Speech by SEC Commissioner:
Remarks Before the ABA Section of Business Law – 5th Annual Conference on Private Investment Funds
by
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
London, England
March 2, 2004
Thank you, Yukako, for your kind introduction. I am happy to be here today to talk with you about a few of the critically important initiatives underway at the SEC. I note the irony in that I am speaking before a group on the topic of "PRIVATE investment funds". Like many things in life these days, the line between private investments and public investments is blurred. Otherwise, you would probably have no interest in hearing what a government regulator has to say!
Before I begin, however, I must note, in order to keep my compliance folks happy - that the views I express here today are my own and do not necessarily reflect those of the SEC as an institution or of the other Commissioners.
I would like to focus on two topics today. First, I will speak very briefly about what is happening in the U.S. mutual fund area. Second, this discussion about mutual funds should frame the next topic - which is one that should be near, but not necessarily dear, to your hearts - the concept of mandatory registration of hedge fund advisers in the United States.
Historically, the U.S. mutual fund industry has had a relatively clean reputation. Much to my profound disappointment, this reputation recently has been tarnished. Despite the hopes of those of many inside and outside the industry, the "late trading" and "market timing" allegations were not limited to a few bad apples involved with one distinct private investment company. Large fund complexes such as Bank One, Bank of America, Putnam, Janus, MFS Investments, Alliance, and others have been named in our investigations, and you can expect that there are more to come.
The ethical problems alleged and proven are huge, although in the context of a $7 trillion industry the actual amounts may not have been. As you know, investment management is a business that is built almost exclusively on acquiring and maintaining the customer's trust. It is one of the only businesses in which a customer gives money and gets - besides the ultimate return -- a promise that those funds will be invested wisely and without self-dealing. In this fragile customer relationship, ethics and confidence are key.
I have been outraged and dismayed by the recent discovery of late trading abuses. These instances of late trading were not just occasional, isolated, or justifiable exceptional cases -- such as where a customer entered a symbol incorrectly and the fund adviser sought to make a correction after hours, or where there was an inadvertent error in processing an order ticket, and the adviser then corrected it. No, the abuses we have seen were clear, systematic, repeated violations of SEC rules and of the obligations of fiduciary duty to the fund shareholders. Simply put, certain chosen investors were allowed to arbitrage a sure thing. There was no risk to the trader, but detriment to the other shareholders.
If this were not enough, perhaps the most disturbing aspect of what has been discovered is that the CEOs at some of these fund complexes were directly involved in these abuses. These CEOs showed an appalling lack of both business and personal ethics. On top of this, these CEOs' cavalier actions put their personal financial interests in front of their business' reputations. And, indeed, put the viability of their businesses at risk. As a former lawyer who spent many years of my professional life working with the fund industry, I am discouraged, to say the least.
So, that is the bad news. The good news, I believe, is that we at the SEC have taken a number of steps recently that should address these abuses. Most of you here are probably intimately aware of these steps, so I do not see a need to discuss our actions in any detail. If you have any specific questions about our recent regulatory actions, I would be happy to discuss them with you when I am finished.
An outgrowth of the unease brought about from these recent mutual fund abuses is that new attention is now being focused on hedge funds and their advisers. As all of you know, hedge funds have generally been operating outside of the U.S. regulatory regime basically since the passage of the Investment Company Act of 1940 and the Investment Advisers Act of 1940. Drawing a line between investors of means who could discern risk (or hire those who could for them) - so-called "sophisticated investors" - and retail investors was one of the fundamental tenets of the securities acts from the beginning.
Frankly, I think part of the reason that hedge funds are getting attention again is because they have a bit of a public relations problem. Recent press accounts indicate that the public largely misunderstands hedge funds. Actually, many view them with much trepidation: The fear of the unknown, so to speak. In various press reports, hedge funds are characterized as "operating in the shadows", "under the SEC's radar", and that they are ensconced in a "culture of secrecy". This crowd is well situated to help educate the public and the SEC about hedge funds, and to help people understand that simply because hedge funds are not garden-variety public investments, they can have a positive impact on our overall marketplace.
