Hedge Fund Forum

According to the SEC, “Alexander James Trabulse sent account statements to investors in his Fahey Fund that inflated the fund’s returns by as much as 200 percent, while using investor money to purchase cars and finance shopping sprees for his family members.”

www dot sec dot gov/news/press/2007/2007-203.htm

It is a illegal and unethical behavior that is common in hedge fund. They try to cover the loss and inflate the return to get the 2/20 management fee. In this case, the regulation helps to prevent the fraud.

Hedge Fund Investor Is A Prince; Hedge Fund Manager Is A Governor.

—-Newest Model for Hedge fund regulation from Roger B. Myerson.*

[My conversation with him occurred on April 24, 2008, Cambridge MA.]

As Roger says, he “consider[s] a model of governors serving a sovereign prince, who wants to deter them from corruption and rebellion.” In hedge fund world, I consider a model of hedge fund managers managing their investors’ money, who want to deter them from fraud and excessive risk.

In Roger’s article, “governors must be penalized when they cause observable crises, but a governor’s expected benefits must never go below the rebellion payoff, which itself is better than what any candidate could pay for the office.” In hedge fund industry, I think hedge fund managers have to be penalized when they cause obvious crises, but a hedge fund manager’s expected benefits must never go below the performance fee, which itself is much higher than the performance fee they could get from fraud.

According to Roger, “governors can trust the prince’s promises only up to a given credit bound.” In hedge fund world, I guess hedge fund managers can have faith in the investors’ loyalty only up to a given credit bound as well.

This paper goes on and on, and the content of the paper provides an alternative approach to regulate or self-regulate the hedge fund industry. He mainly use “an extension of the Becker-Stigler and Sharpiro-Stiglitz dynamic agency models” to address the issues with regard to “judging and punishing high officials of the state,”, which can be used to hedge fund managers as well.

 

As Roger Myerson writes, “For high officials to be deterred from abusing their power, they must be confident that loyal service will bring great expected rewards.” In hedge fund industry, I argue that in order to prevent hedge fund managers from defrauding investors, fund managers have to be confident that their honest disclosure will be greatly compensated.

Even though he did not mention hedge fund, this is a good model to consider in hedge fund industry.

*Roger B. Myerson, the 2007 Nobel Laureate in Economics. “Leadership, Trust, And Power: Dynamic Moral Hazard In High Office,” April 2008. <home.uchicago.edu/~rmyerson/research/power.pdf>

 

 

Assessing the Hedge Fund Industry Regulation Debate

By H.B. Zhang

The hedge fund industry, given its lucrative returns, secret strategies, and hefty fees, has raised the eyebrows of financial regulators and market observers.[1] The debate on the hedge fund industry regulation becomes more fascinating after two Bear Stern’s hedge funds went bankrupt in 2007, two Bayou’s founders were convicted of fraud in 2008,[2] and more hedge funds liquidated due to excessive risk and fraud. Despite these failures, the hedge fund had grown to a 2-trillion-dollar industry, according to John Paulson.[3] However, these failures have fueled a heated debate over hedge fund regulation, aiming at protecting investors from fraud and excessive risk, helping hedge fund managers to foresee potential risks, and ensuring the stability and integrity of the financial market. This paper will evaluate the discussion on hedge fund industry regulation by reviewing relevant academic literature.

 

According to the Securities and Exchange Commission (SEC), “hedge funds pool investors’ money and invest those funds in financial instruments in an effort to make a positive return.”[4] More broadly, a hedge fund is an investment vehicle that is not registered under the Investment Company Act of 1940 and that uses an array of investment strategies to achieve higher risk-adjusted returns than the average returns from a conventional portfolio of stocks and bonds. The problems in the hedge fund industry, such as acts of fraud, excessive risk taking, and lucrative fee structure, caught the public’s attention only after the collapse of the hedge fund Long Term Capital Management (LTCM) in 1998, founded by several Nobel Laureates in Economics.[5]

 

