Hedge Funds, Liquidity and Prime Brokers
FORDHAM JOURNAL OF
CORPORATE & FINANCIAL LAW
Fordham Journal of Corporate & Financial Law
Copyright c 2008 by the authors. Fordham Journal of Corporate & Financial Law is produced
by The Berkeley Electronic Press (bepress). http://ir.lawnet.fordham.edu/jcfl
By Nathan Bryce*
* J.D., expected, Fordham University School of Law, 2009; B.A., cum laude, Cornell
University, 2006. I would like to thank Professor Caroline Gentile for her insight,
support, and recommendations. I would also like to thank the members of the Fordham
Journal of Corporate & Financial Law for their editorial assistance and diligent help
throughout the writing process.
Over the past decade, the hedge fund industry has enjoyed
remarkable growth. The media enthusiastically described the success of
the top-performing funds and the lavish riches they bestowed on their
employees.1 At the same time, however, there were remarkable stories
of failure in the industry.2 Both politicians and economists warned of
the potential dangers hedge funds present to the national and global
economies.3 These warnings and concerns created a debate regarding
the level of regulation needed, if any, over what is currently a largely
unregulated industry.4 This Note argues that while increased regulation
of the hedge fund industry is necessary, the government’s recent and
ongoing attempts to increase regulation are misguided. A self-regulating
body comprised of the brokers that serve the hedge fund industry is the
most efficient and effective instrument to limit the most critical risks
hedge funds present, while still maintaining the numerous benefits hedge
1. See, e.g., Andrew Ross Sorkin, ed., A Billion-Dollar Year for Top Hedge Fund
Managers, N.Y. TIMES, Apr. 10, 2007, http://dealbook.blogs.nytimes.com/2007/04/10/f
or-top-hedge-fund-earners-it-was-a-very-good-year; No Hedge Against Salary, N.Y.
POST, Apr. 10, 2007, available at http://www.nypost.com/seven/04102007/business/no_
2. See, e.g., Struggling Citigroup Hedge Fund Bars Withdrawals, REUTERS, Feb.
15, 2008, http://www.reuters.com/article/fundsFundsNews/idUSN1551782720080215;
Ann Davis, How Giant Bets on Natural Gas Sank Brash Hedge-Fund Trader, WALL ST.
J., Sept. 19, 2006, at A1, available at http://online.wsj.com/article/SB11586171598036
6723-search.html; John Spence, Prosecutors Probing Hedge Funds’ Demise: Report,
MARKETWATCH, Oct. 5, 2007,
3. See, e.g., Regulation of Hedge Funds: Hearing Before the S. Comm. on
Banking, Housing, and Urban Affairs, 109th Cong. (2006) (statement of Christopher
Cox, Chairman, Securities and Exchange Commission); Ben S. Bernanke, Chairman,
Bd. of Governors of the Fed. Reserve Sys., Address at the Federal Reserve Bank of
Atlanta’s 2006 Financial Markets Conference: Hedge Funds and Systemic Risk (May
16, 2006), available at http://www.federalreserve.gov/newsevents/speech/bernanke200
60516a.htm); Nicholas Chan et al., Systemic Risk and Hedge Funds (Nat’l Bureau of
Econ. Research, Working Paper No. 11200, 2005), available at http://www.nber.org/pa
4. Recent Cases, Administrative Law–Judicial Review of Agency Rulemaking–
District of Columbia Circuit Vacates Securities and Exchange Commission’s “Hedge
Fund Rule.”–Goldstein v. SEC, 451 F.3d 873
(D.C. Cir. 2006)
, 120 HARV. L. REV.
1394, 1396 (2007) [hereinafter Judicial Review of Agency Rulemaking].
funds bring to economies. Part I provides a general background of the
hedge fund industry, the current regulatory environment in which hedge
funds operate, and the risks and shortcomings associated with the
current regulatory scheme. Part I also presents the failure of the hedge
fund Long-Term Capital Management as an example of the risks
inherent in the present regulatory scheme. Part II discusses recent
efforts to increase regulation and offers an alternative solution. Part III
examines the potential benefits and limitations of the alternative
I. THE BENEFITS AND THE RISKS OF HEDGE FUNDS
The term “hedge fund” generally refers “to an entity that holds a
pool of securities and perhaps other assets, whose interests are not sold
in a registered public offering and which is not registered as an
investment company under the Investment Company Act [of 19405].”6
A hedge fund’s goal is to provide an absolute return to its investors
regardless of the overall condition of the securities market.7 Hedge
funds trade a variety of securities, such as equities, “fixed income
securities, convertible securities, currencies, exchange-traded futures,
over-the-counter derivatives, futures contracts, commodity options and
other non-securities investments.”8
Hedge funds offer many advantages, both to their investors and to
the securities market as a whole.9 Hedge funds aim to achieve positive
investment returns without the volatility of traditional investments such
as stocks and bonds.10 Hedge fund advisers are able to use more
sophisticated and flexible investment strategies than advisers at entities
such as mutual funds.11 Hedge funds offer investors the opportunity to
diversify their portfolios by providing alternative investment vehicles
5. 15 U.S.C. §§ 80a-1 to -64 (2006).
6. STAFF REPORT TO THE SEC. & EXCH. COMM’N, IMPLICATIONS OF THE GROWTH
OF HEDGE FUNDS 3 (2003) [hereinafter 2003 REPORT].
7. ROBERT A. JAEGER, ALL ABOUT HEDGE FUNDS 2-3 (2003) (providing a
comparison to a mutual fund, where the goal of a typical fund is to provide a return to
the investor that is higher than the related securities market).
8. 2003 REPORT, supra note 6, at 3.
9. See Daniel K. Liffmann, Registration of Hedge Fund Advisers Under the
Investment Advisers Act, 38 LOY. L.A. L. REV. 2147, 2158 (2005).
10. 2003 REPORT, supra note 6, at 4.
