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On the Decision to Regulate Hedge Funds: The SEC's Regulatory Philosophy, Style, and Mission


Troy A. Paredes


Washington University in Saint Louis - School of Law

March 24, 2006

Washington U. School of Law Working Paper No. 06-03-02

Abstract:     
In a controversial move in late 2004, the Securities and Exchange Commission (SEC) decided to require hedge fund managers to register with the agency as investment advisers. Until then, the SEC had largely refrained from ramping up hedge fund regulation, even after the collapse of Long-Term Capital Management in 1998.

Although this article takes some issue with the SEC's decision to regulate hedge funds, its primary focus is not on the particular costs and benefits of regulating hedge funds. The inquiry is broader: what can we learn generally about SEC decision making and securities regulation from the SEC's decision to regulate hedge funds now by subjecting fund managers to the registration requirements of the Investment Advisers Act? Since the SEC consciously shifted direction in deciding to regulate hedge funds - and in doing so overstepped the traditional boundary of securities regulation by looking past the ability of sophisticated and wealthy hedge fund investors to protect themselves - the hedge fund rule prompts reconsideration of SEC decision making, particularly in the aftermath of Enron and the other recent corporate scandals that marked the early 2000s.

Although nobody knows for sure what motivates a regulator, the SEC's decision to adopt its new hedge fund rule is consistent with two views - one political; the other, psychological. First, the SEC did not want to get caught flat footed and embarrassed again, as it had been by Enron, WorldCom, the mutual fund abuses, and securities analyst conflicts of interest; and second, after the earlier scandals, the risk of fraud and other hedge fund abuses weighed disproportionately on the agency, prompting it to act when it had not in the past. The particular concern is that such political and psychological influences result in overregulation.

This article concludes with a suggestion. To mitigate the risk of overregulation, the SEC should increasingly consider using default rules instead of mandatory rules. Defaults at least give parties a chance to opt out if the SEC goes too far. Indeed, in some cases, perhaps the SEC could exercise an even lighter touch and simply articulate best practices.

Number of Pages in PDF File: 70

Keywords: Securities and Exchange Commission, SEC, securities regulation, hedge funds, administrative law, securities markets, default rules

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Date posted: March 29, 2006  

Suggested Citation

Paredes, Troy A., On the Decision to Regulate Hedge Funds: The SEC's Regulatory Philosophy, Style, and Mission (March 24, 2006). Washington U. School of Law Working Paper No. 06-03-02. Available at SSRN: http://ssrn.com/abstract=893190 or http://dx.doi.org/10.2139/ssrn.893190

Contact Information

Troy A. Paredes (Contact Author)
Washington University in Saint Louis - School of Law ( email )
Campus Box 1120
St. Louis, MO 63130
United States
314-935-8216 (Phone)
314-935-5356 (Fax)
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