[Senate Hearing 109-1068]
[From the U.S. Government Publishing Office]
S. Hrg. 109-1068
REGULATION OF HEDGE FUNDS
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HEARINGS
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED NINTH CONGRESS
SECOND SESSION
ON
THE INCREASED SCRUTINY OF THESE LIGHTLY-REGULATED FUNDS AND THE LACK OF
REPORTING REQUIREMENTS, AUDITS, AND INSPECTIONS
__________
TUESDAY, JULY 25, 2006
__________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky EVAN BAYH, Indiana
MIKE CRAPO, Idaho THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina ROBERT MENENDEZ, New Jersey
MEL MARTINEZ, Florida
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Justin Daly, Counsel
Joe Cwiklinski, Counsel
Dean V. Shahinian, Democratic Counsel
Lee Price, Democratic Chief Economist
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
C O N T E N T S
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TUESDAY, JULY 25, 2006
Page
Opening statement of Chairman Shelby............................. 1
Opening statements, comments, or prepared statements of:
Senator Sarbanes............................................. 2
Senator Allard............................................... 3
Senator Hagel................................................ 3
Senator Bunning.............................................. 4
Senator Crapo................................................ 5
Senator Sununu............................................... 5
Senator Bennett.............................................. 6
Senator Stabenow
Prepared statement....................................... 31
WITNESSES
Christopher Cox, Chairman, Securities and Exchange Commission.... 7
Prepared Statement........................................... 31
Response to written questions of:
Senator Bunning.......................................... 44
Senator Crapo............................................ 47
Reuben Jeffery, III, Chairman, Commodity Futures Trading
Commission..................................................... 11
Prepared Statement........................................... 35
Response to written questions of:
Senator Bunning.......................................... 48
Senator Crapo............................................ 52
Randal K. Quarles, Under Secretary for Domestic Finance,
Department of the Treasury..................................... 13
Prepared Statement........................................... 39
REGULATION OF HEDGE FUNDS
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TUESDAY, JULY 25, 2006
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:11 a.m., in Room 538, Dirksen
Senate Office Building, Hon. Richard C. Shelby, Chairman of the
Committee, presiding.
OPENING STATEMENT OF CHAIRMAN SHELBY
Chairman Shelby. The Committee will come to order.
Today the Committee will examine the operation and the
regulation of hedge funds. This hearing is particularly timely,
given last month's Federal Appeals Court decision invalidating
the Securities and Exchange Commission's rule requiring that
certain hedge funds advisers register with the agency.
As the Senate panel with exclusive jurisdiction of hedge
funds, the Banking Committee intends to continue its active
role in overseeing the industry's activities and regulatory
structure.
Hedge funds are flourishing. Just 15 years ago the industry
managed only $50 billion in assets. That number now exceeds $1
trillion. Wealthy investors and large institutions, including
pension funds and universities, have increasingly sought the
portfolio diversification and returns in both bull and bear
markets that hedge funds have been able to provide.
This dramatic growth has attracted the attention of
financial regulators including the SEC. In late 2004, the
Commission adopted its Hedge Fund Rule on the three to two
vote. The agency based its rulemaking on the industry's rapid
growth, the perceived exposure of average investors to hedge
funds, and an increase in enforcement actions brought against
hedge funds.
Now that the rule has been vacated, it is appropriate to
once again consider whether there is a prudent basis for
increased regulation of a dynamic industry that has delivered
considerable returns for its investors and important liquidity
benefits to the markets and has avoided a comprehensive
regulatory scheme on the theory that its sophisticated investor
base can fend for itself.
We must conduct this review in a manner that is mindful of
the context in which hedge funds currently operate in order to
accurately assess the costs and benefits associated with the
choices that we make.
There is a common misperception that hedge funds are
completely unregulated and absolutely secretive investment
vehicles. It is important to note that hedge funds are
currently subject to the market manipulation and anti-fraud
provision of the Federal securities laws. On this point, I want
to note the crucial importance of these laws. They are
fundamental to the operation of the marketplace. It is
absolutely essential for the SEC to uniformly apply these rules
to every individual participating in the capital markets,
without exception.
While we are discussing the integrity of the marketplace
generally, I would like to take a moment and digress from the
topic of hedge funds to express my concern to Chairman Cox
recording the manner in which stock options have been granted
at some companies. I intend to explore these troubling
revelations here further during the question and answer period.
Returning to hedge funds, I would also add that thousands
of funds are currently registered with the SEC and the
Commodity Futures Trading Commission, and thus subject to
oversight and inspections. Moreover, Government regulators have
access to information relating to hedge funds.
I look forward to hearing our witnesses discuss these
issues in more detail.
This morning we will hear testimony from the Honorable
Christopher Cox, Chairman, the Securities and Exchange
Commission; the Honorable Reuben Jeffery, III, Chairman,
Commodity Futures Trading Commission; and the Honorable Randal
K. Quarles, Under Secretary of the Treasury for Domestic
Finance, U.S. Department of the Treasury.
Senator Sarbanes.
STATEMENT OF SENATOR SARBANES
Senator Sarbanes. Thank you very much, Chairman Shelby.
I want to commend Chairman Shelby for convening today's
hearings to examine the hedge funds. Actually, in recent years
this Committee has held several oversight hearings that focus
on hedge funds or at which hedge funds issues were discussed
and I think it is important to underscore that this is an
important area of the Committee's jurisdiction.
The hedge fund industry, as the Chairman has referenced, is
a significant component of the Nation's financial landscape. It
has grown rapidly in recent years. It has an estimated $1.2
trillion of assets under management. Hedge funds have brought
improved liquidity and price efficiency to financial markets.
Millions of Americans are invested in hedge funds, either
directly or more relevantly indirectly through retirement plans
or fund the funds.
Public interest in hedge funds has been growing. Recently,
in a speech to the Federal Home Loan Bank of Atlanta, Chairman
Bernanke of the Federal Reserve noted and I quote him ``The
debate about hedge funds and their effects on financial markets
has now resumed with vigor, spurred no doubt by the creation of
many new funds, large reported in-flow to funds, and a
broadening investor base.''
As investment in hedge funds have grown, public concern has
also grown. This recent article in the Washington Post, which
read Hedge Funds Near Day of Reckoning--I am not quite sure
what the reckoning was to being, but in any event--and a July
20th column in the Wall Street Journal by its Deputy Washington
Bureau Chief David Wessel said, ``How would hedge funds behave
in a crisis? If there is a financial earthquake, will these new
mechanisms turn it into a tsunami? Will we have fewer crises
but bigger ones, that sort that jar whole economies, not just
shake up a few leveraged investors? It is a good time for such
questions.''
Witnesses who previously have testified before this
Committee and other observers have also voiced concerns about
whether there is excessive leverage, the valuation and
transparency of hedge funds assets, whether the standards for
an accredited investor are too low, whether they need to be
adjusted, a potential conflicts of interest involving managers
of hedge funds and mutual funds, and the impact of hedge fund
trading particularly short selling and its potential for market
manipulation on the securities markets.
I join the Chairman in welcoming Chairman Cox, Chairman
Jeffery and Treasury Under Secretary Quarles to the Committee.
We look forward to their testimony about these issues.
Thank you very much, Mr. Chairman.
Chairman Shelby. Senator Allard.
STATEMENT OF SENATOR ALLARD
Senator Allard. Mr. Chairman, I would also like to thank
you for holding this important hearing. Other committees have
some oversight on this, but from my point of view this is the
primary Committee that has oversight as far as hedge funds are
concerned. And so I think this is an important hearing.
Historically, hedge funds provide an investment vehicle for
financially sophisticated investors with sizable capital to
invest. The funds seek to profit in all kinds of markets
through leveraging and other speculative investment practices
that may increase the risk of investment loss. Not all mutual
funds are required to register with the SEC and are not
required to provide the same level of disclosure.
However, as investors look for ways to maximize returns,
more are turning to hedge funds. But do these investors,
particularly those investing in the registered funds of hedge
funds, adequately understand the risks involved? How does less
regulation of hedge funds translate into the capital markets?
This hearing will be a good opportunity to explore these
and other matters. We have an excellent lineup of witnesses
that will be able to provide helpful insight, Mr. Chairman. I
thank them for being here today and look forward to their
testimony.
Thank you for holding this hearing.
Chairman Shelby. Senator Hagel.
STATEMENT OF SENATOR HAGEL
Senator Hagel. Mr. Chairman, thank you. And to our
witnesses, good morning and thank you for your appearance this
morning.
I, like all members of the Committee, Mr. Chairman, will be
interested in hearing what our witnesses have to say. Markets
have, over the years, provided important liquidity for our
economy. We have generally and overwhelmingly benefited from
that liquidity, as we have enhanced our productivity and our
competitive position in the world. There have been spikes of
volatility, bubbles, excesses. We appreciate that.
One of the issues that I know our witnesses will get into
this morning, and it is an area that I would like to ask some
questions on, is do our witnesses believe that hedge funds now
are contributing to an unacceptable amount of volatility in our
markets? What are your projections for the next couple of
years? If we stay where we are, essentially with a very limited
regulatory scheme, is that good? Do we risk continued
volatility or deeper or wider volatility that may, in fact,
impact on our economy and our competitive position in the
world, our future investment opportunities?
Those are the general areas I think, Mr. Chairman, that we
are going to want to hear about today. And I will reserve
further comments and questions until I have an opportunity to
ask the questions.
Thank you.
Chairman Shelby. Senator Bunning.
STATEMENT OF SENATOR BUNNING
Senator Bunning. Thank you, Mr. Chairman.
There have been some major developments since the hearing
on hedge funds in May. As the Chairman mentioned, the SEC rule
requiring hedge funds advisers to register was thrown out by
the D.C. Circuit. So I think it is appropriate to have another
hearing.
The biggest cause for concern about hedge funds is that we
do not know a lot about them. Due to that lack of information,
we cannot be sure how much risk they pose to our financial
systems. I think we need to know more and hopefully we will get
some good answers in this hearing.
A lot of money is invested in hedge funds, some estimate as
high as $1 trillion worldwide. In addition to being a popular
investment option for the wealthy, hedge funds have also become
popular for university endowments and pension funds. A lot of
money and a lot of people's futures are riding on them, and
that raises a lot of questions and concerns.
Not only do hedge funds affect people who are directly
invested in them, but because of their size and speed, they can
affect the entire market when they move. We can all agree that
it is important to take reasonable steps to protect investors.
But even more importantly, we must be sure that we are
keeping a close eye on threats to the stability of our
financial markets. That is why we need to know more about what
hedge funds are doing and what they are not doing. It is not
our job to stop investors from taking any risk. But we need to
address risk to our financial markets and the overall economic
well-being of our country. I hope we can get a better picture
of what is going on and what needs to be done.
I look forward to the hearing, what the SEC has learned in
the brief registration period, and what the agency's plans are
now that the courts have acted. Hopefully, this hearing will
help us to see where we need to go from here.
Thank you very much.
Chairman Shelby. Senator Crapo.
STATEMENT OF SENATOR CRAPO
Senator Crapo. Thank you very much, Mr. Chairman.
I, too, join with everyone who has thanked you for holding
this hearing. It is a very critical and important issue.
It is no secret that I have been a strong critic of the
SEC's Hedge Fund Rule, and it is going to be interesting to me
today to hear from the SEC as to what their intentions are in
terms of moving forward.
I am not going to repeat the kinds of comments that have
already been made by my colleagues here. I share the concerns
that they have raised and the interest that they show.
I do have an additional concern that in this arena, as well
as in many others, I hope that we are going to be able to
create an environment and to find that balance where we create
an environment where business can thrive in the United States
and where we do not get caught up in over regulating business
to the point that we send it overseas. I think that all too
often today we see kind of an overreaction to the need to
assure that we have safety and soundness in our markets, which
I think is a proper objective and which is the line we want to
achieve.
What we are, in my opinion, seeing a dangerous trend in
terms of creating a situation in which the United States is not
necessarily the most favorable climate in which to conduct
business these days.
And so I am going to be looking to see if the incredible
increase in popularity and use of hedge funds has resulted in a
changing dynamic in the marketplace such that it will require
us to extend further regulatory controls and establish new
regulatory regimes in order to assure the safety and soundness
of our markets, or whether we are already at that point where
we have the right balance in place and we simply need to see
the kind of regulatory structure that currently exists properly
and effectively enforced.
It is those kinds of questions that are most interesting to
me, because I believe we have not only the safety and soundness
of our markets at stake here but the issue of whether our
markets will stay our markets if we do not manage and regulate
them properly.
Thank you, Mr. Chairman.
Chairman Shelby. Thank you. Senator Sununu.
STATEMENT OF SENATOR SUNUNU
Senator Sununu. Thank you, Mr. Chairman.
I think as we begin the hearing and prepare to hear from
our witnesses, it is important to be clear about why we are
here. We are here because the D.C. Circuit invalidated a very
significant portion of the hedge fund regulations that the SEC
promulgated in 2004. The D.C. Circuit invalidated this
regulation because this regulation, like several others put
forward by the SEC in the 2002 to 2004 timeframe, was not
designed to address any specific problems that we were seeing
in this area, the financial services industry. And no empirical
evidence was ever provided to argue how, in fact, the proposed
regulations might improve the performance, oversight and
security of this part of the financial services industry, hedge
funds.
And in the absence of any clear definition of a problem
that the regulatory infrastructure is trying to address, and in
the absence of any empirical evidence purporting to demonstrate
how this regulation will improve the efficiency of the markets,
no one should be surprised that a court decides that the way in
which the regulations were put forward was arbitrary or unfair.
I think the lesson here is that in this case the hedge fund
regulation, but in all cases we want the SEC to be clear and
professional and thorough in its recommendation of new
regulations. And that means identifying a problem, being clear
about what we are trying to address, solve or improve in the
financial services industry, make sure that that is consistent
with the SEC's very important mission of protecting average
investors, and then at least make an effort to put together
some empirical data that will suggest that this regulation
might actually solve the problem.
I do not think that is too much to ask. I, and many other
members of this Committee, asked for that very thing time and
time again with regard to this regulation, with regard to other
regulations that have also been struck down by the courts. And
I think if we can make an effort, and I have full faith that
Chairman Cox understands this and that he will make this
effort. But if we can make that effort within the SEC, then I
think we will be less and less likely to have hearings like
this where we all get together and wonder exactly why courts
are striking down regulations and how we proceed from here.
Thank you, Mr. Chairman.
Chairman Shelby. Senator Bennett.
STATEMENT OF SENATOR BENNETT
Senator Bennett. Thank you very much, Mr. Chairman.
My colleagues have covered the issues very well, so let me
just focus on one very small item that is tied to the hedge
fund thing, not suggesting that the other issues are not
important.
By the way, I want to recognize and welcome a fellow
Utahan, Secretary Quarles, to the Committee.
Hedge funds have been in the public eye because of their
involvement in short selling. The whole short selling issue is
a subsidiary issue, I think, of the question of regulation of
hedge funds.
I have engaged in short selling. It has never been
profitable for me. And since I have been in the Senate I have
discovered that there are some who find it profitable because
they never have to cover, and the whole question of naked short
selling has come out.
And I think, in the pursuit of the practice of naked short
selling, we have created an atmosphere where hedge funds may
have been unfairly targeted and that the whole question of
short selling has been attacked as an improper kind of
activity. It is not an improper activity. It is part of the way
the markets work.
But I want to congratulate Chairman Cox on the SEC's
vigilance in going after the naked short selling activity that
has been going on. It was called to my attention by a Utah
company, and frankly not the one that has been in the
headlines, where the organizers of the company had identified
every single share of the stock and had locked it up in such a
fashion that it was not available to be borrowed and there were
still short sales going on. And they said how is this possible
that people are shorting our stock when we are not making any
stock available for that purpose? And that was before the SEC
got involved in chasing this issue.
I may not be able to stay for the whole hearing. I have,
unfortunately, two other conflicts today. But I wanted to use
my opening statement as an opportunity to thank Chairman Cox
for the work the SEC has been doing here, encourage him to
continue to do it, and make it clear that my concern about this
is not an attack on hedge funds as an industry who engage in
short selling because I think, as an industry, there is a place
for them to do that and we need to separate these two issues.
With that, Mr. Chairman, I look forward to the hearing and
the information we will get from our witnesses.
Chairman Shelby. Thank you. Senator Reed.
Senator Reed. Mr. Chairman, I simply want to welcome the
witnesses and look forward to their testimony.
Thank you.
Chairman Shelby. All of your written testimony will be made
part of the record in its entirety. Chairman Cox, we will start
with you. Welcome.
STATEMENT OF CHRISTOPHER COX, CHAIRMAN,
SECURITIES AND EXCHANGE COMMISSION
Mr. Cox. Thank you, Mr. Chairman, ranking member Sarbanes,
members of the Committee. It is a pleasure to be here this
morning. Thank you for inviting me to testify about the
regulation of hedge funds.
It is an especially welcome opportunity to be here with
Secretary Quarles and Chairman Jeffery as representatives of
the President's Working Group on Financial Markets.
As you have recognized, each of us has responsibility for
different but crucial aspects of the world in which hedge funds
operate. That is why the Securities and Exchange Commission is
working closely and cooperatively as a member of the
President's Working Group on the questions of systemic market
risk posed by hedge fund activity, and also the investor
protection issues that stem from the increasing exposure of
retail investors to opportunities for hedge fund investment.
Senator Sarbanes. Mr. Chairman, I think if you would pull
the mic a little closer it would be helpful.
Chairman Shelby. Pull the mic just a little closer.
Mr. Cox. I should emphasize at the outset, Mr. Chairman,
that my testimony today reflects my views as Chairman of the
Securities and Exchange Commission and does not represent the
views of the five-member Commission. The views I am expressing
this morning are solely my own.
It has been 8 years since Long Term Capital Management
collapsed. This spectacular hedge fund collapse left in its
wake serious questions about the threat to our capital markets
as a whole from such significant funds pursuing high risk
strategies with what might be generally, not just in that case,
excessive leverage. In the months that followed, President
Clinton established the President's Working Group on Financial
Markets, with the SEC as a member, to coordinate regulatory
oversight of these issues, as well as other questions that
broadly impact the national securities markets.
Since then the President's Working Group has focused
intently on the concern that the failure of one of more
significant and highly leveraged investment pools, such as the
Long Term Capital Management hedge fund, could threaten the
stability of financial markets. We are more certain now than
ever before that preventing future market instabilities will
require a coordinated effort by all financial securities
regulators.
But given the recent invalidation of the SEC's Hedge Fund
Rule by the United States Court of Appeals, we have been forced
back to the drawing board. Now we have got to devise a new way
to acquire even basic census data that would be necessary to
monitor hedge fund activity in a way that could mitigate
systemic risk.
