The National Law Review‘s winner of the Fall Student Legal Writing Contest is Karol C. Sierra-Yanez of Suffolk University Law School. Karol’s article provides some background on the hedge fund industry and where experts think regulation of this industry may be going. Read on:
This paper aims to provide the reader with a better understanding of what the term hedge fund means, their history and development, and how hedge funds differ from traditional investment vehicles, such as mutual funds. It will focus on the future of the hedge fund industry, specifically, the changes proposed in the Hedge Fund Transparency Act. While some critics and experts in the financial industry see this Act as a way to regulate an investment vehicle capable of affecting the economy, others see it as an invasion into the freedom of hedge fund advisers to develop creative strategies to hedge the risks of their investments and enhance returns.
I. WHAT IS A HEDGE FUND?
To begin with, there is no universally accepted definition of hedge funds. The various definitions refer to hedge funds as private investment vehicles that are subject to less regulation in comparison with more traditional forms of investment, such as mutual funds. Hedge funds are not defined by the Securities and Exchange Commission (SEC), in fact, there is no regulatory or statutory definition of hedge funds.
While the first hedge fund was started in 1949 when Alfred W. Jones developed a system to protect investments against market risk that incorporated various techniques including the use of leverage and short selling, other financially creative hedge fund managers also came along and developed new hedging strategies such as the use of futures and options, strategies that did not exist when Jones developed his fund. With the use of these new strategies, hedge funds started to generate favorable returns again and increasingly grew in popularity, to the point that by 2002, there were an estimated 6,500 hedge funds operating in the United States, managing approximately $600 billion in capital.
II. HOW DO HEDGE FUNDS DIFFER FROM TRADITIONAL INVESTMENTS?
To begin, a major characteristic difference between hedge funds and mutual funds is that mutual funds and their managers are required to register with the United States Securities and Exchange Commission (SEC), whereas hedge funds are unregistered investment vehicles.  Mutual funds must register as investment companies under the Investment Company Act of 1940 and their managers must register under the Investment Advisers Act of 1940; these funds are considered to be “public” investment funds, meaning they are open to the general public and any investor possessing the required capital may invest, regardless of their net worth or level of sophistication.  Hedge funds, on the other hand, are considered “private” investment funds, and are not registered with any government body, and are only open to qualified or accredited investors, including high-net-worth investors, institutions, endowments, family offices and pension programs.
From a sales and marketing standpoint, mutual funds can be purchased in any number of ways, with common examples including directly through a fund management company (e.g. Fidelity), through a mutual fund ‘supermarket’ (e.g. Charles Schwab) or through a broker or financial planner (e.g. Ameriprise Financial). Advertisements for mutual funds can often be found in a variety of published sources, including magazines, newspapers, and on the internet.Hedge funds, meanwhile, are much different in terms of sales and marketing; to be free from certain restrictions, “hedge funds limit access to investors who regulators deem rich and savvy enough to handle the risk.” This is closely related to the fact that hedge funds are referred to as “private placement” vehicles, which refers to the offer and sale of a security not involving a public offering and therefore not subject to filing a registration statement with the SEC under the Securities Act of 1933.
From the standpoint of fees and expenses, mutual funds have what is called an “expense ratio”, which is the percentage of fees paid by investors to the company to cover the costs of managing and operating the fund, as well as marketing and distribution costs.  The expense ratio is the total fee that the investor will pay, besides any transaction costs that are incurred at the time of purchase or sale of the shares. The average equity mutual fund charges an expense ratio somewhere between 1.3% and 1.5%.  Hedge funds, meanwhile, in addition to a management fee (similar to the expense ratio of mutual funds), also charge a percentage of profits earned by the fund. The popular fee arrangement in the hedge fund industry, commonly referred to as “2 & 20”, is to charge 2% of assets under management (the management fee) as well as 20% of profits over a stated benchmark (the performance or incentive fee). 
