There is a high likelihood that some regulations will be imposed on hedge funds in the US. The question is not so much if there will be regulation, but when and how much. This article considers the factors driving regulation.

KEY POINTS

  • A number of factors, taken together, have created an environment that is ripe for regulation.
  • Any hedge fund regulation is likely to resemble the Hedge Fund Rule invalidated in June 2006, and may well include provisions intended to ‘protect’ pension funds and individual investors.

Why is regulation inevitable? There are a number of factors, including:

  • Industry growth and the increasing influence of hedge funds in the capital markets.
  • The absence of genuine regulatory oversight.
  • The changed political landscape.
  • Increased participation by public pension funds and corporate pension plans.
  • Continuing instances of fraud and blow-ups.
  • The lack of transparency.
  • Increasing complexity and concerns of systemic risk.

All of these factors, taken together, have created an environment that is ripe for regulatory oversight. Of course, this does not mean that hedge funds should be regulated. Indeed, there are good arguments that hedge fund regulation is not necessary, and may even be imprudent. Opponents of regulation have argued persuasively that, among other things, hedge funds provide benefits, such as market liquidity, and that regulation will simply drive hedge funds offshore.

There is also a growing concern among market participants about the effect of regulations on the competitiveness of the US capital markets. For example, this past November, the Committee on Capital Markets Regulation, an independent group, issued a report raising a host of concerns about the deleterious impact of the US regulatory and legal systems on the capital markets. The Economist ran a similar cover story in late November. Concerns about excessive regulation, however, do not necessarily augur support for no regulation.

Complicating things further, the last attempt to regulate hedge funds – in the form of the Securities and Exchange Commission’s (‘SEC’) Hedge Fund Rule – is widely viewed as a debacle. The District of Columbia (‘DC’) Circuit Court of Appeals invalidated the rule five months after it became effective. Proponents of regulation will no doubt proceed cautiously to avoid a repeat.

Certainly, the push to regulate hedge funds will face some headwinds. The pragmatic view, however, is that hedge fund regulation is inevitable. The real question is: what will the regulation look like? Preparations for that battle are just beginning.

THE FACTORS DRIVING REGULATION

Industry growth

As the SEC has pointed out, there is little reliable data on the number of hedge funds or the amount of hedge fund assets under management. Some estimate that there are 6,000 to 7,000 hedge funds with more than $1trn in assets under management today, compared to an SEC estimate of 400 funds with a collective $50bn under management in 2002.

With this extraordinary growth, hedge funds have gained increasing influence over many sectors of the capital markets. Some reports indicate that hedge funds on any given day account for more than one quarter of all trading volume on the New York Stock Exchange and a majority of the trading volume in US distressed debt markets and exchange traded funds. Hedge funds are also major market participants in credit derivatives, foreign-exchange and Treasury.

This growth of hedge funds has transformed the industry into a major component of the capital markets structure, and an entire industry has sprung up to service hedge funds. While this growth of hedge funds is not a negative fact in and of itself, it begs the question: why is such a growing and influential sector of the capital markets largely unregulated, when other sectors are regulated?

The absence of genuine regulatory oversight

The US Court of Appeals for the District of Columbia invalidated the Hedge Fund Rule in June 2006 (Goldstein v Securities and Exchange Commission, 451 F.3d 873 (DC Cir 2006)). The structure of hedge funds as limited partnerships was critical to the court’s decision. The issue, put simply, was whether limited partner investors in a hedge fund were ‘clients’ of the hedge fund adviser. The court ruled that limited partner investors were not clients of the adviser; rather, the fund itself is the client of the adviser.

This decision has broad ramifications. First, the decision limits the SEC’s oversight over hedge funds. While the SEC still has jurisdiction over hedge funds, and hedge funds are still subject to anti-fraud provisions found within certain statutes, there is no formal regulatory scheme for hedge funds in the US. (Hedge funds and their advisers that are commodity pool operators or commodity trading advisers are subject to registration with the National Futures Association and the Commodity Futures Trading Commission).

Second, the Goldstein court’s decision extends beyond simply invalidating the Hedge Fund Rule. The court ruled that the adviser owes its fiduciary duties to the fund itself, not the individual limited partner investors in the fund, for the purposes of the Investment Advisers Act of 1940. This ruling has generated significant debate among commentators and observers, and will likely be the subject of future litigation.

