Speech by SEC Commissioner:
Remarks before the Managed Funds Association
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
New York, NY
September 29, 2005
Thank you, Jack for that kind introduction. Before I begin, I must remind you that the views that I express here are my own and do not necessarily represent those of the Securities and Exchange Commission or my fellow commissioners.
I am pleased to be here with you today as you discuss sound practices for hedge funds. This latest version of sound practice guidelines and the prior versions upon which they build belie the notion to which proponents of mandatory registration subscribe that "[u]nregistered hedge fund advisers operate largely in the shadows, with little oversight."1 As the MFA's 2005 Sound Practices notes, "the most effective form of industry oversight is self-evaluation combined with the development of strong practices and internal controls."2 SEC mandates are no substitute for the implementation of careful, consistent controls by hedge fund advisers. To this end, the Sound Practices set forth guidelines for hedge fund advisers to implement such functions as risk monitoring, valuation, business continuity and disaster recovery planning.
The decision of last October, which was taken over Commissioner Glassman's and my opposition, to require all hedge fund advisers to register was a rejection of the notion that this industry can function legitimately without the SEC's blessing. Of course, I need not remind you of that decision, especially those of you who are in the throes of getting your paperwork in on time to meet the February 1st registration deadline, reducing your policies and procedures to writing, and otherwise gearing up for life as an SEC registrant.
Just as some of you are working hard to prepare to deal with us, we at the SEC are struggling to get ready to deal with you. I say "struggling" because we have neither the resources nor the expertise to oversee all of the potential new registrants. The precious time and attention of our examination staff is being diverted to the oversight of advisers that manage the money of a relatively tiny number of sophisticated investors -- my estimate is fewer than 200,000, maybe even 100,000. Compare that number to the more than 90 million mutual fund investors and you would be justified in asking whether we are doing the right thing.
That very question was posed recently by the Government Accountability Office ("GAO"). Just last week, the GAO issued a report on SEC mutual fund oversight. The report cited the hedge fund rule as an "oversight challenge facing the SEC's mutual fund examination program"3 and questioned the "SEC's capacity to effectively monitor the hedge fund industry … given the tradeoffs that the agency has had to make in overseeing the mutual fund industry."4
Tradeoffs are necessary when a staff of approximately 500 examiners oversees 8,000 funds and 8,000 investment advisers. Over the past several years, our Office of Compliance Inspections and Examinations ("OCIE") has experimented with several different approaches to allocating its staff resources. In the course of this experimentation, the length of examination cycles for firms has fluctuated. It is impossible to examine each firm every year or even every other year.
In 1996, Congress recognized this problem, particularly the growing backlog and inability of the SEC to have a credible examination program. At the time, examinations could take place as infrequently as once every 12 to 24 years! So, Congress divided up the responsibility of examining investment advisors between the States and the SEC - generally, those with $25 million or more of assets under management would fall under the SEC's aegis. Congress figured that providing a more manageable universe of advisors for the SEC to follow would create a more realistic examination schedule.
During the ensuing seven years to 2003, the advisor population continued to grow. OCIE started moving to a risk-based approach, which is designed to deploy staff resources into high-risk areas, while allowing for continued monitoring of the largest firms. It assigned firms to a two-, four-, or five year examination cycle, with the largest firms on a two-year cycle. Since 2003, OCIE has made further adjustments to its examination cycle as it relies more heavily on sweep and cause examinations. Of course, a problem with this approach is that some firms deemed to be low-risk could go unexamined for years since OCIE will randomly select for examination only ten percent of these low-risk firms each year. As the GAO observed, our "inability to conduct examinations of all mutual funds within a reasonable period may limit [our] capacity to accurately distinguish relatively higher risk funds from lower risk funds and effectively conduct routine examinations of higher risk funds."5 The GAO also identified weaknesses in OCIE's quality control measures.6 Again, staff shortages seem largely to blame.
Therefore, the hedge fund rule aggravates an already difficult situation. According to staff estimates, by February, up to 1,260 new advisers could register with the SEC in response to the rule, which would increase the pool of registered advisers by as much as 15 percent.7 The SEC's current budgetary problems make it unlikely that we will be able to hire more examiners in response to the increased registrant pool.
