Speech by SEC Staff:
Remarks before the Managed Funds Association Educational Seminar Series 2005: Guidance on the SEC's New Regulatory Framework for Hedge Fund Advisers
Paul F. Roye1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
New York, NY
January 12, 2005
Good afternoon, and thank you, Jack, for that introduction and for inviting me to speak to your seminar. I am pleased to be here today. Before I begin, I would like to remind you that my remarks represent my own views and not necessarily the views of the Securities and Exchange Commission, the individual commissioners or my colleagues on the Commission staff.
I would like to begin by thanking the Managed Funds Association for hosting this educational seminar on the SEC's new regulatory framework for hedge fund advisers. A large amount of attention has been focused on the SEC's rationale for adopting the hedge fund adviser registration requirement and whether a change was justified. But the new rule has been adopted, and I agree with the MFA that it is time to look ahead and focus on what the new rule means for hedge fund advisers. This is an important and timely endeavor-and the focus of my remarks today.
II. No Attempt to Stifle Legitimate Investment Strategies
As I indicated, I do not want to reiterate the reasons for the Commission's regulatory action, but I do want to stress that the Commission was acutely aware of the benefits that hedge funds provide to our financial markets by contributing to market efficiency and enhancing liquidity. Registration of hedge fund advisers under the Investment Advisers Act represented the least intrusive form of regulation available to address the concerns of the Commission in the hedge fund sector of the investment management industry.
We saw no justification for direct regulation of hedge funds themselves under the Investment Company Act. Advisers Act regulation does not result in hedge funds having to register their offerings with the Commission, nor does it require a modification of organizational structures. Adviser registration does not result in the disclosure of proprietary trading strategies, nor does it subject hedge fund advisers to any additional portfolio disclosure requirements. Nor does adviser registration result in public disclosure of a hedge fund adviser's clients.
In the discussion today of the principal regulatory requirements that you will be subject to upon registration as investment advisers, you should take note of the fact that there are no limits on legitimate trading techniques or strategies applicable to registered investment advisers. The investment adviser regulatory regime does not restrict an investment adviser's ability to engage in particular investment strategies, such as short selling, using leverage or investing in particular financial instruments. The Advisers Act is primarily a disclosure and anti-fraud law, focused on managing conflicts of interest and ensuring a fair deal for America's advisory clients. Your investment flexibility will not be hindered by your registration as investment advisers.
There are approximately 8,500 investment advisers registered with the SEC today. They have combined assets under management of approximately $23 trillion. Regulation under the Investment Advisers Act has not stunted their growth or stifled their innovation. They have been able to collect assets, serve clients and pursue proprietary investment strategies within the flexible investment adviser regulatory framework. Many of these investment advisers manage hedge funds, and their hedge fund investing-and the benefits they provide to the market, including liquidity and efficiency-have not been hampered by their registration with us.
In fact, when comparing performance, a recent study found that there were no significant differences between hedge funds managed by unregistered advisers and those managed by registered advisers. Moreover, five of the ten largest and presumably most successful hedge fund advisers are currently registered with the SEC. I have no doubt that the remainder of the hedge fund advisers, who will register as a result of the SEC's new rule, will find that the registration requirement will not impede their investment operations.
In addition, I want to assure you that hedge fund adviser registration is not the SEC's first step down a slippery slope toward more comprehensive regulation of hedge fund activities. Chairman Donaldson made this clear when he rhetorically asked at the meeting adopting the rule, "How can it be seriously argued that our policy objective [in adopting the rule] ultimately is to regulate investment concentration or strategies when we have no authority to do so under the Advisers Act and we have never sought to do so for the past 64 years?"
The SEC has been administering the Advisers Act for over six decades, and during that time, the Commission has not imposed a comprehensive scheme of substantive regulation on advisers. There is no reason for the SEC's approach to change simply because hedge fund advisers are now required to register with the Commission.
