Speech by SEC Commissioner:
Registration under the Advisers Act of Certain Hedge Fund Advisers
Cynthia A. Glassman
U.S. Securities and Exchange Commission
October 26, 2004
In contrast to my enthusiasm for the Securities Act reform proposal considered by us today, this hedge fund proposal is a disappointment to me on many levels. Procedurally, this proposal was rushed through the rulemaking process and appears to have been a fait accompli from its inception. The Chairman and other proponents apparently believe that commenters already had sufficient notice based on the Commission's hedge fund roundtable, as well as last year's staff study, that this proposal would be forthcoming. However, because the roundtable and staff study confirmed that the problems we initially thought would be found in the hedge fund industry do not appear to be present, it was not obvious, certainly not to me, that the proposed rule would be forthcoming. Further, since regulation of hedge funds has broad market implications, any regulatory requirement would more appropriately be addressed as part of a collaborative effort among the President's Working Group members, all of whom I understand have concerns with our proposal. I believe it would be prudent for that collaborative effort to proceed prior to unilateral Commission action.
I am also troubled by the staff's minimization of commenter' concerns in various drafts of this proposal, as well as an undertone that the burden of proof is on those opposed to show that this rule is not warranted. This is backwards. In my view, the burden of proof should be on the Commission to establish that this is the least burdensome and most effective way to accomplish our objective.
The proposal itself is fundamentally the same one from which I dissented in July. While I agree, as I have all along, that we need more information on hedge funds, I disagree with this solution. The comment letters in support of this proposal are not persuasive, and the comment letters against the proposal, which represent the vast majority of submissions, raise many of the same concerns that I did. Accordingly, I am not going to reiterate all of the concerns I raised when this went out for comment, but I do want to highlight a few issues.
The proposal's supporters assert that the proposal is justified by the growing number of fraud enforcement cases involving hedge funds. The staff repeatedly stresses that since the rule was proposed in July, the Commission has brought five new enforcement cases for a total of fifty-one cases over the past five years. Yet a cursory review of the litigation release posted on the Commission's website for each of these new cases demonstrates that the proposed rule would have had no effect on any of them. Four of the cases involved hedge funds below the $25 million threshold required for registration. The fifth case, while involving a fraud that ultimately raised $27 million, did so over an eight-year period. As far as I can tell, none of these cases appears relevant to the proposed rule and, as noted in my initial dissent, the total number of enforcement cases that even tangentially involve hedge funds represents but a small fraction of Commission enforcement actions over the past five years.
Regarding the market timing cases, I would point out that market timing is not per se illegal - what was illegal was mutual funds allowing it when they said they did not. I would also note that we did not initially find this problem in our examinations.
The staff also stresses that the threat of an examination will deter fraudulent activity by hedge fund advisers and thus rejects all alternatives to this proposal because the alternatives lack an examination component. The fallacy of this argument is that the Commission lacks the resources necessary to conduct meaningful hedge fund adviser examinations, and our lack of resources is a matter of public record. As the Chairman himself noted when testifying before Congress this year, the Commission has only 495 staff conducting examinations of approximately 8,000 mutual funds, managed in over 900 fund complexes, as well as more than 8,000 investment advisers. It is no secret that the Commission is rethinking its inspection model, which historically has focused on site visits and information requests. As such, it is difficult to perceive how hedge fund advisers will be deterred by the prospect of an examination when they know that we lack the resources to audit comprehensively their operations. Given that we are already stretched as an agency to examine the mutual fund industry, with about 91 million investors, I question whether we are justified expending significant additional resources in an attempt to examine hedge fund advisers, where the investors are limited to a small number of wealthy and/or sophisticated individuals and institutions.
There are a number of alternatives that could have been explored in lieu of registration, but unfortunately none of them is on the table. First, with the growth of hedge funds, I agree that we need to know more about them. I would support a census, pooling of information from all of the agencies that collect data on hedge funds, and identifying and requiring additional periodic and systematic information to be filed with us once we determine what would be appropriate. I have been supportive of this concept throughout our discussions.
If we really think retailization is a problem, even though our own staff concluded only last year that this was not an issue, we have two very easy options: raise the accreditation standards for investors and/or require registration for funds that allow relatively small investments, perhaps $100,000, or another appropriate cutoff. These conditions would further reduce the number of high net worth individual investors -- estimated already at fewer than 200,000 -- to an even smaller universe of investors. An additional option would be to require the funds of funds that are targeted to retail investors, and all of their component funds, to have registered advisors. Again, I have supported these concepts throughout our discussions.
Regarding pension fund and other institutional investors, who indirectly invest in hedge funds on behalf of individuals, as part of a risk diversification strategy, this new requirement will be counterproductive. Since the trend appears to be for such investment vehicles to limit hedge fund investments to those with registered advisors, our rule would expand the potential universe and encourage even more investment in hedge funds. As an aside, my understanding is we do not have information on the extent to which institutional investors actually invest in hedge funds that do not have registered advisors. However, we do know that they have a fiduciary responsibility to their beneficiaries obligating them to conduct appropriate due diligence before making the investment.
If we are concerned about valuations and fraud, a notice and filing of appropriate information, including audited financial statements, would appear to me to be more useful than the ADV information in the registrations. We already have authority and use it to investigate potential fraudulent abuses in hedge funds now.
I continue to be concerned that the registration and concomitant inspection are the wrong approach. I do not think the ADV form even as amended provides the type of information that would be helpful in identifying fraud, nor do we have the resources and expertise to ferret it out in our examinations. Thus, as I have said before, the proposed approach would unrealistically raise expectations about what we are accomplishing, and would divert significant resources from other inspection activities that are more focused on retail investment vehicles.
Regarding the "seal of approval" concern, I have heard anecdotal evidence that registered hedge funds do make that registration prominent in offering materials. Why would they do that?
I understand that we have a task force looking at a new risk-focused model for investment adviser oversight, including hedge fund advisers. It would have made more sense to me to determine the right model and then apply it to hedge fund advisers if that appeared warranted. Regrettably, the Commission failed to take an opportunity to devise a new model of systematic and robust information gathering, including notice-filing, pooling of information from all of the agencies that collect data on hedge funds, and identifying and requiring additional information to be filed with us once we determine what would be appropriate - before imposing a new, burdensome, and outdated requirement. This would have improved our ability to perceive market trends, detect red flags, and note industry exceptions.
I am disappointed with the approach that was chosen, and know that we can and must do better. If this proposal is approved, I hope that as we prepare for its implementation, we develop a workable oversight model. I want to make perfectly clear that I am not suggesting that we do not need more information about hedge funds and their advisers. However, for all the reasons I have stated today, at the proposing meeting, and in Commissioner Atkins and my dissent, I vote against this proposal. I believe it is the wrong solution to an undefined problem using an ineffective examination model.
As with the proposing release, I plan to file a written dissent to accompany the adopting release.