Current Developments in Monetary and Financial Law, Vol. 5

Chapter 10 Hedge Funds and the SEC: Observations on the Why and How of Securities Regulation

International Monetary Fund
Published Date:
November 2008
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The hedge fund industry is well over a trillion dollar business. Estimates put the number of hedge funds at around 9,000 today, up from an estimated 3,600 funds managing roughly US$450 billion as recently as 1999.1 As the industry grows, so does its impact. Hedge funds add liquidity to financial markets and, as others have put it, hedge funds act as “shock absorbers” that can stabilize financial markets during crises.2 Further, hedge funds promote the integrity of securities markets by engaging in the types of trading that make securities markets more efficient, and they provide opportunities for businesses and investors to shift and manage risk. More efficient and liquid financial markets promote capital formation and business enterprise.

A concern, on the other hand, is that hedge fund activities may also upset financial markets. In particular, the industry’s growth has fueled worries about so-called systemic risk,3 dating back, most notably, to the collapse of Long-Term Capital Management (LTCM) in 1998 and the private bailout of LTCM that the Federal Reserve Bank of New York orchestrated to fend off a chain reaction that threatened global markets if LTCM defaulted.4 More recently, the multi-billion dollar loss at Amaranth Advisors that was tied to a natural gas trade by a single individual at the hedge fund renewed concern that a fund can collapse easily and quickly with widespread consequences, although none resulted from Amaranth’s collapse.5

Separately, there have been a noticeable number of enforcement actions for fraud and insider trading brought by the U.S. Securities and Exchange Commission (SEC or Commission) against hedge funds. Hedge funds were also implicated in the market-timing and late-trading scandals that plagued the mutual fund industry in the early 2000s. And while hedge funds have been increasingly active as shareholders—arguably increasing firm value by holding managers and boards more accountable6—there is growing concern that hedge funds are manipulating business transactions through what Professors Bernard Black and Henry Hu have termed “empty voting,” a variation of vote buying.7

Compensation of hedge fund managers also has been noticed. Successful hedge fund managers can make tens if not hundreds of millions of dollars per year, even in down markets. One study found that the average compensation of the top 25 managers of hedge funds was approximately US$250 million in 2004.8

Despite all of this, concerns about hedge funds have to be kept in proper perspective. Not only do the funds perform a number of key functions that stabilize financial markets, promote capital formation, lead to more efficient securities markets, and facilitate risk management, but the abuses and collapses that have punctuated the industry, while notable, are not indicative of widespread hedge fund behavior. To the contrary, most hedge funds are not engaged in fraudulent or other illicit behavior, and the vast number of hedge fund managers are disciplined traders who make calculated, although risky and speculative, trades.9

Against this backdrop, this chapter addresses three topics that bear on one key aspect of the hedge fund industry: the SEC’s recent efforts to regulate hedge funds.10 The first section of this chapter summarizes the regulation of hedge funds under the U.S. federal securities laws that is intended to protect hedge fund investors. The discussion highlights four basic choices facing the SEC: (1) do nothing; (2) substantively regulate hedge funds directly; (3) regulate hedge fund managers; and (4) regulate hedge fund investors.11 The second section assesses the boundary between market discipline and government intervention in hedge fund regulation. To what extent should hedge fund investors be left to fend for themselves? The final section highlights two factors—politics and psychology—that impact regulatory decision making and help explain why the SEC pivoted in 2004 to attempt to regulate hedge funds when it had abstained from doing so in the past.

Hedge Funds and U.S. Federal Securities Regulation

Hedge funds are characterized not only by the nature of their investments12 but also by the degree to which they are not regulated by the SEC. Hedge funds typically are structured so that they avoid the principal regulatory requirements of the U.S. federal securities laws. The resulting light regulation of such funds is not the product of shenanigans or the exploitation of loopholes. Rather, the Securities Act of 1933 (which regulates public offerings), the Securities Exchange Act of 1934 (which imposes ongoing disclosure and other requirements on public companies), the Investment Company Act of 1940 (which regulates mutual funds), and the Investment Advisers Act of 1940 (which regulates investment advisers) contain longstanding, purposeful exclusions within which hedge funds typically fall.13

In 2004, in a divisive and controversial 3–2 vote for an administrative agency that prefers to act unanimously (Commissioners Atkins and Glassman dissenting), the SEC changed course and decided to regulate hedge funds.14 The SEC’s subsequent hedge fund rule did not substantively regulate hedge fund activities directly, but required hedge fund managers to register with the SEC as investment advisers under the federal Investment Advisers Act.

Section 203(b)(3) of the Investment Advisers Act provides that an investment adviser, such as a hedge fund manager, does not have to register under the Act if, among other things, the adviser has fewer than 15 “clients.” For purposes of Section 203(b)(3), a hedge fund manager has been able to count a fund as a single client. For example, a hedge fund with 100 investors has counted as a single client of the hedge fund manager for the 15-client threshold of Section 203(b)(3). Consequently, a hedge fund manager could manage up to 14 hedge funds, with an unlimited number of investors in the funds, without having to register as an investment adviser under the Investment Advisers Act.

The SEC’s 2004 rule set out to change this. The SEC adopted a new rule—Rule 203(b)(3)-2 under the Investment Advisers Act—to require a hedge fund manager to “look through” the manager’s fund to count each hedge fund investor as a client.15 As a result of the new rule, hedge funds would eclipse the 15-client threshold, and hedge fund managers thus would have to start registering with the SEC as investment advisers. As registered investment advisers, hedge fund managers would have to (1) make certain disclosures with the SEC; (2) deliver basic information to investors; (3) adopt procedures concerning proxy voting by the fund; (4) adopt a code of ethics; (5) implement certain internal controls and compliance procedures; (6) meet certain requirements governing the custody of client funds and securities; and (7) designate a chief compliance officer. Most important, hedge funds would have to maintain specified books and records and make them available to the SEC for examination and inspection.16

This revised regulatory regime, which went into effect in February 2006, lasted only about six months. In Goldstein v. SEC, the federal Court of Appeals for the D.C. Circuit vacated the SEC’s new hedge fund rule, calling it “arbitrary” and effectively reinstating the earlier Investment Advisers Act regime under which hedge fund managers can avoid registering.17

The SEC did not challenge the Goldstein decision,18 but it did consider and ultimately propose a different rule in late 2006.19 Some background is needed before explaining the SEC’s more recent proposal.

The Securities Act of 1933 provides that securities offerings generally must be registered with the SEC.20 There is, however, an important safe harbor from the Securities Act’s registration requirements for offerings that are limited to “accredited investors” in private placements.21 Accredited investors include institutional investors and individual investors who meet certain financial qualifications. Specifically, an individual qualifies as an accredited investor by having a net worth (or joint net worth with a spouse) that exceeds US$1,000,000 or an income exceeding US$200,000 in each of the past two years (or joint income with a spouse exceeding US$300,000 in each of the past two years) if such individual reasonably believes such income thresholds will be met in the present year.22 The logic is that accredited investors are able to fend for themselves—that is, they can assess the risk of a particular investment or bear the risk of financial loss—because they are sufficiently sophisticated or wealthy. Consequently, there is no compelling need for the federal securities laws to protect them—hence the safe harbor exclusion from the Securities Act’s registration requirements for offerings limited to accredited investors.23

As a matter of practice, hedge funds limit the offering of their securities to accredited investors.24 Yet regulators and others have worried that individuals who satisfy the current financial thresholds for accredited investor status are not in fact able to protect themselves. Indeed, the financial thresholds have been fixed for over two decades.25

In its post-Goldstein rulemaking, the SEC proposed a new definition of accredited investor.26 The Commission proposed a new class of accredited investor—the “accredited natural person”—that would apply to securities offerings of hedge funds.27 An individual would qualify as an accredited natural person by meeting the financial thresholds described above and owning US$2.5 million or more in investments (individually or with a spouse).28 This US$2.5 million threshold would be adjusted for inflation in later years.

Amending the definition of accredited investor might be seen as a relatively technical development; it is certainly a less intrusive change than the SEC’s 2004 rule. The Commission’s accredited investor proposal should have a relatively modest impact on the industry as a whole, even though the rule change would deny some investors the chance to invest in hedge funds and thus cut off some capital inflows, particularly for smaller or newer funds.

The SEC’s new proposal, however, is important for reasons aside from its impact on hedge funds. The Commission’s approach informs our understanding of securities regulation by illustrating the range of levers the SEC can pull under a policy of protecting investors. One option would be for the SEC to do nothing else and leave the regulatory regime in place as it existed before 2004. A second option would be for the SEC to regulate hedge funds directly. For example, one could imagine (although the SEC has not proposed this) regulating the types of investments hedge funds can make, how much leverage they can take on, and how managers are compensated. A burdensome regime along these lines presently governs mutual funds under the Investment Company Act of 1940. A third option would be for the SEC to regulate hedge fund managers, as it sought to do earlier by requiring their registration under the Investment Advisers Act.

The proposed definition of an accredited natural person illustrates a fourth option. Namely, the SEC can regulate investors.29 By redefining who qualifies as accredited, the SEC effectively regulates who can invest in hedge funds.30 This proposal does not confer upon the SEC greater regulatory authority, as the short-lived 2004 requirement for investment adviser registration did, but it does target the particular concern that unsophisticated investors, who are not especially wealthy, might invest in hedge funds.

Such investor-side regulation is not new. The SEC has for some time drawn distinctions between various categories of investors, including not only “accredited investors,” but also “qualified clients,” “qualified purchasers,” “sophisticated” investors, and “qualified institutional buyers.” The proposed “accredited natural person” adds another category.31

The SEC’s proposal to limit hedge fund investing to individuals wealthier than traditional accredited investors was widely viewed as reasonable in academic and legal circles since the accredited investor financial thresholds were set 25 years ago.32 If anything, perhaps the financial thresholds under the definition of accredited investor should have been revisited generally, instead of singling out hedge funds.

