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Hedge Fund
Scholarly Compositions - Featured Authors
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Dr.
Troy Paredes
Professor of Law
Washington University in St. Louis
School of Law
Academic Home Page •
Curriculum Vitae
Troy Paredes is a professor at
Washington University School of Law. Paredes teaches corporations,
securities regulation, and corporate finance. His research interests
include corporate governance; the impact of psychology on corporate
decision making and investor behavior; the development of corporate
governance and securities law systems in developing countries; and
executive compensation. Paredes has written several articles and
made numerous presentations on a wide range of topics about
corporate governance, securities regulation, and law and economics.
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Paredes
graduated with highest honors from the University of California at
Berkeley with a degree in economics. His emphasis was on industrial
organization, market structure, and regulatory economics. Paredes
then attended Yale Law School, where he served on the editorial
board of the Yale Journal on Regulation and was a Coker Fellow and
an Olin Fellow in Law and Economics.
Before joining Washington University’s faculty, Paredes was a
corporate and regulatory lawyer. As an attorney, Paredes worked on a
variety of transactions, including leveraged buyouts, mergers and
acquisitions, and private equity and venture capital financings, as
well as on antitrust and regulatory matters in the energy industry.
Paredes maintains his connection to the legal and business
communities by consulting on a variety of corporate, securities, and
regulatory issues. |
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On the Decision to Regulate Hedge Funds:
The SEC’s Regulatory Philosophy, Style, and Mission
by Troy A. Paredes
March 24, 2006
Abstract
In a controversial move in late 2004, the Securities and
Exchange Commission (SEC) decided to require hedge fund managers
to register with the agency as investment advisers. Until then,
the SEC had largely refrained from ramping up hedge fund
regulation, even after the collapse of Long-Term Capital
Management in 1998.
Although this Article takes some issue with the SEC’s decision
to regulate hedge funds, its primary focus is not on the
particular costs and benefits of regulating hedge funds. The
inquiry is broader: What can we learn generally about SEC
decision making and securities regulation from the SEC’s
decision to regulate hedge funds now by subjecting fund managers
to the registration requirements of the Investment Advisers Act?
Since the SEC consciously shifted direction in deciding to
regulate hedge funds – and in doing so overstepped the
traditional boundary of securities regulation by looking past
the ability of sophisticated and wealthy hedge fund investors to
protect themselves – the hedge fund rule prompts reconsideration
of SEC decision making, particularly in the aftermath of Enron
and the other recent corporate scandals that marked the early
2000s.
Although nobody knows for sure what motivates a regulator, the
SEC’s decision to adopt its new hedge fund rule is consistent
with two views – one political; the other, psychological. First,
the SEC did not want to get caught flat footed and embarrassed
again, as it had been by Enron, WorldCom, the mutual fund
abuses, and securities analyst conflicts of interest; and
second, after the earlier scandals, the risk of fraud and other
hedge fund abuses weighed disproportionately on the agency,
prompting it to act when it had not in the past. The particular
concern is that such political and psychological influences
result in overregulation.
This Article concludes with a suggestion. To mitigate the risk
of overregulation, the SEC should increasingly consider using
default rules instead of mandatory rules. Defaults at least give
parties a chance to opt out if the SEC goes too far. Indeed, in
some cases, perhaps the SEC could exercise an even lighter touch
and simply articulate best practices.
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| HEDGE FUND RISK AND OTHER
DISCLOSURES |
Hedge funds, including fund of funds (“Hedge
Funds”), are unregistered private investment partnerships, funds or
pools that may invest and trade in many different markets,
strategies and instruments (including securities, non-securities and
derivatives) and are NOT subject to the same regulatory requirements
as mutual funds, including mutual fund requirements to provide
certain periodic and standardized pricing and valuation information
to investors. There are substantial risks in investing in Hedge
Funds. Persons interested in investing in Hedge Funds should
carefully note the following:
- Hedge Funds represent speculative investments and involve a
high degree of risk. An investor could lose all or a substantial
portion of his/her investment. Investors must have the financial
ability, sophistication/experience and willingness to bear the
risks of an investment in a Hedge Fund.
- An investment in a Hedge Fund should be discretionary capital
set aside strictly for speculative purposes.
- An investment in a Hedge Fund is not suitable or desirable for
all investors. Only qualified eligible investors may invest in
Hedge Funds.
- Hedge Fund offering documents are not reviewed or approved by
federal or state regulators
- Hedge Funds may be leveraged (including highly leveraged) and
a Hedge Fund’s performance may be volatile
- An investment in a Hedge Fund may be illiquid and there may be
significant restrictions on transferring interests in a Hedge
Fund. There is no secondary market for an investor’s investment in
a Hedge Fund and none is expected to develop.
- A Hedge Fund may have little or no operating history or
performance and may use hypothetical or pro forma performance
which may not reflect actual trading done by the manager or
advisor and should be reviewed carefully. Investors should not
place undue reliance on hypothetical or pro forma performance.
- A Hedge Fund’s manager or advisor has total trading authority
over the Hedge Fund.
- A Hedge Fund may use a single advisor or employ a single
strategy, which could mean a lack of diversification and higher
risk.
- A Hedge Fund (for example, a fund of funds) and its managers
or advisors may rely on the trading expertise and experience of
third-party managers or advisors, the identity of which may not be
disclosed to investors
- A Hedge Fund may involve a complex tax structure, which should
be reviewed carefully.
- A Hedge Fund may involve structures or strategies that may
cause delays in important tax information being sent to investors.
- A Hedge Fund may provide no transparency regarding its
underlying investments (including sub-funds in a fund of funds
structure) to investors. If this is the case, there will be no way
for an investor to monitor the specific investments made by the
Hedge Fund or, in a fund of funds structure, to know whether the
sub-fund investments are consistent with the Hedge Fund’s
investment strategy or risk levels.
- A Hedge Fund may execute a substantial portion of trades on
foreign exchanges or over-the-counter markets, which could mean
higher risk.
- A Hedge Fund’s fees and expenses-which may be substantial
regardless of any positive return- will offset the Hedge Fund’s
trading profits. In a fund of funds or similar structure, fees are
generally charged at the fund as well as the sub-fund levels;
therefore fees charged investors will be higher that those charged
if the investor invested directly in the sub-fund(s).
- Hedge Funds are not required to provide periodic pricing or
valuation information to investors.
- Hedge Funds and their managers/advisors may be subject to
various conflicts of interest.
The above general
summary is not a complete list of the risks and other important
disclosures involved in investing in Hedge Funds and, with respect
to any particular Hedge Fund, is subject to the more complete and
specific disclosures contained in such Hedge Fund’s respective
offering documents. Before making any investment, an investor should
thoroughly review a Hedge Fund’s offering documents with the
investor’s financial, legal and tax advisor to determine whether an
investment in the Hedge Fund is suitable for the investor in light
of the investor’s investment objectives, financial circumstances and
tax situation.
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to be net of applicable fees unless otherwise specifically noted. No
representation is made that any fund will or is likely to achieve
its objectives or that any investor will or is likely to achieve
results comparable to those shown or will make any profit at all or
will be able to avoid incurring substantial losses. Past performance
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Indices also may contain securities or types of securities that are
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