Hedge Funds and PR: Getting Serious - and Fast

Hedge funds are under siege - this is nothing new. But what is new is the magnitude and breadth of criticisms being levied against the industry, and at a time when returns and reputations are at a cyclical low. Here is a sampling of the issues being raised by both the SEC and Congress, from Reuters 9/26/2007:

GREENWICH, Connecticut (Reuters) - The U.S. Securities and Exchange Commission is conducting more than 30 investigations into potential hedge fund manager misconduct in the northeast United States alone, with more in other parts of the country, officials said on Wednesday.   

The investigations into potential insider trading, faulty asset valuation, conflicts of interest and other misdeeds are under way despite the agency's setback last year when a federal court struck down a rule requiring the lightly regulated hedge funds to register as investment advisers.

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Connecticut Attorney General Richard Blumenthal, an outspoken advocate on the need for more industry regulation, said the probes are likely to bear fruit in states like his, home to scores of multibillion-dollar hedge funds.   

"There are indications that the investigations will be very productive," Blumenthal said in a keynote speech at the event.

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The SEC has made prosecuting insider trading at hedge funds a major priority this year, including probing ties between the funds and financial institutions that serve them in prime brokerage divisions, said Karpati, who heads an intra-agency working group set up six months ago with about two dozen executives.   

Agency officials said they haven't been deterred by the setback it suffered when a federal court struck down the rule that would have subjected the industry to such measures as spot financial audits, compliance manuals and increased disclosure.

Insider trading. Asset valuation. Conflicts of interest. These are not good things. And while hedge fund managers certainly weren't the most popular kids on the block (from a regulatory standpoint) during the industry's boom over the past five years, they may well be among the most detested right now. And this hasn't gone completely unnoticed by some of the industry's leading figures, including Paul Marshall of Marshall Wace. From FT Alphaville 9/25/2007:

Hedge funds - the bad boys of finance. Or is that private equity? We lose track of who is finance’s enemy number one from one month to the next. But not so long ago the funds were deeply unpopular - accused of stalking the markets, creating volatility, aggressively targeting respected UK companies through short-selling and looking for decent, hard-working public company executives to unseat.

Then private equity got a touch carried away in the FTSE 100 and the buyout groups found themselves being picked over by the unions, parliament and the media. Now the credit markets have closed for business and it’s Northern Rock, the Bank of England, the FSA and the government in the dock for financial mismanagement and endangering the system.

So should hedge funds, and private equity, skulk away thankfully as the fickle public spotlight has found itself another target?

No, argues Paul Marshall, chairman of Marshall Wace and a member of the UK’s hedge fund working group, in an FT comment article. Hedge funds may not be at the centre of the current storm he says, but there is a web of linkages between the banks and hedge funds. “Plus the the similarity of issues facing banks and hedge funds, particularly in relation to valuation and risk management, demonstrates how integral hedge funds have become to the workings of the financial system.”

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Marshall adds that calls for more regulation, in France, Germany and the US should provide an adequate stick for hedge funds to further the process started by the working group under Sir Andrew Large. “The hedge fund industry must be seen to be taking its responsibilities  seriously. If not, others will fill the vacuum.”

I think Paul is spot on. The hedge fund industry needs to be proactive and help shape the dialogue concerning regulation, or else it will lose control and potentially be subject to illogical and politically-motivated rules and policies. One factor working against this adverse outcome is the working group assembled by Hank Paulson that is drawing up a set of hedge fund "best practices," chaired by Russell Read of CalPERS and Eric Mindich of Eton Park. From the Financial Times 9/26/2007:

The appointments, by the president’s working group on financial markets, are part of efforts by Hank Paulson, Treasury secretary, to formulate a private sector-led response to concerns about the activities of hedge funds and avoid potentially draconian regulations.

Russell Read, chief investment officer of Calpers, regarded as one of the most influential jobs in US capital markets, will chair a committee of investors, while Eric Mindich, the chief executive officer of hedge fund Eton Park, will chair an asset managers’ committee.

