Institutionalization, Investment Adviser Regulation, and the Hedge Fund Problem

This Article contends that more effective regulation of investment advisers could be achieved by recognizing that the growth of hedge funds, private equity funds, and other private funds in recent decades is a manifestation of institutionalization in the investment advisory context. That is, investment advisers today commonly advise these “institutions,” which have supplanted other, smaller investors as advisory clients. However, the federal securities statute governing investment advisers, the Investment Advisers Act of 1940, does not address the role of private funds as institutions that now intermediate those smaller investors\u27 relationships to investment advisers. Consistent with that failure, investment adviser regulation regards a private fund, rather than the fund\u27s investors, as both the “client” of the fund\u27s adviser and the “thing” to which the adviser owes its obligations. The regulatory stance that the fund is the client, which recent financial regulatory reform did not change, renders the Advisers Act incoherent in its application to investment advisers managing private funds and, more importantly, thwarts the objective behind the Advisers Act: investor protection. This Article contends that policymakers\u27 focus should be trained primarily on the intermediated investors--those who place their capital in private funds--rather than on the funds themselves and proposes a new approach to investment adviser regulation. In particular, investment advisers to private funds should owe their regulatory obligations not only to the funds they manage but also to the investors in those funds

Investing and Pretending

This Article critically evaluates the CFTC\u27s “swap rules” and identifies the regulatory vision that they reflect. Based on that evaluation, it argues that the swap rules are grounded in a notable distinction between swaps and another financial market instrument--namely, securities. In particular, whereas “investing” is the hallmark of securities transactions, swap transactions fall under the rubric of “pretending,” a concept that this Article employs to elucidate the function and structure of swaps. Each party to a swap pretends that it holds either a long position or a short position in the reference asset, making payments to (or receiving payments from) the other party based on the performance of that position. Although the distinction between investing and pretending is vividly reflected in the CFTC\u27s approach to crafting the swap rules, this Article contends that the distinction is irrelevant for regulatory purposes. Moreover, the substantial regulatory costs arising from the CFTC\u27s pretense-based approach to swap regulation are likely to excessively hinder swap use, as firms seeking to mitigate risk turn to other types of hedging strategies in situations in which using swaps might otherwise be more socially beneficial. With the goal of efficient and coherent regulation in mind, this Article proposes that a substantially better approach to the CFTC\u27s swap rules would be to predicate them not on pretending, as the counterpoint to investing but, rather, on *1560 something that swap transactions and securities transactions have in common--and on which securities regulation, too, is based: the risks arising from speculation

Temporary Securities Regulation

In times of crisis, including during the 2020–2021 global pandemic, the U.S. Securities and Exchange Commission (SEC) has engaged in a type of securities regulation that few scholars have acknowledged, let alone evaluated. Specifically, during recent market crises, the SEC adopted rules that are temporary, designed to help the securities markets and their participants— both public companies and public investment funds, such as mutual funds and ETFs—weather the crisis at hand but go no further. Once that goal has been accomplished, these rules usually expire, replaced by the permanent rules that they temporarily supplanted. Although the temporary-rulemaking endeavor is laudable—and arguably necessary for the sake of maintaining well-functioning markets in times of crisis—neither the SEC nor its observers have sufficiently acknowledged the meaningful risks that temporary rules might present to investors. At the same time, they have not appreciated the opportunities that temporary rules may create for furthering the cause of more effective regulation. This Article seeks to illuminate the potential and the pitfalls of temporary rules, thereby contributing to a better understanding of what is at stake when the SEC adopts them and what considerations should inform the agency’s rulemaking during future crises

