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HEDGING THE GLOBAL MARKET: AVOIDING EXCESSIVE HEDGE FUND 
REGULATION IN A POST-RECESSION ERA 
Jonathan P. Terracciano 
TABLE OF CONTENTS 
INTRODUCTION ………………………………………………………………………………….….2 
I. CURRENT OPERATIONAL AND REGULATORY ENVIRONMENT OF HEDGE FUNDS...........................8 
A. Background and Structure of Hedge Funds ………………………….............................8 
B. Current Legislation Governing Hedge Funds……………………….……………….....14 
1. The Securities Act of 1933…………………………………………………………..…...16 
2. The Exchange Act of 1934……………………………………………………..………...17 
3. The Investment Company Act of 1940……………………………………………….…19 
4. The Investment Advisor Act of 1940………………………………………………..…..21 
II. HEDGE FUNDS’ ROLE IN SYSTEMIC RISK, INVESTOR FRAUD, AND MARKET BENEFITS……….. 23 
A. Systemic Risk……………………………………….………………………..………...24 
1. The Implosion of Long-Term Capital Management & Industry Response………...24 
2. Systemic Risk Concerns Misdirected at Hedge Funds Instead of Banks………......28 
3. The Future of Systemic Risk: Growing Concerns in Offshore Tax Havens……….33 
B. Fraud and Investor Protection…………………..............................................................35 
C. Benefits of Hedge Funds in Financial Markets………………………………....………38 
III. PROPOSED LEGISLATION REGARDING HEDGE FUND REGULATION ……………………...……47 
A. “Hedge Fund Transparency Act of 2009”………………………………………..…….47 
B. “Hedge Fund Adviser Registration Act of 2009”……………………………...……….51 
C. “Private Fund Transparency Act of 2009”……………………………………...………52 
D. “Hedge Fund Study Act”……………………………………………………...………..55 
E. “Stop Tax Haven Abuse Act”………………………………………………..…………56 
CONCLUSION ……………………………………………………………………………………..58 
APPENDIX…………………………………………………………………………………………62
INTRODUCTION 
In the wake of numerous financial institution collapses, there has been an intense public 
and political uproar over who is to blame, how these events occurred, and how to prevent these 
problems in the future. By 2008, the U.S. financial market witnessed extreme turmoil in the 
financial system. The crisis was marred by the collapse of over two hundred banks and financial 
institutions, notably Bear Stearns and Lehman Brothers.1 It was also exemplified by a 
consolidation of several large national banks. The Federal Reserve’s bailout of Bear Stearns in 
the form of a heavily facilitated sale to JP Morgan, along with the virtually forced sale of Merrill 
Lynch to Bank of America were major efforts taken by the U.S. officials in trying to restore 
financial order. Moreover, the government takeovers of the two mortgage giants, Fannie Mae 
and Freddie Mac and insurance giant American International Group (AIG), and the TARP 
(“Troubled Asset Relief Program) bailout of the seventy largest national banks, were other 
ominous signs of the U.S. economy’s fragile state.2 
These events did not resonate well with the public, sparking sharp condemnation amongst 
many politicians, investors, and everyday citizens. News headlines such as “U.S. Recession 
Worst Since Great Depression”3 and “World’s Wealthy Lose Faith in Fund Managers,”4 aptly 
classified the fallout from the market’s turbulence. The crisis was not downplayed by even the 
highest ranking politicians, leading President Obama to characterize the economic chaos at the 
end of 2008 as a “continuing disaster” for the United States.5 Despite the stock market’s rebound 
1 http://www.fdic.gov/bank/individual/failed/banklist.html; Anne Stjern, The Failure of Bear Stearns, Lehman 
Brothers and AIG: Is Another Great Depression in our Future? Associated Content. Sept. 17, 2008. 
http://www.associatedcontent.com/article/1043016/the_failure_of_bear_stearns_lehman.html 
2 Id. 
3 http://www.bloomberg.com/apps/news?pid=20601087&sid=aNivTjr852TI 
4http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article6571355.ece 
5 BBC News. “Obama Calls Recession a Disaster.” Jan. 30, 2009. http://news.bbc.co.uk/2/hi/business/7860892.stm 
2
and relative stabilization of major indices such as the Dow Jones, nearly all believe that the 
“Great Recession” rolls on.6 
The recent failure of several major investment banks and private funds has been both a 
cause and consequence of the deep economic recession that has spread across the world.7 In the 
United States, the financial sector has been especially ravaged by a series of successive private 
fund meltdowns, totaling 1,471 hedge fund failures in 2008, in addition to the bank failures 
previously discussed.8 The recent instability of U.S. and international financial markets stemmed 
from a combination of factors that has shaken investor confidence in these systems. 
The breakdown in market stability and investor confidence can be largely attributed to 
loose lending practices and erroneous subprime mortgage valuation in the United States.9 
Consequently, many financial institutions were excessively leveraged with debt and held major 
positions on overvalued mortgage-backed securities.10 When the subprime mortgage market 
began rapidly crashing, institutions holding large amounts of mortgage-backed securities 
incurred severe losses, mainly through writedowns. Moreover, financial institutions exercised 
mark-to-market writedowns in valuing assets even though they were no actual, tangible asset 
losses.11 This especially proved troublesome to the financial institutions that held massive 
amounts of assets in the form of collateralized debt obligations (CDOs) and mortgage-backed 
6 http://online.wsj.com/article/SB10001424052748703837004575013592466508822.html 
7 Volume 56, Number 8 · May 14, 2009 How to Understand the Disaster By Robert M. Solow. 
http://www.nybooks.com/articles/22655 
8 New Record For Hedge Fund Failures. Anita Raghavan , 03.18.09, 09:30 AM EDT 1,471 hedge funds went out of 
business in 2008. http://www.forbes.com/2009/03/18/hedge-fund-failures-business-wall-street-funds.html. 
9 5 B.Y.U. Int'l L. & Mgmt. Rev. 99; Jenny Anderson & Heather Timmons, Why a U.S. Subprime Mortgage Crisis 
is Felt Around the World, N.Y. TIMES, Aug. 31, 2007, at C1. 
10 Id. 
11 Id. 
3
securities.12 In a frozen market where firms were reluctant to lend and buy assets, the mark-to-market 
accounting method “require[d] that lenders assign a value to an asset based on its current 
market value, as opposed to a more traditional hold-to-maturity model that uses historical income 
and other criteria for valuing assets.”13 Thus, huge amounts of level three assets, which include 
CDOs and subprime mortgage-backed securities, had to be written down to a fraction of their 
original book values as the market for these securities became increasingly illiquid and began to 
vanish.14 
The “maturity mismatch” of long-term, illiquid assets funding short-term debt put firms, 
such as Bear Stearns, in grave danger when a liquidity shock occurred, causing investors to cease 
lending.15 Hence, several firms that were relatively solvent, meaning it had enough assets 
(though somewhat illiquid) to pay off debts, were damaged because their short-term liquidity 
was virtually tapped out. 16 “Liquidity” is characterized as “capital resources necessary to 
conduct normal business without disruption.”17 Illiquidity was a huge problem for firms like Bear 
Stearns, especially in its finals days before merging with JP Morgan. But the fact that banks had 
so many assets tied up in toxic mortgage-backed securities drove fears that many were insolvent 
as well. 18 No one knew how much these level three assets were worth and many feared they 
could be worth only a fraction of what they were valued at. Thus, bank insolvency concerns 
12 Id. 
13 Id. 
14 Id. 
15 Bullard, James. “Systemic Risk and the Macroeconomy: An Attempt at Perspective.” [Speech at Indiana 
University] 2 October 2008. <http://www.stlouisfed.org/news/speeches/2008/10_02_08.html#_ftn3>. 
16 Drum, Kevin. “The Next Step on the Bailout.” Mother Jones 30 September 2008. 
<http://www.motherjones.com/kevin-drum/2008/09/solvency-vs-liquidity>. 
17 Id. 
18 Id. 
4
spread throughout the market from mounting liquidity problems because of these toxic security 
assets.19 
With the exorbitant level of debt raised to finance these now quasi-worthless (or at best 
questionably-valued) securities, the inability to cover losses and debt led to the swift downfall of 
many financial institutions and the overall U.S. financial market.20 Ultimately, the collapse of the 
U.S. market rippled throughout the world because many international investment funds and 
banks held substantial positions in these level three securities from frequent trading with U.S. 
counterparties.21 
In the aftermath of this financial calamity, much of the public and political criticism has 
been directed at hedge funds, based on their huge investments and trading in subprime mortgage-backed 
securities.22 Hedge funds, a specific type of quasi-regulated, private investment vehicle 
(discussed in depth later), were an obvious scapegoat target due to their high debt leverage ratios 
and limited financial transparency to individual investors and institutional counterparties.23 The 
high degree of leverage and inability of regulators and counterparties to assess the true, intrinsic 
19 Id. 
20 http://therealdeal.com/newyork/articles/mark-to-market-makes-a-mess 
21 Id. For example, Germany's Deutsche Bank AG announced $3.11 billon in write-downs, with much of the losses 
stemming from mortgage loans. David Reilly & Edward Taylor, Banks' Candor Makes Street Suspicious, WALL 
ST. J., Oct. 4, 2007, at C1. Switzerland's Credit Suisse Group also earlier announced $1.1 billion in similar losses, 
id., while another Swiss bank, UBS, announced $3.41 billion in write-downs, much of which stemmed from losses 
in securities tied to U.S. subprime mortgages. Jason Singer et al., UBS to Report Big Loss Tied to Credit Woes, 
WALL ST. J., Oct. 1, 2007, at A1; Boyd, Roddy. “The Last Days of Bear Stearns.” Fortune Magazine 31 March 
2008. <http://money.cnn.com/2008/03/28/magazines/fortune/boyd_bear.fortune/index.htm>; Schmerken, Ivy. 
“Counterparty Risk Is a Top Concern in the Wake of the Credit Crisis.” Advanced Trading 15 September 2008. 
<http://www.advancedtrading.com/derivatives/showArticle.jhtml?articleID=210601645>. 
22 Id. Germany's finance minister, Peer Steinbrueck, charged that “[t]here is a sizable, remarkable number of hedge 
funds which are not behaving properly on the market.” Somerville, supra note 1. Further elaborating on the risks 
associated with hedge funds, he asserted that “[n]o expert that I have met up to now could exclude a potential 
financial crisis caused by all these leveraged impacts of hedge funds.” 
23 Leverage is defined as the “use of debt capital in an enterprise or particular financing to increase the effectiveness 
(and risk) of the equity capital invested therein.” “Leverage also increases the magnitude of failure in addition to 
making the equity capital invested more effective, and such large failures may cause harm to overall market 
confidence. Counterparties that trade with hedge funds and parties that provide services to hedge funds may also be 
harmed. In particular, it is feared that the collapse of a large hedge fund would cause the fund's creditors to become 
insolvent, creating a cascading effect throughout the market.” Michael Downey Rice, Prentice-Hall Dictionary Of 
Business, Finance, And Law 208 (1983). 
5
value of various assets under management make hedge funds a source of concern regarding 
systemic risk.24 Also referred to as “contagion,” “systemic risk” is defined as “the danger of 
widespread disruption of financial markets and institutions that, in turn, affects the 
macroeconomy.”25 It is the “potential that a single event, such as a financial institution's loss or 
failure, may trigger broad dislocation or a series of defaults that affect the financial system so 
significantly that the real economy is adversely affected.”26 
Regulators are also concerned with the recent rise in fraud among private funds that has 
hit investors during this period of extreme market vulnerability. Most notably, Bernard L. 
Madoff Investment Securities (BLMIS), a New York-based hedge fund defrauded investors over 
$50 billion through a “Ponzi scheme,” “an investment fraud that involves the payment of 
purported returns to existing investors from funds contributed by new investors.27 More recently, 
the Antiguan-based Stanford International Bank (SIB), and its Chairman Sir Allen Stanford, have 
been indicted for engaging in a scheme to defraud investors of over $7 billion.28 From SIB’s 
practices, and the fact that they shielded themselves from SEC oversight, SEC officials state that 
SIB operated like a typical hedge fund opposed to a bank.29 From these two instances of fraud 
24 See, e.g., Paul Davies et al., Prosecutors Begin a Probe of Bear Funds, WALL ST. J., Oct. 5, 2007, at C1 
(describing the July 2007 collapse of two mortgage-related hedge funds at Bear Stearns after large losses on U.S. 
subprime mortgages, costing investors $1.6 billion). More recently, Bear Stearns required a bailout after massive 
losses on subprime mortgage related securities. Robin Sidel et al., The Week That Shook Wall Street: Inside the 
Demise of Bear Stearns, WALL ST. J., Mar. 18, 2008, at A1. Unlike other bailouts of financial institutions, the Bear 
Stearns bailout required the Federal Reserve Bank to actually take responsibility for $30 billion in securities on 
Bear's books. Id. 
25 Bullard, James. “Systemic Risk and the Macroeconomy: An Attempt at Perspective.” [Speech at Indiana 
University] 2 October 2008. <http://www.stlouisfed.org/news/speeches/2008/10_02_08.html#_ftn3>. 
26 Hedge Funds and Systemic Risk: Perspectives of the President's Working Group on Financial Markets: Hearing 
Before the H. Comm. on Financial Servs., 110th Cong. 63 (2007) [hereinafter Testimony of Steel] (testimony of 
Robert K. Steel, Under Secretary for Domestic Finance, United States Department of the Treasury), available at 
http://www.treasury.gov/press/releases/hp486.htm. 
27 http://www.france24.com/en/20081215-hsbc-faces-1-billion-risk-madoff-scandal-fraud; 
http://www.sec.gov/answers/ponzi.htm 
28 http://www.justice.gov/criminal/vns/caseup/stanfordr.html; Securities and Exchange Commission v. Stanford 
International Bank, et al., Case No. 3-09CV0298-L (N.D.TX.) 
29 Id. 
6
and hundreds more like it, fraud detection and prevention is a second key goal of regulators. The 
failure to detect scandals like these have devastated investor confidence in U.S. regulatory 
agencies, such as the Securities and Exchange Commission (SEC) and the Commodities Futures 
Trading Commission (CFTC).30 
Congress has responded to the crisis with several proposals to overhaul the current 
regulatory system governing hedge funds. Most notably are the “Hedge Fund Transparency Act 
of 2009” (HFTA),31 “Hedge Fund Adviser Registration Act of 2009” (HFRA),32 “Private Fund 
Transparency Act of 2009” (PFTA),33 “Hedge Fund Study Act” (HFSA),34 and “Stop Tax Haven 
Abuse Act.”35 In conjunction with these proposed bills that would directly regulate the hedge 
fund industry, there are bills on the table that would raise corporate tax rates on U.S. investment 
firms that operate domestically, as well as those that operate internationally but have close ties to 
the U.S. market. 
Proposed legislation aimed at minimizing systemic risk and fraud could unintentionally 
bring about a wide departure of U.S. hedge funds into international tax havens, where lax 
regulation and oversight allows and could exacerbate these existing threats. Moreover, a mass 
exodus of hedge funds would also mean the disappearance of many beneficial impacts on the 
U.S. financial market. Legislators and regulators must develop a system that balances efficient 
hedge fund regulation that is no more restrictive than needed to minimize systemic risk and 
fraud, while permitting the benefits of hedge funds to permeate the market, in order to avoid a 
30 http://www.bloomberg.com/apps/news?pid=20601109&sid=afUo_v5lEmwc 
31 Hedge Fund Transparency Act of 2009, S. 344, 111th Cong. (2009). 
32 Hedge Fund Adviser Registration Act of 2009, H.R. 711, 111th Cong. (1st Sess. 2009). 
33 Private Fund Transparency Act of 2009, S. 1276, 111th Cong. (2009). 
34 Hedge Fund Study Act, H.R. 713, 111th Cong. (2009). 
35 Stop Tax Haven Abuse Act, 111th Cong. (2009). 
7
mass exodus of U.S. hedge funds into international tax havens, which have become a growing 
concern in regards to investor fraud, corruption, and systemic risk. 
This paper will examine the current regulatory environment in which hedge funds 
operate, and will argue that although the regulatory system is in need of reform, proposed 
legislation is unnecessarily restrictive and could actually harm U.S. and international markets. 
Part I of this paper will provide information on the background and structure of hedge funds and 
discuss the current bodies of legislation governing the hedge fund industry. Part II will examine 
possible risks and threats hedge funds pose in the financial market, as well as the benefits they 
provide. Part III will address several proposed laws aimed at regulating hedge funds in the 
aftermath of the recent global recession. Part IV will recommend only limited additional 
regulation through a domestically and globally coordinated effort, that will allow the U.S. hedge 
fund industry, and overall financial market, to remain competitive in the global arena. The main 
goals of this new regulatory structure will be better mitigating market risk, improving market 
integrity, and allowing the benefits of hedge funds to operate and grow in the market. 
I. CURRENT OPERATIONAL AND REGULATORY ENVIRONMENT OF HEDGE FUNDS 
A. Background and Structure of Hedge Funds 
In today’s highly developed and advanced financial environment, the term “hedge fund” 
still invokes perceptions of obscurity and ambiguity, even among the most sophisticated 
investors. To this day, the term “hedge fund” lacks a single, universally recognized definition in 
the financial world, resulting in various, and sometimes contradicting, definitions of the term.36 
36 See, e.g., Staff of the Commission's Division of Investment Management and Office of Compliance Inspections 
and Examinations, Implications of the Growth of Hedge Funds: Staff Report to the United States Securities and 
Exchange Commission viii (2003) [hereinafter SEC 2003 Staff Report]; Financial Services Authority (United 
Kingdom), Hedge Funds and the FSA, Discussion Paper 16, at 8 (2002). 
8
Although not statutorily defined in the U.S. or abroad, the industry’s generally “accepted 
definition is that [hedge funds] are privately offered investment vehicles in which the 
contributions of the high net worth participants are pooled and invested in a portfolio of 
securities, commodity futures contracts, or other assets.”37 
The term “hedge fund” is believed to have been coined back in 1949, referring to a 
private investment fund managed by Alfred Winslow Jones under a private partnership 
agreement.38 In that fund, Mr. Jones employed a strategy of holding both long and short equity 
positions to “hedge” the fund portfolio’s risk against market volatility.39 Moreover, Mr. Jones 
pioneered a revolutionary way of charging a “management fee” to investors. Rather than 
charging a percent of assets under management, Jones charged a 20% “performance fee” equal to 
the fund’s returns.40 This strategy has been widely adopted by the hedge fund industry, where 
most hedge funds charge a 15-25% performance fee, in addition to a 2% general management fee 
based on the total value of assets held.41 
Although the fee structure established by Mr. Jones in 1949 is applied by nearly all hedge 
funds today, the investing strategy of “hedging” he employed is not a universal characteristic of 
the entire industry. As the hedge fund industry evolved over time, many hedge funds began to 
utilize different investment strategies, and some hedge funds even did away with “hedging” 
37 Vikrant Singh Negi, Legal Framework for Hedge Fund Regulation. Hedge Funds Consistency Index. Feb. 12, 
2010, available at http://www.hedgefund-index.com/s_negi.asp. 
38 David A. Vaughn, Selected Definitions of “Hedge Fund.” Comments for the U.S. Securities and Exchange 
Commission Roundtable on Hedge Funds. May 14-15, 2003, available at 
http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.htm#footnote_1. 
9 
39 Id. 
40 Christopher Holt, Performance Fees: As Old as Portfolio Management Itself? Seeking Alpha. Jan 20, 2009 
available at http://seekingalpha.com/article/115612-performance-fees-as-old-as-portfolio-management-itself. 
41 Id.
altogether.42 In addition to, or in place of, “hedging,” many current hedge funds draw from a 
pool of over twenty-five investing strategies, such as using leverage, derivatives, and arbitraging 
by investing in multiple markets.43 A fund need not utilize all these methods to be deemed a 
“hedge fund,” but must simply have the capability to engage in them.44 Today, hedge funds are 
defined by their organizational structure and mode of operation, rather than by the investing or 
financial strategies they employ.45 As more and more hedge funds have taken a purely equity-based 
approach to investing without applying any of the aforementioned methods, many “’hedge 
funds’ are not actually hedged, and the term has become a misnomer in many cases.”46 
Although the investing tactics of hedge funds may have morphed over the last sixty 
years, the management and investor structure has primarily remained the same, much like the 
original fee structures. U.S. hedge funds are normally organized as limited liability partnerships 
(“LLP’s”) or limited liability corporations (“LLC’s”), whereby the fund manager serves as the 
general partner (“GP”) and the investors constitute limited partners (“LP’s”).47 Subject to the 
limited partnership agreement and the fiduciary duties that apply under both LLP’s and LLC’s, 
42 Scott J. Lederman, Hedge Funds, in FINANCIAL PRODUCT FUNDAMENTALS: A GUIDE FOR LAWYERS 
11-3, 11-4, 11-5 (Clifford E. Kirsch ed., 2000). Available at http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn. 
10 
htm#footnote_1. 
43 JOHN DOWNES AND JORDAN ELLIOTT GOODMAN, BARRON'S, FINANCE & INVESTMENT 
HANDBOOK 358 (5th ed. 1998). Available at http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn. 
htm#footnote_1; MANAGED FUNDS ASSOCIATION, HEDGE FUND FAQs 1 (2003) 
44 Id. 
45 Supra note 18: Scott J. Lederman, Hedge Funds, in FINANCIAL PRODUCT FUNDAMENTALS: A GUIDE 
FOR LAWYERS 11-3, 11-4, 11-5 (Clifford E. Kirsch ed., 2000). Available at 
http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.htm#footnote_1. 
46 WILLIAM H. DONALDSON, CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION, TESTIMONY 
CONCERNING INVESTOR PROTECTION IMPLICATIONS OF HEDGE FUNDS BEFORE THE SENATE 
COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS, Apr. 10, 2003, available at 
http://www.sec.gov/news/testimony/041003tswhd.htm. 
47 Shartsis Friese, LLP, U.S. Regulation of Hedge Funds 88 (2005); Gerald T. Lins, Hedge Fund Organization, in 
Hedge Fund Strategies: A Global Outlook 98, 98 (Brian R. Bruce ed., 2002); Gregory M. Levy & Bernard A. 
Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res. J., 1997, at 18, available at http:// 
www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf; Jacob Preiserowicz, 
Note, The New Regulatory Regime for Hedge Funds: Has the SEC Gone Down the Wrong Path?, 11 Fordham J. 