Individual investors have viewed things differently. Of the roughly 600 comment letters the SEC received, a notable number rejected the SEC proposal to establish the new accredited natural person category, prompting the SEC to proceed more slowly than initially envisioned. The SEC explained the accredited natural person category in terms of enhanced investor protection:

[M]any individual investors today may be eligible to make investments in privately offered investment pools as accredited investors that previously may not have qualified as such for those investments. Moreover, private pools have become increasingly complex and involve risks not generally associated with many other issuers of securities. Not only do private pools often use complicated investment strategies, but there is minimal information available about them in the public domain. Accordingly, investors may not have access to the kind of information provided through our system of securities registration and therefore may find it difficult to appreciate the unique risks of these pools, including those with respect to undisclosed conflicts of interest, complex fee structures and the higher risk that may accompany such pool’s anticipated returns.33

In their criticism, individual investors have emphasized the other side of the investor protection coin. Many see the SEC’s proposal as unwanted paternalism that denies less-wealthy individuals (i.e., retail investors) an opportunity to invest in an important asset class, namely, hedge funds, as well as private equity funds.34

Two basic, and related, arguments underpin investors’ resistance to the SEC’s proposal. First, diversification is widely touted as the best investment strategy for individual investors. However, the proposed standard for an accredited natural person crimps an individual’s ability to diversify into certain private offerings. Relatedly, hedge funds, as well as private equity funds, can yield outsized, above-market returns, even on a risk-adjusted basis (i.e., alpha). Accordingly, individual investors might want exposure to such investment vehicles to earn higher returns. In this view, investor participation in hedge (and private equity) funds can itself be seen as a form of investor protection.

Second, regulatory efforts that preclude retail investors from investing in hedge funds and other private investment vehicles bolster concerns that the financial game is rigged. Individual investors understandably wonder why an entire category of investments is set aside for wealthy individuals and institutional investors only. To many retail investors, claims of investor protection ring hollow. Rather, they view a proposal such as the accredited natural person definition as further tilting the playing field in favor of the rich and powerful by preserving for them the best investment opportunities. The backdrop here is that retail investors want the same opportunities as wealthy individuals and large institutions, because the fact that wealthy individuals and institutions invest in these private vehicles is evidence of their attractiveness, including for the less-wealthy.35 As the private placement market continues to grow generally, retail investors will increasingly find that they are excluded from a substantial segment of securities markets, and not just from hedge funds.36 Individual investors may lose confidence in the integrity of securities markets when they recognize that two markets exist—one market that is open to all investors, including retail investors (i.e., publicly traded securities and mutual funds); and one that is open only to wealthy individuals and institutional investors (i.e., private placements, including investments in hedge funds, private equity funds, and venture capital funds, as well as privately held operating companies). In such a situation, investors’ trust in the integrity of the legal regime that entrenches the divide is at risk also.37

In sum, individuals caught the SEC’s attention when they expressed a preference for greater participation in private pools of capital, including hedge funds, even if it means less investor protection from the Commission.38 Put differently, it is one thing for the SEC to demand more disclosure and to enforce antifraud requirements aggressively to reduce informational asymmetries so that investors can make better informed decisions in deciding how to allocate their capital. It is quite another for the SEC to protect investors by denying them investment opportunities that the SEC deems to be too risky.39

It is beyond this chapter’s scope to consider how investor-side regulation might feature still more prominently in securities regulation.40 Suffice it to say that more refined investor-side regulation—such as the SEC offered when crafting an accredited investor definition for hedge funds that would not upset the private placement market more broadly—should not be overlooked as an option, notwithstanding that it ultimately may be difficult to achieve politically.

Government Intervention versus Market Discipline

A primary goal of the SEC is to protect investors. Without question, hedge fund investors have limited information, particularly when it comes to understanding a hedge fund’s investments. But it does not follow that more regulation of hedge funds or their managers is warranted to protect hedge fund investors.41

Hedge fund investors are accredited investors and, if the SEC’s 2006 proposal is ultimately adopted, individuals will have to meet an additional investment requirement to qualify as accredited natural persons. The federal securities laws presume that accredited investors, including accredited natural persons, are able to protect themselves, militating against more government intervention on their behalf. That such well-heeled, sophisticated investors choose to invest in a hedge fund that provides its investors with little information should not trigger more SEC oversight. Neither the complexity of hedge fund strategies nor the fact that hedge fund investors may lose money because of fraud or risky trading is grounds for more hedge fund regulation. To the contrary, the risk of loss incentivizes investors to do the kind of due diligence that positions them to protect their own interests, and hedge funds and their managers are already subject to antifraud requirements. Just as hedge fund investors can evaluate the information they do possess about a fund’s investment strategy, back office operations, controls, track record, valuation techniques, and disclosure practices, they can assess and “price” the risk of having imperfect information. Indeed, if they are uncomfortable with the investment, investors can simply walk.

Of course, institutional investors and wealthy individuals do not always perfectly price the risk of a particular investment. Due diligence is costly, and sometimes people are simply wrong in their assessments. In addition, as behavioral finance has taught us, when making investment decisions, people are boundedly rational and suffer from various cognitive biases.42 Consequently, even sophisticated investors with good information make mistakes. Furthermore, in recent years investing in hedge funds has become fashionable. As investors develop a taste for hedge funds, they may rush to invest without doing adequate diligence and analysis.

Notwithstanding these breakdowns in market discipline, the SEC has not engaged in a more textured study of what it means for investors to be able to fend for themselves, in large part because a more textured analysis is too indeterminate and comes at the expense of capital formation. The SEC does not delve into the details of investor behavior. Instead, the regulator has relied on certain financial-based proxies—reflected in the definition of accredited investor—as acceptable measures of investor self-protection. Such a bright-line approach to accredited investor status in turn spurs the private placement market by reducing the risk for issuers when tapping this market.43 As the SEC’s proposed definition of an accredited natural person illustrates, there is room to debate where the appropriate line is separating when the SEC should intervene and when it should not. But it is worth underscoring that a boundary limiting SEC oversight in deference to market discipline is engrained in federal securities regulation and is part of the longstanding accepted structure of the regulatory regime.44

This does not mean, however, that the SEC has no role to play when market discipline predominates. The securities regulator can always look to expand its reach by moving the regulatory line delineating the boundary between SEC oversight and market discipline. The SEC has proposed doing just this by raising the financial hurdle an individual must clear to qualify as accredited to invest in hedge funds. Under the SEC’s proposal, fewer individuals would be accredited and thus fewer individuals would be viewed as able to fend for themselves when investing in a hedge fund. Notably, although the SEC’s accredited natural person proposal narrows the potential pool of hedge fund investors, the SEC does not propose to regulate a fund or its manager so long as the fund’s investors solely comprise institutional investors and accredited natural persons. This is a qualitatively different approach from the SEC’s vacated 2004 rule, which provided for SEC regulation of hedge fund managers, even when all investors were accredited.

Instead of (or in addition to) relocating the boundary between government intervention and market discipline, the SEC can actually facilitate market discipline so that it is more informed and effective. The SEC wields considerable influence as the dominant securities regulator in the United States, and it is highly respected. The Commission could take advantage of its status and reputation in adopting a best-practices mode of regulation.45 That is, the SEC could express its view of best practices without imposing legal requirements. The SEC could articulate best practices formally through SEC releases or informally through the speeches and writings of individual commissioners and division directors. For example, the SEC could stress best practices for the hedge fund industry. Imagine the potential impact on the industry if the SEC chairman, particularly if joined by other commissioners and the directors of the Division of Investment Management and the Division of Corporation Finance, pushed a set of hedge fund best practices in a series of speeches, interviews, TV appearances, and op-eds in publications such as the Wall Street Journal and the Financial Times.46

By endorsing particular best practices, including those coming from the private sector,47 the SEC would provide concrete guidance to investors to use in assessing investment options. Such guidance would be a yardstick against which investors could evaluate a specific investment opportunity. Investors could then allocate their capital as they saw fit with the benefit of the SEC’s input. Further, a hedge fund manager could take the initiative in adopting the SEC-endorsed practices to distinguish the manager and the manager’s fund as cooperative and willing to go above and beyond what the law requires.48 Particularly if larger, more-established hedge funds follow the best practices, other funds may feel pressured to as well.

This is not to say that all best practices urged by the SEC would (or should) be followed. The ultimate outcome would be left for the market participants to determine in the shadow of what the SEC has urged is the right thing to do. More to the point, for best practices to be voluntary in fact and not only in name, the SEC would have to sit tight and refrain from regulating if the best practices it endorsed were not widely accepted.49

A best-practices approach to hedge fund regulation has gained some traction. In February 2007, the President’s Working Group on Financial Markets (PWG)—chaired by the secretary of the Treasury and consisting of the chairmen of the Federal Reserve Board, the SEC, and the Commodity Futures Trading Commission—issued a set of principles and guidelines concerning hedge funds and other private pools of capital.50 The PWG advanced a market-oriented approach to hedge fund oversight that relies on market discipline both to protect hedge fund investors and to ensure that private pools of capital undertake effective risk management for the benefit of hedge fund creditors and counterparties and to limit systemic risk. In September 2007, the PWG announced the creation of two committees—the Asset Managers’ Committee made up of hedge fund managers and the Investors’ Committee made up of hedge fund investors—to come up with best practices for hedge fund managers and hedge fund investors.51 The committees’ proposals will be put out for public comment before being finalized. This is a unique public-private partnership, with the PWG turning to private-sector committees to fashion best practices that the PWG, after notice and comment, presumably expects to sanction.52

When the SEC does regulate more substantively, it still can allow room for flexibility and private ordering by finessing the government intervention/market discipline boundary. Regulators often view themselves as having two choices: impose one-size-fits-all mandates or sit tight and do nothing.53 However, a third choice lies between those two poles. That is, regulators, such as the SEC, can use default rules.

