Speech by SEC Commissioner:
Remarks Before EDHEC Alternative Investment Days 2007
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
November 20, 2007
Thank you Serge [Ledermann] for that kind introduction. Thank you to EDHEC Risk and Asset Management Research Centre for organizing this conference and inviting me to be a part of this first plenary session. The upcoming sessions, which bring together people with a great deal of expertise, promise to be very illuminating, so I am sorry that my Thanksgiving holiday plans require me to return to the United States today. Before I begin, I must tell you that the views that I express here are my own and do not necessarily reflect Commission policy or the views of my fellow Commissioners.
During this trip to Europe, I have been able to accomplish a number of different things, including speaking to this most distinguished group. Of most widespread impact, however, was a public meeting of the SEC last Thursday in which I participated via videoconference from the American Embassy in London. I do not believe that has quite been done before. I quickly realized that one collateral benefit to being piped in by video is that one is not on television camera all the time — particularly since this public meeting lasted 3½ hours! But, it was very appropriate for me to be in Europe for this particular meeting because we achieved a long-held goal that bodes well for the critically important transatlantic relationship. We voted to eliminate the reconciliation requirement for non-U.S. companies that file their financial statements in International Financial Reporting Standards as issued by the International Accounting Standards Board. This change is effective immediately — IFRS financial statements filed for years ending after last Thursday, 15 November, need not be reconciled. We anticipate that the information available to investors will not that much different. In addition, it should result in millions of dollars of savings, both of internal and external costs. These savings for companies, of course, also benefit their shareholders. Our hope is that this move should accelerate the integration of global capital markets and improve the level of financial information available, all to the benefit of investors.
The SEC has taken other steps recently that likewise signal our recognition that non-U.S. companies are valuable participants in our capital markets. Earlier this year we took steps to make it easier for foreign companies to exit the U.S. public capital markets, basically if their trading in the US is less than 5% of their worldwide trading volume. The theory behind easing the deregistration rules is that if we make it possible for companies to leave, then companies are more likely to come in the first place. They know that they will not be trapped if their value proposition for entering the markets changes because of diminished investor interest, regulatory developments, or otherwise. So far, approximately 70 companies have chosen to leave the US under the new rules, but approximately 60 companies have entered the US. So, this should be seen as a normal process.
These two changes to our regulatory system came on top of the repair that we made this year to the implementation of Section 404 of the Sarbanes-Oxley Act, which requires companies to assess their internal controls and auditors to report on that assessment. There were, of course, widespread protests about the cost and ineffectiveness of the initial approach to implementation that was driven primarily by an excessively granular audit standard issued by the Public Accounting Oversight Board, a quasi-governmental entity that the SEC oversees. The old standard was thrown out and a new one installed that should drive a more realistic, top-down approach that is grounded in materiality to consolidated financial statements.
In sum, these changes should help to make our public capital markets an easier place for non-U.S. companies to raise capital. Non-U.S. companies should begin looking at registration in the U.S. in a new light.
Of course, other things have been happening in the marketplace. The market events of this summer made “subprime,” which is the subject of the upcoming panel, edge out all other news of the summer, including David Beckham's inaugural football season for the Los Angeles Galaxy in America. Along with Beckham, whose knee injury kept him off the field for much of the season, we are hoping for a speedy recovery. This hope is warranted because, as U.S. Treasury Secretary Hank Paulson has observed, “We confront these current challenges against the backdrop of a strong economy — not just in the U.S., but globally.”1 Hedge funds are key players in the markets, so their reaction to recent market events will affect the course of that recovery. The way that regulators react to hedge funds also will affect the way in which the recovery proceeds.
Unfortunately, difficult events in the economy often result in renewed calls for more regulation without much concern for how or whether the contemplated regulation will work. Even when there are no market events of particular note, hedge funds are a popular target in a pro-regulation environment. They tend not to be familiar to regulators, the media, or the general public, so they arouse suspicions. People assume that regulation is necessary because, to use the SEC’s words in our failed hedge-fund rulemaking, “[u]nregistered hedge fund advisers operate largely in the shadows, with little oversight.”2
Those words were part of the justification for the SEC’s ill-fated attempt to impose a new regulatory scheme on hedge funds three years ago. The SEC imposed a new registration requirement on hedge fund advisors. It is noteworthy that this new requirement came out of nowhere; there was no particular event that caused the SEC to conclude that hedge fund advisor registration was necessary. Investor protection was one of the primary justifications for the rule, even though the SEC staff had conducted a study in 2003 that found no retailization of hedge funds in the U.S.3 The SEC staff recommended — somewhat incongruously — that the SEC consider requiring hedge fund managers to register as investment advisors under the Investment Advisers Act of 1940. The recommendation was wholeheartedly embraced by a majority of the SEC commissioners. Former Commissioner Cynthia Glassman and I did not share our colleagues’ enthusiasm and dissented from both the proposal and the adoption of the registration requirement.
