1 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION 2 3 In the Matter of: 4 5 OPEN COMMISSION MEETING 6 7 PAGES: 1 through 129 8 PLACE: Securities and Exchange Commission 9 450 Fifth Street, N.W. 10 Washington, D.C. 11 DATE: Tuesday, October 26, 2004 12 13 The above-entitled matter came on for hearing, 14 pursuant to notice, at 10:01 a.m. 15 BEFORE: 16 WILLIAM H. DONALDSON, Chairman 17 CYNTHIA A. GLASSMAN, Commissioner 18 HARVEY J. GOLDSCHMID, Commissioner 19 PAUL S. ATKINS, Commissioner 20 ROEL C. CAMPOS, Commissioner 21 22 23 24 Diversified Reporting Services, Inc. 25 (202) 467-9200 1 C O N T E N T S 2 3 4 1 P R O C E E D I N G S 2 CHAIRMAN DONALDSON: Good morning, everyone. This 3 is an open meeting of the United States Securities and 4 Exchange Commission. We have two items on our agenda this 5 morning. (The discussion of the first item on the agenda, whether to propose new and amended rules and form changes to modify the registration, communications, and offering processes under the Securities Act of 1933, is not included in this transcript.) (Following is the transcript of the Commission’s deliberations on whether to adopt rule 203(b)(3)-2 under the Investment Advisers Act of 1940 to require hedge fund advisers to register with the Commission and whether to adopt certain conforming and transitional amendments to rules 203(b)(3)1, 203(A)-3, 204-2, 205-3, 206(4)-2, 222-2 and Form ADV.) 53 3 CHAIRMAN DONALDSON: Why don't we get going, ladies 4 and gentlemen, if we can. 5 The second and final item on our agenda is a 6 recommendation from the staff from the Division of Investment 7 Management that we adopt rules and amendments proposed last 8 July, to require managers of certain private investment 9 pools, commonly known as hedge funds, to register with the 10 Commission as investment advisers. 11 Most hedge funds are organized in ways that avoid 12 triggering the registration requirements of the Securities 13 Act, Securities Exchange Act, and the Investment Company Act, 14 and many hedge fund managers avoid registration under the 15 Investment Advisers Act by relying on a safe harbor rule 16 adopted by the Commission in 1985, that permits an investment 17 adviser to count a legal organization has a single client, so 18 long as the investment advice provided is based on the 19 organization's investment objectives, rather than those of 20 any owner or owners of the organization. 21 In recent years, the Commission has been faced with 22 escalating growth in the hedge fund industry. The number of 23 funds, investors, and investment managers participating in 24 the industry, as well as the assets under management, are all 25 rising rapidly. 54 1 From what we can tell, the number of hedge funds 2 has increased at least five-fold over the last ten years. 3 The dollar value of funds invested in hedge funds is 4 reportedly approaching a trillion dollars, up 15-fold in the 5 last ten years. 6 Five years ago, the near collapse of the Long-Term 7 Capital Management vaulted these investment vehicles 8 into the headlines, bringing into focus the role that they 9 were playing in the financial markets. At that time, the 10 Commission rejected the idea of changing its rules to 11 preclude hedge fund advisers from relying on the safe harbor. 12 In the intervening period, there have been major 13 changes in the hedge fund industry, both in the number and 14 size of funds, and in the demographics of its investors, that 15 warrant the Commissions' reconsideration of this position. 16 Over two years ago, in June 2002, the Commission 17 decided to reconsider the hedge fund issue. The staff, at 18 the direction of the Commission, commenced a sweeping study 19 of the hedge fund industry. 20 The staff's efforts were complemented by a two-day 21 roundtable held by the Commission in May 2003, and the 22 results of the staff efforts, along with preliminary 23 recommendations, were published in September 2003. 24 The report elicited considerable interest, debate, 25 and discussion within and outside the Commission, and amongst 55 1 a very broad cross section of interested parties, building on 2 the observations made in the staff report, and the public 3 meetings, and the staff investigations that preceded the 4 report. 5 One of the recommendations that the staff made in 6 its 2003 report was that the Commission consider requiring 7 hedge fund advisers to register as investment advisers, 8 taking into account whether the benefits outweighed the 9 burdens of registration. 10 Last July, the Commission proposed new rules and 11 amendments that would implement this recommendation. 12 Recognizing the important policy issues implicated by the 13 proposal, the Commission included an extensive request for 14 comment on each aspect of the proposal. This request was 15 augmented by a series of additional questions posed by 16 Commissioners Glassman and Atkins in their dissenting 17 statement. 18 Following an extensive review of the comments, the 19 division is here this morning to recommend that we adopt the 20 rules substantially as proposed, with revisions that address 21 specific issues raised by the commenters. 22 Before turning this over to you, Paul, to present 23 the division's recommendation, I would like to recognize the 24 members of the staff of the Investment Management Division 25 for their tireless efforts in developing the recommendations 56 1 before us today, in particular Bob Plaze, Jennifer Sawin, 2 Jamey Basham, and Vivien Liu. 3 They've worked extraordinarily hard through this 4 process, and they are to be commended and congratulated on 5 the fine job they've done. 6 Paul, will you please give us the details of your 7 recommendation. 8 MR. ROYE: Thank you, Chairman Donaldson, and good 9 morning to you and the other commissioners. 10 First, I would be remiss that if I didn't also 11 acknowledge up front the assistance of many people on this 12 effort, this study, this review of the hedge fund industry. 13 As you mentioned, Chairman Donaldson, we commenced 14 this effort two years ago, with a study of the gathering of 15 information. We had extensive help from others in the 16 division: Doug Scheidt, Alison Fuller, Elizabeth Osterman, 17 Barbara Chretien-Dar, Nancy Morris, David Grim, Eric Purple 18 and Dan Kahl. 19 We got extensive help from our Office of 20 Compliance, Inspections, and Examinations, led by Lori 21 Richards and Gene Gohlke, who heads up the Investment 22 Management side of OCIE; extensive help from the Division of 23 Enforcement, Steve Cutler, Nancy Doty, Laurie Stewart; and 24 Alan Beller, Amy Starr, and Gerry LaPorte in the Division of 25 Corporation Finance; in our Office of International Affairs, 57 1 Ethiopis Tafara, Elizabeth Jacobs, Stephanie Kim Park, and 2 Sherman Boone; 3 our Office of Economic Analysis, in particular 4 Harvey Westbrook, Chuck Dale, and Jonathan Sokobin, and 5 Chester Spatt; also, last but not least, our Office of 6 General Counsel, Giovanni Prezioso, Arthur Laby, Jill Felker, 7 and Randy Quinn. We sincerely appreciate their efforts, and 8 all the help that they gave us over the course of the last 9 two years. 10 I'm pleased this morning, to present to the 11 Commission our recommendation for a new rule and rule 12 amendments under the Investment Advisers Act that would 13 require hedge fund advisers to be registered with the 14 Commission as investment advisers. As you indicated, Mr. 15 Chairman, this past July the Commission proposed the rule and 16 rule amendments that we're recommending you adopt today. 17 You received letters from 153 commenters, of which 18 29 supported the proposal and 82 opposed it, while 42 19 commenters submitted letters raising questions about 20 particular issues that they wished the Commission to address. 21 Of the major trade associations, the Investment 22 Company Institute, the Investment Counsel Association of 23 America, both of which have many members who advise hedge 24 funds, favored the rule proposal, while the Managed Funds 25 Association, most of whose members manage hedge funds and/or 58 1 commodity pools, opposed the rule. 2 Most, but not all of the hedge fund managers who 3 wrote opposed the rule. Several hedge fund managers who are 4 registered with us as advisers supported the rule, and 5 indicated that registration had not interfered with their 6 operations nor imposed substantial burdens. The ICI and 7 ICAA expressed similar views on behalf of their members, who 8 all are registered advisers. 9 Individual hedge fund investors were split on the 10 proposal. 11 The only two institutional investors who wrote you, 12 the Ohio Public Employees Retirement System and the New 13 Jersey State Investment Council, strongly supported the rule. 14 Interestingly, the Hennessee Group, which is a 15 hedge fund consulting group, submitted a survey that it had 16 performed of foundations and endowments, which are 17 significant investors today in hedge funds, and they reported 18 that 59 percent favored requiring hedge fund advisers to 19 register, while 30 percent opposed such a requirement. 20 But we did not just read the comment letters. In 21 the past year, we have had discussions about hedge funds and 22 our proposals with fellow regulators, including the staff of 23 the Treasury Department, the Federal Reserve Board, the 24 Commodity Futures Trading Commission. 25 We have also met with our colleagues at foreign 59 1 regulators, including the Financial Services Authority in the 2 United Kingdom, which requires hedge fund advisers to be 3 registered with them. 4 The comments and our conversations with fellow 5 regulators provided a wealth of information and insight that 6 has helped us prepare our recommendation for you. 7 The rule proposal, as I indicated, was the result 8 of a process that began over two years ago, that included an 9 extensive staff study of hedge funds and their advisers that 10 we released last year. Our study raised a number of concerns 11 that lead us to recommend that you require registration of 12 hedge fund advisers under the Advisers Act. 13 One concern, as you mentioned, Mr. Chairman, is the 14 tremendous growth in the industry. While no one knows for 15 sure, it is estimated that in the last five years, that hedge 16 fund assets have grown by 260 percent, with assets of 17 approximately $870 billion in approximately 7,000 funds, and 18 some predict that hedge fund assets by the end of the year 19 will reach one trillion dollars. 