(The article featured
below is a selection from Hedge
Funds and Private Equity: Risk Management and Regulatory Update, which is
available to subscribers of that publication.)
SEC Commissioner Designate Paredes Charts Middle Course on Hedge Fund Regulation
SEC Commissioner designate Troy Paredes believes that there is a middle ground
on hedge fund regulation between mandatory rules and doing nothing. He says that
the Commission can adopt best practices for hedge funds or employ what he calls
a default rule under which hedge funds would register with the SEC or explain to
investors why they did not. This latter prescription is similar to the comply or
explain concept employed by European Union corporate governance codes, such as
the UK's Combined Code.
Professor Parades is the heir to the definitive Loss-Seligman-Paredes treatise
on securities regulation. He is a Professor at the Washington University School
of Law; and delivered some faculty working papers on hedge funds regulation.
In the wake of a federal appeals court ruling striking down an SEC rule
requiring hedge fund managers to register with the Commission, Professor Paredes
said that there are others ways besides hedge fund regulation for the SEC to
protect hedge fund investors. For example, the SEC could take advantage of its
status and reputation and adopt a best practices mode of regulation. The SEC
could express its views of best practices without imposing mandatory
requirements. The SEC could articulate best practices formally through SEC
releases or informally through speeches and writings of individual commissioners
and division directors. One such best practice, he suggested, would be for hedge
funds to appoint chief compliance officers.
In his view, hedge fund managers could seize the initiative and adopt
SEC-endorsed best practices to show their willingness to go above and beyond
what the law requires or investors demand. Further, by emphasizing particular
best practices, he reasoned, the SEC would give investors concrete guidance to
use in assessing investment options. Such guidance would be a yardstick that
investors could use to evaluate the investment opportunity to see how it
measures up. Investors could then allocate their capital as they see fit with
the benefit of the SEC's input.
All that said, the Commissioner designate acknowledged that a best practices
approach to hedge fund regulation does have its challenges. For example, a
fundamental challenge is identifying the best practices. Also, it may be hard to
find consensus on best practices among the five SEC Commissioners, let alone
among the staff or between the commissioners and the staff. A best practices
strategy would depend on effective coordination at the SEC.
He also cautioned that best practices must not be allowed to back door into new
mandates. And, even if the SEC accedes to this caution, it is unclear if the
courts would. Best practices could provide a roadmap for the plaintiffs' bar.
The virtue of default rules is that they allow parties to contract around the
law to order their affairs to fit their particular needs. More broadly, he
believes that the ability to opt out of a regulatory regime provides an
important safety valve when regulators would otherwise over regulate. In his
opinion, a default rule requiring hedge fund managers to register with the SEC
or disclose why they have chosen not to register would have been a particularly
apt alternative to the SEC rule mandating registration. Just as hedge fund
investors can evaluate other aspects of a fund's operations, he observed,
investors could assess the value of investment adviser registration against the
backdrop default that managers must register with the SEC.
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