The virtue of default rules is that they allow parties to contract around the default requirement to order their affairs to fit their particular needs and preferences.54 Further, the ability to opt out of the regulatory regime provides an important safety valve when regulators otherwise would overregulate. A default rule that required a hedge fund manager to register under the Investment Advisers Act or disclose why it has chosen not to register would have been a particularly apt alternative to the SEC’s earlier rule mandating investment adviser registration for hedge fund managers. Just as hedge fund investors can evaluate other aspects of a fund’s operations, the investors could assess the value of investment adviser registration against the backdrop default that managers must register with the SEC.55

Although used sparingly in the United States, some precedent exists for such a default-rule approach to securities regulation. Two specific examples can be found in the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley). Sarbanes-Oxley requires public companies to adopt a code of ethics for senior financial officers or explain why no code was adopted.56 The Act also requires public companies to have a financial expert on the audit committee or explain why it does not.57 Another example is the SEC’s 2005 rule permitting, but not requiring, that mutual funds impose a 2 percent mandatory redemption fee on short-term trading.58 More recently, the SEC sought comment on a proposal that would allow shareholders to opt out of the SEC’s regime under Rule 14a-8 of the Securities Exchange Act and decide for themselves what procedures the company would adopt for including nonbinding shareholder proposals in the company’s proxy materials.59 On other occasions, the SEC has explicitly favored mandates over a more liberal regulatory approach. For example, in a 3–2 vote, the SEC in 2004 adopted rules requiring mutual fund boards to have an independent chairman and a supermajority of independent directors, rejecting a proposal that instead would have required a mutual fund to disclose whether its board met these heightened independence standards but without requiring them to do so.60

In the future, when it does regulate, the SEC should give more serious consideration to using defaults over mandates, and in some instances the SEC should do nothing more than take a stance by exhorting particular best practices.

The Politics and Psychology of Securities Regulation

The third topic concerns the SEC as an institution and a decision-making body, focusing on the impact that politics and psychology can have on regulatory judgment.61 Although the discussion focuses on the Commission, the observations apply to any legislative or regulatory body and to risk regulation generally.

Why did the SEC reverse its long-held practice in 2004 and decide to regulate hedge funds? Nobody knows for sure what impacts a particular regulator’s decision making. Group decision making complicates the analysis. That said, the SEC’s decision to regulate hedge funds is consistent with two views. First, that the securities regulator did not want to get caught flat-footed and criticized again, as it had been by the scandals at Enron, WorldCom, and elsewhere, by seeming to take a lax regulatory stance with respect to hedge funds in the post-Enron era. Second, on the heels of the earlier scandals, the risk of fraud and other hedge fund abuses loomed disproportionately large at the SEC, prompting it to act when in the past the regulator had abstained from doing so. Both of these claims play out against the backdrop that regulators generally see themselves as there to do something—which is to say, to regulate.

Because much has been written on the political economy of regulation, the comments that follow are targeted. When considering the political economy of securities regulation, it is important to recognize that the investor class in the United States is expanding. Today, about 50 percent of households are invested in stock, as compared to roughly 19 percent in 1983, 32 percent in 1989, and 40 percent in 1995.62 Not only do more households own stock today than ever before, but, as one would expect, individual wealth increasingly is tied up in stock, as well as other securities.63 Further, the relatively newly expanded but very active business and financial media—CNBC, for example, is a phenomenon of the 1990s stock market boom, and News Corp. recently launched the Fox Business Network—brings more attention and scrutiny to securities markets and their regulation than before. Regulatory decision making is bound to be impacted as securities markets increasingly enjoy widespread participation and as securities and corporate-related questions become leading topics of serious public and political debate. The predictable result is a more pronounced “democratization” of securities regulation as regulators are more responsive to public pressure and the political agenda.64 What is the consequence? The populist politics of securities regulation generally characterizes more regulation, more aggressive government enforcement of securities laws, and lower barriers to private litigation as “pro-investor.”65 This, however, is a stingy reading of “proinvestor” that does not fully account for the cost of government regulation and litigation when it hampers U.S. financial markets and capital formation.66

The SEC’s desire to protect its regulatory domain contributes to this dynamic.67 On several occasions, for example, Congress has held hearings on hedge funds, and some legislation has even been introduced, although it has not advanced very far.68 The SEC may have correctly believed that it had to do something to fend off a Congress that may be anxious to fill any perceived regulatory void with new legislation. The SEC has an institutional interest in assuring its position as the predominant securities regulator in the United States and staking out its turf against potential incursions by Congress or the states.69 Further, the SEC may set itself up for blame if it fails to regulate and a scandal emerges or the market melts down. The SEC can thus protect its own reputation by regulating more aggressively, even at the risk of going too far.

The comparative advantage of an administrative agency over other lawmakers—namely, the agency’s subject matter expertise and its independence and impartiality70—is compromised when its members are responsive to political pressure or public demands in how they regulate or join lawmakers in competing to regulate. Under these circumstances, the risk is that regulators will tend to overregulate.

To avoid painting with too broad of a brush, it is worth recognizing that there may be times when the SEC needs to supply regulation when there is demand for it.71 First, a strong regulatory response may be needed at times, such as during a period of crisis as followed Enron’s collapse, to buttress investor confidence.72 Second, the sort of “democratic” securities regulation contemplated here might help offset more conventional public-choice concerns, counterbalancing regulatory capture or other special-interest influences on securities regulation that can result in too little government oversight of securities markets.73 Third, the SEC may need to regulate enough to avoid stirring public outrage for taking a lax stance and to preserve its own legitimacy as a regulatory body. If the SEC does not respond to the boom in the hedge fund industry, especially given some of the headline-grabbing conduct involving the funds, investors may lose faith in the SEC for allowing the industry to go unchecked. More generally, Main Street may simply demand that power be held accountable, and hedge funds are increasingly powerful.74 The consequences here extend beyond the SEC, because if investors lose faith in the SEC, they may lose faith in the integrity of U.S. securities markets.

The SEC’s decision to regulate hedge funds fits the general contours of the above take on the political economy of securities regulation. There is, however, an interesting twist. As described in the first section of this chapter, the politics of hedge fund regulation have shifted, at least insofar as less-wealthy individuals have rejected the SEC’s proposal to limit further who can invest in hedge funds. While individual investors may welcome SEC efforts to regulate hedge funds or their advisers, they have not welcomed SEC efforts to regulate the investors themselves. This has caused pause at the SEC, which, as noted above, solicited additional comment on its proposed definition of accredited natural person.75

Psychology also impacts regulatory decision making.76 For example, there is a psychological (or behavioral) explanation for the precautionary principle of risk regulation.77 Simply put, the precautionary principle holds that it is better to be safe than sorry—a proactive regulatory policy of anticipation and preemption. The benefit of a precautionary approach to regulation is that it can lead regulators to take prophylactic steps instead of sitting back and only reacting to problems once they arise. However, taking precautions can also lead to excessive regulation as regulators try to avoid some perceived harm, often on the basis of limited information.

Further, the precautionary principle is misleading as a regulatory lodestar. As Professor Cass Sunstein has emphasized, precautionary steps with respect to one risk inevitably lead to other risks.78 The difficult question, then, is what risks should regulators regulate to avoid and what risks should regulators tolerate? What risks weigh most heavily in the regulatory balance? To a large degree, the answer depends on the value placed on various outcomes. For example, when the two goals are at odds, how much investor protection is one willing to trade in exchange for promoting capital formation? The answer not only depends on value judgments, but also on various psychological influences that affect human judgment and decision making by making certain risks more fearful, even when in fact they are not as threatening as they seem.

Investor losses, hedge fund collapses, and jarring frauds are salient events that are readily recalled when crafting regulation, particularly in light of the journalists and politicians who play up the losses and abuses. Accordingly, these events likely will feature more prominently in regulators’ decision making than the actual magnitude of the events warrant. This disproportionate impact of especially salient events on decision making is associated with what is called the availability heuristic, whereby salient risks are more available to one’s mind and thus receive more attention than they deserve, as well as the representativeness heuristic and probability neglect, according to which people tend to overstate the probability that some bad recent occurrence will happen again.79 Furthermore, regulators may be inclined to regulate in response to a perceived risk because regulators may view themselves as being there to regulate, after all.

The other side of the regulatory scale includes the costs of more aggressive securities regulation. These costs are generally described in such sterile and impersonal terms as the risk that more regulation will undercut the flexibility, efficiency, and liquidity of financial markets. These risks are not nearly as stirring as the supposed costs of not regulating. Additionally, regulators may be overconfident in their skill at regulating with the right touch, believing that they can get the benefits of investor protection without the attendant costs. Perhaps regulators’ assessments would be different if the costs of regulation were presented to them more concretely in terms of fewer jobs, lower returns for investors, or fewer investment opportunities.

The bottom line is that regulators, as well as the public and the media, often have an exaggerated concern over fraud and investor losses and, at least by comparison, a dulled sensitivity to the costs of greater investor protection. This is not to say that regulators do not account for the costs of regulation, but only that the costs often do not receive their appropriate due. This is especially true in the wake of a wave of scandal, such as Enron ushered in, or when there is some considerable unknown, as with hedge funds. As a result, regulators’ assessments of the costs and benefits of regulating can become skewed toward avoiding a particularly salient harm. In practice, this means more investor protection—indeed, perhaps too much investor protection at the expense of other goals, such as capital formation.80 This might explain why the SEC chose to regulate hedge funds in 2004 when it did not do so earlier.

To craft an effective securities law regime, regulators must appraise objectively and rationally the costs and benefits of regulating; their judgment cannot be obscured by cognitive biases. An unbiased, more probabilistic analysis of the consequences of risk regulation should lead to a more effective regime that better advances regulatory goals. Even an SEC that emphasizes investor protection may by its own lights overregulate if it irrationally fears another series of scandals.

