The new antifraud rule: Is SEC enforcement the most effective way to protect investors from hedge fund fraud?

Fordham Law Review

Volumn 77, Issue 2, 2008, Pages 851-916

  Lange, Kathleen E ^a  

^a NONE

Author keywords

[No Author keywords available]

Indexed keywords

EID: 58149153263     PISSN: 0015704X     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (531)

1. Complaint at 5, SEC v. Israel, No. 05 civ. 8376 (S.D.N.Y. Sept. 29, 2005) [hereinafter Israel Complaint]. "The Bayou Fund apparently was conceived as a real hedge fund that traded securities." Id. at 2. In January 2003, the Bayou Fund was reorganized and liquidated to create four separate hedge funds: Bayou Accredited Fund, LLC; Bayou Affiliates Fund, LLC; Bayou No Leverage Fund, LLC; and Bayou Superfund, LLC. Id. at 5.
2. Id. at 5.
3. Id. at 2 (alleging defendants "knowingly misrepresented the value and performance of the Bayou Fund and the four successor Funds to clients; [and] issued false and misleading financial statements, account statements and performance summary documents"); see also Greg Farrell, Empty Promises in Hedge Fund Fraud: SEC Says Bayou's Executives Deceived Investors from Start, USA TODAY, Sept. 30, 2005, at B3 (reporting that Samuel Israel and Daniel Marino "disguised trading losses from Bayou's early investors by lying about the fund's performance and padding the results with infusions of cash from Bayou Securities, a stock-trading subsidiary that racked up heavy commissions from Israel's frenetic trading"). One example of their misrepresentations is documented in the funds' 2003 annual statement, in which the defendants reported "that Bayou Superfund had earned more than $25 million." Israel Complaint, supra note 1, at 8. In reality, "Bayou Superfund took in more than $90 million in investments [in 2003], but lost approximately $35 million through trading." Id.
4. Israel Complaint, supra note 1, at 6.
5. Id. Marino was a certified public accountant. Id.
6. Id. at 7 ("In the summaries and year-end financial statements, Israel and Marino again fabricated the [f]und's results in order to make it appear that the [f]und was earning trading profits and achieving earnings targets that the defendants had formulated to create the appearance of modest, steady, and believable growth.").
7. Id. at 5.
8. Id. at 7.
9. Id.
10. Id. at 8.
11. Id. at 9.
12. Id. (internal quotation marks omitted). "Despite the patently dubious nature of the trading programs to which he was being steered, Israel pursued them using monies taken from the [f]unds." Id.
13. Id. at 13.
14. Id.
15. Id. ("Documents obtained from Bayou-related bank accounts show that the accounts were overdrawn before the liquidation and redemption checks were drafted.").
16. See Complaint, San Diego County Employees Ret. Ass'n v. Maounis, No. 07 civ. 2618 (S.D.N.Y. Mar. 29,2007) [hereinafter SDCERA Complaint].
17. Jenny Strasburg, Amaranth Sued by San Diego, Warns of Refund Delays, BLOOMBERG, Mar. 30, 2007, http://www.bloomberg.com/apps/ news?pid=20601087&sid=al 2cSn2AKd5Y&refer=home. New Jersey's pension fund, another Amaranth investor, may "lose $16 million of its $25 million it [originally] invested with Amaranth." Amaranth Fund Details Losses to Investors: Lost $6 billion, Had to Sell Assets to Cover Bad Natural Gas Investments, MSNBC, Sept. 21, 2006, http://www.msnbc.msn.com/id/14927007/.
18. See Strasburg, supra note 17 ("Amaranth's assets peaked at $9.5 billion in August as rising prices increased the value of its holdings.").
19. Id. The complaint seeks damages of at least $150 million based on the retirement plan's initial investment. Id.
20. Id.
21. Id. (quoting SDCERA Complaint, supra note 16, at 2).
22. Id. ("Investors 'must show that the firm engaged in fraud and malfeasance, with direct evidence establishing more than just that someone could have done a better job with a risky investment.'" (quoting Seth Berenzweig, a lawyer with Virginia-based Albo & Oblon LLP)).
23. Josh Gerstein, Lawyers Circle After Failure of Hedge Fund, N.Y. SUN, Oct. 20-22, 2006, at A1.
24. Id.
25. BLACK'S LAW DICTIONARY 685 (8th ed. 2004).
26. See Role of Hedge Funds in the Capital Markets: Hearing Before the Subcomm. on Securities, Insurance, and Investment of the S. Comm. on Banking, Housing, and Urban Affairs, 109th Cong. 4 (2006) [hereinafter Hedge Fund Hearing] (statement of Patrick M. Parkinson, Deputy Director, Division of Research and Statistics, Board of Governors of the Federal Reserve System). "For example, three Federal Reserve examinations of the New York branch of Daiwa Bank between 1992 and 1994 failed to uncover $1.1 billion of hidden trading losses." Id. at 4 n. 10.
27. Michael Pereira, Hedge Fund Taxation, METROPOLITAN CORP. COUNS., Sept. 2007. at 13, available at http://www.metrocorpcounsel.com/pdf/2007/September/13.pdf.
28. Id. These figures were reported in September of 2007. Id.
29. Federal Bureau of Investigation, Hedge Fund Information for Investors, www.fbi.gov/page2/march07/hedge-fund.htm (last visited Oct. 24, 2008).
30. Id.
31. See Goldstein v. SEC, 451 F.3d 873, 875 (D.C. Cir. 2006) ("Investment vehicles that remain private and available only to highly sophisticated investors have historically been understood not to present the same dangers to public markets as more widely available investment companies, like mutual funds."); see also Federal Bureau of Investigation, supra note 29 ("The theory behind their creation was that high-wealth investors are 'financially sophisticated' and therefore did not need or want to incur the additional administrative expense of reporting to a regulatory agency.").
32. ROGER LOWENSTEIN, WHEN GENIUS FAILED: THE RISE and Fall of LONG-TERM CAPITAL MANAGEMENT 24 (2000).
33. STAFF, SEC. & EXCH. COMM'N, IMPLICATIONS of the GROWTH of HEDGE FUNDS 43 (2003), available at http://www.sec.gov/news/studies/hedgefunds0903.pdf [hereinafter STAFF REPORT on the GROWTH of HEDGE FUNDS].
34. Investor Protection and the Regulation of the Hedge Funds Advisers: Hearing Before the S. Comm. on Banking, Housing, and Urban Affairs, 108th Cong. 5-6 (2004) (statement of William H. Donaldson, Chairman, U.S. Securities and Exchange Commission). Best industry estimates indicate "that pensions' investments in hedge funds have increased from $13 billion in 1997 to more than $72 billion so far in 2004, an increase of more than 450 percent." Id. at 6.
35. U.S. Securities and Exchange Commission, Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds, http://www.sec.gov/answers/hedge.htm (last visited Oct. 24, 2008). "A fund of hedge funds is an investment company that invests in hedge funds-rather than investing in individual securities." Id. "Many registered funds of hedge funds have much lower investment minimums (e.g., $25,000) than individual hedge funds. Thus, some investors that would be unable to invest in a hedge fund directly may be able to purchase shares of registered funds of hedge funds." Id.
36. Investor Protection and the Regulation of the Hedge Funds Advisers: Hearing Before the S. Comm. on Banking, Housing, and Urban Affairs, 108th Cong. 8-9 (2004) (testimony of William H. Donaldson, Chairman, U.S. Securities and Exchange Commission). The "retailization" of hedge funds refers to "the increasing ability of less qualified (or retail) investors to access hedge fund investments." Franklin R. Edwards, Hedge Funds and Investor Protection Regulation 15-16 (May 16, 2006) (unpublished conference paper), available at http://www.frbatlanta.org7news/conferen/06fmc/06fmc-edwards. pdf.
37. Goldstein v. SEC, 451 F.3d 873, 874-77 (D.C. Cir. 2006); see infra Part I.C.I.
38. 17 C.F.R. § 275.206(4)-8 (2008); Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles, Investment Advisers Act Release No. IA-2628, 72 Fed. Reg. 44,756, 44,756 (Aug. 9, 2007) [hereinafter SEC Release: Antifraud Rule].