The SEC has been studying hedge funds, and their impact on the U.S. securities markets, for years. The first formal study of hedge funds occurred in early 1969. More than twenty years later, the SEC took another look at hedge funds in 1992 - the result of which was to propose a new exception for hedge funds from the Investment Company Act- the Section 3(c)(7) exception. That same year in response to a Congressional inquiry, the SEC sent detailed information to Congress regarding the nature and regulatory treatment of hedge funds. The focus of this report was on the effect of hedge funds on the equity markets due to their size and market presence.
In 1999, the President's Working Group on Financial Markets under President Clinton issued a report after the near collapse of Long Term Capital Management. This report looked specifically at the issue of whether hedge funds' use of leverage was excessive and had a negative effect on our capital markets. The report made no recommendations to change the current regulatory framework for hedge funds.
In September of last year, the SEC's Division of Investment Management produced a report studying the hedge fund industry and recommended, among other things, that the Commission consider requiring hedge fund managers to register as investment advisers under the Investment Advisers Act of 1940.
In light of this brief history lesson, you might be wondering, what has changed between 1999 and 2003? Why is the SEC again thinking about mandatory hedge fund adviser registration? I submit that it might be a combination of two factors - (1) the pressure on government officials from some quarters to respond to a perceived call for "change" and (2) an overreaction to the current abuses that occurred and are occurring in the mutual fund area.
Let me be clear here, as I mentioned earlier, the recent mutual fund abuses are absolutely deplorable and should be met with the biggest bats that the SEC carries. As far as I can tell, however, registration of hedge fund advisers will have virtually no effect on addressing any of these abuses.
As a threshold matter, I note that there is some discussion in the press that hedge funds have been "involved" and "willing participants" in the recent mutual fund investigations that I mentioned earlier. This discussion is likely occurring because some of the investors that made late trades or market timing trades were hedge funds. While these statements are certainly true, they do not tell the whole story.
In large part, these cases reveal a significant breakdown in the compliance and control procedures of the mutual fund companies and the intermediaries that process their trades. In some cases, we might be able to show that the hedge funds and others received inside information that they knew they should not have received. But, for the most part, it was the mutual fund advisers that broke their own stated policies and acted unethically.
In fact, at the core of most of these cases is favoritism toward certain shareholders by the mutual funds. This is where the SEC has rightly focused its enforcement actions and rule proposals. One other point needs to be made about these cases: Some of the hedge fund advisers "involved" in these cases were already registered with the SEC, a factor that suggests strongly that registration is not a cure-all. Nor is it a guarantee that we will detect these types of abuses before they occur.
At this point, it makes sense to explain briefly what effect registration as an adviser under the Advisers Act will entail. The newly registered hedge fund managers would be subject to examination by the SEC, and they would have to maintain books and records as prescribed by the Advisers Act. The SEC could deny registration to persons with criminal and/or disciplinary backgrounds. Potential investors in hedge funds could access limited information about these funds and their managers through an online web site. Finally, managers of hedge funds would be required to comply with basic disclosure, reporting, and custody provisions with which registered advisers must comply.
There appear to be three main reasons that the 2003 SEC staff report recommended mandatory registration of hedge fund advisers. First, it has been argued that hedge funds, due to their unique trading practices, have a significant impact on our markets, and therefore the SEC needs more information about how they trade. Second, some argue that registration will help to protect investors, especially less sophisticated investors. This is sometimes referred to as the "retailization" of hedge funds. Last, some argue that because hedge fund advisers do not register with the SEC, the SEC knows little about them and the SEC is in a less advantageous position to prevent and deter fraud.
Let's take these one at a time.
