Speech by SEC Staff:
General Session Speaker at the SIA Hedge Funds Conference: New Regulation: Weighing the Impact
Paul F. Roye1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
New York, NY
November 30, 2004
Good morning and thank you for inviting me to be with you here this morning. I appreciate the opportunity to speak with you about the Commission's new rule requiring hedge fund managers to register with the Commission as investment advisers. This rule has been one of the most widely-debated initiatives to come out of the Division of Investment Management since the beginning of my tenure, and I understand that the hedge fund industry is concerned about how it may affect the operation of their business. Indeed, the title of this conference -- "weighing the impact" -- is telling in this regard. Today I would like to present my perspective on the new rule and outline for you how we arrived at our conclusion that the rule was necessary and why the Division staff recommended that the Commission adopt it. I will also review what the rule is intended to accomplish, and, finally, I will discuss what I expect will be the impact on the hedge fund industry. Before I begin, however, I need to remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.
II. So How Did We Get Here?
While the creation of the modern hedge fund, credited to Alfred Winslow Jones, occurred as early as 1949, hedge funds first entered much of the general public's consciousness only about six years ago with the near-collapse of Long Term Capital Management. Although there is no statutory or regulatory definition of a hedge fund, they are typically organized by investment managers who often have a significant stake in the funds they manage and receive a fee based on a percentage of the fund's capital gains and appreciation. Hedge funds also utilize a variety of investment styles and strategies designed to typically achieve a positive, absolute return, rather than measuring performance against a securities index or benchmark. In this way, hedge funds provide substantial benefits to markets and investors by taking speculative, value-driven trading positions that can enhance liquidity and contribute to market efficiency.
Another defining characteristic of hedge funds is that they traditionally have been organized by professional investment advisers in ways that avoid regulation as investment companies under the Investment Company Act as well as the registration requirements of the Securities Act and the Securities Exchange Act. In addition, many hedge fund managers, although they are investment advisers, avoided registration under the Investment Advisers Act by taking advantage of an exemption from registration for small investment advisers - those with fewer than 15 clients. Hedge fund advisers qualified for this exemption by pooling client assets and creating limited partnerships, business trusts or corporations in which clients invest. Because advisers were permitted to count each partnership, trust or corporation as a single client, they avoided registration while maintaining, indirectly, a large number of clients.
While Long Term Capital Management highlighted the significant role hedge funds play in the financial markets, over the last few years we have seen major changes in the hedge fund industry, including tremendous growth in both the number and size of hedge funds, as well as in the demographics of their investors. These developments prompted the Commission, over two years ago, to begin an investigation into the hedge fund industry. What followed was one of the most extensive examinations of any regulatory initiative in which the Division of Investment Management has participated.
Beginning in June 2002, at the direction of the Commission, the staff commenced a sweeping study of the hedge fund industry. The study involved meetings with hedge fund industry participants, a series of exams by the Commission's Office of Compliance Inspections and Examinations, and review of documents and information from 67 different hedge fund managers managing 650 hedge funds with $162 billion of assets under management. 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 shared their views on hedge funds and the appropriateness of the current regulatory structure governing them. In response to Chairman Donaldson's request for comment on issues discussed at the Roundtable, the Commission received about 80 comment letters that helped shape the thinking of the staff and the Commissioners on hedge fund issues. Additionally, over the past two years, Chairman Donaldson testified at several Congressional hearings on hedge funds, and the staff received input and guidance from the President's Working Group on Financial Markets and from fellow regulators both here in the US and abroad.
In September 2003, the staff study culminated in the publication of a report "Implications of Hedge Fund Growth." The primary recommendation in the report was hedge fund adviser registration under the Investment Advisers Act. We saw no justification for direct regulation of hedge funds themselves under the Investment Company Act. Despite reports to the contrary, we have no interest in impeding the manner in which a hedge fund invests or placing restrictions on a hedge fund's ability to trade securities, use leverage, sell securities short or enter into derivatives transactions.
In July, the Commission issued a proposal to implement the staff study's principal recommendation by requiring hedge fund managers to count the number of investors in their hedge funds for purposes of determining whether they qualify for the exemption from registration for advisers with fewer than 15 clients. On October 26th, the Commission voted to adopt the final rule. You should expect the release outlining the final rule to be available shortly.
III. Why is the Rule Necessary?
While some may dispute this, the Commission's decision to both propose and adopt the hedge fund adviser registration initiative was shaped by considerable study, consultation and thoughtful review. Although public comment on rulemakings is typically received only after a proposal has been issued, in this case, the Commission benefited from significant public input throughout the two-year process. In fact, the evidence collected presented such a case for oversight of the hedge fund industry, Chairman Donaldson was prompted to state that "To not accept the staff's recommendation [to require hedge fund adviser registration], would be a major dereliction of the Commission's responsibility."