Recognizing that regulators are human and imperfectly rational introduces a new set of regulatory challenges. How do regulators guard against the kind of unconscious biases that can frustrate good decision making? There are no easy answers to this challenge. However, some possibilities worth considering include more rigorous cost-benefit analysis, “harder-look” judicial review of administrative agency decision making, new organizational structures that might be mined from the experiences of companies, and the use of internal “prediction” markets.81 Indeed, a best-practices approach to regulation and the use of opt-out defaults can provide an effective safety value against the risk of overregulation rooted in regulator psychology or, for that matter, politics.


This inquiry into the SEC’s recent attempts to regulate the hedge fund industry suggests a few basic insights into the “why and how” of securities regulation. First, investor-side regulation is an option as an investor protection strategy. Second, instead of adopting mandates, regulators could adopt defaults or simply urge best practices without adopting any new legal requirements. Third, regulators need to be aware of, and guard against, the impact of politics and psychology in securities regulation. Although the focus in this chapter has been on the SEC, these core points inform the crafting of financial regulation more broadly in both the United States and abroad.

Note: I would like to thank the participants at the International Monetary Fund’s 2006 Seminar on Current Developments in Monetary and Financial Law, for which this chapter was prepared, for their helpful comments and insights. Further, I gratefully appreciate helpful thoughts offered by Bill Bratton, Kathleen Brickey, Michelle Brough, Steve Choi, Scott Kieff, Don Langevoort, Frank Partnoy, Steve Schwarcz, David Skeel, Randall Thomas, and Peter Wallison. This chapter also benefited from comments I received at workshops at the George Washington University Law School and the University of California Hastings College of the Law. For a more extensive analysis of some of the ideas and themes in this chapter, see Troy A. Paredes, “On the Decision to Regulate Hedge Funds: The SEC’s Regulatory Philosophy, Style, and Mission,” 2006 University of Illinois Law Review 975. All mistakes are mine.
1See Counterparty Risk Management Policy Group II, Toward Greater Financial Stability: A Private Sector Perspective (2005), at B-10, available at [hereinafter Toward Greater Financial Stability].
2See, e.g., John G. Gaine, President, Managed Funds Association, “Comments of Managed Funds Association for the U.S. Securities and Exchange Commission Roundtable on Hedge Funds,” May 2003, available at
3Regarding systemic risk, see generally Toward Greater Financial Stability, supra note 1; Nicholas T. Chan et al., “Systemic Risk and Hedge Funds,” MIT Sloan Research Paper No. 4535–05 (2005), available at; Steven L. Schwarcz, “Systemic Risk,” Duke Law School Legal Studies Paper No. 163 (2007), available at For an important speech on the topic by the president and chief executive officer of the Federal Reserve Bank of New York, see Timothy F. Geithner, “Hedge Funds and Derivatives and Their Implications for the Financial System,” September 15, 2006, available at; see also Greg Ip, “Geithner’s Balancing Act: The Fed’s Go-To Man for Financial Crises Takes on Hedge Funds,” Wall Street Journal (February 20, 2007), at C1. For a summary of the concern over systemic risk, see Randall Smith and Susan Pulliam, “As Funds Leverage Up, Fears of Reckoning Rise,” Wall Street Journal (April 30, 2007), at A1.Professor Steven Schwarcz has defined systemic risk as follows:

[T]he risk that (i) an economic shock such as market or institutional failure triggers (through a panic or otherwise) either (x) the failure of a chain of markets or institutions or (y) a chain of significant losses to financial institutions, (ii) resulting in substantial financial-market price volatility (which price volatility may well reflect increases in the cost of capital or decreases in its availability).