The investors committee will include representatives from labour organisations, endowments, foundations, corporate and public pension funds and investment consultants.

Other members of the committees will include Daniel Och, head of Och Ziff Capital Management, William von Mueffling, the former star Lazard hedge fund manager who now runs Cantillon Capital, and James Chanos of Kynikos Associates.

These are smart, cerebral, experienced industry leaders that can bring different perspectives and reason to the proceedings. I have long pushed for private sector-led, self-regulatory solutions governing hedge fund practices. And the time is now for a proactive, industry-driven effort to ensure rational and helpful guidelines are set without regard to the media circus currently engulfing the private equity and hedge fund industries.

The Decline and Fall of the U.S. Capital Markets: Sarbox is Only Part of the Picture

Changes in securities regulation, like changes in tax policy, often gives rise to a variety of intended and unintended consequences which can have a catastrophic effect upon the marketplace. Sarbanes-Oxley ("Sarbox") is one of those changes that is held up as a scourge of new capital formation in the U.S., driving potential issuers to other markets where more issuer-friendly regulatory regimes prevail. There is no question that Sarbox has raised the bar for those considering a public offering in the U.S., whether one is talking about young, emerging growth companies looking towards an IPO or established foreign companies seeking to access new pockets of capital and to raise their global profile. A provocative and insightful editorial by Jonathan Macey in today's Wall Street Journal put forth a theory on the effects of Sarbox and its chilling effect on potential U.S. issuers. And while I directionally agree with Mr. Macey's points, I think they leave out one critical reality: the U.S. capital markets, notwithstanding their historic prominence, are destined to lose power and influence simply due to the growth and maturation of competing markets across the globe. And as these markets often play host to some of the most exciting and rapidly growing companies on the planet, it is natural that their influence should rise relative to the U.S. This is simply a fixture of a changing world and one that cannot be lost in the wake of analyzing the U.S. regulatory landscape.

The framework supporting Mr. Macey's perspective on the impact of Sarbox is as follows:

Over the years two divergent hypotheses emerged to explain America's dominance in the capital markets. On the one hand, economists pointed to structural features to explain America's singular position. After World War II, the U.S. was the world's only source of capital. Europe and Asia, especially Japan, were emerging from vast physical and economic devastation. In sharp contrast the U.S. was building, not rebuilding. The accumulation of U.S. savings and pension assets created the largest pool of investment capital in history.

Professional bureaucrats at the Securities and Exchange Commission and their allies in the corporate and securities bar had another theory. America, they said, was dominant thanks to its superior government regulations and protections for investors. According to this hypothesis, if a company didn't want to go public in the U.S. it must have something to hide.

On this view, the additional regulatory freight brought into play by the 2002 Sarbanes-Oxley Act should have been a godsend. By restoring the confidence in U.S. corporate governance that had been shaken by the Enron-era corporate scandals, America would assure its continued dominance of world capital markets well into the new millennium.

Alas, things have not quite turned out that way. Whatever good might be said of Sarbanes-Oxley (and there isn't much good to be said for its intrusive, circulatory and duplicative grab-bag of rules), the statute has triggered a complete change in the way the world views the U.S. as a center for capital formation.

Mr. Macey is a very bright individual (not to mention a persuasive writer), and provides an accurate and powerful historical context for the attractiveness of the U.S. financial markets and its subsequent decline in the wake of Sarbox. That said, I think the first point - the fact that the U.S. market used to be the only game in town but which is no longer the case - receives precious little attention from both Mr. Macey and other commenators on the Sarbox issue. Let's face it, U.S.-centricity is a problem that has plagued us for centuries, with particularly sharp consequences over the past forty years. And the problem is just getting worse. THE protector of the free world? THE provider of capital and fair markets for capitalists the world over? These previously accurate statements have become weakened over time, not due to some change in U.S. moral or ethical standards but because the world has changed.

