Hedge funds have been of continuing concern to financial regulators. Why is there a special concern about hedge funds now? In the current financial upheaval, many of our largest regulated financial institutions have encountered considerable trouble. The Federal Reserve and other banking regulators have insisted that large financial conglomerates boost their capital to compensate for the decline in value of their assets (generally, their holdings of mortgage-backed securities), and the Securities and Exchange Commission ("SEC") has done the same for the broker-dealers that it regulates. The problem is that they do not have direct control over an unregistered hedge fund, as they do over regulated firms. Professor James Fanto of Brooklyn Law School explains why this flurry of activity may be a prelude to eventual regulation of hedge funds and is thus laying the grounds for future legislation to this effect.
Professor Fanto writes: This inability of financial regulators directly to regulate hedge funds is not for want of trying. A few years ago, after the LTCM episode, the SEC proposed and implemented a regulation that would result in many hedge fund advisors having to register under the Advisers Act. However, the Court of Appeals for the District of Columbia Circuit eventually struck the regulation down as being beyond the SEC’s power. As it happens, despite the decision, some hedge fund advisors elected to remain registered under the Advisers Act. Nevertheless, for those who choose not to register, regulators can regulate them and their funds only indirectly, for example by overseeing the manner in which regulated investment banks and commercial banks engage in transactions with the funds and by gathering information about the funds from these banks.
It is in this context that the President’s Working Group on Financial Markets (which is made up of the main U.S. financial regulators) just received two reports on “best practices” relating to hedge funds, one prepared by hedge fund managers themselves and the other by institutional investors in hedge funds. The reports are designed to reinforce certain principles and practices that hedge funds should adopt and that hedge fund investors should insist upon. These are in general: (i) adequate disclosure to investors, (ii) sound valuation practices, (iii) strong risk management, (iv) necessary business operations and internal control of them, and (v) enhanced compliance and a culture of compliance. The overall purpose of the recommended practices is to prevent hedge fund failure and thus to maintain investor confidence in this industry.
The managers’ report, entitled Best Practices for the Hedge Fund Industry: Report of the Asset Managers’ Committee to the President’s Working Group on Financial Markets, elaborates on these practices from the hedge fund’s and advisor’s perspective. This report recommends that a fund’s offering document provide material information about, among other things, its investment strategy, managers, and valuation practices, that, at a minimum, the fund send quarterly performance information to investors, that its financial information be audited, and that a fund make enough disclosure to counterparties to ensure that they maintain confidence in it. On valuation, the report addresses the risk that hedge fund managers will give a too optimistic value to their assets, particularly with respect to the hard-to-value over-the-counter securities, in order to inflate their compensation and/or to disguise problems in their portfolio. The basic recommendations of the report are to separate valuation from fund management, to apply valuation principles consistently, and to have a supervisory valuation committee composed of senior personnel. For risk management the report insists that a hedge fund have in place procedures and policies (including having a chief risk officer and other specialized personnel) for accurately measuring the various risks (liquidity, leverage, market, counterparty credit, operational) so that it can accurately disclose its risk profile and adequately deal with them. A hedge funds also needs sophisticated trading and business operations since it is often involved in trading with multiple counterparties all over the world, on and off exchanges: the operations must cover matters such as the relationship and oversight of counterparties and service providers, the management and custody of assets, and the implementation of core operations practices, such as accounting and disaster recovery. Finally, the report recommends that a hedge fund have a code of ethics, compliance policies, training of personnel in these issues, and a system to address conflicts of interest (e.g., conflicts committee). In fact, if all of these recommendations are implemented, a hedge fund begins to look a lot like a regulated financial institution. [footnotes omitted]