Schwarcz, “Systemic Risk,” supra, at 14 (citation omitted).For a concise set of recommendations for financial firms to follow for managing their exposure to hedge funds and thus mitigating systemic risk, see Edwin Laurenson et al., “Best Practices for Financial Firms Managing Risks of Business with Hedge Funds,” 38 Securities Regulation & Law Report (BNA) 1477 (2006).
4See generally Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000); Franklin R. Edward, “Hedge Funds and the Collapse of Long-Term Capital Management,” 13 Journal of Economic Perspectives 189 (1999). For a thorough report prepared by the President’s Working Group on Financial Markets in the wake of LTCM’s collapse, see Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management: Report of the President’s Working Group on Financial Markets (1999), available at
5See, e.g., Ann Davis, “How Giant Bets on Natural Gas Sank Brash Hedge-Fund Trader: Up in Summer, Brian Hunter Lost US$5 Billion in a Week as Market Turned on Him,” Wall Street Journal (September 19, 2006), at A1; Ann Davis et al., “What Went Wrong at Amaranth: Mistakes at the Hedge Fund Include Key Trader’s Confusing Paper Gains with Cash Profits,” Wall Street Journal (September 20, 2006), at C1; Phil Izzo, “Getting a Grip on Hedge Fund Risk: Economists See Risk to Financial Markets and Say More Regulation Is Warranted,” Wall Street Journal (October 13, 2006), at C3; Gretchen Morgenson and Jenny Anderson, “A Hedge Fund’s Loss Rattles Nerves,” New York Times (September 19, 2006), at C1. Amaranth’s loss ended up posing no systemic problem. See, e.g., Gregory Zuckerman, “How the Amaranth Wreck Was Contained: J.P. Morgan and Citadel Swooped In, Assumed Risk, Proving Markets’ Resilience,” Wall Street Journal (October 5, 2006), at C3.
6See, e.g., William W. Bratton, “Hedge Funds and Governance Targets,” Georgetown Law and Economics Research Paper No. 928689 (2006) available at; Alon Brav et al., “Hedge Fund Activism, Corporate Governance, and Firm Performance,” ECGICFinance Working Paper No. 139/2006 (2006), available at; Marcel Kahan and Edward B. Rock, “Hedge Funds in Corporate Governance and Corporate Control,” University of Pennsylvania Institute for Law and Economics Research Paper No. 06–16 (2006), available at; Randall S. Thomas and Frank Partnoy, “Gap Filling, Hedge Funds, and Financial Innovation” (2006), Vanderbilt Law and Economics Research Paper No. 06–21, San Diego Legal Studies Paper No. 07–72, available at
7See Henry T.C. Hu and Bernard Black, “Empty Voting and Hidden (Morphable) Ownership: Taxonomy, Implications, and Reforms,” 61 Business Lawyer 1011 (2006); Henry T.C. Hu and Bernard Black, “The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership,” 79 Southern California Law Review 811 (2006); see also Kara Scannell, “How Borrowed Shares Swing Company Votes: SEC and Others Fear Hedge-Fund Strategy May Subvert Elections,” Wall Street Journal (January 26, 2007), at A1. For an analogous analysis, see Shaun Martin and Frank Partnoy, “Encumbered Shares,” 2005 University of Illinois Law Review 775.
8See Riva D. Atlas, “Hedge Funds Are Stumbling but Manager Salaries Aren’t,” New York Times (May 25, 2005), at C5.
9For a fascinating treatment of the history of speculation in the U.S. economy more generally, see Lawrence E. Mitchell, The Speculation Economy: How Finance Triumphed over Industry (San Francisco: Berrett-Koehler, 2007).
10This chapter does not address systemic risk or hedge funds’ role in corporate governance.
11The SEC also can monitor hedge fund activity indirectly through its regulation of broker-dealers.
12Examples of typical hedge fund investment strategies include convertible arbitrage; emerging markets; long/short equity; event-driven; fixed income arbitrage; statistical arbitrage; and global macro. Hedge funds characteristically use leverage, short selling, and derivatives in attempting to exploit market inefficiencies in search of so-called alpha (i.e., risk-adjusted above-market returns). Hedge funds typically seek absolute returns (i.e., positive returns in both up and down markets) instead of simply trying to outperform some market index.
13For an overview of these statutes, see Louis Loss, Joel Seligman, and Troy Paredes, Securities Regulation, 4th ed. (New York: Aspen, 2006), at 326–425. For accounts of hedge fund regulation outside the United States, see International Organization of Securities Commissions, The Regulatory Environment for Hedge Funds: A Survey and Comparison (2006), available at Kara Scannell et al., “No Consensus on Regulating Hedge Funds: Officials Around Globe Aim to Protect Markets but Differ on Methods,” Wall Street Journal (January 5, 2007), at C1.
14Registration Under the Advisers Act of Certain Hedge Fund Advisers, Inv. Adv. Act Rel. 2333 (2004). More information concerning the SEC’s interest in hedge funds is available on the SEC’s Web site at For a more recent assessment of the hedge fund industry by the SEC Chairman, see Christopher Cox, Chairman, U.S. Securities and Exchange Commission, Testimony Concerning the Regulation of Hedge Funds Before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, July 25, 2006, available at Another recent overview of hedge fund issues was provided by the SEC staff. See Susan Ferris Wyderko, Director, Office of Investor Education and Assistance, U.S. Securities and Exchange Commission, Testimony Concerning Hedge Funds Before the Subcommittee on Securities and Investment of the U.S. Senate Committee on Banking, Housing, and Urban Affairs, May 16, 2006, available at
15The rule included an important exception. A hedge fund manager did not have to register under the Investment Advisers Act if the hedge fund contained a “lock-up” of at least two years during which the fund’s investors could not withdraw their capital. The stated purpose of this provision was to distinguish between hedge funds, on the one hand, and private equity and venture capital funds, on the other. Private equity and venture capital funds typically have longer lock-up periods than hedge funds, and the SEC did not intend to subject the managers of private equity and venture capital funds to registration. This provision gave established hedge funds a competitive advantage over upstarts. Less well-known managers of newer or smaller funds would have a more difficult time convincing investors to lock up their capital for two years, as the threat of capital withdrawals is an important means by which investors hold managers accountable. Cf. Daisy Maxey, “At Hedge Funds, Study Exit Guidelines: Amaranth Case Shows Disclosure and Redemption Policies for Investors Can Differ Greatly,” Wall Street Journal (September 23, 2006), at B4. Thus, while managers of more-established funds could realistically attempt to opt out of the SEC’s registration requirement, managers of less-established funds would have to bear the burden of registration.
16Hedge funds still could avoid the demands of the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940. Even before the 2004 rule, hedge fund managers had to comply with antifraud and fiduciary obligations under federal and state law.
17Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). Basically, the court found that the SEC acted arbitrarily and outside its authority in redefining “client” to mean a fund’s investors instead of the fund itself. See Loss, Seligman, and Paredes, supra note 13, at 406–07.
18See SEC Press Release 2006–135 (August 7, 2006).
19Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles; Accredited Investors in Certain Private Investment Vehicles, Sec. Act Rel. 8766 (2006) [hereinafter Accredited Natural Person Proposal]. The SEC has adopted the new antifraud provision it proposed under the Investment Advisers Act, but as of this writing has not yet adopted the aspects of the proposal that relate to accredited investors. See Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles, Inv. Adv. Act Rel. 2628 (2007).After the 2004 hedge fund rule was vacated, many hedge fund managers withdrew from registration with the SEC. See, e.g., Siobhan Hughes, “More Hedge Funds Leave the Ranks of SEC’s Registry,” Wall Street Journal (December 15, 2006), at C4.
20See Loss, Seligman, and Paredes, supra note 13, at 580–801.
21See Loss, Seligman, and Paredes, supra note 13, at chapter 3.C.7 (4th ed., forthcoming 2008).
22In August 2007, the SEC proposed revising the Regulation D definition of accredited investor by, among other things, (1) adding an “investments-owned” standard allowing individuals with investments exceeding a certain level to qualify as accredited, even if they do not meet the present income or wealth thresholds, and (2) requiring future inflation adjustments to the accredited investor financial thresholds for individuals, including individuals investing in hedge funds. See Revisions of Limited Offering Exemptions in Regulation D, Sec. Act Rel. 8828 (2007) [hereinafter Regulation D Proposal]. As of this writing, the SEC has not yet taken final action in the rulemaking.
23For more on the role of such financial thresholds in limiting the reach of the federal securities laws and SEC oversight of securities offerings, see infra the second section of this chapter, “Government Regulation versus Market Discipline.”
24Hedge funds also often have minimum investment requirements that preclude many accredited individual investors from investing. The claim that hedge fund investors need more regulation to protect them is weak given their accredited status. Indeed, more government regulation may lead to moral hazard, in effect undercutting market discipline. This argument was leveled against the SEC’s 2004 rule requiring hedge fund manager registration under the federal Investment Advisers Act. See Troy A. Paredes, “On the Decision to Regulate Hedge Funds: The SEC’s Regulatory Philosophy, Style, and Mission,” 2006 University of Illinois Law Review 975, 990–98 (criticizing the SEC’s 2004 rule as unnecessary because hedge fund investors can protect themselves adequately). But see id. at 999–1001 (recognizing the argument that hedge fund regulation might be warranted to ensure against a loss of investor confidence—a sort of systemic concern that might justify more government oversight, even if hedge fund investors do not need greater protection).If a hedge fund did offer its securities to the public, the fund would be subject to more demanding regulation under the federal securities laws. For examples of public offerings by hedge (and private equity) funds or their investment managers, see Alistair MacDonald, “Hedge Funds to Tap the Public: Two More Firms Plan Listing on Exchange,” Wall Street Journal (January 10, 2007), at C2; Gregory Zuckerman et al., “Hedge-Fund Crowd Sees More Green as Fortress Hits Jackpot with IPO,” Wall Street Journal (February 10, 2007), at A1; Eleanor Laise, “Hedge Funds Beckon Small Investors,” Wall Street Journal (February 14, 2007), at D1. For a private offering with a structure somewhere between a conventional private offering and a public offering, see Henny Sender, “Live at Apollo Management: Plan to Cash In, Limit Scrutiny,” Wall Street Journal (July 17, 2007), at C1.
25The SEC estimates that the accredited investor financial thresholds, if adjusted for inflation, would have increased to approximately US$1.9 million (net worth), US$388,000 (individual income) and US$582,000 (joint income) as of 2006; that when Regulation D was adopted in 1982, approximately 1.87 percent of U.S. households met the accredited investor definition; and that the percentage of households meeting the definition had increased to nearly 8.5 percent by 2003. The SEC estimates that roughly 1.3 percent of households would meet the accredited natural person standard. See Accredited Natural Person Proposal, supra note 19, at 23–24.
26See id. at 14–32. The SEC’s 2004 hedge fund rule would have impacted the accredited investor concept indirectly. As a registered investment adviser, a hedge fund manager would have been subject to certain rules under the federal Investment Advisers Act that generally prohibit an investment adviser from charging a performance fee (for example, the 20 percent or so “carry” or profits interest that hedge fund managers typically charge) from any investor who is not a “qualified client” (i.e., an investor whose net worth does not exceed US$1.5 million or who does not have assets worth at least US$750,000 under management with the fund’s adviser). Under relevant rules, a registered adviser has to look through the fund to determine whether its investors are qualified clients who can be charged a performance fee. Thus many accredited investors who would not qualify as qualified clients, even though they are accredited, would have been kept from investing in hedge funds as hedge fund managers took steps to ensure they did not forego their performance fee.An interesting issue beyond this chapter’s scope concerns whether the carry should be treated as capital gains or ordinary income for tax purposes. See generally Victor Fleischer, “Two and Twenty: Taxing Partnership Profits in Private Equity Funds,” New York University Law Review (forthcoming 2008).
27The proposed accredited natural person standard would also apply to securities offerings of private equity funds, but not venture capital funds.
28This investment threshold would exclude the value of an individual’s personal residence or place of business or other real estate that is not held for investment purposes.
29For an interesting proposal for regulating investors instead of issuers, see Stephen Choi, “Regulating Investors Not Issuers: A Market-Based Proposal,” 88 California Law Review 279 (2000).
30In the SEC’s view, the accredited natural person standard better limits hedge fund investing to individuals who are sophisticated; able to bear the economic risk of the investment; and able to negotiate adequately for information from the fund or at least price the risk of having imperfect information. See also infra the second section of this chapter, “Government Regulation versus Market Discipline.”
31The SEC has proposed yet another category of accredited investor under Regulation D for all private offerings, not just those involving hedge funds. The SEC’s proposal would allow limited advertising of private offerings to investors who qualify as “large accredited investors.” See Regulation D Proposal, supra note 22. This rule release also solicited additional comment on the SEC’s proposed definition of accredited natural person for hedge funds.
32Instead of proposing an additional investment requirement, the SEC could have proposed increasing the income or wealth thresholds for hedge fund investing while leaving these thresholds fixed for other private offerings under Regulation D.
33See Regulation D Proposal, supra note 22, at 17. The SEC’s accredited natural person proposal reflects an important subtlety. The Securities Act of 1933 provides investors with information so they can assess their investment choices. The SEC does not pass on the merits of particular issuers or their offerings. Armed with information, investors may make smart decisions or they may make dumb decisions, but they make their own decisions. By way of contrast, in proposing the accredited natural person definition, the SEC explicitly references the substantive merits of investing in hedge funds, at least insofar as the SEC refers to their “complicated investment strategies” and “unique risks.”The private offering exemption typically emphasizes the characteristics of the individual investors—that is, their sophistication and wealth—without regard to the nature or merits of the investment. For example, there was no heightened investor qualification standard for investing in Internet startups that privately placed their securities in the 1990s during the technology boom. Indeed, there likely would have been a backlash if the SEC had tried to impose a differentiated standard for the private offering exemption based on a belief that investing in “dot-coms” was too risky. However, this is precisely what the SEC has proposed when it comes to hedge funds. See, e.g., Regulation D Proposal, supra note 22, at 48 (“We believe that the different amounts applicable under the definitions [of accredited investor and accredited natural person] are targeted to address concerns about the nature of different types of offerings.”). When crafting the accredited natural person definition, the SEC passed judgment on the merits of investing in hedge funds, deciding that hedge fund investing is riskier than other investments and thus requires more demanding financial hurdles before individuals can invest without the protections of the Securities Act. Yet the SEC is not qualified to judge the nature or riskiness of different investments, be they investments in hedge funds, private equity funds, venture capital funds, public operating companies, or private operating companies. (This is not to say that the SEC never does so. Consider, for example, the heightened regulation of so-called penny stocks. See, e.g., Louis Loss and Joel Seligman, The Fundamentals of Securities Regulation, 5th ed. (New York: Aspen, 2005), at 1093–96. More to the point, even if the SEC were qualified to make such judgments, it is not clear that hedge fund investing is in fact always more complex or risky than these alternatives, including holding publicly traded stock. This calls into question the legitimacy of a special accredited investor standard for private pools of capital.
34In soliciting additional comment on its proposal, the SEC explained: “We received numerous comments disagreeing with the proposed definition of accredited natural person. Most of those submitting comments argued that the proposal limits investor access to private pooled investment vehicles and questioned the dollar amount of the investments standard.” Regulation D Proposal, supra note 22, at 49. See also Kara Scannell, “On the Outside of Hedge Funds Looking In,” Wall Street Journal (September 1, 2007), at B1 (reporting on comments on the SEC’s accredited natural person proposal).
35Since the federal securities laws were adopted in the 1930s, there has been concern that individuals do not actually read the information they are provided and, if they do, do not understand it. William O. Douglas, who later became chairman of the SEC before becoming a U.S. Supreme Court Justice, was among the first to raise this worry:

But those needing investment guidance will receive small comfort from the balance sheets, contracts, or compilation of other data revealed in the registration statement. They either lack the training or intelligence to assimilate them and find them useful, or are so concerned with a speculative profit as to consider them irrelevant.