Moreover, the newly registered hedge fund advisers may pose unique challenges for our examiners. While it is true that many hedge fund advisers already are registered with us, and that many of the things that examiners look for are common to any registered money manager - such as recordkeeping requirements, custody, sufficiency and accuracy of disclosure - the new registrants may employ complex structures that our examiners have not seen before.
The Sound Practices reject one-size-fits-all solutions and recognize that there is a wide variety of hedge fund advisers for which no one approach is universally appropriate. OCIE, overwhelmed by the sheer number of new registrants and by the nuances within the hedge fund industry, may be tempted to impose one-size-fits-all mandates. After all, it is much easier for an OCIE examiner to check for compliance with a uniform set of standards than to take the time to assess whether a particular hedge fund adviser has designed and implemented a set of controls that will be effective given its size, the nature of its investments, and the investment strategy that it employs. Examination models designed for traditional advisers may not easily translate to the hedge fund context in areas such as valuation techniques and risk management.
To familiarize examiners with a broad range of hedge fund issues, OCIE will start an in-depth series of hedge fund training sessions for its examiners next month. In connection with this effort, OCIE has enlisted the assistance of the MFA and others with practical and academic hedge fund experience. I hope that this training will improve examiners' ability to distinguish the true problems from harmless departures from the "standard" approach. While I am heartened by OCIE's attempts to equip its examiners for the diversity and complexity that they will find at hedge funds, I am concerned about the many hours being diverted from the oversight of mutual funds and other registered advisers. We have seen time and again over the years just how difficult it is for any examiner or auditor to ferret out fraud at large and small retail-oriented investment advisors using straightforward long strategies. Fraudsters, of course, tend to be crafty and go to great lengths to hide their fraud.
Even if it were proper to make the protection of the small and sophisticated ranks of hedge fund investors a regulatory priority of the SEC, a registration requirement would not be the right approach. One-size-fits-all regulatory mandates, although generally well-intentioned, deprive investors of decision-making power that is rightfully theirs and may impose costs on investors that do not produce a proportionate return. Investors are best able to make this determination. Because many hedge fund advisers have registered voluntarily, investors for whom this level of oversight is important already can select from among registered advisers. If SEC-registration were perceived to be uniformly desirable, the market - meaning investors -- would eventually lead all hedge fund advisers to register.
Investors will still be able to choose unregistered hedge fund advisers, but to do so, they will have to agree to a lock-up period of more than two years. Advisers to funds that do not permit redemption within two years are not subject to the registration requirement. In structuring the rule in this way, we have strengthened incentives to lengthen lock-up periods and have thereby made it harder for investors to recover their money from bad or fraudulent advisers.
The two year lock-up is intended to distinguish hedge funds from venture capital and private equity funds, which are not deemed appropriate subjects of SEC examinations "at this time."8 As I warned before the rule was adopted, advisers to these kinds of funds should be worried that their time, too, will come. The distinctions between advisers to hedge funds and private equity funds are blurring, particularly as hedge fund managers are looking for new ways to produce the returns that their investors demand. Until registration disparities are eliminated, investors who don't want to absorb the costs of registration may opt for private equity and venture capital funds.
The hedge fund registration requirement may constrain investor choice further by discouraging foreign investment advisers from serving American clients. The rulemaking requires offshore advisers, like U.S. advisers, to look through the funds that they advise and count U.S. clients. Advisers to master funds have to look through to count the U.S. clients of feeder funds. Advisers that hit the magic number of 15 U.S. clients generally are required to register, but are exempt from compliance with some substantive requirements under the Act. The release acknowledges that "as a practical matter, U.S. investors may be precluded from an investment opportunity in offshore funds if their participation resulted in the full application of the Advisers Act and our rules."9 But even "registration light," under which our books and records requirements apply and the prospect of an SEC examination looms, could scare off foreign advisers and cause U.S. investors to miss out on investment opportunities.
Some proponents of hedge fund adviser registration view any fraudulent behavior that involves an unregistered adviser as evidence of the necessity of a registration mandate. I share their belief that we should not tolerate fraud, market manipulation, insider trading, misappropriation of client funds, cherry picking, misvaluation, and favoritism in allocation (just to name a few) from registered or unregistered advisers. However, we do not need registration as a hook to pursue fraud. I would caution registration advocates to moderate their expectations. A former commissioner mused that
if we had been going into the hedge funds [that were involved in market timing] it would have been easy for our inspectors to have seen what was wrong. Using any kind of risk analysis, and looking at how money was being made, it is perfectly clear to me that had we been inspecting hedge funds, we would have picked up the scandals earlier.10
Why, then, did we not discover the practice by looking at the funds, advisers, and broker-dealers that were registered with us? In some cases, funds' advisers entered into agreements with market timers to allow them to time the funds in exchange for promising to keep a certain amount of money invested in the adviser's fund complex. In others, broker-dealers profited handsomely from facilitating market timers' evasion of funds' late trading and market timing restrictions.
