HEDGING THE GLOBAL MARKET: AVOIDING EXCESSIVE HEDGE FUND REGULATION IN A POST-RECESSION ERA

Jonathan P. Terracciano

TABLE OF CONTENTS

INTRODUCTION ………………………………………………………………………………….….2 I. CURRENT OPERATIONAL AND REGULATORY ENVIRONMENT OF HEDGE FUNDS...........................8 A. Background and Structure of Hedge Funds ………………………….............................8 B. Current Legislation Governing Hedge Funds……………………….……………….....14 1. The Securities Act of 1933…………………………………………………………..…...16 2. The Exchange Act of 1934……………………………………………………..………...17 3. The Investment Company Act of 1940……………………………………………….…19 4. The Investment Advisor Act of 1940………………………………………………..…..21 II. HEDGE FUNDS’ ROLE IN SYSTEMIC RISK, INVESTOR FRAUD, AND MARKET BENEFITS……….. 23 A. Systemic Risk……………………………………….………………………..………...24 1. The Implosion of Long-Term Capital Management & Industry Response………...24 2. Systemic Risk Concerns Misdirected at Hedge Funds Instead of Banks………......28 3. The Future of Systemic Risk: Growing Concerns in Offshore Tax Havens……….33 B. Fraud and Investor Protection…………………..............................................................35 C. Benefits of Hedge Funds in Financial Markets………………………………....………38 III. PROPOSED LEGISLATION REGARDING HEDGE FUND REGULATION ……………………...……47 A. “Hedge Fund Transparency Act of 2009”………………………………………..…….47 B. “Hedge Fund Adviser Registration Act of 2009”……………………………...……….51 C. “Private Fund Transparency Act of 2009”……………………………………...………52 D. “Hedge Fund Study Act”……………………………………………………...………..55 E. “Stop Tax Haven Abuse Act”………………………………………………..…………56 CONCLUSION ……………………………………………………………………………………..58 APPENDIX…………………………………………………………………………………………62

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INTRODUCTION

In the wake of numerous financial institution collapses, there has been an intense public

and political uproar over who is to blame, how these events occurred, and how to prevent these

problems in the future. By 2008, the U.S. financial market witnessed extreme turmoil in the

financial system. The crisis was marred by the collapse of over two hundred banks and financial

institutions, notably Bear Stearns and Lehman Brothers.1 It was also exemplified by a

consolidation of several large national banks. The Federal Reserve’s bailout of Bear Stearns in

the form of a heavily facilitated sale to JP Morgan, along with the virtually forced sale of Merrill

Lynch to Bank of America were major efforts taken by the U.S. officials in trying to restore

financial order. Moreover, the government takeovers of the two mortgage giants, Fannie Mae

and Freddie Mac and insurance giant American International Group (AIG), and the TARP

(“Troubled Asset Relief Program) bailout of the seventy largest national banks, were other

ominous signs of the U.S. economy’s fragile state.2

These events did not resonate well with the public, sparking sharp condemnation amongst

many politicians, investors, and everyday citizens. News headlines such as “U.S. Recession

Worst Since Great Depression”3 and “World’s Wealthy Lose Faith in Fund Managers,”4 aptly

classified the fallout from the market’s turbulence. The crisis was not downplayed by even the

highest ranking politicians, leading President Obama to characterize the economic chaos at the

end of 2008 as a “continuing disaster” for the United States.5 Despite the stock market’s rebound

1 http://www.fdic.gov/bank/individual/failed/banklist.html; Anne Stjern, The Failure of Bear Stearns, Lehman Brothers and AIG: Is Another Great Depression in our Future? Associated Content. Sept. 17, 2008. http://www.associatedcontent.com/article/1043016/the_failure_of_bear_stearns_lehman.html

2 Id. 3 http://www.bloomberg.com/apps/news?pid=20601087&sid=aNivTjr852TI 4http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article6571355.ece 5 BBC News. “Obama Calls Recession a Disaster.” Jan. 30, 2009. http://news.bbc.co.uk/2/hi/business/7860892.stm

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and relative stabilization of major indices such as the Dow Jones, nearly all believe that the

“Great Recession” rolls on.6

The recent failure of several major investment banks and private funds has been both a

cause and consequence of the deep economic recession that has spread across the world.7 In the

United States, the financial sector has been especially ravaged by a series of successive private

fund meltdowns, totaling 1,471 hedge fund failures in 2008, in addition to the bank failures

previously discussed.8 The recent instability of U.S. and international financial markets stemmed

from a combination of factors that has shaken investor confidence in these systems.

The breakdown in market stability and investor confidence can be largely attributed to

loose lending practices and erroneous subprime mortgage valuation in the United States.9

Consequently, many financial institutions were excessively leveraged with debt and held major

positions on overvalued mortgage-backed securities.10 When the subprime mortgage market

began rapidly crashing, institutions holding large amounts of mortgage-backed securities

incurred severe losses, mainly through writedowns. Moreover, financial institutions exercised

mark-to-market writedowns in valuing assets even though they were no actual, tangible asset

losses.11 This especially proved troublesome to the financial institutions that held massive

amounts of assets in the form of collateralized debt obligations (CDOs) and mortgage-backed

6 http://online.wsj.com/article/SB10001424052748703837004575013592466508822.html 7 Volume 56, Number 8 · May 14, 2009 How to Understand the Disaster By Robert M. Solow. http://www.nybooks.com/articles/22655

8 New Record For Hedge Fund Failures. Anita Raghavan , 03.18.09, 09:30 AM EDT 1,471 hedge funds went out of business in 2008. http://www.forbes.com/2009/03/18/hedge-fund-failures-business-wall-street-funds.html.

9 5 B.Y.U. Int'l L. & Mgmt. Rev. 99; Jenny Anderson & Heather Timmons, Why a U.S. Subprime Mortgage Crisis is Felt Around the World, N.Y. TIMES, Aug. 31, 2007, at C1. 10 Id. 11 Id.

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securities.12 In a frozen market where firms were reluctant to lend and buy assets, the mark-to-

market accounting method “require[d] that lenders assign a value to an asset based on its current

market value, as opposed to a more traditional hold-to-maturity model that uses historical income

and other criteria for valuing assets.”13 Thus, huge amounts of level three assets, which include

CDOs and subprime mortgage-backed securities, had to be written down to a fraction of their

original book values as the market for these securities became increasingly illiquid and began to

vanish.14

The “maturity mismatch” of long-term, illiquid assets funding short-term debt put firms,

such as Bear Stearns, in grave danger when a liquidity shock occurred, causing investors to cease

lending.15 Hence, several firms that were relatively solvent, meaning it had enough assets

(though somewhat illiquid) to pay off debts, were damaged because their short-term liquidity

was virtually tapped out. 16 “Liquidity” is characterized as “capital resources necessary to

conduct normal business without disruption.”17 Illiquidity was a huge problem for firms like Bear

Stearns, especially in its finals days before merging with JP Morgan. But the fact that banks had

so many assets tied up in toxic mortgage-backed securities drove fears that many were insolvent

as well. 18 No one knew how much these level three assets were worth and many feared they

could be worth only a fraction of what they were valued at. Thus, bank insolvency concerns

12 Id. 13 Id. 14 Id. 15 Bullard, James. “Systemic Risk and the Macroeconomy: An Attempt at Perspective.” [Speech at Indiana University] 2 October 2008. <http://www.stlouisfed.org/news/speeches/2008/10_02_08.html#_ftn3>. 16 Drum, Kevin. “The Next Step on the Bailout.” Mother Jones 30 September 2008. <http://www.motherjones.com/kevin-drum/2008/09/solvency-vs-liquidity>. 17 Id. 18 Id.

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spread throughout the market from mounting liquidity problems because of these toxic security

assets.19

With the exorbitant level of debt raised to finance these now quasi-worthless (or at best

questionably-valued) securities, the inability to cover losses and debt led to the swift downfall of

many financial institutions and the overall U.S. financial market.20 Ultimately, the collapse of the

U.S. market rippled throughout the world because many international investment funds and

banks held substantial positions in these level three securities from frequent trading with U.S.

counterparties.21

In the aftermath of this financial calamity, much of the public and political criticism has

been directed at hedge funds, based on their huge investments and trading in subprime mortgage-

backed securities.22 Hedge funds, a specific type of quasi-regulated, private investment vehicle

(discussed in depth later), were an obvious scapegoat target due to their high debt leverage ratios

and limited financial transparency to individual investors and institutional counterparties.23 The

high degree of leverage and inability of regulators and counterparties to assess the true, intrinsic

19 Id. 20 http://therealdeal.com/newyork/articles/mark-to-market-makes-a-mess 21 Id. For example, Germany's Deutsche Bank AG announced $3.11 billon in write-downs, with much of the losses stemming from mortgage loans. David Reilly & Edward Taylor, Banks' Candor Makes Street Suspicious, WALL ST. J., Oct. 4, 2007, at C1. Switzerland's Credit Suisse Group also earlier announced $1.1 billion in similar losses, id., while another Swiss bank, UBS, announced $3.41 billion in write-downs, much of which stemmed from losses in securities tied to U.S. subprime mortgages. Jason Singer et al., UBS to Report Big Loss Tied to Credit Woes, WALL ST. J., Oct. 1, 2007, at A1; Boyd, Roddy. “The Last Days of Bear Stearns.” Fortune Magazine 31 March 2008. <http://money.cnn.com/2008/03/28/magazines/fortune/boyd_bear.fortune/index.htm>; Schmerken, Ivy. “Counterparty Risk Is a Top Concern in the Wake of the Credit Crisis.” Advanced Trading 15 September 2008. <http://www.advancedtrading.com/derivatives/showArticle.jhtml?articleID=210601645>. 22 Id. Germany's finance minister, Peer Steinbrueck, charged that “[t]here is a sizable, remarkable number of hedge funds which are not behaving properly on the market.” Somerville, supra note 1. Further elaborating on the risks associated with hedge funds, he asserted that “[n]o expert that I have met up to now could exclude a potential financial crisis caused by all these leveraged impacts of hedge funds.” 23 Leverage is defined as the “use of debt capital in an enterprise or particular financing to increase the effectiveness (and risk) of the equity capital invested therein.” “Leverage also increases the magnitude of failure in addition to making the equity capital invested more effective, and such large failures may cause harm to overall market confidence. Counterparties that trade with hedge funds and parties that provide services to hedge funds may also be harmed. In particular, it is feared that the collapse of a large hedge fund would cause the fund's creditors to become insolvent, creating a cascading effect throughout the market.” Michael Downey Rice, Prentice-Hall Dictionary Of Business, Finance, And Law 208 (1983).

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value of various assets under management make hedge funds a source of concern regarding

systemic risk.24 Also referred to as “contagion,” “systemic risk” is defined as “the danger of

widespread disruption of financial markets and institutions that, in turn, affects the

macroeconomy.”25 It is the “potential that a single event, such as a financial institution's loss or

failure, may trigger broad dislocation or a series of defaults that affect the financial system so

significantly that the real economy is adversely affected.”26

Regulators are also concerned with the recent rise in fraud among private funds that has

hit investors during this period of extreme market vulnerability. Most notably, Bernard L.

Madoff Investment Securities (BLMIS), a New York-based hedge fund defrauded investors over

$50 billion through a “Ponzi scheme,” “an investment fraud that involves the payment of

purported returns to existing investors from funds contributed by new investors.27 More recently,

the Antiguan-based Stanford International Bank (SIB), and its Chairman Sir Allen Stanford, have

been indicted for engaging in a scheme to defraud investors of over $7 billion.28 From SIB’s

practices, and the fact that they shielded themselves from SEC oversight, SEC officials state that

SIB operated like a typical hedge fund opposed to a bank.29 From these two instances of fraud

24 See, e.g., Paul Davies et al., Prosecutors Begin a Probe of Bear Funds, WALL ST. J., Oct. 5, 2007, at C1 (describing the July 2007 collapse of two mortgage-related hedge funds at Bear Stearns after large losses on U.S. subprime mortgages, costing investors $1.6 billion). More recently, Bear Stearns required a bailout after massive losses on subprime mortgage related securities. Robin Sidel et al., The Week That Shook Wall Street: Inside the Demise of Bear Stearns, WALL ST. J., Mar. 18, 2008, at A1. Unlike other bailouts of financial institutions, the Bear Stearns bailout required the Federal Reserve Bank to actually take responsibility for $30 billion in securities on Bear's books. Id. 25 Bullard, James. “Systemic Risk and the Macroeconomy: An Attempt at Perspective.” [Speech at Indiana University] 2 October 2008. <http://www.stlouisfed.org/news/speeches/2008/10_02_08.html#_ftn3>. 26 Hedge Funds and Systemic Risk: Perspectives of the President's Working Group on Financial Markets: Hearing Before the H. Comm. on Financial Servs., 110th Cong. 63 (2007) [hereinafter Testimony of Steel] (testimony of Robert K. Steel, Under Secretary for Domestic Finance, United States Department of the Treasury), available at http://www.treasury.gov/press/releases/hp486.htm. 27 http://www.france24.com/en/20081215-hsbc-faces-1-billion-risk-madoff-scandal-fraud; http://www.sec.gov/answers/ponzi.htm 28 http://www.justice.gov/criminal/vns/caseup/stanfordr.html; Securities and Exchange Commission v. Stanford International Bank, et al., Case No. 3-09CV0298-L (N.D.TX.) 29 Id.

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and hundreds more like it, fraud detection and prevention is a second key goal of regulators. The

failure to detect scandals like these have devastated investor confidence in U.S. regulatory

agencies, such as the Securities and Exchange Commission (SEC) and the Commodities Futures

Trading Commission (CFTC).30

Congress has responded to the crisis with several proposals to overhaul the current

regulatory system governing hedge funds. Most notably are the “Hedge Fund Transparency Act

of 2009” (HFTA),31 “Hedge Fund Adviser Registration Act of 2009” (HFRA),32 “Private Fund

Transparency Act of 2009” (PFTA),33 “Hedge Fund Study Act” (HFSA),34 and “Stop Tax Haven

Abuse Act.”35 In conjunction with these proposed bills that would directly regulate the hedge

fund industry, there are bills on the table that would raise corporate tax rates on U.S. investment

firms that operate domestically, as well as those that operate internationally but have close ties to

the U.S. market.

Proposed legislation aimed at minimizing systemic risk and fraud could unintentionally

bring about a wide departure of U.S. hedge funds into international tax havens, where lax

regulation and oversight allows and could exacerbate these existing threats. Moreover, a mass

exodus of hedge funds would also mean the disappearance of many beneficial impacts on the

U.S. financial market. Legislators and regulators must develop a system that balances efficient

hedge fund regulation that is no more restrictive than needed to minimize systemic risk and

fraud, while permitting the benefits of hedge funds to permeate the market, in order to avoid a

30 http://www.bloomberg.com/apps/news?pid=20601109&sid=afUo_v5lEmwc 31 Hedge Fund Transparency Act of 2009, S. 344, 111th Cong. (2009). 32 Hedge Fund Adviser Registration Act of 2009, H.R. 711, 111th Cong. (1st Sess. 2009). 33 Private Fund Transparency Act of 2009, S. 1276, 111th Cong. (2009). 34 Hedge Fund Study Act, H.R. 713, 111th Cong. (2009). 35 Stop Tax Haven Abuse Act, 111th Cong. (2009).

