Speech by SEC Staff:
Remarks Before the 4th Annual Hedge Funds and Alternative Investments Conference
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
The Securities Industry and Financial Markets Association
New York, N.Y.
May 23, 2007
Good morning. It is a pleasure to be here and I appreciate S I F M A inviting me to speak with you at this very relevant conference. Today I propose to update you on the regulatory developments related to the hedge fund industry and discuss the Commission's recent activities in this area. It has now been almost a year since the DC Court of Appeals vacated the Commission's rule requiring hedge fund managers to register with the Commission. Coincidentally, it has also been just over a year that I have been in my current job in the Division of Investment Management. As the court decision left what Chairman Cox has described as a significant hole in the regulatory and oversight structure applicable to hedge funds and their investment advisers, my first 12 months on the job have been focused to a large extent with determining the best way that void could be filled — and how to do so in a balanced manner that would allow the industry to continue to develop while still providing hedge fund investors with appropriate protections. However, I have observed over the past twelve months, that some of the regulatory gap left by the court decision has been addressed, to a certain extent, by a multi-faceted approach to overseeing the industry. Although the Division is continuing to consider how best to monitor hedge funds and their service providers efficiently and effectively, this morning I'd like to review how I believe oversight of hedge funds has evolved over the past year. Before I begin, however, I need to state clearly that my remarks here today represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.
1. Registered Hedge Fund Advisers
To start, one way that those operating hedge funds are being regulated is through the original means contemplated by the rulemaking that was ultimately vacated by the Court — registration of hedge fund advisers with the Commission. Although many advisers to hedge funds did withdraw their registrations following the D.C. Circuit's decision in June last year, a significant number seemed to have voluntarily maintained their registrations. Specifically, about 2,000 of the approximately 10,000 investment advisers currently registered with the Commission indicate they advise at least one hedge fund. While about 350 hedge fund advisers appear to have withdrawn their registration as a result of the court decision, we have also seen 83 advisers register since the decision for a net reduction of only about 270 advisers. Some other hedge fund advisers have withdrawn their registration apparently for reasons other than the decision. Because the impact of the court decision raised certain issues that would have been problematic for newly-registered hedge fund advisers, the staff issued a no-action position, even before the issuance of the Court's mandate, that enabled hedge fund advisers to remain registered with the benefit of certain accommodations the Commission had made regarding certain provisions of the Investment Advisers Act and its rules.
2. Hedge Fund Related Rulemaking
In addition to the staff no-action position, the Commission has engaged in proposed rulemaking in the past twelve months, acting to propose two rules. First, in December last year, the Commission proposed an anti-fraud rule under the Investment Advisers Act that would clarify, in light of the DC Circuit's decision, the ability of the Commission to bring an enforcement action against investment advisers, including those that advise hedge funds, in certain situations. The court decision expressed the view that for purposes of the anti-fraud provisions in the Advisers Act, the client of an investment adviser managing a fund is the fund itself, not the investors in the fund. The rule would clarify that the Commission may bring an action against investment advisers who defraud investors or prospective investors in a hedge fund or other pooled investment vehicle.
The second protection that the Commission has proposed is to revise the availability of Regulation D to certain private investment vehicles (including hedge funds) relying on the section 3(c)(1) exclusion provided by the Investment Company Act. Specifically, in addition to the current accredited investor requirements for individuals ($1 million net worth or $200,000 of income ($300,000 with spouse)), these investors would also have to have $2.5 million in investments. As this audience is certainly aware, hedge funds and other private investment pools have become increasingly complex and involve risks not generally associated with many other issuers of securities. Not only do these funds use complicated investment strategies, but there is minimal information available about them in the public domain. Thus, investors may not have access to the kind of information provided through the Commission's system of securities registration and may find it difficult to appreciate the unique risks of hedge fund investments, such as conflicts of interest, complex fee structures and the higher risk that may accompany these investments' anticipated returns.
The comment period for both these proposals has closed and the Division staff is closely reviewing the over 500 comments the Commission has received. In considering a recommendation for adoption of these regulations, the staff is taking the time necessary to undergo the appropriate analysis to develop a balanced and effective regulatory scheme. Your comments on these proposals have been quite helpful to us as we work towards this goal.
