Speech by SEC Commissioner:
Rule to Prohibit Fraud by Investment Advisers to Certain Pooled Investment Vehicles; Rule to Revise Criteria for Accredited Investors in Certain Private Investment Vehicles

by

Commissioner Roel C. Campos

U.S. Securities and Exchange Commission

SEC Open Meeting
Washington, D.C.
December 13, 2006

I too would like to thank the staff for their efforts on this proposal. I am sure that many people would categorize this project as a thankless task, or, perhaps in light of the holiday season, the gift that keeps on giving. But we cannot kid about the importance of these proposed rules. Not a day goes by without an article gracing our nation's newspapers about the $1.2 trillion dollar hedge fund industry. The impact of hedge funds and like investment pools on our markets is far reaching and expanding. The complexity of these instruments is increasing. The exposure of investors to these instruments is growing. But, the information available about them remains limited.

Let me first focus on the anti-fraud rule. As you have heard, it is an advisers' rule, not a hedge fund rule per se. The SEC must be able to counter fraud in all its incarnations. Sections 206(1) and (2) of the Advisers Act provide us with the necessary authority to address fraud against a fund. But, we have seen frauds that affect shareholders directly, yet fall outside the constructs of 10(b) and 17(a). Some of this illegal conduct also impacts the fund but some does not, and by fund I mean general partner. Sometimes the fund is complicit in the fraudulent activity. It is these abusive practices and our authority over them which require our attention after the Goldstein decision.

There are things I like and dislike about the proposal. For example, the rule will apply to state and federally registered entities; it will apply to shareholders and prospective shareholders; and, it will apply at all times, not just during the offering or sale of a security. Although applicable to all advisers, the rule captures within its first prong most of the fraudulent activity we have seen related to hedge fund fraud — that of material misrepresentations and omissions by fund advisers to fund investors. The second prong tracks the language of 206(4) in providing a catchall provision for fraudulent, deceptive or misleading conduct.

However, the rule does not impose a specific ongoing affirmative disclosure obligation. I believe that one could craft such a rule under the current legal framework that clearly and succinctly sets forth underlying obligations without expanding an adviser's fiduciary duties. The template for this design already exists in rule 206(4)-4.

Accordingly, while this proposal is a very good step in reinstituting the protections that were called into question by the Goldstein decision, I would have gone further to protect investors. Given the time constraints and the need to act quickly to clarify our authority, the proposal succeeds, as previously noted, in capturing many of the examples of fraudulent conduct we have seen thus far with respect to hedge fund advisers, as well as that by advisers generally. I would also note that the proposed rule protects the industry's most valuable asset — its reputation — and has the potential to deal with fraudsters who work in the shadows. But, there is more to be done.

Now, let me say a few words about the accredited investor proposal. The premise for raising the standard is to ensure that investors are not only capable of bearing the economic risk of the investment but also that they understand the merits and risks of that investment. This is a valid purpose but it does not address the larger concern, which is the growing indirect exposure of investors to hedge fund investments through their participation in pension funds, endowments and other investment pools. This greater concern cannot be taken lightly. By 2010, it is predicted that institutional investors will account for more than 50% of the total flows into hedge funds, and retirement plans globally will represent 65% of total institutional flows. This will translate into institutions accounting for more than 40% of hedge fund assets.

Even within the narrow confines of the proposed rule — which is limited to investors in certain 3(c)(1) pools — we must be judicious in finding the right mix between investor protection and market innovation and competition. Net worth and investable assets do not necessarily equate with financial acumen and vice versa; so, we must be careful not to foreclose investment opportunities for individuals based solely on their finances.

Ultimately, the accredited investor proposal affects only a small percent of hedge funds because the vast bulk of hedge funds currently are 3(c)(7) funds. Yet, I would hesitate to broadly assert that we need to protect small investors from investing in hedge funds as a matter of course. Instead, we need to provide all investors with a high degree of transparency regarding the risks associated with such investments and allow them to choose. To the extent that such information is currently limited, and we are not pursuing a regulatory fix to this opacity, some form of added protection is necessary for the time being, such as investment through a fund of funds or this proposed rule.

However, as I asked at the hedge fund roundtable, shouldn't all investors have access to the potential high returns of hedge funds? Does this proposal go too far in limiting individual access to these pools? Have we found the right balance with $2.5 million in investable assets? Does the proposal hinder competition among pools that are just starting to get off their feet? I encourage commenters to share their views.

Together, the anti-fraud rule and the accredited investor rule improve the current regime, but there are additional measures that can and should be taken. As a part of our CSE program, our staff reviews prime brokers and analyzes the risk inherent in hedge fund clients. Our staff also has been evaluating whether there are opportunities to modify Form ADV to provide more information to investors (and ourselves) about particular pooled investment vehicles and their advisers. We are working with our foreign counterparts to analyze their approaches to hedge funds and determine whether there are some guiding principles we should all consider in managing the accompanying risks of hedge funds.

In the end, the reasons for regulating hedge funds are investor protection and systemic risks. These proposals are pieces to the regulatory puzzle presented by hedge funds but I believe a greater degree of oversight will be necessary to see the whole picture.

Now I have some questions.

http://www.sec.gov/news/speech/2006/spch121306rcc5.htm