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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Open Commission Meeting: Considering Registration Under the Investment Advisers Act of Certain Hedge Fund Advisers


Paul F. Roye

Director, Division Of Investment Management
U.S. Securities and Exchange Commission

Washington, D.C.
October 26, 2004

Thank you Chairman Donaldson and good morning to you, and Commissioners Glassman, Goldschmid, Atkins and Campos.

I am pleased to be here this morning to present the Commission with the Division of Investment Management's recommendation for a new rule and rule amendments under the Investment Advisers Act that would require hedge fund advisers to register with the Commission as investment advisers.

This past July, the Commission proposed the rule and rule amendments that we are recommending you adopt today. You received letters from 153 commenters, of which 29 supported the proposal and 82 opposed, while 42 submitted letters raising concerns about particular issues they wished you to address. Of the major trade associations, the Investment Company Institute (ICI), the Investment Counsel Association of America (ICAA) (both of which have many members who advise hedge funds) favored the rule proposal; while the Managed Funds Association (MFA) (most of whose members manage hedge funds and/or commodity pools) opposed the rule.

Most, but not all of the hedge fund managers who wrote, opposed the rule. Two hedge fund managers, both of which are registered investment advisers, supported the rule, and indicated that registration had not interfered with their operations nor imposed substantial burdens. The ICI and ICAA expressed similar views on behalf of their members, all of whom are registered advisers.

Individual hedge fund investors were split on the proposal. The only two institutional investors who wrote you, the Ohio Public Employees Retirement System and the New Jersey State Investment Council, strongly supported the rule. Interestingly, the Hennessee Group submitted a survey it had performed of foundations and endowments-which are significant investors in hedge funds-which reported that 59 percent favored requiring hedge fund advisers to register while 30 percent opposed such a requirement.

But we did not just read the comment letters. In the past year we have had discussions about hedge funds and our proposals with fellow regulators, including the staff of the Treasury Department, the Federal Reserve Board, and the Commodities Futures Trading Commission. We also have met with our colleagues at foreign regulators, including the Financial Securities Authority in the United Kingdom, which requires hedge fund advisers to register.

The comments and our conversations with fellow regulators provide a wealth of information and insight that has helped us prepare our recommendation for you.


The rule proposal was the result of a process that began over two years ago that included an extensive staff study of hedge funds and their advisers that we released last year. The staff study raised a number of concerns that lead us to recommend that you require registration of hedge fund advisers under the Advisers Act.


One concern is the tremendous growth in the industry. While no one knows for sure, it is estimated that in the last five years, hedge funds have grown by 260 percent, with assets of approximately $870 billion in approximately 7,000 funds. Some predict that hedge fund assets will soon reach one trillion dollars. In the last year alone, hedge fund assets have grown over 30 percent. Hedge funds are one fifth the size of equity mutual funds, but are growing at a much faster rate.

Moreover, hedge funds tend to be very active traders. One study estimates hedge funds are responsible for up to 20 percent of equity trading volume in the United States. It is clear that hedge funds advisers are significant market participants, both as managers of assets and traders of securities. This growth and potential impact on our markets simply cannot be ignored.


In spite of the statistics I just reviewed for you, neither we nor any other government agency has reliable data on the hedge fund industry, including data on the number of hedge funds or the amount of their assets. We only have third party surveys and reports, which often conflict and may be unreliable.


Another significant concern is the growing exposure of smaller investors, pensioners and other market participants, directly or indirectly to the impact of hedge fund investing. They are no longer for the very rich. More and more, we see funds pouring in from a new type of investor who can't afford to absorb the large losses as a result of frauds. Lower minimums and the rise of funds of hedge funds are permitting smaller non-traditional investors into hedge funds, directly or indirectly. Moreover, a growing number of public and private pension funds, as well as universities, endowments, and other charitable organizations have begun to invest larger amounts of money in hedge funds These types of institutions may soon increase their investments in hedge funds to over $300 billion.

Investors such as pension plans that have millions of beneficiaries are now exposed to the risks of hedge fund investing. Losses resulting from hedge fund investment strategies and possible hedge fund frauds could affect these institutions' ability to satisfy their obligations to their beneficiaries or to meet other intended goals.


The growth in hedge funds has unfortunately been accompanied by troubling growth in the number of our hedge fund enforcement cases. In the last five years, the Commission has brought 51 cases involving hedge fund fraud, resulting in losses of more than $1.1 billion. These cases are more than ten percent of cases against investment advisers over the same period. You can slice and dice these cases in a number of ways, but they signal to us that this is an area where we should have concerns

In addition, we are seeing hedge funds used to defraud other market participants. Hedge fund advisers were key participants in the recent scandals involving mutual fund late trading and inappropriate market timing. We have counted almost 400 hedge funds and 87 hedge funds advisers involved in these cases. They were most of the late traders and market timers. They picked the pockets of every-day mutual fund investors.