Market Impact
The U.S. financial markets are the most efficient and dynamic markets in the entire world. Our markets are powered by information, technology, and unsurpassed liquidity. Hedge funds, which generally follow an absolute return methodology, are beneficial parts of our marketplace because they contribute to market efficiency and enhance the liquidity of our markets. This activity is a great boost to our marketplace as it can often translate to market efficiencies.
Federal Reserve Chairman Alan Greenspan acknowledged this benefit in 1998. He said "[M]any of the things which [hedge funds] do . . . tend to refine the pricing system in the United States and elsewhere…[T]here is an economic value here which we should not merely dismiss . . . I do think it is important to remember that [hedge funds] . . . , by what they do, they do make a contribution to this country." Indeed, just last month, Chairman Greenspan reiterated this point, noting that hedge funds play an important role in providing market liquidity and that they contribute to the flexibility of our financial system. Importantly, Chairman Greenspan stated that he did not see what purpose registration of hedge fund advisers would serve "unless it goes further…" and this makes him "feel uncomfortable".
Hedge fund advisers typically employ investment strategies that are more complicated and more flexible than mutual fund strategies. Arbitrage is a typical strategy. These advisers are often willing counterparties to entities that wish to protect themselves against downside risk. In fact, the 2003 SEC staff report states clearly that "the absence of hedge funds from these markets could lead to few risk management choices and a higher cost of capital." This is a conclusion that was also stated in the President's Working Group report .
It is important to state these facts clearly because, in general, the investing public does not understand what it is that hedge funds do. Many investors simply have the perception that hedge fund managers are making money for their investors and that these strategies have no impact (or even a negative impact) on the overall markets. This is not the case.
The 2003 staff report suggests that the growth of hedge funds is one reason to consider hedge fund adviser registration. The staff report estimates that there are approximately $600-650 billion of assets under management at hedge funds. This is not a small amount by any means. But we should keep this amount in perspective. For example, mutual fund assets total almost $6.5 trillion. Total market value of corporate equities in the U.S. stock market at the end of 2002 was $11.8 trillion. Assets of insurance companies and commercial banks are also in the trillions.
I recognize that, because of hedge fund's unique strategies, they are responsible for a large percentage of the overall trading activity in our financial markets. Despite this fact, I defer to Chairman Greenspan and other economists as to issues of systemic risk and market impact. In fact, we need to be mindful that monitoring our marketplace for systemic risk is something that the Federal Reserve and the Treasury Department do on a regular basis. We need to be careful that we are not misusing SEC resources by duplicating the efforts of market experts. However, it is certainly a good idea for the SEC to coordinate and share information with these other agencies.
As far as I can tell, the consensus among market experts seems to be that hedge fund adviser registration will not address any of the market impact or systemic risk issues.
Investor Protection
Another reason that some support the concept of mandatory registration of hedge fund advisers is their belief (or at least a fear) that less sophisticated investors are investing in hedge funds. The results of the 2003 SEC staff report on this point need to be stated clearly: they found no evidence that even suggests that significant numbers of retail investors invest directly in hedge funds.
The reasons for this are not difficult to figure out. First, investment minimums in hedge funds are often rather large (some as high as $10 million). Second, and this is a reason that is often overlooked but is quite important, hedge funds are not typically interested in having retail investors as clients because, in general, retail investors do not have the same risk tolerance as the typical hedge fund investor.
I take our responsibility as the investors' advocate very seriously. The question "Will this benefit investors?" is in the back of my mind for every regulatory action that we propose. Since we know that retail investors are not investing directly in hedge funds, I am not sure why we are even considering the issue.
Hedge fund investors typically are high net-worth individuals who satisfy one of two standards - they are either accredited investors or qualified purchasers. I do not need to explain the income requirements of these standards to an informed crowd like this - but suffice it to say that we are talking about wealthy investors. I recognize that more investors are now considered accredited investors under our rules than when the rules were originally imposed in the 1980s. Inflation and rising personal income over 20 years has had an effect. We may well need to look at these limits to see whether they are still appropriate.