20 In the last year alone, hedge fund assets have 21 grown over 30 percent. Hedge funds are one-fifth the size of 22 equity mutual funds, and are growing at a much faster rate 23 than these funds. 24 Moreover, hedge funds tend to be active traders. 25 One study estimates that hedge funds are responsible for up 60 1 to 20 percent of equity trading volume in the United States. 2 It is clear that hedge fund advisers are significant market 3 participants, both as managers of assets and traders of 4 securities. And we think this growth and impact on our 5 markets simply cannot be ignored. 6 Now, in spite of the statistics that I just 7 reviewed for you, neither we nor any government agency has 8 reliable data on the hedge fund industry, including data on 9 the number of funds, or the amount of their assets. We only 10 have third-party surveys and reports, which often conflict, 11 and may be unreliable. 12 Another significant concern is the growing exposure 13 of smaller investors, pensioners, and other market 14 participants, directly or indirectly, to the impact of hedge 15 fund investing. 16 These vehicles are no longer for the very rich. 17 More and more, we see funds pouring in from a new type of 18 investor who can't afford to absorb the large losses as a 19 result of a fraud. 20 Lower minimums and the rise of funds of hedge funds 21 are permitting smaller, non-traditional investors into hedge 22 funds. Moreover, a growing number of public and private 23 pension plans, as well as universities, endowments, and other 24 charitable organizations, have begun to invest larger amounts 25 of money in hedge funds. It's estimated that these types of 61 1 institutions may soon increase their investments in hedge 2 funds to over $300 billion. 3 Investors such as pension plans that have millions 4 of beneficiaries are now exposed to the risks of hedge fund 5 investing. Losses resulting from hedge fund investment 6 strategies, and possible hedge fund frauds, could affect 7 these institutions' ability to satisfy their obligations to 8 their beneficiaries, or to meet other intended goals. 9 The growth in hedge funds has unfortunately been 10 accompanied by troubling growth in the number of our hedge 11 fund enforcement cases. 12 In the last five years, the Commission has brought 13 51 cases involving hedge fund fraud, resulting in losses of 14 more than $1.1 billion. Now, these cases are more than ten 15 percent of cases against investment advisers over the same 16 period. Now, you can slice and dice these cases in a number 17 of ways, but we think they signal to us that this is an area 18 where we should have concerns. 19 In addition, we are seeing hedge funds used to 20 defraud other market participants. Hedge fund advisers were 21 key participants in the recent scandals involving mutual fund 22 late trading and inappropriate market timing. We've counted 23 almost 400 hedge funds and 87 hedge fund advisers involved in 24 these cases. They were most of the late traders and market 25 timers. They picked the pockets of average mutual fund 62 1 investors. 2 Registration under the Advisers Act will give us 3 the tools we need to monitor the activities of hedge fund 4 advisers without imposing burdens on the legitimate 5 investment activities of hedge funds, or interfering with the 6 important role that hedge funds play in our financial 7 markets. 8 The Advisers Act does not require an adviser to 9 follow or avoid any particular investment strategies, nor 10 does it require or prohibit a specific investment. It will 11 not hamper hedge fund operations. 12 A recent study found that there were no significant 13 differences between performance of hedge funds managed by 14 unregistered advisers, and those managed by registered 15 advisers. Five of the ten largest, and presumably most 16 successful hedge fund advisers are today registered with the 17 Commission. 18 More than 8,500 advisory firms, that collectively 19 manage 23 trillion dollars in assets, are registered under 20 the Advisers Act. We see no credible evidence that the 21 Advisers Act has any way impeded their ability to employ 22 successful investment strategies, or to effectively compete 23 with other financial institutions that manage securities 24 portfolios in this country or abroad. 25 Advisers Act registration will allow the Commission 63 1 to address the various concerns that we identified regarding 2 the hedge fund industry. 3 First, registration under the Act will provide the 4 Commission with the ability to collect important information 5 that we now lack about this growing component of the U.S. 6 financial system. 7 Other approaches suggested would require the staff 8 to engage in a complicated and time-consuming forensic 9 exercise to extract an incomplete composite of information 10 about hedge funds. And we think this would essentially 11 require us to put together multiple jigsaw puzzles, without 12 all the pieces. 13 Second, registration under the Advisers Act would 14 give the Commission the ability to conduct examinations of 15 hedge fund advisers. 16 Examinations permit us to identify compliance 17 problems at an early stage, identify practices that may be 18 harmful to investors, and provide a deterrent to unlawful 19 conduct. The prospect of a Commission examination increases 20 the risk of getting caught violating the law, and thus will 21 deter wrongdoers. 22 We are not suggesting that our examination staff 23 will uncover every fraud, and some critics contend that we 24 would be unsuccessful in detecting fraud by hedge fund 25 advisers. 64 1 However, our examination staff uncovered five of 2 the eight cases that we brought against registered hedge 3 fund advisers. There's nothing unique about hedge fund 4 advisers, or the type of frauds they have committed. We 5 brought the same types of actions against unregistered 6 advisers that we brought against registered advisers. 7 Third, registration permits us to screen 8 individuals associated with an adviser, and to deny 9 registration if they have been convicted of a felony, or had 10 a disciplinary record subjecting them to disqualification. 11 We would use this authority to help keep fraudsters and scam 12 artists out of the hedge fund industry. 13 Fourth, registration would require hedge fund 14 advisers to adopt policies and procedures designed to prevent 15 violations of the Advisers Act, and to designate a chief 16 compliance officer. So in other words, hedge fund advisers 17 would have to develop a compliance infrastructure, just like 18 other advisers of similar size. 19 Now, we readily acknowledge that compliance 20 controls cost money, but these are costs all advisers that 21 register with us must bear, including advisers that are much 22 smaller, and have substantially fewer resources and cash flow 23 than many hedge fund advisers. 24 Given the fee revenue generated by many hedge fund 25 managers today, the arguments made by some opponents that 65 1 hedge fund advisers could not afford these costs is simply 2 not credible. 3 Fifth, registration under the Advisers Act would 4 have the salutary effect of requiring many direct investors 5 in most hedge funds to meet wealth standards that are higher 6 than the current minimums. 7 Finally, we believe that the adoption of the rule 8 and rule amendments we recommend today will close a loophole 9 in our regulations that allows an exception designed for 10 advisers providing advice only to a small number of clients, 11 and therefore, not representing a substantial federal 12 interest, to be used by hedge fund advisers, who in some 13 cases manage billions of dollars for thousands of investors. 14 Commenters suggested a variety of alternatives to 15 Adviser Act registration, but none of them, in our judgment 16 would accomplish the goals of this rulemaking. 17 While some of the alternatives would address some 18 of our policy concerns, each of them lacked what we 19 considered an essential component of this rulemaking, the 20 ability to exercise our examination authority, which we view 21 as vital to deterring and detecting fraud in the hedge fund 22 sector of the investment management industry. 23 If we are to maximize our effectiveness, we must 24 have the ability to use our examination authority to monitor 25 hedge fund adviser activity, and protect our financial 66 1 markets. 2 We want to be perfectly clear about the motivations 3 behind our rulemaking, because there are those who have 4 characterized this initiative as an attack on the hedge fund 5 industry, which it is most definitely not. 6 Most participants in the hedge fund industry are 7 honest and ethical, and we deeply appreciate the beneficial 8 role that hedge funds play in our markets. 9 And we do not want to impede the industry's ability 10 to flourish and grow. We simply want to be able to monitor 11 this fast-growing segment of the investment management 12 industry, so as to fulfill our mission to protect investors 13 and the securities markets, and if this rule is adopted, our 14 sincere hope is that the hedge fund industry would join with 15 us to make this initiative work for the industry, and 16 ultimately strengthen hedge funds' role in our securities 17 markets. 18 And with that, we'd be pleased to answer any 19 questions that you may have. 20 CHAIRMAN DONALDSON: Thank you, Paul, for that. 21 Before I ask my colleagues to present their 22 observations on the proposal before us, I'd like to make just 23 a few comments. 