SEC’s New Hedge Fund Rules Lack an Accountant’s Precision

The Securities and Exchange Commission recently announced new rules for hedge funds to report on equity short positions. There’s nothing terrible in the rules, but they will impose pointless costs on investors, mainly because they were written by lawyers rather than accountants.

Of course, every new diktat prompts complaints about the costs, but in this case they are greater than they may seem.

Asking investment managers to detail their short positions sounds easy — just press a button and get a report from your securities database to send to the SEC. The trouble is large investment managers can have hundreds or even thousands of funds, separate accounts, subaccounts, master/feeder funds, advised funds and other legal entities, each with its own balance sheet. In some of these accounts the manager will be deemed to have discretion, in others the discretion will rest with others. Some accounts will have positions in other accounts. Disentangling things to make sure all discretionary positions are included, with no double-counting or non-discretionary positions, is not trivial. And the penalties for even accidental or minor errors, both financial and reputational, can be severe.

Still, the costs might be worth it if the rule would do what the SEC wants. It already has information on gross short sales of stocks by issuer, but the data omits two important distinctions. It does not identify people betting against the stock (those who might be tempted to spread misinformation or manipulate the trading) versus people hedging options or other positions, and it does not separate highly levered funds that might be forced out by a short-squeeze (leading to market instability) versus less-levered investors who can maintain their positions long term.

If accountants were assigned the rule-setting task, the first thing they would do is define consistent sets of reporting entities, reporting periods and data. But the SEC has four different reporting regimes for the four main ways investors take on short positions — short sales, options, swaps and exchange-traded funds. Each of these regimes gathers data from different entities on different bases and reporting periods. There’s no way to aggregate the data to get consistent overall pictures of short selling.

The second accounting problem with the SEC approach is that it aggregates data by investment manager rather than by legal entity. The gross short positions reported by a large investment manager will likely mix bets against issuers with hedges, and positions in highly levered entities with positions in less-levered entities — thereby hopelessly mixing the distinctions the SEC wants to track.