A Defeat for Government Meddling

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By finding that the Securities and Exchange Commission has no authority to require hedge funds to register under the Investment Advisers Act of 1940, the D.C. Circuit Court of Appeals in Philip Goldstein et al v. Securities and Exchange Commission defeated the regulatory ambitions of a former SEC chairman, William Donaldson.

Hedge funds are nimble, low-cost investment vehicles that are privately operated. They are not directly offered to the public and operate outside the regulatory structure of mutual funds and other common investment platforms. Hedge funds typically have higher expected returns – and higher risk characteristics – than the more heavily regulated funds offered directly to the public. Hedge funds manage approximately $1 trillion in investments, while the more heavily regulated mutual funds manage $6 trillion or more.

Registration of hedge fund advisers would have been the beginning of a slippery slope of SEC regulation. It would have substantially raised the costs of operating a hedge fund in America. Much hedge fund activity would have migrated offshore to less regulated locations such as the Cayman Islands and even Europe.

The unfortunate consequences of government meddling in capital markets cannot be overstated. The recent Sarbanes-Oxley law, for example, has done far more than just raise the accounting and auditing costs of publicly traded corporations in America. Several such companies have been taken private in part due to Sarbanes Oxley. Many privately held companies that 10 years ago might have gone public are instead remaining privately held today. Most visibly, those companies going public increasingly are doing so overseas rather than registering with an American exchange.

Sarbanes-Oxley has retarded the growth of large segments of the American financial services industry, and a Donaldson-led SEC might have further exacerbated the situation in the hedge fund industry. When the SEC passed the registration requirement in December 2004, the administration and Congress were powerless to intercede. In the American government, independent agencies such as the SEC have extraordinary powers beyond the normal checks and balances of our Constitution. Even though Sarbanes-Oxley is misguided, it at least has the imprimatur of Congress, the signature of the president, and the unambiguous statutory review of courts.

But even where our government lacks full the range of checks and balances, courageous individuals fill the breach. At the SEC, commissioners Paul Atkins and Cynthia Glassman dissented from Mr. Donaldson’s overreaching registration order. Dissenting from a chairman of one’s own party takes courage.

Usually, regulated entities are strongly advised against suing a federal agency that regulates them. Even the most impartial government agency cannot easily ignore an adversary in court. Philip Goldstein and other hedge funds courageously brought suit against the SEC.

Federal courts can and do offer extraordinary deference to the decisions of federal agencies. The D.C. Circuit Court panel took the more courageous path of finding a federal agency outside the boundaries of law.

Since the hedge fund adviser order of December 2004, a new chairman, Christopher Cox, has taken the reins of the SEC. Experienced in the costs and benefits of government regulation, Mr. Cox is unlikely to resume the institutional empire-building of his predecessor.

America has vibrant financial services not because it is naturally endowed by geography or technology, but because its laws both permit such activities and provide efficient means to enforce rights and resolve disputes among various parties in the financial sector. Investors have committed more than $1 trillion to hedge funds not because they believed the SEC would succeed in imposing government regulations to “protect” them, but precisely because they believed it would fail.

The line between success and failure in a democracy is thin, particularly where normal checks and balances are absent. In the case of registration of hedge fund advisers, we are fortunate that a few courageous individuals stepped forward to preserve the rule of law. Next time, we may not be so lucky.

A former FCC commissioner, Mr. Furchtgott-Roth is president of Furchtgott-Roth Economic Enterprises. He can be reached at hfr@furchtgott-roth.com.

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