Any person who possesses the required capital is generally allowed to invest in the mutual fund of their choice, and most funds have a minimum investment of $1000, making them a relatively accessible investment for most people. In addition, mutual funds stand ready to redeem an investor’s shares at any point in time, a concept called liquidity, making it relatively easy for an investor to get their money back when they would like. Minimum investments for hedge funds are quite steep, and vary from fund to fund, ranging from $100,000 to $1,000,000 or more.  Liquidity, or the ability of an asset to be converted into cash quickly,is quite different between hedge funds and mutual funds. With mutual funds, a net asset value (or “NAV”) is computed every single business day, and investors can redeem their shares at the NAV on a daily basis.  Based on a review of several articles, with hedge funds, like mutual funds, the liquidity depends on the frequency with which they issue and redeem shares, but just much less frequently. Most hedge funds have monthly liquidity with a 35-day notice period, but some are much less liquid, depending on the type of assets invested in and the strategies employed by the fund. Hedge funds are also subject to a “lock-up period”, which is the time period that an investor must hold their assets within a fund before they can be removed. In other words, mutual fund shares have a readily ascertainable market and a fair price, while hedge fund investors have a contract with the manager that essentially allows the manager to dictate the frequency and manner of redemption.
Traditional mutual funds are generally segmented into a few basic categories, such as stock (growth, value, blend), bond (municipal, corporate, government), and money market (cash, t-bills), according to the types of investments they will make as outlined in their prospectus. They do not deviate from their prescribed investment approach, and are generally limited to the types of investments they can make. Hedge funds, however, generally employ sophisticated trading methods, including short selling (when the investor sells borrowed securities), options (financial contracts between two parties), and leverage (the use of borrowed capital to purchase additional assets with the objective of increasing returns). 
According to a Morningstar Methodology Paper published in 2007 titled “The Morningstar Category Classifications for Hedge Funds”, hedge fund managers typically focus on specific areas of the market and/or specific trading strategies. Morningstar states, as an example, “that some hedge funds buy stocks based on broad economic trends, while others search for arbitrage profits by pairing long and short positions in related securities.”
III. PRESENT REGULATORY FRAMEWORK
As discussed briefly in the section outlining the key differences between hedge funds and more traditional investment vehicles, regulatory differences, most of which stem from the fact that participation in hedge funds is mainly the “preserve of sophisticated investors who possess the required knowledge to assess the risks associated with investing in this asset class” are of the utmost importance. Under this sophistication premise, it is maintained that wealthy investors can better fend for themselves and are thus more suited for hedge fund investments, whereas the everyday, less sophisticated investor may not be.
Two of the primary statutory exclusions for hedge funds from the definition of “Investment Company” come from the Investment Company Act of 1940: §3(c)(1) and §3(c)(7). The §3(c)(1) exemption is satisfied when the issuer sells their securities to no more than 100 persons and does not make or will not plan to make a public offering of those securities; the §3(c)(7) exemption, meanwhile, is satisfied when the securities are being sold only to “qualified purchasers” and also like §3(c)(1) the issuer does not make or does not plan to make a public offering of those securities. As one may note, §3(c)(7) makes no reference to the number of investors in a fund in the manner that §3(c)(1) does, and this is where the Securities Exchange Act of 1934 comes into play. Under §12(g) of the Exchange Act, it states that an issuer must “register, disclose information and submit periodic reporting” if the issuer has $10 million or more in assets under management and 500 or more investors. Due to this fact, it comes as no surprise that many hedge funds elect to issue securities to less than 500 investors in order to avoid triggering this requirement. Similarly, those fund managers that operate as Commodity Pool Operators (“CPO”) are able to rely on regulations contained in the Commodity Exchange Act (“CEA”) that “provide an exemption from registration to CPOs that engage in limited commodity futures activities and sell interests solely to certain qualified individuals and that sell interests to highly sophisticated pool participants.
Finally, the Investment Advisers Act of 1940 (not to be confused with the Investment Company Act of 1940), which regulates the activities of investment advisers, also contains one registration exemption that hedge funds commonly rely upon. The registration exemption is called the “private adviser exemption” and is found under §203(b) of the Advisers Act and states that the exemption is satisfied if the adviser “1) has fewer than fifteen clients during the preceding twelve months; 2) [nor] holds himself out to the public as an investment adviser nor acts as an investment adviser to any investment company.” This exemption at first may seem rather difficult to achieve, as it would seem that most hedge funds would have 15 or more investors, but there is a catch. Under the law, hedge fund advisers are able to meet this exemption by satisfying a safe harbor whereby they treat each legal entity (e.g. a single fund, limited partnership, etc) as a single client and are able to invoke the small adviser exemption. As such, many hedge fund advisers avoid registering with the SEC by relying on this de minimis exemption and have fewer than 15 “clients” during the preceding 12 months and do not hold themselves out to the public as investment advisers. This specific exemption will be touched upon further in the paper as it has been the focal point of recent regulation changes affecting the hedge fund industry.
