Hedge Fund Regulation

Hedge Fund Regulation • SEC mission and history • SEC/ government interest in hedge funds • Systemic risk • Regulatory “gaming” • Other issues • Recent SEC registration decision • Bigger questions

Hedge Fund definition revisited • 1940 Investment Company Act exclusion. • Looking for loopholes and opportunities. • Short. • Levered. • Active in public securities markets.

SEC • “The primary mission of the U.S. Securities and Exchange Commission (SEC) is to protect investors and maintain the integrity of the securities markets. • “The laws and rules that govern the securities industry in the United States derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it. • “The SEC also oversees other key participants in the securities world, including stock exchanges, broker-dealers, investment advisors, mutual funds, and public utility holding companies. Here again, the SEC is concerned primarily with promoting disclosure of important information, enforcing the securities laws, and protecting investors who interact with these various organizations and individuals.

Basics • Goal 1: Protect investors • From fraud? • From loss? • From over-charging? • Goal 2: Integrity of the securities markets • Integrity = trustworthiness? • Means: Information disclosure • Fine print caveat emptor • Reduce information asymmetry (insider trading)

History (SEC website) • “Tempted by promises of "rags to riches" transformations and easy credit, most investors gave little thought to the dangers inherent in uncontrolled market operation. During the 1920s, approximately 20 million large and small shareholders took advantage of post-war prosperity and set out to make their fortunes in the stock market. It is estimated that of the $50 billion in new securities offered during this period, half became worthless. • “With the Crash and ensuing depression, public confidence in the markets plummeted. There was a consensus that for the economy to recover, the public's faith in the capital markets needed to be restored. Congress held hearings to identify the problems and search for solutions. • “Based on the findings in these hearings, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934. These laws were designed to restore investor confidence in our capital markets by providing more structure and government oversight. The main purposes of these laws can be reduced to two common-sense notions:

Principles • “Companies publicly offering securities for investment dollars must tell the public the truth about their businesses, the securities they are selling, and the risks involved in investing. • “People who sell and trade securities – brokers, dealers, and exchanges – must treat investors fairly and honestly, putting investors' interests first.

The Commissioners • “The Securities and Exchange Commission has five Commissioners who are appointed by the President of the United States with the advice and consent of the Senate. Their terms last five years and are staggered so that one Commissioner's term ends on June 5 of each year. To ensure that the Commission remains non-partisan, no more than three Commissioners may belong to the same political party. The President also designates one of the Commissioners as Chairman, the SEC's top executive.

Division of Investment Management • “The Division of Investment Management oversees and regulates the $15 trillion investment management industry and administers the securities laws affecting investment companies (including mutual funds) and investment advisers. In applying the federal securities laws to this industry, the Division works to improve disclosure and minimize risk for investors without imposing undue costs on regulated entities. • The Division: • interprets laws and regulations for the public and SEC inspection and enforcement staff; • responds to no-action requests and requests for exemptive relief; • reviews investment company and investment adviser filings; • reviews enforcement matters involving investment companies and advisers; and • develops new rules and amendments to adapt regulatory structures to new circumstances.

Registration of Exchanges,Associations, and Others “The Act requires a variety of market participants to register with the Commission, including exchanges, brokers and dealers, transfer agents, and clearing agencies. Registration for these organizations involves filing disclosure documents that are updated on a regular basis.”

Investment Company Act of 1940 • “This Act regulates the organization of companies, including mutual funds, that engage primarily in investing, reinvesting, and trading in securities, and whose own securities are offered to the investing public. The regulation is designed to minimize conflicts of interest that arise in these complex operations. The Act requires these companies to disclose their financial condition and investment policies to investors when stock is initially sold and, subsequently, on a regular basis. • “The focus of this Act is on disclosure to the investing public of information about the fund and its investment objectives, as well as on investment company structure and operations. It is important to remember that the Act does not permit the SEC to directly supervise the investment decisions or activities of these companies or judge the merits of their investments.

Investment Advisers Act of 1940 • “This law regulates investment advisers. With certain exceptions, this Act requires that firms or sole practitioners compensated for advising others about securities investments must register with the SEC and conform to regulations designed to protect investors. Since the Act was amended in 1996, generally only advisers who have at least $25 million of assets under management or advise a registered investment company must register with the Commission.

Recent Regulatory Interest in Hedge Funds • LTCM (President’s Workgroup) • Mutual Fund Timing Scandals • Manipulation, Short-Sales etc.

LTCM • “At the end of 1997, LTCM returned approximately $2.7 billion in capital to its investors, reducing the capital base of the fund by about 36 percent to $4.8 billion. Despite this reduction in its capital base, however, the hedge fund apparently did not reduce the scale of its investment positions. Put another way, the managers of the Fund decided to increase its balance-sheet leverage by reducing its capital base rather than by increasing its positions.