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mass exodus of U.S. hedge funds into international tax havens, which have become a growing

concern in regards to investor fraud, corruption, and systemic risk.

This paper will examine the current regulatory environment in which hedge funds

operate, and will argue that although the regulatory system is in need of reform, proposed

legislation is unnecessarily restrictive and could actually harm U.S. and international markets.

Part I of this paper will provide information on the background and structure of hedge funds and

discuss the current bodies of legislation governing the hedge fund industry. Part II will examine

possible risks and threats hedge funds pose in the financial market, as well as the benefits they

provide. Part III will address several proposed laws aimed at regulating hedge funds in the

aftermath of the recent global recession. Part IV will recommend only limited additional

regulation through a domestically and globally coordinated effort, that will allow the U.S. hedge

fund industry, and overall financial market, to remain competitive in the global arena. The main

goals of this new regulatory structure will be better mitigating market risk, improving market

integrity, and allowing the benefits of hedge funds to operate and grow in the market.

I. CURRENT OPERATIONAL AND REGULATORY ENVIRONMENT OF HEDGE FUNDS A. Background and Structure of Hedge Funds In today’s highly developed and advanced financial environment, the term “hedge fund”

still invokes perceptions of obscurity and ambiguity, even among the most sophisticated

investors. To this day, the term “hedge fund” lacks a single, universally recognized definition in

the financial world, resulting in various, and sometimes contradicting, definitions of the term.36

36 See, e.g., Staff of the Commission's Division of Investment Management and Office of Compliance Inspections and Examinations, Implications of the Growth of Hedge Funds: Staff Report to the United States Securities and Exchange Commission viii (2003) [hereinafter SEC 2003 Staff Report]; Financial Services Authority (United Kingdom), Hedge Funds and the FSA, Discussion Paper 16, at 8 (2002).

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Although not statutorily defined in the U.S. or abroad, the industry’s generally “accepted

definition is that [hedge funds] are privately offered investment vehicles in which the

contributions of the high net worth participants are pooled and invested in a portfolio of

securities, commodity futures contracts, or other assets.”37

The term “hedge fund” is believed to have been coined back in 1949, referring to a

private investment fund managed by Alfred Winslow Jones under a private partnership

agreement.38 In that fund, Mr. Jones employed a strategy of holding both long and short equity

positions to “hedge” the fund portfolio’s risk against market volatility.39 Moreover, Mr. Jones

pioneered a revolutionary way of charging a “management fee” to investors. Rather than

charging a percent of assets under management, Jones charged a 20% “performance fee” equal to

the fund’s returns.40 This strategy has been widely adopted by the hedge fund industry, where

most hedge funds charge a 15-25% performance fee, in addition to a 2% general management fee

based on the total value of assets held.41

Although the fee structure established by Mr. Jones in 1949 is applied by nearly all hedge

funds today, the investing strategy of “hedging” he employed is not a universal characteristic of

the entire industry. As the hedge fund industry evolved over time, many hedge funds began to

utilize different investment strategies, and some hedge funds even did away with “hedging”

37 Vikrant Singh Negi, Legal Framework for Hedge Fund Regulation. Hedge Funds Consistency Index. Feb. 12, 2010, available at http://www.hedgefund-index.com/s_negi.asp.

38 David A. Vaughn, Selected Definitions of “Hedge Fund.” Comments for the U.S. Securities and Exchange Commission Roundtable on Hedge Funds. May 14-15, 2003, available at http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.htm#footnote_1.

39 Id. 40 Christopher Holt, Performance Fees: As Old as Portfolio Management Itself? Seeking Alpha. Jan 20, 2009 available at http://seekingalpha.com/article/115612-performance-fees-as-old-as-portfolio-management-itself. 41 Id.

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altogether.42 In addition to, or in place of, “hedging,” many current hedge funds draw from a

pool of over twenty-five investing strategies, such as using leverage, derivatives, and arbitraging

by investing in multiple markets.43 A fund need not utilize all these methods to be deemed a

“hedge fund,” but must simply have the capability to engage in them.44 Today, hedge funds are

defined by their organizational structure and mode of operation, rather than by the investing or

financial strategies they employ.45 As more and more hedge funds have taken a purely equity-

based approach to investing without applying any of the aforementioned methods, many “’hedge

funds’ are not actually hedged, and the term has become a misnomer in many cases.”46

Although the investing tactics of hedge funds may have morphed over the last sixty

years, the management and investor structure has primarily remained the same, much like the

original fee structures. U.S. hedge funds are normally organized as limited liability partnerships

(“LLP’s”) or limited liability corporations (“LLC’s”), whereby the fund manager serves as the

general partner (“GP”) and the investors constitute limited partners (“LP’s”).47 Subject to the

limited partnership agreement and the fiduciary duties that apply under both LLP’s and LLC’s,

42 Scott J. Lederman, Hedge Funds, in FINANCIAL PRODUCT FUNDAMENTALS: A GUIDE FOR LAWYERS 11-3, 11-4, 11-5 (Clifford E. Kirsch ed., 2000). Available at http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.htm#footnote_1. 43 JOHN DOWNES AND JORDAN ELLIOTT GOODMAN, BARRON'S, FINANCE & INVESTMENT HANDBOOK 358 (5th ed. 1998). Available at http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.htm#footnote_1; MANAGED FUNDS ASSOCIATION, HEDGE FUND FAQs 1 (2003) 44 Id. 45 Supra note 18: Scott J. Lederman, Hedge Funds, in FINANCIAL PRODUCT FUNDAMENTALS: A GUIDE FOR LAWYERS 11-3, 11-4, 11-5 (Clifford E. Kirsch ed., 2000). Available at http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.htm#footnote_1. 46 WILLIAM H. DONALDSON, CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION, TESTIMONY CONCERNING INVESTOR PROTECTION IMPLICATIONS OF HEDGE FUNDS BEFORE THE SENATE COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS, Apr. 10, 2003, available at http://www.sec.gov/news/testimony/041003tswhd.htm. 47 Shartsis Friese, LLP, U.S. Regulation of Hedge Funds 88 (2005); Gerald T. Lins, Hedge Fund Organization, in Hedge Fund Strategies: A Global Outlook 98, 98 (Brian R. Bruce ed., 2002); Gregory M. Levy & Bernard A. Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res. J., 1997, at 18, available at http:// www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf; Jacob Preiserowicz, Note, The New Regulatory Regime for Hedge Funds: Has the SEC Gone Down the Wrong Path?, 11 Fordham J. Corp. & Fin. L. 807, 812 (2006).

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the general partner (fund manager) in an LLP has near-plenary control over the hedge fund’s

investing activities, notably the overall strategy and debt structure being the two primary

responsibilities.48 As such, under an LLP the general partner will have unlimited liability for any

outstanding debts or obligations in situations where the hedge fund cannot fulfill them.49

Moreover, a hedge fund may pass tax liabilities directly on to investors, known as “flow

through” tax treatment.50 Since the investors are LP’s, making them passive investors with no

direct control over managing the fund’s portfolio, they benefit by only being held liable for

losses to the degree of their investment in sharing in the gains, losses, and income of the fund.51

But on the downside, the LP investors in both LLP’s and LLC’s are afforded only marginal

rights and protection.52

In comparison, when a hedge fund is organized as an LLC, tax liabilities flow through to

investors, in addition to the hedge fund directly incurring tax expenses, known as “double

taxation.”53 Hence, structuring the hedge fund as an LLP is more favorable in terms of tax

liabilities, but an LLC provides one or managing members limited liability where an LLP

imposes unlimited liability upon the GP fund manager.54 Regardless, the fund manager(s) under

either an LLP or LLC are faced with fiduciary duties to their members in conducting operations

and investing for the fund. 55

48 Id. at 90-92. 49 Id. 50 Id. 51 Id. 52 Id. at 91. 53 Id. 54 Id. 55 Id.

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Similar to most other LLP’s and LLC’s in the U.S., hedge funds usually file as an

organization in the State of Delaware.56 Delaware has several distinct benefits tailored to hedge

funds, found nowhere else in the United States.57 First, Delaware provides the most favorable

state tax treatment to hedge funds.58 Second, the Delaware Revised Uniform Limited Partnership

Act (DRULPA) is renown for its lenient and “flexible” LP statutes.59 Third, Delaware allows

“side letters,” which permit hedge fund managers to make supplementary agreements with LP’s

so that they confer additional benefits to specific investors who are preferred over other LP’s.60

From these unique benefits, it is clear why so many hedge funds prefer to file in Delaware rather

than any other state in the U.S..61

The most widespread form of hedge funds that are seen today are organized under a

“master-feeder” organization.62 The “master” fund is formed as a partnership, usually in a “tax

haven” where it is a foreign resident.63 In addition, there are two “feeders,” one being U.S.

domestic feeder for American taxable investors and another feeder for foreign investors or

American investors who are tax exempt.64 The foreign “feeder” is typically organized as a

corporation in a “tax haven,” whereas the U.S. domestic “feeder” is an LLP where income, gains

56 Ron S. Geffner, Delaware--The Hedge Fund Jurisdiction of Choice in the US, Complinet, Feb. 11, 2008, http:// www.hedgefundworld.com/documents/Delawarerev.pdf. 57 Id. 58 Gregory M. Levy & Bernard A. Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res. J., 1997, at 18, available at http:// www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf. 59 Ron S. Geffner, Delaware--The Hedge Fund Jurisdiction of Choice in the US, Complinet, Feb. 11, 2008, http:// www.hedgefundworld.com/documents/Delawarerev.pdf. 60 Id. 61 Gregory M. Levy & Bernard A. Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res. J., 1997, at 18, available at http:// www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf. 62 Martin A. Sullivan and Lee A. Sheppard, Offshore Explorations: Caribbean Hedge Funds, Part I," Tax Notes, Jan. 7, 2008, p. 95 available at http://www.tax.com/taxcom/features.nsf/Articles/35244A221EDD1BF7852573D00071118E?OpenDocument. 63 Id. 64 Id.

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losses, and deductions from investing “flow through” to LP investors.65 Moreover, there is only

one portfolio and one investment vehicle that the fund manager must operate, and income is

allocated to investors based on the amounts of their investments.66

The other, less popular hedge fund structure is known as the “side-by-side” fund.67 There,

U.S. taxable investors form an LLP and have a separate investment vehicle than that of the non-

taxable U.S. investors and foreign investors.68 Though more costly to operate, the “side-by-side”

structure prevents the U.S. taxable investors from adding trade costs to the foreign and non-

taxable U.S. fund while the U.S. domestic fund addresses U.S. tax liabilities.69

65 Id. 66 Id. 67 Id. 68 Id. 69 Id.

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For hedge funds that operate offshore, the “master-feeder” structure is preferred because

it “provides anonymity to investors, blocks exempt investors from being considered owners of

certain kinds of assets, and avoids putting foreign investors directly in a U.S. trade or business

that generates effectively connected income.”70 American and international investors alike are

both enticed off safer, domestic land, into these murky tax havens, which are still skeptically

viewed by many industry experts.71 As we will discuss later, privacy, tax breaks, and higher

returns on investment are the three main factors that attract investors to loosely regulated tax

havens with limited investor protection.72

B. Current Legislation Governing Hedge Funds

70 Id.

71 http://online.wsj.com/article/SB124588728596150643.html. (stating that, “Hedge-fund assets in offshore tax havens such as the Cayman Islands and Bermuda represent more than two-thirds of the roughly $1.3 trillion industry, according to Hedge Fund Research Inc. Of those offshore assets, industry insiders estimate, between $400 billion and $500 billion belongs to U.S. investors, with tax-exempt foundations, endowments and pension funds accounting for about half of that. Investors from outside the U.S. make up the rest.”)

72 Bing Liang & Hyuna Park, Share Restrictions, Liquidity Premium, and Offshore Hedge Funds 3 (Working Paper, Mar. 14, 2008) available at http:// ssrn.com/abstract=967788). (Stating that due to “the tax advantage, offshore investors may collect higher illiquidity premium when their investment has the same level of share illiquidity as the investment of onshore investors. Our results may help explaining why the growth rate has been much higher in offshore funds than in onshore funds (26.4 vs. 15.0 percent per year from 2000 to 2004).”).

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Hedge funds are viewed by many to be largely unregulated compared to other investment

vehicles, such as mutual funds.73 At the state level, “Blue Sky” laws monitoring securities still

exist within each specific state. Under the National Securities Markets Improvement Act of

1996, “Investment advisers which are not registered with the SEC, either because they qualify

for an exemption under the Advisers Act or because they don’t satisfy the assets under

management test of Advisers Act § 203A(a)(1)(A), generally may be deemed ‘investment

advisers.’”74 Thus, such an individual may be required to register as an investment adviser under

a state’s “Blue Sky” laws.75 State “Blue Sky” laws vary across jurisdictions, as some states are

more restrictive on hedge funds than others. For example, Michigan used to prohibit

performance-based compensation fees, which is a key aspect of how hedge fund managers are

compensated.76 At the end of 2009, New York, Massachusetts, and Connecticut have been

dominant state residences for the top one hundred hedge funds, both in terms of sheer quantity

and assets under management.77 None of those states have “Blue Sky” laws that limit or prohibit

performance-based fees and are quite lenient when compared to other state laws.

Although state “Blue Sky” laws have been characterized as “lacking teeth,” hedge funds

and other financial firms are still predominantly governed by several federal securities

regulations.78 The four primary regulations that apply to hedge funds are the Securities Act of

1933, the Exchange Act of 1934, the Investment Company Act, and the Investment Advisor Act

73 Alan L. Kenard, The Hedge Fund Versus the Mutual Fund, 57 Tax Lawyer 133, 133 (2003); see also Tamar Frankel & Lawrence A. Cunningham, The Mysterious Ways of Mutual Funds: Market Timing, 25 Ann. Rev. Banking & Fin. L. 235, 239 (2006). 74 http://www.lexology.com/library/detail.aspx?g=a43ec06b-5249-44f6-8ff7-98906d69a43e 75 Id.. 76 http://www.fosterswift.com/news-publications-Michigan-Securities-Law-Change.html (Michigan’s previous Uniform Securities Act, which was enacted in 1964, was replaced by the new Uniform Securities Act and became effective in October of 2009). 77 http://www.marketfolly.com/2009/05/barrons-hedge-fund-rankings-2009-top.html; http://hedgefundblogman.blogspot.com/2009/08/top-hedge-fund-cities-most-hedge-funds.html (See Appendix). 78 Id.

