As the regulators and financial media wait on pins and needles for the next Enronesque experience in business, much attention has recently been focused on the generally unregulated — at least until now — world of hedge funds.
David Skeel recently published this Legal Affairs article (and this follow up discussion with Business Law Prof blogger Dale Oesterle) in which he argues for more regulation of hedge funds because the pressure that hedge funds face to take unreasonable risks and to show over-the-top returns undermines the integrity of the markets, which will hurt the little guy investor. Meanwhile, in anticipation of the new SEC regulations due to take effect in February that require hedge funds managing more than $25 million to register with the SEC, submit to periodic audits and provide detailed information about their trading, the Wall Street Journal reports today that many funds will not be registering with the Securities and Exchange Commission due to loopholes provided by the agency. The entire thrust of the article is “what are these guys hiding?”
Into this fray enters the indomitable Larry Ribstein with this timely post in which he proposes that everyone back off and think about whether the proposed regulations are really a solution to the supposed problem for which they are intended:

[I]t is important to distinguish between two types of problems that are often melded together in the commentary on hedge funds: the damage that these funds supposedly do to others, and the damage that hedge fund managers do to their investors. Pro-regulatory hedge fund critics often play a kind of shell game, obfuscating the goals of the regulation by sliding between these very different objectives. Regulatory prescriptions for one problem may even exacerbate the other (e.g., the two-year lockup rule).
The basic problem with focusing on the damage hedge funds do to others is that this is often covered, or should be covered, by rules that directly address the supposedly bad behavior. But regulators often find enacting such rules inconvenient, because then they would have to actually identify the bad behavior and show how it is harmful. Itís easier to deal with this problem by tarring the people that are doing it, and putting them out of business ñ the same strategy that worked with Mike Milken and takeovers. This is not only a poor way to address the supposedly bad behavior, but it risks reducing the clearly legal and socially productive behavior that these same supposedly bad guys engage in ñ e.g., disciplining unproductive corporate managers.

As noted earlier here, regulators took a quite similar approach in the wake of Enron to hammer and ultimately constrict a highly productive means for businesses to hedge risk — i.e., structured finance transactions, particularly in the gas trading industry. Professor Ribstein goes on to specify examples of where regulators, on the murkiest of grounds, seek to rein in what they perceive as improper behavior of hedge funds, and then concludes with the following wise advice:

It may be that the real problem with hedge funds, and the real reason they are in the regulatory crosshairs, is that they, like Milken and his ilk, are a potential mechanism for reshaping corporate control. Before we continue down this regulatory path, we ought to better understand why weíre going there, and the potential costs of doing so.

Update: Professor Bainbridge chimes in with this insightful post,, in which he observes the following:

One of the strongest arguments against hedge fund registration was that investors in them are typically institutions (pension funds and so on) and wealthy individuals. In other words, folks for whom caveat emptor arguably is all the protection they need. As with any principal-agent context, liquidity provided one of the principal protections for hedge fund investors. If the manager shirked or otherwise misbehaved, or even just had a run of bad luck, investors could exit. The risk that investors would bail, in turn, provided a substantial incentive for hedge fund managers.
The problem with the SEC’s rule should now be apparent: It’s reducing liquidity by increasing lock up periods during which hedge fund investors can’t run for the exits. (Imagine being in a theater that’s on fire but the doors are locked.) The SEC thus has created a situation in which it is forcing hedge fund investors to go on protecting themselves, while simultaneously disarming investors by depriving them of their most effective weapon.
I’d call that a bad rule. A very bad rule.