Speech by SEC Commissioner:
Remarks Before the 9th Annual Alternative Investment Roundup
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
January 29, 2007
Thank you, David, for your kind introduction. I am happy to be here today. First I should say that I am impressed with the hospitality of the good folks here in Arizona. I half wonder whether they are just being nice to those of us from Washington, because the Phoenix Suns beat the Washington Wizards soundly last week to avenge their loss in December. In case you are not following basketball, the Suns are on quite a winning streak now, and leading in the NBA. Of course, today the Suns are out of town on the road to Milwaukee. Could that schedule be just a coincidence? Or, is it because the basketball players are smart enough to leave town before a bunch of private fund advisors arrive, since their disposable income easily makes them accredited investors, regardless of how high we at the SEC may set the limits?
It is probably appropriate that your conference organizers had me speak just before the next session entitled, "Connecting Wall Street to K Street". Of course, once upon a time the term "Alternative Investments" used to refer to investments that fall outside of the mainstream in terms of the pool of potential investors and the level of regulation to which they are subject. Over the years, however, both of these distinctions have begun to erode and, as you all well know, the government's interest has been piqued. Thus, I suppose that is the reason that you are sitting here listening to me a government regulator this morning instead of networking or discussing investment risks and opportunities.
Because I am a government regulator, before I begin I must note that the views that I express here today are my own and do not necessarily reflect those of the Securities and Exchange Commission or of my fellow Commissioners.
The alternative investment industry has been through interesting events during the last several years. From my perspective as an SEC Commissioner, I have had an all-too-close perspective on some of these events. I would like to share my perspective with you today and then get your thoughts on how we can ensure that the alternative investment industry is permitted to thrive for the benefit of investors and the American and international capital markets.
While many of my comments today will pertain most directly to hedge funds, the implications are broader. I always have believed that the rest of the alternative investment world ought to pay close attention to any steps that are being contemplated with respect to hedge funds, because it may not be long before other alternative investment vehicles face similar treatment. After all, as I believe you discussed in your first panel this morning, the lines between hedge funds and other types of alternative investments are blurring. If you live in a townhouse and your neighbor's townhouse is burning, you had better help man the bucket brigade before your house catches fire too.
As you all know, hedge funds have been in the regulatory spotlight during the past several years. With over $1.2 trillion in worldwide assets under management, the attention is understandable.1 The regulatory response, however, has not always been defensible. This morning I will discuss two regulatory initiatives in the hedge fund arena. The first one failed, but taught the SEC some valuable lessons in the process. The second regulatory initiative is still in the development phase, but I am hopeful that the end product will reflect the lessons that were learned from the first.
First, I would like to go over a bit of a history to show how far we have come and some of the bumps along the way. The SEC has been studying hedge funds and their impact on the U.S. securities markets for many years. The SEC initiated its first formal study of hedge funds in 1969, by which time hedge fund assets had swelled to $1.5 billion. That number probably makes some of you chuckle. Those were the days when my father said that a dollar was worth a dollar. As the SEC noted in its annual report that year, however, "[b]ecause hedge funds are so strongly performance-oriented, they may have a greater impact on the securities markets than their asset size would indicate."2
In 1992, the SEC staff took another look at private investment companies.3 The staff concluded that another exception from the Investment Company Act was needed to facilitate their creation Congress took up that recommendation four years later and adopted the Section 3(c)(7) exception for qualified purchasers.
It was also in 1992 that the Treasury, Federal Reserve, and the SEC in a joint report to Congress speculated that "[t]otal assets in hedge funds certainly run into the tens of billions of dollars."4 That joint report and a response to a Congressional inquiry in the same year5 raised questions about systemic risk, but the SEC staff recommended against extending registration to hedge funds.6
The Long Term Capital debacle of 1998 reawakened concern about systemic risk. The following year, the President's Working Group on Financial Markets made up the heads of the Treasury, the Federal Reserve Board, the CFTC, and the SEC issued a report in response to Long Term Capital.7 This report focused on ways in which to control leverage, but rejected the need for the registration of hedge fund advisors.8
The tide turned in September of 2003, when the SEC's Division of Investment Management completed a new study on hedge funds.9 The staff's report on the hedge fund industry included a number of recommendations, including that the SEC consider requiring hedge fund managers to register as investment advisers under the Investment Advisers Act of 1940. Now, the very curious thing about this report is that its two most important recommendations did not follow from the actual research and findings of the report. For example, the recommendation that the SEC impose registration on hedge funds supposedly would address the staff's concerns about "retailization," even though the report itself specifically said that retailization was not a problem.
