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Volume 13, Number 5 - May/June 2004
Shedding light on hedge funds
The SEC rethinks the lack of regulation
By Steven B. Boehm and Cynthia A. Reid
You've heard of them: hedge funds. But what are they?
The Wall Street Journal recently referred to the hedge fund industry as a
"secretive and powerful investment sector." It is difficult to take issue with this
characterization. To average investors, and to a large extent securities regulators,
hedge funds have remained mysterious, even as the industry has continued to
grow, since they are not required to register with, nor are they required to report
their activities to, any federal agency.
Recently, however, regulators have expended a great deal of time and energy
trying to learn more about these funds. On Sept. 29, 2003, the Securities and
Exchange Commission released a report by its staff titled "Implications of the
Growth of Hedge Funds." This lengthy examination, much anticipated by the
industry, summarizes the findings of an intensive study, which began in June
2002. The report concludes with the staff's recommendations to the commission
as to the regulatory actions that should be considered regarding these investment
vehicles. The SEC will consider these recommendations and could begin drafting
proposed rules in the coming months.
This article attempts to shine some light into the private world of hedge funds by
answering some basic questions about what they are, how they are sold, what the
report addresses, and how the report could affect their future.
What is a hedge fund?In a sense, there is no definite answer to this question
because there is no one accepted definition of a hedge fund. However, in general,
CALENDAR
hedge funds are investment pools that share certain characteristics. They are
almost always structured as partnerships for tax purposes. Their securities are
offered in private offerings to individuals and institutions that meet certain
minimum financial criteria.
Perhaps the most important of the common characteristics of hedge funds is the
lack of regulation. Hedge funds are not regulated by the SEC or any other agency
and they are not required to register as investment companies under the
Investment Company Act of 1940 (nor do they register their securities offerings
under the Securities Act of 1933). Furthermore, the advisers to hedge funds are
not required to register, and frequently are not registered, under the federal
Investment Advisers Act of 1940.
Another commonality is the fees that hedge funds charge. The adviser to a hedge
fund (who manages the day-to-day operations of the fund and picks its
investments) receives a percentage of the fund's capital gains and capital
appreciation (usually around 20 percent), as well as a management fee
(frequently between 1 and 2 percent of the fund's assets annually) based on the
amount of total assets in the fund.
While each hedge fund may have its own investment objective or goal, typically
these funds attempt to achieve an absolute return, meaning that the fund
attempts to increase in absolute value, regardless of the current economic
conditions. The adviser does this by using flexible investment strategies,
frequently involving both long- and short-selling and derivative instruments (like
financial futures), which it can change as the economy changes, and by investing
in a variety of diverse investments.
How big is the hedge fund industry? Since hedge funds are not required to
register, there is no real way of knowing. The SEC estimates, however, that there
are between 6,000 and 7,000 funds that manage approximately $600 to $650
billion in assets. The report predicts that in the next five to 10 years, the assets
invested in hedge funds will exceed $1 trillion.
Why are hedge funds exempt from SEC regulations? Hedge funds are only offered
to wealthy individuals and institutions. A combination of statutory provisions and
rules under the 1933 Act and the Investment Company Act for private rather than
public offerings allow for them — and the securities they issue to investors — to
remain unregistered. Many funds use the safe harbor in the 1933 Act that allows
them to sell to "accredited investors." These are individuals with an annual income
of $200,000 or more, married couples with a joint income of $300,000 or more,
or individuals with a net worth of $1 million.
The advisers to the hedge fund often do not have to register because the Advisers
Act only requires an adviser to register with the SEC if it advises 15 or more
clients (or it is holding itself out to the public as an investment adviser). Since a
hedge fund only counts as one client, notwithstanding the number of investors it
has, the adviser would only have to register if it has more than 13 other clients.
In fact, many investment advisers to hedge funds are not registered.
What are the staff's concerns? To put it simply, the staff is worried about hedge
funds because they are not really sure what hedge funds are actually doing. While
the funds are subject to the general antifraud provisions under the federal
securities laws, they are not subject to any reporting or standardized disclosure
requirements, unlike, say, mutual funds or brokerage firms.
Neither they nor their investment advisers (to the extent that they are not
registered) are subject to examination by the staff. The staff feels that this puts
the SEC in the position of having to wait until something goes wrong at the hedge
fund before regulators are able to learn about it. That was certainly the case when
Long-Term Capital Management, a hedge fund based in Connecticut, ran out of
money in September 1998.