However, even with our current accredited investor standard, we are still talking about high net-worth individuals. Therefore, the next question that we face is do we need to require hedge fund adviser registration in an effort to protect the atypical investors that are investing in hedge funds?
I would like to stress at this point that, in raising concerns about the prudence of requiring hedge fund adviser registration, I am NOT trying to protect the investment vehicles of the wealthy from regulatory scrutiny. As I noted earlier, there is a public misperception that hedge fund investments represent sure-thing investments that only the wealthy can get in on. This is simply not the case. There are busts and booms in the hedge fund area. There are underperforming hedge funds just like there are underperforming mutual funds. And, just like in the mutual fund world, the high-flying hedge funds tend to get the attention, and the underperforming ones get put on the back burner or disappear quickly. Investment strategies go in and out of favor, depending on how well they do. Thus, my position on this issue is based solely on the fact that, if the SEC is going to spend resources to protect investors, then the SEC will get more bang for its buck in areas other than the hedge fund area.
Certainly, some hedge funds, whether registered or not, have behaved unethically, if not illegally, in trying to move markets. Some examples are in the commodities markets, where some funds - and individuals for that matter - have tried to corner markets or influence prices. Another example is the "bear raider" activity, where short sellers plant false rumors about a company, including trying to instigate an SEC investigation under false pretenses (hoping that the news of the investigation will cause the target company's stock to fall).
I am certainly not saying that all hedge funds are as pure as the driven snow. In fact, I am sure there are some with serious problems, just as we have found among registered investment advisers. I expect, for example, that there are serious deficiencies at some funds in disclosure - probably even outright lies as to backgrounds of advisory personnel or as to past performance of individuals or the funds they manage. I am also sure that there are cases out there where hedge funds have been beneficiaries of inside tips that they have received from corporate insiders who are also investors in those funds. In this case, vigorous enforcement is the answer.
And, when the SEC needs to get involved to address these or similar problems - the SEC already has the tools to do just that. Hedge funds and their advisers are not exempt from the antifraud provisions of the securities laws, nor are they exempt from the SEC's subpoena powers. Just as in other areas, we need to have good intelligence, which means knowing the industry and keeping our eyes and ears open to tips. Periodic, retrospective compliance examinations rarely turn up these kinds of activities.
My principal concern is whether we need to dedicate the SEC's limited resources to protect a small number of investors that presumably have the wherewithal to look out for themselves because of their abilities to hire outside advisers to review their investment choices. Put another way, I am unclear why a taxpayer in Peoria, Illinois has to foot the bill to protect the hedge fund investments of people like Bill Gates, Leona Helmsley, or Michael Jackson!
Aside from the issue of providing protection to investors who likely can protect themselves, another concern that I have is how many people would benefit from this effort? I reviewed recent IRS statistics and it is clear that we are talking about relatively few investors. As of the latest statistics compiled by the IRS (tax year 2001), approximately 131 million individual tax returns were filed. Only 194,000 of these returns, or 0.15%, had income over $1 million. Only the top 1% of these 131 million returns had income over $290,000. How much do you think the median household income in the U.S. was? Approximately $28,000. These statistics only consider income, not overall net worth, but they do suggest that, despite the fact that the SEC has not raised the accredited investor threshold in years, it is clear that the overwhelming majority of people in the U.S. are not accredited investors.
We do know that there are huge numbers of investors putting their money into mutual funds. There are approximately 95 million individuals in 54.2 million U.S. households that owned mutual funds in 2002. In contrast, simply looking at the income statistics alone, I am persuaded that there is not a relatively large number of investors putting their money in hedge funds.
Our data is only indirect, so we do not know the precise number of the investors that invest in hedge funds managed by unregistered advisers - the advisers that would be affected if the staff's recommendation were adopted. However, the data that I have seen compiled by the SEC staff indicate that the overall number of investors that we are talking about is quite small - fewer than 200,000 investors. Based on the same data, other calculations indicate that we could be talking about fewer than 100,000 investors. Does it really make sense to dedicate significant staff time and government resources on an effort that will affect these few investors? This use of resources is even more questionable when you consider that this small number of investors is in a much better place to protect themselves from fraud because they have the means to hire outside advisers to help them with their investment decisions.
