Speech by SEC Commissioner:
Should Hedge Funds Be Regulated?
Commissioner Harvey J. Goldschmid
U.S. Securities and Exchange Commission
New York, NY
November 17, 2004
It's always a great pleasure to be back at a Columbia Business School event. The comments I make today are my own and do not necessarily represent the views of the Commission, my fellow Commissioners or the Commission staff. That's our normal disclaimer. The short form of that is nobody in Washington has to take seriously anything I say today.
This is an important topic. As the panel will indicate afterwards, good minds can differ. Glenn Hubbard has already suggested that. But, as for the question, "Should hedge funds be regulated?," my easy answer to that is "yes," at least in the way the SEC wants to do it. On October 26th, I was one of three votes, in a three-to-two Commission vote, in favor of registration.
Before I explain my reasons for voting in favor of registration, let me put the hedge fund issues in a larger context--the context of securities regulation reform in response to the corporate and mutual fund scandals of the 1990s and early 2000s. I suspect it would be common ground in this room to suggest that the scandals have been the most serious in the United States since the Great Depression. It should come as no surprise to anyone that this has been the busiest period in the history of the SEC, with the possible exception of the period around 1934, when the Commission was created and new programs and procedures had to be put into effect.
In terms of causation, my bottom line is that the scandals occurred due to a systemic failure. The checks and balances that we thought would be provided by independent directors, independent auditors, securities analysts, commercial and investment bankers, lawyers, and compliance personnel have too often failed. As most of you know, during the past two years serious SEC enforcement efforts and rule-makings have come in each of these areas. The rule-makings and the enforcement efforts have involved some combination of increased and more timely disclosure (certainly true for public corporations and mutual funds) and enhanced responsibilities for key actors--for directors, officers, accountants, lawyers, and others in the financial community.
In addition, in institutional terms, the Public Company Accounting Oversight Board (PCAOB) and new "reporting up" rules for lawyers are making a large difference. The PCAOB and the rules for lawyers have changed both the substantive standards, and more dramatically, they have changed the way we conduct oversight of accountants and lawyers working with public companies. We've moved from a system of weak state regulation and self-regulation to a federal presence. Now (to varying degrees) there is federal oversight of both professions.
For unregistered hedge fund advisers who have been saying "Why us?," I say you're not alone. Everybody involved with public corporations, mutual funds, and Wall Street has been looked at, and there's been a tightening across the board.
To illustrate the Commission's regulatory approach, and to begin to answer a criticism posed by a very fine paper written by Professor Frank Edwards, let me briefly explain the causes of, and the SEC responses to, the mutual fund scandals. To quote Frank Edwards, "Fraudulent activity occurred in the highly regulated mutual fund industry where the SEC examiners were already inspecting funds and the SEC failed to turn up evidence of the frauds." Now, Frank was kind enough not to cite Eliot Spitzer running ahead of us (on a very good tip) in September 2003, but implicitly, and these are my words, not his, he was suggesting: "Why would SEC inspections or examinations of hedge funds be valuable in the context of the SEC's failure to find out what was happening at mutual funds?"
Step back with me and think about the mutual fund scandals. We have witnessed a grievous breach of trust in the mutual fund area. The seriousness of the scandals can only partially be measured by the money involved. We have roughly quantified shareholder losses at $2 billion in the investigations and enforcement actions we've taken so far; with what's in the pipelines, that number may jump to $3-5 billion. That's a lot, but if you think of Enron, securities holders lost $60 plus billion; if you think of Worldcom, $120 plus billion was lost. So the mutual fund scandals were not so much about the money as about the breach of trust in a business in which trust was the core of what was being sold to more than 90 million Americans. The level of what went on in terms of late trading and in-and-out fast trading (abusive market timing) was a special problem no matter how you look at it. What did we do about it?
First, and this is the usual SEC approach in terms of scandals, the Commission moved quickly on a combination of enforcement cases and rule-makings. In terms of rule-making, the idea was to eliminate the temptations and abuses that went with market timing, late trading, and other practices that we've now prohibited such as directed brokerage. Then, we worked on enhancing disclosure and mutual fund governance reform.
