Speech by SEC Commissioner:
Remarks before the American Academy in Berlin
Commissioner Roel C. Campos
U.S. Securities and Exchange Commission
June 13, 2005
Good evening. First, I'd like to thank Gary Smith for inviting me to the American Academy in Berlin. The Academy's mission to foster intellectual and professional ties between Germans and Americans in the humanities, public affairs, and the arts is a noble one, for which I am pleased to be a participant. I also would like to extend a special thank you to the Federal Economics Ministry for hosting tonight's dinner, and in particular, Minister Wolfgang Clement. It is truly an honor to join you this evening.
Before I begin, I must remind you that the views I express here are my own and do not necessarily represent those of the SEC, the staff or my fellow commissioners.
Tonight I'd like to discuss three concepts which I believe integrated properly produce a successful regulatory equation. They are risk, dialogue and confidence. Risks of various kinds are inherent in all economic activities and are of import to both the regulator and the investor. For instance, as of late, we find ourselves focusing on the operational risk in financial organizations, at issuers and within trading centers. Operational risk refers to potential causes of loss arising from deficiencies in the internal controls, human errors, physical systems failures, and other business execution risks as well as external events. One of the biggest and well known global tools to combat operational risk has been the international standards on capital adequacy for banking institutions embodied in the Basel Accord, and the revision to those standards, known as Basel II. Many aspects of the Sarbanes-Oxley regulation were designed to combat this and other types of risk on the US domestic front - noteworthy for our discussion tonight is Section 404 on internal controls.
Nor can we forget the International Financial Reporting Standards, or IFRS, whose development and ultimate convergence with GAAP is driven by the need within a global market to ensure comparability among issuers in the treatment of risk as evidenced in corporate financials and disclosure. We are faced with risks within the operation of the market centers themselves too. Just two weeks ago the NYSE experienced a technical communications glitch four minutes before the close creating a slight panic for traders who had open positions and a potential headache for clearing firms. Because news had been released during the shut down, the decision was made not to reopen the market because an informational advantage could be unfairly employed since there was no way to tell exactly when orders arrived during the blackout. From these few examples, I think we can all agree that the various risks require differing degrees of risk management and regulation, which often are dictated by the degree and effectiveness of existent market discipline.
Through dialogue, we - the regulators, industry and investors - discuss these inherent risks and the appropriate regulatory responses. Dialogues allow us to encourage movement toward more competitive, better-regulated financial systems and to find ways to mitigate cross border friction as we combat risks. Similar to the notion of risks, dialogues exist on many levels. Not surprisingly, our regulatory opinions are formulated based on national and international concerns, guided by the intricacies of the operation of our own capital systems and markets.
That being said, the transatlantic financial market is not a question of "if" but a question of "when." Capital knows no bounds in today's world. According to statistics by the World Federation of Stock Exchanges, the global financial stock, which now totals more than $118 trillion, could increase to $200 trillion by 2010. At the current time, the role of the US relative to the world in total private debt (51%) and equities securities (45%) has increased while the US share of government debt and bank deposits has dropped (to 25% each). (Notably, the US financial stock is dominated by securities - private equity and debt - to a much greater extent than other markets in the world, with a relatively limited role played by US government debt securities.) Europe is the second largest capital market with 31% of global financial stock and its grown over the past 10 years has outpaced the rest of the world. During that same period, the US market has continued its growth, fueled by expansion in private debt securities and undeterred by the boom-and-bust of the equity market bubble.
Cross-border investments are far larger now than they were 20 years ago. From 1984 to 2003, US investment holding abroad more than tripled after controlling for inflation. Foreign investment in the US rose proportionately much more, by almost a factor of six. Because of increased market turnover, cross-border transactions have grown even faster than cross-border holdings. In 2002, the gross value of cross-border equity trades was 80% of worldwide equity market capitalization, whereas in 1989 cross-border trades equaled only 18% of a much smaller world equity market. Due to its size, liquidity, and economic health, the US continue to attract the lion's share of cross-border equity flows, and foreigners hold an increasing share of its financial stock.
