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

PAREDES.DOC
9/8/2006 9:12:27 AM
980 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2006
point, there is some substance to the bad rap that hedge funds have received.
Hedge funds, for example, were implicated in the market timing
and late trading scandals that have plagued the mutual fund industry. 9
Regulators have questioned whether Wall Street firms who serve as
prime brokers place investors in hedge funds in part because the hedge
funds agree to use the firms for other profitable services relating to the
funds’ trades. 10 The NASD, which regulates broker-dealers, has highlighted
instances indicating that brokers sometimes fail to conduct appropriate
suitability analyses or fully disclose risks when marketing
hedge funds to individual investors. 11 There was also concern that hedge
funds might be manipulating takeover outcomes when a hedge fund with
shares in a target company was flagged for vote buying when it acquired
shares in the bidder and then hedged its long position. 12 In addition to
other enforcement actions that the SEC has brought against hedge funds,
in an extraordinary move in early 2005, the SEC sought and received
emergency relief to stop an alleged $81 million fraud involving a number
of related hedge funds run by the KL Group. 13 Later in 2005, the SEC
and the marketplace witnessed a major fraud at Bayou Management that
brought down the hedge fund. 14
Aside from concerns over illicit behavior in the hedge fund industry,
many people start out skeptical of hedge funds because they do not understand
hedge funds’ investment strategies, including the complex models
that underlie them. 15 Others are troubled because hedge funds often
9. See John C. Coffee, Jr., A Course of Inaction: Where Was the SEC When the Mutual Fund
Scandal Happened, 2004 LEGAL AFF. 46 [hereinafter Coffee, A Course of Inaction]; Roberta S. Karmel,
Mutual Funds, Pension Funds, Hedge Funds and Stock Market Volatility—What Regulation by the
Securities and Exchange Commission is Appropriate?, 80 NOTRE DAME L. REV. 909, 929–33 (2005);
Kate Kelly & Ian McDonald, Invesco, AIM Settle Trading-Abuse Cases, WALL ST. J., Sept. 8, 2004, at
C1; Paul Schott Stevens, Honest Funds, WALL ST. J., Sept. 13, 2004, at A20.
10. See, e.g., Jed Horowitz, Moving the Market: Wall Street Woos Hedge Funds Despite Worries
Over Losses, WALL ST. J., May 16, 2005, at C3; Henny Sender & Gregory Zuckerman, Are Hedge
Funds and Brokers Too Interlocked?—As SEC Opens Talks on Industry, Matchmaking Grabs Attention;
Investor Suitability Is an Issue, WALL ST. J., May 15, 2003, at C1.
11. See, e.g., Susanne Craig, Hedge Funds Can Be Headache for Broker, as CIBC Case Shows,
WALL ST. J., Feb. 22, 2005, at C1; Gregory Zuckerman, Hedge-Fund Ads Prompt NASD’s First Crackdown,
WALL ST. J., Apr. 23, 2003, at C5.
12. See Andrew Ross Sorkin, Icahn Accuses a Hedge Fund of Stock Manipulation, N.Y. TIMES,
Dec. 13, 2004, at C1.
Hedge funds have generally become more active in how the businesses they invest in are run, as
well as in corporate governance. See infra note 101.
13. Press Release, SEC Obtains Emergency Relief Against Palm Beach, Florida, Hedge Funds
for $81 Million Fraudulent Offerings (Mar. 3, 2005), available at http://www.sec.gov/news/press/2005-
27.htm; see also Julie Creswell, Paradise and Money Lost, N.Y. TIMES, Aug. 14, 2005, § 3, at 1.
14. Ian McDonald et al., Hedge-Fund Havoc: Missing Cash and a Principal’s Suicide Note; Letter
Admits Years of Fraud at Bayou, the Police Say; Firm Had Tie to Its Auditor; Unaccounted for: $440
Million, WALL ST. J., Aug. 29, 2005, at A1; Gretchen Morgenson et al., What Really Happened at
Bayou, N.Y. TIMES, Sept. 17, 2005, at C1.
15. See CFA Institute, Hedge Funds 101: What Investors Need to Know, http://www.cfainstitute.
org/investors/hedgefunds101.html.