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of 1940.79 The selected portions of these regulations that follow relate to how hedge funds, and

other similar funds, are presently governed. These four federal securities acts have largely

supplanted individual state “Blue Sky” laws, and are the dominant authority on securities

regulation matters pertaining to financial institutions.80

1. The Securities Act of 1933 (“Securities Act”)

The Securities Act was passed with the intent to provide greater transparency, honesty,

and disclosure on the part of securities firms in issuing initial public offerings (“IPO’s”).81 This

act required firms to register with the Securities and Exchange Commission (“SEC”) securities

that are sold to the public.82 Section 2(1) of the Securities Act defines the term “security” to

include the commonly known debt and ownership interests traded for speculation or investment.

Most notably, securities include “investment contracts,” which have been defined as “a contracts,

transactions, or schemes whereby a person invests his money in a common enterprise and is led

to expect profits primarily from efforts of promoter or a third party, it being immaterial whether

shares in enterprise are evidenced by formal certificate or by nominal interests in physical assets

employed in enterprise.”83 Normally, any firm that makes a public offering of securities will be

required to comply with the registration requirements of the Securities Act.

79 15 U.S.C. §§ 77a-77aa (2000); §§ 78a-78nn (1994); §§ 80a-1-80a-64 (1994); §§ 80b-1-80b-21 (1994). 80 James Cox et al., Securities Regulations 390 (5th ed. 2005) (discussing the limited nature of state “Blue Sky” laws, whereby Congress amended section 18 of the Securities Act of 1933, preempting most state regulations). 81 15 U.S.C. §§ 77a-77aa (2000); Id. §§ 77e, 77aa (mandating firms provide a prospectus, with information about the offering and the issuer such as “a profit and loss statement for not more than three preceding fiscal years” and “a statement of the capitalization of the issuer,” unless the offering is exempted). 82 Id. §§ 77e, 77aa. 83 SEC v. Howey, 328 U.S. 293 (1946) (“The test of an investment contract within Securities Act is whether scheme involves an investment of money in a common enterprise with profits to come solely from efforts of others, and, if test is satisfied, it is immaterial whether enterprise is speculative or nonspeculative or whether there is a sale of property with or without intrinsic value. Securities Act of 1933, §§ 2(1, 3), 3(b), 5(a), 15 U.S.C.A. §§ 77b(1, 3), 77c(b), 77e(a).”)

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However, Section 4(2) of the Securities Act exempts “transactions by an issuer not

involving a public offering.”84 In order to be eligible for this exemption from the registration

requirements, firms must adhere to the restrictions in Rule 506, which provide a safe harbor for

compliance with section 4(2) so long as the firm’s offering is not publicly advertised and no

more than thirty-five purchasers participate in the private offering.85 Moreover, an exempt firm

must offer the securities through a private placement to “accredited investors,” and not through a

solicitation to the general public.86 Often referred to as “sophisticated investors,” “accredited

investors” are generally characterized as having net assets over $1 million or at least $200,000 in

annual income.87 The rule adopts the notion that these wealthy investors have the knowledge,

experience, and financial fortitude to properly address the risks and benefits of private

investments, and can withstand a heavy loss from such an investment.

However, Rule 506 is rather lenient in the sense that the issuing firm is not required to

count the number of accredited investors towards the thirty-five investor limit, and essentially

has no limit on the amount of accredited purchasers they can accept. 88 Though, section 4(2) of

the Securities Act doesn’t allow hedge funds to be exempt from anti-fraud provisions of section

12 and section 17 of the Securities Act. These provisions guard against misrepresentation,

misleading statements, omissions, and deceitful solicitations to investors, by imposing civil

liabilities on funds and/or their employees for engaging in any of these fraudulent practices. 89

2. The Exchange Act of 1934 (“Exchange Act”)

84 15 U.S.C.A. §§ 77d(2). 85 17 C.F.R. § 230.506 (2007). 86 Id. 87 17 C.F.R. § 230.501(a) (2007). 88 Id. § 230.506(b)(2)(ii) 89 15 U.S.C. § 77d(12-17) (2000)

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Congress sought to regulate securities on the secondary securities market when it passed

the Exchange Act in 1934. Congress’ goals were similar to its goals in passing the Securities Act,

which regulated IPO’s, but instead focused on reducing the risk of fraud, price manipulation, and

speculation in the resale of securities when it passed the Exchange Act.90 The Exchange Act

requires securities “dealers” to register with the SEC.91 Under section 3(a)(5) of the Exchange

Act, a “dealer” is defined as “any person engaged in the business of buying and selling securities

for such person's own account through a broker or otherwise.”92 But most hedge funds avoid

registration by positioning themselves as “traders,” “a person that buys and sells securities, either

individually or in a trustee capacity, but not as part of a regular business.”93

Moreover, the SEC requires registration of “equity securities” under Section 12(g) of the

Exchange Act under two different circumstances.94 First, if the equity securities are traded on an

exchange they must be registered with the SEC.95 Second, securities must be registered if the

issuer has at least five hundred (500) holders of record of a non-exempted class of equity security

and over $1 million in assets by fiscal year end (unless the issuance meets one of the

exemptions).96 In either of these two scenarios, the securities issuer is required to adhere to

periodic reporting requirements, proxy requirements, short swing profit provisions, and insider

trading restrictions (which applies to all securities, whether registered, exempt, or otherwise).97

90 Elizabeth Killer and Gregory A. Gehlman, Comment, A Historical Introduction to the Securities Act of 1933 and the Securities Exchange Act of 1934, 49 Ohio St. L.J. 329, 348 (1988). 91 15 U.S.C. §§ 78a-78nn (1994). 92 Id. § 78c(a)(5)(A). 93 Staff Report to the United States Securities and Exchange Commission, Implications of the Growth of Hedge Funds 3 (2003) [hereinafter Staff Report]; 15 U.S.C. §§ 78a-78nn (1994); Hedge funds are not dealers under the trader exemption, which excludes “funds that do not buy and sell securities as part of a regular business.” Id. (citing 15 U.S.C. § 78c(a)(5)(B) & Supp. IV 2004). 94 Id. I§ 78l(g). 95 Id. 96 15 U.S.C. § 78l-(g); 17 C.F.R. § 240.12g-1 (2008). 97 Id. § 78m; 15 U.S.C. § 78o.

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However, the majority of hedge funds will intentionally structure themselves with at most 499

holders of record in order to avoid these requirements (except insider trading restrictions).

Hedge funds may also be required to file reporting and proxy disclosures to the SEC if it

is beneficially owned by one person, where a person owns at least 5% of the fund, or where the

fund has “beneficial ownership” of another company amounting to at least 10% hedge fund

ownership of said company.98 “Beneficial ownership” also entails “any person who, directly or

indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or

shares: (1) Voting power which includes the power to vote, or to direct the voting of, such

security; and/or, 2) Investment power which includes the power to dispose, or to direct the

disposition of, such security.”99 In addition, if a hedge fund manager holds or manages over

$100 million in equity securities, she would be required to disclose positions on a quarterly basis

and keep current ownership records, under section 13(f).100

Despite the various restrictions and regulations imposed on hedge funds and their

managers under the Exchange Act, there are sufficient exemptions and safe harbors to allow

hedge funds to evade SEC registration filings.

3. The Investment Company Act of 1940 (“Company Act”)

The Company Act is perhaps the most valuable source of disclosure and filing

exemptions for hedge funds, which allow them to operate largely out of the regulators’ reach.101

The Company Act was initially aimed at enhancing investment company disclosures, curbing

98 17 C.F.R. § 240.13d (2007); 15 U.S.C. § 78m (2000 & Supp. IV 2004). 99 17 C.F.R. § 240.13d-3(a).

100 Id. § 240.13f-1. 101 15 U.S.C. §§ 80a-1 to 80a-64 (2006).

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self-dealing and conflicts of interests, curtailing excessive fees, and preventing fraud.102 An

“investment company” is defined as an issuer that “holds itself out as being engaged primarily,

or proposes to engage primarily, in the business of investing, reinvesting, or trading in

securities.”103 Firms that are deemed “investment companies” are subject to extensive regulation

in multiple areas of business practice.104 Most notably, the Company Act regulates an investment

company’s structure and areas of corporate governance, the degree of leverage (maximum 33%

debt level of total assets), discretion in corporate asset valuation, share sales and redemptions,

the character of investments, and its relationships with other market entities.105

Based on the definition of “investment company,” hedge funds exhibit characteristics that

would make them likely candidates for regulation under the Company Act.106 However, hedge

funds are eligible for regulatory exemption under the Company Act through either section

3(c)(1) or 3(c)(7) of the Act.107 The 3(c)(1) exemption to regulation exists where an “issuer

whose outstanding securities...are beneficially owned by not more than one hundred persons and

which is not making and does not presently propose to make a public offering of its securities” is

not an investment company.108 In addition, hedge funds can also fall under the 3(c)(7) exemption

where “any issuer, the outstanding securities of which are owned exclusively by persons who, at

the time of acquisition of such securities, are qualified purchasers, and which is not making and

102 Id. at 27. 103 Investment Company Act § 3(a)(1)(A), 15 U.S.C. § 80a-3 (2000 & Supp. IV 2004). 104 Marcia L. MacHarg, Waking Up to Hedge Funds: Is U.S. Regulation Really Taking a New Direction?, in Hedge Funds: Risks and Regulation 55, 61 (Theodor Baums & Andreas Cahn eds., 2004). 105 Houman B. Shadab, Fending for Themselves: Creating a U.S. Hedge Fund Market for Retail Investors, 11 N.Y.U. J. Legis. & Pub. Pol'y 251, 311 (2008) (discussing that the Company Act is improper for regulating hedge funds, since they would face restrictions in using leverage to invest in lilliquid assets. See 15 U.S.C. § 80a-18(f); Willa E. Gibson, Is Hedge Fund Regulation Necessary?, 73 Temp. L. Rev. 681, 694 n.99 (2000); Gordon Altman Butowski Weitzen Shalov & Wein, A Practical Guide to the Investment Company Act 30-31 (1993). 106 Id. 107 15 U.S.C. § 80a-3 (2000 & Supp. IV 2004); 15 U.S.C. 80a-2(a)(51) (2000 & Supp. IV 2004). 108 Investment Company Act § 3(c)(1), 15 U.S.C. § 80a-3 (2000 & Supp. IV 2004).

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does not at that time propose to make a public offering of such securities.”109 The Company Act

defines “qualified purchaser” as any “individual who own over $5 million in investments,

institutional investors who own $25 million investments, and a family-owned company that

owns $5 million in investments.”110

Although the Company Act does not restrict the number of “qualified purchasers” that

may be in a fund, most astute hedge funds will not accept more than 499 investors, so as not to

violate the Exchange Act's provisions.111 As we have seen, many of these regulations overlap

each other and have implications on firms trying to minimize regulation.

4. The Investment Advisers Act of 1940 (“Advisers Act”)

The Advisers Act was aimed at combating abusive practices by investment advisers,

which may have played a role in the stock market crash leading to the Great Depression.112

Under the Advisors Act, “investment adviser” is defined as “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.”113 A hedge fund manager who falls under this classification is required to register

with the SEC, as well as disclose basic information to current and potential clients.114 Most

notably, an investment adviser is obligated to disclose the fee structure, whether the structure can 109 Investment Company Act of 1940, 15 U.S.C. §§ 80a-1-80a-64 (1994), § 80a-3(c)(7)(A). 110 Id. at § 80a-2a(51)(A). 111 15 U.S.C. § 78l-(g); 17 C.F.R. § 240.12g-1 (2008); Staff Report to the United States Securities and Exchange Commission, Implications of the Growth of Hedge Funds 3 (2003) [hereinafter Staff Report]. 112 Investor Advisers Act, 15 U.S.C. § 80b-1 et seq. (2000); Richard S. Cortese, Overview of the Adviser's Act, in Lipper HedgeWorld Annual Guide 113 (2005); SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 187 (1963) (quoting SEC, Investment Trusts and Investment Companies, H.R. Doc. No. 76-477, at 28 (1939)), acknowledging that “conflicts of interest... might incline an investment adviser--consciously or unconsciously--to render advice which was not disinterested.” Id. at 191; Stuart A. McCrary, How to Create and Manage a Hedge Fund: A Professional's Guide 7 (2002). 113 15 U.S.C. § 80b-2(a)(11). 114 17 C.F.R. § 275.204-3(a) (2008).

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be negotiated, the character of the adviser's services, current client base, and any conflicts of

interest that may arise on account of the adviser's business activities.115 The Advisers Act also

generally prohibits performance-based compensation, although a registered adviser may charge a

performance fee under the guidelines set forth in section 3(c)(7) of the Company Act or if all the

fund's investors are qualified clients. In addition, the Adviser Act requires the adviser to submit

to periodic SEC examinations and maintain current books and records for these examinations.116

The heavy majority of hedge fund managers have been exempted from being declared an

“investment adviser” by relying on section 203(b) of the Advisers Act. That section excludes

“any investment adviser who during the course of the preceding twelve 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 adviser to any investment company registered. . . .”117 What’s

more beneficial for hedge fund advisers is that Section 203(b) counts a “legal organization” (i.e.

a hedge fund) as only one, single client.118 Thus, hedge fund advisers can manage up to fourteen

funds before they are required to file registration with the SEC as an investment adviser.119

Together, the current statutory framework allows hedge funds to escape registration and

most government oversight. The weak regulatory framework, coupled with poor market

discipline and foresight of fund managers and investors alike, seems to have made hedge funds a

popular scapegoat for the recent financial crisis. However, the shortcomings of these regulations

can be easily fixed in a de minimis manner, so as not to ruin an industry on the rebound or cause

a mass exodus to offshore tax havens. The next sections will identify the strengths and problems

of hedge funds in the market, and assess how best to tailor portions of proposed legislation, along

115 Tamar Frankel & Clifford E. Kirsch, Investment Management Regulation 85?87 (2d ed. 2003). 116 15 U.S.C. § 80b-5(a)(1); 17 C.F.R. § 275.205-3(d)(1); Id. § 80b-3(c). 117 Id. § 80b-3(b)(3). 118 17 C.F.R. § 275.203(b)(3)-1(2)(i). 119 15 U.S.C. § 80b-3(b)(3).

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with using diplomatic means and establishing a more aligned, unified regulatory foundation, to

mitigate the risks of hedge funds while allowing their strengths to permeate U.S. and global

financial markets.

II. HEDGE FUNDS’ ROLE IN SYSTEMIC RISK, INVESTOR FRAUD, AND MARKET BENEFITS There are several schools of thought regarding the significance of hedge funds in

financial markets. Arguments supporting and criticizing the hedge fund industry have been

staunchly voiced among legislators, regulators, investors, and various financial institutions for

years. As the U.S. struggles to climb out of deep economic recession that continues to plague

financial markets still littered with thousands of fraud cases, hedge funds have been the target of

scrutiny due to their lack of transparency.120 However, a closer inspection of hedge funds will

reveal many benefits they provide to the U.S. financial market that allow the U.S. firms to

effectively compete with foreign firms.121 Moreover, much hedge fund criticism is misdirected

and disproportionate to the harm actually caused by the industry throughout this period of

financial instability.122 Ultimately, the strengths and shortcomings of hedge funds in the U.S.

hinge on the industry’s ties to global markets and the varying regulations across different types

of financial institutions.