24 I think we can agree that by all accounts, the 25 hedge fund industry is growing explosively. As you suggest, 67 1 the number of funds, investors and investment managers 2 participating in the industry, as well as assets under 3 management, are rising rapidly, particularly in the last five 4 years. 5 You acknowledged the benefits of liquidity provided 6 to the markets in which the funds operate, and cited the 7 investment flexibility, mobility, and potential for sustained 8 returns available to hedge fund investors. 9 Likewise, you provided a detailed catalogue of 10 concerns regarding the obligations the SEC must face in terms 11 of investor protection, and enforcement of our security laws, 12 and most particularly, the prevention and prohibition of 13 fraud, our central mission. 14 Your concerns derive not only from the size and 15 growth of the industry, but also from the evolving 16 configuration of the investor base. That ranges from funds 17 of hedge funds available to relatively small investors to 18 the increasing investment by institutions, such as pension 19 funds and endowments and charitable foundations, the 20 beneficiaries of which include individuals whose 21 circumstances vary widely. 22 You cited the increased incidents of fraud 23 perpetrated by those funds, and noted how difficult it is to 24 deter this fraud, or to discover this fraud before it 25 happens, due to our lack of required compliance regime in the 68 1 examination and inspection authority. 2 You've spoken of others already subject to the 3 Investment Advisers Act, who register with as little as $25 4 million under management, when we have not exercised our 5 jurisdiction over the advisers to the $1 trillion hedge fund 6 industry. 7 In short, it would seem that the weight of evidence 8 is overwhelming, and we accept the staff's recommendation. 9 In fact, to not do so would be a major dereliction of the 10 Commission's responsibility. And yet, over the course of the 11 intensive analysis of the past five years, there remain 12 objections by some. 13 As part of a fair attempt to evaluate such 14 objections, I have sought, both personally and 15 professionally, to see the other side of the arguments, 16 arguments which go something like this: 17 The SEC does not have the resources to devote to 18 this task. 19 My answer to this is that we do have the resources, 20 if we are able to apply our manpower and expertise in an 21 effective, risk-based system designed not only for this 22 responsibility, but ultimately, as an underpinning for all 23 examinations and inspections conducted by the Commission. 24 To bring hedge fund managers under the Investment 25 Advisers Act will create a false sense of security, some kind 69 1 of a Good Housekeeping seal of approval. 2 To any student of the role of the SEC, it is clear 3 that in no sense does our oversight of investment companies 4 or investment advisers address itself to the merits of the 5 investments, or the advisers. In fact, the Investment 6 Advisers Act anticipated this concern, and explicitly prohibits 7 registered advisers from making any representation that we 8 have recommended or approved of them. 9 We've not done enough study, nor have we allowed 10 enough time, to receive comments, or entertain alternative 11 registration schemes. 12 As the Investment Management Division has indicated 13 and noted, the intensive review of the issue over the past 14 two years is self evident. The extended exchange of views 15 over that period, the publication of a major study on the 16 topic, out for almost a year of comment, then a formal 17 comment period of customary length after the publication of the 18 proposed rule, and the willingness to review comments, even 19 after the official deadline passed, all seems to refute this 20 argument. 21 I won't catalogue or repeat other areas of 22 disagreement on our proposal, for to do so would be 23 redundant, but I do ask just a couple of rhetorical 24 questions. 25 If more than 40 percent of all existing hedge fund 70 1 managers have already registered voluntarily, and have 2 testified to its being a minimal burden, why is it that the 3 others, or representatives of the others, resist? 4 Without registration, how can we begin to 5 understand fully the impact that hedge fund advisers have on 6 the broad market of individual, institutional, and professional 7 investors, with which the funds trade every single trading 8 day. 9 How can it seriously be argued that our policy 10 objective, ultimately, is to regulate investment companies' 11 concentrations or strategies, when we have no authority to do 12 so under the Investment Advisers Act, and we have never 13 sought to do so for the past 64 years? 14 As we proceed this morning, I look forward to any 15 comments from the staff or my fellow commissioners that might 16 refute or question the general direction of the thoughts and 17 analysis I've just presented, but before I ask the commission 18 colleagues to make their statements, I'd like to ask the 19 staff two questions. 20 And my first question I'd like to direct to 21 Giovanni, as the general counsel of the SEC. 22 Several of the commenters suggested that the 23 Commission does not have authority to adopt a rule that 24 requires hedge fund advisers to look through hedge funds they 25 manage, for purposes of counting clients. 71 1 I would like the general counsel to address these 2 arguments, and give us his analysis of the Commission's 3 authority in this area. 4 MR. PREZIOSO: Thank you, Mr. Chairman. 5 In my view, the Commission does have the authority 6 to adopt the rule changes presented to you by the division 7 today. As you might imagine, we've reflected on this issue 8 at some length in our office, in consultation with our 9 colleagues, especially in light of the comments that have 10 been received that raise this issue. 11 As you know, the topic's also discussed in the 12 draft release that's before the Commission. Let me touch on 13 just a few points that I think are particularly important on 14 this issue. 15 First, the Commission has broad authority under the 16 Advisers Act to engage in rulemaking. And the rules before 17 you today address an important issue under the Act, namely 18 how to determine which advisers qualify for an exemption 19 under Section 203(b)(3). That exemption, as you know, is 20 available to an adviser that has fewer than 15 clients, and 21 that doesn't hold itself out to the public as an investment 22 adviser. 23 Questions about when an investor in a pooled vehicle 24 should be counted as a client, for purpose of this exemption, 25 date back several decades, and they've been viewed as 72 1 appropriate issues for Commission consideration throughout 2 that period. In fact, it's those questions that were one of 3 the principal reasons the Commission adopted the current safe 4 harbor that it adopted in 1985. And at a common sense level, 5 I think this isn't really surprising. 6 Take, for example, an investment manager that has 7 30 clients, with $100 million under management. Imagine the 8 adviser says, "I have a clever idea. I'm going to have all 9 of my clients invest in a limited partnership, and I'm going 10 to follow the same strategies in managing that limited 11 partnership’s assets that I follow in managing their accounts 12 today, and then I won't have to register with the Securities 13 and Exchange Commission." 14 Now, if those clients had been managed similarly, 15 or identically, before, and today, in many cases, they are -- 16 nothing will have changed. Except that now, the investment 17 adviser won't be subject to Commission oversight. 18 And in those circumstances, I think most people 19 would question whether that's the correct legal result, 20 particularly under a statute that has an express provision 21 that prohibits a person from doing indirectly, through 22 another person, something that they can't do directly. 23 A second point that I think merits note is that the 24 Commission has ample evidence from the staff study, from 25 enforcement actions, from the Hedge Fund Roundtable, and from 73 1 other sources, that the role of hedge fund managers in our 2 markets has changed very significantly since the Commission 3 addressed this issue in 1985. At that time, the Commission 4 concluded that an exemption for these advisers could be 5 implemented, consistent with the objectives of Congress when 6 it adopted Section 203(b)(3) in 1940. 7 As you know, and as Paul has mentioned, the 8 exemption originally applied principally to advisers that 9 offered their services to a small number of friends and 10 family members. And today, as you've heard, and as you've 11 commented, advisers to private funds have a much more 12 significant impact on our capital markets, and on a much 13 larger number of investors. 14 A third point worth noting is that the rule targets 15 those investment advisers whose activities most directly 16 implicate the concerns of the Act. The rule applies only 17 where a private fund invests primarily in securities, offers 18 redemption periods of two years or less, and is marketed, 19 based on the investment skills of the adviser. 20 In other words, advisers that offer their advisory 21 services solely to general business corporations, or similar 22 entities, won't be required to look through to shareholders or 23 limited partners in counting clients. 24 Further, the release and the discussion from Paul 25 today identified extensively how registration of advisers to 74 1 these private funds would advance the goals of the Act. 2 Taking all of these considerations into account, I 3 think that this is a classic and appropriate exercise of 4 rulemaking authority to implement the statute's objectives, 5 in light of evolving market conditions. 6 CHAIRMAN DONALDSON: Thanks. I have one other 7 question. 8 Commissioners Glassman and Atkins, in their dissent 9 at the proposing stage, asked commenters to discuss 10 alternatives to registration that addressed the concerns 11 raised in the proposal. Many of the examples of alternatives 12 described in the dissent were ideas that had been considered 13 by the staff and the Commissioners, in the evolution of what 14 ultimately became the Commission's proposal. 