The current lack of such basic data requires me to hedge
when I say that the SEC's best estimate is that there are now
approximately 8,800 hedge funds, with approximately $1.2
trillion in assets. If this estimate is accurate, it implies a
remarkable growth in hedge fund assets of almost 3,000 percent
in the last 16 years.
Last year we believe an estimated 2,000 new hedge funds
opened for business. And although even now hedge funds
represent just 5 percent of all U.S. assets under management,
they account for about 30 percent of all U.S. equity trading
volume. They are particularly active in the convertible bond
market and the credit derivatives market. We are also seeing
hedge funds become more active in such varied activities as the
market for corporate control, private lending, and the trade of
crude petroleum.
It is undeniable that in addition to raising questions,
such as systemic risk and investor protection, hedge funds also
provide investors and our national securities markets with
tangible benefits. They contribute substantially to capital
formation, market efficiency, price discovery, and liquidity.
Some hedge funds provide a way for institutional investors to
reduce their exposure to downside risk.
But given the general lack of disclosure about the way
hedge funds operate, the lack of standards for measuring a
fund's valuation and its performance, the possibilities for
undisclosed conflicts of interest, the unusually high fees, and
the higher risk that accompanies a hedge funds' expected higher
returns, these are not investments for mom and pop. They are
generally risky ventures that simply do not make sense for most
retail investors.
While some refer to an alleged growing trend toward the
retailization of hedge funds, the Commission staff are not
aware of significant numbers of truly retail investors in the
United States investing directly in hedge funds. In my view,
such a development, were it to occur, should be viewed with
alarm.
Indeed, in the wake of the Court of Appeals decision in the
Goldstein case, I intend to recommend to the full Commission
that the SEC take further steps to further limit the marketing
and availability of hedge funds to unsophisticated retail
investors.
The concerns about hedge funds that the SEC enunciated when
we adopted our Hedge Fund Rule in December 2004 remain the same
today. The remarkable pace of hedge fund growth, which we noted
at the time, has continued unabated. The potential for retail
investors to be harmed by hedge fund risk remains as serious a
concern now as then. And the growth in hedge fund fraud that we
have seen accompany the growth in hedge funds implicates the
very basic responsibility of the SEC to protect investors from
fraud, unfair dealing and market manipulation.
And on that point, let me be very clear that
notwithstanding the Goldstein decision hedge funds today remain
subject to SEC regulations and enforcement under the antifraud,
civil liability and other provisions of the Federal securities
laws. We will continue to vigorously enforce the Federal
securities laws against hedge funds and hedge fund advisers who
violate those laws.
Hedge funds are not, should not be, and will not be
unregulated. The challenge for the Securities and Exchange
Commission and the President's Working Group going forward is
rather to what extent to add new regulations, particularly in
light of the recent Court of Appeals ruling.
The Securities Act, the Exchange Act, and the Advisers Act
each provides the Commission with separate authorities to
regulate fraud and unfair dealing by hedge funds. Using this
still valid authority in recent years, the Commission has
brought dozens of enforcement cases against hedge fund managers
who have engaged in fraud or who have violated their fiduciary
obligations.
The number of enforcement cases against hedge fund advisers
has grown from just four in 2001 to more than 90 since then. I
have provided several recent examples of significant hedge fund
cases brought by the Commission in my written testimony.
But while our ability to bring enforcement actions against
hedge funds and their managers remains intact following the
Goldstein decision, the same cannot be said for the
Commission's ability to require hedge fund advisers to register
and submit to inspections. The Commission stated, when we
adopted the Hedge Fund Rule in 2004, that its then-current
program of hedge fund regulation was inadequate. With the
rejection of the Hedge Fund Rule by the Court of Appeals, I
believe that is once again the case. We must move quickly to
address the gaping hole that the Goldstein decision has left.
Immediately following the Goldstein ruling, I instructed
the SEC's professional staff to promptly evaluate the Court's
decision, and to provide me with a set of alternatives that the
SEC could pursue without legislation. That evaluation is still
underway, but I have already decided upon several urgent
courses of action which I can report to this Committee today.
Specifically, I intend to recommend to the full Commission
the following emergency rulemakings and Commission actions:
First, I will recommend that the SEC promulgate a new anti-
fraud rule under the Investment Advisers Act that would have
the effect of looking through a hedge fund to its investors.
This would reverse the effect of the D.C. Circuit's opinion
that the antifraud provisions of Sections 206(1) and 206(2) of
the Act apply only to clients as the Court interpreted that
term, and not to investors in the hedge fund. I believe that
such a rule is possible because the Court itself noted that
another antifraud provision, Section 206(4), is not limited to
fraud against clients.
The result would be a rule that could withstand judicial
scrutiny and which would clearly state that hedge fund advisers
owe a fiduciary obligation to investors in the hedge funds. The
staff is currently analyzing the Commission's authority to
adopt such a rule to ensure that this interpretation is
correct.
Second, I am directing the SEC staff to take emergency
action to ensure that the transitional and exemptive rules
contained in the 2004 Hedge Fund Rule are restored to their
full legal effect. This is necessary to ensure that hedge fund
advisers who were relying on the now invalidated rule are not
suddenly in violation of our regulatory requirements when the
Court issues its final mandate in mid-August.
Likewise, I am directing emergency action to restore to
newly registered hedge fund advisers their qualified exemption
from the recordkeeping requirement for performance data prior
to their registration. They would still be required to maintain
all records they have to substantiate their prior performance.
Without this emergency action prior to mid-August, newly
registered hedge fund advisers that remain registered, but that
did not create records for the periods prior to their
registration, will lose their ability to use their performance
track record. Rather perversely, this would discourage hedge
fund advisers from voluntarily remaining registered.
Yet another emergency action I am directing will restore
the extension of time that was given to advisers for funds of
hedge funds to provide their audited financial statements. The
underlying hedge funds do not typically supply their audited
financials to the fund of funds manager until the 120 day
deadline, so the fund of funds managers need extra time to
complete their audit work and send out the reports. The Hedge
Fund Rule gave it to them, but the Goldstein decision
invalidated that relief. I intend for the Commission to restore
the extension of time from 120 to 180 days.
Similar action is needed to undo yet another effect of the
Goldstein decision, which is to undo the Commission's 2004
Hedge Fund Rule insofar as it applied to offshore advisers to
offshore hedge funds. Those advisers had to register under the
new rule, assuming their funds had more than 14 U.S. investors.
But they would have been subject to different treatment under
the Advisers Act because they could treat the offshore fund as
their client for all other purposes.
The Court's ruling, however, eliminated this aspect of the
rulemaking. And by creating doubt whether registered offshore
advisors will be subject to all of the provisions of the Act
with respect to their offshore hedge funds, the ruling has
created a disincentive for offshore advisers to remain
voluntarily registered.
I have directed the Commission staff to prepare legal
guidance that might remove this disincentive to registration.
Finally, to address my concerns with respect to the
retailization of hedge funds, I have asked the staff to analyze
and report to the Commission on the possibility of amending the
current definitions of accredited investor for purposes of
retail investment in hedge funds without registration. I am
concerned that the current definitions, which are decades old,
are not only out of date, but wholly inadequate to protect
unsophisticated investors from the complex risks of investment
in most hedge funds.
The Commission's Hedge Fund Rule would have had the effect
of increasing the suitability threshold to $1.5 million of net
worth rather than $1 million for any hedge fund that charges a
performance fee. This was an important change and I would like
to see it restored.
In California, the median home price is well over $500,000.
So post-Goldstein, with barely more than $200,000 apiece in
other assets, a California couple could qualify to buy a hedge
fund in an unregistered offering even though that relatively
small amount of assets might represent their entire life
savings in the form of a teacher's or firefighter's retirement
fund.
Beyond these emergency rulemakings and other actions to
restore as much of the pre-Goldstein rule as possible, I have
directed the SEC staff to continue to conduct compliance
examinations of investment advisers who remain registered with
us or who register in the future. All registered hedge fund
advisers are subject to SEC regulation and the SEC will
continue to conduct risk-based examinations of hedge fund
advisers that are registered with the SEC.
While some number of hedge fund advisers will certainly
deregister as a result of the Court's decision, our experience
since Goldstein is that more hedge fund advisers have become
newly registered than have deregistered. In other words, we
have actually experienced a net increase in hedge fund adviser
registrations since the Goldstein decision.
Mr. Chairman, hedge funds are a significant and a growing
part of our financial markets that yield not only risks but
also many benefits for our economic system. Each of us at this
table, as members of the President's Working Group, has an
interest and responsibility to continue working collaboratively
to evaluate both the systemic market risks and retail
investment issues associated with hedge funds in order to
maintain these overall benefits. I and the SEC, for our part,
are committed to doing so.
Thank you for inviting me to testify on this important
subject and I am happy, after the panel concludes, to answer
any questions that you might have.
Chairman Shelby. Thank you, Chairman Cox.
Chairman Jeffery.
STATEMENT OF REUBEN JEFFERY, III, CHAIRMAN, COMMODITY FUTURES
TRADING COMMISSION
Mr. Jeffery. Chairman Shelby, Senator Sarbanes, members of
the Committee, I am pleased to have the opportunity to testify
today on behalf of the CFTC at today's hearing on hedge funds
regulations.
I will concentrate my remarks on how hedge funds intersect
with two of the CFTC's core statutory responsibilities under
the Commodity Exchange Act. They are: promoting market
integrity and protecting the public from fraud in the sale of
futures and commodity options.
The trading in futures and options on commodities,
including those based on physical commodities such as energy
products, has grown at an astonishing pace. The growth in the
trading of these contracts demonstrates that futures markets
function as important risk management tools to an ever growing
number of U.S. investors and businesses.
Hedge funds, no less than other market participants, are
covered by CFTC and exchange market surveillance programs to
the extent that they participate actively in the regulated
futures markets. The CFTC conducts market surveillance to
preserve the important functions of risk management and price
discovery that the futures markets perform in our economy.
The backbone of the Commission's market surveillance
program is its so-called large trader reporting system, with
which many of you are familiar. This serves as an effective
tool for detecting the types of concentrated and coordinated
positions required by a trader or group of traders attempting
to manipulate a market in a particular commodity or financial
product.
In addition, each futures exchange is required, under the
Commodity Exchange Act to affirmatively and effectively monitor
trading, prices and positions on its exchange.
Separately, the CFTC's disclosure-oriented customer
protection regime is key to protecting investors from fraud
involving commodity pools and hedge funds. I should emphasize
that the CFTC does not regulate hedge funds, per se. Rather, if
a hedge fund trades futures or commodity options, the fund is a
so-called ``commodity pool,'' as defined in our Act, and its
operator and adviser may be required to register with the CFTC
unless covered by a registration exemption based on, for
example, the sophistication of its participants or the de
minimis amount of commodity interest traded in the fund.
The CFTC has a simplified regulatory framework for
registered commodity pool operators and trading advisers who
operate or advise pools with participants meeting certain
criteria. The day-to-day oversight of commodity pools and
commodity trading advisers is carried out by the National
Futures Association, the futures industry analog to the NASD in
the securities world.
As part of its self-regulatory responsibilities, the NFA
conducts onsite examinations of pool operators and trading
advisers on a routine, periodic, and exception basis. Whether
registered or unregistered, pool operators and trading advisers
remain subject to the CFTC's anti-fraud authority. Over the
past six fiscal years, the CFTC has brought some 49 enforcement
actions involving commodity pools, hedge funds and CPOs. These
enforcement actions typically involve fraudulent sales
solicitations and/or misappropriation of investor or customer
funds. In many instances, the CFTC works cooperatively with the
NFA, state regulators, criminal authorities and the SEC in
bringing such proceedings.
In closing, the CFTC's mission under the Commodity Exchange
Act involves ensuring market integrity and customer protection.
Hedge funds that trade futures and commodity options implicate
both of those functions. The CFTC will remain vigilant in
utilizing the tools provided in the Act--market surveillance,
disclosure and reporting, and the full force of its enforcement
authority where necessary--to fulfill its statutory
responsibilities as hedge fund participation in the futures
markets continues to expand.
This concludes my remarks and I look forward to your
questions. Thank you.
Chairman Shelby. Secretary Quarles.
STATEMENT OF RANDAL K. QUARLES, UNDER SECRETARY FOR DOMESTIC
FINANCE, DEPARTMENT OF THE TREASURY
Mr. Quarles. Thank you. Thank you, Chairman Shelby, Senator
Sarbanes, and members of the Committee for having me here today
on this panel to contribute to the discussion of a topic that
is of significance for our financial markets, which is the
regulation of hedge funds.
In considering the regulation of any area of financial
activity, an important threshold matter is an understanding of
the role that that activity plays in our financial markets. In
May, before a Subcommittee of this panel I presented testimony
regarding the role that hedge funds play, what hedge funds do
in and for our financial markets. As I said then, if Government
addresses the question of regulation of any financial
institution or activity without a clear understanding of the
place that it plays in our financial system, then we run the
risk of imposing unnecessary or excessive or inappropriate
regulation.
Some of the facts about the hedge fund industry are well
known. They have been referred to today. They are flexible
investment vehicles. They are able to sell short, leverage
their investments, use derivatives in a wide variety of
markets. They have an incentive compensation structure that
provides generous rewards for strong performance. They restrict
their investor base to high net work and institutional
investors. And the industry has grown rapidly, as has already
been remarked this morning, in the last decade to about 9,000
funds globally, managing well over $1 trillion in assets.
What has been less discussed, although this panel has
certainly been active in focusing on this issue, but what has
been less discussed in Washington are the benefits that these
funds bring to our financial markets as their role is evolved
over the years.
First and foremost is liquidity. Because of the varying and
flexible strategies that these funds follow, they are often the
willing buyers and sellers that add significantly to
marketplace liquidity. That is particularly true in some of the
less traditional markets such as the distressed debt and
convertible bond markets where hedge funds represent the
overwhelming majority of trading volume.
Second is price efficiency. Many hedge funds seek to create
returns by targeting discrepancies between two or more markets
with wide bid/ask spreads. That has the unsurprising effect of
narrowing them. And so this private profit-making activity
produces the public good of better price discovery and more
efficient markets.
Third is risk distribution. Concentration of risk is one of
the greatest threats to a smoothly functioning marketplace and
hedge funds help to reduce that concentration through their
willingness to be the counterparties in derivatives
transactions through which financial institutions lay off some
of the large risks that are inherent in their normal
activities.
Without market participants that are willing to trade these
derivatives in significant volumes, which hedge funds have the
flexibility to do, large complex financial institutions that
have clear systemic significance would have to retain more
risk.
But hedge funds do not just continue to a more efficient
marketplace. They can also directly benefit investors. Their
increasing number, the diversity of strategies that they can
follow gives investors more choice. That allows greater
diversification. And their nimble structures can also create
the possibility of seeking to outperform traditional
benchmarks. That is often referred to as generating alpha or
excess returns. That is a clear benefit, obviously, for the
investor of a successful fund.
But while hedge funds provide important benefits to our
financial markets and market players, there are some open
questions about how they might affect the financial systems'
response to stress. Leverage can magnify losses in the
financial system. And while the fund's balance sheet leverage
seems contained, it is harder to measure the degree of so-
called embedded leverage that is involved in many of the
complex structured instruments in which some hedge funds trade.
So well, overconcentrated positions can strain liquidity.
Valuation models that hedge funds use can be vulnerable to
mischief. Some trading practices can present operational
challenges to clearing and settlement systems.
So we face a familiar conundrum: what is the proper
response of Government to a significant marketplace development
that brings clear and important benefits but raises some
questions as it involves?
The lens through which we examine the evolution of any
institution's role in the financial markets often shapes our
view of what, if anything, is the right response. And so it is
important that that lens be as clear and as polished as
possible.
So to that end, the Treasury Department is beginning a
series of meetings to review comprehensively the issues
surrounding the role of hedge funds in our financial system.
These meetings involve the regulatory and oversight community,
fraud outreach to the financial committee including prime
brokers, transaction counterparties, the funds themselves. And
as part of this comprehensive review, we will be working with
the SEC and other PWG members as Chairman Cox and the
Commission consider alternative courses of action following the
D.C. Circuit Court's recent decision.
At the moment, it is too soon to say what, if any,
initiatives will come from this focus. But we intend for it to
be a cooperative and collegial effort with the private sector
with the end being a clear understanding of a rapidly changing
industry.
Thank you and I look forward to your questions.
Chairman Shelby. Thank you, Mr. Secretary.
Chairman Cox, in your testimony you outline some
recommended parameters for any hedge fund regulatory regime.
You assert that there should be no Governmental interference
with the hedge funds' investment strategies or operations,
including its use of derivatives, trading, leverage, and short
selling. In addition, you state there should be no disclosure
requirements related to portfolio, composition or trading
strategies. Finally, you caution that policymakers should pay
careful attention to the cost of any such regulation.
Chairman Cox, why is the avoidance of unnecessary
regulations so important to the continued success of hedge
funds?
Mr. Cox. Mr. Chairman, as you have heard from each of the
members of this panel, we believe, and the President's Working
Group believes, that hedge funds, while posing risks
particularly to retail investors, also provide benefits. They
provide benefits in terms of liquidity, in terms of risk
management, in terms of diversification. And all of these
things are worth preserving.
As a result, when we regulate the capital markets, we want
to be sure that we are achieving the benefits that are
necessary for investor protection or, in the case of other
agencies, to deal with these concerns of systemic financial
risk.
In terms of the SEC, we have an interest directly in
maintaining the integrity and the orderliness of the markets.
But while we are achieving these objectives, we want to make
sure that we do not interfere with the operations of the market
itself.
I should also point out that that list, that desiderata
that comprises a portion of my written testimony, were norms
outlined by Commissioner Goldschmidt in a speech that he made
after the adoption of the Hedge Fund Rule. I think there is
broad agreement among all of the Commissioners--although I
cannot speak, as I said, for others who are not here--on those
general principles.
Chairman Shelby. Chairman Cox, risk and liquidity are what
make markets are they not, in a sense? You cannot have a market
without risk and some liquidity to propel it, can you?
Mr. Cox. That is exactly right and maintaining pools of
liquidity, maintaining overall the function of our capital
markets as deep and liquid, is vitally important.
Chairman Shelby. In your testimony, you also mentioned it
was important for the SEC to have basic census data relating to
hedge funds. What information is currently available to the
Commission? And what additional information is important for
the Commission's investor protection agenda?
Mr. Cox. A fundamental aim of the Hedge Fund Rule that was
invalidated by the Court of Appeals was to identify hedge fund
advisers operating in the United States and hedge funds
operating in the United States. The truth is that before the
rule and now post-Goldstein neither we nor any Government
agency has good data on hedge funds.
As I indicated in my oral presentation just now, for that
reason I have to hedge when I give you statistics. I believe
these numbers to be approximately correct, but the truth is
nobody knows.