120 Dan Margolies, “Obama Budget Seeks More to Fight Financial Fraud.” Reuters, Feb. 1, 2010. http://www.reuters.com/article/idUSN0120695420100201. (“U.S Attorney General Eric Holder said in a speech [in February 2010] that the Justice Department was moving forward on more than 5,000 pending financial institution fraud cases and the FBI was investigating more than 2,800 mortgage fraud cases -- up nearly 400 percent from five years ago.”) 121 Hedge Funds and Systemic Risk: Perspectives of the President's Working Group on Financial Markets: Hearing Before the H. Comm. on Financial Servs., 110th Cong. 63 (2007) [hereinafter Testimony of Steel] (testimony of Robert K. Steel, Under Secretary for Domestic Finance, United States Department of the Treasury), available at http://www.treasury.gov/press/releases/hp486.htm. 122 See Bd. of Governors of the Fed. Reserve Sys., Flow of Funds Accounts of the United States: Flows and Outstandings Third Quarter 2007 (Dec. 6, 2007), available at http://www.federalreserve.gov/releases/z1/20071206/z1.pdf.

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A. The Impact of Hedge Funds on Systemic Risk

The fundamental purpose behind regulating financial institutions is to mitigate “systemic

risk.”123 Furthermore, champions of increasing hedge fund regulation also cite this purpose as

justification for regulatory overhaul.124 “Systemic risk,” or “contagion,” is commonly defined as

the “potential that a single event, such as a financial institution's loss or failure, may trigger

broad dislocation or a series of defaults that affect the financial system so significantly that the

real economy is adversely affected.”125 More generally, it is “the danger of widespread

disruption of financial markets and institutions that, in turn, affects the macroeconomy.”126

1. The Implosion of Long-Term Capital Management & Industry Response

It wasn’t until 1998, when a hedge fund called Long-Term Capital Management (LTCM)

imploded, that regulators began to take a closer look at hedge funds’ impact on systemic risk.127

LTCM was a once highly-regarded hedge fund, founded in 1994 by several financiers who

received Nobel Prizes in economics.128 LTCM took on a highly aggressive arbitrage strategy by

investing in government bonds in order to capitalize on small spreads, most notably in Russian

bonds.129 LTCM pursued an intense arbitrage strategy based on their forecast that the spread

123 Hedge Funds and Systemic Risk: Perspectives of the President's Working Group on Financial Markets: Hearing Before the H. Comm. on Financial Servs., 110th Cong. 63 (2007) [hereinafter Testimony of Steel] (testimony of Robert K. Steel, Under Secretary for Domestic Finance, United States Department of the Treasury), available at http://www.treasury.gov/press/releases/hp486.htm. 124 Id. 125 Id. 126 Bullard, James. “Systemic Risk and the Macroeconomy: An Attempt at Perspective.” [Speech at Indiana University] 2 October 2008. <http://www.stlouisfed.org/news/speeches/2008/10_02_08.html#_ftn3>. 127 Symposium, Crisis in Confidence: Corporate Governance and Professional Ethics Post-Enron, 35 Conn. L. Rev. 1097, 1107 (2003) [hereinafter Crisis in Confidence] 128 Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management 31, 32 (Random House 2000). 129 PRESIDENT'S WORKING GROUP ON FIN. MKTS, HEDGE FUNDS, LEVERAGE, AND THE LESSONS OF LONG-TERM CAPITAL MANAGEMENT, 11 (1999) available at http:// www.ustreas.gov/press/releases/reports/hedgfund.pdf (“Approximately 80 percent of the LTCM Fund's balance-sheet positions were in government bonds of the G-7 countries (viz., the United States, Canada, France, Germany, Italy, Japan, and the United Kingdom).”) [hereinafter PRESIDENT'S WORKING GROUP].

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between bond returns would narrow between industrialized and developing nations.130 However,

LTCM’s forecasts proved to be wrong when Russia underwent a massive debt restructuring,

thereby devaluing its currency.131 This move by Russia would not, in and of itself, have put

LTCM at risk for failure. LTCM had always had high leverage ratio of 25-to-1, which did not

alarm investors up until this point.132 But when Russia restructured its debt and the spread on

bonds increased, LTCM’s leverage ratio skyrocketed to 500-to-1 when the value of the assets

they held plummeted.133 LTCM continued to crumble in the period directly after Russia’s

restructurinng, losing $4.4 billion in less than a month.134 The New York Federal Reserve Bank

finally stepped in and organized a $7 billion bailout of LTCM with fourteen other banks and

funds.135 The Federal Reserve Bank of New York felt that if it did not facilitate a bailout, an

LTCM default could pose a series of cascading financial institution failures that LTCM did

business with.136 With off-balance sheet liabilities over $1 trillion in the form of futures, interest

rate swaps, and over-the-counter (OTC) derivatives, LTCM’s inability to meet counterparty

obligations could have decreased the liquidity of these investments in the market.137 Soon after,

the market price on these investments would plunge, as other firms would be forced to either 130 Joseph G. Haubrich, Some Lessons on the Rescue of Long-Term Capital Management (Federal Reserve Bank of Cleveland, Policy Discussion Paper No. 19, 2007). 131 FIN. SERV. AUTH., HEDGE FUNDS AND THE FSA 8 (2002), available at http://www.fsa.gov.uk/pubs/discussion/dp16.pdf; see also FRANÇOIS-SERGE LHABITANT, HEDGE FUNDS: MYTHS AND LIMITS 12-21 (2002) 132 PRESIDENT'S WORKING GROUP supra note 10, available at http:// www.ustreas.gov/press/releases/reports/hedgfund.pdf (for basis of comparison “[a]t year-end 1998, the five largest commercial bank holding companies had an average leverage ratio of nearly 14-to-1, while the five largest investment banks' average leverage ratio was 27-to-1.”). 133 Id. 134 Joseph G. Haubrich, Some Lessons on the Rescue of Long-Term Capital Management (Federal Reserve Bank of Cleveland, Policy Discussion Paper No. 19, 2007). 135 PRESIDENT'S WORKING GROUP, supra note 10, at 17 (“LTCM itself estimated that its top 17 counterparties would have suffered various substantial losses—potentially between $3 billion and $5 billion in aggregate — and shared this information with the fourteen firms participating in the consortium. The firms in the consortium saw that their losses could be serious, with potential losses to some firms amounting to $300 million to $500 million each.”). 136 Id. 137 U.S. Gen. Acct. Off., Long-Term Capital Management Regulators Need to Focus Greater Attention on Systemic Risk 7 (1999), available at http:// www.gao.gov/archive/2000/gg00003.pdf.

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hold on to sharply declining assets and eventually collapse or liquidate their holdings before

prices dropped even further.138 The inability of one major player, LTCM, to meet its obligations

to its seventeen main counterparties would have resulted in up to $5 billion in aggregate

losses.139 From there, the total potential losses for the counterparties of LTCM’s counterparties

would’ve ballooned to catastrophic levels that could’ve crippled the entire U.S. financial system,

and perhaps even foreign ones.140

Although the LTCM collapse provides a grim, historical example of hedge funds’

potential impact on systemic risk, many positives came out of that incident. Stemming from this

event, the Presidential Working Group was formed.141 The Group is responsible for gathering

more vital, up to date information on hedge funds and making recommendations to the

industry.142

U.S. Treasury Secretary, Timothy Geithner offered a positive, though objective,

assessment on the hedge fund industry since the LTCM debacle in 1998.143 While he was

President and CEO of the Federal Reserve Bank of New York, Geithner noted that average

hedge fund leverage ratios and systemic risk posed by hedge funds have changed for the better

since the 1998 implosion of LTCM.144 Moreover, Geithner proffered five key factors that

evidenced a more stable hedge fund industry and financial market: (1) the total number of hedge

funds has increased greatly, along with total assets under management; (2) increased

138 Id. 139 PRESIDENT'S WORKING GROUP, supra note 10, at 17. 140 Id. 141 President's Working Group on Financial Markets, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management 1 (1999) [hereinafter Working Group Report I], available at http:// www.treasury.gov/press/releases/reports/hedgfund.pdf (the Group consists of officials from the SEC, CFTC, the Federal Reserve Bank, and the U.S. Treasury Department). 142 Id. 143 Timothy F. Geithner, President & CEO, Fed. Reserve Bank of N.Y., Keynote Address: Hedge Funds and Their Implications for the Financial System (Nov. 17, 2004) (transcript available at http:// www.ny.frb.org/newsevents/speeches/2004/gei041117.html). 144 Id.

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diversification of credit exposure by counterparties and lenders; (3) enhanced risk management

practices among hedge funds, counterparties, and lenders; (4) banks' capital relative to risk has

remained constant; and (5) improved infrastructure for clearing and settlements, whose systems

can handle greater trade volumes and are more durable in periods of stress.145 Finally, Geithner

provided a positive outlook on the hedge fund industry, when he expressed that the “U.S.

financial system today is significantly stronger than it was in 1998…. And there is some

evidence that hedge funds have helped contribute to this resilience, not just in the general

contribution they provide by taking on risk, but as a source of liquidity in periods of increased

stress and risk aversion in the rest of the financial system.”146

However, these encouraging statements were tempered with recommendations to

continuously improve investing strategy, due diligence, diversification, risk management,

disclosure, and leverage practices.147 Nevertheless, Geithner and most top officials agree that

hedge funds and their counterparties have adapted quite well since 1998 and are better equipped

to avoid or withstand a crisis similar to what LTCM experienced, but without the need for

Federal Reserve bailouts.148

Systemic risk concerns regarding hedge funds seem to have died down after the industry

and regulators learned several valuable lessons following LTCM’s demise. However, hedge

funds still carry the stigma of posing a grave systemic risk to the economy, which is largely

misplaced.149 For example, the vast majority of credit default swaps (CDSs) hedge funds traded

with banks were not written on toxic underlying securities (i.e. defaulted or subprime

145 Id. 146 Id. 147 Id. 148 Id. 149 Houman Shadab, Don’t Blame all the Shadow Banks, CBS Money Watch, Apr. 13, 2009. (available at: http://moneywatch.bnet.com/economic-news/blog/blog-war/dont-blame-the-shadow-banks/295/).

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mortgages).150 The reality is that hedge funds and the CDSs they traded to banks did not cause

the collapse of financial institutions, because it was the potential for these securities’ misuse and

abuse which the banks took advantage that led to the collapse.151 Since it is readily apparent that

these derivative securities are more likely to be abused by banks, new rules should ensure that

regulated companies, such as banks, trade and value them appropriately.152

2. Systemic Risk Concerns Misdirected at Hedge Funds Instead of Banks

An example that elucidates how hedge funds have suffered excessive, unsubstantiated

criticism that should be directed elsewhere can be seen in bank failures like Bear Stearns. In

2007, Bear Stearns began taking on a highly aggressive debt structure. The bank took on a

leverage ratio of nearly 33.2 to 1, with $11.1 billion in tangible equity backing $395 billion in

assets.153 This highly leveraged structure embodied a relatively high level of risk for the firm,

evidenced by the fact that it was highest of any brokerage firm, and that most commercial banks

have an average leverage ratio of 10 to 1.154 Just a few years earlier, this leverage structure

would have violated SEC regulations, which then required a maximum debt to net capital

(equity) of 15 to 1. But in 2004, the “Consolidated Supervised Entities Program” abolished this

maximum standard, along with revoking minimum capital requirements in case of asset

150 Id. (“It was solely American International Group’s (AIG’s) CDSs written on structured mortgage-related securities held by banks that led to the collateral calls ruinous to AIG and the federal bailout. Those CDSs made up only about 10 percent of AIG’s total CDS obligations at the beginning of 2008. But the Office of Thrift Supervision, which oversaw AIG, failed to prevent the company’s subsidiary from selling too many CDSs. To best prevent the over-concentration of CDS risk of the type that occurred with bond issuers and AIG, regulation should seek to limit the use of CDSs when sold by insurance companies or their unregulated subsidiaries and affiliates.”) 151 Id. (“The main problem with CDSs, which allow any party to sell protection against credit risks that the buyer may be exposed to, was that they allowed banks and insurance companies to concentrate too much mortgage-backed security risk in their portfolios.”) 152 Id. 153 Boyd, Roddy. “The Last Days of Bear Stearns.” Fortune Magazine 31 March 2008. <http://money.cnn.com/2008/03/28/magazines/fortune/boyd_bear.fortune/index.htm>. 154 Id.

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defaults.155 Bear Stearns’ exploitation of these repealed standards propelled it on a path to self-

destruction. What’s more disturbing was that Bear Stearns was carrying over $28 billion in

“level 3” assets, where valuation is based on non-observable market assumptions and relied

heavily on internal information to asses fair value. 156 These types of assets they carried were

highly illiquid, and put the bank at risk for owning assets worth next to nothing.

With a net equity of $11.1 billion and $395 billion in assets, the highly leveraged bank

was even more at risk because of their heavy involvement in Collateralized Debt Obligations

(“CDOs”), which were heavily backed by subprime mortgages. As the real estate market

plummeted and the mortgage default rate skyrocketed, Bear Stearns was forced to make major

value write-downs on these mortgage-backed security assets. Just a few years prior, Bear Stearns

was able to succeed under a highly leveraged debt structure. However, as assets began to

plummet in value and more debt was accrued, the risks of having such a high leverage ratio

began to precipitate.157 In June of 2007, troubles continued to mount when “Bear had to come up

with over $3 billion to bail out one of its funds that was dabbling in CDOs. Incredibly these

funds were seized at the time by Merrill Lynch for $850 million who was only able to get $100

million for them on the auction block.”158

Bear Stearns continued to break down at an exponential rate, when at the end of 2007 it

was forced to write-down an additional $1.2 billion in mortgage backed securities. Bear Stearns’

credit was so poor in its final stages before the merger, that it was even denied a $2 billion

securities-backed repurchase loan (“repo” loan). One market analyst aptly characterized how

155 Protess, Ben. “’Flawed’ SEC Program Failed to Rein in Investment Banks.” Propublica 1 October 2008. <http://www.propublica.org/article/flawed-sec-program-failed-to-rein-in-investment-banks-101>. 156 Pittman, Mark. "Bear Stearns Fund Collapse Sends Shock Through CDOs.” Bloomberg 21 June 2007. <http://www.bloomberg.com/apps/news?pid=20601087&sid=a7LCp2Acv2aw&refer=home>. 157 Id. 158 “The Rise and Fall of the Mighty Bear.” My Budget 360 17 March 2008. <http://www.mybudget360.com/bear-stearns-the-rise-and-fall-of-the-mighty-bear/>.