that offer positive returns, while historically showing a low correlation
to traditional investments in the fixed-income and equity markets.12
In addition to profiting its own investors, hedge funds also benefit
the general securities market. Hedge funds help improve efficiency in
pricing securities in the marketplace.13 Funds may take speculative
trading positions based on extensive research about the true value or
future value of a security, and then execute a “short-term trading
strategy to exploit perceived mispricing of securities.”14 This behavior
tends to cause the market price of the security to move toward its true
Hedge funds also help the overall dispersion of risk in the
marketplace.16 For example, they often serve as counterparties to
entities that wish to hedge risk.17 The result is that risk is more properly
allocated to participants in the financial markets.18 In the case of
mortgaged-backed securities, for example, the reallocation of risks made
possible by hedge funds allows for lower mortgage interest rates
throughout the economy.19 Without hedge funds, the economy would
experience a higher overall cost of capital.20
Despite its many advantages, hedge funds can also have negative
effects on the economy. For instance, the Securities and Exchange
Commission (“SEC”) has noted the potential for hedge fund managers to
defraud its investors.21 In recent years, hedge fund investors have filed a
number of lawsuits alleging fraudulent conduct and misrepresentations
by fund managers.22 Furthermore, some critics argue that hedge funds
can drive the whole market downward by their use of short-selling
(trades based on the expectation that a security’s price will decline)23
and present systemic risk through their ability to affect the liquidity of
Unlike investment vehicles that “buy and hold” securities hoping to
generate a return in the long run, hedge funds generally follow
shortterm investment strategies.25 They take what are designed to be
temporary positions in stocks or other securities, hoping to unwind them
in short periods of time.26 Any disruption in the liquidity of the
securities (or related) markets, therefore, can cause serious disruptions
for a fund’s positions.27
Market liquidity measures the degree of difficulty in exiting a given
trading position and the ability to sell a quantity of a security without
significantly changing the price.28 Hedge funds may analyze and
undertake market positions based on a different perspective than a more
traditional historical or macroeconomic analysis.29 These types of
strategies increase market liquidity because the funds “buy and sell
assets against prevailing market sentiment with the effect of mitigating
temporary supply and demand imbalances.”30 A phenomenon dubbed
“herding” may impair liquidity, however, when multiple hedge funds all
use the same strategy and “seek to liquidate their positions at the same
time.”31 For example, many funds invest in futures or other derivative
contracts that are based on the expected price of a commodity.32
Unexpected or uncontrollable factors often influence the price of
commodities, causing the expected future price to be very speculative.33
Often these speculative contracts are traded on markets that have
significantly fewer participants than stock exchanges.34 Many of these
participants are hedge funds that can hold very large portions of the
market by leveraging their positions.35 While this combination of
leverage and illiquidity in the market creates the potential for high
returns in good times, when adverse market conditions arise, funds may
be unable to exit their very large positions (enhanced by leverage).36 In
other words, hedge funds’ strategies may put them in a position where
they are unable to sell most or all of their securities without substantially
affecting the market price. Because of their leverage, hedge funds
cannot wait until they can sell at a fair market price. They must meet
margin calls from their prime brokers (who extend them credit), and
therefore they may be forced to sell huge quantities of assets at
unfavorable prices in an illiquid market.37 These “fire sales” can have
extremely adverse effects on both market and non-market participants,
to say nothing of the funds’ investors who stand to see their investments
decline significantly in value.38
II. CURRENT REGULATIONS
The current United States regulatory scheme under which hedge
funds operate reflects the federal government’s historical belief that it
has no “interest in regulating advisers that have only a small number of
clients and whose activities are unlikely to affect national securities
markets.”39 In other words, the current regulations were designed with
the assumption that the hedge fund industry as a whole has too small an
effect on market liquidity to justify significant levels of regulation or
monitoring. Recent high-profile failures of hedge funds, however, raise
the question whether it is necessary to rethink the past wisdom regarding
hedge fund regulation (or lack thereof).40 The following securities acts
comprise the regulatory framework in which hedge funds currently
A. The Securities Act of 1933
Under the Securities Act of 1933 (“‘33 Act”), anyone who wishes
to make a public offering of a security must file a registration statement
with the SEC.41 The ‘33 Act requires the registering entity to provide
purchasers with a prospectus containing specific information about the
issuer and the security offered, unless an exemption is available from the
registration requirement.42 To avoid the registration requirement, many
hedge funds rely on the private offering exemption in section 4(2) of the
‘33 Act.43 These funds use Rule 506 of Regulation D to comply with
the requirements of section 4(2).44 Rule 506 states that funds meet the
requirements of 4(2) (and are therefore exempt from registration) if they
refrain from engaging in “general solicitation or advertising” and if they
make offerings only to “accredited investors,” meaning investors who
meet certain income and/or net worth requirements.45
40. See Kevin Carmichael, Paulson Names Panels to Draft Hedge-Fund
Guidelines, BLOOMBERG NEWS, Sept. 25, 2007, available at http://www.bloomberg.co
m/apps/news?pid=newsarchive&sid=ac1R2q8srB08 (discussing Henry Paulson’s
formation of a committee to draft “best practices” guidelines to curb fears that hedge
funds, which “have more than tripled in the past decade,” pose a risk to the financial
system because of their “lack of transparency”).
41. 15 U.S.C. §§ 77a-aa (2006).
42. 2003 REPORT, supra note 6, at 13.
43. Id. at 14 (exempting any “transactions by an issuer not involving any public
45. Id. at 14-16. “[G]eneral solicitation is not present when there is a pre-existing,
substantive relationship between an issuer or its broker-dealer, and the offeree.” Id. at
16. For hedge funds the relationship must have been established 30 days before the
investor can make an investment. Id.
B. The Securities Exchange Act of 1934
The Securities Exchange Act of 1934 (“‘34 Act”) is meant to
protect, inter alia, the efficiency and honesty of the financial markets.46
Section 15 requires “dealers” to register with the SEC.47 The ‘34 Act
defines a “dealer” as “a person that is engaged in the business of buying
and selling securities for its own account.”48 It also distinguishes
“dealers” from “traders.”49 A trader buys and sells securities, not in the
course of business, but solely in an individual or trustee capacity.50
Traders are not required to register with the SEC.51 Entities like hedge
funds that buy and sell securities for investment generally are considered
traders rather than dealers, and are therefore not required to register
under the ‘34 Act.52
C. The Investment Company Act of 1940
Most hedge funds have substantial investments that bring them
within the definition of an “investment company” under the Investment
Company Act of 1940 (“‘40 Act”).53 Hedge funds typically rely,
however, on a statutory exclusion from the definition of “investment
company,” either § 3(c)(1) or § 3(c)(7), to avoid the regulatory
provisions of the ‘40 Act.54 Funds tend to choose § 3(c)(7) because it
permits them to have an unlimited number of “qualified purchasers.”55
D. The Investment Advisers Act of 1940
Almost “all hedge funds’ advisers meet the definition of
‘investment adviser’ under the [Investment] Advisers Act [of 1940
(“Advisers Act”)56].”57 All investment advisers must register with the
SEC and comply with the provisions of the Advisers Act.58 Section
202(a)(11) of the Advisers Act states that an “investment adviser” is
any person who, for compensation, engages in the business of
advising others, either directly or through publications or writings, as
to the value of 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
Investment advisers are required to register with the SEC by using
Form ADV and must keep their information current and provide their
clients with disclosure statements that include certain information
provided in Form ADV.60 Among other things, investment advisers
must disclose to the SEC and to their clients information regarding their
business practices and disciplinary history.61 They must also maintain
records that are subject to periodic examination by the SEC.62
Although most hedge fund advisers fit the definition of an
“investment adviser,” many avoid the registration requirements by
relying on the Advisers Act’s de minimis exemption.63 This exemption,
found in § 203(b), “excludes from registration investment advisers that
have had fewer than 15 clients during the preceding 12 months, do not
hold themselves out generally to the public as an investment adviser and
are not an investment adviser to a registered investment company.”64
Under current SEC rules, a “legal organization,” such as a hedge fund, is
considered a single client.65 Therefore, the rules permit an investment
adviser to manage up to fourteen hedge funds without having to register
with the SEC.66
E. Case Study: Long-Term Capital Management
Long-Term Capital Management (“LTCM”) was a hedge fund
founded in 1994.67 It employed a variety of trading strategies, such as
convergence trading and dynamic hedging.68 From its inception, LTCM
enjoyed a prominent position in the financial community due to the
reputation of its principals69 and its large initial capital stake.70 While it
managed money for only one hundred investors and employed just under
two hundred people, LTCM invested in thousands of derivative
contracts resulting in more than $1 trillion worth of exposure.71
In its early years, LTCM reported stellar returns, ranging from
approximately forty percent in 1995 and 1996 to slightly less than
twenty percent in 1997.72 In 1998, LTCM’s balance sheet included over
$125 billion in assets and a balance-sheet leverage ratio of more than
twenty-five to one.73 The fund held large positions in several markets;