The likelihood that the rule would not achieve its intended consequences and would give rise to unintended consequences also caused concern to our colleagues across the government who had worked with us on the issue of hedge funds in the past. Former Federal Reserve Chairman Alan Greenspan explained bluntly in testimony before the Senate that “the initiative cannot accomplish what it seeks to accomplish.”4
The SEC nevertheless in December 2004 adopted the rule that required hedge fund advisors to register. Several months after the compliance date, in June 2006, a federal court in Washington invalidated the rule.5 The court took issue with the way in which the SEC had gone about forcing hedge fund advisors to register under the Investment Advisers Act.
Under the Act, registration is triggered in part when an advisor has fifteen or more clients. Historically, the SEC had treated a fund as one client of an advisor on the theory that the advice is going directly to the fund and not to each investor in the fund. In connection with the hedge fund rulemaking, the SEC reversed this approach and required hedge fund advisors to look through their hedge funds and count each investor towards the fifteen client registration threshold. The court illustrated the difficulty that arises from the conflicting interests implicit in such an approach through the following example: “Consider an investment adviser to a hedge fund that is about to go bankrupt. His advice to the fund will likely include any and all measures to remain solvent. His advice to an investor in the fund, however, would likely be to sell.”6
So, the SEC’s mandatory registration requirement ended without a further fight by the SEC. We even refunded registration fees to the many advisors who had complied with the rule and chose to deregister after the court’s decision. Others decided to remain registered, presumably in order to maintain the marketing edge that registration brings, particularly to meet ERISA requirements and the conditions contained in many requests for proposals from pension funds.
Advisors who have deregistered after the invalidation of the rule should remember, of course, that registration status does not affect an advisor’s fundamental obligation to his clients. The high standard that applies to people who manage other people’s money applies regardless of whether you choose to be registered. A key part of this responsibility is keeping investors informed of how their money is being managed. Advisors must take great care to make accurate disclosure to investors and prospective investors about matters such as investment strategies, risks, and performance. All advisors — registered or not — must scrupulously avoid taking advantage of hedge fund through misconduct, such as trading ahead of it for personal profit or allocating trades in a way that disfavors the fund. Advisors must also take steps to ensure that investors are treated fairly. Robust valuation procedures are central to ensuring that investors who purchase or redeem get the right price. Hedge fund portfolios tend to be full of hard-to-value securities, but this only heightens the importance of paying proper attention to valuation. Advisors, of course, should also be punctilious about handling confidential, inside information that becomes known to them.
Investors should be diligent in monitoring advisors and demanding the disclosure that they need to do so. Investors’ leverage over advisors turns in part on whether they are able to leave the fund with their money. An unfortunate legacy of the SEC’s registration rule is that some hedge funds instituted longer lock-up periods. Oddly, the rule allowed advisors to avoid registration by extending their lock-up periods beyond two years. Two years was deemed to be the magic line that distinguished advisors to hedge funds from advisors to other types of funds, such as venture capital or private equity funds. Of course, it is not necessarily beneficial to an investor to have his money locked up for a longer period — the ability to withdraw is one of the most effective weapons that investors have against an advisor’s changes in strategy or goals. Thus, a rule intended to protect investors had the opposite effect.
No matter how highly we regulate, we cannot eliminate fraud. The SEC, of course, is committed to pursuing misconduct by market participants of all kinds. Hedge fund advisors, like other market participants, should take steps to avoid misconduct. Well-tailored policies and procedures can help advisors to manage conflicts of interest, guard against the improper use of inside information, accurately value securities, and properly report performance.
