Speech by SEC Commissioner:
Remarks before the SIA Hedge Funds & Alternative Investments Conference
Commissioner Roel C. Campos
U.S. Securities and Exchange Commission
New York, New York
June 14, 2006
Good morning. I'd like to thank Don Kittell, Tom Price, and all of the SIA for asking me to join you here today. I am an enthusiastic supporter of the SIA and its conferences and congratulate the SIA and Mark Lackritz for putting together great conferences such as this one. I believe that such conferences are essential to the exchange and development of ideas between the industry, the public and regulators. Today's topic of hedge funds is no exception.
But before I begin, I must remind you that the remarks I give today are my own and do not represent the Commission, the staff or my fellow Commissioners.
Today, I'd like to spend my time addressing a number of the hot topics concerning hedge funds in an effort to be responsive to the conference topic: A Changing Business and Regulatory Environment. I'd like to start by examining briefly the recent activism of hedge funds and examine the behavior as legitimate investor conduct or that of corporate raider.
Role of Hedge Funds in the Corporate Democracy
In some respects, hedge fund activism is a new phenomenon, for it has been only recently that hedge funds have achieved the size and the focus to significantly affect corporate management. In other respects, however, hedge-fund activism is merely evolutionary, reflecting just another, but perhaps more widespread, variant on shareholder activism that first became prevalent in the 1980s when corporate raiders were all the rage. Regardless, the impetus behind such activism is shareholder profit, be it on an immediate or a distant horizon.
The non-financial companies in the S&P have amassed in the aggregate a record $637 billion in cash holdings that could be used to the benefit of shareholders. Hedge funds are just lining up for their share, but in so doing, they must recognize the position they now hold in the marketplace and they must play by the rules.
The strategies engaged in by activist hedge funds are diverse and multiplying. Three popular strategies include corporate governance, ownership, and buy out efforts or financing. These strategies often reflect whether the hedge fund is interested in a company for the long or the short haul. More frequently, these strategies are employed in combination to ensure the success of the fund in its endeavor. Importantly, within each of these strategies are opportunities for hedge funds to help or to hurt the companies in which they invest large stakes.
In the area of corporate governance, for example, hedge funds are looking for the combination of dividends, acquisitions or share buybacks that will best capitalize on that $637 billion pool of money. Many hedge funds attempt to negotiate with management before seeking to replace directors or other executives with their own candidates. Reports suggest that some beneficial changes are adopted through such discussions. Most would agree that such conduct is positive for all players in the marketplace. In fact, board seats may not always be the activist's goal. Insider trading rules may restrict trading of a company's shares once a manager joins the board. This can create redemption problems for the fund. Consequently, many hedge funds build a significant ownership stake to use as leverage against the company, instead of relying on associated board members.
But the notion of the corporate raider is alive and well within the confines of the corporate governance strategy. Hedge funds may attempt any number of measures to extract the maximum financial benefit from their investment, including trying to force a sell-off of assets and restructuring remaining operations. During the 1980s, this often meant plant closing, mass layoffs, demands for wage and benefit concessions from workers, and seizure of pension plan assets. Despite the passage of time, the same concerns may be legitimate today. The United Steelworkers union has been taking steps to block Algoma Steel from complying with a demand from hedge fund Paulson & Co. that it pay a large distribution to shareholders (of which Paulson is the largest) because the union fears the payout would "threaten Algoma's economic viability." The question of whether hedge funds are black knights or white knights clearly depends on where you stand or sit.
Direct ownership is another activist phenomenon. To name a few, Harbinger Capital Master Fund owns a 7.3% stake in Portland General (PGE) stock; Private Capital Management owns the largest public stake in the New York Times Company; and, hedge funds own approximately 20% of the London Stock Exchange, in anticipation of a merger with another exchange. This strategy of significant ownership may be evidence of a longer term interest in the company and its prosperity. Thus, it may be one of those occasions when the hedge fund's interest is in line with the long-term shareholders - again, a positive for the marketplace.
