[Senate Hearing 108-396]
[From the U.S. Government Publishing Office]
S. Hrg. 108-396
RECENT DEVELOPMENTS IN HEDGE FUNDS
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
ON
THE RECENT DEVELOPMENTS IN HEDGE FUNDS (AN INVESTMENT COMPANY THAT USES
HIGH-RISK TECHNIQUES, SUCH AS BORROWING MONEY AND SELLING SHORT, IN AN
EFFORT TO MAKE EXTRAORDINARY CAPITAL GAINS), FOCUSING ON INVESTOR
PROTECTION
IMPLICATIONS, THE DIFFERENCES BETWEEN HEDGE FUNDS AND INVESTMENT
COMPANIES, REGULATION UNDER FEDERAL SECURITIES LAWS, AND CONFLICTS OF
INTEREST
__________
APRIL 10, 2003
__________
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Affairs
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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 ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island JON S. CORZINE, New Jersey
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Doug Nappi, Republican Chief Counsel
Dean Shahinian, Democratic Counsel
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
(ii)
?
C O N T E N T S
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THURSDAY, APRIL 10, 2003
Page
Opening statement of Chairman Shelby............................. 1
Opening statements, comments, or prepared statements of:
Senator Sarbanes............................................. 2
Senator Sununu............................................... 5
Senator Corzine.............................................. 5
Prepared statement....................................... 31
Senator Dole................................................. 6
Prepared statement....................................... 31
Senator Dodd................................................. 6
Senator Hagel................................................ 6
Senator Allard............................................... 6
Prepared statement....................................... 32
Senator Carper............................................... 18
Senator Schumer.............................................. 23
WITNESS
William H. Donaldson, Chairman, U.S. Securities and Exchange
Commission..................................................... 7
Prepared statement........................................... 32
Response to written questions of:
Senator Shelby........................................... 40
Senator Sarbanes......................................... 53
Senator Sununu........................................... 63
(iii)
RECENT DEVELOPMENTS IN HEDGE FUNDS
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THURSDAY, APRIL 10, 2003
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10 a.m., in room SD-538 of the Dirksen
Senate Office Building, Senator Richard C. Shelby (Chairman of
the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY
Chairman Shelby. The Committee will come to order.
Today, the Committee will be hearing from the SEC Chairman
William Donaldson regarding the hedge fund industry. The
immediate reason for this hearing is to get a progress report
on the ongoing SEC oversight investigation of the hedge fund
industry. I hope that this hearing will shed some light on
developments within an industry that has been the subject of a
great deal of surmise and opinion, but much less in the way of
objective analysis.
Despite the recent bear market, America remains a Nation of
investors. The Internet, cable, satellite TV, and a host of
other technological innovations have made information regarding
the marketplace available just about anywhere at any time. We
are all familiar with the trappings of Wall Street. But at a
time when the floor of the New York Stock Exchange doubles as a
set for a television show, and market analysts are TV
personalities, hedge funds remain the last frontier, an
uncharted area of our capital markets.
Historically, hedge funds have been an outlier in the world
of functional regulation. These investment pools have been, to
borrow Winston Churchill's words regarding Russia, ``A riddle
wrapped in a mystery inside an enigma.'' Hedge funds are not
household names, and their managers have usually gone to great
lengths to avoid public attention. Hedge funds operate in
relative obscurity because they are limited partnerships,
financed through private placements. Like all market
participants, hedge funds are subject to the antifraud
provisions of the Federal securities laws. However, they are
exempt from a regulatory regime like that applied to broker-
dealers, investment-advisers, or publicly traded companies.
Most businesses are focused on their public image and
branding; but hedge funds have not only avoided publicity, as
privately placed offerings, but they are also prohibited from
advertising to the public. As private placements, hedge funds
are the domain of extremely wealthy individuals and
institutional investors. The securities laws deem that such
investors have the acumen and the negotiating power to fend for
themselves to a degree that the ordinary investor cannot. This
is not a hedge fund-specific exemption.
Events of the recent past have attracted unwanted attention
to these funds. The 1998 collapse of Long-Term Capital
Management put hedge funds on the front pages of the business
news. In the intervening years, hedge funds have continued to
attract media attention. Since the beginning of the recent bear
market, much of that attention has focused on the
``retailization'' of hedge funds, the explosive growth in the
number of hedge funds, and an equally explosive growth in the
number of hedge fund closings.
During the recent bear market it appears that hedge funds
have had positive, if not spectacular, results. However,
positive returns have been enough to attract a flight of
capital from more traditional market investments. And the
generous fees that hedge fund managers earn has been enough to
attract many of the best money managers. The desire to retain
talent has led many mutual funds to establish affiliated hedge
funds.
As we consider these issues today, I believe it is
important to remain mindful of the important role that hedge
funds continue to play in our capital markets. Hedge funds are
a liquidity source that permits capital to seek higher rewards,
regardless of the overall market environment. They can provide
expert management for patient capital that understands, and can
bear the risks associated with seeking higher returns. However,
when these funds are made available to less sophisticated
investors through mutual funds, investor protection concerns
arise that deserve careful consideration. These so-called
``funds of funds'' must provide sufficient transparency and
protection for their customers.
The growth of an indirect retail market and other recent
trends in the industry pose a number of investor protection
issues. For instance, are retail investors receiving sufficient
disclosure regarding their investments in so-called ``funds of
funds.'' Is the conflict posed by comanagement of hedge funds
and mutual funds being properly managed? Are any hedge funds
using the opaqueness of the private placement to misuse or
mismanage funds entrusted to them? The Committee looks forward
to answers to this and other questions.
I commend the SEC for its efforts to undertake this
important and timely review of the hedge fund industry and look
forward to Chairman Donaldson's testimony before the Committee
today.
Senator Sarbanes.
STATEMENT OF SENATOR PAUL S. SARBANES
Senator Sarbanes. Thank you very much, Mr. Chairman. I want
to commend you for holding this morning's important hearing on
hedge funds. I join with others in welcoming Bill Donaldson,
the Chairman of the SEC.
I think this is your first opportunity to come back and
testify before the Committee since your confirmation.
Chairman Donaldson. It is, indeed.
Senator Sarbanes. So let me extend a warm welcome to you,
Mr. Chairman.
I also want to note that just yesterday, the Senate
approved the SEC Civil Enforcement Act, which was incorporated
into the Care Act of 2003. This Civil Enforcement Act will
strengthen the SEC's authority to prosecute securities fraud
violations and will augment investor protection. Chairman
Donaldson was very strongly in support of it, and we appreciate
that strong support.
This is legislation that the SEC's Enforcement Division has
sought and it will contribute to their holding securities law
violators accountable for their actions. We look forward to
working it through the balance of the legislative process and
providing those additional civil enforcement tools to the SEC.
Mr. Chairman, in September 1998, the collapse of Long-Term
Capital Management drew international attention to hedge funds.
The Economist called it, ``One of the greatest financial
failures of all time. The hedge fund's losses were spectacular:
around $4 billion in 5 weeks. . . . The fund's implosion came
perilously close to causing a catastrophic failure of the
global financial system.'' That is The Economist, a staid,
responsible magazine. Obviously, the collapse of Long-Term
Capital Management raised very important issues of systemic
risk and excessive leverage.
Since that time, hedge funds actually have grown
tremendously. Industry sources reported that, ``Since the turn
of the century, the hedge fund industry has grown by 82
percent, from $324 billion to $592 billion,'' and, in the last
10 years, the number of hedge funds has grown from about 1,100
to 5,700. Fortune reported that Warren Buffet has said, ``Hedge
funds have become the latest Holy Grail.'' At the same time,
according to The Financial Times, ``Fifty percent of all new
hedge funds closed down within about 3 years of starting up.''
The growth in the industry has been accompanied by an increase
in fraud and in the number of SEC enforcement actions.
Hedge funds used to be investments for the very wealthy.
Hedge fund managers sold only to, ``accredited investors,''
those who earned more than $200,000 per year, or had more than
one million dollars in assets, which enabled them to take
advantage of an exemption in the securities laws.
However, the market for hedge funds has greatly expanded
and spawned funds of funds. Fortune reported that, ``Funds that
make investments in hedge funds are peddling themselves to less
accredited investors as well--dentists, school principals, and
the like--for minimum stakes, as low as $25,000. What is more,
a huge group of shareholders may be in hedge funds and not even
know it--America's retirees, through their retirement plans.''
This raises some concerns about investor protection.
Chairman Donaldson, at his confirmation hearing before this
Committee on February 5--and we keep going back to that
transcript, Chairman Donaldson, as our reference text as we
deal with the SEC--referred to ``A distressing move toward what
I would call the retailization of hedge funds, making them
available to smaller and smaller investors . . . less
sophisticated investors not realizing the risks inherent in the
vehicle.'' And Chairman Donaldson went on to note that hedge
funds are ``pretty much totally unregulated.''
The SEC and other Federal regulators have been looking at
these issues for some time. In 1999, the President's Working
Group on Financial Markets issued a report titled, ``Hedge
Funds, Leverage, and the Lessons of Long-Term Capital
Management.'' In that report, the Working Group recommended
that: First, hedge funds be required to ``disclose additional,
more up-to-date information to the public'' through periodic
reports. Second, public companies should publicly disclose
``summaries of direct material exposures to significantly
leveraged financial institutions.'' And third, financial
regulators, including the SEC, should encourage improvements in
the risk-management systems of securities firms.
More recently, the Commission initiated a major
investigation into the hedge fund industry. And I appreciate
and commend the attention and interest that Chairman Donaldson
is now devoting to this area.
I gather that the SEC, in the middle of next month, is
going to be holding a series of like roundtable discussions
with respect to hedge funds.
Let me just note, there are many important issues to
consider, particularly as they relate to retail investors.
These include: The suitability of offers and sales of hedge
funds to retail investors. The adequacy of information
available to such investors about their investments and their
fund managers. Regulation of hedge funds offered to retail
investors. Conflicts of interest that may arise where a firm
manages both mutual funds and hedge funds. Conflicts of
interest that may result with the higher fees charged to
investors in hedge funds.
There have been a number of articles about the problem with
this, when you do both mutual funds and hedge funds and how, on
the part of the managers, that raises important conflict
questions.
Other issues which have been consistently raised by
commentators include: The valuation of hedge funds and the
reporting of fund performance. The leverage associated with
hedge funds. The potential systemic risks associated with the
failure of a large hedge fund. To go back to the Long-Term
Capital Management situation, the adequacy of market
surveillance to protect against potential market manipulation
by hedge funds, again, I think an interesting and important
question. The lack of information about the size and activities
of the hedge fund industry, including the rate and causes of
hedge fund failures. Possible preferential treatment that
brokerage firms give hedge funds. And whether the minimum
wealth levels of the exemption for sophisticated investors
should be revised. And I think this is only the beginning of
the questions that need to be asked.
Regarding the importance of hedge fund markets, Fortune
magazine in a recent article entitled, ``Where The Money Is
Really Made,'' stated that, ``The hedge fund boom has sweeping
implications, not just for Wall Street traders and a few
thousand well-heeled investors, but, increasingly, for every
American business person, investor, and retiree.''
We look forward to hearing and learning more about these
potential ``sweeping implications.''
Mr. Chairman, I want to commend you again for scheduling
this hearing and launching the Committee on oversight with
respect to this important issue.
I simply close by going back to The Economist's description
of the implications of the collapse of Long-Term Capital
Management. We have to be alert to the risks that might occur
on our watch. The Economist, said then, talking about Long-Term
Capital Management, which they regarded as one of the greatest
financial failures of all time--``The fund's implosion came
perilously close to causing a catastrophic failure of the
global financial system.''
And of course, it is the responsibility of all of us, the
Commission, this Committee, and other financial regulators, to
make sure that we are not at risk of such consequences.
Thank you very much.
Chairman Shelby. Senator Sununu.
COMMENTS OF SENATOR JOHN E. SUNUNU
Senator Sununu. Thank you, Chairman Shelby. I just want to
thank you for holding this very important hearing. I have no
opening statement, Mr. Chairman. I am anxious to hear the
Chairman's testimony.
Chairman Shelby. Senator Corzine.
STATEMENT OF SENATOR JON S. CORZINE
Senator Corzine. Thank you, Mr. Chairman. I have a formal
statement for the record.
Chairman Shelby. It will be made part of the record in its
entirety, without objection.
Senator Corzine. Thank you. Let me express my appreciation
for your holding this hearing. And particularly, let me thank
Chairman Donaldson for his attention to an issue that I think
all of us would be well served to have an oversight and
understanding of as it fits into our economic system.
As one that has benefited and participated along with an
industry called the hedge fund industry, and seen its evolution
from a pretty straightforward long/short structure of investing
to maybe some of the most complicated elements of investing
that have ever been put together, say as Long-Term Capital has
been noted, this is really something that I think we need to
understand in the context of our economic system today, the
$600 billion number cited, the number of funds, the
proliferation is really quite substantial.
And I think there are a number of issues that--and I heard
Senator Sarbanes talk about investor protection issues,
investor suitability, the retailization, funds of funds
structure really changing the whole nature, fee structures on
top of fee structures, that may or may not be understood by
some of those that participate, market integrity issues,
conflicts of interest that can come from mutual funds and hedge
funds being managed by the same people.
Maybe one of the most serious issues is there is no
standardization of evaluation. So how is it easy to compare one
fund to another that I think deserve consideration and some
transparency of discussion about.
We talked about market stability and potential for systemic
risk. Anybody that was seriously close to the Long-Term Capital
situation has to know that the derivative position really takes
that $600 billion number and explodes it into an extraordinary
amount of potential impact for markets.
If you looked at the notional amount, not necessarily the
only way to look at exposures and financial systems. But when
you add the notional amount of some of the derivative positions
associated with a cash position of $600 billion, you are really
talking in the trillions of dollars of impact in the
marketplace in a realistic sense.
And I do not think that we can have such an important
element of our financial system completely outside of some
oversight and understanding by those that provide protection
for the system.
I think this is a very useful beginning and the kinds of
things that the SEC is doing with its roundtable discussion,
are important. Getting the right balance so that we do not
damage our system is equally important.
But we no longer have a very narrow, single-dimensional
element in our hedge fund community. I am not exactly sure how
you even define a hedge fund these days. And I think we need to
have a better understanding of how they operate and their
impact on the market.
I look forward to this hearing and continued discussion on
improving the safety and soundness of our system. And I
congratulate having this hearing and, again, Chairman Donaldson
for his efforts along these lines as well.
Chairman Shelby. Senator Dole.
COMMENT OF SENATOR ELIZABETH DOLE
Senator Dole. Mr. Chairman, in the interest of time, I will
submit my written statement for the record.
Chairman Shelby. Your statement will be made a part of the
record, without objection.
Senator Dodd.
COMMENTS OF SENATOR CHRISTOPHER J. DODD
Senator Dodd. Mr. Chairman, let me, just to move things
along, apologize for racing in here. Let me catch my breath and
ask for uninamous consent to add my statement to the record.
Chairman Shelby. Without objection, it is so ordered.
Senator Hagel.
COMMENTS OF SENATOR CHUCK HAGEL
Senator Hagel. Mr. Chairman, thank you. I have no statement
at this time.
Welcome, Chairman Donaldson.
Chairman Shelby. Senator Allard.
COMMENTS OF SENATOR WAYNE ALLARD
Senator Allard. Mr. Chairman, I do have a statement that I
would like to make a part of the record.
Chairman Shelby. Without objection, it is so ordered.
Senator Allard. I would just comment that hedge funds have
a specific purpose in controlling risk. But once we get beyond
that and they are looked at as more of an investment portfolio,
then I have some real concerns. It takes someone really
knowledgeable to manage these sorts of derivatives.
I want to thank you for holding this hearing. It is very
timely.
Chairman Shelby. Senator Dodd.
Senator Dodd. Mr. Chairman, just a couple of comments.
I think it is important with the schedules that we all keep
around here, people coming and going, and we may not get the
chance to express some of our general thoughts and comments on
this. So, I thought I would take a minute, if I could, with the
Committee's indulgence, just to share a couple of thoughts on
the subject matter.
I want to thank you, Mr. Chairman, for doing this. This is
exactly the kind of hearing that we should be holding and you
are to be commended for placing this as high on the agenda and
as early in the year as you have, and I thank you for doing
that. It is tremendously helpful. We have to stay in touch with
all of these critical issues. And this is a critical component
of our financial markets, and so it is extremely important that
we look at it.
I also want to thank Chairman Donaldson. This is your first
appearance since your confirmation hearing before this
Committee, and we thank you for being here with us today.
It is going to be appropriate and important for us to
review our securities laws, including the various exceptions to
those laws that are operating. And that is what we are going to
be talking to you about today, in no small measure.
Hedge funds, as has been noted, play a very important role
in our capital markets and I think all of us would agree with
that. But given the unsupervised nature of the industry, it is
necessary I think to closely examine two very important
features.
First, is it possible for hedge funds to become so highly
leveraged, to the point that they can create systemic risk? Or
has the market and the regulators learned lessons from previous
events?
Second, are hedge funds, which were intended to be used by
the most sophisticated of investors, being inappropriately
marketed to those who do not understand the nature of the risks
associated with hedge funds?
While we want markets to continue to be creative and
entrepreneurial, we at the same time bear a responsibility to
protect the unsophisticated investors not only from fraud and
deception, but also unsuitable financial investments. That is a
difficult standard to meet, but certainly one that we should
debate and discuss.
While there are other aspects of hedge funds that should be
reviewed, I would urge the Chairman, in his ongoing examination
of hedge funds, to pay particular attention to these points, at
least from my perspective.
So with those points in mind, Mr. Chairman, I thank you
again for doing this today. It is extremely worthwhile and
important.
Chairman Shelby. Chairman Donaldson, we again welcome you
to the Committee and we believe that you will be coming back
and helping us along on other issues.
Please proceed as you wish. Your written statement will be
made a part of the record in its entirety.
STATEMENT OF WILLIAM H. DONALDSON
CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION
Chairman Donaldson. Chairman Shelby, Ranking Member
Sarbanes, and Members of the Committee, I would like to make
just a brief statement here and then get to a number of the
questions that have been implied.
I just want to thank you, first of all, for inviting me to
discuss some of the investor protection implications of hedge
funds and the Securities and Exchange Commission's ongoing
fact-finding investigation into this area. I appreciate the
opportunity to discuss this
important subject with you.
Over the past few years, hedge funds have become more
prominent and more popular. It is estimated that there are
close to 5,700 hedge funds operating in the United States
today, managing approximately $600 billion in assets. In
contrast, in 1990, only about $50 billion was under management.
There are frequent reports of high returns for hedge funds.
Just as frequently, these reports highlight possible areas of
concern, such as the potential conflicts of interest, valuation
concerns, questionable marketing techniques, including, as you
mentioned, the possible retailization of hedge funds, prime
brokers, possible fraud in the hedge fund industry, and the
market impact of hedge fund strategies.
Since June 2002, the SEC staff has been engaged in a review
and investigation of the structure and practices of hedge
funds. The Commission is still at the fact-gathering stage and
have yet to reach any conclusions. But I want to report that I
have ordered us to move to the next stage of our investigation,
and we will be holding, as you noted, important public
roundtables on May 14 and 15.
A little bit of history. Hedge funds have been around in
some form since the establishment of the Jones Hedge Fund in
1949. The term ``hedge fund'' is undefined, including in the
Federal securities laws. Indeed, there is no commonly accepted
universal meaning. As hedge funds have gained stature and
prominence, the term ``hedge fund'' has developed as a catch-
all classification for many unregistered, privately managed
pools of capital. These pools of capital may or may not utilize
the sophisticated hedging and arbitrage strategies that
traditional hedge funds employ, and many appear to engage in
relatively simple equity strategies. Basically, many hedge
funds are not actually hedged, and the term has become a
misnomer in many cases.
The last time the Commission took a really good look at the
hedge fund industry was in 1998, when, as you mentioned, the
Connecticut-based hedge fund, Long-Term Capital Management,
nearly collapsed.
Senator Dodd. You had to say Connecticut, didn't you.
[Laughter.]
Chairman Donaldson. Sorry, Senator.
[Laughter.]
There are lots in other States.
After that incident, the Commission, along with the
Treasury
Department, the Federal Reserve, and the Commodity Futures
Trading Commission, as part of the President's Working Group on
Financial Markets, issued a report on the risk management and
transparency issues raised by Long-Term Capital Management, in
particular, and by highly leveraged institutions in general.
The President's Working Group looked at such issues as the
firms' adherence to their own stated policies, their margin and
collateral requirements, their use of leverage, and whether it
was excessive, and how well their risk models functioned. The
report made serious recommendations that were intended to
improve how firms functioned in these areas; and, based on our
examination of the major brokerage houses that service hedge
funds, many institutions extending leverage to hedge funds seem
to have taken these recommendations to heart.
In addition to this examination of the risk management and
transparency issues, the Commission staff actively supported
the work of the Multidisciplinary Working Group on Enhanced
Disclosure and the subsequent Joint Forum Working Group on
Enhanced Disclosure, which the Commission chairs, and is
ongoing. Both groups address issues of enhanced disclosure for
financial intermediaries, such as banks, securities firms,
insurance companies, and hedge funds. We believe that many in
the hedge fund industry are considering the recommendations of
these two groups and contining to explore ways to improve some
of their practices.
