By H.B. Zhang<\/span><\/p>\n <\/span><\/p>\n The hedge fund industry, given its lucrative returns, secret strategies, and hefty fees, has raised the eyebrows of financial regulators and market observers.[1]<\/span><\/span><\/span><\/span><\/a> The debate on the hedge fund industry regulation becomes more fascinating after two Bear Stern\u2019s hedge funds went bankrupt in 2007, two Bayou\u2019s founders were convicted of fraud in 2008,[2]<\/span><\/span><\/span><\/span><\/a> and more hedge funds liquidated due to excessive risk and fraud. Despite these failures, the hedge fund had grown to a 2-trillion-dollar industry, according to John Paulson.[3]<\/span><\/span><\/span><\/span><\/a> However, these failures have fueled a heated debate over hedge fund regulation, aiming at protecting investors from fraud and excessive risk, helping hedge fund managers to foresee potential risks, and ensuring the stability and integrity of the financial market. This paper will evaluate the discussion on hedge fund industry regulation by reviewing relevant academic literature.<\/p>\n <\/p>\n According to the Securities and Exchange Commission (SEC), \u201chedge funds pool investors\u2019 money and invest those funds in financial instruments in an effort to make a positive return.\u201d[4]<\/span><\/span><\/span><\/span><\/span><\/a> <\/span>More broadly, a hedge fund is an investment vehicle that is not registered under the Investment Company Act of 1940 and that uses an array of investment strategies to achieve higher risk-adjusted returns than the average returns from a conventional portfolio of stocks and bonds. The problems in the hedge fund industry, such as acts of fraud, excessive risk taking, and lucrative fee structure, caught the public\u2019s attention only after the collapse of the hedge fund Long Term Capital Management (LTCM) in 1998, founded by several Nobel Laureates in Economics.[5]<\/span><\/span><\/span><\/span><\/a><\/p>\n <\/p>\n The debate over hedge fund industry regulation has intensified as incidents of fraud have increased, as excessive risk taking has threatened financial market, and as hefty fees have raised the eyebrows of market observers. Many people outside of the hedge fund industry know little about it; at the same time few insiders are willing to openly discuss the rise and ebb of the industry. The performance fee structure is particularly problematic because it encourages fund mangers to increase their returns on investment by any means, including excessive leverage. Although little is known about this industry\u2019s secrecy, what is known is that hedge fund managers will use the most sophisticated strategies to generate absolute returns regardless of market directions. Among the various strategies include excessive leverage (debt-to-equity ratio), long and short positions, derivative trading, global currency trading, market timing, disseminating false news, algorithm trading, black-box trading, and usage of offshore structures. While the knowledge of these strategies will illuminate the discussion on regulation, this paper is not concerned with detailing these market strategies. The paper will focus on three major issues that have caught the eye of the market regulators, fund managers, and financial press; they are fraud, excessive risk, and incentive fee structure. The opposing parties in the debate are obvious: one argues for a regulatory scheme, whereas the other argues against it. Each side has advanced their arguments with cogent debate, and this paper will assess the merits of their opposing arguments.<\/p>\n <\/p>\n The research involves surveying major law review articles for the debate regarding regulation.[6]<\/span><\/span><\/span><\/span><\/a> On the non-regulation side, there are two dominant arguments. One opposes governmental regulation, while the other argues that market can regulate itself. On the regulation side, there are also two prevailing arguments. One proposes loose regulation with SEC guidance; the second proposes to give the SEC the authority to regulate the industry. In order to better understand the arguments and counter-arguments, one must first understand the concerns that have triggered the debate.<\/p>\n <\/p>\n Generally, the concerns stem from the hedge fund industry characteristics, with which the fund generates higher returns than traditional stocks or bonds with lower volatility. For example, hedge fund managers on average can achieve higher returns than the S&P 500 Index, by hedging market risks. On the upside, the return is better than conventional investment vehicles, and the portfolio managers are also incentivized to take on excessive risk to collect management fees, 2% on assets under management and 20% on the return on capital.[7]<\/span><\/span><\/span><\/span><\/a> On the downside, hedge funds induce more risk and fraud, and can undermine financial market stability because of the vast amount of the capital and the abuse of financial leverage. The hedge fund industry\u2019s large size can really disturb the financial market in a dramatic way, either domestically or globally. The risk can wipe out investors in a few trading days, and the lack of disclosure can also prompt accounting fraud that deceives investors. These factors have caught the eye of the federal government and interest groups.<\/p>\n <\/p>\n In theory, these three problems exist through the whole financial sector, but as SEC Chairman Christopher Cox noted, \u201cwe need to protect investors from fraud.\u201d[8]<\/span><\/span><\/span><\/span><\/a> We can see a relationship between the three factors in terms of how the hedge fund industry impacts investors, financial sector, and even larger market. These risks can cause serious consequences, which prompts the need for a risk-mitigating regulation mechanism. Fraud causes damage to the financial industry and the confidence of investors, and therefore needs to be deferred. High volatility of the market also confuses the investors and disturbs normal transactions in the market, and thus needs to be regulated in some way by someone. If these three factors impacting the financial market are met, regulation should be necessary in the sense of protecting investors, rebuilding investors\u2019 confidence and market stability. If these factors are not met, one might leave the hedge fund industry alone. The following section will mainly focus on these three variables in terms of the hedge fund industry regulation debate.