LTCM Position • “Approximately 80 percent of the LTCM Fund’s balance-sheet positions were in government bonds of the G-7 countries • “At the end of August, 1998, the gross notional amounts of the Fund’s contracts on futures exchanges exceeded $500 billion, swaps contracts more than $750 billion, and options and other OTC derivatives over $150 billion. • “using the January 1, 1998, equity capital figure of $4.8 billion, this level of assets still implies a balance-sheet leverage ratio of more than 25-to-1

Crisis • “On July 31, 1998, the LTCM Fund held $4.1 billion in capital, down about fifteen percent from the beginning of the year. During the single month of August, the LTCM Fund suffered additional losses of $1.8 billion, bringing the loss of equity for the year to over fifty percent. • “previously flexible credit arrangements became more rigid and the daily mark-to-market valuations for collateral calls by counterparties became more contentious. • “Bear Stearns, LTCM’s prime brokerage firm, had required LTCM to collateralize potential settlement exposures reducing the fund’s overall liquidity resources

Consortium • “September 22, a Core Group of four of the most concerned counterparties began seriously exploring the possibility of mutually beneficial alternatives to default. The main alternative the Core Group focused on came to be known as the consortium approach and involved the recapitalization of the LTCM Fund through mutual investments by its major counterparties in a recently set up feeder fund and a relatively small investment in a newly set up limited liability company which became a new general partner of the LTCM Fund. Under this approach, the stake of the original owners would be written down to 10 percent and the consortium would acquire the remaining 90 percent ownership share, as well as operational control of LTCM. • The Federal Reserve Bank of New York provided the facilities for these discussions and encouraged the firms involved to seek the least disruptive solution that they believed was in their own collective self-interest.

Systemic Risk • “LTCM itself estimated that its top 17 counterparties would have suffered various substantial losses — potentially between $3 billion and $5 billion in aggregate • Prime Broker. • Futures clearing firms. • Repo and reverse repo counterparties. • OTC derivatives counterparties. • Loan counterparties. • Liquidity and market valuation of positions • Other firm’s affected via prime broker

Meltdown? • First, the liquidation and closing out of positions could have generated significant movements in market prices and rates, affecting the market value of positions held by the LTCM Fund’s counterparties as well as by other market participants. • Second, the resulting rush by the Fund’s counterparties and others to reappraise their credit risks, coupled with an increase in uncertainty, could have exacerbated the broader decline in market liquidity, making it more difficult for market participants to manage risks. • Third, those firms with exposures to LTCM could have encountered increased concerns about their own credit standing, with a resulting rise in their cost of obtaining funds.

Fallout • Leverage risk • Liquidity • Collateral • Govt. role in counter-party risk?

Working Group Recommendations • More frequent and meaningful information on hedge funds should be made public • Public companies, including financial institutions, should publicly disclose additional information about their material financial exposures to significantly leveraged institutions, including hedge funds; • Financial institutions should enhance their practices for counterparty risk management • Regulators should encourage improvements in the risk management systems of regulated entities; • Regulators should promote the development of more risk-sensitive but prudent approaches to capital adequacy; • Regulators need expanded risk assessment authority for the unregulated affiliates of broker-dealers and futures commission merchants; • The Congress should enact the provisions proposed by the President’s Working Group to support financial contract netting in the United States • Regulators should consider stronger incentives to encourage off-shore centers to comply with international standards.

SECURITIES AND EXCHANGE COMMISSION17 CFR Parts 275 and 279[Release No. IA-2333; File No. S7-30-04] • Registration Under the Advisers Act of Certain Hedge Fund Advisers • SUMMARY: The Commission is adopting a new rule and rule amendments under the Investment Advisers Act of 1940. The new rule and amendments require advisers to certain private investment pools (“hedge funds”) to register with the Commission under the Advisers Act. The rule and rule amendments are designed to provide the protections afforded by the Advisers Act to investors in hedge funds, and to enhance the Commission’s ability to protect our nation’s securities markets.

I. Growth of Hedge Funds • “As of the end of August 2004, equity mutual funds’ assets were $3.8 trillion. At $870 billion, hedge funds’ assets were equal to 22.9 percent of this figure. • “hedge funds represent approximately ten to twenty percent of equity trading volume in the United States (Sanford Bernstein 2003) • “One article portrayed a single hedge fund adviser as responsible for an average of five percent of the daily trading volume of the New York Stock Exchange. • Another reported that hedge funds dominate the market for convertible bonds.

