Working Paper No. 09-62:
Dr. Jones and the Raiders of Lost Capital: Hedge Fund Regulation, Part II, a Self-Regulation Proposal

Author(s):

J.W. Verret

Date Posted: December 2009

Availability:
Abstract (below) | Full text (most recent) on SSRN

Abstract:

Hedge funds are a fairly new asset class utilized by institutional investors and wealthy individuals. These funds can sometimes achieve remarkable returns. However, the market practice for fund managers is to charge performance fees that greatly exceed any other investment type in the financial services sector, leading some hedge fund managers to engage in illicit behavior, including fraud, that violates their duty to their investors and tempts institutional investors to violate their fiduciary duty to their principals.

This exploration examines a registration requirement, previously instituted by the Securities and Exchange Commission (SEC) to combat instances of hedge fund fraud, which was struck down during the summer of 2006. This study relies on a survey of general literature on financial regulation, specific commentary on the hedge fund regulatory reforms instituted, models of self-regulation, and analogous examples in other areas of financial regulation that have been successful. The result is a critique of the previous regulatory regime and proposals that will make it more effective.

The rapid expansion of hedge fund investments is transforming the price discovery function of the securities markets, resulting in more efficient valuation and robust flows of capital. However, these innovative strategies morph so rapidly and operationally they are so much leaner, that the simple regulatory strategies of the Securities Acts of 1933, 1934, and 1940 do not lend themselves to cookie cutter application. Further, the decision makers are sharply divided. The Administration has taken a firm stance in not supporting hedge fund regulation. Congress, under Democratic control, has signaled that it is clearly interested in advancing regulation. The SEC, under its previous chairman, was 3-2 in favor of added regulation, though the United States Court of Appeals for the District of Columbia subsequently overturned the form as it was adopted. The current chairman does not support hedge fund registration.

The future consequences of this market shift are far from certain. The challenge is crafting a lasting and expensive governmental administrative structure with justification that must rest, in part, on faith in a particular regulatory philosophy or market efficiency theory. The present incarnation of the market dynamic is entirely novel. Maybe we will institute a regime that will constrain the benefits hedge funds offer. Maybe we will continue to fly blind across a cliff that will make previous financial disasters look like child's play. Risk is part of the financial regulatory game just as much as it is the essence of finance itself. The only reasonable response is to learn from what worked in the past and attempt to model the variables that will persist in the future. Therefore, I am proposing a mean between the thus far advanced regulatory philosophies, using principles we find by analogy in other areas of financial regulation.

A self-regulatory model that utilizes the inherent advantage of firms regulating each other is a major theme of the policy recommendations presented. Crafting regulatory safe harbors, permissive information access, and designing legal defenses that encourage the operation of a self-regulatory entity to monitor this industry can help to overcome the severe disadvantage that bureaucratic regulators face in this field.