Kanjorski Discusses Hedge Fund Regulation

His draft legislation would require hedge funds to register with the SEC.

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As Congress looks to reshape the country's battered financial sector, hedge funds have emerged as a key puzzle piece. And nearly a year after disgraced financier Bernard Madoff's Ponzi scheme ran out of gas, legislators are considering draft proposals that would tighten the leash around the secretive industry.

[See Judge Upholds Advertising Rules in Hedge Fund Case.]

The drafts, released by Democratic Rep. Paul Kanjorski of Pennsylvania, would require private pools of capital with more than $30 million in assets to register with the Securities and Exchange Commission, with an exception for venture capital funds. Practically, this would mean that affected funds would have to disclose information about their fees, risks, trading practices, and other elements of their business.

In an apparent attempt to "hedge" their bets and avoid further intervention, fund lobbyists have supported registration. This marks a rare concession from an industry known for jealously guarding its private status.

Meanwhile, Kanjorksi's drafts would also allow the SEC to ban mandatory-arbitration clauses in brokerage contracts. Separately, legislators have long been considering a similar bill, the Arbitration Fairness Act, which proposes that Congress make the clauses unenforceable. By leaving the decision up to the SEC, Kanjorski is hoping to strike a middle ground.

U.S. News recently spoke with Kanjorski about his hedge fund and arbitration proposals, which he released earlier this month. Kanjorski is the chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises. Excerpts:

Why does hedge fund reform need to be part of the country's broader financial overhaul?

One of the important things that we realized and saw vividly this time is the fact that there were so many pieces of information that weren't known as to who was involved in the market and where they were involved and in what amounts. So it became very clear that what we had to do was to make sure that we had the capacity to tap into all the information as to where the money was, who was in charge of it, what they were doing with it, and what type of long-term risk with leveraging could occur. And so there was little question they were going to be regulated.

Is requiring registration enough to achieve that, or should Congress ideally go further?

I think we should be jealous of how much regulation we put on a business—or anyone for that matter—in our system. If we find that this is not sufficient, the SEC will have the capacity to go beyond what we are doing, and of course Congress can come back and give them additional authority if they need it.

On the flip side, is there a chance that even the hint of regulation will drive private capital overseas?

Anything's possible. But I was just over in Europe, and they're going to coordinate their regulatory reform very closely with ours, so I wouldn't be surprised if we're on the same tack, and we may end up being very close if not identical to each other. . . . If anything, the pressure is that they want high-standard, adequate regulation, too, and they may be pressing us even a bit more.

Past attempts to regulate hedge funds haven't borne much fruit. Is the effort more viable this time around?

Yes. This time we not only have the members of Congress who are aware of some of the problems that we face and the inadequacies and the holes, but we have the industry on board now to a large extent, recognizing that this is a necessary thing and even helping us by making recommendations as to what can get this through and get it solved in a simple way.

Do you attribute this support to a desire for transparency, or is it an attempt to prevent even stricter regulation?

I think it's a good part of the latter, but anyone who has any insight at all should realize that we came very close to going over the edge, and that if we had gone over the edge, there wouldn't be any such thing as hedge funds or venture capital groups. They would have all disappeared. And so I don't think they want to go through that risk again. On the other hand, like anyone, particularly Americans, they want the least amount of regulatory regime as possible. But I think they think we're being rather reasonable in what we're setting up here, in my legislation at least.

To what extent do your proposals represent a convergence of the mutual and hedge fund worlds?

It's a different type of regulatory regime. With hedge funds, we're trying to get information so we can understand where money flows are, where risks are, what kind of drawdowns can be accepted. But mutual funds, of course, are being regulated like a bank. There, we're really in there watching the transactions from day to day.

Why is there an exception for venture capital funds?

There's a strong contingentof venture capital in areas like Silicon Valley, and it's still not as organized an effort that spans the country and organizational structure. And these people are used to sort of being almost Western cowboys, if you will. They have very small entities, small groups, not highly leveraged if leveraged at all, really, and they think that any impingement on them . . . is more expensive to the economy than what would be gained from regulating. The only thing that we would be regulating for is the flow of money, and we will learn that because they actually came to us and said they're willing to provide the information that we would get from formal registration. . . . I think at the end of all this, though, we will probably be able to conclude that for the first time we will have 99 percent [or] 98 percent of the capital in the country identified, located, and a knowledge as to the way it works and its ebb and flow. And we will be able to pull up in a reasonably short period of time an examination to determine what's going on, which I think is the exact purpose for which we we're trying to do this, because it was the holes, the vacuums, the loopholes in the system that allowed so many in the system to escape and not be accounted for.

Your proposals also address mandatory-arbitration clauses. Is the current system broken?

There tends to be a culture that develops. And to some extent some people raise the question of whether the culture gets so infused with corruption that it favors one side of the transactions as opposed to the other, and I think it's highly likely in this area. But that's what we're really facing here—whether or not we're going to give the industry the ability to absolutely write the contract saying you have no choice or whether you're going to have a choice. I think choice is healthy.

[See Could Arbitration Help You Recover Investment Losses?]

How does your proposal relate to the Arbitration Fairness Act?

This is saying, "Look, we can maybe be grown-ups. Let's see if we can.". . . I always try to choose self-regulation first, moderation in all regards first, but if you can't, hey, we've got the heavy hammer.