Statement by SEC Staff at
Open Commission Meeting Considering Registration Under the Advisers Act of Certain Hedge Fund Advisers
Paul F. Roye
Director, Division of Investment Management
U.S. Securities and Exchange Commission
July 14, 2004
Good morning, Chairman Donaldson, and Commissioners Glassman, Goldschmid, Atkins and Campos.
I am pleased to be here this morning to present the Commission with the Division of Investment Management's recommendations for a new rule and rule amendments under the Advisers Act that would require hedge fund advisers to register with the Commission as investment advisers.
Our recommendations come as a result of the Commission staff's extensive study of hedge funds and their managers. Two years ago, the staff began an investigation of hedge funds and hedge fund advisers. We reviewed, with the assistance of the Office of Compliance Inspections and Examinations, some 65 hedge fund advisers (both registered and unregistered) managing approximately 650 different hedge funds with over $160 billion of assets. We also spoke with numerous legal and accounting experts, with risk managers, hedge fund investors, prime brokers, hedge fund industry representatives and consultants, and foreign and domestic regulators. Just over a year ago, you hosted a 2-day Hedge Fund Roundtable so that we could all hear the views of a broad spectrum of interested persons. Last Fall, we provided you with our report on the Implications of the Growth of Hedge Funds.
What did we find?
First, the hedge fund industry is growing by leaps and bounds. As you mentioned, Mr. Chairman, the number of funds has increased fivefold since 1993, and their assets have increased fifteenfold to $850 billion. Some projections suggest that hedge funds will shortly have more than a trillion dollars of assets.
Second, we have seen an increase in fraud cases involving hedge fund advisers. In the last five years, we have identified 46 hedge fund frauds resulting in investor losses of over $1 billion. In these cases, hedge fund advisers have misappropriated funds, misvalued assets to cover losses, and overstated their performance to obtain performance fees to which they were not entitled. As if these cases were not sufficiently troubling, we now know that a number of hedge funds played a prominent role in the late trading and market timing scandals involving mutual funds. Let us not forget the Canary Capital hedge fund--each dollar of the huge profits it made before getting caught came out of the pockets of mutual fund investors.
Third, relatively new vehicles called funds of hedge funds are being offered to smaller investors with investment minimums currently as low as $25,000. These vehicles provide retail investors access to hedge funds that they ordinarily would not be able to invest in directly.
Additionally, more public and private institutions, such as pension plans, have started to entrust their assets to hedge fund advisers. It is not the case anymore that only the wealthy and rich are exposed to the risks of hedge fund investing. Many people listening to these proceedings would be surprised to find out that some substantial portion of their pension fund is invested in a hedge fund, or that part of their union benefit plan is invested in a hedge fund. As returns on equities fell after the end of the last bull market, administrators of pension funds and benefit plans have been increasingly drawn to alternative investments with strategies that can involve substantial risks. These are trends that we only see continuing.
These trends convinced us that the Commission needs to detect and prevent fraud at an earlier stage, and prevent these fraudulent activities from damaging markets and harming average investors who are rapidly becoming the ultimate beneficiaries of hedge fund investments. In most of the hedge fund fraud cases we have seen, the Commission's involvement began long after investors' assets were gone.
We considered the alternatives, and rejected many because they would interfere with the operation of legitimate hedge funds. We recognize that hedge funds play an important role in our markets, and we do not want to do anything that negatively impacts their ability to fulfill this role. Therefore, we do not recommend, for example, subjecting hedge funds to the Investment Company Act or regulating them in the same manner that we regulate mutual funds, which could limit hedge funds' use of certain investment strategies. Instead, we recommend that you close a loophole in the rules under the Investment Advisers Act to require all hedge fund advisers to register as investment advisers. Registration under the Advisers Act would provide an unobtrusive system of regulation that is appropriately tailored to the operation of hedge fund advisers and their funds. Registration would address several concerns and provide numerous advantages.
1. Census Information. Registration would give us basic information about hedge funds-who manages them, their affiliates and who controls the advisers that run them. Today, we cannot even tell you for sure how many hedge funds there are or the amount of assets they hold. This is basic information the Commission needs about an industry that is increasingly becoming an important player in our markets.
2. Deterrence and Early Discovery of Fraud. Registration would give the Commission authority to conduct examinations of all hedge fund advisers. Examinations, which OCIE conducts, permit us to identify frauds in an early stage, permit us to identify compliance problems at an early stage, identify practices that may harm investors, and provide a deterrent to fraudulent conduct.
There are those who will argue that adviser registration and examination will not stop fraud. True, our examiners are never going to catch everything. Police officers do not prevent all crime, but no one offers that as a reason to take them off the streets. It's the threat of being caught that makes a difference in people's behavior. We have seen examples of investment advisers withdrawing their registration once their hedge funds began to experience huge losses and the advisers then proceeded to cover them up. There is nothing unique about hedge fund advisers or the types of fraud that some have committed that suggest our examination program could not play the same role it plays with respect to other advisers. Our examiners will be looking for the same types of frauds committed by other advisers, including misappropriation of assets, falsifying performance records and improper valuation of assets.
