SEC Quest to Regulate Hedge Funds Hits Speed Bump
The D.C. Circuit Court of Appeals invalidates the so-called “Hedge Fund Rule,” requiring the SEC to create a more logical set of comprehensive hedge fund regulations.
Hedge funds were granted a short reprieve from complying with extensive regulation by the Securities and Exchange Commission (SEC or Commission) when in June of 2006 the D.C. Circuit Court of Appeals tossed out the so-called “Hedge Fund Rule” which required hedge funds to register with the Commission.
Hedge Fund Background
1. Introduction to Hedge Funds and Arbitrage Theory
Traditionally, hedge funds have sought to identify pricing anomalies in financial markets to make quick profits and to reduce risk while maintaining return. Using “traditional arbitrage theory,” hedge fund analysts have utilized sophisticated mathematical and computer models to discover securities whose prices were unequal on different markets. They would then buy at the lower price and simultaneously sell at the higher price, making an “arbitrage” profit.
For example, suppose that a commodity is selling for $2.00 per unit on market A, $2.40 per unit on market B, and that transportation costs between the markets is $0.35 per unit. The arbitrager can guarantee a $0.05 profit by buying units on market A and simultaneously selling the units on market B. This guaranteed profit will continue as long as the arbitrager is able to keep anyone else from acting on the disparity in pricing. This was a vital component of hedge fund strategies, since if the seller of the lower priced security found out about the higher price on market B (or the buyer found out about the lower price on market A), the market would adjust the price for the transaction, taking away any profit opportunity for the middle-man arbitrager.
The arbitraging hedge fund is typically in a riskless position because it is not required to risk any of its own money in the transactions—the purchase on market A and “purchase” of transportation costs is fully covered by the sale on market B. In the worst case, the arbitrager could borrow short term funds at a riskless rate of interest to cover the costs.
Traditional hedge fund arbitrage strategy has actually helped increase market efficiency. Since secrecy of the price-mismatches is impossible beyond very short periods of time, arbitrage opportunities disappear nearly as quickly as they arise. This assures that American financial markets are the most efficient in the world, meaning that capital is “correctly priced” in those markets.
2. Beyond the Basics
Hedge funds depend on significantly more complex strategies than simple arbitrage because simple arbitrage opportunities disappear quickly. Because of the large volume of funds they raise, hedge funds act more like private equity funds, taking positions in assets they believe are mis-valued at the time of purchase. They also often take positions in commodities and frequently take positions in non-domestic markets and with non-domestic companies. These activities both diversify their risk positions and complicate regulatory issues.
When these complications are coupled with the extreme flexibility of the investment policies of the hedge funds, regulating them can become an SEC nightmare—civil servants would be regulating companies which are nominally the same but that in fact have wildly different characteristics. In some cases, hedge funds are headed by or use as consultants recipients of the Nobel Prize in Economics. Indeed, SEC regulators may be “out gunned” intellectually and may be regulating arbitrage strategies that existed for only an instant in the past.
3. Hedge Funds and Mutual Funds
Hedge funds and mutual funds both pool together investors’ money and invest in publicly traded securities. Despite that apparent similarity, hedge funds and mutual funds have very different goals.
Mutual funds pursue relative return strategies, taking only “long” positions in securities. They typically invest in a predefined manner, such as “large cap value” or “small cap growth.” Thus, the mutual funds can be compared with benchmarks, such as the S&P 100 Index or the S&P Small Cap 600 Index. A mutual fund may then attempt to beat such an index, meaning that they attempt to outperform relative to the benchmark. In general, if an investor in a mutual fund is unhappy with the performance of his investment, he can liquidate his investment quickly in the ready market for the investment.
Hedge funds attempt to achieve an absolute return, regardless of the performance of an index or benchmark. They do this by taking arbitrage positions in securities and across markets, so that they are not limited to long positions, but may sell short, trade on margin, or use derivative instruments such as options. One other major activity hedge funds engage in is controlling risk. Hedge funds do that through cross-market diversification and by carefully controlling the composition of their portfolios. In general, if an investor in a hedge fund is unhappy with its performance, he may find that there is a time lag before he can liquidate his investment.