With these numbers in mind, one cannot deny that globalization is a reality in the financial markets. As we all know, with this freer flow of capital comes a freer flow of fraud. Accordingly, the task at hand is to develop, where appropriate, high quality and consistent regulatory requirements to govern our markets and address the inherent risks. As a part of this analysis, we all need to recognize where such requirements are unnecessary or impracticable, and the home country's regulation is satisfactory. By combining these two pieces with an active and meaningful dialogue, we will succeed in reaching both our individual and collective goals, while fulfilling our statutory mandates.
And what are those collective goals? They include investor confidence and investor protection - two of the inextricably linked cornerstones of our capital markets. We have all witnessed the economic hardship that derives from a lapse in investor confidence. Such a lapse follows from a perception (reality-based or not) that investor protection is weak or lacking. A subset of investor confidence in the marketplace is investor confidence in the regulatory regime. Are investors' interests guiding the regulatory pen? In addition, regulators themselves must be confident that the regulation is properly crafted to fulfill the investor protection mandate. When taken to its logical end, strengthened global economic growth and development prospects flow from confident investors.
Thus, at its simplest level, I believe a basic equation for both a domestic and transatlantic financial regulatory regime is to identify and evaluate risks through dialogues in order to create and maintain investor confidence.
When one thinks of risk in today's marketplace, hedge funds are not far from the discussion. Even Federal Reserve Chairman Alan Greenspan has voiced concerns about the risks posed by the larger funds. Just last week, despite the praise he has lavished on them in the past, Greenspan stated that hedge funds are headed for a fall. That certainly makes me sit up and listen.
Perhaps a misnomer, the term hedge fund developed into a catch-all classification for many unregistered, unregulated, privately-offered, managed pools of capital, generally excluding, in particular, funds principally involved in venture capital or similar private equity investments. Hedging is but one of the strategies employed by these funds today. Hedge funds also follow event-driven strategies, absolute-return strategies, global asset allocation, and correlation trading.
Many hedge funds are offering new products as quickly as they can be conceived to capitalize on the hedge fund fervor. The latest generation, for example, is a hedge fund index called the investable index. Designed to compete with the fund-of-funds, the investable index offers exposure to the hedge fund universe without paying the extra fees demanded by funds-of-funds. Because of the base index, the investor has some transparency into to the fund compared with funds trading deeply distressed debt with such opacity and illiquidity that daily valuations are impossible.
Every day we read about the growing size, influence, market impact and incredible reach of these investment funds. Hedge funds are attractive largely because of the higher returns and the investment alternatives that are not correlated with the stock markets. Pension funds and institutional investors began to look to hedge funds to beat benchmarks. The number of hedge funds worldwide has increased from fewer than 1000 in 1990 to more than 8000 in 2004. EuroHedge reported that total assets managed by European single-manager hedge funds now exceed $150 billion, and industry assets at the end of 2004 totaled nearly $256 billion, and increase of more than 50% from $168 billion at the end of 2003.
The value of hedge fund assets managed out of London more than tripled from $61 billion dollars to $190 billion between 2002 and 2004. Globally, the UK capital's share of hedge fund assets increased from about 15% to 20% as growth in hedge funds outpaced the US, the leader in terms of fund activity. The industry is continuing to spread out across Europe, with over 100 single-manager funds now trading in France, and with Sweden and Spain also well established as major continental locations for hedge fund management. Plus, the industry has its sights on Asia for the near future.
Part of this growth stems from expansion of hedge funds into other activities that offer profits - activities that put them in direct competition with investment banks. For instance, some of the biggest are lending money. When Malcolm Glazer needed money to finance his takeover of Manchester United, PLC, part of the money came from banks and part of the money (approximately $500 million) came from three US hedge funds (Citadel, Perry Capital and Och-Ziff Capital Management). Cereberus Capital Management, among others, rounds out its business by providing financing for takeovers, rescues and bankruptcy-protection proceedings. In this competition, it is the hedge funds who can quickly commit capital through the use of leverage than traditional investment banks. Yet the hedge funds, as noted in the Wall Street Journal, "loan to own," extending funds with one hand while betting against the company with the other.
