Regulation

Protecting Investors, Promoting Innovation

Hedge funds are subject to many of the same restrictions on their investment and portfolio trading activities as most other securities investors, including the following requirements:

  • Anti-fraud and anti-manipulation requirements, such as Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, as well as insider-trading prohibitions, both in the funds’ investment and portfolio-trading activities, and in the funds’ offers and sales of units to their own investors;60
  • Margin rules,61 which limit use of leverage to purchase and carry publicly traded securities and options;
  • SEC Regulation SHO,62 which regulates short selling;
  • Williams Act amendments63 to the Securities and Exchange Act of 1934 and related SEC rules, which regulate and require public reporting on the acquisition of blocks of securities and other activities in connection with takeovers and proxy contests;
  • SEC, CFTC, and Treasury portfolio and other reporting requirements for large positions; and,
  • FINRA “new issues” rule 2790 (which governs initial public offering allocations).64

Hedge funds must also abide by the rules and regulations of markets in which they seek to buy or sell financial products. For example, when sold through a broker-dealer as the placement agent, hedge funds are subject to suitability requirements under FINRA rules. Hedge funds are also regulated by the terms of certain exemptions from registration under the Securities Act of 1933, the Investment Company Act of 1940, the Investment Advisers Act of 1940, and, in some cases, the Commodity Exchange Act.65 To meet these exemptions, they must limit their offerings to private placements with sophisticated investors, who are able to understand and bear investment risks. The hedge fund must either restrict its beneficial owners to no more than 100 persons and entities (typically all or most of whom are “accredited investors”), or to super-accredited “qualified purchasers” (a category of investor that includes, in brief, individuals with more than $5 million in investments and institutions with more than $25 million in investments).66

“Congress originally was wise to limit the investor pool to those wealthy enough to be able to make judgments on their own, without the help of SEC regulations,” said Wharton Finance Professor Richard Marston, Director of the George Weiss Center for International Financial Research.67 The reasoning, Marston said, is that these individuals and institutions can perform the necessary due diligence themselves and can take on large risks.

Hedge funds are not regulated in the same manner as publicly traded mutual funds. They are not subject to the additional restrictions imposed by the Investment Company Act of 1940—restrictions intended to protect less sophisticated investors when investing in traditional retail funds.

In December 2004, the SEC issued a rule change that required most hedge fund advisers to register with the SEC by February 1, 2006 as investment advisers under the Investment Advisers Act of 1940. The requirement, with minor exceptions, applied to firms managing in excess of $25 million with more than 15 investors. The SEC said it was adopting a “risk-based approach” to monitoring hedge funds as part of an evolving regulatory regime for the industry.68

This rule change was challenged in court (Goldstein v. SEC, 451F.3d873 [D.C.Cir.2006]). In June 2006, the U.S. Court of Appeals for the District of Columbia ruled that the SEC had erred in changing its long-standing interpretations of provisions of the Investment Advisers Act of 1940 and, therefore, hedge fund advisers managing less than 15 funds would no longer be required to register.69

In light of this decision, the SEC adopted a new anti-fraud rule prohibiting investment advisers to pooled investment vehicles, including hedge funds, from defrauding current and prospective investors. The rule clarifies that an adviser’s duty to refrain from fraudulent conduct under the federal securities laws extends to the relationship with the ultimate investors and that the commission may bring enforcement actions under the Investment Advisers Act of 1940 (15 U.S.C. §80b) against investment advisers who defraud investors or prospective investors in those pooled investment vehicles.70

During Senate confirmation hearings in early 2009, Treasury Secretary Timothy Geithner71 and SEC Chairman Mary Schapiro72 both endorsed registration of hedge funds as a means of achieving greater transparency and oversight. Secretary Geithner elaborated on his approach in March 2009, stating that registration and other regulatory requirements, including new disclosure obligations, should be adopted for managers of private pools of capital, not just hedge funds.73 Chairman Schapiro has called for more authority over hedge funds, including the “ability to inspect and examine.” She said, “We need the ability to require the maintenance of books and records and some further rulemaking authority.”74Their recommendations were incorporated into regulatory reform legislation the White House unveiled in July 2009.75

In 2007, the SEC announced the creation of a new hedge fund task force within the Enforcement Division as part of the commission’s latest initiative to “enhance its efforts to combat hedge fund insider trading.”76

Over the last five years (2004 to 2009), the SEC brought more than 100 cases involving hedge funds, according to Commissioner Elisse B. Walter in testimony before the House Financial Services Committee in March 2009.77 “The SEC is focusing on several issues involving hedge funds and other institutional traders, including (i) possible manipulation, abusive short selling and collusion; (ii) valuation concerns with respect to illiquid assets; and (iii) potential insider trading in a host of circumstances, including prior to mergers and acquisitions and in the credit derivatives market,” she said.