In making this statement, Chairman Donaldson cited a number of serious concerns that had arisen throughout the investigation that formed the basis for the staff's recommendation:
1. Tremendous Growth and Great Potential Impact
One of our primary concerns was the industry's tremendous growth. While no one knows for certain, it is estimated that in the last five years, the industry has grown by 260 percent, with assets of $870 billion in approximately 7000 funds. In the last year alone, it is estimated that hedge fund assets have grown over 30 percent. When this explosive growth is coupled with the fact that hedge funds also tend to be very influential and active traders, it becomes clear that hedge funds have a great potential impact on our capital markets. Indeed, one report estimates that hedge funds represent approximately ten to twenty percent of US equity trading. Another report portrayed a single hedge fund adviser as being responsible for an average of five percent of the daily trading volume of the New York Stock Exchange, while another report indicated that hedge funds dominate the market for convertible bonds.
2. The Need for Reliable Industry Data
Yet in spite of hedge funds increasing prominence in our financial system, no government or regulatory agency has reliable data on the hedge fund industry, including the number of hedge funds or how much they have under management. At the Commission, we have been relying on information from third-parties, which often conflict and may be unreliable. Without meaningful information, our ability to fulfill our investor protection mandate by truly understanding the impact that hedge fund advisers have on our securities markets and the broad market of individual, institutional, and professional investors with which hedge funds trade, is severely compromised.
3. Broader Investor Demographic
Another concern was the increasingly broad investor demographic who, directly or indirectly, are investing in hedge funds. Lower minimums and the rise of funds of hedge funds have permitted a growing number of smaller investors into hedge funds. Funds of hedge funds today represent approximately twenty percent of hedge fund capital and are the fastest growing source of capital for hedge funds today. In developed markets outside the United States, hedge funds have sought to market themselves to smaller investors and we can expect similar market pressures to develop in the United States as more hedge funds enter our markets. The beneficiaries of private and public pension plans are also increasingly exposed to the risks of hedge funds as these entities are investing greater amounts in hedge funds. One study on this issue 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 was simply too large to ignore. Loses resulting from hedge fund investing and hedge fund frauds could affect the ability of these entities to satisfy their obligations to their beneficiaries or pursue other intended purposes.
4. Increased Fraud
Finally, the growth in hedge funds has also been accompanied by an increased number of enforcement cases involving hedge funds and their advisers. In the last five years, the Commission has brought 51 cases involving hedge fund fraud, resulting in investor losses of more than $1.1 billion. Hedge fund adviser enforcement cases represented more than 10 percent of the Commission's cases against investment advisers over the same period, providing a strong signal to us that we should be concerned about abusive activity in this area.
In addition, we are seeing hedge funds used to defraud other market participants. Hedge fund advisers were key participants in the recent scandals involving mutual fund late trading and inappropriate market timing. We have identified almost 400 hedge funds and 87 hedge fund advisers involved in these cases and all too often hedge funds were the late traders and abusive market timers.
IV. Need for Commission Action
The SEC is the federal agency with principal responsibility for the enforcement and administration of the federal securities laws and the supervision of the securities markets. Our obligation under these laws, as well as our commitment to protect investors, require us to respond to important market developments and the authority provided us by these laws, permit us to adopt rules and interpret the statutes in order to preserve fair and honest markets.
Our view is that, in light of the growth of hedge funds, the broadening exposure of investors to hedge fund risk and the growing number of instances of malfeasance by hedge fund advisers, our regulatory program for hedge fund advisers was inadequate. We did not have an effective program that would provide us with the ability to deter or detect fraud by unregistered hedge fund advisers. We were forced to rely almost entirely on enforcement actions brought after fraud had occurred and investor assets were gone. We lacked basic information about the industry.
V. What Will Registration of Hedge Fund Advisers Accomplish?
Registration under the Advisers Act will give the Commission the tools it needs to address these various concerns and monitor the activities of hedge fund advisers to proactively address issues within the hedge fund industry.
First, registration will provide the Commission with the basic census-like information about hedge funds and their advisers that we currently lack, including the number of hedge funds, their managers, and their assets under management. With registration, hedge fund advisers also will now be required to provide, in a uniform format, certain fundamental information to their investors 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. The rule also requires hedge fund advisers to maintain auditable books and records.
