NEW YORK — The wild west of hedge funds lives on. Despite having great sway over financial markets, global economies and corporate decision-making, they still won't be regulated.
That's because a federal appeals court overturned a rule that would have brought hedge funds under new supervision by the U.S. Securities and Exchange Commission.
The hedge fund industry is cheering the decision, but no one else should, and that means anyone with investments in public companies, including individual shareholders, pensions or mutual funds.
The now-invalidated SEC rule, which had taken effect on Feb. 1, required most hedge fund managers to register with the SEC, opening up their books to routine inspections by examiners.
That oversight was an outgrowth of the significant boom in the hedge-fund business. While estimates vary on the size of the market, Chicago-based Hedge Fund Research Inc.'s data finds there are nearly 9,000 funds with assets topping well over $1 trillion today, a huge increase from about 600 hedge funds with about $39 billion in assets in 1990.
Hedge funds aren't just for the rich anymore. They have become increasingly popular investment tools that everyone from pension funds to 401(k) plans to endowments use to potentially boost their returns while interest rates are low and stock-market performance hasn't been stellar. Some estimates say hedge funds now account for as much as 20 percent of all U.S. stock trading.
As the business has grown, so has its power. Trading strategies employed by hedge funds are volatile, sophisticated and risky, and because of that, they can greatly influence the markets they are in.
In fact, there is speculation that the recent decline on Wall Street could have much to do with hedge-fund positioning.
Merrill Lynch technical research analyst Mary Ann Bartels wrote in a note to clients this week that the corrective phase that began in mid-May in financial markets, which has since knocked more than 5 percent off of the Standard&Poor's 500 index and the Dow Jones industrial average, was led by hedge funds, namely those that track macro-economic shifts like interest rate policy.
Hedge funds are also being credited with driving much of the booming merger activity worldwide, as they aggressively try to influence corporate managers to do as they see fit through sales and divestitures.
Yet even with the power their wield, hedge funds largely don't have to answer to anyone. That makes them ripe for abuse.
You don't have to look far for examples. In recent years, dozens of funds including Long Term Capital Management, which had two Nobel Prize-winning economists on its staff, and Bayou Group have collapsed due to everything from outright fraud to poor money management.
Just this week, seven current and former NFL players sued the league and its union to recover $20 million they lost in an alleged fraud scheme. They claimed that the union endorsed the services of a hedge fund even though the fund's manager had liens against him.
The SEC rule was an attempt to better police hedge funds by forcing oversight of their strategies and policies. The goal was to give investors more protection.
Too bad a three-judge panel of the U.S. Court of Appeals for the District of Columbia Circuit ruled that the SEC could not require hedge-fund advisers to register with the commission. That decision had nothing to do with whether regulation of hedge funds was a good idea, but centered on a more technical issue over the definition ofclientsfor hedge-fund advisers.
Under securities law, an adviser with more than 15 clients and $30 million under management has to register with regulators. Previously, the hedge funds themselves were considered the funds'clients, not the actual investors in the funds. The new rule changed that to make the investors into the clients.
The court, in its decision Friday, called the SEC rulearbitraryand said the agency failed to make a compelling case for the edict's necessity.
The ruling leaves hedge funds in a regulatory black hole without any rules,said Attorney General Richard Blumenthal of Connecticut, where many hedge funds are based.A measure of transparency would enhance investor confidence in this increasingly important and powerful part of the market, while helping to prevent misconduct from harming consumers and the industry.
Still, the regulation's critics like to point out that it would have given investors false security because they would think that nothing could go wrong since there was regulatory oversight. And as Eliot Raffkind, a partner at Akin Gump Strauss Hauer&Feld LLP, notes, even if the rule was in place, that doesn't mean that the SEC would have had ample resources to watch over every hedge fund.
But wouldn't that be better than not having any checks in place at all?
The SEC has to consider its next move. Among its options is an appeal, which would have to come within 45 days of the court ruling. Congress also could step in, and some legislators are already talking about how to police funds. Or, as Blumenthal said in testimony before Congress this week, thethe states must fill the void if Congress fails to act.
For investors'sake, let's hope that this issue isn't dead.