Corp. & Fin. L. 807, 812 (2006).
the general partner (fund manager) in an LLP has near-plenary control over the hedge fund’s 
investing activities, notably the overall strategy and debt structure being the two primary 
responsibilities.48 As such, under an LLP the general partner will have unlimited liability for any 
outstanding debts or obligations in situations where the hedge fund cannot fulfill them.49 
Moreover, a hedge fund may pass tax liabilities directly on to investors, known as “flow 
through” tax treatment.50 Since the investors are LP’s, making them passive investors with no 
direct control over managing the fund’s portfolio, they benefit by only being held liable for 
losses to the degree of their investment in sharing in the gains, losses, and income of the fund.51 
But on the downside, the LP investors in both LLP’s and LLC’s are afforded only marginal 
rights and protection.52 
In comparison, when a hedge fund is organized as an LLC, tax liabilities flow through to 
investors, in addition to the hedge fund directly incurring tax expenses, known as “double 
taxation.”53 Hence, structuring the hedge fund as an LLP is more favorable in terms of tax 
liabilities, but an LLC provides one or managing members limited liability where an LLP 
imposes unlimited liability upon the GP fund manager.54 Regardless, the fund manager(s) under 
either an LLP or LLC are faced with fiduciary duties to their members in conducting operations 
and investing for the fund. 55 
11 
48 Id. at 90-92. 
49 Id. 
50 Id. 
51 Id. 
52 Id. at 91. 
53 Id. 
54 Id. 
55 Id.
Similar to most other LLP’s and LLC’s in the U.S., hedge funds usually file as an 
organization in the State of Delaware.56 Delaware has several distinct benefits tailored to hedge 
funds, found nowhere else in the United States.57 First, Delaware provides the most favorable 
state tax treatment to hedge funds.58 Second, the Delaware Revised Uniform Limited Partnership 
Act (DRULPA) is renown for its lenient and “flexible” LP statutes.59 Third, Delaware allows 
“side letters,” which permit hedge fund managers to make supplementary agreements with LP’s 
so that they confer additional benefits to specific investors who are preferred over other LP’s.60 
From these unique benefits, it is clear why so many hedge funds prefer to file in Delaware rather 
than any other state in the U.S..61 
The most widespread form of hedge funds that are seen today are organized under a 
“master-feeder” organization.62 The “master” fund is formed as a partnership, usually in a “tax 
haven” where it is a foreign resident.63 In addition, there are two “feeders,” one being U.S. 
domestic feeder for American taxable investors and another feeder for foreign investors or 
American investors who are tax exempt.64 The foreign “feeder” is typically organized as a 
corporation in a “tax haven,” whereas the U.S. domestic “feeder” is an LLP where income, gains 
56 Ron S. Geffner, Delaware--The Hedge Fund Jurisdiction of Choice in the US, Complinet, Feb. 11, 2008, http:// 
www.hedgefundworld.com/documents/Delawarerev.pdf. 
57 Id. 
58 Gregory M. Levy & Bernard A. Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res. 
J., 1997, at 18, available at http:// 
www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf. 
59 Ron S. Geffner, Delaware--The Hedge Fund Jurisdiction of Choice in the US, Complinet, Feb. 11, 2008, http:// 
www.hedgefundworld.com/documents/Delawarerev.pdf. 
60 Id. 
61 Gregory M. Levy & Bernard A. Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res. 
J., 1997, at 18, available at http:// 
www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf. 
62 Martin A. Sullivan and Lee A. Sheppard, Offshore Explorations: Caribbean Hedge Funds, Part I," Tax Notes, Jan. 
7, 2008, p. 95 available at 
http://www.tax.com/taxcom/features.nsf/Articles/35244A221EDD1BF7852573D00071118E?OpenDocument. 
63 Id. 
64 Id. 
12
losses, and deductions from investing “flow through” to LP investors.65 Moreover, there is only 
one portfolio and one investment vehicle that the fund manager must operate, and income is 
allocated to investors based on the amounts of their investments.66 
The other, less popular hedge fund structure is known as the “side-by-side” fund.67 There, 
U.S. taxable investors form an LLP and have a separate investment vehicle than that of the non-taxable 
U.S. investors and foreign investors.68 Though more costly to operate, the “side-by-side” 
structure prevents the U.S. taxable investors from adding trade costs to the foreign and non-taxable 
U.S. fund while the U.S. domestic fund addresses U.S. tax liabilities.69 
13 
65 Id. 
66 Id. 
67 Id. 
68 Id. 
69 Id.
For hedge funds that operate offshore, the “master-feeder” structure is preferred because 
it “provides anonymity to investors, blocks exempt investors from being considered owners of 
certain kinds of assets, and avoids putting foreign investors directly in a U.S. trade or business 
that generates effectively connected income.”70 American and international investors alike are 
both enticed off safer, domestic land, into these murky tax havens, which are still skeptically 
viewed by many industry experts.71 As we will discuss later, privacy, tax breaks, and higher 
returns on investment are the three main factors that attract investors to loosely regulated tax 
havens with limited investor protection.72 
B. Current Legislation Governing Hedge Funds 
14 
70 Id. 
71 http://online.wsj.com/article/SB124588728596150643.html. (stating that, “Hedge-fund assets in offshore tax 
havens such as the Cayman Islands and Bermuda represent more than two-thirds of the roughly $1.3 trillion 
industry, according to Hedge Fund Research Inc. Of those offshore assets, industry insiders estimate, between $400 
billion and $500 billion belongs to U.S. investors, with tax-exempt foundations, endowments and pension funds 
accounting for about half of that. Investors from outside the U.S. make up the rest.”) 
72 Bing Liang & Hyuna Park, Share Restrictions, Liquidity Premium, and Offshore Hedge Funds 3 (Working Paper, 
Mar. 14, 2008) available at http:// ssrn.com/abstract=967788). (Stating that due to “the tax advantage, offshore 
investors may collect higher illiquidity premium when their investment has the same level of share illiquidity as the 
investment of onshore investors. Our results may help explaining why the growth rate has been much higher in 
offshore funds than in onshore funds (26.4 vs. 15.0 percent per year from 2000 to 2004).”).
Hedge funds are viewed by many to be largely unregulated compared to other investment 
vehicles, such as mutual funds.73 At the state level, “Blue Sky” laws monitoring securities still 
exist within each specific state. Under the National Securities Markets Improvement Act of 
1996, “Investment advisers which are not registered with the SEC, either because they qualify 
for an exemption under the Advisers Act or because they don’t satisfy the assets under 
management test of Advisers Act § 203A(a)(1)(A), generally may be deemed ‘investment 
advisers.’”74 Thus, such an individual may be required to register as an investment adviser under 
a state’s “Blue Sky” laws.75 State “Blue Sky” laws vary across jurisdictions, as some states are 
more restrictive on hedge funds than others. For example, Michigan used to prohibit 
performance-based compensation fees, which is a key aspect of how hedge fund managers are 
compensated.76 At the end of 2009, New York, Massachusetts, and Connecticut have been 
dominant state residences for the top one hundred hedge funds, both in terms of sheer quantity 
and assets under management.77 None of those states have “Blue Sky” laws that limit or prohibit 
performance-based fees and are quite lenient when compared to other state laws. 
Although state “Blue Sky” laws have been characterized as “lacking teeth,” hedge funds 
and other financial firms are still predominantly governed by several federal securities 
regulations.78 The four primary regulations that apply to hedge funds are the Securities Act of 
1933, the Exchange Act of 1934, the Investment Company Act, and the Investment Advisor Act 
73 Alan L. Kenard, The Hedge Fund Versus the Mutual Fund, 57 Tax Lawyer 133, 133 (2003); see also Tamar 
Frankel & Lawrence A. Cunningham, The Mysterious Ways of Mutual Funds: Market Timing, 25 Ann. Rev. 
Banking & Fin. L. 235, 239 (2006). 
74 http://www.lexology.com/library/detail.aspx?g=a43ec06b-5249-44f6-8ff7-98906d69a43e 
75 Id.. 
76 http://www.fosterswift.com/news-publications-Michigan-Securities-Law-Change.html 
(Michigan’s previous Uniform Securities Act, which was enacted in 1964, was replaced by the 
new Uniform Securities Act and became effective in October of 2009). 
77 http://www.marketfolly.com/2009/05/barrons-hedge-fund-rankings-2009-top.html; 
http://hedgefundblogman.blogspot.com/2009/08/top-hedge-fund-cities-most-hedge-funds.html (See Appendix). 
78 Id. 
15
of 1940.79 The selected portions of these regulations that follow relate to how hedge funds, and 
other similar funds, are presently governed. These four federal securities acts have largely 
supplanted individual state “Blue Sky” laws, and are the dominant authority on securities 
regulation matters pertaining to financial institutions.80 
1. The Securities Act of 1933 (“Securities Act”) 
The Securities Act was passed with the intent to provide greater transparency, honesty, 
and disclosure on the part of securities firms in issuing initial public offerings (“IPO’s”).81 This 
act required firms to register with the Securities and Exchange Commission (“SEC”) securities 
that are sold to the public.82 Section 2(1) of the Securities Act defines the term “security” to 
include the commonly known debt and ownership interests traded for speculation or investment. 
Most notably, securities include “investment contracts,” which have been defined as “a contracts, 
transactions, or schemes whereby a person invests his money in a common enterprise and is led 
to expect profits primarily from efforts of promoter or a third party, it being immaterial whether 
shares in enterprise are evidenced by formal certificate or by nominal interests in physical assets 
employed in enterprise.”83 Normally, any firm that makes a public offering of securities will be 
required to comply with the registration requirements of the Securities Act. 
79 15 U.S.C. §§ 77a-77aa (2000); §§ 78a-78nn (1994); §§ 80a-1-80a-64 (1994); §§ 80b-1-80b-21 (1994). 
80 James Cox et al., Securities Regulations 390 (5th ed. 2005) (discussing the limited nature of state “Blue Sky” 
laws, whereby Congress amended section 18 of the Securities Act of 1933, preempting most state regulations). 
81 15 U.S.C. §§ 77a-77aa (2000); Id. §§ 77e, 77aa (mandating firms provide a prospectus, with information about the 
offering and the issuer such as “a profit and loss statement for not more than three preceding fiscal years” and “a 
statement of the capitalization of the issuer,” unless the offering is exempted). 
82 Id. §§ 77e, 77aa. 
83 SEC v. Howey, 328 U.S. 293 (1946) (“The test of an investment contract within Securities Act is whether scheme 
involves an investment of money in a common enterprise with profits to come solely from efforts of others, and, if 
test is satisfied, it is immaterial whether enterprise is speculative or nonspeculative or whether there is a sale of 
property with or without intrinsic value. Securities Act of 1933, §§ 2(1, 3), 3(b), 5(a), 15 U.S.C.A. §§ 77b(1, 3), 
77c(b), 77e(a).”) 
16
However, Section 4(2) of the Securities Act exempts “transactions by an issuer not 
involving a public offering.”84 In order to be eligible for this exemption from the registration 
requirements, firms must adhere to the restrictions in Rule 506, which provide a safe harbor for 
compliance with section 4(2) so long as the firm’s offering is not publicly advertised and no 
more than thirty-five purchasers participate in the private offering.85 Moreover, an exempt firm 
must offer the securities through a private placement to “accredited investors,” and not through a 
solicitation to the general public.86 Often referred to as “sophisticated investors,” “accredited 
investors” are generally characterized as having net assets over $1 million or at least $200,000 in 
annual income.87 The rule adopts the notion that these wealthy investors have the knowledge, 
experience, and financial fortitude to properly address the risks and benefits of private 
investments, and can withstand a heavy loss from such an investment. 
However, Rule 506 is rather lenient in the sense that the issuing firm is not required to 
count the number of accredited investors towards the thirty-five investor limit, and essentially 
has no limit on the amount of accredited purchasers they can accept. 88 Though, section 4(2) of 
the Securities Act doesn’t allow hedge funds to be exempt from anti-fraud provisions of section 
12 and section 17 of the Securities Act. These provisions guard against misrepresentation, 
misleading statements, omissions, and deceitful solicitations to investors, by imposing civil 
liabilities on funds and/or their employees for engaging in any of these fraudulent practices. 89 
2. The Exchange Act of 1934 (“Exchange Act”) 
17 
84 15 U.S.C.A. §§ 77d(2). 
85 17 C.F.R. § 230.506 (2007). 
86 Id. 
87 17 C.F.R. § 230.501(a) (2007). 
88 Id. § 230.506(b)(2)(ii) 
89 15 U.S.C. § 77d(12-17) (2000)
Congress sought to regulate securities on the secondary securities market when it passed 
the Exchange Act in 1934. Congress’ goals were similar to its goals in passing the Securities Act, 
which regulated IPO’s, but instead focused on reducing the risk of fraud, price manipulation, and 
speculation in the resale of securities when it passed the Exchange Act.90 The Exchange Act 
requires securities “dealers” to register with the SEC.91 Under section 3(a)(5) of the Exchange 
Act, a “dealer” is defined as “any person engaged in the business of buying and selling securities 
for such person's own account through a broker or otherwise.”92 But most hedge funds avoid 
registration by positioning themselves as “traders,” “a person that buys and sells securities, either 
individually or in a trustee capacity, but not as part of a regular business.”93 
Moreover, the SEC requires registration of “equity securities” under Section 12(g) of the 
Exchange Act under two different circumstances.94 First, if the equity securities are traded on an 
exchange they must be registered with the SEC.95 Second, securities must be registered if the 
issuer has at least five hundred (500) holders of record of a non-exempted class of equity security 
and over $1 million in assets by fiscal year end (unless the issuance meets one of the 
exemptions).96 In either of these two scenarios, the securities issuer is required to adhere to 
periodic reporting requirements, proxy requirements, short swing profit provisions, and insider 
trading restrictions (which applies to all securities, whether registered, exempt, or otherwise).97 
90 Elizabeth Killer and Gregory A. Gehlman, Comment, A Historical Introduction to the Securities Act of 1933 and 
the Securities Exchange Act of 1934, 49 Ohio St. L.J. 329, 348 (1988). 
91 15 U.S.C. §§ 78a-78nn (1994). 
92 Id. § 78c(a)(5)(A). 
93 Staff Report to the United States Securities and Exchange Commission, Implications of the Growth of Hedge 
Funds 3 (2003) [hereinafter Staff Report]; 15 U.S.C. §§ 78a-78nn (1994); Hedge funds are not dealers under the 
trader exemption, which excludes “funds that do not buy and sell securities as part of a regular business.” Id. (citing 
15 U.S.C. § 78c(a)(5)(B) & Supp. IV 2004). 
94 Id. I§ 78l(g). 
95 Id. 
96 15 U.S.C. § 78l-(g); 17 C.F.R. § 240.12g-1 (2008). 
18 
97 Id. § 78m; 15 U.S.C. § 78o.
However, the majority of hedge funds will intentionally structure themselves with at most 499 
holders of record in order to avoid these requirements (except insider trading restrictions). 
Hedge funds may also be required to file reporting and proxy disclosures to the SEC if it 
is beneficially owned by one person, where a person owns at least 5% of the fund, or where the 
fund has “beneficial ownership” of another company amounting to at least 10% hedge fund 
ownership of said company.98 “Beneficial ownership” also entails “any person who, directly or 
indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or 
shares: (1) Voting power which includes the power to vote, or to direct the voting of, such 
security; and/or, 2) Investment power which includes the power to dispose, or to direct the 
disposition of, such security.”99 In addition, if a hedge fund manager holds or manages over 
$100 million in equity securities, she would be required to disclose positions on a quarterly basis 
and keep current ownership records, under section 13(f).100 
Despite the various restrictions and regulations imposed on hedge funds and their 
managers under the Exchange Act, there are sufficient exemptions and safe harbors to allow 
hedge funds to evade SEC registration filings. 
3. The Investment Company Act of 1940 (“Company Act”) 
The Company Act is perhaps the most valuable source of disclosure and filing 
exemptions for hedge funds, which allow them to operate largely out of the regulators’ reach.101 
The Company Act was initially aimed at enhancing investment company disclosures, curbing 
98 17 C.F.R. § 240.13d (2007); 15 U.S.C. § 78m (2000 & Supp. IV 2004). 
99 17 C.F.R. § 240.13d-3(a). 
19 
100 Id. § 240.13f-1. 
101 15 U.S.C. §§ 80a-1 to 80a-64 (2006).
self-dealing and conflicts of interests, curtailing excessive fees, and preventing fraud.102 An 
“investment company” is defined as an issuer that “holds itself out as being engaged primarily, 
or proposes to engage primarily, in the business of investing, reinvesting, or trading in 
securities.”103 Firms that are deemed “investment companies” are subject to extensive regulation 
in multiple areas of business practice.104 Most notably, the Company Act regulates an investment 
company’s structure and areas of corporate governance, the degree of leverage (maximum 33% 
debt level of total assets), discretion in corporate asset valuation, share sales and redemptions, 
the character of investments, and its relationships with other market entities.105 
Based on the definition of “investment company,” hedge funds exhibit characteristics that 
would make them likely candidates for regulation under the Company Act.106 However, hedge 
funds are eligible for regulatory exemption under the Company Act through either section 
3(c)(1) or 3(c)(7) of the Act.107 The 3(c)(1) exemption to regulation exists where an “issuer 
whose outstanding securities...are beneficially owned by not more than one hundred persons and 
which is not making and does not presently propose to make a public offering of its securities” is 
not an investment company.108 In addition, hedge funds can also fall under the 3(c)(7) exemption 
where “any issuer, the outstanding securities of which are owned exclusively by persons who, at 
the time of acquisition of such securities, are qualified purchasers, and which is not making and 
102 Id. at 27. 
103 Investment Company Act § 3(a)(1)(A), 15 U.S.C. § 80a-3 (2000 & Supp. IV 2004). 
104 Marcia L. MacHarg, Waking Up to Hedge Funds: Is U.S. Regulation Really Taking a New Direction?, in Hedge 
Funds: Risks and Regulation 55, 61 (Theodor Baums & Andreas Cahn eds., 2004). 
105 Houman B. Shadab, Fending for Themselves: Creating a U.S. Hedge Fund Market for Retail Investors, 11 
N.Y.U. J. Legis. & Pub. Pol'y 251, 311 (2008) (discussing that the Company Act is improper for regulating hedge 
funds, since they would face restrictions in using leverage to invest in lilliquid assets. See 15 U.S.C. § 80a-18(f); 
Willa E. Gibson, Is Hedge Fund Regulation Necessary?, 73 Temp. L. Rev. 681, 694 n.99 (2000); Gordon Altman 
Butowski Weitzen Shalov & Wein, A Practical Guide to the Investment Company Act 30-31 (1993). 
106 Id. 
107 15 U.S.C. § 80a-3 (2000 & Supp. IV 2004); 15 U.S.C. 80a-2(a)(51) (2000 & Supp. IV 2004). 
108 Investment Company Act § 3(c)(1), 15 U.S.C. § 80a-3 (2000 & Supp. IV 2004). 
20
does not at that time propose to make a public offering of such securities.”109 The Company Act 
defines “qualified purchaser” as any “individual who own over $5 million in investments, 
institutional investors who own $25 million investments, and a family-owned company that 
owns $5 million in investments.”110 
Although the Company Act does not restrict the number of “qualified purchasers” that 
may be in a fund, most astute hedge funds will not accept more than 499 investors, so as not to 
violate the Exchange Act's provisions.111 As we have seen, many of these regulations overlap 
each other and have implications on firms trying to minimize regulation. 
4. The Investment Advisers Act of 1940 (“Advisers Act”) 
The Advisers Act was aimed at combating abusive practices by investment advisers, 
which may have played a role in the stock market crash leading to the Great Depression.112 
Under the Advisors Act, “investment adviser” is defined as “any person who, for compensation, 
engages in the business of advising others, either directly or through publications or writings, as 
to the value of securities or as to the advisability of investing in, purchasing, or selling 
securities.”113 A hedge fund manager who falls under this classification is required to register 
with the SEC, as well as disclose basic information to current and potential clients.114 Most 
notably, an investment adviser is obligated to disclose the fee structure, whether the structure can 
109 Investment Company Act of 1940, 15 U.S.C. §§ 80a-1-80a-64 (1994), § 80a-3(c)(7)(A). 
110 Id. at § 80a-2a(51)(A). 
111 15 U.S.C. § 78l-(g); 17 C.F.R. § 240.12g-1 (2008); Staff Report to the United States Securities and Exchange 
Commission, Implications of the Growth of Hedge Funds 3 (2003) [hereinafter Staff Report]. 
112 Investor Advisers Act, 15 U.S.C. § 80b-1 et seq. (2000); Richard S. Cortese, Overview of the Adviser's Act, in 
Lipper HedgeWorld Annual Guide 113 (2005); SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 187 
(1963) (quoting SEC, Investment Trusts and Investment Companies, H.R. Doc. No. 76-477, at 28 (1939)), 
acknowledging that “conflicts of interest... might incline an investment adviser--consciously or unconsciously--to 
render advice which was not disinterested.” Id. at 191; Stuart A. McCrary, How to Create and Manage a Hedge 
Fund: A Professional's Guide 7 (2002). 
113 15 U.S.C. § 80b-2(a)(11). 
114 17 C.F.R. § 275.204-3(a) (2008). 
21
be negotiated, the character of the adviser's services, current client base, and any conflicts of 
interest that may arise on account of the adviser's business activities.115 The Advisers Act also 
generally prohibits performance-based compensation, although a registered adviser may charge a 
performance fee under the guidelines set forth in section 3(c)(7) of the Company Act or if all the 
fund's investors are qualified clients. In addition, the Adviser Act requires the adviser to submit 
to periodic SEC examinations and maintain current books and records for these examinations.116 
The heavy majority of hedge fund managers have been exempted from being declared an 
“investment adviser” by relying on section 203(b) of the Advisers Act. That section excludes 
“any investment adviser who during the course of the preceding twelve months has had fewer 
than fifteen clients and who neither holds himself out generally to the public as an investment 
adviser nor acts as an investment adviser to any investment company registered. . . .”117 What’s 
more beneficial for hedge fund advisers is that Section 203(b) counts a “legal organization” (i.e. 
a hedge fund) as only one, single client.118 Thus, hedge fund advisers can manage up to fourteen 
funds before they are required to file registration with the SEC as an investment adviser.119 
Together, the current statutory framework allows hedge funds to escape registration and 
most government oversight. The weak regulatory framework, coupled with poor market 
discipline and foresight of fund managers and investors alike, seems to have made hedge funds a 
popular scapegoat for the recent financial crisis. However, the shortcomings of these regulations 
can be easily fixed in a de minimis manner, so as not to ruin an industry on the rebound or cause 
a mass exodus to offshore tax havens. The next sections will identify the strengths and problems 
of hedge funds in the market, and assess how best to tailor portions of proposed legislation, along 
115 Tamar Frankel & Clifford E. Kirsch, Investment Management Regulation 85?87 (2d ed. 2003). 
116 15 U.S.C. § 80b-5(a)(1); 17 C.F.R. § 275.205-3(d)(1); Id. § 80b-3(c). 