Third, in the wake of the Goldstein decision and the high-profile blow-up of Amaranth in September 2006, where the fund lost billions of dollars in the span of a week, several lawmakers have called for legislation to provide greater oversight for hedge funds.

These lawmakers now find themselves in positions of power following the national elections in November.

The changed political landscape

In the November elections, the Democrats took control of both the House of Representatives and the Senate. As a result, Congressman Barney Frank is in line to become Chairman of the House Financial Services Committee, which oversees all of the nation’s financial services sectors.

Congressman Frank seems interested, at a minimum, in evaluating the possible regulation of hedge funds, but where it falls on his list of priorities is unclear. In June 2006, shortly after the Goldstein decision was issued, and in direct response to the decision, he introduced legislation ‘to authorise the registration and monitoring of hedge funds’. The proposed legislation sought to enact, in essence, the invalidated Hedge Fund Rule by amending the Investment Advisers Act of 1940.

More recently, The Miami Herald reported in November that the hedge fund industry expected Congressman Frank to support a bill that would require four federal agencies to make a recommendation whether hedge fund regulations are needed. Similarly, The Seattle Times quoted Mr Frank in a November article as saying ‘The overall regulation of hedge funds is not on the agenda . . . You’re talking about very wealthy people who want to gamble with their money.’ Nevertheless, the same Times article stated that Mr Frank ‘wanted the financial services panel to examine pension-fund investments in hedge funds’.

Increased participation by pension funds

The growth in hedge fund assets has been fueled, in part, by the increasing participation of public, and private, pension plans. According to various reports, more pension plans are investing in hedge funds, and those that have already invested are increasing their allocation percentages. As such, hedge funds can no longer be viewed exclusively as private investment pools ‘for the wealthy’. The retirement plans of the average worker have increasing exposure to hedge funds. Again, this is not negative event in and of itself, but it increases the likelihood that politicians and regulators will feel some obligation to oversee, if not control, the hedge fund industry.

The spectacular blow-up of Amaranth in September 2006 brought heightened focus on pension plans’ investments in hedge funds. Many pension plans had invested in Amaranth, either directly or through funds of funds. If the next hedge fund failure includes public pension plan investors, the pressure on politicians and regulators to ‘do something’ will only increase.

Continuing instances of fraud and blow-ups

The amount of litigation involving hedge funds has increased substantially. The number of SEC enforcement actions involving hedge fund advisers has increased, according to comments made by SEC Chairman Cox. Similarly, since the beginning of 2005, at least seven hedge fund frauds and collapses have resulted in major litigation: Wood River, Bayou, Portus, KL Financial, Philadelphia Alternative Asset Management, Durus and International Management Associates. In addition, the failure of Refco has sparked litigation involving a number of Refco-affiliated hedge funds, whose investors suffered significant losses.

It would be a mistake to dismiss this increase in litigation as a product of, say, the American legal system. In each of the cases listed above, the investors suffered actual losses and the case of fraud, or other wrongdoing, appears to be quite strong.

Something more is at play. In securities litigation parlance, the structure of hedge funds can provide a motive and opportunity for fraud or other misconduct.

Lack of transparency

Most hedge funds provide little, if any, transparency. With few exceptions, US-based hedge funds are structured as private investment partnerships. The investors are limited partners in a limited partnership, which is commonly called the ‘fund’. The general partner of the fund, which is generally an affiliate of the ‘hedge fund adviser’, manages the fund.

Limited partners in a hedge fund are passive investors who generally have no control over management of the fund, unlike mutual funds, which have independent boards and whose shareholders must approve certain actions. Indeed, hedge fund investors are frequently in the dark about actual investments. Limited partner investors often have no visibility into the strategies and positions of hedge funds, again unlike mutual funds which require transparency for their investors.

Funds often justify this lack of transparency on the grounds that the trading strategies and positions are ‘proprietary information’. Many investors view this lack of transparency as an acceptable trade-off for superior performance. Fraudsters, however, have repeatedly taken advantage of investors’ acceptance of investment opacity.

Hedge funds are also opaque on a market level. As unregulated private partnerships, hedge funds have no obligation to report market positions. This opacity has created challenges, such as managing liquidity risk, for regulators and counterparties. Federal Reserve Chairman Bernanke acknowledged these challenges in his remarks at the Federal Reserve Bank of Atlanta’s 2006 Financial Markets Conference. Chairman Bernanke took a dim view of one proposal to address this market-level opacity:

‘A system in which hedge funds and other highly leveraged market participants submit position information to an authority that aggregates that information and reveals it to the market would probably not be able to address the concern about liquidity risk.’

