1
1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION
2
3 In the Matter of:
4
5 OPEN COMMISSION MEETING
6
7 PAGES: 1 through 129
8 PLACE: Securities and Exchange Commission
9 450 Fifth Street, N.W.
10 Washington, D.C.
11 DATE: Tuesday, October 26, 2004
12
13 The above-entitled matter came on for hearing,
14 pursuant to notice, at 10:01 a.m.
15 BEFORE:
16 WILLIAM H. DONALDSON, Chairman
17 CYNTHIA A. GLASSMAN, Commissioner
18 HARVEY J. GOLDSCHMID, Commissioner
19 PAUL S. ATKINS, Commissioner
20 ROEL C. CAMPOS, Commissioner
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22
23
24 Diversified Reporting Services, Inc.
25 (202) 467-9200
1 C O N T E N T S
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3
4
1 P R O C E E D I N G S
2 CHAIRMAN DONALDSON: Good morning, everyone. This
3 is an open meeting of the United States Securities and
4 Exchange Commission. We have two items on our agenda this
5 morning.
(The discussion of the first item on the agenda, whether to propose new and amended rules and form changes to modify the registration, communications, and offering processes under the Securities Act of 1933, is not included in this transcript.)
(Following is the transcript of the Commission’s deliberations on whether to adopt rule 203(b)(3)-2 under the Investment Advisers Act of 1940 to require hedge fund advisers to register with the Commission and whether to adopt certain conforming and transitional amendments to rules 203(b)(3)1, 203(A)-3, 204-2, 205-3, 206(4)-2, 222-2 and Form ADV.)
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3 CHAIRMAN DONALDSON: Why don't we get going, ladies
4 and gentlemen, if we can.
5 The second and final item on our agenda is a
6 recommendation from the staff from the Division of Investment
7 Management that we adopt rules and amendments proposed last
8 July, to require managers of certain private investment
9 pools, commonly known as hedge funds, to register with the
10 Commission as investment advisers.
11 Most hedge funds are organized in ways that avoid
12 triggering the registration requirements of the Securities
13 Act, Securities Exchange Act, and the Investment Company Act,
14 and many hedge fund managers avoid registration under the
15 Investment Advisers Act by relying on a safe harbor rule
16 adopted by the Commission in 1985, that permits an investment
17 adviser to count a legal organization has a single client, so
18 long as the investment advice provided is based on the
19 organization's investment objectives, rather than those of
20 any owner or owners of the organization.
21 In recent years, the Commission has been faced with
22 escalating growth in the hedge fund industry. The number of
23 funds, investors, and investment managers participating in
24 the industry, as well as the assets under management, are all
25 rising rapidly.
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1 From what we can tell, the number of hedge funds
2 has increased at least five-fold over the last ten years.
3 The dollar value of funds invested in hedge funds is
4 reportedly approaching a trillion dollars, up 15-fold in the
5 last ten years.
6 Five years ago, the near collapse of the Long-Term
7 Capital Management vaulted these investment vehicles
8 into the headlines, bringing into focus the role that they
9 were playing in the financial markets. At that time, the
10 Commission rejected the idea of changing its rules to
11 preclude hedge fund advisers from relying on the safe harbor.
12 In the intervening period, there have been major
13 changes in the hedge fund industry, both in the number and
14 size of funds, and in the demographics of its investors, that
15 warrant the Commissions' reconsideration of this position.
16 Over two years ago, in June 2002, the Commission
17 decided to reconsider the hedge fund issue. The staff, at
18 the direction of the Commission, commenced a sweeping study
19 of the hedge fund industry.
20 The staff's efforts were complemented by a two-day
21 roundtable held by the Commission in May 2003, and the
22 results of the staff efforts, along with preliminary
23 recommendations, were published in September 2003.
24 The report elicited considerable interest, debate,
25 and discussion within and outside the Commission, and amongst
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1 a very broad cross section of interested parties, building on
2 the observations made in the staff report, and the public
3 meetings, and the staff investigations that preceded the
4 report.
5 One of the recommendations that the staff made in
6 its 2003 report was that the Commission consider requiring
7 hedge fund advisers to register as investment advisers,
8 taking into account whether the benefits outweighed the
9 burdens of registration.
10 Last July, the Commission proposed new rules and
11 amendments that would implement this recommendation.
12 Recognizing the important policy issues implicated by the
13 proposal, the Commission included an extensive request for
14 comment on each aspect of the proposal. This request was
15 augmented by a series of additional questions posed by
16 Commissioners Glassman and Atkins in their dissenting
17 statement.
18 Following an extensive review of the comments, the
19 division is here this morning to recommend that we adopt the
20 rules substantially as proposed, with revisions that address
21 specific issues raised by the commenters.
22 Before turning this over to you, Paul, to present
23 the division's recommendation, I would like to recognize the
24 members of the staff of the Investment Management Division
25 for their tireless efforts in developing the recommendations
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1 before us today, in particular Bob Plaze, Jennifer Sawin,
2 Jamey Basham, and Vivien Liu.
3 They've worked extraordinarily hard through this
4 process, and they are to be commended and congratulated on
5 the fine job they've done.
6 Paul, will you please give us the details of your
7 recommendation.
8 MR. ROYE: Thank you, Chairman Donaldson, and good
9 morning to you and the other commissioners.
10 First, I would be remiss that if I didn't also
11 acknowledge up front the assistance of many people on this
12 effort, this study, this review of the hedge fund industry.
13 As you mentioned, Chairman Donaldson, we commenced
14 this effort two years ago, with a study of the gathering of
15 information. We had extensive help from others in the
16 division: Doug Scheidt, Alison Fuller, Elizabeth Osterman,
17 Barbara Chretien-Dar, Nancy Morris, David Grim, Eric Purple
18 and Dan Kahl.
19 We got extensive help from our Office of
20 Compliance, Inspections, and Examinations, led by Lori
21 Richards and Gene Gohlke, who heads up the Investment
22 Management side of OCIE; extensive help from the Division of
23 Enforcement, Steve Cutler, Nancy Doty, Laurie Stewart; and
24 Alan Beller, Amy Starr, and Gerry LaPorte in the Division of
25 Corporation Finance; in our Office of International Affairs,
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1 Ethiopis Tafara, Elizabeth Jacobs, Stephanie Kim Park, and
2 Sherman Boone;
3 our Office of Economic Analysis, in particular
4 Harvey Westbrook, Chuck Dale, and Jonathan Sokobin, and
5 Chester Spatt; also, last but not least, our Office of
6 General Counsel, Giovanni Prezioso, Arthur Laby, Jill Felker,
7 and Randy Quinn. We sincerely appreciate their efforts, and
8 all the help that they gave us over the course of the last
9 two years.
10 I'm pleased this morning, to present to the
11 Commission our recommendation for a new rule and rule
12 amendments under the Investment Advisers Act that would
13 require hedge fund advisers to be registered with the
14 Commission as investment advisers. As you indicated, Mr.
15 Chairman, this past July the Commission proposed the rule and
16 rule amendments that we're recommending you adopt today.
17 You received letters from 153 commenters, of which
18 29 supported the proposal and 82 opposed it, while 42
19 commenters submitted letters raising questions about
20 particular issues that they wished the Commission to address.
21 Of the major trade associations, the Investment
22 Company Institute, the Investment Counsel Association of
23 America, both of which have many members who advise hedge
24 funds, favored the rule proposal, while the Managed Funds
25 Association, most of whose members manage hedge funds and/or
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1 commodity pools, opposed the rule.
2 Most, but not all of the hedge fund managers who
3 wrote opposed the rule. Several hedge fund managers who are
4 registered with us as advisers supported the rule, and
5 indicated that registration had not interfered with their
6 operations nor imposed substantial burdens. The ICI and
7 ICAA expressed similar views on behalf of their members, who
8 all are registered advisers.
9 Individual hedge fund investors were split on the
10 proposal.
11 The only two institutional investors who wrote you,
12 the Ohio Public Employees Retirement System and the New
13 Jersey State Investment Council, strongly supported the rule.
14 Interestingly, the Hennessee Group, which is a
15 hedge fund consulting group, submitted a survey that it had
16 performed of foundations and endowments, which are
17 significant investors today in hedge funds, and they reported
18 that 59 percent favored requiring hedge fund advisers to
19 register, while 30 percent opposed such a requirement.
20 But we did not just read the comment letters. In
21 the past year, we have had discussions about hedge funds and
22 our proposals with fellow regulators, including the staff of
23 the Treasury Department, the Federal Reserve Board, the
24 Commodity Futures Trading Commission.
25 We have also met with our colleagues at foreign
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1 regulators, including the Financial Services Authority in the
2 United Kingdom, which requires hedge fund advisers to be
3 registered with them.
4 The comments and our conversations with fellow
5 regulators provided a wealth of information and insight that
6 has helped us prepare our recommendation for you.
7 The rule proposal, as I indicated, was the result
8 of a process that began over two years ago, that included an
9 extensive staff study of hedge funds and their advisers that
10 we released last year. Our study raised a number of concerns
11 that lead us to recommend that you require registration of
12 hedge fund advisers under the Advisers Act.
13 One concern, as you mentioned, Mr. Chairman, is the
14 tremendous growth in the industry. While no one knows for
15 sure, it is estimated that in the last five years, that hedge
16 fund assets have grown by 260 percent, with assets of
17 approximately $870 billion in approximately 7,000 funds, and
18 some predict that hedge fund assets by the end of the year
19 will reach one trillion dollars.
20 In the last year alone, hedge fund assets have
21 grown over 30 percent. Hedge funds are one-fifth the size of
22 equity mutual funds, and are growing at a much faster rate
23 than these funds.
24 Moreover, hedge funds tend to be active traders.
25 One study estimates that hedge funds are responsible for up
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1 to 20 percent of equity trading volume in the United States.
2 It is clear that hedge fund advisers are significant market
3 participants, both as managers of assets and traders of
4 securities. And we think this growth and impact on our
5 markets simply cannot be ignored.
6 Now, in spite of the statistics that I just
7 reviewed for you, neither we nor any government agency has
8 reliable data on the hedge fund industry, including data on
9 the number of funds, or the amount of their assets. We only
10 have third-party surveys and reports, which often conflict,
11 and may be unreliable.
12 Another significant concern is the growing exposure
13 of smaller investors, pensioners, and other market
14 participants, directly or indirectly, to the impact of hedge
15 fund investing.
16 These vehicles are no longer for the very rich.
17 More and more, we see funds pouring in from a new type of
18 investor who can't afford to absorb the large losses as a
19 result of a fraud.
20 Lower minimums and the rise of funds of hedge funds
21 are permitting smaller, non-traditional investors into hedge
22 funds. Moreover, a growing number of public and private
23 pension plans, as well as universities, endowments, and other
24 charitable organizations, have begun to invest larger amounts
25 of money in hedge funds. It's estimated that these types of
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1 institutions may soon increase their investments in hedge
2 funds to over $300 billion.
