Speech by SEC Staff:
Remarks Before the Hedge Fund Best Practices Seminar: Succeeding in the New Regulatory Environment
Cynthia M. Fornelli
U.S. Securities and Exchange Commission1
Hedge Fund Best Practices Seminar
New York, NY
September 14, 2004
Thank you very much for inviting me to speak to you today regarding the SEC's hedge fund adviser registration initiative. This topic could not be more timely, given that the comment period on the Commission proposal closes tomorrow. We have already received a large number of comments (57 as of yesterday), and we expect today and tomorrow to be very busy days in the SEC's mailroom.
Before I discuss the Commission's proposal and what I believe to be the merits of hedge fund adviser registration, I need to remind you that my comments here today are my own views and do not necessarily represent the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.
II. The Commission's Proposal
Exactly two months ago, on July 14th, the Commission voted to propose that hedge fund managers be required to register as investment advisers under the Investment Advisers Act of 1940. As most of you know, under current laws, hedge fund managers are investment advisers, but can avoid registration with the SEC by counting each hedge fund-and not each investor in a hedge fund-as a client for purposes of the exemption from adviser registration for small investment advisers (those that have fewer than 15 clients). The Commission proposed to change the "counting clients" rule, so that hedge fund managers would be required to count the number of investors in their hedge funds for purposes of determining whether they have fewer than 15 clients.
Unlike most of the SEC's rulemakings, the public debate regarding the appropriateness of the current hedge fund regulatory regime and the need for SEC rule changes did not begin with the Commission's proposal. In fact, the hedge fund industry, the investor community, federal regulators and the staff and Commissioners of the SEC have been discussing hedge funds and the oversight of their managers since the Commission, under then Chairman Harvey Pitt, launched a staff study of hedge funds in June 2002, over two years ago. The staff study culminated in a comprehensive staff Report issued last September on the "Implications of the Growth of Hedge Funds." The primary recommendation in that Report was hedge fund adviser registration under the Investment Advisers Act.
Highlighting the staff study was a two-day Hedge Fund Roundtable, held by the Commission, at which hedge fund managers, investors, prime brokers, consultants, regulators, industry observers and others (some of whom are participating in today's panels) shared their views on hedge funds and debated the appropriateness of the current regulatory structure applicable to hedge funds and their advisers. In addition, in response to Chairman Donaldson's request for comment on issues discussed at the Roundtable, the Commission received approximately 80 comment letters, which helped shape the thinking of the staff and the Commissioners on hedge fund issues. Furthermore, in response to a Commission call for comment upon the publication of the staff Hedge Fund Report, the Commission received additional letters commenting on the staff's analysis and recommendations.
The Commission and staff also received valuable input and guidance from the fellow members of the President's Working Group (which includes the heads of the Board of the Federal Reserve, the Department of Treasury and the Commodities Futures Trading Commission in addition to the SEC Chairman); from state securities regulators through the North American Securities Administrators Associations, known as NASAA; and from foreign financial regulators.
Consequently, the Commission's hedge fund adviser registration proposal was shaped by considerable study, consultation and thoughtful review. The Commission benefited from significant public input in advance of its proposal and did not come lightly to the decision to propose registration of hedge fund advisers and take a more active role in its oversight of the hedge fund industry.
III. The Debate
Not all industry participants, however, agree with the decision of the Commission to propose hedge adviser registration as a proactive effort to address a growing and increasingly influential, yet not fully understood, segment of our nation's securities markets.
The Commission's proposal intensified the continuing debate regarding whether the SEC should proactively seek to protect investors. I have been surprised by the intensity of the debate and by the opposition of some to SEC efforts to fulfill its mandates under the federal securities laws. While on its face, this debate may seem complex and multifaceted, it really comes down to a central point: do investors deserve the protection of the U.S. securities laws, even when the investment vehicle they chose provides significant liquidity to the markets?