39. LOWENSTEIN, supra note 32, at 23.
40. Id. (citing Franklin R. Edwards, Hedge Funds and the Collapse of Long-Term Capital Management, J. ECON. PERSP., Spring 1999, at 189, 193).
41. Goldstein, 451 F.3d at 874.
42. Id. at 874-75; see also STAFF REPORT on the GROWTH of HEDGE FUNDS, supra note 33, at viii ("The term generally identifies an entity that holds a pool of securities and perhaps other assets that does not register its securities offerings under the Securities Act and which is not registered as an investment company under the Investment Company Act."); David A. Vaughn, Dechert LLP, Comments for the U.S. Securities and Exchange Commission Roundtable on Hedge Funds (May 13, 2003), http://www.sec.gov/spotlight/hedgefunds/hedge-vaughn.htm (providing fourteen different definitions found in government and industry publications).
43. Goldstein, 451 F.3d at 875 (quoting PRESIDENT'S WORKING GROUP on FIN. MKTS., HEDGE FUNDS, LEVERAGE, and the LESSONS of LONG-TERM CAPITAL MANAGEMENT 1 (1999) [hereinafter LESSONS of LTCM], available at http://www.ustreas. gov/press/releases/reports/hedgfund.pdf).
44. THOMAS P. LEMKE et al., HEDGE FUNDS and OTHER PRIVATE FUNDS: REGULATION and COMPLIANCE § 1.1, at 1-2 (2004-2005 ed. 2004).
45. Id. § 2.8, at 14.
46. STAFF REPORT on the GROWTH of HEDGE FUNDS, supra note 33, at 9 n.27. Each of these formations are beneficial to the investors because they "are generally not separately taxed and, as a result, income is taxed only at the level of the individual investor." Id. Other benefits of these forms of organization include limiting the liability of an investor to the extent of its investment in the fund and providing the general partner with broad authority with respect to management. Id.
47. LEMKE et al., supra note 44, § 2.8, at 14. The general partner is responsible for the general management of the fund, which includes selection of which investments to add to the fund's portfolio, management of the assets and a number of other activities for the fund. Id. § 2.2, at 10. With the exception of the general partner, all investors are limited partners, who "share in the partnership's income, expenses, gains and losses based on the balances in their respective capital accounts, but do not exercise any day-to-day management or control over the partnership." Id. § 2.8, at 14.
48. Id. § 2.2, at 10.
49. Id. § 2.8, at 15. The Agreement of Limited Partnership usually sets forth important aspects of operating the fund, including, but not limited to, who is responsible for managing the fund, the powers of the general partner, the object or purpose of the partnership, indemnification, the management fees and performance allocations and valuation of portfolio assets. Id. § 2.8, at 15-16.
50. STAFF REPORT on the GROWTH of HEDGE FUNDS, supra note 33, at ix.
51. LEMKE et al., supra note 44, § 1.1, at 2; STAFF REPORT on the GROWTH of HEDGE FUNDS, supra note 33, at ix.
52. LEMKE et al., supra note 44, § 1.1, at 2.
53. MANAGED FUNDS ASS'N, SOUND PRACTICES for HEDGE FUND MANAGERS intro., at 8 (2007) [hereinafter SOUND PRACTICES], available at http://www.managedfunds.org/downloads/Sound%20Practices%202007.pdf. This investment approach "can be particularly important in attracting outside investors since it aligns the fund manager's interests with those of outside investors and exposes the fund manager to the same investment risks." LEMKE et al., supra note 44, § 1.1, at 2.
54. SOUND PRACTICES, supra note 53, intro., at 8.
55. Edwards, supra note 36, at 10.
56. Id.
57. STAFF REPORT on the GROWTH of HEDGE FUNDS, supra note 33, at 46.
58. SOUND PRACTICES, supra note 53, intro., at 9.
59. Daniel K. Liffmann, Registration of Hedge Fund Advisers Under the Investment Advisers Act, 38 LOY. L.A. L. REV. 2147, 2159 (2005).
60. SOUND PRACTICES, supra note 53, intro., at 9.
61. Id. intro., at 8. Although a manager's client is considered the hedge fund itself, the manager often communicates with the investors about matters related to the fund, including "its investment objectives, strategies, terms, and conditions of an investment in the hedge fund." Id. intro., at 9.
62. Id. intro., at 8.
63. Id. intro., at 9; see infra Part I.A.2.
64. SOUND PRACTICES, supra note 53, intro., at 9.
65. Id.
66. Id. intro., at 7.
67. STAFF REPORT on the GROWTH of HEDGE FUNDS, supra note 33, at 3 (discussing Alfred Winslow Jones, who "is credited with establishing one of the first hedge funds as a private partnership in 1949"). Hedge funds "may obtain leverage by purchasing securities on margin, selling short, obtaining funding from banks or other sources, engaging in repurchase agreements, or using various derivative or synthetic instruments." LEMKE et al., supra note 44, § 1.1, at 1-2.
68. STAFF REPORT on the GROWTH of HEDGE FUNDS, supra note 33, at 3.
69. Id.
70. Id. at 3-4. Long-only investment strategy is when a fund "purchases and sells securities, but does not sell securities short to a significant extent." LEMKE et al., supra note 44, § 1.2, at 2.
71. See LEMKE et al., supra note 44, § 1.1, at 1-2; STAFF REPORT on the GROWTH oF HEDGE FUNDS, supra note 33, at 4.
72. STAFF REPORT on the GROWTH of HEDGE FUNDS, supra note 33, at 4.
73. Id.
74. Hedge Funds and Systemic Risk: Perspectives of the President's Working Group on Financial Markets: Hearing Before the H. Comm. on Financial Servs., 110th Cong. 5 (2007) (statement of Kevin Warsh, Member, Board of Governors of the Federal Reserve System); STAFF REPORT on the GROWTH of HEDGE FUNDS, supra note 33, at 4.
75. Comment Letter from John G. Gaine, President, Managed Funds Ass'n, to Nancy M. Morris, Sec'y, U.S. Sec. & Exch. Comm'n 2 (Mar. 9, 2007) [hereinafter MFA Letter], available at http://www.sec.gov/comments/s7-25- 06/s72506-567.pdf (quoting Regulation of Hedge Funds: Hearing Before the S. Comm. on Banking, Housing, and Urban Affairs, 109th Cong. 2 (2006) (statement of Randal K. Quarles, Under Secretary for Domestic Finance, U.S. Department of the Treasury)).
76. STAFF REPORT on the GROWTH of HEDGE FUNDS, supra note 33, at viii.
77. Id.
78. SOUND PRACTICES, supra note 53, intro., at 4-5.
79. Edwards, supra note 36, at 7.
80. Id.
81. 15 U.S.C. § 77a-77aa (2006). The Securities Act seeks to "provide full and fair disclosure in securities transactions." STAFF REPORT on the GROWTH of HEDGE FUNDS, supra note 33, at 13. The Act generally "requires issuers to register a security with the SEC before it is offered to the public." Jennifer Ralph Oppold, The Changing Landscape of Hedge Fund Regulation: Current Concerns and a Principle-Based Approach, 10 U. PA. J. BUS. & EMP. L. 833, 843 (2008). Hedge funds typically escape regulation under the Securities Act by obtaining their "investors through private placements rather than a public offering," which requires that they meet "the requirements of section 4(2) or Regulation D" of the Securities Act, and "usually means restricting their investors to 'accredited' investors." Edwards, supra note 36, at 8.
82. 15 U.S.C. § 78a-78111. For a discussion of the Exchange Act and how it regulates hedge funds, see Oppold, supra note 81, at 845-6.
83. 15 U.S.C. § 80a-l to-64.
84. Id. § 80b-l to-21.
85. LEMKE et al., supra note 44, § 1.1, at 1-2.
86. Id.
87. 15 U.S.C. § 80a-3(a)(1)(A).
88. STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supra note 33, at 11. Sections3 and 4 of the Securities Act exempt certain securities and transactions from the registration requirements. ARNOLD S. JACOBS, 5 DISCLOSURE AND REMEDIES UNDER THE SECURITIES LAW § 3.3 n.3 (2008). Section 3(a) exempts specific securities. Id. "In addition to the exemptions provided by statute under Section 3(a), Sections 3(b) and 3(c) permit the SEC to promulgate rules and regulations adding other exempt classes of securities." Id.
