February 26, 2007
To Whom It May Concern:
Philosopher George Santayana coined the phrase, "Those who do not learn from history are doomed to repeat it.” Out of concern that the SEC is ignoring history, I am commenting on the proposed new rules “ . . . designed to provide additional investor protections that would affect . . . hedge funds.” I am a securities lawyer by training having practiced almost six years during which time I conducted numerous initial and secondary public and private securities offerings. I am presently a portfolio manager for a Wall Street investment firm. I have been managing client assets and emotions for almost ten years. I have seen both sides of the U.S. investment industry that the SEC is charged with regulating. The supposed “problem” that the proposed rules are intended to remedy could be solved quite easily with minor proposed rule modifications if the SEC would only consider the historical context.
The ’33 and ’34 Acts are perhaps the most elegant and important statutes Congress has ever enacted save the Constitution and Bill of Rights. They are the twin pistons which have driven the unrivaled U.S. capitalist engine the past 73 years. The two Acts are premised on two simple ideas first posited by Supreme Court Justice Louis D. Brandeis’ trust-busting book Other People’s Money: sunlight is the best antiseptic and electric light the best policeman. Hence, the ’33 Act’s initial disclosure and registration rules and the ’34 Act’s ongoing reporting requirements, respectively. President Franklin D. Roosevelt was influenced by Brandeis’ ideas and the resulting Congressional output of the Acts reflects Roosevelt’s influence in Congress. The SEC, with some guidance from U.S. Supreme Court decisions along the way, has done commendable yeoman’s work enforcing those Acts. I fear, however, from the tenor of the proposed rules, that the SEC is being led astray by a populist movement against “hedge funds” steeped in historical ignorance.
First, no where do the laws of this country define a “hedge fund.” It is a term of art first employed by one Alfred Winslow Jones, an Australian-American sociologist and financial journalist who in 1949 decided to try his hand at investing. In other words, he decided to join them instead of writing about them! The concept as generally accepted is to “hedge” long only positions in stocks with short positions thereby (as least in theory) mitigating systemic or market risk. Unfortunately, the popular press of 2007 uses the term “hedge fund” to describe every single private investment fund or pool that is not publicly registered pursuant to the ’33 Act. Such laziness of definition does a great disservice to the American experiment.
Dow Jones, for example, reports daily on hedge fund benchmarks for Convertible Arbitrage, Distressed Securities, Equity Market Neutral, Even Driven, Merger Arbitrage, and U.S. Equity Long/Short funds. These forms of private investment funds are each very, very different. To assume any present, past or future proposed rules apply equally is ludicrous. To lump them all together under one label “hedge funds” and assume the risks, rewards and headlines affecting one necessarily affect the others is just as absurd. Is this not obvious? Yet here we are in 2007 being asked by the SEC the comment on uniform proposed rules.
Ignoring trumped up populist media hype against “hedge fund” black magic and its potential affect on the financial well-being of every American man, woman and child, the SEC states it is troubled by the following statistic. In 1982 when Regulation D was adopted approximately 1.87% of U.S. households qualified for accredited investor status: individual or joint with spouse net worth of $1 million OR individual income exceeds $200,000 (joint with spouse exceeds $300,000). By 2003, the percentage of U.S. households meeting this definition increased by 350% to approximately 8.47%. Funny thing happened along the way, however. The S&P 500 Total Return Index (stock price capital appreciation PLUS dividends) increased approximately 1,048% during the same period. One need only to have started with about $87,108 in one’s portfolio in 1983 to have $1 million by 2003. An intrepid researcher can do the rest of the digging for historical fact, but I surmise that the percentage of U.S. households with an investment portfolio of $87,018 at the end of 1982 is not too far different from the percentage that today have $1 million. Any difference is most likely due to other history described below which has apparently been ignored by the SEC and populist anti-hedge fund movement.
Since inflation was whipped by Federal Reserve Chairman Paul Volcker, Chairmen Greenspan and Bernanke have presided over an incredible period of monetary and economic stability. This situation and the attendant benefits have no doubt contributed not only to U.S. and even world stock market returns, but allowed U.S. workers to monetize the increasing returns to education resulting in higher salaries. It is no wonder and, indeed, somewhat of an economic miracle, that so many individuals in the U.S. earn annual incomes in excess of $200,000 and joint spouses earn in excess of $300,000! Rule 501(a) does not even attempt to differentiate between gross income, adjusted gross income, W-2 income, K-1 income, or pass-through entity income via Sub S or partnership entities. Income in American is, shall we say, a foggy notion. What good is Rule 501(a) when left to interpretation by self-serving investment promoters in the first place? Does the SEC expect that investment promoters will don a “I am conducting a citizen’s-audit in the name of the IRS” mentality? Of course not. The original logic behind current Rule 501(a) escapes me, let alone the proposed rules.
More disturbing to me, however, is the apparent ignorance by the SEC of two very important historical facts which are easily gleaned from the Congressional Record. While the SEC’s historical national Reg D wealth accumulation nightmare begins in 1982, Americans’ financial independence was won in part by President Gerald Ford’s 1974 enactment of ERISA which created something call an Individual Retirement Account (IRA). On November 10, 1981, the IRS formally described the rules for 401(k) plans. Initial adoption and contribution limits were small. It has taken years of tweaking, interpretation, and modifications to get to this point and Congress and the IRS still tinker with these sorts of plans even today.