The flipside to the long-term interest of the ownership strategy may be the lending strategy. Quick turnarounds can produce tidy profits for early investors. Hedge funds have more flexibility than traditional lenders which may make them more attractive to the struggling or expanding company. In offering financing to a company, a hedge fund may hope or know that it will not get paid back. This eventuality gives the hedge fund leverage in the restructuring process, including possible control of the company when it emerges from bankruptcy. The key question in these situations might be whether any misleading assurances of support were made by the fund to the company.
Quick turnarounds can also produce opportunities for manipulation. It goes without saying that in executing their strategies, the good corporate citizen should not be engaging in insider trading. Yet, we have observed several contexts in which that may indeed be the case. Whether gleaned from research analysts or through information learned in the course of lending, hedge funds may have an opportunity to capitalize on information that may fall within the category of material, non-public information. Think twice. Naked shorting without covering also falls into the category of bad corporate behavior with potential securities violations.
It may be that some hedge funds, like private equity firms have done in Europe, might find themselves in the same boat soon, in other words, subject to the whim of large shareholders. Recent press reports note that more private investment funds are preparing to go public for all of the benefits that accrue with a public offering and listing. The popularity of hedge funds helps to assure that these IPOs are successful.
In employing the three investment strategies I've discussed, as well as others, one must recognize that hedge funds are not traditional institutional investors. As corporate citizens, they are not constrained by the institutional, cultural and political pressures faced by a CalPERS or TIAA-CREF. Further, many new hedge funds are inexperienced but are operating in an arena where experience matters for value creation. One of the very interesting developments is the potential of hedge funds to align with institutional investors to support governance and corporate goals. If hedge funds and pension plans were to join their holdings, they would often control a significant block of shares to be able to pass significant resolutions.
Hedge funds are using both traditional and more aggressive and innovative techniques to push their agendas. For example, you will see the traditional proxy fights at annual meetings designed to sink deals, demand higher merger prices, place candidates on the board and push for the sale of the company. But others are employing new tactics to garner support for their positions. Pershing Square Capital Management executed a media campaign to force McDonald's to restructure. The fund held a standing-room only presentation at a hotel in Times Square that was broadcast online and had a free call-in number. Many hedge funds do not have to borrow money for their battles and can afford long, drawn-out fights. The ability to self-fund may also result in hedge funds taking their efforts to the courts, the SROs, the SEC and, even, the legislature.
Plus, a new business is developing to capitalize on and to counter the challenges brought by these new corporate citizens. In the Time Warner struggle, Carl Icahn hired Lazard Ltd. as an adviser while Time Warner hired Bear Stearns and Goldman Sachs. Pershing Square Capital Management hired BlackStone group to write a fairness opinion of its efforts to restructure fast food giant Wendy's. So far, only a few investment banks, including Merrill Lynch and UBS, have specific departments dedicated to working with activist hedge funds because of the potential conflicts with their clients. Some banks are more willing to work with activists because these funds increasingly have deep pockets to succeed in their challenges. In addition to fees from advising and arranging financing, bankers also can receive follow-up assignments, such as leading divestitures of underperforming units, if an activist client succeeds in forcing change upon a company. Moreover, hedge fund involvement in mergers and acquisitions is now a given that cannot be ignored.
There is no doubt that activist hedge funds may offer ideas and business expertise that should not be dismissed outright. In a recent speech, some thought I went too far when I called proposals desired by hedge funds "free consulting." Even if a hedge fund is looking for short-term gains, it is possible that their strategies will improve a company's long-term prospects as well. Indeed, certain shareholders may be more interested in short-term gains than the overall health of the company. As their strength increases, however, hedge funds' ability to wreck havoc on issuers and the market grows. It is within this context that I challenge hedge funds and investors to be cognizant of the hedge fund's particular role in the corporate democracy.
