The Future of Hedge Fund Regulation

The Obama administration’s proposal for a financial regulatory overhaul continues to send shockwaves through the financial services sector. The virtually unregulated hedge fund and alternative investment industry is likely to receive heightened government oversight under any reform efforts. As this scenario unfolds, the usually low-profile hedge fund community has stepped up its presence in Washington with the goal of influencing new regulations. Despite this renewed outreach, there remains little doubt that this sector will soon face further restrictions both in the U.S. and abroad. These reforms will affect a wide range of issues including registration, transparency, risk management, investor relations, derivatives, due diligence, and capital requirements.

Hedge fund experts Ezra Zask, an affiliate with Analysis Group and former hedge fund manager, and Gaurav Jetley, a vice president at Analysis Group who specializes in securities valuation and risk management, answer pressing questions about the future of hedge fund regulation and litigation:

1. Will the reforms that have recently been proposed by the Obama administration be approved by Congress and become law?
Zask: “Yes, in some shape or form. The majority of time spent over the last few weeks has centered on figuring out exactly what the provisions of the legislation should be, like the level of disclosure and registration. There is a significant amount of public scrutiny and international pressure in favor of regulation. The registration of hedge funds by a central authority, such as the SEC, will certainly pass. Beyond this, the specific details of additional guidelines and disclosures are still unclear.”

Jetley: “Ezra is correct and there is agreement on all sides that additional regulation is good, but disagreement on what type of funds should be forced to register or increase their level of disclosure. For example, large hedge funds without much leverage may argue that they do not pose a risk to the financial system and do not believe they merit the same stringent oversight as highly leveraged funds, which are much riskier.”

2. How do you think these new regulations will affect the hedge fund industry?
Jetley: “New regulations may actually benefit the industry, which helps explain why parts of the hedge fund community are supportive of change. For example, legislation currently in Congress could be advantageous for hedge funds because it would make them less secretive and create a stable regulatory environment. In addition, hedge funds may attract new investors that were traditionally hesitant to participate.”

Zask: “In addition to the new business opportunities, these reforms could be good for hedge funds because they will bring parts of the industry in from the cold, giving funds legitimacy. The potential information that will be available to the public as a result of these proposed regulations will help to lift the veil of secrecy that currently surrounds hedge funds.”

3. Will there be any effect on hedge fund litigation?
Jetley: “Hedge funds will continue to face increased litigation involving issues related to Madoff fraud (lack of due diligence), liquidity levels, margin calls, and misinformation about both risk and return. Legislation or new regulations, though, are unlikely to have a direct impact on hedge fund litigation. There is a relationship between legislation and litigation in the sense that legislative and regulatory action is the government’s attempt to fill gaps in the current system that are highlighted by these lawsuits.”

Zask: “Even though the legislation will not have a direct impact on litigation, as Gaurav mentioned, hedge funds will continue to face lawsuits. We’ve already seen the SEC become more aggressive and I anticipate we will see more and more investigations and litigation from the CFTC and the SEC.”

4. How will hedge fund regulations play out across the globe?
Zask: “I believe one of the biggest hurdles American legislators will face is taking into account how the European Union intends to approach hedge fund regulation. As of late, the EU has been taking a more forceful and stronger view towards hedge fund oversight, and financial regulation in general, than the U.S. Any successful effort will have to meet somewhere in the middle, engaging governments across the world.”

Jetley: “I agree that the call for hedge fund regulation across the globe remains strong and that these efforts must be collaborative in order to succeed. If countries are not working together on these reforms, hedge funds may gravitate to a country or area with less regulation.”

Analysis Group (www.analysisgroup.com) provides economic, financial, and business strategy consulting to leading law firms, corporations, and government agencies. The firm has more than 475 professionals, with offices in Boston, Chicago, Dallas, Denver, Los Angeles, Menlo Park, New York, San Francisco, Washington, and Montreal.