89. 15 U.S.C. § 80a-3(c)(1). Funds that rely on section 3(c)(1) must "comply with Section 4(2) of the Securities Act, and frequently do so by relying on the safe harbor available under Regulation D under that Act." STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supra note 33, at 12. Reliance on Regulation D requires that hedge funds "offer their securities only to 'accredited investors,' and [that they] not engage in any general solicitation or general advertising of their shares." Id. Accredited investors include "individuals with a minimum annual income of $200,000 ($300,000 with spouse) or $1 million in net worth and most institutions with $5 million in assets." Id.
90. 15 U.S.C. § 80a-3(c)(7)(A). Under section 2(a)(51) of the Company Act, a "qualified purchaser" means "any natural person . . . who owns not less than $5,000,000 in investments" or "any person, acting for its own account or the accounts of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis, not less than $25,000,000 in investments." Id. § 80a-2(a)(51)(i), (iv).
91. Federal Bureau of Investigation, supra note 29 ("Hedge funds can invest in equities, bonds, options, futures, commodities, arbitrage and derivative contracts, as well as illiquid investments such as real estate.").
92. Goldstein v. SEC, 451 F.3d 873, 875 (D.C. Cir. 2006).
93. Id. For example, registered investment companies are "foreclosed from trading on margin or engaging in short sales and must secure shareholder approval to take on significant debt or invest in certain types of assets, such as real estate or commodities." Id. (citing 15 U.S.C. §§ 80a-12(a)(1), (a)(3), 80a-13(a)(2)).
94. Id. at 876.
95. LEMKE ET AL., supra note 44, § 3.1, at 25; see also Registration Under the Advisers Act of Certain Hedge Fund Advisers, Investment Advisers Act Release No. IA-2333, 69 Fed. Reg. 72,054, 72,054 (Dec. 10, 2004) [hereinafter SEC Release: Hedge Fund Rule] ("The Act contains a few basic requirements, such as registration with the Commission, maintenance of certain business records, and delivery to clients of a disclosure statement ('brochure').").
96. STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supra note 33, at 20. Section 202(a)(11) of the Advisers Act generally defines an "investment adviser" as one who "for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities." 15 U.S.C. § 80b-2(a)(11).
97. 15 U.S.C. § 80b-3(b)(3).
98. SEC Release: Hedge Fund Rule, supra note 95, at 72,054. Although advisers who take advantage of the "private adviser exemption" must comply with the Act's antifraud provisions, they "do not file registration forms with [the SEC] identifying who they are, do not have to maintain business records in accordance with [SEC] rules, do not have to adopt or implement compliance programs or codes of ethics, and are not subject to Commission oversight." Id. These exempt advisers "are also subject to antifraud provisions of other federal securities laws, including rule 10b-5" under the Exchange Act. Id. at 72,054 n.6.
99. Id. at 72,055 n.10. "Rule 203(b)(3)-l under the Advisers Act provides that an adviser may count a legal organization as a single client if the legal organization receives investment advice based on its investment objectives rather than on the individual investment objectives of its owners." STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supra note 33, at 21 n.72.
100. Goldstein v. SEC, 451 F.3d 873, 876 (D.C. Cir. 2006). Some hedge fund managers do register as an investment adviser because they do not meet the requirements of section 203(b), or they register "voluntarily because their investors demand it or for competitive reasons." STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supra note 33, at 22.
101. Goldstein, 451 F.3d at 877. For a complete account of the story of Long-Term Capital Management (LTCM), see LOWENSTEIN, supra note 32.
102. LOWENSTEIN, supra note 32, at xix.
103. Id. LTCM had amassed $100 billion in assets, virtually all of it borrowed from the major Wall Street banks. Id. The fund had also "entered into thousands of derivative contracts, which had endlessly intertwined it with every bank on Wall Street." Id. These derivative contracts were essentially side bets on market prices and they created more than $1 trillion worth of exposure. Id. If LTCM defaulted on these contracts, these banks "would be exposed to tremendous-and untenable-risks." Id.
104. Id.
105. Id.
106. Id. at xx.
107. Goldstein v. SEC, 451 F.3d 873, 877 (D.C. Cir. 2006).
108. LOWENSTEIN, supra note 32, at xix-xx.
109. Id. at x viii.
110. Id.
111. STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supra note 33, at 2.
112. Id. at vii.
113. Id. at vii-viii.
114. See id. at x.
115. Id.
116. Id.
117. Id. This Note focuses only on the fraud aspects of the Staff Report, but the report also addresses concern over the increasing participation of hedge funds in financial markets, whether they are a danger to the stability of the U.S. financial markets and whether they subject investors to inordinately high levels of risk.
118. Id.
119. Id. at 73. "In most cases involving hedge funds, the Commission institutes enforcement actions against the hedge fund adviser and/or the adviser's principals." Id. at 73 n.252.
120. Id. at 73. The staff listed several factors that may be linked to the increase in the number of hedge fund fraud cases, including "the popularity of hedge fund investments and the large amounts of money they involve (and thus their attractiveness to perpetrators of fraud); the entrance to the industry of inexperienced, untested and, in some cases, unqualified individuals; and lack of adequate controls on the operations of some hedge fund advisers." Id.
121. Id.
122. Id. at 73-74 (footnotes omitted).
123. Id. at 74.
124. Id.
125. Id.
126. Id. ("These documents included account statements and other types of reports to customers, confirmations and pricing sheets.").
127. Id.
128. Id.
129. Id. at 76.
130. Id.
131. Id. Although the Staff Report indicated that registration provides the SEC with an advantage, others argue that there is no evidence that periodic examinations of registered companies aid in preventing fraud. See, e.g., Hedge Fund Hearing, supra note 26; Jenny Anderson, A Modest Proposal to Prevent Hedge Fund Fraud, N.Y. TIMES, Oct. 7, 2005, at C6 ("The commission is not adequately staffed or technologically equipped to effectively regulate the markets today. Adding 5,000 hedge funds to its to-do list is a dangerous undertaking. While it is desirable to have a watchdog, there is no way the staff of the S.E.C. can do it well...."). When expressing his opposition to hedge fund regulation, Commissioner Paul S. Atkins argued that "the commission did not have the resources to police the mutual fund industry-one chock-full of small investors-so taking on the hedge fund industry was an exercise in futility." Anderson, supra.
132. STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supra note 33, at 76.
133. Id. at 76-77.
134. SEC Release: Hedge Fund Rule, supra note 95, at 72,087; see also Goldstein v. SEC, 451 F.3d 873, 877 (D.C. Cir. 2006).
135. 17 C.F.R. § 275.203(b)(3)-2(a) (2008); SEC Release: Hedge Fund Rule, supra note 95, at 72,070.
136. Goldstein, 451 F.3d at 877 (quoting SEC Release: Hedge Fund Rule, supra note 95, at 72,059).
137. Jessica Natali, Note, Trimming the Hedges is a Difficult Task: The SEC's Attempt to Regulate Hedge Funds Falls Short of Expectations, 15 U. Maiami BUS. L. REV. 113, 115 (2006).
138. Id. at 125 (citing STAFF REPORT ON THE GROWTH OF HEDGE FUNDS, supra note 33, at 76-80).
139. SEC Release: Hedge Fund Rule, supra note 95, at 72,054.
140. Goldstein, 451 F.3d at 877 (citation omitted) (quoting 17 C.F.R. § 275.203(b)(3)- 1(d)(D).
141. Id. (quoting 17 C.F.R. § 275.203(b)(3)-2(a)). The rule also triggered] certain regulations that apply only to registered advisers. Most importantly, registered advisers [were required to] open their records to the Commission upon request and [could] not charge their clients a performance fee unless such clients [had] a net worth of at least $1.5 million or at least &750,000 under management with the adviser. Id. at 877 n.3 (citing 15 U.S.C. §§ 80b-4, 80b-5 (2006)).
142. SEC Release: Hedge Fund Rule, supra note 95, at 72,054.
143. Goldstein, 451 F.3d at 874 (quoting 17 C.F.R. § 275.203(b)(3)-2(a)).
144. Id.
145. Id. at 878.
146. Id. The court pointed out that just because a word is not defined, it does not automatically render it ambiguous. Id.