IV. PAST PROPOSED HEDGE FUND REGULATIONS
While hedge funds themselves have been around for decades, they did not grow to such prominence until much more recently. For example, during the post-technology bear market era around 2000 through late 2002 the popularity of hedge funds grew very quickly, and by 2006 there were approximately 8,000 hedge funds globally with assets under management in excess of $1 trillion compared to 1990 when there were only 600 hedge funds with under $40 billion in combined assets under management.
This tremendous outgrowth, which directly results in a significant amount of power and influence within the capital markets, is one of the factors often cited by the SEC as rationale for regulatory action against the hedge fund industry. Other factors include the fact that government agencies generally lack meaningful and reliable data and information about the hedge fund industry as well as the increased “retailization” of hedge funds. An example of such “retailization” would be the fact that U.S. hedge fund of funds that do not meet the aforementioned exemptions and are registered with the SEC do not need to require that all investors be accredited and may accept investments for as little as $25,000. Pension plans, university endowments, and charitable organizations have been investing money in hedge funds, sometimes exposing unsophisticated investors to risky investment strategies. This has led to concerns that unsophisticated investors have invested in vehicles they do not understand.Besides, some hedge funds have been using television commercials to advertise their investment services to unsophisticated investors.
In response to these factors, a 2003 SEC Staff Report investigated the hedge fund industry and concluded that the SEC should require hedge fund advisers to register under the Advisers Act. The SEC had concluded that a number of existing hedge funds were using the private adviser exemption in contradiction of its intended purpose and that a change of the interpretation of the term “client” was justified. Accordingly, in 2004, the SEC, by a vote of 3-2, adopted regulation 203(b)(3)-2, which was an amendment to §203(b)(2) of the Advisers Act, which would require many hedge fund advisers to register with the SEC for the first time. This amendment is referred to as the 2004 Hedge Fund Rule, and defined each investor within a private hedge fund as a “client” for the purpose of determining whether the adviser satisfied the previously discussed private adviser exemption. This Rule applied a “look-through” to hedge funds (in contrast to the previously mentioned safe harbor rule which counted each fund or legal entity as a “client”), whereby each individual investor would be counted as one client, thereby many hedge fund advisers were no longer able to satisfy the private adviser exemption under the Advisors Act and were legally required to register with the SEC. Not surprisingly, the SEC, in support of the passing of this amendment, argued that the registration of hedge fund advisers is necessary “to protect investors in hedge funds and to enhance the Commission’s ability to protect our nation’s securities markets.”
It seemed, however, that from the very beginning there were those who felt the passing of the “Hedge Fund Rule” would do little to no good in actually improving the hedge fund industry. One of the articles used for this research states that “the implementation of this mandatory disclosure will probably have little or no impact in practice” and even continues by saying that “the implementation of this rule might ultimately be counterproductive to the SEC’s goal of the abolishment of the “retailization” of hedge funds.
Unfortunately for the SEC, their efforts aimed at hedge fund regulation were short-lived, as in 2004 hedge fund manager Philip Goldstein, his firm Opportunity Partners LLC, and their general partner Kimball & Winthrop filed suit against the SEC, arguing that the “Commission lacked any power to regulate the hedge fund advisor industry and that only Congress may change the Advisers Act. In doing so, Goldstein et al challenged the enforcement of the recently passed Hedge Fund Rule, arguing that Congress “unambiguously intended the term “client” to mean the fund, and not the investors in the fund. The challenge also claimed that the SEC “drastically exceeded the term’s “probability of meaning” and the SEC’s adoption of the rule was arbitrary and capricious. A three-judge panel of the U.S. Court of Appeals for the District of Columbia Circuit heard arguments in the case of Goldstein v. SEC, and in 2006 they vacated and remanded the Hedge Fund Rule and held that the SEC’s interpretation of the word “client” was “outside the founds of reasonableness”, “arbitrary” and “inconsistent with Congressional intent.” Adding insult to injury, the court even went as far as to say that “the Hedge Fund Rule came close to violating the plain language of the Advisers Act.”