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severe this credit issue was for Bear Stearns: “Being denied such a loan is the Wall Street

equivalent of having your buddy refuse to front you $5 the day before payday. Bear executives

scrambled and raised the money elsewhere. But the sign was unmistakable: Credit was drying

up.”159 Consequently, fears over liquidity and Bear Stearns’ ability to meet its debt obligations

sparked intense naked short-selling of Bear Stearns stock, which drove the price down from

highs of over $100/share in 2007-2008, to $30/share.160 The run on Bear Stearns stock, fueled by

rumor and speculation, resulted in a 47% decline (closing at $30 per share) in stock price in one

day just prior to merger. 161

The type of business transactions Bear Stearns was involved in directly and indirectly

exposed a wide range of institutions to risk. First off, Bear Stearns was a major counterparty to

CDSs. It held notional amounts of $13.4 trillion at the end of 2007, with $1.85 trillion of that

amount consisting of futures and option contracts with other counterparties. 162 These derivative

instruments are used as an insurance policy for debt holders, in the event that the issuer defaults

on payment. The systemic risk these transactions posed, which the Federal Reserve Bank sought

to eliminate, could bring down other banks, just like Bear Stearns. Prior to the buyout in March,

information circulated in the market that hedge funds were reassigning their CDS positions with

Bear Stearns to other firms. Many hedge funds had grown weary of the problems facing Bear

Stearns and did not want to take the risk of being counterparties to its trades. Perpetuated by fear

and rumors, CDS reassignments snowballed as many other funds and dealers pulled their trades

159 Boyd, Roddy. “The Last Days of Bear Stearns.” Fortune Magazine 31 March 2008. <http://money.cnn.com/2008/03/28/magazines/fortune/boyd_bear.fortune/index.htm>. 160 Matsumoto, Gary. “Bringing Down Bear Began as $1.7 Million of Options.” Bloomberg 11 August 2008. <http://www.bloomberg.com/apps/news?pid=20601109&sid=aGmG_eOp5TjE&refer=home>. 161 Id. 162 Boyd, Roddy. “The Last Days of Bear Stearns.” Fortune Magazine 31 March 2008. <http://money.cnn.com/2008/03/28/magazines/fortune/boyd_bear.fortune/index.htm>.

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with Bear Stearns.163 Because 22% of Bear Stearns funding consisted of payables, deposits by

its Hedge Fun customers, these major withdrawals resulted in a lack of funding for Bear Stearns.

These banks fund their long-term illiquid investments, with short-term debt. The fact that

Bear Stearns held such thin capital margins made them highly vulnerable to an abrupt cessation

in short-term lending. This was a driving force behind Bear Stearns’ collapse, as the bank could

not acquire enough funding to manage its operations. The “maturity mismatch” of asset and

liabilities put Bear Stearns in grave danger when a liquidity shock occurred, causing investors to

cease lending. The Federal Reserve Bank sought to mitigate other firms’ risk of encountering

this liquidity problem by trying to maintain the flow of lending within the banking industry. 164

The bankruptcy of Bear Stearns would not only adversely affect the entities it directly

conducted business with, but other institutions that it bore no direct relationships or transactions

with. In most other competitive industries, the failure of one firm would allow the other existing

competitors to pick up market share and grow after it picked up the pieces from the fallout.

However, the institutional structure of the banking industry causes even relatively smaller

players, like Bear Stearns, to have extensive connections with other entities and markets. 165

With Bear Stearns, settlement risks began to appear as it began to crumble, which only

would have exacerbated the problems already plaguing the market. Settlement risk is “the risk

that one party to a financial transaction will default after the other party has delivered.”166 The

concern was that the cumulative effects of these settlement risks could amount to a systemic risk.

Parties that didn’t directly do business with Bear Stearns could be affected from their

163 Schmerken, Ivy. “Counterparty Risk Is a Top Concern in the Wake of the Credit Crisis.” Advanced Trading 15 September 2008. <http://www.advancedtrading.com/derivatives/showArticle.jhtml?articleID=210601645>. 164 Id. 165 Id. 166 Bullard, James. “Systemic Risk and the Macroeconomy: An Attempt at Perspective.” [Speech at Indiana Unversity] 2 October 2008. <http://www.stlouisfed.org/news/speeches/2008/10_02_08.html#_ftn3>.

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relationships with third-parties who did.

Moreover, bankruptcy law was not suited for cases within the banking industry because

banks like Bear Stearns are highly leveraged. These banks fund their long-term illiquid

investments, with short-term debt. The fact that Bear Stearns held such thin capital margins made

them highly vulnerable to an abrupt cessation in short-term lending. This was a driving force

behind Bear Stearns’ collapse, as the bank could not acquire enough funding to manage its

operations. The “maturity mismatch” of asset and liabilities put Bear Stearns in grave danger

when a liquidity shock occurred, causing investors to cease lending. The Federal Reserve Bank

sought to mitigate other firms’ risk of encountering this liquidity problem by trying to maintain

the flow of lending within the banking industry. 167

From a thorough analysis of how Bear Stearns deteriorated, much like several other

regulated financial institutions, it is hard to understand how hedge funds have been the target of

so much criticism when the their threats to systemic risk pale in comparison to banks and

insurance giants. Let us remember, too, that The Federal Reserve, not hedge funds, created the

housing bubble that almost dismantled the global economy.168 Furthermore, Banks transferred

mass amounts of predatory loans to individuals who they should have known could never afford

the homes they were purchasing.169 It was also banks who bundled and securitized these “toxic

assets” and then traded them with reckless abandonment amongst each other.170 Lastly, one of

the biggest, if not the biggest, culprits in the financial meltdown was A.I.G., an insurance

company, not a hedge fund.171 Despite the strong signs pointing to banks as the real threat to

167 Id. 168 Melvyn Krauss, Don’t Blame Hedge Funds, New York Times, Jun. 24, 2009 (available at: http://www.nytimes.com/2009/06/25/opinion/25iht-edkrause.html). 169 Id. 170 Id. 171 Id.

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systemic risk, the regulatory framework of hedge funds is still not perfect and must be enhanced,

though not nearly to the extent that banks and insurance companies require regulatory overhaul.

3. The Future of Systemic Risk: Growing Concerns in Offshore Tax Havens

Despite the seemingly favorable treatment of hedge funds in the State of Delaware, there

has nevertheless been a noticeable migration of hedge funds to offshore tax havens in recent

times.172 Hedge fund incorporation in “tax havens” such as the Cayman Islands, Bahamas,

Bermuda, and British Virgin Islands (“BVI”) have been on the rise since the mid-1990’s.173

Although there is no universally accepted definition of the term “tax haven,” there seems to be

an international consensus that tax havens have the following characteristics: “no or nominal

taxes; lack of effective exchange of tax information with US and other tax authorities; lack of

transparency in the operation of legislative, legal, or administrative provisions; no requirement

for a substantive local presence; and self-promotion as an offshore financial center.”174

Industry experts and regulators estimate the number of hedge funds in the entire industry

at over 10,000, totaling around $1.5-2 trillion in assets under management.175 It is also estimated

that the industry grew from $456.4 billion in 1996 to $1.43 trillion by the end of 2006.176 Hedge

172 Bing Liang & Hyuna Park, Share Restrictions, Liquidity Premium, and Offshore Hedge Funds 3 (Working Paper, Mar. 14, 2008) available at http:// ssrn.com/abstract=967788). 173 "Offshore Explorations: Caribbean Hedge Funds, Part II," Tax Notes, Jan. 7, 2008, p. 95). http://www.tax.com/taxcom/features.nsf/Articles/DE15FD6B5D167E0B852573CB005BB50C?OpenDocument

174 James Hamilton, Using SEC Data, GAO Finds that TARP Recipients Have Subsidiaries in Offshore Tax Havens, CCH Financial Crisis News Center. Jan. 19, 2009 Available at http://www.financialcrisisupdate.com/2009/01/using-sec-data-gao-finds-that-tarp-recipients-have-subsidiaries-in-offshore-tax-havens.html 175 "Offshore Explorations: Caribbean Hedge Funds, Part II," Tax Notes, Jan. 7, 2008, p. 95). http://www.tax.com/taxcom/features.nsf/Articles/DE15FD6B5D167E0B852573CB005BB50C?OpenDocument; Hedge Fund Research Inc., "HFR Industry Report — Year End 2006," available at http://www.hedgefundresearch.com 176 "Offshore Explorations: Caribbean Hedge Funds, Part II," Tax Notes, Jan. 7, 2008, p. 95).

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funds domiciled in the “Big Four” tax havens (Cayman Islands, Bahamas, Bermuda, and BVI)

accounted for 74.9% of all hedge funds domiciled outside the U.S., or 52.3% of the entire

industry, whereas U.S. domiciled funds accounted for only 30.1% of the entire industry.177 This

equates to the “Big Four” holding estimated assets under management of about $731 billion.178

Other studies have uncovered an even greater disparity, finding that 62% of all hedge fund assets

under management are domiciled in the “Big Four” compared to only 23% domiciled in the

U.S..179 These same studies have estimated that the three year growth rates of offshore assets is

more than twice that of onshore funds (130% v. 66%). Moreover, hedge funds registered off

shore, but addressed in the U.S., have recently seen the highest growth rate among all other

hedge fund segments (176%).180

With other studies estimating $12 trillion deposited in tax havens today, the U.S. and

other nations are determined to curb this explosive exodus of funds offshore, where tax dollars

are lost and global financial markets are subject to unpredictable threats.181 Specifically, there

has been growing systemic concerns over the role of offshore hedge funds in tax havens

operating under a veil of almost complete secrecy, where counterparty and market connectivity

of these funds are virtually undiscoverable.182 The U.S. and other countries have limited insight

http://www.tax.com/taxcom/features.nsf/Articles/DE15FD6B5D167E0B852573CB005BB50C?OpenDocument; Hedge Fund Research Inc., "HFR Industry Report — Year End 2006," available at http://www.hedgefundresearch.com. 177 Id. 178 Id. 179 Bing Liang & Hyuna Park, Share Restrictions, Liquidity Premium, and Offshore Hedge Funds 3 (Working Paper, Mar. 14, 2008) available at http:// ssrn.com/abstract=967788). 180 Id. 181 Id. 182 Id.

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as to the exact value of assets in offshore tax havens, the types of instruments and strategies

used, investor identities, and exactly how many hedge funds exist offshore.183

What’s more disturbing is that eighty-three of the largest one hundred public U.S.

companies have subsidiaries in tax havens.184 Moreover, of those eighty-three companies, four

are banks that received over $127 billion in bailout funds through TARP.185 German Chancellor

Angela Merkel, and other world leaders, brought up hedge fund regulation as one of the chief

topics for discussion on a recent G8 Summit meeting.186 This rapid growth in hedge fund

migration into tax havens has been a troubling trend not only for the United States, but for the

greater international community as well.

B. Fraud and Investor Protection Regulators are also highly concerned with mitigating fraud and money laundering among

private funds, especially during this period of extreme market vulnerability. Most notably,

Bernard L. Madoff Investment Securities LLC (BLMIS), a New York-based hedge fund, later

discovered to be a massive “Ponzi scheme,” defrauded investors over $50 billion.187 A “Ponzi

scheme” is characterized as “an investment fraud that involves the payment of purported returns

to existing investors from funds contributed by new investors.188 Mr. Madoff, owner and

perpetrator of the BLMIS fraud, ran a broker dealer service called Madoff Investment Securities,

183 Emil Arguelles, “The Truth About Tax Havens.” San Pedro Daily. Nov. 14, 2009. http://ambergriscaye.com/forum/ubbthreads.php/topics/357954/The_truth_about_tax_havens.html 184 Richard Murphy, “The Stop Tax Haven Abuse Act is on its Way.” Tax Research UK. Mar. 3, 2009. http://www.taxresearch.org.uk/Blog/2009/03/03/the-stop-tax-haven-abuse-act-is-on-its-way/ 185 Id. 186 187 Amir Efrati et al., Top Broker Accused of $50 Billion Fraud, Wall St. J., Dec. 12, 2008, at A1. 188 http://www.france24.com/en/20081215-hsbc-faces-1-billion-risk-madoff-scandal-fraud; http://www.sec.gov/answers/ponzi.htm

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as well as an investment advisory business.189 According to SEC filings, the investment advisory

business had over $17 billion in assets under management.190 It was this investment advisory arm

of his alleged business that housed the fraud, which surfaced in late 2008 when he was unable to

“obtain the liquidity necessary to meet” investors’ demands to withdraw $7 billion dollars from

the fund firm.191

More recently, the Antiguan-based Stanford International Bank (SIB), along with

Chairman Sir Allen Stanford, have been indicted for engaging in a scheme to defraud investors

of over $8 billion.192 With 30,000 investors and over $51 billion in assets, SIB purported itself to

be a bank, despite making no loans.193 Even more spurious is that Chairman Stanford actually

helped rewrite Antiguan banking laws upon setting up his banks operations on the island.194

Moreover, most of its investors’ certificate of deposits (“CD’s”) were invested in private equity

and real estate, despite telling its investors that they were invested primarily in more “liquid”

securities.195 From SIB’s practices, and the fact that they shielded themselves from SEC

oversight, SEC officials state that SIB operated like a typical hedge fund opposed to a bank.196

However, SIB also held offices based in Houston, Texas where Chairman Sir Allen Stanford

defrauded some of SIB’s U.S. and foreign investors with impunity right under regulators

noses.197 Fortunately for defrauded investors, Sir Allen Stanford was unable to escape and go

189 See Complaint at 2-3, United States v. Madoff, 08-MAG-2735 (S.D.N.Y. Dec. 11, 2008) [hereinafter Madoff Complaint]. 190 Id. 191 Id. at 3. 192 http://www.justice.gov/criminal/vns/caseup/stanfordr.html; Securities and Exchange Commission v. Stanford International Bank, et al., Case No. 3-09CV0298-L (N.D.TX.) 193 http://www.financialweek.com/article/20090217/REG/902179991/103/REUTERS 194 Alison Fitzgerald, Stanford Wielded Jets, Junkets, and Cricket to Woo Clients, Bloomberg Feb. 18, 2009 (available at: http://www.bloomberg.com/apps/news?sid=auAqkrxMzKPc&pid=20601109). 195 Id. 196 Id. 197 Emil Arguelles, “The Truth About Tax Havens.” San Pedro Daily. Nov. 14, 2009. http://ambergriscaye.com/forum/ubbthreads.php/topics/357954/The_truth_about_tax_havens.html

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into hiding because the U.S. had extraterritorial jurisdiction over him as a U.S. citizen.198 What’s

alarming is that SIB associates were in Belize soliciting prospective clients prior to the

indictment, but were unsuccessful in doing so.199 This just goes to show how U.S. and other

foreign citizens unfamiliar with tax haven entities could easily be swindled with no

forewarning.200 Although the case is still pending, SIB and Mr. Chairman are charged with

“violations of the anti-fraud provisions of the Securities Act of 1933, the Securities Exchange

Act of 1934 and the Investment Advisers Act, and registration provisions of the Investment

Company Act.”201

Although the Madoff and Stanford incidents represent extreme outlier cases of fraud,

either in terms of the size of the scams or deplorable nature of the crimes themselves, they

nevertheless call attention to the risk of fraud, both domestically and in offshore tax havens.202

Fraud detection and prevention is a second key goal of regulators. The failure to detect scandals

like these have devastated investor confidence in U.S. regulatory agencies, such as the Securities

and Exchange Commission (SEC) and the Commodities Futures Trading Commission

(CFTC).203 Although even the two most extreme cases of fraud did not individually or

collectively rise to the level of systemic risk, both were audacious attempts to defraud investors

by circumventing U.S. regulation with activity in offshore tax havens.