Chairman Shelby. Does the SEC currently have the requisite
statutory authority to address the questionable activities that
hedge funds may engage in?
Mr. Cox. I am not prepared to say yes or no to that
question today because, Mr. Chairman, as I indicated, our
review of our authorities, different authorities than we have
relied upon thus far, is still ongoing.
I have already been able to identify, as I presented,
several actions that I believe--although this is somewhat
tentative--but I believe that we can take these steps. And we
will have to see collectively what all of the remedial measures
amount to and whether or not we think they are sufficient.
But whether or not legislation is necessary or advisable is
always within the prerogative of the Congress, of course.
Chairman Shelby. Thank you.
Secretary Quarles, what is your latest thinking on the
systemic market risk posed by hedge funds? What is the
principal risk involved? And are there new risks on the horizon
that you have identified? And please comment, if you can, on
the steps taken by the President's Working Group to address
these dangers, if you see them out there.
Mr. Quarles. Certainly. I think there is reason to believe
that there is less risk that is posed by the hedge fund
industry than may have been posed in the past, say around the
time of LTCM. You do not have any individual fund that is
nearly as large as LTCM, that has that many assets. You have a
greater diversity of strategies. You have a larger number of
funds.
So at least on the face of it there are a number of factors
that would suggest that this is a more stable industry than it
might have been five or 6 years ago.
On the other side, I think an issue is the question of
embedded leverage. So while balance sheet leverage to hedge
funds in the aggregate is less than it was some years ago, the
leverage of some of these complex instruments is much harder to
measure. I think that is something we need to look at and we
are looking at that in the President's Working Group.
Chairman Shelby. Chairman Cox, a lot of us have been
troubled by the recent revelations relating to the backdating
of stock options. There appears to be some confusion on this
practice.
Could you explain to the Committee today whether backdating
is legal under certain circumstances, and when it is illegal,
and so forth.
In other words, this seems to be a big thing going on with
a lot of companies that does not look very good.
Mr. Cox. You are absolutely right, Mr. Chairman, and this
is, for that reason, an area of special interest both from a
policymaking standpoint and from an enforcement standpoint at
the Securities and Exchange Commission.
Undisclosed backdating, which is one of the ways in which
backdating can be illegal, is a serious potential problem under
the Federal securities laws. It implicates both our accounting
rules and our disclosure rules.
When not properly accounted for, backdated options can
significantly overstate a company's earnings and conceal its
true financial conditions. That potential impact exists both
under the old accounting rule that most companies followed,
which required companies to expense them in the money portion
of option grants, and under the new accounting rules, FAS
123(R).
The Commission's contested civil fraud action against
former executives of Brocade Communications Systems, which you
may be aware of, we announced it last week, is an example of
the serious accounting implications.
In that case we allege that fraudulent option grants went
on for more than 4 years. Brocade restated and revised its
financial statements for 6 years, from 1999 through 2004, and
it resulted in inflation of Brocade's net income by as much as
$1 billion in 2004 alone.
Chairman Shelby. Does that not undermine the integrity of
the marketplace? In other words, the integrity of the
marketplace, confidence in the marketplace, securities market,
are of the utmost importance to all of us, are they not, as
investors?
Mr. Cox. Indeed, Mr. Chairman. And for that reason I
believe that illegal backdating goes to the heart of investor
confidence. And it is one of the reasons that the SEC will be
vigilant in proceeding against it.
Chairman Shelby. Senator Sarbanes.
Senator Sarbanes. Thank you very much, Mr. Chairman.
On May 17th, the Washington Post reported, and I quote
``Some regulators and analysts worry that some sort of market
shock might prompt many investors to withdraw money from hedge
funds at the same time, causing a run on the bank that would
not leave the hedge funds enough cash to refund investors or
make good on their financial contracts.''
I am interested in how each of you would respond to these
concerns about the destabilization that could occur if this
sequence of events were to take place. How much are you
concerned about it? Why don't we start with you, Secretary
Quarles, and we will go across in the other direction.
Mr. Quarles. I think that it is something that, in the
President's Working Group, we are focused on, is ensuring we
understand how the financial system would respond to various
shocks. For the reasons that I described, there are prima facie
some reasons to think that the hedge fund industry is better
situated today than it might have been in the past, both to
respond to shocks and for problems in the hedge fund industry
not to metastasize into general problems in the financial
sector.
One of the main reasons is the emphasis that has been
placed since LTCM on counterparty risk management, so that the
regulated counterparties of the hedge funds, the prime brokers
and the depository institutions that provide financing for the
hedge funds, are more focused than they have been in the past
and have more information than they have had in the past about
overall exposures and about the quality of that credit.
So both because of the increasing number and diversity of
strategies, which in general ought to result in less
correlation, although I think there are some reasons to look at
that and ensure whether there really is significant diversity
on some of these facially diverse strategies, as well as the
emphasis that is placed on counterparty risk management, there
is reason to believe the hedge fund industry is in better shape
for a financial shock than it has been the past.
But we are continuing to look at that question in the
President's Working Group. We are not complacent.
Senator Sarbanes. Anyone want to add to that?
Mr. Cox. Mr. Chairman, I would just echo what Secretary
Quarles said concerning some of the changes that have taken
place in the industry and in the market since the collapse of
Long Term Capital Management in 1998.
Broker dealers have become much more sophisticated in
managing their exposure to hedge funds, we believe, through
secured financing transactions, for example. Prime brokers
active in financing positions for hedge funds have, as a group,
dramatically improved their capacity to monitor the value of
collateral and liquidate positions quickly. And that, in turn,
reduces their risk of loss.
I would note that many of these enhancements are
implementations of the recommendations of the reports issued by
the Counterparty Risk Management Group in 1999 and 2005.
But having said that, if there were, as is posited in the
newspaper article from which you quoted, a systemic downturn, I
am absolutely certain it would heighten the risk of fraud by
hedge fund advisers because some managers would be tempted in
those circumstances to hide losses and to falsify their returns
in order to avoid losing their investors. And that, I think,
places a premium on at least the aims of the approach that the
Commission had taken in our Hedge Fund Rule because for the
hedge fund advisers that are registered, and this will be true
even post-Goldstein for those that remain registered, the
oversight that we exercise through our examination program will
potentially deter some fraud and expose other fraud before it
can seriously harm investors.
The same is true to the extent that all registered advisers
have to implement compliance policies and procedures and
designate a chief compliance officer. These are all important
aspects of our approach that I think we look in other ways to
maintain.
Senator Sarbanes. The AFL-CIO, Richard Trumka, the
Secretary-Treasurer, has written to the Chairman and me, as the
ranking member, about their concern about the pension funds,
worker pension assets, that are then placed in hedge funds. And
they note that in the pension bill that is being considered in
the Congress now there is a move afoot to allow substantially
more pension assets to be invested in hedge funds that will not
be subject to ERISA coverage.
I am interested to know your view on this possibility of
weakening ERISA protection over hedge fund assets and its
implications for worker pension funds?
Mr. Quarles. I can address that.
With respect to the proposal, as I understand it, in the
pension bill, obviously the Department of Labor has the lead
with respect to that issue. But as I understand the proposal,
what is at issue is not really whether pension funds, an
individual pension fund, would have the capacity to increase
its exposure to hedge funds but whether a hedge fund could have
pension funds in the aggregate. You could have, in theory,
1,000 pension funds, each investing $12.73. The question is
what is the aggregate pension asset investment in the hedge
fund?
And the plan assets rules that are in question have never
really dealt with the question of whether an individual pension
fund was overconcentrated in a particular type of asset. There
are other rules to deal with that.
So when you look at the question that way, I think there is
some scope for more flexibility in the aggregate amount of
pension assets that a hedge fund could take given, as I
outlined in my testimony, that again these diversity of
strategies and the diversity of investments that allowing a
pension fund to invest in hedge funds can bring that can be a
benefit to the pension fund.
I think there is some scope for some more flexibility
there. My understanding is that with some refinements the
Department of Labor is also open to that modification.
Senator Sarbanes. Anyone want to add to that?
Mr. Chairman, thank you.
Chairman Shelby. Senator Allard.
Senator Allard. Thank you, Mr. Chairman.
I would like to direct a question to all of you as to how
hedge funds play with offshore entities. We all know that FASB
is trying to bring some convergence together on the accounting
standards in recognition of some of these global markets, and
hedge funds are certainly an example of a global market where
we have domestic as well as offshore hedge funds.
In what ways is the United States working with other
countries to develop some joint regulation as far as hedge
funds are concerned? And what kind of competitive environment
are we in when we get into the international offshore funds?
And what are the dynamics that are being played out there?
Chairman Cox, maybe you would like to start with that?
Mr. Cox. First, I should say that we are working very
closely with the FSA and the United Kingdom on the question of
hedge fund activity or monitoring of hedge fund risk and our
regulatory approaches to hedge funds and their advisers. That
is especially important because together the United States and
the U.K. account for the vast majority of hedge fund activity
and prime brokerage activity.
With respect to accounting standards convergence, I would
like to just remind all of us of some of the recent milestones
that have taken place regarding IFRS since I last appeared
before this Committee. Last year IOSCO announced plans to
create a data base for cataloging interpretations and decisions
in order to improve cross-border enforcement of the application
of these standards. That data base is expected to be launched
later this year.
In February of this year, the FASB and the IASB announced a
memorandum of understanding which provides a road map for the
next 3 years for standard setting to converge the provisions of
U.S. GAAP and IFRS. And I am completely committed to this road
map.
The SEC staff has recently begun reviewing the 2005 IFRS
financial statements and the accompanying U.S. GAAP
reconciliations that have been filed by about 300 foreign
registrants. And that work, I think, is going to help us better
understand how international financial reporting standards are
applied in practice.
Mr. Jeffery. Senator, from our perspective at the CFTC we,
like the SEC, work closely with our fellow regulators, the FSA
being one, elsewhere in the world, as well as through
international forums such as IOSCO and CESR--in discussing
issues related to hedge fund monitoring, evaluation,
regulation, et cetera.
One thing that comes up repeatedly in the world of the CFTC
as it relates to hedge funds is the importance we place on
making sure the things that we do at the agency--with respect
to executing our core mission of maintaining, preserving and
protecting open, competitive and financially sound markets--are
done in a way that will continue to be attractive to financial
institutions, hedge funds and other market participants.
Other regulators certainly have that same view in mind as
they look at their markets. And therefore, when trying to reach
accommodations with regulators where we have differences of
opinion, we tend to be respectful of their views, they of ours,
given that we have a common objective of maintaining investor
protections and market integrity but also making sure from a
U.S. perspective that we maintain our lead as the leading, most
liquid, robust capital markets in the world.
Senator Allard. Mr. Secretary, do you have anything to add?
Mr. Quarles. I think the only thing that I would add is
that this is also a topic that is discussed in the Financial
Stability Forum, the U.S. delegation there chaired by the
Treasury. It also involves the SEC and the Fed. And
international regulators and finance ministers and central
banks come together twice a year and the Financial Stability
Forum where, among other things, hedge funds and their
contribution to financial stability are a frequent topic of
review.
Senator Allard. Chairman Cox, is there any interest or
anything in the EU? As you mentioned in your statement, we do
most of it with the British Commonwealth countries. But
anything out of the EU that is emerging in this area?
Mr. Cox. Indeed, I think that all of our counterpart
regulators in Europe and around the world are interested at a
minimum in acquiring basic census data to the degree that that
is possible.
As I mentioned, one of the emergency actions I have
directed our staff to take relates directly to our ability to
gain census data about offshore hedge funds and hedge fund
advisers in order to undo one of the effects of the Goldstein
decision.
We have got to make sure that we do not deter the offshore
advisers from remaining voluntarily registered. If we can have
continued voluntary registration, we will be able, to that
extent, to gain this kind of census information.
Senator Allard. Thank you, Mr. Chairman. I see my time has
expired.
Chairman Shelby. Thank you.
Senator Reed.
Senator Reed. Thank you very much, Mr. Chairman.
Thank you, gentlemen, for your testimony.
Chairman Cox, since the Court of Appeals decision only a
few hedge fund advisers have deregistered; is that accurate?
Mr. Cox. In fact, the number is 10. And I am advised by the
staff that the vast majority of those are for stated reasons
having nothing to do with the Goldstein decision, such as they
have run out of assets or are going out of business.
Senator Reed. Has anyone registered since the decision?
Mr. Cox. Yes, and indeed the net new registrants as against
deregistration is positive. That means we have more people
registered post-Goldstein.
Senator Reed. So despite the decision, you still have a
significant number of advisers registered with the SEC and
subject to your jurisdiction; is that correct?
Mr. Cox. For the moment that is true. We will have to see
how that plays out over time. But there is no question that is
the case today.
Senator Reed. You point out in your testimony, Chairman
Cox, that the threat of retailization is one that you are
concerned about. It would seem to me that is one I would be
concerned about too, since the basic logic of the hands-off
approach is that sophisticated investors can handle their own
calculation of risk, but the retail market has to be protected
vigorously.
Can you outline, and I know you mentioned this in your
testimony, how you are going to monitor the situation for us to
see if it reaches a critical level? And what steps do you think
you will pursue?
Mr. Cox. At this point we are already beyond monitoring. I
think we know what the situation is. Our suitability rules have
not been changed since 1982. If we adjusted them for inflation,
instead of the $1 million net worth test, for example, we would
be at $1.8 million today. The Hedge Fund Rule, effectively,
would have raised that figure to $1.5 million. So I think we
have got to do what we can.
But what I have asked the staff to do is to tell us what
exactly that might be and under what authorities we might
accomplish this objective.
As you might imagine, in the wake of the Court of Appeals
decision invalidating our rule, this has happened for other
reasons in other cases, we are going to be particularly
punctilious about acting on the basis of solid legal authority.
Senator Reed. But you anticipate a very deliberate
rulemaking process going forward as fast as possible?
Mr. Cox. I do, but I have to add this caution. I am
testifying here today, very clearly, in my own capacity as
Chairman and as one of five Commissioners. We have not had the
opportunity, because we are trying to give you the latest
information of where we are, this is a work in progress, to get
Commission consensus on some of the recommendations that I am
making. So I am, to that degree, a little bit out ahead.
Senator Reed. Thank you very much, Mr. Chairman.
Chairman Jeffery, the Commodity Futures Trading Commission
does monitor some hedge fund activity under your surveillance
program. Can you give me a rough idea of the percentage of
hedge funds that you are looking at?
Mr. Jeffery. I would have to come back to you with specific
answers, as to the percentage of hedge fund activity in our
markets. But it is a very significant part of the exchange
traded commodity and futures markets.
In order to provide data on the extent of hedge fund
participation in U.S. futures markets, we reviewed market
surveillance information collected on a daily basis by the
Commission's large trader reporting system. While hedge funds
are not a separate reporting category, the positions of hedge
funds along with other managed money traders, such as, traders
registered as Commodity Pool Operators (CPO) and Commodity
Trading Advisors (CTA) are reported to the CFTC. A hedge fund
that trades commodity futures may be a commodity pool, and a
CPO is a registered entity that operates a commodity pool. CTAs
direct the trading of clients, including hedge funds and
commodity pools.
The Commission recently reviewed managed money positions on
May 9, 2006. On that date, managed money traders held on
average about 19 percent of the open interest in the 21 largest
commodity futures markets, and about 30 percent of the open
interest in the 20 largest financial futures markets.
Managed money positions are not all on one side of the
market. CFTC data for May 9, for instance, indicates that in
commodity futures markets, managed money traders held on
average about 23 and 16 percent of the long and short open
interest, respectively. In financial futures markets, they held
on average about 36 and 24 percent of the long and short open
interest, respectively.
Trading volume and open interest are measures of market
activity. Volume is the total number of contracts traded for
the day. Open interest is the total number of contracts entered
into and not yet offset during the life of the contract. For
instance, if during the first trading day of any futures
contract A sells 1 contract to B and B buys the 1 contract from
A then sells 1 contract to C, then the volume of trading for
the day is two contracts, and the open interest is one
contract. A is short 1 and C is long 1. B is no longer in the
market.
The CFTC's Large Trader Reporting System tracks open
positions of large traders in all actively traded futures
markets to identify potential market disruptions or
manipulations. For instance, at the close of trading in the
NYMEX Crude Oil contract on May 9 there were 1,090,810 open
contracts, each one representing an obligation to buy 1,000
barrels of crude oil by long traders and sell 1,000 barrels of
oil by short traders on certain future dates. The notional
value of a 1,000 barrel contract of crude oil was $70,690 on
May 9 and is approximately the same value today.
Of these open contracts 200,949 to buy were held by 114 non-
commercial traders each of whom owned at least 25 contracts.
That is, large non-commercial traders such as hedge funds,
other managed money traders and a small number of others held
18.4% of the long side of the market. Seventy-four large non-
commercial traders held 10.5% of the short positions and 22.2%
of the open contracts were held by 117 large non-commercial
traders with spread positions, that is, long in one delivery
month and short in another. Summaries of this information are
published every week by the CFTC as the Commitments of Traders
Report on the Commission's website, www.cftc.gov.
Mr. Jeffery. But again, let me stress something I tried to
make clear in my testimony, and is that hedge funds are treated
exactly like other market participants under the broad
architecture of our statutory mandate. We provide vigorous
market oversight, working with the exchanges, on the exchange
traded markets of hedge funds and other financial institution
and commercial users of those markets.
We also oversee, importantly with the exchanges, the
clearing and settlement function, which is really the
backbone--the financial backbone--of the integrity of the
futures and options trading system in the United States. It was
one of the reasons, frankly, why the futures exchanges in the
U.S. have been so robust and so successful in the recent past,
and hopefully will continue to be so.
And finally, on the enforcement side, we will look at hedge
funds just like anybody else. When we see evidence of bad
behavior, particularly with all the attention today on the
activity in physical commodities markets, energy in particular,
you can be sure that the vigilance of our market surveillance
people and our enforcement attorneys in looking for possible
attempts at manipulation, false reporting or actual
manipulation are very vigorous and very robust.
Again, hedge funds are treated just like every other market
participants. But we are very mindful of their presence,
substantial presence, in the marketplace.
Senator Reed. On a constant basis you are over watching the
markets. Is there any cause for concern about trends or
concentration of manipulation that you are seeing?
Mr. Jeffery. Not to the best of our knowledge. Occasionally
we will find evidence of bad behavior by this or that entity,
hedge fund or otherwise. But no evidence of systemic
manipulation or attempts to influence market prices in a
perverse or unfair way. No, sir.
Senator Reed. Thank you very much.
My time has expired, Mr. Chairman.
Chairman Shelby. Senator Hagel.
Senator Hagel. Thank you, Mr. Chairman.