in some cases these positions gave the fund ownership positions in
futures that represented more than ten percent of the open interest in
foreign futures exchanges.74 Due to LTCM’s vast size, leverage, and
trading strategies, it became vulnerable during the extreme market
conditions that followed from the devaluation of Russia’s currency on
August 17, 1998.75 Russia’s actions, combined with other events that
destabilized the financial markets,76 sparked a “flight to quality” in
which investors sought to limit their exposure to risky securities, thereby
increasing risk spreads and liquidity premiums across the world.77
LTCM bet heavily that risk spreads would decrease, and therefore began
to lose millions of dollars by the minute in August 1998.78
With its total equity rapidly dwindling,79 LTCM needed to exit its
positions quickly, since its potent level of leverage and immense
position greatly magnified even the smallest change in risk spreads.80
At this point LTCM desperately needed a cash infusion and was truly
beginning to feel the pain of illiquidity in the marketplace.81 LTCM’s
traders from many geographic areas, including Brazil, the United
Kingdom, and Japan, all reported that there was no demand for the
fund’s positions.82 In other words, LTCM was unable to “get out of its
humongous trades without moving the markets even more.”83 It was
necessary that LTCM not think about long-term plans,84 but rather
unwind its 60,000 trading positions in order to free up cash to meet
margin calls.85 LTCM’s previously flexible credit arrangements grew
rigid as the fund’s lenders became more contentious with their daily
mark-to-market valuations for collateral calls.86
By early September 1998, LTCM needed new capital by the end of
the month or it would no longer survive.87 The fund’s troubles became a
major concern for many market participants88 who feared that if LTCM
suddenly collapsed it could devastate the already-fragile world
markets.89 While seemingly everyone was liquidating their bonds at
falling prices, LTCM found itself effectively immobilized.90 Due to the
immense size of LTCM, the sale of even a small fraction of one of its
large positions would cause the price of the security to plummet and
would reduce the value of its remaining holdings.91 Compounding
immobility concerns, LTCM had already lost over sixty percent of its
capital in September 1998 alone.92
Wall Street banks worried because many of them held the same
trading positions as LTCM, so any sale of an LTCM position would be
devastating.93 The banks that traded with LTCM and lent money
realized it was in their interest to find an alternative solution that would
cost them less than would a default by LTCM.94 Concerns over an
LTCM meltdown, however, extended far beyond the fund’s banks.
According to Alan Greenspan,
Financial market participants were already unsettled by recent global
events. Had the failure of LTCM triggered the seizing up of
markets, substantial damage could have been inflicted on many
market participants, including some not directly involved with the
firm, and could have potentially impaired the economies of many
nations, including our own.95
Eventually the Federal Reserve Bank of New York became
involved, and a consortium of banks agreed to invest approximately $3.6
billion in the fund in return for a ninety percent equity stake in LTCM’s
portfolio, as well as operational control of the fund.96 Disaster was
averted. However, the systemic risk that an LTCM collapse presented to
the broader financial system induced government officials, academics,
and professionals in the financial community to reexamine the
regulation of, and practices conducted by, hedge funds.
In April 1999, the President’s Working Group on Financial Markets
(“President’s Group”) issued a report
. 97 The principal
policy concern arising from the LTCM episode was how to constrain
excessive leverage.98 The President’s Group acknowledged, however,
that the systemic risk posed by excessive leverage must be balanced
with the benefits leverage confers on markets.99 The report notes that it
would be difficult to place direct constraints on leverage because it is
unreasonable to require a uniform degree of balance-sheet leverage for
all investors, given their diverse exposures to risk and differences in
their relationships to other market participants.100
95. Hedge Fund Operations: Hearing Before the H. Comm. on Banking and
Financial Servs., 105th Cong. 40 (1998) (statement of Alan Greenspan, Chairman,
Board of Governors of the Federal Reserve System), available at http://commdocs.hous
96. 1999 REPORT, supra note 18, at 13-14.
97. See generally id.
98. Id. at 29.
99. Id. at 23, 29 (noting that “leverage can play a positive role in our financial
system, resulting in greater market liquidity, greater credit availability, and a more
efficient allocation of resources in our economy”).
100. Id. at 24 (“For any given leverage ratio, the fragility of a portfolio depends on
the market, credit, and liquidity risks in the portfolio.”) Additionally, the group noted
The President’s Group further noted several problems with the risk
management procedures practiced by LTCM and its counterparties.101
Investment banks, which often extend credit to hedge funds, were in
such fierce competition for LTCM’s business that they tended to offer
the fund unusually relaxed financing terms.102 This led to lower
standards in the extension of credit, or leverage, to LTCM, which then
achieved extremely high levels of assets under management relative to
its equity, which in turn exacerbated the liquidity problems the fund
faced when it attempted to exit its positions in 1998.103
F. The Hedge Fund Rule
The SEC’s adoption of the “hedge fund rule” in December 2004104
is an example of the government’s misguided focus regarding hedge
fund regulation. The rule required hedge fund advisers to register as
investment advisers by February 1, 2006.105 Hedge fund advisers are
now required to register because the definition of “client” was changed
under the Adviser Act for purposes of the “private adviser
The SEC stated that “[t]he rule and rule amendments [we]re
designed to provide the protections afforded by the Advisers Act to
investors in hedge funds, and to enhance the Commission’s ability to
protect [the] nation’s securities markets.”107 The SEC cited three
reasons for the adoption of the rule.108 First, it noted the 260% increase
in hedge fund assets from 1999 to 2004 and forecasts for the continued
expansion of the hedge fund industry.109 Second, it stated that there had
been “substantial and troubling growth in the number of . . . hedge fund
fraud enforcement cases.”110 Finally, it expressed concern regarding the
growing exposure of smaller investors and other market participants,
both indirectly and directly, to hedge funds.111 The most significant area
of increased exposure, according to the SEC, was the number of pension
funds and endowments that were increasing their allocations to hedge
funds.112 This increased exposure to risk through hedge funds means
that “[l]osses resulting from hedge fund investing and hedge fund frauds
may affect the entities’ ability to satisfy their obligations to their
beneficiaries or pursue other intended purposes.”113
The SEC intended the rule to benefit hedge fund investors by
deterring fraud and curtailing losses resulting from hedge fund adviser
fraud.114 It would also benefit investors by disclosing basic information
about hedge fund advisers.115 Perhaps most importantly, the rule was
supposed to result in improved compliance controls at hedge funds.116
The SEC also asserted that the change in registration requirements
would benefit mutual fund investors by curtailing illegal conduct that
exploits mutual funds.117
The new rule would provide a level playing field for hedge fund
advisers by requiring that everyone register.118 The SEC also opined
that registration of hedge fund advisers would “enhance investor
confidence in a growing and maturing industry.”119 The SEC
acknowledged that the rule would create certain costs for the hedge fund
industry.120 Specifically, the rule would create registration costs and
costs for establishing and maintaining a compliance infrastructure for
each hedge fund.121
The hedge fund rule did not receive unanimous support.122 Two
SEC Commissioners dissented, challenging factual predicates on which
the rule was based and the wisdom of the rule.123 Phillip Goldstein, a
hedge fund adviser, also challenged the rule,124 arguing that the SEC
misinterpreted § 203(b)(3) of the Advisers Act.125 In June 2006, the
D.C. Circuit Court of Appeals struck down the hedge fund rule126 in
Goldstein v. Securities & Exchange Commission, reasoning that it was
too arbitrary.127 The court reasoned that the rule’s new definition of
“client” strayed too far from the definition in the statute, and therefore
went beyond Congress’ intent when it passed the Advisers Act.128 The
SEC declined to appeal the ruling.129
G. Investor Protections and the “Moral Hazard”
The focus of the government in creating the hedge fund rule was
misguided. The rule was “designed to provide the protections afforded
by the Advisers Act to investors in hedge funds.”130 While investor
protection regulations are important, they do not adequately reduce
systemic risk.131 In fact, the government’s new rule might have
exacerbated the problem of systemic risk by creating a false sense of
security, or “moral hazard,” in the financial community.132 A concern
arose that investors might not conduct proper due diligence on funds in
which they invested if they had a false sense of confidence in the
regulatory scheme.133 For example, former Secretary of the Treasury
John Snow stated that a “government promise to increase scrutiny would
create ‘a real risk of moral hazard that implies, ‘Don’t worry. Now the
government is watching over you and there aren’t any problems.’’”134
Leading members of Congress have indicated that future hedge fund
regulation will remain primarily focused on investor protection, such as
It seems the need to protect against the threat to liquidity from
excessive leverage outweighs the need to protect against the threat to
investors from adviser fraud.136 Even if the government focused on both
liquidity and investor protection, additional regulation runs the risk of
overreaching, reducing the flexibility of fund managers.137 Such
regulation could reduce the overall advantages the hedge fund industry
offers.138 Government regulation is too blunt an instrument for this
III. A SOLUTION: PRIME BROKERS, SELF-REGULATION,
AND “BEST PRACTICES”
Self-regulation would most likely avoid the excessive and
overbroad restrictions, thereby minimizing the impact on the benefits of
the hedge fund industry. Self-regulation could effectively address the
potential systemic risks hedge funds pose to the world economy.