117 Id. § 80b-3(b)(3). 
118 17 C.F.R. § 275.203(b)(3)-1(2)(i). 
119 15 U.S.C. § 80b-3(b)(3). 
22
with using diplomatic means and establishing a more aligned, unified regulatory foundation, to 
mitigate the risks of hedge funds while allowing their strengths to permeate U.S. and global 
financial markets. 
II. HEDGE FUNDS’ ROLE IN SYSTEMIC RISK, INVESTOR FRAUD, AND MARKET BENEFITS 
There are several schools of thought regarding the significance of hedge funds in 
financial markets. Arguments supporting and criticizing the hedge fund industry have been 
staunchly voiced among legislators, regulators, investors, and various financial institutions for 
years. As the U.S. struggles to climb out of deep economic recession that continues to plague 
financial markets still littered with thousands of fraud cases, hedge funds have been the target of 
scrutiny due to their lack of transparency.120 However, a closer inspection of hedge funds will 
reveal many benefits they provide to the U.S. financial market that allow the U.S. firms to 
effectively compete with foreign firms.121 Moreover, much hedge fund criticism is misdirected 
and disproportionate to the harm actually caused by the industry throughout this period of 
financial instability.122 Ultimately, the strengths and shortcomings of hedge funds in the U.S. 
hinge on the industry’s ties to global markets and the varying regulations across different types 
of financial institutions. 
120 Dan Margolies, “Obama Budget Seeks More to Fight Financial Fraud.” Reuters, Feb. 1, 2010. 
http://www.reuters.com/article/idUSN0120695420100201. (“U.S Attorney General Eric Holder said in a speech [in 
February 2010] that the Justice Department was moving forward on more than 5,000 pending financial institution 
fraud cases and the FBI was investigating more than 2,800 mortgage fraud cases -- up nearly 400 percent from five 
years ago.”) 
121 Hedge Funds and Systemic Risk: Perspectives of the President's Working Group on Financial Markets: Hearing 
Before the H. Comm. on Financial Servs., 110th Cong. 63 (2007) [hereinafter Testimony of Steel] (testimony of 
Robert K. Steel, Under Secretary for Domestic Finance, United States Department of the Treasury), available at 
http://www.treasury.gov/press/releases/hp486.htm. 
122 See Bd. of Governors of the Fed. Reserve Sys., Flow of Funds Accounts of the United States: Flows and 
Outstandings Third Quarter 2007 (Dec. 6, 2007), available at 
http://www.federalreserve.gov/releases/z1/20071206/z1.pdf. 
23
A. The Impact of Hedge Funds on Systemic Risk 
The fundamental purpose behind regulating financial institutions is to mitigate “systemic 
risk.”123 Furthermore, champions of increasing hedge fund regulation also cite this purpose as 
justification for regulatory overhaul.124 “Systemic risk,” or “contagion,” is commonly defined as 
the “potential that a single event, such as a financial institution's loss or failure, may trigger 
broad dislocation or a series of defaults that affect the financial system so significantly that the 
real economy is adversely affected.”125 More generally, it is “the danger of widespread 
disruption of financial markets and institutions that, in turn, affects the macroeconomy.”126 
1. The Implosion of Long-Term Capital Management & Industry Response 
It wasn’t until 1998, when a hedge fund called Long-Term Capital Management (LTCM) 
imploded, that regulators began to take a closer look at hedge funds’ impact on systemic risk.127 
LTCM was a once highly-regarded hedge fund, founded in 1994 by several financiers who 
received Nobel Prizes in economics.128 LTCM took on a highly aggressive arbitrage strategy by 
investing in government bonds in order to capitalize on small spreads, most notably in Russian 
bonds.129 LTCM pursued an intense arbitrage strategy based on their forecast that the spread 
123 Hedge Funds and Systemic Risk: Perspectives of the President's Working Group on Financial Markets: Hearing 
Before the H. Comm. on Financial Servs., 110th Cong. 63 (2007) [hereinafter Testimony of Steel] (testimony of 
Robert K. Steel, Under Secretary for Domestic Finance, United States Department of the Treasury), available at 
http://www.treasury.gov/press/releases/hp486.htm. 
124 Id. 
125 Id. 
126 Bullard, James. “Systemic Risk and the Macroeconomy: An Attempt at Perspective.” [Speech at Indiana 
University] 2 October 2008. <http://www.stlouisfed.org/news/speeches/2008/10_02_08.html#_ftn3>. 
127 Symposium, Crisis in Confidence: Corporate Governance and Professional Ethics Post-Enron, 35 Conn. L. Rev. 
1097, 1107 (2003) [hereinafter Crisis in Confidence] 
128 Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management 31, 32 (Random 
House 2000). 
129 PRESIDENT'S WORKING GROUP ON FIN. MKTS, HEDGE FUNDS, LEVERAGE, AND THE LESSONS OF LONG-TERM CAPITAL 
MANAGEMENT, 11 (1999) available at http:// www.ustreas.gov/press/releases/reports/hedgfund.pdf (“Approximately 
80 percent of the LTCM Fund's balance-sheet positions were in government bonds of the G-7 countries (viz., the 
United States, Canada, France, Germany, Italy, Japan, and the United Kingdom).”) [hereinafter PRESIDENT'S 
WORKING GROUP]. 
24
between bond returns would narrow between industrialized and developing nations.130 However, 
LTCM’s forecasts proved to be wrong when Russia underwent a massive debt restructuring, 
thereby devaluing its currency.131 This move by Russia would not, in and of itself, have put 
LTCM at risk for failure. LTCM had always had high leverage ratio of 25-to-1, which did not 
alarm investors up until this point.132 But when Russia restructured its debt and the spread on 
bonds increased, LTCM’s leverage ratio skyrocketed to 500-to-1 when the value of the assets 
they held plummeted.133 LTCM continued to crumble in the period directly after Russia’s 
restructurinng, losing $4.4 billion in less than a month.134 The New York Federal Reserve Bank 
finally stepped in and organized a $7 billion bailout of LTCM with fourteen other banks and 
funds.135 The Federal Reserve Bank of New York felt that if it did not facilitate a bailout, an 
LTCM default could pose a series of cascading financial institution failures that LTCM did 
business with.136 With off-balance sheet liabilities over $1 trillion in the form of futures, interest 
rate swaps, and over-the-counter (OTC) derivatives, LTCM’s inability to meet counterparty 
obligations could have decreased the liquidity of these investments in the market.137 Soon after, 
the market price on these investments would plunge, as other firms would be forced to either 
130 Joseph G. Haubrich, Some Lessons on the Rescue of Long-Term Capital Management (Federal Reserve Bank of 
Cleveland, Policy Discussion Paper No. 19, 2007). 
131 FIN. SERV. AUTH., HEDGE FUNDS AND THE FSA 8 (2002), available at 
http://www.fsa.gov.uk/pubs/discussion/dp16.pdf; see also FRANÇOIS-SERGE LHABITANT, HEDGE FUNDS: 
MYTHS AND LIMITS 12-21 (2002) 
132 PRESIDENT'S WORKING GROUP supra note 10, available at http:// 
www.ustreas.gov/press/releases/reports/hedgfund.pdf (for basis of comparison “[a]t year-end 1998, the five largest 
commercial bank holding companies had an average leverage ratio of nearly 14-to-1, while the five largest 
investment banks' average leverage ratio was 27-to-1.”). 
133 Id. 
134 Joseph G. Haubrich, Some Lessons on the Rescue of Long-Term Capital Management (Federal Reserve Bank of 
Cleveland, Policy Discussion Paper No. 19, 2007). 
135 PRESIDENT'S WORKING GROUP, supra note 10, at 17 (“LTCM itself estimated that its top 17 counterparties 
would have suffered various substantial losses—potentially between $3 billion and $5 billion in aggregate — and 
shared this information with the fourteen firms participating in the consortium. The firms in the consortium saw that 
their losses could be serious, with potential losses to some firms amounting to $300 million to $500 million each.”). 
136 Id. 
137 U.S. Gen. Acct. Off., Long-Term Capital Management Regulators Need to Focus Greater Attention on Systemic 
Risk 7 (1999), available at http:// www.gao.gov/archive/2000/gg00003.pdf. 
25
hold on to sharply declining assets and eventually collapse or liquidate their holdings before 
prices dropped even further.138 The inability of one major player, LTCM, to meet its obligations 
to its seventeen main counterparties would have resulted in up to $5 billion in aggregate 
losses.139 From there, the total potential losses for the counterparties of LTCM’s counterparties 
would’ve ballooned to catastrophic levels that could’ve crippled the entire U.S. financial system, 
and perhaps even foreign ones.140 
Although the LTCM collapse provides a grim, historical example of hedge funds’ 
potential impact on systemic risk, many positives came out of that incident. Stemming from this 
event, the Presidential Working Group was formed.141 The Group is responsible for gathering 
more vital, up to date information on hedge funds and making recommendations to the 
industry.142 
U.S. Treasury Secretary, Timothy Geithner offered a positive, though objective, 
assessment on the hedge fund industry since the LTCM debacle in 1998.143 While he was 
President and CEO of the Federal Reserve Bank of New York, Geithner noted that average 
hedge fund leverage ratios and systemic risk posed by hedge funds have changed for the better 
since the 1998 implosion of LTCM.144 Moreover, Geithner proffered five key factors that 
evidenced a more stable hedge fund industry and financial market: (1) the total number of hedge 
funds has increased greatly, along with total assets under management; (2) increased 
138 Id. 
139 PRESIDENT'S WORKING GROUP, supra note 10, at 17. 
140 Id. 
141 President's Working Group on Financial Markets, Hedge Funds, Leverage, and the Lessons of Long-Term 
Capital Management 1 (1999) [hereinafter Working Group Report I], available at http:// 
www.treasury.gov/press/releases/reports/hedgfund.pdf (the Group consists of officials from the SEC, CFTC, the 
Federal Reserve Bank, and the U.S. Treasury Department). 
142 Id. 
143 Timothy F. Geithner, President & CEO, Fed. Reserve Bank of N.Y., Keynote Address: Hedge Funds and Their 
Implications for the Financial System (Nov. 17, 2004) (transcript available at http:// 
www.ny.frb.org/newsevents/speeches/2004/gei041117.html). 
144 Id. 
26
diversification of credit exposure by counterparties and lenders; (3) enhanced risk management 
practices among hedge funds, counterparties, and lenders; (4) banks' capital relative to risk has 
remained constant; and (5) improved infrastructure for clearing and settlements, whose systems 
can handle greater trade volumes and are more durable in periods of stress.145 Finally, Geithner 
provided a positive outlook on the hedge fund industry, when he expressed that the “U.S. 
financial system today is significantly stronger than it was in 1998…. And there is some 
evidence that hedge funds have helped contribute to this resilience, not just in the general 
contribution they provide by taking on risk, but as a source of liquidity in periods of increased 
stress and risk aversion in the rest of the financial system.”146 
However, these encouraging statements were tempered with recommendations to 
continuously improve investing strategy, due diligence, diversification, risk management, 
disclosure, and leverage practices.147 Nevertheless, Geithner and most top officials agree that 
hedge funds and their counterparties have adapted quite well since 1998 and are better equipped 
to avoid or withstand a crisis similar to what LTCM experienced, but without the need for 
Federal Reserve bailouts.148 
Systemic risk concerns regarding hedge funds seem to have died down after the industry 
and regulators learned several valuable lessons following LTCM’s demise. However, hedge 
funds still carry the stigma of posing a grave systemic risk to the economy, which is largely 
misplaced.149 For example, the vast majority of credit default swaps (CDSs) hedge funds traded 
with banks were not written on toxic underlying securities (i.e. defaulted or subprime 
145 Id. 
146 Id. 
147 Id. 
148 Id. 
149 Houman Shadab, Don’t Blame all the Shadow Banks, CBS Money Watch, Apr. 13, 2009. (available at: 
http://moneywatch.bnet.com/economic-news/blog/blog-war/dont-blame-the-shadow-banks/295/). 
27
mortgages).150 The reality is that hedge funds and the CDSs they traded to banks did not cause 
the collapse of financial institutions, because it was the potential for these securities’ misuse and 
abuse which the banks took advantage that led to the collapse.151 Since it is readily apparent that 
these derivative securities are more likely to be abused by banks, new rules should ensure that 
regulated companies, such as banks, trade and value them appropriately.152 
2. Systemic Risk Concerns Misdirected at Hedge Funds Instead of Banks 
An example that elucidates how hedge funds have suffered excessive, unsubstantiated 
criticism that should be directed elsewhere can be seen in bank failures like Bear Stearns. In 
2007, Bear Stearns began taking on a highly aggressive debt structure. The bank took on a 
leverage ratio of nearly 33.2 to 1, with $11.1 billion in tangible equity backing $395 billion in 
assets.153 This highly leveraged structure embodied a relatively high level of risk for the firm, 
evidenced by the fact that it was highest of any brokerage firm, and that most commercial banks 
have an average leverage ratio of 10 to 1.154 Just a few years earlier, this leverage structure 
would have violated SEC regulations, which then required a maximum debt to net capital 
(equity) of 15 to 1. But in 2004, the “Consolidated Supervised Entities Program” abolished this 
maximum standard, along with revoking minimum capital requirements in case of asset 
150 Id. (“It was solely American International Group’s (AIG’s) CDSs written on structured mortgage-related 
securities held by banks that led to the collateral calls ruinous to AIG and the federal bailout. Those CDSs made up 
only about 10 percent of AIG’s total CDS obligations at the beginning of 2008. But the Office of Thrift Supervision, 
which oversaw AIG, failed to prevent the company’s subsidiary from selling too many CDSs. To best prevent the 
over-concentration of CDS risk of the type that occurred with bond issuers and AIG, regulation should seek to limit 
the use of CDSs when sold by insurance companies or their unregulated subsidiaries and affiliates.”) 
151 Id. (“The main problem with CDSs, which allow any party to sell protection against credit risks that the buyer 
may be exposed to, was that they allowed banks and insurance companies to concentrate too much mortgage-backed 
security risk in their portfolios.”) 
152 Id. 
153 Boyd, Roddy. “The Last Days of Bear Stearns.” Fortune Magazine 31 March 2008. 
<http://money.cnn.com/2008/03/28/magazines/fortune/boyd_bear.fortune/index.htm>. 
154 Id. 
28
defaults.155 Bear Stearns’ exploitation of these repealed standards propelled it on a path to self-destruction. 
What’s more disturbing was that Bear Stearns was carrying over $28 billion in 
“level 3” assets, where valuation is based on non-observable market assumptions and relied 
heavily on internal information to asses fair value. 156 These types of assets they carried were 
highly illiquid, and put the bank at risk for owning assets worth next to nothing. 
With a net equity of $11.1 billion and $395 billion in assets, the highly leveraged bank 
was even more at risk because of their heavy involvement in Collateralized Debt Obligations 
(“CDOs”), which were heavily backed by subprime mortgages. As the real estate market 
plummeted and the mortgage default rate skyrocketed, Bear Stearns was forced to make major 
value write-downs on these mortgage-backed security assets. Just a few years prior, Bear Stearns 
was able to succeed under a highly leveraged debt structure. However, as assets began to 
plummet in value and more debt was accrued, the risks of having such a high leverage ratio 
began to precipitate.157 In June of 2007, troubles continued to mount when “Bear had to come up 
with over $3 billion to bail out one of its funds that was dabbling in CDOs. Incredibly these 
funds were seized at the time by Merrill Lynch for $850 million who was only able to get $100 
million for them on the auction block.”158 
Bear Stearns continued to break down at an exponential rate, when at the end of 2007 it 
was forced to write-down an additional $1.2 billion in mortgage backed securities. Bear Stearns’ 
credit was so poor in its final stages before the merger, that it was even denied a $2 billion 
securities-backed repurchase loan (“repo” loan). One market analyst aptly characterized how 
155 Protess, Ben. “’Flawed’ SEC Program Failed to Rein in Investment Banks.” Propublica 1 October 2008. 
<http://www.propublica.org/article/flawed-sec-program-failed-to-rein-in-investment-banks-101>. 
156 Pittman, Mark. "Bear Stearns Fund Collapse Sends Shock Through CDOs.” Bloomberg 21 June 2007. 
<http://www.bloomberg.com/apps/news?pid=20601087&sid=a7LCp2Acv2aw&refer=home>. 
157 Id. 
158 “The Rise and Fall of the Mighty Bear.” My Budget 360 17 March 2008. <http://www.mybudget360.com/bear-stearns- 
29 
the-rise-and-fall-of-the-mighty-bear/>.
severe this credit issue was for Bear Stearns: “Being denied such a loan is the Wall Street 
equivalent of having your buddy refuse to front you $5 the day before payday. Bear executives 
scrambled and raised the money elsewhere. But the sign was unmistakable: Credit was drying 
up.”159 Consequently, fears over liquidity and Bear Stearns’ ability to meet its debt obligations 
sparked intense naked short-selling of Bear Stearns stock, which drove the price down from 
highs of over $100/share in 2007-2008, to $30/share.160 The run on Bear Stearns stock, fueled by 
rumor and speculation, resulted in a 47% decline (closing at $30 per share) in stock price in one 
day just prior to merger. 161 
The type of business transactions Bear Stearns was involved in directly and indirectly 
exposed a wide range of institutions to risk. First off, Bear Stearns was a major counterparty to 
CDSs. It held notional amounts of $13.4 trillion at the end of 2007, with $1.85 trillion of that 
amount consisting of futures and option contracts with other counterparties. 162 These derivative 
instruments are used as an insurance policy for debt holders, in the event that the issuer defaults 
on payment. The systemic risk these transactions posed, which the Federal Reserve Bank sought 
to eliminate, could bring down other banks, just like Bear Stearns. Prior to the buyout in March, 
information circulated in the market that hedge funds were reassigning their CDS positions with 
Bear Stearns to other firms. Many hedge funds had grown weary of the problems facing Bear 
Stearns and did not want to take the risk of being counterparties to its trades. Perpetuated by fear 
and rumors, CDS reassignments snowballed as many other funds and dealers pulled their trades 
159 Boyd, Roddy. “The Last Days of Bear Stearns.” Fortune Magazine 31 March 2008. 
<http://money.cnn.com/2008/03/28/magazines/fortune/boyd_bear.fortune/index.htm>. 
160 Matsumoto, Gary. “Bringing Down Bear Began as $1.7 Million of Options.” Bloomberg 11 August 2008. 
<http://www.bloomberg.com/apps/news?pid=20601109&sid=aGmG_eOp5TjE&refer=home>. 
161 Id. 
162 Boyd, Roddy. “The Last Days of Bear Stearns.” Fortune Magazine 31 March 2008. 
<http://money.cnn.com/2008/03/28/magazines/fortune/boyd_bear.fortune/index.htm>. 
30
with Bear Stearns.163 Because 22% of Bear Stearns funding consisted of payables, deposits by 
its Hedge Fun customers, these major withdrawals resulted in a lack of funding for Bear Stearns. 
These banks fund their long-term illiquid investments, with short-term debt. The fact that 
Bear Stearns held such thin capital margins made them highly vulnerable to an abrupt cessation 
in short-term lending. This was a driving force behind Bear Stearns’ collapse, as the bank could 
not acquire enough funding to manage its operations. The “maturity mismatch” of asset and 
liabilities put Bear Stearns in grave danger when a liquidity shock occurred, causing investors to 
cease lending. The Federal Reserve Bank sought to mitigate other firms’ risk of encountering 
this liquidity problem by trying to maintain the flow of lending within the banking industry. 164 
The bankruptcy of Bear Stearns would not only adversely affect the entities it directly 
conducted business with, but other institutions that it bore no direct relationships or transactions 
with. In most other competitive industries, the failure of one firm would allow the other existing 
competitors to pick up market share and grow after it picked up the pieces from the fallout. 
However, the institutional structure of the banking industry causes even relatively smaller 
players, like Bear Stearns, to have extensive connections with other entities and markets. 165 
With Bear Stearns, settlement risks began to appear as it began to crumble, which only 
would have exacerbated the problems already plaguing the market. Settlement risk is “the risk 
that one party to a financial transaction will default after the other party has delivered.”166 The 
concern was that the cumulative effects of these settlement risks could amount to a systemic risk. 
Parties that didn’t directly do business with Bear Stearns could be affected from their 
163 Schmerken, Ivy. “Counterparty Risk Is a Top Concern in the Wake of the Credit Crisis.” Advanced Trading 15 
September 2008. <http://www.advancedtrading.com/derivatives/showArticle.jhtml?articleID=210601645>. 
164 Id. 
165 Id. 
166 Bullard, James. “Systemic Risk and the Macroeconomy: An Attempt at Perspective.” [Speech at Indiana 
Unversity] 2 October 2008. <http://www.stlouisfed.org/news/speeches/2008/10_02_08.html#_ftn3>. 
31
32 
relationships with third-parties who did. 
Moreover, bankruptcy law was not suited for cases within the banking industry because 
banks like Bear Stearns are highly leveraged. These banks fund their long-term illiquid 
investments, with short-term debt. The fact that Bear Stearns held such thin capital margins made 
them highly vulnerable to an abrupt cessation in short-term lending. This was a driving force 
behind Bear Stearns’ collapse, as the bank could not acquire enough funding to manage its 
operations. The “maturity mismatch” of asset and liabilities put Bear Stearns in grave danger 
when a liquidity shock occurred, causing investors to cease lending. The Federal Reserve Bank 
sought to mitigate other firms’ risk of encountering this liquidity problem by trying to maintain 
the flow of lending within the banking industry. 167 
From a thorough analysis of how Bear Stearns deteriorated, much like several other 
regulated financial institutions, it is hard to understand how hedge funds have been the target of 
so much criticism when the their threats to systemic risk pale in comparison to banks and 
insurance giants. Let us remember, too, that The Federal Reserve, not hedge funds, created the 
housing bubble that almost dismantled the global economy.168 Furthermore, Banks transferred 
mass amounts of predatory loans to individuals who they should have known could never afford 
the homes they were purchasing.169 It was also banks who bundled and securitized these “toxic 
assets” and then traded them with reckless abandonment amongst each other.170 Lastly, one of 
the biggest, if not the biggest, culprits in the financial meltdown was A.I.G., an insurance 
company, not a hedge fund.171 Despite the strong signs pointing to banks as the real threat to 
167 Id. 
168 Melvyn Krauss, Don’t Blame Hedge Funds, New York Times, Jun. 24, 2009 (available at: 
http://www.nytimes.com/2009/06/25/opinion/25iht-edkrause.html). 