V. RECENTLY PROPOSED HEDGE FUND REGULATIONS
Despite a lack of early success, the U.S Government did not give up on the subject of hedge fund industry regulation. Looking back at the many concerns related to the hedge fund industry and the financial industry overall, the use of the term “systemic risk” has become rather commonplace when describing the perceived risk inherent in hedge funds. In a paper entitled “Unnecessary Reform: The Fallacies With and Alternatives to SEC Regulation of Hedge Funds”, author Evan M. Gilbert defines systemic risk as “the potential for a modest economic shock to induce substantial volatility in asset prices, significant reductions in corporate liquidity, potential bankruptcies and efficiency losses.” Many including regulators are concerned that the sudden and powerful downfall of large and influential investment funds and/or firms could have drastic and far-reaching effects throughout the entire financial system.
As such, and particularly in the wake of the financial crisis that occurred between 2007 and 2008, regulators sprung into action in 2009 and quickly introduced new measures aimed at the hedge fund industry. The first came on January 29, 2009, when two United States politicians, Senators Chuck Grassley of Iowa and Carl Levin of Michigan, introduced the “Hedge Fund Transparency Act of 2009.” This act would amend the Investment Company Act of 1940 and aim to regulate hedge funds in two specific ways: first, it would require any funds with assets equal to or greater than $50 million to register with the SEC and second it would impose more stringent anti-money laundering obligations. The Act would encompass all §3(c)(1) and §3(c)(7) exempted funds, not just “hedge funds” per se; as such, all privately-held investment funds ranging from hedge funds to venture capital and private equity funds would be affected.
As mentioned, all “large” funds with $50 million or more in assets would be required to register with the SEC; in addition, they would be required to maintain books and records with the SEC, and also comply with any requests for information or examination by the SEC. Finally, periodic electronic reporting (minimum once per year) to the SEC would also be required of all funds.
Besides the Hedge Fund Transparency Act of 2009, other regulatory developments were underway in 2009. In a paper published in March, 2010 entitled “New Developments in Securities Litigation”, author Elizabeth P. Gray, a partner at Willkie Farr & Gallagher LLP, states that “financial regulation of advisers to hedge funds and other private funds is expected to increase substantially during 2010.” She goes on to add that “financial reform bills that would require the registration of advisers to hedge funds as investment advisers with the SEC under the Advisers Act appear to have significant momentum behind them.” Of particular interest is a bill that was sponsored by Congressman Paul Kanjorski of Pennsylvania and approved by the U.S. House of Representatives in December, 2009 which would, if enacted, effectively eliminate the private adviser exemption from registration under §203(b)(3) of the Advisers Act. This particular bill is clearly reminiscent of the previously discussed, and unsuccessful, Hedge Fund Rule of 2004 in that it seeks to amend the meaning of “client” under the Advisers Act and forcibly require advisers with 15 or more clients to require with the SEC. In doing so, these changes in regulation would have many effects similar to those proposed within the Hedge Fund Transparency Act as well as those presently in place for funds abiding by §3(c)(1) and §3(c)(7) of the Advisers Act. Such regulatory requirements would include, among other things, extensive record-keeping requirements, disclosure requirements, rules of conduct, subjectivity to examination processes, and standing ready to provide information to the SEC about the adviser themselves and the funds they manage.
