A Self Regulation Proposal for the Hedge Fund Industry

This post comes to us from J.W. Verret. The text of this post summarizes the author’s analysis from an article titled Dr. Jones and the Raiders of Lost Capital: Hedge Fund Regulation Part II, A Self-Regulation Proposal, which will be published in volume 3 (2007) of the Delaware Journal of Corporate Law.

In 2003, The Securities Exchange Commission instituted a regulation requiring certain hedge funds, previously unregulated, to register as Investment Advisers. That regulation would have meant that funds would have become subject to an intense compliance inspection program. The SEC’s stated goals in instituting this proposal were to minimize instances of fraud perpetrated by hedge funds. Critics of hedge fund registration, such as former Fed Chairman Greenspan, urged that over-regulating hedge funds could mean stifling the liquidity that these funds bring to the securities markets. Other critics argued that hedge funds may have simply moved offshore to avoid the regulation. In the summer of 2006, the District of Columbia Court of Appeals invalidated the 2004 registration provision in Goldstein v. SEC. Since that time, the House Committee on Financial Services, chaired by Rep. Barney Frank, has held hearings into hedge fund regulation. The Administration has announced its intention not to support a further regulatory effort. Though the branches of government are currently at odds, this issue is not likely to go away, especially if Congress and the Executive branch are controlled by the Democratic Party after the ’08 elections.

In the last ten years, nearly 2 trillion investment dollars have flowed into an industry that found itself at the center of a mutual fund fraud investigation in 2004 and now has a starring role in the subprime lending crisis. Anticipating future regulatory efforts, this article intends to design a regulatory scheme that is more effective and less costly than the SEC’s invalidated registration requirement to provide regulators with an alternative to satiate the desire to “do something” in response to eventual interest group pressure. Self-Regulation is a prominent theme in our capital markets. The NASD and NYSE, now merged to form the FINRA, have long regulated member firms and broker dealers. The Federal Reserve is effectively a quasi Self-Regulatory Organization (“SRO”), with member banks nominating the Regional Presidents. One wonders why the idea of self-regulation in the hedge fund industry has not been previously explored as a viable compromise between the existing extreme views on this topic. Bureaucratic regulators are notoriously slow to innovate their approach, especially when compared to the pace of change in the financial markets, but self-regulators are closer to the front lines. In addition, self-regulatory entities are more sensitive to compliance costs. Even in choosing between equally effective regimes, bureaucratic regulators may, however, have incentives other than cost in mind due to heuristic bias that overemphasizes the risk of scandal or the budgetary allocations that come with enhanced regulatory power.

Economic competition theory also supports self-regulation, as a properly structured SRO creates internal competition among market players which results in decision outcomes that are preferential to direct government oversight. A prisoner’s dilemma can result from the regulation game facing the SRO rulemaking body, in which funds would seek to take capital investments from competitors by voting within the SRO for regulations that enhance transparency of a fund’s fiduciary compliance, out of an interest in taking capital flows from competitors who may not. The result is an equilibrium of compliance that could exceed the level of transparency that would exist without the collective action, thus giving more sharpness and binding effect to any best practices that may exist in the industry and providing a more cost effective enforcement avenue for those best practices. The beauty of this approach is that, unlike the SEC, the SRO internalizes the cost of the regulation. The payoffs to decisions on voting for disclosure regulation are based on revealing things of value to hedge fund investors, so the SRO only increases regulatory cost up to the point at which the new regulation is of such a large marginal value to hedge fund investors that they are likely to decide to switch funds if their fund is revealed as being non-compliant.

Looking from a broader overview, hedge funds as an asset class also compete inter-industry for capital with other asset classes, such as private equity, so the entire fund industry would also have an incentive to promote greater accountability with respect to inter-industry competition for capital. This externality to regulation may not be internalized by individual funds, or by the SEC, but an SRO would more readily appreciate that advantage to enhanced transparency. The sector has not been able to promulgate binding rules thus far because the groups suffer from a collective action problem. The advantage to each fund of transparency rules does not make up for the cost of being the first mover in collective action. But with the SEC requiring membership the SRO can then begin to function along the lines of the theory. One way the SEC could encourage membership in the SRO would be to allow an exemption or safe-harbor to any future registration requirement to firms that submit to regulation by the SRO body. It could also initiate official Staff Guidance, in the form of official opinions or no-action letters, to give regulatory and enforcement authority to disclosure decisions made in accordance with SRO rules, in similar relationship to the SEC’s official recognition of GAAP.

In order for self-regulation to work, however, the system must be designed to prevent regulatory capture by the member firms, and this will require gentle oversight from the SEC. The SEC’s oversight role would play out in four ways. It would design the SRO’s charter to define the rulemaking process. One proscription the SEC should include in that charter would be that the SRO rulemaking function should be separate from the SRO enforcement function, and that enforcement personnel should be independent of regulated firms (enforcement decisions are the mostly likely culprits of equilibrium failure in my theory, due to changes in the payoff strategy space, as evidenced by the SEC’s frequent disputes with SRO’s over the level of enforcement over the last 40 years). The SEC would also need to approve any amendments to the SRO charter. Then, it would vet nominees to the rulemaking body to ensure that a diverse group of firms were represented based on fund strategy as well as fund size, ensuring that one fund or one fund class did not dominate the process to promulgate rules to their advantage. One caveat to my approach: systemic risk, or risk that excessive leverage will ripple out into the market, involves the kind of economic externalities that a self-regulatory regime may be ill equipped to handle. The Federal Reserve’s margin rules and the NASD’s broker lending rules are more appropriate approaches for that related concern. Thus, the issues surrounding the subprime lending fiasco, to the extent they derive from abuse of leverage, are more properly issues for those regulatory venues. Nevertheless, the issues are related in that any increase in accuracy in valuing fund’s portfolios could enhance market participants or regulators ability to determine capital adequacy compliance.

Congressional interest in hedge fund regulation continues to fester. In response, the hedge fund sector has stepped up its lobbying function to respond (for instance, the hedge fund lobby is currently courting Congressman Richard Baker of the Subcommittee on Capital Markets). Some members of Congress have hinted at their desire to expressly grant the SEC the authority to require hedge fund registration as a response to the Goldstein decision. It would be to fund manager’s advantage to channel government interest into a self-regulatory mechanism as a more cost-effective and nimble alternative. In the event that the eventual SRO design is subject to light oversight by the SEC, a self-regulatory alternative to outright registration would be in investors’ and beneficiaries’ best interest as well.

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