Others have become clients of the big firms, expecting royal treatment for their large commission payments-in a questionable symbiosis of order flow for information. The securities firms offer hedge funds a dearth of services from execution, to money lending, stock lending, investing in the funds, and providing research and investment ideas for trading. Do these relationships disadvantage other traders and investors? Are these conflicts disclosed or even manageable?
Hedge funds are active not only in the capital arena but also in the corporate arena, as we have seen here in Germany. They are the new activist investor. New York-based Atticus Capital and London-based TCI led the charge to deflate the Deutsche Bourse's bid to take over the LSE as far to expensive. Using the trappings of improved corporate governance and shareholder power to defeat the bid, the hedge funds then overthrew the management of Frankfort's top stock market. Other hedge funds are using these same tactics to force companies to more directly reward holders through buybacks or a sale. In the US, the Globe and Mail reported that Boston-based K Capital Partners LLC recently waged a battle with OfficeMax. As one of the company's largest shareholders, K Capital Partners successfully demanded changes to the board and threatened, "that a break up or sale of the retailer might be needed to maximize shareholder value." K Capital further demanded that the CEO give up certain pay and pension benefits. The CEO resigned the next day. This raises the question of wehther such short-term investors been entitled to such shareholder rights in outright conflict with long-term investors?
Another pressing question arising from the exponential growth of hedge funds is market saturation. Some feel that the industry is overpopulated and not all of the hedge funds can attain the prized returns if they are all following the same strategies. In other words, there is too much liquidity chasing to few deals. In the area of managed futures and convertible arbitrage, for example, hedge funds have become the markets and therefore cannot exploit the inefficiencies of these markets by standing on the sidelines. They directly feel the ups and downs.
According to Tremont Capital Management, in the first quarter of this year, $24.6 billion was invested in hedge funds, 36% below the level a year earlier. That is still more than went into any such fund in any full year before 2001. Tremont also states that around 10% of hedge funds go out of business each year, but that is more than offset by new entrants. Looking at monthly reports, returns for hedge funds were positive in May, compared with a decline in April, despite the losses tied to GM. The average hedge fund is up .35 percent for the year according to preliminary results from Hedge Fund Research. Yet this is not something to celebrate when one considers the stiff fees hedge fund investors pay on average. This is merely tracking the broader markets for which an investor can buy an index fund for much less money.
In addition, if investors get panicky, and start withdrawing large amounts of cash from a fund, the manager is often required to sell holdings to meet the redemptions. Increased diversity within hedge funds may help mitigate the risk of a massive breakdown, but Long Term Capital still looms in the minds of many from its near collapse, and Federal Reserve organized rescue, in 1998.
And there is no accounting for the increase in hedge fund fraud. Just this past March, the Commission obtained emergency relief against a group of hedge funds in Florida for an $81 million fraudulent offering in which the group of hedge funds lured investors by boasting of consistent above-market returns through trading in aggressive growth stocks. The hedge funds maintained the ruse by sending false statement to investors despite the fact that the funds were suffering tremendous trading losses, while the investment advisers and hedge fund managers earned their 20% performance fees.
Although trading under the same rules as mutual funds, hedge funds use different trading strategies and are not subject to the liquidity, diversification and senior security coverage requirements imposed on registered investment companies. They also impose restrictive investment, leverage and redemption limitations that may be in part responsible to the growth of the funds. Their fee structure - a performance fee (often as much as 20%) in addition to a 1-2% management fee - tends to raise eyebrows, particularly as returns slow and merely track the stock market. Even so, hedge funds can make our markets more efficient by using leverage and trading spreads between asset classes as well as creating competitive capital alternatives to investment banking firms.