The debate over hedge fund industry regulation has intensified as incidents of fraud have increased, as excessive risk taking has threatened financial market, and as hefty fees have raised the eyebrows of market observers. Many people outside of the hedge fund industry know little about it; at the same time few insiders are willing to openly discuss the rise and ebb of the industry. The performance fee structure is particularly problematic because it encourages fund mangers to increase their returns on investment by any means, including excessive leverage. Although little is known about this industry’s secrecy, what is known is that hedge fund managers will use the most sophisticated strategies to generate absolute returns regardless of market directions. Among the various strategies include excessive leverage (debt-to-equity ratio), long and short positions, derivative trading, global currency trading, market timing, disseminating false news, algorithm trading, black-box trading, and usage of offshore structures. While the knowledge of these strategies will illuminate the discussion on regulation, this paper is not concerned with detailing these market strategies. The paper will focus on three major issues that have caught the eye of the market regulators, fund managers, and financial press; they are fraud, excessive risk, and incentive fee structure. The opposing parties in the debate are obvious: one argues for a regulatory scheme, whereas the other argues against it. Each side has advanced their arguments with cogent debate, and this paper will assess the merits of their opposing arguments.

 

The research involves surveying major law review articles for the debate regarding regulation.[6] On the non-regulation side, there are two dominant arguments. One opposes governmental regulation, while the other argues that market can regulate itself. On the regulation side, there are also two prevailing arguments. One proposes loose regulation with SEC guidance; the second proposes to give the SEC the authority to regulate the industry. In order to better understand the arguments and counter-arguments, one must first understand the concerns that have triggered the debate.

 

Generally, the concerns stem from the hedge fund industry characteristics, with which the fund generates higher returns than traditional stocks or bonds with lower volatility. For example, hedge fund managers on average can achieve higher returns than the S&P 500 Index, by hedging market risks. On the upside, the return is better than conventional investment vehicles, and the portfolio managers are also incentivized to take on excessive risk to collect management fees, 2% on assets under management and 20% on the return on capital.[7] On the downside, hedge funds induce more risk and fraud, and can undermine financial market stability because of the vast amount of the capital and the abuse of financial leverage. The hedge fund industry’s large size can really disturb the financial market in a dramatic way, either domestically or globally. The risk can wipe out investors in a few trading days, and the lack of disclosure can also prompt accounting fraud that deceives investors. These factors have caught the eye of the federal government and interest groups.

 

In theory, these three problems exist through the whole financial sector, but as SEC Chairman Christopher Cox noted, “we need to protect investors from fraud.”[8] We can see a relationship between the three factors in terms of how the hedge fund industry impacts investors, financial sector, and even larger market. These risks can cause serious consequences, which prompts the need for a risk-mitigating regulation mechanism. Fraud causes damage to the financial industry and the confidence of investors, and therefore needs to be deferred. High volatility of the market also confuses the investors and disturbs normal transactions in the market, and thus needs to be regulated in some way by someone. If these three factors impacting the financial market are met, regulation should be necessary in the sense of protecting investors, rebuilding investors’ confidence and market stability. If these factors are not met, one might leave the hedge fund industry alone. The following section will mainly focus on these three variables in terms of the hedge fund industry regulation debate.

 

Among the surveyed law review articles, there are three major concerns in the regulation debate. The authors, such as Kahan, Rock, Daiel, Verret, Paredes, and Edwards[9], oppose regulation, whereas the authors, such as Silverman, Desmet, Tiffith, J. Pearson, and T. Pearson, are in favor of the regulation.[10] Although each argues from a specific point of view, it is important to note the similarities and differences among their arguments.

 

When assessing similarities, there are four things to note. First, eight articles start off with the example of the bailout of the Long-Term Capital Management (LTCM) by the federal government. According to Paredes, Daniel, Tiffith, Verret, T. Pearson, J. Pearson, Desmet, and Edwards,[11] this catastrophic event triggered massive media and press coverage, and, in light of that fact, the White House, the House of Representatives, and the US Senate founded special committees to investigate the LTCM crisis. LTCM mattered so much in a way that this specific hedge fund was managed by two Nobel Laureates in Economics. Even the top economists could not foresee this crisis coming. In addition, the loss of billions of dollars of investment capital caught the attention of governmental agencies. Thus this event was cited in a majority of the articles surveyed since it caused the SEC to investigate the fraud and risk posed by the hedge fund industry.