In an incident widely discussed in the media and in Congress, the Federal Reserve
Bank of New York organized a $3.6 billion bailout of Long-Term Capital when that
hedge fund was on the brink of failure and officials determined that its failure
would cause major disruptions in the world financial markets.
The disaster at Long-Term Capital came about because of a combination of
factors, including the enormous amounts of money the fund had borrowed and the
bad bets it made on the U.S. and Russian financial markets. Because Long-Term
Capital was able to keep its investments a secret, no one was aware of the
trouble until the situation was bad enough to require an emergency rescue.
The SEC has initiated approximately 40 enforcement actions in the last five years
involving fraud in hedge funds. While the staff report does not argue that this is a
disproportionately large number compared to the number of fraud cases involving
other investment vehicles, it does note that the hedge fund cases involved
significant losses to investors because the SEC did not become involved until
either an investor or service provider suspected the fraudulent activity and
reported it to the agency. While being subject to regulation does not ensure that
fraud will be detected earlier (remember Enron?), the staff believes regulatory
oversight at least increases the chances of earlier detection.
Other regulators are also focusing on hedge funds. New York Attorney General
Eliot Spitzer has been investigating hedge funds for their roles as culprits in the
mutual fund scandals involving so-called market timing and late-trading abuses.
One hedge fund has already agreed to a $40 million settlement for its part in the
scandal. The Spitzer investigation found that the hedge fund was given special
privileges to trade its interests in a number of mutual funds in ways that are
normally prohibited by those mutual funds, or in ways that are illegal. It also
found that these "deals" with hedge funds have cost ordinary investors a
significant amount of money, perhaps in the millions of dollars.
An additional concern of the staff is that there is no regulation of the manner in
which hedge fund advisers value the securities held by the fund. In other words,
the staff is worried that investors may not be paying a fair price to invest in a
hedge fund.
Valuation can be even more of a problem when dealing with funds of hedge funds
(FOHF), an increasingly popular product. An FOHF is exactly what it sounds like,
an investment company (either registered or unregistered) that invests almost
exclusively in hedge funds, usually between 15 and 20. FOFHs are designed to
allow investors, who would not otherwise be able to afford the large minimum
investment requirements of leading hedge funds, to pool their contributions with
others to gain access to these funds.
The staff is concerned about FOHFs — even those that are registered — because,
while registered FOHFs are themselves regulated, the hedge funds they invest in
are not. Also, while registered FOHFs have currently set investment minimums at
a rather high level (ranging between $25,000 and $1 million), there is no specific
requirement that they do this and such funds could begin selling to less wealthy
individuals if they chose to do so.
There is also some concern that there are more people with less financial
sophistication (that is, those who are unable to take care of themselves and, thus,
require SEC protection) getting involved in hedge funds (a few through direct
investment, but most through registered FOHFs and pension plans, or other
institutional investments). The staff also noted instances of some hedge funds
soliciting business in a way that is not permitted by the exemption to registration
on which they are relying.
The staff also appears to be concerned about the lack of information being
provided to those who do invest in hedge funds. As mentioned above, the main
reason hedge funds have remained unregulated is because they sell to those who
have more money than the average person and thus are presumably able to take
care of themselves. Yet, a few of the concerns listed in the report were aimed at
providing more information to this group.
One listed concern was that adequate disclosures (concerning the investment
adviser and the management of the fund) are not being provided to hedge fund
investors. A second concern was that hedge fund investors are not receiving
enough information about the conflicts of interest that their investment adviser
may have concerning the hedge fund and other clients of the adviser. (Conflict
management is obviously on the minds of others recently: In October 2003, UBS
decided to pull DSI International Management as one of its mutual fund managers
to avoid any conflicts of interest since DSI also manages hedge funds).
There is also a concern that the fees paid to so-called "prime brokers" (securities
firms that offer a wide array of special services to hedge funds and other
institutional clients) are not being adequately disclosed to investors.
Do hedge funds provide any benefits to the financial markets?The report did not
focus entirely on the negative side of hedge funds; the staff also acknowledged
the benefits that these funds can provide. It noted that advisers to hedge funds
often perform extensive research about the securities in which they invest. They
then take speculative positions that other investors, with less information, might
be unwilling to take (because the positions seem rather risky). These risky (but
well- researched) investments can enhance the liquidity of the target securities
and contribute to market efficiency.
