Jon Terracciano - Hedging the Global Market

HEDGING THE GLOBAL MARKET: AVOIDING EXCESSIVE HEDGE FUND
REGULATION IN A POST-RECESSION ERA
Jonathan P. Terracciano
TABLE OF CONTENTS
INTRODUCTION ………………………………………………………………………………….….2
I. CURRENT OPERATIONAL AND REGULATORY ENVIRONMENT OF HEDGE FUNDS...........................8
A. Background and Structure of Hedge Funds ………………………….............................8
B. Current Legislation Governing Hedge Funds……………………….……………….....14
1. The Securities Act of 1933…………………………………………………………..…...16
2. The Exchange Act of 1934……………………………………………………..………...17
3. The Investment Company Act of 1940……………………………………………….…19
4. The Investment Advisor Act of 1940………………………………………………..…..21
II. HEDGE FUNDS’ ROLE IN SYSTEMIC RISK, INVESTOR FRAUD, AND MARKET BENEFITS……….. 23
A. Systemic Risk……………………………………….………………………..………...24
1. The Implosion of Long-Term Capital Management & Industry Response………...24
2. Systemic Risk Concerns Misdirected at Hedge Funds Instead of Banks………......28
3. The Future of Systemic Risk: Growing Concerns in Offshore Tax Havens……….33
B. Fraud and Investor Protection…………………..............................................................35
C. Benefits of Hedge Funds in Financial Markets………………………………....………38
III. PROPOSED LEGISLATION REGARDING HEDGE FUND REGULATION ……………………...……47
A. “Hedge Fund Transparency Act of 2009”………………………………………..…….47
B. “Hedge Fund Adviser Registration Act of 2009”……………………………...……….51
C. “Private Fund Transparency Act of 2009”……………………………………...………52
D. “Hedge Fund Study Act”……………………………………………………...………..55
E. “Stop Tax Haven Abuse Act”………………………………………………..…………56
CONCLUSION ……………………………………………………………………………………..58
APPENDIX…………………………………………………………………………………………62

INTRODUCTION
In the wake of numerous financial institution collapses, there has been an intense public
and political uproar over who is to blame, how these events occurred, and how to prevent these
problems in the future. By 2008, the U.S. financial market witnessed extreme turmoil in the
financial system. The crisis was marred by the collapse of over two hundred banks and financial
institutions, notably Bear Stearns and Lehman Brothers.1 It was also exemplified by a
consolidation of several large national banks. The Federal Reserve’s bailout of Bear Stearns in
the form of a heavily facilitated sale to JP Morgan, along with the virtually forced sale of Merrill
Lynch to Bank of America were major efforts taken by the U.S. officials in trying to restore
financial order. Moreover, the government takeovers of the two mortgage giants, Fannie Mae
and Freddie Mac and insurance giant American International Group (AIG), and the TARP
(“Troubled Asset Relief Program) bailout of the seventy largest national banks, were other
ominous signs of the U.S. economy’s fragile state.2
These events did not resonate well with the public, sparking sharp condemnation amongst
many politicians, investors, and everyday citizens. News headlines such as “U.S. Recession
Worst Since Great Depression”3 and “World’s Wealthy Lose Faith in Fund Managers,”4 aptly
classified the fallout from the market’s turbulence. The crisis was not downplayed by even the
highest ranking politicians, leading President Obama to characterize the economic chaos at the
end of 2008 as a “continuing disaster” for the United States.5 Despite the stock market’s rebound
1 http://www.fdic.gov/bank/individual/failed/banklist.html; Anne Stjern, The Failure of Bear Stearns, Lehman
Brothers and AIG: Is Another Great Depression in our Future? Associated Content. Sept. 17, 2008.
http://www.associatedcontent.com/article/1043016/the_failure_of_bear_stearns_lehman.html
2 Id.
3 http://www.bloomberg.com/apps/news?pid=20601087&sid=aNivTjr852TI
4http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article6571355.ece
5 BBC News. “Obama Calls Recession a Disaster.” Jan. 30, 2009. http://news.bbc.co.uk/2/hi/business/7860892.stm
2

and relative stabilization of major indices such as the Dow Jones, nearly all believe that the
“Great Recession” rolls on.6
The recent failure of several major investment banks and private funds has been both a
cause and consequence of the deep economic recession that has spread across the world.7 In the
United States, the financial sector has been especially ravaged by a series of successive private
fund meltdowns, totaling 1,471 hedge fund failures in 2008, in addition to the bank failures
previously discussed.8 The recent instability of U.S. and international financial markets stemmed
from a combination of factors that has shaken investor confidence in these systems.
The breakdown in market stability and investor confidence can be largely attributed to
loose lending practices and erroneous subprime mortgage valuation in the United States.9
Consequently, many financial institutions were excessively leveraged with debt and held major
positions on overvalued mortgage-backed securities.10 When the subprime mortgage market
began rapidly crashing, institutions holding large amounts of mortgage-backed securities
incurred severe losses, mainly through writedowns. Moreover, financial institutions exercised
mark-to-market writedowns in valuing assets even though they were no actual, tangible asset
losses.11 This especially proved troublesome to the financial institutions that held massive
amounts of assets in the form of collateralized debt obligations (CDOs) and mortgage-backed
6 http://online.wsj.com/article/SB10001424052748703837004575013592466508822.html
7 Volume 56, Number 8 · May 14, 2009 How to Understand the Disaster By Robert M. Solow.
http://www.nybooks.com/articles/22655
8 New Record For Hedge Fund Failures. Anita Raghavan , 03.18.09, 09:30 AM EDT 1,471 hedge funds went out of
business in 2008. http://www.forbes.com/2009/03/18/hedge-fund-failures-business-wall-street-funds.html.
9 5 B.Y.U. Int'l L. & Mgmt. Rev. 99; Jenny Anderson & Heather Timmons, Why a U.S. Subprime Mortgage Crisis
is Felt Around the World, N.Y. TIMES, Aug. 31, 2007, at C1.
10 Id.
11 Id.
3

securities.12 In a frozen market where firms were reluctant to lend and buy assets, the mark-to-market
accounting method “require[d] that lenders assign a value to an asset based on its current
market value, as opposed to a more traditional hold-to-maturity model that uses historical income
and other criteria for valuing assets.”13 Thus, huge amounts of level three assets, which include
CDOs and subprime mortgage-backed securities, had to be written down to a fraction of their
original book values as the market for these securities became increasingly illiquid and began to
vanish.14
The “maturity mismatch” of long-term, illiquid assets funding short-term debt put firms,
such as Bear Stearns, in grave danger when a liquidity shock occurred, causing investors to cease
lending.15 Hence, several firms that were relatively solvent, meaning it had enough assets
(though somewhat illiquid) to pay off debts, were damaged because their short-term liquidity
was virtually tapped out. 16 “Liquidity” is characterized as “capital resources necessary to
conduct normal business without disruption.”17 Illiquidity was a huge problem for firms like Bear
Stearns, especially in its finals days before merging with JP Morgan. But the fact that banks had
so many assets tied up in toxic mortgage-backed securities drove fears that many were insolvent
as well. 18 No one knew how much these level three assets were worth and many feared they
could be worth only a fraction of what they were valued at. Thus, bank insolvency concerns
12 Id.
13 Id.
14 Id.
15 Bullard, James. “Systemic Risk and the Macroeconomy: An Attempt at Perspective.” [Speech at Indiana
University] 2 October 2008. <http://www.stlouisfed.org/news/speeches/2008/10_02_08.html#_ftn3>.
16 Drum, Kevin. “The Next Step on the Bailout.” Mother Jones 30 September 2008.
<http://www.motherjones.com/kevin-drum/2008/09/solvency-vs-liquidity>.
17 Id.
18 Id.
4

spread throughout the market from mounting liquidity problems because of these toxic security
assets.19
With the exorbitant level of debt raised to finance these now quasi-worthless (or at best
questionably-valued) securities, the inability to cover losses and debt led to the swift downfall of
many financial institutions and the overall U.S. financial market.20 Ultimately, the collapse of the
U.S. market rippled throughout the world because many international investment funds and
banks held substantial positions in these level three securities from frequent trading with U.S.
counterparties.21
In the aftermath of this financial calamity, much of the public and political criticism has
been directed at hedge funds, based on their huge investments and trading in subprime mortgage-backed
securities.22 Hedge funds, a specific type of quasi-regulated, private investment vehicle
(discussed in depth later), were an obvious scapegoat target due to their high debt leverage ratios
and limited financial transparency to individual investors and institutional counterparties.23 The
high degree of leverage and inability of regulators and counterparties to assess the true, intrinsic
19 Id.
20 http://therealdeal.com/newyork/articles/mark-to-market-makes-a-mess
21 Id. For example, Germany's Deutsche Bank AG announced $3.11 billon in write-downs, with much of the losses
stemming from mortgage loans. David Reilly & Edward Taylor, Banks' Candor Makes Street Suspicious, WALL
ST. J., Oct. 4, 2007, at C1. Switzerland's Credit Suisse Group also earlier announced $1.1 billion in similar losses,
id., while another Swiss bank, UBS, announced $3.41 billion in write-downs, much of which stemmed from losses
in securities tied to U.S. subprime mortgages. Jason Singer et al., UBS to Report Big Loss Tied to Credit Woes,
WALL ST. J., Oct. 1, 2007, at A1; Boyd, Roddy. “The Last Days of Bear Stearns.” Fortune Magazine 31 March
2008. <http://money.cnn.com/2008/03/28/magazines/fortune/boyd_bear.fortune/index.htm>; Schmerken, Ivy.
“Counterparty Risk Is a Top Concern in the Wake of the Credit Crisis.” Advanced Trading 15 September 2008.
<http://www.advancedtrading.com/derivatives/showArticle.jhtml?articleID=210601645>.
22 Id. Germany's finance minister, Peer Steinbrueck, charged that “[t]here is a sizable, remarkable number of hedge
funds which are not behaving properly on the market.” Somerville, supra note 1. Further elaborating on the risks
associated with hedge funds, he asserted that “[n]o expert that I have met up to now could exclude a potential
financial crisis caused by all these leveraged impacts of hedge funds.”
23 Leverage is defined as the “use of debt capital in an enterprise or particular financing to increase the effectiveness
(and risk) of the equity capital invested therein.” “Leverage also increases the magnitude of failure in addition to
making the equity capital invested more effective, and such large failures may cause harm to overall market
confidence. Counterparties that trade with hedge funds and parties that provide services to hedge funds may also be
harmed. In particular, it is feared that the collapse of a large hedge fund would cause the fund's creditors to become
insolvent, creating a cascading effect throughout the market.” Michael Downey Rice, Prentice-Hall Dictionary Of
Business, Finance, And Law 208 (1983).
5

