Do Hedge Funds Need To Be Better Regulated?

by Lei Wang October 22 2007, 12:53

Introduction

One of the hottest topics, when Wall Street recently saw a market turmoil, was whether hedge funds need to be more strictly regulated. As a special investment vehicle designed for large institutions and rich personal investors, hedge funds are notorious for their ruthless trading strategies aiming to reap as high absolute returns as possible, which usually came with very high risks. The financial leverages hedge funds often utilize had more or less contributed to almost every financial crisis we have faced in the last decades. Typical examples include the fall of Long Term Capital Management (LTCM) in late 1990s and its recent counterpart Amaranth in 2006.

 

Therefore, the world has recently seen a desire to put more strict regulations to curb hedge funds by most countries. This was well manifested by what was happening in Germany, which had already started a series of legislatorial moves “against” hedge fund. As Peer Steinbröck, the Finance Minister of Germany commented during G7 meeting of 2007, “any mistakes in the hedge funds’ calculations may well trigger off a vicious circle which will have negative implications similar, or even worse, than the financial crises we saw in the 1990s.” [1] There have been similar moves taken by Steinbröck’s counterparts in the States. For example Connecticut's attorney general, Richard Blumenthal, said after the fall of Amaranth, which lost 6 of its 9 billion assets in less than a week during Sept. 2006, "The facts about mammoth losses by Amaranth offer additional powerful and compelling evidence about the need to reform disclosure and oversight requirements [for hedge funds]." [2]

 

In this article, we will briefly review how hedge funds are currently regulated and what problems they have brought to the financial market. At the end, we will argue that based on what we have seen in the past collapses of hedge funds, restricting their operations by more harsh regulations might not be a good idea.

 

How hedge funds are regulated?

 

Contrary to what people generally call them, hedge funds are actually not “unregulated”. They are no less regulated than mutual funds, which are more familiar to most common people. The illusion that hedge funds lack regulation generally comes from the fact that hedge funds are exempt from certain laws. Before discussing the major problems facing the hedge fund industry, we need to review relevant legislatorial structures for hedge funds and understand why they are “exempt” from certain provisions.

 

First, a hedge fund is nowhere different from any other investment vehicles as a general investment company. It is regulated in two basic aspects: tax laws and securities laws. We will only focus on the part related to security laws in this article as tax issues themselves might bring much more complications in a un necessary manner.

 

Every hedge fund is regulated by the Security Act of 1933 since it is considered as a security. The difference of a hedge fund from another common security is that it usually registers itself under Regulation D as a “private placement”. This is the key different of a hedge fund from a mutual fund or a company publicly offered stock. Thus a hedge fund cannot be advised or offered to the general public. It is, by nature, a game for rich investors.

 

Secondly, a hedge fund is different from another investment company is that it usually qualifies itself for Section 3 (c)(1) of Investment Company Act of 1940[3], which relieves registration requirements if an investment company make distributions among less than 100 investors. Compared with most open-end mutual funds who allow any number of clients to buy their funds every day, hedge funds again demonstrate its intrinsic nature: small and private. The National Securities market Improvement Act of 1996[4] further added one more exemption from SEC registration in section 3 (c) 7 for any investment companies with unlimited client as long as each client has an a net worth of 5 million dollars. These two types of funds are thus nicknamed 3c1 fund and 3c7 funds, which are two most common types for hedge funds legal structures now. That’s also the reasons that people often call hedge funds “unregistered entities”.

 

Third, we review the Investment Advisers Act of 1940[5], which governs bookkeeping and reporting activities for investment companies. It also contains an exemption section 203 (b) 3, which relieves the reporting duties of a fund manager who has less than 15 client. As one hedge fund is usually counted as one client for that manager, most hedge funds are exempted again from reporting to SEC.

 

Besides the basic three Acts we have discussed, there are a few more things that distinguish a hedge fund from another investment vehicle, which could be summarized as liquidity constraints, trading restrictions and marketing restriction. (We will not go to details but interested readers can refer to the book All About Hedge Funds[6])

 

Now we are clear that the fundamental principle under regulating a hedge fund is to avoid unnecessary restrictions as long as it can be considered as activities among a small group of rich people, who can take risks and who have enough money not to become social burdens when their aggressive investment fails.

 

 

What are the most controversial issues?

 

Fall of hedge funds usually make headlines of media and received a lot of following coverage. As modern hedge funds become larger and larger, it seemed that they are bringing in instability. They might no longer look as a private group making investment.