Selfregulation by means of an intra-industry association of prime brokers
would strike a proper balance with regard to risk management, credit
evaluation, and leverage. Section 15(a) of the ‘34 Act authorizes this
practice.139 It provides that “associations may register with the
Commission pursuant to specified terms and conditions, and authorizes
them to promulgate rules designed to prevent fraudulent and
manipulative practices; to promote equitable principles of trade; to
safeguard against unreasonable profits and charges; and generally to
protect investors and the public interest.”140
Prime brokers, commonly a division of large investment banks,
offer a “bundle of services” to hedge funds,141 including “providing
intraday credit to facilitate foreign exchange payments and securities
transactions; providing margin credit to finance purchases of equity
securities; and borrowing securities from investment fund managers on
behalf of hedge funds to support the hedge funds’ short positions.”142
They also contribute clearance and custody services, securities lending,
financing, technology services, and assistance with capital
introductions.143 The role of prime brokers as counterparties in
extending credit to finance funds’ leverage positions and as
intermediaries in funds’ securities transactions place them in unique
positions both to gather real-time information on the total levels of
liquidity in the system and to limit the hedge funds’ ability to overextend
At most large broker-dealers, the board of directors authorizes a
credit management committee to determine risk management policies.145
Credit departments that are independent of the business units that
assume the credit risk execute these policies.146 In accordance with the
general risk management guidelines set by the management committee,
the credit department handles the credit approval process for hedge
funds on behalf of the prime brokerage units.147
Evaluation of a new hedge fund client typically involves the
examination of factors such as “character of management, credit history,
financial performance, permanence of capital and access to additional
capital, liquidity, asset quality, business integrity, experience of fund
management, sensitivity to risk, use of leverage, back office operations,
and mark-to-market procedures.”148 Evaluation of the fund’s risk
exposure is determined by the liquidity of positions held and the
potential amount of leverage employed based on the funds’ proposed
investing strategy.149 Periodic reviews generally occur no less than once
annually.150 If approved, hedge funds then receive internal credit
ratings, which are continually adjusted and which establish the level of
trading the funds may conduct and the level of collateral required.151
Hedge funds are not rated by credit agencies, but banks’ analysts
typically use similar criteria to assess funds’ creditworthiness.152 Unlike
public corporations, however, from which the SEC requires detailed
disclosures,153 hedge funds typically provide less disclosure than public
reporting companies or registered entities.154 Thus, their ratings are
inherently based on more subjective factors, such as the experience and
track record of the hedge fund and its managers.155
Once hedge funds are approved for credit and trading,
counterparties such as prime brokers continually evaluate performance
and may request additional collateral or limit their ability to leverage
positions or execute certain trades.156 Thus, prime brokers, through their
dual role as creditors and counterparties, are best positioned to limit
hedge funds’ use of leverage.157 A self-regulatory body consisting of
prime brokers would be able to use this position to reduce systemic risk
and help maintain proper liquidity in markets.
A. “Prisoner’s Dilemma” and Self-Regulation
The implementation of a “best practice” standard at prime
brokerage firms must be backed by an independent, self-regulatory body
that has the authority to levy significant sanctions against firms that fail
to abide by the standards.158 This is because the brokerage market for
hedge fund business generally behaves in a manner that, absent
enforceable risk management standards, produces a situation similar to
the classical game theory concept of a “prisoner’s dilemma.” The
prisoner’s dilemma describes a situation in which parties have complete
information regarding the consequences of both their choices and their
opponent’s choices, but, due to unilateral incentives to deviate from the
optimal strategy, the parties end up with a suboptimal result.159
The situation confronting financial firms such as brokers resembles
a prisoner’s dilemma. The brokers as a group would be better off if each
firm abided by mutually agreed-upon “best practice standards.”160
Absent a regulatory framework, however, each brokerage firm has a
unilateral incentive to deviate from the optimal “best practice” standards
to overly lax risk management standards.161 A failure to do so would
put the firm at a competitive market disadvantage.162 As a result,
industry standards that are not regulated by a self-governing association
will likely fail to impose the necessary changes in risk management
procedures at prime brokerage units.
The relations between LTCM and its counterparties exhibited the
aforementioned behavior. In that instance, Merrill Lynch, Morgan
Stanley, JPMorgan, and “just about everyone else” waived their usual
requirements for collateral on bond trades with LTCM.163 In fact,
PaineWebber, who refused to relax its standards, got very little business
from LTCM.164 Thus, while smaller firms such as PaineWebber escaped
the damage of LTCM’s collapse, almost all of the major Wall Street
firms, consistent with the behavior predicted by the prisoner’s dilemma,
relaxed their credit standards in their relations with LTCM.165 Absent
any additional regulatory controls, it is likely that financial firms will
continue to exhibit this sort of behavior in the future.
B. Strengths and Limitations of Self-Regulation via Prime Brokers
Prime brokers can best reduce the systemic threats posed by hedge
funds because they would be able to keep proprietary trade secrets
confidential while collecting the necessary information for credit
evaluators to account for liquidity at risk. As mentioned, hedge funds
are largely opaque with regard to the release of information.166 Investors
often have only limited access to their funds’ investment positions, and
hedge fund advisors enjoy wide latitude to change their investment
positions within broad guidelines.167 Through their roles as
counterparties, prime brokers have significant access to hedge funds’
credit exposure.168 Even so, due to the multitude and complexity of
trades hedge funds tend to make, a fund’s broker may not be fully aware
of the fund’s exact trading positions, and consequently of the degree of
risk present in its overall portfolio.169 A self-regulatory body of prime
brokers could facilitate the collection of information needed to
effectively assess the risk of a fund’s portfolio, and thereby allow the
broker to limit leverage while preserving proprietary trade secrets.
