Statement by SEC Commissioner at
Open Meeting Considering Proposed Registration under the Advisers Act of Certain Hedge Fund Advisers
Commissioner Cynthia A. Glassman
U.S. Securities and Exchange Commission
July 14, 2004
As I am the only member of this Commission who was a Commissioner in June 2002 when we authorized the staff to conduct the hedge fund investigation with subpoena power, perhaps I have a somewhat different perspective on how we got here today. At the urging of former Chairman Pitt, the Commission authorized the staff to conduct an investigation "to aid the Commission in assessing whether, given the growth in hedge funds, it is necessary or appropriate in the public interest or for the protection of investors for the Commission to adopt or amend rules and regulations governing hedge funds and their investment advisers and/or for the Commission to recommend legislation to Congress concerning these matters." Of particular concern was whether hedge funds were becoming "retailized" and whether the growth in hedge funds was accompanied by a disproportionate incidence of fraud. Bear in mind that the term "hedge fund" generally refers to an unregistered pooled investment, privately organized, not advertised, and administered by professional investment managers, whose securities are privately placed with wealthy individual and institutional investors.
On May 14-15, 2003, we conducted a hedge fund roundtable, at which 60 panelists, including representatives of federal, state and foreign government regulators, securities industry professionals, and academics testified. This collection of experts essentially suggested that retailization and increased fraud were not the problem. In September 2003, 15 months after the investigation began, the staff released its hedge fund study. Like the roundtable, the staff study found no retailization and no significant increase in fraud. Notwithstanding these findings, the staff recommended registering hedge fund advisers.
Then came the market timing and late trading scandals. The scandals provided another rationale for registration and the concomitant inspection of hedge fund advisers on the theory that had we been inspecting the hedge funds, we would have found the abuses. But we were inspecting the mutual funds involved in the scandals and did not find the abuses despite the fact that we apparently had or could have obtained mutual funds' flow data that should have raised red flags had we understood how to extract the relevant information.
According to the proposing release, we've brought 46 cases against hedge funds in the last five years, eight of which involved registered advisers. There's also a reference to a staff estimate that the market timing cases involved up to 40 different hedge funds. I've had great difficulty trying to sort through these numbers. How many of the hedge funds we've brought actions against were truly hedge funds and not just garden-variety frauds? Of the cases against registered advisers, how many did we bring based on a referral from our examination staff? And apart from the one particular hedge fund adviser that was involved in many of market timing cases, how many other different hedge fund advisers were actually involved in similar activity?
In any event, we need to consider these numbers in context. Regardless of the exact total of the cases we've brought against hedge funds, it is small in absolute numbers and represents less than 2% of our overall enforcement docket, which during the same period totaled more than 2,600 cases.
Another justification that has been offered for registering hedge fund advisors is the increase in pension fund investment in hedge funds. The proposing release cites an increase from $13 billion to $72 billion since 1997. I would note, however, that since the total of private and public pension fund assets is over $6 trillion, the percentage of pension fund exposure to hedge funds is very low less than 1 ½%. Nonetheless, the proposal operates on the presumption that we need to protect pension plan participants. I fail to see the logic in this. Pension plans and plan advisers have their own fiduciary obligations to plan participants. Moreover, given ERISA constraints on pension funds' investments in hedge funds with unregistered advisers, our registration requirement could actually expand the universe of eligible hedge funds and encourage even more pension fund investment in hedge funds. Is this really the outcome we want?
So here we are with a solution, i.e., hedge fund adviser registration, without a clearly articulated problem. Therefore, I have to question whether the registration of hedge fund advisers is the right regulatory answer.
Most importantly, I question the effectiveness of this proposal. How we can be certain that our registration and examination process will be effective when we have not yet determined the nature and scope of the activity we seek to regulate? I am not suggesting that there may not be problems in hedge funds. What I am suggesting is that the staff's recommendation is premature, and another example of form over substance.