169 Id. 
170 Id. 
171 Id.
systemic risk, the regulatory framework of hedge funds is still not perfect and must be enhanced, 
though not nearly to the extent that banks and insurance companies require regulatory overhaul. 
3. The Future of Systemic Risk: Growing Concerns in Offshore Tax Havens 
Despite the seemingly favorable treatment of hedge funds in the State of Delaware, there 
has nevertheless been a noticeable migration of hedge funds to offshore tax havens in recent 
times.172 Hedge fund incorporation in “tax havens” such as the Cayman Islands, Bahamas, 
Bermuda, and British Virgin Islands (“BVI”) have been on the rise since the mid-1990’s.173 
Although there is no universally accepted definition of the term “tax haven,” there seems to be 
an international consensus that tax havens have the following characteristics: “no or nominal 
taxes; lack of effective exchange of tax information with US and other tax authorities; lack of 
transparency in the operation of legislative, legal, or administrative provisions; no requirement 
for a substantive local presence; and self-promotion as an offshore financial center.”174 
Industry experts and regulators estimate the number of hedge funds in the entire industry 
at over 10,000, totaling around $1.5-2 trillion in assets under management.175 It is also estimated 
that the industry grew from $456.4 billion in 1996 to $1.43 trillion by the end of 2006.176 Hedge 
172 Bing Liang & Hyuna Park, Share Restrictions, Liquidity Premium, and Offshore Hedge Funds 3 (Working Paper, 
Mar. 14, 2008) available at http:// ssrn.com/abstract=967788). 
173 "Offshore Explorations: Caribbean Hedge Funds, Part II," Tax Notes, Jan. 7, 2008, p. 95). 
http://www.tax.com/taxcom/features.nsf/Articles/DE15FD6B5D167E0B852573CB005BB50C?OpenDocument 
174 James Hamilton, Using SEC Data, GAO Finds that TARP Recipients Have Subsidiaries in Offshore Tax Havens, 
CCH Financial Crisis News Center. Jan. 19, 2009 Available at http://www.financialcrisisupdate.com/2009/01/using-sec- 
data-gao-finds-that-tarp-recipients-have-subsidiaries-in-offshore-tax-havens.html 
175 "Offshore Explorations: Caribbean Hedge Funds, Part II," Tax Notes, Jan. 7, 2008, p. 95). 
http://www.tax.com/taxcom/features.nsf/Articles/DE15FD6B5D167E0B852573CB005BB50C?OpenDocument 
; Hedge Fund Research Inc., "HFR Industry Report — Year End 2006," available at 
http://www.hedgefundresearch.com 
176 "Offshore Explorations: Caribbean Hedge Funds, Part II," Tax Notes, Jan. 7, 2008, p. 95). 
33
funds domiciled in the “Big Four” tax havens (Cayman Islands, Bahamas, Bermuda, and BVI) 
accounted for 74.9% of all hedge funds domiciled outside the U.S., or 52.3% of the entire 
industry, whereas U.S. domiciled funds accounted for only 30.1% of the entire industry.177 This 
equates to the “Big Four” holding estimated assets under management of about $731 billion.178 
Other studies have uncovered an even greater disparity, finding that 62% of all hedge fund assets 
under management are domiciled in the “Big Four” compared to only 23% domiciled in the 
U.S..179 These same studies have estimated that the three year growth rates of offshore assets is 
more than twice that of onshore funds (130% v. 66%). Moreover, hedge funds registered off 
shore, but addressed in the U.S., have recently seen the highest growth rate among all other 
hedge fund segments (176%).180 
With other studies estimating $12 trillion deposited in tax havens today, the U.S. and 
other nations are determined to curb this explosive exodus of funds offshore, where tax dollars 
are lost and global financial markets are subject to unpredictable threats.181 Specifically, there 
has been growing systemic concerns over the role of offshore hedge funds in tax havens 
operating under a veil of almost complete secrecy, where counterparty and market connectivity 
of these funds are virtually undiscoverable.182 The U.S. and other countries have limited insight 
http://www.tax.com/taxcom/features.nsf/Articles/DE15FD6B5D167E0B852573CB005BB50C?OpenDocument 
; Hedge Fund Research Inc., "HFR Industry Report — Year End 2006," available at 
http://www.hedgefundresearch.com. 
177 Id. 
178 Id. 
179 Bing Liang & Hyuna Park, Share Restrictions, Liquidity Premium, and Offshore Hedge Funds 3 (Working Paper, 
Mar. 14, 2008) available at http:// ssrn.com/abstract=967788). 
180 Id. 
181 Id. 
182 Id. 
34
as to the exact value of assets in offshore tax havens, the types of instruments and strategies 
used, investor identities, and exactly how many hedge funds exist offshore.183 
What’s more disturbing is that eighty-three of the largest one hundred public U.S. 
companies have subsidiaries in tax havens.184 Moreover, of those eighty-three companies, four 
are banks that received over $127 billion in bailout funds through TARP.185 German Chancellor 
Angela Merkel, and other world leaders, brought up hedge fund regulation as one of the chief 
topics for discussion on a recent G8 Summit meeting.186 This rapid growth in hedge fund 
migration into tax havens has been a troubling trend not only for the United States, but for the 
greater international community as well. 
B. Fraud and Investor Protection 
Regulators are also highly concerned with mitigating fraud and money laundering among 
private funds, especially during this period of extreme market vulnerability. Most notably, 
Bernard L. Madoff Investment Securities LLC (BLMIS), a New York-based hedge fund, later 
discovered to be a massive “Ponzi scheme,” defrauded investors over $50 billion.187 A “Ponzi 
scheme” is characterized as “an investment fraud that involves the payment of purported returns 
to existing investors from funds contributed by new investors.188 Mr. Madoff, owner and 
perpetrator of the BLMIS fraud, ran a broker dealer service called Madoff Investment Securities, 
183 Emil Arguelles, “The Truth About Tax Havens.” San Pedro Daily. Nov. 14, 2009. 
http://ambergriscaye.com/forum/ubbthreads.php/topics/357954/The_truth_about_tax_havens.html 
184 Richard Murphy, “The Stop Tax Haven Abuse Act is on its Way.” Tax Research UK. Mar. 3, 2009. 
http://www.taxresearch.org.uk/Blog/2009/03/03/the-stop-tax-haven-abuse-act-is-on-its-way/ 
185 Id. 
186 
187 Amir Efrati et al., Top Broker Accused of $50 Billion Fraud, Wall St. J., Dec. 12, 2008, at A1. 
188 http://www.france24.com/en/20081215-hsbc-faces-1-billion-risk-madoff-scandal-fraud; 
http://www.sec.gov/answers/ponzi.htm 
35
as well as an investment advisory business.189 According to SEC filings, the investment advisory 
business had over $17 billion in assets under management.190 It was this investment advisory arm 
of his alleged business that housed the fraud, which surfaced in late 2008 when he was unable to 
“obtain the liquidity necessary to meet” investors’ demands to withdraw $7 billion dollars from 
the fund firm.191 
More recently, the Antiguan-based Stanford International Bank (SIB), along with 
Chairman Sir Allen Stanford, have been indicted for engaging in a scheme to defraud investors 
of over $8 billion.192 With 30,000 investors and over $51 billion in assets, SIB purported itself to 
be a bank, despite making no loans.193 Even more spurious is that Chairman Stanford actually 
helped rewrite Antiguan banking laws upon setting up his banks operations on the island.194 
Moreover, most of its investors’ certificate of deposits (“CD’s”) were invested in private equity 
and real estate, despite telling its investors that they were invested primarily in more “liquid” 
securities.195 From SIB’s practices, and the fact that they shielded themselves from SEC 
oversight, SEC officials state that SIB operated like a typical hedge fund opposed to a bank.196 
However, SIB also held offices based in Houston, Texas where Chairman Sir Allen Stanford 
defrauded some of SIB’s U.S. and foreign investors with impunity right under regulators 
noses.197 Fortunately for defrauded investors, Sir Allen Stanford was unable to escape and go 
189 See Complaint at 2-3, United States v. Madoff, 08-MAG-2735 (S.D.N.Y. Dec. 11, 2008) [hereinafter Madoff 
Complaint]. 
190 Id. 
191 Id. at 3. 
192 http://www.justice.gov/criminal/vns/caseup/stanfordr.html; Securities and Exchange Commission v. Stanford 
International Bank, et al., Case No. 3-09CV0298-L (N.D.TX.) 
193 http://www.financialweek.com/article/20090217/REG/902179991/103/REUTERS 
194 Alison Fitzgerald, Stanford Wielded Jets, Junkets, and Cricket to Woo Clients, Bloomberg Feb. 18, 2009 
(available at: http://www.bloomberg.com/apps/news?sid=auAqkrxMzKPc&pid=20601109). 
195 Id. 
196 Id. 
197 Emil Arguelles, “The Truth About Tax Havens.” San Pedro Daily. Nov. 14, 2009. 
http://ambergriscaye.com/forum/ubbthreads.php/topics/357954/The_truth_about_tax_havens.html 
36
into hiding because the U.S. had extraterritorial jurisdiction over him as a U.S. citizen.198 What’s 
alarming is that SIB associates were in Belize soliciting prospective clients prior to the 
indictment, but were unsuccessful in doing so.199 This just goes to show how U.S. and other 
foreign citizens unfamiliar with tax haven entities could easily be swindled with no 
forewarning.200 Although the case is still pending, SIB and Mr. Chairman are charged with 
“violations of the anti-fraud provisions of the Securities Act of 1933, the Securities Exchange 
Act of 1934 and the Investment Advisers Act, and registration provisions of the Investment 
Company Act.”201 
Although the Madoff and Stanford incidents represent extreme outlier cases of fraud, 
either in terms of the size of the scams or deplorable nature of the crimes themselves, they 
nevertheless call attention to the risk of fraud, both domestically and in offshore tax havens.202 
Fraud detection and prevention is a second key goal of regulators. The failure to detect scandals 
like these have devastated investor confidence in U.S. regulatory agencies, such as the Securities 
and Exchange Commission (SEC) and the Commodities Futures Trading Commission 
(CFTC).203 Although even the two most extreme cases of fraud did not individually or 
collectively rise to the level of systemic risk, both were audacious attempts to defraud investors 
by circumventing U.S. regulation with activity in offshore tax havens. 
But the nature of these crimes were littered with red flags: Madoff’s impossibly 
consistent returns year after year, Stanford rewriting the very laws that were supposed to regulate 
him, and involvement in suspicious tax havens should have been picked up by SEC officials and 
198 Id. 
199 Id. 
200 Id. 
201 Id. 
202 John Gapper, The Hedge Fund Industry Is Going Down with Dignity, Fin. Times (London), Dec. 6, 2008, at 9 
(Madoff defrauded dozens of charities and non-profits, 
203 http://www.bloomberg.com/apps/news?pid=20601109&sid=afUo_v5lEmwc 
37
other foreign regulators.204 In terms of investor protection against fraud, perhaps it is not 
additional regulation that would serve the hedge fund industry and investors best. Rather, better 
inter-agency communication, additional agency (SEC, CFTC) resources for investigating crimes, 
and better enforcement of current laws would be more effective. 
C. Benefits of Hedge Funds in Financial Markets 
Hedge funds have noticeable and undeniable benefits to financial markets, and are 
playing an “increasingly important role in [the U.S.] financial system.” 205 The rapid growth in 
number of hedge funds and total assets under management are evidence that investors perceive 
them as providing significant value that they could otherwise not obtain through other, more 
traditional investment vehicles.206 Considering that savings funds account for only a small share 
of the overall assets held by hedge funds, the size and importance of the hedge fund industry will 
continue to grow throughout the foreseeable future.207 
It has been previously argued in this Note that hedge funds are chastised more for their 
perceived risks to financial markets rather than heralded for the positive effects they have on 
financial system functions.208 Hedge funds play a critical role in a variety of areas that help make 
the U.S. firms, and the overall market, competitive in the global arena. First, hedge funds “play a 
valuable arbitrage role in reducing or eliminating mispricing” among firms across various 
financial markets.209 They can better allow firms to stamp a true value on assets and ensure 
204 Id. 
205 Timothy F. Geithner, President & CEO, Fed. Reserve Bank of N.Y., Keynote Address: Hedge Funds and Their 
Implications for the Financial System (Nov. 17, 2004) (transcript available at http:// 
www.ny.frb.org/newsevents/speeches/2004/gei041117.html). 
206 Id.; see supra note 172. 
207 Id. 
208 Id. 
209 Id. 
38
liquidity through mark-to-marketing asset pricing.210 This pricing practice, in addition to the 
sheer bulk of assets under management, supply a significant source of liquidity for financial 
markets, in periods of both stability and distress.211 Moreover, hedge funds “add depth and 
breadth to [U.S.] capital markets, providing additional sources of long-term financing for firms 
and start-up ventures.”212 
Frequently criticized for doing this, hedge funds also provide a benefit to the market in 
providing a “source of risk transfer and diversification,” instead of forcing risk averse institutions 
to retain unwanted or illiquid assets on their balance sheets.213 Indirectly, this amounts to a type 
of risk-matching service among themselves and between other firms.214 Thus, hedge funds, 
which typically pursue relatively more risk-seeking investment strategies in hopes of higher 
returns, can provide a good outlet for firms looking to trade away less liquid assets, and in some 
cases, vice versa.215 
As U.S. Treasury Secretary Timothy Geithner so aptly put it, hedge funds “don’t perform 
these functions out of a sense of noble purpose, of course, but they are a critical part of what 
makes the U.S. financial markets work relatively well in absorbing shocks and in allocating 
savings to their highest return. These benefits are less conspicuous than the trauma that has been 
associated with hedge funds in periods of financial turmoil, but they are substantial.”216 
Hedge funds have also indirectly caused other financial institutions to provide market 
benefits, in response to the nature of the hedge fund industry. Since LTCM’s collapse in 1998, 
firms have established better internal due diligence practices to manage the risk of hedge fund 
210 5 B.Y.U. Int'l L. & Mgmt. Rev. 99; Jenny Anderson & Heather Timmons, Why a U.S. Subprime Mortgage Crisis 
is Felt Around the World, N.Y. TIMES, Aug. 31, 2007, at C1. 
211 Supra note 172. 
212 Id. 
213 Id. 
214 Id. 
215 Id. 
216 Id. 
39
exposures.217 In addition, the same firms adaptation in the post-LTCM era included imposing 
tighter credit requirements, demanding more collateral on investments, establishing daily margin 
limits to ensure sufficient capital reserves, and taking a more conservative approach to valuing 
collateral and illiquid assets.218 Of course, not every firm in the market exudes these benefits or 
profits from these investments in every instance of trading. However, diligent investing and firm 
management practices make it possible for these positive aspects to benefit other firms. 
Firms in the market also learned from the LTCM incident, and began paying closer 
attention to future credit exposures that they might encounter in the future.219 Moreover, firms 
have insulated themselves better from risk by establishing superior and more intelligent ways of 
measuring and “stress testing” those credit exposures.220 Firms have also been more proactive in 
seeking out information from hedge funds about the risks of the fund. Firms have done this 
through periodic inquiries into a fund’s investing strategy, leverage ratio, and other aspects that 
may be discoverable, which could improve firm value and risk management.221 
Although these market improvements came about after a near financial catastrophe with 
LTCM’s collapse, the benefits and practices still permeate the market today.222 Unfortunately, 
the stigma surrounding hedge funds as being secretive and exotic investment vehicles likely 
inhibits more benefits from permeating the market due to the apprehension of investors in 
participating in these funds. Regardless, as U.S. Treasury Secretary Geithner commented, it took 
a “major market event to expose the extent of weaknesses in market practice that prevailed prior 
217 Timothy F. Geithner, President & CEO, Fed. Reserve Bank of N.Y., Keynote Address: Hedge Funds and Their 
Implications for the Financial System (Nov. 17, 2004) (transcript available at http:// 
www.ny.frb.org/newsevents/speeches/2004/gei041117.html). 
218 Id. 
219 Id. 
220 Id. 
221 Id. 
222 Timothy F. Geithner, President & CEO, Fed. Reserve Bank of N.Y., Keynote Address: Hedge Funds and Their 
Implications for the Financial System (Nov. 17, 2004) (transcript available at http:// 
www.ny.frb.org/newsevents/speeches/2004/gei041117.html). 
40
to 1998 and to catalyze improvements across the financial community. Those reforms have 
played an important role in reducing risk in the system, alongside the overall improvements in 
capital, risk management, and the financial infrastructure.”223 
Despite the known market benefits hedge funds provide, in the aftermath of the recent 
financial crisis many of these benefits were improperly marginalized, overlooked, and even 
perceived as threats. Hedge funds have been criticized by some politicians and commentators for 
short-selling troubled banks during the market’s decline.224 However, the much-criticized hedge 
fund short sellers are the financial markets' first line of defense against fraud and exaggerated 
valuations.225 More lenient rules on short-selling increase the incentives for companies “to police 
the markets themselves, and can prevent fraudulent or overvalued companies from running even 
higher.”226 Without hedge fund short sellers, markets would be inherently positively-biased, 
resulting in securities being priced less efficiently.227 Moreover, short sellers make for 
outstanding stock analysts who have a keen eye for fraud, mismanagement, or aggressive 
accounting.228 There are several tools and strategies in the market to curb gross, abusive stock 
undervaluations. For example, private equity funds, strategic buyers, and share buybacks all can 
41 
223 Id. 
224 Laurence Fletcher, “Hedge Funds Say Role in Crisis Was Marginal: AIMA,” Reuters, April 2, 2009 
(http://www.reuters.com/article/idUSTRE5315J420090402). 
225 Zac Bissonnette, “SEC Ends Uptick Rule but Vows Crackdown on Naked Short Selling,” 
BloggingStocks, June 14, 2007. (http://www.bloggingstocks.com/2007/06/14/sec-ends-uptick-rule- 
but-vows-crackdown-on-naked-short-selling/). 
226 Id.. 
227 Alex Dumortier, “The Truth About Naked Shorts,” The Motley Fool, Sept. 22, 2008. 
(http://www.fool.com/investing/dividends-income/2008/09/22/the-truth-about-naked-shorts.aspx). 
228 Id.. ( “Take Jim Chanos of Kynikos Associates, for example, who was one of the first (and only) investors to call 
Enron out for its fuzzy accounting. If only more investors had listened to his arguments instead of those of Ken Lay 
and Jeff Skilling.).
help a company prevent abusive, unwarranted devaluations.229 The SEC would be weakening 
one of the best mechanisms in place to proactively stop fraud and overvaluations if it 
discouraged short-selling by placing blame on firms that did so, or made prohibited it all 
together.230 
What the critics are actually referring to when they criticize the hedge funds who short 
sell is what the SEC describes as "abusive naked short selling." This term refers to short sellers 
who (a) sell shares they have not borrowed or have no reasonable expectation of borrowing, and 
(b) cannot deliver those shares on the settlement date of their sale because they do not possess 
them.231 However, the SEC already addressed this alleged problem when it adopted an antifraud 
rule in October of 2008 to thwart abusive naked short selling. “Rule 10b-21 is designed to 
prevent short sellers, including broker-dealers acting for their own accounts, from deceiving 
specified persons about their intention or ability to deliver securities in time for settlement and 
then failing to deliver securities by the settlement date.”232 In addition, the SEC completely 
banned short selling of 799 financial stocks for a brief period in September and October 2008, 
and increased the reporting burden for short sellers.233 Yet, this still did not completely halt the 
downward spiral of several financial institutions after the short-selling hold was lifted. As long 
as short sales are eventually covered, there is no harm in naked short selling unless the short 
seller acted fraudulently or dishonestly. The requirement to borrow shares before short selling is 
229 Zac Bissonnette, “SEC Ends Uptick Rule but Vows Crackdown on Naked Short Selling,” BloggingStocks, June 
14, 2007. (http://www.bloggingstocks.com/2007/06/14/sec-ends-uptick-rule-but-vows-crackdown-on-naked-short-selling/). 
230 Id.. 
231 Id. 
232 Rule 10b-21, Securities Exchange Act of 1934; SEC Release 33-7046. 
(http://www.blankrome.com/index.cfm?contentID=37&itemID=1723). 
233 http://www.sec.gov/news/press/2008/2008-211.htm 
42
a burdensome and unnecessary process that causes market inefficiencies.234 Hedge fund critics 
shouldn't let the investing strategy of short selling blind them from the truth: that severe credit 
problems banks, broker-dealers, and mortgage companies had were self-inflicted, long before 
hedge funds began short selling them.235 
Even if critics cannot subscribe to the foregoing reasons why hedge funds were not at 
fault, they cannot overlook the fact that regulators did little to regulate short-selling if indeed 
they believed it to be harmful. This is evidenced by the fact that regulators suspended the 
“Uptick Rule” in July of 2007.236 The SEC summarized the “Uptick Rule” as follows: "Rule 10a- 
1(a)(1) provided that, subject to certain exceptions, a listed security may be sold short (A) at a 
price above the price at which the immediately preceding sale was effected (plus tick), or (B) at 
the last sale price if it is higher than the last different price (zero-plus tick). Short sales were not 
permitted on minus ticks or zero-minus ticks, subject to narrow exceptions."237 When the rule, 
which had been in place since the 1930’s, was removed in 2007 many critics claim that this 
promoted easier, abusive short-selling of stocks by hedge funds.238 In response to these claims, 
the SEC approved the “Alternative Uptick Rule” in February 2010.239 This rule amended Rule 
201 of Regulation SHO, which was designed “to restrict short selling from further driving down 
the price of a stock that has dropped more than 10 percent in one day. It will enable long sellers 
234 Alex Dumortier, “The Truth About Naked Shorts,” The Motley Fool, Sept. 22, 2008. 
(http://www.fool.com/investing/dividends-income/2008/09/22/the-truth-about-naked-shorts. 
43 
aspx). 
235 Id.. 
236 David Gaffen, “All Hail the Uptick Rule!,” The Wall Street Journal, March 10, 2009. 
(http://blogs.wsj.com/marketbeat/2009/03/10/all-hail-the-uptick-rule/). 
237 Amendments to Exchange Act Rule 10a-1 and Rules 201 and 200(g) of Regulation SHO". SEC. 2008-05-21. 
http://www.sec.gov/divisions/marketreg/tmcompliance/rules10a-200g-201-secg.htm. Retrieved 2009-04-08. 
