Registration of Hedge Fund Advisers under the Investment Advisers Act

39 Pages·2015·2.14 MB·English

by  Daniel K. Liffmann

LLooyyoollaa ooff LLooss AAnnggeelleess LLaaww RReevviieeww
Volume 38
Number 5 Symposium: Theories of Statutory Article 9
Interpretation
12-1-2005
RReeggiissttrraattiioonn ooff HHeeddggee FFuunndd AAddvviisseerrss uunnddeerr tthhee IInnvveessttmmeenntt
AAddvviisseerrss AAcctt
Daniel K. Liffmann
Follow this and additional works at: https://digitalcommons.lmu.edu/llr
Part of the Law Commons
RReeccoommmmeennddeedd CCiittaattiioonn
Daniel K. Liffmann, Registration of Hedge Fund Advisers under the Investment Advisers Act, 38 Loy. L.A.
L. Rev. 2147 (2005).
Available at: https://digitalcommons.lmu.edu/llr/vol38/iss5/9
This Notes and Comments is brought to you for free and open access by the Law Reviews at Digital Commons @
Loyola Marymount University and Loyola Law School. It has been accepted for inclusion in Loyola of Los Angeles
Law Review by an authorized administrator of Digital Commons@Loyola Marymount University and Loyola Law
School. For more information, please contact [email protected].
REGISTRATION OF HEDGE FUND ADVISERS
UNDER THE INVESTMENT ADVISERS ACT
I. INTRODUCTION
"Sunlight is said to be the best of disinfectants; electric light
the most efficient policeman."'
A hedge fund, typically an unregulated investment vehicle for
the affluent investor, holds a variety of securities and other assets.2
Currently, the Securities and Exchange Commission ("SEC")
maintains little reliable data on the hedge fund industry, yet instances
of illegal activity involving hedge funds continue to catch the
agency's attention.3 The SEC has identified fraud, misuse of
leverage, and speculation as the industry's leading problems.4 These
problems include recent late-trading and market-timing scandals, as
well as the 1999 collapse of the massively overleveraged hedge fund
run by Long Term Capital Management. The agency's concerns
about hedge funds parallel the concerns that Franklin Delano
Roosevelt's administration had about investment trusts and their kin
in the early 1930s.5 Those concerns led the New Deal administration
to pioneer the regulatory framework for securities that is currently in
effect.
Today, the hedge fund industry operates in a pre-New Deal state
of regulation. Maintaining this status quo means that the SEC
remains in the dark about many incidents of abuses by hedge fund
advisors. Without any reliable data, the SEC cannot prevent abuses
1. Louis D. BRANDEIS, OTHER PEOPLE'S MONEY, AND How BANKERS
USE IT 92 (A. M. Kelley 2d ed. 1986) (1914).
2. See infra notes 22-27 and accompanying text.
3. See Registration Under the Advisers Act of Certain Hedge Fund
Advisers, 69 Fed. Reg. 45,172 (July 28, 2004) (to be codified at 17 C.F.R. pts.
275, 279) [hereinafter SEC Proposed Rule].
4. See id.
5. See infra notes 39-48 and accompanying text.
2147
2148 LOYOLA OF LOS ANGELES LAWREVIEW [Vol. 38:2147
that harm hedge fund and ordinary investors and that potentially
harm world markets. Pressing the full weight of federal securities
regulations on the hedge fund industry would be consistent with the
hedge fund industry with the historical development of securities
law. Such an approach, however, is not necessary, nor politically
feasible, at this time. A more sensible policy dictates that the SEC
require, as the SEC board finally approved in October 2004,6 that
hedge fund advisers register with the agency. This would enable the
SEC to: (i) begin to understand the hedge fund industry, (ii) attempt
to curb illegal activity of individual funds and their advisers, and (iii)
prevent market disruptions by monitoring overleveraged funds.
Although the SEC proposed rule of registering hedge fund
advisers won a three to two executive board vote, the rule does not
require full compliance until 2006. The rule faced, and continues to
face, intense opposition. According to one calculation, 73 percent of
letters during the comment period for the SEC proposal opposed
registration.7 The voices of opposition include top law firms, hedge
fund groups,9 and some writers in the academic legal community.10
These groups mostly advance provocative economic arguments
against registration, including arguing that registration would impede
the hedge fund industry's growth.