If bad behavior were to become prevalent, the SEC has only a few tools to use. Enforcement action for fraudulent activity is, of course, the primary weapon. Our proxy rules might also be used to discipline corporate activism or proxy fights. SRO listings rules might also offer a basis for regulating bad conduct. In the end, corporate state law actions would likely be where most of the action will occur.
Risk and Hedge Funds
As we all know, investors in hedge funds are looking for exposure to strategies that often have low correlation to stock markets, without having to lock up their money for long periods of time. These strategies involve varying types and degrees of risk that differ from traditional investment strategies and products. The primary concern is whether the growth of hedge funds has the potential to change the overall level or nature of risk in markets and financial institutions. As many have said, hedge funds play a significant role in the marketplace. They provide liquidity, price efficiency, risk distribution, and, as Treasury Under Secretary Randy Quarles recently said, the furtherance of globalization, "which provides more choice for investors and greater efficiency for markets globally."
But such benefits do not come without risk. On the smaller scale, broker dealers may place the interest of hedge fund clients over the interests of other clients because prime brokerage is so lucrative. They also may market and sell interests in hedge funds without adequate concern for the suitability of such investments to their clients. Hedge funds may hide poor-performing assets in side pocket accounts to exclude such assets from the fund's valuation for purposes of calculating performance fees. Some hedge funds require leaving some of the investment in side pockets as a condition for redemption, even though the condition was not disclosed in the investment agreement. On the larger scale, there is the potential for excessive leverage, the concentration of positions, the dependence of valuations upon complex proprietary models, and operational risks for settlement and clearance systems. There is also the risk that hedge funds will all exit at the same time - as purportedly occurred in the 1997/8 Asia Financial Crisis. Performance fee structures give hedge funds an incentive to engage in risky strategies that may not be fully disclosed, and some advisers may not have sufficient risk management processes in place.
After the recent hedge fund hearing held by the U.S. Senate Banking Committee and a spate of speeches by officials from the Federal Reserve, it appears clear that most federal officials continue to argue that the market is the best force for keeping hedge funds in line and direct regulation should be avoided. As a whole, this approach focuses on monitoring operational risk and infrastructure failures and taking a principles-based approach to any regulation. Speaking in mid-May, Federal Reserve Chairman Bernancke emphasized that "the primary mechanism for regulating excessive leverage and other aspects of risk-taking in a market economy is the discipline provided by creditors, counterparties, and investors." And that, "effective market discipline requires that counterparties and creditors obtain sufficient information to reliably assess clients' risk profiles and that they have systems to monitor and limit exposure levels commensurate with each client's riskiness and creditworthiness."
He acknowledged that the complexity of financial products can complicate counterparty risk management, as can competition for hedge fund business, and that liquidity could decline unexpectedly and sharply in a market segment if hedge funds chose or were forced to reduce a large exposure. I would agree with his belief that the key, however, is to ensure that when hedge funds do fail, the effects will be manageable and the potential for adverse consequences to the broader financial system or to real economic activity will be limited.
Indeed, in the months in which hedge funds have had lackluster returns over the past 12 months, there has not been the feared "run-on-the-bank" as hedge fund managers try to reach their monthly targets. The turbulence has been met with an orderly correction. A recent Wall Street Journal article summed it up nicely. "With interest rates going up, all investors are selling at once - hedge funds, mutual funds and everybody else. Hedge funds don't kill markets. Investors reacting to the end of cheap money kill markets."
What then are we at the Commission doing to monitor the market's ability to discipline hedge funds? The Commission is focusing attention on broker-dealers' exposure to hedge fund risks and the broader implications this aspect of the financial system may have. The Commission staff meets regularly with other members of the President's Working Group on Financial Markets, and works with the industry members that comprise the Counterparty Risk Management Policy Group. In addition, the Commission's consolidated supervision program for certain investment banks now allows the staff to examine not only the broker-dealer entities within a group, but also the unregulated affiliates and holding company where certain financing transactions with hedge funds are generally booked. Commission staff meets at least monthly with senior risk managers at these broker-dealer holding companies to review material risk exposures, including those resulting from hedge fund financing and those related to sectors in which hedge funds are highly active. The Commission also is pursing an active examination and inspection program which I will discuss momentarily.