II. Growth in Hedge Fund Fraud • “In the last five years, the Commission has brought 51 cases in which we have asserted that hedge fund advisers have defrauded hedge fund investors or used the fund to defraud others in amounts our staff estimates to exceed $1.1 billion. • “Most disturbing is that hedge fund advisers have been key participants in the recent scandals involving late trading and inappropriate market timing of mutual fund shares. • “Our staff counts almost 400 hedge funds (and at least 87 hedge fund advisers) involved in these cases and others under investigation.

What Fraud?

Day Trading, Stale Pricing and Solutions William N. Goetzmann Yale School of Management

The Problem • Funds sell and redeem shares at incorrect net asset values. • Valuation errors for some funds are predictable. • Traders have increasingly exploited this opportunity. • Safe-harbor reliance on stale prices has slowed response to the problem.

Academic Research • NYT 1997, “…Fidelity Invokes Fine Print and Angers Some Customers..” • Chalmers, Edelin and Kadlec, 2000 • “The Wildcard Option...” • Greene and Hodges, 2000 • “The Dilution Impact…” • Goetzmann, Ivkovic and Rouwenhorst, 2000 • “…Evidence and Policy Solutions” • Zitzewitz, 2000 • “…Associated Trading Profit Opportunity”

Simulated International Stale Price Profits 1990 – 1998Growth in $1 invested in two alternative strategies over the period 1-2-90 through 7-24-98. Buy and hold means equal-weighted investment in 112 Foreign Stock Funds listed on Morningstar. Day-Trading Strategy does not include redemption fees and transactions costs Day Trading Buy and Hold

Occasional Fair Value Pricing • Big event fair pricing. • E.g. Asian crisis. • Allowed, current practice. • Timing still profitable on small move days, however.

Fair Value Securities – CEK & CZ • Adjust security prices based on model estimate. • Security return: R t+1 =  +  Zt + t • Z could be anything: Russell/ ADR/ futures. • Returns are noisy and measurement depends on many factors. • ITG “tree-based” model.

Regulation • Role of ICI • Stale pricing conference • Role of SEC • Opinion should clarify safe harbor(s)

III. Broader Exposure to Hedge Funds • “In developed markets outside the United States, hedge funds have sought to market themselves to smaller investors, and we can expect similar market pressures to develop in the United States as more hedge funds enter our markets. • “Second, the development of “funds of hedge funds” has made hedge funds more broadly available to investors. • “Finally, and perhaps most significantly, in the last few years, a growing number of public and private pension funds,38 as well as universities, endowments, foundations, and other charitable organizations, have begun to invest in hedge funds or have increased their allocations to hedge funds.

Proposal • “We proposed in July of 2004 a new rule that would require hedge fund advisers to count each investor in a hedge fund, rather than only the hedge fund itself, as a client for purposes of the private adviser exemption. • “As a result, most hedge fund advisers would have to register with the Commission and would be subject to SEC oversight. The rule and rule amendments were designed to provide the protections afforded by the Advisers Act to investors in hedge funds, and to enhance the Commission’s ability to protect our nation’s securities markets.

Census Information • “Registration under the Advisers Act provides the Commission with the ability to collect important information that we now lack about this growing segment of the U.S. financial system.

Deterrence of Fraud • “Registration under the Advisers Act enables us to conduct examinations of the hedge fund adviser. • “Some commenters cited to us a sentence from the 2003 Staff Hedge Fund Report that indicated that there was no evidence that hedge fund advisers engaged disproportionately in fraudulent activity. The 2003 Staff Hedge Fund Report was issued before the discoveries of hedge fund involvement in late trading and inappropriate market timing of mutual fund shares. • Second, some commenters asserted that the Commission would be unsuccessful at detecting fraud by hedge fund advisers, pointing to frauds that have occurred involving mutual funds. Such an assertion amounts to a generalized attack on the Commission’s ability to deter and detect fraud in general, and on the premise of statutes that provide us with authority to examine investment advisers • Finally, some commenters suggested that hedge fund advisers are different from other advisers and that our examiners would be unable to fully understand their trading strategies and investments.

Keeping Unfit Persons from Using Hedge Funds to Perpetrate Frauds • “Registration with the Commission permits us to screen individuals associated with the adviser, and to deny registration if they have been convicted of a felony or had a disciplinary record subjecting them to disqualification. We intend to use this authority to help keep fraudsters, scam artists and others out of the hedge fund industry.

Compliance • Registration under the Advisers Act will require hedge fund advisers to adopt policies and procedures designed to prevent violation of the Advisers Act, and to designate a chief compliance officer.

DISSENT OF COMMISSIONERS GLASSMAN & ATKINS • The majority proposes a solution to an ill-defined problem without having given proper consideration to viable alternative solutions in light of the limitations of our own capabilities.