3 Investors such as pension plans that have millions
4 of beneficiaries are now exposed to the risks of hedge fund
5 investing. Losses resulting from hedge fund investment
6 strategies, and possible hedge fund frauds, could affect
7 these institutions' ability to satisfy their obligations to
8 their beneficiaries, or to meet other intended goals.
9 The growth in hedge funds has unfortunately been
10 accompanied by troubling growth in the number of our hedge
11 fund enforcement cases.
12 In the last five years, the Commission has brought
13 51 cases involving hedge fund fraud, resulting in losses of
14 more than $1.1 billion. Now, these cases are more than ten
15 percent of cases against investment advisers over the same
16 period. Now, you can slice and dice these cases in a number
17 of ways, but we think they signal to us that this is an area
18 where we should have concerns.
19 In addition, we are seeing hedge funds used to
20 defraud other market participants. Hedge fund advisers were
21 key participants in the recent scandals involving mutual fund
22 late trading and inappropriate market timing. We've counted
23 almost 400 hedge funds and 87 hedge fund advisers involved in
24 these cases. They were most of the late traders and market
25 timers. They picked the pockets of average mutual fund
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1 investors.
2 Registration under the Advisers Act will give us
3 the tools we need to monitor the activities of hedge fund
4 advisers without imposing burdens on the legitimate
5 investment activities of hedge funds, or interfering with the
6 important role that hedge funds play in our financial
7 markets.
8 The Advisers Act does not require an adviser to
9 follow or avoid any particular investment strategies, nor
10 does it require or prohibit a specific investment. It will
11 not hamper hedge fund operations.
12 A recent study found that there were no significant
13 differences between performance of hedge funds managed by
14 unregistered advisers, and those managed by registered
15 advisers. Five of the ten largest, and presumably most
16 successful hedge fund advisers are today registered with the
17 Commission.
18 More than 8,500 advisory firms, that collectively
19 manage 23 trillion dollars in assets, are registered under
20 the Advisers Act. We see no credible evidence that the
21 Advisers Act has any way impeded their ability to employ
22 successful investment strategies, or to effectively compete
23 with other financial institutions that manage securities
24 portfolios in this country or abroad.
25 Advisers Act registration will allow the Commission
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1 to address the various concerns that we identified regarding
2 the hedge fund industry.
3 First, registration under the Act will provide the
4 Commission with the ability to collect important information
5 that we now lack about this growing component of the U.S.
6 financial system.
7 Other approaches suggested would require the staff
8 to engage in a complicated and time-consuming forensic
9 exercise to extract an incomplete composite of information
10 about hedge funds. And we think this would essentially
11 require us to put together multiple jigsaw puzzles, without
12 all the pieces.
13 Second, registration under the Advisers Act would
14 give the Commission the ability to conduct examinations of
15 hedge fund advisers.
16 Examinations permit us to identify compliance
17 problems at an early stage, identify practices that may be
18 harmful to investors, and provide a deterrent to unlawful
19 conduct. The prospect of a Commission examination increases
20 the risk of getting caught violating the law, and thus will
21 deter wrongdoers.
22 We are not suggesting that our examination staff
23 will uncover every fraud, and some critics contend that we
24 would be unsuccessful in detecting fraud by hedge fund
25 advisers.
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1 However, our examination staff uncovered five of
2 the eight cases that we brought against registered hedge
3 fund advisers. There's nothing unique about hedge fund
4 advisers, or the type of frauds they have committed. We
5 brought the same types of actions against unregistered
6 advisers that we brought against registered advisers.
7 Third, registration permits us to screen
8 individuals associated with an adviser, and to deny
9 registration if they have been convicted of a felony, or had
10 a disciplinary record subjecting them to disqualification.
11 We would use this authority to help keep fraudsters and scam
12 artists out of the hedge fund industry.
13 Fourth, registration would require hedge fund
14 advisers to adopt policies and procedures designed to prevent
15 violations of the Advisers Act, and to designate a chief
16 compliance officer. So in other words, hedge fund advisers
17 would have to develop a compliance infrastructure, just like
18 other advisers of similar size.
19 Now, we readily acknowledge that compliance
20 controls cost money, but these are costs all advisers that
21 register with us must bear, including advisers that are much
22 smaller, and have substantially fewer resources and cash flow
23 than many hedge fund advisers.
24 Given the fee revenue generated by many hedge fund
25 managers today, the arguments made by some opponents that
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1 hedge fund advisers could not afford these costs is simply
2 not credible.
3 Fifth, registration under the Advisers Act would
4 have the salutary effect of requiring many direct investors
5 in most hedge funds to meet wealth standards that are higher
6 than the current minimums.
7 Finally, we believe that the adoption of the rule
8 and rule amendments we recommend today will close a loophole
9 in our regulations that allows an exception designed for
10 advisers providing advice only to a small number of clients,
11 and therefore, not representing a substantial federal
12 interest, to be used by hedge fund advisers, who in some
13 cases manage billions of dollars for thousands of investors.
14 Commenters suggested a variety of alternatives to
15 Adviser Act registration, but none of them, in our judgment
16 would accomplish the goals of this rulemaking.
17 While some of the alternatives would address some
18 of our policy concerns, each of them lacked what we
19 considered an essential component of this rulemaking, the
20 ability to exercise our examination authority, which we view
21 as vital to deterring and detecting fraud in the hedge fund
22 sector of the investment management industry.
23 If we are to maximize our effectiveness, we must
24 have the ability to use our examination authority to monitor
25 hedge fund adviser activity, and protect our financial
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1 markets.
2 We want to be perfectly clear about the motivations
3 behind our rulemaking, because there are those who have
4 characterized this initiative as an attack on the hedge fund
5 industry, which it is most definitely not.
6 Most participants in the hedge fund industry are
7 honest and ethical, and we deeply appreciate the beneficial
8 role that hedge funds play in our markets.
9 And we do not want to impede the industry's ability
10 to flourish and grow. We simply want to be able to monitor
11 this fast-growing segment of the investment management
12 industry, so as to fulfill our mission to protect investors
13 and the securities markets, and if this rule is adopted, our
14 sincere hope is that the hedge fund industry would join with
15 us to make this initiative work for the industry, and
16 ultimately strengthen hedge funds' role in our securities
17 markets.
18 And with that, we'd be pleased to answer any
19 questions that you may have.
20 CHAIRMAN DONALDSON: Thank you, Paul, for that.
21 Before I ask my colleagues to present their
22 observations on the proposal before us, I'd like to make just
23 a few comments.
24 I think we can agree that by all accounts, the
25 hedge fund industry is growing explosively. As you suggest,
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1 the number of funds, investors and investment managers
2 participating in the industry, as well as assets under
3 management, are rising rapidly, particularly in the last five
4 years.
5 You acknowledged the benefits of liquidity provided
6 to the markets in which the funds operate, and cited the
7 investment flexibility, mobility, and potential for sustained
8 returns available to hedge fund investors.
9 Likewise, you provided a detailed catalogue of
10 concerns regarding the obligations the SEC must face in terms
11 of investor protection, and enforcement of our security laws,
12 and most particularly, the prevention and prohibition of
13 fraud, our central mission.
14 Your concerns derive not only from the size and
15 growth of the industry, but also from the evolving
16 configuration of the investor base. That ranges from funds
17 of hedge funds available to relatively small investors to
18 the increasing investment by institutions, such as pension
19 funds and endowments and charitable foundations, the
20 beneficiaries of which include individuals whose
21 circumstances vary widely.
22 You cited the increased incidents of fraud
23 perpetrated by those funds, and noted how difficult it is to
24 deter this fraud, or to discover this fraud before it
25 happens, due to our lack of required compliance regime in the
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1 examination and inspection authority.
2 You've spoken of others already subject to the
3 Investment Advisers Act, who register with as little as $25
4 million under management, when we have not exercised our
5 jurisdiction over the advisers to the $1 trillion hedge fund
6 industry.
7 In short, it would seem that the weight of evidence
8 is overwhelming, and we accept the staff's recommendation.
9 In fact, to not do so would be a major dereliction of the
10 Commission's responsibility. And yet, over the course of the
11 intensive analysis of the past five years, there remain
12 objections by some.
13 As part of a fair attempt to evaluate such
14 objections, I have sought, both personally and
15 professionally, to see the other side of the arguments,
16 arguments which go something like this:
17 The SEC does not have the resources to devote to
18 this task.
19 My answer to this is that we do have the resources,
20 if we are able to apply our manpower and expertise in an
21 effective, risk-based system designed not only for this
22 responsibility, but ultimately, as an underpinning for all
23 examinations and inspections conducted by the Commission.
24 To bring hedge fund managers under the Investment
25 Advisers Act will create a false sense of security, some kind
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1 of a Good Housekeeping seal of approval.
2 To any student of the role of the SEC, it is clear
3 that in no sense does our oversight of investment companies
4 or investment advisers address itself to the merits of the
5 investments, or the advisers. In fact, the Investment
6 Advisers Act anticipated this concern, and explicitly prohibits
7 registered advisers from making any representation that we
8 have recommended or approved of them.
9 We've not done enough study, nor have we allowed
10 enough time, to receive comments, or entertain alternative
11 registration schemes.
12 As the Investment Management Division has indicated
13 and noted, the intensive review of the issue over the past
14 two years is self evident. The extended exchange of views
15 over that period, the publication of a major study on the
16 topic, out for almost a year of comment, then a formal
17 comment period of customary length after the publication of the
18 proposed rule, and the willingness to review comments, even
19 after the official deadline passed, all seems to refute this
20 argument.
21 I won't catalogue or repeat other areas of
22 disagreement on our proposal, for to do so would be
23 redundant, but I do ask just a couple of rhetorical
24 questions.
25 If more than 40 percent of all existing hedge fund
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1 managers have already registered voluntarily, and have
2 testified to its being a minimal burden, why is it that the
3 others, or representatives of the others, resist?
4 Without registration, how can we begin to
5 understand fully the impact that hedge fund advisers have on
6 the broad market of individual, institutional, and professional
7 investors, with which the funds trade every single trading
8 day.
9 How can it seriously be argued that our policy
10 objective, ultimately, is to regulate investment companies'
11 concentrations or strategies, when we have no authority to do
12 so under the Investment Advisers Act, and we have never
13 sought to do so for the past 64 years?
14 As we proceed this morning, I look forward to any
15 comments from the staff or my fellow commissioners that might
16 refute or question the general direction of the thoughts and
17 analysis I've just presented, but before I ask the commission
18 colleagues to make their statements, I'd like to ask the
19 staff two questions.
20 And my first question I'd like to direct to
21 Giovanni, as the general counsel of the SEC.
22 Several of the commenters suggested that the
23 Commission does not have authority to adopt a rule that
24 requires hedge fund advisers to look through hedge funds they
25 manage, for purposes of counting clients.
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1 I would like the general counsel to address these
2 arguments, and give us his analysis of the Commission's
3 authority in this area.
4 MR. PREZIOSO: Thank you, Mr. Chairman.
5 In my view, the Commission does have the authority
6 to adopt the rule changes presented to you by the division
7 today. As you might imagine, we've reflected on this issue
8 at some length in our office, in consultation with our
9 colleagues, especially in light of the comments that have
10 been received that raise this issue.
