Skeel on hedge funds

David Skeel has a provocative article on hedge funds in the current Legal Affairs.  (And see his followup debate with Dale Oesterle.) I admire David, a popular and prolific author on corporate governance and bankruptcy.  But his reasoning on this important topic requires further discussion.

Skeel’s specific topic is the SEC’s new rule requiring increased registration and disclosure by hedge funds, which I have previously criticized. Although he calls this a ““baby step” of reform,” in fact it may cost many funds as much as $500,000 each.  Moreover, disclosure creates a risk of liability for errors in the documents and still more regulatory risk, and may undercut the value of proprietary information, and therefore incentives for research. 

As a result of these risks and costs, the W$J reports that many funds are taking advantage of the two-year lockup exception which, as I’ve discussed, may increase fund owners’ agency costs – a perfect example of filling a supposed regulatory hole by digging another one.

One might call the use of the lockup device an example of the evasive strategies by hedge funds that require regulatory attention.  But then one must consider the value of the rules that hedge funds are supposedly evading. In other words, why is all this necessary, according to Skeel?   

In order to answer this question, it is important to distinguish between two types of problems that are often melded together in the commentary on hedge funds:  the damage that these funds supposedly do to others, and the damage that hedge fund managers do to their investors.  Pro-regulatory hedge fund critics often play a kind of shell game, obfuscating the goals of the regulation by sliding between these very different objectives. Regulatory prescriptions for one problem may even exacerbate the other (e.g., the two-year lockup rule).

The basic problem with focusing on the damage hedge funds do to others is that this is often covered, or should be covered, by rules that directly address the supposedly bad behavior.  But regulators often find enacting such rules inconvenient, because then they would have to actually identify the bad behavior and show how it is harmful.  It’s easier to deal with this problem by tarring the people that are doing it, and putting them out of business – the same strategy that worked with Mike Milken and takeovers.  This is not only a poor way to address the supposedly bad behavior, but it risks reducing the clearly legal and socially productive behavior that these same supposedly bad guys engage in – e.g., disciplining unproductive corporate managers.

Consider in light of the above analysis Skeel’s examples of bad hedge fund behavior that supposedly require regulatory attention:

• Hedge fund manager Richard Perry’s strategy of playing both sides in the Mylan Labs/King Pharmaceuticals takeover.  Skeel notes that this was perfectly legal, but somehow “unethical.”  Well, whatever you call it, if it's bad it should be illegal, and if not, then it shouldn’t.  And it could be stopped without any federal law at all – just by state corporate voting rules.
• Hedge fund managers get significant incentive compensation. One might think the glass was half full because it’s a good way of aligning managers’ incentives with those of the owners.  But for David the glass is three quarters empty because, after all, Enron and WorldCom managers also got incentive compensation. In any event, this would seem to be a problem for the hedge fund investors, many of them quite sophisticated, to consider. If the worry is that super-motivated hedge fund managers will try to cut regulatory corners to serve their investors, then, again, let's worry about those regulatory corners, not about the compensation.
• Some hedge funds have engaged in fraud, e.g. Bayou.  True enough. But now we’ve clearly slid from worrying about what highly motivated managers will do to others (Perry) to what managers will do to their own owners.  Again, not a good regulatory strategy.  In fact, nothing in the SEC’s new rules will do a thing to protect against this. But it’s a useful way to generally tar mutual funds if you want regulation that will curtail the activities of even the honestly managed funds.
• Citadel Investment made money by buying up a large chunk of an issue of 10-year Treasuries, hurting those who held futures on these contracts.  So, in this anecdote, one kind of speculator made money off another. What's the problem?  Well, according to Skeel, sounds like the way “robber barons like Jay Gould” made money.  The big difference, as Skeel admits, is that Gould was engaging in now-illegal market manipulation, while what Citadel is doing is still “entirely within the law.” And if it should be illegal, then make it illegal.  Registering hedge funds won't stop this behavior, but might make it harder for hedge funds to engage in the sort of hedging activities that improve market efficiency.
• Hedge funds have been involved in the market timing and late trading activities in mutual funds that got Spitzer so exercised.  Indeed, it was this "scandal" that led to all the noise about regulating hedge funds. But as I’ve discussed, the problems with these transactions are far less obvious than Spitzer would have us believe, and many of these activities were clearly legal. Moreover, the solution lies in contracts by the mutual funds themselves that, for example, clarify what trading activities are and are not allowed. Spitzer ultimately foundered against Sihpol, the only defendant who called Spitzer’s bluff and took him to court. Well, if you can’t actually show the hedge fund (for whom Sihpol was acting) did anything wrong, the next best thing is to slap regulatory costs on the hedge funds and hope they go away.

The hedge fund registration rule is done.  But as Skeel points out, it’s only a “start," so this debate isn't over. It may be that the real problem with hedge funds, and the real reason they are in the regulatory crosshairs, is that they, like Milken and his ilk, are a potential mechanism for reshaping corporate control.  Before we continue down this regulatory path, we ought to better understand why we’re going there, and the potential costs of doing so.

