on the decision to regulate hedge funds - University of Illinois Law ...

PAREDES.DOC
9/8/2006 9:12:27 AM
990 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2006
nation and inspection authority over hedge funds has been a chief concern
among critics of the SEC’s rule change.
Even opponents of more hedge fund regulation generally concede
that the SEC’s adopted rule change is a measured step, although it remains
to be seen whether this is just the first of many steps toward more
regulation of the industry.
III. INVESTOR PROTECTION VS. SYSTEM PROTECTION
The need to get accurate information into investors’ hands and to
protect them from hedge fund abuses could be argued to justify the
hedge fund rule, as could the need to protect the financial system from
the risk that it will destabilize if losses ripple across financial institutions
when hedge funds suffer major losses. Neither rationale, however, has
enough purchase to justify the SEC’s new rule. First, the SEC traditionally
has not stepped in to protect the kinds of wealthy investors and institutions
who typically invest in hedge funds. Instead, the SEC has deferred
to such well-heeled investors to protect themselves through
market discipline. Second, the SEC has never principally been concerned
with the kinds of systemic risks that hedge fund collapses pose.
Systemic risk is a matter for other regulators such as the Federal Reserve
and the Treasury Department. Long-time Federal Reserve Board
Chairman Greenspan, for one, has been an outspoken critic of the SEC’s
hedge fund rule. 59 That said, the SEC is charged with ensuring that investors
are sufficiently confident in the integrity of securities markets so
that they do not withdraw from the market. Yet one would have to
stretch to argue that recent hedge fund activities have undermined investor
confidence in hedge funds or securities markets generally.
A. Protecting Investors
Although some evidence shows a modest “retailization” of the
hedge fund industry, the vast bulk of hedge fund investors can protect
themselves, at least insofar as the federal securities laws understand investor
self-protection. 60 In particular, wealthy individuals and institu-
59. See Hearing Before the S. Comm. on Banking, Housing, and Urban Affairs, 108th Cong.
(2004) (statement of Alan Greenspan, Chairman, Fed. Reserve Bd. of Governors).
60. “Retailization” refers to the development finding nonaccredited investors increasingly exposed
to hedge funds, such as through investments in so-called “funds of funds” or through pension
funds that invest in hedge funds. See, e.g., Final Hedge Fund Rule Release, supra note 4; see also Jane
J. Kim, Hedge Funds Target Smaller Investors, WALL ST. J., Apr. 27, 2005, at D1; Aaron Lucchetti,
Hedge Funds: Profits and Perils, WALL ST. J., Sept. 15, 2004, at C1; Jeff D. Opdyke, As Scrutiny
Grows, New Breed of Fund Lowers Ante for Individuals; The Schwab Option, WALL ST. J., Jan. 23,
2003, at D1; cf. Karen Damato, Hedge-Fund Action for the Mutual-Fund Set, WALL ST. J., Aug. 30,
2004, at C1 (describing mutual funds that adopt hedge-fund-like investment strategies).
One particular concern of funds of funds, as well as funds of funds of funds, is the layering of fees
that reduces investor returns. See, e.g., Stephen J. Brown et al., Fees on Fees in Funds of Funds, 2 J.
INVESTMENT MGMT. 39 (2004).