Quacks or Bootleggers: Who’s Behind Hedge Fund Regulation?


Attempts by U.S. federal officials to regulate corporate governance have been criticized by prominent scholars as “quackery.”[1] Major reforms like Sarbanes-Oxley and Dodd-Frank may in fact do far more harm than good. But what if these efforts at healing our financial system are more than just poorly designed and executed? What if, instead, they are achieving precisely what they were designed to achieve? What if they were designed not by quacks but by bootleggers?

In 1999, Bruce Yandle, emeritus dean and professor of economics at Clemson University, proposed a public-choice economics version of the old saying, “politics makes strange bedfellows.”[2] It was called the Bootleggers and Baptists Theory. He argued that lasting regulations require the cooperation of two groups: the so-called Baptists, who provide vocal, morality-based policy arguments in favor of the regulations, and the bootleggers, who provide the money necessary to enact and defend the regulations. The name comes from the coalition that supported bans on the sale of alcohol on Sunday—Baptists because they believed it immoral to drink on the Sabbath, bootleggers because the bans limited competition and increased their profits—but the principle applies to a broad range of regulatory issues. In fact, once one grasps the principles of the theory, it becomes difficult to ignore evidence of bootleggers everywhere.

The formula is simple: government regulation that achieves its stated goals poorly, if at all, combined with benefits for competitors of the regulated entity. A good example could be the regulation of hedge funds under Dodd-Frank,

In the wake of the financial meltdown of 2008 to 2009, there was no shortage of Baptists arguing that something had to be done to minimize systemic risk, largely by reforming the market structures that were believed to have contributed to a dangerous accumulation of risk. Hedge funds, despised by some since the collapse of Long Term Capital Management in 1998, received their share of criticism. Enter Dodd-Frank, which had the express goal of “promot[ing] the financial stability of the United States by improving accountability and transparency in the financial system.”[3] So far, so good, for who could possibly be against increased financial stability or improved accountability and transparency?

Speaking in general terms, the Baptists had staked their claim to the moral high ground, but the details of Dodd-Frank indicate that bootleggers might have been lurking behind the scenes. A closer look at the regulatory regime imposed on hedge funds reveals little to like, regardless of one’s view of hedge funds or systemic risk.

To begin, regulation of hedge funds in the name of financial stability makes little sense. Hedge funds engaged in many of the same practices as the rest of the financial industry, but they probably don’t contribute to systemic risk for two reasons. First, they are not large enough to endanger the stability of the broader capital markets. Second, many of the practices for which hedge funds receive criticism (short-selling, emphasis on short-term profits) work against the unwarranted inflation of asset prices, thereby working to deflate bubbles and lower risk.

Even if hedge funds did pose systemic risk, however, Dodd-Frank’s regulations won’t mitigate that risk. The regulatory regime has four primary parts. First, hedge funds are required to register their advisors, thus eliminating the private advisor exemption under the Investment Advisors Act of 1940. Second, those advisors are required to maintain detailed information about the investment positions and strategies of their funds; that information can be audited by the SEC and will almost certainly be part of regular reports that the SEC can now mandate. Third, it will now be more difficult for investors to qualify as “accredited investors” or “qualified clients.” Fourth, every fund must implement internal compliance programs and hire a compliance officer.

These measures will impose high costs on hedge funds, including the cost of collection, maintenance, and transmission of vital fund data to the SEC. The regulations will also make it harder for hedge funds to find qualified investors. None of these costs comes with commensurate benefits to either hedge fund investments or the financial system as a whole. The risk assumed by hedge fund investors is personal risk and must be compensated by the higher returns hedge funds offer above those of competing products. This is a function of markets, not a problem in need of correction. Any systemic risk is unlikely to be mitigated by requiring advisors to register, limiting the number of investors, or requiring disclosure to the SEC.

So, we are left with a regulatory regime that purports to solve a probably non-existent problem in a way virtually guaranteed to fail. Two explanations seem possible. One is that legislators are just incompetent. The other is that government officials do not know what risk hedge funds pose but suspect that it is unacceptably high and wish to gather as much information as possible in preparation for future regulation. Either way, the regulations seem particularly well-designed to harm hedge funds, making the presence of bootleggers likely.

The cost to hedge funds of complying with the regulations will, of course, reduce the return that hedge funds can provide to investors. Potential hedge fund investors will also experience increased difficulty in qualifying as accredited investors. Together, reduced returns and more difficulty qualifying to invest with hedge funds will cause investors to shift their money elsewhere.

More crippling to hedge funds, however, is the way disclosure requirements infringe on the adaptability and secrecy necessary to the hedge fund business. Once information is collected, maintained, and provided to any government agency, its secrecy is compromised. Also, when the SEC can mandate disclosure of investment positions and strategies, adapting those positions and strategies to the realities of a changing marketplace becomes problematic.

If this seems far-fetched, imagine the scenario where a hedge fund discloses investment positions on a Monday but needs to change them completely on Tuesday in order to respond to a previously-unforeseen emerging trend in the market. In the eyes of a skeptical regulator, market necessity will look suspiciously like avoidance of oversight.  Hedge funds will be forced into a choice between limiting the speed at which they innovate or defending against suspicious SEC investigations, either of which will be costly.

Who are the bootleggers who benefit from this arrangement? Two possibilities seem plausible. One is large, traditional financial institutions. The investment vehicles provided by traditional firms are rough substitutes for the services of hedge funds. They are likely to be less risky but also offer lower returns. If regulations lower hedge fund returns, traditional investments with their lower risk become attractive again. The other, related possibility is larger hedge funds that wish to limit competition from smaller rivals. A larger hedge fund will be better able to spread the costs of hiring a compliance officer, registering advisors, and gathering and providing data to the SEC across a larger investment pool, thereby experiencing a smaller reduction in return. Smaller hedge funds, unable to spread the costs as widely, will fail, and their clients will turn either to larger competitors or to more traditional financial institutions. Importantly, these two possible bootlegger scenarios need not be mutually exclusive, as many large financial institutions now have their own hedge funds.

At a basic level, whether quacks or bootleggers are responsible matters little—market function is unnecessarily impaired. At a deeper level, however, bootlegging strikes at the fundamental rule-of-law principles that undergird all free markets and put much more at risk. We owe it to current and future generations to bring to light and eliminate bootlegging. We can start with bootlegging in Dodd-Frank.


[1] Roberta Romano, Quack Corporate Governance, 114 Yale L. J. 1521 (2005); Stephen M. Bainbridge, Dodd-Frank: Quack Federal Corporate Governance Round II, 95 Minn. L. Rev. 1779 (2011).

[2] Bruce Yandle, Bootleggers and Baptists in Retrospect, Regulation, Vol. 22, No. 3, at 5 (1999).

[3] Pub. L. 111-203, Long Title (2010).

This post comes to us from Professor Jeremy Kidd at Mercer University’s Walter F. George School of Law. It is based on his recent working paper, “Quacks or Bootleggers: Who’s Really Regulating Hedge Funds?” available here.