Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
United States housing bubble wikipedia , lookup
Stock trader wikipedia , lookup
Private equity wikipedia , lookup
Interbank lending market wikipedia , lookup
Syndicated loan wikipedia , lookup
Fundraising wikipedia , lookup
Private equity secondary market wikipedia , lookup
Shadow banking system wikipedia , lookup
Fund governance wikipedia , lookup
Investment management wikipedia , lookup
Advertisement Follow ABA myABA | Log In JOIN THE ABA Membership ABA Groups Resources for Lawyers Publishing CLE Advocacy News SHOP ABA About Us MEMBER DIRECTORY Home Membership Events & CLE Committees Initiatives & Awards Publications About Us Contact Us 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]. Back to Top For the Public ABA Approved Law Schools Law School Accreditation Resources For Bar Associations Diversity Lesbian, Gay, Bisexual & Transgender Lawyers Military Lawyers Stay Connected Twitter Facebook Public Education Government and Public Sector Lawyers Senior Lawyers ABA Career Center Solo and Small Firms Contact Us Online Public Resources Judges Law Students Women Lawyers Young Lawyers Lawyers of Color Lawyers with Disabilities Terms of Use | Code of Conduct | Privacy Policy | Your Privacy Rights | Copyright & IP Policy | Advertising & Sponsorship | © 2012 ABA, All Rights Reserved