William O. Douglas, “Protecting the Investor,” 23 Yale Review 521 (1934), at 523–24. For more contemporary analyses of the understandability of disclosures, see, for example, Troy A. Paredes, “Blinded by the Light: Information Overload and Its Consequences for Securities Regulation,” 81 Washington University Law Quarterly 417 (2003) (focusing on the amount of information); Steven L. Schwarcz, “Rethinking the Disclosure Paradigm in a World of Complexity,” 2004 University of Illinois Law Review 1 (focusing on the complexity of information). In short, individual investors routinely do not make informed decisions even when there is wide-scale disclosure, as mandated by the federal securities laws for registered offerings. As a practical matter, however, any concern is largely mitigated because securities markets are sufficiently efficient, along the lines of the well-known efficient capital markets hypothesis. In this view, securities professionals in effect protect unsophisticated retail investors because the buying and selling of informed professional traders ultimately incorporates available public information into securities prices. As then-Professor Frank Easterbrook and Professor Daniel Fischel put it: “The uninformed traders can take a free ride on the information impounded by the market: they get the same price received by the professional traders without having to do any of the work of learning the information.” Frank H. Easterbrook and Daniel R. Fischel, “Mandatory Disclosure and the Protection of Investors,” 70 Virginia Law Review 669 (1984). Index investing validates this point.This raises an interesting rationale for relaxing restrictions governing who invests in hedge funds. It is presumed that investors qualifying as accredited, even under the conventional definition, can protect their own interests. See infra the second section of this chapter, “Government Regulation versus Market Discipline.” Perhaps retail investors, then, should be allowed to “piggyback” on the work and diligence of accredited investors when it comes to hedge funds just as they effectively piggyback on the analysis and trading of securities professionals when it comes to publicly traded securities. With respect to a particular fund, retail investors could “free ride” on the market discipline that accredited investors presently bring to bear when they invest. If market discipline adequately protects accredited investors, why does it not adequately protect retail investors investing along side of them? This argument may have growing force as hedge fund investors are increasingly comprised of institutional investors. Cf. Houman B. Shadab, “The Challenge of Hedge Fund Regulation,” Regulation (Spring 2007), at 41 (summarizing improving transparency of hedge funds). That said, it is worth noting that minimum investment requirements keep smaller investors out of many (perhaps the most attractive) funds, limiting the opportunity to piggyback.
36For data on private offerings, see Securities Industry Association, 2006 Securities Industry Fact Book, at 10–13 [hereinafter 2006 Securities Industry Fact Book].
37See also Brian G. Cartwright, General Counsel, U.S. Securities and Exchange Commission, “The Future of Securities Regulation,” Remarks Before the University of Pennsylvania Institute for Law and Economics, October 24, 2007, available at (discussing what Cartwright referred to as “deretailization”).This is not to say that retail investors necessarily believe that public offerings take place on a level playing field. For example, it became clear during the wave of corporate scandal in the early 2000s that wealthy individuals and institutional investors have preferred access to allocations of initial public offerings; and even after the SEC adopted Regulation FD in 2001 to address so-called selective disclosure, professional traders and analysts still have access to better information than retail investors.
38If desired, one way to expand individual investor access to hedge funds is obvious: do not raise the accredited investor financial thresholds under Regulation D and perhaps even lower them. Indeed, the financial thresholds for individuals to qualify as accredited could be lowered not just for hedge funds but for all private placements exempt from SEC registration requirements.Alternatively, the SEC could consider a blended approach. For example, the SEC could consider limiting the amount a person can invest in a hedge fund depending on the person’s wealth, income, or sophistication. A different approach would be to set different financial thresholds for accredited investor status depending on whether the manager of the fund has registered with the SEC under the Investment Advisers Act. The logic here is that less-wealthy individuals who are deemed unable to fend for themselves under the 1933 Securities Act should have greater access to hedge funds when the government steps up to protect them, as through investment adviser registration. In effect, hedge fund manager registration under the Investment Advisers Act would compensate for the fact that the hedge fund is not registering its own securities offering under the Securities Act. A manager of a fund that prefers to tap into smaller individual investors could simply register as an investment adviser. A third option is to loosen the restrictions on mutual funds so they can more freely adopt investment strategies that resemble those of hedge funds. This would give individual investors more exposure to hedge fund-like strategies through mutual funds, which are governed by the Investment Company Act. Presently, the ability of mutual funds to sell short, acquire securities on margin, and enter derivatives contracts, as hedge funds do, is limited. The director of the SEC’s Division of Investment Management recently spoke to this in a speech to industry insiders:

[W]ith the proper safeguards, I believe the potential benefits from hedge fund-type strategies should not be limited to only wealthy investors. To the extent that there are limitations under the Investment Company Act, the Division staff will work with you through the exemptive application and no-action processes to develop products that not only provide investors greater access to beneficial investment strategies, but also provide them the protections that are necessary. For example, with regard to long/short funds, the staff came out with a no-action position stating that a registered [mutual] fund may take short positions, provided that it has placed liquid securities that could be used to close out its short position in a segregated account with its custodian.

Andrew J. Donohue, Director, Division of Investment Management, U.S. Securities and Exchange Commission, Remarks Before the 4th Annual Hedge Funds and Alternative Investments Conference, May 23, 2007, available at For examples of mutual funds that have adopted hedge fund-like investment strategies, see Eleanor Laise, “Mutual Funds Adopt Hedge-Fund Tactics,” Wall Street Journal (February 21, 2006), at D1; Eleanor Laise, “Mutual Funds Add Exotic Fare to the Mix,” Wall Street Journal (April 4, 2007), at D1. For an analysis of other investments open to retail investors that may be viewed as alternatives to hedge funds, see Steven M. Davidoff, Black Market Capital, Wayne State University Law School Research Paper No. 07–26 (2007), available at; Eleanor Laise, “The Hedge-Fund ‘Clones’: Wall Street Concocts Products with Fewer Barriers, but Will Returns Match?” Wall Street Journal (July 21, 2007), at B1. For a proposed retail fund of hedge funds structure, see Houman B. Shadab, “Fending for Themselves: Regulatory Reform to Create a U.S. Hedge Fund Market for Retail Investors” (2007), available at
39If the SEC were to lower the standards for investing in private offerings so they were more accessible to retail investors, political pressure would surely mount for more regulation when (not if) individuals lose billions of dollars in the collapse of a hedge fund or the bankruptcy of a large private operating company. This is troubling because more regulation would likely interfere with capital formation, a side of the SEC’s mission that often gets overlooked as investor protection gets stressed.
40In discussing whether to allow certain foreign broker-dealers to do business in the United States while satisfying only streamlined U.S. brokerdealer registration requirements, one senior SEC official suggested that such foreign broker-dealers could be limited to doing business with market professionals or large sophisticated investors. See Erik R. Sirri, Director, Division of Market Regulation, U.S. Securities and Exchange Commission, Remarks Before the FIA and OIC New York Equity Options Conference, September 20, 2007, available at
41Whether hedge fund regulation is warranted to serve some other goal is beyond this chapter’s scope.
42For more on behavioral finance, see generally Robert J. Shiller, Irrational Exuberance (Princeton: Princeton University Press, 2000); Andrei Shleifer, Inefficient Markets: An Introduction to Behavioral Finance (Oxford: Oxford University Press, 2000); Lynn A. Stout, “The Mechanisms of Market Inefficiency: An Introduction to the New Finance,” 28 Journal of Corporation Law 635 (2003).
43An integral benefit of such clear-cut proxies is that they create a more certain and predictable regulatory environment in which issuers and investors can operate. The shortcoming is that proxies are always imperfect measures.
44See, e.g., SEC v. Ralston Purina Co., 346 U.S. 119 (1953) (finding that a private offering exempt from the registration requirements of the Securities Act exists when the investors are able to “fend for themselves”). It also is worth stressing that this demarcation is thought to further the goal of capital formation by reducing the regulatory burden in those instances where market discipline adequately holds issuers and their managers accountable.An important distinction is needed. The above discussion is from the particular perspective of whether hedge fund investors can adequately protect their own interests. That is, it focuses on the relationship between hedge funds and their investors. Hedge funds have been criticized in recent years for activities that, although benefiting the hedge fund’s investors, may harm investors in other enterprises and other market participants. Even if greater SEC oversight to protect hedge fund investors is not warranted, hedge funds should not get a free pass from law compliance. Hedge funds are, and should be, subject to federal and state law regulating activities such as market timing, late trading, vote buying, insider trading, and market manipulation. This chapter takes no position on whether laws, regulations, and judicial doctrines governing such behavior should be revised in light of the hedge fund industry’s recent growth.One area receiving heightened attention concerns PIPEs (private investments in public equities). In a typical PIPE transaction, a public company (i.e., the issuer) sells equity securities in a private placement that is not subject to the registration requirements of the federal Securities Act. The issuer later files a resale registration statement under the Securities Act, allowing the initial investors, who acquired their securities in the private placement, to resell the securities to the public. The SEC has brought a number of enforcement actions alleging that hedge funds, as initial investors, have engaged in insider trading in the issuer’s publicly traded securities and have violated the Securities Act registration requirements by selling short the privately placed securities expecting to “cover” the short sale with the newly registered securities once the subsequent registration statement goes effective. See, e.g., Kara Scannell, “SEC Pushes for Hedge-Fund Disclosure: Advisers’ Kinship to Firms’ Workers, Investors Is Studied,” Wall Street Journal (September 19, 2007), at C2.
45Cf. International Organization of Securities Commissions, Principles for the Valuation of Hedge Fund Portfolios (2007) (offering best practices for hedge fund valuation).By way of analogy, the Delaware courts follow a best-practices approach for state corporate law, especially when it comes to the fiduciary duties that delineate the obligations of directors and officers. Delaware judges, through their opinions, speeches, and articles, articulate their vision of good corporate governance but do not hold corporate actors legally liable when they fail to adhere to these practices. See, e.g., Edward B. Rock, “Saints and Sinners: How Does Delaware Corporate Law Work?” 44 UCLA Law Review 1009 (1997); see generally Troy A. Paredes, “A Systems Approach to Corporate Governance Reform: Why Importing U.S. Corporate Law Isn’t the Answer,” 45 William and Mary Law Review 1055, 1087–96 (2004). The following from then-Delaware Supreme Court Chief Justice E. Norman Veasey illustrates the Delaware judiciary’s approach:

All good corporate governance practices include compliance with statutory law and case law establishing fiduciary duties. But the law of corporate fiduciary duties and remedies for violation of those duties are distinct from the aspirational goals of ideal corporate governance practices. Aspirational ideals of good corporate governance practices for boards of directors that go beyond the minimal legal requirements of the corporation law are highly desirable, often tend to benefit stockholders, sometimes reduce litigation and can usually help directors avoid liability. But they are not required by the corporation law and do not define standards of liability.