147. See id. at 879. The court noted, Although the statute does not define 'client,' it does define 'investment adviser' as 'any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.' Id. (quoting 15 U.S.C. § 80b-2(11) (2006)). The court found this definition indicates that an investor is not a client because an adviser to a hedge fund does not advise an investor as to how to handle his capital, but rather, the adviser provides advice to the fund itself as to how to invest the capital it has collected from its investors. Id. at 879-80.
148. Id. at 879-81.
149. Id. at 881 ("At best it is counterintuitive to characterize the investors in a hedge fund as the 'clients' of the adviser.").
150. Id. at 883.
151. See J.W. Verret, Dr. Jones and the Raiders of Lost Capital: Hedge Fund Regulation, Part II, A Self-Regulation Proposal, 32 DEL. J. CORP. L. 799, 810 n.64 (2007) ('"[T]he Commission has not justified treating all investors in hedge funds as clients for the purpose of the rule. If there are certain characteristics present in some investor-adviser relationships that mark a 'client' relationship, then the Commission should have identified those characteristics and tailored its rule accordingly.'" (quoting Goldstein, 451 F.3d at 883)).
152. Id. at 810.
153. See Thomas O. Gorman & William P. McGrath, Jr., What Every Issuer, Director and Officer Should Know About Current SEC Enforcement Policies and Trends, SEC. REG. L.J., Summer 2007, at 1 (2007). When Chairman Cox testified before Congress, he made the following statement: [L]et me make very clear that notwithstanding the Goldstein decision, hedge funds today remain subject to SEC regulations and enforcement under the antifraud, civil liability, and other provisions of the federal securities laws. We will continue to vigorously enforce the federal securities laws against hedge funds and hedge fund advisers who violate those laws. The Regulation of Hedge Funds: Before the S. Comm. on Banking, Housing and Urban Affairs, 109th Cong. 3 (2006) (statement of Christopher Cox, Chairman, U.S. Securities and Exchange Commission).
154. The Regulation of Hedge Funds: Before the S. Comm. on Banking, Housing and Urban Affairs, 109th Cong. 3 (2006) (statement of Christopher Cox, Chairman, U.S. Securities and Exchange Commission).
155. Gorman & McGrath, supra note 153, at 11.
156. 15 U.S.C. § 80b-6(4) (2006); SEC Release: Antifraud Rule, supra note 38, at 44,756.
157. SEC Release: Antifraud Rule, supra note 38, at 44,756.
158. Id.
159. Id. at 44,756-57.
160. Id. at 44,757 n.4 (citations omitted).
161. Id. at 44,756-57.
162. Id. at 44,757 (citing Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006)).
163. See id. at 44,756-57.
164. See id. at 44,757.
165. Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles; Accredited Investors in Certain Private Investment Vehicles; Proposed Rule, Investment Advisers Act Release No. IA-2576, 72 Fed. Reg. 400, 401 (Jan. 4, 2007) [hereinafter Proposal Release: Antifraud Rule].
166. 15 U.S.C. § 80b-6(4) (2006).
167. See Proposal Release: Antifraud Rule, supra note 165.
168. Id. at 401.
169. See SEC Release: Antifraud Rule, supra note 38, at 44,757.
170. Id. at 44,758.
171. Id. at 44,759.
172. See id.
173. Id.
174. Id. Under section 3(c)(1) of the Investment Company Act, issuers of securities (other than short-term paper) of which are beneficially owned by not more than 100 persons and that is not making or proposing to make a public offering of its securities, are exempt from regulation. Id. at 44,758 n.21. Section 3(c)(7) of the Act "excludes from the definition of investment company an issuer the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are 'qualified purchasers' and that is not making or proposing to make a public offering of its securities." Id.
175. Id. at 44,758.
176. 17 C.F.R. § 275.206(4)-8(1)(1) (2008).
177. Proposal Release: Antifraud Rule, supra note 165, at 402.
178. SEC Release: Antifraud Rule, supra note 38, at 44,759.
179. Id.
180. Id. at 44,758-59.
181. Id. at 44,757-58.
182. Id. at 44,759.
183. 17 C.F.R. § 275.206(4)-8(a)(2) (2008).
184. See SEC Release: Antifraud Rule, supra note 38, at 44,759-60.
185. See id. at 44,757, 44,760.
186. Two major concerns with regard to hedge funds are whether their activities are a threat to financial stability, and whether the current legal or regulatory protections adequately protect hedge fund investors. This Note focuses only on the second concern.
187. Federal Bureau of Investigation, supra note 29.
188. Verret, supra note 151, at 825 (pointing to former Federal Reserve Chairman Alan Greenspan as one such critic); see also Nomination of Alan Greenspan: Hearing Before the S. Comm. on Banking, Housing, and Urban Affairs, 108th Cong. 25-26 (2004) (statement of Alan Greenspan, Federal Reserve Chairman), available at http://frwebgate.access.gpo. gov/cgi-bin/getdoc.cgi?dbname=108-senate-hearings&docid=f:22918.pdf.
189. Id. at 827; Douglas Cumming, A Law and Finance Analysis of Hedge Funds 3 (Apr. 5,2008), available at http://ssrn.com/abstract=946298.
190. U.S. Treasury, Office of Domestic Finance, http://www.treas.gov/offices/ domesticfinance/financial-markets/fin-market-policy/(last visited Oct. 24, 2008). The President's Working Group on Financial Markets (PWG) was originally formed to study the stock market crash of 1987, and "since then has periodically issued reports on various issues affecting the U.S. markets, including a 1999 report on hedge funds assessing lessons learned in the wake of the near-collapse of Long Term Capital Management." Kathleen A. Scott, President's Working Group Issues New Guidelines for US Hedge Funds, FIN. SERVS. ADVISORY UPDATE (White & Case LLP, New York, N.Y.), Mar. 2007, at 3, 3, available at http://www.whitecase.com/files/FileControl/c 188a091-498f-43c5-9511- 930b45d47317/7483 b893-e478-44a4-8fed-f49aa917d8cf/Presentation/File/FSAU-March- 07.pdf.
191. INVESTORS' COMM., PRESIDENT'S WORKING GROUP ON FIN. MKTS, PRINCIPLES AND BEST PRACTICES FOR HEDGE FUND INVESTORS 3 (2008) [hereinafter PWG BEST PRACTICES- INVESTORS], available at http://www.amaicmte.org/Public/Investors_Committee_Report. pdf (alterations in original) (internal quotation marks omitted).
192. PRESIDENT'S WORKING GROUP ON FIN. MKTS., AGREEMENT AMONG PWG AND U.S. AGENCY PRINCIPALS ON PRINCIPLES AND GUIDELINES REGARDING PRIVATE POOLS OF CAPITAL (2007) [hereinafter PWG PRINCIPLES AND GUIDELINES], available at http://www.treas.gov/press/releases/ reports/hp272-principles.pdf.
193. Press Release, U.S. Dep't of the Treasury, President's Working Group Releases Common Approach to Private Pools of Capital: Guidance on Hedge Fund Issues Focuses on Systemic Risk, Investor Protection (Feb. 22, 1007) [hereinafter PWG Release], available at http://www.treasury.gov/press/ releases/hp272.htm.
194. Robert K. Steel, Under Sec'y for Domestic Fin., U.S. Dep't of the Treasury, Remarks on Private Pools of Capital (Feb. 27, 2007) [hereinafter Steel on Private Pools on Capital], available at http://www.treasury.gov/ press/releases/hp280.htm.
195. Id.
196. PWG Release, supra note 193.
197. PWG PRINCIPLES AND GUIDELINES, supra note 192, at 1 (quoting LESSONS OF LTCM, supra note 43, at 26).
198. Id.
199. PWG Release, supra note 193.
200. PWG PRINCIPLES AND GUIDELINES, supra note 192, at 1.
201. PWG Release, supra note 193.
202. Id.
203. Id.
204. Steel on Private Pools of Capital, supra note 194.
205. Id.
206. Id.
207. Id.
208. Id.
209. Press Release, U.S. Dep't of the Treasury, PWG Private-Sector Committees Release Best Practices for Hedge Fund Participants (Apr. 15, 2008) [hereinafter PWG Best Practices Release], available at http://www.treasury.gov/press/ releases/hp927.htm.