11 As you know, the topic's also discussed in the
12 draft release that's before the Commission. Let me touch on
13 just a few points that I think are particularly important on
14 this issue.
15 First, the Commission has broad authority under the
16 Advisers Act to engage in rulemaking. And the rules before
17 you today address an important issue under the Act, namely
18 how to determine which advisers qualify for an exemption
19 under Section 203(b)(3). That exemption, as you know, is
20 available to an adviser that has fewer than 15 clients, and
21 that doesn't hold itself out to the public as an investment
22 adviser.
23 Questions about when an investor in a pooled vehicle
24 should be counted as a client, for purpose of this exemption,
25 date back several decades, and they've been viewed as
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1 appropriate issues for Commission consideration throughout
2 that period. In fact, it's those questions that were one of
3 the principal reasons the Commission adopted the current safe
4 harbor that it adopted in 1985. And at a common sense level,
5 I think this isn't really surprising.
6 Take, for example, an investment manager that has
7 30 clients, with $100 million under management. Imagine the
8 adviser says, "I have a clever idea. I'm going to have all
9 of my clients invest in a limited partnership, and I'm going
10 to follow the same strategies in managing that limited
11 partnership’s assets that I follow in managing their accounts
12 today, and then I won't have to register with the Securities
13 and Exchange Commission."
14 Now, if those clients had been managed similarly,
15 or identically, before, and today, in many cases, they are --
16 nothing will have changed. Except that now, the investment
17 adviser won't be subject to Commission oversight.
18 And in those circumstances, I think most people
19 would question whether that's the correct legal result,
20 particularly under a statute that has an express provision
21 that prohibits a person from doing indirectly, through
22 another person, something that they can't do directly.
23 A second point that I think merits note is that the
24 Commission has ample evidence from the staff study, from
25 enforcement actions, from the Hedge Fund Roundtable, and from
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1 other sources, that the role of hedge fund managers in our
2 markets has changed very significantly since the Commission
3 addressed this issue in 1985. At that time, the Commission
4 concluded that an exemption for these advisers could be
5 implemented, consistent with the objectives of Congress when
6 it adopted Section 203(b)(3) in 1940.
7 As you know, and as Paul has mentioned, the
8 exemption originally applied principally to advisers that
9 offered their services to a small number of friends and
10 family members. And today, as you've heard, and as you've
11 commented, advisers to private funds have a much more
12 significant impact on our capital markets, and on a much
13 larger number of investors.
14 A third point worth noting is that the rule targets
15 those investment advisers whose activities most directly
16 implicate the concerns of the Act. The rule applies only
17 where a private fund invests primarily in securities, offers
18 redemption periods of two years or less, and is marketed,
19 based on the investment skills of the adviser.
20 In other words, advisers that offer their advisory
21 services solely to general business corporations, or similar
22 entities, won't be required to look through to shareholders or
23 limited partners in counting clients.
24 Further, the release and the discussion from Paul
25 today identified extensively how registration of advisers to
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1 these private funds would advance the goals of the Act.
2 Taking all of these considerations into account, I
3 think that this is a classic and appropriate exercise of
4 rulemaking authority to implement the statute's objectives,
5 in light of evolving market conditions.
6 CHAIRMAN DONALDSON: Thanks. I have one other
7 question.
8 Commissioners Glassman and Atkins, in their dissent
9 at the proposing stage, asked commenters to discuss
10 alternatives to registration that addressed the concerns
11 raised in the proposal. Many of the examples of alternatives
12 described in the dissent were ideas that had been considered
13 by the staff and the Commissioners, in the evolution of what
14 ultimately became the Commission's proposal.
15 Did the commenters offer any fresh insights about
16 these ideas, or any new alternatives that had not been
17 previously considered?
18 And I'll address that to you, Paul.
19 MR. ROYE: Yes. I think one thing that should be
20 pointed out is that even, you know, prior to the proposal
21 stage, we spent a lot of time thinking through alternatives.
22 Indeed, Mr. Chairman, you, as well as a number of the other
23 Commissioners, pressed us on different approaches to
24 addressing the concerns that we had identified in the staff
25 report.
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1 Many of the alternatives that were highlighted in
2 the comments, we had thought about, we reconsidered during
3 the comment process, when those comments came in. They range
4 from different ways for the Commission to access information,
5 using other regulatory agencies' information.
6 Using that information, along with information from
7 brokers, and others, that we regulate, to piece together a
8 picture of a particular hedge fund adviser's activity, and
9 the industry as a whole.
10 You know, we looked at that, we talked to other
11 regulators about that approach, and again, I think we see
12 that as a patchwork, a puzzle, that we don't have all the
13 pieces. It's going to -- it would be time consuming,
14 described as a forensic exercise, to try to figure out
15 exactly what any particular hedge fund adviser is doing.
16 We think the Advisers Act registration, the
17 information that we get there is a more direct way to focus
18 on that issue.
19 We had commenters suggest we raise the standards
20 under Regulation D, to get at concerns about small
21 investors. That's certainly an alternative that we
22 considered. Reg D goes beyond hedge fund investing,
23 introduces a whole level of complication. Again, the
24 Investment Advisers Act regime would effectively address
25 minimum standards for direct investments in hedge funds.
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1 There were some new ideas in terms of requiring
2 hedge fund advisers to go through an annual audit by the
3 auditors.
4 But as we pointed out in our hedge fund report, we
5 have concerns about exactly what the auditors do in
6 conjunction with those audits, offering to certify that
7 they're in compliance with particular provisions that we deem
8 to be appropriate for hedge fund advisers, under the statute.
9 Again, that kind of approach would not allow us to go in and
10 check whether or not they're indeed honestly certifying
11 compliance with various procedures.
12 So, a number of different approaches.
13 You know, we thought about a hedge fund adviser
14 light approach, in thinking through that approach, and
15 creating a different regime, if you will, for hedge fund
16 advisers.
17 We got into issues of how do you administer that,
18 how is it fair, given the scenario that Giovanni outlined, in
19 terms of how you structure your business and operations. You
20 change clients, you acquire new clients. What does that do?
21 We'd have to administer sort of dueling regimes, here, and we
22 thought that introduced a level of complexity that was just
23 not needed.
24 There's a common theme in all the alternatives.
25 All the alternatives would, for the most part, deny us
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1 two key components of what we view as our objective here.
2 First, the Advisers Act would effectively require
3 the hedge fund advisers to have a compliance program.
4 Compliance policies and procedures, and someone designated to
5 monitor their compliance with the Advisers Act. We think
6 that's very important in a program, in terms of heading off
7 problems, deterring abuses.
8 The other theme was that it would deny us the
9 examination authority. We feel that it's very key, in order
10 for us to be in a position to understand what's going on and
11 to test what's going on in the various hedge fund advisers,
12 and we think it's important to deterring unlawful activity.
13 So, as we've thought about the alternatives, we
14 thought about them before we made the proposal. We've looked
15 at the alternatives that were proposed or suggested in regard
16 to the comments. But we see each of them as deficient in
17 terms of meeting all the goals and objectives that we set out
18 for this rulemaking.
19 CHAIRMAN DONALDSON: Thanks very much.
20 Commissioner Glassman.
21 COMMISSIONER GLASSMAN: Thank you, Mr. Chairman.
22 In contrast to my enthusiasm for the Securities Act
23 reform proposal considered by us today, the hedge fund
24 proposal is a disappointment to me on many levels.
25 Procedurally, the proposal was rushed through the
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1 rulemaking process, and appears to have been a fait accompli
2 from its inception. The Chairman and other proponents
3 apparently believe that the commenters already had sufficient
4 notice, based on the Commission's Hedge Fund Roundtable, as
5 well as last year's staff study, that a proposal would be
6 forthcoming.
7 However, because the Roundtable and the staff study
8 confirmed that the problems we initially thought would be
9 found in the hedge fund industry do not appear to be present,
10 it was not obvious, certainly not to me, that the proposed
11 rule would be forthcoming.
12 Further, since regulation of hedge funds has broad
13 market implications, any regulatory requirement would more
14 appropriately be addressed as part of a collaborative effort
15 among the President's Working Group members, all of whom, I
16 understand, have concerns with our proposal.
17 I believe it would have been prudent for that
18 collaborative effort to proceed prior to unilateral
19 Commission action.
20 I'm also troubled by the staff's minimization of
21 commenters' concerns in various drafts of the proposal, as
22 well as an undertone that the burden of proof is on those
23 opposed to show that this rule is not warranted.
24 That's backwards. In my view, the burden of proof
25 should be on the Commission to establish that this is the
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1 least burdensome and most effective way to accomplish our
2 objective.
3 The proposal itself is fundamentally the same one
4 from which I dissented in July. While I agree, as I have all
5 along, that we need more information on hedge funds, I
6 disagree with this solution.
7 The comment letters in support of this proposal are
8 not persuasive, and the comment letters against the proposal,
9 which represent the vast majority of submissions, raise many
10 of the same concerns that I did.
11 Accordingly, I am not going to reiterate all of the
12 concerns that I raised when this went out for comment. But I
13 do want to highlight a few issues.
14 The proposal's supporters assert that the proposal
15 is justified by the growing number of fraud enforcement cases
16 involving hedge funds. The staff repeatedly stresses that
17 since the rule was proposed in July, the Commission has
18 brought five new enforcement cases, for a total of 51 cases
19 over the past five years. Yet a cursory review of the
20 litigation release posed on the Commission's Website for each
21 of these new cases, demonstrates that the proposed rule would
22 have had no effect on any of them.
23 Four of the cases involve hedge funds below the $25
24 million threshold, and the fifth case, while involving a
25 fraud that ultimately, and a fund that ultimately raised $27
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1 million, did so over an eight-year period.
2 As far as I can tell, none of these cases appears
3 relevant to the proposed rule. And, as I noted in my initial
4 dissent, the total number of enforcement cases that even
5 tangentially involve hedge funds represents just a small
6 fraction of Commission enforcement actions over the past five
7 years.
8 Regarding the market timing cases, I would point
9 out that it is not, per se, illegal to market time. What was
10 illegal was mutual funds allowing market timing when they
11 said they did not. And I would also note that we did not
12 initially find this problem through our examinations.
13 The staff also stresses that the threat of an
14 examination will deter fraudulent activity by hedge fund
15 advisers, and thus rejects all alternatives to this proposal,
16 because the alternatives lack an examination component.
17 The fallacy of this argument is that the Commission
18 lacks the resources necessary to conduct meaningful hedge
19 fund adviser exams, and our lack of resources is a matter of
20 public record.
21 As the Chairman himself noted when he testified
22 before Congress this year, the Commission has only 495 staff
23 conducting examinations of approximately 8,000 mutual funds
24 managed in over 900 fund complexes, as well as more than
25 8,000 investment advisers.
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1 It's no secret that the Commission is rethinking
2 its inspection model, which historically has focused on site
3 visits and information requests. As such, it's difficult to
4 perceive how hedge fund advisers will be deterred by the
5 prospect of an examination, when they know that we lack the
6 resources to audit comprehensively their operations.