VI. THE FUTURE OF HEDGE FUND REGULATION
While it is difficult to say with any real certainty at this time exactly what the future holds for the hedge fund industry, no less trying to predict what future regulations may or may not be enacted, it can certainly be said that many experts and academics alike favor some degree of regulation or another. Long before the term ‘systemic risk’ became everyday vernacular from Wall Street to Main Street, progressive minds felt new regulation would be done. If and when it was done, most would likely agree that future regulation “must reduce the likelihood and potential costs of the failure of systemically important hedge funds whilst at the same time preserving the wider market benefits of hedge funds’ ongoing activities.” It is important that any regulation that is enacted in the years ahead should somehow provide additional transparency, awareness, protection and overall risk management while at the same time allowing hedge fund companies and managers to invest and operate with the degree of anonymity which they deserve and to contribute to overall market efficiency. While some feel that new hedge fund regulations would “create a stable regulatory environment, bring parts of the industry in from the cold, and help lift the veil of secrecy that currently surrounds hedge funds,” others still maintain their rightful concerns.Take for example former US Federal Reserve Board Chairman Alan Greenspan. With his traditionally “laissez-faire” approach to financial markets, he for one might be more inclined to believe that “hedge funds should not be regulated at all because of the efficiency they provide to the financial system.”In a paper he published recently for The Brookings Institute entitled “The Crisis”, Greenspan continues down the “less is more” path, adding that “regulation by its nature imposes restraints on competitive markets. The elusive point of balance between growth and stability has always been a point of contention, especially when it comes to financial regulation. Others, while cognizant of the systemic implications associated with the failure of one or more large hedge funds, agree, too, that the benefits hedge funds provide to the financial system are substantial and that “the trading behavior of hedge funds can improve market efficiency, price discovery and consumer choice. Going even further, and somewhat contrary to what others may say or feel, some believe that “hedge funds may help in alleviating financial crisis.
Others, meanwhile, are taking a much more middle-of-the-road approach, with beliefs that hedge fund regulations can and will help both sides. David Langguth, of EACM Advisors, LLC, a leading investment advisory firm and subsidiary of BNY Mellon Corporation, was quoted in a hedge fund roundtable as saying that “while regulatory initiatives such as increased transparency or registration may affect hedge funds, we do not anticipate measures that will significantly limit most managers’ ability to implement their strategies. Clearly, well designed measures intended to limit potential market abuses generally will be positive for market participants, including hedge funds.”
Looking back again at the failed 2004 Hedge Fund Rule, some feel that “it would be an understatement to say that the Goldstein ruling was a setback for the SEC,” and I cannot say that I disagree. Author Joshua Hess, in a paper entitled “How Arbitrary Really Was the SEC’s Hedge Fund Rule?” argues that the Goldstein decision resulted in a regulatory black hole to which the SEC found itself inadequately able to regulate a financial industry whose continuing growth will have a substantial impact on U.S. financial markets. And, following the series of recent events that have roiled global financial markets, including the outright collapse of Lehman Brothers, the rescue of Merrill Lynch, countless lending institution bankruptcies, and bailout after bailout by central government banks, it feels to many that something, anything, needs to be done. Furthermore, Evan Gilbert, in his paper entitled “Unnecessary Reform: The Fallacies With and Alternatives to SEC Regulation of Hedge Funds” writes that “there appears to be a strong emotional component behind the calls for subjecting hedge funds to SEC registration and disclosure requirements…this fear-based response is understandable, especially in light of the growing number of established institutions either on the brink of collapse, or in some cases actually failing.Once again, something, anything, needs to be done.
Two main ideas that I have come across in my research that stand out as possible solutions include: First, to establish legal limits and/or regulations related to the amount of credit that can be extended to hedge funds by financial institutions. Previously mentioned author Gilbert in his “Unnecessary Reform” paper states, “one of the more straight-forward solutions would be to limit the amount of credit public financial institutions are permitted to extend to hedge funds. Perhaps the most significant concern expressed by those critical of the hedge fund industry is systemic risk…one of the principal causes of systemic failure is failure amongst credit institutions, or more specifically, banks…if banks are limited in the credit they are permitted to extend to hedge funds, any failure of such funds would be less likely to instigate a liquidity crisis.” As previously discussed in the earlier stages of this paper, financial leverage is something specifically available to hedge funds, and a variety of the well-known hedge fund collapses have been attributed to excess amounts of leverage. Therefore, some believe that limiting the amount of credit extended to hedge funds, which is then used to achieve leverage, could help stem systemic risk.