There are those who will argue that the SEC should not focus its resources on hedge fund advisers, but rather concentrate on areas where retail investors have exposure. But as I indicated earlier, smaller investors increasingly are being exposed to the risks of hedge fund investing. Moreover, the Commission already is dedicating resources to hedge fund oversight through the Division of Enforcement, which can only bring actions against hedge fund advisers after investors are harmed and assets gone.
Additionally, as a component of Chairman Donaldson's new risk management/assessment initiative, we have been working to develop an enhanced risk based approach to oversight and examination of not only mutual funds, but also investment advisers, including hedge fund advisers. Chairman Donaldson has specifically directed that members of the Commission's senior staff, including the head of the Office of Compliance Inspections and Examinations, the Director of the Division of Market Regulation, the Chief Economist, the General Counsel, as well as myself, work together to develop risk assessment protocols which could be used to identify investment advisers whose activities are raising `red flags' that suggest a more focused, cause inspection may be in order. Such an approach would permit the Commission to leverage its resources, increase its surveillance capacity and target the use of examination resources to high risk advisers.
Internal Compliance Controls. Registration would require hedge fund advisers to adopt internal compliance controls critically necessary to prevent violations that can harm investors. These hedge fund advisers manage tens of millions of dollars of other people's money under arrangements that are potentially fraught with conflicts but, in many cases, with almost no oversight of their activities. While we are not going to be there all the time; it is important that the hedge fund adviser have a compliance officer who is there day in and day out.
We have heard complaints that registration under the Act is too burdensome and expensive.
- We acknowledge that putting in place compliance policies and procedures involves an investment of resources time and money. But these firms should already have a compliance system in place to prevent violations of the Act's anti-fraud provisions that apply to them even if they are not registered. Moreover, remember that just this year the Commission unanimously adopted an important rule requiring all registered advisers to adopt compliance procedures and policies administered by a chief compliance officer. But many of these advisers manage much less money than most hedge fund advisers. So an argument about the burdens of registration by a hedge fund manager with $100 million under management charging a management fee of 2% plus 20% of profits is simply not credible.
- Many hedge fund advisers register voluntarily under the Act in order to attract investment from certain types of clients. These advisers would not voluntarily subject themselves to burdensome, costly or inflexible regulatory obligations.
We have also heard concerns that registration under the Advisers Act will somehow dull the creativity or impair development of new or aggressive investment strategies. However, the Act does not prohibit or restrict any legitimate investment strategy. Half of the ten biggest (and presumably most successful) hedge fund managers are registered with us.
There also are those who will argue that the answer to addressing hedge fund concerns is to raise the wealth threshold for hedge fund investors. But it should be noted that registration of hedge fund advisers under the Advisers Act will essentially have the effect of requiring all clients invested in hedge funds to meet wealth standards that are higher than the current minimums.
Now, let me clarify what the Division is not recommending you propose today.
- It's not about whether the Commission should have jurisdiction over all hedge fund advisers. You already do; they are subject to the core provisions of the Advisers Act, including the anti-fraud provisions.
- And it's also not about whether the Commission should have oversight over hedge fund advisers. We estimate that close to half of eligible advisers to hedge funds are currently registered with the Commission. OCIE is already examining those advisers.
Rather, the issue on the table today is whether hedge fund advisers should be able to opt out of registration with the Commission, as they currently can. Under the current rules, an adviser that has fifteen or fewer clients (and does not hold itself out generally to the public as an investment adviser) does not have to register under the Act. The exemption was designed to exempt advisers whose business is too small to warrant federal attention. Under our rule 203(b)(3)-1, however, an adviser can count each hedge fund as a single client. Here are the consequences:
- An adviser that manages money for 15 clients must register under the Act. If he sets up a hedge fund, he can manage the same client assets through the hedge fund and avoid registration.
- Without registering under the Act, an adviser can manage 14 hedge funds each one of which can have up to 499 investors and thus manage the assets, albeit indirectly, of almost 7,000 clients. If the hedge funds had investors that were funds of hedge funds, the numbers would increase exponentially.
Some who have come before us objecting to the prospect of requiring all hedge fund advisers to register, when pressed on this issue, have acknowledged that they simply do not want Commission oversight. In moments of candor, lawyers for hedge fund advisers have admitted that their clients often push the line as to what is legally permissible and their clients do not want to be second-guessed. Unfortunately, the Commission's enforcement docket demonstrates that many have crossed that line.
The current situation reminds me of an old story about children at a school party. A line had formed for all the goodies, and a teacher was stationed at the head of the table making sure each child took just one apple. After a while, one of the kids in the class posted a sign at the other end of the table where the cookies were piled saying "take as many cookies as you want, she's watching the apples."
Today, Mr. Chairman, the situation with hedge fund advisers is that the Commission has the ability to watch only the apples but not the cookies. Accordingly, we recommend you propose a new rule requiring all hedge fund advisers to register with the Commission. Now let me turn to Jennifer Sawin who will briefly explain the specifics of the rulemaking.
Check against delivery.