In the end, the recommendations were a half-hearted graft onto the report to enable the new SEC chairman William Donaldson to take up the cause of registration, which he had come into office wanting to do. Awkwardly for him, the staff had done most of the work on the report by the time he became chairman the work on the report had started in 2001 when Harvey Pitt was chairman. Thus, the disconnect between the research and the recommendations.
As you all know, the SEC embraced the registration recommendation by a 3-2 vote over my joint dissent with former Commissioner Cynthia Glassman. The SEC rule was puzzling to our colleagues across the government who had worked with us on the issue of hedge funds in the past. Former Federal Reserve Chairman Alan Greenspan explained bluntly that "the initiative cannot accomplish what it seeks to accomplish."10 Former Treasury Under Secretary Randy Quarles subsequently told the Senate Banking Committee that the Treasury had to "work with the SEC, both bilaterally and through the President's Working Group, to make sure we understood the SEC's rationale for their rule, and what their goals and expectations were regarding its implementation."11 As Under Secretary Quarles so diplomatically hinted, none of the rationales put forward by the SEC seemed logically linked to the concerns identified by the SEC. What is more, as the Government Accountability Office pointed out, the registration mandate for hedge fund advisors threatened to undercut the SEC's oversight of mutual funds.12
Our brief foray into mandatory hedge fund advisor registration was cut short by the D.C. Circuit Court of Appeals last June in Goldstein v. SEC, just months after the registration requirement took effect and before the rule was able to prove its own futility.13 The Court overturned the rule because of the SEC's "manipulation of meaning" with respect to the word "client," which the Commission had redefined solely for the purpose of forcing all hedge fund advisors to register.14 Wisely, Chairman Chris Cox, who inherited the mess, determined not to petition the Supreme Court to hear the case. For those of you who registered and then wanted to de-register because of the ruling, you at least got your filing fee back (never mind the legal and compliance costs entailed in registration). In a word: Sorry.
So what are some of the lessons that the SEC can learn from this brief regulatory escapade? First, the SEC should thoroughly consider why it needs to regulate, before regulating. Second, the SEC should consider whether a proposed regulatory approach will work to meet that need.
Third, the SEC should consider whether the benefits of a particular regulatory approach outweigh the costs. Indirect costs matter too. The registration mandate imposed indirect costs on mutual fund investors, for example, by diverting resources from the oversight of mutual funds, which benefits more than 90 million Americans, to hedge fund advisor oversight, which arguably inures to the benefit of Warren Buffett and Jimmy Buffett, Michael Dell and Michael Jordan, Bill Marriott and Paris Hilton, plus those NBA basketball players that I mentioned earlier. All of these people have either the financial acumen or, more likely, the financial wherewithal, to look out for themselves or hire someone else to do so for them.
Fourth, the SEC should consider whether the proposed regulatory approach is within its regulatory authority. These first four lessons sound fairly obvious, but the SEC too often has found itself in the awkward position of trying to enunciate regulatory objectives and articulate plausible legal and economic justifications only after it has selected a regulatory approach. That is truly an end-justifies-the-means approach.