III. Common Goal
In connection with preparing for implementation of the new hedge fund adviser rule, we hopefully share a common goal of wanting to ensure a smooth and efficient transition as hedge fund advisers register with the Commission. Programs such as this one, which focus on the nuts and bolts of the Advisers Act, the SEC's rules thereunder and the investment adviser registration process, are an important start. We are committed to assisting hedge fund advisers throughout the coming months as you prepare for investment adviser registration and greater SEC oversight.
The Commission provided hedge fund advisers a long transition period-until February 1, 2006-before they must be compliant so that any technical issues that arise as hedge fund advisers prepare for SEC registration could be adequately addressed. The Commission also committed that the staff would be available to work with hedge fund advisers on resolving any technical questions, and speaking for the staff, we certainly intend to follow through on this commitment.
A. Investment Adviser Registration
Today's seminar focuses on some of the core responsibilities of investment advisers registered with the SEC. First, there is the process for registering as an investment adviser with the SEC. Registration is accomplished through an electronic system called the Investment Adviser Registration Depository or "IARD." The system is designed to be interactive and relatively user friendly. It has already been tested out by about 8,500 investment advisers. All of the questions on the IARD registration system are asked in a yes/no or fill-in-the-blank format, and most of the information requested is already readily available to you. Once the SEC declares an adviser's registration effective, the information filed on the IARD becomes publicly available through the SEC's website, in a format that is easy for investors to access.
The second part of the investment adviser registration form is known as the adviser's "brochure" or Part II. Part II contains more comprehensive disclosure regarding an adviser's business practices, fee arrangements and conflicts of interest. Part II is not currently required to be filed with the SEC, but it must be maintained in a registered adviser's files and made available to our staff upon request. In addition, you must provide a copy of Part II to your clients, including your hedge fund investors, and annually offer the updated version of Part II to your clients and hedge fund investors.
It is very likely that the Division will recommend that the Commission revise Part II prior to next February when you are required to register. Under the current proposal to revise Part II, the format of Part II would become a plain English, narrative document. The document could be formatted with charts, graphs and other illustrations, if desired. The staff is also working on recommendations to amend the IARD system so that it can accept the electronic filing of Part II-which then will be made available to the public through the SEC's website.
B. Compliance Policies and Procedures and a Chief Compliance Officer
1. Compliance Policies and Procedures and Code of Ethics
In addition to completing the registration process, hedge fund advisers also must develop compliance policies and procedures, adopt a code of ethics and designate a chief compliance officer. These are, without a doubt, important requirements that will require your thought and attention. However, most hedge fund advisers will not be starting from scratch when it comes to establishing an ethical and compliance-oriented environment. You already owe a fiduciary obligation to your clients and, in an effort to meet that fiduciary obligation, I suspect that you have compliance procedures in place and, in many cases, have established ethical guidelines for your employees. In addition, I expect that many of you already have adopted a number of measures contained in the MFA's 2003 Sound Practices for Hedge Fund Managers, which have been designed to promote a compliance-oriented culture at hedge fund firms.
In preparing your compliance policies and procedures and your codes of ethics that are designed to comply with the SEC's rules, I encourage you to first review the requirements of the rules to ensure that you technically satisfy the regulatory obligations. More importantly, however, I also encourage you to use the updating or preparation of your compliance policies and procedures and code of ethics as an opportunity to perform a risk-based assessment on the operations of your firms so that you can establish policies and procedures that are best designed to ensure that conflicts are managed and your clients are protected. For many advisers that are already registered, the development of their compliance policies and procedures was a constructive and helpful process. In essence, these requirements impose no more than your clients already expect of you as their fiduciary.
One word of caution, however: many advisers may be tempted to adopt so called "off the shelf" compliance manuals or codes of ethics as their own. This can be a dangerous practice. First of all, a "one size fits all" approach often does not work when it comes to compliance matters. Compliance policies and procedures are most effective when they are tailored to the specific size, structure and operations of your advisory firm. Second, many advisers that borrow generic compliance policies and procedures unwittingly sign on to a particular policy or procedure that they are not prepared to implement-and sometimes not even aware that they have obliged themselves to implement. Be careful to tailor your policies and procedures and your codes of ethics to the individualized circumstances of your own firms.
