A Comparative Analysis of Hedge Fund Regulation in the United States and Europe
Reserve, Cato Briefing Papers, Sept.
A Comparative Analysis of Hedge Fund Regulation in the United States and Europe
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A Comparative Analysis of Hedge
Fund Regulation in the United States
George Sami °
Due to their recent astronomical growth, hedge funds have attracted
the attention of the media, investors, investment professionals, and
government regulators, not only in the United States, but in Europe as well.
In 1990, there were approximately 300 hedge funds managing $39 billion in
assets worldwide.' As of 2004, there were approximately 8000 to 9000
hedge funds managing $1 trillion 2 in assets worldwide, with current
estimates reaching as high as $1.4 trillion.3 As an industry, hedge funds
have experienced an average growth rate of 20% since 1990. 4 In addition
to providing investors with diverse financial instruments and investment
strategies, one of the main reasons hedge funds have experienced such
growth is the rate of returns they offer. For example, Caxton Corporation, a
hedge fund founded in 1983, averaged annual returns of at least 30% for
most of its existence.5
Although hedge funds offer qualified investors high returns, potential
losses are severe because of the risky nature of the investment strategies
*J.D. Candidate, 2009, Northwestern University School of Law. I wish to thank Professor
David Ruder for his invaluable help on this paper. I would also like to thank the Executive
and Managing Editors, as well as the Editor-in-Chief and the rest of the JILB staff for their
outstanding editorial help. Last, but not least, I wish to thank my family and friends for their
unending support. Any and all errors are attributable solely to myself.
1 Sargon Daniel, Note, Hedge Fund Registration: Yesterday's Regulatory Schemes for
Today's Investment Vehicles, 2007 COLUM. Bus. L. REv. 247, 249.
2Edward Taylor & Alistair MacDonald, HedgeFunds Get Europe's Clippers, WALL ST.
J., May 23, 2006, at Cl.
3 Shivani Vora, Hedge-Fund Milestones, WALL ST. J., Jan. 30, 2007, available at
these funds utilize. Not until the near collapse of Long-Term Capital
Management (LTCM) did regulators in the United States and Europe start
to appreciate the systemic risk that hedge funds posed to global financial
markets. However, prior to the near collapse of LTCM, hedge fund critics
questioned whether hedge funds contributed to the financial conditions that
led to the Asian Financial Crisis. 6 For example, Malaysian Prime Minister
Mahathir bin Mohamad accused George Soros, founder of one of the
dwuorrinldg'sthlearAgesisatnhFeidngaencfiaulndCsr,i7siso. f8 bringing down the Malaysian currency
This comment will explore in depth the evolution of hedge fund
regulation in the United States, and compare the current state of hedge fund
regulation in the United States with that in Europe, specifically the United
Kingdom, the European Union, and Germany. The comment is comprised
of six sections. Section 11 provides an overview of hedge funds. Section III
explores the evolution and current state of hedge fund regulation in the
United States. Section IV provides an overview of the current regulatory
framework of hedge funds in Europe, more specifically in the United
Kingdom, the European Union, and Germany. Section V compares and
contrasts the United States' hedge fund regulatory framework with that of
Europe. Finally, Section VI, in light of the comparative analysis in Section
V, posits recommendations aimed at improving the United States' current
hedge fund regulatory framework.
The comment concludes that, after the United States' initial attempt to
implement a rules-based approach in regulating hedge funds failed, the
United States temporarily adopted a principles-based approach that
attempted to mimic that of the United Kingdom. However, the United
States' Securities Exchange Commission (SEC) recently proposed new
Rules and adopted a final Rule, which seems to suggest that the United
States has reverted to a rules-based approach. Moreover, the United States'
rules-based approach is deficient because it does not go far enough with
respect to requiring independent fund valuation, falls short of gathering
adequate information about hedge funds, fails to take a risk-based approach,
and, like the United Kingdom, also fails to address the threat of "empty
6 Sherry Shore, Note, SEC Hedge Fund Regulatory Implications on Asian Emerging
Markets: Bottom Line ofBust, 13 CARDOZO J. INT'L & CoMP. L. 563, 577 (2005).
7 Soros Fund Management LLC.
8 Vora, supra note 3.
OVERVIEW OF HEDGE FUNDS
A. Difficulty of Defining a Hedge Fund
Despite the growing attention that hedge funds have received recently,
neither U.S. nor European regulators have been able to formulate a legal or
statutory definition of what constitutes a hedge fund. 9 After recognizing
the difficulty in defining a hedge fund, the SEC has stated that a hedge fund
usually refers to "an entity that holds a pool of securities and perhaps other
assets that does not register its securities offerings under the Securities Act
[of 1933] and which is not registered as an investment company under the
Investment Company Act [of 1940]. " 0
B. Common Characteristics of a Hedge Fund
A discussion of the common characteristics of hedge funds appears to
be more insightful in defining the dimensions of whether an investment
vehicle constitutes a hedge fund. " The first characteristic that is common
to hedge funds is that the funds are usually organized as limited liability
corporations or limited partnerships in order to give the hedge fund
manager maximum control in investing the assets of the fund.' 2 Secondly,
the investors of the fund are usually characterized as limited partners in the
fund and are acquired through private placements, rather than public
offerings.' 3 A third common characteristic of hedge funds is a lock-in 14
period of two years or less. 5 Finally, hedge fund managers often charge a
management fee and a performance incentive fee, which are usually 2% and
20% of fund profits, respectively. 16
C. Types of Hedge Funds and Their Investment Strategies
There are mainly two types of hedge funds, which are distinguished on
the basis of the investment strategies they employ.' 7 One type of hedge
9 Lartease Tiffith, Hedge Fund Regulation: What the FSA is Doing Right and Why the
SEC Should Follow the FSA's Lead, 27 Nw. J. INT'L L. Bus. 497, 500 (2007).
1oSEC STAFF REPORT, IMPLICATIONS OF THE GROWTH OF HEDGE FUNDS, at viii (Sept.
2003) available at http://www.sec.gov/news/studies/hedgefunds09O3.pdf [hereinafter 2003
HEDGE FUND REPORT].
11 Daniel, supranote 1, at 251.
12Tiffith, supra note 9, at 500.
14The "lock-in period" refers to the period of time during which an investor is not
allowed to liquidate his investment or take his or her money out of the fund.
15 2003 HEDGE FUND REPORT, supra note 10, at 139-40.
16Tiffith, supra note 9, at 500.
17Kevin Dowd, Too Big to Fail? Long-Term Capital Management and the Federal
fund is the macro fuand, which usually takes speculative positions18 based
on its analysis of financial and macroeconomic conditions. 19 This type of
hedge fund is usually highly-leveraged, meaning that "the amounts invested
in [its] portfolios, the [fund's] assets, are much greater than [its] share
capital, with investments in excess of capital being financed by
borrowing. '20 Thus, the more leveraged a fund is, the higher the profits
investors will realize if the investment is successful. 21 Equally, if a hedge
fund is highly-leveraged, investors will experience a greater severity of
loss 22 if the investment fails than they would have experienced had the fund
not been as highly-leveraged. Hedge fund managers can obtain leverage
through different means, such as financing, purchasing securities on
margin, and executing derivative transactions.' To mitigate the high level
of risk that is associated with highly-leveraged hedge funds, lenders and
counterparties may require a certain level of capital as collateral for the
credit extended, thereby effectively lowering the fund's asset-to-capital
The other type of hedge fund is the arbitrage fund, which seeks to
exploit price discrepancies in different financial markets primarily through
"short selling., 25 Short selling is an investment strategy whereby a fund
borrows an asse26 and then sells the asset in anticipation of the price
falling. If the price of the asset falls, the stock is repurchased at the lower
price, thereby resulting in a profit for the fund. The discussion of these two
types of hedge funds is not to suggest that they are mutually exclusive.
D. The Advantages and Disadvantages of Hedge Funds
One advantage of hedge funds is that they provide liquidity27 to
18Id. (since this type of hedge fund takes speculative positions, it is "un-hedged," and
thus is a hedge fund in name alone).
21 The success of the investment is dependent on whether profits exceed the cost of
22 If the cost of borrowing exceeds the profit yield, then losses are likely to be great,
possibly to the point of insolvency.
23 Willa E. Gibson, Is Hedge Fund Regulation Necessary?, 73 TEMP. L. REv. 681, 686
25 Id.; Dowd, supra note 17, at 2.
26 Gibson, supra note 23, at 686 (although the asset usually being sold is a stock, other
assets may include instruments such as options, futures, swaps, currencies, and other
instruments of value).