Brehm v. Eisner, 746 A.2d 244, 256 (Del. 2000) (citation omitted).
46The SEC’s 2003 proposal to grant shareholders greater access to the corporate ballot for nominating directors has served as an SEC-endorsed best practice, although it was proposed as a mandate. See Security Holder Director Nominations, Sec. Ex. Act Rel. 48,626 (2003). The SEC’s proposal faced stiff opposition, particularly from the business community, and was not adopted. However, the SEC’s proposal brought greater attention to the issue of director nominations, and there has been a notable market reaction as more and more companies have adopted some version of so-called majority voting. See generally William K. Sjostrom, Jr., and Young Sang Kim, Majority Voting for the Election of Directors (2007), available at
47The private sector has already fashioned best practices for the hedge fund industry. See, e.g., Managed Funds Association, 2005 Sound Practices for Hedge Fund Managers, available at; Toward Greater Financial Stability, supra note 1.The Hedge Fund Working Group, which is based in London, has offered best practices for the European hedge fund industry. See Alistair MacDonald and Deborah Solomon, “Hedge Funds from Europe Take a Crack at Self-Policing,” Wall Street Journal (October 11, 2007), at C1.
48Cf. Eric A. Posner, “Law and Social Norms: The Case of Tax Compliance,” 86 Virginia Law Review 1781 (2000) (developing a signaling theory of law compliance).
49A best-practices approach to regulation does present some challenges. A fundamental challenge is deciding what the best practices are. The five SEC commissioners may not reach agreement on hedge funds or any other topic. A best-practices strategy would depend on effective coordination at the SEC.In addition, there is a real risk that a hedge fund’s failure to follow SEC-endorsed best practices would provide a roadmap for private litigation, and courts might slowly start to incorporate best practices into legal requirements. For example, one could imagine courts coming to view a hedge fund’s failure to follow disclosure or valuation best practices as evidence of fraud.
50A copy of the Agreement Among PWG and U.S. Agency Principals on Principles and Guidelines Regarding Private Pools of Capital is available on the Treasury Department’s Web site at
51See, e.g., Carrie Johnson, “U.S. Aims to Limit Funds’ Risk,” Washington Post (September 26, 2007), at D03; Deborah Solomon, “The Obedience Rules for Hedge Funds,” Wall Street Journal (September 26, 2007), at C3.
52This interesting public/private approach is not new for hedge funds. In 1998 the private sector bailed out LTCM under pressure from the Federal Reserve. It will be worth watching to see just how involved the PWG is in shaping the committees’ recommendations.
53Even when “do nothing” is the best course, it might not be a realistic option for political or other reasons.
54It is worth noting that defaults often are “sticky,” in which case defaults act more like mandates. See, e.g., Omri Ben-Shahar and John Pottow, “On the Stickiness of Default Rules,” 33 Florida State University Law Review 651 (2006); Russell Korobkin, “Inertia and Preference in Contract Negotiation: The Psychological Power of Default Rules and Form Terms,” 51 Vanderbilt Law Review 1583 (1998); Russell Korobkin, “The Status Quo Bias and Contract Default Rules,” 83 Cornell Law Review 608 (1998); Kathryn E. Spier, “Incomplete Contracts and Signalling,” 23 RAND Journal of Economics 432 (1992). One account of stickiness can be traced back to Ronald Coase, who most famously illustrated that the initial legal allocation of entitlements—such as the “right” to have your hedge fund manager register as an investment adviser under the Investment Advisers Act—may be sticky because of transaction costs. See Ronald H. Coase, “The Problem of Social Cost,” 3 Journal of Law and Economics 1 (1960).
55Even when investment adviser registration is an “opt-in” instead of an “opt-out” default, many managers choose to opt in by voluntarily registering under the Investment Advisers Act.The SEC’s investment adviser registration rule did include a sort of opt-out default. If a hedge fund required its investors to commit their capital to the fund for at least two years—the two-year lock-up provision—the fund’s manager did not have to register under the Investment Advisers Act. Indeed, many funds began to institute two-year lock-ups. See, e.g., Gregory Zuckerman and Ian McDonald, “Hedge Funds Avoid SEC Registration Rule,” Wall Street Journal (November 10, 2005), at C1; Eleanor Laise, “Dissecting Hedge-Fund Secrets,” Wall Street Journal (February 4, 2006), at B5. The rule, though, did not allow a hedge fund manager whose fund did not have a two-year lock-up to choose not to register. A true default would have allowed any manager to opt out, subject to the discipline of the market if it did so.
56Sarbanes-Oxley Act § 406. Such a comply-or-explain approach, which essentially is a default, is popular in the United Kingdom.
57Id. § 407.
58Investment Company Act Rule 22c–2(a)(1).
59Shareholder Proposals, Sec. Ex. Act Rel. 56,160, at 50–58 (2007).
60Investment Company Governance, Inv. Co. Act Rel. 26,520 (2004). A particularly provocative suggestion for a default has come from the private sector Committee on Capital Markets Regulation, which had the support of U.S. Treasury Secretary Henry Paulson. In its November 2006 report the Committee recommended allowing shareholders to opt out of private securities class actions in favor of alternative dispute resolution, such as arbitration with or without class actions. See Interim Report of the Committee on Capital Markets Regulation, at 109–14 (November 2006), available at [hereinafter Committee on Capital Markets Reg’n Report].
61For other interesting work studying the SEC as an institution and decision-making body, see, for example, Anne M. Khademian, The SEC and Capital Market Regulation: The Politics of Expertise (Pittsburgh: University of Pittsburgh Press, 1992); Susan M. Phillips and J. Richard Zecher, The SEC and the Public Interest (Cambridge, MA: MIT Press, 1981); Stephen J. Choi and A.C. Pritchard, “Behavioral Economics and the SEC,” 56 Stanford Law Review 1 (2003); Donald C. Langevoort, The SEC as a Lawmaker: Choices About Investor Protection in the Face of Uncertainty (2006), Georgetown Law and Economics Research Paper No. 947510, available at; Jonathan R. Macey, “Administrative Agency Obsolescence and Interest Group Formation: A Case Study of the SEC at Sixty,” 15 Cardozo Law Review 909 (1994); A.C. Pritchard, “The SEC at 70: Time for Retirement?” 80 Notre Dame Law Review 1073 (2005). For a complete history of the SEC, see Joel Seligman, The Transformation of Wall Street: A History of the Securities and Exchange Commission and Modern Corporate Finance, 3rd ed. (New York: Aspen, 2003).
622006 Securities Industry Fact Book, supra note 36, at 64.
63Id. at 65–67. For more historical data, see Loss, Seligman, and Paredes, supra note 13, at 18–29. One might argue that as more people have more of their wealth tied to securities, a swifter and more aggressive regulatory response to perceived concerns with securities markets is warranted. This argument dovetails with the precautionary principle of regulation described below.
64The assumption is that the public will have different risk perceptions than the experts at regulatory agencies. Individual investors, for example, likely are particularly attuned to investor losses as compared to the cost of greater investor protection. See generally Paul Slovic, The Perception of Risk (London: Earthscan Publications, 2000); Cass R. Sunstein, “The Laws of Fear,” 115 Harvard Law Review 1119 (2002).
65Two recent illustrations have received a great deal of media attention. First, the SEC was criticized for not being “pro-investor” when it read the Private Securities Litigation Reform Act of 1995 as creating a more demanding pleading requirement than some had urged in securities fraud class actions. See Brief for the United States as Amicus Curiae Supporting Petitioners, Tellabs, Inc. v. Makor Issues and Rights, Ltd., No. 06–484 (Feb. 9, 2007). In defense of the SEC, the agency was interpreting a statute that, by its terms, requires plaintiffs to plead a “strong inference” of scienter in securities fraud cases in order to root out vexatious litigation. Second, a number of quarters publicly pressured the SEC to file an amicus brief favoring so-called scheme liability in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. Scheme liability would open to liability an issuer’s outside adviser or counterparty involved in a transaction when the issuer misreports the transaction, even though the adviser or counterparty does not itself make any material misstatement or omission. Scheme liability would substantially expand the reach of Rule 10b-5 under the Securities Exchange Act of 1934, the primary federal antifraud provision, and arguably unwind the Supreme Court’s earlier decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. that there is no private right of action for aiding and abetting securities fraud. Again, the claim was that the SEC should be “pro-investor” and side with the investor-plaintiffs. The SEC ultimately voted 3–2 to file a brief supporting the investor-plaintiffs, but the Solicitor General did not file the requested brief and ultimately filed a brief in favor of the defendants. Notably, the chairmen of the House Judiciary Committee and the Financial Services Committee filed their own brief in favor of scheme liability.