Nevertheless, the markets have continued to evolve, and I
believe the time has come for us--the SEC and the President's
Working Group, of which the SEC is a part--again to review
these risk management, transparency, and public disclosure
issues. As part of the SEC's ongoing investigation into the
operations of hedge funds, we are also addressing issues from
the perspective of investor protection and looking into other
issues related to the overall market impact of hedge fund
practices.
Our current investigation is proceeding. The SEC staff have
obtained and reviewed documents and information from 67
different hedge fund managers representing over 650 different
hedge funds and approximately $162 billion under management.
The staff has spoken to brokerage, compliance, risk
management, legal, and other operational personnel of
multibillion-dollar complexes with dozens of employees, as well
as to their portfolio managers. And, at the other end of the
scale, the staff has visited hedge funds where one employee
serves as the marketer, the portfolio manager, the trader, the
operations officer, and the risk manager.
Aside from our inquiries directed to the specific hedge
funds, the staff has met with a variety of experts in their
respective fields to get their perspectives on the hedge fund
industry. In addition to the legal and accounting experts, the
staff has spoken with chief investment officers, risk managers,
prime brokers, representatives from foreign regulators, trade
industry representatives, and hedge fund consultants. Also, a
number of foreign jurisdictions are revisiting their approaches
to hedge funds, and we continue to benefit from discussions
with our foreign counterparts.
In conclusion, let me just assure you that our goal in this
exercise is to determine how we can better protect investors
and our securities markets. By working together, I believe that
we can achieve this goal.
And I want to thank you again for inviting me to speak on
behalf of the Commission. It is a subject that interests me
considerably, and I would be happy to answer any questions you
have.
Thank you.
Chairman Shelby. Thank you, Mr. Chairman.
Chairman Donaldson, your investigation at the SEC is
looking at investment managers who handle both hedge funds and
mutual funds. How common is it for managers to have both types
of funds under their control?
Chairman Donaldson. I think there is an increasing number
of registered advisers who manage mutual fund complexes and so
forth getting into the hedge fund industry in one form or
another.
I do not think that that was particularly prevalent as
recently as 5 or 6 years ago. But, as a number of trends have
come into view, particularly the competition from the hedge
fund industry with the mutual fund industry, I think that they
have been forced to go into that business.
Chairman Shelby. What type of disclosure do these
investment firms typically make to investors in the mutual
funds?
Chairman Donaldson. Well, I am going to go to a few--if I
can find it in my little book here----
Chairman Shelby. Take your time.
Chairman Donaldson. --the regulations. And I do not want to
get into too much detail. But let me just try and categorize
for you.
The hedge funds basically avoid regulation by meeting
criteria that are laid out in four general exclusions or
exceptions.
We have the Investment Company Act of 1940, and there is an
exclusion there. And some of the managers that you are talking
about, mutual fund managers, come under that Act. But there is
an exclusion for the hedge fund part. There is an exemption
from the registration under the Securities Act of 1933. There
is an exception from registration by the hedge fund manager
under the Investment Advisers Act. And there is an exception
from reporting requirements under the Securities and Exchange
Act of 1934.
Under each one of those categories, there are different
ways that hedge fund managers can get themselves out from being
regulated. I can go into more detail if you want, but it gets a
little complex in terms of the numbers.
Chairman Shelby. Sure, it does.
Chairman Donaldson. But under Section 3(c)(1) of the
Investment Company Act of 1940, there is an exclusion if a fund
has no more than 100 investors and there is no public offering.
If you can keep your number of investors under 100 and there is
no public offering, you are excluded from regulation under that
Act.
Another section of the Investment Company Act, 3(c)(7) has
been more recently passed. There is no limit on the number of
investors up to a practical level of about 500. But investors
must be qualified purchasers, and they must be high net-worth
individuals. And under Section 3(c)(7), only high net-worth
individuals, generally individuals who own certain specific
investments worth at least $5 million in investments may
invest; and again, there can be no public offering.
Then there is the exemption under the Securities Act of
1933. And under that exclusion or exemption, hedge funds
generally can sell their securities only to those who qualify
as accredited investors; individuals, as you mentioned earlier,
with a minimum of $200,000 annual income, or $300,000 taken
into consideration with spouses, and a minimum of $1 million in
net assets.
Might I add that, as time has gone on, those criteria which
were set up a long time ago have moved a lot of people into
those categories, if you will, who weren't there before.
Chairman Shelby. Sure.
Chairman Donaldson. Under the Investment Advisers Act,
hedge fund managers, because they are providing advice about
securities of others, fit into the definition of an investment
adviser. However, an adviser with fewer than 15 clients and
that does not publicize itself generally as an investment
adviser is not required to register with the Commission. And
that has the effect under our rules that the hedge fund itself
counts as one client and not the number of investors in the
fund.
So, you can have quite a few investors in that fund.
Chairman Shelby. Mr. Chairman, are mutual fund investors
apprised of the existence of a hedge fund affiliate? Are there
existing requirements for this kind of disclosure under the
securities laws?
Chairman Donaldson. I do not want to give a definite answer
to that.
Chairman Shelby. Do you want to do it for the record?
Chairman Donaldson. I would like to come back to you and
give you an answer on that. I think that if it is there, it is
pretty spotty.
Chairman Shelby. Spotty, at best.
Chairman Donaldson. Spotty.
Chairman Shelby. Senator Sarbanes.
Senator Sarbanes. Thank you very much, Mr. Chairman.
I have to say as I listen to Chairman Donaldson run through
the litany of the various securities legislations and the
exemptions and exceptions that exist, you have this uneasy
sense of people laying these statutes out in front of them and
then charting their course through the exemptions and the
exceptions, and leaving us all with an uneasy feeling that
there are ticking timebombs out there.
Therefore, again, I underscore the timeliness of this
hearing. And I want to commend Chairman Shelby because he is
obviously operating under the old adage that an ounce of
prevention is worth a pound of cure. And I think we have to be
very mindful of that in this instance.
Chairman Donaldson, USA Today, just in January, only a few
months ago, reported that Harry Edelman, the CEO of Farmer Mac,
had talked about possible market manipulation. He said, ``We
have no problem with the publication of legitimate research.
But when short-sellers publish misinformation for the purpose
of enhancing their positions, we find that objectionable.'' And
he went on to accuse certain hedge funds of orchestrating a
disinformation campaign.
The Wall Street Journal, in an article about the same date,
entitled, ``Regulators Review Complaints About Hedge Funds,''
identified additional companies which have complained that
various hedge funds were working in concert to spread negative
information about their stock.
What is the Commission doing to detect and to prevent
market manipulation by hedge funds and other market
participants?
Chairman Donaldson. Under our Market Regulation Division
and the Enforcement Division, we are constantly looking at
allegations of market manipulation.
I think that the issue before the House today is how the
market can be manipulated--there are cases of market
manipulation obviously going on all the time, and I think we
are on top of those.
The question is, how much of that can be attributed to the
specific vehicle, the hedge fund? And as I have indicated,
there is a pretty broad spectrum that we are talking about. I
think the investigation we are doing now, and the focus that
will come from our seminars and roundtables and so forth, will
give us a lot better feel for how much can be attributed to
hedge fund techniques.
Senator Sarbanes. Are the roundtables the concluding step
with respect to your study that can then lead to
recommendations and action?
Chairman Donaldson. We are certainly not having them to put
into the volumes and put on the shelf. I think it is very
important that we give an opportunity to all sorts of people
who are involved in this business to talk about the way that
they are operating their funds.
This is, I think you will see, a mix of people that we are
bringing together. Some will be critical of the hedge fund
industry. Some will be very defensive of their records. And we
are trying to sort that out, and I think we are trying to get
at that--and we do not expect that anybody will come before us
and talk a lot about how they manipulate the market. So, we are
going to have to depend upon our own investigative powers to
get at whether hedge funds are manipulating the market.
Senator Sarbanes. The NASD only a couple of months ago
issued a Notice to Members entitled, ``NASD Reminds Members Of
Obligations When Selling Hedge Funds.''
And they went on to say in that Notice: ``As a result of a
recent review of members that sell hedge funds and registered
products, closed-end funds that invest in hedge funds, so-
called funds of hedge funds, NASD staff is concerned that
members may not be fulfilling their sales practice obligations
when selling these instruments, especially to retail
customers.''
Now what was the conduct by stock brokers that led the NASD
to issue this Notice? And what is the SEC doing about more
closely monitoring sales practices, or taking other appropriate
actions?
Chairman Donaldson. As you know, an entire division of the
SEC is charged with monitoring and reviewing the sales
practices of registered broker-dealers.
I do not know of that specific instance that you referred
to there, but I think we probably discovered evidence--or the
NASD did--that made them feel that they should investigate and
then caution.
I do feel that we are watching very closely--with an
adherence to the regulations I just mentioned--to make sure
that people who are not registered are properly taking
advantage of those various exclusions.
Having said that, the ability to combine smaller and
smaller investors into these pools has been enhanced. And I
think that is right on point here; practices used to sell hedge
fund investments to a less sophisticated person. You can get
down to a pretty small amount of money--a relatively small
amount of money--and still get into one of these funds.
Senator Sarbanes. My time is expired. I presume we will
have a second round.
Chairman Shelby. We will.
Senator Sarbanes. But just on this final point, I think we
may have to close the door on some of those exceptions or
exclusions, or define them in such a way that they accommodate
what needs to be accommodated, but aren't utilized or
manipulated for other purposes that may endanger the stability
of our markets.
Presumably, the Commission is taking a look at that.
Chairman Donaldson. I think you are absolutely correct that
we have to reexamine the various levels and parameters of
exclusions.
I will say that I believe we have to be careful in terms of
the word risk because you can meet hedge fund managers who will
explain to you why their hedging techniques accomplish just the
opposite, how the risk parameters of what they are doing makes
them less risky, let's say, than a common stock or a mutual
fund.
Chairman Shelby. But you cannot take the risk out of the
marketplace, not all of it, anyway, can you?
Chairman Donaldson. No. But in theory--and I am going to
show my age now--I remember Mr. Jones way back in that period
of time when he started the first hedge fund. His thought was
that, if you are going out and analyzing companies and you find
good companies to invest in, but, during that process, you find
companies you think are not so good, if you put equal amounts
of money into both sides and insulate yourself from overall
market risk. And then added to that was leverage, and it took
it on from there. But the idea was risk minimization, not risk
acceptance.
Chairman Shelby. But not elimination of risk.
Chairman Donaldson. No. And, as we have seen in Long-Term
Capital Management and so forth, the risk has been enhanced
through leverage on that end of the spectrum.
Chairman Shelby. Thank you.
Senator Sununu.
Senator Sununu. Thank you, Mr. Chairman.
Mr. Chairman, it seems to me there are two broad concerns
here. The first involves Long-Term Capital Management and what
came out of that crisis. They were able to leverage themselves
to a very large degree with the cooperation of public
institutions. And there is a lot of discussion about the
systematic risk that may or may not have come from their
collapse.
But to the degree that there was systematic risk or
potential for systematic risk, it was because they were allowed
to leverage themselves up to such a high level with the
cooperation of those public institutions and what their
collapse might mean to the public institutions.
And the second is another set of issues that we have also
been talking about, which is the degree to which retail
investors, uninformed investors, ``unsophisticated investors''
described by the statutes, are being exposed to the risks that
are inherent in some of these funds inherent to the markets,
and that is what the Chairman was talking about.
These are both important issues to discuss and to
understand, but I see them as somewhat distinct.
First, let me touch on the issue that grew out of Long-Term
Capital Management. This was a case where we had not just some
large Wall Street firms, but the largest, most prestigious,
most well-regarded Wall Street firms providing a tremendous
amount of leverage, a tremendous amount of debt to a fund
manager. So, you could argue that these were the most
sophisticated investors under any statute, and yet, they made
some extremely poor business decisions with regard to leverage.
It seems to me that the one thing, or maybe the most
important thing that came out of this was I guess the
recognition that just because you have a Nobel Prize in
economics or you have earned a lot of money on Wall Street, you
are not going to necessarily make good investment or policy
decisions no matter where you are working.
Second, the OCC then did take steps to establish guidelines
for lending of financial institutions. Is that correct? And can
you describe the guidelines that came out of this issue? I
think they were posted in 1999.
Chairman Donaldson. Yes, I think that, on the end of the
spectrum that you are talking about, a great deal of progress
has been made as a result of Long-Term Capital's near-demise
and the work that was done after that by the President's
Working Group.
I think that we feel that the firms, the investment banking
firms and banks which supply leverage, if you will, have much
tighter restrictions now.
Senator Sununu. And could I ask you to provide some
description of those new guidelines that were put forward by
the OCC for the record?
Chairman Donaldson. Sure.
Senator Sununu. Just so that we have them in all of their
glory.
With regard to the individual investors or smaller
investors, however we want to describe them, I think it is
important to frame this discussion as understanding that there
are existing regulations.
There is the 1940 Act and we talk about exemption from
regulation. But what we are really providing is a different set
of regulations, regulations having to do with limits on income,
the $200,000 threshold, limits on the assets, the million-
dollar threshold.
I think, like anyone else on this Committee, as you were
going through the different cases, when you have fewer than
100, fewer than 500, it is quite complicated. Perhaps too
complicated. And that may be one of the problems, when you have
so many different sets of circumstances, each with their own
set of guidelines as to who is sophisticated and who is not
sophisticated, yes, good minds, whether here in Washington or
on Wall Street, will find a way to utilize those different
rules effectively to arbitrage the regulations and to find a
way to fit into the cracks.
I would hope that, to the extent that you are looking at
these rules in a comprehensive way, we look at ways that we
might simplify them so that you can apply them more
consistently and more effectively.
One specific question about the million-dollar net worth
provision that is covered under the Act of 1940. When was that
million-dollar threshold established? Was that part of the
original Act in 1940, or was it revised since then? I assume it
was revised. But how old is that threshold?
Chairman Donaldson. Much more recently 1982.
Senator Sununu. So, 1982. Which is important because, at
least in terms of the framers of the statute, a million dollars
in 1982----
Chairman Donaldson. That is a long time.
Senator Sununu. I have never had a million dollars. Some
Members of this Committee have had a million dollars. Some
Members still have a million dollars.
[Laughter.]
But I do know enough to understand that a million dollars
the year I graduated from high school is not the same as a
million dollars today. So, I do think that that may bear some
evaluation or consideration as you go through this process.
Last, in the reading that I have done, some of these hedge
funds or partnerships, are registering with the SEC, which I
was interested to find. By registering with the SEC, they are
covered by yet another set of regulations. And I understand
registering with the SEC actually allows them to accept an even
lower contribution and reduces the income thresholds for
investors even further. That seemed counterintuitive to me to
go in and register with a regulatory body. But somehow, that
allows you to become involved with investors. That actually
increases the concerns or makes you have a greater exposure to
some of the concerns that we just talked about.
What does registering a hedge fund with the SEC mean, and
what does it get you if you are a fund manager?
Chairman Donaldson. I think principally what it does is
allow us, the SEC, to get inside the techniques that are being
used. In other words, it opens the front door for us and allows
us to come in and examine exactly what it is going on. It also
puts disclosure parameters on those funds. In other words,
disclosure of what their techniques are to the public. What
they are doing, how they are doing it.
Senator Sununu. There is a firm public reporting
requirement associated with that registration.
Chairman Donaldson. That is generally what it allows us to
do. And as a matter of fact, that probably is something that we
must really examine in terms of the whole industry. Again, we
have a lot of work to do on this, and I do not want to get
ahead of the Commission or ahead of the staff. But I will say
that, at the end of the day, we need to know more about what is
going on in these institutions.
Senator Sununu. And I appreciate the concern for
information. But I do believe that, at a certain level, the
sophisticated investors, where you are talking about a limited
partnership, the investment managers are selling their internal
knowledge, their expertise, their investment capability.
To the extent that they have to disclose daily, weekly,
even monthly, what their positions are, that takes away from
the value of the advice that they are providing. Also, it can
be counterproductive. And to that end, I ask a simple question.
That is, with all of this discussion of manipulation, we
usually go after the short-sellers. If you force everyone to
disclose today their short positions in every stock that they
held, every short position that they held, do you think that
that would increase or decrease the likelihood of market
manipulation? That is a yes or no.
Chairman Donaldson. The kind of disclosure that I am
referring to, in response to your earlier question, was and is
that it allows us in the front door.
Senator Sununu. I understand that. And I am not suggesting
that you support making everyone disclose their short position.
However, my point is, I believe it makes the market more
subject to manipulation. The point is disclosure does not
always make for a better, more coherent market with a greater
level of integrity, because exposing every player's position at
a particular time can make them and the markets more subject to
manipulation.
Chairman Donaldson. I could not agree with you more.
Senator Sununu. Thank you, Mr. Chairman.
Chairman Donaldson. Thank you.
Chairman Shelby. Senator Corzine.
Senator Corzine. Thank you, Mr. Chairman. I am actually not
aware of any rule that requires even registered broker-dealers
to disclose their short position. I do not think that that is
the kind of disclosure that is in the realm of the various
degrees of what one could consider with regard to whatever the
term regulation means. But I guess that is a point for a
different time.
What oversight, what perspective does the SEC have at all
with those companies that have, as Senator Sarbanes said,
weaned their way through that maze of four or five regulation
exclusions?
What is the SEC's ability to look into the activities? Or
do you have to have a perceived or charged fraud to be able to
take a look at the books and records? Are there any audit
trails? What kind of authority does the SEC have today?
Chairman Donaldson. Well, I would say, generally speaking,
we do not have as broad authority as we would like. However, we
have total authority in instances of fraud and manipulation and
external manifestations of market manipulation, et cetera, to
go in and do something about it.
Senator Corzine. And how would you----
Chairman Donaldson. What we do not have authority over in
many instances is the accounting that is used in hedge funds,
the way they are organized, the whole panoply of other things.
Senator Corzine. Hedge funds required to maintain an audit
trail, so that when you go in----
Chairman Donaldson. We do not have the authority to audit
or examine the audit of hedge funds under these exemptions,
unless we can prove some fraud on investors.
Senator Corzine. How do you, in a first instance, is it
word of mouth that there is a potential fraud? Or how would you
recognize it, that a fraud was taking place?
Chairman Donaldson. There are a lot of different ways.
Clearly, we monitor the markets. The self-regulatory
agencies monitor the markets. We are constantly on the look-out
for market manipulation. People write or call the SEC. People
complain all the time and we examine and follow-up those
complaints of alleged manipulation. So, we have many, many
sources, not unlike the sources we have on potential problems
outside of the hedge fund industry.
Senator Corzine. And within the regimen of the regulated
elements of the industry, you are suggesting that that is the
same way you find market manipulation or fraud? Or is it more
likely to be done through the audit process, either of the
self-regulatory agencies or the Agency?
Chairman Donaldson. There are all sorts of definitions of
manipulation. You are focusing in now on market manipulation.
But there is the possibility that the accounting techniques
that are used to value securities in a hedge fund----
Senator Corzine. Is there a standard for----
Chairman Donaldson. We do not have the authority now to get
at that, unless from some other source we have been told that
there has been fraudulent accounting being used in this
investment vehicle. Then we can go after it.
Senator Corzine. One final question. I am a little unclear
on what the term, retailization, which I have used myself on
occasion, what does that mean?
Chairman Donaldson. Very catchy. What that means is, it
analogizes large institutional investors investing in hedge
funds to a wholesale market. It says that there is a retail
market also, and that refers to people with lesser assets.
And what we are seeing through the more recent changes in
the rules is the ability to package and register hedge funds
for smaller investors.
Senator Corzine. Can you give us some dimension of what you
might think people have been able to access retail----
Chairman Donaldson. These are still, I suspect, fairly
large amounts of money to most people in America. Twenty-five
thousand dollar participation is a lot of money to a lot of
people. That may be retail to Wall Street, but it is a lot of
money. So, you are still at that level. You are not down in the
real mass market of $1,000, $5,000 investment.
Senator Corzine. But well below $1 million set in the 1933
Act.
Chairman Donaldson. Well below, yes.
Senator Corzine. Or the $5 million set in--I think it was
actually the 1996 Act.
Chairman Donaldson. Yes.
Senator Corzine. Thank you.
Chairman Shelby. Senator Dole.
Senator Dole. Mr. Chairman, has the SEC done any studies as
to the extent to which retail investors are investing in
registered investment companies which are investing in hedge
funds? To what extent has any work been done to tell us the
extent of this?
Chairman Donaldson. Well, we are gradually getting a handle
on it. The statistics have a tendency of being repeated over
and over again as being true.
I use the statistic that there are 5,700 hedge funds out
there. I am not sure that that is an exact figure. And so, we
are zeroing in on that, and we are going to zero in, as best we
can, with the resources we have, on just how much retail
investment is either there or about to be there.
Senator Dole. Okay. And how can these registered investment
companies calculate valuations which are not required by the
underlying hedge fund? Has this presented a problem for
registered investment companies?
Chairman Donaldson. I think that this is a real issue,
which is, as I mentioned before, looking at the valuation
techniques that are being used.
Again, you may have a fund of funds, a fund of hedge funds,
if you will; and, within that fund of funds, there may be a
spread of hedge funds from some very large ones with a lot of
history into the more speculative end of the spectrum.