The fifth lesson is that we need to work better with other regulators. Let us work with our colleagues at the Federal Reserve and the Treasury on issues of systemic risk and, because it is more squarely within their purview, defer to them in that area. Incidentally, they have tended towards regulatory restraint with respect to hedge funds, because they have recognized the unique ability of the market in minimizing systemic risk. Federal Reserve Chairman Ben Bernanke observed that regulators would do better to "focus on counterparty risk management [which] places the responsibility for monitoring risk squarely on the private market participants with the best incentives and capacity to do so."15 As Chairman Bernanke explained, such an approach has the added advantage of avoiding the moral hazard that could result from closer regulatory involvement, which will inspire private counterparties of hedge funds to do less, not more, monitoring.16 The recent experience with Amaranth served as a reminder that the market is able to absorb even substantial hedge fund disturbances. The system worked. Chairman Cox has shown a strong commitment to cross-government cooperation on issues of hedge fund risk and leverage.
A sixth lesson that the SEC's experience with the hedge fund registration rule taught is the difficulty of reversing the effects of a regulation once it gets into the rulebooks. The registration initiative, though it was judicially terminated, has continued to affect the hedge fund industry. Many newly registered advisors are weighing whether to maintain their registration. In order to try to persuade them to remain registered, the SEC staff provided no-action relief to allow advisors to rely on certain accommodations included in the now-invalid hedge fund rule. For some, remaining registered is a wise business decision since registration can give a fund a marketing edge. In fact, because of ERISA and the requirements of many requests for proposals from pension funds, there has been for a decade or more a trend towards voluntary hedge fund registration. Even so, more than 350 hedge fund advisors have deregistered since the Goldstein decision.
The rule will continue to have an effect on some investors in hedge funds whose advisors did not register. These advisors avoided registration by extending their lock-up periods beyond two years the crude line of demarcation that was used in the rule to attempt to distinguish advisors to hedge funds from advisors to other types of funds. These advisors are undoubtedly enjoying being able to hold on to investor money for a longer period (in many cases twice as long) and, unless they get investor pressure, are unlikely to switch back to shorter lock-ups now even though the reason for the longer lock-up has been invalidated.
Finally, although the invalidation of the hedge fund rule cannot erase the incendiary criticism to which hedge funds were subject during the debate over registration, I hope that the SEC will approach the issue of hedge fund oversight with greater temperance and subtlety than we have in the past. We need to stop scaring ourselves and others with rhetoric about hedge funds.
Rather than talking about how hedge funds "operate in the shadows," let us take a look at the regulatory constraints on hedge fund advisors that stop them from saying anything about their funds publicly. One irony of the SEC's complaints about the secretive nature of the hedge fund industry is that advertising restrictions on hedge funds have been interpreted broadly so that hedge fund advisors do not dare to say anything publicly. The SEC should consider undertaking the long-overdue task of revising Form D and, as part of that revision, refine the form so that it solicits census information on offerings of private investment funds.
If it is lack of basic information about the industry that keeps government officials up at night, let us sit down with our fellow regulators, including the CFTC, and hedge fund advisors and investors, and take an inventory of available information about hedge funds. Let us look for ways to supplement that information, if it be insufficient. For example, the Financial Crimes Enforcement Network (or "FinCen"), which is part of the Treasury Department, has proposed to require all hedge fund advisors to complete anti-money laundering information requests. If necessary, the proposal could be broadened to seek additional information. But, let's not gather information just for the sake of gathering it let's do it for some purpose that has gone through a cost-benefit analysis.
Rather than speaking ominously of a supposedly growing trend of hedge fund fraud, let us take a closer look at the cases that have been classified as hedge fund fraud. Let us sort through the cases to distinguish garden variety fraudsters masquerading as "hedge fund" advisors from hedge fund advisors that set up a hedge fund with the bona fide intention of managing money, but then make a misstep. If we simply lump all the cases together, we might conclude incorrectly that regulations aimed at legitimate hedge fund advisors will stop everyday thievery. Restrictions that apply to legitimate hedge fund advisors will do nothing to protect our grandparents from being wooed into handing their life-savings over to a smooth-talking thief who promises to multiply their money in a purported "hedge fund." Commissioner Walt Lukken of the CFTC has made this same point. As he noted:
[I]ndividuals who commit fraud by marketing themselves as hedge fund managers and bucketing the profits for themselves … are fraudsters and have little to do with the concerns surrounding the legitimate hedge fund industry. These fraudulent individuals use the term "hedge fund" as a hook to illegally solicit funds from the public. From a regulatory standpoint, this behavior is not a hedge fund problem, per se it is essentially an issue of fraud.17
Of course, illegal and unethical behavior can and does happen among the "best" of people and businesses. These sorts of problems are more likely caught by vigilant investors and regulators keeping their ears open for tips or through market surveillance than by once-every-three-year examinations. Finally, let us not allow isolated instances of fraud to obscure the many benefits that legitimate hedge funds play in the markets. No matter how highly we regulate, we cannot eliminate fraud. And, we certainly cannot, and should not try to, eliminate losses.