Hedge Funds Have Long Been the Subject of SEC Study • PWG LTCM Report

Registration will not Reduce Enforcement Actions • “The 46 cases suggest that the typical "hedge fund" fraud is perpetrated by an adviser that is too small to be registered with the Commission, was registered already with the Commission, or evaded registration requirements. • “Mandatory hedge fund adviser registration would not add to the Commission's ability to combat these types of fraud. • “Importantly, the majority's recitation of these fraud cases illustrates the fact that hedge fund advisers are subject to the antifraud provisions regardless of their registration status.

Form ADV Does Not Meet the Information "Needs" • Part I of Form ADV yields little more than a census of name, address, and amount of assets under management. • Part II of Form ADV, although more substantive, is unlikely to produce information that would prove useful to the Commission because hedge fund advisers will feel compelled to draft their disclosure to protect proprietary information.

Things for Regulators to Worry About • Valuation • Manipulation • Systemic Risk

Valuation: Mutual Fund Timing • “GAO: Distracted SEC Failed to Find Abuses” • April 22, 2005 (Associated Press) — The Securities and Exchange Commission failed to uncover trading abuses throughout the mutual fund industry that cost investors billions because it had other priorities, congressional investigators have found.

GAO Findings • “Prior to September 2003, SEC did not examine for market timing abuses because agency officials viewed other activities as representing higher risks, and believed that companies had financial incentives to control frequent trading because it could lower fund returns. • “First, without independent assessments during examinations of controls over areas such as market timing (through interviews, reviews of exception reports, reviews of independent audit reports, or transaction testing as necessary) the risk increases that violations may go undetected. • Second, SEC can strengthen its capacity to identify and assess evidence of potential risks. Articles in the financial press and academic studies that were available prior to September 2003 stated that market timing posed significant risks to mutual fund company shareholders. • Finally, GAO found that fund company compliance staff often detected evidence of undisclosed market timing arrangements with favored customers but lacked sufficient independence within their organizations to correct identified deficiencies. Ensuring compliance staff independence is critical, and SEC could potentially benefit from their work.

Market Manipulation • Pricing • M&A Events • Short-selling (?)

Ronald Baron, Firm Charged With Market Manipulation • Washington, April 29 (Bloomberg) • “Money manager Ronald S. Baron, his firm Baron Capital Inc. and two of its traders agreed to pay a $2.7 million fine to settle Securities and Exchange Commission charges of making manipulative trades in 1999. • Relying on the firm's internal tape recordings, the SEC charged all four with the unlawful practice of ``marking the close'' in Southern Union Co. stock, then more than 10 percent owned by Baron affiliates. Southern Union was acquiring Pennsylvania Enterprises with the price set by Southern Union's closing price over a 10-day period, the SEC said. • The higher that average, the more favorable the pricing terms would be to (Southern Union) and its existing shareholders,'' the SEC said in a press release.

“Mylan/King deal forerunner to more derivatives engineering in mergers” • Brent Shearer, March 2005: “The Mylan/King saga started last summer when Mylan unleashed a $4 billion all-stock bid for King. Mylan… • “Carl Icahn bought a 9.8% stake in Mylan and vowed to fight the acquisition of King. In the second half of 2004, he threatened a proxy fight and made his own offer for Mylan. He also sued Perry Capital, which had purchased a 9.9% holding in Mylan. • Perry's tactic was to buy a sizeable holding in Mylan and thus secure voting rights. It also made a deal with a brokerage firm that agreed to buy back the stock at the same price at a future date. Icahn's suit maintains that this technique of purchasing of voting rights and employing a derivatives contract to shed financial risk is illegal. • In December, King fueled further controversy by announcing that it was restating its earnings for 2002, 2003, and the first six months of 2004 to recognize expenses growing out of product returns. • Apparently, the restatements put the kibosh on the deal, at least for now.

“Perry's use of a derivative contract to secure voting rights and off-load financial risk” • "Hedge funds use derivatives in other markets so they have the expertise. • “Another aspect of the funds' movement toward active deal involvement is that because they often move in packs. • "You're seeing hedge funds banding together and being able to dictate terms in transactions," Marshall says. He notes that hedge funds have access not only to their own capital pools but also additional leverage that can be supplied by their prime broker. • “The lesson of the clout that hedge funds can bring to deals hasn't been lost on Icahn; he is in the process raising $3 billion for a fund of his own.

What is the SEC Mandate ? • Who gets harmed? • How doe they get harmed? • How will principles of SEC prevent that? • Rational vs. Behavioral Investor decision-making • What can a regulator hope to accomplish? • What will the next crisis be?

Sort-sales • Current Issues • History • Research

Hedge Fund Regulation