Form ADV: Would hedge fund registration have helped Madoff investors?

Could regulation of the hedge fund industry have prevented the Madoff fiasco? Perhaps. But likely not the specific type of regulation envisioned in the SEC’s failed attempt to regulate hedge funds back in 2006.

Ironically, Madoff’s investment advisory business “voluntarily” registered with the SEC that year. That was right around the Commission’s failed bid to have all hedge fund advisers register with it. Many other hedge funds had already done so when Phil Goldstein’s suit against the SEC eventually vacated the ruling. However, the surfeit of fund information that resulted from the registration drive provided academics with a unique chance to compare operational risk factors with more traditional investment risk factors. Stephen Brown, William Goetzmann, Bing Liang, and Christopher Schwarz did just that in this paper called “Mandatory Disclosure and Operational Risk: Evidence from Hedge Fund Registration”. (Brown was recently asked about the topic in this AP piece on Sunday)

The abandoned plan would have seen all hedge fund managers submit a form “ADV” to the SEC containing operational information (see Madoff’s Form ADV here). According to the authors the form was designed as a “deterrence of fraud”:

“The Form ADVs for this larger sample contain a wealth of information, previously unavailable for many managers, about fund characteristics such as potential conflicts of interest and past legal and regulatory problems. Both of these relate directly to the stated purpose of the disclosure, which includes “deterrence of fraud,” “keeping unfit persons from using hedge funds to perpetrate fraud,” “adoption of compliance controls,” or more generally, the “avoidance of operational risk.”

Given the assumption that many hedge fund investors also conduct some of their own due diligence on hedge fund investments, the authors ask the following question:

“…are Form ADV filings simply redundant and expensive, or do they provide valuable, otherwise inaccessible information to participants in the market for hedge fund services, thereby helping them avoid investing in potentially fraudulent firms?”

Stamp of Approval

Last year we wondered if voluntary SEC registration for hedge funds could be misused as a “seal of approval” when marketing hedge funds. The authors of this paper wondered the same thing a year earlier and hypothesized that voluntary registration could be framed as a “signal of quality”…

“…we find evidence that the information in the form has the potential to add value to the investor decision-making process. Hedge funds operated by managers filing Form ADV in 2006 had better past performance and had more assets than those operated by managers who did not file either because they were technically exempt from the filing requirement, or because they simply chose not to file. This result suggests that filing alone may be a potential signal of quality.”

Time’s Justin Fox recently expounded on the moral hazard created by the registration of Madoff’s funds and related brokerage:

“…regulation of such investment funds ‘communicates confidence in a product that is riskier than normal investors should get involved in,’ as then Treasury undersecretary Robert Steel put it at a conference on hedge fund regulation last year.”

“For some investors and fund-of-funds managers, the regulatory imprimatur that the SEC gave Madoff’s brokerage may have communicated confidence in the investment products he sold on the side.”

Potential Conflicts of Interest

According to Brown, Goetzmann, Liang and Schwarz, Form ADV was meant to reveal potential conflicts of interest…

“A number of variables relating to potential conflicts of interest are required by Form ADV. In particular, the form asks whether any employee or entity controlled by the firm is affiliated with another type of financial institution such as a broker-dealer, mutual fund, or limited partnership. It asks about participation in clients’ transactions, including proprietary interest in transactions, sales interest in transactions, brokerage discretion, and custody of client assets. In each of these cases, the potential exists for the manager to influence client decisions, or make decisions on the client’s behalf that benefit the manager at the expense of the client.”

In “Five Ways to Avoid a Ponzi Scheme: Madoff Edition“, U.S. News & World Report recommends that investors “dig deep” by looking at Form ADV. Unfortunately, Madoff’s ADV clearly states that it is affiliates with a broker-dealer. This was a well known fact among many investors who also performed their own due diligence and it did not on its own disqualify their allocation of capital to the fund. Many of the investors who chose to invest in the fund were also aware of this fact. The extent to which the Form ADV was, in fact, instrumental in revealing this information remains a big question mark.

“Problem Funds”

Brown et al divide the roughly 2000 hedge fund ADV forms studied into “non-problem” funds (funds answering “no” to at least one regulatory infraction Section 11) and “problem” funds (funds that answered “yes” at least once - no matter how minor). Approximately 15% of hedge funds were tagged as “problem” funds - about the same percentage as the number of “problem” advisers overall (hedge and traditional).

Interestingly, the “problem” funds had a lower leverage, volatility and return than the “non-problem” funds. As the chart from the paper below shows, problem funds were also slightly bigger and older, and had slightly lower incentive fees and lock-up periods.

Madoff would have been tagged as a “problem fund” by this methodology due to a minor 2005 NASD violation detailed on the ADV. In keeping with other “problem” funds, Madoff was also relatively old and large, and had lower incentive fees (0%).

The study goes on to show that “problem funds” have much higher “external conflicting relationships” - 73% of problem funds are affiliated with a broker dealer, vs. only 24% of “non-problem” funds. (This may not come as a huge surprise given the fact that increased business complexity leads to greater probability of operational infractions.)

To test whether Form ADV is actually redundant, the authors of this examine whether “problem” funds have trouble raising capital. If “problem” funds had trouble raising capital, that might suggest that investors were generally already aware of the fund’s previous infractions or its potential conflicts of interest.

Surprisingly, it turns out that “problem” funds did not actually have trouble raising capital. While this may suggest that investors must have been unaware of the information revealed by Form ADV, it could also just reflect the fact that a fund-raising handicap was off-set by the marketing benefits of being bigger, older, less leveraged, and less volatile.

Prophetically, on February 1, 2006, the day the (late) SEC hedge fund registration rule came into effect, CNNMoney.com noted:

“Opponents also question whether SEC registration will help protect investors against fraudulent managers, especially since some of the SEC’s hedge fund enforcement actions were levied at firms that were already registered with the SEC.”

In the end, Form ADV may indeed have contained information that was material to investors’ decisions on Madoff. But it remains far from clear that Form ADV was, in fact, a critical source for that information or whether it was simply restating what was already known to investors.