Yes, we can grow, but not as fast as Asia and other emerging markets. We just can't, and this is self-evident. Yes, we have incredible wealth, but increasingly powerful pockets of wealth  - durable wealth (read: not just petro-dollar wealth but wealth created through the building of business empires across an array of global industries) - have sprung up in every corner of the globe. And financial markets in these far-flung regions have become more established, more reputable, more respected than ever before, and the trend is clearly poised to continue. So why should we be surprised that issuers are choosing to tap markets other than the U.S. for either primary or secondary equity issuances? We shouldn't be. And while Sarbox doesn't help, it is only one part of a problem that the U.S. equity markets will be facing for a long, long time. And the sooner we face into this reality the better.

It is no different than the need to face into the Social Security mess, as this is a feature of a secular demographic shift that can't be reversed. Global financial markets are getting more powerful; intellectual property is being created more than ever outside of the U.S.; more wealth is being created across the foreign financial landscape; and leading-edge companies are being established in offshore locations to serve global consumers as technology costs have declined and the barriers to bringing ideas to market have fallen. This is an inexorable shift that can't be reversed regardless of changes to the U.S. regulatory framework. I am a big supporter of simplifying both the regulatory and legal paradigms in the U.S., and this will invariably help our competitive positioning relative to London, Hong Kong and nascent exchanges the world over. But it won't change the fact that even the U.S. at its best is facing a decline in its primacy and prestige, and that we have got to wake up and take stock of our role in the global financial ecosystem before we become truly marginalized. Because unless we do, Mr. Market will quickly show who the winners in the 21st century financial markets will be - and the U.S. won't be among them.

The SEC's Silver Bullet - the eInformation Initiative

The eInformation Initiative is Big - awesome

After distilling the news from yesterday's SEC meeting, the item that I feel holds the greatest promise for positively impacting shareholder value is what I refer to as the SEC eInformation Initiative. This incorporates issues raised both yesterday and in prior months, such as Jonathan Schwartz's (the CEO of Sun Microsystems) request to the SEC use his personal blog as the vehicle for communicating with the investment community and the SEC's recently announced XBRL initiative. Salient points from today's Wall Street Journal article are provided here.

The electronic-information rule could affect nearly all shareholders within a year or so. The rule, approved unanimously yesterday, allows companies to distribute via the Internet annual reports and materials on board elections and other matters put before shareholders for a vote, while enabling investors to opt to continue to receive paper reports.

The so-called e-proxy rule will cut printing and mailing costs for corporations. But it will also make it cheaper for activist stockholders to launch fights against corporate boards, because shareholders of companies that distribute information to investors electronically will be able to do likewise.

The agency said it plans to make the e-proxy model mandatory by January 2008, though some members expressed concern about doing that.

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Mr. Cox said the e-proxy rule -- the only one approved in final form yesterday -- was one of several steps toward changing how investors access information. It dovetails with two other technology-based initiatives Mr. Cox is pushing. One will allow investors to quickly compare data in a corporation's financial statement with other companies' data. The other is an upgrade to the search capabilities of the SEC's Internet-based system for storing corporate financial reports, known as Edgar.

"We're trying to qualitatively improve the disclosures investors get," he said.

Business groups have been wary of using Internet-based proxies -- the documents that outline matters put before shareholders for votes. Their main fear is that activist investors would find it much easier to put their proposals before all of a company's shareholders. Consumer groups, on the other hand, have warned that electronic proxies could disenfranchise investors who don't use the Internet.

Some commissioners expressed concern about making the e-proxy rule mandatory, given other changes the SEC is weighing for the proxy process. Commissioners also fretted that a mandatory rule might crimp participation by shareholders without Internet access.

The SEC Moves into the 21st Century - but not without some squawking

This is great stuff. It is nice to see the SEC moving into the 21st century, even if they are dragging some constituencies kicking and screaming. It's the same kind of push-back seen from the wire services when Mr. Schwartz petitioned the SEC for using his blog as a formal investor information dissemination platform. Disintermediating a paid service for the democratizing and flattening (not to mention free) power of the Internet is bad, right? It is if you are either Business Wire or PR News Wire. But it's really great if you are an investor or a company.