Indeed, the industry itself is best situated to design and put in place effective measures to combat hedge fund fraud and otherwise protect hedge fund investors. In recent years, hedge funds have been particularly active in doing this as part of trying to build the industry’s reputation. Some of these measures are a natural byproduct of the industry’s maturing process. As Jean-René Giraud, a Research Associate at EDHEC explained: “The recent institutionalization of the industry has allowed the quality of the operational infrastructure supporting hedge fund operations to be significantly enhanced. Development of prime brokerage technology, the growing success of back office providers and the significant growth of independent administration all contribute to minimizing the level of operational risk embedded in hedge fund investments.”7
The hedge fund industry has worked on best practices for hedge fund managers and due diligence guidance for hedge fund investors. In the United States, the Managed Funds Association unveiled a revised set of “Sound Practices for Hedge Fund Managers” several weeks ago.8 It sets forth recommendations in several areas, including management and trading controls, responsibilities to investors, determining net asset value, and managing risk. It also includes a model due diligence questionnaire for investors. Last spring, the Alternative Investment Management Association likewise revised its Guide to Sound Practices for European Hedge Fund Managers in response to the growth in Europe’s hedge fund industry since the guide was first issued five years ago. Another European effort is the Hedge Fund Working Group’s consultation paper on best practices that is primarily aimed at UK hedge fund advisors, but highlights issues that hedge fund advisors in other places should also be considering.9 Importantly, the Hedge Fund Working Group focused on improving disclosure in order to allow “sufficient freedom for innovation” and to “avoid placing undue hurdles in the path of smaller hedge fund managers, or new market participants who may not be able to comply with a detailed and prescriptive set of operational guidelines.”10 Industry-developed standards of practice are particularly helpful when they are sufficiently flexible to take into account the full range of sizes and types of hedge funds, a type of flexibility that regulators often find it difficult to afford.
Recent efforts by regulators have reflected an understanding of the value of hedge funds and the power of the marketplace in encouraging the hedge fund industry to develop appropriate standards of conduct and provide adequate disclosure. Last May, for example, the Financial Stability Forum (FSF), which brings together national financial regulators, national banks, and other expert organizations, issued an updated report on hedge funds.11 Among other things, it noted the valuable role that investors and counterparties, armed with sufficient disclosure, can play in exercising discipline for the benefit of particular hedge funds and the market as a whole. The FSF report cited recent efforts by the International Organization of Securities Commissions (IOSCO) and the U.S. President’s Working Group on Financial Markets (PWG) as important in encouraging investors and counterparties to set “appropriate expectations for hedge fund managers, including that they have information, valuation, and risk management systems that enable them to provide accurate and relevant information to investors, creditors and counterparties with appropriate frequency, breadth and detail.”12 For its part, IOSCO issued a final paper on hedge fund valuation earlier this month. In February of this year, the President’s Working Group, which is composed of the Treasury Secretary and the chairmen of the Federal Reserve Board, the SEC, and the Commodity Futures Trading Commission, issued a policy statement regarding private pools of capital that supported a market-based approach with government regulation as the exception.13 The statement discussed the obligations of hedge fund advisors, counterparties, regulators, and investors.
Regulators have focused on the role that investors can play out of a recognition that hedge fund investors tend to be sophisticated. As more institutional money from pension funds, endowments, and funds of hedge funds flows into hedge funds, there are greater checks on those funds. Institutional investors and wealthy individual investors without institutional sophistication are able to employ others to help them conduct due diligence on hedge funds. One of the reasons that I argued against requiring hedge fund advisors to register with the SEC was that it would have caused us to devote routine inspection resources to hedge fund advisors when those resources could be better devoted to mutual funds, in which a much larger percent of the population is invested. If something does go wrong, investors in hedge funds are much better equipped to defend their interests than are average mutual fund investors. Indeed, the SEC relies heavily on investor tips in pointing us to wrongdoing by hedge fund advisors.
In order to try to ensure that hedge fund investors can fend for themselves in the United States, decades ago we restricted access to hedge funds to investors that meet certain income or wealth standards. Almost a year ago, the SEC issued for comment a new hedge fund proposal that included a proposed revision to our accredited investor standards.14 The SEC received 600 comments, many of which expressed sentiments along the lines of the following: “That I am sophisticated one day and not sophisticated the next by the stroke of bureaucratic pen is nothing but the nanny-state presuming I couldn’t financially survive without the SEC’s protection.”15 In light of the many critical comments, we deferred consideration of the proposal and sought additional comment as part of a proposal to change accreditation standards in Regulation D, the regulation that provides a framework for private placements of securities.16 Considering hedge fund investor standards in connection with the proposed changes to Regulation D should help us also to work towards greater uniformity of approach across our rule book, which is increasingly filling up with new eligibility standards, none of which looks exactly like another. The only ones that this serves well are lawyers, and even they are writing in to complain.
Last year’s proposal would have significantly narrowed the pool of investors eligible to invest in hedge funds and private equity funds that rely on the exemption in Section 3(c)(1) of the Investment Company Act. Funds that rely on Section (3)(c)(7) may only be sold to “qualified purchasers,” who must have at least $5 million in investments — you can see why this gets complicated. To further complicate things, somewhat oddly, the changes would not apply to venture capital funds.
