New Securities and Exchange Commission Chairman Chris Cox recently told the Wall Street Journal that he plans for the Commission to go forward with its controversial rule requiring hedge fund managers to register with the SEC. Under the rule, registration of a hedge fund with the SEC also would give the SEC power to engage in administrative investigations of fraud or other misconduct, screen out undesirable persons (such as felons) from serving as fund managers, and require funds to adopt internal compliance controls.
Cox's announcement came as somewhat of a surprise, since the rule originally had been proposed over strong dissents by Republican Commission members Cynthia Glassman and Paul Atkins, and the controversy over the rule was widely seen as one of the principal reasons former SEC Chairman William Donaldson stepped down with several years left on his term (presumably under pressure from the White House).
Various political factors may have weighed in Cox's decision, but the likeliest explanation is that he allowed himself to be spooked by several recent high-profile hedge fund problems, most notably the alleged fraud at Bayou Securities. According to a detailed NY Times account:
"... Bayou was founded by Samuel Israel III, a scion of a commodity
-trading family that is well known to Wall Street. [In 1998] Mr. Israel called
two of his colleagues into a conference room. All three men knew the situation
was dire at Bayou - the funds' losses had vastly overwhelmed their gains
for more than two years. Something had to be done, and fast. The solution,
devised by Mr. Israel and a lieutenant, James Marquez, was simple:
produce a fake audit of the funds' performance and try to make up the losses
next year. In the end, of course, the plan failed. The losses compounded
and the results Bayou reported to its investors -- several years of market-beating
returns -- were consistently false."
There is no moral or economic justification for the sort of fraud allegedly perpetrated at Bayou, of course; but neither does this incident justify the SEC's hedge fund rule.
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When the SEC sets out to regulate some aspect of the securities markets, it has two basic tools at its disposal: mandatory disclosure and anti-fraud prohibitions. In many cases, of course, the two are deployed in tandem; when a corporation makes an IPO, for example, it must provide investors with a prospectus prepared in accordance with the SEC's disclosure rules under Reg S-K and, under a number of provisions, is subject to liability for any fraud committed in connection with the offering. In other cases, however, the SEC limits its regulatory oversight to ex post application of the rules against fraud; the various categories of so-called "exempt securities," for example, are exempt from the SEC's disclosure rules but remain subject to anti-fraud provisions such as the famous Rule 10b-5.
Many prominent securities law scholars doubt the utility of mandatory disclosure rules, arguing that firms have more than adequate incentives to voluntarily provide disclosures to potential investors. (I summarized this debate in my article Mandatory Disclosure: A Behavioral Analysis.) But wherever one comes out on that question, there is little dispute that the strongest case for government-mandated corporate disclosure is when a firm makes a large public offering to numerous unsophisticated investors. In such a situation, it is argued, the combination of information asymmetries, collective action problems, and investor vulnerability justifies regulatory intervention.
In contrast, it is generally accepted that the case for government-mandated corporate disclosure is far weaker with respect to smaller private placements of securities to a select group of wealthy and knowledgeable investors. Such investors are assumed to be able to take care of themselves. Indeed, it is precisely for that reason that the SEC adopted Reg D, which allows issuers to sell securities to such investors with far less extensive disclosures than would be required in a public offering.
Hedge funds, of course, look a lot more like the latter than the former. To be sure, as pointed out by the SEC's analysis of the rule when proposed, there has been a slight trend towards retailization of the hedge fund industry. Most hedge funds, however, retain very high minimum account size requirements that effectively exclude everyone except very wealthy individual and institutional investors. As a result, we are dealing here with a product marketed almost exclusively to wealthy, experienced, and knowledgeable investors for whom caveat emptor rather than regulatory oversight is the appropriate answer.
Indeed, for investors wealthy enough to take the risks associated with hedge fund investing, the lack of regulatory oversight is a real blessing. As Morningstar Investments explains:
"Being free of many of the guidelines that constrain mutual funds allows hedge
funds greater flexibility in their strategies. They can borrow money to
invest -- also known as using leverage. Or they can sell borrowed stocks they
expect to plummet -- known as selling short. Or they can engage in trading
currencies and use exotic derivatives to boost returns."
But what about Bayou Securities, you ask? The answer is simple: mandatory disclosure does not prevent fraud. Securities managers who are going to commit fraud will not be deterred from doing so by government disclosure rules -- they will simply use the approved disclosure form to do so. Hence, rigorously enforced proscriptions of fraud seem far more important than mandatory disclosure, insofar as one is the sort of thing that allegedly happened Bayou Securities.
*****
In Chapter 3 of Revelations, St. John passes along the following message to the church in Laodicea: "I know your works; I know that you are neither cold nor hot. I wish you were either cold or hot. So, because you are lukewarm, neither hot nor cold, I will spit you out of my mouth."
It would be an equally apt fate for the SEC's hedge fund rule. The SEC was loath to impose the full panoply of mutual fund policy and disclosure rules on hedge funds, yet the SEC was also unwilling to leave hedge fund regulation to enforcement of the anti-fraud laws already on the books.
Accordingly, it adopted a sort of half-baked compromise that imposes costs without corresponding benefits. On the one hand, nothing about the rule will require that hedge fund investors receive better quality information. On the other hand, given that the SEC is unlikely to devote significant enforcement resources to conducting administrative investigations absent pretty clear evidence of fraud, it's hard to see how the new rule adds much in the way to deterrence of fraud.
Worse yet, what does a cook do with lukewarm food? You stick it in the microwave and heat it back up. Analogously, future hedge fund scandals inevitably will put political and media pressure on the SEC to expand regulation of hedge funds.
Chairman Cox had a golden opportunity to derail the Commission's half-baked plan to regulate hedge funds. Commissioners Glassman and Atkins almost certainly would have joined in support of an effort to repeal the rule. It's a pity he lacked the will to do so.
