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Hedge Fund Regulation

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Hedge funds make up a $1 trillion industry that has assisted in economic growth. There is no necessity for them to be regulated by the SEC, and to do so would be a restraint of trade. There is much controversy over the issue of hedge fund regulation, and there are valid arguments supporting either opinion. To understand and appreciate these arguments, we must first understand the origin of the hedge fund, its history, and its design.

The first hedge fund was created in 1949 by Alfred Winslow Jones. Although the term today is generally associated with a high-risk form of investment, its original meaning was quite to the contrary. It was termed "hedge fund" because of its strategy to hedge market risk by assuming a short position in some stocks while remaining long in others. Jones formed this fund using a limited partnership structure, with the goal of pooling the money of many investors into an unregulated fund that would deliver a higher return than mutual funds. Indeed his investors enjoyed a return that outperformed every mutual fund. In the 1960s, hedge fund managers began to change their activities due to the growing demand. Instead of hedging the risk of the portfolio, they began leveraging it, increasing the risk of the investors' positions. The downturn in the market in the mid-1960s to 1970s humbled the hedge fund managers and investors when they were hurt more than the general investor population. (SIA)

The hedge fund again became popular in the 1980s. By then, there were offering a wider array of products, and more sophisticated strategies. A significant cause for this change was the growing popularity of derivatives such as futures and options. Ordinary investors began putting significant amounts of money into hedge funds, and the bull market was delivering record-setting returns. The market for these funds was polluted by many managers who lacked skillful investment tactics, but continued to earn investors unfathomable returns. This of course was due to incredible performance of the general market during the late 1990s. A good hedge fund however is one that performs well under any market conditions. Many of these "phony" funds were filtered out with the burst of the "Tech Bubble", and the downfall of the "dot-coms." The two most memorable, and most disastrous, were the collapse of the Long Term Capital Management fund in 1998, and the meltdown of Tiger Funds in 2000. (Carus)

This painful downturn has created the controversy over what steps, if any, should be taken to protect hedge fund investors, and to prevent the disastrous results that have taken place in the past. Still scarred from the tremendous losses they suffered, it is quite understandable that many have appealed to the federal government to take action. Some feel that the downturn was caused by their secretive nature, which led managers to take advantage of the investors' ignorance at the latter's expense. They believe therefore that the funds should be required to disclose their investment practices. Others feel that some of their activities should actually be restricted to protect the investors from the high level of risk involved. (Carus)

The idea of regulating investment companies began with the rising popularity of mutual fund in the early 1920s. Many new funds were started at this time and investors liked the idea of buying in to a well diversified portfolio. Many were severely hurt a few years later on October 24 of 1929, also know as Black Thursday, and subsequently by the great depression. (Lederman, 22). The Securities and Exchange Commission (SEC) subsequently instituted the Securities Act of 1933 and the Securities and Exchange Act of 1934. The purpose of these acts was to allow companies, (including investment firms,) to be liable for certain instances of negligence and fraud, and to be required some level of disclosure, such as issuing a prospectus containing specific information about the fund's management, holdings, fees and expenses, and performance. (SEClaw)

In 1940, to further ensure investors' safety, Congress passed the Investment Company Act of 1940, which heightened the standards expected from investment companies. The act required all who fall under its definition of an "investment company," (discussed further below), to register with the Commission, and disclose their investment positions and financial condition. Additionally, it placed significant restrictions on the types of transactions they may undertake. For example, they were restricted from trading on margin and from engaging in short sales, and were required to secure shareholder approval to take on significant debt, or invest in certain types of assets, such as real estate or commodities. Soon after, Congress implemented the Investors Advisement Act of 1940. This act was meant to compliment the Investment Company Act by imposing requirements on the investment advisers, as well. Under this act, any individual who qualifies as an "investment adviser" as defined by the United States Code, (discussed further below), is required by law to be registered with the SEC, and is prohibited from engaging in any fraudulent or deceptive practices. The intention of Congress in its creation of this act was to keep a census of advisers so the SEC can better respond to and take action on complaints against fraudulent advisers. (SEClaw)

Hedge funds, as described by the United States Court of Appeals case, Goldstein v. SEC (discussed below), "are notoriously difficult to define." Rather "they may be defined more precisely by reference to what they are not" (US Court of Appeals). It is for this reason that they were able to bypass the above-mentioned act of Congress. The Securities Act of 1933, as well as the Securities and Exchange Act of 1934 apply only to those companies that are registered with the SEC. It is the subsequent acts that require specifically investment companies, and investment advisors to be registered. Here, the ambiguity of hedge funds has proven to be beneficial.

The Investment Company Act of 1940 defines its subjects as any issuer of securities that "is or holds itself out as being engaged primarily... in the business of investing, reinvesting, or trading in securities." Although this may seem to include hedge funds, most are exempt because they have one hundred or fewer beneficial owners and do not offer their securities to the public, or because their investors are all accredited investors - having total incomes of over $200,000 per year or a net worth of over $1,000,000 - and qualified purchasers - owning at least $5,000,000 in qualified investments. In a similar vein, the Investment Advisers Act of 1940 defines an investment adviser as one who "for compensation, engages in the business



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