The major difference in investing strategies between mutual funds and hedge funds is compounded by the secrecy surrounding the strategy of the hedge fund. While any investor can see the strategy, and typically the largest positions held by mutual funds, hedge funds make no such disclosures. Even if those positions were reported after a time lag, by the time the investor (or the hedge fund competitor) is able to obtain the disclosure, the hedge fund is likely to have moved to a new strategy.
The Regulation of Hedge Funds
1. Background of Regulation
The term “hedge fund” usually refers to an entity that (1) holds a portfolio of securities and possibly other assets, (2) issues interests to investors in private placements not registered under the Securities Act of 1933 (usually in reliance on Regulation D), and (3) is not registered under the Investment Company Act of 1940. Although hedge funds originally utilized investment strategies that involved leverage, short-selling, and other techniques to “hedge” risk, hedge funds today engage in a wide range of investment strategies to increase absolute returns.
In 1998 the hedge fund industry came to the forefront of financial publications with the near collapse of Long-Term Capital Management, a Connecticut-based hedge fund that had more than $125 billion in assets under management. Since many of the country’s major financial institutions were put at risk due to their credit exposure to this fund, a national financial crisis loomed until the president of the Federal Reserve Bank of New York personally intervened to engineer a bailout of the fund. As a result of this debacle, the SEC began a comprehensive study of the United States hedge fund industry.
2. Overview of Historic Hedge Fund Regulation
Until 2005, hedge funds generally were exempt from both the Investment Company Act of 1940 (Investment Company Act) and the Investment Advisers Act of 1940 (Investment Advisers Act). Hedge funds generally met the definition of an investment company under the Investment Company Act. However, hedge funds operated pursuant to an exception in the Investment Company Act which exempts funds with either (1) 100 or fewer beneficial owners and do not offer their securities to the public or (2) all investors are “qualified” high net-worth individuals or institutions. Hedge funds could then rely on the “private adviser exemption” of the Investment Advisers Act, which exempts advisers with fewer than 15 clients. Under this prior regulatory framework, a hedge fund manager counted groups of investors (called “funds of funds”) to which it provided investment advice as one client for purposes of determining the 14 client limit.
The SEC has estimated that approximately 40 to 50 percent of eligible investment advisers to hedge funds are registered under the Investment Advisers Act of 1940. If hedge funds are required to register, these newly registered funds would be required to, among other things, (i) prepare and file a registration form, (ii) refrain from charging performance fees to investors that do not qualify as “qualified clients,” (iii) adopt written compliance procedures and appoint a chief compliance officer, (iv) adopt a written code of ethics, (v) make certain disclosures regarding payment of a cash referral fee to third party placement agents, (vi) enhance record retention, (vii) comply with additional reporting and audit requirements, and (viii) submit to periodic inspections by the SEC. The costs associated with complying with these requirements are high, and while some commentators believe that the costs are not that difficult for the largest of hedge funds to absorb, smaller funds will have a much tougher time, effectively making the new requirements a barrier to entry.
3. The Hedge Fund Rule
The SEC’s comprehensive study came to fruition in September of 2003 with the release of the SEC Staff Report to the Commission titled “Implications of the Growth of Hedge Funds.” The report concluded that hedge fund regulation was necessary because (1) hedge fund assets had grown substantially, (2) there was a trend towards exposure of the hedge funds to ordinary investors, and (3) there was an increase in the number of fraud actions brought against hedge funds.
Those in favor of the SEC regulating hedge funds argue that if hedge funds are required to register with the Commission, fraud and abuse will be deterred, and the SEC will be in a better position to discover those funds with the potential for disaster (such as the Long-Term Capital Management situation).
However, critics of regulation argue that SEC regulation of hedge funds will effectively terminate any traditional arbitrage strategies for two reasons. First, disclosure of strategies may help competitors and the buyers and sellers identify the hedge funds’ methods which would allow bypassing of the hedge fund middle-man profits. Second, increased record-keeping will slow the ability of hedge funds to act on price mismatches since it puts another step into the execution process—one which is already only seconds long. Hedge funds also argue that the cost of complying with disclosure regulations will be enormous and gives unskilled SEC staffers license to look for problems where none exist. The critics also argue that the reporting requirements that go along with such regulation provide only small snapshots of the hedge funds and are not of much use, since hedge fund assets change on a daily or weekly basis.
