Speech by SEC Commissioner:
Keynote Address at the 9th Annual International Conference on Private Investment Funds
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
March 10, 2008
Good morning, and thank you for that kind introduction. It is a pleasure to be here speaking to you today in one of the world's great financial capitals. Before I begin, however, I must give the standard disclaimer that my remarks represent my own views and not necessarily the views of the Commission, individual Commissioners or my colleagues on the Commission staff.
In thinking about the increasingly global nature of the investment management industry, I am concerned that America's regulatory regime is too often pigeonholed as rigid and overly demanding. I believe that the true nature of our regulatory approach is not widely understood, particularly by those outside the U.S. The fact is that we are fortunate as regulators to have an array of tools at our disposal and to have the flexibility to choose the best tool for the job at hand. These tools include the ability to craft more "principles-based" solutions and to work with the investment management industry as it designs its own standards for best practices.
The United States enjoys an extraordinarily broad and deep marketplace of investment advisers. Currently, there are almost 25,000 investment advisers registered in the U.S. About 11,000 of these advisers are registered with the Commission and have approximately US$38.5 trillion of assets under management. Another 13,000 plus advisers (generally smaller advisers and those that do not advise registered funds) are registered at the state-level. The U.S. marketplace also has a significant international component. There are 580 advisers based outside the U.S. that are registered with the Commission. Almost 200 of these are here in the United Kingdom. That is more than twice the number from any other single foreign jurisdiction. Of these U.K. advisers, 147 indicate that they advise hedge funds or other pooled investment vehicles. As you know, estimates of hedge fund assets under management can vary considerably. According to one recent survey done by the publisher HedgeFund Intelligence, assets under management in hedge funds worldwide reached almost US$2.5 trillion by July of 2007. American firms managed more than US$1.4 trillion of these assets. The same survey estimates that assets in European hedge funds reached US$539 billion by the middle of last year. One of our greatest challenges has been to develop a regulatory scheme that is flexible enough to deal with such a diverse and dynamic landscape.
As you know, the system in the United States is often cited as an example of rules-based regulation while the United Kingdom's regime is said to exemplify a principles-based system. I think that, in actuality, neither system is entirely rules-based or principles-based. Rather, each country regulates securities markets through a combination of these two regulatory strategies. In fact, I see great similarity between the U.K.'s principles-based approach to regulation and the approach taken in the United States to regulating investment advisers, including those that advise hedge funds.
II. Rules-Based Regulation and Principles-Based Regulation
Before I turn to the specifics of the regulation of private funds and their advisers in the United States and the United Kingdom, I would like to touch briefly on the topic of rules-based regulation and principles-based regulation.
John Tiner, former chief executive of the FSA, has remarked that "[p]rinciples-based regulation is essentially about outcomes or ends while rules-based regulation is about means. Principles-based regulation allows firms to decide how best to achieve required outcomes and, as such, it allows a much greater alignment of regulation with good business practice."2 Proponents of principles-based regulation also argue that it affords other benefits. These include permitting more nuanced regulation appropriate to today's markets and encouraging the disclosure of key relevant information rather than extensive boilerplate. Such regulation has its drawbacks as well. Although this approach has been largely lauded by industry and regulators, some retail firms in England recently have expressed some concerns. These retail firms reportedly were uncertain how the FSA would interpret breaches of principles and were concerned about possible retrospective enforcement actions in light of the principles-based overhaul of the FSA's anti-money laundering handbook.3
Rules-based regulation also brings its own benefits and drawbacks. Such a regime can satisfy industry demand for specificity with regard to legal duties and compliance responsibilities. It can give a clear baseline of acceptable conduct with regard to investor protection. It also can provide for ease of communication within firms with regard to standards and requirements while affording regulators clear standards and requirements to use in monitoring and enforcement of those firms. Critics, however, charge that such a system can be marked by a number of problems. First, this regulation can result in increased implementation and compliance costs. It also can result in decreased flexibility and the attendant need for formal exemptive relief or additional rulemakings. Finally, it can lead to the creation of boilerplate disclosure documents that may overwhelm investors with information.