value of various assets under management make hedge funds a source of concern regarding
systemic risk.24 Also referred to as “contagion,” “systemic risk” is defined as “the danger of
widespread disruption of financial markets and institutions that, in turn, affects the
macroeconomy.”25 It is the “potential that a single event, such as a financial institution's loss or
failure, may trigger broad dislocation or a series of defaults that affect the financial system so
significantly that the real economy is adversely affected.”26
Regulators are also concerned with the recent rise in fraud among private funds that has
hit investors during this period of extreme market vulnerability. Most notably, Bernard L.
Madoff Investment Securities (BLMIS), a New York-based hedge fund defrauded investors over
$50 billion through a “Ponzi scheme,” “an investment fraud that involves the payment of
purported returns to existing investors from funds contributed by new investors.27 More recently,
the Antiguan-based Stanford International Bank (SIB), and its Chairman Sir Allen Stanford, have
been indicted for engaging in a scheme to defraud investors of over $7 billion.28 From SIB’s
practices, and the fact that they shielded themselves from SEC oversight, SEC officials state that
SIB operated like a typical hedge fund opposed to a bank.29 From these two instances of fraud
24 See, e.g., Paul Davies et al., Prosecutors Begin a Probe of Bear Funds, WALL ST. J., Oct. 5, 2007, at C1
(describing the July 2007 collapse of two mortgage-related hedge funds at Bear Stearns after large losses on U.S.
subprime mortgages, costing investors $1.6 billion). More recently, Bear Stearns required a bailout after massive
losses on subprime mortgage related securities. Robin Sidel et al., The Week That Shook Wall Street: Inside the
Demise of Bear Stearns, WALL ST. J., Mar. 18, 2008, at A1. Unlike other bailouts of financial institutions, the Bear
Stearns bailout required the Federal Reserve Bank to actually take responsibility for $30 billion in securities on
Bear's books. Id.
26 Hedge Funds and Systemic Risk: Perspectives of the President's Working Group on Financial Markets: Hearing
Before the H. Comm. on Financial Servs., 110th Cong. 63 (2007) [hereinafter Testimony of Steel] (testimony of
Robert K. Steel, Under Secretary for Domestic Finance, United States Department of the Treasury), available at
http://www.treasury.gov/press/releases/hp486.htm.
27 http://www.france24.com/en/20081215-hsbc-faces-1-billion-risk-madoff-scandal-fraud;
http://www.sec.gov/answers/ponzi.htm
28 http://www.justice.gov/criminal/vns/caseup/stanfordr.html; Securities and Exchange Commission v. Stanford
International Bank, et al., Case No. 3-09CV0298-L (N.D.TX.)
29 Id.
6

and hundreds more like it, fraud detection and prevention is a second key goal of regulators. The
failure to detect scandals like these have devastated investor confidence in U.S. regulatory
agencies, such as the Securities and Exchange Commission (SEC) and the Commodities Futures
Trading Commission (CFTC).30
Congress has responded to the crisis with several proposals to overhaul the current
regulatory system governing hedge funds. Most notably are the “Hedge Fund Transparency Act
of 2009” (HFTA),31 “Hedge Fund Adviser Registration Act of 2009” (HFRA),32 “Private Fund
Transparency Act of 2009” (PFTA),33 “Hedge Fund Study Act” (HFSA),34 and “Stop Tax Haven
Abuse Act.”35 In conjunction with these proposed bills that would directly regulate the hedge
fund industry, there are bills on the table that would raise corporate tax rates on U.S. investment
firms that operate domestically, as well as those that operate internationally but have close ties to
the U.S. market.
Proposed legislation aimed at minimizing systemic risk and fraud could unintentionally
bring about a wide departure of U.S. hedge funds into international tax havens, where lax
regulation and oversight allows and could exacerbate these existing threats. Moreover, a mass
exodus of hedge funds would also mean the disappearance of many beneficial impacts on the
U.S. financial market. Legislators and regulators must develop a system that balances efficient
hedge fund regulation that is no more restrictive than needed to minimize systemic risk and
fraud, while permitting the benefits of hedge funds to permeate the market, in order to avoid a
30 http://www.bloomberg.com/apps/news?pid=20601109&sid=afUo_v5lEmwc
31 Hedge Fund Transparency Act of 2009, S. 344, 111th Cong. (2009).
32 Hedge Fund Adviser Registration Act of 2009, H.R. 711, 111th Cong. (1st Sess. 2009).
33 Private Fund Transparency Act of 2009, S. 1276, 111th Cong. (2009).
34 Hedge Fund Study Act, H.R. 713, 111th Cong. (2009).
35 Stop Tax Haven Abuse Act, 111th Cong. (2009).
7

mass exodus of U.S. hedge funds into international tax havens, which have become a growing
concern in regards to investor fraud, corruption, and systemic risk.
This paper will examine the current regulatory environment in which hedge funds
operate, and will argue that although the regulatory system is in need of reform, proposed
legislation is unnecessarily restrictive and could actually harm U.S. and international markets.
Part I of this paper will provide information on the background and structure of hedge funds and
discuss the current bodies of legislation governing the hedge fund industry. Part II will examine
possible risks and threats hedge funds pose in the financial market, as well as the benefits they
provide. Part III will address several proposed laws aimed at regulating hedge funds in the
aftermath of the recent global recession. Part IV will recommend only limited additional
regulation through a domestically and globally coordinated effort, that will allow the U.S. hedge
fund industry, and overall financial market, to remain competitive in the global arena. The main
goals of this new regulatory structure will be better mitigating market risk, improving market
integrity, and allowing the benefits of hedge funds to operate and grow in the market.
I. CURRENT OPERATIONAL AND REGULATORY ENVIRONMENT OF HEDGE FUNDS
A. Background and Structure of Hedge Funds
In today’s highly developed and advanced financial environment, the term “hedge fund”
still invokes perceptions of obscurity and ambiguity, even among the most sophisticated
investors. To this day, the term “hedge fund” lacks a single, universally recognized definition in
the financial world, resulting in various, and sometimes contradicting, definitions of the term.36
36 See, e.g., Staff of the Commission's Division of Investment Management and Office of Compliance Inspections
and Examinations, Implications of the Growth of Hedge Funds: Staff Report to the United States Securities and
Exchange Commission viii (2003) [hereinafter SEC 2003 Staff Report]; Financial Services Authority (United
Kingdom), Hedge Funds and the FSA, Discussion Paper 16, at 8 (2002).
8

Although not statutorily defined in the U.S. or abroad, the industry’s generally “accepted
definition is that [hedge funds] are privately offered investment vehicles in which the
contributions of the high net worth participants are pooled and invested in a portfolio of
securities, commodity futures contracts, or other assets.”37
The term “hedge fund” is believed to have been coined back in 1949, referring to a
private investment fund managed by Alfred Winslow Jones under a private partnership
agreement.38 In that fund, Mr. Jones employed a strategy of holding both long and short equity
positions to “hedge” the fund portfolio’s risk against market volatility.39 Moreover, Mr. Jones
pioneered a revolutionary way of charging a “management fee” to investors. Rather than
charging a percent of assets under management, Jones charged a 20% “performance fee” equal to
the fund’s returns.40 This strategy has been widely adopted by the hedge fund industry, where
most hedge funds charge a 15-25% performance fee, in addition to a 2% general management fee
based on the total value of assets held.41
Although the fee structure established by Mr. Jones in 1949 is applied by nearly all hedge
funds today, the investing strategy of “hedging” he employed is not a universal characteristic of
the entire industry. As the hedge fund industry evolved over time, many hedge funds began to
utilize different investment strategies, and some hedge funds even did away with “hedging”
37 Vikrant Singh Negi, Legal Framework for Hedge Fund Regulation. Hedge Funds Consistency Index. Feb. 12,
2010, available at http://www.hedgefund-index.com/s_negi.asp.
38 David A. Vaughn, Selected Definitions of “Hedge Fund.” Comments for the U.S. Securities and Exchange
Commission Roundtable on Hedge Funds. May 14-15, 2003, available at
http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.htm#footnote_1.
9
39 Id.
40 Christopher Holt, Performance Fees: As Old as Portfolio Management Itself? Seeking Alpha. Jan 20, 2009
available at http://seekingalpha.com/article/115612-performance-fees-as-old-as-portfolio-management-itself.
41 Id.

altogether.42 In addition to, or in place of, “hedging,” many current hedge funds draw from a
pool of over twenty-five investing strategies, such as using leverage, derivatives, and arbitraging
by investing in multiple markets.43 A fund need not utilize all these methods to be deemed a
“hedge fund,” but must simply have the capability to engage in them.44 Today, hedge funds are
defined by their organizational structure and mode of operation, rather than by the investing or
financial strategies they employ.45 As more and more hedge funds have taken a purely equity-based
approach to investing without applying any of the aforementioned methods, many “’hedge
funds’ are not actually hedged, and the term has become a misnomer in many cases.”46
Although the investing tactics of hedge funds may have morphed over the last sixty
years, the management and investor structure has primarily remained the same, much like the
original fee structures. U.S. hedge funds are normally organized as limited liability partnerships
(“LLP’s”) or limited liability corporations (“LLC’s”), whereby the fund manager serves as the
general partner (“GP”) and the investors constitute limited partners (“LP’s”).47 Subject to the
limited partnership agreement and the fiduciary duties that apply under both LLP’s and LLC’s,
42 Scott J. Lederman, Hedge Funds, in FINANCIAL PRODUCT FUNDAMENTALS: A GUIDE FOR LAWYERS
11-3, 11-4, 11-5 (Clifford E. Kirsch ed., 2000). Available at http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.
10
htm#footnote_1.
43 JOHN DOWNES AND JORDAN ELLIOTT GOODMAN, BARRON'S, FINANCE & INVESTMENT
HANDBOOK 358 (5th ed. 1998). Available at http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.
htm#footnote_1; MANAGED FUNDS ASSOCIATION, HEDGE FUND FAQs 1 (2003)
44 Id.
45 Supra note 18: Scott J. Lederman, Hedge Funds, in FINANCIAL PRODUCT FUNDAMENTALS: A GUIDE
FOR LAWYERS 11-3, 11-4, 11-5 (Clifford E. Kirsch ed., 2000). Available at
http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.htm#footnote_1.
46 WILLIAM H. DONALDSON, CHAIRMAN, SECURITIES AND EXCHANGE COMMISSION, TESTIMONY
CONCERNING INVESTOR PROTECTION IMPLICATIONS OF HEDGE FUNDS BEFORE THE SENATE
COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS, Apr. 10, 2003, available at
http://www.sec.gov/news/testimony/041003tswhd.htm.
47 Shartsis Friese, LLP, U.S. Regulation of Hedge Funds 88 (2005); Gerald T. Lins, Hedge Fund Organization, in
Hedge Fund Strategies: A Global Outlook 98, 98 (Brian R. Bruce ed., 2002); Gregory M. Levy & Bernard A.
Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res. J., 1997, at 18, available at http://
www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf; Jacob Preiserowicz,
Note, The New Regulatory Regime for Hedge Funds: Has the SEC Gone Down the Wrong Path?, 11 Fordham J.
Corp. & Fin. L. 807, 812 (2006).

the general partner (fund manager) in an LLP has near-plenary control over the hedge fund’s
investing activities, notably the overall strategy and debt structure being the two primary
responsibilities.48 As such, under an LLP the general partner will have unlimited liability for any
outstanding debts or obligations in situations where the hedge fund cannot fulfill them.49
Moreover, a hedge fund may pass tax liabilities directly on to investors, known as “flow
through” tax treatment.50 Since the investors are LP’s, making them passive investors with no
direct control over managing the fund’s portfolio, they benefit by only being held liable for
losses to the degree of their investment in sharing in the gains, losses, and income of the fund.51
But on the downside, the LP investors in both LLP’s and LLC’s are afforded only marginal
rights and protection.52
In comparison, when a hedge fund is organized as an LLC, tax liabilities flow through to
investors, in addition to the hedge fund directly incurring tax expenses, known as “double
taxation.”53 Hence, structuring the hedge fund as an LLP is more favorable in terms of tax
liabilities, but an LLC provides one or managing members limited liability where an LLP
imposes unlimited liability upon the GP fund manager.54 Regardless, the fund manager(s) under
either an LLP or LLC are faced with fiduciary duties to their members in conducting operations
and investing for the fund. 55
11
48 Id. at 90-92.
49 Id.
50 Id.
51 Id.
52 Id. at 91.
53 Id.
54 Id.
55 Id.

