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Verret Proposal on Hedge & PE Funds Included in Dodd-Frank

I published a paper back in 2007, Dr. Jones and the Raiders of Lost Capital: Hedge Fund Regulation Part II, an SRO Proposal, in the Del. J. Corp. L which started as my 3L writing project and eventually became the paper I used to go onto the AALS academic market.  I argued against the SEC’s prior rule requiring hedge fund managers to register with the SEC as investment advisors, I thought the SEC’s rule was unnecessarily costly and would inhibit efficient trades by private funds and inhibit competition in the industry.

I argued that establishing a self-regulatory organization (SRO) for private funds may be a less costly alternative to requiring outright registration.  That’s not to say that I argued we needed to do anything at all, but I recognized that Congress and the SEC would eventually do something with unregulated funds (I was on a panel once with the Director of the Investment Management at the SEC…when I asked him why we needed to regulate hedge funds he promptly answered “because they’re unregulated”).  I argued that we should consider an SRO governed by market participants as a less-costly alternative to a bureaucratically managed initiative.  The brief version of my argument, that also offers more detail on how I would design a hedge fund SRO, is available here.

Well guess what, someone was listening.  The Dodd-Frank Act includes a requirement for the GAO to study instituting a Self-Regulatory Organization for private funds.  The relevant language is below:

SEC. 416. GAO STUDY ON SELF-REGULATORY ORGANIZATION FOR PRIVATE FUNDS.

The Comptroller General of the United States shall?(1) conduct a study of the feasibility of forming a self-regulatory organization to oversee private funds; and (2) submit a report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of such study, of this Act.

Dodd-Frank also included a requirement for investment adviser registration for private funds, but it could have been much worse.  There’s was quite a bit of talk for some time about requiring investment company act registration, which in my view could have destroyed the industry.  So hopefully this proposal will preclude such onerous alternatives.

Our readers know that it’s fairly out of the ordinary for me to support a Dodd-Frank provision.  Well, I guess I better this time, since it was my idea.  It’s one of the best things about being at George Mason.  I wrote a paper, presented it at a number of conferences, then briefed Hill staff, and was then able to have the recommendations from my 3L paper included in the Dodd-Frank legislation.  (Whatever you think about my proposal, you have to admit that’s pretty cool right?)  Now I am grateful for the opportunity to advise the GAO on their mandated study of an SRO for private funds.

One of the things I like about an SRO, as opposed to the SEC, regulating private funds is that the SRO members will more readily internalize the costs and the benefits of the regulation.  The SEC’s cost benefit analysis of new rules proposals is woefully inadequate.

I might anticipate three rapid-fire critiques of my, and of Dodd-Frank’s, idea for a hedge fund SRO.  First, some will argue that self-regulatory organizations will systematically under enforce.  Second, others will suggest that self-regulatory organizations will become subject to capture by the more powerful SEC, much like we often see with Finra.  Third, others will argue that the SROs will merely become agents for facilitating rent-seeking by member firms to impose onerous costs on competitors who may or may not be members but who don’t get a say in the rules.

I have a few responses to those critiques.  In large part, my response is that if (and maybe it’s a big if) Congress and the SEC follow my advice about regulatory architecture for the Private Fund SRO, then those problems can potentially be averted.  As to the under-enforcement argument, I think if designed correctly the members of the SRO who vote on rules will face two main constraints.  First, the under-enforcement and under-regulate issue will be minimized through a prisoner’s dilemma dynamic I describe in the paper, with equilibria that do not permit collusion they may otherwise prefer in their inter-industry competition for capital.  See the full paper for more analysis.

Part of what is required to achieve that dynamic would be a relatively large governing board of the SRO whose selection is overseen by the Commission to ensure that a small number of funds don’t dominate the governing body either directly or through relationships with other funds.  Also, term limits for the governing members and other qualifications to limit tit-for-tat solutions.  Also, the private fund industry as a whole competes with other asset classes for capital, and so the SRO will internalize that interest.  Tailoring the qualifications of the governing members to include small upstart funds as well as larger established funds is also key to minimizing the SRO-as-rent-facilitor critique.

As to the SEC capture argument, I would advocate instituting a rule which would limit SEC review of SRO rules to a high standard, something like an “abuse of discretion” standard.  Then if the SEC overturns an SRO rule or governing board resolution the DC Circuit wouldn’t give deference to that decision.  The SEC and Congress can always threaten to abolish the SRO or pre-empt them, sure, but if the alternative is actual legislation and pre-emption then maybe I’d prefer an SRO that works in the shadow of such a threat.

And finally, to my colleagues who may be uncomfortable with my actually supporting a piece of Dodd-Frank….don’t get too excited, at this point it’s only a GAO study after all.  Besides, it’s my 3L paper, I have to support it.

Filed under: truth on the market

Full post as published by Truth on the Market on October 28, 2010 (boomark / email).