The law of unintended consequences

Tue Apr 6, 2010

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Laws that apply to the general world of finance don't seem to apply to hedge funds. And it could be this that makes hedge funds so attractive to thrill seekers and risk takers...

By Susan Barreto

Laws that apply to the general world of finance don't seem to apply to hedge funds. And it could be this that makes hedge funds so attractive to thrill seekers and risk takers; many of whom signed up for a quiet life.

What am I talking about? Global end investors in hedge funds may be active risk takers and not even know it, thanks to a long-standing regulation in the US that governs what a hedge fund or fund of funds manager can or can not say about himself (or herself) publicly.

Mark Twain once said: "The man that sets out to carry a cat by its tail learns something that will always be useful and which will never grow dim or doubtful."

While hedge fund managers have shown the stealth of a feline in their investment process, the tail risk here is related primarily to interpretation of the Securities and Exchange Commission's Regulation D, which places a ban on general advertising by issuers of unregistered securities.

While the intention of this rule - preventing 'mom and pop' investors from putting their life savings in unregistered, risky investments - is a good one, the unintended consequence of this regulation could be quietly putting institutional investor portfolios at risk.

The issue is that hedge fund and fund of funds compliance officers are now using the ban on general solicitation to control news coverage. This is largely because the interpretation of Regulation D differs from firm to firm in the US.

Some say the rule means no participation in media stories or listing in industry databases. Other attorneys say they can have stories written, but just no performance figures or fund names. And others say they can only talk about their strategy in positive terms in a story about trends in that investment space, which sounds like marketing puff to me, designed to covertly market their product.

And it is this last interpretation that I believe is part of a growing problem. While no hard numbers exist, anecdotally the number of firms asking to be left alone due to Regulation D has grown since the start of the 2008 financial crisis.

The real danger is that an investor these days has no way of knowing whether the manager is hiding behind Regulation D or something more fishy. If it's all positive or all negative, coverage may only tell you the part of the story. The real test could be whether or not your manager's name pops up at all on Google; which, by the way, you can pay to clean up.

Philip Goldstein, the man who won his original case against the SEC over mandatory registration, is suing Massachusetts Secretary William Galvin, who brought an enforcement action against Goldstein's Bulldog Investors for having a public website. Galvin, so far, has been successful in defending his enforcement actions.

One of the briefs in the case, which is being appealed by Goldstein after having lost two appeals, is from an investor who merely wants to access Bulldog's website with the claim that he, the investor, should be able to read whatever he wants anonymously and without providing his personal financial information. The case is ongoing, but Goldstein recently asked media outlets to step up and file an amicus brief.

"This is the United States of America, not Iran or China (which wants to censor Google)," writes Goldstein. "And aren't you fed up with the reticence of hedge fund managers to speak publicly, lest they be accused of engaging in a general solicitation?"

To answer Goldstein's question, journalists may be fed up, but it is really up to investors to tell the SEC to rework this rule with some specific guidelines for managers to follow. Until institutional investors have their say, the unintended veil of secrecy will only hurt those who thought they had something to gain from hedge funds.

ISSN: 2151-1845 / CDC10004H

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