SEC Hedge Fund Registration: Now Just A Seal of Approval?

Today’s supermarket shelves are full of products that enthusiastically display various seals of approval. From the venerable British “Royal Seal of Approval” to the American Dental Association’s “Seal of Acceptance” on toothpaste to the “Flipper Seal of Approval” on cans of tuna (signifying “dolphin friendly” fishing techniques), these seals are important tools used extensively in consumer marketing.  Such endorsements can give shoppers a false sense of safety that economists might define as a moral hazard since it can dissuade shoppers from conducting their own research on a product.  

Note, however, that public health authorities issue no such endorsement for products that, say, don’t kill you.  In order to sell products in most jurisdictions, a certain minimum standard must be met.  In this way, an implicit “seal of approval” (i.e. the law) is offered by the government itself.  By demanding that all products meet their minimum standards of safety, governments place all products on a level playing field and thus avoid endorsing one product over another (they leave that task to Flipper).  But when governments allow both “okayed” and “not okayed” products to directly compete, they effectively enter the endorsement game - leading people to assume someone else has already done their due diligence for them (another moral hazard).       

This article from Money Management Executive (via Financial-Planning.com) says that - contrary to many expectations - hedge fund managers are continuing to register with the SEC even though they don’t have to.  Why?  Because they want the implicit marketing endorsement that comes with registration.  They know that most of the growth in the hedge fund industry over the next few years will be fueled by institutional investors and that these investors need all the assurances they can get that a hedge fund has met some (any) kind of standard.  Reports Money Management Executive:

“‘Some may say, Hey, you know what? What’s the big deal?’ said Thomas R. Westle, an attorney with BlankRome in New York. When no one was registered, it wasn’t an issue, but now institutional investors with a fiduciary responsibility to uphold are getting pickier, he said.

“‘Now you’re out there beating the bushes for new money, and if three funds are registered and two are not, the pension fund might just check off those that are as options,’ Westle said.”

Indeed, during their deliberations over registration, the SEC got an ear full from hedge funds about the moral hazard created by having the SEC provide a de facto “seal of approval”.  According to the (now vacated) rule itself:

“Some commenters urged us not to adopt the rule because Commission oversight of hedge fund advisers might tend to cause hedge fund investors to rely on that oversight instead of performing appropriate due diligence before making an investment in a hedge fund.”

But the SEC wasn’t sold.  They shot back:

“We note, however, that without the new rule requiring registration, a hedge fund adviser can now choose to register under the Advisers Act but then withdraw its registration, for example, at the prospect of an examination. Thus, without the new rule, any moral hazard would already exist, but without necessarily providing hedge fund investors the benefit of our oversight of their advisers.” 

In fact, the SEC’s valiant attempt at regulation explicitly warned against interpreting registration as any kind of implied endorsement in section II.B.7.:

“Congress addressed such arguments in 1940 when it passed the Advisers Act by including a provision in the Act that makes it unlawful for any investment adviser to ‘represent or imply in any manner whatsoever that [the adviser] has been sponsored, recommended, or approved, or that his abilities or qualifications have in any respect been passed upon by the United States or any agency or officer thereof.’”

Still, according to the commentary in the rule, most of the largest hedge funds have always sought registration (likely at the encouragement of their mega-clients).   

But now 90% of registrants have elected to continue the registration process voluntarily.  While voluntary registration sounds better than no registration at all, it creates a situation the SEC may not have initially anticipated.  (After all, its rebuttal to the moral hazard concern assumed all hedge funds would become registered, thus preserving the level playing field, and with it the SEC’s neutrality.)  Apparently in today’s voluntary system, hedge fund marketers are exercising their right to individually determine if the government’s  "Seal of Approval" is worth what amounts to its  "licensing" fee.  In this way, the SEC has inadvertently followed Good Housekeeping, The American Dental Association, and Flipper the dolphin into the marketing endorsement business.     

Read Full Money Management Executive Article at Financial-Planning.com
Read now vacated SEC registration rule
Overview of new SEC proposals (HedgeCo.net)

Addendum: For more lessons from last year’s registration fiasco - particularly pertaining to whether the requisite disclosures made any difference to investors - refer to this academic paper published January 7, 2007.