27 The term "liquidity" means that an asset can easily be traded without having a
significant change on the price of the asset.
financial markets by trading against the market.28 Through short selling,
hedge funds reduce price discrepancies in financial markets.29 In other
words, by constantly seeking to exploit price differences that may exist
across financial markets, hedge funds end up smoothing out price
discrepancies in different financial markets. Moreover, the strategies that
hedge funds employ reallocate risk from investors who tend to be
riskaverse to investors who are risk-prone investors.30 Finally, given the
plethora of investment instruments and strategies they offer qualified
oinpvpeosrttournsi,tiehse dthgaet afruencdosnspirsotevnidtewitihnveeascthorisnvwesitthor'spolertvfeollioof rdisikv.e3r1sification
On the other hand, hedge funds have their fair share of disadvantages.
One disadvantage of hedge funds is the systemic risk that highly-leveraged
hedge funds pose to global financial markets.32 Systemic risk refers to "the
risk that a major market participant's losses in the financial markets may
cause widespread loss to other firms in the market, or cause disruptions to
other industries or to the entire worldwide financial system. 3 3 In other
words, a hedge fund's increased use of leverage increases the possibility
that the hedge fund's losses could be transmitted to creditors,
counterparties, as well as market participants who are not affiliated with the
hedge fund, thereby causing a "domino effect" of financial losses across
The SEC has cited the use of hedge funds for fraudulent purposes as
another disadvantage.3 5 In fact, between 1999 and 2004, the SEC brought
fifty-one cases of hedge fund fraud totaling $1.1 billion in losses to
A third disadvantage is the growing exposure of smaller,
unsophisticated investors to hedge funds. 7 The SEC explained that while
28 Dale Oesterle, Foreword, RegulatingHedge Funds, 1 ENTREPRENEURIAL. Bus. L. J. 1,
29 Tiffith, supra note 9, at 503-04.
30 Gibson, supra note 23, at 688.
3"Id. at 686-87.
32 Id. at 705; DEP'T OF THE TREASURY ET AL., REPORT OF THE PRESIDENT'S WORKING
hedge funds may be appropriate investment vehicles for wealthy and
institutional investors, they are inappropriate investment funds for smaller,
unsophisticated investors who are not in the position to demand disclosure,
appreciate the risk of their investment strategies, or incur the potentially
crippling financial losses.38
Another disadvantage of hedge funds that has recently come to. light
and warrants a closer look is the ability of activist hedge funds to prompt or
block corporate takeovers. 39 Hedge funds, by and large, are able to affect
corporate takeovers and shareholder elections through "empty voting,"
which is the practice of borrowing shares of corporate stock and holding
more votes than the borrower's ownership interest entitles him or her to.
In other words, this process enables someone other than the true owner of
corporate stock to vote those shares. The opportunity for empty voting
arises when brokerage firms or institutional fund managers lend the shares
of their investors to hedge funds, thereby also lending the right to vote those
shares.41 Thus, if a hedge fund borrows a sufficient number of shares of
stock before the record date, it can vote those shares to either promote or
block takeovers depending on which course of action is more profitable for
The practice of empty voting has troubled regulators and investor
advocacy groups for two reasons. First, this practice enables hedge funds to
create a "self fulfilling prophesy" of sorts by allowing them to vote shares
of a company that they may intend to short sell.4 2 In other words, it enables
hedge fund managers to manipulate the market by voting shares of
borrowed stock in such a way that will drop the stock's value, thus enabling
them to repurchase the stock when the price falls.
Second, empty voting undermines a fundamental principle of corporate
law and governance, which is the unity between voting power and
economic ownership of stock.43 The rationale behind the coupling of
voting and economic ownership is that if an investor has an economic stake
in the corporation, then he or she is incentivized to vote his or her shares in
such a way as to maximize the value of the corporation. 4 However, there
is no incentive to do so if voting and ownership are "de-coupled." Neither
38 Id. at 72057-58
39See Henry Hu & Bernard Black, The New Vote Buying: Empty Voting and Hidden
(Morphable) Ownership, 79 S. CAL. L. REv. 811 (2006); Kara Scannell, How Borrowed
Shares Swing Company Votes, WALL ST. J., Jan. 26, 2007 (on file with author).
40 Hu &Black, supra note 39, at 812.
41 Scannell, supra note 39 (stating brokerage firms or institutional fund managers lend
voting shares for a fee, and that the practice of empty voting has developed into an $8 billion
42 Id.; Hu & Black, supra note 39, at 812.
43Hu &Black, supra note 39, at 811.
the SEC nor the Financial Services Authority (FSA), the United Kingdom's
securities regulatory body, has addressed hedge funds' use of empty voting
to affect corporate governance.45
III. THE UNITED STATES' REGULATORY FRAMEWORK OF
Traditionally, hedge funds were unregulated because they usually
qualified for an exemption under the Securities Act of 1933,46 the Securities
Exchange Act of 1934, 47 the Investment Company Act of 1940,48 and the
Investment Advisors Act of 1940. 49 In 2004, the SEC passed a new Rule
(the Hedge Fund Rule) under the Investment Advisers Act to close the
section 203(b) exemption, which, in effect, would subject an overwhelming
majority of hedge funds to SEC registration and regulation. 50 However, in
Goldstein v. SEC,51 the Court of ApRpeals for the D.C. Circuit struck down
the Hedge Fund Rule as "arbitrary." In light of the SEC's decision not to
appeal the Goldstein decision,5 3 the current state of hedge fund regulation
has reverted back to its pre-amended Advisers Act state, which effectively
exempts hedge funds from SEC registration and regulation. However, in
2007, the President's Working Group on Financial Markets (PWG) released
a report (2007 PWG Report) setting out principles and guidelines designed
to provide regulators with guidance in their oversight of hedge funds.
PWG Report concluded that "[p]ublic policies that support market
discipline, participant awareness of risk, and prudent risk managemreinstk.a,r5e5
the best means of protecting investors and limiting systemic
45 Scannell, supra note 39.
Despite the D.C. Circuit's holding in Goldstein that the Hedge Fund Rule
was "arbitrary" and the 2007 PWG Report recommending a
principlesbased approach, the SEC's adoption of Rule 206(4)-8 under the Advisers
Act and proposal of Rules 216 and 509 under the Securities Act seem to
suggest that the SEC has not abandoned its rule-based approach to
regulating hedge funds.
The main objective of the Securities Act is to promote efficient capital
formation while ensuring that firms seeking to obtain capital from the
public provide full and fair disclosure to the public. 56 To that end, Section
5 of the Securities Act prohibits selling or offering to sell unregistered
securities, as well as selling securities without delivering a prospectus
containing certain information about the issuer. 57 Hedge funds, which often
offer interests in a limited partnership, limited liability corporate
partnership, or other legal entities, fall within the Securities Act's definition
of "security" that must be registered. 58 However, hedge funds rely on
Section 4(2)'s private offering exemption to avoid the registration and
prospectus delivery requirements under Section 5.59 Nevertheless, this
exemption is "limited to situations where the offerees have access to the
kind of inform6a0tion afforded by registration under Section 5 of the
Since it would be impractical for a hedge fund manager to ensure that
all investors receive the same disclosure they would otherwise receive
under Section 5, hedge funds rely on Rule 506 of Regulation D for an
exemption. 61 Rule 506 of Regulation D provides a private offering
exemption if an issuer has no more than thirty-five purchasers,62 who are
not "accredited investors,' 63 and does not advertise publicly. 64 A hedge
56 JOHN C. COFFEE ET AL., SECURITIES REGULATION: CASES AND MATERIALS 88 (2007).
57 Securities Act, supra note 46, §§ 5(a)-5(c).
58 Tiffith, supra note 9, at 509.
51 Id. at 509-10.
60 Daniel, supra note 1,at 258 (citing 2003 HEDGE FUND REPORT, supra note 10).
62Id. at 259 (citing 17 C.F.R. § 230.506(b)(2)(i)).
63Id. (citing 17 C.F.R. § 230.50 1(a)(2006)). "Accredited investor" is defined as:
(i) Individuals who have a net worth, or joint worth with their spouse, above
$1,000,000, or have income above $200,000 in the last two years (or joint income
with their spouse above $300,000) and a reasonable expectation of reaching the
same income level in the year of investment; or are directors, officers or general
partners of the hedge fund or its general partner; and [(ii)] certain institutional
investors, including banks; savings and loan associations; registered brokers,
dealers and investment companies; licensed small business investment companies;
A ComparativeAnalysis ofHedge Fund Regulation
fund that seeks to avail itself of the Section 4(2) private offering exemption
through Rule 506 is advised to be very careful in its solicitation because a
mere interview or internet posting may constitute a general solicitation to
the public, which would thereby void the exemption.
Thus, hedge funds are usually exempt from registering with the SEC
under Section 5 if they sell mainly to accredited investors and neither
exceed the thirty-five purchaser threshold for non-accredited investors nor
solicit publicly. Unlike other exemptions, a Rule 506 exemption is very
attractive to hedge funds because there is no monetary limit on the fund.