210. Id.
211. Id.
212. Id.; see also PWG BEST PRACTICES-INVESTORS, supra note 191, at 4.
213. PWG BEST PRACTICES-INVESTORS, supra note 191, at 4. The Investors'Committee plans to "meet semiannually and issue clarifications and additions when appropriate." Id.
214. PWG Best Practices Release, supra note 209 ("The recommendations complement each other by encouraging both types of market participants to hold the other more accountable.").
215. PWG BEST PRACTICES-INVESTORS, supra note 191, at 1.
216. Id. at 2. The Investors' Committee is clear to point out that each individual or institution considering or managing hedge fund allocations is different and therefore, each much evaluate the best practices, "determine which apply, and implement the recommendations that are reasonable given the resources available to the investor, its objectives and risk tolerance, and the particular investments under consideration." Id. at 3.
217. Id. at 1.
218. Id. at 6. In order to assess the appropriateness of a hedge fund program, the Investors Committee instructs a prudent fiduciary to address questions on the following issues: "Temperament"; "Manager Selection"; "Portfolio Level Dynamics"; "Liquidity Match"; "Conflicts of Interest"; "Fees"; and "Citizenship." Id. at 6-7.
219. Id. at 8-9. Some of the important features discussed include the typical fee structure of hedge fund managers, whether hedge funds are newly formed, the experience or sophistication of hedge fund managers. Id. at 9-12.
220. Id. at 12. The list of questions includes the following: "What is the strategic purpose of investing in hedge funds?" "What role will hedge funds play in the total investment portfolio?" "Is the hedge fund program consistent with the applicable investment beliefs, objectives, and risk profile of the investment program?" "What are the performance and risk objectives of the hedge fund investment program?" "Who will manage the hedge fund investment program and what responsibilities will they have?" "What investment guidelines will apply to the range of funds and strategies that can be utilized, the number of funds to be targeted, and the risk and return targets for those funds?" Id.
221. Id. Although due diligence is generally important for all investment activities, the committee warns that particular care should be exercised in due diligence of hedge funds, because of the complex investment strategies they employ; the fact that hedge fund organizations are frequently young and small; their use of leverage and the associated risks; the possibilities of concentrated exposure to market and counterparty risks, and the generally more lightly regulated nature of these organizations. Id.
222. Id. at 13.
223. Id. at 14 ("Key aspects of the monitoring process should include reviewing the investment strategy and investment performance for consistency, maintaining awareness of factors that could indicate potential style drift, and confirming that there has been no material change to the business operations of the fund manager.").
224. Id. at 1. The term "investor" is used narrowly in the Investor's Guide "to refer to the internal and external personnel who are responsible for actually implementing and executing these programs." Id. at 16.
225. Id. at 16. Where appropriate, the committee "specified certain procedures or approaches that [it] believe[s] would add significant transparency and increase investors' ability to understand and evaluate funds' risks and returns." Id.
226. Id. at 16-17.
227. Id. at 17. The report suggests questions that may be used for a due diligence questionnaire, which the committee contends "should ask probing questions into the material aspects of a hedge fund's business and operations." Id. This section also discusses investor considerations and provides best practices with regard to personnel, the "strength of a hedge fund manager's business model," the performance track record of the hedge fund, the fund's "ability to maintain the investment style or styles upon which the investor originally evaluated or selected it as part of a hedge fund portfolio," and model use. Id. at 19-22.
228. Id. at 17.
229. Id.
230. Id. Also, it is noted that "once an applicable lock-up period expires, the decision whether to redeem should be deliberate and scrutinized regularly for as long as the investment remains outstanding." Id.
231. Id. at 22.
232. Id.
233. Id.
234. See id. at 22, 24-37.
235. Id. at 39; see also id. at 37-43.
236. Id. at 43.
237. See id. at 43-48.
238. See id. at 49-57.
239. Id. at 57.
240. ASSET MANAGERS' COMM., PRESIDENT'S WORKING GROUP ON FIN. MKTS., BEST PRACTICES FOR THE HEDGE FUND INDUSTRY, at i-ii (2008) [hereinafter PWG BEST PRACTICES-INDUSTRY] , available at htrp://www.amaicmte.org/Public/AMC_Report.pdf. The Asset Managers' Committee (AMC) notes that the evolution of hedge funds has led to a "greater need for them to develop and maintain robust infrastructure, controls and business practices." Id. at ii. It also notes that sophisticated institutional investors "have demanded that hedge funds demonstrate appropriate infrastructure and controls in managing their activities." Id.
241. Id. at iii.
242. Id. The report establishes a framework for each of the five issues that 1) states the goal and essential elements of the framework; 2) outlines clear and consistently applied policies and procedures that provide a structure to help ensure better educated investors and better managed hedge funds implement the framework; 3) incorporates a regular process for reviewing and updating the framework; and 4) requires adequate resources and knowledgeable personnel to support the framework. Id. at iv.
243. Id. at iv.
244. Id.
245. Id. at v. The "manner and frequency with which these disclosures will be made" should be determined by managers and clearly communicated to investors. Id.
246. Id. ("Public companies produce independently audited, GAAP-compliant financial statements. Because hedge fund investors share the need for accurate, independently verified financial information, we recommend that all hedge funds do (or continue to do) the same."). It is further recommended that managers "provide periodic performance information to investors and provide an investor letter or similar communication and risk report on at least a quarterly basis." Id.
247. Id. at v-vi.
248. Id. at vi.
249. Id. The framework provided "establishes a governance mechanism, such as a valuation committee, which [would] have ultimate responsibility for establishing and monitoring compliance with the manager's valuation policies." Id.
250. Id. at viii ("The common elements of the framework should be that managers identify risks to the portfolio, measure the principal categories of risk (such as liquidity risk, leverage, market risk, counterparty credit risk and operational risk), adopt policies and procedures that establish monitoring and measurement criteria, maintain a regular and rigorous process of risk monitoring, and retain knowledgeable personnel to measure and monitor risk.").
251. Id.
252. Id.
253. Id. at ix.
254. Id.
255. Id.. at x-xi.
256. PWG BEST PRACTICES-INVESTORS, supra note 191, at 16. Some of the groups listed in the Investor's Guide include the Managed Funds Association (MFA), the Greenwich Roundtable, the Alternative Investment Management Association (AIMA), and the Chartered Financial Institute (CFA) Institute. Id.
257. Id.
258. See generally SOUND PRACTICES, supra note 53. The MFA has been "the unifying voice of the hedge fund industry" for over 16 years. Id. preface, at 1. The MFA's mission is "to protect the interests of the industry, to educate policy makers, and to assist its Members [to] better grow and conduct their businesses." Id. For more information about the MFA, see Managed Funds Association, http://www.managedfunds.org (last visited Oct. 24, 2008).
259. SOUND PRACTICES, supra note 53, intro., at 1.
260. Id. intro., at 5.
261. Id. § 2, at 1.
262. Id. §2.1, at 2.
263. Id. § 2.2, at 2.
264. Id. app. II.
265. Stephanie Baum, Hedge Fund Industry Group Tightens Guidelines, FIN. NEWS ONLINE, NOV. 8, 2007, http://www.efinancialnews.com/assetmanagement/index/content/2449136156.
266. Id.
267. SOUND PRACTICES, supra note 53, § 2.2, at 3.
268. Id. § 2.2, at 3.
269. Id. § 2.4, at 5.
270. Id. § 2.5, at 6.
271. Id. §2.8, at 7.
272. Id. § 2.9, at 7.
273. Concept Release Concerning Self-Regulation, Exchange Act Release No. 34-50700, 69 Fed. Reg. 71,256, 71,256 (Dec. 8, 2004) [hereinafter Concept Release].
274. Id. at 71, 257.
275. Id.
276. Id. The New York Stock Exchange (NYSE) Constitution was adopted in 1817, which was followed by the adoption of a range of rules governing the NYSE's "members and listed companies, including member financial responsibility rules and listed company registration and financial reporting rules." Id.
