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Debate Club

Should Hedge Funds Be Regulated?

Dale Oesterle and David Skeel debate.

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Hedge funds are growing like never before. Despite estimates that place the industry's total value above a trillion dollars, funds remain virtually free from the oversight of the Securities Exchange Commission. In the current issue of Legal Affairs, David Skeel argues that "hedge fund misbehavior looks ominously like the edge of the next wave of financial scandals."

Should hedge funds be regulated?

Dale Oesterle is J. Gilbert Reese Chair in Contract Law at Moritz College of Law at The Ohio State University. David Skeel is the S. Samuel Arsht Professor of Corporate Law at the University of Pennsylvania Law School.

Oesterle: 11/8/05, 02:32 PM
The financial press has been abuzz about hedge funds for the past year. Hedge funds are huge pools of equity capital that are lightly regulated. The light regulation enables the funds to raise and deploy capital very quickly and to use very sophisticated financial strategies. Today there are more than 8,000 such funds with more than $1 trillion of capital under management.

In the past year hedge funds have posted dramatic gains. Many of the larger hedge funds had returns in excess of thirty percent last year, well over stock market averages. About twenty hedge fund managers earned in excess of $100 million in compensation. There were also some spectacular failures—the Bayou Group, the Eifuku Master Fund in Japan, and the KL Group. The Eifuku Fund lost $300 million in seven trading days.

Some hedge funds also took an "activist" investor tack, pushing around the incumbent management in blue chip companies such as Time-Warner, Wendy's, McDonalds, Knight Ridder, and General Motors. The funds purchased stakes in the companies, publicly announced that the companies were "underperforming," and demanded structural changes designed to unlock share value, primarily the distribution of excess cash and the spin-off of successful divisions. These actions aroused the attention, and ire, of main street management, a powerful and entrenched interest group indeed.

At present there is evidence that hedge fund earnings are cooling off a bit and there is speculation that fund managers, used to the heydays, will take more extreme positions and massage existing positions to keep the illusion of their past year's glory alive.

This combination of factors—large size, speed, misunderstood sophistication, power to upset established interests, secrecy, periodic failure, and spin—creates an opportunity to foment popular fear of a new breed of shadowy financial monsters. And popular fear creates a cry for government control—too much control.

Historically, hedge funds have operated in the exceptions and exemptions of the Securities Act of 1933 (there is no public offering), the Securities and Exchange Act of 1934 (they are not publicly traded companies), the Investment Company Act of 1940 (they are not mutual funds), and the Investment Advisors Act of 1940 (they are not public investment advisers).

This is not to say that they are "unregulated," as many do. The anti-fraud provisions of the 1933 and 1934 acts apply with full force to the activities of the funds and state laws against investor fraud apply as well. Banking laws also restrict the activities of hedge fund lenders—banks—in significant respects. Thus far the Securities and Exchange Commission has responded with fairly mild registration requirements, to take effect in February of 2006. The SEC narrowed the traditional exemption under the Investment Advisors Act of 1940 enjoyed by the funds and will require funds to register their name and location, the professional history of the funds' managers, and a brief statement of the funds' investment strategy. The SEC will have the option of auditing the accounts of selected funds.

The small opening seedling of regulation will, no doubt, grow. With each new failure (and there will be failures) the SEC will face a harsh round of questioning over why the agency did not catch of the problem. The SEC's knee-jerk, defensive response will be to successively grow its disclosure rules and structural requirements. Soon the SEC will have a new section devoted to hedge funds.

The irony of the hedge fund regulation movement is that financial economists have, for over seventy years, been decrying, first, the lack of independent shareholder involvement in the management of public firms and, second, the lack of swift capital reallocation in American industry. Hedge funds do both perhaps more effectively than any financial institutions in American history and we recoil in fear over the changes.

Hedge funds are a competitive advantage in the world's markets; we should not act to stifle them due to our own fears of innovation.