It is, of course, true that some unregistered hedge fund advisers have committed fraud. Registered hedge fund advisers, however, also employ fallible and yes, even corrupt, human beings. It would be naïve to believe that crooks who call themselves "hedge fund advisers" will register in compliance with our rulemaking and become upstanding citizens. In both the unregistered and the registered context, the SEC is poorly positioned to prevent problems from happening or even to discover them once they do. Regardless of whether an adviser is registered, we often rely on a disgruntled investor or former employee of the adviser or a suspicious third party, such as a prime broker, to alert us. The Sound Practices offer a better answer than registration. I submit that investors can take greater comfort in knowing that a firm has implemented these practices than in knowing that it has registered with the SEC. If they wish, investors could also demand third-party affirmation of compliance with these practices, as registered funds and others do with SAS 70 reviews.
Some have argued that the SEC must try to look wherever it can for fraud, if only to discourage potential fraudsters from taking the risk of being caught. After all, the argument goes, police do not just completely ignore parts of their city and need to be on the look out for crime wherever it may occur. We know that hedge funds are not immune to fraud, so it is incumbent on us to at least turn over some of the rocks to look for the worms.
But, is this a fair comparison? Police departments would be rather derelict if they did not take some sort of risk-based approach to their job and the allocation of their resources. If one area of town is made up of estates with private security guards, the police force might be justified to rely on the occasional call reporting a burglary (rather than sending a patrol car driving through the neighborhood) and focus its attention on more densely populated areas known for high crime or for a large, unprotected population that is susceptible to being victimized. The SEC has broad jurisdiction over the financial markets, and regularly acts on tips with respect to parts of the markets that are unregistered. This applies not only to unregistered advisors and funds, but also to municipal securities, Rule 144A securities, and real estate and other scams that are really securities frauds. These areas are not regularly policed by the SEC, even though we have seen some egregious problems develop at least in some of them.
We cannot put a lifeguard on every beach. In many places, signs that say "No swimming" or "Riptides - Swim at Your Own Risk" must suffice. If you swim anyway, and get into trouble, we hope that the Coast Guard (at considerable expense to the taxpayer) will get to you in time to rescue you. If you go skiing, you know pretty much what to expect when you stick to the blue, red, or black runs. You need to decide what your own risk tolerance is. There may be the unexpected ice patch or mogul, but overall those slopes are groomed and policed. On the other hand, if you want to ski off-piste or go helicopter skiing in the Bugaboos, you had better know what you are doing and take appropriate precautions, including checking out the terrain on your own or hiring someone who can guide you.
In justifying the SEC's hedge fund rule, Chairman Donaldson explained at the time, "[t]he goal [of the hedge fund rule was] simple: to enable the Commission to collect more accurate information and to enhance the Commission's ability to oversee this important industry."11 In recent months, the staff has sat down to consider what information it can glean from Form ADV. They have been disappointed in what they have found. I hate to say that I told you so, but . . .
The information on Form ADV is unlikely to provide any new information to investors who have performed even the most minimal level of due diligence about an adviser. Nor will Form ADV provide us the necessary inputs for our risk-based examination model. What can we do about this? Well, we can ask for more information more often. The staff is mulling over ways to get more data from the industry such as requiring that information be filed periodically with the SEC. Although proponents of registration insisted that they were not interested in hedge fund advisers' investment strategies, might not the staff conclude that strategies are a relevant factor in assessing risk?
I hope that we will deliberate carefully before deciding whether to undertake additional regulation of hedge fund advisers. As you are likely aware, the SEC recently underwent a change of leadership. Chairman Christopher Cox comes to the job as an insightful, engaged, enthusiastic leader. I anticipate that we will see a renewed, receptive attitude to the benefits of an economic, cost-benefit analytical approach to regulation overall. As a consequence, I hope that we will see a reasoned approach towards the implementation of the hedge fund rule. I hope that we will be able to implement the rule in a manner that acknowledges the positive role that hedge funds play in our markets.