The E-proxy Rule - A change with real teeth and a long time coming

So what of this e-proxy rule? This, in my opinion, is huge. How many people who get bulky, annoying proxy materials in the mail actually do anything with them? My guess is very few as a percentage of total proxies distributed. However, if one was to get an email with a link to the issues up for vote at the Annual Meeting of one of their portfolio companies, would that person be more inclined to repond and actually vote? My guess is yes. An unequivocal yes. I think the issue of reduced participation due to those lacking internet access is a red herring. I think the consumer groups and commissioners expressing this view are either way out of touch or on the take. I would contend that a staggeringly high percentage of people to whom proxies are sent have internet access. Further, I'd argue that the goal should be to increase overall participation, and that this represents real democracy. And if the emphasis and resources are placed at the tail end of the distribution, is the greater good really being served? I think not.

Conclusion

Now I know why business groups are afraid of this change, given the greater ease with which proxy fights could be launched. Excellent. This is good, healthy governance. It is high time that the frictions and impediments to shareholder-driven actions are gradually removed. Staggered boards and cumbersome proxy processes. to name two of many. This move is one chip at the edifice of entrenched managements, and if they are scared and lobbying against this change, screw them. And you thought Sarbox made you accountable, how about being accountable to your shareholders, pal? This is awesome.

Once again, I have to applaud Commissioner Cox for this proactive, pragmatic approach to good governance. As I've said in prior posts, he is a dude.

Congratulations, Commissioner

The SEC, after much saber-rattling, decided not to try and appeal the court ruling invalidating the hedge fund registration rule. It is nice to see that cooler heads prevailed. As noted in today's Wall Street Journal, Commissioner Cox raised two very important areas where a measure of SEC regulation would be both welcome and appropriate:

Mr. Cox said the SEC will propose an antifraud rule that would deem hedge-fund investors to be clients, reversing a side effect of the court's decision that regulators worried might undercut investor protections, and will consider increasing minimum asset and income requirements for hedge-fund investors.

Commissioner Cox also went on to note a point I have made in previous posts, that the SEC has both the jurisdiction and responsibility to enforce federal securities laws regardless of whether or not a hedge fund is registered:

Mr. Cox said SEC staffers plan to issue other guidance that will help hedge-fund advisers who are already registered with the SEC to stay registered. He noted the agency will continue to enforce federal securities laws when it finds wrongdoing.

This is the right answer, Commissioner. I am happy that you were able to rise above the uneducated and irresponsible banter and focus on the areas where the SEC can truly add value, and not to add unnecessary costs and bureaucracy in order to placate noisy politicians.

Playing Catch Up

Last Friday, the Public Company Accounting Oversight Board (PCAOB) came out with the warning that auditors should be on the lookout for potential stock options backdating abuses:

WASHINGTON (Dow Jones/AP) -- The Public Company Accounting Oversight Board on Friday issued its first-ever ``audit practice alert,'' warning auditors to be on the lookout for problems in the timing and accounting of stock-option grants.

``Auditors planning or performing an audit should be alert to the risk that the issuer may not have properly accounted for stock options, and as a result, may have materially misstated its financial statements,'' the alert cautioned. It told auditors to assess such risks in the course of an audit and use professional judgment in deciding whether additional scrutiny is warranted.

The oversight board's alert comes on the heels of Securities and Exchange Commission rules approved Wednesday intended to crack down on backdating and other abuses in granting executive stock options.

Huh? Can someone please tell me what's new here? Isn't this what auditors are supposed to do in the first place - that is, uh, audit? Stock option terms and policies would seem to be right in the sweet spot of their perview. "It (PCAOB) told auditors to assess such risks in the course of an audit and use professional judgment in deciding whether additional scrutiny is warranted." What? Use professional judgement? Now I believe a clear, robust public accounting system is critical for the integrity of the financial markets, and also believe that a group like PCAOB has an important place in this process, but these pronouncements are truly embarrassing. It basically sends the message that all that money spent on audit services - and let me tell you firsthand that these services are not cheap - yields questionable results and doesn't serve those for whom it was designed, namely, the public. That such language is used implies to me that the "profession" of public accounting has truly lost its luster, and that the integrity and objectivity which is the supposed currency of the trade has depreciated markedly.