Depending upon what kind of investments the more speculative
end is making, the valuation aspect becomes increasingly
important.
We have seen this in the derivatives market. We see that
the issue of how you value what you own is a huge issue because
it is in many ways in the eye of the beholder. If you own a
huge amount of stock, and the last sale is $50 of that stock
and you have a zillion dollars' worth of it, is it worth $50
for purposes of your statement or is it worth something below
that if you had to sell it all at once? I think that is an
issue that we see in the valuation of these more sophisticated
instruments, not just common stocks.
Senator Dole. Right. And some have argued that if subject
to regulation, hedge funds would quickly ``move'' offshore.
They would move out of U.S. markets. What is your view on that?
And what do you believe the removal of hedge funds would mean
to our securities markets?
Chairman Donaldson. Well, I think that is an issue that
gets brought up. I think I would go back to the fact that most
of these hedge funds have their investors in the United States
and they are investing in U.S. securities, and we have a good
reach into that.
Insofar as the investments are made in offshore, non-U.S.-
regulated companies, and, insofar as the investors are not U.S.
citizens, we have no reach there, unless they somehow come into
our markets and use our markets and buy and sell U.S.
securities.
But I think that it is an issue that we have to be careful
about because I think that what we need is more information. We
need to remember, and I am not talking about the retail end of
this, that some investors want to accept more risk. It is very
hard to make a universal rule as to how you run a hedge fund
because you defeat the very purpose of the fund.
So, we have to remember that there is a market out there
for a riskier and potentially higher potential return
investment. And getting at just exactly how we come out of all
of this, I think we will be very mindful of what you are
saying.
We do not want to drive the business out of this country.
Senator Dole. Okay. Thank you, Mr. Chairman.
Chairman Shelby. Senator Carper.
COMMENTS OF SENATOR THOMAS R. CARPER
Senator Carper. Thanks, Mr. Chairman.
Chairman Donaldson, welcome. How are you holding up in your
new job?
[Laughter.]
Chairman Donaldson. Sipping from the fire hose, as they
say.
[Laughter.]
Senator Carper. I have sipped from a few of those myself.
It is not much fun. Hopefully, the volume will come down a
little bit.
Thanks for your willingness to serve and we wish you well.
What do we need to be doing here to help you in your job? You
have been there a while. What more do we need to be doing to
help you do your job well?
Chairman Donaldson. That is a very good question. I
appreciate this Committee's interest. I appreciate the
opportunity that it gives us now, and I hope in the future to
speak in a public forum about exactly what we are doing.
I think that to have this hearing is a good start for us,
to give you a baseline as to where we are. And I think once we
get done with our seminars and have a chance to continue the
work that has been going on, I think we will be able to come
back to you with the thoughts we have. And you can take it from
there in terms of whether you like our thoughts and whether you
might give us whatever we need to implement whatever we
conclude.
Senator Carper. How many weeks have you been on the
payroll?
Chairman Donaldson. Pardon.
Senator Carper. How many weeks have you been on the payroll
now at the SEC?
Chairman Donaldson. Eight weeks and 2 days.
[Laughter.]
Senator Carper. All right. But who's counting?
[Laughter.]
Senator Sarbanes. Hours and minutes, too.
[Laughter.]
Senator Carper. What have you learned so far that has
surprised you?
Chairman Donaldson. I am sorry, I did not hear you.
Senator Carper. What have you learned so far that maybe
surprised you a little bit?
Chairman Donaldson. On the hedge fund side of things?
Senator Carper. No, no, just broadly. More broadly.
[Laughter.]
Chairman Donaldson. Have you got a few minutes, Senator.
Senator Carper. About five.
[Laughter.]
Chairman Donaldson. Well, I am constantly amazed and
interested in the number of cases, enforcement cases that come
before the Commission at the lowest level in terms of scams,
manipulations, pyramid schemes, all things, involving large
amounts of money perpetrated on unexpected investors.
I am amazed. Having been in the business all my life, I
find it hard to recognize that that is out there, and it
continues to be out there. You cut off the head of one and
something pops up over here.
I think the Commission is doing an outstanding job of
getting at that. And, if I might thank you, we are going to
have more resources to do that.
Senator Carper. I was going to ask, in terms of the
resources that you need and what you are getting, is the
balance getting better in terms of what your needs are for
resources to go after some of those frauds?
Chairman Donaldson. Do we need the resources?
Senator Carper. No. Are you getting more of what you need?
Chairman Donaldson. Yes, we are. We are moving ahead on our
new authorizations. Our trick, if you will, or challenge, is to
make sure that we hire well, that we put people in the right
spots, that we look at our organization, and that we just do
not go out and add a lot of people.
We are before another committee here, if I can put in a
plug, trying very hard to get authorization so that we can hire
accountants faster than we can right now.
Under an exception to the rule, we can hire lawyers
immediately. Accountants, we are really slowed down. And we
have had an agreement with our union. We have put it before the
House Committee, and it will come before the Senate Committee.
We hope that we will get a rule changed that will allow us to
hire accountants and economists and so forth, faster than we
are right now able to do.
Senator Carper. When we created the new Department of
Homeland Security, we included in it provisions authored by
Senators Voinovich and Akaka which deal not just with personnel
issues, accommodations for that new Department, but also more
broadly.
I would just urge that you make sure that the people who
work for you in the personnel area, the human resources area,
are mindful of the kind of flexibilities that are provided for
all agencies, including your own.
Let me ask one specific question, if I could, about hedge
funds.
We spent a lot of time last year under the leadership of
Senator Sarbanes trying to develop legislation that we now call
Sarbanes-Oxley, that is designed, among other things, to make
sure that investors have a better idea what they are buying.
When an investment analyst says buy, they mean buy. When
they say sell, they mean sell. And when they say hold, they
mean hold. When we read financial information from companies,
publicly traded companies, they would not just take the money
to the bank, but actually rely on the information being
provided to us.
In a related area, how much information is currently
available for hedge fund investors regarding the hedge fund
managers, the people actually managing these funds? What do the
investors know about the professional backgrounds of the hedge
fund managers? What do they know about whether there have been
any securities-related problems in the past with these hedge
funds managers? And finally, does the SEC have, do you people
have the sufficient information that you need about these fund
managers?
Chairman Donaldson. I think that the situation is rapidly
changing. I think that because of some of the new exceptions
that are allowed and the fact that we are seeing more funds
registering voluntarily, if you will, there is more information
coming down the pike in a certain segment.
On the other hand, I think a number of professional
investors, large institutions, are going to demand a lot more
information from people who are trying to get them to invest in
their hedge funds.
I think you are going to find that some of the big pension
funds and other professional investors who may have bought a
hedge fund 10 years ago are going to demand now that they know
a lot more about what is going on inside that hedge fund. That
is a sign of a healthy market.
Senator Carper. All right. Well, I hope that that demand
will be met by supply in terms of information that investors
need to make wise decisions.
Thank you, Mr. Chairman.
Chairman Shelby. Chairman Donaldson, you referenced some
legislation. We are going to move that as fast as we can. We
are going to give you the resources at the Securities and
Exchange Commission under your leadership to do the job that
has to be done in America.
Mr. Chairman, before we go to the second round, I also want
to say that we appreciate that your investigation is ongoing,
that many of the questions that we are perhaps asking you may
not be answerable in great detail until you complete your
study. You mentioned this earlier.
We would, at the proper time, after the study is complete,
like for you to return to the Committee, and I hope you will.
But your interim report today on your progress and the
issues you are considering in balance has been very helpful, I
believe even today, looking at it as an interim report.
Having said that, I have some other questions as we start
the second round.
Chairman Donaldson. Sure.
[Laughter.]
Chairman Shelby. In your discussion of the Long-Term
Capital Management report's recommendations regarding margin,
collateral leverage, and risk management, and I believe that in
your written testimony, you stated that many institutions
extending leverage to hedge funds seem to have taken these
recommendations to heart. Some of us are concerned by the use
of qualifying words like many and seem.
Should we read this testimony as indicating that the
lessons of LTCM have been lost on some of the institutions that
extend credit to hedge funds?
Chairman Donaldson. Yes, I think that that is cautionary
language. I think that we would hesitate to say that it has
been solved across the board.
On the other hand, that cautionary language comes from the
fact that we are zeroing in on areas where we think they
haven't done what they should do. And I might add, our ability
to do that is a resource-based thing in terms of our staff time
and so forth.
I think the general trend is in the right direction. I
believe that the very fact that you are having this hearing,
the very fact that it has become such a prominent subject,
heightens the awareness.
Chairman Shelby. Absolutely. In the collapse of Long-Term
Capital Management, as we look back at it, banks were willing
to lend money with little information and basically no
collateral.
Given the recent surge in hedge fund investment, what can
you tell us about the lending practices of Wall Street and
commercial banks to hedge funds? Is there any caution out there
now?
Chairman Donaldson. I am not going to cop out on that
question. I am going to say that the lending practices of Wall
Street investment banking firms clearly fall in our purview.
The lending practices of commercial banks do not.
Chairman Shelby. Absolutely. But how do the banking
regulators and the SEC that you chair interact in terms of
monitoring this type of activity? And if they do not, how could
you?
Chairman Donaldson. That is an excellent question, and it
is a question that is of concern.
I think our President's Working Group has helped us in
terms of talking to the other regulators. As you might know,
and I am sure you do, as a result of Gramm-Leach-Bliley and the
new authority that commercial banks have, there is a tension, a
jurisdictional tension, as to who is regulating what part of
the bank.
And I think we are having some very constructive
conversations about that with the Federal Reserve and with the
Treasury.
Chairman Shelby. Chairman Donaldson, just to lay the
predicate, hedge funds leverage, as we know. That is part of
their deal.
How much they borrow compared to their capital allows them
to earn greater returns, yet also increases the risk. What is
the typical leverage position of hedge funds or the range of
the leverage positions that the SEC has observed in its
investigation?
Chairman Donaldson. I think it is a difficult question to
answer because the leverage borrowing, or rather, the danger of
the borrowing, would depend upon how much hedging has been
done. In other words, if you have a single security and you
borrow against that versus a portfolio that is both long and
short, perhaps you can borrow more against that than you might
against a single security.
And it varies tremendously in terms of the focus of the
hedge fund itself. In a Long-Term Capital situation, they were
dealing with debt instruments, with all sorts of derivative
instruments on top of that, as opposed to dealing with common
stocks or something else, and their borrowings were very high.
Chairman Shelby. In other words, is leverage in the hedge
fund industry, and it is all about leverage, still a concern to
the SEC? Are there sufficient safeguards against systemic risk
here?
Chairman Donaldson. I think we are feeling relatively
better about the Long-Term Capital end of the scale, if I can
say that. And I think we need to know a lot more about the
middle ground as to whether we are concerned.
Chairman Shelby. Investor protection, do these funds
receive adequate information to protect the interests of their
investors? Do you perceive that they are having trouble
assessing all the information that they need? In other words,
why would a fund of funds manager invest with a hedge fund that
would not provide all of the information needed for due
diligence purposes? Is it just because they are hoping for the
greater return?
Chairman Donaldson. I think that, personally, and I do not
speak for the Commission now, there is a need for more
information in terms of those funds that are using the
exemptions, that are not registering and so forth. I think
there is a need for more information. The market will demand
it. In other words, as we have gone through a bad stock market
and you put your money in a hedge fund and after a couple of
years, you have lost a lot of money, you are going to be
demanding that you have more information as to how that money
was lost and what are you doing now than has been true in the
past. In a bull market, people do not really care what you are
doing, so long as you are making money for them.
Chairman Shelby. Sure. Mr. Chairman, are these funds of
funds subject to the same reporting and other requirements as a
typical mutual fund?
Chairman Donaldson. By and large, yes, they are in terms of
reporting. Not restrictions as to the diversification and that
sort of thing. But in terms of reporting, yes.
Chairman Shelby. These funds are charged fees at the hedge
fund level and at the fund of funds level. How are fees
disclosed by these funds?
Chairman Donaldson. That is a major issue. You do have fees
upon fees.
Chairman Shelby. Sure.
Chairman Donaldson. And whether that is properly disclosed,
I will be able to tell you a lot better as we get into this
thing.
Chairman Shelby. As you finish your study, yes.
Senator Sarbanes.
Senator Sarbanes. Senator Schumer hasn't had his first
round.
Chairman Shelby. Excuse me. He slipped in over there.
Senator Schumer.
Senator Schumer. Quiet as a little mouse, as usual.
[Laughter.]
Chairman Shelby. Do you have a statement, Senator Schumer?
COMMENTS OF SENATOR CHARLES E. SCHUMER
Senator Schumer. Thank you, Mr. Chairman. I will be brief.
I just have two questions and I thank you for your testimony.
The first question is this. The record of hedge funds in
terms of performance has been better than the general mutual
fund market. You hear comments from average investors who do
not meet the threshold saying they would like to be able to
take advantage. At the same time, you want to make sure that
they have protections so that people aren't taken advantage of.
And it is opposite sides of the same coin.
Do you have any thoughts, Mr. Chairman, on how we can
extend hedge funds to be available to more average investors,
less wealthy investors, but at the same time make sure that
they are protected?
Chairman Donaldson. Well, I think that is the bottom-line
question--how do you get at what you are talking about? And how
do you do that in a way that doesn't impede the free
determination of what the investment objective of the fund
would be?
And as I said earlier before you came, there is a market
out there for people who want to take more risk to earn more. I
think we have to be very careful that we do not come up with
legislation that prescribes exactly how a fund can invest.
I think the first level here is a level of disclosure, a
level of our having the ability to get inside these funds and
find out what they are doing, and, if they are being sold to
the public, that the disclosure is intelligible. And that is
again something that we will come back to.
Senator Schumer. Now, my second question relates to the USA
PATRIOT Act.
You know that there is an antimoney-laundering provision in
the PATRIOT Act at Section 352. And can you tell us how you are
working with the industry and other agencies to make sure that
hedge funds are complying with the antimoney-laundering
guidelines to make sure that someone is not figuring out, here
is an unregulated area. Here is a way that I can get money to
places that the law would prohibit.
Chairman Donaldson. Yes. It is a matter of real concern.
As you know, there have been a number of laws that target
pure laundering of money. And those laws originally pertained
to the banking industry, commercial banking industry and the
financial institutions where it is pretty obvious that there
are big cashflows in and out, readily identifiable.
As we have moved in after September 11, I think there has
been more thinking about other kinds of funds, where it is not
so obvious where the money comes from and where it is going to,
as it might be in a bank.
I think we are making good progress. The President's
Working Group--the Chairman of the SEC, the Chairman of the
Federal Reserve, the Secretary of the Treasury, the Chairman of
the Commodities Future Corporation, and our staffs--is working
on this.
Senator Schumer. Just one comment. This is not related to
the hedge funds.
I know that yesterday, a white paper came out between the
SEC, the FED, and the OCC about New York City and the location
of alternative sites. I thought it was thoughtful, mindful of
New York City's position as the financial capital of the world.
I appreciate the change in course.
As you know, we have talked about it, as I have with
Chairman Greenspan and the head of the OCC. I just hope when we
do the second white paper, it will have the same thoughtful
nature to it, mindful of New York's centrality as the world's
financial capital. To undo that by some kind of regulation
would not only hurt New York City--obviously, it would--but
also the whole country.
Chairman Donaldson. Thank you.
Senator Schumer. So, I appreciate your careful and
thoughtful revisions there.
Chairman Donaldson. Thank you.
Senator Schumer. Thank you, Mr. Chairman.
Senator Sarbanes. Thank you, Senator Schumer.
Chairman Donaldson, I wanted to ask about how you address
the assertion that there is an inherent conflict of interest
with firms running both mutual funds and hedge funds, that the
different fee and compensation structures for portfolio
managers, analysts, and traders provide incentives for them to
act differently when they are managing hedge funds alongside of
mutual funds. We have gotten a number of comments from people
about the problems in these areas. What is your view of that?
Chairman Donaldson. I think there is the potential for
people who are running pools of money in one investment
organization--on the one hand, you have regular fees, mutual
fund kind of fees. On the other hand, you have 20 percent of
the profits and so on. And there is certainly the theoretical
temptation to favor one side versus the other.
I think that any substantial investment institution that
gives into that temptation and doesn't monitor it and doesn't
have rules and regulations of a self-regulatory nature, it
won't be in business very long. And if we have the right to go
in and inspect, we check for it, and if we find it, we will
take action against them.
I do not want to say any more than that, other than that we
are aware of that potential conflict and it certainly is on our
checklist, if you will.
Senator Sarbanes. Mr. Chairman, to sharpen the issue, let
me just read to you some of the communications we have
received.
One of the most important issues is firms that run hedge
funds and mutual funds together. Many asset management firms
have started hedge funds in the last few years due to the much
higher fees and less stringent regulations, but run them side-
by-side with mutual funds. They are often run by the same
portfolio managers.
The main reason mutual fund firms start hedge funds is to
keep their star portfolio managers from leaving to set up their
own fund. Some of the biggest mutual fund companies in the
country are doing this. This practice presents incredible
conflicts.
Some firms use the visibility of their mutual funds on Wall
Street to gain access to research, ideas, IPO's, et cetera,
from the brokerage houses, but use the benefits in
disproportion for their higher-fee hedge funds.
I am very much concerned about this--``Some firms have been
known to short a stock in the hedge fund, hold on to it in
their mutual funds because they are not allowed to sell short,
and then sell the mutual fund position at a later date, thus,
causing downward pressure on the stock price and making the
short position more valuable. ''
Then they go on about the use of soft dollars to pay for
research and information service and skewing that to the hedge
fund. What about this short position and the implications of
that?
Chairman Donaldson. You know, you bring a number of issues
up there.
Let me just say this. On our regular inspections, under the
Investment Advisers Act, we look at the allocation of stock
purchases.
In other words, if a fund group buys a huge block of stock,
we look at how they distribute that stock into the various
funds that they are managing. And if we see something that is
fraudulent about that, or favoring one account over another, we
get on that.
I think that the same thing is true now as the hedge funds
are in mutual fund groups. This is an age-old concern that is
not just pertinent to hedge funds, an age-old concern of are
you being fair in the allocation of your purchases.
Now on the shorting side, again, I cannot react to that
specific allegation, but we are sure hearing you. And you can
be sure that, if that is true, we will do something about it.
Senator Sarbanes. Presumably, part of the problem is this
explosive growth in the hedge fund industry at a time when the
SEC's ability to monitor was not keeping pace because of the
shortage of resources.
Now, you have gotten a very hefty boost in your budget this
year and we hope for a further substantial increase next year.
I know you testified before the Appropriations Committees on
the budget, which would take you to about, I think, $842
million from $468 in a fairly short period of time.
So, we are very encouraged that we can deliver that for the
Commission. I want to just echo Chairman Shelby's statement
that I know the House is working on that legislation on the
hiring process. And as soon as it comes over here, I am sure we
will be ready to move it ahead.
Chairman Shelby. Absolutely.
Senator Sarbanes. How are you doing on the pay parity
issue? I will leave aside the hiring of new people because I
know that is related in part to the legislation.
Chairman Donaldson. Right.
Senator Sarbanes. But you have the authority and now you
have the money to do pay parity for your existing employees.
And that is important I think for morale and for not losing
good people, and also the money to upgrade the information
technology.
Chairman Donaldson. Right.
Senator Sarbanes. How are you doing on those fronts?
Chairman Donaldson. Okay.
Senator Sarbanes. After 8 weeks, 2 days, and--I do not know
if I begin your day at 8 a.m.----
Chairman Shelby. Twenty-seven minutes.
[Laughter.]
Senator Sarbanes. Three hours and 37 minutes, yes.
[Laughter.]
Chairman Donaldson. On the pay parity side, I think the
news is good in terms of our turnover, of people we are losing.
I forget the exact figures, but before pay parity, we were
losing people with something like a 20-percent attrition rate.
Since pay parity has come in, our attrition rate is down to
about 4 percent. That may not be exact.
Senator Sarbanes. Now, you are encompassing parity on
benefits as well as just salaries, aren't you, in your concept
of pay parity?
Chairman Donaldson. Yes, I believe that is so.
Senator Sarbanes. I certainly hope it is so because
benefits are a very important part of the compensation package.
I think if you do not include that in, there is still going to
be a significant discrepancy between what the SEC is doing and
what other Federal financial regulatory agencies are doing.
This is only pay parity between Federal regulatory
agencies. It doesn't even touch the issue of how much more the
private sector can offer. But, of course, we have always had to
contend with that. You should not be losing people to other
Government agencies because they have been authorized to give
pay parity and the SEC has not delivered on it.
Chairman Donaldson. No. I think pay parity has helped a
lot. I might add that perhaps the economy's softness makes it
not quite as easy to leave, or desirable to leave, in terms of
trying to be realistic about this.
On the other hand, I think the challenges facing the SEC
now are such that that heightens the public service instinct of
a lot of very good people out there who want to come to work in
an agency that is doing something good. I think we are seeing
that, and we definitely are seeing it on the legal side in
terms of the caliber of people that are available to us now.
This gets back to the fact that we want to hire people and
not just all lawyers. We want to hire these other disciplines.
And there we are at the competitive disadvantage because we
cannot move swiftly. And so we need some help there.
But I think, clearly, that pay parity has helped a lot.