66The November 2006 report of the Committee on Capital Markets Regulation addresses the concern that U.S. capital markets are losing their competitive edge, in part because of a more burdensome legal environment in the aftermath of the Sarbanes-Oxley Act of 2002 and more aggressive government enforcement. See Committee on Capital Markets Reg’n Report, supra note 60. Shortly after the Committee on Capital Markets Regulation issued its report, New York City Mayor Michael Bloomberg and U.S. Senator Charles Schumer (New York) issued a similar report, prepared by McKinsey and Company, on the need to sustain the financial leadership of New York and the United States. See, e.g., Aaron Lucchetti, “Moving the Market: Identity Crisis for New York?” Wall Street Journal (January 22, 2007), at C3. The report responds to concerns that U.S. financial firms are being adversely impacted as U.S. capital markets become relatively less attractive as compared to foreign markets because of, among other factors, a more demanding U.S. regulatory and enforcement environment in the aftermath of Enron’s collapse and the enactment of Sarbanes-Oxley. To the extent that U.S. capital markets lose some of their competitive edge, it uniquely impacts New York as the center of the U.S. financial system. The U.S. Chamber of Commerce was next to weigh in, issuing a report in early 2007 on U.S. competitiveness in global financial markets. See, e.g., Kara Scannell, “Panel Urges Steps to Boost Allure of U.S. Markets,” Wall Street Journal (March 12, 2007), at A1.
67See, e.g., Macey, supra note 61.
68The New York Times recently reported on criticism of hedge funds coming from certain Republican presidential candidates. See “In Debate, Hedge Funds Take Some Hits,” New York Times, DealBook (Andrew Ross Sorkin, ed.) (October 10, 2007), available at
69Indeed, investment adviser registration for hedge fund managers may have been a less intrusive government response than alternatives that could have come from Congress had the SEC not taken any steps to regulate the industry.
70For a classic treatment of the role of independent administrative agencies with subject matter expertise, see James M. Landis, The Administrative Process (New Haven: Yale University Press, 1938); see also Seligman, supra note 61, at 60–62 (discussing Landis’s views in the context of securities regulation and the SEC).
71Further, securities regulators may learn from the public’s views and thus should not disregard populist pressure out of hand. See, e.g., Slovic, supra note 64. Neither, for that matter, should securities regulators disregard the views of corporate America and Wall Street.
72That said, regulating in the name of investor confidence, instead of zeroing in on the more concrete substantive merits of a proposal, can lead to loose regulatory analysis that can have longstanding adverse consequences for securities markets. See Choi and Pritchard, supra note 61, at 33 (“The SEC often uncritically states that it seeks to protect investors—and in particular, that absent the SEC’s efforts, investor confidence in the market will deteriorate. Rarely, however, does the SEC verify that its assumptions are correct. The SEC instead simply asserts that investor confidence demands its latest regulatory intervention.”). During her tenure at the SEC, Commissioner Cynthia Glassman stressed the need for more rigorous economic analysis at the agency. See, e.g., Cynthia A. Glassman, Commissioner, U.S. Securities and Exchange Commission, “Observations of an Economist Commissioner on Leaving the SEC,” Remarks Before the National Economists Club, July 6, 2006, available at
73For public-choice analyses of securities regulation, see, for example, Phillips and Zecher, supra note 61; Donald C. Langevoort, “The SEC as a Bureaucracy: Public Choice, Institutional Rhetoric, and the Process of Policy Formation,” 47 Washington and Lee Law Review 527 (1990); Macey, supra note 61. Cf. Brody Mullins and Kara Scannell, “Hedge Funds Coming of Age Politically,” Wall Street Journal (April 19, 2007), at A6 (discussing increasing political activity of the hedge fund industry).By way of illustrating the role of special interests in securities regulation, the accounting industry successfully lobbied in the late 1990s and 2000 to blunt SEC efforts to fashion more demanding independence requirements for outside auditors; and in the early to mid-1990s, business interests successfully lobbied to prevent the Financial Accounting Standards Board from requiring the expensing of stock options, a particular concern of high-tech companies. See Seligman, supra note 61, at 714–41.It is worth noting the possibility that at least some hedge funds may have welcomed the SEC’s foray into hedge fund regulation. First, established funds may have welcomed hedge fund manager registration because it seemed to erect an entry barrier that disadvantaged smaller, less-established competitors. See supra note 15.Second, SEC regulation today may have fended off an even more aggressive future crackdown by the SEC, let alone Congress, if hedge fund manager registration averted some lurking hedge fund meltdown. As it stands, given the present reliance on market discipline, one can reasonably anticipate a heavy-handed regulatory or legislative response if there is a major hedge fund collapse with widespread consequences. Consider, for example, the attention focused on the regulation of credit rating agencies in the aftermath of the credit crunch in the subprime market in 2007. See, e.g., John C. Coffee, Jr., “The Mortgage Meltdown and Gatekeeper Failure,” New York Law Journal (September 20, 2007), at 5; see also Erik R. Sirri, Testimony Concerning Recent Events in the Credit and Mortgage Markets and Possible Implications for U.S. Consumers and the Global Economy, Before the Financial Services Committee, U.S. House of Representatives, September 5, 2007, available at, greater SEC oversight may have lent legitimacy to the industry and assuaged the “fear factor”—that is, the free-floating anxiety of some investors and lawmakers that hedge funds simply are too secretive and shadowy, particularly given their impact on financial markets, to be lightly regulated.
74Cf. John C. Coates IV, “Private vs. Political Choice of Securities Regulation: A Political Cost/Benefit Analysis,” 41 Virginia Journal of International Law 531, 572–73 (2001) (explaining the “suspicion of secret power”). I appreciate Professor Donald Langevoort’s highlighting this point to me.
75See Regulation D Proposal, supra note 22.
76See generally Choi and Pritchard, supra note 61.
77Regarding the precautionary principle of risk regulation, see generally Cass R. Sunstein, Laws of Fear: Beyond the Precautionary Principle (Cambridge: Cambridge University Press, 2005) [hereinafter Sunstein, Laws of Fear]; Frank B. Cross, “Paradoxical Perils of the Precautionary Principle,” 53 Washington and Lee Law Review 851 (1996); David A. Dana, “A Behavioral Economic Defense of the Precautionary Principle,” 97 Northwestern University Law Review 1315 (2003); Cass R. Sunstein, “Beyond the Precautionary Principle,” 151 University of Pennsylvania Law Review 1003 (2003) [hereinafter Sunstein, “Beyond the Precautionary Principle”]; Cass R. Sunstein, “Precautions Against What? The Availability Heuristic and Cross-Cultural Risk Perception,” 57 Alabama Law Review 75 (2005).
78See, e.g., Sunstein, “Beyond the Precautionary Principle,” supra note 77, at 1020–29.
79See generally Daniel Kahneman and Shane Frederick, “Representativeness Revisited: Attribute Substitution in Intuitive Judgment,” in Thomas Gilovich et al. eds., Heuristics and Biases: The Psychology of Intuitive Judgment (Cambridge: Cambridge University Press, 2002), at 49, 60–73; Amos Tversky and Daniel Kahneman, “Availability: A Heuristic for Judging Frequency and Probability,” in Daniel Kahneman et al. eds., Judgment Under Uncertainty: Heuristics and Biases (Cambridge: Cambridge University Press, 1982), at 163, 175–78. For more particularized treatment of these biases in the context of the precautionary principle, see, for example, Dana, supra note 77, at 1321–36; Sunstein, “Beyond the Precautionary Principle,” supra note 77, at 1035–54. For a critical analysis that questions these biases, see Charles Yablon, “The Meaning of Probability Judgments: An Essay on the Use and Misuse of Behavioral Economics,” 2004 University of Illinois Law Review 899.
80During other periods, such as a sustained bull market, other biases, including overconfidence, may be triggered, resulting in too little regulation and government oversight and enforcement that is too lax. Indeed, politics also cut against more regulation during rising markets. There is no investor demand for more regulation when the economy is booming and investment portfolios are growing. Lawmakers, understandably, do not want to be seen as interfering with “good times” when there is no palpable risk to regulate.
81For analyses of these and other proposals, see, for example, Sunstein, Laws of Fear, supra note 77; Michael Abramowicz, “Information Markets, Administrative Decisionmaking, and Predictive Cost-Benefit Analysis,” 71 University of Chicago Law Review 933 (2004); William N. Eskridge and John Ferejohn, “Structuring Lawmaking to Reduce Cognitive Bias: A Critical Review,” 87 Cornell Law Review 616 (2002); Robert W. Hahn and Cass R. Sunstein, “A New Executive Order for Improving Federal Regulation? Deeper and Wider Cost-Benefit Analysis,” 150 University of Pennsylvania Law Review 1489 (2002); Jeffrey J. Rachlinski and Cynthia R. Farina, “Cognitive Psychology and Optimal Government Design,” 87 Cornell Law Review 549 (2002); Mark Seidenfeld, “Cognitive Loafing, Social Conformity, and Judicial Review of Agency Rulemaking,” 87 Cornell Law Review 486 (2002); Cass R. Sunstein, “Cognition and Cost-Benefit Analysis,” 29 Journal of Legal Studies 1059 (2000).Concerning judicial review of SEC decision making, the U.S. Court of Appeals for the D.C. Circuit ruled that the SEC, in adopting new mutual fund board independence requirements, violated the Administrative Procedure Act when it failed adequately to consider the costs of enhanced board independence and the alternative proposed by two dissenting commissioners. Chamber of Commerce of the United States of Am. v. SEC, 412 F.3d 133 (D.C. Cir. 2005); see also Chamber of Commerce of the United States of Am. v. SEC, 443 F.3d 890 (D.C. Cir. 2006). For two cases finding that the SEC had overstepped its authority in adopting new rules concerning, respectively, hedge funds and broker-dealers, see Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006), and Fin. Planning Ass’n v. SEC, 482 F.3d 481 (D.C. Cir. 2007).

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