15 Did the commenters offer any fresh insights about 16 these ideas, or any new alternatives that had not been 17 previously considered? 18 And I'll address that to you, Paul. 19 MR. ROYE: Yes. I think one thing that should be 20 pointed out is that even, you know, prior to the proposal 21 stage, we spent a lot of time thinking through alternatives. 22 Indeed, Mr. Chairman, you, as well as a number of the other 23 Commissioners, pressed us on different approaches to 24 addressing the concerns that we had identified in the staff 25 report. 75 1 Many of the alternatives that were highlighted in 2 the comments, we had thought about, we reconsidered during 3 the comment process, when those comments came in. They range 4 from different ways for the Commission to access information, 5 using other regulatory agencies' information. 6 Using that information, along with information from 7 brokers, and others, that we regulate, to piece together a 8 picture of a particular hedge fund adviser's activity, and 9 the industry as a whole. 10 You know, we looked at that, we talked to other 11 regulators about that approach, and again, I think we see 12 that as a patchwork, a puzzle, that we don't have all the 13 pieces. It's going to -- it would be time consuming, 14 described as a forensic exercise, to try to figure out 15 exactly what any particular hedge fund adviser is doing. 16 We think the Advisers Act registration, the 17 information that we get there is a more direct way to focus 18 on that issue. 19 We had commenters suggest we raise the standards 20 under Regulation D, to get at concerns about small 21 investors. That's certainly an alternative that we 22 considered. Reg D goes beyond hedge fund investing, 23 introduces a whole level of complication. Again, the 24 Investment Advisers Act regime would effectively address 25 minimum standards for direct investments in hedge funds. 76 1 There were some new ideas in terms of requiring 2 hedge fund advisers to go through an annual audit by the 3 auditors. 4 But as we pointed out in our hedge fund report, we 5 have concerns about exactly what the auditors do in 6 conjunction with those audits, offering to certify that 7 they're in compliance with particular provisions that we deem 8 to be appropriate for hedge fund advisers, under the statute. 9 Again, that kind of approach would not allow us to go in and 10 check whether or not they're indeed honestly certifying 11 compliance with various procedures. 12 So, a number of different approaches. 13 You know, we thought about a hedge fund adviser 14 light approach, in thinking through that approach, and 15 creating a different regime, if you will, for hedge fund 16 advisers. 17 We got into issues of how do you administer that, 18 how is it fair, given the scenario that Giovanni outlined, in 19 terms of how you structure your business and operations. You 20 change clients, you acquire new clients. What does that do? 21 We'd have to administer sort of dueling regimes, here, and we 22 thought that introduced a level of complexity that was just 23 not needed. 24 There's a common theme in all the alternatives. 25 All the alternatives would, for the most part, deny us 77 1 two key components of what we view as our objective here. 2 First, the Advisers Act would effectively require 3 the hedge fund advisers to have a compliance program. 4 Compliance policies and procedures, and someone designated to 5 monitor their compliance with the Advisers Act. We think 6 that's very important in a program, in terms of heading off 7 problems, deterring abuses. 8 The other theme was that it would deny us the 9 examination authority. We feel that it's very key, in order 10 for us to be in a position to understand what's going on and 11 to test what's going on in the various hedge fund advisers, 12 and we think it's important to deterring unlawful activity. 13 So, as we've thought about the alternatives, we 14 thought about them before we made the proposal. We've looked 15 at the alternatives that were proposed or suggested in regard 16 to the comments. But we see each of them as deficient in 17 terms of meeting all the goals and objectives that we set out 18 for this rulemaking. 19 CHAIRMAN DONALDSON: Thanks very much. 20 Commissioner Glassman. 21 COMMISSIONER GLASSMAN: Thank you, Mr. Chairman. 22 In contrast to my enthusiasm for the Securities Act 23 reform proposal considered by us today, the hedge fund 24 proposal is a disappointment to me on many levels. 25 Procedurally, the proposal was rushed through the 78 1 rulemaking process, and appears to have been a fait accompli 2 from its inception. The Chairman and other proponents 3 apparently believe that the commenters already had sufficient 4 notice, based on the Commission's Hedge Fund Roundtable, as 5 well as last year's staff study, that a proposal would be 6 forthcoming. 7 However, because the Roundtable and the staff study 8 confirmed that the problems we initially thought would be 9 found in the hedge fund industry do not appear to be present, 10 it was not obvious, certainly not to me, that the proposed 11 rule would be forthcoming. 12 Further, since regulation of hedge funds has broad 13 market implications, any regulatory requirement would more 14 appropriately be addressed as part of a collaborative effort 15 among the President's Working Group members, all of whom, I 16 understand, have concerns with our proposal. 17 I believe it would have been prudent for that 18 collaborative effort to proceed prior to unilateral 19 Commission action. 20 I'm also troubled by the staff's minimization of 21 commenters' concerns in various drafts of the proposal, as 22 well as an undertone that the burden of proof is on those 23 opposed to show that this rule is not warranted. 24 That's backwards. In my view, the burden of proof 25 should be on the Commission to establish that this is the 79 1 least burdensome and most effective way to accomplish our 2 objective. 3 The proposal itself is fundamentally the same one 4 from which I dissented in July. While I agree, as I have all 5 along, that we need more information on hedge funds, I 6 disagree with this solution. 7 The comment letters in support of this proposal are 8 not persuasive, and the comment letters against the proposal, 9 which represent the vast majority of submissions, raise many 10 of the same concerns that I did. 11 Accordingly, I am not going to reiterate all of the 12 concerns that I raised when this went out for comment. But I 13 do want to highlight a few issues. 14 The proposal's supporters assert that the proposal 15 is justified by the growing number of fraud enforcement cases 16 involving hedge funds. The staff repeatedly stresses that 17 since the rule was proposed in July, the Commission has 18 brought five new enforcement cases, for a total of 51 cases 19 over the past five years. Yet a cursory review of the 20 litigation release posed on the Commission's Website for each 21 of these new cases, demonstrates that the proposed rule would 22 have had no effect on any of them. 23 Four of the cases involve hedge funds below the $25 24 million threshold, and the fifth case, while involving a 25 fraud that ultimately, and a fund that ultimately raised $27 80 1 million, did so over an eight-year period. 2 As far as I can tell, none of these cases appears 3 relevant to the proposed rule. And, as I noted in my initial 4 dissent, the total number of enforcement cases that even 5 tangentially involve hedge funds represents just a small 6 fraction of Commission enforcement actions over the past five 7 years. 8 Regarding the market timing cases, I would point 9 out that it is not, per se, illegal to market time. What was 10 illegal was mutual funds allowing market timing when they 11 said they did not. And I would also note that we did not 12 initially find this problem through our examinations. 13 The staff also stresses that the threat of an 14 examination will deter fraudulent activity by hedge fund 15 advisers, and thus rejects all alternatives to this proposal, 16 because the alternatives lack an examination component. 17 The fallacy of this argument is that the Commission 18 lacks the resources necessary to conduct meaningful hedge 19 fund adviser exams, and our lack of resources is a matter of 20 public record. 21 As the Chairman himself noted when he testified 22 before Congress this year, the Commission has only 495 staff 23 conducting examinations of approximately 8,000 mutual funds 24 managed in over 900 fund complexes, as well as more than 25 8,000 investment advisers. 81 1 It's no secret that the Commission is rethinking 2 its inspection model, which historically has focused on site 3 visits and information requests. As such, it's difficult to 4 perceive how hedge fund advisers will be deterred by the 5 prospect of an examination, when they know that we lack the 6 resources to audit comprehensively their operations. 7 Given that we are already stretched as an agency 8 to examine the mutual fund industry, with about 91 million 9 investors, I question whether we are justified expending 10 significant additional resources in an attempt to examine 11 hedge fund advisers, where the investors are limited to a 12 small number of wealthy and/or sophisticated individuals and 13 institutions. 14 There are a number of alternatives that could have 15 been explored in lieu of registration, but unfortunately, 16 none of them is on the table. 17 First, with the growth of hedge funds, I do agree 18 that we need to know more about them. I would support a 19 census, pooling of information from all of the agencies that 20 collect data on hedge funds, and identifying and requiring 21 additional periodic and systematic information to be filed 22 with us, once we determine what would be appropriate. I've 23 been supportive of this concept throughout our discussions. 