The SEC is missing the point by seeking comment on proposed rules to protect investors. Rather, it should be seeking comment on how to perpetuate our successful capitalist experiment. How did 8.47% of U.S. households end up meeting Rule 501(a)’s accredited investor definition by 2003? A nation of supposedly non-savers saved more money than they had ever been allowed to do so before in a tax-advantaged manner during the biggest bull market in history. In layman’s terms, U.S. households invested a lot of money in stocks inside those new IRAs and 401(k) plans in 1983 and earned about 1,048% total return on those investments over twenty years (about 12.97% annually on average). Congratulations, America! Thank you Paul Volcker, Ronald Reagan, Alan Greenspan, Ben Bernanke, the U.S. Congress, and, most of all, that ingenious and creative economic animal, the U.S. consumer.
One might argue that I am mistaking a bull market for intelligence. The dumb investors just got lucky, it might be claimed, and they will not be as lucky if allowed to invest in “hedge funds.” I disagree. American investors are far more sophisticated and educated today with respect to investments than they were in 1933 and 1934. The investment industry and Wall Street have educated the American public via 401(k) plan enrollment meetings, financial media, and academic training. Witness the explosion of the do-it-yourself investment industry with the rise of the Internet. There has been no shortage of information about investments in America the past 25 years, which brings me to my salient point.
The SEC serves a necessary paternalistic purpose: to protect investors by enforcing a fair playing field and full disclosure. The Great Depression and 1929 market crash certainly influenced the motivation for the Acts. Caveat emptor cannot stand in the investment world because the cost to society is too great if someone loses life savings to a Ponzi scheme or con artist. Our babies have grown up, however, and we have to let them go at some point. With respect to STOCKS American investors are able to take care of themselves now and the proposed rules ignore this reality.
A distinction should be made by the SEC concerning any changes to Rule 501(a) or any other definition of accredited investor or qualified purchaser with respect to private investment funds (“hedge funds”) that invest solely in U.S. publicly listed stocks whether long only, market neutral or long/short. Investors are more than capable of evaluating the merits of a portfolio manager that claims to be able to make money on a falling stock. The manager will either make or lose money betting on stocks to rise or fall and all currently existing reporting requirements are more than adequate. Morningstar, Value Line, and similar services reinforce this fact. In fact, I urge the SEC to consider removing any accredited investor qualifications for purposes of investing in U.S. equity-only hedge funds (whether long only or long/short) if the fund agrees to register as an Investment Company pursuant to the 1940 Act. If the fund refuses to do so, it may still accept investors under current 501(a) rules (however illogical they may be). Australia has been successfully operating under such a system for years. This would result in an explosion of publicly traded U.S. equity-only type hedge funds which would introduce market forces and level the playing field further as only competition can. Investors would benefit greatly by having quicker and easier access to alternative investments (“alternative” due to the short component).
By removing or loosening accredited investor guidelines with respect to U.S. equity-only funds, the SEC can get to the heart of the matter: regulating more complex private investment funds. The more complex funds cannot be lumped together with U.S. equity-only funds. The U.S. Supreme Court in SEC v. Ralston Purina Co., 346 U.S. 119, 125, 126-27 (1953) basically said accredited investors were able to fend for themselves financially and intellectually. As long as offerees had physical and intellectual access to the kind of information afforded by registration under the ’33 Act, a private offering was permissible. Giving someone a prospectus or private placement memorandum was not enough, according to the Supreme Court. The recipient actually had to understand what it said and be able to withstand the loss of the investment.
American investors today have the intellectual capacity to understand mutual funds which invest in U.S. stocks. To wit, the subscriber base of Morningstar, Value Line, Kiplinger’s, The Wall Street Journal, Money, etc. Why wouldn’t they have the same intellectual capacity to understand a long/short hedge fund which invests in the very same U.S. stocks? The investment minimums would presumably have to fall due to reasons of severe competition among publicly traded hedge funds which would naturally play into investors’ ability to withstand loss of their investment.
My arguments and logic do not extend, however, to any other forms of private investment funds. American investors have not been educated the past 25 years to understand the complexities of fixed income hedge funds (bond markets are not at all transparent to retail customers), currency hedge funds, merger-arb, convertible-arb, or any other of the myriad complex private investment funds. They do not possess the intellectual capacity required under SEC v. Ralston Purina Co. to properly and fully assess the risks attendant thereto. The SEC is right to increase oversight and investment requirements concerning such funds. Too many investors now have the ability to purchase such funds. While a fund of funds mechanism would lessen direct exposure to disaster for individual investors, maintaining current Rule 501(a) accredited investor standards (or even lowering the requirements) would most likely entail SEC directives with respect to the relatively high fee structure commonly charged by fund of funds else investors will most likely not benefit regardless.
In summary, I urge the SEC to consider the historical context of the proposed rules. The confluence of IRA and 401(k) savings schemes, the greatest bull market in history, and stable monetary and economic environments have resulted in great success for U.S. investors. They are more sophisticated than ever before with respect to stocks. Wall Street has spent billions advertising and educating the American public. The financial media (and more recently the Internet) has furthered this education. Investors need not be as protected from themselves today with respect to stock mutual funds. The same logic should be extended to so-called hedge funds which only invest in U.S. listed stocks, whether long or short. A distinction must be made. The proposed rules should apply only to those private investment funds where investors’ intellectual, as well as physical, access is truly limited.
Jeffrey A. Sexton, Attorney