Uncertain Futures in Evolving Financial Markets

Today\u27s publicly offered investment funds, including mutual funds, have ever more diverse investment strategies, as they increasingly invest in financial instruments that, in earlier years, had been the province of only the most sophisticated investors. Although the new landscape of investment possibilities may substantially benefit retail investors, one financial instrument attracting increasing amounts of retail investors\u27 assets is acutely troublesome: the commodity futures contract. Futures originated as a means for farmers and other producers of agricultural commodities to ensure that their products could be sold at reasonable prices. Early on, the goals of futures regulation centered on one particular risk facing futures market participants—manipulative trading that destabilizes futures markets--with little emphasis on other risks, including risks to futures traders\u27 assets. Over the years, that goal has remained largely static. As this Article argues, that is the problem. The many retail investors that now participate (indirectly) in the futures markets are at risk as a result of the inadequate regulation of futures commission merchants (“FCMs”), the brokerage firms that are essential for futures transactions. “Inadequate” regulation in this context, moreover, means inadequate procedural regulation— regulation aimed at protecting assets that a brokerage customer deposits with a broker for purposes of carrying out her trading activities. The weaknesses of the procedural regulation of FCMs are evident in rules governing both FCMs\u27 operations and the liquidation of insolvent FCMs. And the deficiencies are more than theoretical, having become all-too-evident in the wake of two recent FCM bankruptcies. Proposing tailored policymaking solutions, this Article further contends that futures regulation can become substantially more effective—and do so in a cost-effective manner that need not excessively disrupt existing regulatory approaches. These proposals would not only help protect retail investors as they navigate new investment options; they would also help fortify the promising role that futures trading has begun to play in twenty-first century financial markets

Moving Beyond the Clamor for Hedge Fund Regulation : A Reconsideration of Client under the Investment Advisers Act of 1940

This Article argues that, from both theoretical and pragmatic perspectives, a better approach would be for law to regard private fund investors as clients of the managers of those funds for all purposes under the investment advisory regulatory regime. In making these arguments, it dissects the doctrinal and historical underpinnings and sources of the current doctrine--legislative history and case law, in particular, but also SEC interpretations and rule changes. In light of the policy considerations-- including investor protection--that gave rise to the Advisers Act, the growth of the investment advisory industry and private funds\u27 role in it, and lessons learned from recent turmoil in the financial markets, a doctrine that regards private fund investors as the clients of the funds\u27 managers is more coherent and better policy. Part II discusses the current regulatory regime governing investment advisers, including the exemption from investment adviser registration that many large fund managers have relied on to avoid SEC regulation, which considers each fund a single client. Reviewing prominent cases on investment adviser regulation and obligations, Part II also traces the origins of the doctrine that the person who is the direct recipient of an investment adviser\u27s services is to be regarded as the client of that adviser--which, in turn, has been employed to support the doctrine that a fund (rather than its investors) is the adviser\u27s client. Part III surveys some of the implications and incongruities arising from that doctrine, including the effective under-regulation of large investment advisers and augmentation of agency costs and other inefficiencies. It also discusses how recent and likely legislative changes are unlikely to remedy those deficiencies. Part IV discusses the misunderstanding of the adviser-client relationship and the misinterpretation of precedent evident in recent, prominent cases supporting the current doctrine. It further shows that current doctrine is contrary to--or at least gains no support from--the legislative history of the Advisers Act. Part V focuses on an alternative doctrine, one in which fund investors are deemed clients for purposes of investment advisers\u27 regulatory obligations. That Part posits both that this alternative doctrine alleviates incongruities in current regulation and that it is consistent with fiduciary principles

Institutionalization, Investment Adviser Regulation, and the Hedge Fund Problem

This Article contends that more effective regulation of investment advisers could be achieved by recognizing that the growth of hedge funds, private equity funds, and other private funds in recent decades is a manifestation of institutionalization in the investment advisory context. That is, investment advisers today commonly advise these “institutions,” which have supplanted other, smaller investors as advisory clients. However, the federal securities statute governing investment advisers, the Investment Advisers Act of 1940, does not address the role of private funds as institutions that now intermediate those smaller investors’ relationships to investment advisers. Consistent with that failure, investment adviser regulation regards a private fund, rather than the fund’s investors, as both the “client” of the fund’s adviser and the “thing” to which the adviser owes its obligations. The regulatory stance that the fund is the client, which recent financial regulatory reform did not change, renders the Advisers Act incoherent in its application to investment advisers managing private funds and, more importantly, thwarts the objective behind the Advisers Act: investor protection. This Article contends that policymakers’ focus should be trained primarily on the intermediated investors—those who place their capital in private funds—rather than on the funds themselves and proposes a new approach to investment adviser regulation. In particular, investment advisers to private funds should owe their regulatory obligations not only to the funds they manage but also to the investors in those funds