There are also reports that the SEC is looking into significantly increasing our professional staff in preparation for examinations of hedge fund advisers. With the utmost respect for those who support the idea of mandatory hedge fund adviser registration, I believe that we would better serve our constituency if we put these resources and this new personnel into an area that affects virtually all investors - mutual funds. The revelations of the abuses in the mutual fund area suggests that there is significant room for improvement in our oversight of them, and that this oversight is badly needed.
Further, if the SEC is convinced that hedge funds are a problem that needs to be addressed right now - should we not be allocating more resources to a known problem that needs our attention - the relationship between hedge funds and prime brokers? We already have examination authority regarding prime brokers, and we know that there are risks present in the prime-broker hedge fund relationship, such as credit risk and potential conflicts of interest with inadequate disclosure. If we did this, no one would argue that the SEC was overreaching and we already have the programs in place to examine these brokers. Indeed, I understand that this is where the FSA focuses much of its attention in its review of hedge fund activity. Again, if we have questions or see potential problems, we have statutory subpoena power to proceed immediately to find out more directly from the hedge fund in question.
If investor protection were the basis for considering mandatory hedge fund adviser registration, then we should ensure that registration does not create unintended consequences. The fact that an investment adviser is registered with the SEC can easily send the wrong message to investors. Investment adviser registration is largely a notice and disclosure requirement. Unlike in the broker context, there are no capital requirements, and no testing or suitability requirements for investment advisers. I would not expect the typical investor to be aware of or understand this distinction. Thus, I am quite concerned that adviser registration suggests that the SEC has passed on the legitimacy or qualifications of the adviser.
Indeed, we know that one reason that hedge fund advisers volunteer to register with the SEC is for marketing purposes. These funds use their registration with us as a means to demonstrate that they chose to comply with routine examinations and some SEC scrutiny. Some large investors, particularly large pension funds because of ERISA and other reasons, specify that they only consider registered advisers when they choose their money managers. However, I am concerned that mandatory registration of hedge fund advisers will create the false impression among the general public that we are doing more than we actually are with regard to a particular fund. Registration does not guarantee that we will find problems or even spot potential risks. It does not mean that we have signed off on the fund's internal controls or its advisers. It can easily create false impressions, however, especially if hedge fund advisers seek to utilize SEC registration for competitive purposes.
In the 2003 staff report, the staff suggested that it is concerned about indirect investment in hedge funds by unsophisticated individuals via pension plans or funds-of-hedge funds.
These are issues that might raise legitimate concerns that need further study. But, regarding pension plans, we must not lose sight of the fact that a pension plan administrator has a fiduciary obligation to the plan's participants. This fiduciary needs to ensure that its investment choices are prudent and that the fiduciary has all the information that it needs to make this determination. If this duty is breached, then the problem falls squarely on the shoulders of this fiduciary. Further, if a pension plan makes a "significant" investment in a hedge fund, that hedge fund might be subject to ERISA's regulatory regime. Moreover, pension plan administrators, because of their size, are generally in a better position to obtain information about the hedge fund that is more valuable than the limited information that the SEC receives through the registration process.
Funds-of-hedge funds are registered mutual funds whose underlying investments consist of hedge funds. The SEC staff's 2003 report noted that there were 82 registered funds-of-hedge funds, with approximately $3.7 billion under management. These funds-of-hedge funds do raise unique concerns.
For example, there is a concern about how the underlying hedge fund assets are valued. Yet, many registered funds holding illiquid securities face similar valuation issues. This also is certainly an issue with unregistered private equity funds. But, for some unexplained reason, the SEC staff did not recommend registration of these types of investments and wants to distinguish hedge funds and private equity funds.
