the fund to ensure alignment of interests with the fund investors.8
"Hedge fund" does not have a universally accepted definition and is not statutorily defined by the federal securities laws.9 The term "hedge" refers to the strategy of one of the first hedge funds established by Alfred Winslow Jones in 1949.'° A hedging strategy consists of purchasing a security and taking an offsetting position in a related security." A simple example of a common hedge involves taking a long position in a security and "hedging" the risk by simultaneously selling a futures contract.12 Today, the hedge fund industry is unified by a simple investment goal: they place an emphasis on absolute returns as opposed to relative returns. …