B. The Securities Exchange Act of 1934
Under the Securities Exchange Act of 1934 (the Exchange Act), a
dealer in securities, or "any person engaged in the business of buying and
selling securities for such person's own account. . . ." is required to register
with the SEC.66 Thus, hedge funds fall within the regulatory scope of the
Exchange Act because they qualify as "dealers" in securities or "person[s]
who sell and buy securities for their own account. 67 Section 12(g) of the
Exchange Act requires a dealer whose assets are held by more than 500
people and has assets in excess of $1 million by the end of its most current
fiscal year to register. 68 Thus, hedge funds are able to avoid having
interests in their funds considered securities by not having more than 499
investors in each fund.
C. The Investment Company Act of 1940
Under the Investment Company Act of 1940 (the Investment Act),
investment companies or companies that invest in pooled funds of small
investors are required to register with the SEC and are thus subject to
regulation. 69 Thus, virtually every hedge fund would fall under the purview
of the Investment Act because they constitute either investment companies
or companies that pool investment funds. However, section 3(c)(1) and
section 3(c)(7) provide hedge funds with two separate exemptions from
registering under the Investment Act.
Section 3(c)(1) exempts "[a]ny issuer 70 whose outstanding
corporations; partnerships; limited liability companies and business trusts with
more than $5,000,000 in assets.
64 Securities Act, supra note 46, § 230.506.
65 Coffee, supra note 56, at 88.
66 Exchange Act, supranote 47, § 78c(a)(5).
68 Exchange Act, supra note 47, § 781.
69 See generally Investment Company Act, supra note 48.
70 As mentioned earlier, hedge funds would be considered issuers since they offer
securities... are beneficially-owned by not more than one hundred persons
and which is not making a public offering of its securities ' 7I from the
definition of an investment company under the Investment Act. Generally,
hedge funds qualify for a section 3(c)(1) exemption.72 However, the
exemption is unavailable if either one of the exemption's two requirements
is not satisfied.73 The first requirement is that a fund must have fewer than
100 investors. Each individual investor is considered a beneficial owner,
unless the investor is an "investing entity," which is an entity that owns at
least 10% of the hedge fund's voting securities. 74 If an investor is deemed
to be an investing entity, then a hedge fund is required to look through the
investing entity and count each beneficial owner of the entity as an
investo7r.675 The second requirement is that the offering be private, or
Section 3(c)(7) exempts "[a]ny issuer, the outstanding securities of
which are owned exclusively by persons who, at the time of the acquisition
of such securities, are qualified purchasers, and which is not making and
does not at that time propose to make a public offering of such securities. 77
Section 2(a)(51)(A) defines a "qualified purchaser" as any person who
owns at least $5 million in investments.7 8 The rationale behind the section
investors interests in the fund as limited partnerships or limited liability company
memberships, which would constitute a security.
71 Investment Company Act, supra note 48, § 3(c)(1).
72 Gibson, supra note 23, at 694.
14 Id. at 694-95.
77Investment Company Act, supra note 48, § 3(c)(7).
78 Investment Company Act, supra note 48, § 2(a)(5 1)(A). This section actually provides
four alternative definitions of who or what constitutes a "qualified purchaser," the most
relevant of which is the one provided in the text. Section 2(a)(51)(A) defines a "qualified
(i) [A]ny natural person (including any person who holds a joint, community
property, or other similar shared ownership interest in an issuer that is excepted
under section 80a-3(c)(7) of this title with that person's qualified purchaser's
spouse) who owns not less than $5,000,000 in investments, as defined by the
(ii) [A]ny company that owns not less than $5,000,000 in investments and that is
owned directly or indirectly by or for 2 or more natural persons who are related as
siblings or spouse (including former spouses), or direct lineal descendants by birth
or adoption, spouses of such persons, the estates of such persons, or foundations,
charitable organizations, or trusts established by or for the benefit of such persons;
(iii) [A]ny trust that is not covered by clause (ii) and that was not formed for the
3(c)(7) exemption is that wealthy sophisticated investors are not in need of
the protection provided by the securities laws because they either possess
the knowledge to appreciate risky investments or have the financial means
to absorb the loss from a risky investment.
Nevertheless, a hedge fund would qualify if it only sells securities to
qualified investors and does not make or propose to make a public offering.
Section 3(c)(7), unlike Section 3(c)(1), does not limit the number of
investors in a fund. 79 However, hedge funds usually limit the number of
investors to less than 500 to avoid registration under the Exchange Act.80
D. Investment Advisers Act of 1940
The Investment Advisers Act of 1940 (the Advisers Act) requires
investment advisers to register with the SEC and comply with Rules
promulgated by the SEC, which regulate investment advisers' practices and
conduct. 8 1 The purpose of the Advisers Act is to protect investors who rely
on the advice of investment advisers by providing them (and the SEC) with
current information on investment advisers. 82 Section 2(a)(l 1) of the
Advisers Act defines an "investment adviser" as:
[A]ny person who, for compensation, engages in the business of
advising others, either directly or through publications or writings, as
to the value of the securities or as to the advisability of investing in,
purchasing, or selling securities, or who, for compensation and as
part of a regular business, issues or promulgates analyses or reports
concerning securities. 83
At first glance, it would appear that hedge funds fall squarely within
the definition of an investment adviser since they advise clients on a host of
investment instruments, strategies, and opportunities. However, Rule
203(b)'s small adviser or de minimis exemption exempts from registration
"any investment adviser who during the course of the preceding twelve
specific purpose of acquiring the securities offered, as to which the trustee or other
person authorized to make decisions with respect to the trust, and each settler or
other person who has contributed assets to the trust, is person described in clause
(i), (ii), or (iv); or
(iv) [A]ny person, acting for its own account or the accounts of other qualified
purchasers, who in the aggregate owns and invests on a discretionary basis, not
less than $25,000,000 in investments.
79Gibson, supra note 23, at 695-96.
80 Id. at 696.
81See Investment Advisers Act, supra note 49.
82Gibson, supranote 23, at 696.
83Investment Advisers Act, supra note 49, § 2(a)(1 1) [15 U.S.C. § 80b-2(a)(l 1)].
months has had fewer than fifteen clients and who neither holds himself out
generally to the public as an investment adviser nor acts [as] an investment
advisor to an investment company... [or] a business development
company .... , 8 4 In other words, as long as a hedge fund has not had more
than fourteen clients in the last twelve months and has not held itself out as
an investment adviser, it is exempt from registering as an investment
adviser under the Advisers Act. It is crucial to point out that prior to the
SEC's adoption of the Hedge Fund Rule in 2004, hedge funds were not
required to "look through" each fund and count the number of investors in
each fund of pooled investments. Rather, each fund counted as one client,
irrespective of the number of investors within that fund.85
E. SEC Passes the Hedge Fund Rule Under the Investment Advisers
Act of 1940
1. The Near Collapse ofLong-Term CapitalManagement
U.S. regulators did not pay hedge funds much attention until the near
collapse of LTCM in 1998. LTCM was a large, highly-leveraged 86 macro
hedge fund that used complex investment strategies to exploit arbitrage
opportunities in foreign financial markets. 87 LTCM had speculated heavily
that spreads between the prices of Western government and
emergingmarket bonds, specifically Russia, would become narrower. 88 However,
after the Russian government devalued the ruble and put a halt on future
debt repayments, the creditworthiness of emerging-market bonds
deteriorated, thereby expanding the spread between Western government
and emerging-market bonds. 89 As a result, LTCM lost over half of its
equity capital, causing fear that the unraveling of LTCM would threaten the
stability of the international bond market.9 Fortunately, a bailout was
orchestrated by the New York Federal Reserve which saved LTCM from
insolvency. 91 However, the fallout from the near collapse of LTCM
attracted the attention of the U.S. Congress, which led the SEC to consider
regulating the hedge fund industry. 92
84 Investment Advisers Act, supra note 49, at R. 203(b)(3) [15 U.S.C. § 80b-3(b)(3)]
85 Advisers Act Release, supra note 35, at 72058.
86 Tiffith, supranote 9, at 506 (stating that LTCM's debt-to-equity ratio was once 42:1).
87 McClean, supranote 33, at 115.
88 Dowd, supra note 17, at 3-4.
90 McClean, supra note 33, at 116.
A ComparativeAnalysis of Hedge Fund Regulation
On April 28, 1999, the PWG released its report on the near collapse of
LTCM and the lessons learned from the incident. 93 According to the report,
one lesson that arose out of the near collapse of LTCM was that
highlyleveraged financial institutions can increase the level of systemic risk to
global financial markets. 94 Moreover, although market discipline 95 is an
effective tool to minimize the risk from excessive leverage, there are some
cases in which market discipline fails because creditors may either lack the
incentive or the means to evaluate the riskiness of a firm. 9 As a corollary
to the possibility of market discipline failure, it appears that, in some cases,
highly-leveraged firms do not provide creditors, counterparties, or investors
with sufficient disclosure for these parties to evaluate their exposure to risk.