One area within the Commission's purview that could use an immediate regulatory touch, especially with respect to hedge funds, is in the area of asset valuation. Hedge funds often invest in illiquid or complex assets for which there is no public market, and fund administrators rely on pricing from the fund advisers. To avoid dilution and unfairness, valuation numbers must be accurate and unbiased. A key element of monitoring the risk of hedge funds is to understand the valuation used by said funds and counterparties to the funds. The complexity of the strategies employed by hedge funds as they aim for absolute returns adds to the barrier of understanding regarding the specific risk posed by the investments. With each twist, another layer of valuation is added on, obfuscating any clear understanding of the underlying risk. The SEC has stated that it would issue additional valuation guidance, but we have yet to do so. Now that Buddy Donohue has joined us as the Director of Investment Management, I would urge him and Chairman Cox to move this project to the front burner. In fact, other jurisdictions are interested in valuation too.
Just this past March, the International Organization of Securities Commissions (IOSCO) published a consultation report entitled, "The Regulatory Environment for Hedge Funds - A Survey and Comparison." The report was mandated as an update to a 2003 hedge fund report to take account of any regulatory developments in the member jurisdictions. The report concluded with four observations. First, there is no formal, legal definition of the term "hedge fund." Second, hedge fund advisers and hedge funds are regulated in most of the jurisdictions. Third, there are few reports of significant retailization, but some jurisdictions believe this is changing. Hong Kong, for example, permits hedge funds to be sold to retail investors with few restrictions. And, fourth, there have been incidents of hedge fund fraud.
But the IOSCO efforts do not end there, after urging by the FSA, IOSCO has stated that it will strive to develop principles around valuation issues, on the assumption that unit pricing errors may have an impact on the interests of investors in the fund more generally. When it comes to valuation, there seems to be a consistent theme among regulators of not seeking to interfere with the operation of hedge funds but wanting to ensure that the valuation process is independent and objective. In other words, investors and regulators should have disclosure regarding the process - policies and procedures - used for valuation but would not review the actual valuation itself. Theoretically, by following a sound methodology, a discipline is imposed on the valuation process. The challenge in such a project lies in the different size, models, and treatment of such funds in the various jurisdictions. I am eager to participate in and follow the development of this project.
Latest OCIE Developments
Turning closer to home, I'd like to take a moment to address some concerns I have heard from the industry regarding the OCIE examinations of hedge fund advisers. The first of these concerns relates to the length of the examinations and the length of document requests used during the examinations.
Let me begin by saying I am not here to apologize for the staff or make excuses for the examination process. As a former prosecutor, I am keenly aware that the counterparty to any action, be it enforcement, examination or simply informal inquiry, rarely has a kind word to say about the experience even if it goes as well as could be hoped for. I am not suggesting that our process is flawless, but I am stating that the Agency and staff try to be responsive to legitimate complaints about the process and to be as efficient as possible without compromising the goals of the examination. Remember, examinations are designed to detect compliance deficiencies and violations for the protection of investors.
To that end, focusing on the length of the examination and the length of the document request for purposes of complaining misses the point. We are all professionals with a job to do. To properly conduct an examination, we cannot set a finite time period - an examination will take as long as it will take. Likewise, in developing a document request, the staff must explore the categories of risk identified in its risk assessment profile. Said assessment is derived through an analysis of Form ADV data, which, as you know, is not without its limitations. Omitting one or two of these categories from a document request, before communicating with the subject of an examination, therefore defeats the purpose of using a risk-based analysis system.
To provide some certainty, however, the OCIE staff attempts to conclude examinations within 120 days from completion of the field work. Why, you ask, can we not provide more certainty? Because examinations, much like anything else, vary in degrees of complexity. These variables directly correlate with the length of the examination and can be both within and outside of the examiner's control.