7 Given that we are already stretched as an agency
8 to examine the mutual fund industry, with about 91 million
9 investors, I question whether we are justified expending
10 significant additional resources in an attempt to examine
11 hedge fund advisers, where the investors are limited to a
12 small number of wealthy and/or sophisticated individuals and
13 institutions.
14 There are a number of alternatives that could have
15 been explored in lieu of registration, but unfortunately,
16 none of them is on the table.
17 First, with the growth of hedge funds, I do agree
18 that we need to know more about them. I would support a
19 census, pooling of information from all of the agencies that
20 collect data on hedge funds, and identifying and requiring
21 additional periodic and systematic information to be filed
22 with us, once we determine what would be appropriate. I've
23 been supportive of this concept throughout our discussions.
24 If we really think retailization is a problem, even
25 though our own staff concluded only last year that this was
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1 not an issue, we have two very easy options: raise the
2 accreditation standards for investors, and/or require
3 registration for funds that allow relatively small
4 investment, perhaps $100,000, or another appropriate cutoff.
5 These conditions would further reduce the number of
6 high net worth individual investors -- estimated already at
7 fewer than 200,000 -- to an even smaller universe of
8 investors.
9 An additional option would be to require the funds
10 of funds that are targeted to retail investors, and all of
11 their component funds, to have registered advisers. Again, I
12 have supported these concepts throughout our discussions.
13 Regarding pension fund and other institutional
14 investors, who indirectly invest in hedge funds on behalf of
15 individuals, as part of a risk diversification strategy, this
16 new requirement will be counterproductive. Since the trend
17 appears to be for such investment
18 vehicles to limit hedge fund investments to those with
19 registered advisers, our rule would expand the potential
20 universe, and encourage even more investment in hedge funds.
21 As an aside, my understanding is, we do not have
22 information on the extent to which institutional investors
23 actually invest in hedge funds that do not have registered
24 advisers. However, we do know that they have a fiduciary
25 responsibility to their beneficiaries, obligating them to
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1 conduct appropriate due diligence before making the
2 investment.
3 If we are concerned about valuations and fraud, a
4 notice and filing of appropriate information, including
5 audited financial statements, would appear to me to be more
6 useful than the ADV information in the registrations. We
7 already have authority, and clearly use it, to investigate
8 potential fraudulent abuses in hedge funds now.
9 I continue to be concerned that the registration
10 and concomitant inspection are the wrong approach. I do not
11 think the ADV, even as amended, provides the type of
12 information that would be helpful in identifying fraud, nor
13 do we have the resources and expertise to ferret it out in
14 our examinations.
15 Thus, as I have said before, the proposed approach
16 would unrealistically raise expectations about what we are
17 accomplishing, and would divert significant resources from
18 other inspection activities that are more focused on retail
19 investment vehicles.
20 Regarding the seal of approval, I have heard
21 anecdotal evidence that registered hedge funds do make that
22 registration prominent in offering materials. Why would they
23 do that? I understand that we have a task force looking at a
24 new risk-focused model for investment adviser oversight,
25 including hedge fund advisers.
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1 It would have made sense to me to determine the
2 right model, and then apply it to the hedge funds if that
3 were -- to the hedge fund advisers, if that were warranted.
4 Regrettably, the Commission has failed to take an
5 opportunity to devise a new model of systematic and robust
6 information gathering, including notice of filing, pooling of
7 information from all the agencies that collect data on hedge
8 funds, and identifying and requiring additional information
9 to be filed with us, once we determine what would be
10 appropriate, before imposing a new, burdensome, and outdated
11 requirement. This would have improved our ability to
12 perceive market trends, to detect red flags, and to note
13 industry exceptions.
14 As I said, I'm disappointed with the approach that
15 was chosen, and I know that we can and we must do better. If
16 this proposal is approved, I hope that as we prepare for its
17 implementation we develop a workable oversight model.
18 I want to make perfectly clear that I am not
19 suggesting that we don't need more information about hedge
20 funds and their advisers. However, for all the reasons I
21 have stated today, at the proposing meeting, and in
22 Commissioner Atkins' and my dissent, I vote against this
23 proposal.
24 I believe it's the wrong solution to an undefined
25 problem, using an ineffective examination model. As with the
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1 proposing release, I plan to file a written dissent to
2 accompany the adopting release, if this is adopted. Perhaps
3 there will be another vote against it.
4 I do have a few questions.
5 First, regarding the other agencies, especially the
6 CFTC request for exemptions, I understand the staff believes
7 that the concerns of the CFTC have already been addressed in
8 the proposal, or are specifically provided for in the
9 Investment Advisers Act.
10 Given that the CFTC felt compelled to request an
11 exemption on the eve of this meeting, my question is, what
12 coordination did we undertake with the CFTC and the other
13 federal agencies, prior to going forward with this proposal,
14 and what input did we receive from them?
15 In this regard, I note that there's a letter from
16 Congressman Baker, dated October 7th, to Treasury Secretary
17 Snow, asking the President's Working Group to arrange for the
18 sharing of data on hedge funds prior to the Commission
19 undertaking unilateral regulatory action.
20 Although the Chairman -- our Chairman -- was copied
21 on this letter, it wasn't posted on the public comment files
22 of our Website, and I only became aware of its existence
23 yesterday.
24 MR. ROYE: With regard to the CFTC, and the letter
25 that came in a day or so ago, requesting that in the rule, we
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1 provide an exemption for hedge fund advisers who are
2 registered with the CFTC as a commodity trading advisor or a
3 commodity pool operator, we considered that issue. I think
4 it was raised in eight or nine other comment letters as a
5 possible approach. We've talked to the CFTC about this
6 issue, and how we might proceed.
7 Our conclusion is that we certainly agree that
8 there should not be regulatory overlap and duplication, and
9 we should try to work toward minimizing the burdens that we
10 impose on folks in this sector.
11 But the CFTC's responsibility is enforcing the
12 commodity futures laws. Ours is enforcing the federal
13 securities laws. In 2000, the U.S. Congress focused on this
14 issue of duplication, regulatory overlap.
15 Any hedge fund adviser, if this rule is approved,
16 will still have the ability to rely on the statutory
17 exemption that if their primary business in running hedge
18 funds and other clients is engaged in futures trading, then
19 they are exempt, they would be exempt from our jurisdiction.
20 If their primary business is managing securities,
21 where we obviously have an interest, they would not have that
22 exemption available to them. So we think that
23 this issue has largely been resolved by the Congress,
24 with the Commodity Futures Modernization Act,
25 but we also think that, on a going-forward basis, if
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1 this is adopted, that it would be beneficial to work very
2 closely with the CFTC, in terms of how we target our
3 resources, how we use our examination authority, how they use
4 their authority, who they go in to look at. Information
5 sharing, we think, is an important component of making this
6 work going forward, and minimizing burdens.
7 As far as the other regulatory agencies, in light
8 of concerns expressed by members of the President's Working
9 Group, we got together with members of the Fed, to talk about
10 our concerns about hedge funds, why we're concerned about the
11 area, and had a dialogue with them. Same thing with the
12 Treasury Department.
13 And Bob, if you want to expand on --
14 COMMISSIONER GLASSMAN: Did you listen to anything
15 they said, or you just had a dialogue?
16 MR. ROYE: Well, we certainly listened to what they
17 had to say. We listened to, you know, their concerns.
18 I think that, you know, again, the bottom line is
19 that we have the responsibility for enforcing the federal
20 securities laws. And, you know, they expressed views in
21 terms of what this approach might mean, what impacts that it
22 might have.
23 I think that some of the commenters echoed those
24 concerns, and, you know, we considered those carefully. I
25 mean, we are sensitive to -- you know, we don't want to have
88
1 adverse impacts. We tried to make that very clear.
2 We appreciate the role that hedge funds play in our
3 markets, the liquidity that they provide, and that's why we
4 didn't pursue other alternatives, like Investment Company Act
5 registration, for hedge funds.
6 We viewed the Advisers Act as a regime that, while
7 it does impose some costs and some burdens, doesn't interfere
8 with how the hedge funds are managed or operated, but gives
9 us a window into what's going on. And we thought that was
10 important.
11 MR. PLAZE: The real impact it's on is not so much
12 what we did, but what we didn't do, and we were listening to
13 all of these agencies, and the Treasury Department, which we
14 worked on extensively in their hedge fund, by the way, their
15 hedge fund anti money-laundering rules.
16 And so, if you look at it from one perspective, we
17 did not necessarily follow any particular recommendations,
18 but the release is littered with statements, or footnotes,
19 that act on their sensitivities. And so, I think it did have
20 a significant impact.
21 COMMISSIONER GLASSMAN: So, are you suggesting that
22 the CFTC in particular, and the members of the President's
23 Working Group would be supportive of this, at this point?
24 MR. ROYE: No.
25 COMMISSIONER GLASSMAN: No. I didn't think so.
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1 One other question on the cost/benefit analysis,
2 which unfortunately we only got the first draft of about a
3 week ago, and have seen a few more drafts in the last week.
4 There's no, as far as I can tell, there's no
5 aggregation of costs, no ongoing cost estimate, no compliance
6 officer cost estimate. It seems to focus on the qualitative
7 issues. It's pretty weak on the quantitative measures. How
8 did you include the commenters' cost quantitative estimates
9 in your estimates?
10 MR. BASHAM: I can address that.
11 We had two primary areas of costs to deal with, and
12 the first was the cost of converting to registered status,
13 which we estimated the average cost being at $20,000 in
14 professional fees, and $25,000 of internal costs, and we got
15 this estimate by talking to law firms who are in the business
16 of advising hedge fund advisers as they proceed with their
17 Commission registration. And these costs are average costs,
18 so they might be higher or lower, depending on the firm's
19 existing compliance infrastructure, or the complexity of its
20 business.
21 Some commenters did say that this estimate was too
22 low, but they didn't provide us with any estimates of their
23 own and others submitted estimates setting the number much
24 higher, at around $300,000. But if you look at the analysis
25 behind their figures, you see that almost all of this cost
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1 was attributable to retaining a chief compliance officer.
2 Now, if a --
3 COMMISSIONER GLASSMAN: Wouldn't retaining a chief
4 compliance officer be part of the requirement of registering?
5 MR. BASHAM: Well, we believe that it would be the
6 exception, rather than the rule, for a newly-registered hedge
7 fund firm to add a staff position for a chief compliance
8 officer.
9 We don't allow -- we don't have data that will
10 allow us to quantify this to any reasonable degree of
11 certainty, but it would be unusual for a firm to require a
12 full-time chief compliance officer, unless the firm has at
13 least several hundred thousand dollars of assets under
14 management.
15 Excuse me --
16 COMMISSIONER GLASSMAN: You mean million.
17 MR. BASHAM: -- several hundred million. Thank
18 you.
19 COMMISSIONER GLASSMAN: Where did you come up with
20 that thought?
21 MR. BASHAM: That's based on our experience with
22 the compliance rule that went into effect for all registered
23 advisers this month.
