November 17, 2010
Hedge-Fund Populism
Posted by Jeff Schwartz

I’ve never been fully on board with the idea that hedge funds should be required to register with the SEC.  It finally became law, however, as part of the Dodd-Frank Act, which imposes the requirement on hedge-fund advisers with more than $150 million in assets.  Looking at the new legislation, I think you can make plausible arguments in favor of the rule, though my feeling is that the new requirement may be more symbolic than substantive.

The increased transparency and oversight could be justified as mechanisms to address the risk of hedge-fund fraud, as well as the systemic risk that some of these funds pose.  But the registration requirement does not seem to map all that well onto either goal. 

The idea that registration could help protect investors from fraud is reasonable.  It might deter fraud or make it easier to detect.  But the Madoff scandal gives reason for pause.  Madoff was registered as an investment adviser and his operations had raised red flags with the SEC.  Yet the agency failed to uncover the far-reaching misconduct.  What this shows is that registration alone is insufficient, and perhaps secondary.  More importantly, the SEC needs to right the ship in terms of enforcement.  If this happens, then perhaps the rule will prove to be a useful investor-protection tool.  While the Act does beef up the SEC’s powers in this regard, my intuition is that the problem is cultural rather than regulatory.

Registration as a response to systemic risk is also questionable.  As the LTCM collapse illustrates, hedge funds can give rise to this concern.  But the Act’s systemic-risk provisions address this.  The Act holds “nonbank financial compan[ies]” that pose a risk to the financial system to certain prudential standards.  In addition, hedge funds will be required to open their books to regulators, so that they can determine which funds to subject to this scrutiny.  While it’s arguable that the SEC could see something in registration-related reports that would otherwise be missed, this seems like a rather thin justification given the SEC’s traditional area of expertise.

Considering this provision reminds me of a line from one of Donald Langevoort’s recent articles wherein he shares his view that

“part of the motivation for the substantive and procedural disclosure requirements of U.S. securities regulation increasingly is disconnected from shareholder or investor welfare per se, and instead relates to the desire to impose norms that we associate with public governmental responsibility—accountability, transparency, openness and deliberation—on nongovernmental institutions that have comparable power and impact on society.”

Perhaps similar logic is at work here.  Rather than clearly reflecting any specific normative goal, perhaps hedge-fund registration is a populist response to the unease caused by the vast accumulation of capital in secretive, profitable, and risky endeavors. 

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