The second recommendation I have come across that I also agree with would be to impose more strict requirements for so-called “accredited investors”. Author David Schneider in his papered titled “If at First You Don’t Succeed: Why the SEC Should Try and Try Again to Regulate Hedge Fund Advisors” argues that the SEC could discourage hedge funds from allowing investors to invest in the hedge fund by changing the definition of an accredited investor. By definition under the Securities Act, an accredited investor is any individual with a net worth that exceeds $1 million or any person with an income in excess of $200,000 in each of the two most recent years. Amazingly, however, Schneider points out an almost unbelievable fact, which is that this net worth/income benchmark has not changed since 1982, and that due to the presence of inflation (rising prices, incomes, etc) and increasing net worth, more and more investors have been satisfying the accredited investor benchmark. It seems to me that it would be worthwhile to adjust the “accredited investor” threshold every year based on inflation rates, so that as incomes and net worth levels continue to rise, more and more individuals do not suddenly qualify as potential hedge fund investors. The income and net worth thresholds should be increased each and every year, so that it remains equally difficult with each passing year for individuals to become qualified as hedge fund investors.
Apart from the aforementioned recommendations, there is one additional point that continues to stand out as something that the government, at least it would appear, should tend to be more concerned with. As I have come to recognize through my research, hedge funds were originally an activity generally for the ultra rich – those with upper-tier income levels, high net worth, and money to spare, and lose. It was the last condition – the fact that they could essentially bare to lose some part of their net worth – that made them suitable hedge fund investors. But yet, over time, so-called institutional investors, such as pension plans, endowments, foundations, schools, hospitals, and so on, have all started to gradually wade further and further into the hedge fund waters. Institutional investors have pensioners and retirees to take care of, and if hedge fund investments go too far and returns go too astray, then those depending on the long-term benefits their retirement assets will provide are the ones who will lose. As such, I believe it is the government’s responsibility and duty to make sure that pension plans and other institutional investors, both public and private, have a strong handle on their investment choices and that they are fully informed as to the possible risks that hedge funds can present.
Hedge funds have enjoyed almost complete anonymity for a number of years, and it has become very evident over the past few years that while hedge funds are not to blame for the various problems our financial system has been dealing with, they certainly do play a very large part. Having more information about them, their actions, their clients, their assets, and so forth, will only help to add a much needed layer of transparency within our fragile financial system. There is also a need to let the financial system be a free flowing system, one that is not encumbered by over-bearing rules and regulations.
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Id. at 2. See also James E. McWhinney, A Brief History of the Hedge Fund,http://www.investopedia.com/articles/mutualfund/05/HedgeFundHist.asp.
Financial leverage is essentially the borrowing of capital in order to invest additional assets in a company, hoping that the company’s return is higher than the loan’s interest rate, thus generating excess return on equity. Gabelli, supra, at 2. See also, The Layman’s Finance crisis Glossary,http://news.bbc.co.uk/2/hi/uk_news/magazine/7620678.stm(last updated Sept. 19, 2008).
After reading about short selling and put in rather simple words, short selling is the act of borrowing assets (such as securities) from a third party after which point they are sold in the hope that the value of the assets will go down before repurchasing them again after which point they are then returned to the third party, thus making a profit on the price difference. Securities and Exchange Commission, http://www.sec.gov/news/press/2008/2008-235.htm(last visited Oct. 1, 2008) (Statements of the SEC regarding short selling and issuer stock repurchases. The SEC was explaining the implication of short selling in the light of the current financial crisis and actions taken to control operation).
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David Schneider, If at First You Don’t Succeed: Why the SEC Should Try and Try Again to Regulate Hedge Fund Advisers, 9 J. Bus. & Sec. L. 261, 276 (2009).
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Desmet, supra, at 22.
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Taylor, supra, at 7.
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Taylor, supra, at 2.
 Id.at 3.
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Joshua Hess, How Arbitrary really was the SEC’s “Hedge Fund Rule”? The Future of Hedge Fund Regulation in Light of Goldstein, Amaranth Advisors, and Beyond, 110 W. Va. L. Rev. 913, 940 (2008).
 Gilbert, supra, at 343.
Id. at 345.
 Schneider, supra, at 308.
© 2010 Karol C. Sierra-Yanez