Senator Sarbanes. I will just close with this.
I think I am encouraged to hear that. I think you, as
Chairman, should seize on the opportunity in terms of
attracting talent of, I do not know, maybe visiting law schools
and Ph.D. programs and saying, it is a new day at the SEC. Look
at what the Congress has done for our budget.
I even had a hearing the other day before the Senate
Appropriations Subcommittee that deals with my budget and the
Chairman of the Subcommittee said to me, the check is in the
bank.
[Laughter.]
I hope he's right. We will see.
Chairman Donaldson. I heard that. I did hear that.
Senator Sarbanes. Yes. Well, it was a nice thing to hear.
And so you can say to them, we are doing very exciting
things at the SEC. There is a real challenge. And if you really
want to serve the public interest and strengthen the American
economy and the integrity of our markets, which has been such
an important part of our economic strength, here is an
opportunity for you to come to a refurbished, dynamic SEC and
make an important contribution.
I think you, as the new Chairman, are in a position to
really make that case and really enhance the attractiveness of
the SEC to people. So, on the one hand, you strengthen the
context for the people you have, which of course, I relate very
much to pay parity, and on the other, the new leadership being
provided, and then reach out in terms of attracting new people
to the Commission.
I wish you the very best in that endeavor.
Chairman Donaldson. Thank you.
Senator Sarbanes. Thank you, Mr. Chairman.
Chairman Shelby. Mr. Chairman, I want to add before I
recognize Senator Sununu again, I appreciate how you are
asserting the authority you and your staff of the SEC that had
been, a lot of us thought, abdicated in recent years, and I
commend you for that.
Chairman Donaldson. Thank you.
Chairman Shelby. Because if you are not assertive, somebody
else will assert the authority and fill the vacuum, as I am
sure you well know.
Senator Sarbanes. Mr. Chairman, I may leave. Could I just
say, as I understand it, you indicated to Chairman Donaldson
that when they complete the study that is underway----
Chairman Shelby. We will have him back.
Senator Sarbanes.We want him to come back and present the
findings to the Committee.
Chairman Shelby. Absolutely.
Senator Sarbanes. Is that correct?
Chairman Shelby. Well, we would. We would like that, Mr.
Chairman.
Chairman Donaldson. I would be delighted to come back.
Chairman Shelby. I think that that would be in order.
Thank you, Senator Sarbanes.
Senator Sununu.
Senator Sununu. Thank you.
Chairman Donaldson, I very much want you to succeed and
want you to be able to retain good people and I am willing to
do a lot of things in order to help you achieve that goal. But
depressing the economy is not one of them. We will fund you, we
will encourage your organization, but I think we are all
rooting for a strong economy. I know you are.
On these registered investment companies, I want to be
clear, I understand what that term means. How many of them are
there in total, registered investment companies, if I may use
that term?
Chairman Donaldson. Registered hedge funds or registered
investment companies?
Senator Sununu. Feel free to make the distinction and give
me the number of both.
Chairman Donaldson. Six thousand registered investment
companies and 60 registered funds of hedge funds.
Senator Sununu. Sixty?
Chairman Donaldson. Six thousand and 60. Sixty registered
funds of hedge funds.
Senator Sununu. Six zero. Sixty registered funds of hedge
funds?
Chairman Donaldson. Yes.
Senator Sununu. Sixty hedge funds that are registered
investment companies. And we have been talking a lot about
funds of funds. Do they need to be registered investment
companies?
Chairman Donaldson. Yes. Generally speaking, most of them,
I suspect, are registering now.
I think that the companies that are promoting funds of
funds and so forth, are generally financial institutions that
will register before----
Senator Sununu. And have registered the funds, one of the
60.
Chairman Donaldson. Yes.
Senator Sununu. What is the minimum investment for one of
these registered hedge funds or for a registered investment
company? Is it the same thing?
Chairman Donaldson. Well, it varies. In terms of the
minimum investment, I am told, in some of the more recent ones,
you can get down as low as $25,000, I think.
Senator Sununu. Is there any limitation put on someone's
salary or net worth for investing in one of these registered
hedge funds?
Chairman Donaldson. Again, we have to be specific because
there are so many different levels of qualification.
Senator Sununu. You have only 60 hedge funds, though.
Chairman Donaldson. There are 60 funds of hedge funds that
are registered.
Senator Sununu. There is no minimum contribution. No
minimum salary requirement. No minimum asset requirement.
Chairman Donaldson. Excuse me.
Senator Sununu. Sure. Take your time.
[Pause.]
Chairman Donaldson. There is no, at this point, regulatory
minimum. But some of the fund groups have their own minimum.
Senator Sununu. Sure. They elect a minimum. But I am
talking about the regulations. Those that aren't registered,
unless I have misheard the testimony, if you are not
registered, you have a salary minimum of $200,000 per year and
an asset minimum of a million dollars.
Chairman Donaldson. That is in terms of your ability to
invest.
Senator Sununu. Yes.
Chairman Donaldson. But that does not address how much
money you can invest. And how much money you can invest would
be a minimum that would be set by the fund itself.
Senator Sununu. I understand. But what is the salary and
the asset threshold for a registered hedge fund? Again, the
answer that I think I heard was zero.
Chairman Donaldson. None. None right now.
Senator Sununu. I think that is an important distinction to
make because a lot of the concerns--again, we get back to these
concerns that the Chairman and the Ranking Member and others
have shared about these investment vehicles. And to the extent
that we are not providing enough information and retailizing--I
appreciated Senator Corzine's question because that was a
question I had myself. What does that really mean?
To the extent that these concerns are prevalent, it seems
to me they are most prevalent in the one area where, in theory,
we have the greatest regulatory leverage, which is those firms
that are registered. And that seems to me to be a very great
paradox, not that we should be surprised. Where the Federal
Government is concerned, we have these kinds of unexpected
consequences or problems that are sometimes created by our
effort to do good.
So, I think that that is an important distinction to make.
And I know from your previous answers that is one of the things
you are going to be addressing in your review.
Did you want to make an additional comment?
Chairman Donaldson. No. I think that, generally speaking,
some of the funds that have been around the longest are ones
that are getting on the cutting edge of voluntarily
registering.
I think that some of the funds that are being started
within the context of existing banks or mutual fund complexes
or whatever, are going to register. I do not believe they can
run an unregistered fund side-by-side in a big investment fund
complex. So, I think there is voluntary and accepted
registration going on.
Senator Sununu. I guess to conclude my point on this topic,
I would want to make sure as a policymaker, and as you come out
with your report, that registering is a good thing for
consumers. And to be blunt, I haven't been convinced that it is
a good thing for consumers at this point because they are
registering, which may give you more access to information as
you go about your job as a regulator within the SEC regarding
disclosure.
But there may not be--may not be--protections or
information provided to consumers. They are not necessarily
seeing any direct advantage of the registration process.
My final question. Do you have to be a registered
investment adviser to manage a mutual fund?
Chairman Donaldson. Yes.
Senator Sununu. And do you have to be a registered
investment adviser to manage a hedge fund?
Chairman Donaldson. No.
Senator Sununu. Even if the hedge fund is a registered
investment company?
Chairman Donaldson. If it is registered, you do.
Senator Sununu. So if it is a registered investment
company, you do. But otherwise, you do not.
Thank you.
Thank you very much, Mr. Chairman.
Chairman Shelby. Chairman Donaldson, we appreciate your
appearance today. We look forward to working with you and we
look forward to this report when it is finished.
Chairman Donaldson. Thank you.
Chairman Shelby. Mr. Chairman, thank you.
The hearing is adjourned.
[Whereupon, at 11:48 a.m., the hearing was adjourned.]
[Prepared statements and responses to written questions
supplied for the record follow:]
PREPARED STATEMENT OF SENATOR JON S. CORZINE
Mr. Chairman, thank you very much for holding this important
hearing. Chairman Donaldson, I thank you for joining us today, and let
me commend you for what has been, by all accounts, a successful early
tenure at the SEC.
The hedge fund industry has changed dramatically since A.W. Jones
created the first hedge fund in 1949. Originally created by Jones as an
alternative investment strategy, hedge funds today represent a $600
billion industry that employs a wide variety of complex and often risky
investment strategies. When one considers the use of leveraging and
derivative instruments, the actual impact of hedge funds on our
financial markets and on underlying commodities is potentially huge.
In recent years, the importance of hedge funds has grown
substantially as a much broader range of investors have sought out
these funds, largely because their average returns have exceeded those
of the S&P, the Dow, and the Nasdaq.
Once the exclusive domain of wealthy, and presumed highly
sophisticated investors, today's hedge fund investors include teachers,
firefighters, nurses and retirees, as well as public and private
pensions funds, universities, and endowment funds.
Yet while hedge funds promise higher returns, the pursuit of those
rewards also comes with increased risks. As hedge funds have grown, so
too have hedge fund
closures. In addition, we have seen an increase in hedge fund fraud.
The retailization of hedge funds and the increasing impact of hedge
funds on our financial markets make it important that we carefully
examine this industry and the many public policy issues at stake.
The SEC has begun such an examination, and I commend Chairman
Donaldson for his interest in this matter. This Committee also has an
important responsibility to address these issues, and I commend Senator
Shelby for holding this hearing.
We need to consider a host of issues.
What does the growth of the hedge fund industry mean for investors
and financial markets? Do those who invest in these funds have
sufficient information to evaluate their risks? What challenges do the
practices of hedge funds and fund managers pose to those charged with
ensuring the integrity of our markets? And, 5 years after the collapse
of Long-Term Capital Management, what has been learned--and, more
importantly, done--to mitigate the systemic risks posed by these funds?
It is my sense that the current system of hedge fund regulation is
inadequate given the rapid change this industry has undergone. Some
improvements may be able to occur through administrative action.
Others, however, may well require legislation. Hopefully, the report
that comes out of the SEC investigation will shed light on the areas of
most urgent need.
Chairman Donaldson and Chairman Shelby, I am committed to working
with both of you to ensure that the SEC has the tools it needs to
protect investors and our financial markets, while promoting the
continued growth of this industry.
I look forward to today's testimony, and again thank you, Chairman
Donaldson, for joining us.
----------
PREPARED STATEMENT OF SENATOR ELIZABETH DOLE
I would like to express my appreciation to you for holding this
hearing on recent developments in hedge funds. Approximately $600
billion is currently invested in hedge funds. The hedge fund industry
represents both an important component to the capital market structure
and a useful investment option. In addition, the industry provides
important liquidity to the organized exchanges as well as the over-the-
counter and less liquid markets.
Back in 1998, we all gained a quick education about the perils of
hedge funds when Long-Term Capital Management created a market crisis
that wound up affecting all sorts of people with no previous knowledge
of hedge funds. Long-Term Capital Management was run by an unusually
distinguished group of money managers, from long-time Wall Street
professionals to Nobel Prize-winning academics. The end result showed
that regardless of knowledge or skill, many have overestimated their
understanding of the markets and paid the price. However, we were
fortunate that major Wall Street firms were convinced to act together
so as to minimize further detrimental impacts on the financial markets.
Hedge funds are in many ways the opposite of mutual funds. While
hedge funds are limited to those wealthy and sophisticated in the
market, many investors of different incomes can invest in a mutual
fund. While many mutual funds are very large billion dollar operations,
hedge funds are known to be smaller. Mutual funds have investment
limitations, disclosure requirements, and allow investors to move their
money in and out as they choose. Hedge funds, on the other hand, have
very little--if any--disclosure features, and require investors to keep
their money with the fund for a specified period.
Because of the requirements in the securities laws that hedge fund
investors be ``sophisticated,'' the people whose money is at risk in
these funds are not the people I worry about in our economy. However,
one recent trend of concern is registered investment companies which
invest in hedge funds. These investment companies do not require the
investor to be ``sophisticated'' or necessarily wealthy. It is the less
sophisticated or lower income investors whom we should be concerned
about since they cannot afford to lose their investment, and they may
not understand the risks which hedge funds can take. I believe it is
this trend that Chairman Donaldson spoke about at his February 5
confirmation hearing when he cited, ``A distressing move toward the
`retailization' of hedge funds.''
I am pleased that Chairman Donaldson has taken time out of his busy
schedule to join us here today and share his thoughts and views on this
subject. I look forward to hearing his testimony and discussing these
issues with him.
Thank you.
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PREPARED STATEMENT OF SENATOR WAYNE ALLARD
I would like to thank Chairman Shelby for holding this important
hearing to learn about the recent developments in the Securities and
Exchange Commission's Hedge Fund Study.
The ability to produce positive returns despite the condition of
the market makes the practice of hedging a unique tool for asset growth
in the United States. In the past, hedge funds have proven to be an
extremely successful vehicle for the well-educated, advanced investor.
Recently, the search for capital and promising investment vehicles have
increased the retailing of hedge fund products, and similarly,
increased the participation of investors with smaller portfolios.
This growth of hedge fund participation raises potential concerns
for the protection of the investor and the impact of hedge funds on
U.S. markets. The Securities and Exchange Commission has a difficult
task before them in determining their role in regulating the industry
and educating the investor.
Thank you, Chairman Donaldson, for coming before the Committee
today to discuss what will be an issue of increasing importance in the
U.S. financial markets. I look forward to your testimony.
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PREPARED STATEMENT OF WILLIAM H. DONALDSON
Chairman, U.S. Securities and Exchange Commission
April 10, 2003
Chairman Shelby, Ranking Member Sarbanes, and distinguished Members
of the Committee, thank you for inviting me to testify today to discuss
hedge funds generally and the Securities and Exchange Commission's
ongoing fact-finding investigation into hedge funds. I appreciate
having the opportunity to discuss this important subject with you.
Over the past few years, hedge funds have become more prominent and
more popular. Sources have estimated that there are close to 5,700
hedge funds operating in the United States today with approximately
$600 billion under management. To put this number in perspective, today
there are approximately $6.3 trillion of assets under management in the
mutual fund industry. In 1990, it is estimated that only $50 billion
was under management in hedge funds, demonstrating the rapid increase
in a relatively short period of time. There have been frequent reports
of high returns of hedge funds that outperform registered investment
companies. But, just as frequently, these reports highlight possible
areas of concern, such as potential conflicts of interest, questionable
marketing techniques, valuation concerns, and market impact of hedge
fund strategies.
As you know, the SEC staff has been engaged in an investigation of
the structure and practices of hedge funds since June 2002. Because
hedge funds continue to grow in status and increase the ranks of their
investors, our investigation grows more
important every day. We at the Commission are still at the fact-
gathering stage and have yet to reach any conclusions. But I want to
report that we are moving to the next stage of our investigation. As
part of the investigation's advancement, the
Commission will be holding public roundtables on May 14 and 15. As I
said before this Committee at my confirmation hearing, I believe there
are many unanswered questions related to hedge funds, and I am anxious
to take a deeper look at both their risks and rewards.
Hedge funds have been around in some form since the establishment
of the Jones Hedge Fund in 1949. The term ``hedge fund'' is undefined,
including in the Federal securities laws. Indeed, there is no commonly
accepted universal meaning. As hedge funds have gained stature and
prominence, though, ``hedge fund'' has developed into a catch-all
classification for many unregistered privately managed pools of
capital. These pools of capital may or may not utilize the
sophisticated hedging and arbitrage strategies that traditional hedge
funds employ, and many appear to engage in relatively simple equity
strategies. Basically, many ``hedge funds'' are not actually hedged,
and the term has become a misnomer in many cases.
The last time the Commission took a good look at hedge funds was in
1998, when Long-Term Capital Management nearly collapsed. As you may
recall, LTCM was a Connecticut-based hedge fund whose investment
strategy employed a tremendous amount of borrowed money, or leverage.
This strategy caused it to suffer approximately $1.8 billion in losses
in August 1998, when Russia devalued the ruble.
After LTCM's near collapse, the Commission, along with the Treasury
Department, the Federal Reserve, and the Commodity Futures Trading
Commission, as part of the President's Working Group on Financial
Markets, issued a report on the risk management and transparency issues
raised by LTCM in particular and of ``highly leveraged institutions''
in general.\1\ The President's Working Group looked at such issues as
firms' adherence to their own stated policies, their margin and
collateral requirements, their use of leverage and whether it was
excessive, and how well their risk models functioned. The report made
serious recommendations that were intended to improve how firms
functioned in these areas; and, based on our examination of the major
brokerage houses that service hedge funds, many institutions extending
leverage to hedge funds seem to have taken these recommendations to
heart.
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\1\ ``Hedge Funds, Leverage, and the Lessons of Long-Term Capital
Management,'' April 1999.
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In addition to this examination of the risk management and
transparency issues, the Commission staff actively supported the work
of the Multidisciplinary Working Group on Enhanced Disclosure (MWGED).
The MWGED and the subsequent Joint Forum Working Group on Enhanced
Disclosure (JFWGED), which the Commission chairs, both address issues
of enhanced disclosure for financial intermediaries (i.e., banks,
securities firms, insurance companies, and hedge funds). The MWGED
issued its report in April 2001, and the work of the JFWGED is ongoing,
but we believe many in the hedge fund industry are considering the
recommendations of these two groups and continuing to explore ways to
improve some of their practices.
Nonetheless, the markets have continued to evolve, and I believe
the time has come for us--the SEC and the President's Working Group--
again to review these risk management, transparency, and public
disclosure issues.\2\ As part of the SEC's ongoing investigation into
the operations of hedge funds, we are also addressing issues from the
perspective of investor protection. These issues include the recent
growth of the industry; the ``retailization'' of hedge funds--meaning
the increasing availability of these products and how and to whom they
are available; an apparent increase in reported fraud involving hedge
funds; and conflicts of interests. Additionally, I am interested in
looking into other issues related to the overall market impact of hedge
fund practices.
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\2\ Certainly, we must be cognizant of how the lack of public
information about hedge funds also plays a critical part in a hedge
fund's investment strategy. Many hedge funds are concerned about third
parties uncovering their strategies. For example, an investor knowing
that a hedge fund holds a large short position in a security could use
that information to the detriment of the hedge fund by trading against
that short position.
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The Commission also has been very active in working with our
colleagues at Treasury, the Federal Reserve, and other financial
regulators to explore and address the potential use of hedge funds as
vehicles for money laundering and terrorist
financing. As mandated by the USA PATRIOT Act, Treasury, the Federal
Reserve, and the SEC issued a report to Congress that addressed the
regulation of investment companies, including hedge funds, as it
related to money laundering.\3\ Additionally, Treasury, in coordination
with the CFTC, the Federal Reserve, and the SEC, has proposed
regulations that would require certain unregistered investment
companies, including hedge funds, to establish anti-money laundering
programs.\4\
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\3\ ``A Report to Congress in Accordance with Section 356(c) of the
Uniting and Strengthening America by Providing Appropriate Tools
Required to Intercept and Obstruct Terrorism Act of 2001 (USA PATRIOT
Act),'' December 31, 2002.
\4\ The proposed regulation was issued September 26, 2002 [67 FR
60617].
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Differences Between Hedge Funds and Investment Companies
In order to fully understand the many questions associated with
hedge funds, we must first examine the characteristics that distinguish
them from registered investment companies. Unlike registered investment
companies, investors in hedge funds usually must commit their money to
hedge funds for extended periods of time and cannot redeem an
investment without prior notice. In fact, some hedge funds permit
investors to redeem only once or twice per year. Moreover, hedge funds
are not subject to the diversification requirements imposed on
registered investment companies and, therefore, may concentrate their
portfolios in a handful of investments, thereby increasing their
potential exposure to market fluctuations.
Hedge funds typically do not have boards of directors. Hedge funds
also do not have to report their results in a standardized format. And
while registered investment companies generally pay an advisory fee
based on a percentage of assets under management, hedge funds typically
pay both an asset-based fee (typically one to two percent of assets) as
well as a performance fee. The performance fee is typically 20 percent
or more of the hedge fund's annual profits (realized or not) but often
may be paid only if the hedge fund's performance exceeds a benchmark
set forth in the fund's offering documents.
Hedge funds are not subject to borrowing and leverage restrictions
that apply to registered investment companies. Thus, a hedge fund may
leverage its portfolio beyond the extent that a registered investment
company may do so. On the other hand, many hedge funds employ
investment strategies with limited or no leverage.
One of the most significant differences between hedge funds and
registered investment companies, for our purposes, is that because hedge
funds typically are not registered with the Commission, they are not
directly subject to examination and inspection by the Commission.
Regulation of Hedge Funds Under the Federal Securities Laws
The exclusions from registration under the Federal securities laws
that apply to hedge funds and their securities offerings are central to
the questions that currently surround hedge funds. The exclusions
define the investment strategies that hedge funds may pursue, the types
of investors who generally may invest in hedge funds, and how hedge
fund securities may be sold. Hedge funds are able to avoid regulation
by meeting criteria that are laid out in four general exclusions or
exceptions: (1) the exclusion from registration of the fund under the
Investment Company Act of 1940, (2) the exemption from registration of
the fund's securities under the Securities Act of 1933, (3) the
exception from registration of the hedge fund manager under the
Investment Advisers Act of 1940, and (4) the exception from reporting
requirements under the Securities Exchange Act of 1934.