This is a question for Chairman Cox but I would be
interested in receiving the responses of you, Chairman Jeffery,
as well as you, Secretary Quarles.
Chairman Cox, you note in your testimony, and I will read a
very brief part of this on page five, ``As you consider the
possibility of legislation'' and then you say some other things
and then you get to the point, ``I would counsel that, to the
maximum extent possible, our actions should be nonintrusive.
There should be no interference with the investment strategies
or operations of hedge funds, including their use of
derivatives trading, leverage, or short selling. Nor should the
Federal Government trample upon their creativity, their
liquidity, or their flexibility.''
In your mind, what kind of legislation should this
committee be considering?
Mr. Cox. I thought at first you wanted me to justify the
desiderata that were set forth in the testimony, which I find
much easier to do than to answer the harder question which you
actually put, which is what kind of legislation----
Senator Hagel. If I could help you a little bit, since you
have mentioned it. Since you have talked about the possibility
of legislation, what kind of legislation should there be? I
assume then you believe we should pass legislation?
Mr. Cox. That is not what I mean in my formal testimony,
nor what I mean to say to you just now. What I mean to state
very quickly is that, particularly as a former Member of
Congress, I recognize that it is the prerogative of the
legislative branch in addressing questions such as this, to
pass legislation if you see fit.
I also observe that that effort is already underway in this
body and the other body. Whether that amounts to anything
remains to be seen. But what I did offer in my formal testimony
is the good offices of the Securities and Exchange Commission
and our professional staff in providing any advice and
technical expertise that you might request or require.
But I am instead, as Chairman, in the meanwhile, focused on
exercising to the maximum extent possible, our existing
statutory authorities so that we can report more fully and
robustly to you very soon on what we have been able to
accomplish and where the gaps remain.
Senator Hagel. Let me ask you this question.
Mr. Cox. There are very big gaps, post-Goldstein, no
question, that have to be filled.
Senator Hagel. Mr. Chairman, recognizing what you said,
your experience on both sides of the table, in light of your
new responsibilities over the last year, what your colleagues
have said this morning and what you have said, do you believe,
in fact, the SEC has the adequate authority to deal with this
issue and future issues that may arise?
We have talked this morning about volatility,
destabilization possibilities, derivatives, all of the dynamics
that are part of the fabric of what we are talking about. Do
you believe you have the authority? If you do not, then I
assume you believe that you need additional authority through
legislation? Is that correct? Not correct? Where are you on
that?
Mr. Cox. We are right in the middle of that river. We have
swum halfway across and we are rapidly paddling to the other
side.
As I mentioned earlier, we have already got underway
emergency measures, some rulemakings, some perhaps no action
letters, perhaps legal advice that we might provide that will
restore to some degree greater or less what was there pre-
Goldstein.
I have also asked other divisions beyond the Investment
Management Division to help us examine what legal authorities
we might have. I do not have all of those answers yet. But I
think very soon we will be able to fill out the rest of this
picture so not only we but you can assess whether or not what
we have got is adequate.
But I can state categorically right now that the regulatory
regime implemented by the Securities and Exchange Commission
vis-a-vis hedge funds and their advisers is inadequate and we
are working very quickly to fill that gap.
Senator Hagel. And so it is still an open question whether
you need additional authority to through legislation. Is that
fair?
Mr. Cox. That is correct.
Senator Hagel. Gentleman, any additional comments you would
like to offer on this issue of legislation and what would be
required? Additional law or authority? Chairman Jeffery.
Mr. Jeffery. Yes, Senator, thank you.
As it relates to the futures world, the exchange-traded
futures world and the Commodity Exchange Act, we have said on a
number of cases that we believe the CFTC has the tools it needs
that are necessary to supervise the markets we regulate. Again,
hedge funds and all market participants.
When one engages in a discussion like today's and other
dialogs on hedge funds, the two recurring concerns one has,
among others, is one of investor protection. And the other is a
concern related to systemic risk.
In the futures world, under the Commodity Exchange Act, the
investor protection concerns, the way we get at those is
through a disclosure-based regime, which is described in
greater detail in the written submission for today, related to
so-called commodity pool operators and commodity trading
advisers.
In terms of the more profound concern related to systemic
risks where the Act and those of us involved with the Commodity
Futures Trading Commission are active, is on these important
areas of market and exchange oversight and that of clearing
organization oversight. We feel that we have the tools
necessary to effectively carry out our mission in that regard
with respect to actual businesses that are engaged in markets
for physical commodities and hedging transactions, and other
market participants of a financial nature, hedge funds
included.
That does not mean that we cannot always find and look for
ways to do our jobs better. Every day we try to do that.
Senator Hagel. Thank you. Secretary Quarles.
Mr. Quarles. Simply that I do think it would be premature
for us to recommend any legislation, whether there is any need
for legislation, until we have completed this comprehensive
review that I have described. I think that is a necessary
predicate.
Senator Hagel. What is the timeline on the completion of
the review?
Mr. Quarles. We have not set a deadline but we are
proceeding promptly with the various relevant groups to ensure
we brought them together.
Senator Hagel. End of the year?
Mr. Quarles. As I said, we have not set a timeline but we
are not considering that this is an extremely long process
either.
Senator Hagel. Thank you. Mr. Chairman, thank you.
Senator Sarbanes. Is this the President's Working Group on
Financial Markets that is doing this review?
Mr. Quarles. At the moment it involves the members of the
President's Working Group, but also other relevant regulars as
well, such as the New York Fed and some of the other
regulators.
So technically it would say we are not viewing this as
necessarily under the aegis of the President's Working Group
but it is something the President's Working Group will be
discussing.
Senator Sarbanes. I appreciate Chairman Cox talking about
the prerogatives of the legislative branch, but let us set that
to one side for the moment and proceed on the premise that we
look to the regulators who have, after all, a high degree of
professionalism in dealing with these issues and staff that
focus on this and not much beyond this for counsel and advice
on how we ought to proceed.
So I am anxious to pinpoint the responsibility. Who is the
responsible person for informing the Congress on what you think
needs to be done to cover any gaps with respect to inadequacy
and how we deal with the hedge funds?
So if something goes wrong down the road, we can say you
know, we looked to you to tell us and you did not tell us. Are
you in charge of this effort, Secretary Quarles?
Mr. Quarles. Well, when you put it that way----
[Laughter.]
Mr. Quarles. The Treasury Department is being active in
convening the regulators and others to form a view. Obviously,
there are important areas of responsibility of each of the
President's Working Group.
So until you have asked your question, we have not viewed
this as a sort of we are standing up and saying if you do not
hear from us, you have not heard the last word. But we are
being very active in attempting to form the view that you have
requested.
Senator Sarbanes. The SEC, as I understand it, is moving
ahead in terms of following up on this court's decision.
Mr. Cox. We are, indeed, and I see no reason for diffidence
in answering the question as you put it. Our requirement that
hedge fund advisers register, which went into effect in
February but was then invalidated, rather unequivocally
established the Commission as the primary national regulator of
hedge fund advisers. That registration would have preempted
most State law. It would have preempted the CFTC, or supplanted
the CFTC, which had recently adopted exemptive rules,
effectively vacating the space.
It would have permitted the Commission to maintain a
uniform national regime. And that would benefit not only
investors, I think, but also the hedge fund industry and it
would permit the SEC to work with foreign national regulators
as a single U.S. regulator.
So it is in the wake of the dismantling of that approach
that we meet here today. And we are working as quickly as we
can to try and, if not put Humpty Dumpty back together again,
then to erect something more sturdy that will accomplish some
of the same objectives.
Senator Sarbanes. Thank you, Mr. Chairman.
Chairman Shelby. Chairman Cox, yesterday you may have seen
the Financial Times article.
Mr. Cox. I read it every day.
Chairman Shelby. The CFA Center for Financial Market
Integrity and the Business Roundtable Institute for Corporate
Ethics published a report focusing on the issuer, analysts,
institutional investor, asset manager, and hedge fund manager
communities. The report called for corporate leaders to end the
practice of providing quarterly earnings guidance. This was the
lead story.
What is your reaction to this recommendation? There has
been a lot of stuff written, a lot of pressure put upon
executives to meet their quarterly earnings estimates, they
made guidance market, rather than the long-term health of the
company.
Mr. Cox. Yes. I think that these are, in the main, healthy
recommendations because concerns with short-termism have been
with us for some time and there are many attendant pathologies.
Obviously, the problems that we have seen with manipulating
earnings, managing earnings, smoothing earnings and so on are
derivative of that kind of short-termism.
Chairman Shelby. This could be a step in the right
direction, could it not?
Mr. Cox. Yes. And I think if it amounts to nothing more
than a contribution to the general ethos in which we all
operate, these kinds of norms being enunciated at high levels,
that is a good thing.
Senator Sarbanes. A long time distinguished State Attorney
General recently said ``Right now hedge funds are in a
regulatory void without disclosure or accountability. States
will fill the void.''
I would be interested in your comments on this possibility
and what its implications are.
Mr. Cox. I believe you are referring to the comments of the
Connecticut Attorney General. With respect to the Blue Sky
authorities the SEC in this, as in virtually all securities
regulatory instances, takes the view that we have got to
exercise our authorities in a complementary way.
Obviously, if one level of government does nothing, that
leaves the others to act in a vacuum and that may be the
prospect to which that comment refers.
I think there is zero risk that that is going to be the
future. Instead, I think you will see the SEC continue to
operate in this sphere, as you will presumably see Connecticut
and other States doing what they can.
At minimum, in the area of anti-fraud activity, we have got
to put our resources together. And as I indicated, Goldstein
notwithstanding, the SEC has been increasingly active in moving
against hedge fund and hedge fund adviser fraud. We have gone
from just four cases in 2001 to over 90 since then.
Senator Sarbanes. Recently Bloomberg News and Newsweek
reported that the Bush Administration's Task Force on Corporate
Crime will discuss hedge fund fraud at its next meeting at the
end of this month. The Deputy Attorney General, Paul McNulty,
spoke in strong terms about this as an emerging threat.
Can you give us some idea where that task force is headed
with regard to hedge funds?
Mr. Cox. I will be in a much better position to tell you
after the meeting takes place. I intend to attend that meeting.
Senator Sarbanes. Anyone else have any information on it?
Will Treasury be at that meeting?
Mr. Quarles. We will be, through our General Counsel's
office.
Mr. Jeffery. As will the CFTC.
Chairman Shelby. We need to get you back after the meeting.
Senator Sarbanes. Do you have enough resources? In other
words, budget, manpower, and so forth, to do what has to be
done in this area? Or are you in need?
Mr. Cox. With respect to the SEC, that is an area where
legislation would make a difference. There are some things that
we can do with regulatory authority. There are other things
that we cannot do.
Chairman Shelby. Legislation or money?
Mr. Cox. I do not mean to make the authorizer/appropriator
distinction, although with you, Chairman Shelby, I do not have
to.
Chairman Shelby. We will talk about money in another
committee with you.
Mr. Cox. All right, I will subside.
Senator Hagel. You recognize the Chairman is both.
Mr. Cox. I do, indeed.
Chairman Shelby. Chairman of the other Committee,
Appropriations.
Senator Sarbanes. How about the CFTC and the Treasury?
Mr. Jeffery. Well, resource allocation is a constant
challenge in every organization, but as our statute is
currently structured and our mission defined, subject to the
goodwill of Congress and continued budget appropriations along
the lines that have been requested, we believe we have the
resources sufficient to our job as currently constituted.
Senator Sarbanes. Treasury?
Mr. Quarles. With respect to the Treasury, I mean I never
want to say we have enough resources. But with respect to this
issue, for what our role is, I think we are covered.
Senator Sarbanes. Mr. Chairman, I just want to close out by
saying I think it is very important that you carry through with
these work programs. You have this uneasy feeling of the whole
area here that we do not really know very well. We do not fully
understand.
And you constantly get--you know, Business Week had an
article in May saying--and just listen to this, it may be a
small thing but still. ``Smaller colleges are moving
aggressively in the hedge funds. They may be putting their
endowments in jeopardy.''
The article identified some small colleges that invested 60
or 80 percent of their endowments in hedge funds and was
concerned that these institutions may lack financial
sophistication to fully understand the risks.
Is that a legitimate concern, would you say? Would you
dismiss this concern?
Mr. Quarles. I would not dismiss the concern. I would
certainly note that if you have a small institution that is
unlikely to have in-house expertise, there are a variety of
ways to outsource that expertise, to hire professional
advisers, to invest through funds of funds in order to ensure
that you are not taking on more risk than you ought.
Senator Sarbanes. Thank you, Mr. Chairman.
Chairman Shelby. Senator Hagel.
Senator Hagel. Mr. Chairman, thank you.
Chairman Cox, I wanted to ask a specific question, which
you are well aware of the issue regarding the cases concerning
Overstock and Biovale, where hedge funds are alleged to have
paid securities analysts to issue misleading research to the
marketplace.
Do you believe the SEC has the authority to deal with a
critical component of not just the hedge funds, but the entire
investment environment and universe in the market of
independent research and analysis? Obviously, we have two
specific cases here.
But as you are analyzing, as we have talked this morning,
on future needs, if it comes to that through legislation,
obviously this is a big part of it. If there is some question
in the marketplace by investors about the independence, the
actual independence of research and analysis, that obviously
destabilizes everything. And it affects all decisions.
So what is the SEC doing to deal with this? I think this is
as critical a component of this issue as any one thing, the
legitimate independence of research and analysis.
The second part of that question is do you believe you have
the authority to deal with it?
Mr. Cox. Yes indeed, I believe we have both the resources
and the authorities that we need to deal with this problem on a
policy basis and on an enforcement basis. One of the ways that
we are proceeding to attack this problem is through
enforcement, as well as policymaking.
Senator Hagel. What specifically can you tell us about
these two cases?
Mr. Cox. To the extent that they are ongoing, I cannot.
Senator Hagel. What will you be recommending in the way of
changes to not just deal with this but strengthen it? What can
you tell us, aside from you think you have the authority?
Mr. Cox. Well, we began from the premise that research is
vitally important to the market, that there are pressures on
independent research right now and that the SEC needs to
examine its own rules to make sure that we are encouraging and
not diminishing the provision of independent research.
Second, we have a rubric of law and rules that need to be
examined for opportunities to strengthen the requirements of
independence and the freedom of research providers from
interference or manipulation themselves.
Senator Hagel. Do you believe that as you are analyzing all
of the dynamics of authorities and hedge funds in particular
that this is going to be something that you will come to the
Committee with, with additional information as to not just
needs in the area of authority, statutory authority? But again
this is as critical a component of this, at least in my
opinion. I suspect the market, if they have no confidence in
this or if there is a question of the confidence of the quality
of that analysis and research, then it skews everything.
So how do you respondent then to that question? When will
you--is this part of your overall analysis and review? When
would you have been prepared?
Mr. Cox. Well, with respect to enforcement actions and
ongoing investigations, we can report the moment that those
become public or that we take actions in a public venue, in
court, before in ALJ, before the Commission.
With respect to the findings of our respective divisions
and offices concerning this problem, we can report on an
ongoing basis. And I would be more than pleased to do so.
Senator Hagel. Thank you.
Secretary Quarles, a question for you. The issue of Long
Term Capital Management has been raised. It was raised at the
beginning of Chairman Cox's testimony this morning, referencing
the Federal Reserve and Chairman Greenspan in particular, what
Greenspan said about that issue and how it could have
destabilized our markets for all of the reasons you understand
if we had not interfered.
Using that Long Term Capital Management as an example, here
is the question: obviously, the excessive leverage that we saw
in that case, it posed a very real systemic risk for all our
markets. And you three this morning have talked about systemic
risk, which is not unimportant obviously in your roles as
regulators. The markets are the markets, and we recognize that.
We do not want to tie down a market to the point where we lose
the point of a market.
But specifically, as you know, and the Treasury has been
very deeply involved in the GSE issue. This issue has arisen,
in particular with Fannie and Freddie, on their significant use
of derivatives. And we have talked about this here.
With the LTCM issue as an example, here is the question. Do
you think there are corollary lessons to be learned here as we
review the specific environment of hedge funds and the larger
universe of the market with excessive leverage in particular?
And in particular to that, derivatives where Fannie and
Freddie use, to a great extent, and then the systemic risk
associated with that?
Mr. Quarles. I think absolutely. I think the lessons of
LTCM are as you have noted. They are one, leverage. They are
two, concentration of risk. And they are three, counterparty
risk management, market discipline, if you will. The reason
that you had the problems with LTCM is that you did not have
adequate market discipline because counterparties did not have
sufficient transparency in order to appropriately evaluate
their risks. And so you had excessive leverage for an entity
that turned out then to have systemic consequence.
I think you can walk through--right now when you look at
the hedge fund industry, you are actually in a better situation
than you were at that time on all three of those fronts. I do
not want to say that there is no possibility of problem. Not at
all. But you are in a better situation on leverage, on
counterparty risk management, and on market discipline than you
were at the time of LTCM.
For the GSEs, by contrast, you have the problem of lack of
market discipline because of the perceived Government backstop,
the misperception of Government backstop. You have lack of
market discipline. You have lack of counterparty risk
management, again because of the perception of the Government
standing behind those companies.
As a consequence, you have the ability to buildup excessive
leverage in a way that creates systemic risk. I think that is a
concern. And that is the fundamental reason that we have been
proposing what we have proposed for the GSEs.
Senator Hagel. Thank you. Mr. Chairman, thank you.
Chairman Shelby. Thank you, Senator Hagel.
I want to thank the panel for your participation today. We
have a vote on the floor now.
The Committee is adjourned.
[Whereupon, at 11:50 a.m. the hearing was adjourned.]
[Prepared statements, response to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF SENATOR DEBBIE STABENOW
Thank you, Mr. Chairman for scheduling this hearing today.
Although hedge funds have been around for a long time, they have
certainly grabbed my attention in the last 5 years. In 2001, there were
only 2,000 hedge funds and today, that number has grown more than 300%.
As we all know--there is simply too little known about the
estimated 9,000 hedge funds and their investments totaling $2.4
trillion according to the SEC.
What concerns me even more is that pension funds, charities, and
university endowments are investing in hedge funds despite the lack of
information. The problem is that when something goes wrong, no one is
able to obtain any information about the fund's assets or activities.
Unfortunately, in Michigan, we know about pension failures. The
idea of creating more harm to working families who have contributed
their own earnings to a pension plan is extremely concerning to me. We
need to make sure that everyone understands what is at stake with hedge
fund investments.
As a committee, I believe we should not be guessing about what
would happen if something went wrong with a $2.4 trillion industry. We
should do all we can to protect investors and those families who have
worked hard to retire with a pension.
I look forward to hearing the panel's recommendations.
Thank you, Mr. Chairman.
