SEC Commissioner designate Troy Paredes believes that there is a middle ground on hedge fund regulation between mandatory rules and doing nothing. He says that the Commission can adopt best practices for hedge funds or employ what he calls a default rule under which hedge funds would register with the SEC or explain to investors why they did not. This latter prescription is similar to the comply or explain concept employed by European Union corporate governance codes, such as the UK’s Combined Code.
Professor Paredes is the heir to the definitive Loss-Seligman-Paredes treatise on securities regulation. This blog was honored to have Professor Paredes as a guest blogger for a week last October. He is a Professor at the Washington University School of Law; and delivered some faculty working papers on hedge funds regulation. On a posting on this blog on October 17, 2007, Professor Paredes discussed hedge fund regulation and best practices.
In the wake of a federal appeals court ruling striking down an SEC rule requiring hedge fund managers to register with the Commission, Professor Paredes said that there are others ways besides hedge fund regulation for the SEC to protect hedge fund investors. For example, the SEC could take advantage of its status and reputation and adopt a best practices mode of regulation. The SEC could express its views of best practices without imposing mandatory requirements. The SEC could articulate best practices formally through SEC releases or informally through speeches and writings of individual commissioners and division directors. One such best practice, he suggested, would be for hedge funds to appoint chief compliance officers.
In his view, hedge fund managers could seize the initiative and adopt SEC-endorsed best practices to show their willingness to go above and beyond what the law requires or investors demand. Further, by emphasizing particular best practices, he reasoned, the SEC would give investors concrete guidance to use in assessing investment options. Such guidance would be a yardstick that investors could use to evaluate the investment opportunity to see how it measures up. Investors could then allocate their capital as they see fit with the benefit of the SEC’s input.
All that said, the Commissioner designate acknowledged that a best practices approach to hedge fund regulation does have its challenges. For example, a fundamental challenge is identifying the best practices. Also, it may be hard to find consensus on best practices among the five SEC Commissioners, let alone among the staff or between the commissioners and the staff. A best practices strategy would depend on effective coordination at the SEC.
He also cautioned that best practices must not be allowed to back door into new mandates. And, even if the SEC accedes to this caution, it is unclear if the courts would. Best practices could provide a roadmap for the plaintiffs’ bar.
The virtue of default rules is that they allow parties to contract around the law to order their affairs to fit their particular needs. More broadly, he believes that the ability to opt out of a regulatory regime provides an important safety valve when regulators would otherwise over regulate. In his opinion, a default rule requiring hedge fund managers to register with the SEC or disclose why they have chosen not to register would have been a particularly apt alternative to the SEC rule mandating registration. Just as hedge fund investors can evaluate other aspects of a fund’s operations, he observed, investors could assess the value of investment adviser registration against the backdrop default that managers must register with the SEC.