The 2003 SEC staff report notes that these fund-of-funds are only marketing these vehicles to accredited investors and the minimum investments are high (ranging from $25,000 to $1 million). There is risk here and the SEC does need to keep a close watch on how fund-of-hedge funds develop and whether these investment vehicles are reaching the retail investor. That said, I fail to see how compulsory adviser registration does anything to advance the ball to address these potential issues.
Assist the Enforcement Program
Another primary rationale for considering mandatory registration of hedge fund advisers is that the SEC will be able to detect and prevent fraud earlier, before there are significant shareholder losses. Detecting and preventing investor losses early is a laudable, absolutely essential goal -- one that I support strongly.
This very issue was considered by the President's Working Group in 1999. In this report, the group concluded that "requiring hedge fund managers to register as investment advisers would not seem to be an appropriate method to monitor hedge fund activity". There has not been a sea change between 1999 and now regarding hedge fund activity, so I am not sure why the SEC would have thought that it was an inappropriate method then, but it is a good approach now.
In a time where investor confidence is particularly fragile, we need to be concerned with reality, not merely atmospherics. Is it reasonable to assume that sending in our examination teams annually or once every few years will have a significant impact? Our examination staff is a group of dedicated professionals that take their responsibilities seriously. Like many organizations, our examination staff has some senior examiners, but most of the examiners that are in the field, doing the on-the-ground work, are relatively junior professionals without a lot of experience. This is not atypical and it should not be surprising. Law firms generally have junior associates doing due diligence. Accounting firms often have their junior staff doing audit work in the field. Our organization is no different.
Thus, we need to question seriously the virtue of requiring these examinations. Many hedge funds employ strategies that are highly complex and unique to the particular fund manager. We cannot expect that there will be any consistency in trading strategies or approaches across various hedge funds. It will be very difficult for our examination staff to discover and deter fraud if they are not sure what they are looking at or should be looking for. We need to question: are we setting up our examination teams to fail? And are we asking too much of them when they could be building expertise in areas that affect many more investors?
There is some discussion that if we perform regular examinations of advisers, then the SEC can get involved earlier and protect assets before they are gone. This is a big assumption and fuels my concern that we are setting up false expectations.
An ugly truth is that if people intend to commit fraud and intend to hide their actions, it is unlikely that a routine examination will ferret out the fraudulent actions. I do not want to sound pessimistic, I simply recognize that morality cannot be legislated into existence. We did not discover some of the recent trading abuses in the mutual fund area before we were tipped off on what to look for. We did not discover the fraud at Enron and Worldcom when we had access to their periodic filings. Please do not misconstrue my comments as criticism of our staff and its efforts. We just need to recognize that it is very difficult to discover fraud, especially when the perpetrators are trying actively to prevent detection. And, if we suspect fraud, we currently have the authority to investigate, as we have in the past.
Putting all of this in context, I recognize that many of you are probably not overly concerned about the prospect of routine SEC examinations. You likely recognize that it is not terribly burdensome nor will it significantly impact your business. What I would like to hear from you all is, do you think that this approach will have ANY impact on combating fraud in hedge funds? Would you be concerned if you believed that this approach is merely a first step in more substantive regulation of hedge fund activity, business models, and business practices? Last, are you concerned that this activity might create incentives for hedge fund managers to move to other private investment vehicles like venture funds or private equity funds?
One of Chairman Donaldson's highest priorities for the SEC is to set up a group that will be focused on risk assessment - an office devoted to try and predict where tomorrow's problems will be so that the SEC can be proactive and address them early. This is a wonderful idea - one that I have been supportive of from the beginning. If this new office did an analysis, and if it concluded that hedge funds represent a large threat to investors that cannot be addressed by any means other than by mandatory registration of hedge fund advisers, then I cannot imagine why I would not support this approach. Until we get to that point, I remain concerned that this is not where we should be placing our troops in this battle to protect investors.
Thank you for your time.
http://www.sec.gov/news/speech/spch030204psa.htm