24 MR. PLAZE: The compliance rule does not require
25 the appointment of a new position. It requires somebody in
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1 the firm to be designated. In the hedge fund area, there --
2 COMMISSIONER GLASSMAN: There is an opportunity
3 cost there, for that person.
4 MR. PLAZE: Obviously. But there's also current
5 compliance obligations, which firms have.
6 Remember, all of these firms are subject to the
7 anti-fraud provisions of the Advisers Act, are subject to a
8 number of other obligations under the securities laws and
9 other statutes, so you have to have somebody at the firm
10 concerned about this. Our concern, of course, is that there is
11 nobody concerned about this, and this winds up in our
12 enforcement cases, sometimes. So, you're going to have a
13 firm --
14 COMMISSIONER GLASSMAN: Not too often.
15 MR. PLAZE: -- yeah, you're going to have firms
16 dealing with this in various ways. The largest firms already
17 have compliance. They have significant reputational risk
18 -- value at risk, and they have these. You have the smallest
19 firms --
20 COMMISSIONER GLASSMAN: So what is our deterrent
21 effect for those?
22 MR. PLAZE: The smallest firms.
23 COMMISSIONER GLASSMAN: I'm sorry. For the large
24 firms --
25 MR. PLAZE: The deterrent effect for those firms is
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1 that that chief compliance officer suddenly says "I'll never
2 be able to explain what you want to do when the guys from the
3 SEC come in here."
4 We suddenly strengthen that person's position
5 within the firm considerably, and if you disagree with me,
6 you need to find out what's going on right now, in the
7 registered firms, where the compliance rule that you voted on
8 last year is having a tremendous effect in terms of the
9 position that person holds within the firm and their
10 ability -- the principal ability, not only their personal
11 reputation, their personal career position, but they're going
12 to have to deal, that chief compliance officer has to deal
13 with our examiners when we come in, and that's the stick that
14 chief compliance officer wields.
15 Now, without that stick, he has his own -- he or
16 she has their own personality, and their own relationship,
17 hopefully, with the executives that they can deal with. But
18 the strongest stick is when the guys from the SEC come in,
19 "I'll never be able to explain what you want to do."
20 And I think that's considerable for the larger
21 firms. The smaller firms -- what Jamey is saying is that there
22 is somebody that may provide these services right now,
23 that'll be designated.
24 At the margin, it's somewhere between the various
25 small firms and the medium-size firms. There are people that
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1 are going to make a big decision to hire an entirely new
2 position. And we factored that into the cost.
3 The problem here is we have so little information
4 about hedge fund advisers, other than the ones that are
5 registered with us. And we can't even distinguish those from
6 other advisers under our current regime. Very difficult to
7 try to figure out what hedge fund advisers put into what
8 category.
9 For the smaller ones, they typically start business
10 in a turn-key operation from a prime broker. They set them
11 up in the office. They set them up with their electronic
12 equipment. They give them desk space, they provide them with
13 back-office services.
14 Our best guess is that that kind of a turn-key
15 operation in the future will include a chief compliance
16 officer that will not be dedicated full-time to a hedge fund
17 consisting of two or three traders, will be a marginal cost,
18 but it will not be the $300,000 cost, because that chief
19 compliance officer will have similar responsibilities for a
20 number of people set up at the prime broker, so that they
21 will act to minimize those costs.
22 The comment letters that we got that suggested
23 these very high costs assumed a stand-alone operation with a
24 fully-loaded chief compliance officer, and that is going to
25 occur, at some percentage of the firms, the trouble is, we
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1 just don't know at what percentage that will occur.
2 But we think that there are other business models
3 available, both at the upper end of the spectrum, which
4 suggests costs already effected, and the smaller end of the
5 spectrum, which would go to mitigate that larger cost.
6 But unfortunately, we simply don't have the data to
7 classify hedge fund advisers where they would fall. And that
8 explains, I think, the lack of real good quantitative data.
9 COMMISSIONER GLASSMAN: Did we have the economists
10 do any kind of statistical estimations to try to figure this
11 out?
12 MR. SPATT: We have not. We've reviewed, and we've
13 commented upon the cost benefit that's been done by IM.
14 COMMISSIONER GLASSMAN: Okay. Thank you.
15 CHAIRMAN DONALDSON: Commissioner Goldschmid.
16 COMMISSIONER GOLDSCHMID: Thank you, Mr. Chairman.
17 In case anyone hasn't noticed it, there may not be
18 unanimity on these hedge fund issues. I do share the
19 Chairman's views. As Chairman Donaldson and Paul Roye have
20 indicated, the new hedge fund adviser rules and amendments
21 result from extensive examinations and reviews by the SEC
22 staff, and by the Commission itself.
23 In my time on the Commission, we have had two days
24 of Hedge Fund Roundtables, testimony at several Congressional
25 hearings, a review and publication of the excellent staff
95
1 report in September of 2003, the proposed rulemaking in July
2 2004, and numerous discussions at public forums, with the
3 staff, and with various commenters.
4 Today's rulemaking, in short, is the culmination of
5 a long and very serious process. We have weighed carefully
6 concerns of parts of the hedge fund community, and others
7 worried about counterproductive effects.
8 We have looked at suggestions for alternatives, but
9 they've been inadequate and wanting, compared to what I
10 believe is our modest, pragmatic, balanced regulatory
11 approach.
12 I have tried to think through the hedge fund issues
13 by asking myself the following key questions:
14 Why alter what has been the SEC's largely hands-off
15 approach? We have always gone after fraud.
16 What are the public policy concerns that now compel
17 the Commission to act? My answers have largely been heard
18 before, but given the controversy, they ought to be heard
19 again.
20 First, we know too little about this dramatically
21 growing industry, and what little we know, has, at least for
22 me, had alarm bells ringing.
23 In terms of growth, eight or ten years ago there
24 was roughly a billion dollars in hedge funds. The staff's
25 September 2003 report used the $600 billion figure. Our
96
1 proposed rulemaking in July 2004, used an $850 billion
2 figure. Today, we're talking about $870 billion, and the
3 Chairman correctly indicated that most estimates are towards
4 a trillion, as early as the end of the year.
5 Moreover, as Paul Roye indicated, all of these
6 figures are unreliable and soft. And that is part of the
7 basic problem, and as Commissioner Glassman indicated, that
8 may be common ground among the five of us here.
9 Our information is inadequate, and this is a
10 growing, powerful part of the financial community. We need
11 accurate information about the aggregate size of the hedge
12 fund industry -- how leveraged it is at any given time; their
13 trading patterns, and the management and size of any given
14 fund.
15 Second is the reasons to think about the regulation
16 of investment advisers. There has been a recent increase in
17 fraud cases involving hedge funds.
18 Now, that's true, with the qualification about
19 slicing and dicing that Paul Roye used, of fund clients, or
20 shareholders themselves. But it's particularly true about
21 the corrupting influence that unregistered hedge funds have
22 had on mutual funds. It was true in the Canary context, and
23 in too many other instances that have been public, and that
24 could become public in the future. That corrupting influence
25 has led to scandals about late reporting, and abusive timing.
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1 Finally, on the so-called retailization issue, it's
2 not just the funds of the wealthy anymore, but more and more
3 the general public's savings and charitable funds are being
4 put at risk, as indicated in large and sharply increasing
5 amounts from public and private pension funds, from funds of
6 hedge funds, and from endowments and other charitable
7 institutions that are being invested.
8 The next question I suppose is what are the
9 advantages or benefits of hedge fund investment adviser
10 registration? They've already been discussed, and I'll give
11 you shorthand.
12 First, it's accurate information for public policy
13 purposes. Second, disclosure about advisers will be very
14 useful. Some investors -- many investors appear to use due
15 diligence to find out about advisers, but that's an
16 expensive, costly process. Why require each one to repeat
17 what others have done, and what if some are not doing? Getting
18 information out about advisers will save costs, and be useful
19 to all concerned.
20 The recordkeeping requirements are important. The
21 chief compliance officer and compliance programs are
22 important. Now, that may add cost, but who in their right
23 mind wants these institutions, and particularly the large
24 ones, operating without effective compliance programs?
25 OCIE inspections have to be thought about, too.
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1 They should bring about important accountability and
2 deterrence. And I'm not suggesting that every fraudster will
3 be stopped, or deterred. But whether one analogizes the tax
4 audits, or police patrols, one knows that the risk of getting
5 caught and punished has significant deterrent effect, and
6 particularly on potential white-collar wrongdoers.
7 As Paul Roye indicated earlier, where hedge fund
8 advisers were registered, five of eight of recent cases in
9 the last five years have been uncovered by OCIE inspections.
10 I have, of course, discussed with the staff whether we have
11 the ability and resources to inspect hedge fund advisers.
12 Registration would increase the present number of advisers
13 registered by roughly 12 percent, but all numbers here are
14 soft, again, because of the inadequacy of our information.
15 We used a range of 8 to 15 percent in our original
16 proposing release in July. I am satisfied that better
17 investment adviser compliance programs required as of October
18 2004, are growing efficiency, and our risk-based assessment
19 programs and tools, and the ability, if necessary, to increase
20 the current $25 million threshold for SEC registration,
21 in combination, provide adequate assurance that we will be
22 able to do the job effectively, and the risk-based ability
23 to inspect gives an important deterrence effect, knowing
24 we can come in will have a meaningful effect on real people.
25 In terms of deterrence, or in terms of
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1 disadvantages, rather, let me make absolutely clear my view,
2 which the Chairman has stated, too, and I think we all
3 believe.
4 There will be no interference with investment
5 strategies of hedge funds, with their operations, with their
6 creativity, with their liquidity, with their flexibility.
7 We've demonstrated that with the 40 or 50 percent of advisers
8 that are already registered.
9 And the costs here are relatively low, in terms of
10 both dollar costs and burdens. If there's more money added
11 to the cost of compliance programs, which appears to be the
12 only item of any significant expense, that will be very
13 useful to anyone who's invested in that fund. A cost/benefit
14 analysis -- the benefits here are overwhelming.
15 Let me close on -- and I just have a statement, I
16 have no questions.
17 A rational regulatory system responds to warning
18 signals and substantial and growing risk. This is the context
19 in which we address hedge funds today. Given the
20 substantial and growing risks for millions of investors, in
21 pension funds, and funds of funds, and other investment
22 vehicles, the SEC can no longer turn a blind eye. Our
23 fundamental mandate is protection of investors in the public
24 interest. Paul Roye, Bob Plaze, and their staff have done
25 wonderful work.
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1 But I'd like to stop a second and pay a particular
2 tribute to the Chairman. His leadership, his strength, his
3 wisdom, the decency he brings to the job is enormously
4 helpful to the public, and very much in the great traditions
5 of the SEC. Thank you.
6 CHAIRMAN DONALDSON: Commissioner Atkins.
7 COMMISSIONER ATKINS: Thank you, Mr. Chairman.
8 Well, I find it very telling that we are gathered
9 here to consider this rulemaking on the 26th of October,
10 because today is just two days before the comment period on
11 this proposal would have ended, had we granted the requests
12 of several commenters, including the National Venture Capital
13 Association, to extend the comment period. They had asked
14 for a 90-day period, instead of the 48 days, which was the
15 effective length of the comment period after the proposal was
16 published in the Federal Register.
