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

PAREDES.DOC
9/8/2006 9:12:27 AM
1000 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2006
differently, one can think of federal securities regulation as addressing a
“lemons problem” that can arise in securities markets when investors are
unable to protect themselves from having imperfect information. 99
Yet, even in the name of promoting investor confidence, the SEC’s
regulatory reach is limited and does not encompass regulatory steps designed
to reduce leverage or otherwise manage systemic risk in financial
markets. 100 It should not be enough to trigger SEC intervention in the
hedge fund industry when accredited investors choose to invest in highly
leveraged hedge funds that engage in speculative and risky trades, or
when financial institutions continue to extend credit to and execute deals
with such funds, regardless of the potential investor and counterparty
losses.
More importantly, if anything, the explosion of the hedge fund industry
to a trillion dollar business, while sharpening concerns over systemic
risk, belies the need for SEC intervention. Money continues to
flood into hedge funds. There is no lemons problem leading investors to
flee hedge funds, and the hedge fund industry does not suffer from a lack
of investor confidence. To the contrary, investors might be too confident
investing in hedge funds. The most serious concern for hedge fund investors
is not imperfect information or fraud, but the increasing difficultly
managers have generating risk-adjusted above-market returns—so-called
99. For the classic work on the lemons problem, see George A. Akerlof, The Market for “Lemons”:
Quality Uncertainty and the Market Mechanism, 84 Q.J. ECON. 488 (1970). For an application of
the lemons problem to securities regulation, see, for example, Paredes, supra note 67, at 470–72; Edward
Rock, Securities Regulation as Lobster Trap: A Credible Commitment Theory of Mandatory Disclosure,
23 CARDOZO L. REV. 675 (2002).
100. Nor, for that matter, should the SEC be in the business of regulating to prevent bubbles in
any particular type of asset class or investment vehicle or to discourage speculation (in any case, how
does one decide when a bubble exists or that there is excessive speculation?). Whether other authorities,
such as the Federal Reserve or the Treasury Department, should play such a role is beyond the
scope of this article. Notably, though, the Federal Reserve has been blamed before for fueling bubbles,
such as the inflated stock market in the 1990s. Recently, then-Federal Reserve Board Chairman
Greenspan has recognized that the U.S. housing market has “a lot of local bubbles” that have been
fueled by the Fed’s easy-money policy of keeping interest rates low. See Edmund L. Andrews, Greenspan
Is Concerned About “Froth” in Housing, N.Y. TIMES, May 21, 2005, at C1; cf. Jeannine Aversa,
Greenspan Builds Case for Limiting Fannie, Freddie Holdings, ASSOCIATED PRESS, May 19, 2005 (reporting
that Greenspan has urged limits on the holdings of Fannie Mae and Freddie Mac to deleverage
these entities’ balance sheets, a type of substantive intervention that Greenspan has argued
against when it comes to hedge funds). For an interesting analysis of the potential role of law in preventing
market crashes generally, see Frank Partnoy, Why Markets Crash and What Law Can Do
About It, 61 U. PITT. L. REV. 741 (2000). See also Henry T.C. Hu, Faith and Magic: Investor Beliefs
and Government Neutrality, 78 TEX. L. REV. 777 (2000) (analyzing what, if anything, government
should do to address the prospect of bubbles in U.S. stocks, focusing on the SEC and the Fed, and
criticizing the “stock-based investor religion” that has been fostered and that “has distorted market
demand for stocks”); Karmel, supra note 9 (suggesting a role for the SEC in curbing speculation).
The Supreme Court has itself limited the reach of the federal securities laws by circumscribing the
SEC’s regulatory purview to disclosure-related matters, unless the relevant statute provides (or at least
contemplates) otherwise. See, e.g., Santa Fe Indus., Inc. v. Green, 430 U.S. 462 (1977); see also Paredes,
supra note 67, at 423 n.17. But see Chamber of Commerce of U.S. v. SEC, 412 F.3d 133, 138–40
(D.C. Cir. 2005) (presenting an arguably more expansive reading of SEC authority under the Investment
Company Act).