After the near collapse of LTCM, the interconnectedness of global financial
against hedge fund regulationH.9o7wever, the PWG ultimately recommended
markets became apparent.
The SEC's Staff Report on the Implications of the Growth of Hedge
After the significant growth in the size and influence of hedge funds,
the SEC's Staff launched an investigative study aimed at reviewing the
operations and practices of hedge. funds. 98 The report identified areas of
concern to the Staff as well as potential recommendations to address these
One area of concern to the Staff was that the SEC lacked information
about hedge fund advisers, and thus the SEC was unable to evaluate the
effects of the investment strategies used by hedge funds.l 00 Moreover, the
Staff expressed concern over the lack of regulatory measures which would
ensure that hedge funds provide investors with sufficient disclosure to make
informed investment decisions. 101
The Staff was also concerned that hedge fund investors may not have
sufficient information about hedge fund advisers and the advisers'
93 See 1999 PWG REPORT, supra note 32, at 1.
94 Id. at 32.
95 Id. at 25 (defining "market discipline" as the process through which creditors and
counterparties increase the cost of credit or reduce credit to firms when such firms expose
creditors and counterparties to increased levels of risk through excessive leverage).
96 Id. at 25-26.
management of the fund. 01 2 In addition, there was concern that hedge fund
advisers did not disclose potential conflicts of interest to hedge fund
The Staff's main concern was the lack of independent review over the
process through which hedge fund advisers value their funds' assets. i04
This deficiency not only raised questions about the true value of a hedge
fund's assets, but also raised concerns about the ability of registered funds
(that invest in hedge funds) to accurately value their interests in hedge
After identifying areas of concern, the SEC Staff made
recommendations aimed at addressing these concerns. First, the Staff
recommended that the SEC consider passing a new Rule requiring hedge
fund advisers to register with the SEC as investment advisers under the
Advisers Act, while taking into account whether the benefits outweigh the
burdens of registration.10 6 Second, the SEC Staff suggested that the SEC
consider addressing issues with respect to advisers' valuation of hedge fund
assets, suitability, and fee disclosure relating to registered funds of hedge
funds (FOHF).' 07 Third, the Staff advised the SEC to encourage the hedge
fund industry to establish and further develop industry-wide best
practices. 108 Finally, the Staff advised the Commission to maintain its
current efforts to improve investor education about hedge funds. 09
The Hedge FundRule-Registration Under the Advisers Act of Certain
On December 2, 2004, the SEC took up the Staff's recommendation to
pass a new Rule requiring hedge fund advisers to register with the SEC as
investment advisers, and passed the Hedge Fund Rule. "0 The SEC justified
the Hedge Fund Rule based on the concerns raised in the 2003 Staff Report
as well as new concerns that had come to light since the 2003 report. "'
The SEC mentioned as a new concern the growing exposure of
104 2003 HEDGE FUND REPORT, supra note 10, at xi.
107 Id. at xii; SEC, Hedging Your Bets: A Heads up on Hedge Funds and Fund of Hedge
Funds, What are "Funds of Hedge Funds"?, http://www.sec.gov/answers/hedge.htm
(defining a fund of hedge funds as "an investment company that invests in hedge
fundsrather than investing in individual securities").
108 2003 Hedge Fund Report, supra note 10, at xiii.
110 Advisers Act Release, supra note 35, at 72059.
"' Id. at 72059-67.
qualified investors to hedge funds through public and private pension funds,
university endowments, foundations, and charitable organizations that
invest in hedge funds. 112
The Hedge Fund Rule requires hedge funds to "look through" each
private fund and count each investor as a "client" towards the fourteen
client threshold for Rule 203(b)-3's private adviser exemption. 113 The SEC
stated that the Hedge Fund Rule:
[W]ould require hedge fund advisers to count each investor in a
fund, rather than only the hedge fund itself, as a client for purposes
of the private adviser exemption. As a result, most hedge fund
advisers would have to register with the Commission and would be
subject to SEC oversight."-'
Moreover, the Hedge Fund Rule redefined "private fund" to fit the mold of
a hedge fund. 115 The definition was based on three characteristics 16 which
distinguished hedge funds from other types of private funds, such as private
equity and venture capital funds.' 17
F. The Hedge Fund Rule Struck Down as "Arbitrary" in Goldstein v. SEC
Eight days after the SEC announced the adoption of the Hedge Fund
challenging the Hedge Fund Rule's equation of "client" with "investor."su11i8t
Rule, Phillip Goldstein, an investment advisory firm, brought
Goldstein argued that the SEC misinterpreted the Advisers Act because the
word "client," traditionally and rightly, referred to the actual fund, not the
number of investors in the fund.' 9 The Advisers Act does not define the
word "client."' 120 The SEC argued that since the Advisers Act does not
define "client" the Advisers Act is "ambiguous as to the method of counting
clients."' 121 The Court of Appeals for the D.C. Circuit held that the SEC's
Hedge Fund Rule was "arbitrary" because "there [was] a disconnect
112Id. at 72057-58 In addition, the Commission mentioned growing hedge fund fraud as
a new concern. See id. at 72058.
"'3Id. at 72058.
114Id. (emphasis added) (citations omitted).
"' Id. at 72068-69.
116 Adviser's Act Release, supra note 35, at 72073 (stating that the three characteristics
are: (1) whether a fund is exempt from the Investment Company Act under either § 3(c)(1)
or § 3(c)(7), (2) a lock-in period of two years, and (3) whether the only interest in the fund is
based on the advisory skills of the investment advisor).
118Goldstein v. SEC, 451 F.3d 873, 874
(D.C. Cir. 2006)
"'9Id. at 878.
between the factors the [SEC] cited and the Rule it promulgated.' ' 122 The
Court reasoned that just because the Advisers Act did not define the word
"client" did not mean that Congress authorized an agency to define the
word by default. 123 In fact, the Court pointed out that the legislative history
suggests that Congress understood "client" to refer to24investment company
entities themselves, not the investors in those entities. 1
G. Post-GoldsteinHedge Fund Regulation
After the SEC decided not to appeal the Goldstein decision, 125 it
became apparent that the SEC's initial attempt to implement a rules-based
approach in regulating hedge funds had failed. Initially, it was unclear
whether the SEC would abandon its rules-based approach for a
principlesbased approach or if it would continue its rules-based approach in
regulating hedge funds. In early 2007, the PWG released a set of principles
to guide U.S. regulators in their oversight of hedge funds.126 The PWG's
release seemed to suggest that U.S. regulators initially considered adopting
a principles-based approach post-Goldstein.
Ultimately, that proved not to be the case. Shortly after the PWG's
release, the SEC published three releases: the Private Pooled Investment
Vehicle Release, 127 the Prohibition of Fraud by Advisers Release, 128 and the
Revisions of the Limited Offering Release,' 2 culminating in the adoption
of new final Rule 206(4)-8 under the Advisers Act, the proposal of three
new Rules (Rules 216, 507 and 509 under the Securities Act), and the
proposed revision to the Rule 501(a) accredited investor qualification
standards. The new final Rule, the three new proposed Rules, and the
proposed revision to Rule 501(a) seem to suggest that the SEC has not
abandoned its pre-Goldstein rules-based approach in regulating hedge
122 Id. at 882-84.
123 Id. at 878.
124 Goldstein, 451 F.3d at 879-80.
125 See generally SEC Press Release 2006-135, supra note 53.
126 2007 PWG STUDY, supra note 54.
127 Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles: Accredited
Investors in Certain Private Investment Vehicles, Securities Act Release No. 8766,
Investment Advisers Act Release No. 2576, 72 Fed. Reg. 399 (proposed Dec. 27, 2006)
[hereinafter Private Pooled Investment Vehicle Release].
128 Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles, Investment
Advisers Act Release No. 2628, 72 Fed. Reg. 44756 (released Aug. 3, 2007) (effective Sept.
10, 2007) [hereinafter Prohibition of Fraud by Advisers Release].
129 Revisions of Limited Offering Exemption in Regulation D, Securities Act Release No.
8828, 72 Fed. Reg. 45116 (proposed Aug. 3, 2007) [hereinafter Revision of Limited
Offering Exemption Release].
