Statement by SEC Commissioner at
Open Meeting Considering Proposed Registration under the Advisers Act of Certain Hedge Fund Advisers
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
July 14, 2004
Thank you, Mr. Chairman.
In a well-intentioned effort to be proactive, we are proposing a rule that compels advisers to thousands of hedge funds to register with the Commission. The consequences of this action are far-reaching. We cannot hide from the fact that this apparently simple proposal creates a new regulatory regime. I fear that we are setting off at a frenetic pace down the road of regulatory overreaction, without pausing to consider where we want to go. I cannot vote in favor of this proposal.
A close reading of this proposal suggests to me that the Commission's debate about compulsory registration of hedge fund advisers might be finished and that this discussion and the comment process are merely an administrative formality to be endured in order to get the rule in place. We have yet to determine what we hope for from this change, let alone whether this proposal will get us what we want. I hope that public comment adds perspective and fills in the gaps.
A look at what the Commission and its staff have concluded previously about hedge fund adviser registration leads to the conclusion that this proposal is not the solution.
As the release points out, the Commission has studied hedge funds since the 1960s. As recently as 1992, in response to a Congressional inquiry, the Commission's staff discussed the "difficulties" that unregulated advisers pose to our enforcement efforts. The report concluded "the Commission has substantial powers to obtain information for enforcement purposes, including the power to compel testimony and document production." Further, the report noted that "the purpose of regulation is to protect investors, not to simplify investigations" and "the potential need to obtain information from hedge funds for enforcement purposes would not seem to be an adequate reason for registration."
Seven years later, the SEC, as a member of the President's Working Group on Financial Markets, issued a report after the near collapse of Long Term Capital Management. This report concluded "requiring hedge fund managers to register as investment advisers would not seem to be an appropriate method to monitor hedge fund activity".
Last year, our staff again studied the hedge fund industry, but this time issued a report that recommended, among other things, that the Commission consider requiring hedge fund managers to register as investment advisers under the Advisers Act.
What has changed between 1999 and 2003 to make the staff and the Commission conclude that mandatory hedge fund adviser registration is the right approach? Our release dismisses the conclusion in the PWG report because the 1999 and 2003 reports were supposedly focused on "different purposes". This dismissal seems contrived. Proponents of this rule suggest that information collection can help to identify anomalies and marketplace risks risks that led to the collapse of LTCM. Thus, the prior conclusions of the PWG are certainly relevant to our deliberations and should not be dismissed so cavalierly.
The pessimist in me worries that we are being opportunistic the "whip count" suggests that there are enough votes to pass a rule, and the current climate stifles criticism of anything dubbed "investor protection". Thus, some might feel that we should act while we have the opportunity. More specifically, I submit that our recent embrace of mandatory hedge fund adviser registration might be a combination of two factors: first, an overreaction to the recently-discovered abuses in the mutual fund area and second, a belief that an increase in fraud cases involving hedge funds requires that we act now to avoid embarrassment down the road.
Let us take these concerns one at a time. The recent mutual fund abuses are absolutely deplorable and should be met with the biggest bats that the SEC carries. In fact, we have levied some of the stiffest fines in history to combat these abuses and we are considering regulatory changes to address any underlying systemic problems. However, mandatory registration of hedge fund advisers will do nothing to keep the mutual fund managers on the straight-and-narrow.
Our release characterizes the market timing and late trading cases as a "new species of hedge fund fraud". While certainly pithy, this label is somewhat misleading. Some hedge funds were involved and profited handsomely from market timing and late trading. If we determine that the hedge fund advisers violated the law, then they should be punished with the same zeal as we have punished the mutual fund advisers.
Calling these "hedge fund" cases, however, distracts us from scrutinizing the significant breakdown in the compliance and control procedures of the mutual fund companies and the intermediaries that process their trades. It was these fiduciaries that betrayed the fund shareholders. It was the registered mutual fund advisers that broke their own stated policies and violated securities laws. A look at footnote 43 of the release, which lists these cases, shows that our enforcement actions have been targeted at the regulated advisers of mutual funds, not the hedge funds. We should not call this "hedge fund fraud" any more than we should call an adviser who steals money from a fund to buy his girlfriend a BMW "paramour fraud".
Looking at the second point, is the increase in hedge fund fraud cases something that we should get concerned about? Of course. This agency should always be concerned when it sees fraudulent conduct trending upward. But, it is also our responsibility to keep these trends in perspective. There has been an increase in hedge fund cases since 2000. However, is this increase dramatic when compared to the increased number of enforcement cases initiated during each of these years? The staff's 2003 Hedge Fund Report states that there is "no evidence indicating that hedge funds or their advisers engage disproportionately in fraudulent activity." Of course, I am troubled about the increase in enforcement actions that we have brought, but true hedge funds advisers, the entities that would be affected by the rule, do not appear to be involved in a disproportionate percentage of them.
Even if we assume, for the sake of argument, that the increase in hedge fund cases suggests that fraud is a problem, will our solution address this problem?