Exclusion from Registration Under the Investment Company Act of 1940
Hedge funds typically do not register with the SEC. They rely on
one of two exclusions under the Investment Company Act of 1940 to avoid
registration. The first exclusion under Section 3(c)(1) of the
Investment Company Act limits investors in the hedge fund to 100
persons, while the second exclusion under Section 3(c)(7) of the
Investment Company Act, which was added to the Investment Company Act
in 1996, imposes no numerical limit on the number of investors.\5\
Instead, it generally looks to the size and nature of the investments
of an individual. Thus, investors in funds that utilize the 3(c)(7)
exemption generally must be ``qualified purchasers.'' Qualified
purchasers are defined to include high net worth individuals (generally
individuals who own certain specified investments worth at least $5
million) and certain companies. The theory is that wealthy investors do
not need the full protections of the registration provisions of the
Federal securities laws.
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\5\ Although there is no specific numeric limitation on the number
of investors in a Section 3(c)(7) fund, the Federal securities laws
generally require any issuer with 500 or more investors and $10 million
of assets to register its securities and to file public reports with
the Commission. Most hedge funds do not wish to register their
securities, and therefore they stay below the 500 investor level.
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Exemption from Registration Under the Securities Act of 1933
Importantly, both of these exclusions require hedge funds to sell
their securities in non-public offerings. Thus, most hedge funds rely
on one of a handful of exemptions under the Securities Act in order to
avoid making a public offering. In order to be classified as a non-
public offering, the hedge fund securities may not be offered for sale
using general solicitation or advertising. Additionally, hedge funds
generally sell their securities only to those who qualify as
``accredited investors.'' The term ``accredited investor'' includes
individuals with a minimum of $200,000 in annual
income or $300,000 in annual income with their spouses, or a minimum of
$1,000,000 in net assets. It also includes most organized entities with
over $5,000,000 in assets, including registered investment
companies.\6\
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\6\ This exemption also permits a private issuer to sell to up to
35 nonaccredited investors, but in that case, those investors must be
``sophisticated'' persons--meaning that they must be capable of
evaluating the merits and risks of their investment--and the issuer
must provide disclosure to those investors comparable to that in public
offerings.
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Because these limitations under the Securities Act apply at lower
levels than the ``qualified purchaser'' exemption for 3(c)(7) funds,
these 3(c)(7) funds may only be offered or sold to investors who are
qualified purchasers, as well as accredited investors. Other hedge funds,
that do not qualify as 3(c)(7) funds, may be offered
and sold to accredited investors, whether or not they are also
qualified purchasers. Finally, a fast-growing group of funds of hedge
funds are registered under the Securities Act and may be publicly
offered and sold.
Exception from Registration Under the Investment Advisers Act of 1940
Managers of hedge funds meet the definition of ``investment
adviser'' under the Investment Advisers Act of 1940 because they are in
the business of providing investment advice about securities to others.
Under this Act, an investment adviser with fewer than 15 clients that
does not publicize itself generally as an invest-
ment adviser is not required to register with the Commission. Because
Commission regulations count each hedge fund, rather than each investor
in the hedge fund, as one client, some hedge fund managers may not be
required to register with the Commission.\7\ Unregistered advisers are
not directly subject to the Commission's examination and inspection
program. But it is important to note that all hedge fund managers--
whether registered as investment advisers or not--are subject to the
antifraud provisions of the Investment Advisers Act.
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\7\ We understand that some hedge fund managers voluntarily
register with the Commission because some investors, particularly many
foreign investors, prefer their managers to be registered. Others
register because they also advise registered investment companies,
which are
required to be advised only by registered investment advisers.
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Exception from Reporting Requirements Under the Securities
Exchange Act of 1934
Hedge funds generally are not subject to the reporting requirements
of the Securities Exchange Act because they are operated so as not to
trigger registration of their securities under that statute. However,
if a hedge fund holds large public equity
positions, the manager, like any other large institutional manager,
must publicly disclose those positions. This disclosure, however, does
not necessarily provide significant insight into any particular hedge
fund's portfolios or strategies because the manager is permitted to
aggregate all clients' holdings into one report. In addition,
disclosure is not required of short and debt positions.
The Commission's Investigation of Hedge Funds
Our investigation has been primarily focused on the investor
protection implications of the growth in hedge funds. Once we have
concluded that work, we plan to share our conclusions with other
members of the President's Working Group so that we jointly can
consider whether to review other market issues, including market
impact, leverage, and counterparty risk. Furthermore, let me assure you
that the SEC will continue to use the full extent of its authority to
examine the risk assessment policies and procedures of broker-dealers,
especially those of the larger firms, which are more likely to have
counterparty exposure to hedge funds or otherwise be exposed to risk
from hedge fund investments. Because many of these firms are affiliated
with other types of financial institutions, such as banks, that may
also have hedge fund exposure, firms' credit practices may also be
subject to examination by other financial regulators. While our current
investigation is not yet complete, I want to share with you some of the
issues on which we have been focusing, including: (1) conflicts or
interest, (2) retailization, (3) prime brokers, and (4) fraud.
Conflicts of Interest
Side-by-Side Products
Investment advisers to registered investment companies increasingly
are offering hedge fund investments to their clients--both to satisfy
clients who are seeking
alternative investments, and to provide opportunities for their most
talented investment managers who otherwise might defect to higher
paying positions with
hedge funds. The result, that the advisers manage hedge funds alongside
registered investment companies, raises the potential for conflicts of
interests.
For example, hedge fund managers often have large stakes in the
hedge funds that they advise and/or they collect performance fees from
their hedge fund clients. Consequently, there is the potential that a
hedge fund manager may be tempted to favor its hedge fund clients over
its registered investment company clients in allocating lucrative
trades.
Hedge fund investments may be managed differently than they are in
a registered investment company. For performance and other reasons, a
hedge fund manager may determine to sell a security short in a hedge
fund's portfolio, while holding the same security long in a mutual
fund's portfolio.
I stress that these types of potential conflicts are the same as
those that exist for any investment adviser that manages both
registered investment companies and private client accounts.
Valuation
Other potential conflicts of interest are inherent in hedge funds
alone. Registered investment companies must price their portfolio
securities at market or, if there is no market, at their current ``fair
value''--determined in good faith by the fund's board of directors.
Hedge funds are not subject to these requirements. Thus, for example,
hedge funds may determine that the appropriate price of a security is
its inherent price, a price that looks to the future. Or it may
substitute its determination of the value of a security for a market
price.
These valuation determinations are, of course, subject to the
antifraud provisions of the Federal securities laws, but otherwise they
are permissible. Ultimately, it may be impossible for an investor to
know the actual value of a hedge fund's portfolio securities.
``Retailization'' of Hedge Funds
Another primary focus of our investigation involves the
``retailization'' of hedge funds.
``Middle Class'' Hedge Funds
I earlier mentioned the term ``accredited investor.'' This
qualification is the standard measure used by some private hedge funds
to determine who may invest in their offerings, and it is a hedge
fund's basis for meeting the standards of one of the four general
exemptions from registration. The monetary amounts used to determine
accredited investor status essentially have remained the same since
1982. With the sustained growth in incomes and wealth in the 1990's,
however, more investors meet this standard, despite recent economic
downturns. Although the Commission is not aware of any systematic
investor losses or other failures caused by the current accredited
investor standard, we could of course consider adjusting it, if
appropriate. A global change to the standard, however, could impact
significantly the availability of securities registration exemptions to
other companies. In particular, we would carefully consider the effect
of any adjustment to the standard on the opportunities for small
business capital formation before proposing any change.
In addition, the Internet has changed forever how companies
communicate with their current and prospective investors. Just plugging
the term ``hedge fund'' into any search engine will elicit hundreds of
responses. If hedge fund sponsors fail to follow the law, every
investor with access to the Internet could easily obtain materials that
could constitute an offering of securities to the public, triggering
registration and other requirements under the securities laws.
Appropriate regulation of Internet offerings is a challenge for the
Commission, as it is for other regulatory agencies. The Commission
staff watches how the Internet is used to offer securities to the
public, including offerings by hedge funds. Our policy goal is to
strike a balance between encouraging use of the Internet for legitimate
capital formation and at the same time preventing fraud and abuse. If
we become concerned that our rules and guidelines need to be changed,
or enforcement action needs to be taken, to prevent abuse by hedge
funds or others engaged in purported capital formation activity, we
will act accordingly.
Funds of Hedge Funds
Registered investment companies that invest all, or substantially
all, of their assets in an underlying pool of hedge funds are another
means of increased availability of hedge funds to public investors.
These funds are a recent phenomenon, evolving from the laws governing
the structure of 3(c)(7) funds. The Commission's Division of Investment
Management has seen a boom in these funds. In summer 2002, the first
fund of hedge funds became eligible to sell its securities to the
public. Subsequently, there have been 17 other funds of hedge funds
cleared for the public market. All of these funds currently are subject
to fund-specific minimum investment requirements of at least $25,000.
However, there is now no Federal
requirement for a minimum investment, and it is possible that funds
might seek to lower this requirement making these types of funds
available to a greater number of investors with even less capital.
These possibilities also implicate the need to focus on suitability
determinations and sales practices of those marketing hedge funds.
Funds of hedge funds raise special concerns because they permit
investors to invest indirectly in the very hedge funds in which they
likely may not invest directly due to the legal restrictions. Because
of the influence that accompanies the large size of their investment,
registered funds of hedge funds can compel the underlying hedge funds
to provide more information to investors than they would typically get.
However, even funds of hedge funds do not get the same volume and
frequency of information as investors in a registered investment
company or mutual fund.
Prime Brokers
The growth in the number of hedge funds has also highlighted
another aspect of the hedge fund industry that we need to better
understand. Hedge funds generally use one or more broker-dealers, known
as ``prime brokers,'' to provide a wide variety of services.
Prime brokerage is a system developed by full-service broker-
dealers to facilitate the clearance and settlement of securities trades
for substantial retail and institutional customers who are active
market participants. Prime brokerage involves three distinct parties:
The prime broker, the executing broker, and the customer. The prime
broker is the broker-dealer that clears and finances the customer
trades executed by one or more executing broker-dealers at the behest
of the customer. The prime broker is responsible for all applicable
margin and Regulation T requirements for the customer.
Generally, customers, such as hedge funds, believe a prime
brokerage arrangement is advantageous because the prime broker acts as
a clearing facility for the customer's securities transactions wherever
executed, as well as a central custodian for all the customer's
securities and funds.
Prime brokers offer certain other services to hedge funds that are
typically offered to other substantial customers such as margin loans
and risk management services, but prime brokers may offer other
services that are particularly directed to their hedge fund customers.
For example, some prime brokers provide ``capital introduction''
services to hedge funds. These services, which range from sponsoring
investor conferences to arranging individual meetings and preparing
informational documents, are aimed at bringing hedge fund managers
together with potential investors. We are looking into these services
and the way they are disclosed to investors.
Hedge Fund Fraud
Fraud is, of course, always a primary concern to us. I emphasize
that I do not intend to imply that hedge funds or their managers
generally engage in nefarious or illegal activities. I have no reason
to believe that fraud is more prevalent in hedge funds than it is
anywhere else. Nevertheless, there have been complaints by some issuers
that hedge funds have acquired large short positions in their stocks
and have then attempted to drive the share price down through the
issuance of highly critical and allegedly inaccurate reports on their
finances.
The Division of Enforcement will continue to investigate
allegations of manipulative short selling by hedge funds as it deems
warranted. From a regulatory perspective, the Commission recognizes
that, while short selling can add important benefits to the market,
such as facilitating liquidity, hedging, and pricing efficiency, it
also may be used as a tool for manipulation. In this regard, the
Commission will consider amendments to existing short sale regulation,
as necessary, to curb potential manipulation by all market
participants, including hedge funds, without unnecessarily restricting
liquidity.
More generally, we have recently experienced a sharp increase in
the number of hedge fund frauds that we have investigated and that have
resulted in enforcement action. In fact, last year we instituted twice
the number of enforcement actions against hedge funds or their managers
than we instituted in any of the four previous years.
Examples of charges filed by the Commission include: Making false
or misleading statements in offering documents; misappropriating
assets; market manipulation in a variety of guises; reporting false or
misleading performance, including with respect to valuation of
securities; insider trading; and fraudulently allocating investment
opportunities.
These charges generally are not unique to hedge funds. But hedge
funds present us with a unique challenge. Because hedge funds typically
are not registered with us, we are limited in our ability to detect
problems before they result in harm to investors or the securities
markets.
Market Impact
In addition to the risk management and transparency issues
addressed by the President's Working Group and the investor protection
aspects that the Commission has been primarily focused on to this
point, I believe the Commission's investigation should explore other
market impact issues specifically in the context of hedge funds because
of the substantial assets under their management. We would, of course,
consider these market impact issues with other members of the
President's Working Group. The Commission already aggressively enforces
the anti-manipulation provisions of the Federal securities laws. It may
be that there are other, more subtle or nuanced results of hedge fund
activity that merit attention.
Among the matters that I believe we should look at is the impact
of hedge fund trading. There is nothing inherently nefarious about
hedge fund trading strategies, including short selling. However, they
may disproportionately affect the market or certain issuers. This is a
special concern because we don't know enough about the activities of
these hedge funds.
I think we need to determine whether the information firewalls of
hedge fund industry participants are adequate and whether information
flow within or among hedge fund managers is an area that merits attention.
Our understanding is that prime brokers' policies include strict
information firewalls, but there may be other aspects of information
flow that should be considered.
The nature of managers' returns on hedge funds, either through
investments in the funds or through carried interests, also may affect
trading behavior. While some of the resulting issues relating to risk-
taking are properly issues of disclosure and investor protection, it is
also possible that there are resulting market impacts that merit
attention, and I believe our investigation should consider that
possibility.
The Progress of the Investigation
Our current investigation is proceeding well. The Commission's
Division of Investment Management, alongside our Office of Compliance
Inspections and Examinations, has been gathering information on
investor protection issues to assist the Commission in its
investigation and in preparation for the roundtables in May. The staff
has obtained and reviewed documents and information from 67 different
hedge fund managers representing over 650 different hedge funds and
approximately $162 billion under management.
The staff has also visited and engaged in discussions with a number
of different hedge fund managers. When the staff visited these
managers, they inquired into various aspects of their business,
depending on their size and level of sophistication. The staff talked
to brokerage, compliance, risk management, legal, and other operational
personnel of multi-billion dollar complexes with dozens of employees,
as well as to their portfolio managers. At the other end of the
spectrum, the staff visited hedge funds where one employee serves as
marketer, portfolio manager, trader, operations officer, and risk
manager.
Aside from our inquiries directed to specific hedge funds, the
staff has met with a variety of experts in their respective fields to
get their perspectives on the hedge fund industry. In addition to legal
and accounting experts, the staff has spoken with chief investment
officers, risk managers, prime brokers, representatives from foreign
regulators, trade industry representatives, and hedge funds
consultants. Also, a number of foreign jurisdictions are revisiting
their approaches to hedge funds, and we continue to benefit from
discussions with our foreign counterparts.
Hedge Fund Roundtable
As you know, we are taking our investigation to the next step. As
part of this we have scheduled two full days of hedge fund roundtable
discussions to take place in Washington on May 14 and 15. These
discussions will focus primarily on the investor protection issues
mentioned earlier. Leading experts in the world of hedge funds will
provide their views on hedge funds and the issues that concern us. In
addition, we will solicit comments from the general public to secure
their views. At the end of this process, my current goal is to produce
a report that will summarize what we have found and where we should go.
I believe we should make public what we have found and what conclusions
we have reached.
Investor Education Efforts
Before I close, I would like to tell you about efforts that we and
others are making to provide the public with tools to help to evaluate
the potential risks of hedge funds and funds of hedge funds. Since the
creation of the Commission's website at www.sec.gov, we have used the
website to educate and alert investors to issues relating to
securities. Among other things, the website generally discusses hedge
funds and funds of hedge funds. We have also used that website to
provide investors with a laundry list of questions they should ask
before investing in these products.
In addition, Commission staff developed a website advertising a
simulated hedge fund, Guaranteed Returns Diversified, Inc. (GRDI or
greedy, for short). This website demonstrates how easy it is to be
taken in by false statements and seeks to sensitize investors to their
vulnerability. The Commission's website provides a link to the fake
scam, although we have discovered that most are finding it by surfing
the Internet looking for quick and easy returns. Since we launched this
website on February 13, 2003, we have had over 70,000 hits on it!
Finally, the NASD has increased its efforts to ensure that
investors are not steered to unsuitable investments. At the beginning
of this year, the NASD issued a Notice To Members that reminds broker-
dealers of their obligations when selling hedge funds and funds of
hedge funds. These obligations include steps to ensure that proper
disclosures are made to customers about these products and that broker-
dealers consider the suitability of these products for their customers.
Conclusion
In conclusion, let me assure you that our goal in this exercise is
to determine how we can better protect investors and our securities
markets. By working together, I believe that we can achieve this goal.
Thank you again for inviting me to speak on behalf of the
Commission and the investing public. I would be happy to answer any
questions that you may have.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY
FROM WILLIAM H. DONALDSON
Q.1.a. Your investigation is looking at investment managers who
handle both hedge funds and mutual funds. How many firms have
personnel (that is, fund managers) that are responsible for
both types of funds? How many individual managers have
responsibility for both types of funds?
A.1.a. The Commission doesn't collect data on hedge funds. We
do, however, collect data on advisers registered with the
Commission, and we know that 1,431 advisers registered with the
Commission advise both investment companies and some kind of an
unregistered pooled investment vehicle, which would include
funds typically referred to as hedge funds. This number
represents just over 18 percent of all SEC-registered advisers
and is based on the responses to Items 5D(4) and 5D(6) of Form
ADV (the registration form advisers file with the Commission).
We do not, however, ask advisers specific questions about
their internal management activities with respect to hedge
funds or other unregistered pooled investment vehicles.
Consequently, we do not have data on the number of individuals
employed by investment advisers who have responsibility for
both registered and unregistered funds.
Q.1.b. What type of disclosure do these investment firms
typically make to investors in the mutual fund?
A.1.b. Investment advisers to registered investment companies,
including advisers to mutual funds, increasingly are offering
hedge fund investment opportunities to their clients. When an
adviser manages a hedge fund alongside a registered investment
company, it raises potential conflicts of interests. Notably,
however, the nature of these conflicts is similar to those for
an adviser managing a registered investment company alongside a
private client account or accounts--a practice which is
relatively commonplace in the fund industry.
The relevant registration forms do not expressly require
that these potential conflicts be disclosed as a specific
principal risk of investment in the fund. Put another way, the
forms are not designed to mandate which specific risks must be
disclosed. Rather, the forms require that all material risks be
disclosed. The forms also set out where in the registration
statement the more significant material risks must be
disclosed.
Most mutual fund managers, of course, do not also manage
hedge funds. But when that is the case, the mutual fund must
analyze the potential conflicts raised by that dual role and
determine whether or not disclosure to fund shareholders is
necessary. Disclosure might not be necessary, for example,
where the particular mutual fund and hedge fund use very
different investment strategies or are otherwise unlikely to
make investment decisions regarding the same investments.
The staff typically does not see mutual funds disclosing
these potential conflicts as a specific material risk of
investment. Investors, however, do receive important related
information in connection with a fund's brokerage allocation
procedures. The applicable registration forms for open- and
closed-end funds expressly call for disclosure relating to the
fund's brokerage allocation procedures in the fund's statement of
additional information. Funds sometimes disclose securities
allocation procedures involving the fund and other accounts of
the adviser (whether those other accounts are private client
accounts, other registered investment vehicles, or hedge funds).
A mutual fund also must describe in its prospectus the
adviser's experience, as well as the recent business experience
of the portfolio manager. This disclosure would require general
information regarding hedge funds managed.
Finally, and regardless of any disclosure obligations, it
is very important to note that an adviser to a mutual fund is
subject to the antifraud provisions of the Investment Advisers
Act of 1940, and has a fiduciary duty to treat all clients
fairly pursuant to that Act. Accordingly, during our
examinations of investment companies, we scrutinize the
adviser's procedures in this area to ascertain whether the fund
is being managed in an appropriate manner along with other
accounts, including hedge funds, managed by the adviser.
Q.1.c. What safeguards do investment firms have in place to
guard against preferential treatment of the hedge fund?
A.1.c. Advisers that manage hedge funds and other pools of
assets or individual accounts have substantial conflicts of
interest when a hedge fund pays a performance fee. Investment
advisers, even those exempt from registration with the
Commission, owe their clients fiduciary duties that prohibit
the adviser from acting on such conflicts to harm clients.
Although it is difficult to generalize across the industry,
many investment advisers have also established the policies and
procedures designed to prevent these types of conflicts from
harming clients, including:
Establishing written compliance policies that, among
other things, provide for the fair allocation of investment
opportunities among clients.
Adopting written codes of ethics that proscribe
illegal, unethical, or inappropriate conduct by the
adviser's employees.
Establishing supervisory procedures designed to
prevent em-
ployees from causing the adviser to breach its fiduciary
duties by favoring hedge fund clients, including monitoring
for patterns of trading that, although effected in
accordance with compliance procedures, indicate a
possibility of abuse.
Structuring portfolio manager compensation to
ameliorate incentives to act on conflicts.
These are policies and procedures similar to those advisers
use to guard against other types of conflicts of interest. Our
experience is that larger advisory firms are more likely to
have written, formal procedures than smaller organizations.