Similar to most other LLP’s and LLC’s in the U.S., hedge funds usually file as an
organization in the State of Delaware.56 Delaware has several distinct benefits tailored to hedge
funds, found nowhere else in the United States.57 First, Delaware provides the most favorable
state tax treatment to hedge funds.58 Second, the Delaware Revised Uniform Limited Partnership
Act (DRULPA) is renown for its lenient and “flexible” LP statutes.59 Third, Delaware allows
“side letters,” which permit hedge fund managers to make supplementary agreements with LP’s
so that they confer additional benefits to specific investors who are preferred over other LP’s.60
From these unique benefits, it is clear why so many hedge funds prefer to file in Delaware rather
than any other state in the U.S..61
The most widespread form of hedge funds that are seen today are organized under a
“master-feeder” organization.62 The “master” fund is formed as a partnership, usually in a “tax
haven” where it is a foreign resident.63 In addition, there are two “feeders,” one being U.S.
domestic feeder for American taxable investors and another feeder for foreign investors or
American investors who are tax exempt.64 The foreign “feeder” is typically organized as a
corporation in a “tax haven,” whereas the U.S. domestic “feeder” is an LLP where income, gains
56 Ron S. Geffner, Delaware--The Hedge Fund Jurisdiction of Choice in the US, Complinet, Feb. 11, 2008, http://
www.hedgefundworld.com/documents/Delawarerev.pdf.
57 Id.
58 Gregory M. Levy & Bernard A. Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res.
J., 1997, at 18, available at http://
www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf.
59 Ron S. Geffner, Delaware--The Hedge Fund Jurisdiction of Choice in the US, Complinet, Feb. 11, 2008, http://
www.hedgefundworld.com/documents/Delawarerev.pdf.
60 Id.
61 Gregory M. Levy & Bernard A. Barton, Venue Matters--Where to Structure Your Hedge Fund, Hedge Fund Res.
J., 1997, at 18, available at http://
www.nptradingpartners.com/resourcenews/aPDFandOther/VenueStructureHedgeFund.pdf.
62 Martin A. Sullivan and Lee A. Sheppard, Offshore Explorations: Caribbean Hedge Funds, Part I," Tax Notes, Jan.
7, 2008, p. 95 available at
http://www.tax.com/taxcom/features.nsf/Articles/35244A221EDD1BF7852573D00071118E?OpenDocument.
63 Id.
64 Id.
12

losses, and deductions from investing “flow through” to LP investors.65 Moreover, there is only
one portfolio and one investment vehicle that the fund manager must operate, and income is
allocated to investors based on the amounts of their investments.66
The other, less popular hedge fund structure is known as the “side-by-side” fund.67 There,
U.S. taxable investors form an LLP and have a separate investment vehicle than that of the non-taxable
U.S. investors and foreign investors.68 Though more costly to operate, the “side-by-side”
structure prevents the U.S. taxable investors from adding trade costs to the foreign and non-taxable
U.S. fund while the U.S. domestic fund addresses U.S. tax liabilities.69
13
65 Id.
66 Id.
67 Id.
68 Id.
69 Id.

For hedge funds that operate offshore, the “master-feeder” structure is preferred because
it “provides anonymity to investors, blocks exempt investors from being considered owners of
certain kinds of assets, and avoids putting foreign investors directly in a U.S. trade or business
that generates effectively connected income.”70 American and international investors alike are
both enticed off safer, domestic land, into these murky tax havens, which are still skeptically
viewed by many industry experts.71 As we will discuss later, privacy, tax breaks, and higher
returns on investment are the three main factors that attract investors to loosely regulated tax
havens with limited investor protection.72
B. Current Legislation Governing Hedge Funds
14
70 Id.
71 http://online.wsj.com/article/SB124588728596150643.html. (stating that, “Hedge-fund assets in offshore tax
havens such as the Cayman Islands and Bermuda represent more than two-thirds of the roughly $1.3 trillion
industry, according to Hedge Fund Research Inc. Of those offshore assets, industry insiders estimate, between $400
billion and $500 billion belongs to U.S. investors, with tax-exempt foundations, endowments and pension funds
accounting for about half of that. Investors from outside the U.S. make up the rest.”)
72 Bing Liang & Hyuna Park, Share Restrictions, Liquidity Premium, and Offshore Hedge Funds 3 (Working Paper,
Mar. 14, 2008) available at http:// ssrn.com/abstract=967788). (Stating that due to “the tax advantage, offshore
investors may collect higher illiquidity premium when their investment has the same level of share illiquidity as the
investment of onshore investors. Our results may help explaining why the growth rate has been much higher in
offshore funds than in onshore funds (26.4 vs. 15.0 percent per year from 2000 to 2004).”).

Hedge funds are viewed by many to be largely unregulated compared to other investment
vehicles, such as mutual funds.73 At the state level, “Blue Sky” laws monitoring securities still
exist within each specific state. Under the National Securities Markets Improvement Act of
1996, “Investment advisers which are not registered with the SEC, either because they qualify
for an exemption under the Advisers Act or because they don’t satisfy the assets under
management test of Advisers Act § 203A(a)(1)(A), generally may be deemed ‘investment
advisers.’”74 Thus, such an individual may be required to register as an investment adviser under
a state’s “Blue Sky” laws.75 State “Blue Sky” laws vary across jurisdictions, as some states are
more restrictive on hedge funds than others. For example, Michigan used to prohibit
performance-based compensation fees, which is a key aspect of how hedge fund managers are
compensated.76 At the end of 2009, New York, Massachusetts, and Connecticut have been
dominant state residences for the top one hundred hedge funds, both in terms of sheer quantity
and assets under management.77 None of those states have “Blue Sky” laws that limit or prohibit
performance-based fees and are quite lenient when compared to other state laws.
Although state “Blue Sky” laws have been characterized as “lacking teeth,” hedge funds
and other financial firms are still predominantly governed by several federal securities
regulations.78 The four primary regulations that apply to hedge funds are the Securities Act of
1933, the Exchange Act of 1934, the Investment Company Act, and the Investment Advisor Act
73 Alan L. Kenard, The Hedge Fund Versus the Mutual Fund, 57 Tax Lawyer 133, 133 (2003); see also Tamar
Frankel & Lawrence A. Cunningham, The Mysterious Ways of Mutual Funds: Market Timing, 25 Ann. Rev.
Banking & Fin. L. 235, 239 (2006).
74 http://www.lexology.com/library/detail.aspx?g=a43ec06b-5249-44f6-8ff7-98906d69a43e
75 Id..
76 http://www.fosterswift.com/news-publications-Michigan-Securities-Law-Change.html
(Michigan’s previous Uniform Securities Act, which was enacted in 1964, was replaced by the
new Uniform Securities Act and became effective in October of 2009).
77 http://www.marketfolly.com/2009/05/barrons-hedge-fund-rankings-2009-top.html;
http://hedgefundblogman.blogspot.com/2009/08/top-hedge-fund-cities-most-hedge-funds.html (See Appendix).
78 Id.
15

of 1940.79 The selected portions of these regulations that follow relate to how hedge funds, and
other similar funds, are presently governed. These four federal securities acts have largely
supplanted individual state “Blue Sky” laws, and are the dominant authority on securities
regulation matters pertaining to financial institutions.80
1. The Securities Act of 1933 (“Securities Act”)
The Securities Act was passed with the intent to provide greater transparency, honesty,
and disclosure on the part of securities firms in issuing initial public offerings (“IPO’s”).81 This
act required firms to register with the Securities and Exchange Commission (“SEC”) securities
that are sold to the public.82 Section 2(1) of the Securities Act defines the term “security” to
include the commonly known debt and ownership interests traded for speculation or investment.
Most notably, securities include “investment contracts,” which have been defined as “a contracts,
transactions, or schemes whereby a person invests his money in a common enterprise and is led
to expect profits primarily from efforts of promoter or a third party, it being immaterial whether
shares in enterprise are evidenced by formal certificate or by nominal interests in physical assets
employed in enterprise.”83 Normally, any firm that makes a public offering of securities will be
required to comply with the registration requirements of the Securities Act.
79 15 U.S.C. §§ 77a-77aa (2000); §§ 78a-78nn (1994); §§ 80a-1-80a-64 (1994); §§ 80b-1-80b-21 (1994).
80 James Cox et al., Securities Regulations 390 (5th ed. 2005) (discussing the limited nature of state “Blue Sky”
laws, whereby Congress amended section 18 of the Securities Act of 1933, preempting most state regulations).
81 15 U.S.C. §§ 77a-77aa (2000); Id. §§ 77e, 77aa (mandating firms provide a prospectus, with information about the
offering and the issuer such as “a profit and loss statement for not more than three preceding fiscal years” and “a
statement of the capitalization of the issuer,” unless the offering is exempted).
82 Id. §§ 77e, 77aa.
83 SEC v. Howey, 328 U.S. 293 (1946) (“The test of an investment contract within Securities Act is whether scheme
involves an investment of money in a common enterprise with profits to come solely from efforts of others, and, if
test is satisfied, it is immaterial whether enterprise is speculative or nonspeculative or whether there is a sale of
property with or without intrinsic value. Securities Act of 1933, §§ 2(1, 3), 3(b), 5(a), 15 U.S.C.A. §§ 77b(1, 3),
77c(b), 77e(a).”)
16