As a result of the SEC’s Staff Report on hedge funds, the SEC introduced a series of rules that have been collectively termed the “Hedge Fund Rule.” The first rule redefined an investment company to include any “company” that (a) was exempt from registration under the Investment Company Act by virtue of having fewer than 100 investors or only qualified investors; (b) permitted its investors to redeem their interests within two years of investing; and (c) marketed itself on the basis of the “skills, ability or expertise of the investment adviser.”
The second rule required that these funds count as clients the shareholders, limited partners, members, or beneficiaries of the fund for the purposes of complying with the investor quantity limitations.  This meant that the term “client” would now be interpreted to mean “investor.” Since every hedge fund had previously counted groups of investors as one “client,” in effect, this rule meant that the number of clients each hedge fund advised had instantly increased many fold such that no hedge fund could meet the “private issuer exemption” from registration. Thus, each hedge fund would be required to register with the Commission by February 1, 2006.
4. Goldstein v. SEC
Prior to the registration date, an investment advisory firm owned by Phillip Goldstein challenged the second part of the “Hedge Fund Rule” which equated “client” with “investor” in the United States Court of Appeals for the District of Columbia Circuit.
Goldstein argued that (1) the SEC exceeded its statutory authority in adopting the Hedge Fund Rule, (2) the Hedge Fund Rule was not a reasonable interpretation of the Investment Advisers Act of 1940 (Investment Adviser Act), and (3) the SEC’s rule was arbitrary and capricious.
The SEC responded first that the Hedge Fund Rule was necessary because of the conclusions by the SEC staff in the “Implications of the Growth of Hedge Funds.” The SEC then argued that the rules, which effectively required hedge funds to register with the SEC, would specifically address these three concerns by (1) compiling census information about hedge fund advisers, (2) deterring fraud by hedge fund advisers through commission examinations, (3) keeping unfit persons from advising hedge funds, (4) requiring hedge fund advisers to adopt compliance controls, and (5) limiting ordinary investors’ exposure to hedge fund investments.
B. Analysis of the Decision
In a unanimous decision by the United States Circuit Court for the District of Columbia, the Court struck down the Hedge Fund Rule. Disagreeing with the SEC’s interpretation of the word “client,” the Court held that the Hedge Fund Rule was “arbitrary” and that the SEC departed from prior interpretations of the term “client” under the Advisers Act in extending the meaning of the term to include investors in hedge funds. Specifically, the panel found that the agency had revised its own previous definition of “client” in order to justify regulating hedge funds under old acts of Congress. The Court reasoned that the SEC was established to regulate issuers who offer securities to the public, not those who offer securities to private, qualified clients of high net worth and sophistication like the investors involved in the these specific hedge funds.
The decision created much uncertainty within the hedge fund industry. Would the SEC appeal? Would the SEC try to regulate the funds in different ways? Should currently registered hedge funds de-register so as to not incur the costs associated with continued registration? The SEC answered these questions as the summer went on through testimony to the U.S. Senate, an official letter to the American Bar Association, and subsequent press announcements.
5. Recent Developments
On July 25, 2006, SEC Chairman Christopher Cox testified before the U.S. Senate Committee on Banking, Housing and Urban Affairs on the SEC’s response to the Goldstein decision. The Chairman testified that new rules were planned that would expand the Commission’s authority to hold hedge fund advisers accountable for fraud against individual hedge fund investors, remove legal impediments that might otherwise force currently registered hedge fund advisers to deregister, and update protections for unsophisticated investors by raising the personal asset and income requirements for those seeking to invest in hedge funds by qualifying as “sophisticated investors.”
On August 7, 2006, the SEC staff announced that it would not appeal the Goldstein decision. Instead, the SEC planned to issue new compliance rules and guidance for hedge funds. The rules are to include a new anti-fraud rule that recognizes hedge fund investors as clients, effectively reversing the effect of the Goldstein decision. The SEC staff is also considering minimum asset and income requirements for individuals permitted to invest in hedge funds. The announcement also included a reminder that hedge funds still remain subject to the general anti-fraud and civil liability provisions of federal securities fraud.