1. The Agreement Among the President'sWorking Group and U.S.
Agency Principalson Principlesand Guidelines RegardingPrivatePools of
On February 22, 2007, the PWG released a set of principles that was
aimed at providing regulators guidance in their oversight of private pools of
capital, including hedge funds.130 The ten principles mainly focused on
systemic risk and investor protection. The PWG stated that "[p]ublic
policies that support market discipline, participant awareness of risk, and
limiting systemmaicnargisekm."e1n31t are the best means of protecting investors and
With respect to systemic risk, 132 the PWG stated that the most
effective mechanism for mitigating systemic risk is the exercise of market
discipline by creditors, counterparties, and investors. 133 In other words,
creditors and counterparties, who are generally large, sophisticated financial
firms, have the proper incentives and expertise to adjust the credit available
to hedge funds according to the level of risk and the fund's valuation
Moreover, the PWG advised creditors and counterparties to establish
policies, procedures, and protocols that address "how the quality of
information from a private pool of capital should affect margin, collateral,
and other credit terms and other aspects of counterparty risk
management."'134 More specifically, creditors and counterparties should
conduct due diligence, including but not limited to reviewing a fund's
ability to appropriately measure and manage its exposure to market, credit,
liquidity, and operational risk. 135 As part of their due diligence inquiry,
creditors and counterparties were advised to conduct rigorous stress
testing1 36 which takes into account adverse market liquidity that would
result from several market participants unwinding transactions
Fund managers should have valuation, risk management, and
information systems that meet industry standards and enable them to
130 2007 PWG STUDY, supra note 54, at 1.
132 Id. at 3 (defining "systemic risk" as the "possibility that losses at one or more entities
could threaten the stability of the broader financial system.").
133 Id. (Principle 6).
134 Id. at 3-4 (Principle 7).
135 Id. at 4 (Principle 7.1).
136 2007 PWG Study, supra note 54, at 4 (describing "stress testing" as the process
through which one can "quantify the impact of adverse market events, both at the level of an
individual counterparty and aggregated across counterparties.").
provide creditors and counterparties with accurate information.1 38 Where a
fund does not provide sufficient information to conduct a thorough due
diligence inquiry, the PWG advised creditors and cou3n9terparties to tighten
margin, collateral, and other credit terms accordingly. 1
With respect to investor protection, the PWG stated that "[i]nvestor
protection concerns can be best addressed most effectively through a
combination of market discipline and regulatory policies that limit direct
investment in such pools to more sophisticated investors.' 4 ° More
specifically, the PWG advised investors not to expose themselves to levels
of risk they cannot tolerate, given their investment objectives and portfolio
diversification goals. 141 Moreover, individuals that invest in private pools
of capital, such as hedge fund investors, are encouraged to obtain historical
and continuous information which is necessary to perform due diligence,
evaluate the investment strategies of these funds, and assess the level of risk
posed by these funds. 142
Investors were encouraged to obtain information ranging from the fund
adviser's qualifications to potential conflicts of interest that the adviser
might have. 143 More importantly, investors were advised to analyze the
valuation methodology, performance calculation processes, and operational
risk management systems used by the fund, and to ensure that there was an
independent audit scheme of fund processes and systems. 144 With respect
to concerns that less sophisticated investors are indirectly exposed to hedge
funds through pension funds, charitable organizations, or funds of hedge
funds, the PWG advised that sound practices by the fiduciaries of these
funds are the best way to address such concerns.
Finally, the PWG advised regulators to communicate their
expectations as to what constitutes "prudent management of counterparty
credit exposures,"1 46 considering "developments in financial markets
advances in best practices for counterparty credit risk management."a1n4d7
Moreover, regulators were encouraged to use formal and informal channels
across financial markets and borders in order to obtain information about
private pools of capital.1 48 Regulators were also advised to cooperate and
138 Id. at 5 (Principle 9).
139Id. at 4 (Principle 7.4).
140 Id. at 1.
141Id. at 2 (Principle 3).
1422007 PWG STUDY, supranote 54, at 2. (Principle 4).
143Id. (Principles 4.2 and 4.4).
coordinate with authorities in other countries in gathering and sharing
information about these funds. 149 Ultimately, the PWG recommended a
principles-based approach rather than a rules-based approach in regulating
hedge funds. 150
In the Private Pooled Investment Vehicle Release, the SEC proposed
three new Rules designed to provide additional protection for those who
invest in pooled investment vehicles, such as hedge funds. 5 ' Rule
206(4)8, proposed under the Advisers Act, would prohibit investment advisers of
pooled investment funds from making false or misleading statements of
material fact or otherwise defrauding investors or prospective investors in
those pooled funds. 52 Because the SEC adopted Rule 206(4)-8 as proposed
itnheitRsuPlreohwiibllitbioendoeffeFrrraeuddunbtyil ASdevcitsioenrs VR-eBle.1a5s4e, 153 an in-depth discussion of
The SEC also proposed Rules 216 and 509 under the Securities Act. 55
These Rules would revise the definition of the term "accredited investor" as
it relates to natural persons but only within the context of the offer and sale
of securities in privately-offered investment pools. 156 The SEC proposed
these Rules because of concern that the current definition of the term
"accredited investor" did not provide sufficient protection for those who
invest in privately offered investment pools. 15 The SEC explained that,
due to an increase in the value of investors' personal residences since 1982,
many investors now qualify as accredited investors but lack the financial
faicnuamnceinaltolosinsevse.st58in pooled funds or the means to absorb potentially severe
In the Pooled Private Investment Release, the Commission
distinguished between the Investment Company Act's definitions of
investment pools under Sections 3(c)(1) and 3(c)(7). 159 The SEC pointed
151See generally Private Pooled Investment Vehicle Release, supra note 127 (stating that
Northwestern Journal of
International Law &Business
out that protections available for investors in pools relying on a Section
3(c)(7) exclusion are unavailable for investors in pools relying on a Section
3(c)(1) exclusion. 160 Currently, a natural person must meet a two-prong test
to qualify for investment in a 3(c)(7) pool. First, the individual must own at
least $5,000,000 in certain investments at the time of investing.' 6 1 Second,
the individual must be a "qualified purchaser" who also meets the definition
of an "accredited investor." 162 Through proposed Rules 216 and 509, the
SEC seeks to extend the same two-prong test to those who invest in 3(c)(1)
Proposed Rules 216 and 509 would only apply to the offer and sale of
securities in investment vehicles as defined in the Rules and would exclude
private funds, such as venture capital funds.1 64 The Rules would define
"private investment vehicle" to mean an issuer that woul6d5 be considered an
investment company absent a Section 3(c)(1) exclusion.'
More importantly, the Rules created a new category of accredited
investor called "accredited natural person," which is defined as:
[A]ny natural person who meets the requirements specified in the
current definition of accredited person, as [that] term relates to
natural persons, and would add a requirement that such person also
must own (individually, or jointly with the person's spouse) not less
than $2,500,000 (as adjusted every five years for inflation) in
investments at the time of purchase of securities issued by private
investment vehicles under Regulation D or section 4(6). 166
In other words, to qualify as an accredited natural person for a 3(c)(1)
investment pool, a person must (i) have a net worth (individually or
combined with spouse) of more than $1,000,000, or have an income of
more than $200,000 (or joint income with his or her spouse of more than
$300,000) and reasonably expect to make the same income during the year
of investment and (ii) own at least $2,500,000 in investments. 167
Effectively, the proposed Rules would make it much harder for
individuals to invest in pooled investment vehicles, such as hedge funds. In
explaining why it added the $2,500,000-in-investment requirement, the
SEC said that when Regulation D was adopted in 1982, only "1.87% of
161 15 U.S.C. § 80a-2 (2007).
162 Private Pooled Investment Vehicle Releas%,, supra note 127, at 411.
164 Id. at 405.
167 Regulation D, 17 C.F.R. § 230.51(a)(5)-(6) (2008); Private Pooled Investment
Vehicle Release, supra note 127, at 405.
U.S. households qualified for accredited investor status" and were therefore
able to invest in pooled investment vehicles. 168 The Commission pointe16d9
out that by 2003, the percentage had increased to 8.47% of households,
mainly due to an appreciation in the value of real estate. 170 However, with
the proposed $2,500,000 investment requirement for individuals, only 1.3%
of U.S. households would qualify for accredited natural person status. 171
In the Prohibition of Fraud by Advisers Release, the SEC adopted Rule
206(4)-8 under the Advisers Act as proposed in the Private Pooled
Investment Vehicle Release. 172 Final Rule 206(4)-8 effectively extends the
SEC's anti-fraud Rules for registered and unregistered investment advisers
to pooled investment vehicles and thereby protects investors and
prospective investors in such vehicles.'73
The purpose of Rule 206(4)-8 was to address the ambiguity in the D.C.
