Regulators can monitor them through their prime brokerage accounts; banks can watch them through their lending arrangements; and sometimes their managers choose to register under the Investment Advisers Act. So why are there more calls for regulation and oversight of hedge funds? The answer lies in the fact that the hedge fund universe is expanding; and not just in market participation, which has grown to an estimated $1.2 trillion, but in the nature and scope of its business. The role of the hedge fund has developed over time from a little understood pooled investment vehicle for wealthy and sophisticated investors to more conspicuous and influential endeavors such as investment banking and lending. It is in these latter roles that regulators have seemed to take more notice. In light of such recent incidents as the recent $6.5 billion loss suffered by Connecticut-based Amaranth Advisors and the Movie Gallery insider trading investigation, hedge funds are back on the front page and it has prompted discussion that they may need to attempt self-regulation of some kind or another.
The most recent furor has erupted over allegations that certain hedge funds may have been using their dual roles as investors and bankers in a way that allowed them to misuse otherwise nonpublic information in their trading activity. It was recently alleged that hedge fund creditors to Movie Gallery, a movie rental chain, obtained confidential financial information by participating in a teleconference between the firm and its creditors, and subsequently traded on that information. Regulators are investigating whether or not recipients of nonpublic information did anything wrong, but the entire scenario highlights what many regulators have begun to worry about with regard to the lax federal and state regulation of hedge funds. While investment banks are required to maintain “Chinese walls” to protect confidential information from misappropriation, hedge funds, who are not regulated like banks, generally have not demonstrated enough safeguards to prevent the sharing of information. Regulators now hope that their concerns can be addressed in one of two ways: further regulation by the Securities and Exchange Commission or self-regulation by the hedge fund industry.
It appears that steps have been taken down each avenue. On the legislative front, the New York Times reported that several members of Congress are seeking suggestions regarding ways in which the government could improve hedge fund transparency. Lawmakers and regulators have been unable to find a regulatory alternative since a recent decision by the D.C. Circuit Court struck down a rule promulgated by the SEC, which would have required hedge fund managers to register under the Investment Advisers Act. Recently, the SEC announced its plans to consider revising the minimum standards for investors in hedge funds, tightening the income and net worth requirements. The Commission has also indicated a willingness to assess the application of the antifraud statutes to hedge funds.
On the fund side, however, the Loan Syndications and Trading Association (LSTA), among whose members are banks and hedge funds, issued a Statement of Principles to “outline broad guidelines for the receipt, use and distribution by and to, loan market participants of confidential information that is generally available in the loan market and that may at times include material non-public information.” The concern is of the flow and misuse of non-public financial information gathered by its members in their “loan market activities” and applied in connection with their “securities market activities.” The principles suggest many key items for market participants such as hedge funds to consider, such as implementing internal controls for the flow of information in order to avoid entering into securities transactions on the basis of nonpublic information, tailoring the internal controls to the nature of the firm’s business, and enforcing information walls, trading restrictions and the like.
For now, there is no concrete regulation in the works that appears as aggressive as the manager registration rule struck down by the D.C. Circuit. There are, as mentioned some changes being considered by the commission, but it is possible that a government regulatory initiative could be delayed by demonstrable regulation from within the industry. The LSTA guidelines are a start in the right direction. As hedge funds continue to grow, so do their capabilities. As they continue to offer more services to the industry, they become more vital to the market. It is imperative that the fund industry promotes and develops strong internal compliance. The alternative may be increased government regulation.