 

Second, fraud is a common issue and concern that fascinates all authors in this debate. All the authors examined, such as Paredes, Daniel, Silverman, Tiffith, Desmet, Pearson, and Edwards,[12] mentioned acts of fraud by portfolio managers.[13] Different people define fraud differently. This paper is concerned with a narrow scope of fraud, defined as an act to deceive investors, rather than other types of fraud, as Kahan pointed out, “hedge funds have even sought appointment as lead plaintiffs in securities fraud class actions under the Private Securities Litigation Reform Act.”[14][15] while Skilverman, Tiffith, Desmet, and Pearson argue that the systemic risk of fraud can be prevented by regulation.[16] Therefore, fraud is an interesting topic that has intrigued everyone’s interest. Due to the illegal activities by some meticulous portfolio managers and traders, fraud was uncovered among many hedge funds in the last two years, and many lawsuits were brought by the SEC against several of those managers. Now the SEC proactively monitors and investigates the fraudulent acts of hedge fund managers in order to protect the integrity of the financial market and the investors’ confidence in the market. Kahan’s paper mentions fraud in some degree, even though they might not agree upon the issue of the industry regulation. More specifically, each one of them has a different focus. For example, Paredes argues that fraud is not serious enough to subject the hedge fund industry to SEC regulation,

 

Third, risk is also a common variable that all the authors cited in their papers extensively, from different angles, to justify either regulation or non-regulation. In terms of risks, Paredes argues that regulation after the Enron scandal is aligned with the preemptive approach.[17] The SEC is there to protect the market from the major risk brought by hedge funds. Kahan, Paredes, Daniel, Desmet, Pearson, and Edwards[18] all focus on risk in the debate, even though they may not agree upon the questionable regulation. As Robert Steel[19] said, “Risks posed by private pools of capital are best addressed through market discipline, disclosure and transparency, not through new laws, regulations or registration.”[20][21] However, SEC Chairman Cox, in response, warned that the hedge-fund risk was the potential threat to the retail investors, and recommended the SEC to assure the obligation to protect investors from the risks posed by the hedge fund managers.

 

Fourth, most of the law review articles relate the incentive fees to hedge fund fraud which is subject to regulation. All mentioned performance fees except David I. Silverman in different perspectives. The fees charged to investors are, under rule of thumb in the industry, 2 percent of the assets under management and 20 percent of the return on investment. Considering the minimum requirement to invest in a hedge fund is at least $750,000, the 2 percent is a decent paycheck, let alone the lucrative fees on the return on investment.[22] Being lured by this hefty fee, some hedge fund managers engage in meticulous behaviors, such as fraud, insider trading, or excessive leverage. This fee structure encourages fund managers to take fraudulent actions and excessive risks on the money they are managing. Most of the authors, such as Verret, Pearson, Desmet, Daniel, Tiffith, and Paredes,[23] mention this fee issue regardless of their views. The fee structure might bring some consequences to the hedge fund industry or it might bring bright future of the Wall Street, and it all depends on which author’s argument is adopted.

 

Overall, fraud, risk, and incentive fees are three issues and concerns written extensively in the law review articles. However, each scholar concludes differently from the reasons in proportion of the evidence they use. They do not have the comprehensive scheme to consider all different angles which might impact the destiny of the regulation on hedge fund industry. As noted here, the insufficient reasoning impediments the comprehensiveness of the SEC’s regulation scheme. This limitation can be overcome by collaborating all works to the extent that the reasoning of regulation should be based upon.

 

Besides the reasons and logic behind the debate, there is also the difference, which is another common characteristic of the scholarly articles. The proposal brought by each scholar is usually different, but there are four areas in all. See the figure below.

 

Hedge Fund Regulation

Yes

No

Standard Regulation

No Regulation

Strengthening Regulation

Market-oriented Self-regulation

 

 

On the regulation side, some propose not only to regulate, but also to strengthen the regulation. On the other side of the debate, there are also two voices. One proposes no regulation, whereas the other is supportive of a self regulatory scheme. There are total four types of proposals in the rich law review articles surveyed.