Here are the facts. The potential for securities fraud in the hedge fund industry is great and increasing. The number of hedge funds in existence has increased five-fold over the last 10 years. Assets in hedge funds now approach $1 trillion, up fifteen-fold over the same period. Of course, while growth and success are not fraudulent, there is often an increased potential for fraud, as the lure of big money returns and opportunities to game a partially unregulated system become irresistible for some unsavory operators. Already, over the past five years, the Commission has brought 46 enforcement cases asserting that hedge fund investors have been defrauded of an estimated $1 billion by their advisers.
Many investment managers - some experienced and some not so experienced - have abandoned other sectors of the investment management industry to take advantage of hedge funds' lucrative performance-compensation arrangements. These arrangements -which, as you know, are typically a two percent management fee plus a 20 percent or higher performance fee - provide powerful incentives for potentially unscrupulous managers to claim inflated performance, however achieved or demonstrated, whether by over-valuing their portfolios; engaging in market manipulating activities; or unfairly allocating "hot" IPOs to hedge funds to the detriment of other entities they manage.
Moreover, hedge funds can have a disproportionate impact on the market relative to their size, using borrowing, leverage and quick in and out trading techniques to affect millions of smaller, less sophisticated investors each day on the "other side of the transaction." As the recent mutual fund scandals demonstrate, innocent investors can be gravely impacted by hedge fund manager misdeeds. In addition to the 46 fraud enforcement cases brought by the Commission in the last 5 years, at least another 40 hedge funds or their advisers have been implicated in the abusive market timing and late trading schemes that defrauded millions of mutual fund investors.
The proposed rule requiring registration of hedge fund advisers is designed to confront the likelihood of increased fraud in a number of ways. Registration would provide the Commission with basic, census-like information about the hedge fund industry, such as the number of hedge funds, their managers, and their assets under management. Registration also would require hedge fund advisers to provide, in a uniform format, certain fundamental information to their investors. Information such as any disciplinary history of a hedge fund's principals and how the hedge fund manager identifies possible conflicts of interest and how those conflicts are addressed.
Undoubtedly, the rule also would require hedge fund advisers to maintain auditable books and records and to appoint a compliance officer to administer the adviser's own policies and procedures designed to ensure compliance with U. S. securities laws. And finally, registration allows the Commission to inspect hedge fund advisers in order to prevent fraud or at least detect it early on before the blood is on the floor. The mere potential of an inspection works wonders for making the negligent careful and the fraudulent compliant.
The rule would allow the SEC to better oversee hedge fund managers without in any way impeding the way that hedge funds go about trading. The proposed SEC approach would not limit the amount of leverage hedge funds use, force them to alter or disclose their legitimate proprietary trading strategies or impede their contributions to the formation of capital or providing the markets with liquidity. This is because the Commission is seeking to regulate hedge fund managers under the Investment Advisers Act - which is primarily a disclosure and antifraud law - and not under the Investment Company Act - which is a law that grants us greater authority to restrict and even prohibit certain investments and transactions.
Currently, we estimate that 40 percent to 50 percent of hedge fund advisers voluntarily are registered with us, and many of these advisers have been registered for some time. Clearly, these advisers do not feel constrained by the registration and inspection process. Indeed, numerous hedge fund managers not only accept the proposal to register as a reasoned approach to addressing a growing concern regarding hedge funds, but also encourage the SEC's action as a way of ensuring the integrity of this growing industry. They acknowledge that registration will lead to better compliance by all of those in the industry and will raise the bar on hedge fund compliance standards.
While some may disagree with the Commission's hedge fund adviser registration proposal, it is motivated by the belief that all investors deserve the protections provided under the Advisers Act. Even hedge funds that market to investors with a minimum $1 million investment can commit fraud that harms average investors. The significant number of cases in which hedge fund managers were involved in late trading and abusive market timing of mutual funds are classic examples of average investors "on the other side of the transaction" suffering from fraud perpetrated by hedge funds.
Hedge funds are no longer the province of only the wealthy and sophisticated. Many employees--such as teachers, police officers and firefighters--participate in public pension funds that in turn invest in hedge funds. Often an employee's pension is his/her only form of investment. These employees can ill afford to sustain massive losses caused by unregulated hedge fund managers. To put this into perspective, one study on the issue has calculated a 450 percent increase in pension fund investments in hedge funds over the past seven years. This growth in the level of pension plan participation in hedge funds is simply too large for the Commission to ignore.