But the nature of these crimes were littered with red flags: Madoff’s impossibly

consistent returns year after year, Stanford rewriting the very laws that were supposed to regulate

him, and involvement in suspicious tax havens should have been picked up by SEC officials and

198 Id. 199 Id. 200 Id. 201 Id. 202 John Gapper, The Hedge Fund Industry Is Going Down with Dignity, Fin. Times (London), Dec. 6, 2008, at 9 (Madoff defrauded dozens of charities and non-profits, 203 http://www.bloomberg.com/apps/news?pid=20601109&sid=afUo_v5lEmwc

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other foreign regulators.204 In terms of investor protection against fraud, perhaps it is not

additional regulation that would serve the hedge fund industry and investors best. Rather, better

inter-agency communication, additional agency (SEC, CFTC) resources for investigating crimes,

and better enforcement of current laws would be more effective.

C. Benefits of Hedge Funds in Financial Markets Hedge funds have noticeable and undeniable benefits to financial markets, and are

playing an “increasingly important role in [the U.S.] financial system.” 205 The rapid growth in

number of hedge funds and total assets under management are evidence that investors perceive

them as providing significant value that they could otherwise not obtain through other, more

traditional investment vehicles.206 Considering that savings funds account for only a small share

of the overall assets held by hedge funds, the size and importance of the hedge fund industry will

continue to grow throughout the foreseeable future.207

It has been previously argued in this Note that hedge funds are chastised more for their

perceived risks to financial markets rather than heralded for the positive effects they have on

financial system functions.208 Hedge funds play a critical role in a variety of areas that help make

the U.S. firms, and the overall market, competitive in the global arena. First, hedge funds “play a

valuable arbitrage role in reducing or eliminating mispricing” among firms across various

financial markets.209 They can better allow firms to stamp a true value on assets and ensure

204 Id. 205 Timothy F. Geithner, President & CEO, Fed. Reserve Bank of N.Y., Keynote Address: Hedge Funds and Their Implications for the Financial System (Nov. 17, 2004) (transcript available at http:// www.ny.frb.org/newsevents/speeches/2004/gei041117.html). 206 Id.; see supra note 172. 207 Id. 208 Id. 209 Id.

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liquidity through mark-to-marketing asset pricing.210 This pricing practice, in addition to the

sheer bulk of assets under management, supply a significant source of liquidity for financial

markets, in periods of both stability and distress.211 Moreover, hedge funds “add depth and

breadth to [U.S.] capital markets, providing additional sources of long-term financing for firms

and start-up ventures.”212

Frequently criticized for doing this, hedge funds also provide a benefit to the market in

providing a “source of risk transfer and diversification,” instead of forcing risk averse institutions

to retain unwanted or illiquid assets on their balance sheets.213 Indirectly, this amounts to a type

of risk-matching service among themselves and between other firms.214 Thus, hedge funds,

which typically pursue relatively more risk-seeking investment strategies in hopes of higher

returns, can provide a good outlet for firms looking to trade away less liquid assets, and in some

cases, vice versa.215

As U.S. Treasury Secretary Timothy Geithner so aptly put it, hedge funds “don’t perform

these functions out of a sense of noble purpose, of course, but they are a critical part of what

makes the U.S. financial markets work relatively well in absorbing shocks and in allocating

savings to their highest return. These benefits are less conspicuous than the trauma that has been

associated with hedge funds in periods of financial turmoil, but they are substantial.”216

Hedge funds have also indirectly caused other financial institutions to provide market

benefits, in response to the nature of the hedge fund industry. Since LTCM’s collapse in 1998,

firms have established better internal due diligence practices to manage the risk of hedge fund 210 5 B.Y.U. Int'l L. & Mgmt. Rev. 99; Jenny Anderson & Heather Timmons, Why a U.S. Subprime Mortgage Crisis is Felt Around the World, N.Y. TIMES, Aug. 31, 2007, at C1. 211 Supra note 172. 212 Id. 213 Id. 214 Id. 215 Id. 216 Id.

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exposures.217 In addition, the same firms adaptation in the post-LTCM era included imposing

tighter credit requirements, demanding more collateral on investments, establishing daily margin

limits to ensure sufficient capital reserves, and taking a more conservative approach to valuing

collateral and illiquid assets.218 Of course, not every firm in the market exudes these benefits or

profits from these investments in every instance of trading. However, diligent investing and firm

management practices make it possible for these positive aspects to benefit other firms.

Firms in the market also learned from the LTCM incident, and began paying closer

attention to future credit exposures that they might encounter in the future.219 Moreover, firms

have insulated themselves better from risk by establishing superior and more intelligent ways of

measuring and “stress testing” those credit exposures.220 Firms have also been more proactive in

seeking out information from hedge funds about the risks of the fund. Firms have done this

through periodic inquiries into a fund’s investing strategy, leverage ratio, and other aspects that

may be discoverable, which could improve firm value and risk management.221

Although these market improvements came about after a near financial catastrophe with

LTCM’s collapse, the benefits and practices still permeate the market today.222 Unfortunately,

the stigma surrounding hedge funds as being secretive and exotic investment vehicles likely

inhibits more benefits from permeating the market due to the apprehension of investors in

participating in these funds. Regardless, as U.S. Treasury Secretary Geithner commented, it took

a “major market event to expose the extent of weaknesses in market practice that prevailed prior

217 Timothy F. Geithner, President & CEO, Fed. Reserve Bank of N.Y., Keynote Address: Hedge Funds and Their Implications for the Financial System (Nov. 17, 2004) (transcript available at http:// www.ny.frb.org/newsevents/speeches/2004/gei041117.html). 218 Id. 219 Id. 220 Id. 221 Id. 222 Timothy F. Geithner, President & CEO, Fed. Reserve Bank of N.Y., Keynote Address: Hedge Funds and Their Implications for the Financial System (Nov. 17, 2004) (transcript available at http:// www.ny.frb.org/newsevents/speeches/2004/gei041117.html).

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to 1998 and to catalyze improvements across the financial community. Those reforms have

played an important role in reducing risk in the system, alongside the overall improvements in

capital, risk management, and the financial infrastructure.”223

Despite the known market benefits hedge funds provide, in the aftermath of the recent

financial crisis many of these benefits were improperly marginalized, overlooked, and even

perceived as threats. Hedge funds have been criticized by some politicians and commentators for

short-selling troubled banks during the market’s decline.224 However, the much-criticized hedge

fund short sellers are the financial markets' first line of defense against fraud and exaggerated

valuations.225 More lenient rules on short-selling increase the incentives for companies “to police

the markets themselves, and can prevent fraudulent or overvalued companies from running even

higher.”226 Without hedge fund short sellers, markets would be inherently positively-biased,

resulting in securities being priced less efficiently.227 Moreover, short sellers make for

outstanding stock analysts who have a keen eye for fraud, mismanagement, or aggressive

accounting.228 There are several tools and strategies in the market to curb gross, abusive stock

undervaluations. For example, private equity funds, strategic buyers, and share buybacks all can

223 Id.

224 Laurence Fletcher, “Hedge Funds Say Role in Crisis Was Marginal: AIMA,” Reuters, April 2, 2009 (http://www.reuters.com/article/idUSTRE5315J420090402).

225 Zac Bissonnette, “SEC Ends Uptick Rule but Vows Crackdown on Naked Short Selling,” BloggingStocks, June 14, 2007. (http://www.bloggingstocks.com/2007/06/14/sec-ends-uptick-rule-but-vows-crackdown-on-naked-short-selling/). 226 Id.. 227 Alex Dumortier, “The Truth About Naked Shorts,” The Motley Fool, Sept. 22, 2008. (http://www.fool.com/investing/dividends-income/2008/09/22/the-truth-about-naked-shorts.aspx). 228 Id.. ( “Take Jim Chanos of Kynikos Associates, for example, who was one of the first (and only) investors to call Enron out for its fuzzy accounting. If only more investors had listened to his arguments instead of those of Ken Lay and Jeff Skilling.).

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help a company prevent abusive, unwarranted devaluations.229 The SEC would be weakening

one of the best mechanisms in place to proactively stop fraud and overvaluations if it

discouraged short-selling by placing blame on firms that did so, or made prohibited it all

together.230

What the critics are actually referring to when they criticize the hedge funds who short

sell is what the SEC describes as "abusive naked short selling." This term refers to short sellers

who (a) sell shares they have not borrowed or have no reasonable expectation of borrowing, and

(b) cannot deliver those shares on the settlement date of their sale because they do not possess

them.231 However, the SEC already addressed this alleged problem when it adopted an antifraud

rule in October of 2008 to thwart abusive naked short selling. “Rule 10b-21 is designed to

prevent short sellers, including broker-dealers acting for their own accounts, from deceiving

specified persons about their intention or ability to deliver securities in time for settlement and

then failing to deliver securities by the settlement date.”232 In addition, the SEC completely

banned short selling of 799 financial stocks for a brief period in September and October 2008,

and increased the reporting burden for short sellers.233 Yet, this still did not completely halt the

downward spiral of several financial institutions after the short-selling hold was lifted. As long

as short sales are eventually covered, there is no harm in naked short selling unless the short

seller acted fraudulently or dishonestly. The requirement to borrow shares before short selling is

229 Zac Bissonnette, “SEC Ends Uptick Rule but Vows Crackdown on Naked Short Selling,” BloggingStocks, June 14, 2007. (http://www.bloggingstocks.com/2007/06/14/sec-ends-uptick-rule-but-vows-crackdown-on-naked-short-selling/). 230 Id.. 231 Id. 232 Rule 10b-21, Securities Exchange Act of 1934; SEC Release 33-7046. (http://www.blankrome.com/index.cfm?contentID=37&itemID=1723). 233 http://www.sec.gov/news/press/2008/2008-211.htm

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a burdensome and unnecessary process that causes market inefficiencies.234 Hedge fund critics

shouldn't let the investing strategy of short selling blind them from the truth: that severe credit

problems banks, broker-dealers, and mortgage companies had were self-inflicted, long before

hedge funds began short selling them.235

Even if critics cannot subscribe to the foregoing reasons why hedge funds were not at

fault, they cannot overlook the fact that regulators did little to regulate short-selling if indeed

they believed it to be harmful. This is evidenced by the fact that regulators suspended the

“Uptick Rule” in July of 2007.236 The SEC summarized the “Uptick Rule” as follows: "Rule 10a-

1(a)(1) provided that, subject to certain exceptions, a listed security may be sold short (A) at a

price above the price at which the immediately preceding sale was effected (plus tick), or (B) at

the last sale price if it is higher than the last different price (zero-plus tick). Short sales were not

permitted on minus ticks or zero-minus ticks, subject to narrow exceptions."237 When the rule,

which had been in place since the 1930’s, was removed in 2007 many critics claim that this

promoted easier, abusive short-selling of stocks by hedge funds.238 In response to these claims,

the SEC approved the “Alternative Uptick Rule” in February 2010.239 This rule amended Rule

201 of Regulation SHO, which was designed “to restrict short selling from further driving down

the price of a stock that has dropped more than 10 percent in one day. It will enable long sellers

234 Alex Dumortier, “The Truth About Naked Shorts,” The Motley Fool, Sept. 22, 2008. (http://www.fool.com/investing/dividends-income/2008/09/22/the-truth-about-naked-shorts.aspx). 235 Id.. 236 David Gaffen, “All Hail the Uptick Rule!,” The Wall Street Journal, March 10, 2009. (http://blogs.wsj.com/marketbeat/2009/03/10/all-hail-the-uptick-rule/). 237 Amendments to Exchange Act Rule 10a-1 and Rules 201 and 200(g) of Regulation SHO". SEC. 2008-05-21. http://www.sec.gov/divisions/marketreg/tmcompliance/rules10a-200g-201-secg.htm. Retrieved 2009-04-08. 238 Id.. 239 http://www.sec.gov/news/press/2010/2010-26.htm

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to stand in the front of the line and sell their shares before any short sellers once the circuit

breaker is triggered.”240

Critics who chastise hedge funds for short selling financial companies in 2007 and 2008

are misdirecting their blame if they truly feel short selling was a contributing mechanism to the

crisis. Regulators were the ones who removed the “Uptick Rule” in 2007, so they would be hard-

pressed to blame hedge funds who undertook this completely legal investing strategy. Moreover,

the new “Alternative Uptick Rule” is viewed as a feel good rule with “no teeth,” considering the

new rule only helps in times of extreme market volatility but goes unnoticed in times of market

stability.241 Thus, if any blame could be attributed to short-selling, it should be bestowed on

regulators who removed the “Uptick Rule” and not hedge funds who acted properly under the

law. Moreover, many in the market believe that short-selling is not a legitimate, substantial

threat, but even if it is the “Alternative Uptick Rule” is not strong enough to prevent the

perceived threat. 242

Perhaps one of the biggest relative benefits hedge funds provided in the midst of the

financial crisis was that they did not burden the government or taxpayers with billion dollar

bailouts and forced, U.S. Treasury-backed mergers. Moreover, there were no systemically

notable hedge fund collapses either.243 In the aftermath of the financial crisis, the hedge fund

industry has recovered and outperformed far better than other financial institutions. It must be

noted that “banks such as CitiGroup, brokers such as Bear Stearns and Lehman Brothers, home

240 Id.. 241 Chuck Jaffe, “Coming up Short: SEC’s New Version of ‘Uptick Rule” lets Investors Down,” Market Watch, March 3, 2010. (http://www.marketwatch.com/story/new-uptick-rule-for-stocks-lets-investors-down-2010-03-03). 242 Chuck Jaffe, “Coming up Short: SEC’s New Version of ‘Uptick Rule” lets Investors Down,” Market Watch, March 3, 2010. (http://www.marketwatch.com/story/new-uptick-rule-for-stocks-lets-investors-down-2010-03-03). 243 Laurence Fletcher, “Hedge Funds Say Role in Crisis Was Marginal: AIMA,” Reuters, April 2, 2009 (http://www.reuters.com/article/idUSTRE5315J420090402).