<\/p>\n <\/p>\n Among the surveyed law review articles, there are three major concerns in the regulation debate. The authors, such as Kahan, Rock, Daiel, Verret, Paredes, and Edwards[9]<\/span><\/span><\/span><\/span><\/a>, oppose regulation, whereas the authors, such as Silverman, Desmet, Tiffith, J. Pearson, and T. Pearson, are in favor of the regulation.[10]<\/span><\/span><\/span><\/span><\/a> Although each argues from a specific point of view, it is important to note the similarities and differences among their arguments.<\/p>\n <\/p>\n When assessing similarities, there are four things to note. First, eight articles start off with the example of the bailout of the Long-Term Capital Management (LTCM) by the federal government. According to Paredes, Daniel, Tiffith, Verret, T. Pearson, J. Pearson, Desmet, and Edwards,[11]<\/span><\/span><\/span><\/span><\/a> this catastrophic event triggered massive media and press coverage, and, in light of that fact, the White House, the House of Representatives, and the US Senate founded special committees to investigate the LTCM crisis. LTCM mattered so much in a way that this specific hedge fund was managed by two Nobel Laureates in Economics. Even the top economists could not foresee this crisis coming. In addition, the loss of billions of dollars of investment capital caught the attention of governmental agencies. Thus this event was cited in a majority of the articles surveyed since it caused the SEC to investigate the fraud and risk posed by the hedge fund industry.<\/p>\n <\/p>\n Second, fraud is a common issue and concern that fascinates all authors in this debate. All the authors examined, such as Paredes, Daniel, Silverman, Tiffith, Desmet, Pearson, and Edwards,[12]<\/span><\/span><\/span><\/span><\/a> mentioned acts of fraud by portfolio managers.[13]<\/span><\/span><\/span><\/span><\/a> Different people define fraud differently. This paper is concerned with a narrow scope of fraud, defined as an act to deceive investors, rather than other types of fraud, as Kahan pointed out, \u201chedge funds have even sought appointment as lead plaintiffs in securities fraud class actions under the Private Securities Litigation Reform Act.\u201d[14]<\/span><\/span><\/span><\/span><\/a>[15]<\/span><\/span><\/span><\/span><\/a> while Skilverman, Tiffith, Desmet, and Pearson argue that the systemic risk of fraud can be prevented by regulation.[16]<\/span><\/span><\/span><\/span><\/a> Therefore, fraud is an interesting topic that has intrigued everyone\u2019s interest. Due to the illegal activities by some meticulous portfolio managers and traders, fraud was uncovered among many hedge funds in the last two years, and many lawsuits were brought by the SEC against several of those managers. Now the SEC proactively monitors and investigates the fraudulent acts of hedge fund managers in order to protect the integrity of the financial market and the investors\u2019 confidence in the market. Kahan\u2019s paper mentions fraud in some degree, even though they might not agree upon the issue of the industry regulation. More specifically, each one of them has a different focus. For example, Paredes argues that fraud is not serious enough to subject the hedge fund industry to SEC regulation,<\/p>\n <\/p>\n Third, risk is also a common variable that all the authors cited in their papers extensively, from different angles, to justify either regulation or non-regulation. In terms of risks, Paredes argues that regulation after the Enron scandal is aligned with the preemptive approach.[17]<\/span><\/span><\/span><\/span><\/a> The SEC is there to protect the market from the major risk brought by hedge funds. Kahan, Paredes, Daniel, Desmet, Pearson, and Edwards[18]<\/span><\/span><\/span><\/span><\/a> all focus on risk in the debate, even though they may not agree upon the questionable regulation. As Robert Steel[19]<\/span><\/span><\/span><\/span><\/a> said, \u201cRisks posed by private pools of capital are best addressed through market discipline, disclosure and transparency, not through new laws, regulations or registration.\u201d[20]<\/span><\/span><\/span><\/span><\/a>[21]<\/span><\/span><\/span><\/span><\/a> However, SEC Chairman Cox, in response, warned that the hedge-fund risk was the potential threat to the retail investors, and recommended the SEC to assure the obligation to protect investors from the risks posed by the hedge fund managers.<\/p>\n <\/p>\n Fourth, most of the law review articles relate the incentive fees to hedge fund fraud which is subject to regulation. All mentioned performance fees except David I. Silverman in different perspectives. The fees charged to investors are, under rule of thumb in the industry, 2 percent of the assets under management and 20 percent of the return on investment. Considering the minimum requirement to invest in a hedge fund is at least $750,000, the 2 percent is a decent paycheck, let alone the lucrative fees on the return on investment.[22]<\/span><\/span><\/span><\/span><\/a> Being lured by this hefty fee, some hedge fund managers engage in meticulous behaviors, such as fraud, insider trading, or excessive leverage. This fee structure encourages fund managers to take fraudulent actions and excessive risks on the money they are managing. Most of the authors, such as Verret, Pearson, Desmet, Daniel, Tiffith, and Paredes,[23]<\/span><\/span><\/span><\/span><\/a> mention this fee issue regardless of their views. The fee structure might bring some consequences to the hedge fund industry or it might bring bright future of the Wall Street, and it all depends on which author\u2019s argument is adopted.<\/p>\n <\/p>\n Overall, fraud, risk, and incentive fees are three issues and concerns written extensively in the law review articles. However, each scholar concludes differently from the reasons in proportion of the evidence they use. They do not have the comprehensive scheme to consider all different angles which might impact the destiny of the regulation on hedge fund industry. As noted here, the insufficient reasoning impediments the comprehensiveness of the SEC\u2019s regulation scheme. This limitation can be overcome by collaborating all works to the extent that the reasoning of regulation should be based upon.<\/p>\n <\/p>\n Besides the reasons and logic behind the debate, there is also the difference, which is another common characteristic of the scholarly articles. The proposal brought by each scholar is usually different, but there are four areas in all. See the figure<\/span> below.<\/p>\n <\/span><\/p>\n <\/p>\n <\/p>\n
![\"Organization](\"\/\/\/C:\/DOCUME%7E1\/pubtest\/LOCALS%7E1\/Temp\/msohtml1\/01\/clip_image001.gif\")
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