In addition to opacity at the investor level and the market level, most investments in hedge funds are illiquid. The redemption process for limited partnership shares is governed by the limited partnership agreement, and some funds require multi-year ‘lock-ups’. In addition, there is no liquid market for limited partnership units in a hedge fund, unlike shares in mutual funds, stocks or other securities. Th us, getting capital out of a hedge fund can be far more difficult than selling shares in a mutual fund or a publicly traded corporation.

Further, the rich fee structure that most hedge funds impose – commonly 2 per cent of assets and 20 per cent of profits – rewards results and attracts the most talented managers. It can also encourage negative behaviours, such as excessive risk taking and ‘aggressive’ accounting. Amaranth provides an excellent example of the pitfalls of excessive risk tasking while Bayou is an example of accounting fraud.

At a time when hedge funds are renowned for their lack of transparency and incentives for risk taking, they are, ironically, among the biggest participants in the most complex areas of the capital markets.

Complexity

The capital markets have become increasingly complex in the last decade. In July 2005, a policy group comprised of leading professionals from Wall Street, called the Counterparty Risk Management Policy Group II (‘CRMPG’), issued a report that underscored many of the risks that are endemic to hedge funds.

This report echoed a report by the staff of the SEC – ‘Implications of the Growth of Hedge Funds’– issued in September 2003. The CRMPG repeatedly returned to a single theme: complexity in the financial markets and its impact on the stability of those markets.

Hedge funds, as a whole, have contributed to this market complexity, through their use of new financial products, leverage and expectations of continued liquidity. According to the CRMPG, the market for complex financial products, such as credit derivatives, has grown exponentially since 1999. Credit derivatives, and similar products, ‘pose challenges for risk measurement and pricing’. Hedge funds are major participants in the credit derivative markets.

The SEC has observed that many hedge funds employ leverage strategies to increase returns, but leverage can also magnify investment losses. Unlike Registered Investment Companies, there are no restrictions on the amount of leverage that a hedge fund may employ, beyond what a lender or counterparty will permit. Leverage can be particularly devastating in connection with illiquid securities, because valuing such securities can be difficult and selling under pressure can produce losses, as in Amaranth and Long Term Capital Management.

The CRMPG observed that many hedge funds ‘now have sizeable investments and assets that are highly illiquid even in normal market conditions.’ As such, hedge funds and investors may be underestimating the risk of a liquidity crisis, where the market for an asset suddenly dries up.

The CRMPG specifically highlighted so-called ‘crowded trades’ as a significant risk factor. In a crowded trade, many different firms independently ‘put on’ the same trade or set of correlated trades. If they all attempt to unwind their positions simultaneously, liquidity can evaporate, leading to rapid, unanticipated price changes. Crowded trades are difficult to detect, and are often characterised by preliminary periods of (illusory) low volatility and increased liquidity. Given the growth of hedge funds, and their demand for complex financial instruments, a sudden flight to quality – as in 1998 – could have a severe impact on the liquidity and price of assets held by hedge funds.

WHAT WILL REGULATION LOOK LIKE?

It would take a crystal ball to assess what hedge fund regulation will look like.

We can, however, make an educated guess. Given that Congressman Frank will likely chair the House Financial Services Committee, and he already filed a Bill to enact the elements of the Hedge Fund Rule, any hedge fund regulation in the United States will likely bear more than a passing resemblance to the Hedge Fund Rule. As such, hedge fund advisers would probably have to register with the SEC and submit to periodic examinations. Hedge funds would probably not have to provide information on trading strategies or market positions.

It is also possible that Congress may require more disclosure from those funds that ‘accept’ pension dollars. It is also foreseeable that Congress may increase the qualifying standards for individual investors, which Congressman Frank has mentioned.

All bets are off , however, in the event of an industry-wide scandal, or a financial shock traceable to hedge fund activities. In such an event, Congress may impose a regulatory scheme that is far more onerous than the Hedge Fund Rule.

In the end, when it comes to what the regulation will look like, anything can change. What is not likely to change is that regulation is coming.

Timothy W Mungovan and Jonathan Sablone are partners at Nixon Peabody LLP, and co-chair the Firm’s Investment Partnership Litigation Team. Between them, they have handled dozens of investment partnership disputes and are involved in several of the most high-profile hedge fund failures.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.