Conspicuously absent on both sides of the registration discourse,
is any attempt to examine hedge funds in the historical context of
securities regulation. This Note shows that many issues that drove
the original federal securities regulations are the same issues driving
the push to regulate the hedge fund industry today, and explains why
the current controversy concerning the hedge fund industry should
6. See Press Release, SEC Proposes Securities Offering Reform, Requires
Registration of Hedge Fund Investment Advisers (Oct. 27, 2004), available at
http://www.sec.gov/news/press/2004-150.htm [hereinafter SEC Press Release].
7. Managed Funds Association, The SEC's Proposal: The Public
Commentary-A Summary, availablea t http://www.mfainfo.org/images/PDF/
SEC-Summary-Comments-Memo.pdf (last visited Apr. 10, 2005) [hereinafter
Managed Funds Comment].
8. Id.; see also Letter from Marianne K. Smythe et al., Director, Division
of Investment Management, Wilmer, Cutler, Pickering, Hale & Dorr LLP, to
Jonathan Katz, Secretary, Securities & Exchange Commission 9 (Sept. 8,
2004) [hereinafter Hale & Dorr Letter].
9. Managed Funds Comment, supra note 7.
10. See, e.g., ERIK J. GREUPNER, Hedge Funds Are HeadedD own-market:
A Callf or IncreasedR egulation?,4 0 SAN DIEGO L. REv. 1555 (2003).
December 2005] HEDGE FUND ADVISORS & IAA 2149
ultimately be resolved in favor of registration.
Part II of this Note examines the context and purpose behind the
securities regulation framework currently in place in the United
States. It is important to examine the circumstances and the intent
under which those regulations were passed in order to understand
why registering hedge fund advisers is consistent with the overall
scheme of securities regulation.
Part III of this Note first describes what is generally known
about the hedge fund industry. The focus then shifts to the details of
how hedge funds avoid the complex securities regulations of the
New Deal. Part III also explains the problems of fraud, leverage, and
speculation that the hedge fund industry imposes onto investors and
world markets as a whole.
Part IV supports registration as the proper method of dealing
with these risks posed by the hedge fund industry. Finally, Part IV
of this Note analyzes the utility of registration and the arguments
against it. By placing the current issue of hedge fund regulation in
an historical perspective, this Note shows that the SEC's October
2004 decision1 to require the registration of hedge fund advisers is
necessary and consistent with the overall goals of securities
regulation.
II. SECURITIES REGULATION AND THE
INVESTMENT TRUSTS OF THE 1920s
The hedge fund industry currently operates under a regulatory
scheme similar to that of the 1920s securities industry.
Consequently, an overview of the securities industry during this
period will illustrate how the current problems posed by the hedge
fund industry are reminiscent of the securities problems that the New
Deal Administration sought to address.
A. State Regulations and Problems in the
Securities Industry During the 1920s and the Depression Era
Understanding why hedge funds adviser registration comports
with the overall scheme of New Deal securities regulation first
11. See SEC Press Release, supra note 6.
2150 LOYOLA OF LOS ANGELES LA WREVIEW [Vol. 38:2147
requires examining the circumstances surrounding the passage of
those regulations. Before the Federal Government established the
elaborate securities regulations of the New Deal, states had passed
their own Blue Sky12 laws to regulate securities. By 1933 all states
but Nevada had some securities or Blue Sky laws.' 3 The Blue Sky
laws were ineffective for many reasons including: (i) lobby efforts by
the Investment Bankers Association, (ii) use of the mails to conduct
securities operations across state lines, and (iii) reluctance by states
to pass or enforce tough measures that may distract industry from the
State. 14
Large, uninformed increases in investor speculation in securities
markets and large increases in securities fraud characterized the Blue
Sky regulation period.15 Congress estimates that about half of the
almost $50 billion worth of new securities issued after World War I
are actually worthless.16
Promoters and managements inspired and profited by this
buying extravaganza. In their.., desire to get a portion of
this easy capital they issued securities for overvalued
properties, pyramided and complicated corporate structures,
over-expanded, [and] over-borrowed ... . [B]ankers like-
wise too frequently forgot their duty of counselors ... they
12. JOEL SELIGMAN, THE TRANSFORMATION OF WALL STREET 44 (1982).
The blue sky laws .were so named because they were "intended to check stock
swindlers so barefaced they 'would sell building lots in the blue sky."' Id.