The Commodities Futures Trading Commission (CFTC) regulates those hedge fund advisers registered as commodity pool operators (CPO) or commodity trading advisers (CTA). The CFTC has authorized the National Futures Association (NFA), a self-regulatory organization for the U.S. futures industry, to conduct day-to-day monitoring of registered CPOs and CTAs. The CFTC, like the SEC and bank regulators, “can use their existing authorities—to establish capital standards and reporting requirements, conduct risk-based examinations, and take enforcement actions—to oversee activities, including those involving hedge funds, of broker dealers, of futures commission merchants, and of banks, respectively.”80

In January 2009, two blue-ribbon, private-sector committees established by the President’s Working Group on Financial Markets issued separate yet complementary sets of policies for hedge fund investors and asset managers.81 The best practices for the asset managers called on hedge funds to adopt comprehensive best practices in all aspects of their business, including the critical areas of disclosure, valuation of assets, risk management, business operations, compliance, and conflicts of interest.82 The best practices for investors include a Fiduciary’s Guide and an Investor’s Guide. The Fiduciary’s Guide provides recommendations to individuals charged with evaluating the appropriateness of hedge funds as a component of an investment portfolio. The Investor’s Guide provides recommendations to those charged with executing and administering a hedge fund program once a hedge fund has been added to the investment portfolio.83

Investors’ Rigorous ‘Due Diligence’

Through “due diligence,” investors identify managers with whom to invest and then monitor those managers to ensure that investing with them is appropriate for the investor. The level of quantitative and qualitative analysis is considerable to understand fully the operational and financial risks of a hedge fund.

Institutional investors or their financial managers generally require a private investment company to provide answers to detailed questions regarding its background, strategies, research, personnel, returns, compliance programs, risk profile, and accounting and valuation practices. Prospective investors also review liquidity restrictions, management and performance fees, and any applicable lock-up periods.

As part of the due diligence process, investors successfully demand from hedge fund managers effective internal controls to discourage fraud, according to research published in June 2009 by professors from the University of Pennsylvania’s Wharton School of Business and the University of Chicago. Investors also use the fees they pay as part of their incentives to ensure strong internal controls. “[W]e find a positive association between the quality of internal controls and the performance fees rewarded to managers, which is consistent with investors protecting against potential financial misstatements by placing less emphasis on the reported performance when internal controls are less likely to detect or prevent managers from manipulating reported performance.”84 Other research shows that due diligence can be an important source of the “alpha” (meaning performance above a benchmark) in a well-designed hedge fund portfolio strategy.85

Pension funds typically have in place extensive due diligence review processes to protect the interests of their beneficiaries and safeguard their funds’ health. Under the Employee Retirement and Income Security Act (ERISA), plan fiduciaries are expected to meet general standards of prudent investing.86

At the California Public Employees’ Retirement System (CalPERS), three layers of supervision monitor the decisions about hedge fund investments. These are the fund’s internal staff and two outside advisors (Pacific Alternative Asset Management Co. and UBS). “Within CalPERS, a committee of highly skilled investment professionals reviews every hedge fund investment before it is added to the CalPERS portfolio. The committee also oversees manager due diligence, selection, contract negotiation, portfolio construction, risk analytics, and manager monitoring. Investment staff and program advisers spend hundreds of hours researching individual hedge funds, auditing their investment processes, interviewing the hedge fund managers, checking references, reviewing broker statements, talking to their auditors, examining their compliance systems, and plotting performance before an investment is made.”87

CalPERS monitors monthly returns and risk profiles to ensure managers deliver as promised—with the same questions, scrutiny, examination, and thoughtfulness that went into selecting the manager in the first place. CalPERS staff speak with every hedge fund manager monthly and visit them semi-annually.

The Teacher Retirement System of Texas (TRS) conducts a similarly rigorous process, which begins with a review of the fund’s overall investment strategy. That leads to the selection of a “premier list” of investment firms based on various parameters and counsel from experts employed by the fund, according to Britt Harris, the TRS chief investment officer.88 These firms are then subjected to a “certification process,” which includes more than 100 questions across eight categories (organization, investment process, portfolio exposure, risk management, operations, policies and procedures, transparency, and fund terms). An extensive risk management evaluation follows for those firms that become certified. “The final portion of the selection process involves a detailed evaluation of the specific portfolio that the potential manager is likely to purchase, making sure that incentive structures are carefully established, and a thorough negotiation of legal terms.”89

Time Involved in Due Diligence

Due Diligenge

SOURCE: 2009 Deutsche Bank Alternative Investment Survey. March 2009. Available at: http://www.deutsche-bank.de
Model Due Diligence Questionnaire