______
PREPARED STATEMENT OF CHRISTOPHER COX
Chairman, Securities and Exchange Commission
July 25, 2006
Chairman Shelby, Ranking Member Sarbanes and Members of the
Committee:
Thank you for inviting me to testify today about the regulation of
hedge funds. It is an especially welcome opportunity to appear on this
panel with other members of the President's Working Group on Financial
Markets, including the Department of the Treasury and the Commodity
Futures Trading Commission.
As you have recognized, each of us has responsibility for
different, but crucial aspects of the world in which hedge funds
operate. That's why the Securities and Exchange Commission is working
closely and cooperatively with the other members of the President's
Working Group on the questions of the systemic market risks posed by
hedge fund activity, and the investor protection issues that stem from
the increasing exposure of retail investors to hedge fund investment
opportunities.
I should emphasize at the outset, Mr. Chairman, that my testimony
today reflects my views as Chairman of the SEC, and does not represent
the position of the five-member Commission. The views I am expressing
this morning are solely my own.
It has been eight years since Long Term Capital Management
collapsed, after losing $4 billion in just five weeks. Then-Fed
Chairman Alan Greenspan said at the time that, had the Federal Reserve
Bank of New York not intervened to organize a $3.6 billion bailout by
the fund's creditor banks, the bankruptcy of LTCM ``could have
potentially impaired the economies of many nations, including our
own.'' LTCM was effectively liquidated by early 2000.
This spectacular hedge fund collapse left in its wake not only
ruined investors, but also serious questions about the threat to our
capital markets as a whole from such significant funds pursuing high
risk strategies with excessive leverage. In the months that followed,
President Clinton established the President's Working Group on
Financial Markets, with the SEC as a member, to coordinate regulatory
oversight of these issues as well as other questions that broadly
impact the national securities markets.
Since then, the President's Working Group has focused intently on
the concern that the failure of one or more significant and highly
leveraged investment pools, such as the Long Term Capital Management
hedge fund, could threaten the stability of financial markets. We are
more certain now than ever before that preventing future market
instabilities will require a coordinated effort by all financial
securities regulators.
But given the recent invalidation of the SEC's hedge fund rule by
the United States Court of Appeals, we have been forced back to the
drawing board to devise a workable means of acquiring even basic census
data that would be necessary to monitor hedge fund activity in a way
that could mitigate systemic risk.
The current lack of such basic data requires me to hedge when I say
that the SEC's best estimate is that there are now approximately 8,800
hedge funds, with approximately $1.2 trillion of assets. If this
estimate is accurate, it implies a remarkable growth in hedge fund
assets of almost 3,000% in the last 16 years. Much of this growth is
attributable to increased investment by institutions. This includes not
only investment companies and investment banks, but also private and
public pension plans, endowments, and foundations.
Last year, we believe an estimated 2,000 new hedge funds opened for
business. There were just over 2,500 hedge fund advisers registered
with the Commission at the end of June 2006. Half of those registered
following the Commission's hedge fund rule. The vast majority of the
registered hedge fund advisers, 88% of them, are domiciled in the
United States.
Although hedge funds represent just 5% of all U.S. assets under
management, they account for about 30% of all U.S. equity trading
volume. They are particularly active in the convertible bond market and
the credit derivatives market. We are also seeing hedge funds becoming
more active in such varied activities as the market for corporate
control, private lending, and the trading of crude petroleum.
It is undeniable that in addition to raising questions such as
systemic risk and investor protection, hedge funds also provide
investors and our national securities markets with tangible benefits.
They contribute substantially to capital formation, market efficiency,
price discovery, and liquidity. By actively participating in
derivatives markets, hedge funds can help counterparties reduce or
manage their own risks. Some hedge funds provide a way for
institutional investors to reduce their exposure to downside risk by
allocating a portion of their portfolio to an investment with a low
correlation to overall market activity.
But given the general lack of public disclosure about the way hedge
funds operate, the lack of standards for measuring a fund's valuation
and its performance, the possibilities for undisclosed conflicts of
interest, the unusually high fees, and the higher risk that accompanies
a hedge fund's expected higher returns, these are not investments for
Mom and Pop. They are generally risky ventures that simply don't make
sense for most retail investors.
While some refer to an alleged growing trend toward the
``retailization'' of hedge funds, the Commission's staff are not aware
of significant numbers of truly retail investors investing directly in
hedge funds. In my view, such a development, were it to occur, should
be viewed with alarm. Indeed, in the wake of the Court of Appeals
decision in the Goldstein case, I intend to recommend to the full
Commission that the SEC take formal steps to further limit the
marketing and availability of hedge funds to unsophisticated retail
investors.
In addition to the threat of retailization, the increased
investment in hedge funds by institutional investors with retail
constituencies, such as public and private pension plans, fund of funds
investments, universities, endowments, foundations and other charitable
organizations, carries with it the potential for retail exposure to
hedge fund risk. This trend, however, is still in its infancy. A recent
industry report by Greenwich Associates indicates that 80% of public
pension funds, and 82% of corporate funds, have little or no investment
in hedge funds. Those corporate pensions that actively invest in hedge
funds allocate on average only 5.3% of their assets to this entire
investment class. Public pensions that actively invest in hedge funds
allocate 5.1%.
The trend among endowments toward hedge fund investments is more
pronounced. Nearly two-thirds of endowments invest in hedge funds, and
those that do allocate an average of 18% to them. Whether or not this
sort of institutional investment directly impacts retail investors, it
surely is increasing the potential impact that hedge funds might have
on our capital markets.
The concerns about hedge funds that the SEC enunciated when we
adopted our hedge fund rule in December 2004 remain the same today. The
remarkable pace of hedge fund growth, which we noted at the time, has
continued unabated. The potential for retail investors to be harmed by
hedge fund risk remains as serious a concern now as then. And the
growth in hedge fund fraud that we have seen accompany the growth in
hedge funds implicates the very basic responsibility of the SEC to
protect investors from fraud, unfair dealing and market manipulation.
And on that point, let me make very clear that notwithstanding the
Goldstein decision, hedge funds today remain subject to SEC regulations
and enforcement under the antifraud, civil liability, and other
provisions of the federal securities laws. We will continue to
vigorously enforce the federal securities laws against hedge funds and
hedge fund advisers who violate those laws. Hedge funds are not, should
not be, and will not be unregulated. The challenge for the SEC and the
President's Working Group going forward is, rather, to what extent to
add new regulations, particularly in light of the recent Court of
Appeals ruling.
The fact that hedge funds remain subject to the same prohibitions
against fraud as other market participants, and their managers have the
same fiduciary obligations as other investment advisers, directly
addresses the Commission's concern with the growth in hedge fund fraud.
The Securities Act, the Exchange Act, and the Advisers Act each
provides the Commission with separate authorities to regulate fraud and
unfair dealing by hedge funds. Using this still valid authority over
the past several years, the Commission has brought dozens of
enforcement cases against hedge fund managers who have engaged in fraud
or have violated their fiduciary obligations.
The number of enforcement cases against hedge funds has grown from
just four in 2001 to more than 60 since then. These cases involve hedge
fund managers who have misappropriated fund assets; engaged in insider
trading; misrepresented portfolio performance; falsified their
experience and credentials; and lied about past returns. We have
brought cases for inaccurate disclosure of trading strategies;
undisclosed preferential treatment of hedge fund clients at the expense
of other clients; market manipulation; illegal short selling; and
improper valuation of assets. In some cases we have worked side-by-side
with criminal authorities who have brought criminal actions as well.
Recent examples of significant hedge fund cases brought by the
Commission include:
SEC v. CMG-Capital Management Group Holding Company, LLC and
Keith G. Gilabert, Litigation Release No. 19680 (May 1, 2006)--In
April 2006, the SEC filed an action in federal court charging a
California hedge fund manager and his advisory firm with
misappropriating more than $14 million in funds and misleading
investors about the hedge fund's returns. The Commission is seeking
permanent injunctions, disgorgement, and civil penalties against
the defendants.
SEC v. Nelson J. Obus, Peter F. Black, Thomas Bradley
Strickland, Wynnefield Partners Small Cap Value L.P., Wynnefield
Partners Small Cap Value L.P. I, Wynnefield Partners Small Cap
Value Offshore Fund, Ltd., Litigation Release No. 19667 (Apr. 25,
2006)--In April 2006, the SEC filed an insider trading case in
federal court against a hedge fund manager and two others in
connection with trading for three hedge funds in advance of the
public announcement of a merger agreement, resulting in illicit
gains of over $1.3 million. The Commission is seeking injunctions
against the defendants, as well as disgorgement, civil penalties,
and orders barring the hedge fund manager from acting as an officer
or director of a public company.
SEC v. Kirk S. Wright, et al., Litigation Release No. 19581
(Feb. 28, 2006)--In February 2006, the Commission obtained a
temporary restraining order and other emergency relief in federal
court to halt an ongoing offering fraud involving the sale of
investments in seven hedge funds by an Atlanta-based promoter and
investment advisers controlled by him. The Commission alleged that
the defendants raised as much as $185 million from up to 500
investors through the fraudulent investment scheme, and that the
advisers provided investors with statements that misrepresented the
amount of assets in the hedge funds and the returns earned by the
funds. The Commission is seeking permanent injunctions against the
defendants, an accounting and disgorgement of ill-gotten gains, and
civil penalties.
SEC v. Deephaven Capital Management, LLC and Bruce Lieberman,
Litigation Release 19683 (May 2, 2006) (also see Investment
Advisers Act Release No. 2517 (May 26, 2006))--In May 2006, the SEC
charged hedge fund adviser Deephaven Capital Management, LLC and
its former portfolio manager with insider trading based on
information that 19 PIPE offerings were about to be publicly
announced. Deephaven has agreed to disgorge $2.7 million in
unlawful profits and to pay $343,000 in prejudgment interest and a
$2.7 million civil penalty. The portfolio manager agreed to pay a
$110,000 civil penalty and agreed to be barred from associating
with an investment adviser for three years.
But while our ability to bring enforcement actions against hedge
funds and their managers remains intact following the Goldstein
decision, the same cannot be said for the Commission's ability to
require hedge fund advisers to register and submit to inspections. The
Commission stated, when we adopted the hedge fund rule in 2004, that
its then-current program of hedge fund regulation was inadequate. With
the rejection of the hedge fund rule by the Court of Appeals, I believe
that is once again the case. We must move quickly to address the hole
that the Goldstein decision has left. Some improvements will be
possible through administrative action. Others, however, may well
require legislation.
As you consider the possibility of legislation, which is of course
the prerogative of the Congress, the SEC stands ready to assist you
with technical advice and assistance should you request it. As a
general principle, which I would apply both to the Commission's future
regulatory actions in this area as well as to any potential
legislation, I would counsel that to the maximum extent possible our
actions should be non-intrusive. There should be no interference with
the investment strategies or operations of hedge funds, including their
use of derivatives trading, leverage, and short selling. Nor should the
federal government trammel upon their creativity, their liquidity, or
their flexibility. The costs of any regulation should be kept firmly in
mind. Similarly, there should be no portfolio disclosure provisions. A
hedge fund's ability to keep confidential its trading strategies and
portfolio composition should be protected. And hedge funds should be
able to continue to charge their clients performance fees, just as they
do now.
Immediately following the Goldstein ruling, I instructed the SEC's
professional staff to promptly evaluate the court's decision, and to
provide me with a set of alternatives that the SEC could pursue without
legislation. That evaluation is still underway, but I have already
decided upon several urgent courses of action which I can report to
this Committee today. Specifically, I intend to recommend to the full
Commission the following emergency rulemakings and Commission actions:
First, I will recommend that the SEC promulgate a new anti-fraud
rule under the Investment Advisers Act that would have the effect of
``looking through'' a hedge fund to its investors. This would reverse
the side-effect of the Goldstein decision that the anti-fraud
provisions of Sections 206(1) and 206(2) of the Act apply only to
``clients'' as the court interpreted that term, and not to investors in
the hedge fund. I believe that such a rule is possible because the
court itself noted that another anti-fraud provision, Section 206(4),
is not limited to fraud against ``clients.'' The result would be a rule
that could withstand judicial scrutiny, and which would clearly state
that hedge fund advisers owe serious obligations to investors in the
hedge funds. The staff is currently analyzing what the contours of such
a rule might be, given the Commission's authority to adopt such a rule
under Section 206(4).
Second, I am directing the SEC staff to take emergency action to
insure that the transitional and exemptive rules contained in the 2004
hedge fund rule are restored to their full legal effect. This is
necessary to insure that hedge fund advisers who were relying on the
now-invalidated rule are not suddenly in violation of our regulatory
requirements when the court issues its final mandate in mid-August.
For example, among the provisions of the hedge fund rule that the
court invalidated was a section governing the Advisers Act's
restrictions on performance fees for hedge fund adviser contracts that
were entered into before the hedge fund rule went into effect. This
section of the hedge fund rule was designed to prevent a hedge fund
adviser from having to renegotiate the terms of its existing advisory
contracts, or from having to expel from the fund (including venture
capital and private equity funds as well as hedge funds) pre-existing
investors who are not ``qualified clients.''
Likewise, I am directing emergency action to restore to newly
registered hedge fund advisers their qualified exemption from the
recordkeeping requirement for performance data prior to their
registration. (They would still be required to maintain all records
they have to substantiate their prior performance.) Without this
emergency action prior to mid-August, newly registered hedge fund
advisers that remain registered, but that did not create records for
the periods prior to their registration, will lose the ability to use
their performance track record. Rather perversely, that would
discourage hedge fund advisers from voluntarily remaining registered.
Yet another emergency action I am directing will restore the
extension of time that was given to advisers for funds of hedge funds
to provide their audited financial statements. The underlying hedge
funds do not typically supply their audited financials to the fund of
funds manager until the 120-day deadline, so the fund of funds managers
need extra time to complete their audit work and send out the reports.
The hedge fund rule gave it to them, but the Goldstein decision
invalidated that relief. I intend for the Commission to restore the
extension of time from 120 to 180 days.
Similar action is needed to undo yet another effect of the
Goldstein decision, which is to undo the Commission's 2004 hedge fund
rule insofar as it applied to off-shore advisers to off-shore hedge
funds. Those advisers had to register under the new rule (assuming
their funds had more than 14 U.S. investors), but they would have been
subject to different treatment under the Advisers Act because they
could treat the off-shore fund as their ``client'' for all other
purposes. The Court's ruling, however, eliminated this aspect of the
rulemaking; and by creating doubt whether registered offshore advisers
will be subject to all of the provisions of the Act with respect to
their offshore hedge funds, the ruling has created a disincentive for
offshore advisers to remain voluntarily registered. I have directed the
Commission staff to address this disincentive to registration.
Finally, to address my concerns with respect to the retailization
of hedge funds, I have asked the staff to analyze and report to the
Commission on the possibility of amending the current definition of
``accredited investor'' as applied to retail investment in hedge funds
without registration. I am concerned that the current definition, which
is decades old, is not only out of date, but wholly inadequate to
protect unsophisticated investors from the complex risks of investment
in most hedge funds. Under the Commission's Regulation D, for example,
one definition of an ``accredited investor'' is ``Any natural person
whose individual net worth, or joint net worth with that person's
spouse, at the time of his purchase exceeds $1,000,000.'' This does not
exclude one's residence. The Commission's hedge fund rule would have
had the effect of increasing this suitability threshold to $1.5 million
of net worth, rather than $1 million, for any hedge fund that charges a
performance fee.
This was an important change, and I would like to see it restored.
In California, the median home price is well over one-half million
dollars. So post-Goldstein, with barely more than $200,000 apiece in
other assets, a California couple could qualify to buy a hedge fund in
an unregistered offering--even though that relatively small amount
might represent their entire life savings in the form of a teacher's or
fire fighter's retirement fund.
Beyond these emergency rulemakings and other actions to restore as
much of the pre-Goldstein rule as possible, I have directed the SEC
staff to continue to conduct compliance examinations of investment
advisers who remain registered with us, or register with us in the
future. All registered hedge fund advisers are subject to SEC
regulation, and the SEC will continue to conduct risk-based
examinations of hedge fund advisers that are registered with the SEC.
The purpose of these exams will be to evaluate the hedge fund adviser
compliance programs, and to detect violations of the securities laws.
Our continuing oversight of hedge fund advisers who remain
registered with the SEC post-Goldstein will cover the majority of the
over 2,500 of the hedge fund advisers of which we are aware. Because
fully half of these advisers were registered with the SEC before the
hedge fund rule required it, we anticipate that at least this number
will voluntarily remain registered. And while some number of hedge fund
advisers will certainly de-register as a result of the court's
decision, our experience since Goldstein is that more hedge fund
advisers have become newly registered than have de-registered. In other
words, although these are early returns and may not be indicative of
the final outcome, we have actually experienced a net increase in hedge
fund registrations since the Goldstein decision.
We are also working with other regulators, including the CFTC and
the other members of the President's Working Group, to coordinate our
hedge fund oversight efforts. As I have noted, each member agency of
the President's Working Group has a unique responsibility and provides
a critical perspective when it comes to the efficient and effective
functioning of our capital markets. In addition, we are working in
close coordination with the Financial Services Authority in the United
Kingdom, since together the U.S. and the U.K. account for the vast
majority of the world's hedge fund activity, including prime brokerage.
As we move forward, it will be important that we view the whole
picture as we work to evaluate both the systemic market risks and the
retail investment issues associated with the growing presence of hedge
funds in our capital markets. Hedge funds are a significant and growing
part of our financial markets that yield not only risks but also many
benefits for our economic system. Each of us at this table, as members
of the President's Working Group, has an interest and responsibility to
continue working collaboratively to evaluate both the systemic market
risks and retail investment issues associated with hedge funds in order
to maintain these overall benefits. I and the SEC are committed to
doing so.
Thank you for inviting me to testify on this important subject. I
am happy to answer any questions you may have.
______
PREPARED STATEMENT OF REUBEN JEFFERY, III
Chairman, Commodity Futures Trading Commission
July 25, 2006
Chairman Shelby, Senator Sarbanes, and Members of the Committee, I
am pleased to have an opportunity to testify on behalf of the CFTC on
the regulation of hedge funds.
I will focus my remarks today on how hedge funds intersect with the
CFTC's statutory responsibilities under its governing statute, the
Commodity Exchange Act (the CEA). At the outset, I should emphasize
that the CFTC does not regulate ``hedge funds'' per se. However, the
CFTC encounters hedge funds as it performs two of its critical missions
under the CEA: promoting market integrity and protecting the public
from fraud in the sale of futures and commodity options. Hedge funds
are on the CFTC's market surveillance radar when they trade in the
regulated futures and commodity options markets. With respect to
investor protection, if a collective investment vehicle, such as a
hedge fund, trades futures or commodity options, the fund is a
``commodity pool'' and its operator and advisor may be required to
register with the CFTC and meet certain disclosure, reporting, and
recordkeeping requirements.