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Skeel: 11/9/05, 09:14 AM
I certainly agree that hedge funds provide quick capital reallocation. And I'm all for putting more pressure on underperforming managers, as a few hedge funds have done.

What worries me is that an awful lot of hedge funds aren't busy trying to whip corporate America into shape. Too many seem to be just as happy to cut regulatory corners or to push through lousy deals if this produces the outsized profits their investors demand. It isn't an accident that hedge funds have been in the middle of nearly every financial scandal in the last several years, from the mutual fund scandals to recent allegations of vote buying in connection with several recent acquisitions.

Part of the problem with the hedge funds is, as a reporter friend of mine likes to say, there's simply too much money chasing too few legitimate opportunities. And the incentive to take extreme positions (as you put it) is magnified by the way hedge fund managers get paid. The big money (and the reason so many people are leaving investment banks to run hedge funds) comes from the fact that hedge fund managers usually get 20% of the profits they bring in. This creates a huge incentive to bring in profits however they can.

With over a trillion dollars under management, and both the ability and the incentive to cut corners, it seems to me the least we can do is shine a little light on the industry. The new SEC rule wouldn't do much more than that. It requires a modest amount of disclosure, plus the possibility of an occasional SEC audit.

I'm struck that your argument against this very limited regulatory step focuses not on the regulation itself, but on a slippery slope argument—that the SEC regulation will just keep on growing. This is the complaint almost everyone makes. But what about the initial regulation itself? Do you think we're better off with no new disclosure and no new oversight at all for an industry that has mushroomed far beyond what anyone would have dreamed?

Certainly the hedge fund industry itself thinks so. But the industry also has violently resisted the first tentative efforts by private entities to rate hedge funds and their managers. The industry doesn't seem to want anyone shedding more light on it in any way. With the misbehavior we've already seen, and the huge amount of money sloshing around, surely this can't be the right solution.

Oesterle: 11/9/05, 06:55 PM
Your questions are good ones. Let me make three points as a prelude to an answer.

First, your Legal Affairs piece on hedge funds was a long list of specific instances of hedge fund misbehavior. Several of the allegations are of activities that I do not believe are financial abuses and we could have some entertaining disagreements on the merits of each. Perhaps you can persuade me that I have overlooked something.

For example, I do not see a problem with a hedge fund, or anyone for that matter, borrowing stock before an important shareholder vote so as to vote the stock and return it to the lender thereafter. I even have trouble understanding the furor over "naked shorting." Attacks on hedge funds for engaging in these activities are really a mask for an important debate on whether a given activity itself should be allowed or prohibited. Indeed, a demand for hedge fund regulation could obscure or retard a resolution of more important, market-wide behavioral issues.

Second, granting that hedge funds have, at some level, engaged in legally questionable activities, one should question whether they are structurally more prone to such behavior than other, more traditional market players—institutional investors or private equity funds. The danger in the argument is that we conflate instances of poor or inopportune business judgment (hedge funds take risky positions and many will necessarily rack up some substantial loses) with instances of illegal behavior to generate a stew of discontent. This stew of discontent will feed excessive government regulation.

Your argument that hedge funds take extreme positions and are pressured to generate returns is an argument for investor caution, which will no doubt mature over time as investors get more comfortable with dealing with the fund managers. It is not an argument, necessarily, for regulation of those who take extreme risks or, perish the thought, for attempting to prohibit or constrain extreme risk taking. Risk taking is, and ought to be, the right of knowledgeable market participants.

Some calls for the regulation of hedge funds, particularly those that would put hedge funds under the Investment Company Act of 1940 would effectively kill hedge funds' ability to take risky positions.

Third, if one is committed to the position that "extreme" risk taking needs heavy regulation, even though the arrangement falls into what we would traditionally view as the "private" contract arena, the regulation has to be tailored to the problem identified. Government must, in descending order of severity, prohibit the activity defined as extreme, specifically clear the defined activity ("merit regulation"), limit permission of the activity to a small class of licensed managers, or limit clients to a privileged few. None of these choices seems palatable to me. Perhaps we should discuss this further.

