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It will take a good scam to rein in hedge funds

Date: Monday, March 17, 2008
Author: Economic Times

 MUMBAI: They strike you as the archetypal “good cop, bad cop” combine. Former Congressmen Paul Sarbanes and Michael Oxley, co-authors of the famous (or dreaded, if you were to believe listed US firms) Sarbanes-Oxley Act, feel there is a strong case for regulating US hedge funds. Unfortunately, they also feel this is unlikely until some financial disaster involving a hedge fund takes place. In their view, there is a common thread between the ongoing subprime crisis and the previous corporate scandals at the start of the century: the lack of transparency.

Mr Sarbanes and Mr Oxley were in Mumbai on Friday to attend a seminar on corporate governance and capital markets.

In an exclusive chat with ET, the duo spoke their mind on a wide range of issues affecting financial markets. The obvious topic was the ongoing crisis in the US subprime loan market. Is it a case of inadequate disclosures, or poor understanding of the derivative products involved? “The (Sarbanes Oxley) Act requires a lot of disclosures, but that does not mean what might be disclosed may turn out to be large losses,” says the 75-year-old Sarbanes, who has spent 30 years in the US Senate.

 His partner, Mr Oxley, who now serves Nasdaq as its vice-chairman, is more forthright on the subject. “A lot of it was about the lack of transparency in the secondary market, where it is difficult to assess risk. And I think there was a pricing fraud,” says the 64-year-old, who had served in FBI for three years before entering politics.

“The parallel between Enron, Worldcom and the current crisis is the lack of transparency in the process,” he added. On the contentious issue of regulating hedge funds in the US, the duo are not very hopeful. “The only way to get a regulatory regime for hedge funds is a huge scandal. Else, it is difficult to get a momentum,” says Mr Oxley. Hedge funds have opposed efforts to bring them under the regulatory ambit, as they largely cater to a select set of affluent investors.

However, Mr Sarbanes pointed out that many hedge funds have come out with a fund-of-funds concept to make small investors put their money. That was not the way it was intended to be when hedge funds sought to be excluded from regulatory glare.

“There is a saying, a crisis is a wonderful thing to waste; that is what it may take,” he said ruefully. “But I hope it doesn’t come to that because the LTCM (Long-Term Capital Management) episode in the late 90s was extremely serious,” he added.

What about the perception that stringent regulatory framework in the US is driving companies to other markets? The duo wouldn’t agree. “I think that has more to do with the development of capital markets globally,” points out Mr Sarbanes. In the olden days, somebody looking to raise capital would have to go either to New York or London, he says.

“But now Chinese companies are going to Shanghai or Hong Kong. Many companies are even going to Paris. There is a lot of liquidity and capital raising has become more easier than before,” he says.

When it was instituted in 2002 in the wake of widespread corporate frauds in the US, the Sarbanes-Oxley Act sparked outrage among listed firms, which felt the cost of implementing those norms was huge. Has that opposition subsided over a period of time? Yes, claim Sarbanes-Oxley.

Many companies, after working through the process of implementing the compliance rules, have reached the conclusion that they served a useful purpose and are benefiting out of it, says Mr Sarbanes. “I think the initial costs have come down substantially,” Mr Oxley concurs.

“With the recent changes in accounting standards by SEC (the Securities Exchange Commission which regulates the US markets), there is going to be a top-down, risk-based scaleable model for smaller companies,” Mr Oxley adds.