 

First, some authors are regulation advocates. Authors, such as Silverman and Desmet,[24] are in favor of this way. In addition, T. Pearson and J. Pearson are strong supporters of enhancing regulation.[25] They all argue that regulation, such as registration of hedge fund with the SEC, will mitigate risk of volatility brought by hedge fund, will prevent future fraud, and will protect investors from paying expected fees that are orchestrated. For example, Silverman mentioned that “recent high profile hedge fund frauds have highlighted the need for greater regulatory involvement.”[26]

Second, some authors are in favor of loose regulation under the SEC’s guidance. Tiffith concerns with this approach. He said that, “it made sense that regulators such as the FSA and the SEC provided limited regulation to allow them to flourish.”[27] By doing this, investors can be protected, market risk can be predicted, and fraud can be mitigated to the least degree. It is a neutral approach, comparing to the strengthening approach above by Pearson.

 

Third, some authors are against regulation. Kahan and Rock[28] are in favor of this approach. They argue that “at this point, no regulatory intervention is warranted.”[29] The regulation is not justified simply by citing risk and fraud, even the degree of the fraud is not warranted to regulation.[30] According to their article, market allows the existence of fraud and risk to prevent the federal government from overregulation. In their own words, “there is no cost for the SEC to over-regulate.”[31] By writing that, this approach is the direct counter-argument of the regulation.

 

Fourth, some authors propose self-regulation to the extent that market can regulate itself, even though they oppose the regulation by the governmental agencies. Daniel, Verret, and Paredes argue for this approach.[32] Edwards is closer to this approach even though her proposal is neutral. They all mention that the cost is too high to regulate, and that this current regulation can prompts to future’s over-regulation by the federal government as precedent. It is rather let the market to decide the outcome rather than let the government involve in the regulation issue.

 

Overall, the difference or divergence among those three variables can reiterate the debate on hedge fund industry regulation. By noting the difference, we can better understand the effects of regulation in terms of mitigation of fraud and risk, and protection of investors and markets.

In addition, there is one limitation among those law review articles. All authors are using their reasoning to conclude their arguments, however what seems unsatisfactory is that they all ignore the positive side of the hedge fund itself. It is true that fraud and risk is substantial, and market integrity and confidence is also important. However, the authors’ analysis justifies their positions only in a narrow sense since they do not consider any potential benefits of hedge funds. Without introducing benefits of hedge funds into the debate, the authors do not fairly craft sound research designs, or present balanced views of central issue on the hedge fund industry regulation.

 

According to the synthesis, these ten law review articles are from top-notch ones in the database to fuel the debate on hedge fund industry regulation. By considering these three variables—risk, fraud, and fees—some authors, such as Silverman, Tiffith, Desmet Pearson,[33] think they are problematic. However, some authors, such as, Kahan, Rock, Daniel, Veret, Paredes, and Edwards,[34] do not think the risk is severe enough to justify regulation.

 

Also, it is interesting to note that all the authors cited in this paper are using the three major concerns, suchas fraud, risk, and incentive fees, to argue for or against the hedge fund industry regulation. Some authors stressed the severity of the risk and fraud to justify the regulation, whereas some argue that the costs of overregulation are much higher than the benefits of mitigation of risk and fraud. It is fascinating to see the different perspectives by using the “same” evidence.

 

Given the analysis above, the further research is to design an experiment to analyze the impact of the regulation on the market. The further research study will provide a more pragmatic way to deal with fraud and risk. It can also be used as a guide book for the hedge fund managers to foresee potential risk and fraud in their portfolios. It further serves a potential guideline for the SEC to regulate the industry.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

References:

David I. Silverman, “Developments In Banking And Financial Law: 2005: III. Hedge Fund Industry,” 25 Ann. Rev. Banking & Fin. L. 21, 2006.

J.W. Verret , “Dr. Jones And The Raiders Of Lost Capital: Hedge Fund Regulation, Part II,A Self-Regulation Proposal,” 32 Del. J. Corp. L. 799, 2007.

Lartease Tiffith, “Hedge Fund Regulation: What The FSA Is Doing Right And Why The SEC Should Follow The FSA’s Lead,” 27 Nw. J. Int’l L. & Bus. 497, Winter 2007.

 

Laura Edwards, “Looking Through The Hedges: How The Sec Justified Its Decision To Require Registration Of Hedge Fund Advisers,” 83 Wash. U. L. Q. 603, 2005.

