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Do we need better regulated hedge funds?

As a special investment vehicle designed for large institutions and rich investors, hedge funds are notorious for their ruthless trading strategies aiming to reap high returns, usually these returns come with very high risks. We have noted that financially leveraged hedge funds have often contributed to financial crisis.1 Investors have often demanded to put strict regulations to curb misuses of hedge funds.

Mistakes in the hedge funds’ calculations may well trigger off a vicious circle which brings with it negative implications similar, or even worse, than the financial crisis we witnessed in the recent past.2 There have been moves as proposed by Steinbröck’s in many States. It may be noted, the losses by Amaranth offer a powerful and compelling evidence of lose regulatory controls. It proposes reforms in the disclosure and oversight requirements sector.3 How hedge funds are currently regulated in USA and what problems they have brought to the financial market is the subject matter of this discussion. In spite of our past experience in the shape of collapses of hedge funds, restricting their operations by more harsh regulations might not be a good idea.

Regulatory requirements for hedge funds in USA Hedge funds are actually not “unregulated”. They are no less regulated than mutual funds, which are more familiar to most common people. The illusion that hedge funds lack regulation generally comes from the fact that hedge funds are exempt from certain laws. Hence we need to review relevant legislatorial structures for hedge funds and understand why they are “exempt” from certain provisions.

A hedge fund is not different from any other investment vehicle as a general investment company.4 It is regulated in two basic aspects: tax laws and securities laws. The part related to security laws will be focused as tax issues themselves might bring much more complications in an unnecessary manner.5

Hedge funds are regulated by the Security Act of 1933 since hedge funds are considered as a security. The difference of a hedge fund from another common security is that it usually registers itself under Regulation D as a “private placement”. We can term it as the key difference of a hedge fund from a mutual fund. A hedge fund thus cannot be advised or offered to the general public.6 Here the question arises whether or not the hedge funds are subject to regulations that are designed to protect investors?

The Emergent picture in this regard depicts that:

(i) Unlike mutual funds, hedge funds are not subject to regulations meant for protecting the investors

(ii) Depending on the size of hedge funds, fund managers may not be required to register or to fill public reports with SEC

(iii) Hedge funds are subject to same prohibitions against fraud as are applicable to other market participants

(iv) Hedge fund manger owe a fiduciary duty to the funds they manage

(v) Federal and state law protections available to mutual funds are not available to hedge funds

(vi) In a hedge fund it is difficult to fully evaluate the terms of an investment.

New controls on hedge funds

New regulatory requirements were introduced through title IV of the Dodd-Frank Act. The new law:7

(i) Introduced filing of reporting form PF

(ii) Repealed the exemption available to hedge fund advisers8

A hedge fund in relation to form PF can be treated as:

A private fund (other than a securitized asset fund), that (a) pays a performance fee or allocation calculated by taking into account unrealised gains (other than a fee or allocation the calculation of which may take into account unrealized gains solely for the purpose of reducing such fee or allocation to reflect net unrealized losses); (b) may borrow an amount in excess of one-half of its net asset value (including any committed capital) or may have gross notional exposure in excess of twice its net assets value (including any committed capital); or (c) may sell securities or other assets short or enter into similar transactions other than for the purpose of hedging currency exposure or managing duration.9

Here we should know some characteristics of large and qualifying hedge funds, for example:

(a) Form PF defines a ‘large hedge fund advisor’ generally as an adviser and its related persons who collectively, have at least $1.5 billion in hedge fund assets under management as of the last day of any month in the adviser’s fiscal quarter immediately preceding its most recently completed fiscal quarter.10

(b) Form PF defines a ‘qualifying hedge fund’ as one that has a net asset value (individually or in combination with any feeder funds, parallel funds and/or dependent parallel managed accounts) of at least $500 million as of the last day of any month in the fiscal quarter immediately preceding the adviser’s most recently completed fiscal quarter.11

— The compliance obligations

— Compliance rule requires a registered adviser to do

a) Implementation of written policies and procedures

b) An annual review

c) Designating of a chief compliance officer12

The books and record rule requires keeping, true, accurate, updated, record keeping relating to firm’s advisory business. The requirements of form ADV include:

(a) Completion and filing of an updated form

(b) Form’s registration with IARD

(c) Form must be filed within 90 days after the end of firm’s fiscal year.

(d) All needed amendments must be filed immediately.

The requirements of code of ethic and advertisement rule

These requirements are:

(a) Adoption of a code of ethics;

(b) Setting up of standards of business;

(c) Misleading and untrue advertisements stand prohibited; and

(d) The performance data must disclose true facts.

Hedge fund advisors and their obligations

Investment advisors owe their clients:

(a) Loyalty;

(b) Good faith;

(c) Fair allocation of fees and expenses;

(d) Identification of conflicts presented by investments and to ensure that such conflicts are properly mitigated and disclosed;

(e) Evaluation of the risk posed by structure and processes to effectively reduce, and effectively control the risks

(f) Carrying out of effective internal audits; and

(g) Maintaining risk management system including proper staffing and appropriate organisation structure

Controversial issues

Fall of hedge funds usually makes headlines of media and receives a lot of attention of investors and financial institutions. As hedge funds become larger and larger, it appears that they bring in instability in the market. They might no longer look as a private group making investment.