The plan before us is to register hedge fund advisers and then figure out what we should be doing. This strikes me as putting the cart before the horse. My approach would be to decide what information is useful before we decide how best to get it. Lest this be mistaken for a delaying tactic, I would like to point out that I have been advocating this approach for months. What I have suggested is a more robust study that focuses on identifying the qualitative and quantitative information that would raise red flags and provide systematic data on hedge fund trends and practices. Our staff study, although it represents a lot of work and contains much descriptive information, is not sufficient for this purpose.
I am also concerned about the resource issue. As an economist, I cannot ignore opportunity costs. We do not have unlimited resources. Whatever resources we devote to regulating hedge fund advisors, are resources that we could be devoting to other, perhaps higher, priorities. I continue to ask whether investors would be better served if we devoted such resources to more effective regulation of mutual funds, the investment of choice for over 90 million Americans, as opposed to hedge funds, whose investors are limited to institutions and likely fewer than 1 million sophisticated high net worth individuals.
Taking this concern into account, the proposing release seeks to minimize the burden of registration. It downplays the complexities involved in registering as an investment adviser and suggests that, although our exam staff will have a greater universe of investment advisers to examine, this increase will be offset by a risk-based approach to examinations and inspections. I disagree on both counts. I do not believe that advisers undertake the process of registration lightly nor do I believe that targeted exams would necessarily be less taxing in terms of our own resources. But we can't have our cake and eat it too. Registration implies inspection. If we do it right, it costs serious resources and expertise that I don't think we have. If we don't do it right, we are providing a false sense of security.
Another concern is unintended consequences. As Federal Reserve Chairman Greenspan has stated, hedge funds provide great liquidity to our capital markets. If well-meaning, but ineffective regulation inhibits hedge funds from performing their important function of lubricating our financial system, it could have a negative effect on our economy. Moreover, ineffective regulation of hedge funds could confer a seal of approval on hedge funds that could very well encourage greater investment in hedge funds by persons and entities for whom such investments are not necessarily appropriate.
So, what would I suggest we do?
- First, we need to know the scope of the industry. My understanding is that we could get basic census information on hedge funds through a notice filing system or possibly through the hedge funds' filings under the USA Patriot Act.
- Once we identify the funds and their advisers, we could consider requiring the periodic filing of information as yet unidentified that we could monitor remotely, looking for red flags and trends. Identifying the appropriate information would require a more robust study than we have undertaken so far, as I described earlier. This would include a survey of hedge funds, hedge fund investors, prime brokers, bank lenders and auditors and other relevant sources, and review of the vast array of data that we and other regulatory agencies already receive.
- If we are concerned about retailization, we should be considering ways to raise directly the eligibility criteria for hedge fund investors.
- If we are concerned about the lack of disclosure, we could survey hedge fund investors regarding the information, if any, they are unable to obtain and consider whether there is a role for prime brokers to play.
- If we are worried about improper allocation practices involving advisers to both hedge funds and mutual funds, mutual fund advisers are already registered, so this proposal is unnecessary.
- If we are worried about fraud in hedge funds, including improper valuation, let's be clear that hedge fund advisers are subject to the antifraud provisions whether they're registered or unregistered. As far as detecting fraud, we should look for red flags and common themes in investor complaints and examinations of the already regulated broker-dealers, prime brokers and mutual funds that are involved in hedge fund trading, and in our hedge fund enforcement cases.
- If we are worried about systemic risk issues, these are more properly addressed jointly with the Treasury and the Federal Reserve.
I wouldn't normally vote against going out for comment on a rule proposal. But this proposal puts us on the wrong track and doesn't ask for comment on a number of the alternatives that I believe we should consider.
I agree completely that we need to know more about hedge funds. But I do not believe that we can responsibly address these concerns without having a clear picture of the activity we are trying to protect against and a more realistic assessment of our own capabilities. The proposal seems innocuous on its face, but it's not. Registration implies inspection. Effective inspection of these specialized vehicles requires resources in terms of expertise and information that I don't think we have and it will divert resources away from our oversight of mutual funds and other regulated entities. If effective inspection is not what we have in mind or what we can deliver, we will be appear to be doing more than we are, and that will be a disservice to investors.
Therefore, I cannot support this recommendation.