Guest Blogger: Prof. Troy A. Paredes
In the aftermath of the Goldstein decision (451 F.3d 873 (D.C. Cir. 2006), ¶93,890) overturning the SEC’s hedge fund rule, the Commission has been reevaluating its options for regulating hedge funds. Among other things, Chairman Cox has suggested increasing the financial thresholds for individuals to qualify as “accredited investors.” This makes good sense, as the financial thresholds have been fixed for years. I support this move even though I opposed the SEC’s original hedge fund rule.
I opposed the SEC’s original hedge fund rule for a number of reasons, one of which was my belief that the SEC, in adopting the rule, elided an animating principle of federal securities regulation that demarcates the limits of such regulation. That is, the SEC (with the exception of Commissioners Atkins and Glassman who dissented) looked past the ability of sophisticated and wealthy hedge fund investors to protect themselves. The fact that well-heeled investors (let alone large institutions) may lose money because of a hedge fund fraud or because of risky hedge fund bets is not a basis for more hedge fund regulation. (And there has been no finding of meaningful “retailization.”) Indeed, the risk of loss incentivizes investors to do the kind of diligence that enables them to protect their own interests. If such investors are “accredited,” we assume that they are able to assess and price the risks they identify. That they may fail to do so is not grounds for government intervention in the name of investor protection. (On the other hand, hedge funds are, and should be, subject to longstanding prohibitions against fraud and market manipulation. Hedge funds should not get a free pass when they engage in illegal conduct. And the SEC should continue working with the President’s Working Group on so-called systemic risk concerns.)
If regulators are concerned that current accredited investors can’t fend for themselves, the proper fix is to reconsider who qualifies as an accredited investor. The proper fix is not for the SEC to engage in more regulation of the underlying investment vehicle (even in the form of investment adviser registration). More to the point, if the SEC steps in to regulate if it decides that sophisticated and wealthy hedge fund investors can’t fend for themselves, then what stops regulators from turning their attention to venture capital and private equity firms?
This does not mean that the SEC has to be entirely hands off once it redefines who is and is not an accredited investor. Rather, the SEC could do more to facilitate such investors in doing diligence. The SEC, in other words, can bolster market discipline. For example, the SEC could articulate best hedge fund practices. The SEC could express its view of best practices formally through releases or informally through the speeches of commissioners and division directors. For example, instead of the new hedge fund rule, the SEC could have emphasized particular best practices for the hedge fund industry that hedge fund managers and investors would have been encouraged, but not required, to follow. The SEC could still do this concerning valuation, back-office operations, compliance, and other topics.
By emphasizing best practices, the SEC can provide investors concrete guidance to use in assessing hedge funds or any other investment opportunity. Such guidance provides a yardstick against which investors can evaluate the opportunity to see how it measures up. Investors can then allocate their capital as they see fit with the benefit of the SEC’s input.