24 If we really think retailization is a problem, even 25 though our own staff concluded only last year that this was 82 1 not an issue, we have two very easy options: raise the 2 accreditation standards for investors, and/or require 3 registration for funds that allow relatively small 4 investment, perhaps $100,000, or another appropriate cutoff. 5 These conditions would further reduce the number of 6 high net worth individual investors -- estimated already at 7 fewer than 200,000 -- to an even smaller universe of 8 investors. 9 An additional option would be to require the funds 10 of funds that are targeted to retail investors, and all of 11 their component funds, to have registered advisers. Again, I 12 have supported these concepts throughout our discussions. 13 Regarding pension fund and other institutional 14 investors, who indirectly invest in hedge funds on behalf of 15 individuals, as part of a risk diversification strategy, this 16 new requirement will be counterproductive. Since the trend 17 appears to be for such investment 18 vehicles to limit hedge fund investments to those with 19 registered advisers, our rule would expand the potential 20 universe, and encourage even more investment in hedge funds. 21 As an aside, my understanding is, we do not have 22 information on the extent to which institutional investors 23 actually invest in hedge funds that do not have registered 24 advisers. However, we do know that they have a fiduciary 25 responsibility to their beneficiaries, obligating them to 83 1 conduct appropriate due diligence before making the 2 investment. 3 If we are concerned about valuations and fraud, a 4 notice and filing of appropriate information, including 5 audited financial statements, would appear to me to be more 6 useful than the ADV information in the registrations. We 7 already have authority, and clearly use it, to investigate 8 potential fraudulent abuses in hedge funds now. 9 I continue to be concerned that the registration 10 and concomitant inspection are the wrong approach. I do not 11 think the ADV, even as amended, provides the type of 12 information that would be helpful in identifying fraud, nor 13 do we have the resources and expertise to ferret it out in 14 our examinations. 15 Thus, as I have said before, the proposed approach 16 would unrealistically raise expectations about what we are 17 accomplishing, and would divert significant resources from 18 other inspection activities that are more focused on retail 19 investment vehicles. 20 Regarding the seal of approval, I have heard 21 anecdotal evidence that registered hedge funds do make that 22 registration prominent in offering materials. Why would they 23 do that? I understand that we have a task force looking at a 24 new risk-focused model for investment adviser oversight, 25 including hedge fund advisers. 84 1 It would have made sense to me to determine the 2 right model, and then apply it to the hedge funds if that 3 were -- to the hedge fund advisers, if that were warranted. 4 Regrettably, the Commission has failed to take an 5 opportunity to devise a new model of systematic and robust 6 information gathering, including notice of filing, pooling of 7 information from all the agencies that collect data on hedge 8 funds, and identifying and requiring additional information 9 to be filed with us, once we determine what would be 10 appropriate, before imposing a new, burdensome, and outdated 11 requirement. This would have improved our ability to 12 perceive market trends, to detect red flags, and to note 13 industry exceptions. 14 As I said, I'm disappointed with the approach that 15 was chosen, and I know that we can and we must do better. If 16 this proposal is approved, I hope that as we prepare for its 17 implementation we develop a workable oversight model. 18 I want to make perfectly clear that I am not 19 suggesting that we don't need more information about hedge 20 funds and their advisers. However, for all the reasons I 21 have stated today, at the proposing meeting, and in 22 Commissioner Atkins' and my dissent, I vote against this 23 proposal. 24 I believe it's the wrong solution to an undefined 25 problem, using an ineffective examination model. As with the 85 1 proposing release, I plan to file a written dissent to 2 accompany the adopting release, if this is adopted. Perhaps 3 there will be another vote against it. 4 I do have a few questions. 5 First, regarding the other agencies, especially the 6 CFTC request for exemptions, I understand the staff believes 7 that the concerns of the CFTC have already been addressed in 8 the proposal, or are specifically provided for in the 9 Investment Advisers Act. 10 Given that the CFTC felt compelled to request an 11 exemption on the eve of this meeting, my question is, what 12 coordination did we undertake with the CFTC and the other 13 federal agencies, prior to going forward with this proposal, 14 and what input did we receive from them? 15 In this regard, I note that there's a letter from 16 Congressman Baker, dated October 7th, to Treasury Secretary 17 Snow, asking the President's Working Group to arrange for the 18 sharing of data on hedge funds prior to the Commission 19 undertaking unilateral regulatory action. 20 Although the Chairman -- our Chairman -- was copied 21 on this letter, it wasn't posted on the public comment files 22 of our Website, and I only became aware of its existence 23 yesterday. 24 MR. ROYE: With regard to the CFTC, and the letter 25 that came in a day or so ago, requesting that in the rule, we 86 1 provide an exemption for hedge fund advisers who are 2 registered with the CFTC as a commodity trading advisor or a 3 commodity pool operator, we considered that issue. I think 4 it was raised in eight or nine other comment letters as a 5 possible approach. We've talked to the CFTC about this 6 issue, and how we might proceed. 7 Our conclusion is that we certainly agree that 8 there should not be regulatory overlap and duplication, and 9 we should try to work toward minimizing the burdens that we 10 impose on folks in this sector. 11 But the CFTC's responsibility is enforcing the 12 commodity futures laws. Ours is enforcing the federal 13 securities laws. In 2000, the U.S. Congress focused on this 14 issue of duplication, regulatory overlap. 15 Any hedge fund adviser, if this rule is approved, 16 will still have the ability to rely on the statutory 17 exemption that if their primary business in running hedge 18 funds and other clients is engaged in futures trading, then 19 they are exempt, they would be exempt from our jurisdiction. 20 If their primary business is managing securities, 21 where we obviously have an interest, they would not have that 22 exemption available to them. So we think that 23 this issue has largely been resolved by the Congress, 24 with the Commodity Futures Modernization Act, 25 but we also think that, on a going-forward basis, if 87 1 this is adopted, that it would be beneficial to work very 2 closely with the CFTC, in terms of how we target our 3 resources, how we use our examination authority, how they use 4 their authority, who they go in to look at. Information 5 sharing, we think, is an important component of making this 6 work going forward, and minimizing burdens. 7 As far as the other regulatory agencies, in light 8 of concerns expressed by members of the President's Working 9 Group, we got together with members of the Fed, to talk about 10 our concerns about hedge funds, why we're concerned about the 11 area, and had a dialogue with them. Same thing with the 12 Treasury Department. 13 And Bob, if you want to expand on -- 14 COMMISSIONER GLASSMAN: Did you listen to anything 15 they said, or you just had a dialogue? 16 MR. ROYE: Well, we certainly listened to what they 17 had to say. We listened to, you know, their concerns. 18 I think that, you know, again, the bottom line is 19 that we have the responsibility for enforcing the federal 20 securities laws. And, you know, they expressed views in 21 terms of what this approach might mean, what impacts that it 22 might have. 23 I think that some of the commenters echoed those 24 concerns, and, you know, we considered those carefully. I 25 mean, we are sensitive to -- you know, we don't want to have 88 1 adverse impacts. We tried to make that very clear. 2 We appreciate the role that hedge funds play in our 3 markets, the liquidity that they provide, and that's why we 4 didn't pursue other alternatives, like Investment Company Act 5 registration, for hedge funds. 6 We viewed the Advisers Act as a regime that, while 7 it does impose some costs and some burdens, doesn't interfere 8 with how the hedge funds are managed or operated, but gives 9 us a window into what's going on. And we thought that was 10 important. 11 MR. PLAZE: The real impact it's on is not so much 12 what we did, but what we didn't do, and we were listening to 13 all of these agencies, and the Treasury Department, which we 14 worked on extensively in their hedge fund, by the way, their 15 hedge fund anti money-laundering rules. 16 And so, if you look at it from one perspective, we 17 did not necessarily follow any particular recommendations, 18 but the release is littered with statements, or footnotes, 19 that act on their sensitivities. And so, I think it did have 20 a significant impact. 21 COMMISSIONER GLASSMAN: So, are you suggesting that 22 the CFTC in particular, and the members of the President's 23 Working Group would be supportive of this, at this point? 24 MR. ROYE: No. 25 COMMISSIONER GLASSMAN: No. I didn't think so. 89 1 One other question on the cost/benefit analysis, 2 which unfortunately we only got the first draft of about a 3 week ago, and have seen a few more drafts in the last week. 4 There's no, as far as I can tell, there's no 5 aggregation of costs, no ongoing cost estimate, no compliance 6 officer cost estimate. It seems to focus on the qualitative 7 issues. It's pretty weak on the quantitative measures. How 8 did you include the commenters' cost quantitative estimates 9 in your estimates? 