The Managed Funds Association prepared a questionnaire to help investors identify the questions they should consider before making a hedge fund investment. The questionnaire covers the following categories:

Investment manager overview

  • Firm description
  • Personnel
  • Service providers
  • Compliance system and registration with regulatory authorities
  • Infrastructure and controls
  • Business continuity

Overview of activities of investment manager

  • Vehicles managed
  • Other businesses
  • Conflicts of interest
  • Fund information
  • Fund overview and investment approach
  • Fund capital and investor base
  • Fund terms
  • Performance history
  • Risk management
  • Valuation
  • Fund service providers
  • Investor communications
Source: Managed Funds Association, Model Due Diligence Questionnaire for Hedge Fund Investors. Available at: http://www.managedfunds.org
Hedge funds are designed by law to operate with optimum flexibility.
“The hedge fund legal regime includes not only federal securities law but also the entity and contract law provisions governing the fund, its manager, and investors.”
Houman B. Shadab,
Senior Research Fellow, George Mason University, September 25, 200878


“Hedge fund advisers have improved disclosure and become more transparent about their operations, including risk management practices, probably as a result of recent increases in investments by institutional investors . . . and guidance provided by regulators and industry groups.”
Government Accountability Office
May 7, 200979
  • 60. 15 U.S.C. § 78j; 17 C.F.R § 240.10b-5.
  • 61. 12 C.F.R. parts 220.1 and 221.1
  • 62. 17 C.F.R. §§ 242.200-.203.
  • 63. 63. Exchange Act §§ 13(d), 13(e), 14(d), 14 (e), and 14 (f); 15 U.S.C. §§ 78 m(d), 78 m(e), 78 n(d), 78 n(e), and 78 n(f).
  • 64. NASD Notice to Members 05-65.
  • 65. 15 U.S.C. § 78j.
  • 66. 17 CFR § 240.10b-5.
  • 67. Knowledge@Wharton, op.cit., footnote 25.
  • 68. SEC, Registration Under the Advisers Act of Certain Hedge Fund Advisers. Release No. IA-2333. File No.: S7-30-04. 17 CFR Parts 275 and 279. Available at: http://www.sec.gov/rules/final/ia-2333.htm
  • 69. Todd Zaun, “Goldstein v. Securities and Exchange Commission.” Business, Entrepreneurship and the Law. Available at: http://law.pepperdine.edu/jbel/content/vol1/zaun-final.pdf. The decision of the U.S. Court of Appeals for the District of Columbia can be viewed at: http://online.wsj.com/public/resources/documents/hedgefund20060623.pdf
  • 70.SEC, Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles. Release No. IA-2628, File No. S7-25-06. Available at: http://www.sec.gov/rules/final/2007/ia-2628.pdf.
  • 71. David Lawder and Tim Ahmann, “Geithner: Strengthen Derivatives, Hedge Fund Rules.” Reuters, January 23, 2009. Available at: http:// uk.reuters.com. In his Senate confirmation hearing, Treasury Secretary Timothy Geithner said: “I support the goal of having a registration regime for hedge funds because we need greater information and better disclosure in the marketplace.
  • 72. FinAlternatives, “SEC Nominee Favors Hedge Fund Registration.” January 16, 2009. Available at: http://www.finalternatives.com/node/6632. At her confirmation hearing, SEC Chairman Mary Schapiro expressed support for hedge fund registration. “Mary Schapiro told the Senate Banking Committee at her nomination hearing yesterday that she would consider resurrecting the registration rule, which was thrown out by a federal court in 2006. Requiring hedge funds to show their books to regulators ‘will give us a better handle on who is out there and what they are doing,’ Schapiro said.”
  • 73. Robert Schmidt, “Geithner to Seek Power Over Hedge Funds, Derivatives.” Bloomberg, March 26, 2009. Available at: http://www.bloomberg.com
  • 74. Rachelle Younglai, “SEC Needs Hedge Fund Authority: Schapiro.” Reuters. April 29, 2009. Available at: http://www.reuters.com/articlePrint?articleId=USTRE53R78220090429. “Schapiro Seeks Rulemaking Power Over Hedge Funds.” Bloomberg. May 1, 2009. Available at: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=azz5UNZyvpcA.
  • 75. U.S. Department of the Treasury, “Financial Regulatory Reform: A New Foundation.” July 15, 2009. Available at: http://www.financialstability.gov/docs/regs/FinalReport_web.pdf
  • 76. Jesse Westbrook and Jenny Strasburg, “SEC Scrutinizes Hedge Funds in Insider-Trading Probe.” Bloomberg. September 18, 2008. Available at: http://www.bloomberg.com/apps/news?pid=20601087&sid= ay6NbPBZtUa4&refer=home.
