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U.S. Securities and Exchange Commission

Closing Statment by SEC Chairman
at July 14, 2004 Open Meeting


Chairman William H. Donaldson

U.S. Securities and Exchange Commission

Washington, D.C.
July 14, 2004

Registration of Hedge Fund Advisers

The discussion this morning has been excellent, and to my mind, helpful in making clear what the proposal before us today does not do.

  • First, this proposal would not require hedge funds to register as investment companies. These are not mutual funds, and we are not suggesting that they be regulated as if they were.
  • Second, this proposal would not extend Commission jurisdiction where it does not already exist. Hedge fund advisers are investment advisers for purposes of the Investment Advisers Act and the Commission is responsible for their oversight, even though we have, in the past, exempted them from registration. This proposal would simply close the information gap that opened because of that earlier Commission decision.
  • Third, this proposal does not establish a new regulatory scheme. Investment advisers have been regulated by the Commission for sixty years — the regulatory scheme is mature and well-developed. The only issue on the table is whether to continue to permit hedge fund advisers to be exempt from certain aspects of this scheme.
  • Fourth, this proposal would not in any way impede the legitimate operations of hedge funds and the vital role they can, and in many cases do, play in our financial markets. Hedge funds can and do contribute to market efficiency and liquidity; they play an important role in allocating investment risks by serving as counterparties to investors who seek to hedge risks; and they provide investors with greater diversification of risk by offering them exposure uncorrelated with market movements. Nothing in this proposal would impair any of these benefits to the marketplace.

In contrast, consider what the proposal in fact would do, if finally adopted. Once implemented, the proposed rule would have the following immediate benefits:

  • It would provide the Commission basic, vital information about the hedge fund industry that we simply do not have today — how many hedge funds there are, how much money is invested in hedge funds, who is managing hedge funds, the employees and clients of these hedge fund managers, the other business these managers conduct, and the people who control these hedge fund managers.
  • Second, the rule would make available to investors and regulators basic information about these advisers through the disclosure on the Commission's Form ADV, making it much easier for them to make informed judgments about hedge funds. For example, the form would give investors access to information about the adviser's experience and disciplinary history that is currently either unavailable or available only by undertaking significant investigative burdens.
  • Third, the rule would likely deter violations of the securities laws by hedge funds merely by requiring registration. The mere prospect of getting caught for such violations through examinations and inspections will give hedge fund managers the incentive to avoid such violations in the first place.
  • And finally, like any other currently registered investment adviser, registration under the rule would require hedge fund managers to adopt compliance policies and procedures, designate a compliance officer, and maintain books and records in a manner that will help them establish a culture of compliance and heighten their sensitivity to existing fiduciary obligations.


Others here at the table, and outside of this room, have offered up a number of arguments favoring continued inaction by the Commission. However, I am not convinced that these criticisms justify opposing adoption of the proposal, much less serve as reason to oppose putting the proposal out for comment.

A. Hedge fund investors do not need SEC protection

Critics of the proposal have tried to dismiss investor protection concerns — arguing that only wealthy persons directly invest in hedge funds and that investors who are indirectly exposed to the risks of hedge funds through pension plans and other institutions are shielded by the fiduciaries who are responsible for managing those institutions. First, our mission is to protect all investors. Rather than question whether hedge fund investors deserve the SEC's protection, it is more appropriate to determine the most effective means of providing hedge fund investors with the SEC's protection. Second, a hedge fund's investors are not the only investors who are at risk from the hedge fund's activities. Every transaction by a hedge fund has an investor, small or large, on the other side of that transaction — don't those investors deserve our best efforts to protect them?

B. Registration will be unduly burdensome

Critics have also argued that it will be unduly burdensome to hedge fund advisers to register with the Commission and to be subject to inspections by the Commission's staff. Adviser registration imposes few regulatory burdens on registrants, none of which should in any way impede the operation of a legitimate hedge fund. Unlike provisions in the Investment Company Act that apply to mutual funds, the provisions of the Investment Advisers Act do not require or prohibit any particular investment strategies, nor do they prohibit or limit specific investments. The Advisers Act's most significant provisions — those which require full and fair client disclosure and prohibit fraud — apply regardless of whether the adviser is registered. The costs of registration are relatively low, and are today met by thousands of small advisory firms that have substantially less cash flow than many hedge fund advisers. The principal ongoing cost is the development and maintenance of compliance policies and procedures, which hedge fund advisers, whether or not registered, already need, in large measure to comply with the Investment Advisers Act.