As a result of the Goldstein decision, many hedge funds are contemplating withdrawing from registration since many believe that compliance costs of record retention and audits are economically inefficient. On August 10, 2006, the staff of the Division of Investment Management of the SEC provided guidance to the hedge fund industry following the Goldstein decision through a “no-action” letter to the American Bar Association’s (ABA) Subcommittee on Private Investment Entities. In the letter, the SEC staff opined on a number of specific situations now faced by those in the hedge fund industry. Of particular note, the ABA had requested confirmation that a hedge fund adviser that had registered because of the hedge fund rules would be permitted to de-register. Their concern involved the exemption from registration upon which the hedge funds would now rely.
The exemption of Section 203(b)(3) of the Advisers Act exempts from registration any investment adviser who, during the preceding 12 months, has had fewer than 15 clients and who does not hold itself out generally to the public as an investment adviser nor acts as an investment adviser to any registered investment company or business development company. Those hedge funds that had been registered by the Commission had, by definition, held themselves out as a registered investment company and may have taken on additional clients above the 14 maximum and would therefore be unable to rely on the exemption. However, the SEC staff assured hedge funds that they could rely on this exemption if the fund withdrew from registration by February 1, 2007, and within 12 months after withdrawing, the fund must again have a maximum of 14 clients. The SEC staff will also ignore the requirement of forbearance of holding oneself out as an investment company for the time during which the hedge fund was registered.
In September of 2006, the case for regulating hedge funds was boosted by another debacle, one in which investors may not have recognized the level of risk to which they were exposed in their investment. Amaranth Advisers, a six-year-old hedge fund based in Greenwich, Connecticut utilized the strategies of convertible arbitrage, which involves buying a convertible bond and selling short a percentage of the stock into which the bond is convertible, statistical arbitrage, which involves taking advantage of pricing “anomalies” in the market, energy trading, merger arbitrage, and usual stock trading. After hitting a high of $9 billion assets under management earlier in the year, Amaranth lost 50 percent of its value, or $5 billion in one week.
The losses resulted from trading natural gas futures on margin, when Amaranth gambled that natural gas futures would increase even though domestic inventories were continually growing. If a natural disaster such as a hurricane had occurred, the gamble would have paid off exponentially. However, due to the lack of natural disasters and forecasts for mild winters, those natural gas futures continued to decline. Magnifying the losses was the leverage that Amaranth had amassed. While trading on margin on stock exchanges normally requires 50 percent capital as collateral, trading on margin in options and futures requires only 10 percent capital as collateral. This magnifies gains or losses by tenfold. Additionally, while hedge funds typically utilize financial models to monitor potential gains and losses and to control for risk, these models are based on historical data, and this year was particularly different from the norm for the natural gas markets. As a result, investors in the hedge fund lost one-half of their total investment—in only one week. While it is not unusual for investors to experience significant losses when they trade on commodities, since hedge fund strategies are kept secret, it is possible that investors did not know that this was the risky type of trading strategy for which their investment was being used.
Conclusion and the Future of Hedge Fund Registration
The makeup of the Commission has changed since the Hedge Fund Rule was approved. The rule was originally backed by former SEC Chairman William Donaldson and the two Democratic commissioners in a 3-2 vote. Now that the chairman has been replaced by Republican Christopher Cox, and the vacant commission position was filled with Republican Kathleen Casey, whether the new regulation will be as sweeping as that which was invalidated remains to be seen.
Chairman Cox’s testimony and subsequent SEC press releases make it clear that the Goldstein decision will only be a short reprieve for hedge funds. The Goldstein decision should not be interpreted as a judicial determination that hedge funds should not be regulated, but advice from the judiciary that to effectively regulate the industry, the regulation should be based on a comprehensive set of rules, not simply a new rule that re-interprets a law previously passed by Congress. As a result, hedge funds should expect extensive regulation akin to the previous “Hedge Fund Rule” in the near future.
Keith “Adam” Peter is a JD and MBA candidate in his final year of studies at the Pepperdine University School of Law and Graziadio School of Business and Management. Adam is also a CFA Level One Candidate and has clerked at the Securities and Exchange Commission (SEC) and the National Association of Securities Dealers (NASD). Adam currently works as an associate at an investment bank in Century City, and as a graduate assistant
for John Paglia, PhD, assistant professor of finance at the Graziadio School. He may be emailed at firstname.lastname@example.org.