Update: In a comment, Bill Sjostrom raises the issue of the need to protect the securities markets from potential havoc from a LTCM-type meltdown.  This is a good point, and in fact I previously discussed this problem. But a hedge fund registration requirement, particularly given the loopholes, seems ill-designed to deal with this issue.

Update 2:  A comment below suggests that hedge fund regulation is an effort to protect the mainstream mutual fund industry from competition.  I agree, and made this point in an earlier post.   

Comments

[Bill Sjostrom]

Larry,

What are your thoughts on the argument advanced by the SEC that hedge fund regulation is “necessary to protect our nation’s securities markets?” Specifically, hedge funds control $1 trillion in highly leveraged capital. With this much capital involved, if a sophisticated trading strategy goes awry, it could reek havoc on the markets. See Long-Term Capital Management.

[John]

I'm in complete agreement with your points #1, 2, and 4, but #3 and 5 seem to me to be badly off-base.

#3: Worrying about what managers will do to their owners isn't a bad regulatory strategy; it's one of the most important concerns of the securities laws. And the proposed hedge fund rule will indeed do a lot to protect against fraud: Hedge fund managers will have to adopt compliance programs and appoint chief compliance officers, and they will be subject to periodic examinations by the SEC. We know from experience with other regulated entities that these are significant antifraud measures, though of course they will not be 100% effective. And, of course, it is up for discussion whether the improved compliance will be worth the cost; I tend to think that it will be, but I consider it a close question.

#5: I don't think there's any question that the widespread late trading and market timing was a real scandal, or that at least some hedge funds were doing something seriously wrong. As far as mutual funds are concerned, I believe Judge Motz got it right in his insightful Investor Class opinion in the Janus case: Late trading is itself illegal, and while market timing itself is lawful, it nevertheless is prohibited by Rule 10b-5 if it is engaged in by favored market insiders at the expense of long-term mutual fund investors from whom it is concealed and who have a right to rely upon its prevention by fund advisers' and managers' good-faith performance of their fiduciary obligations. Spitzer's mistake with Sihpol was to proceed criminally, where there were difficult issues of intent, instead of civilly, where it could easily have been shown that Sihpol acted improperly. The late trading/market timing problems do not, of course, show that hedge funds need to be regulated (nor did the SEC rely heavily on this issue in its justification for the rules, although the scandal may have contributed to an overall sense that further regulatory action was needed in the investment management world). Whether hedge funds should be regulated turns on the issue discussed in the preceding paragraph: Whether the direct and indirect costs of regulation outweighs the improved compliance and reduced fraud that can be expected to follow from their managers' registration.

[david skeel]

Thanks for the kind words, Larry, and the feeling is mutual-- your writing and this blog are a great service.

Your comment are very nicely argued (like the similar arguments Dale Oesterle has made in our exchange at the Legal Affairs website). Let me make two quick comments in reply (and I'll make more in a final post to Legal Affairs tomorrow.)

First, disclosure certainly isn't free and it does create the possibility of litigation (just as discl does for corporations generally) but the benefits are huge. We've seen enough hedge fund misbehavior already for it to be clear that at least limited disclosure is essential. The concerns about proprietary info are overblown (corporate issuers made the same complaints about the securities acts) and easily addressed (e.g., proprietary info could be omitted from public disclosure and privately audited by the SEC). And $500,000 is a lot of money, but a lot of hedge funds would treat it as little more than a rounding error.

As for your suggestions that the problems I identify be dealt with with other regulations, I'm all for some of the other regulations but most of them won't work well in the absence of disclosure requirements. I agree that state voting rules shd be used to address the vote buying problem, but as it currently stands, it's rare that anyone knows the hedge funds are vote buying. The state rules won't work unless there's a mechanism for assuring that the behavior comes to light.

[Bob Smith]

>It may be that the real problem with hedge funds, and the real reason they are
>in the regulatory crosshairs, is that they, like Milken and his ilk, are a
>potential mechanism for reshaping corporate control.

I think it more likely that they're under attack because they're real competition for the more highly regulated mutual fund industry. When hedge funds were small it was no big deal, but now that they're getting big they represent a huge pool of wealthy investors that the mutual fund industry has no real hope of capturing unless they can squash the hedge funds under the SEC's regulatory thumb.

[david skeel]

Both here and in an email conversation, Larry asks 1) whether hedge fund registration would prevent Bayou type frauds; and 2)whether it would stop the vote buying tricks I describe in the article that prompted the Legal Affairs debate. Disclosure and audit obviously doesn't prevent every fraud, but there surely will be fewer rather than more if investors and the SEC have a better idea what the funds are doing. As for the vote buying, I do think it should be prohibited. Part of the solution is for state courts (such as Delaware) to disqualify votes cast by a shareholder who has an economic incentive to vote against the best interests of the company who's shares she is voting. This in fact is precisely how these kinds of problems are handled in bankruptcy. But disqualification alone isn't enough, b/c there's no simple way to determine when someone has engaged in vote buying. This is where the registration and audit regime comes in. If hedge funds had been required to register and were subject to SEC audit, it might have been possible to determine if the disastrous HP-Compaq merger was approved as a result of hedge fund vote buying, as many people suspect.