Circuit's decision in Goldstein.174 The uncertainty in the Court's decision
pertained to whether the SEC has the power to bring enforcement actions
under the Advisers Act against investment advisers of pooled investment
vehicles who defraud investors through material misrepresentations or
omissions. 175 The SEC explained that in Goldstein, the Court distinguished
sections 206(1) and (2) from section 206(4) under the Advisers Act in that
"section 206(4) ...is not limited to conduct aimed at clients or prospective
clients of [hedge funds]."' 176 Section 206(4) explicitly gives the SEC the
authority to "define and prescribe means reasonably designed to prevent...
acts, practices, and courses of business as are fraudulent, deceptive, or
manipulative."' 177 The SEC promulgated Rule 206(4)-8 under its authority
under section 206(4). 178
More specifically, Rule 206(4)-8(a)(1) prohibits investment advisers
from making false or misleading statements to investors or prospective
168Private Pooled Investment Vehicle Release, supra note 127, at 406.
10 Id. at 407.
'71Id. at 406.
172Prohibition of Fraud by Advisers Release, supra note 128, 44756 (explaining that this
"new rule under the Advisers Act... would prohibit advisers to pooled investment vehicles
from defrauding investors or prospective investors in pooled investment vehicles.").
"' Id. at 44757.
17715 U.S.C. § 80b-6.
178Prohibition of Fraud by Advisers Release, supra note 128, at 44757.
investors in pooled investment vehicles. 179 With respect to current
investors, the Rule forbids the making of false or misleading statements in
account statements. 8 Further, the Rule prohibits advisers from making
false or misleading statements in "private placement memoranda, offering
cainrdcuplaerrss,onoarl rmesepetoinnsgess atrora n'rgeeqduetshtrsoufgohr cparoppitoaslailnst,r'odeuleccttiroonniscersvoicliecsi.t"at1i8o1ns,
Rule 206(4)-8(a)(2) makes it illegal for an adviser to "otherwise
engage in any act, practice, or course of business that is fraudulent,
deceptive, or manipulative
investor in [a] pooled investmwenitthverheiscpleec."t1 t8o2 any investor or prospective
Rule 206(4)-8 also clarifies that an adviser's duty to refrain from
fraudulent conduct against the fund also extends to "ultimate investors" and
that the SEC may bring enforcement actions against advisers who defraud
current or prospective investors in hedge funds or other pooled investment
vehicles. 183 Moreover, the Rule applies to both registered and unregistered
investment advisers. 184
Rule 206(4)-8 defines a pooled investment vehicle as "any investment
company defined in section 3(a) of the Investment Company Act and any
privately offered pooled investment vehicle that is excluded from the
definition of investment company by reason of either section 3(c)(1) or
3(c)(7) of the Investment Company Act." 185 In other words, the Rule
applies to private equity funds, venture capital funds, hedge funds, and
other pools that invest in securities. 186
Unlike Rule 1Ob-5 under the Exchange Act, the SEC need not show
that an adviser acted with scienter under Rule 206(4)-8. 187 Thus,
negligently or recklessly deceptive behavior falls within the scope of the
Rule. Finally, Rule 206(4)-8 creates neither a fiduciary duty between
advisers and investors or prospective investors nor a private right of
17117 C.F.R § 275.206(4)-8(a)(1) (2008).
180 Prohibition of Fraud by Advisers Release, supra note 128, at 44757.
181Id. at 44758.
182 17 C.F.R. § 275.206(4)-8(a)(2) (2008).
183 Prohibition of Fraud by Advisers Release, supra note 128, at 44757 (stating that "an
Revision ofLimited Offering Exemption Release (August 3, 2007)
In the Revision of Limited Offering Exemption Release,
proposed revisions to the limited offering exemption in Regulatitohne DS.E1C89
There were four parts to the revision. First, the SEC proposed new Rule
507, which created a new exemption from registration under the Securities
Act for offers and sales of securities to "large accredited investors."1 90
Second, the SEC proposed to revise the definition of the term "accredited
investor" under Rule 501(a) of Regulation D to reflect developments since
the Rule's adoption.1 9' Third, the SEC proposed to shorten the time
required by the integration safe harbor.1 2 Finally, the Commission
proposed uniform disqualification provisions to all offerings seeking to rely
on Regulation D. 193 For the sake of brevity, I will discuss only the first two
Proposed Rule 507 would create a new exemption from the
registration provisions under the Securities Act for offers and sales of
securities to "large accredited investors." Under Proposed Rule
investments-owned standard is substituted for the assets-owned stan5d0ar7d, . a9n4
Moreover, in order for a legal entity or institutional investor to achieve
large accredited investor status it must have at least $10,000,000 in
investments rather than the current Rule 501(a) requirement of $5,000,000
in assets. 195 Individuals, or "natural persons" must have at least $2.5
million in investments or have an annual income of $400,000 (or $600,000
combined income with spouse) to qualify as a large accredited investor,
rather than the current Rule 501(a) standard of $1,000,000 in assets or
$200,000 annual income (or $300,000 combined income with spouse) for
an accredited investor.' 96
The proposed Rule would permit limited advertising that satisfies the
requirements of Rule 507, though general solicitations are still
prohibited.197 Announcements would be required to state that (i) offers or
sales are only extended to large accredited investors, (ii) no money or
consideration will be accepted through the announcement, (iii) securities
have not been registered or approved by the SEC, and (iv) the offering was
made pursuant to an exemption.' 9 8
189 See Revision of Limited Offering Exemption Release, supra note 129.
'90 Id. at 45117.
191 Id. at 45122.
192 Id.at 45128.
193 Id. at 45133.
195Revision of Limited Offering Exemption Release, supra note 129, at 45118.
' 97 Id. at 45120.
Under the proposed revision to Rule 501(a)'s accredited investor
standard, there would be an alternative investments-owned standard to the
current assets-owned standard. 199 Legal entities or institutional investors
would be able to achieve accredited investor status by owning at least
$5,000,000 in investments.2 °° Individuals would be able to achieve
accredited investor status by owning at least $750,000 in investments,
rather than the current net worth or income thresholds.2 1 Moreover, the
SEC proposed to adjust the dollar-amount thresholds to reflect inflation
every five years.20 2
IV. EUROPE'S REGULATORY FRAMEWORK FOR HEDGE FUNDS
A. The United Kingdom's Regulatory Framework of Hedge Funds
The approach taken by the Financial Services Authority (FSA), the
regulatory body of financial markets in the United Kingdom, for regulating
hedge funds is a principles-based approach. This approach contrasts with
the SEC's rules-based approach. In its oversight of hedge funds, the FSA
has focused on risks associated with market stability, investor protection
barriers, and valuation standards.0 3
As part of its principles-based approach, the FSA identifies threats to
the stability of financial markets, and then allocates resources to monitoring
such threats depending on their severity.20 4 For example, the FSA
established the Center for Hedge Fund Supervision (the Center), which is
charged with the responsibility of supervising twenty of the United
Kingdom's largest hedge funds.2 05 These funds may either have significant
market impact or pose a great risk to financial markets. The Center is
responsible for "relationship management of high-impact hedge fund
enforcement and public initiatives that can benefit from such exauptehrotirsiez.a,ti20o6n,
managers, driving relevant thematic work and support
In 2002, the FSA published a discussion paper (DP 16) stating that it
would not prohibit the marketing of hedge fund products and services to the
public as long as they abided by certain regulations. 207 The FSA stated that
only "authorized persons" who abide by the "collective scheme
200 Id. at 45123.
201Revision of Limited Offering Exemption Release, supra note 129, at 45123.
202 Id. at 45126.
203 Michael J. Schmidt, Note, "Investor Protection" in Europe and the United States:
Impactingthe Future ofHedge Funds,25 WIS. INT'L L.J. 161, 181 (2007).
207 Tiffith, supra note 9, at 520.
requirements" may conduct general solicitations.2 8 More specifically, one
of these requirements is that funds have to be authorized by the FSA.2 °9
The other requirement is that funds report "particulars" about their
investment strategies. 2 10 Not surprisingly, most hedge funds are not
authorized because they strongly oppose the latter requirement for fear that
their novel strategies will become public knowledge.
In light of hedge fund growth on a global scale, the increase in hedge
fund fraud, and the increased role of hedge funds in providing market
liquidity, the FSA decided to reevaluate its regulatory framework of hedge
funds. In 2005, the FSA published two discussion papers (DP)
concerning the risks and potential problems caused by hedge funds.21 3 DP
05/03 focused on the risks consumers are exposed to as a result of the
growing "retailization" of private investment pools, such as hedge funds.2 14
DP 05/04 focused on risks and concerns related to hedge funds and the
manner through which the FSA should address these risks and concerns. 215
More specifically, the paper identified numerous potential key risks. First,
the FSA expressed concern about potential serious market disruption and
erosion of consumer confidence, not only in hedge funds but also in their
creditors and counterparties.21 6 Second, the FSA was also concerned abo2u1t7
the possibility of liquidity disruption leading to disorderly markets.
