Dustin G. Hall, The Elephant in the Room: Dangers of Hedge Funds in our Financial Markets

60 Fla. L. Rev. 183 (2008) | | | |

INTRODUCTION :: Hedge funds are our modern titans of industry, and like their predecessors they now represent the best and the worst of the new global economy. These minimally regulated investment entities -in which historically only super-rich investors could have an interest -have recently had profound impacts on financial markets around the world. In early 1992, for example, George Soros, the now-famous hedge fund manager, made it big by using his hedge fund, Soros Fund Management LLC, to leverage a massive bet that the British pound would be ejected from the European Exchange Rate Mechanism. The bet reportedly earned Mr. Soros over a billion dollars and the title of “the man who broke the Bank of England.” A few years later, after another huge currency bet, the Malaysian Prime Minister accused Mr. Soros of bringing down the Malaysian currency.

In the summer of 1998, Long-Term Capital Management (LTCM), an extremely over- leveraged hedge fund, burst onto the public scene after its bets turned sour, nearly causing a catastrophic collapse of the world banking system. LTCM used approximately $ 2.2 billion in investors’ funds to leverage approximately $ 125 billion worth of borrowed money, which LTCM further leveraged into $ 1.25 trillion in open trading positions. The U.S. Treasury Department came to the rescue when these positions turned against LTCM and arranged a buyout of LTCM’s defaulted positions.

In September 2006, Amaranth Advisers, another highly leveraged hedge fund, lost roughly $ 5 billion in value in a week when it lost its bets on the natural-gas market. Further, in the first two months of 2007, Red Kite Management’s hedge fund lost nearly twenty percent of its $ 1 billion metals- trading investments when its bets that copper and zinc futures would rise met sharply declining spot prices.

The above incidents all involved hedge funds engaging in legal activities. However, many recent events have exposed the hedge fund industry as one wrought with illegality. For example, in 2003, a number of hedge funds were implicated in the mutual fund market-timing scandal that rocked Wall Street. Within the last couple of years, the Securities and Exchange Commission (SEC) has investigated instances of insider trading by numerous hedge funds, including one of the nation’s most prominent funds, Pequot Capital Management. And in early March 2007, the SEC brought one of the largest insider-trading actions since the mid-1980s, and the individuals charged included several hedge fund employees.

These examples are just a small sampling of the numerous instances in which hedge funds have had potentially disastrous effects on the market, pushed the limits of legal activities, or become entangled in criminal activities. But most worrisome is unsophisticated investors’ new found access to hedge funds through endowments, pensions, and other charitable entities, funds of hedge funds (FOHFs), and publicly traded shares of hedge fund management companies.

Against this backdrop of illegality, the D.C. Circuit, in Goldstein v. SEC, vacated an SEC rule intended to protect investors from hedge fund abuses. This rule, the “Hedge Fund Rule,” would have allowed the SEC to gather vital information about the secret and elusive world of hedge funds. Unfortunately, the Goldstein court’s unsound and narrow reasoning serves as a prime example of the extent to which the current regulatory regime has ignored the fundamental motivations of our securities laws.

This Note argues that the current judicial and regulatory stances on hedge funds fail to appreciate and account for the tremendous dangers that hedge funds pose not only to the security of our financial markets but also to the individual investors that securities regulations are designed to protect. To appreciate fully these failures, it is necessary to understand better the history of hedge funds and their recent explosion in popularity and in market power. To aid in this understanding, Part II of this Note discusses the four principal acts that regulate the securities markets and how hedge funds exist and function outside those regulations. Part III analyzes the Goldstein decision and explains the administrative law and normative failures of the court’s analysis. In Part IV, this Note discusses the unsatisfactory reactions to Goldstein and offers a few modest proposals to address the dangers that hedge funds pose. Part V concludes.

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