The examination process generally proceeds as follows. Whether it be a broker dealer, a mutual fund adviser, or a hedge fund adviser, the OCIE staff identifies parties for examination through a risk-based analysis. The staff begins an examination with a letter to the entity asking for document production. The execution of this production request follows a negotiated process which varies in length based on the discussions between the parties. The next step involves the on-sight portion of the examination. The time involved in this step also varies depending on the firm, its schedule, access to personnel, the issues under review, and possible questions unearthed during the examination that require production of additional documents or additional interviews with personnel.
The majority of analysis takes place after the field work is complete. The 120 day clock that I mentioned runs from the time the staff completes its interviews and leaves the "on-sight." Hedge fund advisers do not receive any special treatment with respect to this process. In fact, using a back of the envelope review, it would appear that the number of hedge fund adviser examinations since the start of the registration period in February has been roughly proportionate to the percent of hedge fund advisers in the adviser population as a whole. Moreover, examinations of hedge fund advisers is not new. In the course of examining asset management activities, OCIE has examined 400 or so hedge fund advisers who were registered with the Commission prior to the registration requirement.
Even so, with the implementation of the registration rule, there have been some modifications and fine-tuning to the review process to more accurately reflect the differences between hedge fund advisers and other advisers. Moreover, the staff recognizes that there is no one-size-fits-all compliance model within even a sector of advisers, such as hedge fund advisers. But as you would expect, there has to be a starting point - a framework - from which individual examinations are tailored. As we discussed earlier, refining an examination to the peculiarities of an individual adviser potentially will add to the length of time required to complete the exam, but this is time well spent from which benefits accrue immediately to the adviser and the examination staff, and even, in the end, to the investor.
The development of the changes to the review process has been an interactive and ongoing process directly involving the industry, as promised at the time the registration requirement was adopted. In fact, some of you may have been speakers at seminars with the OCIE staff. Currently, the staff is halfway through its extensive twenty-two session training program. The staff also is learning from its early investigations and using this information to better craft efficient and meaningful examinations. In addition, discussions have been undertaken related to modifying the existing Form ADV to include a few specific data points, such as the identity of the auditor or whether the adviser prepares its own account statement or who the prime broker is. After thinking about the types of frauds we have seen over the past two years, I believe this information would be instrumental to producing an informed investor with respect to all classes of advisers, not just hedge fund advisers. It also would add to the staff's ability to better risk-target examinations to those firms posing the greatest compliance risk. Plus, there is the potential deterrent effect of having to disclose this information on the Form ADV.
I have heard concerns voiced that the staff is using the information it gathers in examinations to craft rule changes that will go further down the regulatory path or that registration is just the first step to more regulation. I would caution critics and the industry against gun-jumping. At this time, the Commission has not stated that it plans to develop further regulations in this arena. I believe that any such regulation currently would be premature. I personally have seen no evidence of the need for further regulation. As we stated during the adoption of the rule, the registration requirement is a disclosure-based approach, with a compliance and inspection component, to a class of advisers within the fund industry. Our decision was a calculated measure to shed light into the rapidly growing hedge fund industry without requiring or prohibiting an adviser to follow any particular investment strategy, risk strategy, or requiring or prohibiting specific investments. I should note that the U.S. regulations are no more onerous than those imposed by other jurisdictions, some of which require licensing of managers.
The diversity of strategies, the variant on sizes, the differing governance structures - all of these factors, among numerous others, contribute to the complexity of the hedge fund industry and, therefore, to the greater need for the SEC to gather reliable and meaningful data so as not to underestimate the intricacies of the industry as the Commission fulfills its mandate to investors. As I said before, we recognize that one-size does not fit all. Moreover, as our understanding grows, our examination process improves. As Chairman Cox said recently, "We're also training our inspectors specifically for the purpose of understanding how to inspect hedge funds…This is a new emphasis for the Commission. We're devoting significant resources to it."