10 MR. BASHAM: I can address that. 11 We had two primary areas of costs to deal with, and 12 the first was the cost of converting to registered status, 13 which we estimated the average cost being at $20,000 in 14 professional fees, and $25,000 of internal costs, and we got 15 this estimate by talking to law firms who are in the business 16 of advising hedge fund advisers as they proceed with their 17 Commission registration. And these costs are average costs, 18 so they might be higher or lower, depending on the firm's 19 existing compliance infrastructure, or the complexity of its 20 business. 21 Some commenters did say that this estimate was too 22 low, but they didn't provide us with any estimates of their 23 own and others submitted estimates setting the number much 24 higher, at around $300,000. But if you look at the analysis 25 behind their figures, you see that almost all of this cost 90 1 was attributable to retaining a chief compliance officer. 2 Now, if a -- 3 COMMISSIONER GLASSMAN: Wouldn't retaining a chief 4 compliance officer be part of the requirement of registering? 5 MR. BASHAM: Well, we believe that it would be the 6 exception, rather than the rule, for a newly-registered hedge 7 fund firm to add a staff position for a chief compliance 8 officer. 9 We don't allow -- we don't have data that will 10 allow us to quantify this to any reasonable degree of 11 certainty, but it would be unusual for a firm to require a 12 full-time chief compliance officer, unless the firm has at 13 least several hundred thousand dollars of assets under 14 management. 15 Excuse me -- 16 COMMISSIONER GLASSMAN: You mean million. 17 MR. BASHAM: -- several hundred million. Thank 18 you. 19 COMMISSIONER GLASSMAN: Where did you come up with 20 that thought? 21 MR. BASHAM: That's based on our experience with 22 the compliance rule that went into effect for all registered 23 advisers this month. 24 MR. PLAZE: The compliance rule does not require 25 the appointment of a new position. It requires somebody in 91 1 the firm to be designated. In the hedge fund area, there -- 2 COMMISSIONER GLASSMAN: There is an opportunity 3 cost there, for that person. 4 MR. PLAZE: Obviously. But there's also current 5 compliance obligations, which firms have. 6 Remember, all of these firms are subject to the 7 anti-fraud provisions of the Advisers Act, are subject to a 8 number of other obligations under the securities laws and 9 other statutes, so you have to have somebody at the firm 10 concerned about this. Our concern, of course, is that there is 11 nobody concerned about this, and this winds up in our 12 enforcement cases, sometimes. So, you're going to have a 13 firm -- 14 COMMISSIONER GLASSMAN: Not too often. 15 MR. PLAZE: -- yeah, you're going to have firms 16 dealing with this in various ways. The largest firms already 17 have compliance. They have significant reputational risk 18 -- value at risk, and they have these. You have the smallest 19 firms -- 20 COMMISSIONER GLASSMAN: So what is our deterrent 21 effect for those? 22 MR. PLAZE: The smallest firms. 23 COMMISSIONER GLASSMAN: I'm sorry. For the large 24 firms -- 25 MR. PLAZE: The deterrent effect for those firms is 92 1 that that chief compliance officer suddenly says "I'll never 2 be able to explain what you want to do when the guys from the 3 SEC come in here." 4 We suddenly strengthen that person's position 5 within the firm considerably, and if you disagree with me, 6 you need to find out what's going on right now, in the 7 registered firms, where the compliance rule that you voted on 8 last year is having a tremendous effect in terms of the 9 position that person holds within the firm and their 10 ability -- the principal ability, not only their personal 11 reputation, their personal career position, but they're going 12 to have to deal, that chief compliance officer has to deal 13 with our examiners when we come in, and that's the stick that 14 chief compliance officer wields. 15 Now, without that stick, he has his own -- he or 16 she has their own personality, and their own relationship, 17 hopefully, with the executives that they can deal with. But 18 the strongest stick is when the guys from the SEC come in, 19 "I'll never be able to explain what you want to do." 20 And I think that's considerable for the larger 21 firms. The smaller firms -- what Jamey is saying is that there 22 is somebody that may provide these services right now, 23 that'll be designated. 24 At the margin, it's somewhere between the various 25 small firms and the medium-size firms. There are people that 93 1 are going to make a big decision to hire an entirely new 2 position. And we factored that into the cost. 3 The problem here is we have so little information 4 about hedge fund advisers, other than the ones that are 5 registered with us. And we can't even distinguish those from 6 other advisers under our current regime. Very difficult to 7 try to figure out what hedge fund advisers put into what 8 category. 9 For the smaller ones, they typically start business 10 in a turn-key operation from a prime broker. They set them 11 up in the office. They set them up with their electronic 12 equipment. They give them desk space, they provide them with 13 back-office services. 14 Our best guess is that that kind of a turn-key 15 operation in the future will include a chief compliance 16 officer that will not be dedicated full-time to a hedge fund 17 consisting of two or three traders, will be a marginal cost, 18 but it will not be the $300,000 cost, because that chief 19 compliance officer will have similar responsibilities for a 20 number of people set up at the prime broker, so that they 21 will act to minimize those costs. 22 The comment letters that we got that suggested 23 these very high costs assumed a stand-alone operation with a 24 fully-loaded chief compliance officer, and that is going to 25 occur, at some percentage of the firms, the trouble is, we 94 1 just don't know at what percentage that will occur. 2 But we think that there are other business models 3 available, both at the upper end of the spectrum, which 4 suggests costs already effected, and the smaller end of the 5 spectrum, which would go to mitigate that larger cost. 6 But unfortunately, we simply don't have the data to 7 classify hedge fund advisers where they would fall. And that 8 explains, I think, the lack of real good quantitative data. 9 COMMISSIONER GLASSMAN: Did we have the economists 10 do any kind of statistical estimations to try to figure this 11 out? 12 MR. SPATT: We have not. We've reviewed, and we've 13 commented upon the cost benefit that's been done by IM. 14 COMMISSIONER GLASSMAN: Okay. Thank you. 15 CHAIRMAN DONALDSON: Commissioner Goldschmid. 16 COMMISSIONER GOLDSCHMID: Thank you, Mr. Chairman. 17 In case anyone hasn't noticed it, there may not be 18 unanimity on these hedge fund issues. I do share the 19 Chairman's views. As Chairman Donaldson and Paul Roye have 20 indicated, the new hedge fund adviser rules and amendments 21 result from extensive examinations and reviews by the SEC 22 staff, and by the Commission itself. 23 In my time on the Commission, we have had two days 24 of Hedge Fund Roundtables, testimony at several Congressional 25 hearings, a review and publication of the excellent staff 95 1 report in September of 2003, the proposed rulemaking in July 2 2004, and numerous discussions at public forums, with the 3 staff, and with various commenters. 4 Today's rulemaking, in short, is the culmination of 5 a long and very serious process. We have weighed carefully 6 concerns of parts of the hedge fund community, and others 7 worried about counterproductive effects. 8 We have looked at suggestions for alternatives, but 9 they've been inadequate and wanting, compared to what I 10 believe is our modest, pragmatic, balanced regulatory 11 approach. 12 I have tried to think through the hedge fund issues 13 by asking myself the following key questions: 14 Why alter what has been the SEC's largely hands-off 15 approach? We have always gone after fraud. 16 What are the public policy concerns that now compel 17 the Commission to act? My answers have largely been heard 18 before, but given the controversy, they ought to be heard 19 again. 20 First, we know too little about this dramatically 21 growing industry, and what little we know, has, at least for 22 me, had alarm bells ringing. 23 In terms of growth, eight or ten years ago there 24 was roughly a billion dollars in hedge funds. The staff's 25 September 2003 report used the $600 billion figure. Our 96 1 proposed rulemaking in July 2004, used an $850 billion 2 figure. Today, we're talking about $870 billion, and the 3 Chairman correctly indicated that most estimates are towards 4 a trillion, as early as the end of the year. 5 Moreover, as Paul Roye indicated, all of these 6 figures are unreliable and soft. And that is part of the 7 basic problem, and as Commissioner Glassman indicated, that 8 may be common ground among the five of us here. 9 Our information is inadequate, and this is a 10 growing, powerful part of the financial community. We need 11 accurate information about the aggregate size of the hedge 12 fund industry -- how leveraged it is at any given time; their 13 trading patterns, and the management and size of any given 14 fund. 15 Second is the reasons to think about the regulation 16 of investment advisers. There has been a recent increase in 17 fraud cases involving hedge funds. 18 Now, that's true, with the qualification about 19 slicing and dicing that Paul Roye used, of fund clients, or 20 shareholders themselves. But it's particularly true about 21 the corrupting influence that unregistered hedge funds have 22 had on mutual funds. It was true in the Canary context, and 23 in too many other instances that have been public, and that 24 could become public in the future. That corrupting influence 25 has led to scandals about late reporting, and abusive timing. 