238 Id.. 
239 http://www.sec.gov/news/press/2010/2010-26.htm
to stand in the front of the line and sell their shares before any short sellers once the circuit 
breaker is triggered.”240 
Critics who chastise hedge funds for short selling financial companies in 2007 and 2008 
are misdirecting their blame if they truly feel short selling was a contributing mechanism to the 
crisis. Regulators were the ones who removed the “Uptick Rule” in 2007, so they would be hard-pressed 
to blame hedge funds who undertook this completely legal investing strategy. Moreover, 
the new “Alternative Uptick Rule” is viewed as a feel good rule with “no teeth,” considering the 
new rule only helps in times of extreme market volatility but goes unnoticed in times of market 
stability.241 Thus, if any blame could be attributed to short-selling, it should be bestowed on 
regulators who removed the “Uptick Rule” and not hedge funds who acted properly under the 
law. Moreover, many in the market believe that short-selling is not a legitimate, substantial 
threat, but even if it is the “Alternative Uptick Rule” is not strong enough to prevent the 
perceived threat. 242 
Perhaps one of the biggest relative benefits hedge funds provided in the midst of the 
financial crisis was that they did not burden the government or taxpayers with billion dollar 
bailouts and forced, U.S. Treasury-backed mergers. Moreover, there were no systemically 
notable hedge fund collapses either.243 In the aftermath of the financial crisis, the hedge fund 
industry has recovered and outperformed far better than other financial institutions. It must be 
noted that “banks such as CitiGroup, brokers such as Bear Stearns and Lehman Brothers, home 
240 Id.. 
241 Chuck Jaffe, “Coming up Short: SEC’s New Version of ‘Uptick Rule” lets Investors Down,” 
Market Watch, March 3, 2010. (http://www.marketwatch.com/story/new-uptick-rule-for-stocks-lets- 
44 
investors-down-2010-03-03). 
242 Chuck Jaffe, “Coming up Short: SEC’s New Version of ‘Uptick Rule” lets Investors Down,” Market Watch, 
March 3, 2010. (http://www.marketwatch.com/story/new-uptick-rule-for-stocks-lets-investors-down-2010-03-03). 
243 Laurence Fletcher, “Hedge Funds Say Role in Crisis Was Marginal: AIMA,” Reuters, April 2, 2009 
(http://www.reuters.com/article/idUSTRE5315J420090402).
Jon Terracciano - Hedging the Global Market
Jon Terracciano - Hedging the Global Market
Jon Terracciano - Hedging the Global Market
Jon Terracciano - Hedging the Global Market
Jon Terracciano - Hedging the Global Market
Jon Terracciano - Hedging the Global Market
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Jon Terracciano - Hedging the Global Market
Jon Terracciano - Hedging the Global Market
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Jon Terracciano - Hedging the Global Market
Jon Terracciano - Hedging the Global Market
Jon Terracciano - Hedging the Global Market
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Jon Terracciano - Hedging the Global Market

  • 1. HEDGING THE GLOBAL MARKET: AVOIDING EXCESSIVE HEDGE FUND REGULATION IN A POST-RECESSION ERA Jonathan P. Terracciano TABLE OF CONTENTS INTRODUCTION ………………………………………………………………………………….….2 I. CURRENT OPERATIONAL AND REGULATORY ENVIRONMENT OF HEDGE FUNDS...........................8 A. Background and Structure of Hedge Funds ………………………….............................8 B. Current Legislation Governing Hedge Funds……………………….……………….....14 1. The Securities Act of 1933…………………………………………………………..…...16 2. The Exchange Act of 1934……………………………………………………..………...17 3. The Investment Company Act of 1940……………………………………………….…19 4. The Investment Advisor Act of 1940………………………………………………..…..21 II. HEDGE FUNDS’ ROLE IN SYSTEMIC RISK, INVESTOR FRAUD, AND MARKET BENEFITS……….. 23 A. Systemic Risk……………………………………….………………………..………...24 1. The Implosion of Long-Term Capital Management & Industry Response………...24 2. Systemic Risk Concerns Misdirected at Hedge Funds Instead of Banks………......28 3. The Future of Systemic Risk: Growing Concerns in Offshore Tax Havens……….33 B. Fraud and Investor Protection…………………..............................................................35 C. Benefits of Hedge Funds in Financial Markets………………………………....………38 III. PROPOSED LEGISLATION REGARDING HEDGE FUND REGULATION ……………………...……47 A. “Hedge Fund Transparency Act of 2009”………………………………………..…….47 B. “Hedge Fund Adviser Registration Act of 2009”……………………………...……….51 C. “Private Fund Transparency Act of 2009”……………………………………...………52 D. “Hedge Fund Study Act”……………………………………………………...………..55 E. “Stop Tax Haven Abuse Act”………………………………………………..…………56 CONCLUSION ……………………………………………………………………………………..58 APPENDIX…………………………………………………………………………………………62
  • 2. INTRODUCTION In the wake of numerous financial institution collapses, there has been an intense public and political uproar over who is to blame, how these events occurred, and how to prevent these problems in the future. By 2008, the U.S. financial market witnessed extreme turmoil in the financial system. The crisis was marred by the collapse of over two hundred banks and financial institutions, notably Bear Stearns and Lehman Brothers.1 It was also exemplified by a consolidation of several large national banks. The Federal Reserve’s bailout of Bear Stearns in the form of a heavily facilitated sale to JP Morgan, along with the virtually forced sale of Merrill Lynch to Bank of America were major efforts taken by the U.S. officials in trying to restore financial order. Moreover, the government takeovers of the two mortgage giants, Fannie Mae and Freddie Mac and insurance giant American International Group (AIG), and the TARP (“Troubled Asset Relief Program) bailout of the seventy largest national banks, were other ominous signs of the U.S. economy’s fragile state.2 These events did not resonate well with the public, sparking sharp condemnation amongst many politicians, investors, and everyday citizens. News headlines such as “U.S. Recession Worst Since Great Depression”3 and “World’s Wealthy Lose Faith in Fund Managers,”4 aptly classified the fallout from the market’s turbulence. The crisis was not downplayed by even the highest ranking politicians, leading President Obama to characterize the economic chaos at the end of 2008 as a “continuing disaster” for the United States.5 Despite the stock market’s rebound 1 http://www.fdic.gov/bank/individual/failed/banklist.html; Anne Stjern, The Failure of Bear Stearns, Lehman Brothers and AIG: Is Another Great Depression in our Future? Associated Content. Sept. 17, 2008. http://www.associatedcontent.com/article/1043016/the_failure_of_bear_stearns_lehman.html 2 Id. 3 http://www.bloomberg.com/apps/news?pid=20601087&sid=aNivTjr852TI 4http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article6571355.ece 5 BBC News. “Obama Calls Recession a Disaster.” Jan. 30, 2009. http://news.bbc.co.uk/2/hi/business/7860892.stm 2
  • 3. and relative stabilization of major indices such as the Dow Jones, nearly all believe that the “Great Recession” rolls on.6 The recent failure of several major investment banks and private funds has been both a cause and consequence of the deep economic recession that has spread across the world.7 In the United States, the financial sector has been especially ravaged by a series of successive private fund meltdowns, totaling 1,471 hedge fund failures in 2008, in addition to the bank failures previously discussed.8 The recent instability of U.S. and international financial markets stemmed from a combination of factors that has shaken investor confidence in these systems. The breakdown in market stability and investor confidence can be largely attributed to loose lending practices and erroneous subprime mortgage valuation in the United States.9 Consequently, many financial institutions were excessively leveraged with debt and held major positions on overvalued mortgage-backed securities.10 When the subprime mortgage market began rapidly crashing, institutions holding large amounts of mortgage-backed securities incurred severe losses, mainly through writedowns. Moreover, financial institutions exercised mark-to-market writedowns in valuing assets even though they were no actual, tangible asset losses.11 This especially proved troublesome to the financial institutions that held massive amounts of assets in the form of collateralized debt obligations (CDOs) and mortgage-backed 6 http://online.wsj.com/article/SB10001424052748703837004575013592466508822.html 7 Volume 56, Number 8 · May 14, 2009 How to Understand the Disaster By Robert M. Solow. http://www.nybooks.com/articles/22655 8 New Record For Hedge Fund Failures. Anita Raghavan , 03.18.09, 09:30 AM EDT 1,471 hedge funds went out of business in 2008. http://www.forbes.com/2009/03/18/hedge-fund-failures-business-wall-street-funds.html. 9 5 B.Y.U. Int'l L. & Mgmt. Rev. 99; Jenny Anderson & Heather Timmons, Why a U.S. Subprime Mortgage Crisis is Felt Around the World, N.Y. TIMES, Aug. 31, 2007, at C1. 10 Id. 11 Id. 3
  • 4. securities.12 In a frozen market where firms were reluctant to lend and buy assets, the mark-to-market accounting method “require[d] that lenders assign a value to an asset based on its current market value, as opposed to a more traditional hold-to-maturity model that uses historical income and other criteria for valuing assets.”13 Thus, huge amounts of level three assets, which include CDOs and subprime mortgage-backed securities, had to be written down to a fraction of their original book values as the market for these securities became increasingly illiquid and began to vanish.14 The “maturity mismatch” of long-term, illiquid assets funding short-term debt put firms, such as Bear Stearns, in grave danger when a liquidity shock occurred, causing investors to cease lending.15 Hence, several firms that were relatively solvent, meaning it had enough assets (though somewhat illiquid) to pay off debts, were damaged because their short-term liquidity was virtually tapped out. 16 “Liquidity” is characterized as “capital resources necessary to conduct normal business without disruption.”17 Illiquidity was a huge problem for firms like Bear Stearns, especially in its finals days before merging with JP Morgan. But the fact that banks had so many assets tied up in toxic mortgage-backed securities drove fears that many were insolvent as well. 18 No one knew how much these level three assets were worth and many feared they could be worth only a fraction of what they were valued at. Thus, bank insolvency concerns 12 Id. 13 Id. 14 Id. 15 Bullard, James. “Systemic Risk and the Macroeconomy: An Attempt at Perspective.” [Speech at Indiana University] 2 October 2008. <http://www.stlouisfed.org/news/speeches/2008/10_02_08.html#_ftn3>. 16 Drum, Kevin. “The Next Step on the Bailout.” Mother Jones 30 September 2008. <http://www.motherjones.com/kevin-drum/2008/09/solvency-vs-liquidity>. 17 Id. 18 Id. 4
  • 5. spread throughout the market from mounting liquidity problems because of these toxic security assets.19 With the exorbitant level of debt raised to finance these now quasi-worthless (or at best questionably-valued) securities, the inability to cover losses and debt led to the swift downfall of many financial institutions and the overall U.S. financial market.20 Ultimately, the collapse of the U.S. market rippled throughout the world because many international investment funds and banks held substantial positions in these level three securities from frequent trading with U.S. counterparties.21 In the aftermath of this financial calamity, much of the public and political criticism has been directed at hedge funds, based on their huge investments and trading in subprime mortgage-backed securities.22 Hedge funds, a specific type of quasi-regulated, private investment vehicle (discussed in depth later), were an obvious scapegoat target due to their high debt leverage ratios and limited financial transparency to individual investors and institutional counterparties.23 The high degree of leverage and inability of regulators and counterparties to assess the true, intrinsic 19 Id. 20 http://therealdeal.com/newyork/articles/mark-to-market-makes-a-mess 21 Id. For example, Germany's Deutsche Bank AG announced $3.11 billon in write-downs, with much of the losses stemming from mortgage loans. David Reilly & Edward Taylor, Banks' Candor Makes Street Suspicious, WALL ST. J., Oct. 4, 2007, at C1. Switzerland's Credit Suisse Group also earlier announced $1.1 billion in similar losses, id., while another Swiss bank, UBS, announced $3.41 billion in write-downs, much of which stemmed from losses in securities tied to U.S. subprime mortgages. Jason Singer et al., UBS to Report Big Loss Tied to Credit Woes, WALL ST. J., Oct. 1, 2007, at A1; Boyd, Roddy. “The Last Days of Bear Stearns.” Fortune Magazine 31 March 2008. <http://money.cnn.com/2008/03/28/magazines/fortune/boyd_bear.fortune/index.htm>; Schmerken, Ivy. “Counterparty Risk Is a Top Concern in the Wake of the Credit Crisis.” Advanced Trading 15 September 2008. <http://www.advancedtrading.com/derivatives/showArticle.jhtml?articleID=210601645>. 22 Id. Germany's finance minister, Peer Steinbrueck, charged that “[t]here is a sizable, remarkable number of hedge funds which are not behaving properly on the market.” Somerville, supra note 1. Further elaborating on the risks associated with hedge funds, he asserted that “[n]o expert that I have met up to now could exclude a potential financial crisis caused by all these leveraged impacts of hedge funds.” 23 Leverage is defined as the “use of debt capital in an enterprise or particular financing to increase the effectiveness (and risk) of the equity capital invested therein.” “Leverage also increases the magnitude of failure in addition to making the equity capital invested more effective, and such large failures may cause harm to overall market confidence. Counterparties that trade with hedge funds and parties that provide services to hedge funds may also be harmed. In particular, it is feared that the collapse of a large hedge fund would cause the fund's creditors to become insolvent, creating a cascading effect throughout the market.” Michael Downey Rice, Prentice-Hall Dictionary Of Business, Finance, And Law 208 (1983). 5
  • 6. value of various assets under management make hedge funds a source of concern regarding systemic risk.24 Also referred to as “contagion,” “systemic risk” is defined as “the danger of widespread disruption of financial markets and institutions that, in turn, affects the macroeconomy.”25 It is the “potential that a single event, such as a financial institution's loss or failure, may trigger broad dislocation or a series of defaults that affect the financial system so significantly that the real economy is adversely affected.”26 Regulators are also concerned with the recent rise in fraud among private funds that has hit investors during this period of extreme market vulnerability. Most notably, Bernard L. Madoff Investment Securities (BLMIS), a New York-based hedge fund defrauded investors over $50 billion through a “Ponzi scheme,” “an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors.27 More recently, the Antiguan-based Stanford International Bank (SIB), and its Chairman Sir Allen Stanford, have been indicted for engaging in a scheme to defraud investors of over $7 billion.28 From SIB’s practices, and the fact that they shielded themselves from SEC oversight, SEC officials state that SIB operated like a typical hedge fund opposed to a bank.29 From these two instances of fraud 24 See, e.g., Paul Davies et al., Prosecutors Begin a Probe of Bear Funds, WALL ST. J., Oct. 5, 2007, at C1 (describing the July 2007 collapse of two mortgage-related hedge funds at Bear Stearns after large losses on U.S. subprime mortgages, costing investors $1.6 billion). More recently, Bear Stearns required a bailout after massive losses on subprime mortgage related securities. Robin Sidel et al., The Week That Shook Wall Street: Inside the Demise of Bear Stearns, WALL ST. J., Mar. 18, 2008, at A1. Unlike other bailouts of financial institutions, the Bear Stearns bailout required the Federal Reserve Bank to actually take responsibility for $30 billion in securities on Bear's books. Id. 25 Bullard, James. “Systemic Risk and the Macroeconomy: An Attempt at Perspective.” [Speech at Indiana University] 2 October 2008. <http://www.stlouisfed.org/news/speeches/2008/10_02_08.html#_ftn3>. 26 Hedge Funds and Systemic Risk: Perspectives of the President's Working Group on Financial Markets: Hearing Before the H. Comm. on Financial Servs., 110th Cong. 63 (2007) [hereinafter Testimony of Steel] (testimony of Robert K. Steel, Under Secretary for Domestic Finance, United States Department of the Treasury), available at http://www.treasury.gov/press/releases/hp486.htm. 27 http://www.france24.com/en/20081215-hsbc-faces-1-billion-risk-madoff-scandal-fraud; http://www.sec.gov/answers/ponzi.htm 28 http://www.justice.gov/criminal/vns/caseup/stanfordr.html; Securities and Exchange Commission v. Stanford International Bank, et al., Case No. 3-09CV0298-L (N.D.TX.) 29 Id. 6
  • 7. and hundreds more like it, fraud detection and prevention is a second key goal of regulators. The failure to detect scandals like these have devastated investor confidence in U.S. regulatory agencies, such as the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC).30 Congress has responded to the crisis with several proposals to overhaul the current regulatory system governing hedge funds. Most notably are the “Hedge Fund Transparency Act of 2009” (HFTA),31 “Hedge Fund Adviser Registration Act of 2009” (HFRA),32 “Private Fund Transparency Act of 2009” (PFTA),33 “Hedge Fund Study Act” (HFSA),34 and “Stop Tax Haven Abuse Act.”35 In conjunction with these proposed bills that would directly regulate the hedge fund industry, there are bills on the table that would raise corporate tax rates on U.S. investment firms that operate domestically, as well as those that operate internationally but have close ties to the U.S. market. Proposed legislation aimed at minimizing systemic risk and fraud could unintentionally bring about a wide departure of U.S. hedge funds into international tax havens, where lax regulation and oversight allows and could exacerbate these existing threats. Moreover, a mass exodus of hedge funds would also mean the disappearance of many beneficial impacts on the U.S. financial market. Legislators and regulators must develop a system that balances efficient hedge fund regulation that is no more restrictive than needed to minimize systemic risk and fraud, while permitting the benefits of hedge funds to permeate the market, in order to avoid a 30 http://www.bloomberg.com/apps/news?pid=20601109&sid=afUo_v5lEmwc 31 Hedge Fund Transparency Act of 2009, S. 344, 111th Cong. (2009). 32 Hedge Fund Adviser Registration Act of 2009, H.R. 711, 111th Cong. (1st Sess. 2009). 33 Private Fund Transparency Act of 2009, S. 1276, 111th Cong. (2009). 34 Hedge Fund Study Act, H.R. 713, 111th Cong. (2009). 35 Stop Tax Haven Abuse Act, 111th Cong. (2009). 7
  • 8. mass exodus of U.S. hedge funds into international tax havens, which have become a growing concern in regards to investor fraud, corruption, and systemic risk. This paper will examine the current regulatory environment in which hedge funds operate, and will argue that although the regulatory system is in need of reform, proposed legislation is unnecessarily restrictive and could actually harm U.S. and international markets. Part I of this paper will provide information on the background and structure of hedge funds and discuss the current bodies of legislation governing the hedge fund industry. Part II will examine possible risks and threats hedge funds pose in the financial market, as well as the benefits they provide. Part III will address several proposed laws aimed at regulating hedge funds in the aftermath of the recent global recession. Part IV will recommend only limited additional regulation through a domestically and globally coordinated effort, that will allow the U.S. hedge fund industry, and overall financial market, to remain competitive in the global arena. The main goals of this new regulatory structure will be better mitigating market risk, improving market integrity, and allowing the benefits of hedge funds to operate and grow in the market. I. CURRENT OPERATIONAL AND REGULATORY ENVIRONMENT OF HEDGE FUNDS A. Background and Structure of Hedge Funds In today’s highly developed and advanced financial environment, the term “hedge fund” still invokes perceptions of obscurity and ambiguity, even among the most sophisticated investors. To this day, the term “hedge fund” lacks a single, universally recognized definition in the financial world, resulting in various, and sometimes contradicting, definitions of the term.36 36 See, e.g., Staff of the Commission's Division of Investment Management and Office of Compliance Inspections and Examinations, Implications of the Growth of Hedge Funds: Staff Report to the United States Securities and Exchange Commission viii (2003) [hereinafter SEC 2003 Staff Report]; Financial Services Authority (United Kingdom), Hedge Funds and the FSA, Discussion Paper 16, at 8 (2002). 8
  • 9. Although not statutorily defined in the U.S. or abroad, the industry’s generally “accepted definition is that [hedge funds] are privately offered investment vehicles in which the contributions of the high net worth participants are pooled and invested in a portfolio of securities, commodity futures contracts, or other assets.”37 The term “hedge fund” is believed to have been coined back in 1949, referring to a private investment fund managed by Alfred Winslow Jones under a private partnership agreement.38 In that fund, Mr. Jones employed a strategy of holding both long and short equity positions to “hedge” the fund portfolio’s risk against market volatility.39 Moreover, Mr. Jones pioneered a revolutionary way of charging a “management fee” to investors. Rather than charging a percent of assets under management, Jones charged a 20% “performance fee” equal to the fund’s returns.40 This strategy has been widely adopted by the hedge fund industry, where most hedge funds charge a 15-25% performance fee, in addition to a 2% general management fee based on the total value of assets held.41 Although the fee structure established by Mr. Jones in 1949 is applied by nearly all hedge funds today, the investing strategy of “hedging” he employed is not a universal characteristic of the entire industry. As the hedge fund industry evolved over time, many hedge funds began to utilize different investment strategies, and some hedge funds even did away with “hedging” 37 Vikrant Singh Negi, Legal Framework for Hedge Fund Regulation. Hedge Funds Consistency Index. Feb. 12, 2010, available at http://www.hedgefund-index.com/s_negi.asp. 38 David A. Vaughn, Selected Definitions of “Hedge Fund.” Comments for the U.S. Securities and Exchange Commission Roundtable on Hedge Funds. May 14-15, 2003, available at http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.htm#footnote_1. 9 39 Id. 40 Christopher Holt, Performance Fees: As Old as Portfolio Management Itself? Seeking Alpha. Jan 20, 2009 available at http://seekingalpha.com/article/115612-performance-fees-as-old-as-portfolio-management-itself. 41 Id.