C. Liquidity: Risks Mitigated by Self-Regulation by Prime Brokers
Simply put, “market discipline failed [with] Long-Term Capital
Management . . . .”170 Its reputation, initial success, and potential for
fees led to intense competition among Wall Street investment banks for
LTCM’s business.171 As a result, the fund was able to command terms
that led to a gradual deterioration of credit evaluation and risk
management by the brokerages and banks with which it dealt.172
Additionally, due to its size, LTCM dealt with many different
brokerages and banks.173 As a result, no individual counterparty could
assess “the depth of LTCM’s liquidity problems.”174 Essentially, each
counterparty (or brokerage) had only a small snapshot of LTCM’s risk
profile. With such a limited picture it is doubtful the “counterparties
were aware of the nature of the exposures and risks the hedge fund had
accumulated, such as the [f]und’s exposure to market liquidity and
funding liquidity risks.”175 Many bankers, when they arrived at
LTCM’s Connecticut offices to inspect its books at the height of the
fund’s troubles, were shocked to see the extent of its leverage and the
volume of its trading positions.176
D. Amaranth Advisors
The hedge fund, Amaranth Advisors (“Amaranth”), is another
example of the importance of risk management procedures in relation to
prime brokers, and the importance of liquidity at risk to a fund’s
ultimate success or failure. Amaranth was a Connecticut-based hedge
fund that suffered billions of dollars in losses within a matter of days in
September 2006.177 Amaranth, like most funds, used leverage to
increase its return on equity.178 It invested in natural gas futures
contracts, a highly illiquid commodity.179 The particular positions
Amaranth held in natural gas immediately prior to its fall are
unknown.180 At one point, Amaranth was said to have entered into
contracts “representing more than 50% of the monthly demand for
natural gas in the United States.”181 Some estimates indicate that at one
point the fund held forty percent of the positions on the New York
Mercantile Exchange (“NYMEX”).182 Other experts concluded that
Amaranth held up to eighty percent of the total open interest for natural
gas futures on the NYMEX.183 Regardless of the actual percentage,
Amaranth’s massive market share in natural gas futures contracts was a
significant factor in its inability to liquidate its assets in the market.184
When natural gas prices failed to drop as the fund’s head energy trader
expected, Amaranth was forced to sell its portfolio to JPMorgan (its
prime broker), and Citadel Investments (another large hedge fund).185
E. Liquidity at Risk, Self-Regulation, and Prime Brokers
Brokers for LTCM and Amaranth ultimately failed to account for
liquidity risk when they extended leverage to the funds.186 Although
“[m]odels for liquidity risk are not as common place as models for
market risk,”187 financial firms have begun to improve their models for
evaluating value at risk.188 Without information on the total trading
levels, positions, and leverage of a fund, especially in relation to the
total market, prime brokers and other counterparties are in danger of
critically ignoring liquidity risk.189
Information regarding the total liquidity and trading levels in
markets would allow brokers to establish certain warning levels
regarding a hedge fund’s positions so as to allow the broker to limit
excessive leverage and the potentially disastrous liquidity problems that
could follow. A self-regulating body comprised of prime brokers could
gather information on trading levels and positions, while establishing
procedures to maintain the proprietary trading secrets of hedge funds.
They could then consolidate and analyze this information to measure the
total liquidity at risk.190 Credit evaluation committees are already
separate from the business units within the bank that extends leverage,191
and reasonable measures could be implemented to maintain the
confidentiality of information within the credit management and/or risk
management areas of financial firms.192
Fines or similar monetary penalties would be the easiest and most
effective methods of enforcement. Ultimately, the industry must
develop standards and specific penalties for all infractions. Whatever
the penalty, it must be severe enough to overcome the collective action
problem presented by the prisoner’s dilemma situation that currently
exists among brokers.193 In other words, the penalty for an infraction,
such as overextending leverage, must exceed the potential short-term
gain a broker could realize by relaxing its credit terms.194
Undoubtedly some concerns may arise regarding the confidentiality
of the information.195 The fear of losing business, however, gives
financial firms a strong incentive to maintain confidentiality, and a
selfregulatory body would be able to determine an appropriate level of
punishment for such a breach. Additionally, since the government could
step in to regulate the hedge fund industry,196 a self-regulatory body has
an incentive to maintain confidential information to avoid this
alternative. Self-regulation is the most promising way of preventing
excessive government regulation by maintaining the necessary risk
management controls to address the total liquidity problem. “Any direct
U.S. regulations restricting their flexibility will doubtless induce the
more aggressive funds to emigrate from under [U.S.] jurisdiction.”197
F. Public Relations and Recent Government Efforts
In recent years, political pressure to further regulate the hedge fund
industry has increased.198 Many factors have contributed to this trend:
the fact that hedge funds are “open only to the rich;”199 the industry’s
increased profile due to recent hedge fund failures; increased focus on
the tax rate of “carried interest,” which makes up a large portion of fund
managers’ pay;200 the industry’s rapid growth;201 and the rising level of
investment in hedge funds by pension funds and endowments.202 Public
opinion already helped push a tax bill through Congress that would more
than double the taxes paid by fund managers on “carried interest.”203
Additionally, an increasing number of alternative asset management
firms, such as hedge funds, have chosen to tap the capital markets by
going public.204 Such moves have raised awareness of the high
compensation hedge fund professionals earn.205 These factors will
continue to place pressure on elected officials to increase regulation. A
self-regulatory body approved by the SEC has the potential to “prove a
decent hedge of its own against more-intrusive alternatives.”206
Recent changes in state law also reflect the increased pressure to
regulate.207 The California Department of Corporations (“CDC”), for
example, recently announced its intention to eliminate a registration
exemption for certain investment advisers.208 The proposed amendment
essentially mirrors the SEC’s 2004 hedge fund rule by requiring any
person who fits California’s definition of an “investment adviser” to
register with the CDC.209 Essentially, the amendment would require
registration of those hedge fund managers who are no longer subject to
federal registration as a result of the Goldstein decision.210 This type of
state action serves as a reminder that “[t]he hedge fund industry must be
Taxes; House Democrats Offer Bill; Blackstone Shares Rise in IPO, WASH. POST, June
, at D01.
204. Becky Yerak, Citadel Hiring Points to IPO, CHI. TRIB., Sept. 19, 2007,
available at 2007 WLNR 18329808 (noting that “[a]lternative investment firms such as
hedge funds and private-equity firms increasingly have been tapping public markets”).
205. See Andrew Dolbeck, U.S. Legislators vs. Private Equity Firms, WKLY. CORP.
GROWTH REP., July
, available at 2007 WLNR 14506913.