The new SEC rules, slated to go into effect in February require funds larger than $25 million and with more than 15 investors to file as registered investment advisors. The rules affect funds with a lock up of under two years and require appointment of chief compliance officers.
The Commission pursued registration only after an in-depth study of the available information on hedge funds conducted through a staff study and Commission roundtable. The trends uncovered during the staff's analysis of hedge funds raise the same concerns worldwide about the risk associated with these funds, including the rapid growth of an opaque industry of which no government agency has reliable data, the potential for systemic risk to the markets due to hedge funds influence, broader investor exposure (both retail and pension/retirement fund), their fee structure, the absence of uniform performance reporting and valuation-not to mention disclosure and transparency generally, and the growth in hedge fund fraud. If the regulator can't tell what's going on in the industry, how is the investor supposed to do so? Compounded by the lack of available data and transparency, the inability to examine hedge fund advisers makes it difficult to uncover fraud and other misconduct.
The concept of registration under the Advisers Act was selected because of its minimalist approach in both regulatory burden and in cost but extensive benefits of census information, deterrence of fraud (through inspections), barring unfit persons from the industry, adoption of compliance controls, and limits on retailization. Heeding the advice of Federal Reserve Chairman Alan Greenspan, the registration requirement neither requires an adviser to follow or avoid any particular investment strategies, nor does it require or prohibit specific investments, in order to protect the resilience and flexibility of the markets. Moreover, the Commission carefully crafted the registration requirements to allow exemptions for, among others things, private-equity pools, grandfathering existing clients and addressing foreign components of the hedge fund industry. In other words, our regulatory approach has been to leave the success or failure of hedge funds to market forces.
Despite a mixed review, many in the industry have stated that they can and will live with the requirements. Some hedge funds have begun to prohibit their investors from withdrawing their money for two years, allowing them to fall under an exception to the pending change that was included to avoid including farcing private-equity firms to register. Others are using registration as a "seal of approval." Still others predict that the cost of registering will drop as much as 50% a year from now, because the frenzy to prepare fro registration will have died down, reducing pricing for advisory and other fees.
Other jurisdictions are actively examining the inherent risk in the hedge fund sector. As you know, Germany's first hedge funds were launched in March of 2004. Germany was one of the last big markets to authorize the use of hedge funds and the BaFin has been careful in its approach to the funds. I understand a report was issued today by a group of experts appointed by Chancellor Schroeder that analyzes the industry and possible regulatory approaches. Although I have yet to see the report (and I am interested in reading it), the newspaper reports that the experts advised against adopting rules that restrict voting rights for shares held by certain types of investors. Instead, it recommends that companies grant a dividend bonus to shareholders who exercise their voting rights. Also, the report suggest lowering the threshold whereby shareholders are forced to publish the size of their holding in a company, and it stresses that any regulatory intervention into the activities of hedge funds should be coordinated at an international level. British regulators too have launched a wide-ranging review of the industry and are set to publish a concept paper this month. In Canada, the Ontario Securities Commission and Bank of Canada are conducting a joint study of hedge fund influence in the markets. This small sample demonstrates the universal concerns raised by the risks to our investors, markets and issuers associated with hedge funds. Going forward, we all must continue to review this industry and share our thoughts and findings.
I would like to briefly remark on the recent hedge fund fall out with GM and the trading strategy that appears to have been employed by a number of hedge funds with respect to GM and possibly Ford. Capital structure arbitrage involves shorting the equity of GM while purchasing some of its senior debt. The proposition is that, in the event of the downgrade that was widely anticipated and in fact occurred, the equity would be hurt more than the senior debt. So the short position in the equity would outperform the long position in debt. At the same time, the potential impact of improvements in GM's credit or general market events while the trade was on would be blunted by holding a spread rather than an outright position. Of course, Kirk Kerkorian, by announcing a tender offer around the time the debt was downgraded, threw people trading these strategies through a loop. They lost on the debt when the downgrade came sooner than expected, and they lost on the short position in equity when the tender offer was announced.