However, Section 4(2) of the Securities Act exempts “transactions by an issuer not
involving a public offering.”84 In order to be eligible for this exemption from the registration
requirements, firms must adhere to the restrictions in Rule 506, which provide a safe harbor for
compliance with section 4(2) so long as the firm’s offering is not publicly advertised and no
more than thirty-five purchasers participate in the private offering.85 Moreover, an exempt firm
must offer the securities through a private placement to “accredited investors,” and not through a
solicitation to the general public.86 Often referred to as “sophisticated investors,” “accredited
investors” are generally characterized as having net assets over $1 million or at least $200,000 in
annual income.87 The rule adopts the notion that these wealthy investors have the knowledge,
experience, and financial fortitude to properly address the risks and benefits of private
investments, and can withstand a heavy loss from such an investment.
However, Rule 506 is rather lenient in the sense that the issuing firm is not required to
count the number of accredited investors towards the thirty-five investor limit, and essentially
has no limit on the amount of accredited purchasers they can accept. 88 Though, section 4(2) of
the Securities Act doesn’t allow hedge funds to be exempt from anti-fraud provisions of section
12 and section 17 of the Securities Act. These provisions guard against misrepresentation,
misleading statements, omissions, and deceitful solicitations to investors, by imposing civil
liabilities on funds and/or their employees for engaging in any of these fraudulent practices. 89
2. The Exchange Act of 1934 (“Exchange Act”)
17
84 15 U.S.C.A. §§ 77d(2).
85 17 C.F.R. § 230.506 (2007).
86 Id.
87 17 C.F.R. § 230.501(a) (2007).
88 Id. § 230.506(b)(2)(ii)
89 15 U.S.C. § 77d(12-17) (2000)

Congress sought to regulate securities on the secondary securities market when it passed
the Exchange Act in 1934. Congress’ goals were similar to its goals in passing the Securities Act,
which regulated IPO’s, but instead focused on reducing the risk of fraud, price manipulation, and
speculation in the resale of securities when it passed the Exchange Act.90 The Exchange Act
requires securities “dealers” to register with the SEC.91 Under section 3(a)(5) of the Exchange
Act, a “dealer” is defined as “any person engaged in the business of buying and selling securities
for such person's own account through a broker or otherwise.”92 But most hedge funds avoid
registration by positioning themselves as “traders,” “a person that buys and sells securities, either
individually or in a trustee capacity, but not as part of a regular business.”93
Moreover, the SEC requires registration of “equity securities” under Section 12(g) of the
Exchange Act under two different circumstances.94 First, if the equity securities are traded on an
exchange they must be registered with the SEC.95 Second, securities must be registered if the
issuer has at least five hundred (500) holders of record of a non-exempted class of equity security
and over $1 million in assets by fiscal year end (unless the issuance meets one of the
exemptions).96 In either of these two scenarios, the securities issuer is required to adhere to
periodic reporting requirements, proxy requirements, short swing profit provisions, and insider
trading restrictions (which applies to all securities, whether registered, exempt, or otherwise).97
90 Elizabeth Killer and Gregory A. Gehlman, Comment, A Historical Introduction to the Securities Act of 1933 and
the Securities Exchange Act of 1934, 49 Ohio St. L.J. 329, 348 (1988).
91 15 U.S.C. §§ 78a-78nn (1994).
92 Id. § 78c(a)(5)(A).
93 Staff Report to the United States Securities and Exchange Commission, Implications of the Growth of Hedge
Funds 3 (2003) [hereinafter Staff Report]; 15 U.S.C. §§ 78a-78nn (1994); Hedge funds are not dealers under the
trader exemption, which excludes “funds that do not buy and sell securities as part of a regular business.” Id. (citing
15 U.S.C. § 78c(a)(5)(B) & Supp. IV 2004).
94 Id. I§ 78l(g).
95 Id.
96 15 U.S.C. § 78l-(g); 17 C.F.R. § 240.12g-1 (2008).
18
97 Id. § 78m; 15 U.S.C. § 78o.

However, the majority of hedge funds will intentionally structure themselves with at most 499
holders of record in order to avoid these requirements (except insider trading restrictions).
Hedge funds may also be required to file reporting and proxy disclosures to the SEC if it
is beneficially owned by one person, where a person owns at least 5% of the fund, or where the
fund has “beneficial ownership” of another company amounting to at least 10% hedge fund
ownership of said company.98 “Beneficial ownership” also entails “any person who, directly or
indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or
shares: (1) Voting power which includes the power to vote, or to direct the voting of, such
security; and/or, 2) Investment power which includes the power to dispose, or to direct the
disposition of, such security.”99 In addition, if a hedge fund manager holds or manages over
$100 million in equity securities, she would be required to disclose positions on a quarterly basis
and keep current ownership records, under section 13(f).100
Despite the various restrictions and regulations imposed on hedge funds and their
managers under the Exchange Act, there are sufficient exemptions and safe harbors to allow
hedge funds to evade SEC registration filings.
3. The Investment Company Act of 1940 (“Company Act”)
The Company Act is perhaps the most valuable source of disclosure and filing
exemptions for hedge funds, which allow them to operate largely out of the regulators’ reach.101
The Company Act was initially aimed at enhancing investment company disclosures, curbing
98 17 C.F.R. § 240.13d (2007); 15 U.S.C. § 78m (2000 & Supp. IV 2004).
99 17 C.F.R. § 240.13d-3(a).
19
100 Id. § 240.13f-1.
101 15 U.S.C. §§ 80a-1 to 80a-64 (2006).

self-dealing and conflicts of interests, curtailing excessive fees, and preventing fraud.102 An
“investment company” is defined as an issuer that “holds itself out as being engaged primarily,
or proposes to engage primarily, in the business of investing, reinvesting, or trading in
securities.”103 Firms that are deemed “investment companies” are subject to extensive regulation
in multiple areas of business practice.104 Most notably, the Company Act regulates an investment
company’s structure and areas of corporate governance, the degree of leverage (maximum 33%
debt level of total assets), discretion in corporate asset valuation, share sales and redemptions,
the character of investments, and its relationships with other market entities.105
Based on the definition of “investment company,” hedge funds exhibit characteristics that
would make them likely candidates for regulation under the Company Act.106 However, hedge
funds are eligible for regulatory exemption under the Company Act through either section
3(c)(1) or 3(c)(7) of the Act.107 The 3(c)(1) exemption to regulation exists where an “issuer
whose outstanding securities...are beneficially owned by not more than one hundred persons and
which is not making and does not presently propose to make a public offering of its securities” is
not an investment company.108 In addition, hedge funds can also fall under the 3(c)(7) exemption
where “any issuer, the outstanding securities of which are owned exclusively by persons who, at
the time of acquisition of such securities, are qualified purchasers, and which is not making and
102 Id. at 27.
103 Investment Company Act § 3(a)(1)(A), 15 U.S.C. § 80a-3 (2000 & Supp. IV 2004).
104 Marcia L. MacHarg, Waking Up to Hedge Funds: Is U.S. Regulation Really Taking a New Direction?, in Hedge
Funds: Risks and Regulation 55, 61 (Theodor Baums & Andreas Cahn eds., 2004).
105 Houman B. Shadab, Fending for Themselves: Creating a U.S. Hedge Fund Market for Retail Investors, 11
N.Y.U. J. Legis. & Pub. Pol'y 251, 311 (2008) (discussing that the Company Act is improper for regulating hedge
funds, since they would face restrictions in using leverage to invest in lilliquid assets. See 15 U.S.C. § 80a-18(f);
Willa E. Gibson, Is Hedge Fund Regulation Necessary?, 73 Temp. L. Rev. 681, 694 n.99 (2000); Gordon Altman
Butowski Weitzen Shalov & Wein, A Practical Guide to the Investment Company Act 30-31 (1993).
106 Id.
107 15 U.S.C. § 80a-3 (2000 & Supp. IV 2004); 15 U.S.C. 80a-2(a)(51) (2000 & Supp. IV 2004).
108 Investment Company Act § 3(c)(1), 15 U.S.C. § 80a-3 (2000 & Supp. IV 2004).
20

does not at that time propose to make a public offering of such securities.”109 The Company Act
defines “qualified purchaser” as any “individual who own over $5 million in investments,
institutional investors who own $25 million investments, and a family-owned company that
owns $5 million in investments.”110
Although the Company Act does not restrict the number of “qualified purchasers” that
may be in a fund, most astute hedge funds will not accept more than 499 investors, so as not to
violate the Exchange Act's provisions.111 As we have seen, many of these regulations overlap
each other and have implications on firms trying to minimize regulation.
4. The Investment Advisers Act of 1940 (“Advisers Act”)
The Advisers Act was aimed at combating abusive practices by investment advisers,
which may have played a role in the stock market crash leading to the Great Depression.112
Under the Advisors Act, “investment adviser” is defined as “any person who, for compensation,
engages in the business of advising others, either directly or through publications or writings, as
to the value of securities or as to the advisability of investing in, purchasing, or selling
securities.”113 A hedge fund manager who falls under this classification is required to register
with the SEC, as well as disclose basic information to current and potential clients.114 Most
notably, an investment adviser is obligated to disclose the fee structure, whether the structure can
109 Investment Company Act of 1940, 15 U.S.C. §§ 80a-1-80a-64 (1994), § 80a-3(c)(7)(A).
110 Id. at § 80a-2a(51)(A).
111 15 U.S.C. § 78l-(g); 17 C.F.R. § 240.12g-1 (2008); Staff Report to the United States Securities and Exchange
Commission, Implications of the Growth of Hedge Funds 3 (2003) [hereinafter Staff Report].
112 Investor Advisers Act, 15 U.S.C. § 80b-1 et seq. (2000); Richard S. Cortese, Overview of the Adviser's Act, in
Lipper HedgeWorld Annual Guide 113 (2005); SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 187
(1963) (quoting SEC, Investment Trusts and Investment Companies, H.R. Doc. No. 76-477, at 28 (1939)),
acknowledging that “conflicts of interest... might incline an investment adviser--consciously or unconsciously--to
render advice which was not disinterested.” Id. at 191; Stuart A. McCrary, How to Create and Manage a Hedge
Fund: A Professional's Guide 7 (2002).
113 15 U.S.C. § 80b-2(a)(11).
114 17 C.F.R. § 275.204-3(a) (2008).
21