277. JAMES D. COX ET AL., SECURITIES REGULATION: CASES AND MATERIALS 3 (5th ed. 2006). First, Congress promulgated the Securities Act. Act of May 27, 1933, ch. 38, 48 Stat. 74 (codified as amended at 15 U.S.C. §§ 77a-77aa (2006)). The Securities Act regulates the public offering and sale of securities in interstate commerce. COX ET AL., supra, at 3. This was followed by the Exchange Act, which gave birth to the SEC. Act of June 6, 1934, ch. 404, title I, § 1, 48 Stat. 881 (codified as amended at 15 U.S.C. §§ 78a-78111).
278. Concept Release, supra note 273, at 71,257. See generally 15 U.S.C. §§ 78a-78111.
279. COX ET AL., supra note 277, at 16. This addition to the Exchange Act provided for a "considerable degree of self-regulation for the nation's stock exchanges." Marianne K. Smythe, Government Supervised Self-Regulation in the Securities Industry and the Antitrust Laws: Suggestions for an Accommodation, 62 N.C. L. REV. 475, 477 (1984).
280. COX ET AL., supra note 277, at 16. Over-the-counter (OTC) securities are securities that are not registered with a stock exchange. Smythe, supra note 279, at 483. The stock market crash of 1929 severely damaged the public reputation of OTC securities dealers. "In 1933, in an effort to improve their collective image, OTC dealers formed the Investment Bankers Code Committee ('IBCC'), which promulgated industry best practices." Concept Release, supra note 273, at 71,257. After observing the efforts of such groups, "the Commission and leaders of the investment banking community generally agreed that an industry association needed official legal status in order to effectively carry out the task of self-regulating the OTC market." Id.
281. Concept Release, supra note 273, at 71,257; see The Maloney Act, Pub. L. No. 75-719, 52 Stat. 1070 (1938) (codified as amended at 15 U.S.C. § 78o). The Maloney Act authorized the SEC "to register national securities associations." Concept Release, supra note 273, at 71,256 n.4. Under the original Exchange Act, OTC brokers and dealers were directly regulated by the SEC. However, after the Act was passed it became apparent that it would be too burdensome for the SEC to directly regulate this OTC market. Smythe, supra note 279, at 483-84.
282. COX ET AL., supra note 277, at 16. "[T]here are four types of [self-regulatory organizations (SROs)] embraced by the Exchange Act: the national securities exchanges, the national securities association, registered clearing agencies, and the Municipal Securities Rulemaking Board (MSRB)." Id. The two most important SROs are the exchanges and the National Association of Securities Dealers (NASD). Id. "A 'national securities exchange' is a securities exchange that has registered with the SEC under Section 6 of the Securities Exchange Act of 1934." U.S. Securities and Exchange Commission, Exchanges, http://www.sec.gov/divisions/marketreg/ mrexchanges.shtml (last visited Oct. 24, 2008). There are currently ten securities exchanges registered as national securities exchanges with the SEC. Id. The ten registered national securities exchanges are: American Stock Exchange; Boston Stock Exchange; Chicago Board Options Exchange; Chicago Stock Exchange; International Securities Exchange; Nasdaq Stock Market LLC; National Stock Exchange (formerly the Cincinnati Stock Exchange); New York Stock Exchange; NYSE Area, Inc. (formerly the Pacific Exchange); and Philadelphia Stock Exchange. Id.
283. Concept Release, supra note 273, at 71,257. The NASD was the only registered national securities association until recently. The NFA was "registered for the limited purpose of regulating the activities of members who are registered as brokers or dealers in security futures products under Section 15(b)(11) of the Exchange Act." Id. at 71,257 n.26.
284. COX ET AL., supra note 277, at 16.
285. Id.
286. Id.
287. Id.
288. Id.; see 15 U.S.C. § 78o(b)(8)-(9) (2006).
289. COX ET AL., supra note 277, at 1022. The potential conflicts of interest raised by allowing for this type of self-regulation led Congress to provide the SEC a degree of oversight of SRO activity.
290. Id. at 1021.
291. Id. at 1022. Each SRO has rules that govern conduct by members in order to protect investors, securities markets, and the trading markets operated by the SRO in question. Id.
292. Id. at 1021-22.
293. Id. at 1022.
294. Id.
295. Id.
296. Id.
297. 15 U.S.C. §§ 78s(d)(2), 78q(a)(1) (2006).
298. Concept Release, supra note 273, at 71,256.
299. Joel Seligman Should Investment Companies Be Subject to a New Statutory Self- Regulatory Organization?, 83 WASH. U. L.Q. 1115, 1120 (2005) (quoting JOEL SELIGMAN, THE TRANSFORMATION OF WALL STREET: A HISTORY OF THE SECURITIES AND EXCHANGE COMMISSION AND MODERN CORPORATE FINANCE 440 (3d ed. 2003)).
300. Id.; see also Concept Release, supra note 273, at 71,256 (noting that the securities laws "reflect Congress'[s] determination to rely on self-regulation as a fundamental component of U.S. market and broker-dealer regulation, despite this inherent conflict of interest").
301. Concept Release, supra note 273, at 71,257.
302. Id.
303. U.S. SEC. & EXCH. COMM'N, REPORT PURSUANT TO SECTION 21(A) OF THE SECURITIES EXCHANGE ACT OF 1934 REGARDING THE NASD AND THE NASDAQ Market 7 (1996) (discussing some of the advantages of SROs).
304. Concept Release, supra note 273, at 71,257. In enacting the Maloney Act in 1938, Congress stated that an approach to securities regulation relying solely on government regulation "would involve a pronounced expansion of the organization of the [SEC]; the multiplication of branch offices; a large increase in the expenditure of public funds; an increase in the problem of avoiding the evils of bureaucracy; and a minute, detailed, and rigid regulation of business conduct by law." Id. (citation omitted).
305. Id.
306. See generally Smythe, supra note 279.
307. Proposal Release: Antifraud Rule, supra note 165.
308. SEC Release: Antifraud Rule, supra note 38, at 44,757.
309. Id.
310. Id. at 44,757.
311. Comment Letter from Sullivan & Cromwell LLP to Nancy M. Morris, Sec'y, U.S. Sec. & Exch. Comm'n 2 (Mar. 9, 2007) [hereinafter Sullivan & Cromwell Letter], available at http://www.sec.gov/comments/s7-25-06/ s72506-559.pdf (quoting S. REP. NO. 86-1760, at 8 (1960)).
312. Comment Letter from Elizabeth Krentzman, Gen. Counsel, Inv. Co. Inst., to Nancy M. Morris, Sec'y, U.S. Sec. & Exch. Comm'n 3-4 (Mar. 9, 2007) [hereinafter ICI Letter], available at http://www.sec.gov/comments/s7-25- 06/s72506-565.pdf.
313. Comment Letter from Keith F. Higgins, Chair, Comm. on Fed. Regulation of Sec., Am. Bar Ass'n, to Nancy M. Morris, Sec'y, U.S. Sec. & Exch. Comm'n 2 (Mar. 12, 2007) [hereinafter ABA Letter], available at http://www.sec.gov/comments/s7-25-06/s72506-584.pdf; see also Sullivan & Cromwell Letter, supra note 311, at 2 ("Congress contemplated, therefore, that the Commission's rulemaking authority would be used to articulate and deal adequately with specific fraudulent activities, e.g., 'such problems as a material adverse interest in securities which the adviser is recommending to his clients.'" (quoting S. REP. NO. 86-1760, at 8 (1960))).
314. See Sullivan & Cromwell Letter, supra note 311, at 2 n.4 (citing as examples "Rule 206(4)-1 (detailing advertisement content of registered advisers that has a tendency to mislead); Rule 206(4)-2 (specifying conditions pursuant to which a registered adviser may [take] custody [of] client funds and securities); Rule 206(4)-3 (specifying conditions pursuant to which a registered adviser may make cash payments for client solicitations); Rule 206(4)-4 (requiring registered advisers to disclose certain financial and disciplinary information to clients); Rule 206(4)-6 (requiring written policies and procedures, and disclosure to clients, in respect of proxy voting by registered advisers); and Rule 206(4)-7 (requiring registered advisers to have chief compliance officers and compliance policies and procedures)"); see also ABA Letter, supra note 313, at 2.