In developing the Commission's regulatory approach related to hedge funds, the Commission is also working closely with our fellow U.S. financial regulators. In this regard, the proposed new rules are consistent with another development in the area of hedge fund regulation — the recently signed President's Working Group paper on private pools of capital. As you know, the President's Working Group consists of the leaders of the four major US financial regulators — Treasury, the Federal Reserve, the Commodity Futures Trading Commission, as well as the Commission — and has, among other things, been focused on better coordinating hedge fund oversight. The Commission is a party to the Working Group statement that recognizes that private pools of capital, such as hedge funds, bring significant benefits to the financial markets. The statement also endorsed limiting the offering of private pools only to investors with the sophistication to identify, analyze, and bear the risks associated with them and ensuring that investors in those pools obtain accurate and timely historical and ongoing material information.
Another way the Commission staff is working to make sure we get it right when it comes to regulating and monitoring hedge funds is to pay attention to what regulators in other countries are doing. Hedge funds are truly a global phenomenon and throughout my first year at the Commission, I have had numerous meetings with foreign regulators to hear their perspectives and compare and contrast the various regulatory approaches to governing the industry.
Perhaps the most relevant scheme to the US market is that of the UK and, consequently, I have paid particular attention to the FSA's regulatory approach and industry developments in that country. In fact, just over 100 hedge fund advisers located in the UK are currently registered with the Commission, more than from any other foreign jurisdiction and accounting for about half of the registered advisers located outside the US who indicate that they advise hedge funds. In becoming more familiar with the U.K.'s regulatory scheme, I have been struck by the similarity of the UK's principle-based approach to regulation, as opposed to the use of detailed, prescriptive rules, and the approach taken here to regulating advisers, including those that advise hedge funds, under the Investment Advisers Act of 1940. When enacting the Advisers Act, Congress recognized the diversity of advisory relationships and through the principle-based statute provides them great flexibility, with the overriding obligation of fiduciary responsibility. In spite of this similarity in approach, the regulatory scheme in the UK differs from the current scheme here in certain regards. For example, the FSA requires advisers to hedge funds to register, imposing certain qualification and disclosure requirements, while advisers here are not subject to these requirements. Although I believe we always need to be careful not to succumb to regulatory competition, and the potential race to the bottom that it can lead to, the differences in the UK and US approaches to hedge fund regulation are particularly notable at a time when the US has been under fire for having more rigid regulatory requirements that are reportedly driving market participants to more favorable foreign jurisdictions.
3. Hedge Fund Oversight Through Examination and Enforcement
The third way in which the hedge fund industry is being overseen is through the Commission's examination and enforcement programs. In these ways, the staff can identify areas where hedge fund advisers are deficient in their compliance with the federal securities laws and influence their behavior, if necessary, through enforcement and the threat of enforcement. I would like to briefly review with you some of the deficiencies the Commission's exam staff has identified regarding investment advisers to hedge funds.
One area in which the Commission's exam staff has identified deficiencies with respect to hedge fund advisers is their insider trading policies. When considering these policies, the staff looks at whether they are tailored to the specific facts and circumstances of the firm and considers factors such as the affiliations of investors in the hedge funds and the likelihood that those investors could be mined for non-public information, as well as the types of investment strategies a hedge fund follows, such as distressed debt and bank loan participations, as well as the use of long/short equities.
Another area in which the Commission's examination staff has identified deficiencies with respect to hedge fund advisers is in regard to their compliance policies and procedures, specifically as they address the possible use of non-public information to make investment decisions for hedge funds and personal accounts. An important component of compliance procedures in regard to this issue is the regular use of insightful forensic tests to determine any interesting patterns of investment decisions that evidence a problem in this area. For example, if the percentage of profitable trades in personal accounts of affiliated persons who are active traders are conspicuously high, it may be reasonable to make some additional inquiries as to why these people have so many winning trades in their personal accounts.