C. SEC resource issues

It has also been argued that the Commission's resources will be used more effectively if we leave hedge fund fraud, if we can uncover it, to the enforcement division, and focus our prophylactic efforts on mutual funds and other products that are directly marketed to retail investors.

As I have said before — critics cannot have it both ways. They cannot demand that the Commission try to prevent and detect emerging, but as of yet unforeseen harms, while at the same time argue against collection of information to facilitate identification of such harms.

Learning from past practices that can and are being improved, we will be smarter about how we use our resources, including using our resources in ways that are proportionate to the risks involved and the benefits to be achieved. That is why I have made risk assessment a priority for the Commission staff, and why I have formed a working group within the SEC, comprised of senior staff from different offices and divisions, to explore how the Commission goes about overseeing investment adviser registrants, including hedge fund advisers.

However, development and refinement of our risk assessment approach to investment advisers should proceed on a parallel track to the proposal to require registration of all hedge fund advisers. It is unwise to make one a prerequisite to the other.

D. Insufficient study of the problem

Finally, it has been suggested that there has been insufficient analysis of the issues and that the Commission should not act without further study.

The Commission has already devoted considerable staff resources to studying hedge funds. The most recent staff study, published in September 2003, was based on a review of 65 hedge fund advisers, managing approximately 650 different hedge funds with more than $160 billion of assets. The Commission complemented the study by holding a two-day roundtable in which representatives of a broad-spectrum of the hedge fund industry and other interested persons participated. The Commission also received approximately 80 comment letters in connection with the staff study.

Frankly, the SEC's ability to study hedge funds in any greater depth is severely constrained by the Commission's past decision not to require them to register. We have only a rough estimate about how big the hedge fund industry is. We don't know how many people are investing directly or indirectly in these products, and we don't know who all of the participants are. And we don't know what the impact of their daily transactions is on investors in the marketplace.

At the beginning of this meeting I said that the Commission's traditional approach to hedge funds has been to "sit back and see what happens." In view of the changes in this industry, and the trajectory it appears to be on, I believe this course is no longer responsible. In fact, I have argued that the Commission needs to take a proactive, aggressive, risk-based approach to potential securities law violations across the board. As many of you have heard me say — the Commission needs to "look over the hill and around the corner" for indicators of future problems and violations. It turns out the hedge fund industry is a one-trillion-dollar corner along Wall Street, with "warning signs" flashing at us. We simply can't afford to continue to walk by and ignore it.

To my mind, the question is not whether the Commission should give up its "sit back and see what happens" approach to protect investors who could be harmed by the securities law violations of hedge fund managers. The only question is how best to do that.

I understand that reasonable minds differ on these issues, and I respect the views of my fellow Commissioners on the proposal. But I strongly believe that we need to begin now to look around that $1 trillion corner on Wall Street and vote to publish this proposed rule for comment today.


Before I ask the Commissioners to vote on the recommendation, I would like to conclude with a few final thoughts.

First, much has been made about the division within the Commission on the recommendation before us today. As I pointed out during our last open meeting, fewer than one percent of the 1607 Commission votes since I became Chairman have resulted in a vote that was not unanimous. I also pointed out at our last open meeting, that if all of the decisions we are asked to make were easy and self-evident, there would be no need to have five people sitting on this panel.

Although we have achieved a unanimous consensus in roughly 99% of the votes this Commission has taken, a failure to decide a pressing, difficult matter in to order reach unanimity — or to not act at all because attempts at compromise delayed, stalled, or shelved decisive action, brings into question the very founding philosophy of this Commission, which dictates an ability to act based on decisions decided by a majority. In fact, I would argue that the healthy debate within the Commission to date on the matter of hedge funds has produced a better proposal for us to consider today — a proposal that in its simplicity and cost-effectiveness goes to the heart of the information gap that must be filled if we are to discharge our regulatory responsibility. Moreover, the focus of the final rule will be better yet because of the continuing debate that will result from the formal public comment process.

Finally, I would like to thank Paul and his staff for all their hard work on this rulemaking package. In particular, I'd like to mention Bob Plaze, Jennifer Sawin, Jamie Basham, and Vivian Liu.

Check against delivery.



Modified: 07/14/2004