be negotiated, the character of the adviser's services, current client base, and any conflicts of
interest that may arise on account of the adviser's business activities.115 The Advisers Act also
generally prohibits performance-based compensation, although a registered adviser may charge a
performance fee under the guidelines set forth in section 3(c)(7) of the Company Act or if all the
fund's investors are qualified clients. In addition, the Adviser Act requires the adviser to submit
to periodic SEC examinations and maintain current books and records for these examinations.116
The heavy majority of hedge fund managers have been exempted from being declared an
“investment adviser” by relying on section 203(b) of the Advisers Act. That section excludes
“any investment adviser who during the course of the preceding twelve months has had fewer
than fifteen clients and who neither holds himself out generally to the public as an investment
adviser nor acts as an investment adviser to any investment company registered. . . .”117 What’s
more beneficial for hedge fund advisers is that Section 203(b) counts a “legal organization” (i.e.
a hedge fund) as only one, single client.118 Thus, hedge fund advisers can manage up to fourteen
funds before they are required to file registration with the SEC as an investment adviser.119
Together, the current statutory framework allows hedge funds to escape registration and
most government oversight. The weak regulatory framework, coupled with poor market
discipline and foresight of fund managers and investors alike, seems to have made hedge funds a
popular scapegoat for the recent financial crisis. However, the shortcomings of these regulations
can be easily fixed in a de minimis manner, so as not to ruin an industry on the rebound or cause
a mass exodus to offshore tax havens. The next sections will identify the strengths and problems
of hedge funds in the market, and assess how best to tailor portions of proposed legislation, along
115 Tamar Frankel & Clifford E. Kirsch, Investment Management Regulation 85?87 (2d ed. 2003).
116 15 U.S.C. § 80b-5(a)(1); 17 C.F.R. § 275.205-3(d)(1); Id. § 80b-3(c).
117 Id. § 80b-3(b)(3).
118 17 C.F.R. § 275.203(b)(3)-1(2)(i).
119 15 U.S.C. § 80b-3(b)(3).
22

with using diplomatic means and establishing a more aligned, unified regulatory foundation, to
mitigate the risks of hedge funds while allowing their strengths to permeate U.S. and global
financial markets.
II. HEDGE FUNDS’ ROLE IN SYSTEMIC RISK, INVESTOR FRAUD, AND MARKET BENEFITS
There are several schools of thought regarding the significance of hedge funds in
financial markets. Arguments supporting and criticizing the hedge fund industry have been
staunchly voiced among legislators, regulators, investors, and various financial institutions for
years. As the U.S. struggles to climb out of deep economic recession that continues to plague
financial markets still littered with thousands of fraud cases, hedge funds have been the target of
scrutiny due to their lack of transparency.120 However, a closer inspection of hedge funds will
reveal many benefits they provide to the U.S. financial market that allow the U.S. firms to
effectively compete with foreign firms.121 Moreover, much hedge fund criticism is misdirected
and disproportionate to the harm actually caused by the industry throughout this period of
financial instability.122 Ultimately, the strengths and shortcomings of hedge funds in the U.S.
hinge on the industry’s ties to global markets and the varying regulations across different types
of financial institutions.
120 Dan Margolies, “Obama Budget Seeks More to Fight Financial Fraud.” Reuters, Feb. 1, 2010.
http://www.reuters.com/article/idUSN0120695420100201. (“U.S Attorney General Eric Holder said in a speech [in
February 2010] that the Justice Department was moving forward on more than 5,000 pending financial institution
fraud cases and the FBI was investigating more than 2,800 mortgage fraud cases -- up nearly 400 percent from five
years ago.”)
122 See Bd. of Governors of the Fed. Reserve Sys., Flow of Funds Accounts of the United States: Flows and
Outstandings Third Quarter 2007 (Dec. 6, 2007), available at
http://www.federalreserve.gov/releases/z1/20071206/z1.pdf.
23

A. The Impact of Hedge Funds on Systemic Risk
The fundamental purpose behind regulating financial institutions is to mitigate “systemic
risk.”123 Furthermore, champions of increasing hedge fund regulation also cite this purpose as
justification for regulatory overhaul.124 “Systemic risk,” or “contagion,” is commonly defined as
the “potential that a single event, such as a financial institution's loss or failure, may trigger
broad dislocation or a series of defaults that affect the financial system so significantly that the
real economy is adversely affected.”125 More generally, it is “the danger of widespread
disruption of financial markets and institutions that, in turn, affects the macroeconomy.”126
1. The Implosion of Long-Term Capital Management & Industry Response
It wasn’t until 1998, when a hedge fund called Long-Term Capital Management (LTCM)
imploded, that regulators began to take a closer look at hedge funds’ impact on systemic risk.127
LTCM was a once highly-regarded hedge fund, founded in 1994 by several financiers who
received Nobel Prizes in economics.128 LTCM took on a highly aggressive arbitrage strategy by
investing in government bonds in order to capitalize on small spreads, most notably in Russian
bonds.129 LTCM pursued an intense arbitrage strategy based on their forecast that the spread
124 Id.
125 Id.
127 Symposium, Crisis in Confidence: Corporate Governance and Professional Ethics Post-Enron, 35 Conn. L. Rev.
1097, 1107 (2003) [hereinafter Crisis in Confidence]
128 Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management 31, 32 (Random
House 2000).
129 PRESIDENT'S WORKING GROUP ON FIN. MKTS, HEDGE FUNDS, LEVERAGE, AND THE LESSONS OF LONG-TERM CAPITAL
MANAGEMENT, 11 (1999) available at http:// www.ustreas.gov/press/releases/reports/hedgfund.pdf (“Approximately
80 percent of the LTCM Fund's balance-sheet positions were in government bonds of the G-7 countries (viz., the
United States, Canada, France, Germany, Italy, Japan, and the United Kingdom).”) [hereinafter PRESIDENT'S
WORKING GROUP].
24

between bond returns would narrow between industrialized and developing nations.130 However,
LTCM’s forecasts proved to be wrong when Russia underwent a massive debt restructuring,
thereby devaluing its currency.131 This move by Russia would not, in and of itself, have put
LTCM at risk for failure. LTCM had always had high leverage ratio of 25-to-1, which did not
alarm investors up until this point.132 But when Russia restructured its debt and the spread on
bonds increased, LTCM’s leverage ratio skyrocketed to 500-to-1 when the value of the assets
they held plummeted.133 LTCM continued to crumble in the period directly after Russia’s
restructurinng, losing $4.4 billion in less than a month.134 The New York Federal Reserve Bank
finally stepped in and organized a $7 billion bailout of LTCM with fourteen other banks and
funds.135 The Federal Reserve Bank of New York felt that if it did not facilitate a bailout, an
LTCM default could pose a series of cascading financial institution failures that LTCM did
business with.136 With off-balance sheet liabilities over $1 trillion in the form of futures, interest
rate swaps, and over-the-counter (OTC) derivatives, LTCM’s inability to meet counterparty
obligations could have decreased the liquidity of these investments in the market.137 Soon after,
the market price on these investments would plunge, as other firms would be forced to either
130 Joseph G. Haubrich, Some Lessons on the Rescue of Long-Term Capital Management (Federal Reserve Bank of
Cleveland, Policy Discussion Paper No. 19, 2007).
131 FIN. SERV. AUTH., HEDGE FUNDS AND THE FSA 8 (2002), available at
http://www.fsa.gov.uk/pubs/discussion/dp16.pdf; see also FRANÇOIS-SERGE LHABITANT, HEDGE FUNDS:
MYTHS AND LIMITS 12-21 (2002)
132 PRESIDENT'S WORKING GROUP supra note 10, available at http://
www.ustreas.gov/press/releases/reports/hedgfund.pdf (for basis of comparison “[a]t year-end 1998, the five largest
commercial bank holding companies had an average leverage ratio of nearly 14-to-1, while the five largest
investment banks' average leverage ratio was 27-to-1.”).
133 Id.
134 Joseph G. Haubrich, Some Lessons on the Rescue of Long-Term Capital Management (Federal Reserve Bank of
Cleveland, Policy Discussion Paper No. 19, 2007).
135 PRESIDENT'S WORKING GROUP, supra note 10, at 17 (“LTCM itself estimated that its top 17 counterparties
would have suffered various substantial losses—potentially between $3 billion and $5 billion in aggregate — and
shared this information with the fourteen firms participating in the consortium. The firms in the consortium saw that
their losses could be serious, with potential losses to some firms amounting to $300 million to $500 million each.”).
136 Id.
137 U.S. Gen. Acct. Off., Long-Term Capital Management Regulators Need to Focus Greater Attention on Systemic
Risk 7 (1999), available at http:// www.gao.gov/archive/2000/gg00003.pdf.
25

hold on to sharply declining assets and eventually collapse or liquidate their holdings before
prices dropped even further.138 The inability of one major player, LTCM, to meet its obligations
to its seventeen main counterparties would have resulted in up to $5 billion in aggregate
losses.139 From there, the total potential losses for the counterparties of LTCM’s counterparties
would’ve ballooned to catastrophic levels that could’ve crippled the entire U.S. financial system,
and perhaps even foreign ones.140
Although the LTCM collapse provides a grim, historical example of hedge funds’
potential impact on systemic risk, many positives came out of that incident. Stemming from this
event, the Presidential Working Group was formed.141 The Group is responsible for gathering
more vital, up to date information on hedge funds and making recommendations to the
industry.142
U.S. Treasury Secretary, Timothy Geithner offered a positive, though objective,
assessment on the hedge fund industry since the LTCM debacle in 1998.143 While he was
President and CEO of the Federal Reserve Bank of New York, Geithner noted that average
hedge fund leverage ratios and systemic risk posed by hedge funds have changed for the better
since the 1998 implosion of LTCM.144 Moreover, Geithner proffered five key factors that
evidenced a more stable hedge fund industry and financial market: (1) the total number of hedge
funds has increased greatly, along with total assets under management; (2) increased
138 Id.
139 PRESIDENT'S WORKING GROUP, supra note 10, at 17.
140 Id.
141 President's Working Group on Financial Markets, Hedge Funds, Leverage, and the Lessons of Long-Term
Capital Management 1 (1999) [hereinafter Working Group Report I], available at http://
www.treasury.gov/press/releases/reports/hedgfund.pdf (the Group consists of officials from the SEC, CFTC, the
Federal Reserve Bank, and the U.S. Treasury Department).
142 Id.
143 Timothy F. Geithner, President & CEO, Fed. Reserve Bank of N.Y., Keynote Address: Hedge Funds and Their
Implications for the Financial System (Nov. 17, 2004) (transcript available at http://
www.ny.frb.org/newsevents/speeches/2004/gei041117.html).
144 Id.
26

diversification of credit exposure by counterparties and lenders; (3) enhanced risk management
practices among hedge funds, counterparties, and lenders; (4) banks' capital relative to risk has
remained constant; and (5) improved infrastructure for clearing and settlements, whose systems
can handle greater trade volumes and are more durable in periods of stress.145 Finally, Geithner
provided a positive outlook on the hedge fund industry, when he expressed that the “U.S.
financial system today is significantly stronger than it was in 1998…. And there is some
evidence that hedge funds have helped contribute to this resilience, not just in the general
contribution they provide by taking on risk, but as a source of liquidity in periods of increased
stress and risk aversion in the rest of the financial system.”146
However, these encouraging statements were tempered with recommendations to
continuously improve investing strategy, due diligence, diversification, risk management,
disclosure, and leverage practices.147 Nevertheless, Geithner and most top officials agree that
hedge funds and their counterparties have adapted quite well since 1998 and are better equipped
to avoid or withstand a crisis similar to what LTCM experienced, but without the need for
Federal Reserve bailouts.148
Systemic risk concerns regarding hedge funds seem to have died down after the industry
and regulators learned several valuable lessons following LTCM’s demise. However, hedge
funds still carry the stigma of posing a grave systemic risk to the economy, which is largely
misplaced.149 For example, the vast majority of credit default swaps (CDSs) hedge funds traded
with banks were not written on toxic underlying securities (i.e. defaulted or subprime
145 Id.
146 Id.
147 Id.
148 Id.
149 Houman Shadab, Don’t Blame all the Shadow Banks, CBS Money Watch, Apr. 13, 2009. (available at:
http://moneywatch.bnet.com/economic-news/blog/blog-war/dont-blame-the-shadow-banks/295/).
27