Rethinking U.S. Investment Adviser Regulation

(Excerpt) Now, in the aftermath of Dodd-Frank’s enactment and the SEC’s associated bout of rulemaking, one might think that the Advisers Act’s regulatory regime is a workable and effective one, equipped to address—and address efficiently—the investor-protection risks that the twenty-first-century investment adviser industry produces. In fact, however, Dodd-Frank did not touch— and, indeed, Dodd-Frank’s crafters indicated no awareness of— many of the Advisers Act’s longstanding troubles. Additionally, the changes Dodd-Frank brought about have their own considerable deficiencies. As this Article contends, the U.S. investment adviser regulatory regime, now seventy-four years old, is in need of more than a few statutory amendments and new SEC rules. For the sake of the investor-protection goals of securities regulation, the promotion of market integrity, and regulatory efficiency, U.S. investment adviser regulation needs to be rethought and reformed. Focusing both on longstanding and new regulatory weaknesses, this Article highlights five grounds for that conclusion

The Modern Corporation Magnified: Managerial Accountability in Financial Services Holding Companies

This Article\u27s goal is to revisit early and thoughtful commentary on the fundamental problem of the large corporate enterprise--managerial accountability to shareholders-- to show that this fundamental problem is dramatically pronounced--magnified, if you will--in the types of enterprises that were at the center of the financial crisis, whether too big to fail or not. In particular, The Modern Corporation articulated that the evolution of economic organization has separated the beneficial ownership of property from those who control it and that this disjunction has created an irresolvable tension between shareholders and management. Nowhere is that tension more pronounced than in the context of FSHCs, raising questions regarding whether the standard tools of corporate governance are equipped to address it. This Article first recalls the primary contours of Adolf Berle and Gardiner Means\u27s acclaimed observations regarding the separation of ownership and control in the “modern corporation,” as well as their conclusions about the implications of those observations for the doctrine of shareholder primacy. Second, the Article describes how the activities of FSHCs generally differ from what we think corporations do and, certainly, from what Berle and Means conceived of as the purpose of corporations or, indeed, any business enterprise. In particular, rather than deploying physical property for the purpose of producing goods or providing services and, beyond that, creating economic value for the property\u27s ultimate owners, FSHCs deploy their and their customers\u27 and clients\u27 financial assets for the purpose of generating profits through trading and investment activities. Third, this Article articulates how those business activities render more acute the problem of the separation of ownership and control that Berle and Means observed. In particular, FSHC shareholders face additional peril as a result of managerial incentives that cultivate excessive risk-taking, which is often difficult to temper, and heavy regulation, which raises the prospect of both regulatory enforcement actions and regulatory capture--all fueled by rules under the Bankruptcy Code that, in the event of insolvency, limit a firm\u27s rights to recoup assets transferred in its final days. Additional risk derives from FSHCs\u27 relationships to their subsidiaries, which typically do carry on activities that fall within the more traditional role of corporate activity, such as performing broker-dealer or banking services. This discussion highlights that, because FSHCs are an evolved specimen of the modern corporation, there should be heightened concern regarding the possibility that FSHC managers may not be looking after shareholders\u27 best interests. Finally, this Article concludes that the special concerns that FSHCs produce both portend and necessitate rethinking the problem of managerial accountability in large, publicly traded corporations. The Article suggests, consistent with Berle and Means\u27s conclusions, that the notion of shareholder primacy should be supplanted--but does so without necessarily embracing the notion that corporations should be managed in the interests of innumerable constituencies. Rather, the Article raises the possibility that many of the concerns associated with FSHCs\u27 activities could be addressed through a greater governance focus on one constituency, in particular: those who seek out, and benefit from, FSHCs\u27 traditional and foundational business operations--namely, clients and customers