Getting back to Frank Edward's point, let me use late trading as a way of explaining what SEC inspections can do and cannot do. Going into a mutual fund, our inspectors would not have been able to see late trading. Indeed, that information came to Eliot Spitzer through a tip. The papers and documents at the banks, brokers, and funds were fraudulent. They showed the trading had taken place before 4:00 p.m. No inspector could have known that was untrue had he or she looked at the mutual fund itself.
But if we had been going into the hedge funds - - there were thirty or forty or maybe more that were involved in egregious ways - - it would have been easy for our inspectors to have seen what was wrong. Using any kind of risk analysis, and looking at how money was being made, it is perfectly clear to me that had we been inspecting hedge funds, we would have picked up the scandals earlier.
Now, you should all understand that late trading is simply looting. Events have occurred after the markets closed at 4:00 p.m., and you know that, as a result, dramatic portfolio changes will occur. In good news situations, late trading allowed hedge funds (and others) to buy at cheap prices. Eliot Spitzer correctly said it's like betting on a horse race after the race has been run. It takes no skill, no intelligence, and no financial acumen of any type. It involved corrupt payments to those who facilitated the late trading. That's the basic background in terms of what went wrong in mutual funds, and, obviously, the hedge fund linkage is real.
Let me begin talking specifically about hedge funds by confronting the myth that a rush to judgment has taken place. The new hedge fund adviser rule and amendments were approved by the Commission on October 26th. This action was the culmination of a long and serious process. We weighed carefully the concerns of the hedge fund community and others worried about counterproductive effects. We looked at possible less restrictive alternatives, but they were inadequate compared to what I believe is a modest, pragmatic, balanced regulatory approach.
In trying to think through these issues, I asked myself, "Why alter what has been the SEC's largely hands-off approach with respect to hedge funds?" We've always prosecuted fraud, but the question is: "Why intervene now? What compelling public policy concerns would get you there?"
First, we know too little about this dramatically growing industry, and what we do know has alarm bells ringing, at least for me. Eight or ten years ago, hedge funds held roughly $100 billion in assets. In September 2003, an SEC staff report put the figure at $600 billion. When the Commission acted on its proposed rule-making in July 2004, hedge fund assets were estimated to be $850 billion. Most estimates suggest that there will be a trillion dollars in hedge funds by the end of 2004. Moreover, all of these figures are from industry sources and are unreliable. Some Wall Street estimates have suggested a $1.5 trillion figure. We need accurate information about the aggregate size of hedge funds, about how leveraged they may be, about their trading patterns, etc. More - - and more accurate- - information will both protect investors and significantly enhance the Commission's ability to protect our securities markets.
Second, there has been a recent increase in cases involving hedge fund fraud, both on hedge fund investors (e.g., involving misappropriation, false valuation, and fraudulent promotion) and on others. Canary and too many other unregistered hedge fund advisers had a corrupting influence (e.g., through "sticky assets" and side payments) on mutual funds that resulted in the late trading and abusive timing scandals.
Finally, there is the issue of retailization which Glenn Hubbard mentioned earlier. Hedge funds are no longer dealing just with the funds of the wealthy. More and more, the general public's savings and charitable funds are being put at risk. Hedge funds are involved with large and sharply increasing amounts from private and public pension funds, funds of hedge funds, and endowments and other charitable institutions. My cab driver in New York yesterday owned the medallion to the cab. He told me that he was about to begin to put money into hedge funds. Under the rules of the game now, plumbers, cab owners, lawyers, and pharmacists all are qualified to invest. I think Frank Edwards is going to try to make a case that that's good, but these are risky ventures and do not make sense for most of those kinds of investors.
Now, in terms of cost-benefit analysis, what are the advantages of the kind of regulation of investment advisers to hedge-funds that's contemplated? One, accurate information about the funds themselves will now be available to the SEC (e.g., on aggregate size, leverage, etc.). Two, disclosure about the hedge fund advisers will take place. Such adviser information is now generally available to investors who do "due diligence," but now the information will be publicly available. Such disclosure will deter fraudsters from entering the business and save investors separate, costly, duplicative investigations and other "due diligence" expense. Why would you want to have "due diligence" investigations repeated time and time again by different investors as opposed to making the information available publicly and all in one place?