13. Id. at 45.
14. See Elisabeth Keller & Gregory A. Gehlmann, Introductory Comment:
A Historical Introduction to the Securities Act of 1933 and the Securities
Exchange Act of 1934, 49 OHIO ST. L.J. 329, 332-33 (1988) (citing Federal
Securities Act: Hearings on H.R. 4314 Before the H. Interstate and Foreign
Commerce Comm., 73d Cong. 99, 100 (1933) (DEPT. OF COMMERCE, A STUDY
OF THE ECONOMIC AND LEGAL ASPECTS OF THE PROPOSED FEDERAL
SECURITIES ACT), reprinted in 2 LEGISLATIvE HISTORY OF THE SECURITIES
ACT OF 1933 AND SECURITIES EXCHANGE ACT OF 1934 item 20, at 100 (comp.
by J.S. Ellenberger & E. Mahar 1973)). The Investment Bankers Association
riddled local securities laws with so many exceptions that they were essentially
ineffectual. SELIGMAN, supra note 12, at 45. By operating across state lines,
securities traded through interstate commerce came under the regulatory
purview of the U.S. Congress, not the states. Id.
15. Keller & Gehlmann, supra note 14, at 335.
16. Id. at 334 (citing H.R. REP. No. 73-85, at 2 (1933), reprinted in 2
LEGISLATIVE HISTORY OF THE SECURITIES ACT OF 1933 AND SECURITIES
EXCHANGE ACT OF 1934 item 18, at 2 (comp. by J.S. Ellenberger & E. Mahar
1973)).
December 2005] HEDGE FUND ADVISORS & IAA 2151
reaped a harvest on the popularity of management and fixed
'7
trusts.
"[S]everal million citizens with small incomes were raiding their
savings, reducing their immediate purchasing power and mortgaging
their future in order to speculate. Ninety percent of these market
transactions in the twenties, it has been estimated, were gambling
ventures rather than permanent investments."'18 Investors were often
exploited, and accounting scandals typified by "duplicity in
bookkeeping"'19 were common. Holding companies and pyramid
schemes proliferated, fooling investors into thinking they were
investing in prosperous businesses when they really were investing
in pools of debt laced with deceptive bookkeeping.20
This era also saw the rise of the investment trusts into which
over four and a half million Americans placed their savings,
ultimately losing an estimated three billion dollars.21 In the four-year
period from 1926 to 1929, the "good times," the number of
investment trust companies grew by 600 and their total assets
increased from $1 billion to $8 billion.22 A variety of financial
players, including large investment houses, operated investment
trusts that typically consisted of pooled investment vehicles and
often were used to hedge risk.23 The trusts "were little better than
gambling establishments in which the innocent patron intrusted [sic]
his stakes not even to a fellow player picked at random but to the
croupier-whose main interest, of course, was to represent 'the
house.'"24 Most trusts resisted disclosing their holdings, as required
to be listed on the New York Stock Exchange, and consequently,
traded mainly in Boston and Chicago.25 Trusts often used leverage26
17. Id. at 335 n.58 (quoting Laylin K. James, The Securities Act of 1933, 32
MICH. L. REV. 624, 626 (1934)).
18. DIXON WECTER, THE AGE OF THE GREAT DEPRESSION 5 (MacMillan
Co. 1952).
19. Id.
20. See id. at 5-6.
21. Id. at 6.
22. SELIGMAN, supra note 12, at 222.
23. JOHN KENNETH GALBRAITH, THE GREAT CRASH 1929, at 46-65
(Houghton Mifflin Co. 1979).
24. WECTER, supra note 18, at 6.
25. GALBRAITH, supra note 23, at 49. Highly respected trust managers
favored refusal of the hedge funds to disclose holdings as a prudent move to
prevent runs on securities. Id.
2152 LOYOLA OF LOS ANGELES LA WREVIEW [Vol. 38:2147
aggressively, a practice that some critics attributed to be a main
cause of the 1929 stock market crash."
Despite the prevalence of fraud, speculation and the lack of
transparency28 in the investment industry, the twenties were a time of
great economic growth in the United States.29 Manufacturing and
output rose steadily, as did industrial production and business
earnings.30 From May 1924 to the end of 1927, the New York Times
industrial average increased almost 150%.31
Growth and speculation ran their course "[b]etween September
1, 1929, and July 1, 1932, [when] the value of all stocks listed on the
New York Stock Exchange shrank from a total of nearly $90 billion
to just under $16 billion- a loss of 83 percent., 32 During a similar
period, the value of New York Stock Exchange bonds declined from
$49 billion to $31 billion.33 Correspondingly, Gross National
Product ("GNP") fell by about a third during this same period.34
Some blamed the stock market crash on "bear raids" or abusive
short selling of securities.35 The more widely accepted explanation
26. "In an investment trust leverage was achieved by issuing bonds,
preferred stock, as well as common stock to purchase, more or less exclusively,
a portfolio of common stocks." Id. at 57.