  • 10. altogether.42 In addition to, or in place of, “hedging,” many current hedge funds draw from a pool of over twenty-five investing strategies, such as using leverage, derivatives, and arbitraging by investing in multiple markets.43 A fund need not utilize all these methods to be deemed a “hedge fund,” but must simply have the capability to engage in them.44 Today, hedge funds are defined by their organizational structure and mode of operation, rather than by the investing or financial strategies they employ.45 As more and more hedge funds have taken a purely equity-based approach to investing without applying any of the aforementioned methods, many “’hedge funds’ are not actually hedged, and the term has become a misnomer in many cases.”46 Although the investing tactics of hedge funds may have morphed over the last sixty years, the management and investor structure has primarily remained the same, much like the original fee structures. U.S. hedge funds are normally organized as limited liability partnerships (“LLP’s”) or limited liability corporations (“LLC’s”), whereby the fund manager serves as the general partner (“GP”) and the investors constitute limited partners (“LP’s”).47 Subject to the limited partnership agreement and the fiduciary duties that apply under both LLP’s and LLC’s, 42 Scott J. Lederman, Hedge Funds, in FINANCIAL PRODUCT FUNDAMENTALS: A GUIDE FOR LAWYERS 11-3, 11-4, 11-5 (Clifford E. Kirsch ed., 2000). Available at http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn. 10 htm#footnote_1. 43 JOHN DOWNES AND JORDAN ELLIOTT GOODMAN, BARRON'S, FINANCE & INVESTMENT HANDBOOK 358 (5th ed. 1998). Available at http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn. htm#footnote_1; MANAGED FUNDS ASSOCIATION, HEDGE FUND FAQs 1 (2003) 44 Id. 45 Supra note 18: Scott J. Lederman, Hedge Funds, in FINANCIAL PRODUCT FUNDAMENTALS: A GUIDE FOR LAWYERS 11-3, 11-4, 11-5 (Clifford E. Kirsch ed., 2000). Available at http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.htm#footnote_1. 46 WILLIAM H. DONALDSON, CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION, TESTIMONY CONCERNING INVESTOR PROTECTION IMPLICATIONS OF HEDGE FUNDS BEFORE THE SENATE COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS, Apr. 10, 2003, available at http://www.sec.gov/news/testimony/041003tswhd.htm. 47 Shartsis Friese, LLP, U.S. Regulation of Hedge Funds 88 (2005); Gerald T. Lins, Hedge Fund Organization, in Hedge Fund Strategies: A Global Outlook 98, 98 (Brian R. Bruce ed., 2002); Gregory M. Levy & Bernard A. Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res. J., 1997, at 18, available at http:// www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf; Jacob Preiserowicz, Note, The New Regulatory Regime for Hedge Funds: Has the SEC Gone Down the Wrong Path?, 11 Fordham J. Corp. & Fin. L. 807, 812 (2006).
  • 11. the general partner (fund manager) in an LLP has near-plenary control over the hedge fund’s investing activities, notably the overall strategy and debt structure being the two primary responsibilities.48 As such, under an LLP the general partner will have unlimited liability for any outstanding debts or obligations in situations where the hedge fund cannot fulfill them.49 Moreover, a hedge fund may pass tax liabilities directly on to investors, known as “flow through” tax treatment.50 Since the investors are LP’s, making them passive investors with no direct control over managing the fund’s portfolio, they benefit by only being held liable for losses to the degree of their investment in sharing in the gains, losses, and income of the fund.51 But on the downside, the LP investors in both LLP’s and LLC’s are afforded only marginal rights and protection.52 In comparison, when a hedge fund is organized as an LLC, tax liabilities flow through to investors, in addition to the hedge fund directly incurring tax expenses, known as “double taxation.”53 Hence, structuring the hedge fund as an LLP is more favorable in terms of tax liabilities, but an LLC provides one or managing members limited liability where an LLP imposes unlimited liability upon the GP fund manager.54 Regardless, the fund manager(s) under either an LLP or LLC are faced with fiduciary duties to their members in conducting operations and investing for the fund. 55 11 48 Id. at 90-92. 49 Id. 50 Id. 51 Id. 52 Id. at 91. 53 Id. 54 Id. 55 Id.
  • 12. Similar to most other LLP’s and LLC’s in the U.S., hedge funds usually file as an organization in the State of Delaware.56 Delaware has several distinct benefits tailored to hedge funds, found nowhere else in the United States.57 First, Delaware provides the most favorable state tax treatment to hedge funds.58 Second, the Delaware Revised Uniform Limited Partnership Act (DRULPA) is renown for its lenient and “flexible” LP statutes.59 Third, Delaware allows “side letters,” which permit hedge fund managers to make supplementary agreements with LP’s so that they confer additional benefits to specific investors who are preferred over other LP’s.60 From these unique benefits, it is clear why so many hedge funds prefer to file in Delaware rather than any other state in the U.S..61 The most widespread form of hedge funds that are seen today are organized under a “master-feeder” organization.62 The “master” fund is formed as a partnership, usually in a “tax haven” where it is a foreign resident.63 In addition, there are two “feeders,” one being U.S. domestic feeder for American taxable investors and another feeder for foreign investors or American investors who are tax exempt.64 The foreign “feeder” is typically organized as a corporation in a “tax haven,” whereas the U.S. domestic “feeder” is an LLP where income, gains 56 Ron S. Geffner, Delaware--The Hedge Fund Jurisdiction of Choice in the US, Complinet, Feb. 11, 2008, http:// www.hedgefundworld.com/documents/Delawarerev.pdf. 57 Id. 58 Gregory M. Levy & Bernard A. Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res. J., 1997, at 18, available at http:// www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf. 59 Ron S. Geffner, Delaware--The Hedge Fund Jurisdiction of Choice in the US, Complinet, Feb. 11, 2008, http:// www.hedgefundworld.com/documents/Delawarerev.pdf. 60 Id. 61 Gregory M. Levy & Bernard A. Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res. J., 1997, at 18, available at http:// www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf. 62 Martin A. Sullivan and Lee A. Sheppard, Offshore Explorations: Caribbean Hedge Funds, Part I," Tax Notes, Jan. 7, 2008, p. 95 available at http://www.tax.com/taxcom/features.nsf/Articles/35244A221EDD1BF7852573D00071118E?OpenDocument. 63 Id. 64 Id. 12
  • 13. losses, and deductions from investing “flow through” to LP investors.65 Moreover, there is only one portfolio and one investment vehicle that the fund manager must operate, and income is allocated to investors based on the amounts of their investments.66 The other, less popular hedge fund structure is known as the “side-by-side” fund.67 There, U.S. taxable investors form an LLP and have a separate investment vehicle than that of the non-taxable U.S. investors and foreign investors.68 Though more costly to operate, the “side-by-side” structure prevents the U.S. taxable investors from adding trade costs to the foreign and non-taxable U.S. fund while the U.S. domestic fund addresses U.S. tax liabilities.69 13 65 Id. 66 Id. 67 Id. 68 Id. 69 Id.
  • 14. For hedge funds that operate offshore, the “master-feeder” structure is preferred because it “provides anonymity to investors, blocks exempt investors from being considered owners of certain kinds of assets, and avoids putting foreign investors directly in a U.S. trade or business that generates effectively connected income.”70 American and international investors alike are both enticed off safer, domestic land, into these murky tax havens, which are still skeptically viewed by many industry experts.71 As we will discuss later, privacy, tax breaks, and higher returns on investment are the three main factors that attract investors to loosely regulated tax havens with limited investor protection.72 B. Current Legislation Governing Hedge Funds 14 70 Id. 71 http://online.wsj.com/article/SB124588728596150643.html. (stating that, “Hedge-fund assets in offshore tax havens such as the Cayman Islands and Bermuda represent more than two-thirds of the roughly $1.3 trillion industry, according to Hedge Fund Research Inc. Of those offshore assets, industry insiders estimate, between $400 billion and $500 billion belongs to U.S. investors, with tax-exempt foundations, endowments and pension funds accounting for about half of that. Investors from outside the U.S. make up the rest.”) 72 Bing Liang & Hyuna Park, Share Restrictions, Liquidity Premium, and Offshore Hedge Funds 3 (Working Paper, Mar. 14, 2008) available at http:// ssrn.com/abstract=967788). (Stating that due to “the tax advantage, offshore investors may collect higher illiquidity premium when their investment has the same level of share illiquidity as the investment of onshore investors. Our results may help explaining why the growth rate has been much higher in offshore funds than in onshore funds (26.4 vs. 15.0 percent per year from 2000 to 2004).”).
  • 15. Hedge funds are viewed by many to be largely unregulated compared to other investment vehicles, such as mutual funds.73 At the state level, “Blue Sky” laws monitoring securities still exist within each specific state. Under the National Securities Markets Improvement Act of 1996, “Investment advisers which are not registered with the SEC, either because they qualify for an exemption under the Advisers Act or because they don’t satisfy the assets under management test of Advisers Act § 203A(a)(1)(A), generally may be deemed ‘investment advisers.’”74 Thus, such an individual may be required to register as an investment adviser under a state’s “Blue Sky” laws.75 State “Blue Sky” laws vary across jurisdictions, as some states are more restrictive on hedge funds than others. For example, Michigan used to prohibit performance-based compensation fees, which is a key aspect of how hedge fund managers are compensated.76 At the end of 2009, New York, Massachusetts, and Connecticut have been dominant state residences for the top one hundred hedge funds, both in terms of sheer quantity and assets under management.77 None of those states have “Blue Sky” laws that limit or prohibit performance-based fees and are quite lenient when compared to other state laws. Although state “Blue Sky” laws have been characterized as “lacking teeth,” hedge funds and other financial firms are still predominantly governed by several federal securities regulations.78 The four primary regulations that apply to hedge funds are the Securities Act of 1933, the Exchange Act of 1934, the Investment Company Act, and the Investment Advisor Act 73 Alan L. Kenard, The Hedge Fund Versus the Mutual Fund, 57 Tax Lawyer 133, 133 (2003); see also Tamar Frankel & Lawrence A. Cunningham, The Mysterious Ways of Mutual Funds: Market Timing, 25 Ann. Rev. Banking & Fin. L. 235, 239 (2006). 74 http://www.lexology.com/library/detail.aspx?g=a43ec06b-5249-44f6-8ff7-98906d69a43e 75 Id.. 76 http://www.fosterswift.com/news-publications-Michigan-Securities-Law-Change.html (Michigan’s previous Uniform Securities Act, which was enacted in 1964, was replaced by the new Uniform Securities Act and became effective in October of 2009). 77 http://www.marketfolly.com/2009/05/barrons-hedge-fund-rankings-2009-top.html; http://hedgefundblogman.blogspot.com/2009/08/top-hedge-fund-cities-most-hedge-funds.html (See Appendix). 78 Id. 15
  • 16. of 1940.79 The selected portions of these regulations that follow relate to how hedge funds, and other similar funds, are presently governed. These four federal securities acts have largely supplanted individual state “Blue Sky” laws, and are the dominant authority on securities regulation matters pertaining to financial institutions.80 1. The Securities Act of 1933 (“Securities Act”) The Securities Act was passed with the intent to provide greater transparency, honesty, and disclosure on the part of securities firms in issuing initial public offerings (“IPO’s”).81 This act required firms to register with the Securities and Exchange Commission (“SEC”) securities that are sold to the public.82 Section 2(1) of the Securities Act defines the term “security” to include the commonly known debt and ownership interests traded for speculation or investment. Most notably, securities include “investment contracts,” which have been defined as “a contracts, transactions, or schemes whereby a person invests his money in a common enterprise and is led to expect profits primarily from efforts of promoter or a third party, it being immaterial whether shares in enterprise are evidenced by formal certificate or by nominal interests in physical assets employed in enterprise.”83 Normally, any firm that makes a public offering of securities will be required to comply with the registration requirements of the Securities Act. 79 15 U.S.C. §§ 77a-77aa (2000); §§ 78a-78nn (1994); §§ 80a-1-80a-64 (1994); §§ 80b-1-80b-21 (1994). 80 James Cox et al., Securities Regulations 390 (5th ed. 2005) (discussing the limited nature of state “Blue Sky” laws, whereby Congress amended section 18 of the Securities Act of 1933, preempting most state regulations). 81 15 U.S.C. §§ 77a-77aa (2000); Id. §§ 77e, 77aa (mandating firms provide a prospectus, with information about the offering and the issuer such as “a profit and loss statement for not more than three preceding fiscal years” and “a statement of the capitalization of the issuer,” unless the offering is exempted). 82 Id. §§ 77e, 77aa. 83 SEC v. Howey, 328 U.S. 293 (1946) (“The test of an investment contract within Securities Act is whether scheme involves an investment of money in a common enterprise with profits to come solely from efforts of others, and, if test is satisfied, it is immaterial whether enterprise is speculative or nonspeculative or whether there is a sale of property with or without intrinsic value. Securities Act of 1933, §§ 2(1, 3), 3(b), 5(a), 15 U.S.C.A. §§ 77b(1, 3), 77c(b), 77e(a).”) 16
  • 17. However, Section 4(2) of the Securities Act exempts “transactions by an issuer not involving a public offering.”84 In order to be eligible for this exemption from the registration requirements, firms must adhere to the restrictions in Rule 506, which provide a safe harbor for compliance with section 4(2) so long as the firm’s offering is not publicly advertised and no more than thirty-five purchasers participate in the private offering.85 Moreover, an exempt firm must offer the securities through a private placement to “accredited investors,” and not through a solicitation to the general public.86 Often referred to as “sophisticated investors,” “accredited investors” are generally characterized as having net assets over $1 million or at least $200,000 in annual income.87 The rule adopts the notion that these wealthy investors have the knowledge, experience, and financial fortitude to properly address the risks and benefits of private investments, and can withstand a heavy loss from such an investment. However, Rule 506 is rather lenient in the sense that the issuing firm is not required to count the number of accredited investors towards the thirty-five investor limit, and essentially has no limit on the amount of accredited purchasers they can accept. 88 Though, section 4(2) of the Securities Act doesn’t allow hedge funds to be exempt from anti-fraud provisions of section 12 and section 17 of the Securities Act. These provisions guard against misrepresentation, misleading statements, omissions, and deceitful solicitations to investors, by imposing civil liabilities on funds and/or their employees for engaging in any of these fraudulent practices. 89 2. The Exchange Act of 1934 (“Exchange Act”) 17 84 15 U.S.C.A. §§ 77d(2). 85 17 C.F.R. § 230.506 (2007). 86 Id. 87 17 C.F.R. § 230.501(a) (2007). 88 Id. § 230.506(b)(2)(ii) 89 15 U.S.C. § 77d(12-17) (2000)
  • 18. Congress sought to regulate securities on the secondary securities market when it passed the Exchange Act in 1934. Congress’ goals were similar to its goals in passing the Securities Act, which regulated IPO’s, but instead focused on reducing the risk of fraud, price manipulation, and speculation in the resale of securities when it passed the Exchange Act.90 The Exchange Act requires securities “dealers” to register with the SEC.91 Under section 3(a)(5) of the Exchange Act, a “dealer” is defined as “any person engaged in the business of buying and selling securities for such person's own account through a broker or otherwise.”92 But most hedge funds avoid registration by positioning themselves as “traders,” “a person that buys and sells securities, either individually or in a trustee capacity, but not as part of a regular business.”93 Moreover, the SEC requires registration of “equity securities” under Section 12(g) of the Exchange Act under two different circumstances.94 First, if the equity securities are traded on an exchange they must be registered with the SEC.95 Second, securities must be registered if the issuer has at least five hundred (500) holders of record of a non-exempted class of equity security and over $1 million in assets by fiscal year end (unless the issuance meets one of the exemptions).96 In either of these two scenarios, the securities issuer is required to adhere to periodic reporting requirements, proxy requirements, short swing profit provisions, and insider trading restrictions (which applies to all securities, whether registered, exempt, or otherwise).97 90 Elizabeth Killer and Gregory A. Gehlman, Comment, A Historical Introduction to the Securities Act of 1933 and the Securities Exchange Act of 1934, 49 Ohio St. L.J. 329, 348 (1988). 91 15 U.S.C. §§ 78a-78nn (1994). 92 Id. § 78c(a)(5)(A). 93 Staff Report to the United States Securities and Exchange Commission, Implications of the Growth of Hedge Funds 3 (2003) [hereinafter Staff Report]; 15 U.S.C. §§ 78a-78nn (1994); Hedge funds are not dealers under the trader exemption, which excludes “funds that do not buy and sell securities as part of a regular business.” Id. (citing 15 U.S.C. § 78c(a)(5)(B) & Supp. IV 2004). 94 Id. I§ 78l(g). 95 Id. 96 15 U.S.C. § 78l-(g); 17 C.F.R. § 240.12g-1 (2008). 18 97 Id. § 78m; 15 U.S.C. § 78o.
  • 19. However, the majority of hedge funds will intentionally structure themselves with at most 499 holders of record in order to avoid these requirements (except insider trading restrictions). Hedge funds may also be required to file reporting and proxy disclosures to the SEC if it is beneficially owned by one person, where a person owns at least 5% of the fund, or where the fund has “beneficial ownership” of another company amounting to at least 10% hedge fund ownership of said company.98 “Beneficial ownership” also entails “any person who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or shares: (1) Voting power which includes the power to vote, or to direct the voting of, such security; and/or, 2) Investment power which includes the power to dispose, or to direct the disposition of, such security.”99 In addition, if a hedge fund manager holds or manages over $100 million in equity securities, she would be required to disclose positions on a quarterly basis and keep current ownership records, under section 13(f).100 Despite the various restrictions and regulations imposed on hedge funds and their managers under the Exchange Act, there are sufficient exemptions and safe harbors to allow hedge funds to evade SEC registration filings. 3. The Investment Company Act of 1940 (“Company Act”) The Company Act is perhaps the most valuable source of disclosure and filing exemptions for hedge funds, which allow them to operate largely out of the regulators’ reach.101 The Company Act was initially aimed at enhancing investment company disclosures, curbing 98 17 C.F.R. § 240.13d (2007); 15 U.S.C. § 78m (2000 & Supp. IV 2004). 99 17 C.F.R. § 240.13d-3(a). 19 100 Id. § 240.13f-1. 101 15 U.S.C. §§ 80a-1 to 80a-64 (2006).