Yet, I again would caution against jumping to the conclusion that the SEC has secret plans to regulate hedge funds. There are no such plans to my knowledge. Since I interact with our staff, Chairman and Commissioners on this topic regularly, I believe that I would know if there were a secret plan.
As with many of the dire predictions surrounding the Commission's hedge fund registration requirement, I believe fears regarding examinations were overstated. Reports in the press have described positive experiences thus far, noting that the staff has been thorough and is taking its responsibilities seriously. I have heard of high levels of cooperation and flexibility during examinations too. I am sure there are some negative experiences as well and I hope you will tell me or the staff about them so we can remedy any genuine problems.
Moreover, the Commission staff is working with the CFTC to coordinate, and perhaps, consolidate, examinations of hedge fund advisers that are also actively engaged in commodities business. Likewise, the Commission staff is working with the FSA to coordinate policy and oversight of the 165 hedge funds advisers registered with the Commission that are located in the UK. Such outreach to our fellow regulators is instrumental to improving efficiencies within our examination program, including expanding our education regarding hedge funds generally - the approach taken to their regulation by other regulators - and sharing oversight responsibilities.
We are not seeing a flood of hedge funds offshore or a closed-door policy to US investors in foreign hedge funds. The predicted rush to lock-up funds has not materialized either. We are hearing about some of all of these behaviors, but nothing startling. And, there are some funds that we hear are waiting out the lawsuit. But, because of the recent opacity surrounding hedge funds, we do not know how many hedge funds exist. The MFA believes the industry consists of 5000 to 7000 funds. That's a lot of leeway. Consequently, neither supporters nor opponents of the rule can really say that the few examples we've seen thus far provide us with meaningful data as to the rules' immediate effect on the industry and investor access to hedge funds. The real learning curve has just started - for us, for investors, for the industry.
Not surprisingly, we are still finding instances of fraud. Over the past seven years, the SEC has brought 96 enforcement cases against investment advisers for defrauding hedge fund investors, or using hedge funds to defraud others. But that is just a fact of life when you're in the territory of managing money - hedge fund advisers are no more culpable than mutual fund advisers, per se, but they are no more exempt from fraud either.
Opponents of the registration rule argue that the rule will not uncover more fraud and is, consequently, an unnecessary burden. While I would disagree with that contention on its face, I would also note that such a single-minded comment ignores the complexity of our regulation. The rule was not proposed solely for its fraud detection component. The Commission already had the ability to investigate suspected fraud at any hedge fund. The rule was proposed to shine sunlight on a rapidly growing industry touching an ever-expanding universe of investors. There are several benefits to the carefully crafted, limited regulatory approach taken by the Commission. Of course, there is the potential increase in fraud detection. Like the IRS, the finite number of examinations will create deterrence, focus the industry on adopting best practices, and in the end, protect the industry's reputation and help maintain investor confidence. In fact, I would argue that the industry has a strong incentive to support examinations to establish high standards and reputation in the industry.
Time will tell how well we do. Our examiners' skills and our examinations will surely improve over time. I am committed that our examinations be reasonable and fair to the industry. Because of the number of hedge funds relative to the size of our examination staff, many funds, certainly those that are not large and those that do not engage in what is deemed as risky activities, will rarely see our examiners.
I believe that the SEC's limited regulation framework is the right light touch. There is no intent to further impose regulation and no intent to regulate the operational decisions and strategies of funds - such as the use of leverage, short selling, use of derivatives, to name a few.
In the end, the key I believe is for the industry to be actively engaged with the SEC, pointing out any problems or unfairness, and participating in the training of our examiners. Indeed, the industry has a large stake in having our examiners be well educated as to the workings of the industry. This model of cooperation and joint working groups has worked well to date. I am pleased that my role as an active intermediary between the industry and our SEC staff has resulted in beneficial improvements in our regulation and rules.
If we continue this cooperation and joint work between the hedge fund industry and the SEC, I am certain that investors and the industry will be well served.
Thank you very much for your kind attention.