My testimony today will address four topics. First, I will share
some observations regarding the participation of hedge funds in the
regulated futures markets. Second, I will describe the CFTC's
surveillance methods used to monitor large traders, including many
hedge funds. Third, I will describe the CFTC's investor protection
regime aimed at protecting investors from fraudulent practices in the
sale of commodity pools, including hedge funds. Finally, I will comment
on our recent enforcement activities involving commodity pools and
hedge funds.
Participation of Hedge Funds in Futures Markets
Futures markets serve an important role in our economy by providing
a means of transferring risk from those who do not want it to those
willing to accept it for a price. Traders who are trying to reduce
their exposure to price risks, that is, ``hedgers,'' typically include
those who have an underlying commercial interest in the commodity upon
which the futures contract is based. For example, futures contracts
allow a bank to transfer its risk exposure to rising interest rates, a
grain merchant to hedge an expected purchase of corn, or an oil refiner
to lock in the price of its heating oil and gasoline output. In order
for these hedgers to reduce the risk they face in their day-to-day
commercial activities, they need to trade with someone willing and able
to accept the risk. Data from the CFTC's Large Trader Reporting System
indicate that hedge funds, and other professionally managed funds,
facilitate the needs of commercial hedgers to mitigate their price
risks, and add to overall trading volume, which contributes to the
formation of liquid and well-functioning markets.
CFTC large trader data also show that hedge funds and other
professionally managed funds hold significant arbitrage positions
between related markets. These arbitrage positions are structured to
profit from temporary mispricing between related contracts (e.g.,
prices for October delivery vs. prices for November delivery) and, when
structured as such, are unrelated to the overall level of futures
prices. These arbitrage trades play a vital role in keeping prices of
related markets (and prices of related contracts within the same market
complex) in proper alignment with one another.
One notable market development in recent years has been increased
participation by hedge funds and other financial institutions in
futures markets for physical commodities. These institutions view
commodities as a distinct ``asset class'' and have allocated a portion
of the portfolios they manage into futures contracts tied to commodity
indexes. The total investment in commodity-linked index products by
pension funds, hedge funds and other institutional investors has been
estimated by industry observers to exceed $100 billion in assets. A
significant portion of this amount finds it way into the regulated
futures markets, either through direct participation by those whose
commodity investments are benchmarked to a commodity index, or through
participation by commodity index swap dealers who use futures markets
to hedge the net risk associated with their dealing activities.
Notably, although the percentage of participation by hedge funds has
increased in recent years, commercial traders in these markets remain,
by far, the largest segment of trading category.
Surveillance Methods Used by the CFTC to Monitor Large Traders--
Including Hedge Funds
In the CFTC's world of regulated futures exchanges, market
integrity is essential to preserving the important functions of risk
management and price discovery that the futures markets perform in the
U.S. economy. The CFTC relies on a program of market surveillance to
ensure that markets under CFTC jurisdiction are operating in an open
and competitive manner, free of manipulative influences or other price
distortions. The backbone of the CFTC's market surveillance program is
its Large Trader Reporting System. This system captures end-of-day
position-level data for market participants meeting certain criteria.
Positions captured in the Large Trader Reporting System typically make
up 70 to 90 percent of all positions in a particular exchange-traded
market. The Large Trader Reporting System is a powerful tool for
detecting the types of concentrated and coordinated positions required
by a trader or group of traders attempting to manipulate the market.
For surveillance purposes, the large trader reporting requirements for
hedge funds are the same as for any other large trader.
Using large trader reports, CFTC economists monitor futures market
trading activity, looking for large positions that might be used to
manipulate prices. Each day, for all active futures and option
contracts traded on the regulated exchanges, surveillance staff members
monitor the daily activities of large traders and key price
relationships. In addition, CFTC market analysts maintain close
awareness of supply and demand factors and other developments in the
underlying cash markets through review of trade publications and
government reports, and through industry and exchange contacts. Staff
also closely tracks the net positions of managed money traders as a
class to monitor for any market irregularities or trends. The CFTC's
surveillance staff routinely reports to the Commission on surveillance
activities at weekly surveillance meetings.
Market surveillance, however, is not conducted exclusively by the
CFTC. Each futures exchange is required under the CEA to affirmatively
and effectively supervise trading, prices, and positions. The CFTC
examines the exchanges to ensure that they have devoted appropriate
resources and attention to fulfilling this important responsibility.
The CFTC staff's findings from these rule enforcement reviews are
reported to the CFTC, and are publicly posted on the CFTC Website
(www.cftc.gov). Furthermore, exchanges impose position limits, where
appropriate, to guard against manipulation. For example, NYMEX imposes
spot month speculative limits on its energy contracts.
When the CFTC's surveillance staff identifies a potentially
problematic situation, the CFTC engages in an escalating series of
communications with the largest long- and short-side traders--which may
be hedge funds--to address the concern. Typically, the CFTC's staff
consults and coordinates its activities with exchange staff. This
targeted regulatory oversight by CFTC staff and the exchanges is quite
effective in resolving most potential problems. However, hedge funds
normally roll out of positions prior to the expiration month when
manipulation is most likely to occur, because most do not have the
capabilities to make or take delivery of the underlying commodity.
Given the CFTC's statutory role as an oversight regulator, and the
exchanges' statutory responsibility to monitor trading to prevent
manipulation, the law requires that the exchanges take the lead in
resolving problems in their markets, either informally or through
emergency action. If an exchange fails to take actions that the CFTC
deems necessary, the CFTC has broad emergency powers to direct the
exchange to take such action which, in the CFTC's judgment, is
necessary to maintain or restore orderly trading in, or liquidation of,
any futures contract. Fortunately, most issues are resolved without the
need for the CFTC's emergency powers, as the CFTC has had to take
emergency action only four times in its history.
Just as the CFTC's market surveillance program monitors the
activity of all large traders on the regulated futures exchanges to
maintain an orderly operation of the markets, the system of financial
safeguards in the futures industry is focused on ensuring that the
financial distress of any single futures market participant, whether it
be a hedge fund or any other participant, does not have a
disproportionate effect on the overall market. This is primarily
accomplished through a clearinghouse's financial safeguards. This
includes the margin deposited by clearing member firms and guarantee
funds. Futures clearinghouses perform periodic risk evaluations of
clearing member firms in an attempt to detect potential weaknesses in
financial condition or risk controls. In addition, each firm has its
own financial and capital safeguards in place to protect itself from
the financial distress of a customer--including a hedge fund customer.
CFTC's Oversight Authority With Respect to Operators and Advisors of
Commodity Pools, Including Hedge Funds
Of no less importance is the CFTC's responsibility to protect
investors who participate--whether directly or through participation in
a professionally managed fund--in the futures markets through a diverse
array of commodities products. To that end, the CFTC maintains a
customer protection regime that, pursuant to the CEA, relies on full
and timely disclosure to protect investors from abusive or overreaching
sales practices. This encompasses participation in commodity pools,
including hedge funds.
Registration is the cornerstone of the CFTC's customer protection
scheme. As of June 30, 2006, there were approximately 1,600 Commodity
Pool Operators (CPOs) and 2,600 Commodity Trading Advisors (CTAs)
registered with the CFTC, operating and advising approximately 2,300
commodity pools. In annual reports filed for 2005, these CPOs reported
total assets under management for commodity pools of approximately $700
billion, of which less than five percent represent direct investments
in the futures markets.
The primary purposes of registration are to ensure a person's
fitness to engage in business as a futures professional and to identify
those persons whose activities are covered by the CEA. Generally
speaking, those who operate or manage a commodity pool must register
with the CFTC as CPOs, and those who make trading decisions on a pool's
behalf must register as CTAs. Registration is not dependent on whether
commodity interests are traded for speculative or hedging purposes, or
on whether they are the predominant investment traded or advised.
Notable exclusions or exemptions are available for operators of pools
that are otherwise regulated; that have only sophisticated participants
and de minimis commodity interest trading; and that have only the very
highest level of sophisticated participants, regardless of the amount
of commodity interests traded. Hedge fund operators frequently fall
within one of the latter two exemptions from CPO registration.
Once registered, a CPO or CTA must comply with certain disclosure,
reporting, and recordkeeping requirements designed to ensure that
prospective and current participants in commodity pools receive all the
information that is material to their decision to make, or maintain, an
investment in the pool. For example, prospective participants must
receive information regarding the pool's investment program, risk
factors, conflicts of interests, and performance data and fees.
Thereafter, a CPO must provide pool participants with an account
statement at least quarterly, and an annual report containing specified
financial statements which must be certified by an independent public
accountant and presented in accordance with Generally Accepted
Accounting Principles (GAAP).
The CFTC has established a simplified regulatory framework for
registered CPOs and CTAs who operate or advise pools whose participants
meet certain criteria. Relief from full compliance with the disclosure,
reporting, and recordkeeping requirements is available where, for
example, pool participants are CFTC or SEC registrants, ``inside
employees'' of the CPO or CTA, or persons who earn $200,000 annually
and who have assets worth at least $2 million. Many of the pools for
which CPOs are exempt from disclosure, reporting, and recordkeeping
regulations are likely to be hedge funds.
Having outlined what CFTC regulation involves, it is important to
note the limits of that regulation. The CFTC's mandate under the CEA
does not include imposing limits on the pool's market risk or leverage
parameters, or the instruments that may be traded, or imposing capital
requirements or risk assessment procedures.
Finally, day-to-day oversight functions of CPOs and CTAs are
carried out by the National Futures Association (NFA), the futures
industry analogue of the National Association of Securities Dealers.
NFA's responsibilities include the registration processing function and
review of CPO and CTA disclosure documents and pool financial
statements. Consistent with the disclosure-based regulatory regime
under the CEA, review of pool financial statements focuses on ensuring
that they include all required information and conform to applicable
accounting standards, but does not include an analysis of the pool's
underlying transactions themselves. As part of its self-regulatory
responsibilities, NFA conducts on-site examinations of CPOs and CTAs on
a routine, periodic basis. NFA generally examines all CPOs and CTAs
within two years of their becoming active, and every four years
thereafter.
CFTC Enforcement Overview: Commodity Pools, Hedge Funds and CPOs
The CFTC takes its enforcement responsibilities with respect to
CPOs, CTAs, and commodity pools very seriously. Whether registered or
unregistered, exempt or not exempt, CPOs and CTAs remain subject to the
CFTC's anti-fraud authority.
Over the past 6 fiscal years, the CFTC has brought 49 enforcement
actions involving commodity pools, hedge funds and CPOs. These
enforcement actions typically involve investments in commodity pools,
including self-styled hedge funds, in which the investors' funds were
misappropriated or misused, or where investors were victimized by
solicitation fraud involving misrepresentations of assets under
management and/or profitability. The CFTC's Division of Enforcement
currently has 55 pending investigations of commodity pools, hedge funds
and CPOs.
The majority of the CFTC's pool fraud cases have been brought
against unregistered CPOs. These cases tend to involve ponzi schemes or
outright misappropriation, as opposed to legitimate hedge fund
operations. Sanctions in CFTC enforcement actions can include permanent
injunctions, asset freezes, prohibitions on trading on CFTC-registered
entities, disgorgement of ill-gotten gains, restitution to victims,
revocation or suspension of registration, and civil monetary penalties.
The CFTC has taken enforcement action in several well-publicized
recent hedge fund frauds. While the futures activities of these funds
were not necessarily the primary cause of the problems, the CFTC took
action against its registrants to punish their illegal conduct, deter
future violations, and seek recovery of monies taken from innocent
victimized investors. The following cases filed during the past year
are illustrative:
On June 21, 2005, the CFTC filed an enforcement action against
Philadelphia Alternative Asset Management Co., LLC (PAAM), a registered
CPO, and Paul M. Eustace, a registered associated person and president
of PAAM, alleging fraudulent solicitation and false reporting involving
hedge funds and commodity pools. On the day that the complaint was
filed, the CFTC froze approximately $70 million of the defendants'
assets.
On September 29, 2005, the CFTC filed an enforcement action
alleging misappropriation and fraud involving Connecticut hedge fund
manager and registered CPO Bayou Management, LLC (Bayou Management),
its principals Samuel Israel III (a registered associated person) and
Daniel E. Marino, and Richmond Fairfield Associates, Certified Public
Accountants. The complaint alleges that the defendants misappropriated
customer funds, acquired funds through false pretenses, engaged in
unauthorized trading, and misrepresented material facts to actual and
prospective investors, including the rates of return the hedge funds
earned, the value of assets under management, and the existence and
identity of the accounting firms that had purportedly audited the hedge
funds.
In many instances, the CFTC works cooperatively with NFA, state
regulators, criminal authorities and/or the SEC in bringing such
actions. In Bayou, for example, Israel and Marino, based upon the same
conduct alleged by the CFTC, pleaded guilty to criminal charges brought
by the U.S. Attorney's Office for the Southern District of New York.
The CFTC also coordinated its Bayou investigation with the SEC, which
filed a parallel enforcement action under the federal securities laws.
Conclusion
In closing, the CFTC's primary mission under the CEA includes
ensuring market integrity and customer protection. Hedge funds that
trade futures and commodity options on CFTC-regulated exchanges
implicate both. Thus, the CFTC monitors participation by hedge funds in
the regulated futures markets, as it does with other large traders, in
order to ensure that these markets operate free of price distortions.
The CFTC also administers a disclosure-based regime designed to ensure
that investors participating in commodity pools receive all the
information that is material to their decision to invest in pools; when
problems are uncovered, the full force of the CFTC's enforcement
authority is devoted to prosecuting those responsible. The CFTC will
remain vigilant in utilizing the tools provided in the CEA--market
surveillance, disclosure, reporting and recordkeeping, and enforcement
authority--to fulfill its statutory responsibilities as hedge fund
participation in the futures markets continues to expand.
This concludes my remarks. I look forward to your questions.
______
PREPARED STATEMENT OF RANDAL K. QUARLES
Under Secretary for Domestic Finance, Department of the Treasury
July 25, 2006
Chairman Shelby, Ranking Member Sarbanes, Members of the Committee,
good morning, it is a pleasure to be here today. I would like to thank
you for holding this hearing and allowing the Treasury Department to
present its views. I am pleased to be here today to contribute to a
discussion of a topic that is of critical importance to our financial
markets, namely the regulation of hedge funds.
In May, before a subcommittee of this panel, I presented testimony
regarding the role that hedge funds play; that is, what hedge funds do
for and in our financial markets. As I said then, if government
addresses the question of regulation of any financial institution or
activity without a clear understanding of the place it plays in our
financial system, we run the risk of imposing unnecessary, excessive,
or inappropriate legislation.
As we consider the regulation of hedge funds, we should keep in
mind that the role they fulfill in our financial markets is
continuously evolving; and in recent years it has been evolving
rapidly. Therefore, before I turn to the subject of today's hearing, I
would like to reiterate some of the key points from the testimony I
gave in May 2006, in which I discussed some of the characteristics of
hedge funds and some of the potential benefits and risks that they can
present.
Background
Despite the fact that hedge funds are today the subject of everyday
discussion in the financial press and among policymakers, there is no
universally accepted definition of a hedge fund. A recent report by the
International Organization of Securities Commissions (IOSCO) on the
results of a survey of the regulatory approaches toward hedge funds of
20 IOSCO members revealed that none of the survey respondents had a
formal definition of ``hedge fund.'' In the late '90s, the President's
Working Group on Financial Markets (PWG) defined a hedge fund as ``any
pooled investment vehicle that is privately organized, administered by
professional investment managers, and not widely available to the
public.'' Though this was a useful working definition for the PWG's
purposes, it is limited in how widely it can be applied, in large part
because it does not distinguish hedge funds from other forms of
unregistered capital pools that are generally recognized to have
distinctive features, such as private equity funds and venture capital
funds. In my May testimony I suggested that there are a number of
features that can help to distinguish hedge funds from other capital
pools, including: legal structure; investment objective and strategy;
compensation scheme; investor base and capital commitment; and
disclosure.
As I testified in May, hedge funds have experienced dramatic
growth, especially in recent years. They have grown from an estimated
$50 billion in assets in 1988 to about $300 billion in 1998 to over $1
trillion in assets today.\1\ Current estimates suggest that there are
about 9,000 hedge funds.
---------------------------------------------------------------------------
\1\ The data about the hedge fund industry are not precise.
Therefore, many of the figures noting the size and growth of the
industry are estimates and Treasury has not independently verified
them.
---------------------------------------------------------------------------
Hedge funds employ a variety of investment strategies that vary
considerably depending on the goals and needs of the investors and the
types of instruments in which the fund invests. Much, if not all, of
this growth has been market driven, and, as a consequence, it has been
subject to a significant amount of market discipline. As hedge funds
have grown, their investor base has evolved, bringing increasing levels
of professional analysis to the investor side of the relationship. Each
new group of investors has imposed certain forms of discipline on hedge
funds, resulting in the hedge fund market becoming much more
``institutionalized'' as it has developed. In addition, since the
failure of Long Term Capital Management (LTCM) in 1998 hedge fund
investors--and creditors--have recognized the need for more discipline
regarding the use of leverage and collateral, and hedge fund investors
now demand more transparency of their fund managers. Therefore, while
the hedge fund market has grown dramatically in the past twenty years,
there is at least some reason to believe this growth has been subject
to reasonable private sector discipline.
Hedge funds clearly provide certain benefits to the financial
markets. At the same time, they can also put stresses on it that need
attention. In my May testimony, I discussed at length many of the
benefits and potential risks that can arise from the activities of
hedge funds. Hedge funds impart potential benefits both to the
financial marketplace, in general, as well as to investors.
In the financial marketplace, hedge funds provide liquidity, price
efficiency, and risk distribution, and contribute to the further global
integration of markets. Because of the varying strategies employed by
hedge funds, they are often the willing buyers or sellers that provide
additional liquidity to financial markets. Hedge funds contribute even
more significantly to marketplace liquidity in less traditional
markets. Many hedge funds seek to create returns by targeting price
inefficiencies, including wide bid/ask spreads. While this activity
certainly benefits the hedge funds that are profiting from the trades,
it has the salutary effect of creating narrower spreads and more
efficient markets. Hedge funds can help mitigate market-wide
concentrations of risk by transferring and distributing market risk
through their willingness to be counterparties in derivatives trades.
Today, there is no question that hedge funds are among the dominant
participants in the re-distribution of market risk. In their search for
the next profit opportunity, hedge funds often lead the way to
identifying new and emerging markets. These markets often provide
opportunities that no longer exist in more mature marketplaces. This,
in turn, leads to further globalization of our marketplace which
provides more choice for investors and greater efficiency of markets
globally.