In answer to your question then of whether the nascent hedge fund regulations are worthwhile I would suggest that the regulations do not address the essential complaint about hedge funds. They either must grow to address the complaints directly or they should not be put in place. I would prefer the latter.

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Skeel: 11/10/05, 10:17 AM
These are wonderfully insightful comments. You won't be surprised that I disagree with many of your key assumptions. But I think these are precisely the issues we should be focusing on.

I absolutely agree that it would be a huge mistake to try to prevent hedge funds from taking risk or to limit the range of investments they can engage in. After all, risk-taking has always been what makes the American economic system great. And even unpopular investments such as shorting a stock (that is, betting that its price will go down) are crucially important to the liquidity and efficiency of the markets. Pulling hedge funds fully into the Investment Company Act of 1940 would limit hedge funds' ability to short stocks and take leveraged positions; this would be a mistake. (This is one of the main differences between hedge funds and mutual funds—mutual funds face significant limitations on their investments). After all, it was a short seller who was the first to point out that Enron was an emperor with no clothes.

What worries me is not that hedge funds can sell short and take risks, but that we have very little idea just how much risk a given fund has taken on, since there's so little disclosure; and too many hedge fund investments are designed to enable hedge funds to profit by affirmatively destroying value. On this issue, I couldn't disagree with you more about the effects of hedge fund vote buying. I explain the mechanics of this in some detail in the Legal Affairs article that prompted this debate. But the bottom line is that some hedge funds buy votes and try to use the votes to make sure that a company goes through with a lousy transaction. It's one thing to bet that a company's stock will decline in value. It's quite another thing—and deeply disturbing in my view—when hedge funds profit by actively destroying value.

I do think these problems are structural, not just isolated, for the reasons I noted in my first post. Hedge funds have huge amounts of money, there are often unrealistic profit expectations, and hedge fund managers get a huge paycheck if they do make profits (or can pretend that they did). Sound familiar? This was the same recipe that contributed to Enron and the other corporate scandals. I keep thinking about the footage in Alex Gibney's Enron movie showing Enron's efforts to manipulate the California energy markets by congesting the system and routing electricity out of the state and back in. Much of this wasn't technically illegal. But it was deeply immoral. Enron had huge amounts of money to work with, its traders faced huge pressure to make profits, and the results were devastating for California consumers. (If you've not seen the movie, the clips of Enron's energy traders rejoicing as fires magnified the crisis, saying things like "burn, baby, burn," are chilling). I worry that the same dynamic may be at work in too many hedge funds.

This brings up another point: I'm not so worried about the wealthy individuals and investors who invest in hedge funds, though disclosure might help them comparison shop a bit more. (Troy Paredes, a professor at Washington University, points this out in an article that is generally critical of regulation). I'm worried about the effects on everyone else.

Let me conclude this post by changing the subject slightly. An article in today's Wall Street Journal points out that many hedge funds are evading the new SEC rule. The rule only applies to funds that let their investors pull out their money less than two years after they put it in. By requiring a longer lock-in, hedge funds evade the regulation. Any thoughts on these efforts to avoid the regulation (which everyone who looked at the regulation knew would occur)?

Oesterle: 11/10/05, 03:29 PM
In your latest response you make three important points, points about which readers will no doubt be concerned, and I will respond to each in turn.

First, on hedge fund "vote buying," a term of inherent opprobrium, your analysis (and that of Professors Martin and Partnoy in their soon to be published paper on "Encumbered Shares") omits consideration of the interest of an important party to the basic, archetypical transaction—the lender of the shares.

You worry that a hedge fund that borrows shares, votes them, and returns them can vote the shares against the interest of the company without cost or retribution. No, the rental fee charged by the lender of the shares, who will get the shares back after the vote, will take into account the likelihood that the shares as returned will be devalued. If a hedge fund is likely to vote to hurt a company, the fund must pay the lender for the right to do so. The rental charge on the shares should approximate the loss that the hedge fund would suffer if the fund had purchased the shares outright, voted them to hurt the company, and sold them.