Marcel Kahan and Edward B. Rock, “Hedge Funds In Corporate Governance And Corporate Control,” 155 U. Pa. L. Rev. 1021, May 2007.

Recent Case: Administrative Law – Judicial Review of Agency Rulemaking – District of Columbia Circuit Vacates Securities and Exchange Commission’s “Hedge Fund Rule.” – Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). 120 Harv. L. Rev. 1394, March 2007.

Sargon Daniel, “Hedge Fund Registration: Yesterday’s Regulatory Schemes For Today’s Investment Vehicles,” 2007 Colum. Bus. L. Rev. 247, 2007.

 

Thierry Olivier Desmet , “Understanding Hedge Fund Adviser Regulation,” 4 Hastings Bus. L.J. 1., Winter, 2008.

 

Thomas C. Pearson and Julia Lin Pearson, “Protecting Global Financial Market Stability And Integrity: Strengthening SEC Regulation Of Hedge Funds,” 33 N.C.J. Int’l L. & Com. Reg. 1., Fall, 2007.

Troy A. Paredes, “On The Decision To Regulate Hedge Funds: The Sec’s Regulatory Philosophy, Style, And Mission,” 2006 U. Ill. L. Rev. 975, 2006.

---

[1] Note from my previous article review paper for Prof. Joe Bond, 2008.

 

[2] Bayou was one of the largest hedge funds in the US. Bloomberg Financial News. April 13, 2008. <http://www.bloomberg.com/apps/news?pid =20601087&sid=aVlLdx7bzyzo &refer=home> (accessed April 13, 2008).

 

[3] This conversation occurred at Harvard Business School in April, 2008. John Paulson is a hedge fund manager, and made billions on Subprime.

 

[4] The Securities and Exchange Commission official website, March 30, 2008. <http://www.sec.gov /answers/hedge.htm> (accessed March 30, 2008).

 

[5] Thomas C. Pearson and Julia Lin Pearson, “Protecting Global Financial Market Stability And Integrity: Strengthening SEC Regulation Of Hedge Funds,” 33 N.C.J. Int’l L. & Com. Reg. 1. 2007.

 

[6] Incidentally five authors are against regulation, while five are in favor of regulation. See the references section at the end of this paper.

 

[7] This conversation occurred at Harvard Business School in April, 2008. John Paulson is a hedge fund manager, and made billions on Subprime.

 

[8] A conversation with him at Harvard Kennedy School, Spring, 2008.

 

[9] See the reference section at the back of the paper.

 

[10] Ten articles are selected from the top law reviews in the US recently. See the reference section at the back of the paper.

 

[11] See the references section at the back of the paper.

 

[12] Ibid.

 

[13] Ibid.

 

[14] Marcel Kahan and Edward B. Rock, “Hedge Funds In Corporate Governance And Corporate Control,” 155 U. Pa. L. Rev. 1021. 2007

 

[15] Troy A. Paredes, “On The Decision To Regulate Hedge Funds: The Sec’s Regulatory Philosophy, Style, And Mission,” 2006 U. Ill. L. Rev. 975. 2006.

 

[16] See references section at the back of this paper.

 

[17] Troy A. Paredes, “On The Decision To Regulate Hedge Funds: The Sec’s Regulatory Philosophy, Style, And Mission,” 2006 U. Ill. L. Rev. 975. 2006.

 

[18] See the reference section at the back of the paper.

 

[19] Robert Steel is the Undersecretary of Treasury.

 

[20] J.W. Verret , “Dr. Jones And The Raiders Of Lost Capital: Hedge Fund Regulation, Part II,A Self-Regulation Proposal,” 32 Del. J. Corp. L. 799, 2007.

 

[21] Thierry Olivier Desmet , “Understanding Hedge Fund Adviser Regulation,” 4 Hastings Bus. L.J.1., Winter, 2008.

[22] This conversation occurred at Harvard Business School in April, 2008. John Paulson is a hedge fund manager, and made billions on Subprime.

 

[23] See the reference section at the back of the paper.

 

[24] See the references section at the end of this paper.

 

[25] Thomas C. Pearson and Julia Lin Pearson, “Protecting Global Financial Market Stability And Integrity: Strengthening SEC Regulation Of Hedge Funds,” 33 N.C.J. Int’l L. & Com. Reg. 1. 2007.