2. Chief Compliance Officer
I would like to say a word about the chief compliance officer requirement. The rule requiring a chief compliance officer adopts a flexible approach so that advisers can appoint a chief compliance officer who is best suited to the needs of your firms. There is no mandate that you hire an outside person to serve as your chief compliance officer. Indeed, many advisers already have someone who is primarily responsible for overseeing compliance. Depending on the size of your advisory firm and the nature of the services you offer, it may not be necessary to have a full-time chief compliance officer. Again, you know your firms best, and the rule provides you the flexibility necessary to design a chief compliance officer position that is appropriate for you.
I also want to emphasize that the staff views a firm's chief compliance officer as our partner in the protection of investors. We are hoping to establish a CCO outreach program so that we can foster communication among chief compliance officers and between chief compliance officers and our staff.
C. SEC Examination Process
One important item on your agenda today, and a matter that I believe has been a cause of concern for some hedge fund advisers, is the SEC examination process. Many hedge fund advisers are already subject to SEC examination and have not found the process overly burdensome. While no one enjoys having someone look over their shoulder, it can impose a healthy and constructive discipline.
Under the Advisers Act, investment advisers are required to maintain prescribed books and records. In many cases, these are records that most responsible businesses are maintaining already. We are interested, however, in ways in which we can modernize and supplement adviser books and records requirements so that we can make more effective use of technology to oversee investment advisers. Chairman Donaldson has established an Investment Adviser Task Force comprised of senior SEC staff members to, among other things, examine the role of technology as a regulatory tool to enhance the Commission's efficiency and effectiveness. The upcoming registration of additional hedge fund advisers has caused the staff to take a hard look at how we can leverage our resources, and limit unnecessary intrusiveness, in conducting our investment adviser examinations. And as you prepare for registration, we welcome your views in this regard.
IV. Coordination with the CFTC
As I discuss the examination process, I want to assure you that we plan to work with the Commodity Futures Trading Commission in order to assure a smooth implementation of the new adviser registration rule, and a coordinated approach to oversight going forward. Where possible, I hope that we can engage in information sharing techniques with the CFTC. In addition, we hope to eliminate unnecessary duplication in CFTC and SEC oversight of investment advisers that are dually registered.
As you are probably aware, the Investment Advisers Act and the Commodity Exchange Act already contain exemptions designed to avoid duplicative regulation of investment advisers and commodity trading advisors. Commodity trading advisors who are registered with the CFTC are not required to register with the SEC if their business does not consist primarily of acting as an investment adviser. The Commodity Exchange Act contains a parallel exemption for registered investment advisers whose business does not consist primarily of acting as a commodity trading advisor. In addition, a commodity trading advisor could rely on a separate exception from the definition of investment adviser under the Advisers Act if the CTA limits its securities advice to advice about U.S. government securities.
If it is necessary to clarify issues under these various exemptions in light of the SEC's new hedge fund adviser registration rule, we are certainly open to working with the CFTC and hedge fund advisers on those issues. As I said, we hope to implement the new rule in a manner that is not overly burdensome or unnecessarily duplicative for hedge fund advisers.
In conclusion, while some may not invite regulation, I do believe that there can be positive outcomes for the hedge fund industry as a result of the SEC's new hedge fund adviser registration rule. If nothing else, the rule likely will cause hedge fund advisers to re-assess their compliance processes and ethical cultures. In addition, it will focus hedge fund adviser attention on the primacy of the fiduciary obligation that all investment advisers owe their clients. In this regard, hedge funds' important role in our financial system can be enhanced and strengthened.
All of this, I believe, will benefit your hedge fund investors-without imposing regulatory interference on your investing techniques and strategies. Hedge fund advisers who are honest, ethical, play by the rules, and adhere to their fiduciary duty to put their clients' interest before their own, have nothing to fear from the Commission and hedge fund adviser registration.
We look forward to working with you over the coming months as you prepare for SEC registration. And I thank you for listening and the opportunity to speak before you today.