The Hedge Fund ‘Transparency’ (Regulation) Act of 2009

On January 29, Senators Grassley and Levin introduced The Hedge Fund Transparency Act, a revision to Grassley’s previously proposed legislation – Hedge Fund Registration Act of 2007 (S.1402). The 2009 Act calls for an amendment to the Investment Company Act of 1940. While titled a ‘transparency’ act, the proposed bill effectively broadens the regulatory authority of the SEC. The Act of 1940 defines an investment company and details the regulation set forth by U.S. Securities and Exchange Commission (SEC), primarily overseeing traditional mutual funds and closed-end funds. The act as currently written allows hedge funds to avoid being listed as investment companies because they are not open to the general public and often via pooled entities have fewer than 15 investors. Hedge Funds are only open to “qualified purchasers” or sophisticated investors (pension funds, endowments, wealthy individuals, etc) and thus are allowed to engage in higher risk, higher reward investments without the regulatory burden of the SEC.

As mentioned, hedge funds are currently not “investment companies” and are thus not subject to SEC oversight. Under the proposed bill, hedge funds would qualify as investment companies, but with special qualifications reducing the required level of disclosure and amount regulation. The availability of mutual funds to retail investors warrants the high degree of regulation and disclosure. The act would require all hedge funds to disclose the following:

(a) List the companies and natural individuals who are the beneficial owners of the fund
(b) Explain the ownership structure
(c) List of affiliated financial institutions
(d) Minimum investment commitment required from an investor
(e) Total number of investors in the fund
(f) Name of the fund’s primary accountant and broker
(g) Current value of the fund’s assets and assets under management (AUM) – effectively disclosing returns

Grassley and Levin provide three arguments for amendment, two of which have some merit. First, hedge funds have exploded by number of firms (10,000) and assets under management ($1.8 trillion), thus hedge funds play a significant role in the financial markets. Second, pension plans, endowments and charities invest in hedge funds leaving working class Americans and all sector of the economy susceptible to hedge fund activity. Last and most importantly, hedge funds have become commingled with the regulated financial sectors; many financial services holding companies of federally insured banks and insurance companies are also owners of hedge fund affiliates. As the funds encroach on the regulated and insured sectors, the ripple effects become severe, as exhibited in 2008. Levin highlighted in his speech on the Senate Floor such effects: Bear Sterns two affiliated hedge funds failed, Merrill Lynch’s investments in Bear Stern’s funds contributed to ML’s failure, with ML’s demise imminent, Bank of America (a FDIC insured depository institution) acquired ML. Bank of America, which received TARP funds, is now further susceptible the volatile and secretive hedge fund world. It is murky how the proposed disclosure would have prevented our current financial meltdown. Listing affiliated financial institutions would provide retail investors with some information regarding the potential risk to public listed firms; however, assessing the magnitude of losses would likely prove difficult.

It is important to note that hedge funds are not completely without regulation. Institutional investment managers, hedge funds qualify, with over $100 million in capital invested in exchange traded securities are required to report via Form 13F a listing of security holdings within 45 days of quarter-end. Said listings are available to the public via EDGAR.

The proposed regulatory requirement do not appear to onerous for the funds, nor is the mild disclosure likely to materially impact the funds ability to quietly build positions – often a key to ‘generating alpha’. Levin concluded his speech with the following remarks “The ‘Hedge Fund Transparency Act’ will protect investors, and it will help protect our financial system.” In analyzing the proposed legislation, it is unclear how the small amount of transparency will protect investors. Hedge funds will be subject some oversight by the understaffed SEC, but it is difficult to ascertain if the proposed level of disclosure would have reduced the carnage in the markets in 2008. Levin further noted that “It is time to bring hedge funds under the federal regulatory umbrella”, which indeed this entry-level regulation will open up hedge funds to further regulation in the future. Restrictions on holdings and leverage would be particularly negative for fund managers. Hedge funds are at the top of a slippery slope of regulation which will hopefully not continue the US march toward less competitive capital markets.

SEC Drops the Ball – Madoff Investment Securities and Consolidated Supervised Entities

On December 11, 2008 former NASDAQ Chairman, Bernard L. Madoff, was arrested for securities fraud relating to his firm Bernard L. Madoff Investment Securities LLC. Madoff admitted to his senior employees that he was effectively running a giant ponzi scheme and the fraudulent losses may total $50 billion. Madoff’s business included investment advisory ($17.1B AUM), a NASDAQ market maker ($700mm in capital), and a broker dealer.

As a broker dealer and market maker where was the SEC? Perhaps the SEC was turning a blind eye, or simply trusting their own. Bernie Madoff has been in the securities business since the 1960’s and was the former Chairman of the NASDAQ. The SEC’s basic mission is to protect investors:

“The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation”

“The SEC oversees the key participants in the securities world, including securities exchanges, securities brokers and dealers, investment advisors, and mutual funds.”

Madoff’s firm was not taking capital from naive retail investors; Madoff’s investors included the $7.3B Fairfield Sentry Ltd and the $2.8B Kingate Global Fund Ltd. These sophisticated, qualified investors likely did not complete all of the necessary diligence on the firm. Madoff utilized a split strike conversion strategy which is an option arbitrage strategy trading equity and at-the-money puts verse out-of-the-money calls. Despite this complicated, volatile, esoteric strategy, Madoff generated consistent high single-digit returns with limited volatility. Furthermore, CNBC reports the hedge fund due diligence firm Aksia found a 2005 letter to the SEC stating that Madoff was running a “ponzi scheme”.

The Madoff disaster highlights the continued lack of oversight from the SEC. The SEC allowed investment banks to have voluntary supervision which has no doubt fueled the problems facing Wall Street today. In August 2004, the SEC past Consolidated Supervision of Broker-Dealer Holding Companies, allowing large investment banks, labeled consolidated supervised entities (CSE) to be regulated at the holding company level as opposed to regulating the banks individual business lines. The goal was to reduce the amount of duplicate oversight from the regulatory body. The SEC required Require that CSE holding companies maintain regulatory capital commensurate with the risk of their activities. The SEC state “the amendments should help the Commission to protect investors and maintain the integrity of the securities markets by improving oversight of broker-dealers and providing an incentive for broker-dealers to implement strong risk management practices.” The Basel Standards established three Basel “Pillars” to assess the CSEs, minimum regulatory capital, supervisory review, and disclosure of the capital, risk exposures, and risk assessment processes of the institution.

While the SEC may be stretched too thin, the self-governing system was not adequate to regulate the banks. The banks appeared not to have understood the amount of risk exposure in the credit markets or the potential counter party risk of the credit default swap market. Only a few institutions saw the credit crisis coming, but perhaps with greater oversight of the broker dealers, alternative asset management firms, and market markers, the SEC could have pooled this knowledge to require larger capital requirements for the CSEs. On the heals (hopefully no the toes) of this financial crisis, the US Government should reassess the role of the SEC and potentially even increase the resources available to the regulatory body.