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Is the Dodd-Frank Act a Game Changer for Hedge Funds?

 Why this mammoth legislation will have a profound impact on hedge funds. 

Terry Tian, 02/28/2012

When people talk about hedge funds, one of the first things that comes to mind is that hedge funds are unregulated. Indeed, this has been true for several decades. Since the first hedge fund launched in the 1940s, the entire industry has largely operated under special exemptions of the Securities Act of 1933 and the Investment Advisers and Investment Company Acts of 1940. The idea was that hedge funds were only available to a small segment of highly sophisticated investors who didn't merit sweeping regulatory protection.

As the hedge fund industry flourished and gradually turned into a multitrillion business, however, its impact on the financial system spread far beyond this small group of wealthy investors. A series of hedge fund-led disasters, fueled by excess leverage and lack of transparency (namely, Long Term Capital Management in 1998, the subprime mortgage crisis of 2007, and the Bernard Madoff Ponzi's scheme in 2008) have threatened the financial integrity of the United States several times over the past 15 years.

The Securities Exchange Commission has attempted to regulate hedge funds on more than one occasion, but its efforts have been thwarted by a lack of congressional authority. Only when the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law by President Obama on July 21, 2010, did Congress grant this authority, but the SEC has yet to implement much of the Act's recommendations. Will the Dodd-Frank Act become a turning point for the hedge fund industry, or will it simply flounder as have past regulatory attempts?

The Road to Regulating Hedge Funds
First, a word on the history of hedge fund regulation in the United States: Regulating hedge funds is not as simple as it sound--lawmakers must balance between market efficiency and protecting investors. Historically, hedge funds have been able to avoid registering their offerings with the SEC though Regulation D (sections 504-506) of the Securities Act of 1933 and Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940. These exemptions limit the amount of the unregistered offering (in some cases), the accredited/sophisticated nature of the underlying investors, the total number of underlying investors, and most important, the ability to generally solicit or market these exempt hedge fund securities.

Hedge fund advisors circumvent regulation through the Investment Advisers Act of 1940. As long as hedge fund managers do not hold themselves out to the public as investment advisors, and as long as they advise fewer than 15 clients, no federal registration is required. Interestingly, the so-called "client" is not limited to a natural person--a fund is counted as a single client, too. Therefore, a hedge fund manager can advise up to 14 hedge funds and manage hundreds of investors' money without having to register.

The SEC tried to close this registration loophole in late 2004 by clarifying that a "client" is the underlying hedge fund investor. The SEC also defined the term hedge fund (or private fund) to mean an investment pool with less than a two-year lockup. This new regulation was ineffective, unfortunately, as many hedge funds simply increased their lockup periods to avoid registration. The ones that couldn't (or chose to not to) avoid registration were rescued in June 2006 when the Federal Court of Appeals case Goldstein v. SEC vacated the new regulation on the basis that the SEC had exceeded its statutory authority and that its interpretation of the term client was arbitrary and unreasonable.

The battle between hedge funds and regulators was far from over, however. The financial crisis began in 2007 with extraordinarily overleveraged hedge funds dumping dubious securities termed collateralized debt obligations en masse, costing investors billions and leading to the demise of banks such as Bear Stearns. Then in 2008, Bernard Madoff confessed to the largest Ponzi scheme in history, made possible by the lack of transparency afforded to hedge funds. These events legitimized the urgency and necessity to reform hedge fund regulation, and the SEC was finally granted the authority they needed.

The Dodd-Frank Act: Rules, Implications, and Impact The Dodd-Frank Act, signed into law for more than a year now, is still a work in progress--a great number of important details are yet to be finalized. But a few very important rule affecting hedge funds were recently enacted, and several of the proposed new rules are already showing their potential to change the entire industry.

Terry Tian is an alternative investments analyst at Morningstar.
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