Registration will also permit us to screen individuals associated with an adviser and to deny registration if they have been convicted of a felony or had a disciplinary record subjecting them to disqualification. In this way, we can seek to keep fraudsters, scam artists and others who have a record of fraudulent behavior out of the hedge fund industry.
To further assist in reducing the potential for fraud, hedge fund advisers are now required to adopt policies and procedures designed to prevent violations of the Advisers Act and to designate a chief compliance officer. Many hedge fund advisers, whether registered or unregistered, already have these in place. In addition, these requirements do not dictate that firms adopt a specific compliance program, but rather represent the basic compliance practices that all well-run advisers - including those that advise hedge funds - should follow. This requirement will better protect hedge fund investors and will benefit hedge fund advisers who should have a compliance infrastructure commensurate with the nature of their operations and the risks involved.
Finally, the new rule gives the Commission the ability to examine hedge fund advisers. Examinations permit us to identify compliance problems at an early stage and practices that may be harmful to investors. They also provide a deterrent to unlawful conduct as even the mere potential of an examination, and the increased risk of getting caught, may work to discourage wrongdoers.
The ability to conduct hedge fund examinations also allows the Commission to extend to hedge funds a new risk management initiative set forth by Chairman Donaldson. The initiative is intended to anticipate potential risks to investors and the markets in order to avert crises and scandals before they develop. As part of this program, the staff has been working to develop an enhanced risk based approach to oversight and examination of investment 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, and myself, work together to develop risk assessment protocols that could be used to identify investment advisers whose activities are raising "red flags." It is anticipated that this approach will allow the Commission to increase its surveillance capacity and better target the use of examination resources to high risk advisers.
VI. Impact on Hedge Fund Industry
I would now like to turn to the question of the day: How will the requirement that hedge fund managers be required to register impact the operations of the hedge fund industry? For the majority of participants in the hedge fund industry, who I believe are honest and ethical, the impact on their operations will be very small. And that is exactly what was intended. As I noted at the meeting at which the Commission considered adoption of the rule: "in recommending that hedge fund managers be required to register, we recognize and deeply appreciate the beneficial role that hedge funds play in our financial markets and we do not intend to impede the industry's ability to flourish and grow." Chairman Donaldson seconded this sentiment when he rhetorically asked: "How can it be seriously argued that our policy objective [in adopting the rule] 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?"
Our goal is to develop an oversight regime for the hedge fund industry that imposes minimal regulatory burdens and hindrances on its participants while providing the Commission the tools to fulfill its investor protection mandate. The requirement that hedge fund advisers register under the Advisers Act strikes the right balance and will not interfere with hedge funds' important function as the providers of efficiency and liquidity in our markets.
First, as referenced by Chairman Donaldson, the Advisers Act is primarily a disclosure and anti-fraud law and does not require an adviser to follow or avoid any particular investment strategies, or prohibit specific investments. Registration under the Act simply will not hamper the legitimate operation of hedge funds. For example, we estimate that currently 40 to 50 percent of hedge fund advisers voluntarily are registered with us, many of them for some time. When comparing performance, a recent study found that there were no significant differences between hedge funds managed by unregistered advisers and those managed by registered advisers. Moreover, five of the ten largest and presumably most successful hedge fund advisers are registered with the Commission. Also, more than 8,500 advisory firms that collectively manage over 23 trillion dollars in assets are registered under the Advisers Act. We have seen no credible evidence that the Act has in any way impeded their ability to employ successful investment strategies or to effectively compete with other financial institutions that manage securities portfolios in this country or abroad.
We also understand from hedge fund managers who are registered investment advisers, that registration does not interfere with their operations nor impose substantial burdens. While we expect that this will be true for most hedge fund advisers now required to register, we hope that allowing firms well over one year, until February 2006, to comply with the rule will minimize any transition burdens. In the Division of Investment Management, we also look forward to working with participants in the hedge fund industry and will do what we can to help you understand and implement the new requirements.
The new requirement for hedge fund adviser registration is the result of a long and intensive process that involved substantial public debate. Although the new rule will not adversely affect the day-to-day operations of the hedge fund business, the creation of a system of compliance and oversight is a milestone in the history of the hedge fund industry. History has shown that in the securities markets, the introduction of appropriate and balanced regulation has served as a springboard for substantial industry growth and development. This has been the case with the enactment of the Advisers Act, as there are now 8,500 advisers registered with the Commission with over $23 trillion of assets under management. With hedge fund adviser registration, I believe that the appropriate balance has been met, and that hedge funds' important role in our financial system, will not only be preserved, but enhanced and strengthened.
Thank you for listening.