Speech by SEC Commissioner:
Remarks at the Federal Reserve Bank of Atlanta Financial Markets Conference 2006
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
Policy Session II: Hedge Funds and Investor Protection Regulation
Sea Island, Georgia
May 17, 2006
It is a pleasure to be here again this year. Our policy session, devoted to hedge funds and investor protection regulation, is very timely and I believe we will have a lively discussion. Let me begin by introducing today's participants. Our presenter is Franklin R. Edwards. Holding a PhD in Economics from Harvard University and a JD from New York University Law School, Frank is a professor of finance and economics at the Graduate School of Business at Columbia University, and holds the Arthur F. Burns Chair in Free and Competitive Enterprise at Columbia. His paper, "Hedge Funds: Creators of Risks?" provides an overview of recent Securities and Exchange Commission regulation and an analysis of what such regulation may accomplish in the context of investor protection.
Our discussants are Gay Huey Evans and Dwight Anderson. Gay is the president of Tribeca Global Management (Europe) Ltd., which she joined in September 2005. Tribeca is one of 12 investment centers that together make up Citigroup Alternative Investments. Prior to joining Tribeca, Gay served from 1998 to 2005 as the Director of Markets at the UK Financial Services Authority, where she was responsible for the UK Listing Authority, supervision of all market infrastructure providers, market policy and market surveillance. Dwight is the principal of Ospraie Management LLC, which serves as the investment adviser to the Ospraie Funds, with some $4 billion assets under management. Dwight previously served in senior capacities at Tudor Investment Corporation and Tiger Management, and was an associate at JP Morgan. I am sure that their practical industry experience and their perspectives from both sides of the Atlantic will inform our discussion today.
Before turning to Frank's paper, I would like to spend a few minutes to share my perspective on these issues and to provide a context for the discussion. Also, let me give the standard disclaimer that the views I express are my own and do not necessarily reflect the views of the other Commissioners, the Commission or its staff.
In December 2004, the Commission adopted its rule requiring certain hedge fund advisers to register with the Commission. The deadline for registration was only this past February, and more than a thousand hedge fund advisers registered.
As you may know, Commissioner Paul Atkins and I dissented from this rule. My dissent was not because of a lack of interest in obtaining information from and about hedge funds, but rather, because I thought it important for us to first define what information we believed would be helpful in order to gain a better understanding of hedge funds and how they impact our securities markets. And I would note that I agree with Jerry Corrigan's comments this morning on a more principles-based approach.
Ironically, at the open meeting when the Commission voted to adopt the rule, then-Chairman Donaldson stated that a task force had been constituted to identify hedge fund risks and he implied that the task force would develop a targeted examination model. In my view, the task force should have completed its work prior to the promulgation of the rule. This critical step would have informed our decision and enabled us specifically to tailor a rule to address actual, as opposed to hypothetical, concerns. Instead, we adopted a rule that requires an adviser to a private fund to file a Form ADV if it manages at least $25 million and the fund permits investors to redeem their interests within two years of purchasing them. Form ADV or the Uniform Application for Investment Adviser Registration is a mandatory form used by investment advisers. The first part of this form requires the adviser to answer a number of questions about its business practices, who owns and controls the entity, and who provides investment advice on the entity's behalf. The second part of the form is the adviser's brochure, which the adviser is obligated to deliver to prospective clients and annually offer to current clients. Advisers are required to file an annual update amending their Form ADV.
As we noted in our written dissent at the time, and as Frank notes in his paper, Form ADV is unlikely to provide information that the Commission needs to monitor hedge fund activities and identify fraud, and there is little information that will assist hedge fund investors in evaluating the nature of hedge fund investments or the risks associated with those investment strategies. Moreover, the rule has unintended - but readily predictable - consequences that were also addressed in the dissent. It has encouraged a number of hedge funds to extend their lock-up periods to two years, thereby reducing liquidity. The rule has also required us to reallocate our limited resources to inspect more than a thousand additional advisers on top of the many thousands that our examination staff already is required to examine. Since we have not expanded our examination staff, this reallocation results in the diversion of resources that would otherwise be available to inspect the much larger universe of advisers to mutual funds, 529 plans, and annuities - whose investors number more than 90 million, relative to the fewer than 1 million individual and institutional hedge fund investors.
