The U.S. House of Representatives Committee on Oversight and Government Reform (the “Committee”)1 held a hearing on Thursday, November 13, 2008. The topics were the role of hedge funds in the current financial crisis, systemic risk posed by the hedge fund industry, the need for regulation of the hedge fund industry as well as hedge fund manager compensation. In the first half of the hearings, the Committee interviewed a panel of independent experts2 (the “independent experts”), consisting of academics and researchers, and in the second half of the hearings the Committee interviewed a panel of prominent leaders in the hedge fund industry3 (the “hedge fund managers”).
The independent experts and the hedge fund managers generally agreed that hedge funds were not the cause of the current financial crisis, though some independent experts suggested that hedge funds may have contributed to the crisis. Ruder and Lo agreed that the hedge fund industry probably poses systemic risks to the financial system. Ruder and Lo emphasized that there is too little information and transparency in the hedge fund industry to assess how hedge funds contributed to the crisis and, more generally, to assess the nature of the systemic risks posed by the hedge fund industry. The hedge fund managers emphasized the positive contribution hedge funds have made to the financial system, such as providing the markets with increased liquidity, reduced volatility, better price discovery and enhanced returns in addition to disciplining corporate management and providing a broad array of strategies allowing investors to diversify their portfolios.
In addition, one hedge fund manager suggested that hedge funds, as a class, may not be a source of systemic risk because hedge funds represent such a diverse set of strategies.
Ruder, Lo and the hedge fund managers generally agreed that greater transparency is needed. The general consensus among the independent experts and the hedge fund managers was that standardized derivative contracts traded over an exchange with a clearinghouse acting as an intermediary and guarantor would be an important step to overcome counterparty and risk opacity problems that have contributed to the current crisis.
Ruder and Lo advocated oversight by a central regulator and suggested that the Federal Reserve, with primary responsibility for systemic risk monitoring, would be in the best position to take on such a role. They contemplated a regulatory regime where hedge funds would be required to register with the Securities and Exchange Commission (the “SEC”), the SEC would have inspection powers to monitor risk positions and risk management systems and the SEC would alert the Federal Reserve when it identifies concerns. In addition, Lo and Ruder suggested that they may be in favor of required public disclosure of “large” derivative positions.
Shadab’s position is that regulation of hedge funds would counteract many of the benefits of hedge funds. Specifically, the regulatory task would be enormous and would require the regulators to understand a constantly shifting set of circumstances for not only hedge funds, but also banks, lenders, counterparties and other market participants. This would create a false sense of security by market participants, and such a false sense of security was a contributing factor in the current crisis.
The hedge fund managers generally were not opposed to a central regulator and increased transparency, but were averse to any disclosure requirements to the public, although Falcone suggested he would support regulation requiring some public disclosure. Most of the hedge fund managers agreed that regulation should focus on the management of systemic risk rather than on investor protection. Committee members expressed concern for investors, in particular with respect to the level of information they receive from the hedge funds they invest in. The hedge fund managers pointed out that hedge funds are currently subject to various provisions of the securities laws and that many have voluntarily registered with the SEC as investment advisers.
The independent experts and most of the hedge fund managers generally agreed that regulation of hedge fund leverage or other market activities is not desirable, though some hedge fund managers expressed support for regulation of leverage at the financial institution level. The hedge fund managers pointed out that hedge fund leverage is monitored and controlled by lenders and therefore regulated indirectly.
The hedge fund managers were not of the opinion that the typical hedge fund compensation structure leads to excessive risk taking and emphasized that managers are typically large investors in their own funds and their interests are aligned with the customers’ interests. A manager’s compensation is typically performance based and subject to “high water marks” or claw-back provisions.
Bankman, who participated on the panel of independent experts solely to discuss taxation of manager compensation, took the position that hedge fund managers are able to take advantage of a “loophole” which allows them to be taxed at the long term capital gains rate for a portion of their income. His view was that this “loophole” creates an inefficiency from a tax perspective because it taxes one occupation differently than other occupations. This, according to Bankman, results in one tax rate being applied to a hedge fund manager and a different tax rate being applied to the same income earned by someone in another occupation, which interferes with the free flow of labor.
The hedge fund managers argued that the so called “loophole” in the tax treatment of a portion of a manager’s compensation is the same tax treatment applicable to any partnership and that any change to tax treatment should apply universally to all partnerships and not single out the hedge fund industry. Committee members argued that compensation earned on the profit from a customer’s investment is more akin to wages for a job (ordinary income) than to a partner’s sale of a partnership (capital gains).
While no statement regarding future regulation or proposed future actions came out of the hearings, the testimony may provide a glimpse of the direction that regulation could take. We will continue to monitor the dialogue regarding hedge fund regulation and any action taken to regulate hedge funds.