Registration under the Advisers Act will give us the tools we need to monitor the activities of hedge fund advisers without imposing burdens on the legitimate investment activities of hedge funds or interfering with the important role that hedge funds play in our financial markets.

The Advisers Act does not require an adviser to follow or avoid any particular investment strategies, nor does it require or prohibit specific investments. It will not hamper hedge funds. A recent study found that there were no significant differences between performance of hedge funds managed by unregistered advisers and those managed by registered advisers. Moreover, five of the ten largest and presumably most successful hedge fund advisers are today registered with the Commission.

More than 8,500 advisory firms that collectively manage over 23 trillion dollars in assets are registered under the Advisers Act. We have seen no credible evidence that the Advisers Act has in any way impeded their ability to employ successful investment strategies or to effectively compete with other financial institutions that manage securities portfolios in this country or abroad.


Advisers Act registration will allow the Commission to address the various concerns we have identified regarding the hedge fund industry.

a. Census Information

First, registration under the Advisers Act will provide the Commission with the ability to collect important information that we now lack about this growing component of the U.S. financial system. Other approaches suggested would require the staff to engage in a complicated and time-consuming forensic exercise to extract an incomplete composite of information about hedge fund advisers. They would require us to put together multiple jig-saw puzzles without all the pieces.

b. Deterrence of Fraud

Second, registration under the Advisers Act would give the Commission the ability to conduct examinations of hedge fund advisers. Examinations permit us to identify compliance problems at an early stage, identify practices that may be harmful to investors and provide a deterrent to unlawful conduct. The prospect of a Commission examination increases the risk of getting caught violating the law and thus will deter wrongdoers.

We are not suggesting that our examination staff will uncover every fraud, and some critics contend that we would be unsuccessful in detecting fraud by hedge fund advisers. However, our examination staff uncovered five of the eight cases we have brought against registered hedge fund advisers. There is nothing unique about hedge fund advisers or the types of frauds they have committed. We have brought the same types of actions against unregistered advisers that we have brought against registered advisers.

c. Barring Unfit Persons from Hedge Fund Industry

Third, registration permits us to screen individuals associated with an adviser and to deny registration if they have been convicted of a felony or had a disciplinary record subjecting them to disqualification. We would use this authority to help keep fraudsters and scam artists out of the hedge fund industry.

d. Adoption of Compliance Controls

Fourth, registration would require hedge fund advisers to adopt policies and procedures designed to prevent violations of the Advisers Act and to designate a chief compliance officer. In other words, hedge fund advisers would have to develop a compliance infrastructure-just like other advisers of similar size.

We readily acknowledge that compliance controls cost money, but these are costs all advisers registered with us must bear, including advisers that are much smaller and have substantially fewer resources and cash flow than many hedge fund advisers. Given the fee revenue generated by hedge funds today, the arguments made by some opponents that hedge fund advisers could not afford these costs is simply not credible.

e. Limits on Retailization

Fifth, registration under the Advisers Act will have the salutary effect of requiring many direct investors in most hedge funds to meet wealth standards that are higher than the current minimums.

f. Proper Administration of Advisers Act

Finally, we believe that the adoption of the rule and rule amendments we recommend today will close a loophole in our regulations that allows an exception designed for advisers providing advice only to a small number of clients, and therefore not representing a substantial federal interest, to be used by hedge fund advisers to manage in some cases billions of dollars for potentially thousands of investors.


Commenters suggested a variety of alternatives to Advisers Act registration, but none of them in our judgment would accomplish the goals of this rulemaking. While some of the alternatives would address some of our policy concerns, each of them lacked what we consider an essential component of this rulemaking - the ability to exercise our examination authority, which we view as vital to deterring and detecting fraud in the hedge fund sector of the investment management industry. If we are to maximize our effectiveness, we must have the ability to use our examination authority to monitor hedge fund adviser activity and protect our financial markets.


I want to be perfectly clear about the motivations behind our rulemaking because there are those who have characterized this initiative as an attack on the hedge fund industry, which it is most definitely not. Most participants in the hedge fund industry are honest and ethical. We deeply appreciate the beneficial role that hedge funds play in our markets, and we do not want to impede the industry's ability to flourish and grow. We simply want to be able to monitor this fast growing segment of the investment management industry so as to fulfill our mission to protect investors and the securities markets. And if this rule is adopted, our sincere hope is that the hedge fund industry would join with us to make this initiative work for the industry and ultimately strengthen hedge funds' role in our securities markets.

We would be pleased to answer any questions regarding the rule and rule amendments we recommend you adopt today.


Modified: 10/26/2004