97 1 Finally, on the so-called retailization issue, it's 2 not just the funds of the wealthy anymore, but more and more 3 the general public's savings and charitable funds are being 4 put at risk, as indicated in large and sharply increasing 5 amounts from public and private pension funds, from funds of 6 hedge funds, and from endowments and other charitable 7 institutions that are being invested. 8 The next question I suppose is what are the 9 advantages or benefits of hedge fund investment adviser 10 registration? They've already been discussed, and I'll give 11 you shorthand. 12 First, it's accurate information for public policy 13 purposes. Second, disclosure about advisers will be very 14 useful. Some investors -- many investors appear to use due 15 diligence to find out about advisers, but that's an 16 expensive, costly process. Why require each one to repeat 17 what others have done, and what if some are not doing? Getting 18 information out about advisers will save costs, and be useful 19 to all concerned. 20 The recordkeeping requirements are important. The 21 chief compliance officer and compliance programs are 22 important. Now, that may add cost, but who in their right 23 mind wants these institutions, and particularly the large 24 ones, operating without effective compliance programs? 25 OCIE inspections have to be thought about, too. 98 1 They should bring about important accountability and 2 deterrence. And I'm not suggesting that every fraudster will 3 be stopped, or deterred. But whether one analogizes the tax 4 audits, or police patrols, one knows that the risk of getting 5 caught and punished has significant deterrent effect, and 6 particularly on potential white-collar wrongdoers. 7 As Paul Roye indicated earlier, where hedge fund 8 advisers were registered, five of eight of recent cases in 9 the last five years have been uncovered by OCIE inspections. 10 I have, of course, discussed with the staff whether we have 11 the ability and resources to inspect hedge fund advisers. 12 Registration would increase the present number of advisers 13 registered by roughly 12 percent, but all numbers here are 14 soft, again, because of the inadequacy of our information. 15 We used a range of 8 to 15 percent in our original 16 proposing release in July. I am satisfied that better 17 investment adviser compliance programs required as of October 18 2004, are growing efficiency, and our risk-based assessment 19 programs and tools, and the ability, if necessary, to increase 20 the current $25 million threshold for SEC registration, 21 in combination, provide adequate assurance that we will be 22 able to do the job effectively, and the risk-based ability 23 to inspect gives an important deterrence effect, knowing 24 we can come in will have a meaningful effect on real people. 25 In terms of deterrence, or in terms of 99 1 disadvantages, rather, let me make absolutely clear my view, 2 which the Chairman has stated, too, and I think we all 3 believe. 4 There will be no interference with investment 5 strategies of hedge funds, with their operations, with their 6 creativity, with their liquidity, with their flexibility. 7 We've demonstrated that with the 40 or 50 percent of advisers 8 that are already registered. 9 And the costs here are relatively low, in terms of 10 both dollar costs and burdens. If there's more money added 11 to the cost of compliance programs, which appears to be the 12 only item of any significant expense, that will be very 13 useful to anyone who's invested in that fund. A cost/benefit 14 analysis -- the benefits here are overwhelming. 15 Let me close on -- and I just have a statement, I 16 have no questions. 17 A rational regulatory system responds to warning 18 signals and substantial and growing risk. This is the context 19 in which we address hedge funds today. Given the 20 substantial and growing risks for millions of investors, in 21 pension funds, and funds of funds, and other investment 22 vehicles, the SEC can no longer turn a blind eye. Our 23 fundamental mandate is protection of investors in the public 24 interest. Paul Roye, Bob Plaze, and their staff have done 25 wonderful work. 100 1 But I'd like to stop a second and pay a particular 2 tribute to the Chairman. His leadership, his strength, his 3 wisdom, the decency he brings to the job is enormously 4 helpful to the public, and very much in the great traditions 5 of the SEC. Thank you. 6 CHAIRMAN DONALDSON: Commissioner Atkins. 7 COMMISSIONER ATKINS: Thank you, Mr. Chairman. 8 Well, I find it very telling that we are gathered 9 here to consider this rulemaking on the 26th of October, 10 because today is just two days before the comment period on 11 this proposal would have ended, had we granted the requests 12 of several commenters, including the National Venture Capital 13 Association, to extend the comment period. They had asked 14 for a 90-day period, instead of the 48 days, which was the 15 effective length of the comment period after the proposal was 16 published in the Federal Register. 17 But why should we extend the comment period for a 18 rule that was essentially written in stone when it was 19 proposed? Despite the constricted comment period, we 20 received over, as you hear, 150 comment letters, only about 21 30 of which supported the proposal. Many commenters raised 22 complex technical concerns about how the registration 23 requirement would work in practice. I am disappointed that 24 in the rush to get a rule adopted we took so little time to 25 consider these comment letters. 101 1 It's also hard to hit the Trifecta of having the 2 "Wall Street Journal," the "New York Times," and the 3 "Washington Post" editorial pages being against our action. 4 I think we are rightfully viewed as being dismissive of the 5 concerns that commenters raised. Unfortunately, we have also 6 refrained from hashing out the issues with, among others, our 7 colleagues in the President's Working Group, the Treasury, 8 the CFTC, and the Federal Reserve, as well as others, such as 9 the Department of Labor. 10 Earlier this month, as you heard Commissioner 11 Glassman say, Chairman Baker wrote to the President's Working 12 Group to ask it to intervene before we acted. I saw that 13 letter at the same time that Commissioner Glassman did, just 14 yesterday. 15 Chairman Greenspan has warned us that "[t]he 16 initiative cannot accomplish what it seeks to accomplish." 17 With due deference to Chairman Greenspan and the tough job 18 that he has, I cannot think of a time when he has been so 19 clear. 20 I am befuddled as to why we are charging ahead in 21 the face of such a groundswell of principled opposition to 22 this action. Comity and cooperation is more than just 23 talking to someone. It means listening and responding, and 24 working together. 25 I sometimes feel that we are in a Moby Dick-like 102 1 pertinacious pursuit of one particular whale, as Herman 2 Melville described in his colorful prose. 3 The Commission would do better to keep its eye 4 trained on the mutual funds and broker dealers to whom 5 average Americans entrust so much of their money, rather than 6 hedge fund advisers, who manage the money of, at most, 7 200,000 well-heeled individuals and institutions. Average 8 investors expect the Commission to monitor the entities 9 handling their money, whereas hedge fund investors do not 10 rely on Commission oversight. 11 No one is forcing them to put their money into 12 unregistered hedge funds. They have a choice, the ability to 13 get advice, and the market power to do otherwise. They 14 perform, or can hire someone else to perform for them, due 15 diligence to lower their risk of investing in hedge funds. 16 Risk averse investors could insist, for example, 17 on getting audit reports, or a third-party internal control 18 review. If they suspect fraud or malfeasance, they can 19 figure out where to turn for help. 20 But now, we are upsetting this private/public 21 balance, and taking on a task that we might not have the 22 resources to perform as well as the private sector does. 23 In response to the argument that hedge fund 24 investors are fully capable of taking care of themselves, 25 proponents of registration raise cries of retailization. 103 1 They say that hedge funds are surreptitiously reaching into 2 the pockets of unsuspecting retail investors, including 3 investors and funds of hedge funds, and vulnerable retirees. 4 In addition, they charge that pension, endowment, 5 and charitable institution money is pouring into hedge funds 6 at great threat to the welfare of their beneficiaries. 7 First, the 2003 staff hedge fund report found no 8 retailization. Second, for each of these fiduciary entities, 9 an investment professional stands between the hedge fund and 10 the retail investor. The investment professional is not only 11 paid, but is legally obligated under federal and state law, 12 to look out for the best interests of the entity. 13 A pension plan administrator has a fiduciary 14 obligation to the plan's participants. Because these 15 entities tend to be large, the investment professionals 16 representing them generally are in a better position than the 17 SEC would be, through its registration process, to obtain 18 information about hedge funds in which they invest, to ensure 19 that their investment choices are prudent, and that the 20 fiduciaries have all the information that they need to make 21 their investment determination. 22 Third, we can take actions to ensure that investors 23 in the funds of hedge funds satisfy investment minimums. 24 Finally, as for the pension funds, we need to put 25 the issue in perspective. The $72 billion invested by 104 1 pension funds is only 8 percent of the total hedge fund 2 investments, and more importantly, just 1 percent of the U.S. 3 pension fund assets. 4 Maybe we ought to be more concerned about the 99 5 percent of the other pension fund investments. Maybe we 6 ought to let the Department of Labor, which is charged by 7 Congress to look after pension funds under the ERISA act, 8 weigh in on pension funds, and on whether they perceive this 9 as an issue. 10 As I noted at the proposal stage, it would be 11 useful for us to have more information about hedge fund 12 advisers. 