Overview

WHAT IS A HEDGE FUND?

There is no universal definition of a hedge fund. The term "hedge fund" has "developed into a catch-all classification for many unregistered privately managed pools of capital. These pools of capital may or may not utilize sophisticated hedging and arbitrage strategies that traditional hedge funds employ and many appear to engage in relatively simple equity strategies."† Hedge funds typically attempt to exploit market inefficiencies through temporary price discrepancies in commodity and securities markets. Hedge funds exploit market inefficiencies by selling short stock, utilizing sophisticated hedging strategies to reduce interest rate volatility and other risks from market exposure, and using futures contracts or derivatives to leverage their portfolio. Almost all hedge funds attempt to locate mispriced securities, in differing forms, within the world's financial market. Then, using debt, hedge funds expend, or leverage, their positions in the mispriced securities to reap maximum gains for investors while incurring as little risk as possible.

† U.S. Securities and Exchange Commission, Testimony Concerning Protection Implications of Hedge Funds before the Senate Committee on Banking, Housing and Urban Affairs, William H. Donaldson, Chairman (Apr. 10, 2003).

BRIEF HISTORY OF HEDGE FUNDS

The emergence of hedge funds as serious players in financial markets is a recent phenomenon. The first hedge fund was created in 1949. It employed a strategy consisting of using leverage and long and short selling to produce positive returns in both up and down markets. During the 1940s, 50s and 60s, hedge funds only used leverage and short selling to hedge their stock portfolio's movement in the equity markets. Through the 70s and 80s hedge funds became more complex and risky. Some hedge funds continued to take long positions in the market but utilized fewer short positions. The increased reliance on long positions caused hedge funds to be riskier, which was only exacerbated by their increased use of leverage. During this time period, new types of hedge funds were born that relied on different investment strategies. At the same time, hedge funds became more popular because of the high returns they were able to offer. The 1990s saw an exponential growth in the number of hedge funds as wealth grew and investment requirements fell. During this time, there was also rapid growth in the types of strategies that hedge funds employed. As competition grew, traditional strategies no longer generated high returns, and hedge fund managers were forced to devise the new and diverse strategies, which are employed today.

HISTORY OF HEDGE FUND REGULATION

Traditionally, the U.S. has not regulated hedge funds. The SEC first began to look at the impact of hedge funds as early as 1969. In 1971, the SEC conducted an economic study in which the Commission "described the activities of hedge funds, noted the serious conflicts of interest that hedge fund advisers had, and noted their growth." At that time the hedge fund industry was still small and seemed to have a negligible effect on U.S. markets. For the next twenty years, the SEC paid little interest to the hedge fund industry. All of this changed with the Long-Term Capital Management debacle.

In the mid-1990s Long-Term Capital Management ("LTCM") was a large, highly leveraged hedge fund. In 1998, Russia 's unexpected financial crisis caused the unraveling of this highly leveraged fund, which threatened the security of international bond markets. To avoid the impending fallout, the president of The New York Federal Reserve Bank, William McDonough, orchestrated a bailout among prominent banks to save LTCM. Although LTCM was saved from insolvency, the hedge fund industry was thrust into the national spotlight. The media coverage forced the U.S. Congress and those in the investment community to consider greater regulation for the hedge fund industry.

THE CURRENT REGULATORY SCHEME - EXEMPTIONS AND SAFE HARBORS

Those involved in issuing and investing in securities are genreally subject to applicable securities regulations, which are typically derived from three sources: The Securities Act of 1933, The Exchange Act of 1934, and the 1940 Investment Advisers Act. Hedge funds have largely avoided the SEC's scrutiny by utilizing exemptions and safe harbors found in these three provisions.

Most hedge funds avoided registration under the 1933 Act by relying on the Section 4(2) exemption that applies to firms that sell securities through a nonpublic offering to sophisticated investors. The idea was that the offerees were able to obtain and analyze the financial data from the offeror and did not need the protections afforded by registration. The sophisticated investors who usually invest in hedge funds must have the requisite knowledge and access to information that meets the statutory categories of accredited investors contained in Reg. D of the 1933 Act. This allows hedge funds which offer nonpublic offerings to be exempt from the 1933 Act.

The relationship between hedge funds and the Exchange Act is different from that of the Securities Act. Specifically, the Exchange Act requires that "broker-dealers submit to SEC regulatory oversight and that persons holding certain securities positions report those positions to the SEC." Hedge fund managers are generally not considered "broker-dealers." As a result, hedge funds only come within the purview of the Exchange Act if they acquire certain amounts of securities holdings.

Hedge funds are generally considered to satisfy the definition of an investment company under the Investment Advisers Act. To avoid registering with the SEC, hedge funds utilize certain exemptions from registration specified in the Act. Before 1996, hedge funds almost exclusively used the exception in section 3(c)(1) to avoid registration under the Investment Advisers Act and the resulting regulation as an investment company. This exception allows hedge funds to sell interests to no more than 100 accredited investors as defined by regulation D of the 1933 Act as long as a public offering is not made.

In 1996, another avenue of evasion was created by Congress. The National Securities Markets Improvement Act of 1996 (NSMIA) amended the 1940 Act. This amendment included an exception from the definition of investment company under section 3(c)(7) for private investment funds that sell to an unlimited number of qualified purchasers and do not make a public offering of such securities. Read in conjunction with section 12(g)(1)(B) of the Exchange Act, section 3(c)(7) allows hedge funds to sell interests to 499 investors who must meet the higher net worth requirement of a qualified purchaser.

The aggregate result of these regulations encourage hedge funds have a relatively small number of financially sophisticated investors. These investors are presumed competent to ascertain the risk involved in such investments. Until recently, the requirements and exemptions applicable to hedge funds were deemed sufficient to comply with the SEC's objectives of protecting investors and maintaining market integrity.

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