As noted in a previous post, I believe those in the position of responsibility on which others rely, i.e., fiduciaries such as pension funds, accountants, lawyers, etc., must be held accountable for their actions (or their lack of action as the case may be). Once the integrity of these players falls into question, the underpinnings of the marketplace they are supposed to serve weakens considerably. My hope is that "bold" pronouncements like those made by the PCAOB on Friday are few and far between, because if fundamental issues like those discussed above require comment a wholesale review of the public accounting profession may be in order.

Do Hedge Funds Give Rise to Externalities?

As mentioned in several earlier blog posts, I have very strong opinions on the issue of hedge fund regulation. As discussed in Wednesday's New York Times, Christopher Cox, Chairman of the SEC, made several particularly interesting comments during Tuesday's Senate hearings:

“I am concerned that the current definition, which is decades old, is not only out of date but wholly inadequate to protect unsophisticated investors from the complex risks of investment in most hedge funds,” he[Cox] said.

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The commission has the authority to investigate any kind of fraud it suspects, but the court’s decision to throw out the registration requirement limits its ability to conduct routine exams and improve its understanding of the industry.

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The Treasury Department, meanwhile, has formed a group to examine potential risks in the industry, including the exposure that many large banks could have to certain trades. The group, which first met a few weeks ago, will work with members of the hedge fund industry and the banks who manage their accounts. 

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[Randal K. Quarles, under secretary for domestic finance at the Treasury Department] said one risk he saw was embedded leverage, or bets that hedge funds have taken with derivatives that are less apparent on the balance sheet. 

Now I could sit here and address Mr. Cox's comments one by one, but I think the entire issue here can be addressed through a single word, a powerful economic concept called externalities. Per Wikipedia:

In economics, an externality is the effect of a transaction between two parties on a third party who is not involved in the carrying out of that transaction. Externalities can be either positive, when an external benefit is generated, or negative, when an external cost is generated from a market transaction.

An externality occurs when a decision causes costs or benefits to stakeholders other than the person making the decision, often, though not necessarily, from the use of common goods (for example, a decision which results in pollution of the atmosphere would involve an externality). In other words, the decision-maker does not bear all of the costs or reap all of the gains from his or her action. As a result, in a competitive market too much or too little of the good will be consumed from the point of view of society. If the world around the person making the decision benefits more than he does, such as in areas of education, or safety, then the good will be underprovided; if the costs to the world exceed the costs to the individual making the choice in areas such as pollution or crime then the good will be overprovided from society's point of view.

So, to me the real question is - "Does the hedge fund industry give rise to externalities that warrant government regulation?" Tom Evslin, himself a free-marketeer, recently had a great post on externalities and provided classic economic arguments for where government regulation might be warranted (even for those in favor of free markets).

For externalities to be present in the hedge fund industry, the crux of the argument has to revolve around those who are impacted by hedge funds but themselves are not directly involved in hedge funds. This would seem to break down into two core constituencies:

1. non-accredited investors who are indirectly invested in hedge funds through pension plans and other pooled investment vehicles; and


2. market participants of all types who are potentially effected by the trading activities of hedge funds and its impact on the global financial markets.

Interestingly enough, I would say that these two constituencies are generally the focus of the more rational arguments I’ve seen for regulating hedge funds, and I’ll briefly explain my views on each.

Non-accredited investors : Chairman Cox raises the issue of protecting the individual (read: unsophisticated and non-accredited) investor. I buy this argument as long as we are talking about what constitutes an unsophisticated investor. The accreditation requirements go a long way towards separating those for whom investing in hedge funds is appropriate and those for whom it is not, and it probably does make sense to raise the net worth and income thresholds. Ok, now what? Most of the arguments I've seen have to do with non-accredited investors indirectly investing in hedge funds through their holdings in pension plans, which themselves invest in hedge funds.

