Speech by SEC Commissioner:
Open Meeting to Consider the Registration of Hedge Fund Advisers
Paul S. Atkins
U.S. Securities and Exchange Commission
October 26, 2004
I find it very telling that we are gathered here to consider this rulemaking on the 26th of October. Today is just two days before the comment period on this proposal would have ended had we granted the requests of several commenters, including the National Venture Capital Association, to extend the comment period. They had asked for a 90-day period, instead of the 48 days, which was the effective length of the comment period after the proposal was published in the Federal Register. But why should we extend the comment period for a rule that was essentially written in stone when it was proposed?
Despite the constricted comment period, we received over 150 comment letters, only 30 of which supported the proposal. Many commenters raised complex technical concerns about how the registration requirement would work in practice. I am disappointed that in the rush to get a rule adopted, we took so little time to consider these comment letters. It's also hard - but the majority has managed to do it - to hit the trifecta of having the Wall Street Journal, the New York Times and the Washington Post editorial pages being against our action. We are rightfully viewed as being dismissive of the concerns commenters raised.
Unfortunately, we have also refrained from hashing out the issues with, among others, our colleagues in the President's Working Group (the Treasury, the CFTC, and the Federal Reserve), as well as others such as the Department of Labor. Earlier this month, Congressman Baker, Chairman of the Capital Markets Subcommittee of the House Financial Services Committee, wrote to the President's Working Group to ask it to intervene before we acted. Chairman Greenspan has warned us that "the initiative cannot accomplish what it seeks to accomplish." With due deference to Chairman Greenspan and the tough job that he has, I cannot think of a time when he has been so clear! I am befuddled as to why we are charging ahead in the face of such a groundswell of principled and public opposition to this action. Comity and co-operation is more than just talking to someone - it means listening and responding and working together. Unfortunately, we did none of these things. I sometimes feel that we are in a Moby-Dick-like "pertinacious pursuit of one particular whale," as Herman Melville described in his colorful prose.
The Commission would do better to keep its eye trained on the mutual funds and broker-dealers to whom average Americans entrust so much of their money, rather than hedge fund advisers who manage the money of at most 200,000 well-heeled individuals and institutions. Average investors expect the Commission to monitor the entities handling their money, whereas hedge fund investors do not rely on Commission oversight. No one is forcing them to put their money into hedge funds - they have a choice, the ability to get advice, and the market power to do otherwise. They perform, or can hire someone else to perform for them, due diligence to lower their risk of investing in hedge funds. Risk-averse investors could insist, for example, on getting audit reports or a third-party internal control review. If they suspect fraud or malfeasance, they can figure out where to turn for help. But now we are upsetting the private-public balance and taking on a task that we might not have the resources to perform as well as the private sector does.
In response to the argument that hedge fund investors are fully capable of taking care of themselves, proponents of registration raise cries of "retailization". They say that hedge funds are surreptitiously reaching into the pockets of unsuspecting retail investors, including investors in funds of hedge funds and vulnerable retirees. In addition, they charge that pension, endowment and charitable institution money is pouring into hedge funds at great threat to the welfare of their beneficiaries.
First, the 2003 Staff Hedge Fund Report found no retailization. Second, for each of these fiduciary entities, an investment professional stands between the hedge fund and the retail investor. That investment professional is not only paid, but is legally obligated under federal and state law, to look out for the best interests of the entity. A pension plan administrator has a fiduciary obligation to the plan's participants. Because these entities tend to be large, the investment professionals representing them generally are in a better position than the SEC would be through its registration process to obtain information about hedge funds. They have the resources to ensure that their investment choices are prudent and that they, as fiduciaries, have all the information that they need to make their investment determinations. Third, we can take actions to ensure that investors in funds of hedge funds satisfy investment minimums.
Finally, as for pension funds, we need to put the issue in perspective. The $72 billion invested in pension funds is only 8 per cent of total hedge fund investments and, more importantly, just 1 per cent of U.S. pension fund assets. Maybe we ought to be more concerned about the other 99% of pension fund investments.
Maybe we ought to let the Department of Labor, which is charged by Congress to look after pension funds under ERISA, weigh in on pension funds and whether they perceive this as an issue.
As I noted at the proposal stage, it would be useful for us to have more information about hedge fund advisers. Commenters showed a commendable willingness to work with us to get us the information we need. They suggested a number of alternatives for achieving this, including requiring unregistered investment advisers to file and annually update information statements with the Commission. This approach would have enabled us to develop a complete picture of the advisory industry without imposing undue costs on advisers who choose not to register.
In addition, we could have worked with other regulators to standardize and formalize information sharing. We could have worked with entities that are already regulated, such as prime brokers. Through these avenues, we would have been able to obtain exactly the information we need to monitor the industry and root out fraud. By contrast, requiring hedge fund advisers to fill out Form ADV will yield only snippets of useful information. We missed all these opportunities that could have produced a less costly, more streamlined approach that likely would have found unanimous support on the Commission and perhaps even among affected investors and advisers.
