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

PAREDES.DOC
9/8/2006 9:12:27 AM
1004 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2006
registration may deter not only bad conduct, but also good conduct. Although
investment adviser registration is a measured regulatory step,
with it comes SEC examinations and inspections. These examinations
and inspections, especially when conducted by a staff that is inexperienced
in hedge fund matters and investment strategies, run some risk of
regulatory second guessing of legitimate behavior and trading. 109 It is inappropriate,
then, to look only to the four corners of the hedge fund rule
in evaluating its potential impact on the hedge fund industry. One has to
allow for the risk that the rule will crimp certain investment strategies
and financial innovations or will keep some reputable managers out of
the hedge fund business altogether. In either case, the efficiency, stability,
and smooth functioning of financial markets is potentially jeopardized,
particularly if there is a significant shock to financial markets that
hedge funds are not as ready to absorb.
But judgment on this point should not be passed too quickly. SEC
examinations and inspections actually have a bright side. The need for
more aggressive SEC regulation may be defused if the SEC uncovers
misconduct early before it metastasizes. Would we have the Sarbanes-
Oxley Act, for example, if the SEC had uncovered the frauds at Enron
and WorldCom years earlier? Some hedge fund regulation today, particularly
in the relatively mild form of investment adviser registration,
may be worth the cost, including the overdeterrence of beneficial hedge
fund behavior, if such regulation reduces the likelihood of a future SEC
crackdown. 110
For reasons such as those highlighted in Part IV below, it seems that
the SEC was too ready to regulate hedge funds. 111 Of course, if the SEC
does not end up with adequate funding or staffing to carry out its initiatives
actively, 112 or if hedge funds end up a low priority at the SEC, the
fact that the SEC reversed course to regulate hedge fund managers will
be less consequential in practice. The SEC’s interest in regulating hedge
funds will undoubtedly ease, at least in the near term, with Christopher
Cox replacing William Donaldson as SEC chairman. 113
109. See, e.g., Paul S. Atkins, Comm’r, U.S. Sec. & Exch. Comm’n, Speech by SEC Commissioner:
Remarks Before the Managed Funds Association (Sept. 29, 2005) (discussing the lack of staff expertise
regarding hedge funds).
110. See Coates, supra note 103, at 567–79 (discussing SEC “re-regulation” after a scandal or economic
downturn and how early regulatory efforts may defuse the demand for more aggressive future
regulation).
111. For a concise summary of the issues and a conclusion that hedge fund regulation was appropriate
“as long as the oversight isn’t overzealous,” see Frank Partnoy, Road Rules for Hedge Funds,
N.Y. TIMES, Dec. 15, 2004, at A2.
112. In the past, the SEC, by many accounts, often has been understaffed and underfunded. See,
e.g., Joel Seligman, Self-Funding for the Securities and Exchange Commission, 28 NOVA L. REV. 233,
236–50 (2004).
113. A Cox-led SEC should result in a deregulatory shift at the agency. See, e.g., Stephen Labaton,
Acting Quickly, Bush Nominates Congressman to Lead S.E.C., N.Y. TIMES, June 2, 2005, at A1;
Deborah Solomon et al., Cox’s Nomination to Run SEC Signals a Regulatory Shift, WALL ST. J., June