Q.2.a. The securities fraud laws that the SEC enforces apply to
hedge funds. According to some press reports, the SEC has
brought about two dozen cases against hedge funds since 1998.
Have these all been antifraud cases?
A.2.a. From 1998 through 2002, the Commission has brought
approximately 28 enforcement actions relating to hedge funds.
All but one of these actions included charges of securities
fraud; some of these actions alleged additional violations of
other provisions of the Federal securities laws. The remaining
enforcement action charged violations of the registration
provisions of the Securities Act and the Investment Company
Act, and of the books-and-records provision of the Investment
Advisers Act.\1\
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\1\ See In the Matter of Prime Advisors, Inc., et al., Release No.
7560, July 31, 1998.
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Q.2.b. What was the nature of the fraud?
A.2.b. The fraud charges in these hedge fund cases were based
primarily on allegations that the hedge funds and/or their
advisers made misrepresentations concerning: (i) the past,
present, or future performance of the fund; (ii) the risk
associated with investing in the fund; (iii) the adviser's
qualifications or experience; (iv) the current value of the
fund or an investor's interest in it; (v) the fund's trading
strategy; (vi) use of fund assets; and/or (vii) the extent of
losses. In many of these cases, the fund or its adviser
misappropriated investors' monies.
Q.2.c. How did the SEC become aware of the fraud?
A.2.c. While we cannot report how the fraud was learned of in
each of these cases, the Commission frequently learns of frauds
such as these from investors who have suffered losses or who
are solicited to invest. We also may learn of hedge fund
misconduct from a third-party that conducts business with the
fund, such as a brokerage firm or auditor.
Q.2.d. Are we seeing evidence of more abuses in this industry
or are we just seeing more cases because the industry has
grown?
A.2.d. It is difficult to identify the cause (or causes) of the
recent increase in cases relating to hedge funds. It may relate
to the growth in the industry. It is also likely that as public
awareness of hedge funds has increased, those intent upon
defrauding investors are using the allure of hedge funds to
attract victims. In these situations, the violators may have no
intention of establishing a legitimate hedge fund, but simply
market the fraudulent investment opportunity as a hedge fund.
Q.2.e. Given the ability of less sophisticated investors to
access hedge funds, will the SEC be re-evaluating its
enforcement
program?
A.2.e. The Commission aggressively combats all types of fraud,
including fraud relating to hedge funds. As the hedge fund
industry continues to grow and hedge funds become more
available to retail investors, the enforcement program's focus
on hedge fund fraud will grow more acute.
Q.3.a. Hedge funds typically own assets that are difficult to
value--either because they are not broadly traded or because of
unique characteristics of the assets. What are the typical
guidelines for valuation and reporting for hedge funds?
A.3.a. Valuation. The Federal securities laws generally do not
require hedge funds to value their assets in any particular
manner. Hedge funds, however, typically disclose to their
investors how they value their assets.
The manager of a hedge fund typically values the fund's
assets. As a general matter, however, hedge funds ordinarily
use: (a) market prices to value securities for which the market
quotations are readily available, and (b) ``fair value'' to
value securities and other assets for which market quotations
are not readily available. Although there is no uniform
methodology for determining fair value, fair value generally is
the price that the fund might reasonably expect to receive for
a security or other asset upon its current sale. Many hedge
funds use pricing information from pricing services, such as
Bloomberg, Reuters, and FT Interactive Data, to value their
assets. Some hedge funds value the securities of nonpublicly
traded companies at cost and generally do not revalue them
until a public trading market exists for the securities or the
issuer engages in a subsequent round of equity financing. Some
hedge funds also utilize ``side pocket'' accounting, whereby
illiquid assets are essentially not considered when determining
the funds' net asset values (NAV) until the funds sell the
assets.
Hedge fund financial statements typically are prepared in
accordance with generally accepted accounting principles
(GAAP). GAAP generally requires the use of fair values when
market prices are not readily available. Hedge funds, however,
are not subject to the requirements of Regulation S-X under the
Securities Act of 1933, which specifies the form and content of
financial statements and standards concerning auditor
independence.
Independent public accountants typically audit the year-end
financial statements of hedge funds. Most auditors attempt to
verify the accuracy of hedge funds' securities valuations by
comparing them with values they obtain from pricing services.
For certain assets for which prices are not readily available,
however, auditors generally review and assess the
reasonableness of the hedge fund manager's valuation process;
most auditors do not attempt to verify the actual prices of the
assets.
Reporting. The Federal securities laws generally do not
require hedge funds to provide reports to the Commission or to
their investors. Many hedge funds, however, provide their
investors with quarterly, semi-annual, or annual reports. Hedge
funds also commonly provide their investors with copies of
their year-end audited financial statements. Some hedge funds
also provide their investors with monthly or quarterly account
statements. In addition, some hedge funds post performance and
other information on password-protected websites that are
available to their investors.
Q.3.b. Are intermediary ``funds of funds'' making sure that
they receive fair valuations?
A.3.b. A small but growing number of funds of hedge funds
(FOHF's) have registered with the Commission in the past
several years. These funds are required by the Investment
Company Act of 1940 to value their portfolio securities by
using: (a) the market value of the securities when market
quotations are ``readily available'' and (b) the fair value of
the securities when market quota-
tions are not readily available. As there generally are no
readily available market prices for interests in the underlying
hedge funds in which registered FOHF's invest, the FOHF's are
required to value such interests at their fair value.
Registered FOHF's generally disclose to their investors how
they value their interests in hedge funds. The disclosure
typically sets forth the steps that the FOHF's and their
managers take to ensure that they value their assets fairly.
Registered FOHF's often disclose in their offering documents
that, prior to investing in a hedge fund, their managers
conduct due diligence reviews of the valuation methodologies
used by the hedge fund. Such reviews typically include
examining the hedge fund's offering documents and obtaining
additional relevant information from the fund's manager. Many
registered FOHF's rely on valuation information provided to
them by the hedge funds in which they invest. Registered FOHF's
also typically disclose that they generally lack access to the
information that would be needed to confirm independently the
accuracy of valuation information provided by the underlying
hedge funds. In addition, registered FOHF's typically disclose
that, in the event that they have information that causes them
to question the valuation information reported by a hedge fund,
they will fair value their interest in the hedge fund based on
any relevant information, including the reported valuation
information, available to them.
The financial statements of registered FOHF's must be
audited annually by independent public accountants, and the
financial statements of many hedge funds also are audited
annually by independent public accountants. These audits may
provide some degree of assurance that registered FOHF's are
valuing their assets appropriately. As noted above, auditors
generally review and assess the reasonableness of a hedge
fund's valuation process when auditing the fund's financial
statements.
Q.3.c. If retail investors are involved in hedge funds, what
can be done to ensure that the value of their investments is
reported appropriately?
A.3.c. Retail investors generally may invest in FOHF's
registered under the Investment Company Act and whose
securities are registered under the Securities Act. Four
elements can help to ensure the value of retail investors'
investments in registered FOHF's are reported appropriately:
(1) review by the Commission's staff of the funds' offering
documents and financial statements; (2) examinations of FOHF's
by the Commission's examination staff; (3) audits of the FOHFs'
financial statements by independent public accountants; and (4)
oversight by the FOHF independent directors of the valuation
process.
The Investment Company Act places the responsibility for
fair value pricing of portfolio securities on the investment
company's board of directors.\2\ Therefore, investment company
directors should demand sufficient information to be
comfortable that the valuations of underlying hedge fund
investments are accurate.
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\2\ Section 2(a)(41) of the Investment Company Act.
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The Commission's staff closely reviews the offering
documents of FOHF's seeking to register as investment companies
to ensure that their valuation policies and procedures are
fully consistent with regulatory requirements. Examinations by
the Commission's staff of the actual valuation practices of
registered FOHF's and their financial statements also should
help to ensure registered FOHF's are valuing their portfolio
securities in a manner consistent with regulatory requirements
and their disclosures to investors.
Finally, audits of the financial statements of registered
FOHF's and hedge funds by independent public accountants should
also provide some assurance that registered FOHF's and hedge
funds are valuing and reporting their investments
appropriately.
Q.3.d. Should there be a requirement for independent
verification of the valuations?
A.3.d. Given our limited experience with these vehicles, it is
difficult to determine, at this time, whether there should be a
requirement for independent verification of hedge funds'
valuations. We are aware that some FOHF's will invest only with
underlying hedge funds that agree to provide information to an
independent third party to value the hedge funds' assets and
report to the FOHF. At least one jurisdiction, Hong Kong,
generally requires independent verification of hedge funds'
valuations. We are studying these recently adopted requirements
and intend to consult with the Hong Kong Securities and Futures
Commission concerning the operation of these requirements for
hedge funds and FOHF's in Hong Kong.
Q.4.a. Hedge funds are well-known as an option for the
sophisticated or ``accredited'' investor, currently defined as
someone with $1 million in net worth or annual salary of
$200,000. These values have not changed in many years. Do these
levels need to be adjusted to accommodate changes in income and
wealth since they were adopted?
A.4.a. The monetary amounts used to determine accredited
investor status essentially have remained the same since 1982.
With the sustained growth in incomes and wealth in the 1990's,
however, more investors meet this standard, despite recent
economic downturns. It may, therefore, be appropriate to
consider whether the definition should be updated to increase
the levels of income or net worth.
The Commission would, of course, consider adjusting the
``accredited investor'' definition, if appropriate. Before
proposing any adjustments, the Commission must consider a
number of factors. First, the Commission is not aware of any
systematic investor losses or other failures caused by the
current accredited investor standard. Second, the Commission
may wish to reconsider using the definition as a surrogate for
investor sophistication, and that concept also may be worthy of
consideration. Third, a global change to the accredited
investor standards, however, could impact significantly the
availability of securities registration exemptions to other
companies. In particular, the Commission would consider
carefully the effect of any adjustment to the standard on the
opportunities for small business capital formation before
proposing any change.
Q.4.b. What is the current industry practice regarding minimum
levels for investing in funds of funds?
A.4.b. Your inquiry raises two separate, but related,
questions. First, has an industry practice developed around the
minimum initial investment required by registered FOHF's? And,
second, have investors in these funds been required to meet
certain other investor eligibility requirements?
All of the FOHF's registered with the Commission to date as
investment companies have registered as closed-end funds under
the Investment Company Act. Some also have registered their
securities under the Securities Act. Notably, none of these
registered FOHF's currently trades on an exchange.
With regard to the first question, all of these registered
FOHF's subject investors to fund-specific minimum initial
investments of no less than $25,000. Some require a $25,000
initial minimum, others $50,000, and a few impose much greater
initial minimums (in some cases, $1 million). A few also
disclose that they will reduce, or reserve the right to waive,
the required minimum in limited circumstances, such as when the
investor already is an existing client of the adviser with
substantial assets under management, or when the investor is an
officer or employee of the adviser.
However, there is no Federal requirement that FOHF's impose
any minimum initial investment.\3\ A registered FOHF,
therefore, could lower its minimum initial investment so as to
make itself available to a greater number of investors with
less capital.\4\ The emergence of these products implicates the
need to focus on the suitability determinations and sales
practices of those marketing the registered FOHF's, as well as
the underlying hedge funds.
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\3\ Some foreign jurisdictions, such as Hong Kong, France, and
Australia, do require a minimum investment in the FOHF's they regulate.
\4\ In fact, one FOHF whose registration statement is pending with
the staff proposes to trade its shares on an exchange without any
minimum initial investment requirement. That fund also would not impose
other common investor eligibility standards, such as those we discuss
later in this answer.
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With regard to the second question, as we noted above, the
underlying hedge fund investments typically limit their U.S.
investors to those who satisfy specific eligibility standards.
All of the FOHF's currently registered with the Commission have
imposed specific
eligibility standards, regardless of whether those standards
are required under Federal law. All of these registered FOHF's
restrict their sales to investors that at least satisfy the
``accredited investor'' standard, even those funds engaged in a
public offering and thereby required to register their
securities under the Securities Act and their funds under the
Investment Company Act. In addition to certain institutional
investors, ``accredited investors'' are defined generally as
natural persons with individual or joint net worth of
$1,000,000, or individual income in each of the last 2 years in
excess of $200,000, or joint income for the same period in
excess of $300,000.
But those registered FOHF's charging a performance-based
fee (that is, a fee based on the capital gains or capital
appreciation of the fund or a client's account) are required to
impose specific eligibility standards pursuant to the
Investment Advisers Act. Such funds must limit their investors
to ``qualified clients.'' That term generally is defined as
investors with individual or joint net worth exceeding
$1,500,000, or with assets under the adviser's management of at
least $750,000, or investors who are ``qualified purchasers''
for purposes of the Investment Company Act (defined as, among
other things, an investor with at least $5,000,000 in
investments).
Therefore, with respect to minimum initial investments, a
FOHF need not impose any specific eligibility standards if it
does not charge a performance-based fee or register its
securities under the Securities Act. However, not imposing
these standards voluntarily would raise suitability and sales
practices concerns.
Q.4.c. Alternatively, should there be a floor set on the
minimum level at which retail investors can buy into hedge
funds through the ``funds of funds'' structure?
A.4.c. As noted above, there is no Federal requirement that
registered FOHF's impose a minimum initial investment on
investors. Further, investors in some of the currently offered
FOHF's need not satisfy, as a matter of law, specific
eligibility standards. Nevertheless, all current registered
FOHF's voluntarily impose minimum initial investments and
specific eligibility standards.\5\
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\5\ It the absence of a legal mandate, suitability and related
considerations (discussed below) may be major factors in why these
funds are adopting such policies.
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With respect to eligibility standards, this result
primarily is due to changes made to the Federal securities laws
in the National Securities Markets Improvement Act of 1996
(NSMIA). Those changes provided greater leeway for the creation
of registered FOHF's and expanded the kinds of hedge funds that
could be offered (primarily through enactment of Section
3(c)(7) of the Investment Company Act). Further, after NSMIA, a
hedge fund in which a FOHF invests need not ``look through''
the FOHF, to its investors, to determine who is a ``qualified
purchaser'' for purposes of Section 3(c)(7).\6\
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\6\ Put another way, the registered FOHF (or a mutual fund) would
be the ``qualified purchaser'' for Section 3(c)(7) purposes in the
unregistered hedge fund, regardless of the bona fides of the investors
in that registered FOHF or mutual fund. However, Rule 2a51-3 under the
Investment Company Act provides that a fund shall not be deemed to be a
qualified purchaser if it was formed for the specific purpose of
acquiring the securities of a 3(c)(7) fund, unless each of the top
fund's beneficial owners is a qualified purchaser.
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In a FOHF, the adviser's expertise and sophistication, in
effect, is substituted for that of each investor. The investors
are protected through the purchase of a registered product. The
adviser to a registered FOHF must register with the Commission
and is subject to regulation under the Advisers Act. Investors
also are protected through comprehensive regulation of the
registered fund and Commission oversight under the Investment
Company Act. Moreover, if the fund conducts a public offering
and registers its securities under the Securities Act,
additional statutory provisions protect the investors.
As important, investment advisers and broker-dealers who
recommend FOHF's must ensure that such recommendations are
suitable for the particular investor. Advisers are fiduciaries
owing their clients a duty to provide only suitable investment
advice.\7\ To do this, advisers must make reasonable
determinations that their advice is suitable for a particular
client based on that client's financial situation and
investment objectives. This duty is enforceable under Section
206 of the Advisers Act.
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\7\ See Suitability of Investment Advice Provided by Investment
Advisers, Investment Advisers Act Release No. 1406 (March 16, 1994).
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The Federal securities laws and the rules of various self-
regulatory organizations (SRO's) require a broker-dealer to
have a reasonable basis for believing its recommendations are
suitable for a particular investor. Recently, one SRO, the
National Association of Securities Dealers, issued a Notice to
Members reminding its broker-dealers of their suitability and
sales practice obligations concerning the sale of FOHF's and
hedge funds.\8\
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\8\ Notice to Members 03-07 (February 2003). This notice emphasized
a broker-dealer's obli-
gation to: Provide a balanced disclosure in promotional efforts;
perform a reasonable-basis
suitability determination; perform a customer-specific suitability
determination; and provide adequate training and supervision of persons
selling these products.
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Investor net worth has long been a useful proxy for
suitability and sophistication generally. For example, if a
prospective investor in a FOHF has $750,000 invested elsewhere
with an adviser, or has considerable other assets, those facts,
though perhaps not dispositive, would be relevant to the
investment's suitability and the investor's ability to
withstand the loss of the entire investment in the FOHF. It is
not so clear that a minimum initial investment
requirement has the same efficacy as a proxy for suitability or
sophistication. For example, an investor might seek to
diversify his/her small investment portfolio with a small
investment in a FOHF. The investor might not be terribly savvy
or wealthy, since he/she might satisfy that fund's voluntarily
imposed accredited investor eligibility standard primarily
because of the net worth of the investor's house. Requiring
that investor to make a $50,000 minimum initial investment
would not seem to advance the cause of investor protection.
Rather, imposition of such a minimum could have potentially
perverse results--the loss of the entire investment likely
would have dire consequences to the investor.
We certainly are not opposed to funds imposing such
minimums on their own initiative, nor are we opposed to
investment advisers or broker-dealers looking to such minimums,
in conjunction with all other relevant factors, in reaching a
suitability determination in a given instance. However, we
question whether investment minimums alone adequately protect
less sophisticated investors.
Q.5.a. Britain's Financial Services Authority (FSA) does not
allow hedge funds to be marketed to retail investors--although
they are considering options for opening up hedge funds to
retail investors. They are also trying to limit the amount that
hedge funds can borrow in order to prevent any systemic risks.
Is the SEC reviewing the FSA's work in this area?
A.5.a. The Commission is currently reviewing and considering
how other jurisdictions, including the United Kingdom, regulate
hedge funds. An examination of the regulation of hedge funds in
other jurisdictions may assist the Commission in determining
whether the U.S. regulatory regime for hedge funds and hedge
fund managers should be amended.
With respect to the FSA's work, hedge funds, as a general
matter, currently may not be marketed and sold to retail
investors in the United Kingdom. The FSA, however, recently
solicited comments on whether hedge funds should be permitted
to be marketed and sold to retail investors in light of
considerable changes both to the hedge fund market and the
structure of regulation in the United Kingdom.\9\ The comments
received by the FSA generally indicated that hedge fund product
providers and investment managers do not have a great desire to
produce or to sell retail hedge fund products in the United
Kingdom and there is no significant demand from retail
investors for access to such products. After reviewing the
comments, the FSA concluded that its current regulatory regime
is appropriate and that no changes are required.\10\ The FSA
stated that it would continue to monitor the hedge fund market
to determine whether to amend the regulations for hedge
funds.\11\
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\9\ FSA Discussion Paper 16 (August 2002), available at http://
www.fsa.gov.uk/pubs/discussion/16/.
\10\ FSA Feedback Statement on DP 16 (March 2003), available at
http://www.fsa.gov.uk/pubs/discussion/fs16/.
\11\ The FSA noted that there were several significant obstacles to
changing the regulatory regime to permit the marketing and sale of
hedge funds to retail investors. For example, few hedge funds currently
are established in the United Kingdom because the tax regime is
unfavorable, especially compared to certain offshore jurisdictions. In
addition, existing regulations would limit the type of hedge funds that
could be authorized in the United Kingdom to those that meet certain
key investor protections, such as risk spreading, independent
depository, regular valuation, rights of redemption, limitations on
borrowing, and disclosure.
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The FSA also requested comments on the appropriateness of
its regulatory regime for hedge fund managers. Hedge fund
managers based in the United Kingdom must be authorized by the
FSA even if the funds that they manage are offshore. The
comments received by the FSA generally indicated that the FSA's
current regulatory regime for United Kingdom-based hedge fund
managers is appropriate. The FSA concluded that it would not be
appropriate to introduce rules specifically to regulate hedge
fund managers. The FSA stated that it would continue to monitor
the hedge fund market to determine whether to amend the
regulations that apply to hedge fund managers.
Q.5.b. What have other countries with mature capital markets
done?
A.5.b. Most jurisdictions permit hedge funds to be marketed and
sold to sophisticated investors or institutional investors
without requiring the hedge funds to be authorized by the
securities regulator in the jurisdiction. Most jurisdictions,
however, do not permit hedge funds to be marketed and sold to
retail investors. A few jurisdictions, such as Hong Kong,
Singapore, and Switzerland, do permit hedge funds to be
marketed and sold to retail investors.
In jurisdictions that permit hedge funds to be marketed and
sold to retail investors, hedge funds are subject to various
restrictions that are designed to address the retail investor
protection issues. For example, each jurisdiction requires a
minimum investment in a hedge fund.\12\ Each jurisdiction also
requires specific disclosures in hedge fund prospectuses and
marketing materials regarding fund policies, strategies, and
risks.\13\ In two of the three jurisdictions, the prospectus
also must contain information about the fund's valuation
procedures.\14\ Hedge funds must have external audits by
independent auditors in at least two jurisdictions.\15\ At
least two jurisdictions require regular reports to
investors.\16\ In addition, in all three jurisdictions, hedge
fund managers must meet certain experience and expertise
requirements.\17\
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\12\ Hong Kong, Singapore, and Switzerland require a minimum
investment in a hedge fund of $50,000 (or, for a capital guaranteed
hedge fund, with no minimum investment), approximately $58,000, and
approximately $11,000 respectively.