The exam staff has also identified many of the same deficiencies with respect to hedge fund advisers as are identified with respect to advisers to traditional products, such as issues relating to trading, brokerage, best execution, valuation, marketing and incomplete books and records.
The Commission has also remained very active in its pursuit of enforcement actions against hedge fund advisers. In the last eight years, the Commission has brought over 100 enforcement cases against investment advisers to hedge funds or their personnel, including against advisers not registered with the Commission.
4. Institutionalization of the Hedge Fund Industry
Another way that hedge funds are being regulated in the U.S. is through self-imposed mechanisms that have developed as the industry has evolved and become more mature and established. The development of these mechanisms was, I believe, prompted in part by the changing type of hedge fund investors. Hedge funds, as you know, are no longer the exclusive investment choice of high net worth individuals. Rather, the increasing popularity of these funds among institutional investors such as endowments, pension funds and funds of funds has led to changes in the industry as hedge fund advisers have responded to the requirements of these clients. This resulting institutionalization of hedge funds has been leading to an evolving, market-oriented regulation of the industry, at least for the segment of the industry with these types of investors. For example, pension funds, subject to the "prudent person" standard of ERISA, may be more cautious, more risk averse and demand greater quality oversight of their capital such as more transparency, risk information and reliable valuation techniques. As a result, industry best practices among hedge funds with these investors have developed and risk measurement and management technology has, I believe, become more sophisticated.
5. Investment in Registered Products
A fifth way in which hedge funds or at least hedge fund trading techniques, in a sense, are being regulated is through the rise of new products that provide retail investors the benefits of typical hedge fund investment strategies, but through mutual fund products registered with the Commission and that are subject to the protections of the Investment Company Act. An example is the so-called long/short, or 130/30 funds that have gained increased popularity in the past year. These funds apply the common hedge fund strategies of shorting and leveraging but do so within the regulatory limits allowing funds to leverage up to one-third the value of their assets and to engage in short sales as high as 50% of assets. Other hedge fund-type funds are using leverage, usually involving borrowed money or derivatives, in order to increase their returns.
These types of funds, while providing retail investors exposure to hedge fund investment strategies, may, like hedge funds themselves, raise certain regulatory and investor protection concerns. For example, conflicts of interest issues may arise when an adviser is managing both a long/short fund and a traditional mutual fund in a side-by-side arrangement. In this situation the manager could be tempted to short stocks that the long-only fund may be about to sell, or one fund's shorting could have a negative impact on a fund that planned to sell, thereby raising concerns that one fund was favored over another. In addition, I have in the past expressed concerns about funds using leverage and derivatives in a retail context, particularly for retirement investors who are investing in funds based on the potential yields they can provide. Derivatives are complicated, and, as I have said before, it is imperative that funds, and those that sell fund shares, are clear about how yield is generated, whether yield is from income, and the risks that may be associated with a fund and its yield generation techniques. Investors may be taking on more risk than they realize. Furthermore the introduction of increasingly complicated alternative products may raise issues for firms in adapting their operational processes to keep up with concerns such as tracking and valuation, and any other issues they must address to remain compliant with requirements under the Commission's regulations.
However, with the proper safeguards, I believe the potential benefits from hedge fund-type strategies should not be limited to only wealthy investors. To the extent that there are limitations under the Investment Company Act, the Division staff will work with you through the exemptive application and no-action processes to develop products that not only provide investors greater access to beneficial investment strategies, but also provide them the protections that are necessary. For example, with regard to long/short funds, the staff came out with a no-action position stating that a registered fund may take short positions, provided that it has placed liquid securities that could be used to close out its short positions in a segregated account with its custodian.
I want to thank SIFMA again for inviting me to speak with you this morning. The area of hedge funds is an incredibly exciting and dynamic area to be a part of at this time. I am certainly enjoying my role in determining how to provide hedge fund investors necessary protections, as well as appropriate access to hedge fund vehicles, while at the same time allowing the hedge fund industry to grow and evolve. I am hopeful that if we all do our part in encouraging compliance with each regulatory facet governing the industry, hedge funds will remain a positive and beneficial force in our capital markets. I thank you for listening this morning and hope you enjoy the rest of the conference.