These are just a few of the lessons that I hope that the SEC will consider as it approaches future rulemaking. I encourage those of you who are watching the Commission to remind us of these lessons if we start to forget them.
In December, we issued for comment a new hedge fund proposal that embodies some of the lessons learned from the vacated mandatory registration rule.18 It is more narrowly tailored although it does reach beyond hedge funds to other pooled investment vehicles. It is also better suited than was the overturned rule to address well-articulated concerns. Some, however, including former Chairman William Donaldson, apparently think that the proposal does not go far enough, if news reports are accurate.19
The proposed rules would do two things.
First, they would clarify the SEC's authority to bring enforcement actions against investment advisors for fraud against investors and prospective investors in their funds (as opposed to fraud against the funds themselves). Basically, if you had any doubt, thou shalt not rip off thy limiteds. Clarifying the SEC's authority after the Goldstein decision seems like an acceptable step, although I believe that it is not truly necessary given the broad authority that the SEC has under existing antifraud rules.
One noteworthy aspect of this proposed rule is that it is not based on intent, as most anti-fraud rules are. Thus, someone may find that he has violated the rule unintentionally. In that way, the rule is similar to Section 206(2) under the Investment Advisers Act, which outlaws activities that "operate" as a fraud thus, no intent is necessary. Appropriately, however, there would be no private right of action under the rule, and the rule would not create a fiduciary duty from the advisor to the investor. This is appropriate because the advisor already has a fiduciary duty to the fund that is where the fiduciary duty should lie since the circumstances and attributes of each limited can vary quite a bit.
Second, our rule proposal would significantly narrow the pool of investors eligible to invest in hedge funds and private equity funds. The SEC's accreditation standards were put into place in 1982 and are meant to limit hedge fund access to investors who can afford to enlist help in their due diligence before investing and who can afford to bear any losses. Years of inflation and rapidly rising housing values have expanded the number and kinds of people who meet the current accreditation standards.
The proposal would create a new category of accredited investor for private investment pools that would include anyone who satisfies the existing $1,000,000 net worth or the $200,000 net income test and owns at least $2.5 million in investments, which would exclude the person's home. The new investment minimum would be adjusted for inflation every five years. Essentially, then, the proposed rule would layer an additional requirement on top of the existing accredited investor requirements for Section (3)(c)(1) funds. Section (3)(c)(7) funds would not be affected since investors in those funds already are similarly subject to a two-part test.
I invite you all to examine this portion of the proposal carefully. Did we get the level and mechanics of the threshold right? The changes in accreditation do not apply to venture capital funds. Is there a principled reason for treating venture capital funds differently than other private investment vehicles? Does the proposed rule adequately allow for employee investments? As proposed, employees would have to satisfy the two-part test unless they were counted among the permissible 35 non-accredited purchasers. Should the proposed rule be changed to permit grandfathering of current hedge fund investors? As it is written now, an investor would have to satisfy the tests at the time of investment, which means that an existing investor in a hedge fund might be precluded from making additional investments. The comment period is open until March 9, so I encourage you to let us know what you think.