The SEC’s accreditation standards were put into place in 1982. Since then, years of inflation and rapidly rising housing prices (even taking into account the current flattening in housing values) have expanded the population that meets the current accreditation standards. The proposal would create a new category of accredited investor called an “accredited natural person” that would include anyone who satisfies the existing $1,000,000 net worth or the $200,000 net income test and owns at least $2.5 million in investments. A person’s home would not count towards the $2.5 million. The new investment minimum would be adjusted for inflation every five years. Essentially, then, the proposed rule would layer the additional investment requirement on top of the existing accredited investor requirements. The second time that we asked for comment, we suggested an income test as an alternative to the $2.5 million investment test. Depending, of course, on the income levels chosen, this could expand the number of eligible hedge fund investors. A more direct approach would be simply to update existing standards to reflect inflation.
The new round of comment, which ended last month, generated fewer comments than the first round. Nevertheless, commenters still offered many suggestions for improvement. Not surprisingly, we heard from a number of commenters who urged us to address the lack of consistency in our eligibility standards rather than adding to the inconsistency by adopting another standard. Commenters also pointed out that the SEC’s approach to accreditation standards ignores the reality that other investments, including other private offerings and penny stocks, might well be riskier than hedge funds. Other commenters suggested that we make exceptions for knowledgeable employees and existing investors who want to make follow-on investments. Commenters also suggested that the SEC consider entirely different approaches such as administering financial sophistication tests, imposing diversification requirements on hedge fund investors, or taking into consideration whether individuals have graduate degrees from accredited institutions. Another important, related issue raised by commenters is whether the SEC ought to allow limited advertising for hedge funds as it is proposing to do for certain other private offerings.
I share commenters’ concerns — although not necessarily all of their suggested solutions — and worry about the potential unintended effects of raising the accredited investor threshold. Practically speaking, low net-worth retail investors are not targeted by hedge fund advisors. Indeed, the current regulatory structure is based on the premise that hedge funds are open only to a fairly narrow subset of investors. I worry, however, that the proposed threshold, which would markedly constrain the ranks of hedge fund investors, would make it very difficult for new hedge fund advisors to enter the market. These advisors will have to try to attract capital from what may prove to be an inordinately small pool of potential investors.
The accredited investor proposal was paired with another less controversial proposal that the SEC adopted in August. The new rule clarifies the SEC’s authority to bring enforcement actions against investment advisors to pooled investment vehicles, including hedge funds, for fraud against investors and prospective investors (as opposed to the funds themselves).17 Basically, if you had any doubt, thou shalt not rip off thy limiteds. I wholeheartedly supported shoring up our authority to pursue hedge fund advisors who, for example, send out false performance data to investors. But, I believe that one should be shown to have committed fraud with knowledge, not merely negligently. In my view, the rule should not be used to pursue advisors that mistakenly provide inaccurate information without intention to defraud.
This leads me to the broader point that we must be careful not to lead investors into thinking that our regulatory system can insure them from losses or protect them from every mistake that hedge fund advisors make. Otherwise, investors might be lulled into conducting less rigorous due diligence and monitoring their investments less intensely. This, too, was one of my concerns about the SEC’s hedge fund advisor registration requirement. Although registration is by no means an SEC seal of approval, if investors believe that it is, then they are less likely to undertake adequate due diligence before investing. We must help investors in hedge funds to get the information that they need to make their own assessments of the risk and return of potential investment opportunities. If they are wrong, we need to let them bear the consequences. The Financial Economists Roundtable, a group of financial economists that issues annual policy statements on topics of current relevance, was correct in warning government regulators to “vow not to bail out hedge funds” because “[t]he prospect of free government ‘bail out’ insurance creates adverse incentives for speculative behavior.”18 As Noël Amenc and EDHEC pointed out in response, there are times when banking regulators must address systemic issues, whatever the cause.19 When large hedge funds fail, systemic fears invariably surface, but the market has thus far shown itself capable of absorbing failures.
On the opposite end of the spectrum from systemic concerns are concerns that hedge funds are affecting the decision-making of individual companies. Hedge fund activism potentially threatens the interests of shareholders in the companies in which activist hedge funds are invested. These concerns are also being raised about sovereign wealth funds. Activist shareholders may push their own agenda on a company for reasons unrelated to the company’s welfare. That is their right — they own the stock. But, other shareholders should be able to have accurate and adequate disclosure about what is going on, especially if their vote is sought through a proxy solicitation.