  • 20. self-dealing and conflicts of interests, curtailing excessive fees, and preventing fraud.102 An “investment company” is defined as an issuer that “holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities.”103 Firms that are deemed “investment companies” are subject to extensive regulation in multiple areas of business practice.104 Most notably, the Company Act regulates an investment company’s structure and areas of corporate governance, the degree of leverage (maximum 33% debt level of total assets), discretion in corporate asset valuation, share sales and redemptions, the character of investments, and its relationships with other market entities.105 Based on the definition of “investment company,” hedge funds exhibit characteristics that would make them likely candidates for regulation under the Company Act.106 However, hedge funds are eligible for regulatory exemption under the Company Act through either section 3(c)(1) or 3(c)(7) of the Act.107 The 3(c)(1) exemption to regulation exists where an “issuer whose outstanding securities...are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities” is not an investment company.108 In addition, hedge funds can also fall under the 3(c)(7) exemption where “any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and 102 Id. at 27. 103 Investment Company Act § 3(a)(1)(A), 15 U.S.C. § 80a-3 (2000 & Supp. IV 2004). 104 Marcia L. MacHarg, Waking Up to Hedge Funds: Is U.S. Regulation Really Taking a New Direction?, in Hedge Funds: Risks and Regulation 55, 61 (Theodor Baums & Andreas Cahn eds., 2004). 105 Houman B. Shadab, Fending for Themselves: Creating a U.S. Hedge Fund Market for Retail Investors, 11 N.Y.U. J. Legis. & Pub. Pol'y 251, 311 (2008) (discussing that the Company Act is improper for regulating hedge funds, since they would face restrictions in using leverage to invest in lilliquid assets. See 15 U.S.C. § 80a-18(f); Willa E. Gibson, Is Hedge Fund Regulation Necessary?, 73 Temp. L. Rev. 681, 694 n.99 (2000); Gordon Altman Butowski Weitzen Shalov & Wein, A Practical Guide to the Investment Company Act 30-31 (1993). 106 Id. 107 15 U.S.C. § 80a-3 (2000 & Supp. IV 2004); 15 U.S.C. 80a-2(a)(51) (2000 & Supp. IV 2004). 108 Investment Company Act § 3(c)(1), 15 U.S.C. § 80a-3 (2000 & Supp. IV 2004). 20
  • 21. does not at that time propose to make a public offering of such securities.”109 The Company Act defines “qualified purchaser” as any “individual who own over $5 million in investments, institutional investors who own $25 million investments, and a family-owned company that owns $5 million in investments.”110 Although the Company Act does not restrict the number of “qualified purchasers” that may be in a fund, most astute hedge funds will not accept more than 499 investors, so as not to violate the Exchange Act's provisions.111 As we have seen, many of these regulations overlap each other and have implications on firms trying to minimize regulation. 4. The Investment Advisers Act of 1940 (“Advisers Act”) The Advisers Act was aimed at combating abusive practices by investment advisers, which may have played a role in the stock market crash leading to the Great Depression.112 Under the Advisors Act, “investment adviser” is defined as “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.”113 A hedge fund manager who falls under this classification is required to register with the SEC, as well as disclose basic information to current and potential clients.114 Most notably, an investment adviser is obligated to disclose the fee structure, whether the structure can 109 Investment Company Act of 1940, 15 U.S.C. §§ 80a-1-80a-64 (1994), § 80a-3(c)(7)(A). 110 Id. at § 80a-2a(51)(A). 111 15 U.S.C. § 78l-(g); 17 C.F.R. § 240.12g-1 (2008); Staff Report to the United States Securities and Exchange Commission, Implications of the Growth of Hedge Funds 3 (2003) [hereinafter Staff Report]. 112 Investor Advisers Act, 15 U.S.C. § 80b-1 et seq. (2000); Richard S. Cortese, Overview of the Adviser's Act, in Lipper HedgeWorld Annual Guide 113 (2005); SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 187 (1963) (quoting SEC, Investment Trusts and Investment Companies, H.R. Doc. No. 76-477, at 28 (1939)), acknowledging that “conflicts of interest... might incline an investment adviser--consciously or unconsciously--to render advice which was not disinterested.” Id. at 191; Stuart A. McCrary, How to Create and Manage a Hedge Fund: A Professional's Guide 7 (2002). 113 15 U.S.C. § 80b-2(a)(11). 114 17 C.F.R. § 275.204-3(a) (2008). 21
  • 22. be negotiated, the character of the adviser's services, current client base, and any conflicts of interest that may arise on account of the adviser's business activities.115 The Advisers Act also generally prohibits performance-based compensation, although a registered adviser may charge a performance fee under the guidelines set forth in section 3(c)(7) of the Company Act or if all the fund's investors are qualified clients. In addition, the Adviser Act requires the adviser to submit to periodic SEC examinations and maintain current books and records for these examinations.116 The heavy majority of hedge fund managers have been exempted from being declared an “investment adviser” by relying on section 203(b) of the Advisers Act. That section excludes “any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to any investment company registered. . . .”117 What’s more beneficial for hedge fund advisers is that Section 203(b) counts a “legal organization” (i.e. a hedge fund) as only one, single client.118 Thus, hedge fund advisers can manage up to fourteen funds before they are required to file registration with the SEC as an investment adviser.119 Together, the current statutory framework allows hedge funds to escape registration and most government oversight. The weak regulatory framework, coupled with poor market discipline and foresight of fund managers and investors alike, seems to have made hedge funds a popular scapegoat for the recent financial crisis. However, the shortcomings of these regulations can be easily fixed in a de minimis manner, so as not to ruin an industry on the rebound or cause a mass exodus to offshore tax havens. The next sections will identify the strengths and problems of hedge funds in the market, and assess how best to tailor portions of proposed legislation, along 115 Tamar Frankel & Clifford E. Kirsch, Investment Management Regulation 85?87 (2d ed. 2003). 116 15 U.S.C. § 80b-5(a)(1); 17 C.F.R. § 275.205-3(d)(1); Id. § 80b-3(c). 117 Id. § 80b-3(b)(3). 118 17 C.F.R. § 275.203(b)(3)-1(2)(i). 119 15 U.S.C. § 80b-3(b)(3). 22
  • 23. with using diplomatic means and establishing a more aligned, unified regulatory foundation, to mitigate the risks of hedge funds while allowing their strengths to permeate U.S. and global financial markets. II. HEDGE FUNDS’ ROLE IN SYSTEMIC RISK, INVESTOR FRAUD, AND MARKET BENEFITS There are several schools of thought regarding the significance of hedge funds in financial markets. Arguments supporting and criticizing the hedge fund industry have been staunchly voiced among legislators, regulators, investors, and various financial institutions for years. As the U.S. struggles to climb out of deep economic recession that continues to plague financial markets still littered with thousands of fraud cases, hedge funds have been the target of scrutiny due to their lack of transparency.120 However, a closer inspection of hedge funds will reveal many benefits they provide to the U.S. financial market that allow the U.S. firms to effectively compete with foreign firms.121 Moreover, much hedge fund criticism is misdirected and disproportionate to the harm actually caused by the industry throughout this period of financial instability.122 Ultimately, the strengths and shortcomings of hedge funds in the U.S. hinge on the industry’s ties to global markets and the varying regulations across different types of financial institutions. 120 Dan Margolies, “Obama Budget Seeks More to Fight Financial Fraud.” Reuters, Feb. 1, 2010. http://www.reuters.com/article/idUSN0120695420100201. (“U.S Attorney General Eric Holder said in a speech [in February 2010] that the Justice Department was moving forward on more than 5,000 pending financial institution fraud cases and the FBI was investigating more than 2,800 mortgage fraud cases -- up nearly 400 percent from five years ago.”) 121 Hedge Funds and Systemic Risk: Perspectives of the President's Working Group on Financial Markets: Hearing Before the H. Comm. on Financial Servs., 110th Cong. 63 (2007) [hereinafter Testimony of Steel] (testimony of Robert K. Steel, Under Secretary for Domestic Finance, United States Department of the Treasury), available at http://www.treasury.gov/press/releases/hp486.htm. 122 See Bd. of Governors of the Fed. Reserve Sys., Flow of Funds Accounts of the United States: Flows and Outstandings Third Quarter 2007 (Dec. 6, 2007), available at http://www.federalreserve.gov/releases/z1/20071206/z1.pdf. 23
  • 24. A. The Impact of Hedge Funds on Systemic Risk The fundamental purpose behind regulating financial institutions is to mitigate “systemic risk.”123 Furthermore, champions of increasing hedge fund regulation also cite this purpose as justification for regulatory overhaul.124 “Systemic risk,” or “contagion,” is commonly defined as the “potential that a single event, such as a financial institution's loss or failure, may trigger broad dislocation or a series of defaults that affect the financial system so significantly that the real economy is adversely affected.”125 More generally, it is “the danger of widespread disruption of financial markets and institutions that, in turn, affects the macroeconomy.”126 1. The Implosion of Long-Term Capital Management & Industry Response It wasn’t until 1998, when a hedge fund called Long-Term Capital Management (LTCM) imploded, that regulators began to take a closer look at hedge funds’ impact on systemic risk.127 LTCM was a once highly-regarded hedge fund, founded in 1994 by several financiers who received Nobel Prizes in economics.128 LTCM took on a highly aggressive arbitrage strategy by investing in government bonds in order to capitalize on small spreads, most notably in Russian bonds.129 LTCM pursued an intense arbitrage strategy based on their forecast that the spread 123 Hedge Funds and Systemic Risk: Perspectives of the President's Working Group on Financial Markets: Hearing Before the H. Comm. on Financial Servs., 110th Cong. 63 (2007) [hereinafter Testimony of Steel] (testimony of Robert K. Steel, Under Secretary for Domestic Finance, United States Department of the Treasury), available at http://www.treasury.gov/press/releases/hp486.htm. 124 Id. 125 Id. 126 Bullard, James. “Systemic Risk and the Macroeconomy: An Attempt at Perspective.” [Speech at Indiana University] 2 October 2008. <http://www.stlouisfed.org/news/speeches/2008/10_02_08.html#_ftn3>. 127 Symposium, Crisis in Confidence: Corporate Governance and Professional Ethics Post-Enron, 35 Conn. L. Rev. 1097, 1107 (2003) [hereinafter Crisis in Confidence] 128 Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management 31, 32 (Random House 2000). 129 PRESIDENT'S WORKING GROUP ON FIN. MKTS, HEDGE FUNDS, LEVERAGE, AND THE LESSONS OF LONG-TERM CAPITAL MANAGEMENT, 11 (1999) available at http:// www.ustreas.gov/press/releases/reports/hedgfund.pdf (“Approximately 80 percent of the LTCM Fund's balance-sheet positions were in government bonds of the G-7 countries (viz., the United States, Canada, France, Germany, Italy, Japan, and the United Kingdom).”) [hereinafter PRESIDENT'S WORKING GROUP]. 24
  • 25. between bond returns would narrow between industrialized and developing nations.130 However, LTCM’s forecasts proved to be wrong when Russia underwent a massive debt restructuring, thereby devaluing its currency.131 This move by Russia would not, in and of itself, have put LTCM at risk for failure. LTCM had always had high leverage ratio of 25-to-1, which did not alarm investors up until this point.132 But when Russia restructured its debt and the spread on bonds increased, LTCM’s leverage ratio skyrocketed to 500-to-1 when the value of the assets they held plummeted.133 LTCM continued to crumble in the period directly after Russia’s restructurinng, losing $4.4 billion in less than a month.134 The New York Federal Reserve Bank finally stepped in and organized a $7 billion bailout of LTCM with fourteen other banks and funds.135 The Federal Reserve Bank of New York felt that if it did not facilitate a bailout, an LTCM default could pose a series of cascading financial institution failures that LTCM did business with.136 With off-balance sheet liabilities over $1 trillion in the form of futures, interest rate swaps, and over-the-counter (OTC) derivatives, LTCM’s inability to meet counterparty obligations could have decreased the liquidity of these investments in the market.137 Soon after, the market price on these investments would plunge, as other firms would be forced to either 130 Joseph G. Haubrich, Some Lessons on the Rescue of Long-Term Capital Management (Federal Reserve Bank of Cleveland, Policy Discussion Paper No. 19, 2007). 131 FIN. SERV. AUTH., HEDGE FUNDS AND THE FSA 8 (2002), available at http://www.fsa.gov.uk/pubs/discussion/dp16.pdf; see also FRANÇOIS-SERGE LHABITANT, HEDGE FUNDS: MYTHS AND LIMITS 12-21 (2002) 132 PRESIDENT'S WORKING GROUP supra note 10, available at http:// www.ustreas.gov/press/releases/reports/hedgfund.pdf (for basis of comparison “[a]t year-end 1998, the five largest commercial bank holding companies had an average leverage ratio of nearly 14-to-1, while the five largest investment banks' average leverage ratio was 27-to-1.”). 133 Id. 134 Joseph G. Haubrich, Some Lessons on the Rescue of Long-Term Capital Management (Federal Reserve Bank of Cleveland, Policy Discussion Paper No. 19, 2007). 135 PRESIDENT'S WORKING GROUP, supra note 10, at 17 (“LTCM itself estimated that its top 17 counterparties would have suffered various substantial losses—potentially between $3 billion and $5 billion in aggregate — and shared this information with the fourteen firms participating in the consortium. The firms in the consortium saw that their losses could be serious, with potential losses to some firms amounting to $300 million to $500 million each.”). 136 Id. 137 U.S. Gen. Acct. Off., Long-Term Capital Management Regulators Need to Focus Greater Attention on Systemic Risk 7 (1999), available at http:// www.gao.gov/archive/2000/gg00003.pdf. 25
  • 26. hold on to sharply declining assets and eventually collapse or liquidate their holdings before prices dropped even further.138 The inability of one major player, LTCM, to meet its obligations to its seventeen main counterparties would have resulted in up to $5 billion in aggregate losses.139 From there, the total potential losses for the counterparties of LTCM’s counterparties would’ve ballooned to catastrophic levels that could’ve crippled the entire U.S. financial system, and perhaps even foreign ones.140 Although the LTCM collapse provides a grim, historical example of hedge funds’ potential impact on systemic risk, many positives came out of that incident. Stemming from this event, the Presidential Working Group was formed.141 The Group is responsible for gathering more vital, up to date information on hedge funds and making recommendations to the industry.142 U.S. Treasury Secretary, Timothy Geithner offered a positive, though objective, assessment on the hedge fund industry since the LTCM debacle in 1998.143 While he was President and CEO of the Federal Reserve Bank of New York, Geithner noted that average hedge fund leverage ratios and systemic risk posed by hedge funds have changed for the better since the 1998 implosion of LTCM.144 Moreover, Geithner proffered five key factors that evidenced a more stable hedge fund industry and financial market: (1) the total number of hedge funds has increased greatly, along with total assets under management; (2) increased 138 Id. 139 PRESIDENT'S WORKING GROUP, supra note 10, at 17. 140 Id. 141 President's Working Group on Financial Markets, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management 1 (1999) [hereinafter Working Group Report I], available at http:// www.treasury.gov/press/releases/reports/hedgfund.pdf (the Group consists of officials from the SEC, CFTC, the Federal Reserve Bank, and the U.S. Treasury Department). 142 Id. 143 Timothy F. Geithner, President & CEO, Fed. Reserve Bank of N.Y., Keynote Address: Hedge Funds and Their Implications for the Financial System (Nov. 17, 2004) (transcript available at http:// www.ny.frb.org/newsevents/speeches/2004/gei041117.html). 144 Id. 26
  • 27. diversification of credit exposure by counterparties and lenders; (3) enhanced risk management practices among hedge funds, counterparties, and lenders; (4) banks' capital relative to risk has remained constant; and (5) improved infrastructure for clearing and settlements, whose systems can handle greater trade volumes and are more durable in periods of stress.145 Finally, Geithner provided a positive outlook on the hedge fund industry, when he expressed that the “U.S. financial system today is significantly stronger than it was in 1998…. And there is some evidence that hedge funds have helped contribute to this resilience, not just in the general contribution they provide by taking on risk, but as a source of liquidity in periods of increased stress and risk aversion in the rest of the financial system.”146 However, these encouraging statements were tempered with recommendations to continuously improve investing strategy, due diligence, diversification, risk management, disclosure, and leverage practices.147 Nevertheless, Geithner and most top officials agree that hedge funds and their counterparties have adapted quite well since 1998 and are better equipped to avoid or withstand a crisis similar to what LTCM experienced, but without the need for Federal Reserve bailouts.148 Systemic risk concerns regarding hedge funds seem to have died down after the industry and regulators learned several valuable lessons following LTCM’s demise. However, hedge funds still carry the stigma of posing a grave systemic risk to the economy, which is largely misplaced.149 For example, the vast majority of credit default swaps (CDSs) hedge funds traded with banks were not written on toxic underlying securities (i.e. defaulted or subprime 145 Id. 146 Id. 147 Id. 148 Id. 149 Houman Shadab, Don’t Blame all the Shadow Banks, CBS Money Watch, Apr. 13, 2009. (available at: http://moneywatch.bnet.com/economic-news/blog/blog-war/dont-blame-the-shadow-banks/295/). 27
  • 28. mortgages).150 The reality is that hedge funds and the CDSs they traded to banks did not cause the collapse of financial institutions, because it was the potential for these securities’ misuse and abuse which the banks took advantage that led to the collapse.151 Since it is readily apparent that these derivative securities are more likely to be abused by banks, new rules should ensure that regulated companies, such as banks, trade and value them appropriately.152 2. Systemic Risk Concerns Misdirected at Hedge Funds Instead of Banks An example that elucidates how hedge funds have suffered excessive, unsubstantiated criticism that should be directed elsewhere can be seen in bank failures like Bear Stearns. In 2007, Bear Stearns began taking on a highly aggressive debt structure. The bank took on a leverage ratio of nearly 33.2 to 1, with $11.1 billion in tangible equity backing $395 billion in assets.153 This highly leveraged structure embodied a relatively high level of risk for the firm, evidenced by the fact that it was highest of any brokerage firm, and that most commercial banks have an average leverage ratio of 10 to 1.154 Just a few years earlier, this leverage structure would have violated SEC regulations, which then required a maximum debt to net capital (equity) of 15 to 1. But in 2004, the “Consolidated Supervised Entities Program” abolished this maximum standard, along with revoking minimum capital requirements in case of asset 150 Id. (“It was solely American International Group’s (AIG’s) CDSs written on structured mortgage-related securities held by banks that led to the collateral calls ruinous to AIG and the federal bailout. Those CDSs made up only about 10 percent of AIG’s total CDS obligations at the beginning of 2008. But the Office of Thrift Supervision, which oversaw AIG, failed to prevent the company’s subsidiary from selling too many CDSs. To best prevent the over-concentration of CDS risk of the type that occurred with bond issuers and AIG, regulation should seek to limit the use of CDSs when sold by insurance companies or their unregulated subsidiaries and affiliates.”) 151 Id. (“The main problem with CDSs, which allow any party to sell protection against credit risks that the buyer may be exposed to, was that they allowed banks and insurance companies to concentrate too much mortgage-backed security risk in their portfolios.”) 152 Id. 153 Boyd, Roddy. “The Last Days of Bear Stearns.” Fortune Magazine 31 March 2008. <http://money.cnn.com/2008/03/28/magazines/fortune/boyd_bear.fortune/index.htm>. 154 Id. 28
  • 29. defaults.155 Bear Stearns’ exploitation of these repealed standards propelled it on a path to self-destruction. What’s more disturbing was that Bear Stearns was carrying over $28 billion in “level 3” assets, where valuation is based on non-observable market assumptions and relied heavily on internal information to asses fair value. 156 These types of assets they carried were highly illiquid, and put the bank at risk for owning assets worth next to nothing. With a net equity of $11.1 billion and $395 billion in assets, the highly leveraged bank was even more at risk because of their heavy involvement in Collateralized Debt Obligations (“CDOs”), which were heavily backed by subprime mortgages. As the real estate market plummeted and the mortgage default rate skyrocketed, Bear Stearns was forced to make major value write-downs on these mortgage-backed security assets. Just a few years prior, Bear Stearns was able to succeed under a highly leveraged debt structure. However, as assets began to plummet in value and more debt was accrued, the risks of having such a high leverage ratio began to precipitate.157 In June of 2007, troubles continued to mount when “Bear had to come up with over $3 billion to bail out one of its funds that was dabbling in CDOs. Incredibly these funds were seized at the time by Merrill Lynch for $850 million who was only able to get $100 million for them on the auction block.”158 Bear Stearns continued to break down at an exponential rate, when at the end of 2007 it was forced to write-down an additional $1.2 billion in mortgage backed securities. Bear Stearns’ credit was so poor in its final stages before the merger, that it was even denied a $2 billion securities-backed repurchase loan (“repo” loan). One market analyst aptly characterized how 155 Protess, Ben. “’Flawed’ SEC Program Failed to Rein in Investment Banks.” Propublica 1 October 2008. <http://www.propublica.org/article/flawed-sec-program-failed-to-rein-in-investment-banks-101>. 156 Pittman, Mark. "Bear Stearns Fund Collapse Sends Shock Through CDOs.” Bloomberg 21 June 2007. <http://www.bloomberg.com/apps/news?pid=20601087&sid=a7LCp2Acv2aw&refer=home>. 157 Id. 158 “The Rise and Fall of the Mighty Bear.” My Budget 360 17 March 2008. <http://www.mybudget360.com/bear-stearns- 29 the-rise-and-fall-of-the-mighty-bear/>.
  • 30. severe this credit issue was for Bear Stearns: “Being denied such a loan is the Wall Street equivalent of having your buddy refuse to front you $5 the day before payday. Bear executives scrambled and raised the money elsewhere. But the sign was unmistakable: Credit was drying up.”159 Consequently, fears over liquidity and Bear Stearns’ ability to meet its debt obligations sparked intense naked short-selling of Bear Stearns stock, which drove the price down from highs of over $100/share in 2007-2008, to $30/share.160 The run on Bear Stearns stock, fueled by rumor and speculation, resulted in a 47% decline (closing at $30 per share) in stock price in one day just prior to merger. 161 The type of business transactions Bear Stearns was involved in directly and indirectly exposed a wide range of institutions to risk. First off, Bear Stearns was a major counterparty to CDSs. It held notional amounts of $13.4 trillion at the end of 2007, with $1.85 trillion of that amount consisting of futures and option contracts with other counterparties. 162 These derivative instruments are used as an insurance policy for debt holders, in the event that the issuer defaults on payment. The systemic risk these transactions posed, which the Federal Reserve Bank sought to eliminate, could bring down other banks, just like Bear Stearns. Prior to the buyout in March, information circulated in the market that hedge funds were reassigning their CDS positions with Bear Stearns to other firms. Many hedge funds had grown weary of the problems facing Bear Stearns and did not want to take the risk of being counterparties to its trades. Perpetuated by fear and rumors, CDS reassignments snowballed as many other funds and dealers pulled their trades 159 Boyd, Roddy. “The Last Days of Bear Stearns.” Fortune Magazine 31 March 2008. <http://money.cnn.com/2008/03/28/magazines/fortune/boyd_bear.fortune/index.htm>. 160 Matsumoto, Gary. “Bringing Down Bear Began as $1.7 Million of Options.” Bloomberg 11 August 2008. <http://www.bloomberg.com/apps/news?pid=20601109&sid=aGmG_eOp5TjE&refer=home>. 161 Id. 162 Boyd, Roddy. “The Last Days of Bear Stearns.” Fortune Magazine 31 March 2008. <http://money.cnn.com/2008/03/28/magazines/fortune/boyd_bear.fortune/index.htm>. 30
  • 31. with Bear Stearns.163 Because 22% of Bear Stearns funding consisted of payables, deposits by its Hedge Fun customers, these major withdrawals resulted in a lack of funding for Bear Stearns. These banks fund their long-term illiquid investments, with short-term debt. The fact that Bear Stearns held such thin capital margins made them highly vulnerable to an abrupt cessation in short-term lending. This was a driving force behind Bear Stearns’ collapse, as the bank could not acquire enough funding to manage its operations. The “maturity mismatch” of asset and liabilities put Bear Stearns in grave danger when a liquidity shock occurred, causing investors to cease lending. The Federal Reserve Bank sought to mitigate other firms’ risk of encountering this liquidity problem by trying to maintain the flow of lending within the banking industry. 164 The bankruptcy of Bear Stearns would not only adversely affect the entities it directly conducted business with, but other institutions that it bore no direct relationships or transactions with. In most other competitive industries, the failure of one firm would allow the other existing competitors to pick up market share and grow after it picked up the pieces from the fallout. However, the institutional structure of the banking industry causes even relatively smaller players, like Bear Stearns, to have extensive connections with other entities and markets. 165 With Bear Stearns, settlement risks began to appear as it began to crumble, which only would have exacerbated the problems already plaguing the market. Settlement risk is “the risk that one party to a financial transaction will default after the other party has delivered.”166 The concern was that the cumulative effects of these settlement risks could amount to a systemic risk. Parties that didn’t directly do business with Bear Stearns could be affected from their 163 Schmerken, Ivy. “Counterparty Risk Is a Top Concern in the Wake of the Credit Crisis.” Advanced Trading 15 September 2008. <http://www.advancedtrading.com/derivatives/showArticle.jhtml?articleID=210601645>. 164 Id. 165 Id. 166 Bullard, James. “Systemic Risk and the Macroeconomy: An Attempt at Perspective.” [Speech at Indiana Unversity] 2 October 2008. <http://www.stlouisfed.org/news/speeches/2008/10_02_08.html#_ftn3>. 31
  • 32. 32 relationships with third-parties who did. Moreover, bankruptcy law was not suited for cases within the banking industry because banks like Bear Stearns are highly leveraged. These banks fund their long-term illiquid investments, with short-term debt. The fact that Bear Stearns held such thin capital margins made them highly vulnerable to an abrupt cessation in short-term lending. This was a driving force behind Bear Stearns’ collapse, as the bank could not acquire enough funding to manage its operations. The “maturity mismatch” of asset and liabilities put Bear Stearns in grave danger when a liquidity shock occurred, causing investors to cease lending. The Federal Reserve Bank sought to mitigate other firms’ risk of encountering this liquidity problem by trying to maintain the flow of lending within the banking industry. 167 From a thorough analysis of how Bear Stearns deteriorated, much like several other regulated financial institutions, it is hard to understand how hedge funds have been the target of so much criticism when the their threats to systemic risk pale in comparison to banks and insurance giants. Let us remember, too, that The Federal Reserve, not hedge funds, created the housing bubble that almost dismantled the global economy.168 Furthermore, Banks transferred mass amounts of predatory loans to individuals who they should have known could never afford the homes they were purchasing.169 It was also banks who bundled and securitized these “toxic assets” and then traded them with reckless abandonment amongst each other.170 Lastly, one of the biggest, if not the biggest, culprits in the financial meltdown was A.I.G., an insurance company, not a hedge fund.171 Despite the strong signs pointing to banks as the real threat to 167 Id. 168 Melvyn Krauss, Don’t Blame Hedge Funds, New York Times, Jun. 24, 2009 (available at: http://www.nytimes.com/2009/06/25/opinion/25iht-edkrause.html). 169 Id. 170 Id. 171 Id.