Registered funds of hedge funds also have exposed investors to hedge fund investing for minimums as low as $25,000, and hedge fund enthusiasts increasingly ask why only rich people should have access to the high, non-market-correlated returns that many hedge funds have historically offered.
The SEC has been observing hedge funds for years, with increasing concern about the strong growth of those funds and the lack of regulatory oversight of their securities activities. The growth is accelerating and seems to reflect a perceived investor need to protect assets from the type of erosion experienced as the market bubble of the "dot.com era" broke. Many of us at the Commission, as laid out in the staff's Hedge Fund Report and the Commission's proposing release, believe that hedge fund adviser registration is a necessary tool to enable us to prevent fraud in this booming industry. As Chairman Donaldson has said, waiting to act until a major hedge fund fraud explodes, sucking up millions of dollars in lost investments, is unconscionable. To criticize the Commission for not identifying emerging risks early enough with one breath and then arguing against a fundamental tool to better allow us to do just that with another breath, perplexes me.
IV. Risk-Based Focus
Given the astounding growth of the investment management and hedge fund industries, the Commission is acting to create a new risk-based method of focusing all of our resources to better achieve an efficient approach to our surveillance and enforcement responsibilities. This is an approach that is an absolute necessity if we are to effectively manage the new human and technological resources accorded the Commission by Congress to address the escalating complexity and size of the investment markets, and the new forms of fraud and manipulation that are evolving, including in the hedge fund area.
The techniques we are developing will put new hedge fund manager oversight responsibilities at the forefront of our enhanced approach to oversight for all investment advisers. Chairman Donaldson has established an Investment Adviser Task Force at the SEC to examine more proactive and focused methods to oversee advisers. In addition, the Commission staff is actively reviewing the role of technology as a regulatory tool to enhance the Commission's effectiveness as a market overseer.
V. Complementing CFTC Activity
I believe it is important to keep in mind that the Commission's efforts to bolster our oversight of hedge fund advisers will complement CFTC and NFA oversight and examination of commodity pool operators and commodity trading advisors. The SEC's program for overseeing investment advisers and the CFTC's program for overseeing CPOs and CTAs are statutorily designed to be complementary.
In 2000, with passage of the Commodity Futures Modernization Act, Congress took a significant step to avoid duplicative regulation in this area. Under the current statutory framework established by that Act, the CFTC would register and oversee those hedge fund managers that are primarily engaged in the business of acting as commodity trading advisors. The SEC's proposal is not seeking to require Investment Advisers Act registration of hedge fund advisers whose business consists primarily of advising others with respect to investments in futures. Under the Investment Advisers Act, hedge fund advisers that are registered as CTAs with the CFTC can qualify for an exemption from SEC registration if their business does not consist primarily of acting as an investment adviser.
In addition, the CFTC has restructured its oversight of certain hedge fund advisers. As you are aware, the CFTC recently adopted rules that permit many hedge fund advisers to avoid registering as CPOs or CTAs. New entrants to the industry have an opportunity to structure their activities so as to avoid CFTC registration, and existing hedge fund advisers may deregister with the CFTC.
In conclusion, I would like to stress that I fully agree with those, including our fellow financial regulators, who believe that hedge funds can and do play a vital role in our economy by contributing to market efficiency and liquidity. I believe it is important to stress that the Commission's hedge fund adviser registration proposal, if adopted, would not interfere with this important function.
However, I also believe it is important to bear in mind that the Commission's mandate is different from that of other federal financial regulators, who are focused on the safety, soundness, and the systemic properties of our financial institutions and oversight of our commodities markets. The SEC's mission is to protect securities investors and the U.S. securities markets. Is it possible to do that while still preserving the efficiency and liquidity that have made our markets the envy of the world? Yes. We are committed to this goal, and hedge fund adviser registration will help us achieve it.
Thank you very much. It has been a pleasure to be with you this morning.