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lenders such as Fannie Mae and Freddie Mac, insurers such as AIG, and money market funds run

by giants such as Fidelity-all have failed or been bailed out.”244

The hedge fund industry’s benefits can be understood by comparing the incentive

structures of the various financial entities in the market.245 The U.S. financial system continues

to be “riddled with conflicts of interests and skewed incentives” that have harmed investor

confidence and destroyed numerous firms.246 However, hedge funds have succeeded in avoiding

these pitfalls because of its ownership structure. Hedge fund managers have well-aligned

incentives in large part because most mangers have their own capital invested in their funds.247

Thus, hedge fund managers are speculating and investing with capital that is their own, a

compelling incentive to avoid losses or reckless management. Unlike hedge fund managers, bank

traders are essentially risking other people’s money and can still earn compensation even when

the bank performs poorly.248

In turn, the ownership structure causes most hedge funds to be more conservative in its

leverage strategies than typical banks. “The average hedge fund borrows only one or two times

its investors’ capital, and even those that are considered highly leveraged borrow less than ten

times.”249 In contrast, investment banks such as Goldman Sachs, Bear Stearns, and Lehman

Brothers carried leverage ratios of 30 to 1 leading into the crisis, and commercial banks like Citi

244 Role of Hedge Funds in Financial Crisis Focus of July 19 Economic Perspectives Posted by Hopeton on July 18, 2010. Reviewing Sebastian Mallaby, author of More Money Than God: Hedge Funds and the Making of a New Elite (http://econpers.wordpress.com/2010/07/18/role-of-hedge-funds-in-financial-crisis-focus-of-july-19-economic-perspectives/).

245 Etienne Rolland-Piegue, “Book Review: More Money Than God: Hedge Funds and the Making of a New Elite, by Sebastian Mallaby,” June 2010. (http://aidfinancial.net/2010/08/22/more-money-than-god-hedge-funds-and-the-new-elite-to/).

246 Id.. 247 Id.. 248 Id.. 249 Id..

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were even more leveraged.250 Many market players have characterized hedge funds as “paranoid

outfits,” in perpetual fear that margin calls from brokers or widespread, simultaneous client

redemptions could destroy the fund.251 Hedge fund managers “live and die by their investment

returns, so they focus on them obsessively.”252 This also plays into how hedge fund managers

deal with managing risk. Hedge funds have wide latitude in making their own risk decisions,

undistracted by lax regulations that allowed banks to achieve outrageous leverage ratios in

thinking it was sound business. Moreover, hedge funds are not subject to credit ratings by

Moody’s and Fitch, in comparison to banks who paid these rating agencies to assess their

worthiness as an investment. As we have seen, the conflict of interest inherent in the banks

paying the very rating firms who were rating them created a false sense of security for banks and

quite possibly gave rise to unethical behavior.253 Ultimately, the hedge fund industry as a whole

survived the financial meltdown relatively well. They did not play a big role on contributing to

the subprime mortgage machine by not purchasing toxic mortgage securities and often made

money by shorting them.254

Hedge fund incentives are well-aligned in terms of how the funds internally operate.

Typically, hedge funds are better managed and organized than banks and brokerages. The

management culture within hedge funds tends to encourage a sense of team morale and

collaboration, along with individual performance. Hence, most hedge funds see less business

cannibalization and selfish, cutthroat behavior among employees, which could ultimately harm

250 Etienne Rolland-Piegue, “Book Review: More Money Than God: Hedge Funds and the Making of a New Elite, by Sebastian Mallaby,” June 2010. (http://aidfinancial.net/2010/08/22/more-money-than-god-hedge-funds-and-the-new-elite-to/). 251 Id.. 252 Id.. 253 Id.. 254 Id..

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the business.255 Hedge funds also have a compelling incentive to improve existing knowledge

and innovate new strategies and theories to maximize performance. In fact, hedge fund managers

and have often been ahead of academia in developing new theories on how the market

operates.256

Perhaps the most the most powerful incentive hedge funds have to act in a way that promotes

their sustainability is that they are not too big to fail. There is no precedent that government will ever

stand behind hedge funds, provide a backstop, or bail them out. Even in the most notorious case of

hedge fund failure, the 1998 LTCM collapse, the Federal Reserve “oversaw [LTCM’s] burial but

provided no taxpayer money to cover its losses.”257 In essence, as one financial expert put it, “[hedge

funds] are safe to fail, even if they are not fail-safe.”258 In comparison, the U.S. government has set a

reckless precedent and compounded the moral hazard at the heart of finance in its response to the crisis.

Banks understand that they can be too big or connected to fail, evidenced by the fact that they have been

bailed out. Thus, banks, brokerages, and insurance giants can now feel a sense of entitlement and expect

to be rescued all over again in the event of another self-inflicted meltdown. This causes banks to have

only a limited incentive to avoid excessive risk and precarious leverage levels, making another financial

crisis at the hands of major financial institutions all the more probable.259

III. PROPOSED LEGISLATION REGARDING HEDGE FUND REGULATION

A. Hedge Fund Transparency Act of 2009

255 Id.. 256 Id.. (For instance, “they poked holes in the efficient-market theory long before the hypothesis came into disrepute among researchers.”). 257 Id.. 258 Id.. 259 Id..

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On January 29, 2009, Senators Chuck Grassley (R-Iowa) and Carl Levin (D-Michigan)

introduced the Hedge Fund Transparency Act of 2009 (HFTA)260 as an amendment to the

Investment Company Act of 1940 (the “Company Act”). The proposed bill would impose new

registration and disclosure requirements on hedge funds, as well as on certain private equity

buyout funds, venture capital funds, structured finance vehicles, and some real estate funds.261

Currently, funds with at least $50 million in assets that comply with provisions contained in

Section 3(c)(1) (funds with fewer than 100 beneficial owners) or 3(c)(7) (funds made up solely

of "qualified purchasers") of the Company Act are an exception to the definition of “investment

company” and thus do not have to register with the SEC.262

However, under the proposed bill, Sections 3(c)(1) and 3(c)(7) would be struck from the

Company Act and relocated to Sections 6(a)(6) and 6(a)(7). Thus, a private fund operating in

accordance with current Section 3(c)(1) or 3(c)(7) would be an “investment company” under the

bill, but would be exempt from the provisions of Section 6, which impose additional disclosure

requirements. As a result, funds with at least $50 million in assets would be required to

“register” with the SEC in order to claim an exemption from the more extensive filing and

registration requirements imposed on traditional investment companies (such as mutual funds)

by the Company Act under Section 6(a)(6) or 6(a)(7). Although the proposed bill would require

$50 million and over funds (“large investment companies”) to file with the SEC, the provisions

contained in Sections 6(a)(6) and 6(a)(7) of the Company Act would exempt them from certain

filing and registration requirements that are applicable to traditional registered investment

260 Hedge Fund Transparency Act of 2009, S. 344, 111th Cong. (2009). 261 Robert C. Lee, David M. Mahle, John M. Saada, Jr., Anthony L. Perricone, Kent R. Richey and Randall B. Schai, United States: Hedge Fund Transparency Act Of 2009: Congress Considers Expansion Of Investment Fund Regulation. Feb. 12, 2009. http://www.mondaq.com/unitedstates/article.asp?articleid=74142 262 15 U.S.C. § 80a-3 (2000 & Supp. IV 2004); 15 U.S.C. 80a-2(a)(51) (2000 & Supp. IV 2004); http://www.hedge-fund-transparency-act.com/

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companies (such as mutual funds) under the Company Act.263 But these $50 million and over

funds who are composed of no more than one hundred owners or of all qualified purchasers will

be exempt from the normal filing and registration requirements of the Company Act, but still

must meet the four following requirements:

1. Registering with the SEC.

2. Maintaining books and records that the SEC may require.

3. Cooperating with any request by the SEC for information or examination.

4. Filing an information form with the SEC electronically, at least once a year. This

form, which would be made freely available to the public in an electronic,

searchable format, must include:

a. The name and current address of each individual who is a beneficial owner

of the private investment fund.

b. The name and current address of any company with an ownership interest

in the private investment fund.

c. The name and current address of the investment company’s primary

accountant and primary broker.

d. An explanation of the structure of ownership interests in the private

investment fund.

e. Information on any affiliation with another financial institution.

f. A statement of any minimum investment commitment required of a

limited partner, member, or investor.

g. The total number of any limited partners, members, or other investors.

263 Id.

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h. The current value of the assets of the company and the assets under

management by the company.

Although “large investment companies” that meet the criteria outlined above will be

exempt from many of the onerous requirements placed on traditional registered investment

companies, the new legislation would unequivocally authorize the SEC to oversee and supervise

these private funds. Moreover, “qualified investors” whose privacy and anonymity are currently

protected by Section 3(c)(1) and 3(c)(7) of the Company Act would no longer enjoy such

treatment upon the new bill’s disclosure guidelines. It should also be noted that funds with less

than $50 million in assets would still not be required to register with the SEC under the proposed

bill.

The proposed bill would also establish anti-money laundering regulations for funds with

at least $50 million in assets that rely on the new 6(a)(6) and 6(a)(7) Sections of the Company

Act.264 If ratified, the bill would require “large investment companies” to establish anti-money

laundering programs and report suspicious transactions under 31 U.S.C.A. §5318(g) and (h).265

Within 180 days of the bill’s enactment, the U.S. Treasury Secretary would set minimum

requirements for such programs, calling for the use of risk-based due diligence policies,

procedures and controls reasonably designed to ascertain the identity of and evaluate any foreign

person that supplies funds or plans to supply funds to be invested with the advice or assistance of

such investment company.266 Moreover, these funds would be subject to the "120 hour rule,"

which requires institutions to provide information to federal agencies within 120 hours of

receiving a request for information related to anti-money laundering compliance.267 The bill’s

264 Id. 265 Id. 266 Id. 267 Id.

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anti-money laundering compliance obligations would be effective within one year of the bill’s

enactment, regardless of whether the Treasury has promulgated its rules. The proposed HFTA is

currently being considered by the Senate Committee on Banking, Housing, and Urban Affairs.268

B. Hedge Fund Adviser Registration Act of 2009

In congruence with the new changes to the Company Act under the proposed HFTA,

House Representatives Michael Castle (R-Del) and Michael Capuano (D-Mass) introduced the

Hedge Fund Adviser Registration Act of 2009 (“HFARA”) on January 27, 2009. The HFARA

would not just affect hedge fund investment advisers, but would affect private equity and venture

capital fund investment advisers as well.

The HFARA would strike Section 203(b)(3) of the Investment Advisers Act of 1940 (the

“Advisers Act”), which exempts “private advisers” from SEC registration as Registered

Investment Advisers (“RIA’s”). A “private adviser” is defined as “any investment adviser who

(i) has had fewer than fifteen clients during the preceding twelve months, (ii) does not advise

registered investment companies or regulated business development companies, and (iii) does

not hold itself out to the public as an investment adviser.” The HFARA’s striking of this

exemption would have profound implications for presently unregistered advisers of investment

companies. Currently, a private investment fund adviser (i.e. general manager) can consider the

private investment fund vehicle it manages (rather than the number of individuals investing in

the fund) as one, single client assuming the adviser provides investment advice to further the

objectives of the vehicle as a whole (opposed to the individual investment objectives of each

client). However, if the HFARA is ratified, advisers of funds under Section 3(c)(1) or 3(c)(7) of

268 http://www.govtrack.us/congress/bill.xpd?bill=s111-344.

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the Company Act would no longer receive the “Private Advisers” registration exemption under

section 203(b)(3) of the Advisers Act .

The proposed HFARA would subject RIA’s to SEC oversight of the activities and

practices. RIA’s would also have to comply with the extensive regulatory requirements imposed

by the Advisers Act, such as record keeping, compliance programs, advertising and marketing

restrictions, solicitation arrangements and annual disclosures. The proposed HFARA has since

been referred to the House Committee on Financial Services.269

C. Private Fund Transparency Act of 2009

As a competing bill to the “Hedge Fund Transparency Act” introduced back in January

2009, U.S. Senator Jack Reed (D-RI) introduced the “Private Fund Transparency Act of 2009”

(“PFTA”)270 on June 16, 2009. This proposed bill is aimed at protecting investors, identifying

and mitigating systemic risk, and preventing fraud. Like other proposed legislation, this bill

seeks to amend the Advisers Act in order to require hedge fund, private equity fund, venture

capital fund, and other private investment pool advisers to register with the SEC.

The PFTA would limit the private adviser exemption contained in the Advisers Act to

“foreign private advisers,” a new term defined in the bill as “any investment adviser who has no

place of business in the United States; during the preceding 12 months has had fewer than 15

clients in the United States; and assets under management attributable to clients in the United

States of less than $25,000,000, or such higher amount as the Commission may, by rule, deem

appropriate in accordance with the purposes of this title; and neither holds itself out generally to

the public in the United States as an investment adviser, nor acts as an investment adviser to any

269 http://www.govtrack.us/congress/bill.xpd?bill=h111-711. 270 Private Fund Transparency Act of 2009, S. 1276, 111th Cong. (2009).

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investment company registered under the Investment Company Act of 1940, or a company which

has elected to be a business development company pursuant to section 54 of the Investment

Company Act of 1940, and has not withdrawn its election.”271 As such, U.S. domestic hedge

fund advisers of private funds with more than $30 million in assets under management would be

mandated to register with the SEC.

In general, the proposed bill would:

• Require all hedge fund and other investment pool advisers that manage more than

$30 million in assets to register as investment advisers with the SEC.

• Provide the SEC with the authority to collect information from the hedge fund

industry and other investment pools, including the risks they may pose to the

financial system.

• Authorize the SEC to require hedge funds and other investment pools to maintain

and share with other federal agencies any information necessary for the

calculation of systemic risk.

• Clarify other aspects of SEC’s authority in order to strengthen its ability to

oversee registered investment advisers.

Specifically, the PFTA would remove the registration exemption in Section 203(b)(2) of the

Advisers Act and would replace it with an exemption for “foreign investment advisers.” The

(b)(3) exemption that would be removed was for investment advisers with fewer than 15 clients

that hold themselves out as investment advisers, which was the exemption most often used by

private funds.

271 Id.

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In terms of reporting, “The Commission is authorized to require any investment adviser

registered under this title to maintain such records and submit such reports as are necessary or

appropriate in the public interest for the supervision of systemic risk by any Federal department

or agency, and to provide or make available to such department or agency those reports or

records or the information contained therein.”272 The fact that the bill does not define “systemic

risk” reveals the broad authority of the SEC to demand various reports from private funds.

Moreover, in a press release by the U.S. Treasury Department, the proposed PFTA would

require registered private fund advisers to comply with “Substantial regulatory reporting

requirements with respect to the assets, leverage, and off-balance sheet exposure of their advised

private funds; disclosure requirements to investors, creditors, and counterparties of their advised

private funds; strong conflict-of-interest and anti-fraud prohibitions; robust SEC examination and

enforcement authority and recordkeeping requirements; requirements to establish a

comprehensive compliance program 273

Private fund clients would also no longer be afforded the degree of privacy that they

currently enjoy, if the new bill is ratified. The PFTA would strike Section 210(c) of the Advisers

Act, which prohibits the SEC from requiring the disclosure of an investment adviser’s clients

(except in a SEC proceeding or enforcement action). Thus, investment advisers would be forced

to disclose their client lists and private investment funds would be forced to disclose their

investors to the SEC. This bill appears far more burdensome than the proposed HFTA and the

HFARA, and provides strong incentives for hedge fund advisers to manage their funds off-shore.