Michael D. Kinsman is a member of the Graziadio Business Report Advisory Board. He is a professor of finance and accounting at the Graziadio School of Business and Management. A former systems analyst for General Electric Corporation, a financial analyst for Pacific Telephone, and a consultant for a variety of large and small firms, Dr. Kinsman operates a CPA and consulting firm in Laguna Beach. He has written and lectured on a variety of subjects and has been published in the Journal of Finance, the Journal of Accountancy, and other periodicals. MKinsman@pepperdine.edu
 This paper has benefited from the excellent comments of an anonymous reviewer whose comments have been integrated into this paper.
 Barbara Kiviat, “Hello, Hedge Funds.” Time 168, no. 23 (12/4/2006).
 Inv. Adv. Act Release No. 2333 (Dec. 10, 2004), 2004 WL 2785492, at 3.
 U.S. Treasury, http://www.treas.gov/press/releases/reports/hedgfund.pdf. (no longer accessible).
 See 15 U.S.C. § 80a-3(c) (1) and 15 U.S.C. § 80a-3(c)(7).
 15 U.S.C. § 80b-3(b)(3)-1(d).
 Inv. Adv. Act Release No. 2266 (July 20, 2004), 2004 WL 1636422, at 24; Inv. Adv. Act Release No. 2333 (Dec. 10, 2004), 2004 WL 2785492, at 6 n.62.
 Inv. Adv. Act Release No. 2333 (Dec. 10, 2004), 2004 WL 2785492, at 3.
 Kara Scannell, “SEC Dealt Setback As Court Rejects Hedge-Fund Rule,”
The Wall Street Journal, June 24, 2006, at A1.
 See 15 U.S.C. § 80a-3(c)(1) and 15 U.S.C. § 80a-3(c)(7).
 See 15 U.S.C. § 80a-3(d).
 17 C.F.R. § 275.203(b)(3)-1(d)(1).
 15 U.S.C. § 275.203(b)(3)2-a.
 The Hedge Fund Rule was approved by the five-member Commission in a 3-2 vote. The two dissenting Commission members, Cynthia Glassman and Paul Atkins vigorously dissented from the rule, arguing that the proposed rule was unnecessary and exceeded the SEC’s authority.
 Goldstein v. SEC, No. 04-1434, DC Ct. App (June 23, 2006) (“Goldstein”).
 Securities and Exchange Commission, Testimony Concerning the Regulation of Hedge Funds, at http://www.sec.gov/news/testimony/2006/ts072506cc.htm.
 Securities and Exchange Commission, Statement of Chairman Cox Concerning the Decision of the U.S. Court of Appeals in Phillip Goldstein, et al. v. SEC, at http://www.sec.gov/news/press/2006/2006-135.htm.
 American Bar Association Subcommittee on Private Investment Entities (pub. avail. Aug. 10, 2006) available at http://www.sec.gov/news/press/2006/2006-135.htm.
 Ann Davis, Henny Sender, and Gregory Zuckerman, “What Went Wrong at Amaranth,” The Wall Street Journal, Sept. 20, 2006, sec. C1.
About the Author(s)
Adam Peter, is a JD and MBA candidate in his final year of studies at the Pepperdine University School of Law and Graziadio School of Business and Management. Adam is also a CFA Level One Candidate and has clerked at the Securities and Exchange Commission (SEC) and the National Association of Securities Dealers (NASD). Adam currently works as an associate at an investment bank in Century City, and as a graduate assistant for John Paglia, PhD, assistant professor of finance at the Graziadio School.
Michael D. Kinsman, PhD, CPA, is a member of the Graziadio Business Review Advisory Board. He is a professor of finance and accounting at the Graziadio School of Business and Management. A former systems analyst for General Electric Corporation, a financial analyst for Pacific Telephone, and a consultant for a variety of large and small firms, Dr. Kinsman operates a CPA and consulting firm in Laguna Beach. He has written and lectured on a variety of subjects and has been published in the Journal of Finance, the Journal of Accountancy, and other periodicals.