mortgages).150 The reality is that hedge funds and the CDSs they traded to banks did not cause
the collapse of financial institutions, because it was the potential for these securities’ misuse and
abuse which the banks took advantage that led to the collapse.151 Since it is readily apparent that
these derivative securities are more likely to be abused by banks, new rules should ensure that
regulated companies, such as banks, trade and value them appropriately.152
2. Systemic Risk Concerns Misdirected at Hedge Funds Instead of Banks
An example that elucidates how hedge funds have suffered excessive, unsubstantiated
criticism that should be directed elsewhere can be seen in bank failures like Bear Stearns. In
2007, Bear Stearns began taking on a highly aggressive debt structure. The bank took on a
leverage ratio of nearly 33.2 to 1, with $11.1 billion in tangible equity backing $395 billion in
assets.153 This highly leveraged structure embodied a relatively high level of risk for the firm,
evidenced by the fact that it was highest of any brokerage firm, and that most commercial banks
have an average leverage ratio of 10 to 1.154 Just a few years earlier, this leverage structure
would have violated SEC regulations, which then required a maximum debt to net capital
(equity) of 15 to 1. But in 2004, the “Consolidated Supervised Entities Program” abolished this
maximum standard, along with revoking minimum capital requirements in case of asset
150 Id. (“It was solely American International Group’s (AIG’s) CDSs written on structured mortgage-related
securities held by banks that led to the collateral calls ruinous to AIG and the federal bailout. Those CDSs made up
only about 10 percent of AIG’s total CDS obligations at the beginning of 2008. But the Office of Thrift Supervision,
which oversaw AIG, failed to prevent the company’s subsidiary from selling too many CDSs. To best prevent the
over-concentration of CDS risk of the type that occurred with bond issuers and AIG, regulation should seek to limit
the use of CDSs when sold by insurance companies or their unregulated subsidiaries and affiliates.”)
151 Id. (“The main problem with CDSs, which allow any party to sell protection against credit risks that the buyer
may be exposed to, was that they allowed banks and insurance companies to concentrate too much mortgage-backed
security risk in their portfolios.”)
152 Id.
153 Boyd, Roddy. “The Last Days of Bear Stearns.” Fortune Magazine 31 March 2008.
<http://money.cnn.com/2008/03/28/magazines/fortune/boyd_bear.fortune/index.htm>.
154 Id.
28

defaults.155 Bear Stearns’ exploitation of these repealed standards propelled it on a path to self-destruction.
What’s more disturbing was that Bear Stearns was carrying over $28 billion in
“level 3” assets, where valuation is based on non-observable market assumptions and relied
heavily on internal information to asses fair value. 156 These types of assets they carried were
highly illiquid, and put the bank at risk for owning assets worth next to nothing.
With a net equity of $11.1 billion and $395 billion in assets, the highly leveraged bank
was even more at risk because of their heavy involvement in Collateralized Debt Obligations
(“CDOs”), which were heavily backed by subprime mortgages. As the real estate market
plummeted and the mortgage default rate skyrocketed, Bear Stearns was forced to make major
value write-downs on these mortgage-backed security assets. Just a few years prior, Bear Stearns
was able to succeed under a highly leveraged debt structure. However, as assets began to
plummet in value and more debt was accrued, the risks of having such a high leverage ratio
began to precipitate.157 In June of 2007, troubles continued to mount when “Bear had to come up
with over $3 billion to bail out one of its funds that was dabbling in CDOs. Incredibly these
funds were seized at the time by Merrill Lynch for $850 million who was only able to get $100
million for them on the auction block.”158
Bear Stearns continued to break down at an exponential rate, when at the end of 2007 it
was forced to write-down an additional $1.2 billion in mortgage backed securities. Bear Stearns’
credit was so poor in its final stages before the merger, that it was even denied a $2 billion
securities-backed repurchase loan (“repo” loan). One market analyst aptly characterized how
155 Protess, Ben. “’Flawed’ SEC Program Failed to Rein in Investment Banks.” Propublica 1 October 2008.
<http://www.propublica.org/article/flawed-sec-program-failed-to-rein-in-investment-banks-101>.
156 Pittman, Mark. "Bear Stearns Fund Collapse Sends Shock Through CDOs.” Bloomberg 21 June 2007.
<http://www.bloomberg.com/apps/news?pid=20601087&sid=a7LCp2Acv2aw&refer=home>.
157 Id.
158 “The Rise and Fall of the Mighty Bear.” My Budget 360 17 March 2008. <http://www.mybudget360.com/bear-stearns-
29
the-rise-and-fall-of-the-mighty-bear/>.

severe this credit issue was for Bear Stearns: “Being denied such a loan is the Wall Street
equivalent of having your buddy refuse to front you $5 the day before payday. Bear executives
scrambled and raised the money elsewhere. But the sign was unmistakable: Credit was drying
up.”159 Consequently, fears over liquidity and Bear Stearns’ ability to meet its debt obligations
sparked intense naked short-selling of Bear Stearns stock, which drove the price down from
highs of over $100/share in 2007-2008, to $30/share.160 The run on Bear Stearns stock, fueled by
rumor and speculation, resulted in a 47% decline (closing at $30 per share) in stock price in one
day just prior to merger. 161
The type of business transactions Bear Stearns was involved in directly and indirectly
exposed a wide range of institutions to risk. First off, Bear Stearns was a major counterparty to
CDSs. It held notional amounts of $13.4 trillion at the end of 2007, with $1.85 trillion of that
amount consisting of futures and option contracts with other counterparties. 162 These derivative
instruments are used as an insurance policy for debt holders, in the event that the issuer defaults
on payment. The systemic risk these transactions posed, which the Federal Reserve Bank sought
to eliminate, could bring down other banks, just like Bear Stearns. Prior to the buyout in March,
information circulated in the market that hedge funds were reassigning their CDS positions with
Bear Stearns to other firms. Many hedge funds had grown weary of the problems facing Bear
Stearns and did not want to take the risk of being counterparties to its trades. Perpetuated by fear
and rumors, CDS reassignments snowballed as many other funds and dealers pulled their trades
160 Matsumoto, Gary. “Bringing Down Bear Began as $1.7 Million of Options.” Bloomberg 11 August 2008.
<http://www.bloomberg.com/apps/news?pid=20601109&sid=aGmG_eOp5TjE&refer=home>.
161 Id.
30

with Bear Stearns.163 Because 22% of Bear Stearns funding consisted of payables, deposits by
its Hedge Fun customers, these major withdrawals resulted in a lack of funding for Bear Stearns.
These banks fund their long-term illiquid investments, with short-term debt. The fact that
Bear Stearns held such thin capital margins made them highly vulnerable to an abrupt cessation
in short-term lending. This was a driving force behind Bear Stearns’ collapse, as the bank could
not acquire enough funding to manage its operations. The “maturity mismatch” of asset and
liabilities put Bear Stearns in grave danger when a liquidity shock occurred, causing investors to
cease lending. The Federal Reserve Bank sought to mitigate other firms’ risk of encountering
this liquidity problem by trying to maintain the flow of lending within the banking industry. 164
The bankruptcy of Bear Stearns would not only adversely affect the entities it directly
conducted business with, but other institutions that it bore no direct relationships or transactions
with. In most other competitive industries, the failure of one firm would allow the other existing
competitors to pick up market share and grow after it picked up the pieces from the fallout.
However, the institutional structure of the banking industry causes even relatively smaller
players, like Bear Stearns, to have extensive connections with other entities and markets. 165
With Bear Stearns, settlement risks began to appear as it began to crumble, which only
would have exacerbated the problems already plaguing the market. Settlement risk is “the risk
that one party to a financial transaction will default after the other party has delivered.”166 The
concern was that the cumulative effects of these settlement risks could amount to a systemic risk.
Parties that didn’t directly do business with Bear Stearns could be affected from their
163 Schmerken, Ivy. “Counterparty Risk Is a Top Concern in the Wake of the Credit Crisis.” Advanced Trading 15
September 2008. <http://www.advancedtrading.com/derivatives/showArticle.jhtml?articleID=210601645>.
164 Id.
165 Id.
Unversity] 2 October 2008. <http://www.stlouisfed.org/news/speeches/2008/10_02_08.html#_ftn3>.
31

32
relationships with third-parties who did.
Moreover, bankruptcy law was not suited for cases within the banking industry because
banks like Bear Stearns are highly leveraged. These banks fund their long-term illiquid
investments, with short-term debt. The fact that Bear Stearns held such thin capital margins made
them highly vulnerable to an abrupt cessation in short-term lending. This was a driving force
behind Bear Stearns’ collapse, as the bank could not acquire enough funding to manage its
operations. The “maturity mismatch” of asset and liabilities put Bear Stearns in grave danger
when a liquidity shock occurred, causing investors to cease lending. The Federal Reserve Bank
sought to mitigate other firms’ risk of encountering this liquidity problem by trying to maintain
the flow of lending within the banking industry. 167
From a thorough analysis of how Bear Stearns deteriorated, much like several other
regulated financial institutions, it is hard to understand how hedge funds have been the target of
so much criticism when the their threats to systemic risk pale in comparison to banks and
insurance giants. Let us remember, too, that The Federal Reserve, not hedge funds, created the
housing bubble that almost dismantled the global economy.168 Furthermore, Banks transferred
mass amounts of predatory loans to individuals who they should have known could never afford
the homes they were purchasing.169 It was also banks who bundled and securitized these “toxic
assets” and then traded them with reckless abandonment amongst each other.170 Lastly, one of
the biggest, if not the biggest, culprits in the financial meltdown was A.I.G., an insurance
company, not a hedge fund.171 Despite the strong signs pointing to banks as the real threat to
167 Id.
168 Melvyn Krauss, Don’t Blame Hedge Funds, New York Times, Jun. 24, 2009 (available at:
http://www.nytimes.com/2009/06/25/opinion/25iht-edkrause.html).
169 Id.
170 Id.
171 Id.