  • 33. systemic risk, the regulatory framework of hedge funds is still not perfect and must be enhanced, though not nearly to the extent that banks and insurance companies require regulatory overhaul. 3. The Future of Systemic Risk: Growing Concerns in Offshore Tax Havens Despite the seemingly favorable treatment of hedge funds in the State of Delaware, there has nevertheless been a noticeable migration of hedge funds to offshore tax havens in recent times.172 Hedge fund incorporation in “tax havens” such as the Cayman Islands, Bahamas, Bermuda, and British Virgin Islands (“BVI”) have been on the rise since the mid-1990’s.173 Although there is no universally accepted definition of the term “tax haven,” there seems to be an international consensus that tax havens have the following characteristics: “no or nominal taxes; lack of effective exchange of tax information with US and other tax authorities; lack of transparency in the operation of legislative, legal, or administrative provisions; no requirement for a substantive local presence; and self-promotion as an offshore financial center.”174 Industry experts and regulators estimate the number of hedge funds in the entire industry at over 10,000, totaling around $1.5-2 trillion in assets under management.175 It is also estimated that the industry grew from $456.4 billion in 1996 to $1.43 trillion by the end of 2006.176 Hedge 172 Bing Liang & Hyuna Park, Share Restrictions, Liquidity Premium, and Offshore Hedge Funds 3 (Working Paper, Mar. 14, 2008) available at http:// ssrn.com/abstract=967788). 173 "Offshore Explorations: Caribbean Hedge Funds, Part II," Tax Notes, Jan. 7, 2008, p. 95). http://www.tax.com/taxcom/features.nsf/Articles/DE15FD6B5D167E0B852573CB005BB50C?OpenDocument 174 James Hamilton, Using SEC Data, GAO Finds that TARP Recipients Have Subsidiaries in Offshore Tax Havens, CCH Financial Crisis News Center. Jan. 19, 2009 Available at http://www.financialcrisisupdate.com/2009/01/using-sec- data-gao-finds-that-tarp-recipients-have-subsidiaries-in-offshore-tax-havens.html 175 "Offshore Explorations: Caribbean Hedge Funds, Part II," Tax Notes, Jan. 7, 2008, p. 95). http://www.tax.com/taxcom/features.nsf/Articles/DE15FD6B5D167E0B852573CB005BB50C?OpenDocument ; Hedge Fund Research Inc., "HFR Industry Report — Year End 2006," available at http://www.hedgefundresearch.com 176 "Offshore Explorations: Caribbean Hedge Funds, Part II," Tax Notes, Jan. 7, 2008, p. 95). 33
  • 34. funds domiciled in the “Big Four” tax havens (Cayman Islands, Bahamas, Bermuda, and BVI) accounted for 74.9% of all hedge funds domiciled outside the U.S., or 52.3% of the entire industry, whereas U.S. domiciled funds accounted for only 30.1% of the entire industry.177 This equates to the “Big Four” holding estimated assets under management of about $731 billion.178 Other studies have uncovered an even greater disparity, finding that 62% of all hedge fund assets under management are domiciled in the “Big Four” compared to only 23% domiciled in the U.S..179 These same studies have estimated that the three year growth rates of offshore assets is more than twice that of onshore funds (130% v. 66%). Moreover, hedge funds registered off shore, but addressed in the U.S., have recently seen the highest growth rate among all other hedge fund segments (176%).180 With other studies estimating $12 trillion deposited in tax havens today, the U.S. and other nations are determined to curb this explosive exodus of funds offshore, where tax dollars are lost and global financial markets are subject to unpredictable threats.181 Specifically, there has been growing systemic concerns over the role of offshore hedge funds in tax havens operating under a veil of almost complete secrecy, where counterparty and market connectivity of these funds are virtually undiscoverable.182 The U.S. and other countries have limited insight http://www.tax.com/taxcom/features.nsf/Articles/DE15FD6B5D167E0B852573CB005BB50C?OpenDocument ; Hedge Fund Research Inc., "HFR Industry Report — Year End 2006," available at http://www.hedgefundresearch.com. 177 Id. 178 Id. 179 Bing Liang & Hyuna Park, Share Restrictions, Liquidity Premium, and Offshore Hedge Funds 3 (Working Paper, Mar. 14, 2008) available at http:// ssrn.com/abstract=967788). 180 Id. 181 Id. 182 Id. 34
  • 35. as to the exact value of assets in offshore tax havens, the types of instruments and strategies used, investor identities, and exactly how many hedge funds exist offshore.183 What’s more disturbing is that eighty-three of the largest one hundred public U.S. companies have subsidiaries in tax havens.184 Moreover, of those eighty-three companies, four are banks that received over $127 billion in bailout funds through TARP.185 German Chancellor Angela Merkel, and other world leaders, brought up hedge fund regulation as one of the chief topics for discussion on a recent G8 Summit meeting.186 This rapid growth in hedge fund migration into tax havens has been a troubling trend not only for the United States, but for the greater international community as well. B. Fraud and Investor Protection Regulators are also highly concerned with mitigating fraud and money laundering among private funds, especially during this period of extreme market vulnerability. Most notably, Bernard L. Madoff Investment Securities LLC (BLMIS), a New York-based hedge fund, later discovered to be a massive “Ponzi scheme,” defrauded investors over $50 billion.187 A “Ponzi scheme” is characterized as “an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors.188 Mr. Madoff, owner and perpetrator of the BLMIS fraud, ran a broker dealer service called Madoff Investment Securities, 183 Emil Arguelles, “The Truth About Tax Havens.” San Pedro Daily. Nov. 14, 2009. http://ambergriscaye.com/forum/ubbthreads.php/topics/357954/The_truth_about_tax_havens.html 184 Richard Murphy, “The Stop Tax Haven Abuse Act is on its Way.” Tax Research UK. Mar. 3, 2009. http://www.taxresearch.org.uk/Blog/2009/03/03/the-stop-tax-haven-abuse-act-is-on-its-way/ 185 Id. 186 187 Amir Efrati et al., Top Broker Accused of $50 Billion Fraud, Wall St. J., Dec. 12, 2008, at A1. 188 http://www.france24.com/en/20081215-hsbc-faces-1-billion-risk-madoff-scandal-fraud; http://www.sec.gov/answers/ponzi.htm 35
  • 36. as well as an investment advisory business.189 According to SEC filings, the investment advisory business had over $17 billion in assets under management.190 It was this investment advisory arm of his alleged business that housed the fraud, which surfaced in late 2008 when he was unable to “obtain the liquidity necessary to meet” investors’ demands to withdraw $7 billion dollars from the fund firm.191 More recently, the Antiguan-based Stanford International Bank (SIB), along with Chairman Sir Allen Stanford, have been indicted for engaging in a scheme to defraud investors of over $8 billion.192 With 30,000 investors and over $51 billion in assets, SIB purported itself to be a bank, despite making no loans.193 Even more spurious is that Chairman Stanford actually helped rewrite Antiguan banking laws upon setting up his banks operations on the island.194 Moreover, most of its investors’ certificate of deposits (“CD’s”) were invested in private equity and real estate, despite telling its investors that they were invested primarily in more “liquid” securities.195 From SIB’s practices, and the fact that they shielded themselves from SEC oversight, SEC officials state that SIB operated like a typical hedge fund opposed to a bank.196 However, SIB also held offices based in Houston, Texas where Chairman Sir Allen Stanford defrauded some of SIB’s U.S. and foreign investors with impunity right under regulators noses.197 Fortunately for defrauded investors, Sir Allen Stanford was unable to escape and go 189 See Complaint at 2-3, United States v. Madoff, 08-MAG-2735 (S.D.N.Y. Dec. 11, 2008) [hereinafter Madoff Complaint]. 190 Id. 191 Id. at 3. 192 http://www.justice.gov/criminal/vns/caseup/stanfordr.html; Securities and Exchange Commission v. Stanford International Bank, et al., Case No. 3-09CV0298-L (N.D.TX.) 193 http://www.financialweek.com/article/20090217/REG/902179991/103/REUTERS 194 Alison Fitzgerald, Stanford Wielded Jets, Junkets, and Cricket to Woo Clients, Bloomberg Feb. 18, 2009 (available at: http://www.bloomberg.com/apps/news?sid=auAqkrxMzKPc&pid=20601109). 195 Id. 196 Id. 197 Emil Arguelles, “The Truth About Tax Havens.” San Pedro Daily. Nov. 14, 2009. http://ambergriscaye.com/forum/ubbthreads.php/topics/357954/The_truth_about_tax_havens.html 36
  • 37. into hiding because the U.S. had extraterritorial jurisdiction over him as a U.S. citizen.198 What’s alarming is that SIB associates were in Belize soliciting prospective clients prior to the indictment, but were unsuccessful in doing so.199 This just goes to show how U.S. and other foreign citizens unfamiliar with tax haven entities could easily be swindled with no forewarning.200 Although the case is still pending, SIB and Mr. Chairman are charged with “violations of the anti-fraud provisions of the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Advisers Act, and registration provisions of the Investment Company Act.”201 Although the Madoff and Stanford incidents represent extreme outlier cases of fraud, either in terms of the size of the scams or deplorable nature of the crimes themselves, they nevertheless call attention to the risk of fraud, both domestically and in offshore tax havens.202 Fraud detection and prevention is a second key goal of regulators. The failure to detect scandals like these have devastated investor confidence in U.S. regulatory agencies, such as the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC).203 Although even the two most extreme cases of fraud did not individually or collectively rise to the level of systemic risk, both were audacious attempts to defraud investors by circumventing U.S. regulation with activity in offshore tax havens. But the nature of these crimes were littered with red flags: Madoff’s impossibly consistent returns year after year, Stanford rewriting the very laws that were supposed to regulate him, and involvement in suspicious tax havens should have been picked up by SEC officials and 198 Id. 199 Id. 200 Id. 201 Id. 202 John Gapper, The Hedge Fund Industry Is Going Down with Dignity, Fin. Times (London), Dec. 6, 2008, at 9 (Madoff defrauded dozens of charities and non-profits, 203 http://www.bloomberg.com/apps/news?pid=20601109&sid=afUo_v5lEmwc 37
  • 38. other foreign regulators.204 In terms of investor protection against fraud, perhaps it is not additional regulation that would serve the hedge fund industry and investors best. Rather, better inter-agency communication, additional agency (SEC, CFTC) resources for investigating crimes, and better enforcement of current laws would be more effective. C. Benefits of Hedge Funds in Financial Markets Hedge funds have noticeable and undeniable benefits to financial markets, and are playing an “increasingly important role in [the U.S.] financial system.” 205 The rapid growth in number of hedge funds and total assets under management are evidence that investors perceive them as providing significant value that they could otherwise not obtain through other, more traditional investment vehicles.206 Considering that savings funds account for only a small share of the overall assets held by hedge funds, the size and importance of the hedge fund industry will continue to grow throughout the foreseeable future.207 It has been previously argued in this Note that hedge funds are chastised more for their perceived risks to financial markets rather than heralded for the positive effects they have on financial system functions.208 Hedge funds play a critical role in a variety of areas that help make the U.S. firms, and the overall market, competitive in the global arena. First, hedge funds “play a valuable arbitrage role in reducing or eliminating mispricing” among firms across various financial markets.209 They can better allow firms to stamp a true value on assets and ensure 204 Id. 205 Timothy F. Geithner, President & CEO, Fed. Reserve Bank of N.Y., Keynote Address: Hedge Funds and Their Implications for the Financial System (Nov. 17, 2004) (transcript available at http:// www.ny.frb.org/newsevents/speeches/2004/gei041117.html). 206 Id.; see supra note 172. 207 Id. 208 Id. 209 Id. 38
  • 39. liquidity through mark-to-marketing asset pricing.210 This pricing practice, in addition to the sheer bulk of assets under management, supply a significant source of liquidity for financial markets, in periods of both stability and distress.211 Moreover, hedge funds “add depth and breadth to [U.S.] capital markets, providing additional sources of long-term financing for firms and start-up ventures.”212 Frequently criticized for doing this, hedge funds also provide a benefit to the market in providing a “source of risk transfer and diversification,” instead of forcing risk averse institutions to retain unwanted or illiquid assets on their balance sheets.213 Indirectly, this amounts to a type of risk-matching service among themselves and between other firms.214 Thus, hedge funds, which typically pursue relatively more risk-seeking investment strategies in hopes of higher returns, can provide a good outlet for firms looking to trade away less liquid assets, and in some cases, vice versa.215 As U.S. Treasury Secretary Timothy Geithner so aptly put it, hedge funds “don’t perform these functions out of a sense of noble purpose, of course, but they are a critical part of what makes the U.S. financial markets work relatively well in absorbing shocks and in allocating savings to their highest return. These benefits are less conspicuous than the trauma that has been associated with hedge funds in periods of financial turmoil, but they are substantial.”216 Hedge funds have also indirectly caused other financial institutions to provide market benefits, in response to the nature of the hedge fund industry. Since LTCM’s collapse in 1998, firms have established better internal due diligence practices to manage the risk of hedge fund 210 5 B.Y.U. Int'l L. & Mgmt. Rev. 99; Jenny Anderson & Heather Timmons, Why a U.S. Subprime Mortgage Crisis is Felt Around the World, N.Y. TIMES, Aug. 31, 2007, at C1. 211 Supra note 172. 212 Id. 213 Id. 214 Id. 215 Id. 216 Id. 39
  • 40. exposures.217 In addition, the same firms adaptation in the post-LTCM era included imposing tighter credit requirements, demanding more collateral on investments, establishing daily margin limits to ensure sufficient capital reserves, and taking a more conservative approach to valuing collateral and illiquid assets.218 Of course, not every firm in the market exudes these benefits or profits from these investments in every instance of trading. However, diligent investing and firm management practices make it possible for these positive aspects to benefit other firms. Firms in the market also learned from the LTCM incident, and began paying closer attention to future credit exposures that they might encounter in the future.219 Moreover, firms have insulated themselves better from risk by establishing superior and more intelligent ways of measuring and “stress testing” those credit exposures.220 Firms have also been more proactive in seeking out information from hedge funds about the risks of the fund. Firms have done this through periodic inquiries into a fund’s investing strategy, leverage ratio, and other aspects that may be discoverable, which could improve firm value and risk management.221 Although these market improvements came about after a near financial catastrophe with LTCM’s collapse, the benefits and practices still permeate the market today.222 Unfortunately, the stigma surrounding hedge funds as being secretive and exotic investment vehicles likely inhibits more benefits from permeating the market due to the apprehension of investors in participating in these funds. Regardless, as U.S. Treasury Secretary Geithner commented, it took a “major market event to expose the extent of weaknesses in market practice that prevailed prior 217 Timothy F. Geithner, President & CEO, Fed. Reserve Bank of N.Y., Keynote Address: Hedge Funds and Their Implications for the Financial System (Nov. 17, 2004) (transcript available at http:// www.ny.frb.org/newsevents/speeches/2004/gei041117.html). 218 Id. 219 Id. 220 Id. 221 Id. 222 Timothy F. Geithner, President & CEO, Fed. Reserve Bank of N.Y., Keynote Address: Hedge Funds and Their Implications for the Financial System (Nov. 17, 2004) (transcript available at http:// www.ny.frb.org/newsevents/speeches/2004/gei041117.html). 40
  • 41. to 1998 and to catalyze improvements across the financial community. Those reforms have played an important role in reducing risk in the system, alongside the overall improvements in capital, risk management, and the financial infrastructure.”223 Despite the known market benefits hedge funds provide, in the aftermath of the recent financial crisis many of these benefits were improperly marginalized, overlooked, and even perceived as threats. Hedge funds have been criticized by some politicians and commentators for short-selling troubled banks during the market’s decline.224 However, the much-criticized hedge fund short sellers are the financial markets' first line of defense against fraud and exaggerated valuations.225 More lenient rules on short-selling increase the incentives for companies “to police the markets themselves, and can prevent fraudulent or overvalued companies from running even higher.”226 Without hedge fund short sellers, markets would be inherently positively-biased, resulting in securities being priced less efficiently.227 Moreover, short sellers make for outstanding stock analysts who have a keen eye for fraud, mismanagement, or aggressive accounting.228 There are several tools and strategies in the market to curb gross, abusive stock undervaluations. For example, private equity funds, strategic buyers, and share buybacks all can 41 223 Id. 224 Laurence Fletcher, “Hedge Funds Say Role in Crisis Was Marginal: AIMA,” Reuters, April 2, 2009 (http://www.reuters.com/article/idUSTRE5315J420090402). 225 Zac Bissonnette, “SEC Ends Uptick Rule but Vows Crackdown on Naked Short Selling,” BloggingStocks, June 14, 2007. (http://www.bloggingstocks.com/2007/06/14/sec-ends-uptick-rule- but-vows-crackdown-on-naked-short-selling/). 226 Id.. 227 Alex Dumortier, “The Truth About Naked Shorts,” The Motley Fool, Sept. 22, 2008. (http://www.fool.com/investing/dividends-income/2008/09/22/the-truth-about-naked-shorts.aspx). 228 Id.. ( “Take Jim Chanos of Kynikos Associates, for example, who was one of the first (and only) investors to call Enron out for its fuzzy accounting. If only more investors had listened to his arguments instead of those of Ken Lay and Jeff Skilling.).
  • 42. help a company prevent abusive, unwarranted devaluations.229 The SEC would be weakening one of the best mechanisms in place to proactively stop fraud and overvaluations if it discouraged short-selling by placing blame on firms that did so, or made prohibited it all together.230 What the critics are actually referring to when they criticize the hedge funds who short sell is what the SEC describes as "abusive naked short selling." This term refers to short sellers who (a) sell shares they have not borrowed or have no reasonable expectation of borrowing, and (b) cannot deliver those shares on the settlement date of their sale because they do not possess them.231 However, the SEC already addressed this alleged problem when it adopted an antifraud rule in October of 2008 to thwart abusive naked short selling. “Rule 10b-21 is designed to prevent short sellers, including broker-dealers acting for their own accounts, from deceiving specified persons about their intention or ability to deliver securities in time for settlement and then failing to deliver securities by the settlement date.”232 In addition, the SEC completely banned short selling of 799 financial stocks for a brief period in September and October 2008, and increased the reporting burden for short sellers.233 Yet, this still did not completely halt the downward spiral of several financial institutions after the short-selling hold was lifted. As long as short sales are eventually covered, there is no harm in naked short selling unless the short seller acted fraudulently or dishonestly. The requirement to borrow shares before short selling is 229 Zac Bissonnette, “SEC Ends Uptick Rule but Vows Crackdown on Naked Short Selling,” BloggingStocks, June 14, 2007. (http://www.bloggingstocks.com/2007/06/14/sec-ends-uptick-rule-but-vows-crackdown-on-naked-short-selling/). 230 Id.. 231 Id. 232 Rule 10b-21, Securities Exchange Act of 1934; SEC Release 33-7046. (http://www.blankrome.com/index.cfm?contentID=37&itemID=1723). 233 http://www.sec.gov/news/press/2008/2008-211.htm 42
  • 43. a burdensome and unnecessary process that causes market inefficiencies.234 Hedge fund critics shouldn't let the investing strategy of short selling blind them from the truth: that severe credit problems banks, broker-dealers, and mortgage companies had were self-inflicted, long before hedge funds began short selling them.235 Even if critics cannot subscribe to the foregoing reasons why hedge funds were not at fault, they cannot overlook the fact that regulators did little to regulate short-selling if indeed they believed it to be harmful. This is evidenced by the fact that regulators suspended the “Uptick Rule” in July of 2007.236 The SEC summarized the “Uptick Rule” as follows: "Rule 10a- 1(a)(1) provided that, subject to certain exceptions, a listed security may be sold short (A) at a price above the price at which the immediately preceding sale was effected (plus tick), or (B) at the last sale price if it is higher than the last different price (zero-plus tick). Short sales were not permitted on minus ticks or zero-minus ticks, subject to narrow exceptions."237 When the rule, which had been in place since the 1930’s, was removed in 2007 many critics claim that this promoted easier, abusive short-selling of stocks by hedge funds.238 In response to these claims, the SEC approved the “Alternative Uptick Rule” in February 2010.239 This rule amended Rule 201 of Regulation SHO, which was designed “to restrict short selling from further driving down the price of a stock that has dropped more than 10 percent in one day. It will enable long sellers 234 Alex Dumortier, “The Truth About Naked Shorts,” The Motley Fool, Sept. 22, 2008. (http://www.fool.com/investing/dividends-income/2008/09/22/the-truth-about-naked-shorts. 43 aspx). 235 Id.. 236 David Gaffen, “All Hail the Uptick Rule!,” The Wall Street Journal, March 10, 2009. (http://blogs.wsj.com/marketbeat/2009/03/10/all-hail-the-uptick-rule/). 237 Amendments to Exchange Act Rule 10a-1 and Rules 201 and 200(g) of Regulation SHO". SEC. 2008-05-21. http://www.sec.gov/divisions/marketreg/tmcompliance/rules10a-200g-201-secg.htm. Retrieved 2009-04-08. 238 Id.. 239 http://www.sec.gov/news/press/2010/2010-26.htm
  • 44. to stand in the front of the line and sell their shares before any short sellers once the circuit breaker is triggered.”240 Critics who chastise hedge funds for short selling financial companies in 2007 and 2008 are misdirecting their blame if they truly feel short selling was a contributing mechanism to the crisis. Regulators were the ones who removed the “Uptick Rule” in 2007, so they would be hard-pressed to blame hedge funds who undertook this completely legal investing strategy. Moreover, the new “Alternative Uptick Rule” is viewed as a feel good rule with “no teeth,” considering the new rule only helps in times of extreme market volatility but goes unnoticed in times of market stability.241 Thus, if any blame could be attributed to short-selling, it should be bestowed on regulators who removed the “Uptick Rule” and not hedge funds who acted properly under the law. Moreover, many in the market believe that short-selling is not a legitimate, substantial threat, but even if it is the “Alternative Uptick Rule” is not strong enough to prevent the perceived threat. 242 Perhaps one of the biggest relative benefits hedge funds provided in the midst of the financial crisis was that they did not burden the government or taxpayers with billion dollar bailouts and forced, U.S. Treasury-backed mergers. Moreover, there were no systemically notable hedge fund collapses either.243 In the aftermath of the financial crisis, the hedge fund industry has recovered and outperformed far better than other financial institutions. It must be noted that “banks such as CitiGroup, brokers such as Bear Stearns and Lehman Brothers, home 240 Id.. 241 Chuck Jaffe, “Coming up Short: SEC’s New Version of ‘Uptick Rule” lets Investors Down,” Market Watch, March 3, 2010. (http://www.marketwatch.com/story/new-uptick-rule-for-stocks-lets- 44 investors-down-2010-03-03). 242 Chuck Jaffe, “Coming up Short: SEC’s New Version of ‘Uptick Rule” lets Investors Down,” Market Watch, March 3, 2010. (http://www.marketwatch.com/story/new-uptick-rule-for-stocks-lets-investors-down-2010-03-03). 243 Laurence Fletcher, “Hedge Funds Say Role in Crisis Was Marginal: AIMA,” Reuters, April 2, 2009 (http://www.reuters.com/article/idUSTRE5315J420090402).