315. Sullivan & Cromwell Letter, supra note 311, at 2; see also Comment Letter from Schulte Roth & Zabel LLP, to Nancy M. Morris, Sec'y, U.S. Sec. & Exch. Comm'n 4 (Mar. 9, 2007) [hereinafter Schulte Letter], available at http://www.sec.gov/comments/s7-25-06/s72506-549. pdf.
316. ABA Letter, supra note 313, at 3.
317. Sullivan & Cromwell Letter, supra note 311, at 2-3.
318. Id. at 2 ("The Second Prong provides no detail as to what constitutes fraudulent, deceptive or manipulative conduct and verges on stating a tautology: 'it shall constitute a fraudulent, deceptive, or manipulative act, practice, or course of business ... to ... otherwise engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative ....'").
319. Id.
320. Id.
321. Id.; see Schulte Letter, supra note 315, at 2.
322. Schulte Letter, supra note 315, at 3.
323. Id.
324. Id. at 2.
325. SEC Release: Antifraud Rule, supra note 38, at 44,761-63.
326. Id. at 44,762.
327. Id.
328. Id.
329. Id.
330. Id.
331. Id. (quoting Schreiber v. Burlington N., Inc., 472 U.S. 1, 8 (1985)).
332. Id.
333. Id. (citing Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976)).
334. Id. (quoting Hochfelder, 425 U.S. at 199).
335. Id.
336. Id.
337. Id. (citing SEC v. Steadman, 967 F.2d 636, 647 (D.C. Cir. 1992)).
338. Steadman, 967 F.2d at 647 (citing Aaron v. SEC, 446 U.S. 680 (1980)).
339. Aaron, 446 U.S. at 695-96.
340. Id. at 696.
341. Id. (footnote omitted).
342. Id. "In addition, the Court in Hochfelder noted that the term 'to employ,' which appears in both § 10(b) and § 17(a)(1), is 'supportive of the view that Congress did not intend § 10b to embrace negligent conduct." Id. at 696 n.14 (quoting Hochfelder, 425 U.S. at 199 n.20).
343. Id. at 696-97. "This reading follows directly from Capital Gains, which attributed to a similarly worded provision in § 206(2) of the Investment Advisers Act of 1940 a meaning that does not require a 'showing [of] deliberate dishonesty as a condition precedent to protecting investors.'" Id. at 697 (quoting SEC v. Capital Gains Research Bureau, 375 U.S. 180,200(1963)).
344. Id.
345. Steadman, 967 F.2d at 641, 647.
346. Id.
347. Id.
348. See id.
349. Id. (quoting Aaron, 446 U.S. at 697).
350. Id.
351. ABA Letter, supra note 313, at 4.
352. SEC Release: Antifraud Rule, supra note 38, at 44,762 (citing Aaron, 446 U.S. at 696-97).
353. ABA Letter, supra note 313, at 4 ("Section 206(4) prohibits conduct that 'is fraudulent, deceptive, or manipulative' . . . and focuses on whether the investment adviser is culpable on the basis of engaging in conduct that is 'fraudulent, deceptive or manipulative.'").
354. Id.
355. Id. (explaining that a practice or course of business that "operates" as a fraud is much more inclusive because the practice or course of business may not necessarily itself be a fraud).
356. Id.
357. SEC Release: Antifraud Rule, supra note 38, at 44,762.
358. Id.
359. Id. (citing Schreiber v. Burlington N., Inc. 472 U.S. 1 (1985); Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976)). In Hochfelder, 425 U.S. at 199, the Supreme Court stressed that the "[u]se of the word 'manipulative' is especially significant."
360. SEC Release: Antifraud Rule, supra note 38, at 44,762. "Section 15(c)(2) makes it unlawful for brokers and dealers to effect transactions in or induce the purchase or sale of securities in connection with which they 'engage[] in any fraudulent, deceptive, or manipulative act or practices, or make[] any fictitious quotation.'" Id. (alterations in original) (quoting 15 U.S.C. § 78o(c)(2) (2006)).
361. Id.
362. Id. (quoting 15 U.S.C. § 78n(e)).
363. Id.
364. Schreiber, 472 U.S. at 11.
365. ABA Letter, supra note 313, at 4 (internal quotation marks omitted) (quoting Schreiber, 472 U.S. at 11-12).
366. SEC Release: Antifraud Rule, supra note 38, at 44,762 (quoting Schreiber, 474 U.S. at 11 n. 11).
367. Id. As Atkins noted, in O'Hagan, the Court "considered whether Rule 14e-3(a), which prohibits trading on undisclosed information in connection with a tender offer, exceeds the SEC's authority under Section 14(e) given that the prohibition applies regardless of whether there is a duty to disclose."
368. Id. at 44,763 (alterations in original) (quoting United States v. O'Hagan, 521 U.S. 642, 672-73 (1997)) (internal quotation marks omitted).
369. Id.
370. Id.
371. Id.
372. Id. (quoting O'Hagan, 521 U.S. at 673-74).
373. Id.
374. Id.
375. Id.
376. Id.
377. ABA Letter, supra note 313, at 3.
378. Id.
379. Id.
380. SEC Release: Antifraud Rule, supra note 38, at 44,759.
381. Id.
382. MFA Letter, supra note 75, at 10.
383. ABA Letter, supra note 313, at 3.
384. Comment Letter from Nora M. Jordan, Yukako Kawata, Leor Landa & Danforth Townley, Davis Polk & Wardwell LLP, to Nancy M. Morris, Sec'y, U.S. Sec. & Exch. Comm'n 2 (Mar. 9, 2007), available at http://www.sec.gov/comments/s7-25-06/s72506-570.pdf.
385. Comment Letter from David A. Vaughan & George J. Mazin, Dechert LLP, to Nancy M. Morris, Sec'y, U.S. Sec. & Exch. Comm'n 4 (Mar. 9, 2007), available at http://www.sec.gov/comments/s7-25-06/s72506-562.pdf.
386. Id.
387. Id.
388. Comment Letter from Kurt N. Schacht, Managing Dir. & Linda L. Rittenhouse, Senior Policy Analyst, CFA Ctr. for Fin. Mkt. Integrity, to Nancy M. Morris, Sec'y, U.S. Sec. & Exch. Comm'n 1 (Mar. 9, 2007) [hereinafter CFA Letter], available at http://www.sec.gov/comments/s7-25-06/s72506-537. pdf.
389. SEC Release: Antifraud Rule, supra note 38, at 44,759 (citing ABA Letter, supra note 313; ICI Letter, supra note 312; Schulte Letter, supra note 315; Sullivan & Cromwell Letter, supra note 311).
390. Id. at 44,757 (quoting S. Rep. No. 86-1760, at 4 (I960)).
391. SEC Release: Antifraud Rule, supra note 38, at 44,758.
392. Id.
393. Id. at 44,759.
394. Id.
395. Id. (citing ABA Letter, supra note 313, at 3).
396. Id. (citing ABA Letter, supra note 313, at 3).
397. See SEC v. Steadman, 967 F.2d 636 (D.C. Cir. 1992) (holding that scienter is not required under section 206(4)).
398. See supra Part II.A.2.
399. Steadman, 967 F.2d at 647.
400. SEC Release: Antifraud Rule, supra note 38, at 44,759.
401. Id. (quoting O'Hagan, 521 U.S. at 672-73).
402. Id.
403. Id. at 44,759-60.
404. Harvey Westbrook, Jr., Hedge Fund Industry Structure and Regulatory Alternatives 6 (Sept. 8, 2003), available at http://wvw.q-group.org/ archives-folder/pdf/Westbrook.pdf.
405. Id.
406. Id. at 7.
407. See Verret, supra note 151, at 800, 818 (following the arguments supporting use of SROs in our capital markets); see also generally Paul G. Mahoney, The Exchange as Regulator, 83 VA. L. REV. 1453 (1997) (arguing that exchanges serve as more effective regulators than government institutions due to their inability to respond to rapid market innovation).
408. Verret, supra note 151, at 826.
409. Westbrook, supra note 404, at 22.
410. Id.
411. Id. at 23.
412. Id. at 24-25.
413. Id.
414. Verret, supra note 151, at 835 n.182 (quoting PWG PRINCIPLES and GUIDELINES, supra note 192, at 5).
415. Kurt Schacht, Strict Conduct Code Needed for Hedge Fund Managers, INVESTMENT NEWS, Aug. 20, 2007, at 8, available at http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20070820/FREE/70816005/ 1011/TOC. Kurt Schacht is the managing director of the CFA Centre for Financial Market Integrity. CFA has also developed a self-regulatory template related to the hedge fund industry titled "The Asset Manager Code of Professional Conduct," which "focuses on setting a baseline for compliance, professional conduct and investor protections." Id.