\13\ In Hong Kong, the prospectus must disclose the types of
investment instruments permitted, the extent of diversification and
leverage, and the risk implications to investors. The prospectus also
must contain a disclaimer regarding the risk of price fluctuations
during the payout period, which can last as long as 90 days. In
Singapore, all marketing material must disclose fees and charges, refer
to the risks of investing in the fund, and include disclaimers that:
(1) investment in a hedge fund carries special risks and may not be
suitable to investors averse to such risks; (2) if not a capital
guaranteed fund, that investors may lose all or a large part of their
investment; or if a capital guaranteed fund, that investors are subject
to the credit risk of the guarantor or the default risk of the issuer;
and (3) hedge funds may not be suitable for all types of investors and
are not intended to be a complete investment strategy for any investor.
In Switzerland, the prospectus must disclose all special risks, the
redemption procedures, and include a glossary of terms.
\14\ In Hong Kong, the prospectus must disclose the valuation
methods, frequency of valuation and the identity and qualifications of
the valuation agent, which must be independent. In Switzerland, the
prospectus must disclose the valuation method.
\15\ In Switzerland, the external auditors must demonstrate
professional expertise in the area of alternative investments in which
the hedge fund invests. In Hong Kong, an auditor that is independent of
the management company and the trustee/custodian must audit the annual
report of the fund.
\16\ In Hong Kong, the hedge fund manager must issue a quarterly
narrative report to holders on the fund activities during the reporting
period. The report must be distributed within one month of the end of
the period it covers. In Switzerland, an annual report must be issued
discussing the development of the fund's investment style and strategy,
as well as the valuation of any difficult-to-value investments.
\17\ In Hong Kong, a hedge fund manager must have $100 million in
assets under management that follows hedge fund strategies, 5 years of
general experience in hedge fund strategies and 2 years of experience
in the same strategy as that of the proposed hedge fund. In Singapore,
a hedge fund manager must demonstrate expertise in managing hedge
funds, and at least two executives of the manager must have 5 years of
experience in hedge fund management. In Switzerland, a hedge fund
manager must have 5 years of experience in the investment area
concerned and have a minimum capital of approximately $755,590. In all
of these jurisdictions, the regulator has the authority to prohibit the
public offering of a hedge fund if the fund manager does not have the
proper experience or expertise.
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Many jurisdictions permit funds of hedge funds to be
marketed and sold to retail investors.\18\ Funds of hedge funds
are subject to various restrictions that are designed to
address retail investor protection issues. In most
jurisdictions that permit funds of hedge funds to be marketed
and sold to retail investors, the prospectus and marketing
material must contain information describing the risks of such
an investment.\19\ In most, if not all, foreign jurisdictions
that permit funds of hedge funds to be marketed and sold to
retail investors, the regulator scrutinizes the experience and
competence of a manager before authorizing that manager to
manage a fund of hedge funds.\20\ Most jurisdictions that
permit funds of hedge funds to be marketed and sold to retail
investors require investors to make a minimum investment in a
fund of hedge funds.\21\
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\18\ Australia, Bermuda, Cayman Islands, Hong Kong, Ireland, Italy,
Japan, Luxembourg, Singapore, Switzerland, and the United Kingdom. In
the United Kingdom, funds of hedge funds that invest on a conventional
long-only basis may be listed on exchanges. Germany currently does not
permit funds of hedge funds to be marketed and sold to retail
investors, but it is planning to allow such access in the future.
\19\ In France, marketing material must contain a disclaimer that
the fund is illiquid and intended only for investors who do not require
immediate liquidity. In Hong Kong, funds of hedge funds must provide a
disclaimer that some or all of the underlying funds and their fund
managers are not subject to regulation by the securities regulator. In
Ireland, a fund of hedge funds must disclose special information on
risks including certain disclaimers, and the fund must disclose its
diversification policies and information about the underlying funds and
their fees. In Singapore, a fund of hedge funds must meet the same
requirements as a hedge fund with regard to disclosure of risks and
disclaimers. See supra footnote 13. In Switzerland, the prospectus of a
fund of hedge funds must include a disclaimer that the fund can lose up
to 100 percent of its investment in a single underlying fund.
\20\ In Australia, fund of hedge fund managers must demonstrate
expertise and experience as well as financial resources to be licensed.
In Hong Kong, fund of hedge fund managers must: (1) be regulated in a
jurisdiction with an acceptable regulatory regime; (2) have $100
million in aggregate assets under management that follows hedge fund
strategies; and (3) have 5 years of experience in managing hedge funds
strategies and 2 years of experience managing funds of hedge funds.
Fund of hedge fund managers must demonstrate appropriate expertise and
provide information to the Central Bank of Ireland regarding
appropriate controls to be authorized in Ireland. In Luxembourg, the
regulator pays particular attention to expertise and financial standing
of the managers of hedge funds when considering their applications for
authorization. In Singapore, fund of hedge fund managers must have
expertise in managing such funds.
\21\ Luxembourg has no explicit minimum investment requirement, but
the regulator may impose one if the fund of hedge funds is perceived to
be risky. Minimum investments in Australia can be as low as $1-$2,000,
while other jurisdictions (Hong Kong, Ireland, the Netherlands,
Singapore, and Switzerland) generally require a minimum investment of
$10-$15,000.
Q.5.c. To what extent is the SEC looking at how the
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international community governs hedge funds?
A.5.c. The Commission has been a participant in the Financial
Stability Forum (FSF) since it was convened in April 1999, to
promote international financial stability through information
exchange and international cooperation in financial supervision
and surveillance. The FSF has been studying the implications
for global economic stability of highly leveraged institutions
(which include hedge funds).\22\ In addition, the Commission
participates in meetings of the International Organization of
Securities Commissions (IOSCO). Over the past few years,
IOSCO's Technical Committee, as well as Standing Committee 5 on
Investment Management have examined the regulations governing
hedge funds in the international community.\23\ Most recently,
the Commission hosted speakers from the United Kingdom and
France at its Hedge Fund Roundtable in May 2003, which was
convened to investigate the structure and practices of hedge
funds. The Commission seeks to benefit from the experience of
other jurisdictions in examining the issue of regulation of
hedge funds.
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\22\ The FSF has published three papers: ``Recommendations and
Concerns Raised by Highly Leveraged Institutions (HLI's): An
Assessment'' (March 2002); ``Progress in Implementing the
Recommendations of the Working Group on HLI's'' (May 2001); and
``Working Group on Highly Leveraged Institutions'' (April 2000).
\23\ For example, in 1999, IOSCO's Technical Committee issued a
report entitled, ``Hedge Funds and Other Highly Leveraged
Institutions,'' and in 2003, it published a paper entitled ``Regulatory
and Investor Protection Issues Arising from the Participation by Retail
Investors in (Funds of ) Hedge Funds.''
Q.6.a. Press Reports have focused a great deal of attention on
hedge funds because of their extensive use of short selling,
particularly in what has been a downward trending market. Does
the SEC monitor short selling? How? Does the SEC monitor short
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selling by hedge funds? How?
A.6.a. As you are probably aware, short selling in itself is
not an illegal activity, although there are rules in place
governing the way in which short sales are carried out. For
example, Rule 10a-1(a)(1) under the Securities Exchange Act of
1934 (Exchange Act) provides that, subject to certain
exceptions, an exchange-listed security may be sold short: (i)
at a price above the price at which the immediately preceding
sale was effected (plus tick), or (ii) at the last sale price
if it is higher than the last different price (zero-plus tick).
Conversely, short sales are not permitted on minus ticks or
zero-minus ticks, subject to narrow exceptions. The operation
of these provisions is commonly described as the ``tick test.''
A similar ``bid test'' applies to short sales effected in
Nasdaq National Market
Securities, and prohibits NASD members, subject to certain
exceptions, from effecting short sales at or below the best bid
when the best bid displayed is below the preceding best bid in
a security.
In addition, the self-regulatory organizations, such as the
New York Stock Exchange and the National Association of
Securities Dealers, have adopted rules to help ensure delivery
of securities sold short by settlement date. These rules
generally require that, prior to effecting short sales, member
firms must affirm that they will receive delivery of the
security from the customer, or that the firm can borrow the
security on behalf of the customer or on its own behalf for
delivery by settlement date. Short sellers are also subject to
other costs, such as margin requirements, net capital
requirements for broker-dealers, capital and risk management
standards, and costs imposed by the equity lending market.
The SRO's conduct surveillance regarding compliance with
short sale regulation. In addition, the Commission's Office of
Compliance Inspections and Examinations also conducts
examinations for potential violations with respect to exchange-
listed securities. While a hedge fund that is not registered
with the Commission as either a broker-dealer or investment
company would not be subject to examination, the Commission
could and does examine broker-dealers effecting short sales on
behalf of hedge funds.
Q.6.b. Has the SEC discovered any evidence of the abuse of
short selling?
A.6.b. There have been press reports documenting complaints by
issuers that they were the victims of attacks by hedge funds.
These issuers have alleged that the hedge funds accumulated
large short positions in their stocks, and then sought to drive
the share price down through the issuance of highly critical
and allegedly inaccurate reports on their finances. The
Commission has also recently investigated and brought actions
against certain parties engaging in manipulative naked short
selling as part of what is commonly called a ``death spiral''
scheme. In these schemes a party providing financing receives
from a public company debentures that are later convertible
into the stock of the issuer, typically at a discount to the
current market price. The parties providing financing, which in
some instances may be operating as hedge funds, and may engage
in extensive, naked short selling designed to lower the price
of the issuer's stock, thus realizing profits upon the
conversion of the
debentures.
The Division of Enforcement will continue to investigate
allegations of manipulative short selling by hedge funds as it
deems warranted. From a regulatory perspective, the Commission
recognizes that while short selling adds important benefits to
the market, such as facilitating liquidity, hedging, and
pricing efficiency, it also may be used as a tool for
manipulation. In this regard, the Commission will consider
amendments to existing short sale regulation, as necessary, to
curb potential manipulation by all of the market participants,
including hedge funds, without unnecessarily restricting
liquidity.
Q.6.c. To what degree are some of the standard mutual funds, or
other ``buy side'' market participants now using short selling?
A.6.c. As a general matter, mutual funds engage in short
selling to a very limited extent. While many mutual funds
reserve the right to engage in short selling as part of their
overall investment strategies, many of these funds infrequently
or never engage in short selling. Recent annual and semi-annual
reports filed with the Commission indicate that, during a
recent reporting period, approximately 230 mutual funds engaged
in short sales, as did approximately 30 closed-end funds. The
press also has reported that there are approximately 50
specialized mutual funds with combined assets of $6 billion
that consistently employ short selling and related hedging
strategies.\24\ The NYSE and Nasdaq publicly disclose monthly
open short interests for their listed companies.
---------------------------------------------------------------------------
\24\ See ``Fund Trackers Mull Categories for Hedge Techniques,''
Ignites (www.ignites.com), May 28, 2003.
Q.7.a. In a down market environment, hedge funds are more
attractive to pension fund investors who need the positive
returns to meet their commitments. To what extent are the
pension funds
---------------------------------------------------------------------------
involved in the hedge fund market?
A.7.a. Press reports suggest that pension plans generally are
not heavily invested in hedge funds, but that many plans are
exploring the possibility of making investments in hedge funds.
Because the Commission regulates neither pension plans nor
hedge funds, we do not maintain data on the extent to which
pension plans have invested in hedge funds.
Q.7.b. Do you believe that the pension fund managers are asking
for and receiving the type of disclosure that they need to
understand the risks involved?
A.7.b. We generally have insufficient information to determine
whether pension plan managers are requesting and receiving the
type of disclosure that they need to understand the risks
involved in investing in hedge funds. Under ERISA, however,
pension plan managers generally have a fiduciary duty to
exercise prudence in investigating, evaluating, and making
investments for their plans. As a result, we believe that
pension plan managers should be asking for and receiving the
information that they need to understand the risks involved in
investing in particular hedge funds.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES
FROM WILLIAM H. DONALDSON
Q.1. In 1999, the President's Working Group on Financial
Markets under the Clinton Administration issued a report
titled, ``Hedge Funds, Leverage, and the Lessons of Long-Term
Capital Management.'' In that report, the Working Group made a
number of recommendations.
Which of the 1999 Working Group's recommendations are
currently supported by the SEC and by the Bush Administration's
Working Group? Which of the regulatory recommendations of the
1999 Working Group have been adopted? Which have not? Please be
specific and give the rationale for any given regulation within
the SEC's jurisdiction which has not been implemented.
A.1. The Commission continues to support the recommendations
made by the President's Working Group on Financial Markets. As
described below, the recommendations that fall within the
jurisdiction of the Commission have been implemented or are the
subject of further study in order to develop an implementation
strategy that best furthers the goals of the President's
Working Group.
Recommendation 1--Disclosure and Reporting
The President's Working Group recommended that public
companies be required to provide disclosures concerning their
material exposures to significantly leveraged financial
institutions.
Since the report, Commission staff participated in the
Multidisciplinary Working Group on Enhanced Disclosure also
known as the Fisher Group (Fisher Group). The Fisher Group was
established by the Basel Committee on Banking Supervision, the
Committee on the Global Financial System of the G10 central
banks, the Interna-
tional Association of Insurance Supervisors, and the Interna-
tional Organization of Securities Commissions. In April 2001,
the Fisher Group issued a final report with recommendations for
improving public disclosure practices of financial institutions
and suggested that hedge funds be encouraged to make similar
disclosures--when material--to investors, counterparties, and
creditors. The recommended disclosures included intraperiod
market risk exposures, qualitative discussions of funding
liquidity risk with quantitative supporting information, and
counterparty credit exposures categorized by business line,
credit quality, and maturity. Public securities firms, in large
part, are complying with the recommendations through the
disclosures they make in their regulatory filings and annual
reports. The Fisher Group also recommended that regulators and
market participants collaborate further on improving market and
counterparty credit risk disclosures. SEC staff currently is
chairing a multinational group--the Joint Forum Working Group
on Enhanced Disclosure--that is studying these issues as a
follow up to the report and recommendations of the Fisher
Group.
Recommendation 2--Supervisory Oversight
The President's Working Group recommended that bank,
securities, and futures regulators monitor and encourage
improvements in the risk management systems of regulated
entities.
This recommendation is consistent with Commission practice.
The Commission's Office of Compliance, Inspections and Exams
(OCIE) conducts internal controls and risk management exams of
broker-dealers. These reviews focus on a firm's systems,
procedures, resources, and overall performance in the
assessment, monitoring, and control of all risks at the firm.
The examiners look for areas where a firm's controls are weak
or inadequate and make findings as appropriate. OCIE also
conducts targeted exams that focus on specific risks. For
example, it currently is conducting a
series of examinations of broker-dealers that are significantly
involved in businesses and services related to hedge funds.
In addition, the Commission's Division of Market Regulation
has staff committed to a Risk Assessment Program (RAP), which
focuses on broker-dealer holding companies. The RAP staff
monitors the financial condition and operating results of 160
broker-dealer holding companies. This includes obtaining
quarterly reports that contain detailed information on the
legal structure of the holding company and consolidating
financials. This information is not routinely provided to other
regulators and allows for analysis of the leverage, capital
adequacy, risktaking, and business of each legal entity that is
included in the holding company structure. The information
provided by the reporting firms generally does not include
external counterparty credit risk exposure.
The RAP staff also meets monthly with the independent risk
managers at the five independent broker-dealers most active as
dealers in financial derivatives. It also meets quarterly with
risk managers at several bank-owned broker-dealers that are
significant participants in this area. Several of these firms
also are among the dominant providers of prime brokerage
services to hedge funds. The information provided at these
meetings is the same information used by the firms internally
to manage their market and counterparty credit risk exposures.
These meetings give the RAP staff perspective on how securities
firms manage these risks firmwide. They also provide the RAP
staff with intra-period information on significant market and
external counterparty credit risk exposures. The analysis of
the risk exposures at these firms provides a unique perspective
into market trends with respect to risk exposures and capital
allocation. Although the meetings are voluntary, the
participating firms have been very cooperative in helping the
RAP staff understand their risks.
In addition to these efforts, Commission staff members
represent the Commission on a number of multinational working
groups that have studied, or are studying, counterparty credit
risk issues, including the aforementioned Joint Forum Working
Group on Enhanced Disclosure and the Fisher Group, as well as
the Financial Stability Forum (FSF).
Recommendation 3--Enhanced Private Sector Practices
for Counterparty Risk Management
The President's Working Group recommended that financial
institutions implement improved risk management procedures.
Securities firms have implemented this recommendation. The
market and counterparty credit risk procedures of the
securities firms most involved with hedge funds have been
substantially augmented and improved since 1998. These firms
have devoted significant resources to hiring qualified risk
managers. They also have purchased and developed highly
innovative technological tools for measuring and aggregating
risk, booking transactions, and tracking documentation. On the
industry-wide level, they formed the Counterparty Risk
Management Policy Group (CRMPG). In June 1999, CRMPG issued a
report titled ``Improving Counterparty Risk Management
Practices.'' The recommendations in this report have provided
firms with useful guidance in improving counterparty credit
risk procedures.
Recommendation 4--Capital Adequacy
The President's Working Group has recommended that
prudential supervisors and regulators promote the development
of more risk-sensitive approaches to capital adequacy.
The Commission has taken necessary steps toward making its
broker-dealer capital rule more risk-sensitive. In 1997, the
Commission adopted rules that allow securities firms to
establish
special broker-dealer affiliates that operate as over-the-
counter derivatives dealers. These firms are permitted to
calculate market and credit risk charges using internal models.
The Commission is drawing on this experience in implementing
rules for investment bank holding companies under the Gramm-
Leach-Bliley Act.
Recommendation 5--Expanded Risk Assessment for the
Unregulated Affiliates of Broker-Dealers and Futures
Commission Merchants
The President's Working Group recommended enhancing the
current authority of the Commission to require financial
information about the unregulated affiliates of broker-dealers.
The Commission has authority to collect certain information
about material affiliates of broker-dealers. This authority has
been implemented through the RAP described above. The mandatory
reporting required under the RAP generally does not include
external counterparty credit risk exposures; it is limited to
credit exposures among affiliates. On the other hand, the
voluntary reporting by several of the largest securities firms
provides RAP staff with in-
formation on firm-wide external counterparty credit exposures.
Gramm-Leach-Bliley authorized the Commission to implement
recordkeeping rules at the securities firm holding company
level. However, firms would elect to be subject to these rules;
they would not be mandatory. If the recommendation was
implemented, it would enhance the Commission's authority to
obtain information about market and external counterparty
credit risk exposures at the broker-dealer holding company
level. The voluntary disclosures made by the larger broker-
dealers at the monthly RAP meetings would serve as a valuable
template for implementing such authority. The goal would be to
limit the reporting to the most useful
information for assessing systemic risk issues. This would
entail a flexible approach and one that did not cause an influx
of less relevant information.
Recommendation 6--Bankruptcy Code Issues
The Working Group recommended changes to the U.S.
bankruptcy code to improve close-out netting provisions.
The proposed changes would expand the categories of
financial contracts eligible for netting and permit netting
across different types of contracts. The proposals also would
clarify that a U.S. court could apply U.S. bankruptcy code
protections in an ancillary proceeding. This would prevent a
judicial stay from halting netting and liquidation rights
recognized under U.S. law. Netting and liquidation rights are
integral to prudent risk management by financial institutions.
Accordingly, the Commission supports passage of a bill that
accomplishes them.
Recommendation 7-- Offshore Financial Centers and
Tax Havens
The Working Group recommended that the U.S. regulators work
with foreign counterparts to encourage offshore financial
centers to adopt internationally agreed upon standards to
reduce the incentive for hedge funds to move their operations
abroad.
While some hedge funds may move offshore for regulatory
purposes, their assets and the collateral they pledge generally
remain in the United States. Therefore, locating offshore does
not necessarily increase credit risk. However, international
borders and secrecy havens, in particular, do further
complicate the already limited ability of U.S. regulators to
obtain access to hedge fund
information and records. Therefore, removing incentives for
hedge funds to move offshore is helpful. Commission staff
efforts through IOSCO, the Financial Action Task Force and the
FSF have contributed to a reduction in the number of incentives
for a hedge fund to move offshore. In addition, through the G7
and other political avenues, Commission staff encouraged a
number of other jurisdictions to join in the effort to
strengthen, among other things, the
supervisory systems and standards of offshore financial
centers. Multilateral initiatives have focused on removing the
``opacity'' incentive for hedge funds to move operations to an
offshore financial center or ``non-cooperative'' jurisdiction.
Through the IOSCO, FATF, and FSF, Commission staff continues to
encourage the implementation of laws, regulations, and
practices that follow international standards. A majority of
offshore financial centers have enhanced their regimes for
regulatory oversight, including reporting, recordkeeping, and
information sharing requirements.
The President's Working Group specifically noted that the
ability of offshore financial centers to join IOSCO and Basel-
sponsored working groups should be made contingent on progress
toward implementation of international supervisory standards.
This factor continues to be a membership criterion for IOSCO.
Q.2.a. It is my understanding that much of what is known about
hedge funds is not precise. For example, it is not known
exactly how many hedge funds there are; what is the size of the
market, who are the investors, who are the managers; and how
they impact the market. What information does the SEC routinely
collect about hedge funds? How often is this information
collected? Does the SEC have the authority it needs to collect
adequate information to protect retail investors?