  • 77. Elisse B. Walter, Testimony Concerning Securities Law Enforcement in the Current Financial Crisis Before the United States House of Representatives Committee on Financial Services. March 20, 2009. Available at: http://www.sec.gov. See also: Luis A. Aguilar, “Hedge Fund Regulation on the Horizon—Don’t Shoot the Messenger.” Speech. June 18, 2009. Available at: http://www.sec.gov/news/speech/2009/spch061809laa.htm
  • 78. Houman B. Shadab, “The Law and Economics of Hedge Funds: Financial Innovation and Investor Protection.” Berkeley Business Law Journal, Vol. 6, Fall 2009. Available at: http://ssrn.com/ abstract=1066808.
  • 79. GAOffice, Hedge Funds: Overview of Regulatory Oversight, Counterparty Risks, and Investment Challenges. GAO- 09-677T. May 7, 2009. Available at: http://www.gao.gov/products/ GAO-09-677T . See also: GAO, Hedge Funds: Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline, But Continued Attention Is Needed. Report No.: 09-200. January 2008. Available at: http://www.gao.gov/new.items/d08200.pdf.
  • 80. Ibid.
  • 81. Treasury Department, “PWG Private-Sector Committees Finalize Best Practices for Hedge Funds.” Press Release, January 16, 2009. Available at: http://www.treasury.gov/press/releases/hp1361.htm . See also: Treasury Department, “PWG Private-Sector Committees Release Best Practices for Hedge Fund Participants.” Press Release, April 15, 2008. Available at: http://www.ustreas.gov/press/releases/hp927.htm
  • 82. Asset Managers’ Committee, Best Practices for the Hedge Fund Industry. Report of the Asset Managers’ Committee to the President’s Working Group on Financial Markets. January 15, 2009. Available at: http://www.amaicmte.org/Public/AMC%20Report%20-%20Final.pdf . See also: Asset Managers’ Committee, Best Practices for the Hedge Fund Industry. Report of the Asset Managers’ Committee to the President’s Working Group on Financial Markets. April 15, 2008. Available at: http://www.amaicmte.org/Public/AMC_Report.pdf.
  • 83. The Investors’ Committee, Principles and Best Practices for Hedge Fund Investors. Report of the Investors’ Committee to the President’s Working Group on Financial Markets. January 15, 2009. Available at: http://www.amaicmte.org/Public/Investors%20Report%20-%20Final.pdf. See also: The Investors’ Committee. Principles and Best Practices for Hedge Fund Investors. Report of the Investors’ Committee to the President’s Working Group on Financial Markets. April 15, 2008. Available at: http://www.amaicmte.org/Public/Investors_Committee_Report.pdf
  • 84. Gavin Cassar and Joseph J. Gerakos, “Determinants of Hedge Fund Internal Controls and Fees.” June 29, 2009. Available at: http://ssrn.com/abstract=1268456. See also: Knowledge@Wharton, “Hedge Fund Clamp-down? Research Says Investors Can Watch Out for Themselves.” July 8, 2009. Available at: http://knowledge.wharton.upenn.edu/article.cfm?articleid=2276
  • 85. Stephen J. Brown, Thomas L. Fraser, and Bing Liang,”Hedge Fund Due Diligence: A Source of Alpha in a Hedge Fund Portfolio Strategy.” January 21, 2008. Available at: http://ssrn.com/abstract=1016904
  • 86. GAO, Defined Benefit Pension Plans: Guidance Needed to Better Inform Plans of the Challenges and Risks of Investing in Hedge Funds and Private Equity. GAO-08-692. August 2008. Available at: http://www.gao.gov/new.items/d08692.pdf . “ERISA’s prudent man standard is satisfied if the fiduciary has given appropriate consideration to the following factors (1) the composition of the plan portfolio with regard to diversification of risk; (2) the volatility of the plan investment portfolio with regard to general movements of investment prices; (3) the liquidity of the plan investment portfolio relative to the funding objectives of the plan; (4) the projected return of the plan investment portfolio relative to the funding objectives of the plan; and (5) the prevailing and projected economic conditions of the entities in which the plan has invested and proposes to invest. 29 C.F.R. § 2550.404a-1(b) (2007).” Ibid. “Under ERISA, a fiduciary is a person who (1) exercises discretionary authority or control over plan management or any authority or control over plan assets; (2) renders investment advice regarding plan moneys or property for direct or indirect compensation; or (3) has discretionary authority or responsibility for plan administration. 29 U.S.C. §1002(21).”
  • 87. CalPERS Web site. Available at: http://www.calpers.ca.gov
  • 88. Britt Harris, Perspectives on Hedge Fund Registration. Testimony before the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises. May 7, 2009. Available at: http://www.house.gov/apps/list/hearing/financialsvcs_dem/testimony_-_harris,_trst.pdf
  • 89. Ibid.