More Lessons From The Market Crisis
Over the last few weeks as the market crisis has continued to unfold, SEC Chairman Cox has repeated requested additional authority from Congress over credit default swaps and investment bank holding companies. Yesterday, we discussed the need to examine financial instruments other than credit default swaps when considering the adequacy of current regulation under the federal securities laws.
A related question involves the adequacy of regulation regarding significant market participants. To date, Chairman Cox has limited his requests to Congress for additional authority over market participants to investment bank holding companies. Currently there are no investment bank holding companies. Just a few brief months ago of course, investment bank holding companies such as Goldman, Lehman and Bear Stearns were major Wall Street players. Now none are left. All have either collapsed or become subject to the banking regulators. This raises the question of why the Chairman has limited his request regarding market participants to currently non-existent entities.
The limited nature of the Chairman’s request is even more curious if we go back just two years ago. Then, the Commission tried to regulate hedge funds. The SEC issued rules requiring these major market players to register with it. The Circuit Court for the District of Columbia struck that regulation down as beyond the reach of the SEC in Goldstein v. SEC, 451 F.3d 871 (D.C. Cir. 2006). Although the SEC chose to accept the result in that ruling and not appeal, Mr. Cox told Congress that “[h]edge funds are not, should not be, and will not be unregulated.” Testimony Concerning the Regulation of Hedge Funds (July 25, 2006) discussed here.
Subsequently, the SEC passed additional antifraud rules in this area, discussed here. The Commission also brought a number of enforcement actions involving hedge funds. Perhaps the most high profile of these cases are those involving PIPE offerings where the Commission alleged violations of Section 5 for the sale of unregistered securities in connection with covering short sales and Section 10(b) insider trading against hedge funds. To date, in those cases which have litigated, the Commission has lost each of the Section 5 claims and one of the insider trading claims while the others are still in litigation – the cases are proving unsuccessful.
If the Chairman thought the Commission would regulate hedge funds through litigation, the clear lesson seems to be that this is not a substitute for regulation and disclosure. The current Madoff scandal, which is still unfolding, is perhaps the most poignant example of the inadequacy of litigation. There, a huge fund apparently founded on fraud collapsed in the wake of the market crisis, leaving investors with huge losses. While the SEC has brought an enforcement action against Mr. Madoff, that case will probably prove to be of little consolation to investors, being too little, too late. This is frequently the result if litigation, which is usually after the fact, is substituted for regulation and disclosure.
This in turn makes the limited request for authority by Chairman Cox even more curious. Why is it limited to entities which no longer exist? What happened to his vow to regulate hedge funds? Those funds, which no doubt are suffering in the current market, may have huge losses and some could collapse, injuring investors and further damaging the already very fragile markets. Since there is little disclosure in this area nobody really knows what the potential impact on investors and the market might be. Adequate disclosure could help reduce these risks and any investor and market impact. After the fact litigation clearly will not.