206. Targeting Hedge Funds, supra note 196.
207. See generally J. Matthew Mangan & Alexandra C. Sparling, California
Proposes Rule Change That Will Require Certain Hedge Fund Advisers to Register
with the State and Proposes New Rules Affecting Licensed California Advisers
Generally, K&L GATES HEDGE FUND ALERT (K&L Gates, New York, N.Y.), Oct. 2007,
208. Donald S. Davidson & Cortney Scott, California to Require Pooled Investment
Vehicle Managers to Register as Investment Advisers and Also Proposes Changes in its
Books and Records Rules and Reporting Requirements for Broker-Dealers and
Investment Advisers (Bingham McCutchen, New York, N.Y.), Oct. 15, 2007,
209. See id. The definition of an “investment adviser” includes advisers who have a
place of business in California or has six or more clients in California, and is exempt
from registration under the SEC’s de minimis exception contained in § 203(b)(3) of the
Advisers Act. Id.
seen to be taking its responsibilities seriously . . . . If not, others will fill
G. Self-Regulation and Legal Liability: Good for Brokers, Too
The establishment of industry standards, or “best practices,” may be
necessary for prime brokers to limit legal liability arising from their
contractual obligations to hedge funds. Amaranth,212 in addition to
serving as a warning of the effects of poor risk management, also serves
as a reminder that the absence of endorsed, standardized industry
practices may leave participants vulnerable to liability without any
affirmative defenses to claims of misconduct and fraudulent action. In
November 2007, Amaranth sued its broker, JPMorgan,213 alleging that
JPMorgan’s refusal to clear a proposed trade of its energy portfolio to
Goldman Sachs breached the two parties’ contract governing their
trading relationship.214 The complaint also alleged that JPMorgan
interfered with a proposed sale of the energy portfolio to the
Chicagobased hedge fund Citadel.215 Amaranth alleged that JPMorgan contacted
Citadel after Citadel reached an agreement with Amaranth and informed
it that Amaranth’s financial condition was worse than the fund had
Amaranth’s lawsuit raises important questions about the
relationship between hedge funds and prime brokers. While the lawsuit
is still in its infancy, and its outcome is unclear, endorsed industry
standards would nevertheless help protect the brokerage industry from
future allegations by their hedge fund clients of tortious conduct. Such
standards would serve as guidelines for balancing brokers’ contractual
obligations with their own self-interests. More importantly, industry
standards would guide brokers in balancing their contractual obligations
to clients, while maintaining standards that help protect against
unnecessary systemic risk. If a situation similar to Amaranth’s arises in
the future, a prime broker should not have to choose between breaking
its obligations to clients and unnecessarily increasing its risk. A
selfregulatory body would help brokers to achieve the proper balance of
H. Future Trends in the Industry
Recent developments suggest that investment banks that serve as
prime brokers to hedge funds have begun to move toward establishing
self-regulatory frameworks to govern their dealings with advisers,
showing that they may be receptive to the establishment of a
selfregulatory body. Morgan Stanley, one of the world’s leading providers
of prime brokerage services,217 recently launched LiquidFunds, a hedge
fund platform designed to enhance liquidity and transparency for
institutional investors.218 According to one of the program’s managing
directors, “[t]he LiquidFunds program will help people overcome th[eir]
reluctance [in investing] by delivering an alternative range of hedge
funds that provide the liquidity and transparency that investors demand,
within a self-regulatory regime.”219 Each participating fund must
undergo a three-stage due diligence process prior to enrollment in the
program.220 Greenwich Alternative Investments (“GAI”) administers
the due diligence process.221 “In the initial screening stage, each
prospective manager is screened against static criteria for track record,
minimum assets under management and performance.”222 In the second
stage, GAI conducts an on-site visit with the investment manager
culminating in an assessment of the investment strategy.223 The third
stage involves an ongoing assessment of the fund through monthly
reviews of its performance.224
Funds participating in the program must comply with specific
investment guidelines.225 Investors have the option to buy and sell their
hedge fund positions on a weekly basis.226 The funds must adopt
common corporate governance standards and must issue daily risk
reports.227 The reports must include an “assessment of whether each
fund is in compliance with the program’s investment guidelines.”228
Additionally, Morgan Stanley has retained a risk analytics provider,
GlobeOp Risk Services Ltd.,229 to provide “sensitivity, scenario, stress,
and [value at risk] analysis . . . .”230
The launch of programs like LiquidFunds represents a positive step
by the industry to improve risk management procedures, but more needs
to be done. The program’s scope is limited, as it only governs funds that
choose to enroll. It therefore fails to adequately address liquidity
problems and systemic risk. While such programs are a step in the right
direction, they should not be the end goal of the industry. Nevertheless,
the hedge fund industry’s movement toward self-regulatory standards on
a firmwide level provides hope for the success of a proposal to impose
self-regulatory standards on the entire industry.
I. The Limitations of Self-Regulation via Prime Brokers
An association of brokers that imposes penalties on its members for
failure to follow certain standards must avoid the risk of imposing limits
on leverage that are too strict, such as prematurely withholding credit or
ceasing to execute a fund’s trades.231 For example, if a fund used new
trading strategies or traded in a new type of security, a broker’s model
for credit evaluation could exaggerate the actual risk inherent in the
fund’s portfolio. Prematurely withholding leverage would result in a
situation similar to that preceding the collapse of Amaranth and LTCM,
forcing a fund to sell its assets for less than their true market value.
Despite this concern, the benefits of self-regulatory limits on
leverage outweigh these potential dangers. Uniform standards, strictly
enforced across the industry, would provide advance warning of funds
that are approaching hazardous levels of leverage. Additionally, on
average, a hedge fund is only leveraged at around twice its asset base.232
Restrictions and standards governing leverage and liquidity risk should
only be used in extreme situations (like an Amaranth or LTCM) and
should not impair the vast majority of funds.
Ultimately, an environment that allows the vast majority of funds to
operate unimpaired and to maintain total liquidity, thereby drastically
reducing systemic risk, would be the most beneficial to the hedge fund
industry, brokerages, and the investing public.
Hedge funds benefit the economy in many ways, but they also
present many risk management challenges for the funds, the brokers, and
the market as a whole. Maintaining benefits while limiting risks
requires a balance among many interests. Current regulations fail to
achieve this balance because they inadequately reduce systemic risk.
Recent attempts by both federal and state governments have also failed
to address this risk, and future government regulation may impose
unnecessarily broad rules that would limit the benefits of hedge funds.
Self-regulation at the broker level can properly balance hedge funds’
risks and benefits by quickly evaluating current market conditions and
adjusting accordingly. This regulation must be supported by an
organization with the authority to impose penalties for non-compliance,
neutralizing participating firms’ incentives to unilaterally deviate from
industry standards. An association of brokers offers numerous
advantages to the participating parties, and is likely to find support in the
hedge fund industry.
12. See id. at 5.
13. See id. at 4.
14. Id .
15. Id .
16. Peter Cook & Scott Lanman, Paulson Says Regulators Should Watch Systemic Risk, Investors , BLOOMBERG NEWS , Feb . 22 , 2007 .
17. 2003 REPORT, supra note 6 , at 4.
18. See PRESIDENT'S WORKING GROUP ON FIN . MKTS., HEDGE FUNDS , LEVERAGE, AND THE LESSONS OF LONG-TERM CAPITAL MANAGEMENT A-6 ( 1999 ), available at http://www.treas.gov/press/releases/reports/hedgfund.pdf [hereinafter 1999 REPORT].
19. See id. at A- 7 .
20. 2003 REPORT, supra note 6 , at 5.
21. See Regulation of Hedge Funds, supra note 3.
22. See , e.g., Complaint, San Diego County Employees Ret. Ass'n v . Maounis, No. 07 Civ . 2618 (S.D.N .Y. Mar. 29 , 2007 ).