In this regard there are two major problems; first one is the high leverages of hedge funds which are usually used to boost its gains.13 The hunger for high-leveraged position simply originates from the greed for high returns. This remains as one of the major problems for central bankers and security administrators.

Most hedge funds exploit proprietary trading models, and they don’t want other people to follow or analyze their trading styles. And one understands that they don’t want to disclose their holdings. But with almost opaque trading books, most financial problems could be deeply hidden. That’s what exactly happened during the asset-backed security crisis.14 Majority of the investment banks had chosen to bail out their child hedge funds instead of disclosing their position for applying bankruptcy because they don’t want to make their positions of asset backed securities public.

Do we need more regulations?

A major problem which a hedge fund brings with it is high leverage. A default of such a large magnitude can be detrimental to the market and investors. This argument is one crucial driving force for those who propose more regulations. However, hedge funds usually establish their high leveraged positions by mutual agreed contracts with other fully functional and consenting parties.15

The problem of reporting or disclosures is also difficult to regulate. If quarterly reports are needed from each hedge fund, it could result into ton of papers being sent to SEC. Such is hedge fund’s nature that it usually has very frequent account turnovers looking for quick and imminent profits. This will make it impossible for SEC staffs to examine all their trading activities or positions. Most reported activities or positions would be stale on a quarterly basis so the report itself could become useless. It may be noted that investors in hedge fund are usually rich people and they have necessary resources to carry out due diligence. The hedge funds should disclose their performance to potential clients and they are capable of striking a good balance between keeping their strategies secret and marketing to a small circle of private investors.16

There is another problem that is how a hedge fund can be legally defined.17 these issues and problems force us to rethink about the existing regulatory regimes and for bringing the required changes. The court specifically attacked the SEC’s definition of the word client by saying that regulators do not provide a detailed explanation of what the word hedge fund means in the context of commercial practices.18 There is only small difference between hedge funds and other equities or venture capital products, which differs in strategy but are similar in legal structures. Private equity and venture capital don’t bring troubles that hedge fund bring to its users in the form of high risks. The fundamental challenge for policy makers is there for that how to achieve the appropriate balance between efficiency and financial resilience.19

(The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates)

1. We have witnessed such crisis in the recent past. For example, the fall of Long Term Capital Management (LTCM) in late 1990s and Amaranth in 2006.

2. See comments of Peer Steinbröck, the Finance Minister of Germany during G7 meeting of 2007.

3. See remarks of Richard Blumenthal, Connecticut’s attorney general after the fall of Amaranth, which lost 6 of its 9 billion assets in less than a week during September 2006,

4. Since a hedge fund pools investor’s money, invests the same and makes effort to gain positive returns either by short selling or by speculative investment.

5. Although hedge funds have limited protection under the law, these funds are not required to provide same level of disclosure as one receives from mutual funds, though they do have same prohibitions against fraud as applicable to other market participants, the exceptions to registrations with SEC and limited level of disclosures.

6. It is, by nature, a game for rich investors.

7. Section 403 of the Dodd-Frank Act. Title IV repealed the “private adviser exemption” contained in section 203(b)(3) of the Advisers Act on which many advisers, including those to many hedge funds, private equity funds and venture capital funds, relied in order to avoid registration under the Advisers Act. The adopting release, Rules Implementing Amendments to the Investment Advisers Act of 1940, Release No IA-3221 (Jun. 22, 2011), 76 Fed. Reg. 42950 (Jul. 19, 2011) is available at: http://www.sec.gov/rules/final/2011/ia-3221.pdf.

8. Rule 203-1(e).

9. http://www.sec.gov/rules/final/2011/ia-3308-formpf.pdf.

10. Rule 203-1(e).

11. Id.

12. Rule 206(4)-7, see adopting release at http://www.sec.gov/rules/final/ia-2204.htm.

13. The fall of Long Term Capital Management in 1997 is a well-known example and the fall of Amaranth in 2006 appears to be the repeat of the same cycle.

14. Mostly in the area of sub prime mortgage-backed securities.

15. There are no reasons that the legislators should forbid this. The banks or any institutions providing money or loans should automatically tighten their fund and restrict more on their lending requirement. Thus the situation should be considered as something the market could adjust to with better due diligence. There is indeed not much left to do for the regulators.

16. Therefore, requiring hedge funds to report to SEC or the general public is not necessary.

17. One of the SEC’s requirement asking large hedge funds to register with them was struck down by a New York District Court

18. Goldstein v. S.E.C.,451 F.3d 873, 877 (C.A.D.C. 2006).

19. See for example, Timothy F. Geithner’s: Hedge Funds and Derivatives and Their Implications for the Financial System (September 15, 2006), available at http://www.ny.frb.org/newsevents/speeches/2006/gei060914.html.

Zafar Azeem, "Do we need better regulated hedge funds?," Business recorder. 2013-01-03.
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