In one example, a hedge fund owned a significant stake in a company targeted in a stock-for-stock tender offer. The hedge fund stood to profit greatly if the acquisition went through. However, dissident shareholders of the acquiring company were objecting that the deal was overpriced and should be abandoned. So the hedge fund purchased a 9.9 percent stake of the acquiring company, but then entered into equity swaps and other transactions to eliminate any of its economic interest in the acquirer. Consequently, it had no reporting obligations under the rules of that particular jurisdiction. Thus, you had a situation where this hedge fund could vote a significant block of the acquirer’s shares to approve a transaction which would, in turn, benefit the hedge fund but arguably hurt the shareholders of the acquirer. As shareholder access to the proxy looms large on the SEC’s agenda, we need to consider the ramifications of giving activist investors additional leverage. They could use that leverage to negotiate backroom deals with management potentially to the detriment of other shareholders.
Thank you all for your attention this morning. I hope that you enjoy the rest of your conference. I welcome your thoughts on these subjects or any others. You can help the SEC and other regulators to set aside the rhetoric that has too often framed the way we approach hedge fund regulation and replace it with a rational approach to hedge fund regulation that is based on accurate information about the industry. I am pleased that the hedge fund industry has shown a new willingness to discuss these issues with regulators. I hope that you will take part in that discussion. My door is always open and, for those of you who do not plan to make a trip to Washington, I would be happy to hear from you by telephone.
1 Remarks by Henry M. Paulson, Secretary of the Department of Treasury, at Georgetown University Law Center (Oct. 16, 2007) (available at: http://www.ustreas.gov/press/releases/hp612.htm).
2 Registration Under the Advisers Act of Certain Hedge Fund Advisers, Investment Advisers Act Release No. 2266 at text accompanying n.64 (July 20, 2004).
3 Staff Report to the SEC, Implications of the Growth of Hedge Funds at 80 (Sept. 2003) (available at: http://www.sec.gov/news/studies/hedgefunds0903.pdf).
4 Testimony of Alan Greenspan, Chairman, Federal Reserve Board of Governors, before the Senate Banking, Housing and Urban Affairs Committee (July 20, 2004).
5 Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).
6 Id. at 882.
7 Jean-René Giraud, Mitigating Hedge Funds’ Operational Risks: Benefits and Limitations of Managed Account Platforms at 9 (June 2005) (available at: http://www.edhec-risk.com/best_execution/mitigating_hf_operational_risks/
8 Available at: http://www.managedfunds.org/mfas-isound-practicesi.asp.
9 Hedge Fund Working Group, Hedge Fund Standards: Consultation Paper, Part 2; The Best Practice Standards (Oct. 2007) (available at: http://www.mondovisione.com/pdf/HFWG%20Consultation%20Paper%20Part%20II.pdf).
10 Id. at Part 2, p. 7.
11 Financial Stability Forum, Update of the Report on Highly Leveraged Institutions (May 19, 2007) (available at: http://www.fsforum.org/publications/publication_21_82.html).
12 Id. at 7.
13 Agreement among PWG and Agency Principals on Principles and Guidelines Related to Private Pools of Capital (Feb. 22, 2007) (available at: http://www.treasury.gov/press/releases/reports/hp272_principles.pdf).
14 Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles; Accredited Investors in Certain Investment Vehicles, Investment Advisers Act Release No. 2576 (Dec. 27, 2006) (available at: http://www.sec.gov/rules/proposed/2006/33-8766fr.pdf).
15 Comment Letter of Buzz Lynn (Feb. 24, 2007) (available at: http://www.sec.gov/comments/s7-25-06/blynn4531.htm).
16 Revisions of Limited Offering Exemptions in Regulation D, Securities Act Release No. 8828 (Aug. 3, 2007) (available at: http://www.sec.gov/rules/proposed/2007/33-8828.pdf).
17 Prohibition of Fraud by Advisers to Certain Pooled Investment Vehicles, Investment Advisers Act Release No. 2628 (Aug. 3, 2007) (available at: http://www.sec.gov/rules/final/2007/ia-2628.pdf).
18 Statement of the Financial Economists Roundtable on Hedge Funds at 9 (Nov. 3, 2005) (available at: http://www.luc.edu/orgs/finroundtable/HedgeFundStatement.htm) (hereinafter, “FER Statement”).
19 Noël Amenc and Mathieu Vaissié of the EDHEC Risk and Asset Management Centre, Response to the “Statement of the Financial Economists Roundtable on Hedge Funds” (Dec. 2005) (available at: http://www.edhec-risk.com/features/RISKArticle.2006-01-18.1658/attachments/EDHEC%20Response%20to%20FER%20 Statement%20on%20Hedge%20Funds.pdf).