Hedge funds can have a direct positive impact on the investing
community. Speaking broadly, hedge funds can provide investors with
opportunities for diversification, ``alpha'' or excess returns, and
capital protection in down markets. Hedge funds provide investors with
more choices of both instruments and investment strategies. More
choices allow investors the ability to diversify their investment
portfolios, which is a common goal of many investors. In contrast to
conventional investment vehicles employing traditional ``go-long''
strategies, the flexibility in the hedge fund structure enables
strategies that attempt to produce positive returns in both bull and
bear markets; that is, providing opportunities for generating ``alpha''
or excess returns, even in thriving years, and for capital protection
(or better) in declining markets. It is worth noting that as the hedge
fund industry grows and becomes more mature and institutionalized,
excess returns have become harder to find. In addition, a common
technique employed by many hedge funds attempting to generate excess
returns is employing leverage, which, of course, presents its own
specific set of concerns.
While hedge funds can provide benefits to investors and the overall
marketplace, they present some risk as well. There are risks that hedge
funds' aggregate employment of large amounts of leverage or over-
concentration of certain positions could have negative consequences for
the marketplace. Certain valuation risks also are present in the hedge
fund industry. Other risks involve operational challenges associated
with the over-the-counter (OTC) clearance and settlement systems. Many
of these risks, however, are not unique to hedge funds.
Leverage refers to the use of repurchase agreements, short
positions, derivative contracts, loans, margin, and other forms of
credit extension to amplify returns. With increased leverage, of
course, comes increased risk. As discussed by the PWG in its report
after the LTCM failure, excessive leverage can greatly magnify negative
effects of market conditions. Linked closely with the issue of leverage
and the potential for impaired liquidity in a period of market stress
is the issue of concentration of market positions or ``crowded
trades.'' Sometimes referred to as ``herding,'' crowded trades can
arise to the extent that hedge fund managers are inclined to pursue the
same or similar investment strategies. If numerous market participants
establish large positions on the same side of a trade, especially in
combination with a high degree of leverage, this concentration can
contribute to a liquidity crisis if market conditions compel traders
simultaneously to seek to unwind their positions. The risk, of course,
is market disruption and illiquidity, possibly exacerbating the risk of
a systemic financial market crisis.
As hedge funds become larger, their valuation policies and
procedures become more important to the marketplace as a whole.
Valuation is often dependent on complex proprietary models, but because
of their proprietary nature, these models have not been subject to
broad-based scrutiny and there is a concern that there could be
unanticipated changes that might only present themselves in certain
market conditions. Moreover, valuation concerns are exacerbated in the
hedge fund industry because hedge fund adviser compensation is tied to
period returns which, of course, requires periodic asset valuations.
With respect to OTC settlement and clearance systems, hedge funds as a
group do not pose a greater operational risk than any other group of
market participants. However, operational risks can be posed by certain
market conditions and certain technological conditions in certain
products, particularly new products, where technological and legal
infrastructures tend to lag product development and volume growth.
These acute ``growing pains'' have developed most recently in the
credit derivatives market across a wide spectrum of participants.
Thus, hedge funds, or any other group of participants, potentially
could have a disruptive impact if there were concentrations of
positions or attempted mass liquidation in illiquid markets. However,
many of these issues and concerns have been or are actively being
addressed--outside of a formal scheme of direct regulation of hedge
funds--both by policymakers and by private sector groups.
In its report on LTCM, the PWG cautioned that problems can arise
when financial institutions do not employ sufficient discipline in
their credit practices with customers and counterparties. To this end,
the PWG made several recommendations designed to help buttress the
market-discipline approach to constraining leverage. Numerous public
and private sector groups, such as Counterparty Risk Management Group
II (also known as the Corrigan Group), also took up the cause of
enhancing counterparty credit risk management, and many have continued
to focus on emerging developments such as the growth of products
containing embedded leverage. These efforts and others have had the
positive effects that I alluded to earlier.
Valuations and correlations also can change rapidly in unexpected
ways and these changes can have a ripple effect in the marketplace,
especially if the instruments are concentrated and illiquid. In July
2005, the Corrigan Group issued a number of ``guiding principles'' and
recommendations for all types of participants. It recommended that: (1)
investment in risk management systems should continue, with full model
testing and validation and independent verification; and (2) analytics
should include stress testing, scenario analysis, and expert judgment,
with special attention to the inputs and assumptions.
The Federal Reserve Bank of New York, Counterparty Risk Management
Group II, Bank for International Settlements, International Swap and
Derivatives Association, The Bond Market Association, and Depository
Trust & Clearing Corporation all have made recommendations or
undertaken efforts to strengthen the technological and legal aspects of
the settlement and clearance systems for all market participants. The
International Monetary Fund has also raised issues generally related to
market concentrations and illiquidity and the potential for systemic
risk in its recent ``Global Financial Stability Report,'' and member
countries and regulators continue to develop and coordinate policies
and approaches to deal with these issues globally.
Treasury and the PWG can contribute significantly to these policy
debates in the first instance by facilitating communication in the
official sector and with industry participants and academics regarding
credit risk management, concentration of risks, valuation techniques
and models, and clearance and settlement systems. While the PWG
continues to discuss these issues and formulate and coordinate actions
and plans, we are encouraged by these positive developments noted
above.
Regulation of Hedge Funds
The PWG's position on direct regulation of hedge funds
In its 1999 report on LTCM, the PWG was mainly concerned about the
systemic risks posed by hedge funds and other highly leveraged
institutions. Specifically, the PWG was concerned that excessive and
unconstrained leverage could, in an episode of unusual market stress,
lead to a general breakdown in the functioning of the financial
markets. Accordingly, the PWG made a series of recommendations designed
to encourage hedge funds, hedge funds' counterparties, and regulators
to focus on enhancing market-wide practices for counterparty risk
management. A number of the private sector initiatives I have already
mentioned were initiated in direct response to the PWG's
recommendations.
One recommendation the PWG did not make, however, was for the
direct regulation of hedge funds. The PWG stated that, ``if further
evidence emerges that indirect regulation of currently unregulated
market participants is not working effectively to constrain leverage,''
then direct regulation of hedge funds, among other measures, ``could be
given further consideration to address concerns about leverage.'' Even
with that caveat, the PWG took care to emphasize that it believed its
recommendations ``would best address concerns related to systemic risk
without the potential attendant costs of direct regulation of hedge
funds.'' To date, the PWG has not observed evidence that ``indirect''
methods of constraining leverage are not working effectively.
SEC Hedge Fund Adviser Registration Rule
In late 2004, the Securities and Exchange Commission (SEC) issued a
final rule that required hedge fund advisers to register with the
Commission, mainly out of a perceived need to address increasing
instances of hedge fund fraud and a concern that less sophisticated
investors were becoming increasingly exposed to hedge fund investments,
either directly or indirectly through their pension plans. The rule
went into effect on February 1, 2006, prompting more than 1,100
previously unregistered hedge fund advisers to register with the SEC.
Neither Treasury nor the PWG ever took a formal position on the
rule. We did work with the SEC, however, both bilaterally and through
the PWG, to make sure we understood the SEC's rationale for their rule,
and what their goals and expectations were regarding its
implementation. Although we did not formally comment on the SEC's
proposed rule, we did ask the SEC to work with the Commodity Futures
Trading Commission (CFTC) to avoid potential duplicative registration
requirements for CFTC-registered commodity pool operators and commodity
trading advisers.
This past June, the U.S. Court of Appeals for the D.C. Circuit
ruled that the SEC's hedge fund adviser registration rule was arbitrary
in the way it redefined the term ``client'' so as to bring hedge fund
advisers under the registration requirements of the Investment Advisers
Act, and the court therefore vacated the rule. SEC Chairman Cox, in his
statement on the Court's decision, expressed a very pragmatic approach
to dealing with this decision. He noted that the SEC will continue to
work with the PWG as it reevaluates its approach to hedge fund activity
and as the SEC considers alternative courses of action. We look forward
to working with Chairman Cox and the SEC staff on these issues.
Conclusion
Thank you again for allowing the Treasury Department to participate
this afternoon. As I have mentioned, the question of the regulation of
hedge funds must be carefully considered in light of the important role
they play in our financial markets.
It is for that reason that Treasury is examining in detail the
issues I have discussed this morning, with a view to evaluating whether
the growth of hedge funds--as well as other phenomena such as
derivatives and additional alternative investments and investment
pools--hold the potential to change the overall level or nature of risk
in our markets and financial institutions. This examination will
involve bringing key government officials together to review their
approaches to these financial market issues. The first such meeting was
held last week, chaired by Assistant Secretary of the Treasury Emil
Henry, and will be followed by further discussions in the future. We
are also beginning a broad outreach to the financial community to help
us examine these questions. As part of this comprehensive review
chaired by the Treasury, we will be working with the SEC--both
bilaterally and through the PWG--as Chairman Cox and the Commission
consider alternative courses of action following the D.C. Circuit
Court's recent decision.
Looking forward, we will be focused on seeking to understand in the
most comprehensive way possible whether and how changes in the
structure of the financial services industry--of which the rapid growth
of new forms of capital accumulation, such as hedge funds, is just one
example--have materially affected the efficiency with which markets
intermediate risk, whether risk is pooled in different ways or in
different places than it has been in the past--and if so, what
appropriate policy responses might be. We will seek to be forward
looking and to think about these changes not in a fragmented fashion,
but in a comprehensive way. At the moment it is too soon to say what
initiatives will result from this focus, but this is the lens through
which we will filter the various ideas and efforts with which we will
all be grappling over the next few years.
______
RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM
CHRISTOPHER COX
Q.1. I read last week that at least 10 hedge fund managers have
filed to de-register since the D.C. Circuit struck down the
S.E.C.'s registration requirement. How many fund advisers have
moved to deregister since the ruling last month, and did you
get any valuable information from those who did register?
A.1. As of September 14, 106 investment advisers to hedge funds
have withdrawn from SEC registration since the Court of Appeals
for the District of Columbia Circuit issued the Goldstein
opinion. Information filed by these investment advisers
indicates that almost 40% of them withdrew for reasons
unrelated to the Court's ruling. Some 1260 hedge fund advisers
registered with the Commission because of the rulemaking, and
we have no reliable way to estimate how many of them will
eventually withdraw their SEC registrations, or for what
reasons. We suspect that withdrawals will continue for the next
several months as hedge fund advisers evaluate their options.
Many hedge fund advisers and their attorneys have informed us
that they plan to remain registered; some have changed their
business model or accepted new clients so that they must remain
registered, while some others are choosing to remain registered
because their investors demand it. To smooth the transition,
the Commission's staff provided no-action and interpretive
responses to a letter from the American Bar Association that
addressed many issues that arose from the Court's decision. The
staffs response is available at http://www.sec.gov/divisions/
investment/noaction/aba081006.pdf.
The Commission did get valuable information from the hedge
fund advisers that registered. First, as the Commission pointed
out in the adopting release, prior to the rule's adoption no
government agency had any reliable data on basic census
information on hedge fund managers. From the information hedge
fund advisers filed with us, we were able to construct the most
comprehensive picture to date of hedge fund advisers operating
in the United States or managing money for U.S. investors. Data
included the number of advisers, number of funds, hedge fund
adviser disciplinary information, and the advisers' financial
industry affiliations. The information that we have collected
has also assisted the Commission's Office of Compliance
Inspections and Examinations in carrying out its risk-based
examination program, which has lead to several referrals to our
Division of Enforcement for further review. We will continue to
collect data from registered hedge fund advisers, but as some
hedge fund advisers withdraw their registrations and some new
hedge fund advisers choose not to register the data will be
incomplete.
Q.2. As the hedge fund industry has evolved, even more people
are getting in to hedge funds through different investment
vehicles such as funds of funds. Without unified regulation, do
people have an unfair advantage in the market by being able to
choose an investment that is unregulated? And does the current
system of regulation give the larger investor such as the
university endowment fund an unfair advantage over a small
individual investor?
A.2. In many cases, both Congress and the Commission have
operated under a long-standing principle that wealthy or
sophisticated investors have the ability to protect themselves
(or hire experts to help them protect themselves) and therefore
have access to certain investments that others may not have. I
think this approach has served both retail and institutional
investors well, and am uncertain of the benefits of alternative
approaches that might need to either (i) treat all investors as
institutional investors and thus eliminate important investor
protections afforded to retail investors, or (ii) treat all
investors as retail investors and deny institutional and
similar investors access to useful investments such as hedge
funds.
Q.3. I asked Mr. Quarles this question at the last hearing on
hedge funds, so now I am going to ask Chairman Cox and Chairman
Jeffery. In a regulated mutual fund industry, many questionable
practices that were not in the best interest of the individual
investor and the markets had to be regulated by government
intervention. Why would we assume in a lightly regulated hedge
fund industry that we wouldn't encounter similar indiscretions
by managers? And do you think transparency requirements should
be similar for mutual funds and hedge funds?
A.3. The Commission has not assumed that hedge fund managers
would be less likely to participate in questionable or illegal
practices. Indeed, one reason for the Commission's rulemaking
was the growing number of enforcement actions we were bringing
against hedge fund managers. We remain concerned about
malfeasance in this area and are considering how to address it
through further rulemaking. While there may be a need for some
amount of greater transparency of hedge funds (such as that
suggested by the President's Working Group on Financial Markets
in 1999), I believe that requiring transparency similar to that
required of mutual funds would be unwise. Disclosure of
portfolio positions could undermine some of the types of
investment strategies pursued by hedge funds.
Q.4. Have you seen evidence of market manipulation by hedge
funds?
A.4. Yes. In fact, the Commission has brought enforcement cases
against hedge fund managers that have involved either market
manipulation or illegal short-selling.
The Commission has brought an action alleging that hedge
fund advisers manipulated the market by creating the appearance
of greater demand for two stocks than actually existed. SEC v.
Scott Sacane et al. (Oct. 2005). The individual defendants in
that case both pled guilty to related criminal charges and have
been barred by the Commission from associating with an
investment adviser. One defendant has settled the Commission's
civil action, paying disgorgement and a civil penalty.
The Commission has also brought an enforcement action
against a hedge fund manager for scalping. SEC v. Berton M.
Hochfeld (Nov. 2005). The Commission alleged that the
defendant, while employed as a research analyst with a broker-
dealer, failed to disclose in research reports distributed to
the broker's clients, that a hedge fund he controlled
maintained positions in stocks that were the subjects of his
research reports. On numerous occasions, he allegedly directed
trades in the subject stocks immediately after the issuance of
his research reports that was contrary to the information in
the reports.
In another case, SEC v. Michael Lauer, Lancer Management
Group, LLC, et al., (July 23, 2003), the Commission alleged
that the defendants systematically manipulated the month end
closing prices of certain securities held by their funds to
overstate the value of the funds' holdings. The complaint
alleged that the manipulative trading practices employed by the
defendants were designed to attract new investors and to induce
current investors to stay in the funds and to raise the value
of the funds, both of which resulted in increased management
fees paid to the defendants.
The short selling cases can be generally categorized into
two groups. The first group involved allegations of illegal
activities in connection with ``PIPE'' (``Private Investment in
Public Equity'') transactions. SEC v. Hilary Shane (May 2005);
SEC v. Langley Partners (March 2006); and SEC v. Deephaven
Capital Management (May 2006). While the specific facts alleged
in each case vary, the general pattern is as follows: In these
cases, the Commission has alleged that hedge fund advisers have
agreed to buy public company shares in a private offering from
the issuer on a confidential basis. The PIPE transaction will
dilute the public float, which may decrease the issuer's share
price. The hedge fund adviser then misuses its knowledge of the
impending PIPE to sell shares of the public company short,
profiting when the share price decreases due to the dilutive
effect of the PIPE transaction that it entered into. The second
group involved allegations of rule violations regarding the
source of shares used to cover short sales. In the Matter of
Galleon Management (May 2005); In the Matter of Oaktree Capital
(May 2005); and In the Matter of DB Investment Managers (a
subsidiary of Deutsche Bank) (May 2005). These actions allege
violations of a rule that prohibits covering a short sale with
securities obtained in a public offering if the short sale
occurred within five business days before the pricing of the
offering.
Q.5. Have you seen evidence of systemic risks or instability
caused by hedge funds?
A.5. There were two episodes over the past two years during
which a significant number of hedge funds experienced losses.
In May 2005, credit rating agencies' downgrade of the U.S.
automobile manufacturing sector precipitated a painful period
for a number of hedge funds that traded credit derivatives. A
year later, in May 2006, a spike in equity and emerging market
debt volatility resulted in losses for a number of hedge funds
trading in those markets. During neither of these events did we
see any evidence that hedge funds were having difficulty in
meeting collateral calls from prime brokers or over-the-counter
derivatives counterparties. Such difficulties would be early
warning signs of events that might have systemic implications
for the broader financial system.
Nonetheless, we continue to encourage the major securities
firms that we supervise on a consolidated basis to strengthen
their credit and operational risk management infrastructure,
which will further reduce the likelihood of systemic
instability. A useful blueprint in this regard remains the
report published by the Counterparty Risk Management Policy
Group in July 2005 entitled ``Toward Greater Financial
Stability: A Private Sector Perspective.'' We have regular
discussions with firms under our supervision regarding their
progress in implementing the recommendations regarding the
management of exposures to hedge funds produced by that
industry group.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM CHRISTOPHER
COX
Q.1. Chairman Cox, will the SEC appeal the Goldstein decision
or seek a rehearing? When does the SEC intend to make public
its position with respect to the decision? Will advisers who
registered under the rule be required to file a Form ADV-W to
withdraw their registrations?
A.1. On August 7, 2006, I issued a statement (available at
http://www.sec.gov/news/prcss/2006/2006-13S.htm) indicating
that the Commission would not seek en banc review of the
Goldstein decision or petition the U.S. Supreme Court for a
writ of certiorari. Any adviser that wishes to withdraw its
registration with the Commission must file Form ADV-W. As noted
earlier, we believe a substantial number of hedge fund advisers
will need to, or choose to, remain registered.
Q.2. In the past, the PWG has rejected direct regulation of
hedge funds. Can you tell us a little more about what is
involved in fostering market discipline in the hedge fund
context and if this is a superior approach to direct
regulation?
A.2. Market discipline in the hedge fund context relies on
adequate information reaching participants, including
counterparties and investors. The Commission has always
supported dissemination of adequate information so that
investors and counterparties can make informed decisions and
the market can act efficiently. Because hedge funds are offered
privately, this information exchange is often privately
negotiated. The Commission, of course, would take appropriate
action in the event of fraud.
Q.3. The media and the press always tend to suggest that hedge
funds are unregulated or that hedge funds are the wild west of
capital markets. It that true? It is my understanding that
hedge funds are subject to the same anti-fraud and anti-
manipulation requirements as any other market participant, as
well as a host of other rules and regulations. Can you please
clarify this for the record by providing a list of all the
rules and regulations hedge funds and their activities therein,
are subject?