Moreover, the FSA stated that the inadequacy of methodologies to evaluate
risk and imprudent risk management were areas of concern.218 The FSA
highly recommended that hedge funds establish and maintain significant
stress testing procedures. 21 9 Finally, the FSA stated that deficiencies in
asset valuation methodologies and inadequate information systems were of
concern because they created a "significant potential for ill-informed
investment decisions. 220 The FSA solicited comments from market
212 Id. at 521.
213 Schmidt, supranote 203, at 181.
214 See generally Financial Services Authority,
Products-Consumer Protection in a Rapidly Changing World (June 2005), available at
http://www.fsa.gov.uk/pubs/discussion/dp0503.pdf [hereinafter DP 05/03].
215 See generally Financial Services Authority, Hedge Funds: A Discussion of Risk and
Regulatory Engagement (June 2005), available at http://www.fsa.gov.uk/pubs/
discussion/dp05-04.pdf [hereinafter DP 05/04].
216 Id. at 6.
participants on whether the risks it identified in DP 05/04 were correct and
whether any of the risk mitigation recommendations it made warranted
further analysis. 221
In March 2006, the FSA published Feedback Statement 06/02 (FS
06/02) setting out the responses that it received for the questions it posited
in DP 05/04. The FSA concluded that it would not institute any new
regulations on hedge fund advisers unless there is a market failure requiring
regulatory remedies. 222 The FSA found two areas in which it believed there
was a market failure.223 The FSA identified the first market failure where
the adequacy of asset valuations is difficult or impossible to evaluate due in
large part to hedge funds' investments in illiquid financial instruments.224
This market failure would be further amplified where •fund managers• hav22e5
conflicts-of-interest or have an incentive to manipulate asset valuations.
The FSA identified hedge funds' uses of side-letters226 as the second market
failure. 227 Referring to side-letters, the FSA said that "[t]hese result in
some, often large, investors receiving more information and preferential
(early) redemption terms compared with other investors in the same share
class (who may be unaware that side letters exist and who will be denied
[the same] terms)., 228 After stating that the use of side-letters constitutes a
breach of business integrity, the FSA went on to say that, "[a]s a minimum
we would expect acceptable market practice to be for managers to ensure
that all investors are informed when a side-letter is granted and any
conflicts that may arise are adequately managed., 229 The FSA emphasized
that it will further study hedge funds' use of side-letters and will establish
regulatory measures if needed.230
B. European Union's Regulatory Framework of Hedge Fund-Like
The European Union's approach to regulating hedge fund-like
investment products is unique in that its primary objective is to create or
promote integrated investment products that are common to all member
221 DP 05/04, supra note 215, at 65.
222 Financial Services Authority, Feedback Statement on DP 05/04 Hedge Funds: A
Discussion of Risk and Regulatory Engagement 7 (Mar. 2006), available at
http://www.fsa.gov.uk/pubs/discussion/fs0602.pdf [hereinafter FS 06/02].
223 Id.at 7.
227 Id.at 6.
228 FS 06/02, supra note 222, at 6.
Investor protection is also an objective insofar as it promotes a
investment method for investors throughout the European
Undertakings for Collective Investment in Transferable Securities
(UCITS), which account for 70% of the managed assets in Europe, are
similar to U.S. mutual funds.23 3 Although traditionally these funds were
limited to using investment in derivatives as a risk management tool, they
are now free to invest heavily in derivatives after the passage of the UCITS
III legislation.234 However, UCITS III investment products are far more
heavily regulated than any hedge fund is in the United States or the United
With the heightened regulatory oversight of UCITS III funds comes
greater investor protection.23 For retail investors, who are largely locked
out of the U.S. and the U.K. hedge fund markets, UCITS III funds provide
the best of both worlds in that they offer investors hedge fund-styled
investments with the heightened regulatory oversight of UCITS 111.237
The European Union is unclear as to the level of systemic risk that
hedge funds pose, and thus, does not have a common regulatory scheme for
hedge funds.2 38 Although the European Union is focused on preventing
regulatory fragmentation for the sake of improving cross-border
marketability, it feels that it does not possess the knowledge to pass an
informed regulatory framework.239
C. Germany's Regulatory Framework of Hedge Funds
Germany's regulatory approach, which is characterized by substantial
regulatory measures, is interesting because it is diametrically opposite to the
United States' approach. 240 The SEC's approach is indirect regulation with
a prohibition on general solicitation of investors.24 1 On the other hand,
Germany allows public solicitation, while heavily regulating how hedge
funds are managed.242
While it appears that Germany's regulatory scheme has had some
231 Schmidt, supra note 203, at 177.
232 Id. at 178.
233 Id. at 177.
234 Id. at 177-178.
23 Id. at 178.
236 Id. at 178-179.
237 Schmidt, supra note 203, at 178-79.
239 Id. at 179.
240 Id. at 179-80.
141 Id. at 166-167.
242 Id. at 180.
Northwestern Journal of
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success, it is crucial to point out that Germany's share of the hedge fund
market is relatively small, 243 and thus the cost of regulation is lower than in
other countries, such as the United States and the United Kingdom, which
have relatively large shares of the hedge fund market.
A. Germany's Approach
Despite the fact that mandatory registration and regulation of hedge
funds was struck down in Goldstein, such an approach would inevitably
lead to hedge funds moving offshore or moving to other jurisdictions that
are not as heavily regulated as the United States. For this reason, the
German approach is not recommended, as it would threaten the United
States' robust capital markets.
Germany is at peace with the risk of losing market share in the hedge
fund market because its market share is minuscule.244 In contrast, the SEC
has recognized and appreciated the positive attributes of hedge funds, which
include providing alternative forms of investment and greater liquidity,
smoothing out pricing discrepancies, and reallocating risk to the most
efficient risk bearer.
B. European Union's Approach
Although the European Union does not have much of an approach, it is
nevertheless cautious and hesitant to implement any regulatory framework
before having sufficient information about the hedge fund industry. The
United States should consider adopting a more cautious approach that
studies in detail the possible impact of regulatory measures before
In retrospect, it appears, and many scholars suggest, that the SEC's
Hedge Fund Rule was implemented somewhat prematurely, and that the
SEC should have conducted more research before deciding to approve it.245
In fact, one scholar argues that there were psychological forces which drove
the passage of the Hedge Fund Rule.246 More specifically, he argues that
after the near collapse of LTCM, the SEC felt the psychological pressure of
243 Schmidt, supra note 203, atl80.
244 On the other hand, the United States and the United Kingdom comprise 85% of the
hedge fund market, and risk deflating their respective capital markets. Schmidt, supra note
203, at 187.
245Daniel, supra note 1, at 272-73.
246 See Troy A. Paredes, On the Decision to Regulate Hedge Funds: The SEC's
Regulatory Philosophy, Style, Mission, 2006 U. ILL. L. REv. 975 (2006) (arguing that after
such scandals as Enron and Worldcom, the risk of fraud and other hedge fund abuses
disproportionately affected the SEC, causing the agency to act when it had not in the past).
consideration of such a s wtheaenpingexreurlcei.si2n47g
taking action, rather
required in the
C. United Kingdom's Approach
The United Kingdom's approach does not require registration unless a
hedge fund plans to solicit to the general public. The United States'
approach is the same with respect to public solicitations. However, this is
where the similarities between the two approaches end.
The United Kingdom's approach, which is principles-based, is
characterized by a risk-based monitoring scheme. This approach is
effective and is narrowly tailored since it identifies hedge funds that pose
the highest levels of systemic risk, and in turn monitors them. This is a
practical approach since it would be impractical and inefficient to monitor
funds that do not pose a risk. Moreover, this approach is more
costeffective than mandatory registration and regulation because resources are
allocated based on the level of risk a fund poses. This approach is superior
to mandatory registration because if hedge funds move offshore, then there
will be a greater, more detrimental risk of limited or no oversight. The
United Kingdom also requires that funds have independent third parties
evaluate their valuation processes. This part of the United Kingdom's
approach is discussed more in detail in part VI-A.
In light of final Rule 206(4)-8, proposed Rules 216, 507 and 509, and
the proposed revision to Rule 501(a), it appears that the United States has
not abandoned its pre-Goldstein rules-based approach in regulating hedge
funds. The United States' rules-based approach is deficient because it does
not go far enough with respect to requiring independent fund valuation,
falls short of gathering adequate information about hedge funds, fails to
take a risk-based approach, and, like the United Kingdom, also fails to
address the threat of empty voting.
A. Independent Valuation
One way of ensuring investor protection is through independent, third
party valuation of hedge funds' assets, especially when hedge funds are
heavily invested in illiquid assets.
