Hedge Fund Regulation and Fund Governance: Evidence on the Effects of Mandatory Disclosure Rules

• Author: COLLEEN HONIGSBERG
• DOI: http://doi.org/10.1111/1475-679X.12270
• Published date: 01 September 2019
• Date: 01 September 2019

DOI: 10.1111/1475-679X.12270

Journal of Accounting Research

Vol. 57 No. 4 September 2019

Printed in U.S.A.

Hedge Fund Regulation and Fund

Governance: Evidence on the

Effects of Mandatory Disclosure

Rules

COLLEEN HONIGSBERG

∗

Received 4 October 2016; accepted 4 March 2019

ABSTRACT

This paper uses three alternating changes in hedge fund regulation to study

whether regulation reduces hedge funds’ misreporting, and, if so, why reg-

ulation is effective. Relative to public companies, hedge fund regulation is

relatively light. Much of the regime is a “comply-or-explain” framework that

allows funds to forego compliance with governance rules, providing that they

disclose their lack of compliance. The results show that regulation reduces

misreporting at hedge funds. Further analysis suggests that the disclosure

∗Stanford Law School.

Accepted by Christian Leuz. I am greatly indebted to the five members of my dissertation

committee: Fabrizio Ferri, Robert J. Jackson, Jr., Wei Jiang, Sharon Katz, and Shivaram Ra-

jgopal. I also wish to extend a special thank you to two anonymous referees, Jennifer Arlen,

Bobby Bartlett, Thomas Bourveau, Ryan Bubb, Matt Cedergren, Jim Cox, Konhee Chang, Rob

Daines, Miguel Duro, Jacob Goldin, Joe Grundfest, Luzi Hail, Matt Jacob, Mattia Landoni,

Gillian Metzger, Josh Mitts, Jim Naughton, Fernan Restrepo, Ethan Rouen, Steven Davidoff

Solomon, Randall Thomas, Ayung Tseng, and Forester Wong for their helpful comments and

suggestions. I am also very grateful for feedback I received from workshops at the Ameri-

can Accounting Association, the American Law & Economics Association, Columbia Busi-

ness School, and the Utah Winter Accounting Conference. A legal-oriented version of this

paper was previously circulated under the title Disclosure versus Enforcement and the Opti-

mal Design of Securities Regulation. An online appendix to this paper can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

845

CUniversity of Chicago on behalf of the Accounting Research Center,2019

846 C.HONIGSBERG

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.

JEL codes: G20; G23; G28; K22; M42; M48

Keywords: mandatory disclosure; hedge funds; SEC regulation; financial

misreporting; auditing

1. Introduction

Most hedge funds were not subject to mandatory disclosure or gover-

nance requirements until recently. Even when such requirements were im-

posed, the regime put in place was relatively light. Rather than mandatory

rules to which funds must adhere, much of the regulatory framework for

hedge funds is a “comply-or-explain” regime—funds are required to dis-

close whether they comply with a set of governance provisions, but they may

forego compliance providing that they disclose their lack of compliance.

The effectiveness of this regulatory regime has been greatly debated—as

has the general question of whether hedge funds should be regulated in

the first place (Securities Exchange Commission (SEC) [2003]). Many pol-

icy makers have argued that regulating hedge funds is unnecessary because

funds’ investors are sophisticated enough to detect and deter financial mis-

conduct without government assistance (Atkins [2006]). Opponents have

questioned this argument, however, pointing out that the majority of hedge

funds’ investors are institutional investors who may suffer from a “double

agency problem” (Karantininis and Nilsson [2007]). According to these

opponents, institutional investors may not be incentivized to fully detect

and deter wrongdoing because the separation of client (the primary bene-

ficiary) 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]).

For these reasons, it is unclear ex ante whether regulation affects hedge

funds’ misreporting. To address this question, my analysis exploits three

changes in hedge fund regulation. First, in 2004, the SEC adopted a rule

requiring that the majority of hedge funds 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 infer-

ences on the question of whether hedge fund regulation reduces misre-

porting because the three events created alternating changes in the reg-

ulatory regime. Second, the setting allows for a better understanding of

why regulation is effective. Upon registration, funds are typically subject

HEDGE FUND REGULATION AND FUND GOVERNANCE 847

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 registered funds, the funds that became registered under this new

classification were exempt from both government inspections and compli-

ance requirements—these funds were only subject to the disclosure rules.

This setting therefore allows for examination of the disclosure rules in iso-

lation, providing an opportunity to study whether this specific regulatory

component is effective.

My study points to three key findings. First, I find that hedge fund reg-

ulation 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 (al-

though this result should be interpreted as descriptive because the deci-

sion to withdraw is highly endogenous). Second, I provide evidence sug-

gesting that regulation reduced misreporting by spurring funds to make

changes to their internal governance. In particular, after the newly regis-

tered funds had to publicly disclose whether they were audited and the

name of any such auditor, many hired and/or switched auditors. On aver-

age, 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.

All tests are difference-in-differences regressions that compare the hedge

funds affected by the regulatory changes to a group of control funds that

were already registered with the SEC and did not have a change in regula-

tory status. To address selection concerns, I include a series of robustness

tests (e.g., matched samples and placebo tests). Following prior literature,

I identify misreporting using two suspicious patterns in the monthly per-

formance returns that hedge funds report to commercial databases. First, I

use the incidence of a fund’s “kink” at zero—that is, the presence of more

small gains than would be expected based on the number of small losses.

This measure is thought to capture whether the fund has managed its re-

turns to avoid reporting a loss, and is the best-known predictor of detected

fraud at hedge funds (Bollen and Pool [2012]). Second, following Agarwal,

Daniel, and Naik [2011], I determine whether the fund engages in “cookie

jar” accounting by testing whether the fund reports abnormally high re-

turns in December.

My paper contributes to several areas of literature. First, I contribute

to the literature on comply-or-explain disclosure regimes. Long popular

overseas, comply-or-explain regimes are becoming increasingly popular

in the U.S. as regulators express concern over one-size-fits-all governance

regulation. For example, Sarbanes-Oxley (SOX) does not mandate that

a “financial expert” sit on the audit committee, but it does require