Capital Markets

Lawmakers: Hedge-Fund Risk Hits Pensions

Big worries are seen in "the commingling of sophisticated and unsophisticated capital."
David KatzMarch 13, 2007

Pension investments in hedge funds deserve Congressional scrutiny — and perhaps new laws — to protect ordinary investors from the risks that the funds represent, House members and hedge-fund managers agreed on Tuesday.

While executives who manage the lightly regulated capital pools contended that hedge funds pose no special risk to the economic system, they acknowledged at a House Financial Services Committee hearing that average investors have become increasingly exposed to serious personal financial loss.

The gathering was the first in a series called by Rep. Barney Frank, the Massachusetts Democrat who chairs the committee, with later hearings slated to probe the relationship of hedge funds to insider training and to include testimony by the President’s Working Group on Capital Markets chaired by U.S. Treasury Secretary Henry Paulson. Last week, Chuck Grassley, the ranking Republican on the Senate Finance Committee, proposed legislation that would require most hedge funds to register with the Securities and Exchange Commission.

Over the years since the infamous 1998 collapse and subsequent bailout of Long Term Capital Management, “the nature of investors [in hedge funds] have changed,” noted Kenneth Brody, a founder of Taconic Capital Advisors and chairman of the investment committee of the University of Maryland. “It’s not just wealthy individuals, but pension funds.”

At least one Congressman saw the risk spreading beyond pension holders. “We do have to concern ourselves with the taxpayers,” said Rep. Al Green, a Texas Democrat, “because we have the commingling of sophisticated and unsophisticated capital” in hedge fund investing. If pension beneficiaries lose their retirement money because of bad hedge-fund investments, then taxpayers could be forced to pay for the pensioners’ social services, he said.

Brody’s answer was, like Grassley’s, to require mandatory registration of hedge-fund advisers by the SEC. What registration provides, the hedge-fund manager said, “is self-discipline and self-policing, because [registration] comes with the threat of an SEC investigation.” Last June, however, the D.C. Circuit Court of Appeals overturned an SEC rule requiring most hedge fund advisers to register with the commission by Feb. 1, 2006.

Since then, hedge fund advisers have been able to avoid any regulation by the SEC because the Investment Advisers Act of 1940 exempts advisers from registering with the SEC if they have fewer than 15 clients. Hedge funds have been able define the word “client” as the hedge fund itself, rather than the investors who own shares in it. Thus, an adviser serving two hedge funds is exempt from registration, even if the funds have many more than 15 investors.

Like many other hedge funds, however, Taconic Capital Advisors registers voluntarily with the SEC. Brody pointed out that a number of the requirements of registration — including the designation of a chief compliance officer; the presence of written policies and procedures; a code of ethics; and retention of books and records — “promote investor protection.”

Others, however, felt that mandatory registration would create a “moral hazard” because it would be an ineffective rule that would spawn the mere appearance of oversight while serious misdeeds could go undetected. “In my judgment, registration doesn’t work. You can have a label on your door and you could still be a bad actor,” said Rep. Richard H. Baker, a Louisiana Republican.

Questioned by Frank, representatives of two hedge fund associations, the Coalition of Private Investment Companies and the Managed Funds Association, said they would have no problems with legislation calling for books and records retention. Frank also pressed Gerald Corrigan, a Goldman Sachs managing director and former New York Federal Reserve chief, on the question of whether the federal government had a role in mandating disclosures of hedge fund communications not usually privy to the public. Corrigan, first saying that he favored the establishment of best-practices benchmarks, finally conceded that the federal government should have some role.

The rarely discussed topic of the financial exposure corporations face in investing in hedge funds surfaced briefly at the hearing. Apparently concerned by reports that Sears had recently been turning from its traditional retail emphasis to hedge-fund-like investing, Rep. David Scott, a Georgia Democrat, asked: “Are you worried that more and more of our nation’sÂ…corporations will turn to hedge funds and unrelated investments to survive?” Witnesses shrugged off that concern as a management issue rather a concern specific to hedge funds.