Currently, the United States relies solely on hedge fund managers'
valuation processes, and does not require independent evaluation of these
processes. Although Principle 9.2 of the 2007 PWG Report advises
248Schmidt, supra note 203, at 184.
managers to comply with "industry sound standards" in establishing
valuation procedures, it seems that the onus is placed on the shoulders of
investors, creditors, and counterparties to inquire into a fund's valuation
procedures. 249 In contrast, the United Kingdom's FSA requires that an
independent third party value a fund's assets.250 Moreover, the FSA
strongly stresses improved standards in valuation procedures of hedge
funds. However, one constraint is that the effectiveness of independent
valuation may be limited by a fund's illiquid and off-balance sheet
investments, in which case a regulatory body would have to rely on a
Nevertheless, the United States should consider adopting the FSA's
policy on independent third party valuation and emphasis on improved
B. Registration and Reporting Requirements
In light of Goldstein, the United States cannot regulate hedge funds
through mandatory registration and reporting requirements. Although the
Hedge Fund Rule may have been excessive in terms of its regulatory scope,
it is unlikely that the United States will be able to set up any type of
effective system of oversight without the ability to collect information
about hedge funds and their investment strategies.
The current approach that the United States has adopted in attempting
to overcome this obstacle is to advise investors to "obtain accurate and
timely historical and ongoing material information necessary to perform
due diligence regarding the pool's strategies, terms, conditions, and risk
management, thereby enabling such investors to make informed investment
decisions.,, 251 This approach is flawed for two reasons. First, it is unlikely
that investors, including sophisticated investors, will have sufficient
expertise so as to be able to evaluate such information and make informed
decisions. Second, this approach neglects the old adage that lessons of the
past, such as the near demise of LTCM, are easily forgotten, especially
during market upswings. Thus, during such times, investors are less likely
to scrutinize information provided by managers. In contrast, one reason
U.K. hedge fund regulation has become the paradigmatic hedge fund
regulatory framework is because U.K. hedge fund managers are subject to
reporting requirements and monitoring by the FSA. 252 An all-or-nothing
49 See 2007
PWG STUDY, supra note 54, at 5 (failing to indicate how specific
compliance procedures should be implemented).
250 Schmidt, supra note 201, at 183.
51 See 2007
PWG STUDY, supra note 54, at 2.
252 See Schmidt, supra note 203, at 185-187 (arguing that U.K. regulations focus on
monitoring and safeguarding against the influences of systematic risk may make it the leader
in hedge fund regulation).
approach to requiring registration and reporting is unlikely to lead to an
effective system of oversight.
Thus, the SEC should consider policies or measures that incentivize
hedge funds to voluntarily register with the SEC.
C. Risk-Based Approach
One of the hallmarks of the United Kingdom's principles-based
approach is the informal processes that allow for oversight, such as
negotiations and compromises between hedge fund managers and the FSA.
Although this approach may not be feasible for overseeing an entire market
of hedge funds, it is an effective approach when used to reach out to the
funds that have the most impact on the market and thus pose the greatest
The FSA has created what has come to be known as a "center of hedge
fund expertise" (the Center) to supervise the fifteen to twenty-five hedge
funds that have the largest impact on the market. 253 The Center is
responsible for "relationship management of high-impact hedge fund
managers, driving relevant thematic work and supporting authorization,
enforcement and policy initiatives that [can] benefit from such
expertise.254 This approach is effective for two reasons. First, it is
costeffective since it focuses on the funds that have the most effect on the
market. Second, it provides an opportunity to establish a relationship of
trust with the industry, which could lead to greater transparency, greater
accuracy in disclosures, and ultimately better protection for investors.
Under the U.S. approach, regulators are encouraged to "take full
advantage of both formal and informal channels of coordination and
cooperation across financial industry sectors .... , 25 5 Although this
approach is a step in the right direction, it falls short because it lacks
concrete structures for its implementation, in contrast to the U.K. approach.
D. Address the Threat of Empty Voting
As discussed earlier in this note, the practice of empty voting, a term
coined by Henry Hu and Bernard Black, refers to where an investor holds
more votes than his or her economic ownership.256 Generally, corporate
law makes voting power proportionate to an investor's ownership stake in a
company.257 This is a fundamental tenet of corporate governance because it
253Tiffith, supra note 9, at 524.
254 Id. (quoting Financial Services Authority, Hedge Funds: A Discussion of Risk and
Regulatory Engagement 41 (June 2005)).
255See 2007 PWG STuDY, supra note 54, at 6.
256 Hu & Black, supra note 39, at 812.
257 Id. at 811.
enables investors to hold directors and managers accountable. In other
words, the coupling of ownership and voting power enables investors to
ensure that directors are managing the company in such a way as to ensure
that the long-term profits of the company are maximized.
However, recent capital market developments allow outside investors
and corporate insiders to "decouple" voting power of a security from its
ownership interest. 258 Some hedge funds have been active in the
decoupling of interest and voting. In extreme cases, funds may hold the
right to vote a large block of votes without having any economic stake in a
company. 259 The practice of empty voting has troubled regulators and
investor advocacy groups for a couple of reasons. One reason is that it
enables hedge funds to interfere with corporate governance by allowing
them to block or to approve corporate takeovers or mergers. Another more
disturbing reason is that the practice allows for the creation of perverse
incentives, such as profiting through market manipulation. For example, a
hedge fund may have investments in a position counter to that of the
company, and thus would have an incentive to vote its shares in a way that
is detrimental to the long-term financial success of the company for the sake
of short-term profits.
With respect to regulation, neither the FSA nor the SEC has addressed
the practice of empty voting. 260 Thus, the United States as well as the
United Kingdom should consider adopting disclosure measures that require
hedge funds to reveal not only voting power, but also their ownership
interest in a company. 22661 Moreover, since empty voting is international in
scope, the United States should consider coordinating their oversight
system with those of other countries, especially the United Kingdom.262
In light of final Rule 206(4)-8, proposed Rules 216, 507 and 509, and
the proposed revision to Rule 501(a), it appears that the United States has
not abandoned its pre-Goldstein rules-based approach in regulating hedge
funds. Moreover, the United States' rules-based approach has proven to be
deficient in several respects. First, the U.S. approach does not go far
enough with respect to requiring independent fund valuation. In addition, it
falls short of establishing an information-gathering mechanism that
contributes to investor protection. Moreover, the U.S. approach does not
allocate regulatory resources based on the relative risk that a hedge fund
258 Id. at 812.
260 See Scannell, supra note 39 (noting that both the SEC and the FSA have expressed
concerns over the effect empty voting may have on protecting voters' interests).
261 Hu & Black, supra note 39, at 876.
262 Id. at 886.
poses. Finally, the United States, like the United Kingdom, has not
addressed the potential risks that accompany the practice of empty voting.
46 15 U.S.C. §§ 77a - 77aa ( 2005 ) [hereinafter Securities Act] .
47 15 U.S.C. §§ 78a - 78nn ( 2007 ) [hereinafter Exchange Act] .
48 Investment Company Act of 1940 , 15 U.S.C. §§ 80a-1 - 80a- 64 ( 2007 ) [hereinafter Investment Company Act].
49 Investment Advisers Act of 1940 , 15 U.S.C. § 80b-1 - 80b- 21 ( 2007 ) [hereinafter Advisers Act]; Sean M. Donahue , Note, Hedge Fund Regulation: The Amended Investment Advisers Act Does Not Protect Investors From the Problems Created by Hedge Funds, 55 CLEV . ST. L. REV. 235 , 249 ( 2007 ).
50 See Advisers Act Release , supra note 35 , at 72058.
51451 F. 3d 873 (D.C. Cir . 2006 ).
52 Id. at 884.
53 Press Release 2006- 135 , Sec. Exch. Comm'n, Statement of Chairman Cox Concerning the Decision of the U.S. Court of Appeals in PhillipGoldstein , et al. v. SEC 2006 - 135 ( Aug . 7, 2006 ), available at http://www.sec.gov/news/press/2006/2006- 135 .htm [hereinafter SEC Press Release 2006- 135 ].
54 PRESIDENT'S WORKING GROUP ON FINANCIAL MARKETS , AGREEMENT AMONG PWG AND U.S. AGENCY PRINCIPALS ON PRINCIPLES AND GUIDELINES REGARDING PRIVATE POOLS OF CAPITAL (Feb . 22, 2007 ), 1, available at http://www.treas.gov/press/releases /reports/hp272 _principles. pdf [hereinafter 2007 PWG Study].
51 Id. at 1. 2. The Report on Hedge Funds , Leverage, and the Lessons ofLong-Term CapitalManagement ( 1999 ) PrivatePooledInvestment Vehicle Release-ProposalofRule 206(4)-8 UnderAdvisers Act and ProposalofRules 216 and 509 Under Securities Act (December 27 , 2006 ) 3 . ProhibitionofFraudby Advisers Release-Adoption ofFinalRule 206 ( 4 )- 8 ( August 3 , 2007 )