Is Systemic Risk Prevention the New Paradigm? A Proposal to Expand Investor Protection Principles to the Hedge Fund Industry

Abstract

The Dodd-Frank Act finally achieved the inevitable. It subjects hedge funds to significant regulatory oversight even though they were previously exempt from regulation. In 2006, the SEC notoriously failed at this task when the D.C. Court of Appeals held that the agency acted outside of its rulemaking authority in attempting to regulate hedge fund advisers. Through the passage of the Dodd-Frank Act, Congress finally finished what the SEC started by using the current political climate to close this regulatory loophole. The Dodd-Frank Act is a step in the right direction, but it leaves an important question largely unanswered: Should hedge fund investors actually be protected under our federal securities laws?

While the Dodd-Frank Act will require many hedge fund advisers to register under the Advisers Act, the extent to which this will actually protect investors is unclear. Overall, the Dodd-Frank Act seems to be limited to systemic risk prevention. Many researchers in this area agree with this approach and believe that investor protection is inapplicable in this case, since such investors are typically institutions or wealthy individuals who can presumably fend for themselves. This view is consistent with traditional notions of investor protection, which reject the argument that investor protection principles should be expanded to hedge fund investors. In contrast, this article focuses on the need for greater protection of these investors since the hedge fund industry has morphed into its own distinct marketplace that has grown increasingly complex. As such, this article specifically argues that the Dodd-Frank Act does not provide hedge fund investors with enough information to adequately protect themselves from the unique informational challenges associated with hedge fund investments. These unique issues encompass an overall lack of standardization within the industry, particularly with respect to its disclosure practices, risk assessments, and valuation procedures. Furthermore, the losses of these sophisticated investors can adversely impact unsuspecting retail investors as well the entire economy, which makes the expansion of investor protection concepts a pressing issue. This article concludes by proposing an alternative regulatory framework that creates uniform and mandatory measures of risk and valuation, which would provide reliable and consistent disclosures to investors, and create more transparency within the hedge fund marketplace.