17 But why should we extend the comment period for a
18 rule that was essentially written in stone when it was
19 proposed? Despite the constricted comment period, we
20 received over, as you hear, 150 comment letters, only about
21 30 of which supported the proposal. Many commenters raised
22 complex technical concerns about how the registration
23 requirement would work in practice. I am disappointed that
24 in the rush to get a rule adopted we took so little time to
25 consider these comment letters.
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1 It's also hard to hit the Trifecta of having the
2 "Wall Street Journal," the "New York Times," and the
3 "Washington Post" editorial pages being against our action.
4 I think we are rightfully viewed as being dismissive of the
5 concerns that commenters raised. Unfortunately, we have also
6 refrained from hashing out the issues with, among others, our
7 colleagues in the President's Working Group, the Treasury,
8 the CFTC, and the Federal Reserve, as well as others, such as
9 the Department of Labor.
10 Earlier this month, as you heard Commissioner
11 Glassman say, Chairman Baker wrote to the President's Working
12 Group to ask it to intervene before we acted. I saw that
13 letter at the same time that Commissioner Glassman did, just
14 yesterday.
15 Chairman Greenspan has warned us that "[t]he
16 initiative cannot accomplish what it seeks to accomplish."
17 With due deference to Chairman Greenspan and the tough job
18 that he has, I cannot think of a time when he has been so
19 clear.
20 I am befuddled as to why we are charging ahead in
21 the face of such a groundswell of principled opposition to
22 this action. Comity and cooperation is more than just
23 talking to someone. It means listening and responding, and
24 working together.
25 I sometimes feel that we are in a Moby Dick-like
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1 pertinacious pursuit of one particular whale, as Herman
2 Melville described in his colorful prose.
3 The Commission would do better to keep its eye
4 trained on the mutual funds and broker dealers to whom
5 average Americans entrust so much of their money, rather than
6 hedge fund advisers, who manage the money of, at most,
7 200,000 well-heeled individuals and institutions. Average
8 investors expect the Commission to monitor the entities
9 handling their money, whereas hedge fund investors do not
10 rely on Commission oversight.
11 No one is forcing them to put their money into
12 unregistered hedge funds. They have a choice, the ability to
13 get advice, and the market power to do otherwise. They
14 perform, or can hire someone else to perform for them, due
15 diligence to lower their risk of investing in hedge funds.
16 Risk averse investors could insist, for example,
17 on getting audit reports, or a third-party internal control
18 review. If they suspect fraud or malfeasance, they can
19 figure out where to turn for help.
20 But now, we are upsetting this private/public
21 balance, and taking on a task that we might not have the
22 resources to perform as well as the private sector does.
23 In response to the argument that hedge fund
24 investors are fully capable of taking care of themselves,
25 proponents of registration raise cries of retailization.
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1 They say that hedge funds are surreptitiously reaching into
2 the pockets of unsuspecting retail investors, including
3 investors and funds of hedge funds, and vulnerable retirees.
4 In addition, they charge that pension, endowment,
5 and charitable institution money is pouring into hedge funds
6 at great threat to the welfare of their beneficiaries.
7 First, the 2003 staff hedge fund report found no
8 retailization. Second, for each of these fiduciary entities,
9 an investment professional stands between the hedge fund and
10 the retail investor. The investment professional is not only
11 paid, but is legally obligated under federal and state law,
12 to look out for the best interests of the entity.
13 A pension plan administrator has a fiduciary
14 obligation to the plan's participants. Because these
15 entities tend to be large, the investment professionals
16 representing them generally are in a better position than the
17 SEC would be, through its registration process, to obtain
18 information about hedge funds in which they invest, to ensure
19 that their investment choices are prudent, and that the
20 fiduciaries have all the information that they need to make
21 their investment determination.
22 Third, we can take actions to ensure that investors
23 in the funds of hedge funds satisfy investment minimums.
24 Finally, as for the pension funds, we need to put
25 the issue in perspective. The $72 billion invested by
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1 pension funds is only 8 percent of the total hedge fund
2 investments, and more importantly, just 1 percent of the U.S.
3 pension fund assets.
4 Maybe we ought to be more concerned about the 99
5 percent of the other pension fund investments. Maybe we
6 ought to let the Department of Labor, which is charged by
7 Congress to look after pension funds under the ERISA act,
8 weigh in on pension funds, and on whether they perceive this
9 as an issue.
10 As I noted at the proposal stage, it would be
11 useful for us to have more information about hedge fund
12 advisers.
13 Commenters showed a commendable willingness to work
14 with us, to get us the information that we need. They
15 suggested a number of alternatives for achieving this,
16 including requiring unregistered investment advisers to file,
17 and to annually update information statements with the
18 Commission.
19 This approach would have enabled us to develop a
20 complete picture of the advisory industry, without imposing
21 undue costs on advisers who choose not to register.
22 In addition, we could have worked with other
23 regulators to standardize, formalize information sharing.
24 We could have worked with entities that are already
25 regulated, such as prime brokers. Through these avenues, we
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1 would have been able to obtain exactly the information that
2 we need to monitor the industry, and root out fraud.
3 By contrast, requiring hedge fund advisers to fill
4 out a Form ADV will yield only snippets of useful
5 information.
6 We missed all of these opportunities that could
7 have produced a less costly, more streamlined approach that
8 likely would have found unanimous support on the Commission,
9 and perhaps even among the affected investors and advisers.
10 Proponents of registration insist that filling the
11 information void is only one of the objectives of
12 registration. They insist that the Commission, which already
13 has the authority to conduct for-cause examinations of
14 unregistered advisers, also needs routine inspection
15 authority, which only registration could afford.
16 I do not dispute that we need to be ever vigilant
17 for hedge fund fraud, and that undoubtedly there is fraud
18 occurring. But subjecting hedge fund advisers to routine
19 examinations is unlikely to be an effective deterrent.
20 Certainly, a perfectly-timed examination could turn
21 up wrongdoing, but with so many registrants, and so few
22 examiners, perfect timing is a lot to ask.
23 We've been in the process of augmenting our
24 examination team in order to address the overextension of our
25 examination program for current registrants. Our budget has
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1 doubled over the past two years. So it seems unwise to shift
2 resources away from traditional areas of oversight, so soon
3 after we made the case that those areas are understaffed.
4 Hedge fund advisers tend to employ more complex
5 investment strategies than the typical registered adviser,
6 especially those who advise mutual funds. If hedge funds
7 become a primary focus for us, we will need to train all of
8 our examiners, most of whom have no background in this area,
9 so that they are able to recognize unique issues that arise
10 in the hedge fund context. Otherwise, we are simply setting
11 them up to fail.
12 Market surveillance is a far more effective,
13 targeted way of finding fraud, and would allow us to leverage
14 the knowledge and expertise of the self regulatory
15 organizations. In addition to being costly for us, the new
16 registration requirement will be costly to affected advisers,
17 and these costs will be passed on to investors.
18 Registration is more than filling out a simple
19 form, filing it, and forgetting about it. A Form ADV, which
20 is a public disclosure form, is a potential litigation
21 document, and therefore, cannot be filed without a lawyer's
22 blessing. Lawyers' blessings, as most people in this room
23 know, never come cheap.
24 Registered advisers face numerous requirements,
25 including record-keeping, custody, and compliance
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1 requirements. All of these impose costs.
2 We are told to take comfort in the fact that
3 advisers to hedge funds are handsomely paid for their work,
4 especially as compared to the so-called run-of-the-mill
5 registered advisers. So, the argument goes, they can afford
6 the extra cost of regulation in a marketplace that has seen
7 the trend of hedge fund management fees increase from a low
8 of one and 20, up towards two and 25 these days.
9 I do not take comfort in seeing resources diverted
10 from other uses, such as hiring new employees, or purchasing
11 outside research, to cover the costs of compliance with our
12 regulatory mandates. These management fees, which investors
13 have agreed out of self interest to pay, presumably reflect
14 the risky nature of establishing a hedge fund, and the high
15 costs for extracting expensive top talent.
16 Proponents also argue that, to the extent there are
17 costs, we are just leveling the playing field between those
18 hedge fund advisers who have already registered voluntarily,
19 and the ones who remain in the so-called shadows.
20 As an initial matter, I reject the insinuations
21 underlying this initiative, that hedge fund advisers who have
22 chosen not to register have done something wrong, or have
23 something to hide. We should not be so hasty to assume the
24 worst about anyone who is not registered with us.
25 Moreover, we can all come up with a long list of
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1 enforcement actions against registered advisers to shatter
2 the myth that all registrants are pure as the driven snow.
3 Hedge fund advisers, like other businesses,
4 register if it is cost-effective for them to do so. If the
5 benefits of registration, such as wider appeal to pension
6 funds and other investors, do not outweigh the costs, then
7 hedge fund advisers do not register.
8 We cannot assume that the cost/benefit balance will
9 be the same for every hedge fund adviser. Mandating across-
10 the-board registration only serves to eliminate any benefit
11 registered advisers enjoyed in being able to distinguish
12 themselves from unregistered advisers.
13 But, if we are intent on leveling the playing
14 field, we should focus on the line that we have drawn between
15 hedge fund advisers and advisers to other types of private
16 pools. Why have we not applied the registration requirement
17 to advisers of private equity and venture capital funds?
18 Valuation issues are critically important in these funds, as
19 well.
20 Our argument for excluding advisers to other types
21 of unregistered investment companies looks particularly weak
22 when we see that the only real line of demarcation employed
23 in the rulemaking is the length of the redemption period.
24 A hedge fund adviser can avoid application of the
25 rule by simply extending its redemption period beyond two
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1 years. Instead of the so-called 529 plans named after the
2 tax section that middle class investors use to save tax-free
3 money for college, wealthy investors will now have what I
4 would like to be the first to dub 735 plans, which will stand
5 for the 735-day lock-up period necessary to avoid the rule,
6 and take into account any leap year with a day or two to
7 spare.
8 This two-year distinction does not capture a
9 legitimate regulatory distinction among funds. If this trend
10 towards longer lock-up periods takes hold because of our
11 rule -- longer lock-up periods are already becoming more
12 standard, after all, in the marketplace today -- it actually
13 harms investors, who will now have less freedom to vote with
14 their feet by pulling their money out of a hedge fund that
15 is mismanaged. We are simply encouraging an industry trend
16 towards longer lock-ups.
17 Proponents argue that the recent spate of hedge
18 fund enforcement actions justifies our preoccupation with
19 hedge funds.
20 As I discussed at the open meeting on this rule
21 when we proposed it, this approach would not have done much
22 to stop the fraud underlying the 46 cases cited in the
23 proposal. The additional five cases cited in the adopting
24 release do not strengthen the case, as Commissioner Glassman
25 said. Most of the advisers at issue in the cases were either
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1 too small to be registered, or already registered, or should
2 have been registered.
3 We will not protect unsophisticated investors from
4 fraudsters by requiring legitimate advisers to hedge funds
5 open only to sophisticated investors, to register.
