Should Wall Street be afraid of the new rules established by the Dodd-Frank Act? For more than 30 years until the enactment of the Dodd-Frank Act, the hedge-fund industry had resisted attempts by the Securities and Exchange Commission to register hedge-fund managers. The SEC’s last attempt to register hedge-fund managers failed in 2006 when the United States District Court of Appeals for the District of Columbia in Goldstein v. SEC vacated the registration of hedge-fund managers by the SEC as arbitrary. All hedge-fund managers who had registered with the SEC under the invalidated rule deregistered after the Goldstein decision.
The industry’s opposition to regulatory oversight can be traced back to several factors. Since the inception of the hedge-fund industry, hedge-fund managers considered regulatory oversight an infringement on their ability to generate absolute returns. Hedge-funds evolved in a regulatory environment that allowed them through so-called safe harbors to stay exempt from regulatory oversight. Hedge-funds’ ability to operate without regulatory oversight facilitated successful hedge-fund launches, generated higher returns and attracted investors.
The Dodd-Frank Act appears to be the last chapter in the debate on hedge-fund adviser registration and disclosure. Title IV of the Dodd-Frank Act authorized the SEC to register hedge-fund managers and demand enhanced disclosure. The SEC now requires the disclosure of financing information, risk metrics, strategies and products used by hedge-fund managers, performance and changes in performance, positions held by the investment adviser, percentage counterparties and credit exposure, assets traded using algorithms, and the percentage of equity and debt, among others.
The new rules are controversial and precipitated vehement industry complaints. Industry representatives allege the Dodd-Frank rules result in lower profits and undermine managers’ competitiveness. Given its limited resources, it is unclear how the SEC will evaluate the new information it collects.1 Industry representatives also voiced concern about the confidentiality of disclosure and the impact on the industry if information should be leaked to the market or to hedge-funds’ competitors. There is also a concern that the new Dodd-Frank Act requirements could push new market entrants out of the market because of higher startup costs.
Despite these concerns and industry grumbling, the hedge-fund industry is taking the new regulatory environment under the Dodd-Frank Act in stride.2 Hedge-fund investors’ rate of return was not affected by the registration and disclosure requirements. The new regulatory regime has not affected the asset size of hedge-funds. Hedge-fund managers are not planning changes in their portfolio structure or operations, nor are they planning any other strategic responses. Fund managers are also not changing the size of the assets they hold to avoid the application of Dodd-Frank Act regulations.
Although compliance with Dodd-Frank Act requirements has increased costs for the hedge-fund industry, the industry is adjusting well to the new cost structure. Costs have increased because of outsourced compliance work, hiring of additional counsel, new record-keeping policies, the hiring of additional staff, as well as new investor communications and marketing materials. For most hedge-fund managers the cost of compliance ranges from $50,000 to $200,000, and most hedge-fund managers have spent less than 500 hours per year to comply with the new registration and reporting requirements. These additional costs seem manageable for most hedge-funds. It is too early to tell if additional burdens stemming from the Dodd-Frank Act will slow down hedge-fund activity and reduce investor returns.
So far, the hedge-fund industry has no reason to fear the Dodd-Frank Act; however, there is one caveat: the SEC and the newly founded Financial Stability Oversight Council (FSOC) have the authority to further increase the regulatory oversight to address systemic concerns posed by the private fund industry. Unless both regulators substantially increase the regulatory oversight, the hedge-fund industry should be well-prepared to adjust to the new regulatory environment under the Dodd-Frank Act.
About the Author: Wulf Kaal is an associate professor at the University of St. Thomas School of Law. Before entering the academy, he graduated with a Ph.D., J.D., M.B.A. and LL.M. and worked for Cravath, Swaine & Moore, L.L.P., in New York City and Goldman Sachs in London. Kaal specializes in hedge-fund regulation, international finance, European law and corporate law securities regulation. He has published in leading European law and finance journals and leading American law reviews.
1 Wulf A. Kaal, Hedge-fund Regulation via Basel III, 44 Vand. J. Transnat’l L. 389 (2011).
2 Wulf A. Kaal, Hedge-fund Manager Registration under the Dodd-Frank Act - An Empirical Study, 50 San Diego L. Rev. (2013) (forthcoming).
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