systemic risk, the regulatory framework of hedge funds is still not perfect and must be enhanced,
though not nearly to the extent that banks and insurance companies require regulatory overhaul.
3. The Future of Systemic Risk: Growing Concerns in Offshore Tax Havens
Despite the seemingly favorable treatment of hedge funds in the State of Delaware, there
has nevertheless been a noticeable migration of hedge funds to offshore tax havens in recent
times.172 Hedge fund incorporation in “tax havens” such as the Cayman Islands, Bahamas,
Bermuda, and British Virgin Islands (“BVI”) have been on the rise since the mid-1990’s.173
Although there is no universally accepted definition of the term “tax haven,” there seems to be
an international consensus that tax havens have the following characteristics: “no or nominal
taxes; lack of effective exchange of tax information with US and other tax authorities; lack of
transparency in the operation of legislative, legal, or administrative provisions; no requirement
for a substantive local presence; and self-promotion as an offshore financial center.”174
Industry experts and regulators estimate the number of hedge funds in the entire industry
at over 10,000, totaling around $1.5-2 trillion in assets under management.175 It is also estimated
that the industry grew from $456.4 billion in 1996 to $1.43 trillion by the end of 2006.176 Hedge
Mar. 14, 2008) available at http:// ssrn.com/abstract=967788).
173 "Offshore Explorations: Caribbean Hedge Funds, Part II," Tax Notes, Jan. 7, 2008, p. 95).
http://www.tax.com/taxcom/features.nsf/Articles/DE15FD6B5D167E0B852573CB005BB50C?OpenDocument
174 James Hamilton, Using SEC Data, GAO Finds that TARP Recipients Have Subsidiaries in Offshore Tax Havens,
CCH Financial Crisis News Center. Jan. 19, 2009 Available at http://www.financialcrisisupdate.com/2009/01/using-sec-
data-gao-finds-that-tarp-recipients-have-subsidiaries-in-offshore-tax-havens.html
; Hedge Fund Research Inc., "HFR Industry Report — Year End 2006," available at
http://www.hedgefundresearch.com
33

funds domiciled in the “Big Four” tax havens (Cayman Islands, Bahamas, Bermuda, and BVI)
accounted for 74.9% of all hedge funds domiciled outside the U.S., or 52.3% of the entire
industry, whereas U.S. domiciled funds accounted for only 30.1% of the entire industry.177 This
equates to the “Big Four” holding estimated assets under management of about $731 billion.178
Other studies have uncovered an even greater disparity, finding that 62% of all hedge fund assets
under management are domiciled in the “Big Four” compared to only 23% domiciled in the
U.S..179 These same studies have estimated that the three year growth rates of offshore assets is
more than twice that of onshore funds (130% v. 66%). Moreover, hedge funds registered off
shore, but addressed in the U.S., have recently seen the highest growth rate among all other
hedge fund segments (176%).180
With other studies estimating $12 trillion deposited in tax havens today, the U.S. and
other nations are determined to curb this explosive exodus of funds offshore, where tax dollars
are lost and global financial markets are subject to unpredictable threats.181 Specifically, there
has been growing systemic concerns over the role of offshore hedge funds in tax havens
operating under a veil of almost complete secrecy, where counterparty and market connectivity
of these funds are virtually undiscoverable.182 The U.S. and other countries have limited insight
; Hedge Fund Research Inc., "HFR Industry Report — Year End 2006," available at
http://www.hedgefundresearch.com.
177 Id.
178 Id.
Mar. 14, 2008) available at http:// ssrn.com/abstract=967788).
180 Id.
181 Id.
182 Id.
34

as to the exact value of assets in offshore tax havens, the types of instruments and strategies
used, investor identities, and exactly how many hedge funds exist offshore.183
What’s more disturbing is that eighty-three of the largest one hundred public U.S.
companies have subsidiaries in tax havens.184 Moreover, of those eighty-three companies, four
are banks that received over $127 billion in bailout funds through TARP.185 German Chancellor
Angela Merkel, and other world leaders, brought up hedge fund regulation as one of the chief
topics for discussion on a recent G8 Summit meeting.186 This rapid growth in hedge fund
migration into tax havens has been a troubling trend not only for the United States, but for the
greater international community as well.
B. Fraud and Investor Protection
Regulators are also highly concerned with mitigating fraud and money laundering among
private funds, especially during this period of extreme market vulnerability. Most notably,
Bernard L. Madoff Investment Securities LLC (BLMIS), a New York-based hedge fund, later
discovered to be a massive “Ponzi scheme,” defrauded investors over $50 billion.187 A “Ponzi
scheme” is characterized as “an investment fraud that involves the payment of purported returns
to existing investors from funds contributed by new investors.188 Mr. Madoff, owner and
perpetrator of the BLMIS fraud, ran a broker dealer service called Madoff Investment Securities,
183 Emil Arguelles, “The Truth About Tax Havens.” San Pedro Daily. Nov. 14, 2009.
http://ambergriscaye.com/forum/ubbthreads.php/topics/357954/The_truth_about_tax_havens.html
184 Richard Murphy, “The Stop Tax Haven Abuse Act is on its Way.” Tax Research UK. Mar. 3, 2009.
http://www.taxresearch.org.uk/Blog/2009/03/03/the-stop-tax-haven-abuse-act-is-on-its-way/
185 Id.
186
187 Amir Efrati et al., Top Broker Accused of $50 Billion Fraud, Wall St. J., Dec. 12, 2008, at A1.
188 http://www.france24.com/en/20081215-hsbc-faces-1-billion-risk-madoff-scandal-fraud;
http://www.sec.gov/answers/ponzi.htm
35

as well as an investment advisory business.189 According to SEC filings, the investment advisory
business had over $17 billion in assets under management.190 It was this investment advisory arm
of his alleged business that housed the fraud, which surfaced in late 2008 when he was unable to
“obtain the liquidity necessary to meet” investors’ demands to withdraw $7 billion dollars from
the fund firm.191
More recently, the Antiguan-based Stanford International Bank (SIB), along with
Chairman Sir Allen Stanford, have been indicted for engaging in a scheme to defraud investors
of over $8 billion.192 With 30,000 investors and over $51 billion in assets, SIB purported itself to
be a bank, despite making no loans.193 Even more spurious is that Chairman Stanford actually
helped rewrite Antiguan banking laws upon setting up his banks operations on the island.194
Moreover, most of its investors’ certificate of deposits (“CD’s”) were invested in private equity
and real estate, despite telling its investors that they were invested primarily in more “liquid”
securities.195 From SIB’s practices, and the fact that they shielded themselves from SEC
oversight, SEC officials state that SIB operated like a typical hedge fund opposed to a bank.196
However, SIB also held offices based in Houston, Texas where Chairman Sir Allen Stanford
defrauded some of SIB’s U.S. and foreign investors with impunity right under regulators
noses.197 Fortunately for defrauded investors, Sir Allen Stanford was unable to escape and go
189 See Complaint at 2-3, United States v. Madoff, 08-MAG-2735 (S.D.N.Y. Dec. 11, 2008) [hereinafter Madoff
Complaint].
190 Id.
191 Id. at 3.
192 http://www.justice.gov/criminal/vns/caseup/stanfordr.html; Securities and Exchange Commission v. Stanford
International Bank, et al., Case No. 3-09CV0298-L (N.D.TX.)
193 http://www.financialweek.com/article/20090217/REG/902179991/103/REUTERS
194 Alison Fitzgerald, Stanford Wielded Jets, Junkets, and Cricket to Woo Clients, Bloomberg Feb. 18, 2009
(available at: http://www.bloomberg.com/apps/news?sid=auAqkrxMzKPc&pid=20601109).
195 Id.
196 Id.
197 Emil Arguelles, “The Truth About Tax Havens.” San Pedro Daily. Nov. 14, 2009.
http://ambergriscaye.com/forum/ubbthreads.php/topics/357954/The_truth_about_tax_havens.html
36

into hiding because the U.S. had extraterritorial jurisdiction over him as a U.S. citizen.198 What’s
alarming is that SIB associates were in Belize soliciting prospective clients prior to the
indictment, but were unsuccessful in doing so.199 This just goes to show how U.S. and other
foreign citizens unfamiliar with tax haven entities could easily be swindled with no
forewarning.200 Although the case is still pending, SIB and Mr. Chairman are charged with
“violations of the anti-fraud provisions of the Securities Act of 1933, the Securities Exchange
Act of 1934 and the Investment Advisers Act, and registration provisions of the Investment
Company Act.”201
Although the Madoff and Stanford incidents represent extreme outlier cases of fraud,
either in terms of the size of the scams or deplorable nature of the crimes themselves, they
nevertheless call attention to the risk of fraud, both domestically and in offshore tax havens.202
Fraud detection and prevention is a second key goal of regulators. The failure to detect scandals
like these have devastated investor confidence in U.S. regulatory agencies, such as the Securities
and Exchange Commission (SEC) and the Commodities Futures Trading Commission
(CFTC).203 Although even the two most extreme cases of fraud did not individually or
collectively rise to the level of systemic risk, both were audacious attempts to defraud investors
by circumventing U.S. regulation with activity in offshore tax havens.
But the nature of these crimes were littered with red flags: Madoff’s impossibly
consistent returns year after year, Stanford rewriting the very laws that were supposed to regulate
him, and involvement in suspicious tax havens should have been picked up by SEC officials and
198 Id.
199 Id.
200 Id.
201 Id.
202 John Gapper, The Hedge Fund Industry Is Going Down with Dignity, Fin. Times (London), Dec. 6, 2008, at 9
(Madoff defrauded dozens of charities and non-profits,
203 http://www.bloomberg.com/apps/news?pid=20601109&sid=afUo_v5lEmwc
37

other foreign regulators.204 In terms of investor protection against fraud, perhaps it is not
additional regulation that would serve the hedge fund industry and investors best. Rather, better
inter-agency communication, additional agency (SEC, CFTC) resources for investigating crimes,
and better enforcement of current laws would be more effective.
C. Benefits of Hedge Funds in Financial Markets
Hedge funds have noticeable and undeniable benefits to financial markets, and are
playing an “increasingly important role in [the U.S.] financial system.” 205 The rapid growth in
number of hedge funds and total assets under management are evidence that investors perceive
them as providing significant value that they could otherwise not obtain through other, more
traditional investment vehicles.206 Considering that savings funds account for only a small share
of the overall assets held by hedge funds, the size and importance of the hedge fund industry will
continue to grow throughout the foreseeable future.207
It has been previously argued in this Note that hedge funds are chastised more for their
perceived risks to financial markets rather than heralded for the positive effects they have on
financial system functions.208 Hedge funds play a critical role in a variety of areas that help make
the U.S. firms, and the overall market, competitive in the global arena. First, hedge funds “play a
valuable arbitrage role in reducing or eliminating mispricing” among firms across various
financial markets.209 They can better allow firms to stamp a true value on assets and ensure
204 Id.
206 Id.; see supra note 172.
207 Id.
208 Id.
209 Id.
38