As I mentioned, I believe that both of our countries regulate markets through a combination of these strategies. The approach we have taken in the United States to regulating investment advisers resembles in many respects the principles-based approach to regulation here. When enacting the Investment Advisers Act of 1940, Congress recognized the diversity of advisory relationships and through a principles-based statute provided them great flexibility, with the overriding obligation of fiduciary responsibility. Congress chose not to subject registered advisers to a "fit and proper" test. As you know, the FSA, by contrast, generally imposes certain qualification requirements.
In implementing the Investment Advisers Act, the Commission has followed a more rules-based approach on those regulatory issues that it believes call for a certain level of specificity, such as investment adviser recordkeeping. On the other hand, many recent Commission rulemakings continue to adhere to a more flexible principles-based approach. For example, in 2003 the Commission adopted two principles-based sets of rulemakings under the Investment Company Act and the Investment Advisers Act mandating that registered investment companies and investment advisers develop compliance policies and procedures.
Another example of the Commission's consideration of a principles-based regulatory response is its unanimous decision on February 13th of this year to propose rule amendments that would require investment advisers to prepare and deliver to clients and prospective clients a narrative brochure written in plain English. Most registered advisers currently use a check-the-box, fill-in-the-blank form for their brochures. The Commission's proposal for a plain English narrative brochure, if adopted, would give investors more detailed information about an adviser's business practices. This information includes the types of advisory services they provide, the fees they charge, and the risks that clients can anticipate. The proposed narrative also would require disclosure of the adviser's disciplinary history, including any securities law violations, as well as conflicts of interest. Such conflicts could include the use of affiliates to execute transactions, the use of client brokerage to obtain "soft dollars benefits" and the adviser's interests in certain transactions. This proposed narrative structure would afford advisers broader parameters in which to craft disclosure that is appropriate to their business. If adopted, the brochures would be required to be delivered to clients and prospective clients and also would be available to the public through the Investment Adviser Public Disclosure Web site (IARD).
The Commission's proposal addresses disclosure, which, in tandem with fiduciary duty, is at the core of the principles that govern the relationship between advisers and their clients. If adopted, this clear, current and meaningful disclosure will help empower clients to make informed decisions when hiring advisers and to manage the advisory relationship on an ongoing basis. This proposal also seeks to address developing areas of concern like conflicts of interest arising from the side-by-side management of clients who pay performance fees (such as hedge funds) and those who do not.
I understand that last month the FSA also moved forward on an investment adviser disclosure initiative. As you know, on November 1, 2007, the FSA implemented its new regime for the conduct of the investment business, the Conduct of Business Sourcebook (COBS). On February 19th of this year, the FSA published a consultation paper containing proposals to build on the COBS' principles-based approach to disclosure. The paper deals with the introduction of a single document that is aimed at providing key information about investment advisers' services and costs in a more streamlined fashion. The FSA's approach also continues to give advisers considerable discretion about how their information is presented.
III. Regulation of Private Funds and their Investment Advisers
Now I would like to talk a little more specifically about the regulation and oversight of private funds and their advisers. In the U.S., many hedge funds, private equity funds and venture capital funds meet the technical definition of "investment company" in section 3(a) of the Investment Company Act. These funds generally rely on the exclusion from the definition of investment company contained in either section 3(c)(1) or section 3(c)(7) of the Investment Company Act. Section 3(c)(1) excepts from the definition of investment company any issuer whose outstanding securities are owned by not more than 100 investors and which is not making (or proposing to make) a public offering. Section 3(c)(7) excludes any issuer whose outstanding securities are owned exclusively by certain sophisticated or wealthy investors known as "qualified persons" and which is not making (or proposing to make) a public offering.
An adviser to a private fund must register as an investment adviser in the United States unless that adviser is able to qualify for an exemption in the Investment Advisers Act. Many advisers to private funds rely on the "de minimis" exemption under section 203(b)(3) of the Advisers Act. This section excludes any investment adviser that has had fewer than 15 clients during the preceding 12 months, doesn't hold itself out generally to the public as an investment adviser and doesn't advise a registered fund. All advisers, however, (whether registered or unregistered) remain subject to the anti-fraud provisions of the Advisers Act.