Ah, now we're getting somewhere. This could be an externality, right? But wait, pensions fund managers, they are, what is that word, fiduciaries. Hmmm, maybe it is their responsibility to make sure that their investments are being managed properly and their constituencies are being protected. And they are sophisticated, right? They either have large in-house investment teams or smaller teams that leverage the work of “skilled” pension consultants like Mercer, Hewitt, Hennessee, Cambridge Associates, etc.

So is there really an externality here? My answer - NO. Why use regulation to protect people who themselves are protected through the accreditation standards, and whose agency involvement (via indirect investment through pension funds) is being represented by those who are legally responsible for looking after their best interests? Seems like overkill to me.

Market participants: The above article addresses a number of issues relating to hedge funds’ impact on the financial markets, which clearly effects investors everywhere whether or not they are invested in hedge funds. The article mentions the SEC’s power to investigate fraud (and, in fact, other concerns) in the absence of explicit regulation, as well as the Treasury Department’s newly-formed group “… to examine potential risks in the industry, including the exposure that many large banks could have to certain trades.” This group will also include hedge funds. I saw this first-hand in my earlier career in derivatives and trading, where both the SEC and Treasury interviewed myself and several of my colleagues (in trading, structuring and prime brokerage) to ask questions, investigate issues and collect data on hot-button issues, i.e., concentration of risk, number of unconfirmed trades, KYC/AML procedures, etc. Let me tell you, this kind of tacit regulation and review works like a charm. It is not “check the box” regulation – it is sitting eye-to-eye with someone who has the power to make your life very, very painful. When your internal counsel gets a call from the SEC, Treasury or the OCC, you hop to it, get your ducks in a row and prepare to be grilled. This is a healthy process and keeps people on their toes, knowing that they can get a call at any time.

And the interesting thing is that while hedge funds themselves might not be “regulated” in the classic sense (though in my earlier post about regulation, I argue that hedge funds are, in fact, effectively regulated), their key trading counterparties and liquidity providers – the banks and prime brokers – are. Further, the principal engine of growth in hedge fund AUM – pension funds and endowments – are fiduciaries, who themselves are legally on the hook for protecting their constituencies. So I really don’t see how those with the power, authority and responsibility for protecting and preserving the integrity of U.S.-based institutions’ impact on the financial markets don’t already have the requisite tools at their disposal. So is this a true externality? I don’t think so.

One final comment on this issue of regulation to protect investors from bad behavior: Through legislation, the SEC filing process and coordination with the FASB (the body which promulgates financial accounting rules), the government has already taken extensive steps to regulate public companies and mutual funds (presumably, the argument being that individual investors themselves can't influence what happens inside a corporation or a mutual fund and, therefore, needs to be protected). Let's take a quick look at their record in using regulation to address perceived externalities in the financial markets: (1) Enron; (2) WorldCom; (3) Cendant; (4) Every company ensnared in the options-backdating scandal; (5) and about 5,000 other examples.

Oh, and let's not forget the issues with Directors' conflicts in mutual funds, the mutual fund market timing scandal, just to name a few. How often have we read statements to the effect of, "Hedge funds have an unfair advantage over mutual funds because they are less transparent."  I'll tell you - a lot, and this contention is a bunch of baloney. Time and time again it has been proven that "regulation by filling in forms" works poorly. The simple act of filling in a form doesn't ensure honesty, integrity or presentation of substance over form.

It is time that people both inside and outside the Beltway wake up to the fact that regulations, while appropriate where externalities exist, are not a panacea and should not be solely relied upon to ensure good behavior. Investors themselves need to do their homework, and those in the position of fiduciary responsibility need to be held accountable for doing the homework on behalf of their less sophisticated constituents. Further, the government already has very powerful and effective tools at their disposal outside of formal regulation, and from personal experience I can tell you that this process – periodic meetings with members from the SEC and Treasury, similar to that used by the FSA in the UK – is very effective. Let’s focus on the goal here, folks, and not simply create another opportunity for ill-conceived and costly legislation to dampen an essential and vibrant marketplace.

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.