[Discussion of Exhibit A]
The Commission does not know everything that it would like to know about hedge funds and hedge fund advisers. This chart demonstrates, however, that our proposed solution does not fill in these information gaps. Moreover, our proposed solution would not even address most of the fraud cases that appear to be the proponents' primary reason for supporting this rule.
I have many other concerns with the conclusions drawn and the unintended consequences of this release and rule. Some of these are: the unsupported fear that retail investors are exposed to hedge funds; the diversion of significant resources when it is abundantly clear that we have more work to do in other, more traditional, areas under our jurisdiction; the unwillingness to work with other government agencies to determine whether the government already possesses the information that we claim is so elusive; the effect of this rule on new entrants to the marketplace; and, the less-than-candid suggestion that this is simply an inexpensive non-burdensome rule.
I hope that comments address these issues. I hope that the Commission will assess those comments with an open mind.
Putting all of this in context, I recognize that many in the hedge fund community might not be overly concerned about the prospect of registering with the SEC. Hedge fund advisers might be prepared to accept the administrative hassle and fill out the Form ADV.
If that were the end of the matter, then I might counsel them to accept their fate in gracious silence. But, there is more to the story; registration is just the camel's nose under the tent. I recommend that hedge fund advisers ask themselves some questions:
- Would you be concerned if you believed that this approach is merely a first step in the process of more substantive regulation of hedge fund activity, business models, and business practices? In answering this, you might consider the new compliance rules to which all registered advisers are subject.
- Would you be concerned if you knew that you could be subjected to disruptive an ad-hoc requests for information, including all emails in a prescribed format?
I would recommend that advisers to venture capital and private equity funds ask themselves: Why are you so special? Why are you not inevitably next? Advisers to these funds should realize that, if worries about proper valuation are driving this rulemaking at least in part, why are those issues not equally as valid for your funds?
I also recommend that investors in all of these funds ask themselves what they will gain from this proposal more protection or ultimately just a narrower range of investment options as fewer advisers offer their services?
Investors whose savings are managed by the advisers and funds already under our regulatory purview should ask themselves why their regulator is planning on adding to the entities it inspects rather than using its newly available resources to improve its oversight of mutual funds and advisers registered under existing rules?
Fraud deterrence is a laudable goal, but so is avoiding regulatory overreach. Our release makes it abundantly clear that we do not know what information we want or need. I cannot imagine that we will figure this out in the next sixty days. Until we have a better idea of what we are looking for, I will not ask taxpayers to foot the bill for a fishing expedition carried out to protect institutions or the very rich from investment losses.
Despite my policy concerns, I appreciate the staff's hard work on this proposal.
I should also extend a welcome to our new chief economist, Chester Spatt. You have joined us at an auspicious time.
I have just one question. What type of information could you receive in the comment process that would persuade you that this approach is inadvisable?
Mr. Chairman, I intend to submit a written dissent for inclusion in the Commission's release.
- So, what is the problem that we are hoping to solve? The fact sheet that the staff has distributed and the draft release on page 13 states that in the past 5 years, there were 46 enforcement actions against after hedge fund advisers that defrauded investors.
- Would our proposed solution solve this problem? Let's look at the cases:
- 8 of these 46 cases involve HF advisers who were already registered with the SEC. This rule would not help in those instances, because the advisers were already registered.
- In 5 of the 46 cases, the fund should have been registered under the Investment Company Act, so their advisers already should have been registered under current rules. Investment Company Act registration brings even more comprehensive regulation than Advisers Act regulation.
- In 20 of the 46 cases, the hedge funds were too small to be covered by the proposed rulemaking. They all had assets under $25 million. Many were well below that amount.
- In 2 cases, the fraud involved a principal of a registered BD or IA. (We already had full regulatory oversight in these cases.)
- 3 of the 46 cases were garden-variety fraud designed to swindle investors, regardless of whether the vehicles were called hedge funds, venture capital funds, limited partnerships or prime banks. Registration might have deterred them from using the term "hedge fund", but would not have deterred the fraud itself.
- So, of the 46 cases that we started with, we are left with only 8. Even these 8 present challenges for proponents of the rule.
- Most involve valuation problems, which have been notoriously difficult for us to detect even if the adviser is registered.
- In some of the larger cases, only perfect timing by examiners would have provided any benefit to investors.
- In some of these cases, we received tips from knowledgeable parties who suspected the fraud, and we went in within months of the fraud's inception. Absent a lucky coincidence, could registration have improved upon this timing?
- Most of the cases involved purposeful concealment of illegal behavior. Routine examinations are notoriously ineffective at ferreting out fraud in these cases. Fraudsters lie, cheat and steal they do not notify the Commission of their fraudulent intentions.
- A quick scan through the litigation releases on our website betrays the fact that even registered advisers engage in fraudulent behavior and cause investor losses.
- So, what is our proposed solution? We seek to require registration of all hedge fund advisers. I fear that doing so will only create the false impression that hedge funds have the Commission's seal of approval and lessen the likelihood that hedge fund investors will look before they leap.