Offshore Hedge Funds

Hedge funds that are organized in the United States are designated as domestic hedge funds.

These funds require investors to pay income taxes on all earnings from the hedge fund.

Funds located outside the United States and structured under foreign laws are designated

as offshore hedge funds. Many offshore financial centers encourage hedge funds to locate

in their countries. The major centers include the Cayman Islands, Bermuda, Dublin,

and Luxembourg. The Cayman Islands is estimated to be the location of approximately

75 percent of all hedge funds. Offshore hedge funds are regulated in that they must obey

the rules of the host country. However, the rules in most of these countries are not gener-

ally burdensome and provide anonymity to fund investors. Further, offshore hedge funds

are not subject to U.S. income taxes on distributions of profit or to U.S. estate taxes on

fund shares. Europe is the fastest-growing area for offshore hedge funds, with total assets

managed of $914 billion.

When compared to domestic hedge funds, offshore hedge funds have been found to

trade more intensely, due to the low or zero capital gains tax for offshore funds. Further,

offshore hedge funds tend to engage less often in positive feedback trading (rushing to buy

when the market is booming and rushing to sell when the market is declining) than domes-

tic hedge funds. Finally, offshore hedge funds have been found to herd (mimic each other’s

behavior when trading while ignoring information about the fundamentals of valuation)

less than domestic hedge funds. Many hedge fund managers maintain both domestic and

offshore hedge funds. Given the needs of their client investors, hedge fund managers want

to have both types of funds to attract all types of investors.

Regulation of Hedge Funds

While mutual funds are very highly regulated, hedge funds are generally unregulated.

Mutual funds in the United States are required to be registered with the SEC. Although
hedge funds fall within the same statutory category as mutual funds, they operate under

two exemptions from registration requirements as set forth in the Investment Company

Act of 1940. First, funds are exempt if they have less than 100 investors; second, funds are

exempt if the investors are “accredited.” To comply with SEC exemptions, hedge funds are

also sold only via private placements. Thus, hedge funds may not be offered or advertised

to the general investing public.

Nevertheless, hedge funds are prohibited from abusive trading practices and a number

of funds got mixed up in the scandals plaguing the mutual fund industry in the 2000s. For

example, Canary Capital Partners and its managers agreed to pay $30 million from its

illicit profits as well as a $10 million penalty to the SEC to settle allegations that it engaged

in illegal trading practices with mutual fund companies, including making deals after the

market had closed and promising to make substantial investments in various funds man-

aged by the mutual funds. In March 2007, the SEC charged 14 defendants in a scheme

involving insiders at UBS Securities, Morgan Stanley, and several hedge funds and hedge

fund managers. The SEC claimed that the defendants made $15 million in illicit profits

through thousands of illegal trades, using inside information misappropriated from UBS.

Just two months prior to this announcement, regulators announced an investigation of UBS

and other banks that leased office space to hedge fund traders. Regulators stated a concern

about the relationship between the banks and their hedge fund “hotel guests,” looking at

whether the banks might be using the real estate relationships as a way to entice hedge

funds to do business with them, possibly at the expense of the funds’ investors. Specifi-

cally, there was an investigation into whether hedge funds located in bank buildings were

paying higher than normal trading fees to banks to compensate them for the office space

and failing to disclose this expense to investors.

More recently, the late 2000s saw two highly publicized scandals associated with
hedge funds. The first was that of Bernard L. Madoff Investment Securities. The Madoff

investment scandal occurred after the discovery that the asset management business of for-

mer NASDAQ Chairman Bernard Madoff was actually a giant “Ponzi” scheme. According

to a federal criminal complaint, client statements showing $65 billion in stock holdings

were fictitious, and there was no indication that any stocks were purchased since the mid-

1990s. Alerted by his sons, federal authorities arrested Madoff on December 11, 2008. The

firm was placed in liquidation and a trustee was appointed on December 15, 2008, after

Bernard Madoff confessed to having stolen customer property over a period of many years.

On March 12, 2009, Madoff pled guilty to 11 felonies and admitted to operating what has

been called the largest investor fraud ever committed by an individual. On June 29, 2009,

he was sentenced to 150 years in prison with restitution of $170 billion. Although Madoff

did not operate as a hedge fund, he operated through various funds of hedge funds.