6 Finally, there are serious questions about the
7 Commission's statutory authority to proceed without specific
8 Congressional authorization to do so. Rather than
9 recommending statutory amendments, it seems that we have
10 chosen to make a tortured end run around the statute, by
11 redefining who a client is for certain types of investment
12 advisers.
13 So, I, to add a little bit of levity, and so not to
14 disappoint, I thought that I hope that ultimately, we do not
15 wind up looking like the gunslinger in this Gary Larson "Far
16 Side" cartoon, where he shot the guy dead, and only then
17 realized that there were some questions that he should have
18 asked, and in light of all our discussion today, responses
19 that he might have heeded.
20 So, from the outset, I've been open about my
21 disappointment and distaste for this idea that is presented
22 before us today. So accordingly, I plan to vote "No" here in
23 a few minutes, and then, if the rule is approved, then I
24 intend to join again with Commissioner Glassman, and file a
25 written dissent.
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1 So that being said, and notwithstanding everything
2 else, I recognize that behind this incredibly quick timetable
3 is an incredibly overworked staff, so I appreciate your hard
4 work, and wish you Godspeed. Thank you.
5 CHAIRMAN DONALDSON: Thank you.
6 Commissioner Campos?
7 COMMISSIONER CAMPOS: Thank you, Chairman
8 Donaldson.
9 Well, Commissioner, I can tell you, I appreciated
10 that cartoon. That was the -- today, it's clear that we have
11 different rationales and we have different views of
12 this particular proposal, and this particular finalization of
13 the rule. I think it's pretty clear that the case and
14 rationale for the final rule has been made fairly well by the
15 staff, and has been presented in great detail in the release.
16 Not to repeat some of the arguments that have
17 already occurred, essentially, hedge funds have grown
18 dramatically. There's about a trillion dollars invested in
19 hedge funds today. At the rate of current growth, the
20 amounts managed by hedge funds could be several trillion
21 dollars in short order. The amounts keep growing, and there
22 is much troubling evidence of fraudulent activity.
23 It is clear that hedge funds are not doing business
24 in a vacuum, and it is not the case, in my view, of a few
25 rich people playing by themselves in a corner. No one can
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1 seriously argue that hedge funds do not impact, directly, or
2 indirectly, public funds -- mutual funds, as demonstrated by
3 the timing and the late trading cases and through -- pension
4 funds have been affected, and may be affected in the future
5 by the activities of hedge fund managers.
6 Clearly, there is smoke, and there is danger, and
7 light needs to be shed on a dark corner. To ignore this
8 situation, it seems to me, would be irresponsible in my view,
9 both to investors, and to the industry.
10 Essentially, the industry and many commenters have
11 proposed one simple idea, with several variations. The idea
12 seems to be create a registry of some sort, and require
13 annual audited reports.
14 So to put it in the simplest context, what we have
15 had, in terms of alternatives, when one filters out all the
16 different comments, and the different commentary that we
17 received, we have a registry versus registration under the
18 Investment Advisers Act.
19 I certainly respect the views of the practitioners,
20 and their associations and counsel. However, I do not
21 believe that the registry idea and its variations would be
22 sufficient, given the problems that we have discerned.
23 Obtaining information is an important part of our objective,
24 but it’s not the exclusive goal.
25 Again, I have a hard time seeing the argument that
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1 having examination and compliance procedures in place doesn't
2 offer deterrence. It's simply the wrong paradigm.
3 Would anyone suggest that registration under the
4 '34 Act should be abolished because we can't foresee, or we
5 can't detect every item of fraud? Would anyone argue that
6 cops on the beat make a difference, or that tax audits keep
7 individuals who are tempted to cheat from doing so?
8 Registration under the Advisers Act provides,
9 among other things, for clear standards under developed case
10 law of fiduciary to its investors. Books and records
11 requirements. A compliance system to be established by the
12 fund manager, and the right of our agency to conduct
13 examinations.
14 Now, having said that, a very important part of our
15 agency's obligation, in my view, is to discuss fully with the
16 regulated community, and with commenters. The agency
17 historically has always sought to have the regulated industry
18 help design the right regulation and oversight.
19 During this process, I've tried to be a part of
20 that. I have sought to keep an open mind, and to listen, and
21 to discuss with all who had opinions on this matter. Late
22 last week I promoted, I arranged and participated in meetings
23 with industry representatives of the Managed Funds
24 Association, and our senior staff. I listened, the staff
25 listened, and our Chairman and his staff listened.
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1 Although so many quibble or argue that the agency
2 did not listen enough or read enough of the commentary, I
3 believe that this final rule has significant accommodations
4 to the industry, and these particular accommodations have
5 helped me to support it.
6 First of all, I want to point out that the
7 effective date of this particular final rule is over a year
8 away, in 2006. This allows great flexibility to the
9 industry.
10 There are technical rules that allow
11 grandfathering, so certain individual investors who may not
12 qualify after the effectiveness, can qualify. Planning can
13 occur. Significantly, the industry and their advisers will
14 have more time to point out problems to our staff.
15 Items that are unclear in the rulemaking can be
16 brought to light, and I am confident, and I know that our
17 staff will welcome those kind of inputs, and will work with
18 the industry and their advisers. I can't emphasize how
19 important I think that is.
20 One of the areas that concerned me greatly was the
21 so-called barrier-to-entry problem. I believe, again, that
22 much has been done in the final rule to help with that
23 particular problem.
24 Essentially -- and I think it's important to
25 emphasize this -- insiders and executives, and significantly,
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1 partners, including passive partners, will not have their
2 contributions counted against the $25 million limit. As I
3 understand the way it will work, a passive partner to a hedge
4 fund adviser would not have his or her investment count
5 against the limit, so this would allow managing substantially
6 above the $25 million limit, and not be registered.
7 I've also asked many questions, and I am confident
8 that the marketplace will adjust and mitigate the cost of
9 compliance. As has been said, there does not need to be
10 hired an individual to separately take on the position of
11 compliance officer. There are business models, there are
12 prime brokers who are sponsoring hedge fund advisers, and I
13 believe that that and other arrangements will work out, and
14 will mitigate those costs.
15 Now, I would like to take a moment to address one
16 of the most controversial aspects of the proposal, and that
17 is the compliance oversight by the Commission. Even those
18 opponents who support some type of information exchange
19 consistently have argued against the examination requirement.
20 They contend that the Commission staff lacks resources,
21 experience, and structure -- essentially, a justifiable and
22 well-modeled plan.
23 Although I believe some of these concerns stem from
24 our own, or from their own prior experiences with our OCIE,
25 which, by the way, the Commission and the OCIE are working
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1 hard to rectify, some of these concerns seem to be rhetoric
2 that miss the point. The heart of the argument, the heart of
3 this particular argument, nonetheless, does resonate with me.
4 Accordingly, I took this problem to the Chairman,
5 and I mentioned to him that I was concerned that our
6 particular oversight was not sufficiently developed, and that
7 I was concerned, also, about our ability within the
8 resources. I am pleased to report that he also had similar
9 reservations, and that he also has given this much thought.
10 In response to these concerns, I'm pleased to say
11 that Chairman Donaldson has directed the formation of a task
12 force of SEC staff members, to be responsible for the
13 development of processes by which Commission examinations of
14 registered investment advisers will become truly risk-
15 filtered and risk-based.
16 Headed by Charles Fishkin, our director of the
17 Commission's Office of Risk Assessment, this task force is
18 comprised of staff members from the Office of Compliance,
19 Inspection and Examinations, OCIE; the Division of Investment
20 Management; the General -- or, I'm sorry, the Office of
21 General Counsel; the Office of Economic Analysis; and the
22 Office of Information Technology.
23 The staff group will begin meeting immediately,
24 following the Commission's approval of final rules, should
25 they be approved, requiring the registration of hedge fund
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1 advisers. Their goal is to have a risk-based inspection
2 program operational by February 1, 2006.
3 Although we anticipate that the group's initial
4 deliberations will be internal to the Commission staff, it is
5 our expectation -- my expectation -- that the group will seek
6 input from investment advisers that are currently registered
7 with the Commission, as well as those investment advisers who
8 will be required to become registered as a result of the
9 hedge fund initiative.
10 We anticipate that by the time this new compliance
11 inspection regime has been fully developed, it will reflect
12 significant input, and further comment from the regulated
13 community. Again, this is one of the reasons I'm so pleased
14 to see a long period before the effective date for today's
15 rules.
16 So on two tracks, consultation with the industry
17 and their advisers will continue. Our staff will continue to
18 receive comments, and meet as they customarily do, with the
19 industry, with respect to the rules that are being finalized
20 today. At the same time, the new task force will study very
21 carefully what it is that our agency can do, given our
22 resources, and given what we can do with respect to our
23 examination procedures.
24 Again, we are now studying, and our particular
25 agency is interested in looking at risk-based examinations,
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1 and studying particular problems that may be discerned. I
2 support the adoption of the proposal, and now I'd like to ask
3 a few questions, if I might.
4 As we all know, Paul and Bob, the Commission has
5 received a good deal of comment on aspects of the rule that
6 will affect the operation of hedge funds, and I know that the
7 staff has made a number of changes and clarifications that
8 address some of these comments, and produce a much clearer
9 definition and set of rules.
10 As I've said before, the changes have, in my mind,
11 significantly reduced barriers to entry, and I want to explore
12 that a little bit, or I also believe, address some of the
13 limits on innovation that others have been concerned about.
14 So, let me ask a few questions in that area.
15 One of the concerns is that we do not disrupt the
16 relationship between the hedge fund manager and the pool, so
17 as to raise questions about whether hedge fund investors are
18 clients for other purposes, and if there are special duties to
19 them that would be inconsistent with managing a pooled vehicle.
20 How have we dealt with that?
21 MR. PLAZE: Well, we've included a sentence in the
22 draft release, making it absolutely clear that the rulemaking
23 is solely limited to the method of counting clients for
24 purposes of Section 203(b)(3), and doesn't alter the duties
25 or obligations owed by hedge fund advisers to clients, or
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1 investors in any respect.
2 COMMISSIONER CAMPOS: As far as counting clients,
3 under the rule, or actually the current rule, off-shore
4 advisers only have to count clients that are U.S. persons.
5 Commenters were concerned about the definition of U.S.
6 person, and whether it works for hedge funds. Could you
7 explain how that is addressed in the rule?
8 MR. PLAZE: Yes. The issue arises with respect to
9 an offshore adviser. Since an offshore adviser only has to
10 count U.S. clients in order to determine whether they have a
11 registration obligation -- whether they have more than 14
12 clients, the question is how do you determine whether
13 somebody is a U.S. client? The Advisers Act rule looks --
14 the Advisers Act looks consistently to the residence of a --
15 of a U.S. person.
16 But the commenters raised the question, well what
17 if the client is -- is under this rule, and the investor and
18 the hedge fund is a corporation, or a trust, or a managed
19 account, what -- what are we going to use -- they don't have
20 residences, and so, we've clarified that in the case of a --
21 a corporation or a business entity -- it's the place of
22 organization. A trust, it's the location of the trustee.
