By James Hamilton, J.D., LL.M.
The SEC should not divert agency oversight resources from areas where retail investor assets are concentrated to the regulation of hedge funds whose investors have either the financial acumen or wherewithal to look out for themselves or to hire someone else to do so for them, said Commissioner Paul Atkins in remarks at the Chicago Federal Reserve Bank. Hedge fund investors can likely afford to bear a loss if they or their adviser makes a poor decision, he continued, since they are not betting their last dollar on a hedge fund manager. Further, if things go wrong, they have the means to take effective steps on their own, including private actions and reporting malfeasance to the proper authorities. His remarks are part of a growing SEC-FED consensus that market discipline, not direct regulation, is the key to the proper oversight of hedge funds.
The suggestion that hedge funds were drawing increasing numbers of retail investors is overblown, in his view, and is not supported by the staff report that preceded the adoption of the SEC rule requiring hedge fund advisers to register. He recognized that there are also worries about retail investors' indirect exposure to hedge funds through their pension funds; a fear shared by congressional leaders. However, he emphasized that retail investors with such indirect exposure to hedge funds are protected by a sophisticated intermediary who makes the investment decisions.
After the SEC mandatory hedge fund adviser registration rule was cut short by the D.C. Circuit Court of Appeals last year, the Commission decided to take an entirely different approach to unregistered funds. Mr. Atkins detailed a number of different threads making up this approach. For example, the SEC is intensifying its cooperation with other regulators, including the Federal Reserve Board, on issues of systemic risk and information collection. Unregistered funds are undeniably significant players in the capital markets, acknowledged Comm. Atkins, and regulators need to monitor systemic risk.
In his view, the restrained regulatory approach of relying on market discipline enunciated after the LTCM debacle has recently been affirmed as the market continues to demonstrate a capacity to minimize and absorb systemic risk. In this regard, the commissioner agrees with Fed chair Ben Bernanke that the market discipline approach has the added advantage of avoiding the moral hazard that could result from closer regulatory involvement, which in turn would inspire private counterparties of hedge funds to do less.
Another step the SEC has taken since the hedge fund registration rule was judicially overturned is a proposal to raise the threshold for investors in private pools of capital. The proposal would create a new category of accredited investor for private investment pools that would include anyone who satisfies the existing $1,000,000 net worth or the $200,000 net income test and owns at least $2.5 million in investments, which would exclude the person's home. The new investment minimum would be adjusted for inflation every five years. Essentially, the proposed rule would layer an additional requirement on top of the existing accredited investor requirements for Section (3)(c)(1) funds. Section (3)(c)(7) funds would not be affected since investors in those funds already are similarly subject to a two-part investment test.
The commissioner worries about how the new threshold will affect newly established advisors without much of a track record. These advisors will have to try to attract capital from what may prove to be a very small pool of potential investors, he fears. Thus, if adopted, the rule could prove to be a significant barrier to entry for new advisors.
Indeed, the SEC is continuing to look at whether the proposal got the accreditation levels right. He noted that the Commission will solicit additional comment in connection with a forthcoming proposal to amend Regulation D, a series of rules that apply to private placements. Soliciting comment in connection with the proposed changes to Regulation D should help the SEC work towards greater uniformity of approach across its rule book.