Another unintended consequence is that the rule, which was promulgated with the goal of inhibiting "retailization" of hedge funds, perversely may increase such retailization. Specifically, because pension funds tend to limit hedge fund investments to those with registered advisers, the mandatory registration of all advisers that meet the criteria has expanded the potential universe and thereby affords even more opportunities for investment in hedge funds. Also, our registration may be seen as a seal of approval by investors. Further, to the extent that the Commission adopted its rule out of concern that unsophisticated individual retail investors would get burned by investing in hedge funds, the Commission could have considered raising the minimum wealth threshold. As Frank notes in his paper, this has occurred indirectly because hedge funds that wish to impose a performance fee (the vast majority) may do so only if their investors are qualified. A "qualified client" has a minimum wealth threshold of $1.5 million net worth, which amount is higher than the "accredited" investor wealth threshold ($200,000 annual income or $1 million net worth) that a hedge fund could use where it has fewer than 100 investors. Nonetheless, the Commission could have considered raising the minimum wealth threshold for qualified investors.
Yet another unintended consequence of the rule is that it has decreased investment opportunities for US investors. As a result of the requirement that hedge fund advisers look through the fund and count individual US investors, I have heard that some non-US based funds now restrict US investors in order to avoid having to register.
A lawsuit challenging the Commission's adoption of this rule is pending, and the Court of Appeals has heard oral argument in the case, but has not issued a decision. Accordingly, unless and until this rule is taken off the books, the agency must enforce it. Thus, in anticipation of the rule's implementation, the Commission beefed up its inspection processes by providing specialized training to approximately 420 of its examiners specifically for the purpose of understanding how to inspect hedge fund advisers. As part of this training, we have drawn on the expertise and resources of academics and hedge fund experts. Our examination staff also have applied a risk assessment algorithm to all Form ADV filings that the Commission has received since September 2005 in order to identify and assess potential risks.
So, where does that leave us today? Here are the latest statistics:
- As of March 31, 2006, there were just over 10,000 advisers registered with the SEC.
- Of these 10,000 advisers, approximately 2,400 (24%) are hedge fund advisers.
- Of these 2,400 registered hedge fund advisers, 1149 (46%) registered with the SEC after adoption of the rule (most did so by the February 1, 2006 compliance date; 170 did so after February 1 but before March 31, 2006).
- The vast majority of registered hedge fund advisers are based in the US (over 2,100, or 88% of the 2,400 total). In contrast, 165 hedge fund advisers based in the UK (7% of the 2,400) are registered with the SEC.
- Since February 1, 2006, the Commission's Office of Compliance Inspections and Examinations has started 375 examinations of advisers and funds. Of these, 88 (or 23.4%) are of hedge fund advisers.
The Commission is not alone in looking at hedge funds. In particular, in June 2005, the UK FSA published a discussion paper entitled "Hedge Funds: A discussion of risk and regulatory engagement" in which the FSA identified key risks associated with hedge funds and solicited public input on potential risk mitigation actions. In March 2006, the FSA published the feedback it had received and potential next steps. Also, in February 2006 the Technical Committee of the International Organization of Securities Commissions (IOSCO) approved a project by IOSCO Standing Committee 5 to develop standards of good practice for hedge fund valuation. The Standing Committee intends to present a paper for publication and public comment in or about June 2007, and it will be interesting to see what best practice recommendations are contained therein.
So, what does this all mean vis-à-vis hedge funds and investor protection regulation? Let me pose the following questions:
- What do investors need to know about hedge funds in order to make informed decisions?
- What information should the SEC be examining in order effectively to regulate hedge funds?
- Should we as regulators enable retail investors to invest in funds with hedge fund type products? Should we leave this up to the market?
- If so, how should this be accomplished - through hedge funds, mutual funds, funds of funds?
- If we increase hedge fund regulation, are we essentially turning hedge funds into mutual funds?
- Hedge fund advisers that register must comply with a host of other requirements, including designating a chief compliance officer. These requirements impose additional costs. How significant are these costs to investors and do they outweigh any benefits to investors?
If you don't address these directly in your remarks, we can get back to them during the question and answer session. So, let's turn to our presenter, Frank Edwards, to start the discussion.