Speech by SEC Chairman:
SEC Open Meeting: Registration of Hedge Fund Advisers
William H. Donaldson
U.S. Securities and Exchange Commission
October 26, 2004
The second, and final, item on our agenda is a recommendation from the staff of the Division of Investment Management that we adopt rules and amendments, proposed last July, to require managers of certain private investment pools, commonly known as hedge funds, to register with the Commission as investment advisers.
Most hedge funds are organized in ways that avoid triggering the registration requirements of the Securities Act, the Securities Exchange Act, and the Investment Company Act, and many hedge fund managers avoid registration under the Investment Advisers Act by relying on a safe harbor rule, adopted by the Commission in 1985, that permits an investment adviser to count a legal organization as a single client so long as the investment advice provided is based on the organization's investment objectives rather than those of any owner or owners of the organization.
In recent years, the Commission has been faced with escalating growth in the hedge fund industry - the number of funds, investors, and investment managers participating in the industry, as well as the assets under management are all rising rapidly. From what we can tell, the number of hedge funds has increased at least five-fold over the last 10 years. The dollar value of funds invested in hedge funds is reportedly approaching the $1 trillion mark - up fifteen-fold in the last 10 years.
Five years ago, the near-collapse of the Long Term Capital Management hedge fund vaulted these investment vehicles into the headlines - bringing into focus the role they were playing in the financial markets. At that time, the Commission rejected the idea of changing its rules to preclude hedge fund advisers from relying on the safe harbor. In the intervening period, there have been major changes in the hedge fund industry - both in the number and size of funds, and in the demographics of its investors - that warrant the Commission's reconsideration of this position.
Over two years ago - in June 2002 -- the Commission decided to reconsider the hedge fund issue. The staff, at the direction of the Commission, commenced a sweeping study of the hedge fund industry. The staff's efforts were complemented by a two-day roundtable held by the Commission in May 2003, and the results of the staff's efforts, along with preliminary recommendations were published in September 2003.
The report elicited considerable interest, debate and discussion within and outside the Commission, and amongst a broad cross-section of interested parties -- building on the observations made in the staff report, and the public meetings and staff investigations that preceded the report.
One of the recommendations that the staff made in its 2003 report was that the Commission consider requiring hedge fund advisers to register as investment advisers, taking into account whether the benefits outweighed the burdens of registration. Last July, the Commission proposed new rules and amendments that would implement this recommendation.
Recognizing the important policy issues implicated by the proposal, the Commission included an extensive request for comment on each aspect of the proposal. This request was augmented by a series of additional questions posed by Commissioners Glassman and Atkins in their dissenting statement. Following an extensive review of the comments, the Division is here this morning to recommend that we adopt the rule substantially as proposed, with revisions that address specific issues raised by the commenters.
Before I ask my colleagues to present their observations on the proposal before us I would like to make a few comments.
I think we can agree that by all accounts the hedge fund industry is growing explosively. As you suggest, the number of funds, investors, and investment managers participating in the industry, as well as assets under management are rising rapidly, particularly in the past five years. You have acknowledged the benefits of liquidity provided to the markets in which the funds operate and cite the investment flexibility, mobility, and potential for sustained returns available to hedge fund investors.
Likewise, you have provided a detailed catalogue of concerns regarding the obligations the SEC must face in terms of investor protection and enforcement of our securities laws, and most particularly the prevention and prohibition of fraud - our central mission. Your concerns derive not only from the size and growth of the industry but also from the evolving configuration of the investor base. That ranges from funds of hedge funds, available to relatively small investors, to the increasing investment by institutions such as pension funds and endowments and charitable foundations, the beneficiaries of which include individuals whose circumstances vary widely.
You have cited the increased incidence of fraud perpetrated by those funds and noted how difficult it is to deter this fraud or to discover this fraud before it happens due to our lack of a required compliance regime and examination and inspection authority.
You have spoken of others already subject to the Investment Advisers Act, who register with as little as $25 million under management, when we have not exercised our jurisdiction over the advisers to the some $1 trillion dollar hedge fund industry.
In short, it would seem that the weight of evidence is overwhelming that we accept the staff recommendation. In fact, to not do so would be a major dereliction of the Commission's responsibility. And yet, over the course of the intensive analysis of the past five years there remain objections by some.
And as part of a fair attempt to evaluate such objections, I have sought, personally and professionally, to see the other side of the arguments. Arguments which go something like this:
- The SEC does not have the resources to devote to this task. My answer to this is that we do have the resources if we are able to apply our manpower and expertise in an effective, risk-based system designed not only for this responsibility but ultimately as an underpinning for all examinations and inspections conducted by the Commission.
- To bring hedge fund managers under the Investment Advisers Act will create a false sense of security - a kind of good housekeeping seal of approval. To any student of the role of the SEC, it is clear that in no sense does our oversight of investment companies or investment advisers address itself to the merits of the investments or the advisers. In fact, the Investment Advisers Act anticipated this concern and explicitly prohibits registered advisers from making any representation that we have recommended or approved them.
- We have not done enough study, nor have we allowed enough time to receive comments or entertain alternative registration schemes. As the Investment Management Division has noted, the intensive review of the issue over the past two years is self-evident. The extended exchange of views over that period, the publication of a major study on the topic out for almost a year of comment, then a formal comment period of customary length after the publication of proposed rules, and the willingness to review comments even after the official deadline passed, all seem to refute this argument.
I won't catalog or repeat other areas of disagreement on the proposal, for to do so would be redundant. But I do ask several rhetorical questions:
- If more than 40% of all existing hedge fund managers have already registered voluntarily and have testified to its being a minimal burden, why is it that others resist?
- Without registration, how can we begin to understand fully the impact that hedge fund advisers have on the broad market of individual, institutional, and professional investors with which the funds trade?
- How can it be seriously argued that our policy objective ultimately is to regulate investment concentrations or strategies, when we have no authority to do so under the Advisers Act, and we have never sought to do so for the past 64 years?
As we proceed this morning I look forward to any comments from the staff or Commission that might refute or question the general direction of my thoughts and analysis.
But before I ask my Commission colleagues for their statements, I would like to ask the staff two questions:
Several of the commenters suggested that the Commission does not have authority to adopt a rule that requires hedge fund advisers to 'look through' the hedge funds they manage for purposes of counting clients. I would like the General Counsel to address these arguments - and give us his analysis of the Commission's authority in this area.
Alternatives to Registration
Commissioners Glassman and Atkins, in their dissents at the proposing stage, asked commenters to discuss alternatives to registration that addressed the concerns raised in the proposal. Many of the examples of alternatives described in the dissent were ideas that had been considered by the staff and the Commissioners in the evolution of what ultimately became the Commission's proposal. Did the commenters offer any fresh insights about these ideas, or any new alternatives that had not previously been considered?