Only a handful of comments have come in so far, but a number of these are from investors who would not meet the new threshold and object to their proposed exclusion from hedge funds. One of these early commenters explained his objection as follows: "Many of us have heard the expression the rich get richer. Part of the reason that statement is frequently true is because the rich see investment opportunities that the rest never see. And part of the reason the rest never see them is accredited investor rules."20 Another commenter suggested that a better approach would be for the SEC to administer a financial sophistication test on its website.21 Only those who passed the exam would be permitted to invest in hedge funds.
I share these commenters' concerns about the potential unintended effects of raising the accredited investor threshold. It is difficult to draw appropriate lines, and I suspect that the SEC would find it even more difficult to administer sophistication tests. Practically speaking, low net-worth retail investors are not the target audience of hedge fund advisors. Most hedge fund advisors simply do not have the capability to target and service these investors, who have relatively little to invest. The Managed Funds Association, for example, prepared a white paper in 2003 that suggested an increase in accredited investor standards for natural persons.22 I do worry about how the new threshold will affect newly established hedge fund advisors without much of a track record. These advisors will have to try to attract capital from what may prove to be a very small pool of potential investors. The rule, therefore, may prove to be a barrier to entry.
Less-affluent investors might take comfort in the fact that even wealthy investors may be backing away from hedge funds. According to a recent survey by Spectrem Group, in 2006 there was a 29 percent decline in hedge fund investments by households with $25 million or more in assets.23 To address the concerns of investors who will not satisfy the new test, the Commission should do what it can to pave the way for access to alternative investments through products with appropriate safeguards. Specifically, the Commission needs to be open to new products. As things work now, proposals for new products are all too often met with suspicion and often they fall between the cracks between the Commission's Divisions of Investment Management, Market Regulation, and Corporation Finance.
I would like to end my remarks today by addressing an issue that has been featured prominently in the news over the past week so-called "empty voting" and "vote morphing."24 Professors Henry Hu and Bernard Black from the University of Texas Law School addressed these activities in a number of recent articles,25 and I raised the issue a week ago today in the corporate governance context of direct shareholder nomination of directors a policy issue that has been debated for several years now. Empty voting and vote morphing derive from the fact that, in today's financial markets, economic interests and voting rights do not always go together. Share lending programs and equity derivative instruments make it possible for voting rights to belong to someone who does not hold an economic interest.
In one example, a hedge fund owned a significant stake in a company targeted in a stock-for-stock tender offer. The hedge fund stood to profit greatly if the acquisition went through. However, dissident shareholders of the acquiring company were objecting that the deal was overpriced and should be abandoned. So the hedge fund purchased a 9.9 percent stake of the acquiring company, but then entered into equity swaps and other transactions to eliminate any of its economic interest in the acquirer. Thus, you had a situation where this hedge fund could vote a significant block of the acquirer's shares to approve a transaction which would, in turn, benefit the hedge fund but arguably hurt the shareholders of the acquirer.
As far as I can see, there is nothing illegal about the practice, although it does add complexity to the corporate governance discussion, particularly because of the lack of transparency of the voting. Indeed, in many cases, the economic benefit to a shareholder of having a vote in a particular corporate decision may be outweighed by the economic benefits attainable through share lending you cannot both lend your shares and vote them at the same time. It also raises interesting fiduciary-duty issues: Should those of you who manage money on behalf of others be taking the most economically profitable course, even if that means foregoing a vote, if you do not have a great interest in the outcome of the vote? I do find it ironic, however, to hear pension funds that have profited richly from the practice of stock lending decrying voting by borrowers.
As a consequence, though, the fundamental historical assumption that shareholders will vote in accordance with their ownership interests has been called into question. A shareholder who votes at a shareholder meeting might hold no economic interest, or possibly even, a negative economic interest in the corporation. This situation reminds us that principles about voting in the political context are not perfectly applicable to voting in the corporate context.
Thank you all for your attention this morning. I hope that you enjoy the rest of your conference. Through the continued efforts of people like you who invest in, advise, or provide services to the alternative investment sector I am confident that our markets will continue to exhibit unparalleled efficiency and liquidity. In the meantime, I am interested to hear what is on your minds. I would be happy to take questions about the issues that I discussed or anything else that the Commission should be thinking about.