23. See e.g., Thomas C. Pearson & Julia Lin Pearson , Protecting Global Financial Market Stability and Integrity: Strengthening SEC Regulation of Hedge Funds , 33 N.C. J. INT'L L . & COM . REG. 1 , 36 ( 2007 ).
24. Chan , supra note 3 , at 1.
25. See 1999 REPORT, supra note 18 , at A - 2 .
26. Id .
27. See Desmond Eppel, Risky Business: Responding to OTC Derivative Crises, 40 COLUM. J. TRANSNAT'L L . 677 , 688 ( 2002 ).
28. See BANK FOR INTERNATIONAL SETTLEMENTS, THE JOINT FORUM, THE MANAGEMENT OF LIQUIDITY RISK IN FINANCIAL GROUPS n . 1 ( 2006 ), http://www.bis.org/publ/joint16.pdf.
29. See 1999 REPORT, supra note 18 , at A - 5 .
30. Id .
31. Deloitte's Financial Services Group, Precautions That Pay Off - Risk Management and Valuation Practices in the Global Hedge Fund Industry , MONDAQ, May 3, 2007 , http://www.mondaq.com/article.asp?articleid= 48142 . When a large number of hedge fund advisers are using the same strategy, it is referred to as 'herding' or 'crowded trades .' Id.
32. See JAEGER , supra note 7 , at 153.
33. See Neil Behrmann, Derivatives Trade: Hard to Prepare for the Unexpected, BUS . TIMES, May 2, 2007 , available at 2007 WLNR 8230503; Geithner on Credit Innovations, SEC . INDUS. NEWS, May 28 , 2007 available at 2007 WLNR 10050556; Buffet Warns on Investment 'Time Bomb' , BBC NEWS, Mar. 4 , 2003 , http://news.bbc.co.uk/2/hi/business/2817995.stm.
34. See JAEGER , supra note 7 , at 153.
35. See id. at 138.
36. See id.
37. See ROGER LOWENSTEIN , WHEN GENIUS FAILED: THE RISE AND FALL OF LONGTERM CAPITAL MANAGEMENT 42-43 (Random House, 2000 ).
38. See Matthew Goldstein , A Secret Society: Hedge Funds and Their Mysterious Success , 6 J. INT'L BUS . & L. 111 , 116 ( 2007 ).
39. Registration Under the Advisers Act of Certain Hedge Fund Advisers, Investment Advisers Act Release No . IA-2333, 84 SEC Docket 1032 (Dec. 2 , 2004 ), available at http://www.sec.gov/rules/final/ia-2333.htm [hereinafter Hedge Fund Rule].
61. 2003 REPORT, supra note 6 , at 21.
62. Id .
63. Id . (noting that hedge funds are still not exempt from the antifraud provisions found in the '34 Act) .
64. Id .
65. Id . The SEC changed the definition of a client under § 203(b ) in December 2004 . See infra Part II.F. The new rule was eventually struck down, however, by the D.C. Circuit Court of Appeals. See id .
66. 2003 REPORT, supra note 6 , at 21.
67. 1999 REPORT, supra note 18 , at 10.
68. Id . Convergence trading is “the practice of taking offsetting positions in two related securities in the hopes that the price gap between the two securities will move in a favorable direction.” See id . at 10 n.13. Dynamic hedging is “the practice of managing nonlinear price exposure (i.e., from options) through active rebalancing of underlying positions, rather than by arranging offsetting hedges directly.” See id . at 10 n.14.
69. See LOWENSTEIN , supra note 37, at xix. The fund was run by John W. Meriwether, a bond trader at Salomon Brothers in the 1980's and well-known on Wall Street. See id. The fund also boasted many former professors, Ph.D.'s, and two Nobel Prize winners . See id.
70. Id .
123. Id . at 878.
124. Id .
125. Id .
126. Id . at 884.
127. Id .
128. See id. at 883-84.
129. Gretchen Morgenson & Jenny Anderson , A Hedge Fund's Loss Rattles Nerves , N.Y. TIMES , Sept. 19 , 2006 , at C1.
130. Hedge Fund Rule, supra note 39.
131. Isaac Lustgarten , De Facto Regulation of Hedge Funds Through the Financial Services Industry and Protection Against Systemic Risk Posed by Hedge Funds , 26 No. 10 BANKING & FIN . SERVS. POL'Y REP . 1 , 1 - 2 ( 2007 ).
132. See Craig Torres & Anthony Massucci , Bernanke Backs ' Light' Regulation of Hedge Funds , BLOOMBERG NEWS , Apr . 12 , 2007 (reporting Chairman Bernanke as saying that heavy regulation after the collapse of LTCM “would have increased moral hazard”).
133. See id.
134. Kevin Carmichael , Cerberus's Snow Says 'Lighter' Regulation Best for Hedge Funds , BLOOMBERG NEWS , Oct. 31 , 2006 .
135. See , e.g., Systemic Risk: Examining Regulators' Ability to Respond to Threats to the Financial System: Hearing Before the H . Comm. on Financial Servs., 110th Cong . 1 ( 2007 ) (statement of Barney Frank , Chairman, H. Comm . on Financial Servs.) (“We obviously have the concern about systemic risk . . . [a]nd I have been saying that it seemed to me less important than investor protection .”), available at http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=110_house_hearings&doci d=f: 39903 .pdf.
136. See , e.g., 1999 REPORT, supra note 18 at ii (noting that “the principal policy issue arising out of the events surrounding the near collapse of LTCM is how to constrain excessive leverage . . . [and the resulting] likelihood of a general breakdown in the functioning of financial markets”).
137. See Carmichael, supra note 134.
138. See supra Part I; see , e.g., Judicial Review of Agency Rulemaking, supra note 4 , at 1401 ( noting that government “legislation will almost certainly fail to anticipate future trends”); David Enrich & Arden Dale, Hedge Fund, Regulate Thyself-Could Self-Policing Help Avoid More Government Oversight?, WALL ST . J., Oct . 14 , 2006 , at B4.
139. 15 U.S.C. § 78o- 3 ( 2006 ).
140. United States v. Nat'l Ass'n of Sec . Dealers, Inc., 422 U.S. 694 , 700 n. 6 ( 1975 ).
141. 1999 REPORT, supra note 18 , at 17.
142. Id .
143. See , e.g., Morgan Stanley, Prime Brokerage Services, http://www.morganstanle y.com/institutional/primebrokerage/index. html (last visited Mar . 16 , 2008 ).
144. See 1999 REPORT, supra note 18 , at 25.
145. Id . at B- 7 .
146. Id .
147. Id .
158. See J.W. Verret , Dr. Jones and the Raiders of Lost Capital: Hedge Fund Regulation , Part II , A Self-Regulation Proposal , 32 DEL. J. CORP . L. 799 , 818 ( 2007 ).
159. See Robert G. Bone , Who Decides? A Critical Look at Procedural Discretion, 28 CARDOZO L. REV . 1961 , 1997 ( 2007 ).
160. See Philipp M. Hildebrand , Hedge Funds and Prime Broker Dealers: Steps Towards a “Best Practice Proposal,” FIN . STABILITY REV., April 2007 , at 75, available at http://www.banque-france.fr/gb/publications/telechar/rsf/2007/etud7_ 0407 .pdf.
161. See Robert P. Sieland , Caveat Emptor! After All the Regulatory Hoopla , Securities Analysts Remain Conflicted on Wall Street , 2003 U. ILL. L. REV . 531 , 548 ( 2003 ).