A.3. Press articles typically refer to hedge funds as ``lightly
regulated'' investment pools. In a sense, they are correct.
Hedge funds are organized and operated so that they are not
subject to the Investment Company Act of 1940. In addition,
hedge funds issue securities in ``private offerings'' that are
not registered with the Commission under the Securities Act of
1933, and hedge funds are not required to make periodic reports
under the Securities Exchange Act of 1934. After the Goldstein
decision some hedge fund advisers will not be registered under
the Advisers Act. Further, until the Commission adopts a new
rule, hedge fund advisers may not have the same fiduciary
obligations as other advisers.
However, hedge funds are subject to the same prohibitions
against fraud as are other market participants. In addition,
they are or may be--depending upon their investment and
offering activities--subject to provisions of state, federal
and foreign securities laws too numerous to comprehensively
list. These include:
Registration with and regulation by the Commission as
a broker-dealer, as an investment adviser, or registration
of the hedge fund or its securities);
Compliance with Regulation D in making the private
placements of their securities.
Compliance with position and transaction reporting
under rules of the SEC, CFTC and Federal Reserve Board.
Compliance with commodities laws and regulations,
including registration requirements, that may apply if the
hedge fund is trading in futures.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM REUBEN
JEFFERY, III
Q.1. I asked Mr. Quarles this question at the last hearing
on hedge funds, so now I am going to ask Chairman Cox and
Chairman Jeffery. In a regulated mutual fund industry, many
questionable practices that were not in the best interest of
the individual investor and the markets had to be corrected by
government intervention. Why would we assume in a lightly
regulated hedge fund industry that we wouldn't encounter
similar indiscretions by managers? And do you think
transparency requirements should be similar for mutual funds
and hedge funds?
A.1. As the Committee is aware, the Commodity Futures Trading
Commission (``CFTC'') does not regulate mutual funds and I will
defer to Chairman Cox to respond with respect to issues
concerning them. Under the Commodity Exchange Act (``Act''),
the CFTC has jurisdiction over persons who operate and advise
collective investment vehicles that trade CFTC-regulated
commodity futures and options contracts. Generally speaking,
those who operate or manage a commodity pool must register with
the CFTC as CPOs, and those who make trading decisions on a
pool's behalf must register as CTAs. Some of these commodity
pools, or collective investment vehicles, have been commonly
referred to as ``hedge funds.'' The CFTC does not use that term
because neither the Act nor CFTC regulations refer to that term
nor define it.
Pursuant to the Act's investor protection mandate, the CFTC
has implemented a regulatory scheme for CPOs and CTAs that
fosters full and timely disclosure intended to protect
investors from abusive or overreaching sales practices by
persons who operate or advise commodity pools. Registration is
the cornerstone of this scheme. The primary purposes of
registration are to ensure a person's fitness to engage in
business as a futures professional and to identify those
persons whose activities are covered by the CEA. Notable
exclusions or exemptions from registration are available for
operators of pools that are otherwise regulated; that have only
sophisticated participants and de minimis commodity interest
trading; and that have only the very highest level of
sophisticated participants, regardless of the amount of
commodity interests traded. Hedge fund operators frequently
fall within one of the latter two exemptions from CPO
registration. Irrespective of registration status, all CPOs and
CTAs are subject to the anti-fraud and anti-manipulation
prohibitions of the Act and CFTC regulations and they must make
their books and records available to the CFTC and National
Futures Association (``NFA''), a futures industry's analogue to
the National Association of Securities Dealers, upon request.
Registration triggers certain disclosure, reporting, and
recordkeeping requirements designed to ensure that prospective
and current participants in commodity pools receive all the
information that is material to their decision to make, or
maintain, an investment in the pool. For example, prospective
participants must receive information regarding the pool's
investment program, risk factors, conflicts of interests, and
performance data and fees. Thereafter, a CPO must provide pool
participants with an account statement at least quarterly, and
an annual report containing specified financial statements
which must be certified by an independent public accountant and
presented in accordance with Generally Accepted Accounting
Principles.
The oversight functions of CPOs and CTAs are carried out by
the NFA. In this capacity, NFA is responsible for registration
processing, review of CPO and CTA disclosure documents, review
of commodity pool annual reports and related extension filings,
and processing of exemption notices under Part 4 of the
Commission's regulations. In addition, NFA monitors CPO and CTA
sales practices and conducts periodic examinations of CPOs and
CTAs.
The CFTC maintains an oversight role with respect to NFA's
performance. CFTC staff engages in ongoing communication and
coordination with NFA with regard to NFA's supervision of CPO
and CTA compliance. For example, NFA and CFTC staff members
meet quarterly to discuss registration issues, meet as needed
to discuss CPO and CTA oversight issues, and communicate
frequently on issues that must be handled promptly. In
addition, Commission staff conducts periodic oversight
examinations of NFA's compliance program for CPOs and CTAs. The
most recent oversight examination was completed in early 2006.
The CFTC takes very seriously its responsibility to protect
investors--whether directly or through participation in a
professionally managed fund--in the futures markets. Toward
that end, the CFTC works to ensure that investors participating
in commodity pools receive all the information that is material
to their decision to invest in pools, and when problems are
uncovered, devotes the full force of the CFTC's enforcement
authority to prosecuting those responsible.
Q.2. Since we are talking about hedge funds today, how much do
you think hedge fund activity in the commodities sector has
contributed to a hike in energy and commodity prices?
A.2. The energy market is perhaps one of the most difficult
commodity sectors in which to isolate individual factors that
influence prices. These markets are subject to significant
geopolitical influences, they involve complex inter-product
pricing structures due to the large number of refined products
that are derived from crude oil and natural gas, and there have
been extensive changes and shifts in the underlying demand and
supply fundamentals over the past 5 years, which have
significantly impacted prices.
In a study of large traders in energy markets first issued
last year by the CFTC's Office of the Chief Economists, the
staff concluded that overall, the exchange-traded futures-
trading of hedge funds does not appear to have exerted
appreciable upward pressure on energy prices. This study
indicates that non-commercial traders, a category of traders
that generally includes ``speculators'' and hedge funds, are
more likely than not are responding to position changes by
commercial traders (i.e., companies or individuals with
commercial interests in the commodity underlying the futures
contracts). In other words, when a commercial trader sells, it
will often be a non-commercial trader who takes the other side
of the transaction as the buyer. When a commercial trader buys,
it will often be a non-commercial trader who is the seller.
This observation is consistent with the notion that non-
commercial traders respond to price changes and are not the
cause of price changes.
Surveillance data on large non-commercial traders also does
not infer a significant price impact by hedge funds. Large non-
commercial traders typically hold positions on both sides of
the market, although they have tended to be slightly net long
in their overall positions. For example, as of September 5,
2006, large non-commercial traders held 15.3% of long open
interest and 11.3% of short open interest in the NYMEX crude
oil contract. In the unleaded gasoline contract, they held
12.8% of long open interest and 10.1% of short open interest.
An exception to this pattern is the gasoline blendstock, or
RBOB, contract where non-commercials held 16.1% of the long
open interest, but only 1.1% of short open interest.
Nonetheless, despite being net long in these contracts, prices
have fallen significantly over the period. This observation is
contrary to the argument that the net long positions of non-
commercials, and hedge funds in particular, have lifted prices.
It should also be noted that that typically well over half of
the open interest in these markets is held by large commercial
entities.
In addition to holding outright long and short positions in
energy markets, large non-commercials hold significant calendar
spread positions. Such positions tend to be neutral in their
effect on price levels. Spread positions are structured to
speculate on relative price differences (e.g., prices for
October delivery vs. prices for November delivery), and when
structured as such, are unrelated to the overall level of
futures prices for individual commodities and therefore are not
responsible for changes in the level of these prices. As of
September 5, 2006, large non-commercial traders held spread
positions equal to 20% of the crude oil market, 13.1% of the
heating oil market and 38.6% of the natural gas market.
In addition to calendar spreads, it is unknown what portion
of the outright positions reflected in the surveillance data
are positions held by large non-commercials that represent
product spreads, such as the crack spread, which is a position
between related products (crude oil and refined products).
Again, positions related to such spreads would not tend to
influence the overall level of prices in the energy complex.
Q.3. Have you seen evidence of market manipulation by hedge
funds?
A.3. Commission surveillance staff monitors on an ongoing basis
trading activity in all futures contracts on the regulated
futures exchanges to detect and prevent market manipulation.
The backbone of the CFTC's market surveillance program is its
Large Trader Reporting System. This system captures end-of-day
position-level data for market participants meeting certain
criteria. Positions captured in the Large Trader Reporting
System typically make up 70 to 90 percent of all positions in a
particular exchange-traded market. The Large Trader Reporting
System is a powerful tool for detecting the types of
concentrated and coordinated positions required by a trader or
group of traders attempting to manipulate the market. For
surveillance purposes, the large trader reporting requirements
for hedge funds are the same as for any other large trader.
The Commission's surveillance staff closely monitors large
positions, particularly in expiring futures contracts, to
detect and deter manipulation, market abuses, market
disruptions and other sources of price distortion. Surveillance
seeks to prevent these problems before they occur and
surveillance staff has been involved in all actively traded
exchange futures contracts with a very wide assortment of
traders. Should the Commission suspect that there is evidence
that manipulation has occurred, or even has been attempted; the
matter may be referred to the Commission's enforcement staff.
While the Commission staff has reviewed the activities in the
futures markets of certain hedge funds as part of inquiries and
analysis of whether certain activity was legal, the Commission
has not filed a complaint alleging manipulation against a hedge
fund.
Q.4. Have you seen evidence of systemic risks or instability
caused by hedge funds?
A.4. The activities of managed money accounts in the futures
markets regulated by the CFTC have not created systemic risk to
date. Although managed money accounts have incurred substantial
losses in futures markets, these situations have not had
systemic effects. In such cases, losses have not spilled over
as brokerage firms and clearing organizations continued to meet
all their obligations. The CFTC has noted however, that
potential risk is increasing as managed money accounts
establish larger and more complex positions in the futures
markets. Consequently, CFTC financial surveillance efforts have
focused increasingly on such accounts.
Through the large trader reporting system, staff can
identify the traders with the largest positions. Using
internally-developed tools, staff can stress test the positions
to identify potential losses the account might incur in extreme
market moves. These potential losses can be compared to the
margin requirements for the positions and to the capital
resources of the brokerage firm carrying the account. To the
extent these comparisons raise concerns; staff can contact the
clearing organization, the brokerage firm, and/or the trader to
determine what steps are being taken to mitigate the risks.
Staff continues to work to refine its techniques.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM REUBEN
JEFFERY, III
Q.1. Chairman Jeffrey, in a Financial Times article on July
20th, you were quoted responding to a Permanent Subcommittee on
Investigation's staff report titled: ``The Role of Market
Speculation in Rising Oil and Gas Prices: A Need to Put the Cop
Back on the Beat.'' You were quoted as saying: ``I can't resist
taking exception to the notion that the cop has not been on the
beat. Our enforcement experience over the past several years
belies that notion and shows a strong record of commitment and
vigilance in the area of anti-manipulation and false reporting
in the energy sector.'' Would you please expand upon these
comments?
A.1. The Commission maintains its commitment to addressing
potential problems in the energy markets through a combination
of vigilant surveillance and vigorous enforcement.
Commission surveillance staff monitors on an ongoing basis
trading activity in all futures markets to detect and prevent
market manipulation. Commission staff also routinely consults
with staff from the Federal Energy Regulatory Commission (FERC)
and the Energy Information Administration in analyzing events
in these energy markets.
The Commission's Division of Enforcement has broad
authority to conduct investigations to determine whether any
persons have violated, are violating, or are about to violate
the provisions of the Commodity Exchange Act. For example,
since December 2002 the Enforcement Program has investigated
energy market conduct that potentially involved: (1) false
reporting of natural gas trading to companies that compile and
publish natural gas index prices for delivery hubs throughout
the United States; and/or 2) attempts to manipulate and/or
manipulation of natural gas index prices. In addition, the
Enforcement Program's investigation of the TET physical propane
market resulted in the Commission's filing of an enforcement
action against BP Products North America, Inc. charging
manipulation and attempted manipulation.
From December 2002 to date, the Commission has filed a
total of 34 enforcement actions charging a total of 54
respondents/defendants (30 companies and 24 individuals). The
Commission has settled 25 of these enforcement actions and
obtained $298,263,500 in civil monetary penalties. Nine CFTC
energy market-related enforcement actions remain pending.
Complementing the effect of its direct enforcement action, the
Commission has also achieved great success in this program area
by working cooperatively with the Department of Justice on
criminal actions.
The Commission's energy market enforcement actions only
tell a part of the story, however, because certain Enforcement
Program investigations conclude that no misconduct occurred and
the energy markets were operating properly. For example, while
it is the Commission's policy to not publicly comment on its
investigations, in August 2004 the Commission announced the
completion of its seven-month investigation of the sharp upward
movement in prices in the natural gas market that occurred in
late 2003 when natural gas futures contracts more than doubled
in price within a short period. The Commission's investigation
did not uncover evidence that any entity or individual engaged
in activity with an intent to cause an artificial price in
natural gas. According to the information obtained during the
investigation, the increase in natural gas prices during that
time was the result of distinct factors, including market
reaction to colder than expected weather in the northeast
United States during the first week in December 2003, and
market statements and projections regarding the inventory of
natural gas in underground storage caverns made in late
November/early December 2003.
The Commission's 25 settled energy market enforcement
actions include: In re Dynegy Marketing & Trade, et al., CFTC
Docket No. 03-03 (CFTC filed Dec. 18, 2002) ($5 million civil
monetary penalty); CFTC v. Enron Corp., et al., No. H-03-909
(S.D. Tex. filed March 12, 2003) ($35 million civil monetary
penalty; CFTC v. Hunter Shively, No. H-03-909 (S.D. Tex filed
March 12, 2003) ($300,000 civil monetary penalty); In re El
Paso Merchant Energy, L.P., Docket No. 03-09 (CFTC filed March
26, 2003) ($20 million civil monetary penalty); In re WD Energy
Services Inc., Docket No. 03-20 (CFTC filed July 28, 2003) ($20
million civil monetary penalty); In re Williams Energy
Marketing And Trading, et al., Docket No. 03-21 (CFTC filed
July 29, 2003) ($20 million civil monetary penalty); In re
Enserco Energy, Inc., Docket No. 03-22 (CFTC filed July 31,
2003) ($3 million civil monetary penalty); In re Duke Energy
Trading And Marketing, L.L.C., Docket No. 03-26 (CFTC filed
Sept. 17, 2003) ($28 million civil monetary penalty); CFTC v.
American Electric Power Company, Inc., et al., No. C2 03 891
(S.D. Ohio filed Sept. 30, 2003) ($30 million civil monetary
penalty); In re CMS Marketing Services and Trading Company, et
al., Docket No. 04-05 (CFTC filed Nov. 25, 2003) ($16 million
civil monetary penalty); In re Reliant Energy Services, Inc.,
Docket No. 04-06 (CFTC filed Nov. 25, 2003) ($18 million civil
monetary penalty); In re Harmon, Docket No. 03-25 (CFTC filed
Jan. 16, 2004) ($8,500 civil monetary penalty); In re Aquila
Merchant Services, Inc., Docket No. 04-08 (CFTC filed Jan. 28,
2004) ($26.5 million civil monetary penalty); In re Calpine
Energy Services, L.P., CFTC Docket No. 04-11 (CFTC filed Jan.
28, 2004) ($1.5 million civil monetary penalty); In re ONEOK
Energy Marketing And Trading Company, L.P., et al., Docket No.
04-09 (CFTC filed Jan. 28, 2004) ($3 million civil monetary
penalty); In re Entergy-Koch Trading, LP, Docket No. 04-10
(CFTC filed Jan. 28, 2004) ($3 million civil monetary penalty);
In re e prime, Inc., Docket No. 04-12 (CFTC filed Jan. 28,
2004) (a wholly-owned subsidiary of Xcel Energy, Inc.; $16
million civil monetary penalty); In re Knauth, Docket No. 04-15
(CFTC filed May 10, 2004) ($25,000 civil monetary penalty); In
re Western Gas Resources, Inc., Docket No. 04-17 (CFTC filed
July 1, 2004) ($7 million civil monetary penalty); In re Coral
Energy Resources, L.P., Docket No. 04-21 (CFTC filed July 28,
2004) ($30 million civil monetary penalty); In re Biggs, Docket
No. 04-22 (CFTC filed Aug. 11, 2004) ($30,000 civil monetary
penalty); In re BP Energy Co., Docket No. 05-02 (CFTC filed
Nov. 4, 2004) ($100,000 civil monetary penalty); In re Cinergy,
CFTC Docket No. 05-03 (CFTC filed November 16, 2004) ($3
million civil monetary penalty); In re Mirant, CFTC Docket No.
05-05 (CFTC filed Dec. 6, 2004) ($12.5 million civil monetary
penalty); In re McKenna, CFTC Docket No. SD 05-03 (CFTC May 20,
2005) (registration revocation); and In re Shell Trading US
Company, et al., CFTC Docket No. 06-02 (CFTC filed Jan. 4,
2006) ($300,000 civil monetary penalties).
The Commission's nine pending energy market enforcement
actions include: CFTC v. NRG Energy, Inc., No. 04-cv-3090 MJD/
JGL (D. Minn. filed July 1, 2004) (charging false reporting);
CFTC v. Bradley, et al., No. 05CV62-CVE-FHM (N.D. Okla. filed
Feb. 1, 2005) (charging false reporting and attempts to
manipulate); CFTC v. Johnson, et al., No. H-05-0332 (S.D. Texas
filed Feb. 1, 2005) (charging false reporting and attempts to
manipulate); CFTC v. McDonald, et al., No. 1:05-CV-0293 (N.D.
Ga. filed Feb. 1, 2005) (charging false reporting and attempts
to manipulate); CFTC v. Whitney, No. H 05-333 (S.D. Texas filed
Feb. 1, 2005) (charging false reporting and attempts to
manipulate); CFTC v. Reed, et al., No. 05-D-178 (D. Colo. filed
Feb. 1, 2005) (charging false reporting and attempts to
manipulate); CFTC v. Richmond, No. 05-M-668 (OES) (D. Colo.
filed April 12, 2005) (charging false reporting and attempts to
manipulate); CFTC v. Foley, No. 2:05 849 (S.D. Ohio filed Sept.
14, 2005) (charging false reporting and attempted
manipulation); and CFTC v. BP Products North America, Inc., No.
06C 3503 (N.D. Ill. filed June 28, 2006 (charging manipulation,
cornering the market, attempts to manipulate).