Recent EU Vote
If you will permit me a moment to diverge topics, I'd like to take a moment to loosely theorize about the fallout of the recent votes in France and the Netherlands on the proposed new EU constitution.
As we all know, through tremendous efforts the EU has fundamentally overhauled the legal framework of its financial markets. The Financial Services Action Plan includes 42 legislative measures designed, among other things, to create a single market in financial services throughout the EU. The challenge is to have the new measures implemented, interpreted and enforced consistently across all 25-member states. Like Sarbanes-Oxley, these measures are having a tremendous effect on the regulation of the EU capital markets and have necessitated major adjustments on the part of issuers, accountants and lawyers, and regulators affected by the legislation in each of the 25 jurisdictions. In fact, these conflicts, among other financial issued, contributed to the impetus for a US-EU financial markets regulatory dialogue - a dialogue that until then had only been its infancy. Importantly, the Financial Services Action Plan is separate from, but in addition to, regulatory changes and associated conflicts that would stem from the proposed constitution.
I would posit that while all of these conflicts and potential changes together may have contributed on some level to the rejection of the proposed constitution at the polls, the "no" vote is unrelated to the EU-US regulatory agenda and dialogue. In France, a founding member of the EU, the vote was 54.87 percent opposed and 45.13 percent in favor, and in the Netherlands, also a founding member of the EU, the numbers came in at 61.6 percent opposed and 38.4 percent in favor. One day after the Dutch vote, Latvia was the tenth country to ratify the constitution. Latvia followed Germany, Austria, Greece, Hungary, Italy, Lithuania, Slovakia, Slovenia and Spain. With Latvia's vote, almost half of the EU's 454 million citizens have approved the constitution. So what does it mean that two of the member states have voted against the proposed constitution?
Some have suggested that the campaign for approval in both of these countries became a referendum on the current governments' economic record and one reporter characterized it as a vote against, "smothering their cultures in a vast superstate." In both countries, the press reported that opponents feared an influx of cheap labor as France and the Netherlands struggle to reduce high unemployment. In the Netherlands, reports also suggested opposition to Turkey's bid to join the EU bloc, not to mention the introduction of the euro and the fact that despite waning clout, the Netherlands remain the biggest contributors per head to the EU's multi-billion euro budget.
What have not been suggested as reasons for voting against the proposed constitution are the EU efforts to address the globalization of the financial markets and accordant EU-US dialogue. Likewise, I have not read about any fears that investment opportunities are curtailed under the framework set forth in the Financial Services Action Plan or that investor protections have been weakened. There does not appear to be any desire to change the course of progress with respect to any of the initiatives on which I have spoken today. I believe this is partially because, as I noted moments ago, the proposed constitution and the Financial Services Action Plan are separate, albeit related, initiatives. The recognition that the globalization horse is out of the barn is a universal sentiment -as well it should be. As I see it, the more we focus on a transatlantic financial market, the more likely and the sooner it will develop, as possible.
I believe another factor is the simple reason that the EU is 50 years old this month. On the grand scale, European integration is a tremendous accomplishment. As your foreign minister, Joschka Fischer, stated in his remarks to this Academy earlier this month, had the vote been on getting out of the EU altogether, the constitution would have passed by a large margin. I think that sums it up quite nicely. And now I'll spare you further musings.
In conclusion, I would echo US Treasury Assistant Secretary for International Affairs Randal Quarles' recent sentiment that close contact among US and foreign regulators and financial institutions leads to better policy reform and development which ultimately improves the quality of financial regimes and enhances opportunities for competition in each other's markets. In other words, we must continue to talk about the risks facing our financial markets and the decisions we make with respect to those risks and the reasons behind those decisions. Only then will we achieve the financial stability on which investors will stake their hard earned money. Risk, dialogue and confidence - an equation for success.