Another highly publicized scandal occurring in the late 2000s involved Galleon Group

LLC, one of the largest hedge fund management firms in the world before announcing

its closure in October 2009. The firm was at the center of a 2009 insider trading scandal

that resulted in investors pulling capital from the firm rapidly. Twenty people, including

Galleon Group LLC co-founder Raj Rajaratnam, were criminally charged in what federal

authorities call the biggest prosecution of alleged hedge fund insider trading in the United

States. Prosecutors said they had evidence from wiretaps, trading records, and cooper-

ating witnesses to prove widespread trafficking in illegal insider information—including

an insider trading operation that paid sources for nonpublic information—that netted the

hedge fund more than $20 million.

Possibly as a result of the trading abuses and scandals and the role that hedge funds
played in the financial crisis, the SEC and other regulators began scrutinizing the hedge

fund industry more closely. Specifically, in 2003 the SEC recommended that large hedge

funds register as investment advisors with the SEC, subjecting them to periodic audits

and inspections. Only about 25 percent of hedge funds were registered with the SEC at

the time. In 2007, after years of examination and reflection, a committee of U.S. financial

system regulators concluded that current regulations on hedge funds were sufficient to

prevent hedge funds from threatening the financial system’s stability. The report, compiled

by the heads of the U.S. Treasury, Federal Reserve, SEC, and Commodity Futures Trading

Commission (the President’s Working Group on Financial Markets), concluded that while

hedge funds present challenges for market participants and policymakers, their risks can be

maintained through a combination of market discipline and limiting access to the private

pools of capital to wealthy investors.

The hedge fund industry faced increased calls for regulation at the start of the

2008–2009 financial crisis. Although hedge funds did not play a major role in the emer-

gence of the credit crisis, as only around 5 percent of their assets were invested in mortgage-

backed securities in September 2007, it is alleged that they contributed to volatility in 2008

through short-selling transactions and massive selling of shares due to deleveraging and

redemptions. Further, the actions of funds such as Bernard L. Madoff Investment Securi-

ties and Galleon Group lent further support to calls for greater regulation.

As a result, 2009 saw an abundance of calls for increased regulation of the industry.

For example, January 2009 saw the introduction of the Hedge Fund Transparency Act

of 2009, which called for all funds in excess of $50 million in assets (“large funds”) to

be required to register with the SEC and maintain books and records according to SEC

requirements. It also called for the disclosure of information regarding the identity (includ-
ing addresses) of the fund’s “beneficial owners,” the amount of the fund’s assets, the

fund’s equity structure, affiliations the fund may have with other financial institutions, the

minimum investment commitment required of investors, and the total number of investors.

However, this bill never got to a vote. In March of 2009, Larry Summers, Director of the

National Economic Council for Barack Obama, said the United States wants large hedge

funds and private-equity firms to be subjected to “rigorous public scrutiny,” compared

with the minimal oversight they now face. In July, the Obama administration released

TG-214, a fact sheet with the administration’s proposals for regulating hedge funds. The

proposal called for all funds with more than $30 million in assets to be required to register

with the SEC. Once registered, funds would be subject to: substantial regulatory reporting

requirements with respect to the assets, leverage, and off-balance-sheet exposure of their

advised private funds; disclosure requirements for investors, creditors, and counterpar-

ties of their advised private funds; strong conflict-of-interest and antifraud prohibitions;

robust SEC examination and enforcement authority and recordkeeping requirements; and

requirements for establishing a comprehensive compliance program. The administration’s

main rationale for the above requirements was to protect the financial system from sys-

temic risk.

The House of Representatives’s proposal for hedge fund regulation, from August 6,

2009, and the final bill, the Wall Street Reform and Consumer Protection Act of 2010, lost

much of the initial proposal’s enthusiasm. The later proposal called for the regulation of

hedge funds under less-stringent conditions than banks and lenders. Specifically, the bill

now requires that hedge funds with assets under management exceeding $100 million reg-

ister with the SEC under the Investment Advisers Act. This is similar to the requirements
specified for mutual funds. Also similar to mutual fund regulations, hedge

fund advisors are required to report financial information on the funds they

manage to an extent that is sufficient to assess whether any fund poses a threat

to the financial system. The data are kept confidential and can be shared only

with the Financial Stability Oversight Council which the legislation has set

up to monitor potential shocks to the economic system. Finally, should the

government determine that a hedge fund has grown too large or become too

risky, the hedge fund is placed under the supervision of the Federal Reserve.

Thus, while the financial overhaul bill requires large hedge funds to be reg-

istered with the SEC, the regulations imposed on hedge funds continue to be

much less onerous than those imposed on mutual funds.