In practice, when hedge funds borrow shares, the fees charged are small because lenders believe, correctly, in all but isolated cases, that the funds will vote in the firm's interest, not against it, and that the funds just have a stronger incentive than the share owner/lenders to do so, given the funds' leveraged stake.

Second, your discussion of officials at Enron rejoicing as fires burned in California is at odds with your opening discussion of the importance of risk taking in the American economy. The Enron officials' acts are disgusting but inevitable in some form when traders play the short side. Those who bet on professional football cheer, at some level, when the star quarterback of an opposing team is carried off the field—but, according to social conventions, they just should not be too public about it. Taking business risks and profiting from a short side position is often not pretty. But it should not, as you agree, be illegal, nor cause those who short the market to be heavily constrained by government rules and regulations.

Third, you noted today's Wall Street Journal article. The fine bit of reporting makes two significant points. First, funds will alter their arrangements to avoid the new SEC regulation, locking in investor funds longer. This does not help fund investors. And second, hedge funds believe that the new regulation is not "slight" or "minimal." The new rules cost some funds a whopping $500,000 a year; other funds worry about the potentially crippling time lost in a minute-to-minute, bet-the-house trading business when dealing with SEC examiners who do not understand the trading strategies and will take time to be educated; and some funds worry about the inevitable heightened exposure to private and public litigation that additional mandatory disclosures on technical matters, especially those on trading patterns, will bring. The new rules, not the possible future extensions of the rules (the "slippery slope" position), are a problem.

The new hedge fund regulation, as I have previously argued, does not fit the complaints made against the funds by broadside critics (nor should it or could it) and it is socially expensive, changing private arrangements for regulatory, not business rationale.

David, I recognize that you speak for many with your lucid, articulate comments; many are uncomfortable with and concerned about this new financial force. I think existing anti-fraud and contract laws are up to the task of punishing those hedge fund managers who misbehave.

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Skeel: 11/11/05, 10:52 AM
Your three points very nicely sum up the differences in our views, so why don't I conclude by simply taking each in turn.

First, you point out that one of the standard techniques for buying votes is to borrow the shares from a lender, and argue that the lender will ensure that hedge funds bear the cost of any misbehavior. This is a very nice point, but I think you're way too optimistic about the implications. For starters, this stock borrowing technique is only one of many ways to buy votes. Moreover, the lenders in these transactions generally have no idea what the hedge fund will be doing with the shares; it's quite a stretch to assume they'll price the possibility of misbehavior accurately, and even if they did, the effect would be to force honest hedge funds to subsidize the cost of other hedge funds' misbehavior.

Second, your metaphor of people quietly cheering when the quarterback for a team they have bet against (legally, one hopes) is injured is a very nice metaphor, but it gets my point exactly wrong. My concern isn't with hedge funds quietly cheering an injury (the analogy here is to shorting a stock, which I said is fine); the hedge funds I'm talking about are doing the equivalent of going out and hurting the quarterback themselves. They're not just cheering when a company does badly; they're actively destroying the value. This hedge fund behavior is more like Tonya Harding trying to smash the knees of her principal skating competitor, than like a fan silently smiling in the stands.

Finally, of course, hedge funds don't think the new regulation is slight or minimal. They're in the business of saying that the sky will fall if anyone sheds any light on what they're doing. (Interestingly, I think the two-year lock-in will have mixed effects; if investors really want the right of immediate withdrawal, I bet a lot of hedge funds will give in and accede to oversight; and although longer lockins sacrifice the disciplining effect of withdrawals—as Larry Ribstein notes—there's also a bit less pressure to make huge immediate profits). Don't get me wrong. I agree that hedge funds are very important to the U.S. markets. But the scandals we've seen, and the huge pressures the face to make money any way they can, we need at least a little information about what they're doing.

Thanks so much for joining me in this debate, Dale. You've made an impressive case for your views, and I look forward to continuing this very important conversation in other venues.

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