 

[26] David I. Silverman, “Developments In Banking And Financial Law: 2005: Iii. Hedge Fund Industry,” 25 Ann. Rev. Banking & Fin. L. 21, 2006.

 

[27] Lartease Tiffith, “Hedge Fund Regulation: What The FSA Is Doing Right And Why The SEC Should Follow The FSA’s Lead,” 27 NW. J. INT’L L. & BUS. 497, Winter 2007.

 

[28] See the reference section at the back of the paper.

 

[29] Marcel Kahan and Edward B. Rock, “Hedge Funds In Corporate Governance And Corporate Control,” 155 U. Pa. L. Rev. 1021, May, 2007.

 

[30] Ibid.

 

[31] Ibid.

[32] See the reference section at the back of the paper.

 

[33] See the references section at the end of this paper.

 

[34] Ibid.

Hank Paulson, US Treasury Secretary,  proposed a new loose regulatory scheme for the hedge fund industry yesterday to improve the processes and transparency. Among areas include risk, valuation, disclosure, and fraud.

(Source: Associated Press. Washington. “Paulson unveils hedge fund guidelines–Investor group, advisory panel propose ‘best practices’ for fund managers and investors.” 4.15.08)

Hedge Fund Regulation Is Necessary.

ARTICLE: Protecting Global Financial Market Stability and Integrity: Strengthening SEC Regulation of Hedge Funds . BY: Thomas C. Pearson and Julia Lin Pearson.

33 N.C.J. Int’l L. & Com. Reg. 1
“proposes regulation to provide ordinary investor protection against fraud, to improve market efficiency through increased disclosure by hedge funds, and for other rules of conduct and governance for greater integrity in the market.”
“This article proposes more effective solutions involving a coordinated international approach to hedge fund regulation. The hedge fund regulations proposed in this article aim to achieve a reliably stable financial system, financial market integrity through greater transparency, and protection for all investors from fraud.”
[yes regulation, but enhancing it.]

DEVELOPMENTS IN BANKING AND FINANCIAL LAW: 2005: III. HEDGE FUND INDUSTRY . BY: David I. Silverman. 25 Ann. Rev. Banking & Fin. L. 21
“Hedge fund fraud has become a significant cause of concern for the SEC”
“Recent high profile hedge fund frauds have highlighted the need for greater regulatory involvement.”
[yes regulation]

COMMENT: Hedge Fund Regulation: What the FSA Is Doing Right and Why the SEC Should Follow the FSA’s Lead. By: Lartease Tiffith. 27 NW. J. INT’L L. & BUS. 497
“The SEC is overlooking more important concerns: market risk, liquidity risk, the lack of capital requirements, and excessive economic leverage.”
“how the near collapse of Long-Term Capital Management (“LTCM”) was the first major indication to the U.S. Securities and Exchange Commission (“SEC”) and United Kingdom’s Financial Services Authority (“FSA”) that some type of regulation of hedge funds was needed”
“it made sense that regulators such as the FSA and the SEC provided limited regulation to allow them to flourish”
[yes regulation, but limited guidance]
ARTICLE: UNDERSTANDING HEDGE FUND ADVISER REGULATION. By: Thierry Olivier Desmet. 4 Hastings Bus. L.J. 1
“despite these numerous objections to domestic hedge fund adviser regulation, and before the D.C. Circuit’s fateful ruling, much of the hedge fund industry was at peace with the fact that such regulation was unavoidable and was here to stay”
“After reviewing the matter closely the Commission concluded that hedge funds may pose a threat to investment consumers and to financial stability and attempted to act proactively and responsibly to avoid unnecessary harm to investors.”
“the Commission unanimously adopted a new antifraud rule under the Advisers Act, designed to protect investors in pooled investment vehicles.”
[yes regulation]

RECENT CASE: Administrative Law – Judicial Review of Agency Rulemaking – District of Columbia Circuit Vacates Securities and Exchange Commission’s “Hedge Fund Rule.” – Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). 120 Harv. L. Rev. 1394

“because of the many forms that these funds take and their incentives to embrace secrecy and avoid regulation, legislation will almost certainly fail to anticipate future trends. Administrative regulation is a viable solution.”
[yes regulation]