27. Id. at 56-65 (describing investment trusts and their use of leverage); see
also WECTER, supra note 18, at 6-7 (describing the expansion of credit and
investment trusts' use of leverage).
28. "[T]he typical offering circular prior to 1933 contained little of the
information needed to estimate the worth of a security." Keller & Gehlmann,
supra note 14, at 335.
29. While the rich enjoyed the largest economic gains, more and more
people were "well-off." GALBRAITH, supra note 23, at 2.
30. From the early to mid-twenties until 1928, the number of manufacturing
establishments increased from 183,900 to 206,700 with a corresponding rise in
the output value from $60.8 billion to $68 billion, and the Federal Reserve
index of industrial production rose from 67 to 110. Id. at 2-3 (citing U.S.
Department of Commerce, Bureau of the Census, Statistical Abstract of the
United States, 1944-45, FED. RES. BULL., Dec. 1929).
31. Id. at 7-9. The New York Times industrial average increased during
this period from 106 to 245. Id.
32. SELIGMAN, supra note 12, at 1.
33. Id. at 1.
34. GALBRAITH, supra note 23, at 168.
35. 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 SECuRrrIES AND EXCHANGE COMMISSION 40 n.138 (2003)
[hereinafter SEC STAFF REPORT] (citing 7 Louis Loss & JOEL SELIGMAN,
December 2005] HEDGE FUND AD VISORS & IAA 2153
for the crash is overall speculation in the financial markets.36 The
Depression has proven more difficult to explain, but probably
resulted from a combination of: (i) great disparities in income, (ii)
fragile corporate structures; (iii) poor banking structures, (iv) trade
imbalance, and (v) flawed economic projections.37 The Hoover
administration responded to the initial crash by conducting
investigations, holding commission hearings, and seeking voluntary
compliance by corporations with suggested reforms.38 When these
measures failed to produce results, the American people elected
Franklin Delano Roosevelt. Roosevelt swiftly moved to regulate the
securities markets, employing the skills of Felix Frankfurter, then a
Harvard Law professor, and a host of others.39
B. The New Deal Response-FederalS ecurities Regulations
After the Depression took hold, for Roosevelt and the New
Dealers, "[m]aking capitalism live up to its pretensions necessitated a
restoration of public confidence in the governing symbols and basic
currency of the economic order-investment securities.'A4 In
response, the New Deal securities regulations included: the
Securities Act of 1933 ("SA"),41 the Securities Exchange Act of
1934 ("SEA"),42 the Investment Company Act of 1940 ("ICA"),43
and the Investment Advisers Act of 1940 ("IAA").44 Congress
passed these securities acts intending to protect potential securities
investors."
SECURITIES REGULATION 3203-04 & 3204 n.213 (3d ed. 1989)).
36. GALBRAITH, supra note 23, at 168-71.
37. Id. at 177-86.
38. See SELIGMAN, supra note 12, at 2-38. Led by committee counsel
Ferdinand Pecora, the Senate Banking and Currency Committee conducted
investigations instrumental to later securities regulation. Id. at 1-2, 39.
39. See id. at 39-241 (giving a comprehensive account of the New Deal
securities regulations).
40. MICHAEL E. PARRISH, SECURITIES REGULATION AND THE NEW DEAL 3
(1970).
41. Pub. L. No. 73-22, 48 Stat. 74 (codified as amended at 15 U.S.C.
§§ 77a-77aa (1982 & Supp. IV 1986)).
42. Pub. L. No. 73-291, 48 Stat. 881 (codified as amended at 15 U.S.C.
§§ 78a-78kk (1982 & Supp. IV 1986)).
43. Pub. L. No. 76-768, 54 Stat. 789 (codified as amended at 15 U.S.C.
§§ 80a-1 to 80a-64 (1982 & Supp. IV 1986)).
44. Pub. L. No. 76-768, 54 Stat. 847 (codified as amended at 15 U.S.C.
§§ 80b-1 to 80b-21 (1982 & Supp. IV 1986)).
2154 LOYOLA OFL OS ANGELES LA WREVIEW [Vol. 38:2147
Accordingly, to understand why registering hedge fund advisers
comports with the overall scheme of New Deal securities regulation,
it is important to examine the congressional intent behind those
individual regulations. Any evidence regarding the intent of specific
exceptions and exemptions that hedge funds currently use to avoid
regulation must also be examined.