272 Id. 273 http://www.ustreas.gov/press/releases/tg214.htm

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The proposed PFTA is currently being considered by the Senate Committee on Banking,

Housing, and Urban Affairs.274

D. Hedge Fund Study Act Rep. Michael Castle introduced the Hedge Fund Study Act (“HFSA”) on January 27,

2009. The HFSA directs President Obama’s “Working Group on Financial Markets (the “PWG”)

to conduct a study of the hedge fund industry,” including:275

1. “the changing nature of hedge funds and what characteristics define a hedge fund;

2. the growth of hedge funds within financial markets;

3. the growth of pension funds investing in hedge funds;

4. whether hedge fund investors can adequately protect themselves from hedge fund

investment risks;

5. whether hedge fund leverage is effectively constrained;

6. the investor and market risk posed by hedge funds;

7. various international approaches to the regulation of hedge funds; and

8. the benefits of the hedge fund industry to the economy and the markets.”

The HFSA would mandate that within 180 days of its ratification, the PWG present its

findings to the House Committee on Financial Services and the Senate Committee on Banking,

Housing and Urban Affairs. The HFSA would also require the PWG to present potential

legislation regarding hedge fund disclosure to regulators and the public, as well as

274 http://www.govtrack.us/congress/bill.xpd?bill=s111-1276. 275 Hedge Fund Study Act, H.R. 713, 111th Cong. (2009).

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recommendations regarding the extent of regulatory oversight on the hedge fund industry. The

proposed HFSA has since been referred to the House Committee on Financial Services.276

E. Stop Tax Haven Abuse Act

On February 12, 2009 Senator Carl Levin (D-MI) sparked a growing campaign to combat

fraud, systemic risk, and tax evasion in various offshore secrecy jurisdictions by introducing a

bill in Congress called the “Stop Tax Haven Abuse Act.”277 Although there is no official

statutory definition of “tax haven,” the Organization for Economic Cooperation and

Development (OECD) provides the most commonly referred to definition in the international

community. “Tax havens” are determined as follows: “The absence of tax or a low effective tax

rate on the relevant income is the starting point of any evaluation. No or only nominal taxation

combined with the fact that a country offers itself as a place, or is perceived to be a place, to be

used by non-residents to escape tax in their country of residence may be sufficient to classify that

jurisdiction as a tax haven. Similarly, no or only nominal taxation combined with serious

limitations on the ability of other countries to obtain information from that country for tax

purposes would typically identify a tax haven."278

The “Stop Tax Haven Abuse Act” would authorize the U.S. Treasury Department “to

take special measures against foreign jurisdictions and financial institutions that impede U.S. tax

276 http://www.govtrack.us/congress/bill.xpd?bill=h111-713. 277 Stop Tax Haven Abuse Act, 111th Cong. (2009). http://levin.senate.gov/newsroom/release.cfm?id=308949; levin.senate.gov/.../2009/PSI.StopTaxHavenAbuseAct.030209.pdf 278 Written Testimony of Jeffrey Owens, Director, OECD Center for Tax Policy and Administration Before Senate Finance Committee on Offshore Tax Evasion, May 3, 2007. finance.senate.gov/hearings/testimony/2007test/050307testjo.pdf; James Hamilton, Using SEC Data, GAO Finds that TARP Recipients Have Subsidiaries in Offshore Tax Havens, CCH Financial Crisis News Center. Jan. 19, 2009 Available at http://www.financialcrisisupdate.com/2009/01/using-sec-data-gao-finds-that-tarp-recipients-have-subsidiaries-in-offshore-tax-havens.html

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enforcement."279 With an estimated $12 trillion deposited in tax havens today, the U.S. and other

nations are determined to curb this explosive exodus of funds offshore.280 This proposed bill is

aimed at recovering over $100 billion that is lost by the IRS each year due to tax haven abuse.281

The most significant aspects of this bill in preventing tax haven exploitation are: listing

all “offshore secrecy jurisdictions”; treat offshore firms controlled and managed in the U.S. as

taxable domestic entities for income tax; permitting more in-depth investigations of offshore

entities and the tax havens they operate in; enhanced disclosure of offshore entities’ holdings and

transactions; close offshore dividend tax loophole where offshore funds evade taxes on U.S.

stock dividends; more severe penalties for entities who fail to disclose offshore accounts;

improved information exchange among the U.S., other countries and tax haven jurisdictions; and

broaden tax filing requirements for passive foreign investment funds to include entities that may

not own a passive foreign fund but have formed, received income from, sent capital to, or

generally benefited from a passive foreign investment fund.282 The proposed “Stop Tax Haven

Abuse Act” has since been referred to the House Subcommittee on Courts and Competition

Policy.283

279 Stop Tax Haven Abuse Act, 111th Cong. (2009), Section 102. 280 Emil Arguelles, “The Truth About Tax Havens.” San Pedro Daily. Nov. 14, 2009. http://ambergriscaye.com/forum/ubbthreads.php/topics/357954/The_truth_about_tax_havens.html 281 Global Financial Integrity: Support for Levin Stop Tax Haven Abuse Bill Grows. Mar. 16, 2009. PR Newswire Association LLC. http://proquest.umi.com.libezproxy2.syr.edu/pqdweb?index=13&did=1661785821&SrchMode=1&sid=5&Fmt=3&VInst=PROD&VType=PQD&RQT=309&VName=PQD&TS=1268135948&clientId=3739&cfc=1 282 Id. 283 http://www.govtrack.us/congress/bill.xpd?bill=h111-1265.

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CONCLUSION

Ultimately, most agree that the current system of hedge fund regulation does need to be

strengthened. This is plainly seen by the fact that he majority of U.S. officials and investors, and

even more than a third of all hedge fund managers, favor additional hedge fund regulation to

some extent.284 Moreover, the type and degree of additional regulation is a delicate matter that

requires a careful balance of preserving the market benefits of hedge funds while mitigating the

threats to market stability and investor confidence.

Many of the market benefits provided by hedge fund industry exist in large part because

of the fact that they are only subject to modest regulations, whereby primarily wealthy investors

can seek above average returns in the market by seeking out more risky and/or illiquid

investment opportunities. Privacy and anonymity for these investors is another typical reason

why sophisticated investors choose these less traditional investment vehicles over more

traditional ones. Forcing hedge fund managers to disclose sensitive information, such as client

lists, would be far too invasive and the limited potential benefits of disclosure would likely not

outweigh the risks of disenfranchising a huge portion of the hedge fund investor population.

Moreover, if hedge funds were regulated like mutual funds, for example, it would

severely limit their ability to pursue typical strategies seen in the market today that provide so

many benefits. Under a mutual fund regulatory structure, hedge funds would not be able to

pursue a typical leverage strategy of between 2-to-1 to 10-to-1.285 This overbearing restriction set

forth in Section 18(f) of the Company Act would severely limit hedge funds investment

284 Tomoeh Murakami Tse, “For Hedge Funds, Biggest Fear Is More Regulation.” The Washington Post, Jun. 25, 2009 (In 2009, “43 percent [of hedge fund managers] said there is the "right amount" of regulation now, 37 percent said they favored more regulation, according to the survey, which was commissioned by RSM McGladrey, a financial services consultancy. Eighteen percent favored looser oversight.”) (available at: http://www.washingtonpost.com/wp-dyn/content/article/2009/06/24/AR2009062403450.html). 285 Investment Company Act § 18(f), 15 U.S.C. § 80a-18 (2000 & Supp. IV 2004).

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strategies in long-term, illiquid securities. Moreover, this act would also seriously prohibit their

ability to fundamentally operate as a hedge fund, due to the asset diversification requirements set

forth in the Act.286 The freedom of hedge funds to pursue a wide range of investing and

leveraging tactics is what make them so versatile and provides the market with greater flexibility

in matching institutions up based on risk preferences, liquidity needs, and capital constraints.287

As we have discussed, the hedge fund industry is a diverse lot of firms. Presently, hedge funds

operate in a variety of ways: “merger arbitrage, long/short equity investing, credit arbitrage,

statistical arbitrage, subprime assets, and all the other segments of market investment.”288 And

yet hedge funds have been equally vilified, mostly by people, institutions, and countries that

stand at the other end of their investment strategies.

It would be foolishly cavalier to infer from the financial crisis that there is basic or direct

correlation between the degree of risk different institutions have on the market and the extent

they are regulated.289 From this Note’s analysis, we witnessed that banks and other highly

regulated financial institutions had a far greater impact in bringing about the financial crisis than

hedge funds did.290 The responsibility for regulators is to create an overall regulatory system

where officials can better enforce existing laws on the table for regulated companies. Moreover,

any additional regulations on a type of institution should not harm other entities, but rather

provide incentives to self-regulate themselves. This was readily seen following the LTCM

collapse, where regulated financial institutions took it upon themselves to manage their risk more

286 Id. 287 Timothy F. Geithner, President & CEO, Fed. Reserve Bank of N.Y., Keynote Address: Hedge Funds and Their Implications for the Financial System (Nov. 17, 2004) (transcript available at http:// www.ny.frb.org/newsevents/speeches/2004/gei041117.html). 288 Etienne Rolland-Piegue, “Book Review: More Money Than God: Hedge Funds and the Making of a New Elite, by Sebastian Mallaby,” June 2010. (http://aidfinancial.net/2010/08/22/more-money-than-god-hedge-funds-and-the-new-elite-to/). 289 Houman Shadab, Don’t Blame all the Shadow Banks, CBS Money Watch, Apr. 13, 2009. (available at: http://moneywatch.bnet.com/economic-news/blog/blog-war/dont-blame-the-shadow-banks/295/). 290 Id.

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appropriately and be more sophisticated as to the way they approached investing and how they

used certain financial instruments. In the end, regulators should not stifle private risk-seeking

investing, as it would simultaneously stifle private risk mitigation and self-regulation, which is

what hedge funds and the overall financial system really needs.

However, the regulatory debate is not so simple and limited to just the U.S.. Markets are

globally connected now and the problem with hedge fund migration to tax havens poses serious

long-term threats to market stability and investor confidence, as migration rates continue to surge

every year. The problem with tax haven abuses has been characterized as an internationally-

linked, systemic problem that implicates the global financial market.291 However, foreign

investment funds that operate offshore could circumvent these regulations by establishing their

investment-decision making outside the U.S.. Not only could this increase systemic risk by

operating in clandestine, offshore jurisdictions, but could disadvantage U.S. domestic funds,

perhaps resulting in increased migration of funds and their operations completely offshore out of

the bill’s reach.292 This might also be fueled by the likelihood of increased compliance costs

hedge funds would endure to ensure they are complying with this bill, and any of the previously

mentioned bills that might be passed.

The U.S. has tried to deal with cross-border tax evasion by U.S. citizens and residents,

but has seemingly allowed foreign entities to escape their own countries’ foreign income taxes

by providing confidentiality and tax-free treatment for certain investments in the U.S..293 Up to

this point, the U.S. has failed to establish a “coherent, coordinated, consistent, and systematic

291 Id. 292 Id. 293 Comisky and Lee, ‘Increased IRS Scrutiny of Offshore Activity: Raising the Stakes for U.S. Citizens With Bank Accounts Abroad,‘ 20 JOIT 38 (January 2009).

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approach” with other nations to combat offshore tax evasion.294 The problem will be

exacerbated as Mallaby notes, “the countries that like hedge funds the best are also the ones that

host them.” One may also conjecture that countries that use hedge funds for their sovereign

wealth investments will also develop a liking for them, as did universities endowments and other

institutional investors looking for higher returns.295

The U.S. must work with the international community in establishing standards of

regulation and communication that can better equip them to prevent threats of systemic risk. One

regulator said, “If only one dominant market is regulated you will have a race to the lowest

unregulated market. Regulating them both in tandem would make it more difficult to move to a

third jurisdiction."296

None of the proposed bills on it sown or in conjunction with each other provide the right

balance of risk mitigation and market benefit permeation. The tax restrictions would close

loopholes, but then make U.S. hedge funds at a competitive disadvantage. The only real strategy

is better enforcement of existing laws, which will prompt hedge funds to better regulate

themselves, thus improving market stability and efficiency. Regulators cannot kill an industry on

the rebound, after having a windfall comeback year after being wrongfully accused of being the

culprit. Regulators must be delicate and look to new proposed legislation that better suits the

industry than the current bodies presently proposed.

294 David Spencer, Cross-Border Tax Evasion and Bretton Woods II (Part 1). Journal of International Taxation, May 2009. 20 JITAX 45. 295 Etienne Rolland-Piegue, “Book Review: More Money Than God: Hedge Funds and the Making of a New Elite, by Sebastian Mallaby,” June 2010. (http://aidfinancial.net/2010/08/22/more-money-than-god-hedge-funds-and-the-new-elite-to/). 296 David Spencer, Cross-Border Tax Evasion and Bretton Woods II (Part 1). Journal of International Taxation, May 2009. 20 JITAX 45.

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APPENDIX

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Hedge Fund: Offshore Evasion vs. Investment in Domestic Partnership

-----------------------------------

U.S. Investor

U.S. Partner Not Reporting

in Domestic Offshore Fund

Partnership — Income — U.S.

U.S. Income Withholding Difference:

Tax Rate on Tax Rate on Tax Reduction

Type of Income Individual Corporation From Evasion

---------------------------------------------------------------------------

Qualified Dividend 15% 30% -15%

Portfolio Interest 35% 0% +35%

Long-Term Capital Gain 15% 0% +15%

Short-Term Capital Gain 35% 0% +35%

Table 1. Assigning Hedge Fund Assets to Caribbean, Method I (Total non-U.S. assets, end of 2006 equals $976.1 billion; dollar amounts in millions) -------------------------------------------------------------------- HFR Estimates of Number of Funds Estimated Assets ------------------------------- (previous column Domicile World Total Non-U.S. Total times 2006 total) -------------------------------------------------------------------- Bahamas 1.7% 2.5% $24,172 Bermuda 7.7% 11.0% $107,028 B.V.I. 9.3% 13.3% $129,384 Cayman Islands 33.7% 48.2% $470,450 Total "Big Four" 52.3% 74.9% $731,035 Other Non-U.S. 17.5% 25.1% $245,076 United States 30.1% 0.0% World Total 100.0% 100.0% -------------------------------------------------------------------- Source: Hedge Fund Research Inc., "HFR Industry Report — Year End 2006," available at http://www.hedgefundresearch.com.

Some care must be taken in interpreting these figures. Asset totals represent total equity investment in hedge funds. Hedge funds often leverage their investment in the hope of supercharging returns to their equity investors. If a hedge fund has a debt-equity ratio of 2:1, the assets it invests in would be three times larger than those reported as assets under management.

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("Offshore Explorations: Caribbean Hedge Funds, Part II," Tax Notes, Jan. 7, 2008, p. 95). http://www.tax.com/taxcom/features.nsf/Articles/DE15FD6B5D167E0B852573CB005BB50C?OpenDocument

http://hedgefundblogman.blogspot.com/2009/08/top-hedge-fund-countries.html

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http://hedgefundblogman.blogspot.com/2009/08/top-hedge-fund-countries.html