In recent years, much of the Commission's focus in the private fund area has been on hedge funds and their advisers. In June 2006, the U.S. Court of Appeals for the District of Columbia vacated a Commission rule which required certain hedge fund managers to register as investment advisers. Since that decision, the Division of Investment Management has been focused on determining the best way to properly discharge responsibilities regarding hedge funds and their advisers efficiently and effectively. A balanced and effective regulatory regime would allow the industry to continue to evolve while still providing hedge fund investors with appropriate protections. In developing recommendations regarding the regulation of hedge fund advisers, I am cognizant of the global nature of this industry. How regulators in other jurisdictions handle the oversight and monitoring of hedge funds and their advisers is relevant. I myself have had a number of meetings with my foreign counterparts in an effort to benefit from their experience, approaches and perspectives. Over the past year and a half, I also have paid particular attention to the FSA's regulatory approach and to industry developments here. I believe that the United Kingdom's regulatory regime remains very relevant to our own.
A significant number of hedge fund advisers, both in the U.S. and abroad, currently are registered with the Commission. Of course, should a foreign adviser choose to register in the United States, we do not require that adviser to maintain an office on American soil. The Commission staff's view of the extraterritorial application of the Advisers Act is generally that if you are a foreign adviser registered with the Commission and comply with certain recordkeeping and disclosure requirements, the provisions of the Advisers Act do not usually extend to your non-U.S. clients.
In addition to the registration of some hedge fund advisers, the Commission also oversees private funds and their advisers through its enforcement program. In response to the vacating of the Commission's rule, the Commission adopted an anti-fraud rule under the Advisers Act this past August that clarifies the Commission's ability to bring enforcement actions against investment advisers, including those that advise hedge funds, in certain situations. Pursuant to this rule, the Commission clarified that it may bring an action against investment advisers who defraud investors or prospective investors in a hedge fund or other private pooled investment vehicle. In addition, the Commission remains very active in its pursuit of enforcement actions against both registered and unregistered advisers and their personnel. Recent cases in this area have focused on behavior we all would agree is wrong, including insider trading, fraud, illegal short selling, late trading and deceptive market timing, undisclosed or inappropriate conflicts of interest and misappropriation of assets.
The Commission's examination program allows the staff to identify areas where registered private fund advisers may be deficient in their compliance with the federal securities laws and to recommend enforcement actions, where appropriate. This program tends to focus on hedge fund advisers, as opposed to other private fund advisers, because more hedge fund advisers are registered with the Commission. In its work with registered hedge fund advisers, the Commission's exam staff has identified deficiencies in several major areas, including with respect to insider trading policies and compliance policies and procedures. When considering insider trading policies, the staff looks at whether they are tailored to the specific facts and circumstances of the firm and its clients. The staff then considers factors such as the affiliations of investors in the hedge funds and the likelihood that those investors could be mined for non-public information. The staff also looks to the types of investment strategies a hedge fund follows, such as distressed debt and bank loan participations, as well as the use of long/short equities. In the area of compliance policies and procedures, the exam staff has highlighted specific concerns with respect to how a registered hedge fund adviser's policies and procedures address the possible use of non-public information to make investment decisions for hedge funds and personal accounts. The regular use of forensic tests to determine any interesting patterns of investment decisions that may potentially evidence a problem in this area can be an important component of effective compliance programs. The Commission's exam staff also has identified some of the same deficiencies with respect to hedge fund advisers as they have identified with respect to advisers to traditional products, such as issues relating to trading, brokerage, best execution, valuation, marketing and incomplete books and records.
I also recognize that the Commission regulates registered funds that engage in typical hedge fund investment strategies. These strategies include both so-called long/short, or 130/30, funds and other hedge fund-type registered funds that use leverage, usually involving borrowed money or derivatives, in order to increase or decrease their returns. In the past, I have expressed concern that these types of funds, while providing retail investors exposure to hedge fund investment strategies, may, like hedge funds themselves, raise certain regulatory and investor protection concerns. Conflicts of interest issues might arise when an adviser is managing both a long/short fund and a traditional mutual fund in a side-by-side arrangement. I also believe that funds need to adapt their operational processes to keep up with concerns, such as valuation, raised by increasingly complex alternative products.