The Other Securities Regulator: A Case Study in Regulatory Damage

Although the Securities and Exchange Commission is the primary securities regulator in the United States, the Department of Labor also engages in securities regulation. It does so by virtue of its authority to administer the Employee Retirement Income Security Act (ERISA), the statute that governs the investment of retirement assets. In 2016, the DOL used its securities regulatory authority to adopt a rule that, for the first time, designates securities brokers who provide investment advice to retirement investors as fiduciaries subject to ERISA\u27s stringent transaction prohibitions. The new rule\u27s objective is salutary, to be sure. However this Article shows that, by way of its reformation of many advisers\u27 relationships with their retirement-investor customers, the \u27fiduciary rule imperils retirement investors in ways that are not immediately evident and that other scholars have not noticed. First, the rule promotes a particular investment strategy—namely, passive investing—for all retirement investors, regardless of their individual needs or objectives. Second, as a thought experiment demonstrates, the rule portends a constriction of most retirement investors\u27participation in the securities markets and a still-wider gap, in terms of investment opportunities and performance, between these investors and their sophisticated counterparts. Despite these difficulties and speculation that the Trump administration would scuttle the rule, moreover the rule\u27s effects are likely enduring. Given the damage that the fiduciary rule threatens to inflict on retirement investors, the DOL\u27s adoption of it is an episode of failed rulemaking—one that, as this Article contends, may be traced to doctrinal factors: US. securities regulation is based on the notion that regulation should be neutral as among firms\u27 business and financial objectives and should harness, without necessarily abolishing, financial professionals\u27 conflicts of interest. Yet with its fiduciary rule, the DOL has effectively forsaken the principle of neutrality and deployed a scorched earth strategy against conflicts. With a view toward addressing the special concerns that shared regulatory authority creates, the Article delves into the lessons arising from this episode and how policymakers might better promote regulatory objectives and sound policy going forward

Downstream Securities Regulation

Securities regulation wears two hats. Its “upstream” side governs firms in connection with their obtaining financing in the securities markets. That is, it *1590 regulates firms\u27 and issuers\u27 offers and sales of securities, whether in public offerings to retail investors or in private offerings to institutional investors. Its “downstream” side, by contrast, governs financial services providers, who assist with investors\u27 activities in those markets. Their services include providing advice regarding securities investments, as investment advisers do; aggregating investors\u27 assets for purposes of enabling those investors to invest their assets collectively, as mutual funds do; and acting as “middlemen” between buyers and sellers of securities, as broker-dealers do. Yet neither scholars nor policymakers have adequately understood that the regulation of financial services providers under the securities laws is substantively different from the regulation of issuers. They have not, in other words, adequately understood downstream securities regulation. The problems arising from this oversight are evident in laws and rules designed to protect investors from the excesses of brokerage firms, fraudulent conduct in the mutual fund industry, and hedge-fund managers\u27 self-interested conduct, as well as in those enacted in the wake of Enron\u27s bankruptcy and other corporate scandals. Moreover, the harm to investors is real: brokerage firm customers have struggled for the return of their deposited funds after the firm\u27s bankruptcy; mutual fund shareholders have suffered from market timing scandals; shareholders of financial services firms have been harmed by fraud, notwithstanding antifraud statutes meant to protect them. This Article is the first scholarly work to articulate how securities regulation encompasses two distinct spheres of regulation, each of which is based on its own core principles - and, importantly, each of which necessitates its own regulatory approaches. The Article contends that policymakers\u27 longstanding failure to recognize that securities regulation is bimodal has produced a securities regulatory regime scattershot with flaws and vulnerabilities. Securities regulation could become substantially better if those who make and influence it had a more complete understanding of how it works - how all parts of it work. Note: Reprinted in 47 Sec. L. Rev. § 2.3 (2015) and 57 Corp. Prac. Commentator 183 (2015)