Proponents of registration insist that filling the information void is only one of the objectives of registration. They insist that the Commission, which already has the authority to conduct "for-cause" examinations of unregistered advisers, also needs routine inspection authority, which only registration could afford. I do not dispute that we need to be ever vigilant for hedge fund fraud, and that undoubtedly there is fraud occurring, but subjecting hedge fund advisers to routine examinations is unlikely to be an effective deterrent. Certainly a perfectly timed examination could turn up wrongdoing, but with so many registrants and so few examiners, perfect timing is a lot to ask for.
We have been in the process of augmenting our examinations team in order to address the overextension of our examinations program for current registrants. Our budget has doubled over the past two years. So, it seems unwise to shift resources away from traditional areas of oversight so soon after we made the case that those areas were understaffed. Hedge fund advisers tend to employ more complex investment strategies than the typical registered adviser, especially those who advise mutual funds. If hedge funds become a primary focus for us, we will need to train more of our examiners, most of whom have no background in this area, so that they are able to recognize unique issues that arise in the hedge fund context. Otherwise, we are simply setting them up to fail. Market surveillance is a far more effective, targeted way of finding fraud, and would allow us to leverage the knowledge and expertise of the self-regulatory organizations.
In addition to being costly for us, the new registration requirement will be costly to affected advisers, and these costs will be passed on to investors. Registration is more than filling out a simple form, filing it, and forgetting about it. A Form ADV, which is a public disclosure form, is a potential litigation document and, therefore, cannot be filed without a lawyer's blessing. Lawyers' blessings never come cheap. Registered advisers face numerous requirements, including recordkeeping, custody, and compliance requirements. All of these impose costs.
We are told to take comfort in the fact that advisers to hedge funds are handsomely paid for their work, especially as compared to the so-called run-of-the-mill registered advisers. So, the argument goes, they can afford the extra cost of regulation in a marketplace that has seen the trend of hedge fund management fees increase from a low of "1 and 20" up towards "2 and 25". I don't take comfort in seeing resources diverted from other uses, such as hiring new employees or purchasing outside research, to cover the costs of compliance with our regulatory mandates. These management fees, which investors have agreed, out of self-interest, to pay, presumably reflect the risky nature of establishing a hedge fund and the high costs for attracting expensive, top talent.
Proponents also argue that, to the extent there are costs, we are just leveling the playing field between those hedge fund advisers who have already registered voluntarily and the ones who remain in the so-called "shadows". As an initial matter, I reject the insinuations underlying this initiative that hedge fund advisers who have chosen not to register have done something wrong or have something to hide. We should not be so hasty to assume the worst about anyone who is not registered with us. Moreover, we can all come up with a long list of enforcement actions against registered advisers to shatter the myth that all registrants are pure as the driven snow. Hedge fund advisers, like other businesses, register if it is cost-effective for them to do so. If the benefits of registration, such as wider appeal to pension funds and other investors, do not outweigh the costs, then hedge fund advisers do not register. We cannot assume that the cost-benefit balance will be the same for every hedge fund adviser. Mandating across-the-board registration only serves to eliminate any benefit registered advisers enjoyed in being able to distinguish themselves from unregistered advisers.
But, if we are intent on leveling the playing field, we should focus on the line we have drawn between hedge fund advisers and advisers to other types of private pools. Why have we not applied the registration requirement to advisers of private equity and venture capital funds? Valuation issues are important in these funds also.
Our argument for excluding advisers to other types of unregistered investment companies looks particularly weak when we see that the only real line of demarcation employed in the rulemaking is the length of the redemption period. A hedge fund adviser can avoid application of the rule by simply extending its redemption period beyond two years. Instead of the so-called "529 plans" for the hoi polloi (named after the tax section that middle-class investors use to save tax-free for college), wealthy investors will now have what I would like to be the first to call "735 plans", which will stand for a hedge fund with a 735-day lock-up period necessary to avoid the rule and take into account any Leap Year, with a day or two to spare.
This two-year distinction does not capture a legitimate regulatory distinction among funds. If our rule accelerates a trend towards longer lock-up periods - longer lock-up periods are already becoming more standard in the marketplace - our rule will have actually harmed investors, who will now have less freedom to vote with their feet by pulling their money out of a hedge fund that is mismanaged. We are simply encouraging an industry trend towards longer lock-ups.
Proponents argue that the recent spate of hedge fund enforcement actions justifies our preoccupation with hedge funds. As I discussed at the last open meeting on this rule, this approach would not have done much to stop the fraud underlying the 46 cases cited in the proposal. The additional five cases cited in the adopting release do not strengthen the case. Most of the advisers at issue in the cases were either too small to be registered, were already registered, or should have been registered. We will not protect unsophisticated investors from fraudsters by requiring legitimate advisers to hedge funds, open only to sophisticated investors, to register.
Finally, there are serious questions about the Commission's statutory authority to proceed without specific Congressional authorization to do so. Rather than recommending statutory amendments, it seems that we have chosen to make a tortured end run around the statute by redefining who a client is for certain types of investment advisers.
So, I hope that we do not wind up looking like the gunslinger in this Gary Larson Far Side cartoon. The gunslinger shot his opponent dead and only then realized that there were some questions he should have asked. In light of our discussion today, there are both questions that we first should have asked and responses that we might have heeded.
From the outset I have been open about my distaste for this idea. Accordingly, I plan to join again with Commissioner Glassman and file a written dissent. That being said, I recognize that behind this incredibly quick timetable is an overworked staff. I appreciate your hard work.