 

When analyzing the fall of a hedge fund, two major problems have been discussed again and again. The first one is the high leverages hedge funds usually use to boost its gains. The famous fall of Long Term Capital Management in 1997 is a well-known example and the fall of Amaranth in 2006 seemed simply repeating the history. The hunger for high-leveraged position simply originates from the greed for high returns. Thus this remains one of the top problems for central bankers or security administrators in most countries.

 

Aside from that, financial industry often suffers from the issue that hedge funds usually don’t like to disclose their position or trading activities, or anything they can avoid to open. Since most hedge funds exploit certain proprietary trading models, they don’t want other people to follow or analyze their trading styles. Thus it is understandable that they don’t want to disclose their holding. But with almost opaque trading books, most financial problems could be deeply hidden. That’s what exactly happened during the asset-backed security crisis (mostly in the area of sub prime mortgage-backed securities) in this summer. Most investment banks had chosen to bail out their child hedge funds instead of disclosing their position for applying bankruptcy because they don’t want make their positions of asset backed securities public. 

 

Do we need more regulations?

 

Until this point, there is really not much we can do to better regulate the hedge fund sector. As we have discussed earlier, the first problem a hedge fund might bring is its high leverage. In today’s world, a default of a large leveraged position could be detrimental to the whole market and every single investor could be harmed from it. This argument is one crucial driving force for those who propose more regulations. However, hedge funds usually establish their high leveraged positions by mutual agreed contracts with other fully functional and consenting parties. There are no reasons that the legislators should forbid this. The banks or any institutions providing money or loans should automatically tighten their fund and restrict more on their lending requirement. Thus the situation should be considered as something the market could adjust to with better due diligence. There is indeed not much left to do for the regulators.

 

The second problem of reporting or disclosures is also difficult to regulate. If quarterly reports are needed from each hedge fund, it could results into ton of papers being sent to SEC. Such is hedge fund’s nature that it usually has very frequent account turnovers looking for quick and imminent profits. This will firstly first make it impossible for SEC staffs to examine all their trading activities or position. Secondly, most reported activities or position would be stale on a quarterly basis so the report itself could become useless. Thirdly, investors in hedge fund are usually rich people and they have necessary resources to carry out due diligence. The hedge fund should be willing to disclose their performance to potential clients and they are well capable of striking a good balance between keeping their strategies secret and marketing to a small circle of private investors. Therefore, requiring hedge funds to report to SEC or the general public is not necessary.

 

Aside from the two issues, we face more practical problems as to how a hedge fund is legally defined. One of the SEC’s requirement asking large hedge funds to register with them was struck down by a New York District Court because of exactly this reason. “The court specifically attacked the SEC's definition of the word ‘client’, saying regulators did not provide a detailed enough explanation of what the word means in the context of a hedge fund.”[7]. The court specifically attacked the SEC's definition of the word "client,'' saying regulators did not provide a detailed enough explanation of what the word means in the context of a hedge fund. It is also well known that there is only small difference between hedge funds and other private investment entities like private equity or venture capital, which differs in strategy but bear similar legal structures from hedge funds. Private equity and venture capital don’t bring troubles that hedge fund bring to us so that we can’t put the same regulations to all of them.

 

We conclude this article by how Timothy F. Geithner, the President of Federal Reserve Bank of New York, put it, “The fundamental challenge for policy is how to achieve the appropriate balance between efficiency and financial resilience.”[8] 


[1] Gabriel Rozenberg, German G7 hosts press for tighter hedge fund regulation, The Times, February 10, 2007, available at http://business.timesonline.co.uk/tol/business/economics/article1361621.ece.

[2] Ellen Florian Kratz, Hedge hunting season in Connecticut -- In the wake of the Amaranth disaster, Connecticut Attorney General Richard Blumenthal seeks to reform the hedge fund industry, Fortune, October 4, 2006, available at http://money.cnn.com/magazines/fortune/fortune_archive/2006/10/16/8388653/index.htm.

[3] 15 U.S.C § 80a-3 (2006).

[4] 15 U.S.C § 78a (2006) .

[5] 15 U.S.C § 80b (2006).

[6] Robert A. Jaeger, All About Hedge Funds : The Easy Way to Get Started (1st edition, 2002).

[7] Goldstein v. S.E.C.,451 F.3d 873, 877 (C.A.D.C. 2006).

[8] Timothy F. Geithner, President and Chief Executive Officer, Address at the Distinguished Lecture 2006: Hedge Funds and Derivatives and Their Implications for the Financial System (Sep. 15, 2006), available at http://www.ny.frb.org/newsevents/speeches/2006/gei060914.html.

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