416. Id.
417. Westbrook, supra note 404, at 25; see also supra notes 31-34 and accompanying text.
418. Id. at 18-27. Some of the regulatory approaches that Harvey Westbrook explores are "restrictions on the number (or type) of investors, investment management restrictions, disclosure based regulations (requiring some disclosure of holdings to fund investors), [and] risk management based regulations (requiring specified risk management procedures to be followed)." Id. at 18-19.
419. Id. at 25.
420. Id.
421. Id. Westbrook describes operational risk as "the fund specific risk of a particular hedge fund's business operations." Id. at 9. It can be decomposed into several different categories, such as "money transfer risk, valuation risk, systems risk, clearance risk, regulatory risk, [and] human factor risk." Id. Due to "the idiosyncratic nature of operational risk, and its variability across the hedge fund industry, operational risk can not be adequately measured by standard risk measures, but is appropriately evaluated only through fundamental bottoms-up analysis and due diligence." Id.
422. Id. at 26.
423. Id.
424. Id.
425. Id. In order for this approach to effectively reduce operational risk, "institutions must limit, at least to some degree, their investments to certified hedge funds." Id. Limitations to investing in these certified funds would be necessary because "[i]f the certification signal does not attract sufficient investment, institutional or otherwise, hedge funds will have no reason to subject themselves to additional due diligence requirements." Id. In addition, in order for other investors to take the certification process seriously, the institutions themselves must take it seriously. Id.
426. Id. at 27.
427. See Verret, supra note 151; see also Simeon G. Mann, Too Far over the Hedge: Why the SEC's Attempt to Further Regulate Hedge Funds Had to Fail & What, If Any, Alternative Solutions Should Be Considered, 82 ST. JOHN'S L. REV. 315, 354-57 (2008).
428. See Seligman, supra note 299, at 1126.
429. Id.
430. See generally Verret, supra note 151 (reviewing the Hedge Fund Rule promulgated by the SEC, which was struck down in 2006 by the D.C. Circuit in Goldstein).
431. Id. at 815-16.
432. Id. at 800.
433. Id at 811.
434. Id. at 816. Verret measures costs as "(1) compliance costs of hedge funds, (2) [the] opportunity cost of trades not undertaken due to an artificial dampening of risk appetite, (3) legal costs of private and governmental compliance, and (4) enforcement costs." Id. at 815 (citations omitted). Benefits are "measured as investment appreciation due to fraud prevention, less any appreciation realized as a result of fraud that is never ultimately discovered by the market." Id.
435. Id.
436. Id.
437. Id.
438. Id.
439. See id.
440. Id.
441. Id.
442. Id. at 817.
443. Id.
444. Id.
445. Id.
446. Id. at 817-18.
447. Id. at 818.
448. Id.
449. Id.
450. See supra Part I.C.3.
451. Verret, supra note 151, at 818.
452. Id. at 819.
453. Id. at 820. "Strategic behavior arises when two or more individuals interact and each individual's decision turns on what that individual expects the others to do." DOUGLAS G. BAIRD, ROBERT H. GERTNER & RANDAL C. PICKER, GAME THEORY and the LAW 1 (1994). The theories addressing this strategic behavior can "offer insights into how legal rules affect the way people behave." Id.
454. BAIRD ET al., supra note 453, at 310 (emphasis omitted).
455. Id. at 21 (emphasis omitted).
456. Id.
457. Id.
458. Id.
459. Id.
460. Id.
461. Verret, supra note 151, at 819.
462. Id. at 820.
463. Id.
464. Id.
465. Id. at 820-21.
466. Id at 821.
467. Id.
468. Id.
469. Id.
470. Id.
471. Id. at 822. "The result is an equilibrium of compliance that could exceed the level of transparency that would exist without the collective action, thus giving more sharpness and binding effect to any best practices that may exist in the industry and providing a more cost effective enforcement avenue for those best practices." Posting of Holger Spamann to Harvard Law School Corporate Governance Blog, http://blogs.law.harvard.edu/corpgov/2008/01/ 24/a-self-regulation-proposal-for-the-hedge-fund-industry (Jan. 24, 2008, 11:02 EST).
472. Verret, supra note 151, at 822. Even if the firms individually would have initially chosen to vote for FDV, "each firm would anticipate that the other firm would vote to create the signal, because it could profit by taking market share." Id.
473. Id.
474. Id. at 823 ("In effect, not only will individual fund managers want a signal about their low operational risk vis-á-vis their internal competition for capital, they will have an added incentive to create such a signal to aid in their external competition for capital with other asset classes.").
475. Id. at 833.
476. Id.
477. Id. at 836. "[S]tatutory self-regulation subject to SEC supervision generally has been effective in major applications only when the Commission has been willing to threaten or actually use its regulatory authority to create incentives for securities industry regulation." Seligman, supra note 299, at 1119.
478. Verret, supra note 151, at 836.
479. Id. (citing Seligman, supra note 299, at 1124).
480. Id.
481. Id.
482. Id.
483. Id.
484. Id.
485. Id. at 836-37.
486. Id. at 837. The need for SEC approval "would also ensure that, as the landscape of the hedge fund industry changed, the SRO rulemaking body membership continued to represent the disparate players well." Id.
487. Id. This requirement was established in the NASD settlement.
488. Id.
489. Id.
490. Id.
491. 15 U.S.C. § 80b-6 (2006); see supra Part I.C.2.
492. SEC Release: Antifraud Rule, supra note 38, at 44,757 (quoting S. REP. No. 86-1760, at 4 (I960)).
493. 15 U.S.C. § 80b-6 (emphasis added); see supra Part I.C.2.
494. 17 C.F.R. § 275.206(4)-8(a)(1) (2008).
495. Id.; see also ABA Letter, supra note 313, at 3.
496. SEC Release: Antifraud Rule, supra note 38, at 44,759 (listing various antifraud laws and rules, including rule 10b-5 under the Exchange Act).
497. Id.
498. 17 C.F.R. § 275.206(4)-8(a)(2).
499. See supra note 373 and accompanying text.
500. SEC Release: Antifraud Rule, supra note 38, at 44,759 (citing ABA Letter, supra note 313; ICI Letter, supra note 312; Schulte Letter, supra note 315; Sullivan & Cromwell Letter, supra note 311).
501. Id.
502. Id. at 44,758-59.
503. Id. at 44,757.
504. See generally Part I.C.2.
505. SEC Release: Antifraud Rule, supra note 38, at 44,762 (internal quotation marks omitted).
506. Id.
507. See supra notes 332-35 and accompanying text.
508. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 199 (1976); see also supra notes 332-35 and accompanying text.
509. See supra Parts I.C. 1, II.A.2
510. Goldstein v. SEC, 451 F.3d 873, 882 (D.C. Cir. 2006) ("That the Commission wanted a hook on which to hang more comprehensive regulation of hedge funds may be understandable. But the Commission may not accomplish its objective by a manipulation of meaning.").
511. SEC v. Steadman, 967 F.2d 636, 647 (D.C. Cir. 1992).
512. BLACK'S LAW DICTIONARY 685 (8th ed. 2004).
513. Id.
514. See supra notes 332-35 and accompanying text.
515. See supra Part I.A. 2.
516. See supra notes 108-15 and accompanying text.
517. See Part I.B.2.
518. See Verret, supra note 151, at 810.
519. See, e.g., id.; supra note 131.
520. Id.
521. Id.
522. STAFF REPORT on the GROWTH of HEDGE FUNDS, supra note 33, at 74.
523. Id.
524. See supra Part I.D.2.
525. See supra Part II.C.2.
526. Verret, supra note 151, at 836 (citing Seligman, supra note 299, at 1124); see also supra Part II.C.2.
527. See generally National Futures Association, About NFA, http://www.nfa.futures.org/aboutnfa/indexAbout.asp (last visited Oct. 24, 2008).
528. Id.
529. Id.
530. Id.
531. Id.