Three, there will be recordkeeping requirements, but, again, not at all onerous. Typical accounting records are already normally kept, and there will be some special requirements from the SEC. But again, these will be very moderate. Four, there will be protection for when the hedge funds keep custody of client assets. Again, it will be a safeguard that's very useful but not very costly. Five, there will be compliance safeguards. A chief compliance officer and internal compliance programs will be needed. The hedge funds covered will have a minimum of $25 million of assets to be in the federal system. Who would want to invest in a fund without a serious compliance program? The same thing is true of ethical codes that are going to be required.
Finally, there's a good deal of discussion (that goes back to Frank Edwards' earlier point) about whether SEC examinations and inspections of hedge funds would make a difference. Clearly, I think they would have made a large difference in exposing the mutual fund scandals, and I think that's a consensus view of the staff at the Commission. But the examination program is even more important than that. Roughly forty percent of investment advisers to funds are registered with the Commission today. Five of the eight cases brought against registered advisers in the past three years have come by way of SEC inspections.
More importantly, inspections, and the threat of inspections, bring about accountability and deterrence. I'm not suggesting that inspections are going to catch all fraudsters or that all will be deterred. But, whether one analogizes to tax audits or police patrols, one knows that the risk of getting caught and punished has a significant deterrent effect, particularly on white collar wrongdoers. The threat of SEC inspections, which are getting more sophisticated, is a real disincentive to wrongdoing.
Now, of course, the issue of the SEC's ability to carry out these examinations and inspections is fairly raised. Again, the figures are soft, and the data are imperfect, so we don't know exactly how many additional inspections will be required. The estimate is for roughly a 12 percent increase in inspections. I'm satisfied that the Commission staff will be able to do the job effectively. We now have serious compliance programs for investment advisers in general (these went into effect October of 2004). Also, we are growing more efficient, more sophisticated, and our risk-based assessment programs and tools will allow the SEC staff to increase its inspection capacity. In the unlikely event that the staff is stretched too thin, the Commission has the ability, if necessary, to raise the current $25 million figure and reduce the number of inspections. In terms of planning time, the increase in inspections does not take effect until February 2006.
The Commission's regulatory approach to hedge funds is meant to be non-intrusive. There will be no interference with their investment strategies, with their operation, with their creativity or liquidity, or with their flexibility. In general, the costs of this regulatory scheme will not be very high. The world is full of thousands of investment advisers that are now regulated, and that regulation has not been burdensome in terms of either time or dollars. Again, roughly forty percent of the hedge fund industry is already regulated through registered investment advisers.
Hedge fund advisers will be able to continue their current investment programs without SEC interference. Derivative trading, leverage, short selling-all of these will continue without any interference from the SEC. Similarly, there are no portfolio disclosure provisions. A hedge fund's ability to keep things secret (e.g., trading strategies and portfolio composition) will continue. In terms of what we're doing, hedge funds will be able to continue to charge their clients performance fees, just as they do now.
There is a modification, a tightening, in terms of who can invest, but the Commission has grandfathered all current investors. After February 2006, you'll need $1.5 million of net worth rather than $1 million, and getting into hedge funds with just $200,000 or $300,000 of income won't be possible, except for those who have been grandfathered. I think that's all for the best. These are not investments that ought to be open to everybody; there is simply too much risk in the kind of trading that's being done.
Let me close on two notes. One, a rational regulatory system responds to warning signals and to substantial and growing risk. This is the context in which the Commission moved ahead on October 26th. Given the substantial and growing risk for the millions of investors who are involved in pension funds, in funds of funds, and in other investment vehicles with hedge fund holdings, the SEC simply could no longer turn a blind eye.
Finally, on an optimistic note, please understand that over the past two years serious SEC rule-makings and enforcement efforts have occurred in area after area. Officers and directors, accountants, lawyers, and others in the financial community, now including hedge fund advisers, have been dealt with sensibly and with balance. In general, the scandals of the 1990s and early 2000s have forced us to face serious systemic imperfections, but they've also made it possible for us to bring about healing and reform. My view is that what's been done will allow the United States to maintain its status as the world's leader in corporate accountability, disclosure, and financial integrity.