A.2.a. The Commission does not routinely collect any data about
hedge funds. Because hedge funds typically qualify for
exemptions from the Investment Company Act of 1940 and the
periodic reporting requirements of the Securities Exchange Act
of 1934, the Commission does not have authority to collect
information from hedge funds under those statutes. The
Commission does have authority to collect information about
hedge funds from their advisers under the Investment Advisers
Act of 1940, although most hedge fund
advisers currently qualify for exemption from registration
under Section 203(b)(3) of the Advisers Act because they manage
fewer than fifteen funds and do not hold themselves out as an
investment adviser. We believe that the Commission has
administrative authority to require all hedge fund advisers to
register under the Advisers Act, and thus could use this
authority to collect information to protect hedge fund
investors.
Q.2.b. It is my understanding that much of what is known about
hedge funds is not precise. For example, it is not known
exactly how many hedge funds there are; what is the size of the
market, who are the investors, who are the managers; and how
they impact the market. What information does the SEC routinely
collect about hedge funds? How often is this information
collected? Does the SEC have the authority it needs to collect
adequate information to determine the impact of hedge fund
trading activities on the securities markets?
A.2.b. Many hedge funds use broker-dealers to execute their
securities transactions and maintain custody of their assets,
and a few hedge funds are registered as broker-dealers. Also,
the RAP staff monitors the counterparty credit risk exposures
of the largest investment banks. Thus, the SEC, through its
oversight and examination authority, can review hedge fund
activities to the extent that they involve broker-dealers or
registered investment advisers. However, as discussed above,
the Commission does not have the authority to collect
information directly from hedge funds or managers who are not
registered with the Commission, except through subpoena.
Accordingly, the Commission's ability to determine the impact
of hedge fund trading on the securities markets is limited.
Q.3. With respect to funds of hedge funds, how are they valued?
What is the frequency of such valuations? How reliable is the
valuation? How does the SEC protect retail investors in funds
of hedge funds from receiving inaccurate valuations of their
shares?
A.3. A small but growing number of FOHF's have registered with
the Commission in the past several years. These funds are
required by the Investment Company Act of 1940 to value their
portfolio
securities by using: (a) the market value of the securities
when market quotations are ``readily available,'' and (b) the
fair value of the securities when market quotations are not
readily available. As there generally are no readily available
market prices for interests in the underlying hedge funds in
which registered FOHF's invest, the FOHF's are required to
value such interests at their fair value.
Registered FOHF's generally disclose to their investors how
they value their interests in hedge funds. The disclosure
typically sets forth the steps that the FOHF's and their
managers take to ensure that they value their assets fairly.
Registered FOHF's often disclose in their offering documents
that, prior to investing in a hedge fund, their managers
conduct due diligence reviews of the valuation methodologies
used by the hedge fund. Such reviews typically include
examining the hedge fund's offering documents and obtaining
additional relevant information from the fund's manager. Many
registered FOHF's rely on valuation information provided to
them by the hedge funds in which they invest. Registered FOHF's
also typically disclose that they generally lack access to the
information that would be needed to confirm independently the
accuracy of valuation information provided by the underlying
hedge funds. In addition, registered FOHF's typically disclose
that, in the event that they have information that causes them
to question the valuation information reported by a hedge fund,
they will fair value their interest in the hedge fund based on
any relevant information, including the reported valuation
information, available to them.
Registered FOHF's are required to provide a valuation of
their assets at least semi-annually. Many registered FOHF's
effect purchases and redemptions on a quarterly basis and,
therefore, value their assets for those events. In addition,
some registered FOHF's calculate their valuations more
frequently, such as monthly, for purposes of calculation fees.
The financial statements of registered FOHF's must be
audited annually by independent public accountants, and the
financial statements of many hedge funds also are audited
annually by independent public accountants. These audits may
provide some degree of assurance that registered FOHF's are
valuing their assets appropriately. As noted above, auditors
generally review and assess the reasonableness of a hedge
fund's valuation process when auditing the fund's financial
statements.
Q.4. Have the number of hedge fund related complaints received
by the SEC increased over the past few years? What is the
nature of these complaints? Please be as specific as possible.
A.4. Prior to this year, the SEC's Office of Investor Education
and Assistance did not separately count how many investor
contacts discussed hedge funds. Instead, our data system
collected information about the nature of the conduct discussed
in the investor's
letter. Earlier this year, as hedge funds began to be marketed
more heavily to retail investors, we added a code to track the
number of investor contacts involving hedge funds. Our records
show that 37 people, 7 of whom wished to remain anonymous,
contacted the SEC this year (since January) concerning hedge
funds. What follows are details about these contacts.
Eighteen investors raised the possibility of fraud. Five of
the eighteen expressed concern that their money may have been
stolen, rather than put into a hedge fund. Six investors
contacted the SEC because they had been unable to withdraw
funds from hedge funds. Six investors alleged that various
hedge funds were illegally shorting stocks, or otherwise
manipulating the market. Two investors contacted the SEC to ask
about the status of SEC investigations into hedge funds in
which they were invested. One person forwarded an article that
alleged insider trading in a hedge fund and asked that we
investigate the matter. Whenever an investor raises credible
allegations of fraud, our Office practice is to refer the
matter to Enforcement.
One investor complained to the SEC that a securities
salesperson from a firm where she holds an account approached
her and tried to get her to invest in a hedge fund that was too
risky. Whenever an investor raises credible allegations of
sales practice abuses, we refer the matter to Enforcement.
Four investors suggested that the SEC needed to intensify
regulation over hedge funds. Two asked that the SEC not
regulate hedge funds further.
One investor asked for a copy of materials referenced in
the discussion during our roundtable on hedge funds held on May
14 and 15, 2003.
One person wrote to the SEC requesting the regulations and
requirements governing the origin, funding, and operation of a
hedge fund, plus any applications for registration and
licensing as may be necessary.
Three investors contacted our Office to check the
backgrounds and/or addresses of particular hedge funds.
Q.5. In your surveillance of the securities markets have you
considered identifying companies whose stocks have exhibited
unusual trading patterns to determine whether hedge fund
trading has played a prominent role in this trading activity?
A.5. There have been press reports documenting complaints by
issuers that they were the victims of attacks by hedge funds.
These issuers have alleged that the hedge funds accumulated
large short positions in their stocks, and then sought to drive
the share price down through the issuance of highly critical
and allegedly inaccurate reports on their finances. The
Commission has also recently investigated and brought actions
against certain parties engaging in manipulative naked short
selling as part of what is commonly called a ``death spiral''
scheme. In these schemes a party providing financing receives
from a public company debentures that are later convertible
into the stock of the issuer, typically at a discount to the
current market price. The parties providing financing, which in
some instances may be operating as hedge funds, may engage in
extensive naked short selling designed to lower the price of
issuer's stock, thus realizing profits upon conversion of the
debentures.
The Division of Enforcement will continue to investigate
allegations of manipulative short selling by hedge funds as it
deems warranted. From a regulatory perspective, the Commission
recognizes that while short selling adds important benefits to
the market, such as facilitating liquidity, hedging, and
pricing efficiency, it also may be used as a tool for
manipulation. In this regard, the Commission will consider
amendments to existing short sale regulation, as necessary, to
curb the potential manipulation by all market participants,
including hedge funds, without unnecessarily restricting
liquidity.
Q.6. At the Committee hearing, I read from one communication we
have received regarding the conflicts that mutual funds appear
to have when they also run hedge funds. According to another
source:
The conflicts are in several areas: (1) The different fee
and compensation structures for portfolio managers, analysts,
and traders incent them to act differently when managing hedge
funds alongside mutual funds. Firms are not required to put up
a Chinese wall between the two operations. It is often not
feasible to do so due to expense constraints. This is
compounded when mutual fund firms allow their portfolio
managers to open hedge funds as a retention device to prevent
them from leaving the firm. To maximize their compensation and
that of their team, they tend to devote considerably more
energy to managing the hedge fund than their mutual funds. (2)
The ability to short stocks in a hedge fund also causes
conflicts with investment teams running long only money. There
are many instances where a decision to short a stock in a hedge
fund is made simultaneously with a decision to sell in the long
fund. The hedge fund investors naturally benefit when the
mutual fund sales are done. (3) There is also the case where
the benefits of running mutual funds, such as access to
research through use of commission dollars from the mutual fund
business, is transferred disproportionately to the hedge fund
investor.
Does the SEC probe these issues in their regular
examinations? Has the SEC heard similar allegations and, if so,
how is it addressing them?
A.6. When the Commission's examination staff conducts
examinations of registered investment advisers that manage both
mutual funds and hedge funds, the staff pays particular
attention to the types of conflicts of interest to which this
question refers. The Commission's ongoing investigation of the
hedge fund industry also has focused on these conflicts of
interest. These conflicts of interest, however, are not new,
nor are they unique to side-by-side management of mutual funds
and hedge funds. These types of conflicts may exist whenever an
investment adviser: (i) manages accounts that pay performance-
based fees in addition to accounts that pay asset-based fees;
and (ii) sells a security short on behalf of a client when
another client sells a long position in that same security.
The Commission's risk-based approach to examinations
considers investment advisers that manage both mutual funds and
hedge funds as posing a higher level of regulatory risk due to,
among other things, the presence of conflicts of interest. Such
entities can expect to be examined by the Commission's staff
more frequently than lower-risk mutual funds and investment
advisers. The Commission's examinations generally focus on how
registered investment advisers manage these conflicts of
interest, and whether the conflicts are disclosed to mutual
fund boards of directors and mutual fund investors. For
example, the examinations focus on the separation of duties
(for example, the use of information barriers) and other
internal controls that are designed to manage conflicts of
interest in such entities. The examinations also focus on
whether the investment advisers' conduct in relation to the
mutual funds and hedge funds is consistent with their fiduciary
duties and in compliance with their obligations under the
Federal securities laws.
The Commission also addresses conflicts of interest by
instituting enforcement cases in appropriate instances when the
conflicts of
interest result in unlawful activity. For example, the
Commission has instituted enforcement actions against
investment advisers that preferred their performance fee-paying
clients over their other clients in the allocation of ``hot''
initial public offerings.\1\
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\1\ See In the Matter of F.W. Thompson Company, Ltd., Investment
Advisers Act Release No. 1895 (September 7, 2000); In the Matter of
McKenzie Walker Investment Management, Inc.,
Investment Advisers Act Release No. 1571 (July 16, 1996).
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The Commission is continuing to explore what additional
measures can be taken to isolate the conflicts of interest
resulting from side-by-side management of mutual funds and
hedge funds. The staff intends to address these and other
issues in a report to the Commission, to be completed later
this year, that will summarize the staff 's findings and make
recommendations with respect to the investor protection
implications of the growth in the hedge fund industry.
Q.7. In the Fortune article that was dated March 31, 2003
``Where the Money's Really Made'' it stated, ``The hedge fund
boom has sweeping implications not just for Wall Street traders
and a few thousand well-heeled investors, but increasingly for
every American businessperson, investor, and retiree.''
Please comment on this statement and the potential
``sweeping implications'' for retail investors that are raised.
A.7. The Fortune article states that the ``hedge fund boom''
has implications for many U.S. investors. We agree that the
growth of the hedge fund industry has a number of implications
for U.S. investors, including:
Institutional investors that historically have not
invested in hedge funds, such as pension plans, may now be
investing in hedge funds. As a result, retirement and other
assets may be subject to the risks associated with hedge
funds.
An increasing number of potentially less sophisticated
investors have become eligible to invest, and may be
investing, in hedge funds, subjecting themselves to the
risks associated with hedge funds.
A small but growing number of registered investment
companies invest all or a significant portion of their
assets in hedge funds.\2\ Since these funds of hedge funds
are increasingly registering their securities under the
Securities Act, they can be sold to retail investors who
would then be subject to the risks associated with hedge
funds.
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\2\ Following amendments to the Investment Company Act enacted in
1996, certain hedge funds may sell their securities without regulation
under the Federal securities laws to up to 499 qualified purchasers,
including to most registered investment companies. Among other things,
a qualified purchaser generally includes ``any person, acting for its
own account or the accounts of other qualified purchasers, who in the
aggregate owns and invests on a discretionary basis, not less than
$25,000,000 in investments.'' Section 2(a)(51)(A)(iv) of the Investment
Company Act.
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More assets are invested in hedge funds, which are
generally not subject to the investor protection provisions
of the Federal securities laws, and the managers of many of
those hedge funds are not subject to the regulatory
oversight of the Commission.
Hedge funds engage in strategies, such as short
selling, that may have a significant impact on the
financial markets.
The Commission staff has been gathering, and is continuing
to gather, information relating to the implications of hedge
fund growth in the course of its ongoing investigation of the
hedge fund industry. While we have reached no conclusions yet,
the staff is considering these implications and will report to
the Commission whether the existing regulatory framework
continues to be appropriate in light of the growth of the hedge
fund industry.
Q.8. I am aware that since June 2002, the SEC has been
conducting an investigation of the hedge fund industry's
structure and practices. What safeguards are in place to reduce
the likelihood of another failure of the type of Long-Term
Capital Management? What risks do large hedge funds pose to the
financial system?
A.8. Since the near collapse of the LTCM in 1998, there have
been significant changes in the hedge fund industry. The large
macro hedge funds of the 1990's (Soros, Tiger) have scaled back
or ceased operations. While assets under management at hedge
funds have continued to grow, the majority of funds are
relatively small entities. Broker-dealers that extend credit to
hedge funds have substantially improved their counterparty
credit risk management in light of the LTCM. Most exposures to
hedge funds are fully collateralized, including excess
collateral. Moreover, broker-dealer credit-risk departments
have been upgraded and credit procedures strengthened and
refined. In enhancing their procedures, broker-dealers have
adopted recommendations of the CRMPG in its June 1999 report
titled, ``Improving Counterparty Risk Management Practices.''
Nonetheless, there is still room for improvement. The CRMPG
report recognized the difficulty in quantifying the credit risk
associated with leveraged counterparties. In certain
circumstances, large degrees of leverage may pose very little
risk while a counterparty with little leverage may cause great
exposure. Multinational working groups, such as the Fisher
Group, continue to study the issue of counterparty credit risk
exposure.
The LTCM experience is helpful in analyzing the risks posed
by a large hedge fund. The LTCM employed maximum leverage to
profit on inefficiencies in the global financial markets. The
LTCM used its market power to exact favorable transaction terms
from its counterparties. In particular, it was able to enter
into securities repurchase agreements with very little margin
required. When the market value of the collateral dropped,
counterparties called for additional collateral more quickly.
In order to meet these collateral calls, the LTCM in many cases
sold its most liquid assets first leaving the less liquid
assets to meet future liquidity demands. The value of the less
liquid assets dropped as the LTCM moved to liquidate them. This
contributed to volatility, which put stress on other entities
holding similar positions. Broker-dealers learned from this
experience and generally no longer provide such favorable
transaction terms to hedge funds. However, the business
opportunities associated with a large hedge fund could put
pressure on a financial institution's credit risk procedures.
Also in the period just prior to its near collapse, the
LTCM sold to other market participants large volumes of
financial products that provided protection against adverse
movements in various equity indices. To create these positions,
the LTCM sold options to counterparties such as broker-dealers
and banks, which used the options to hedge their own securities
positions. At the time of its troubles, the LTCM essentially
was the sole provider of these hedging tools. Accordingly, the
LTCM experience demonstrates the danger of multiple major
market participants establishing identical credit exposures
with a single counterparty that is not subject to an effective
disclosure regime.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SUNUNU
FROM WILLIAM H. DONALDSON
Q.1. For hedge funds that register as investment companies with
the Securities and Exchange Commission, what disclosures
regarding assets and liabilities are required? What other
disclosure or audit requirements are these funds subject to?
A.1. All of the hedge funds currently registered as investment
companies with the Commission have registered as closed-end
funds. Like all other closed-end funds, these hedge funds are
subject to numerous requirements designed to protect investors.
A registered closed-end hedge fund must follow the reporting
requirements of the Investment Company Act similar to those
followed by other registered investment companies. For
instance, the hedge fund must register on the form applicable
to all other closed-end funds. That form does not distinguish
between the disclosures--financial disclosures or otherwise--
required for a closed-end fund operating as a hedge fund, and
for any other kind of closed-end fund.
A closed-end fund's prospectus contains important
information about: Its fees and expenses, investment objectives
and strategies, risks, performance, valuation policies, and
more. The fund's statement of additional information (SAI)
includes information that is not necessarily needed by
investors to make an informed decision, but that some investors
find useful. The SAI generally includes information, or
additional information, about: The fund's history and its
policies; officers, directors, and persons controlling the
fund;
advisory and other services; brokerage commissions; and tax and
other matters.
The SAI also generally includes the fund's financial
statements. In the initial registration statement, the fund's
statement of assets and liabilities is commonly referred to as
the ``seed balance sheet.'' Like any closed-end fund, the seed
balance sheet for a registered hedge fund reflects the initial
minimum of $100,000 contributed by the adviser to make the fund
operational. It also reflects the hedge fund's assets and
liabilities, and those are presented in the same manner as
those for any other closed-end fund.
After a registered hedge fund commences operations, it must
file and provide to shareholders financial statements semi-
annually, just like other registered investment companies. The
form and content of the financial statements of a registered
hedge fund is the same as that of any registered closed-end
fund. Financial reporting for publicly registered investment
companies is governed by the rules of Regulation S-X.\1\
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\1\ The initial balance sheet must be audited. The fund also must
undergo an annual audit after each fiscal year end.
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In the statement of assets and liabilities, a registered
investment company typically reports investments in securities
as the first asset because of their relative importance to
total assets. Other assets reported include, among other
things, receivables for securities sold, and dividends and
subscriptions receivable from shareholders. Liabilities
reported include, among other things, payables for various
operational expenses, accrued liabilities for securities sold
short, open option contracts written, and distributions payable
to shareholders.
Other financial statements and schedules that must be
disclosed in a registered investment company's (registered
hedge fund or otherwise) shareholder reports include:
a schedule of investments--a detailed list of the
portfolio securities as of the latest period; \2\
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\2\ Those ``funds of hedge funds'' that invest solely in other
hedge funds only would report the underlying hedge funds in which they
invested, not the underlying investments made by those underlying hedge
funds.
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a statement of operations--shows increase or decrease
in net assets resulting from investment activities by
reporting investment income from dividends, interest, and
other income less expenses, and the amount of gain or loss
from investment and foreign currency transactions;
a statement of changes in net assets--summarizes
results from operations, dividends, and distributions to
shareholders, capital share transactions, and capital
contributions;
financial highlights--contains per share operating
performance data for a typical share outstanding (for those
investment companies that are unitized), as well as total
investment return, analytical ratios, and other
supplemental data for a period of at least 5 years; and
a statement of cash flow--explains changes in cash and
cash equivalents. The statement classifies cash receipts
and cash payments as resulting from operating, investing,
and financing activities and includes a reconciliation of
net cash provided by and used for operating activities to
net increase or decrease in net assets from operating
activities.\3\
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\3\ A registered investment company need not include a statement of
cash flows in its shareholder report if it meets certain criteria,
including that the fund's net assets be made up of
highly liquid investments throughout the period. Funds of hedge funds
invariably have to supply a statement of cash flows because they do not
meet this criterion.
In addition to filing semi-annual reports, registered
investment companies must file Form N-SAR semi-annually. The N-
SAR is a regulatory report used by the Commission to review
whether the registered investment companies are in compliance
with the Investment Company Act. It is not provided to
shareholders but is publicly available.
N-SAR includes similar information reported in the
financial statements. A closed-end fund must provide the
aggregate number of shares and net consideration paid for all
repurchases of the fund's stock during the reporting period,
and also must disclose rate schedules for fees paid to
investment advisers. The fund also must provide, among other
things, the top ten brokers with whom it executed commission
and non-commission trades. In addition, the annual N-SAR
includes an auditor's report on the fund's internal controls.
In that report, the auditor must identify any material
weaknesses in the fund's accounting system or in the fund's
internal controls.
Q.2. Following the LTCM's collapse, the President's Working
Group on Financial Markets issued a report addressing the
excessive leveraging by hedge funds and banks lending to hedge
funds. As part of this report, the Fed and the OCC issued new
guidelines with instructions to banks lending to hedge funds.
Please detail these guidelines, as well as the degree to which
they have been implemented, and their effectiveness in limiting
inappropriate leverage in financial institutions.
A.2. We must defer to the Fed and the OCC to provide a detailed
response to this question. We can report that Commission staff
members have worked alongside U.S. banking regulators in a
number of groups that have examined issues related to highly
leveraged institutions. For example, staff members participated
in a Working Group on Highly Leveraged Institutions for the
Financial Stability Forum. In the course of this work, U.S.
banking regulators reported that a 2000 review found a decline
in the aggregate level of U.S. national bank exposure to highly
leveraged institutions and a decline in the number of
institutions providing credit to that sector. The banking
supervisors also report that the banks are doing a better job
of due diligence and ongoing monitoring of hedge fund
counterparties. Finally, they report that U.S. banks continue
to work on improving the measurement of potential future
exposure as part of their efforts to improve counterparty
credit risk management.