1. The 1933 Securities Act
In a message to Congress on March 29, 1933, Franklin Delano
Roosevelt said:
Of course, the Federal Government cannot and should not
take any action which might be construed as approving or
guaranteeing that newly issued securities are sound in the
sense that their value will be maintained or that the
properties which they represent will earn profit.
There is, however, an obligation upon us to insist that every
issue of new securities to be sold in interstate commerce
shall be accompanied by full publicity and information, and
that no essentially important element attending the issue
shall be concealed from the buying public.45
Congress responded later that same year, enacting the SA largely as a
disclosure statute based on the English Companies Act46 and as one
that remained true to Roosevelt's words.47 The SA's preamble states
the Act's purpose: "to provide full and fair disclosure of the
character of securities sold in interstate commerce... and to prevent
fraud in the sale thereof, and for other purposes.'A8
45. James M. Landis, The Legislative History of the Securities Act of 1933,
28 GEO. WASH. L. REV. 29, 30 (1959) (citing H.R. REP. No. 73-85, at 2
(1933)). Landis was one of the main drafters of the Securities Act and a
protdg6 of securities regulation champion Felix Frankfurter. SELIGMAN, supra
note 12, at 61-62 (giving a concise account of Landis' legal background).
46. See SELIGMAN, supra note 12, at 46.
47. Landis, supra note 45, at 30-49. "The Securities Act of 1933 was
really a 'rotten egg statute.' You could sell all the rotten eggs you wanted if
you told people fully how rotten they were. Alas, a lot of rotten eggs were sold
under this statute and you suspect that a lot of them are continuing to be sold."
Symposium, New Approaches to Disclosure in Registered Security Offerings,
28 Bus. LAW. 505, 505 (1973) (remarks of panelist member A.A. Sommer).
48. Keller & Gehlmann, supra note 14, at 342 n.130 (quoting S. REP. No.
73-47 at 1 (1933), reprinted in 2 LEGISLATIVE HISTORY OF THE SECURrrIES
December 2005] HEDGEF UND AD VISORS & IAA 2155
Nevertheless, the bureaucracy at the time, untrained in complex
securities matters, believed it was unnecessary to regulate
sophisticated investors spending their own money.49 The prevailing
opinion of the drafters was that the federal government should not
concern itself with the sale of securities to a limited group of
experienced investors.50 This idea resulted in the Act's exemption
for sales other than those made by "an issuer, underwriter, or
dealer""51 and "transactions "not involving [a] public offering."52
Thus, the distinction between public and private offerings has set the
scope of the SA.53
2. The 1934 Securities Exchange Act
"Congress intended the SEA to curb notable exchange abuses,
especially speculation and market manipulation."54 Congress
designed the SEA to:
establish the Securities and Exchange Commission to
regulate the securities business; require the stock exchanges
to adopt rules of fair dealing; apply the full disclosure
requirements of new securities under the Securities Act to
all securities traded on a national exchange; and instruct the
Federal Reserve Board to regulate the use of borrowed
55
money in the stock market".
Critics of the Act, however, claimed that the SEA was a step toward
communism in the United States, and some "characterized the bill's
proponents variously as radicals or Bolsheviks or 'a bunch of Jews
ACT OF 1933 AND SECURnIEs EXCHANGE ACT OF 1934 item 17, at I (comp.
by J.S. Ellenberger & E. Mahar 1973)); see also A.C. Frost & Co. v. Coeur
D'Alene Mines Corp., 312 U.S. 38, 40 (1941) (citing the Securities Act of
1933, 48 Stat. 74, 78 (codified as amended at 48 Stat. 881, 905-06 (1934)).
49. See Landis, supra note 45, at 37.
50. Id.; SEC v. Ralston Purina Co., 346 U.S. 119, 126 (1953) (holding that
"the exemption question turns on the knowledge of the offerees").
51. Landis, supra note 45, at 37.
52. 15 U.S.C. § 77d(2) (2000).
53. Landis, supra note 45, at 37.
54. Keller & Gehlmann, supra note 14, at 348 (citing John E. Tracy &
Alfred Brunson McChesney, The Securities Exchange Act of 1934, 32 MICH.
L. REv. 1025, 1027 (1934)); Steve Thel, The Original Conception of Section
10(b) of the Securities Exchange Act, 42 STAN. L. REv. 385,423 (1990).
55. Keller & Gehlmann, supra note 14, at 347.