162. Id .
163. See LOWENSTEIN , supra note 37, at 45-46.
164. Id . at 46.
165. The list of LTCM's partners that participated in the Fed-orchestrated bailout of LTCM as a result of their own exposure included Goldman Sachs , Morgan Stanley Dean Witter, Merrill Lynch, Chase Manhattan, JPMorgan, Lehman Brothers, Salomon Smith Barney, and Bankers Trust . Id at xviii.
166. See Pearson & Pearson, supra note 23, at 26.
167. See Judicial Review of Agency Rulemaking, supra note 4 , at 1400. These broad guidelines are usually set out in a fund's prospectus . Id.
168. See 1999 REPORT, supra note 18 , at B - 4 n.21.
169. See , e.g., LOWENSTEIN, supra note 37 , at 155 (“ Because none of [LTCM's] banks had the whole picture, none saw that most of its trades were hedged and tended to offset one another . . . .”).
170. Torres & Massucci, supra note 132 (quoting Federal Reserve Board Chairman , Ben Bernanke).
171. See LOWENSTEIN , supra note 37, at 45-46.
172. See id. at 46.
173. See id.
174. 1999 REPORT, supra note 18 , at 14.
175. Id . at 14-15.
176. See LOWENSTEIN , supra note 37, at 169-70.
177. Judicial Review of Agency Rulemaking, supra note 4 , at 1394.
178. See Lessons from Amaranth Helpful for Clients, INV . NEWS, Oct. 2 , 2006 , available at 2006 WLNR 17341763.
179. See Maggie Shea, Commodities Growth: The Good, the Bad and the Blowups , HEDGEWORLD DAILY NEWS, Feb. 14 2007 , available at 2007 WLNR 2945725.
180. See Ludwig B. Chincarini , The Amaranth Debacle: A Failure of Risk Measures or a Failure of Risk Management? 2 (Apr . 5, 2007 ) (unpublished working paper ), available at http://ssrn.com/abstract=952607.
181. Complaint at 4, San Diego County Employees Ret. Ass'n v . Maounis , No. 07 - CV-2618 (S.D.N .Y. Mar. 29 , 2007 ).
182. See Press Release, Senate Comm. on Homeland Sec. & Governmental Affairs, Investigations Subcomm. Releases Levin-Coleman Report on Excessive Speculation in the Natural Gas Market (June 25 , 2007 ), available at http://hsgac.senate.gov/index.cfm? Fuseaction=PressReleases.View&PressRelease_id=1493& Affiliation=R [hereinafter Levin- Coleman Report].
183. Chincarini , supra note 180, at 25.
184. See id. at 28.
185. See id. at 2. Experts concluded that Amaranth's “fire sale” had an extremely adverse effect on natural gas prices in the United States in 2006 . See Levin-Coleman Report, supra note 182.
186. See Chincarini, supra note 180 , at 20 , 28 .
187. Id . at 23.
188. See id. at 23-24.
189. See id. at 25-26.
190. In the case of a fund that uses multiple prime brokers, the self-regulatory organization could either provide each prime broker with the necessary information to evaluate liquidity at risk, or evaluate a fund's liquidity at risk at the self-regulatory level and then inform the broker if the fund's risk profile exceeded acceptable standards .
191. See 1999 REPORT, supra note 18 , at B - 7 .
192. A similar situation already exists with investment banks. The banks are responsible for maintaining a “chinese wall,” the purpose of which is to prevent the flow of information between the investment banking and research divisions of the companies (in order to prevent certain conflicts of interest) . See Lisa Smith, The Chinese Wall Protects Against Conflicts of Interest , INVESTOPEDIA, http://www.investopedia.com/articles/analyst/090501.asp. While the SEC and banks are constantly working to improve the systems currently in place, the self-regulatory measures set up by the banks have largely been successful . See, e.g., Analyzing the Analysts: Hearing Before the Subcomm. on Capital Markets, Insurance, and Government Sponsored Enterprises of the H . Comm. on Financial Servs., 107th Cong . 70 - 72 ( 2001 ) (statement of Laura S . Unger, Acting Chairman, Securities and Exchange Commission), available at http://financialservices.house.gov/media/pdf/107- 25 .pdf.
193. See supra Part III.A.
194. The short-term gains brokers receive by relaxing credit terms usually comes in the form of increased financing fees, either through increases in volume of lending, or in total clients .
195. See Regulation of Hedge Funds, supra note 3 (noting the need to protect proprietary information of hedge fund traders).
196. See Editorial , Targeting Hedge Funds, WALL ST . J., Oct . 31 , 2006 , at A18; Bill McIntosh, Hedge Funds Work to Address Critics' Concerns, HEDGEWORLD DAILY NEWS , Sept . 26 , 2007 , available at 2007 WLNR 18905748. [hereinafter McIntosh , Critics' Concerns].
197. Fallen Star: The Testimony; Excerpts from Greenspan Remarks Before Congress , N.Y. TIMES , Oct. 2 , 1998 , at C3, available at http://query.nytimes.com/gst/fu llpage. html?res=9B01E6DB1538F931A35753C1A96E958260.
198. See generally Targeting Hedge Funds, supra note 196 , at A18 ; Matt Chambers, Fanning the Flames: An Influx of Hedge Funds is Making Energy Markets More Volatile Than Ever, WALL ST . J., Oct . 16 , 2006 , at R6.
199. See Targeting Hedge Funds, supra note 196 , at A18.
200. Raymond J. Elson & Leonard G. Weld , Carried Interest: What Is It and How Should It Be Taxed?, 77 CPA J. 46, Nov. 1 , 2007 , available at 2007 WLNR 22804390.
201. See , e.g., 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 , 498 ( 2007 ); Sargon Daniel, Hedge Fund Registration: Yesterday's Regulatory Schemes for Today's Investment Vehicles, 2007 COLUM . BUS. L. REV. 247 , 253 - 54 ( 2007 ).
202. Tiffith , supra note 201, at 517.
203. See David Cho & Tomoeh Murakami Tse, Managers of Funds May Face Stiff 211 . McIntosh , Critics' Concerns, supra note 196.
212. See supra Part II.
213. Summons and Complaint, Amaranth LLC v. J.P. Morgan Chase , No. 603756 ( Nov . 13, 1997 ); Katherine Burton, Amaranth Sues JPMorgan for Disrupting Transactions (Update 2), BLOOMBERG NEWS , Nov . 14 , 2007 , available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=acglx.akXLhE.
214. Summons and Complaint, supra note 213, at 5.
215. Id . at 7.
216. Id . at 8.
217. See , e.g., Morgan Stanley Top Prime Broker, HEDGE FUND DAILY , Oct. 24 , 2007 , http://www.institutionalinvestor.com/article.aspx?articleID= 1533465 (reporting that Alpha magazine named Morgan Stanley best overall prime brokerage for the third year in a row).
218. Bill McIntosh , Morgan Stanley Launches LiquidFunds with $200 Million, HEDGEWORLD DAILY NEWS , Aug . 6, 2007 , available at 2007 WLNR 15102398.
219. Id . (quoting Ted Hood, managing director of LiquidFunds) .
220. Id .
221. Id .
222. Id .
223. Id .
224. Id .
232. Adam Shell , Could Hedge Funds Cause Market Meltdown?, USA TODAY, May 18 , 2005 , at 1B, available at http://www.usatoday.com/money/markets/us/2005-05-18 - hedge-funds-usat_x .htm.