One thing that will determine how well we achieve these objectives is how well we work with other regulators. We did not make serious efforts to reach out to other regulators before we adopted the hedge fund rule. At the meeting adopting the rule, Commissioner Glassman famously asked the staff if they had talked to the other regulators regarding alternatives to our registration requirement. Upon getting the response that yes, they had, she asked: "Well, did you listen to what they had to say?" We should have worked with our counterparts to assess the collective data about hedge fund advisers. Now that the rule is in place, we should coordinate closely with the CFTC, Treasury, the Federal Reserve, the Department of Labor and others domestically to determine how best to parcel out our regulatory responsibilities. We also should work with foreign regulators to gain a better understanding about the interaction of our requirements with foreign regulatory frameworks. Systemic concerns about hedge funds should be handled at the level of the President's Working Group ("PWG"), which is made up of the heads of the Treasury, the Federal Reserve, the CFTC, and the SEC.
As we have seen, though, the SEC ignored alternatives and ploughed ahead. The Adopting Release reassuringly dismissed "inchoate fears" "about what the Commission might in the future do that could adversely affect the operation of hedge funds."12 Those of you who had already voluntarily registered might have taken some comfort in those words. Others of you are undertaking the preliminary steps to meet the rule's February 1st registration deadline, but, after the initial hassles of registering, are not anticipating much of a burden. Are you comfortable in accepting assurances that the burdens of registration are minimal when some registered advisers are undergoing multiple simultaneous document requests or examinations conducted by different regional offices of the SEC? Are you confident of the SEC's regulatory restraint when registered advisers are complaining that it has become common practice for SEC examiners to request all of a firm's email in searchable format with very short turnaround times? Can you rest assured that the recently introduced requirements that advisers must designate a chief compliance officer and develop and maintain written compliance policies and procedures will not be followed by other substantive requirements?
Some of you, counting on the disproportionately small number of SEC examiners, may be planning to toss the dice and assume that you will not make it onto the SEC's radar screen. That is not good business practice for you nor the best service to your investors. A wiser approach is to take this opportunity to improve your operations by implementing the Sound Practices in a manner that is consistent with your business model. The bottom line is that while registration with the SEC is unlikely to make your investors sleep better, your adherence to the Sound Practices will enable them to sleep soundly.
Ultimately, we cannot overstate that this discussion comes down to what is best for investors in this space - their empowerment over how they want to spend their own money, since they are the ones who in the end bear the costs of regulation. Some wags say that hedge funds are merely compensation schemes in search of an investment strategy. In that case, I can guarantee you that the costs of regulation will eventually be passed on to the investor. The investors in hedge funds are not investing out of necessity, but choice. They can vote with their feet, especially before they hand over a check. They have the ultimate power to decide whether or not they want the protection of registration.
That is what is so false about what I call the "pension fund canard" - the assertion that because pension funds invest in hedge funds, the average pension fund beneficiary is exposed to hedge fund risk. Needless to say, that goes for any unregistered investment - 144a securities, OTC derivatives, and real estate. Most importantly, pension funds have both the legal, fiduciary duty and the means to hire managers and advisers to help them invest their beneficiaries' money wisely.
I like to compare these sorts of rules to buying insurance on a house. Some people are very risk averse and arguably buy too much insurance in order to feel safe. They bear that cost voluntarily and with notice. Others might not buy any -- preferring to self-insure and take the risk. Many more are somewhere in the middle. Some in fact call many of our SEC mandates "insurance" against unhappy or tragic events for investors. Thus, in many cases, these rules decide for investors how much "insurance" they should have through a one-size-fits-all approach. Insurance generally may be helpful -- it protects against the down side and can bolster confidence. Unfortunately, sometimes we may have no idea whether a particular insurance policy is worthwhile, is related to the risks it seeks to address, will provide any commensurate benefits to those who pay the premiums, or worse, create a moral hazard for investors in their investment decisions because they rely on government action. In that case, it is best to let them make their own decisions.
Thank you for your time and attention. I look forward to working with you as you join the ranks of registered advisers. I welcome your questions and comments now or as they arise in connection with or after registration. Please feel free to call, or if you're in Washington, DC, to stop by my office.