The Effects of Mandatory Disclosure Rules on Hedge Fund Governance

In a new paper, I add to the debate over hedge fund regulation by introducing empirical evidence that hedge fund registration requirements reduce misreporting. Using three alternating changes in hedge fund regulation, my study finds consistent evidence that registration reduces hedge funds’ misreporting — and provides evidence on why this regulatory regime is effective. In particular, my analysis suggests that the disclosure requirements led funds to make changes in their internal governance, such as hiring or switching the fund’s auditor, and that these changes induced funds to report their financial performance more accurately.

It was initially unclear whether regulation would reduce hedge funds’ misreporting. Relative to public companies, hedge fund regulation is light. Much of it is a “comply-or-explain” regime that allows funds to forego compliance with governance rules, providing that they disclose their lack of compliance. From a policy perspective, the relatively light regulation is often thought to reflect the differing views on the effectiveness and necessity of regulating hedge funds. Indeed, some argue that regulations are unnecessary because funds’ investors are sophisticated enough to detect and deter financial misconduct without government assistance (Atkins [2006]). Opponents have questioned this argument, however, pointing out that the majority of hedge funds’ investors are institutional investors that may suffer from a “double agency problem” (Karantininis and Nilsson [2011]). According to this theory, institutional investors may not have an incentive to fully deter wrongdoing because the separation of client (the primary beneficiary) and investor (the investing institution) creates an agency problem that is similar to the agency problem between a firm’s managers and its owners (Gilson and Gordon [2013]).

To evaluate the effectiveness of hedge fund regulation, my empirical analysis exploits three major changes in the regulatory regime. First, in 2004, the SEC adopted a rule requiring the majority of hedge funds to register with a government securities regulator, thus subjecting these funds to mandatory disclosure, government inspections, and compliance rules. Second, in 2006, the courts vacated the SEC’s rule, allowing the funds to withdraw from registration. Third, in 2011, the SEC again adopted rules requiring funds to register with a government securities regulator (these rules were adopted in accordance with the Dodd-Frank Act).

This setting is unique for two reasons. First, it allows for stronger inferences on the question of whether hedge fund registration reduces misreporting, because the three events created alternating changes in the regulatory regime. Second, the setting allows for a better understanding of why registration is effective. Upon registration, funds are typically subject to a number of concurrent changes, including government inspections, compliance requirements, and mandatory disclosure. However, a unique feature of the Dodd-Frank Act is that it created a secondary classification of hedge funds known as Exempt Reporting Advisers. Unlike the majority of newly regulated funds, the funds that became regulated under this new classification were exempt from both government inspections and compliance requirements and subject only to the disclosure rules. This setting therefore allows for examination of the disclosure rules in isolation.

My study points to three key findings. First, hedge fund registration reduces misreporting. Misreporting decreased at the funds that were required to register with the SEC, and increased at the funds that withdrew from registration after the courts vacated the SEC’s rule. Second, evidence suggests that registration reduced misreporting by spurring funds to make changes to their internal governance. In particular, after the newly regulated funds had to publicly disclose whether they were audited and the name of any such auditor, many hired or switched auditors. On average, the funds that made such changes experienced greater declines in misreporting. Finally, by examining the funds only subject to disclosure rules, I show that the imposition of mandatory governance disclosures, even without other concurrent regulatory changes, can significantly decrease misreporting.

My paper contributes to several areas of literature. First is the literature on “comply-or-explain” disclosure regimes. Long popular overseas, such regimes are gaining favor in the U.S. as regulators express concern over one-size-fits-all governance regulation. Second, the paper contributes to literature on the real effects of disclosure rules. As a first step, I contacted personnel at the funds in my sample to discuss their experience with registration, and many indicated that the new disclosures spurred them to make internal governance changes. I ran empirical tests and found evidence consistent with this feedback. In particular, the newly registered funds were more likely to switch their auditors, and following the Dodd-Frank Act, to hire auditors. The funds that made these changes had greater decreases in misreporting. By providing evidence that comply-or-explain leads to changes in auditing, which in turn leads to a reduction in misreporting, I provide evidence of this specific mechanism.

Finally, my paper contributes to the hedge fund literature by providing the first evidence of the effectiveness of disclosure to regulate hedge funds. Although a small number of studies have suggested that hedge fund regulation reduces misreporting (Cumming and Dai [2010]; Hoffman [2013]; Dimmock and Gerken [2015]), all of these studies have focused on mandatory rules, regulatory examinations, or both. None has studied the use of disclosure to regulate hedge funds. This is an important question given the longstanding debate over the effectiveness of mandating disclosure for hedge funds, whose investors already have access to substantial amounts of information (Cassar et al. [2018]; Brown et al. [2008]; Atkins [2006]). By providing evidence that disclosure rules can induce governance changes that, in turn, reduce misreporting, my study provides new evidence on this longstanding debate.

REFERENCES

Atkins, P. “Protecting Investors Through Hedge Fund Advisor Registration: Long on Costs, Short on Returns.” Keynote Remarks Made at the Inaugural Edward Lane-Reticker Speaker Series Sponsored by the Morin Center for Banking and Financial Law. Annual Review of Banking & Financial Law 25 (2006): 537-556.

Brown, S. J.; W. N. Goetzmann; B. Liang; and C. Schwarz. “Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration.” Journal of Finance 63 (2008): 2785-2815.

Cassar, G.; J. Gerakos; J. Green; J. Hand; and M. Neal. “Hedge Fund Voluntary Disclosure.” The Accounting Review 93 (2018): 117-135.

Cumming, D., and N. Dai. “Hedge Fund Regulation and Misreporting Returns.” European Financial Management 16 (2010): 829-857.

Dimmock, S. G., and W. C. Gerken. “Regulatory Oversight and Return Misreporting by Hedge Funds.” Review of Finance 20 (2015): 795-821.

Gilson, R. J., and J. N. Gordon. “The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights.” Columbia Law Review 113 (2013): 863-927.

Hoffman, P. J. “Does Audit Regulation Stifle Misreporting? The Case of the Hedge Fund Industry.” Working paper, SSRN, 2013.

Karantininis, K., and J. Nilsson (Eds.). Vertical Markets and Cooperative Hierarchies: The Role of Cooperatives in the Agri-food Industry. Dordrecht: Springer, 2007.

This post comes to us from Associate Professor Colleen Honigsberg at Standford Law School. It is based on her recent paper, “Hedge Fund Regulation and Fund Governance: Evidence on the Effects of Mandatory Disclosure Rules,” published in the Journal of Accounting Research and available here.