Finally, hedge funds in the United States, in a sense, also are self-regulating through self-imposed mechanisms that have developed as the industry has evolved and matured. I believe that a change in the nature of hedge fund investors has helped to spur the creation of such standards. Increasingly, institutional investors like endowments, pension funds and funds of funds have looked to invest in hedge funds and other alternative investment vehicles. Such clients may be more cautious, sophisticated, and, in some cases, risk averse than high-net worth individuals and other traditional hedge fund investors. They also may demand greater transparency, improved risk information and reliable valuation techniques. As a result, industry best practices among hedge funds that serve these investors are developing, and risk measurement and management technology has, I believe, become more sophisticated. Industry leaders here in the United Kingdom also have stepped forward to help encourage and develop voluntary best-practice standards for hedge funds and those that manage them.
IV. Hedge Fund Working Group's Final Report on Hedge Fund Standards
On January 22nd of this year, the Hedge Fund Working Group issued its final report containing voluntary best-practice standards for the industry in the U.K. Let me commend the Hedge Fund Working Group and its members for their efforts in developing these important guidelines. The standards, built upon the FSA's own eleven principles of good business conduct, contain recommendations tailored to the particular challenges faced by hedge funds and their advisers. For example, the report recommends that managers be transparent about fees and risks and also in their dealings with prime brokers and lenders. The standards call for valuation to be done independently from portfolio management, where possible, and for hedge fund managers to prepare disclosure covering all material aspects of the valuation process and valuation procedures and controls. Such disclosure would be made available to investors — on a confidential basis — upon their request. The report also recommends that funds implement a governance structure that is capable of addressing conflicts between advisers and investors.
A similar initiative is under way in the United States. The President's Working Group on Financial Markets (PWG) consists of the leaders of the four major U.S. financial regulators — the Department of the Treasury, the Federal Reserve, the Commodity Futures Trading Commission and the Securities and Exchange Commission. As you probably know, the PWG provided its own principles-based guidance in February 2007. Among other things, the PWG principles recognize that private pools of capital, such as hedge funds, bring significant benefits to the financial markets. The principles recommend that private pools be offered only to investors with the sophistication to identify, analyze, and bear the risks associated with them and that investors in those pools obtain accurate and timely historical and ongoing material information. The PWG established two private sector committees which have been tasked with developing best practices using this guidance. One committee is comprised of investors, including representatives from pension funds, endowments, investment consultants and non-U.S. investors. The other is comprised of representatives of a diverse group of hedge fund managers. I am hopeful that the two committees will release their own reports shortly. Although these committee reports may differ from the Hedge Fund Working Group's final report, I believe that they will cover much common ground.
According to the Hedge Fund Working Group's chairman, Sir Andrew Large, the Hedge Fund Standards Board, which will officially take up the mantle of the Hedge Fund Working Group later this year, will continue the working group's own efforts at cooperation and information sharing with the PWG. It also will be evaluating the differences between the Hedge Fund Working Group's standards and those contained in the reports to be issued by the PWG's committees. Such coordination and cooperation serves as an excellent model for the way in which industry can work together with regulators around the globe to develop smart and sensible solutions to hedge fund regulatory issues and to strengthen and enhance confidence in all of our markets.
My staff and I will continue to work with the industry to encourage compliance by private funds and their advisers with all regulatory requirements and with the industry's own best-practice standards. With such compliance, I believe that hedge funds and other private funds can remain a positive and beneficial force in our capital markets all over the world. I also believe that we should continue to learn from the market's own successes and failures, from the approach of our regulatory counterparts here in the United Kingdom and across the globe, and from our cooperation with industry professionals like you. What we learn will enable us, in turn, to continue to choose the most appropriate tools to address each regulatory challenge we face. I thank you for your attention this morning and hope you enjoy the rest of the conference.