Additionally, the staff stated that they believe that hedge funds offer investors an
important risk management tool through the use of the absolute return strategy,
including short-selling the stock of companies whose future prospects appear
more negative than positive.
What were the staff's recommendations? The following is a summary of the
recommendations that the staff made to the commission in the report:
Consider requiring hedge fund advisers to register under the Advisers Act, taking
into account whether the benefits outweigh the burdens of registration.
The impact of registration could be significant. Registered advisers are subject to
regular examination by the SEC staff. Such examinations routinely include a
review of various aspects of the advisers' interaction, and the documentation of
the relationship, with their clients.
Another major effect of adviser registration would be to effectively raise the
"wealth quotient" for direct investment in hedge funds. This is because advisers
that are registered under the act are only allowed to charge a performance fee (a
percentage of capital gains and appreciation) — as all hedge fund advisers
currently do — if the individual investor has either $750,000 invested with the
adviser or a net worth of $1.5 million (compare this with the accredited investor
standard that many hedge funds currently use).
Consider requiring hedge fund advisers to provide a special brochure to their
clients in lieu of the brochure that the Advisers Act currently requires.
If advisers are required to register, the staff is concerned that the information
that registered advisers are currently required to disclose to investors is not
appropriate in the case of a hedge fund because of the special nature of the
operation of a hedge fund.
Consider prohibiting any registered investment company from investing in a
hedge fund unless the board of the registered company adopts valuation
procedures to ensure that the hedge fund's assets are valued consistent with the
valuation procedures required under the Investment Company Act.
This recommendation is directly tied to the staff's concern about the valuation
performed by hedge fund advisers.
This recommendation also highlights the staff's particular concern over registered
FOHFs.
Consider requiring additional disclosure in prospectuses of funds that invest in
other funds (including hedge funds) to show the fees of the underlying funds.
Turning again to the concerns about FOHFs, the staff is worried that investors are
paying "layers" of fees (the fees at the underlying hedge fund level as well as the
top level) that they are not aware of. Requiring this additional disclosure would
force all registered companies to disclose all layers of fees.
Continue (along with other regulatory bodies) to monitor broker-dealers to
ensure that they are only marketing hedge funds to suitable investors.
Consider permitting general solicitation (that is, advertising) by hedge funds that
only sell to "qualified purchasers" (institutions and individuals with a great deal of
money in investments — at least $5 million for an individual).
Such solicitation is currently prohibited by the exemptions from registration on
which the hedge funds rely.
Monitor services provided to hedge funds by prime brokers.
This suggestion focuses more on the activities of the prime brokers than on the
hedge funds. The staff is concerned that the prime brokers are not complying
with the regulations to which they are subjected.
If the staff is so concerned about hedge funds, why are there are so few specific
recommendations for regulating them? You may be wondering, after reading the
numerous concerns of the commission staff, why haven't they recommended
specific substantive regulation for hedge funds? While stricter regulation in the
form of registration might seem to be the simplest answer to address the staff's
concerns, it was not even mentioned in the report. One reason could be a
difference in opinion among the commissioners themselves.
The commission consists of five commissioners, each with his or her own opinion
as to what should be done about hedge funds. While this is a report by the staff
and not the commission, there is likely — as with most things political — a good
deal of behind-the-scenes negotiating that goes on before anything is published.
The contents of the staff's report may reflect, among other things, input from
and negotiation among the commissioners. Indeed, according to the press, at
least two of the commissioners have expressed concern that the SEC's resources
are being spent investigating hedge funds.
What's next? This is perhaps the most difficult question to answer. With all of
the time and energy the staff invested in the report, it is likely that some
regulatory action will be taken in the future with respect to hedge funds.
However, as the SEC's fund regulators have a lot on their plate right now
concerning the recent mutual fund scandals, and given the apparent
divergence in opinion among the commissioners themselves, it is unclear
when this action will take place or what it will entail.
One thing does seem to be clear: Although their advisers, and thus ultimately
the hedge funds themselves, may be subject to SEC scrutiny, it is unlikely
that hedge funds themselves will fall under a substantive regulatory regime
like their mutual fund counterparts. Absent such regulation, some of the
mysteries of the hedge fund world will remain unsolved.
Boehm is a partner and Reid an associate with Sutherland Asbill & Brennan
LLP, in Washington. Reid is not yet admitted to the bar in Washington but
practices
under
the
supervision
of
Boehm.
Boehm's
e-mail is
[email protected]; Reid's is [email protected].
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