23 And so, we've made -- we've made those issues -- we've
24 answered those questions. They've never been asked before,
25 which was surprising to us when we got the comment letters
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1 before, because these rules have been on the books for quite
2 a number of year now.
3 COMMISSIONER CAMPOS: It just seems to me there was
4 a lot of concern about that, and -- and this is -- these are
5 very helpful. Just on another technical item, when -- when a
6 non-U.S. person is -- invests in a hedge fund, and later
7 moves to the United States, does that person then become a
8 U.S. person, thus forcing the hedge fund manager to register?
9 MR. PLAZE: That's -- that was a new issue, too,
10 because in a normal advisory relationship, when someone moves
11 to the United States, you would expect them to be a U.S.
12 person, and we would not change that. Commenters
13 persuasively argued that with a pooled investment vehicle, it's
14 a different -- one needs to take a different approach. And
15 we were persuaded, and under the rules, as we recommend that
16 you adopt today, you would look to the -- the residency, or
17 the place of organization of the person at the time he or she
18 invests in the pool.
19 COMMISSIONER CAMPOS: I mentioned this in my
20 statement, but have you clarified -- or maybe you can make
21 sure that I'm correct, here -- regarding a hedge fund manager
22 himself as a client, and what about the family of the advisers,
23 and other key employees?
24 MR. PLAZE: Well, this is actually one of the most
25 significant changes from the proposal, and an idea that came
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1 about by commenters, again, persuading us. And so, there are
2 some significant changes, particularly for small hedge funds.
3 Under the -- under the rules we recommend you adopt today,
4 you would exclude in counting employees to the 14 -- key
5 executives, partners, key employees of the advisory firm.
6 And this is important for your small firms, because
7 typically, you start with a group of -- of partners, or
8 insiders, who put together the capital.
9 And you'd only -- you would exclude those people
10 who -- who would be typically involved in the start-up of a
11 small hedge fund. Members of the family, your partners --
12 even passive partners in the advisory firm itself. Those are
13 people you're going into business with. The Advisers Act is
14 not about protecting people you're in business with. The
15 Advisers Act is about protecting people whose professional
16 services you are offering, and those would be the outside
17 investors, when they eventually come into the pool.
18 And you would be able to exclude many of those, also,
19 from -- from the assets -- the proprietary assets of the firm
20 would not be counted, in terms of the $25 million threshold.
21 And the practical effect of that is that firms are going to
22 be able to conduct business for a longer period of time than
23 you might have thought, given the 14 client and the $30
24 million threshold before they come into registration with the
25 SEC.
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1 COMMISSIONER CAMPOS: Again, I mentioned, and I'm
2 drawing a lot of comfort form the fact that there's a year
3 period before the effective date. Can you comment about how
4 that will work?
5 MR. PLAZE: Well, that -- that's an important
6 period, because we understand that some firms are going to
7 have to examine their business operations, and are going to
8 have to hire advisers, and we have given plenty of time for
9 new firms to come into compliance with our compliance rule,
10 and we've given similar time for firms. Let me give you some
11 transition areas during this period that's very important.
12 One is that we have statements in the release that
13 the staff stands prepared to deal and assist with technical
14 issues that came up. About seven or eight years ago, we
15 adopted a set of rules under 3(c)(7) of the Investment
16 Company Act that dealt with hedge funds. And during the
17 implementation period, the staff issued quite a lengthy
18 interpretive letter, issuing -- explaining issues that we
19 hadn't fully seen, and ones that Congress left open when it
20 did its statute. It stands ready to provide similar guidance
21 here.
22 But in addition, the transition period contains a
23 number of -- of -- of transitional rules that are important.
24 Would you like me to go through those transition rules, also?
25 COMMISSIONER CAMPOS: I think that'd be useful.
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1 Sure.
2 MR. PLAZE: One is that all current investors in
3 hedge funds are grandfathered, as are other clients of hedge
4 fund advisers. Therefore, no one is going to have to leave
5 the hedge fund who perhaps wouldn't be eligible to be in the
6 hedge fund in the future, as a result of the effect of the
7 performance fee rules. Under the performance fee rules, a
8 client -- you look through the fund, and you require clients
9 to have a certain amount of wealth or sophistication in order
10 to be in that fund. Those are essentially waived for all
11 clients in the fund -- already in the fund, as of the day of
12 the compliance date, which is -- we mentioned is in February
13 of 2006.
14 And secondly, in measuring 14 clients, under the
15 statute, you look back 12 months. So let's say if you only
16 have one client today, but indeed, if cumulatively you had 14
17 clients over the past 12 months, you might have a
18 registration obligation. And indeed, you could certainly see
19 a situation with the hedge fund, that it had a number of
20 investors six months ago, but it doesn't today. Some have
21 left for whatever reason.
22 Now, what we would do is, we would modify the
23 measure of -- of look-backs, so that the look-back begins on
24 the compliance date in February 2006, so that you wouldn't
25 have retroactive registration obligations on hedge funds who
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1 would perhaps have gotten smaller -- hedge fund advisers have
2 gotten smaller, or because they've rearranged their business
3 arrangements to avoid registration. So, we avoid the -- the
4 “I gotcha” application of that statutory provision.
5 And secondly, the two-year redemption limitation.
6 That is, if you have redemption -- if the fund offers
7 redemption rights of more than -- two years, if it offers
8 redemption rights for investments that have been in the fund
9 less than two years, it's going to have to register. It's
10 going to be a private fund. We would not make that
11 retroactive. We'd only apply that to securities that are
12 offered -- interests in the hedge fund that are offered after
13 the compliance date. So, funds that have entered into
14 business arrangements with a certain expected set of rules,
15 are not going to be -- have those retroactively applied.
16 And finally, we have our
17 recordkeeping requirements dealing with performance
18 information, which have to be substantiated
19 back from the first day of that performance period. We would
20 relax those for these hedge fund advisers of course, they would
21 still be subject to the anti-fraud provisions, which really
22 weren't on notice that they were required to keep those --
23 those records, having not had a registration obligation. So
24 these are important, I think, transition provisions that will
25 really alleviate the impact of these rules on -- on hedge
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1 fund managers that have heretofore been operating under a
2 separate set of rules.
3 COMMISSIONER CAMPOS: Thank you, that -- that is at
4 least reassuring to me. Mr. Chairman, I hope that it is
5 clear from this statement, and from our particular release
6 that the industry understands that the agency is seeking to
7 work with it, to make these rules realistic and not overly
8 burdensome, and that we will continue to do so. We certainly
9 -- the door is open, and the invitation is there, and I know
10 that you are supportive of that -- of that particular
11 approach. And I -- and I do hope that -- that those out
12 there will not let themselves get into this tailspin of -- of
13 a toxic environment, and instead, come in, work with us, have
14 these rules be effective, and -- and appropriately designed,
15 as we have already. But again, we -- we have the structure
16 now, and -- and I think it's something that can be very --
17 very palatable to the industry.
18 At the end of the day, I believe that the industry
19 can win with this situation. This should provide deterrence,
20 and when one thinks about the reputational capital, and the
21 -- and the loss that could occur to the industry with -- with
22 a small hiccup -- with a small scandal, I think this kind of
23 system is worth having in place, and is worth the cost.
24 Thank you.
25 CHAIRMAN DONALDSON: Thank you. Do you -- any of the
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1 Commissioners have any comments? We're getting close to the
2 conclusion, here.
3 COMMISSIONER GLASSMAN: I do. It will be short.
4 I'm glad Commissioner Campos mentioned the task force. As I
5 said in my remarks, I -- I think it will be useful to have
6 the task force. I would have preferred that the task force
7 do its work first, to determine the right model, and apply it
8 to the hedge funds. And I would point out that I asked the
9 Chairman to do such a thing over a year ago, to look at the
10 kind of information that we need from hedge funds, and the
11 best way to get it. And unfortunately, that hasn't been
12 done. Had it been done, we'd be in a very different place
13 today.
14 CHAIRMAN DONALDSON: Commissioner Atkins?
15 COMMISSIONER ATKINS: I think I've said my piece.
16 Thank you.
17 CHAIRMAN DONALDSON: I'm sorry. Took you out of
18 order. Commissioner Campos.
19 COMMISSIONER CAMPOS: I've said my piece, as well.
20 CHAIRMAN DONALDSON: Let me just make two remarks,
21 because I -- I believe that there have been -- I don't want
22 to rehash all that's been said. I think we've been over it,
23 and over it. There are two remarks that were made here that
24 I want to clarify. The first is the reference to the
25 President's Working Group. And I want to make sure that my
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1 colleagues on that organization understand, and the people
2 sitting at this table in this room understand that the
3 President's Working Group does not -- I think the statement
4 was, we were proceeding without the concurrence of the
5 President's Working Group, and the President's Working Group
6 is not an organization that -- that has a concurrence to it.
7 It's an advisory group. Comments made by members of that
8 group are made in their own individual capacity, just as the
9 comments that I make are made in my capacity as Chairman of
10 this regulatory agency. The other gentlemen on that group
11 have different roles. I think that needs to be made clear.
12 I also want to just comment one moment on the issue
13 of -- of the task force, and the formation of the task force.
14 As all of us at this table know, we've been working since the
15 day I got here as Chairman of the Commission, to -- to put
16 together a risk-based approach to our entire method of
17 operation. And we've had to bring in the structure to do
18 that. We've had to bring in the people to chair the office.
19 We have now advanced to the point where we have a risk-based
20 approach throughout the entire agency, and we've now got a
21 special sub-group of something that's already going, that's
22 going to focus, and thank goodness they are, as Commissioner
23 Campos stated.
24 So, I just want to say that, you know, I've of
25 course given consideration to the discussion -- arguments pro
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1 and con, and I fully support the staff's recommendation. In
2 connection with what Commissioner Campos said, I want to note
3 that a number of important issues were discussed this
4 morning, particularly in response to the questions of those
5 of other Commissioners, and I'd like to ask the Commission to
6 authorize the staff to make appropriate revisions to the
7 final release, to reflect the key points we've covered.
8 Subject, of course, to the approval of each of the
9 Commissioners who favor the rule.
10 However, before I officially call the question, I
11 just want to say a few words. I appreciate and welcome the
12 insights and observations that have been offered by all of my
13 colleagues this morning, and throughout this process. I've
14 said before, if all of the decisions we were asked to make were
15 easy, and self-evident, there'd be no need to have five
16 people sitting on this panel. And while we may not always
17 have agreed, disagreements are driven by the bedrock respect
18 we share for this institution that we serve. They provide
19 valuable evidence that the process works, and it works well.
20 To each of my colleagues, I extend my thanks and
21 congratulations. These are difficult decisions. The
22 rigorous debates that we've had have been crucial to the
23 development of this initiative. And with that, I will call
24 the question, do the Commissioners vote to approve the
25 staff's recommendation?
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1 (Voice vote.)
2 CHAIRMAN DONALDSON: Okay. That -- that, then, is
3 an approval by a vote of three to two. Thank you all. And
4 that's the end of the meeting. Thanks.
5 (Whereupon, at 1:09 p.m., the meeting was
6 concluded.)
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