liquidity through mark-to-marketing asset pricing.210 This pricing practice, in addition to the
sheer bulk of assets under management, supply a significant source of liquidity for financial
markets, in periods of both stability and distress.211 Moreover, hedge funds “add depth and
breadth to [U.S.] capital markets, providing additional sources of long-term financing for firms
and start-up ventures.”212
Frequently criticized for doing this, hedge funds also provide a benefit to the market in
providing a “source of risk transfer and diversification,” instead of forcing risk averse institutions
to retain unwanted or illiquid assets on their balance sheets.213 Indirectly, this amounts to a type
of risk-matching service among themselves and between other firms.214 Thus, hedge funds,
which typically pursue relatively more risk-seeking investment strategies in hopes of higher
returns, can provide a good outlet for firms looking to trade away less liquid assets, and in some
cases, vice versa.215
As U.S. Treasury Secretary Timothy Geithner so aptly put it, hedge funds “don’t perform
these functions out of a sense of noble purpose, of course, but they are a critical part of what
makes the U.S. financial markets work relatively well in absorbing shocks and in allocating
savings to their highest return. These benefits are less conspicuous than the trauma that has been
associated with hedge funds in periods of financial turmoil, but they are substantial.”216
Hedge funds have also indirectly caused other financial institutions to provide market
benefits, in response to the nature of the hedge fund industry. Since LTCM’s collapse in 1998,
firms have established better internal due diligence practices to manage the risk of hedge fund
210 5 B.Y.U. Int'l L. & Mgmt. Rev. 99; Jenny Anderson & Heather Timmons, Why a U.S. Subprime Mortgage Crisis
is Felt Around the World, N.Y. TIMES, Aug. 31, 2007, at C1.
211 Supra note 172.
212 Id.
213 Id.
214 Id.
215 Id.
216 Id.
39

exposures.217 In addition, the same firms adaptation in the post-LTCM era included imposing
tighter credit requirements, demanding more collateral on investments, establishing daily margin
limits to ensure sufficient capital reserves, and taking a more conservative approach to valuing
collateral and illiquid assets.218 Of course, not every firm in the market exudes these benefits or
profits from these investments in every instance of trading. However, diligent investing and firm
management practices make it possible for these positive aspects to benefit other firms.
Firms in the market also learned from the LTCM incident, and began paying closer
attention to future credit exposures that they might encounter in the future.219 Moreover, firms
have insulated themselves better from risk by establishing superior and more intelligent ways of
measuring and “stress testing” those credit exposures.220 Firms have also been more proactive in
seeking out information from hedge funds about the risks of the fund. Firms have done this
through periodic inquiries into a fund’s investing strategy, leverage ratio, and other aspects that
may be discoverable, which could improve firm value and risk management.221
Although these market improvements came about after a near financial catastrophe with
LTCM’s collapse, the benefits and practices still permeate the market today.222 Unfortunately,
the stigma surrounding hedge funds as being secretive and exotic investment vehicles likely
inhibits more benefits from permeating the market due to the apprehension of investors in
participating in these funds. Regardless, as U.S. Treasury Secretary Geithner commented, it took
a “major market event to expose the extent of weaknesses in market practice that prevailed prior
218 Id.
219 Id.
220 Id.
221 Id.
40

to 1998 and to catalyze improvements across the financial community. Those reforms have
played an important role in reducing risk in the system, alongside the overall improvements in
capital, risk management, and the financial infrastructure.”223
Despite the known market benefits hedge funds provide, in the aftermath of the recent
financial crisis many of these benefits were improperly marginalized, overlooked, and even
perceived as threats. Hedge funds have been criticized by some politicians and commentators for
short-selling troubled banks during the market’s decline.224 However, the much-criticized hedge
fund short sellers are the financial markets' first line of defense against fraud and exaggerated
valuations.225 More lenient rules on short-selling increase the incentives for companies “to police
the markets themselves, and can prevent fraudulent or overvalued companies from running even
higher.”226 Without hedge fund short sellers, markets would be inherently positively-biased,
resulting in securities being priced less efficiently.227 Moreover, short sellers make for
outstanding stock analysts who have a keen eye for fraud, mismanagement, or aggressive
accounting.228 There are several tools and strategies in the market to curb gross, abusive stock
undervaluations. For example, private equity funds, strategic buyers, and share buybacks all can
41
223 Id.
224 Laurence Fletcher, “Hedge Funds Say Role in Crisis Was Marginal: AIMA,” Reuters, April 2, 2009
(http://www.reuters.com/article/idUSTRE5315J420090402).
225 Zac Bissonnette, “SEC Ends Uptick Rule but Vows Crackdown on Naked Short Selling,”
BloggingStocks, June 14, 2007. (http://www.bloggingstocks.com/2007/06/14/sec-ends-uptick-rule-
but-vows-crackdown-on-naked-short-selling/).
226 Id..
227 Alex Dumortier, “The Truth About Naked Shorts,” The Motley Fool, Sept. 22, 2008.
(http://www.fool.com/investing/dividends-income/2008/09/22/the-truth-about-naked-shorts.aspx).
228 Id.. ( “Take Jim Chanos of Kynikos Associates, for example, who was one of the first (and only) investors to call
Enron out for its fuzzy accounting. If only more investors had listened to his arguments instead of those of Ken Lay
and Jeff Skilling.).

help a company prevent abusive, unwarranted devaluations.229 The SEC would be weakening
one of the best mechanisms in place to proactively stop fraud and overvaluations if it
discouraged short-selling by placing blame on firms that did so, or made prohibited it all
together.230
What the critics are actually referring to when they criticize the hedge funds who short
sell is what the SEC describes as "abusive naked short selling." This term refers to short sellers
who (a) sell shares they have not borrowed or have no reasonable expectation of borrowing, and
(b) cannot deliver those shares on the settlement date of their sale because they do not possess
them.231 However, the SEC already addressed this alleged problem when it adopted an antifraud
rule in October of 2008 to thwart abusive naked short selling. “Rule 10b-21 is designed to
prevent short sellers, including broker-dealers acting for their own accounts, from deceiving
specified persons about their intention or ability to deliver securities in time for settlement and
then failing to deliver securities by the settlement date.”232 In addition, the SEC completely
banned short selling of 799 financial stocks for a brief period in September and October 2008,
and increased the reporting burden for short sellers.233 Yet, this still did not completely halt the
downward spiral of several financial institutions after the short-selling hold was lifted. As long
as short sales are eventually covered, there is no harm in naked short selling unless the short
seller acted fraudulently or dishonestly. The requirement to borrow shares before short selling is
229 Zac Bissonnette, “SEC Ends Uptick Rule but Vows Crackdown on Naked Short Selling,” BloggingStocks, June
14, 2007. (http://www.bloggingstocks.com/2007/06/14/sec-ends-uptick-rule-but-vows-crackdown-on-naked-short-selling/).
230 Id..
231 Id.
232 Rule 10b-21, Securities Exchange Act of 1934; SEC Release 33-7046.
(http://www.blankrome.com/index.cfm?contentID=37&itemID=1723).
233 http://www.sec.gov/news/press/2008/2008-211.htm
42

a burdensome and unnecessary process that causes market inefficiencies.234 Hedge fund critics
shouldn't let the investing strategy of short selling blind them from the truth: that severe credit
problems banks, broker-dealers, and mortgage companies had were self-inflicted, long before
hedge funds began short selling them.235
Even if critics cannot subscribe to the foregoing reasons why hedge funds were not at
fault, they cannot overlook the fact that regulators did little to regulate short-selling if indeed
they believed it to be harmful. This is evidenced by the fact that regulators suspended the
“Uptick Rule” in July of 2007.236 The SEC summarized the “Uptick Rule” as follows: "Rule 10a-
1(a)(1) provided that, subject to certain exceptions, a listed security may be sold short (A) at a
price above the price at which the immediately preceding sale was effected (plus tick), or (B) at
the last sale price if it is higher than the last different price (zero-plus tick). Short sales were not
permitted on minus ticks or zero-minus ticks, subject to narrow exceptions."237 When the rule,
which had been in place since the 1930’s, was removed in 2007 many critics claim that this
promoted easier, abusive short-selling of stocks by hedge funds.238 In response to these claims,
the SEC approved the “Alternative Uptick Rule” in February 2010.239 This rule amended Rule
201 of Regulation SHO, which was designed “to restrict short selling from further driving down
the price of a stock that has dropped more than 10 percent in one day. It will enable long sellers
234 Alex Dumortier, “The Truth About Naked Shorts,” The Motley Fool, Sept. 22, 2008.
(http://www.fool.com/investing/dividends-income/2008/09/22/the-truth-about-naked-shorts.
43
aspx).
235 Id..
236 David Gaffen, “All Hail the Uptick Rule!,” The Wall Street Journal, March 10, 2009.
(http://blogs.wsj.com/marketbeat/2009/03/10/all-hail-the-uptick-rule/).
237 Amendments to Exchange Act Rule 10a-1 and Rules 201 and 200(g) of Regulation SHO". SEC. 2008-05-21.
http://www.sec.gov/divisions/marketreg/tmcompliance/rules10a-200g-201-secg.htm. Retrieved 2009-04-08.
238 Id..
239 http://www.sec.gov/news/press/2010/2010-26.htm

to stand in the front of the line and sell their shares before any short sellers once the circuit
breaker is triggered.”240
Critics who chastise hedge funds for short selling financial companies in 2007 and 2008
are misdirecting their blame if they truly feel short selling was a contributing mechanism to the
crisis. Regulators were the ones who removed the “Uptick Rule” in 2007, so they would be hard-pressed
to blame hedge funds who undertook this completely legal investing strategy. Moreover,
the new “Alternative Uptick Rule” is viewed as a feel good rule with “no teeth,” considering the
new rule only helps in times of extreme market volatility but goes unnoticed in times of market
stability.241 Thus, if any blame could be attributed to short-selling, it should be bestowed on
regulators who removed the “Uptick Rule” and not hedge funds who acted properly under the
law. Moreover, many in the market believe that short-selling is not a legitimate, substantial
threat, but even if it is the “Alternative Uptick Rule” is not strong enough to prevent the
perceived threat. 242
Perhaps one of the biggest relative benefits hedge funds provided in the midst of the
financial crisis was that they did not burden the government or taxpayers with billion dollar
bailouts and forced, U.S. Treasury-backed mergers. Moreover, there were no systemically
notable hedge fund collapses either.243 In the aftermath of the financial crisis, the hedge fund
industry has recovered and outperformed far better than other financial institutions. It must be
noted that “banks such as CitiGroup, brokers such as Bear Stearns and Lehman Brothers, home
240 Id..
241 Chuck Jaffe, “Coming up Short: SEC’s New Version of ‘Uptick Rule” lets Investors Down,”
Market Watch, March 3, 2010. (http://www.marketwatch.com/story/new-uptick-rule-for-stocks-lets-
44
investors-down-2010-03-03).
242 Chuck Jaffe, “Coming up Short: SEC’s New Version of ‘Uptick Rule” lets Investors Down,” Market Watch,
March 3, 2010. (http://www.marketwatch.com/story/new-uptick-rule-for-stocks-lets-investors-down-2010-03-03).
243 Laurence Fletcher, “Hedge Funds Say Role in Crisis Was Marginal: AIMA,” Reuters, April 2, 2009
(http://www.reuters.com/article/idUSTRE5315J420090402).

Jon Terracciano - Hedging the Global Market

Jon Terracciano - Hedging the Global Market

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