PrintSummary: Based on statements by the Administration and the SEC, analyzes potential consequences of requiring hedge funds and other managers of private funds to register with the SEC. The analysis notes that proposal largely defers the details so that the impact will depend on the interpretations and enforcement that the SEC adopts after the legislation is passed.
Given the administration’s proposed foundation for Financial Regulatory Reform, the presence of multiple bills in Congress, and the vocal acquiescence of the hedge fund industry itself, it appears certain that most hedge fund advisers will be required to register under the Advisers Act by year-end. The prospects are sketchier, but comments from Mary Schapiro at the SEC and some of the legislative momentum indicate that the funds themselves may be required to register under the 40 Act. Hedge Fund registration of either sort obviously isn’t an end in itself, however – the response of the industry and any cost/benefit assessments will depend on what is to follow registration.
For example, registration could be a precursor to having the regulators / SROs increase their oversight of individual hedge fund activity. For the more visible recent problems like Madoff and Stanford Financial, however, the primary problem seems to have been gaps in the effectiveness of the oversight performed in its ability to achieve the twin goals of protecting investors from abuses and protecting the system from catastrophic risks.
The secondary problem has been the high compliance cost imposed on registered entities to achieve these limited benefits, as documented in SIFMA’s study of the Costs of Compliance in the securities industry. The recent scandals clearly undercut many assumptions underlying the asserted value of the hedge fund regulation already in place.
Given access and repeated guidance, regulators who arguably focused more on monitoring technical compliance than detecting intentional fraud were unable to find the what should have been obvious problems at Madoff. Many of the sophisticated accredited investors, institutions and even funds-of-funds who are presumably able to look out for themselves also were unable to spot, or simply overlooked, the red flags at Madoff’s firm (though the smart money appears to have known there was a problem).
The resulting impact on investors demonstrates the need to do better on the first goal of regulation – to protect investors. Unfortunate stories from many of Madoff’s victims undercut the idea that we can safely rely on “accredited” investors to have the requisite sophistication to deal with a fund just because they have sufficient assets.
Conversely, in all of the recent references to hedge funds, it’s hard to find an issue with the second goal – to protect against a material systemic impact during a downturn that results from the conduct of individual funds.
It could be argued that the pattern of fund transactions to implement certain strategies increased the pressure on some stocks, industries or the market in general at inopportune times, but this type of systemic exposure across firms (as with CDSs during the present crisis or historically with portfolio insurance in 1987) is not something highlighted in the Administration’s document or Congressional proposals. Instead, their focus is on identifying firms whose individual conduct or failure has the potential to materially harm the system. To obtain the ability to identify hedge funds in this category is one key reason given for requiring registration and filings by hedge funds.
Thus, the utility of any new filing requirement remains to be demonstrated as the Congress, Administration and the regulators specify what consequences will follow from the all-but inevitable requirement to register, and what added capabilities will be developed by the regulators to productively use their added leverage.
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