Topic
Can regulation on hedge fund able to protect the investors and maintain securities market stability?
Introduction
Hedge fund was used to be wealthy people and institutional investors investment vehicles (collectively “sophisticated investors”). In the eyes of the regulators, the sophisticated investors were knowledgeable to understand the risks of the hedge fund or even if they did not have the knowledge, they had the resources to employ lawyer or accountant for assistance. Thus, the regulator could afford not offering the investor protection. This kind of belief was radically changed after the near collapse of Long Term Credit Management (LTCM) in 1998. The change was not onto offering protection to the sophisticated investors, where the protection was to the financial market stability and investors.
Literature Review
The dissertation will first study the common hedge fund structure i.e. Limited Partnerships and various related parties role e.g. limited partner investors, general partner, investment adviser, custodian, prime broker/ sub-custodian and administrator. What are the advantages of being such structure? Will this bypass the stringent relevant securities law and generate tax saving? In addition, it will study the purpose of various constituent documents such as Private Placement Memorandum, Limited Partnership Agreement, Investment Management Agreement, Subscription Form, and Prime Brokerage Agreement and whether these kinds of documents are able to offer protection to the investors.
The dissertation will evaluate the exemption clauses in the securities related regulations which allow hedge fund to be distributed to certain type of investors. Among the securities, it will study Investment Company Act 1940, Securities Act 1933, Securities Exchange Act 1934 and Investment Adviser Act 1940.
Investment Company Act 1940
The 1940 Act is the principal US securities statue governing investment companies. It regulates every aspect of an investment company’s operations, including its governance and structure, leveraging by issuance of debt and other senior securities, investment and concentration limits, sales and redemptions of shares, valuation etc. Private hedge funds, unlike regulated investment companies such as mutual funds, are exempt from 1940 Act restrictions on engaging in investment strategies such as leverage, short selling, or taking concentrated positions in a single industry, firm, or sector.
Securities Act 1933
The 1933 Act is to protect investors with emphasis on the initial distribution of securities rather than subsequent trading. It requires registration with the SEC and dissemination of certain mandatory information concerning the securities before offering to the public. However, most private hedge funds are offered through private placement exemption in order to avoid registration.
Securities Exchange Act 1934
The 1934 Act is to govern subsequent trading such as adequate disclosure to investor, securities fraud, market misconduct etc. It empowers the SEC to require periodic reporting of information of the public securities issuer. Private hedge fund generally seeks to limit the securities owners in order to avoid being subject to reporting requirements.
Investment Adviser Act 1940
The Investment Adviser Act requires the investment adviser with certain amount asset under management and number of clients to register with the SEC. Registered investment advisers are required to comply with all the rules and regulations. Private hedge fund adviser usually structure the hedge fund as a limited partnership and acts as a general partner to the hedge fund. As such, it may count a limited partnership as a single client to avoid registration.
Other regulations
It will also study the other relevant regulations such as Commodity Exchange Act, Anti Money Laundering Regulation and Customer Privacy Regulations and other central banks such as FSA regulation towards on the hedge fund.
Problems of Non-Regulations
The unregulated hedge fund philosophy was challenged when it revealed the near collapse of Long Term Capital Management in 1998 and by the Federal Reserve’s Intervention to facilitate a creditor-rescue of LTCM.
LTCM employed trading strategies involving very high leverage and massive amounts of complex derivatives positions. On Aug 31, 1998, LTCM, with an equity base of around USD 2.3 billion, held over USD 100 billion of assets on its balance sheet and had off-balance sheet derivatives positions with a notional value totaling more than USD 1.4 trillion. Its debt to equity ratio was around 28:1. By September 1998, LTCM lost 50% of its equity and was in danger of not being able to meet collateral obligations on its derivatives positions. More importantly, had it failed to meet a collateral obligation, or missed a required debt payment, its derivatives counterparties had the legal right to terminate and liquidate their positions with LTCM, which they would have done in order to protect themselves against incurring greater losses. Not even LTCM’s filing for bankruptcy protection could have prevented this. The dissertation will study why did a single hedge fund like LTCM get to be so large and so highly leveraged that its bankruptcy could threaten global financial stability? Second, why did the banks and securities firm i.e. LTCM’s primary creditors and counterparties willing to provide such large of credit limit to LCM? Third, it was very abnormal the Federal Reserve to intervene in order to organize a creditor work-out for LTCM, why could not let LTCM filed for bankruptcy protection and prevented the immediate liquidation of its asset, as most other firms do?
In May 14 and 15 2003, the SEC held a Hedge Fund Roundtable Discussion and invited a broad spectrum of the hedge fund industry and interest persons to participate in a discussion of hedge fund issue. At the close of the Roundtable Discussion, the SEC Chairman requested the staff provide a report of its and findings and recommendations resulting from the hedge fund study. The findings and recommendations have become the foundation of the new rules to the hedge fund managers. With effect on 1 February 2006, most of the hedge fund managers were subject to the registration. Hence, the hedge fund manager will be regularly inspected by the regulator. This dissertation will evaluate the effectiveness of the new rules and predict what will be reactions of the hedge fund managers? Will they move to off-shore to avoid regulator inspection?
Hedge Fund Retailization
Over the past years, the hedge fund has become retailisation. Funds of hedge funds are become the mainstream. These funds of hedge funds are registered under the Securities Act of 1933 and therefore are not restricted to selling their securities only to “sophisticated investors”. The minimum investment amount could be as low as few thousands US dollar. The appearance of the fund of hedge fund is a regulated investment vehicle, however the underlying funds are all unregistered hedge funds. This dissertation will evaluate whether there is adequate protection to the retail investor and whether this kind of fund of hedge fund is suitable to retail investors. This study will extend further whether pension funds should invest into hedge fund. Most pension fund claimed that it may gain diversification by investing into hedge fund, so does this potential gains outweigh the risk involved?
Method
This dissertation is concentrated on using qualitative method. It will evaluate different securities statue and critically assess their changes from non regulation towards regulation. This is the early stage of the new regulation being effect, it will evaluate or predict how the hedge fund investment adviser reacts. Quantitative method may also be employed to study the historical returns of hedge funds and traditional long only funds and their correlation to the stock/ bond markets.
Research Questions
This dissertation will address on the following questions:
1. Where did regulation go wrong on the hedge fund? Critically discuss the impact of the failure of LTCM to the securities market stability.
2. What are the regulators such as SEC and FSA currently doing on the hedge fund? What are the new regulations and evaluate their effectiveness?
3. Should hedge fund be offered to the retail investors and pension funds?
4. What will be the reaction of the hedge fund manager as a result of tightened regulatory environment?
Conclusion
Finally, it will evaluate whether regulation of hedge fund can protect investors and financial stability. Also, it will provide what additional measures could be enhanced to protect investors and financial stability.
References
Credit:ivythesis.typepad.com
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