Much Ado About Nothing - the Hedge Fund Regulation Debate

The Wall Street Journal reported reported this Saturday that lawyers Eric Roth and Michael Cherish of the law firm Wachtell, Lipton, Rosen & Katz - the vigorous (and highly paid) defenders of under-performing corporations - sent a letter to clients indicating that "[U]nregistered hedge funds typically enjoy greater advantages of stealth and flexibility...The transparency and restraint created by the Hedge Fund Rule make for a fairer fight when hedge funds attack." The WSJ went on to paraphrase the Wachtell letter that "public companies "can only hope" that hedge-fund regulation endures in some other form."

What are Eric and Michael talking about? Ever heard of a 13D filing? Familiar with those extremely clear and direct letters (written by both hedge fund and activist mutual fund managers) to management of poorly performing companies indicating that they might want to take certain very straight-forward steps to enhance shareholder value? It is, in fact, in the manager's best interest to communicate both their ownership stake in a company and their intentions and ideas for value creation as they want others to buy into their vision (by buying into the company) and supporting their cause. Also, are those quarterly shareholding disclosures provided by hedge funds that voluntarily register with the SEC really that useful to corporate managements? And, perhaps most importantly, are these (now defunct) regulations supposed to be for the benefit of investors or the entrenched managements who don't want to bothered with vocal and well-heeled shareholders with brains, ideas and the impetus and desire to effect change?

Based upon my own experience as the CEO of a Registered Investment Advisor and one who is familiar with the registration requirements under the Form ADV, I would say that the SEC's principal objective in regulating hedge funds is to protect investors, not the corporations in whom they are invested. And if you want to argue that the Appellate Court's overturning the SEC's legitimacy with respect to the Hedge Fund Rule is a bad thing for investors, I would take the other side of that argument as well.

Hedge funds are already subject to significant regulations, SEC rule or not. The SEC can ask for a hedge fund's books and records if they have basis for a concern that places investors at risk or believe a violation may have taken place. Investors can (and often do) request extensive information from hedge funds during the due diligence process, and this process can often take months for large, sophisticated institutions. Furthermore, investors who are also fiduciaries (like pension funds) have an obligation to do thorough due diligence prior to investment in order to protect the individuals who make up their constituency. Finally, the allocators and managers of risk capital, the prime brokers, can alter margin and credit requirements based upon the strength of a hedge fund's management structure, risk reporting, operating environment and returns.

The classic blow-ups frequently cited as reasons for why additional hedge fund regulations should be imposed - LTCM and Bayou - could have been prevented if the key players in the hedge fund business (prime brokers, investors and fiduciaries) had done their jobs, regulation aside. In fact, in was investor complaints that led to the inquiry into Bayou and ultimately stopped the fraud in its tracks, according to the Attorney General of the State of Connecticut. SEC registration doesn't by itself prevent bad behavior - it is the market participants themselves that have to assume responsibility for punishing those that don't operate in a professional manner and with the highest ethical standards. If investors in LTCM had asked more questions and demanded better answers, would they have provided the capital necessary to create the bust that eventually transpired? I doubt it.

But none of this speaks to those poor corporations whom Wachtell is worrying about. I guess it is good to know that they are looking out for their clients, regardless of the logic or veracity of their motivations.