13 Commenters showed a commendable willingness to work 14 with us, to get us the information that we need. They 15 suggested a number of alternatives for achieving this, 16 including requiring unregistered investment advisers to file, 17 and to annually update information statements with the 18 Commission. 19 This approach would have enabled us to develop a 20 complete picture of the advisory industry, without imposing 21 undue costs on advisers who choose not to register. 22 In addition, we could have worked with other 23 regulators to standardize, formalize information sharing. 24 We could have worked with entities that are already 25 regulated, such as prime brokers. Through these avenues, we 105 1 would have been able to obtain exactly the information that 2 we need to monitor the industry, and root out fraud. 3 By contrast, requiring hedge fund advisers to fill 4 out a Form ADV will yield only snippets of useful 5 information. 6 We missed all of these opportunities that could 7 have produced a less costly, more streamlined approach that 8 likely would have found unanimous support on the Commission, 9 and perhaps even among the affected investors and advisers. 10 Proponents of registration insist that filling the 11 information void is only one of the objectives of 12 registration. They insist that the Commission, which already 13 has the authority to conduct for-cause examinations of 14 unregistered advisers, also needs routine inspection 15 authority, which only registration could afford. 16 I do not dispute that we need to be ever vigilant 17 for hedge fund fraud, and that undoubtedly there is fraud 18 occurring. But subjecting hedge fund advisers to routine 19 examinations is unlikely to be an effective deterrent. 20 Certainly, a perfectly-timed examination could turn 21 up wrongdoing, but with so many registrants, and so few 22 examiners, perfect timing is a lot to ask. 23 We've been in the process of augmenting our 24 examination team in order to address the overextension of our 25 examination program for current registrants. Our budget has 106 1 doubled over the past two years. So it seems unwise to shift 2 resources away from traditional areas of oversight, so soon 3 after we made the case that those areas are understaffed. 4 Hedge fund advisers tend to employ more complex 5 investment strategies than the typical registered adviser, 6 especially those who advise mutual funds. If hedge funds 7 become a primary focus for us, we will need to train all of 8 our examiners, most of whom have no background in this area, 9 so that they are able to recognize unique issues that arise 10 in the hedge fund context. Otherwise, we are simply setting 11 them up to fail. 12 Market surveillance is a far more effective, 13 targeted way of finding fraud, and would allow us to leverage 14 the knowledge and expertise of the self regulatory 15 organizations. In addition to being costly for us, the new 16 registration requirement will be costly to affected advisers, 17 and these costs will be passed on to investors. 18 Registration is more than filling out a simple 19 form, filing it, and forgetting about it. A Form ADV, which 20 is a public disclosure form, is a potential litigation 21 document, and therefore, cannot be filed without a lawyer's 22 blessing. Lawyers' blessings, as most people in this room 23 know, never come cheap. 24 Registered advisers face numerous requirements, 25 including record-keeping, custody, and compliance 107 1 requirements. All of these impose costs. 2 We are told to take comfort in the fact that 3 advisers to hedge funds are handsomely paid for their work, 4 especially as compared to the so-called run-of-the-mill 5 registered advisers. So, the argument goes, they can afford 6 the extra cost of regulation in a marketplace that has seen 7 the trend of hedge fund management fees increase from a low 8 of one and 20, up towards two and 25 these days. 9 I do not take comfort in seeing resources diverted 10 from other uses, such as hiring new employees, or purchasing 11 outside research, to cover the costs of compliance with our 12 regulatory mandates. These management fees, which investors 13 have agreed out of self interest to pay, presumably reflect 14 the risky nature of establishing a hedge fund, and the high 15 costs for extracting expensive top talent. 16 Proponents also argue that, to the extent there are 17 costs, we are just leveling the playing field between those 18 hedge fund advisers who have already registered voluntarily, 19 and the ones who remain in the so-called shadows. 20 As an initial matter, I reject the insinuations 21 underlying this initiative, that hedge fund advisers who have 22 chosen not to register have done something wrong, or have 23 something to hide. We should not be so hasty to assume the 24 worst about anyone who is not registered with us. 25 Moreover, we can all come up with a long list of 108 1 enforcement actions against registered advisers to shatter 2 the myth that all registrants are pure as the driven snow. 3 Hedge fund advisers, like other businesses, 4 register if it is cost-effective for them to do so. If the 5 benefits of registration, such as wider appeal to pension 6 funds and other investors, do not outweigh the costs, then 7 hedge fund advisers do not register. 8 We cannot assume that the cost/benefit balance will 9 be the same for every hedge fund adviser. Mandating across- 10 the-board registration only serves to eliminate any benefit 11 registered advisers enjoyed in being able to distinguish 12 themselves from unregistered advisers. 13 But, if we are intent on leveling the playing 14 field, we should focus on the line that we have drawn between 15 hedge fund advisers and advisers to other types of private 16 pools. Why have we not applied the registration requirement 17 to advisers of private equity and venture capital funds? 18 Valuation issues are critically important in these funds, as 19 well. 20 Our argument for excluding advisers to other types 21 of unregistered investment companies looks particularly weak 22 when we see that the only real line of demarcation employed 23 in the rulemaking is the length of the redemption period. 24 A hedge fund adviser can avoid application of the 25 rule by simply extending its redemption period beyond two 109 1 years. Instead of the so-called 529 plans named after the 2 tax section that middle class investors use to save tax-free 3 money for college, wealthy investors will now have what I 4 would like to be the first to dub 735 plans, which will stand 5 for the 735-day lock-up period necessary to avoid the rule, 6 and take into account any leap year with a day or two to 7 spare. 8 This two-year distinction does not capture a 9 legitimate regulatory distinction among funds. If this trend 10 towards longer lock-up periods takes hold because of our 11 rule -- longer lock-up periods are already becoming more 12 standard, after all, in the marketplace today -- it actually 13 harms investors, who will now have less freedom to vote with 14 their feet by pulling their money out of a hedge fund that 15 is mismanaged. We are simply encouraging an industry trend 16 towards longer lock-ups. 17 Proponents argue that the recent spate of hedge 18 fund enforcement actions justifies our preoccupation with 19 hedge funds. 20 As I discussed at the open meeting on this rule 21 when we proposed it, this approach would not have done much 22 to stop the fraud underlying the 46 cases cited in the 23 proposal. The additional five cases cited in the adopting 24 release do not strengthen the case, as Commissioner Glassman 25 said. Most of the advisers at issue in the cases were either 110 1 too small to be registered, or already registered, or should 2 have been registered. 3 We will not protect unsophisticated investors from 4 fraudsters by requiring legitimate advisers to hedge funds 5 open only to sophisticated investors, to register. 6 Finally, there are serious questions about the 7 Commission's statutory authority to proceed without specific 8 Congressional authorization to do so. Rather than 9 recommending statutory amendments, it seems that we have 10 chosen to make a tortured end run around the statute, by 11 redefining who a client is for certain types of investment 12 advisers. 13 So, I, to add a little bit of levity, and so not to 14 disappoint, I thought that I hope that ultimately, we do not 15 wind up looking like the gunslinger in this Gary Larson "Far 16 Side" cartoon, where he shot the guy dead, and only then 17 realized that there were some questions that he should have 18 asked, and in light of all our discussion today, responses 19 that he might have heeded. 20 So, from the outset, I've been open about my 21 disappointment and distaste for this idea that is presented 22 before us today. So accordingly, I plan to vote "No" here in 23 a few minutes, and then, if the rule is approved, then I 24 intend to join again with Commissioner Glassman, and file a 25 written dissent. 111 1 So that being said, and notwithstanding everything 2 else, I recognize that behind this incredibly quick timetable 3 is an incredibly overworked staff, so I appreciate your hard 4 work, and wish you Godspeed. Thank you. 5 CHAIRMAN DONALDSON: Thank you. 6 Commissioner Campos? 7 COMMISSIONER CAMPOS: Thank you, Chairman 8 Donaldson. 9 Well, Commissioner, I can tell you, I appreciated 10 that cartoon. That was the -- today, it's clear that we have 11 different rationales and we have different views of 12 this particular proposal, and this particular finalization of 13 the rule. I think it's pretty clear that the case and 14 rationale for the final rule has been made fairly well by the 15 staff, and has been presented in great detail in the release. 16 Not to repeat some of the arguments that have 17 already occurred, essentially, hedge funds have grown 18 dramatically. There's about a trillion dollars invested in 19 hedge funds today. At the rate of current growth, the 20 amounts managed by hedge funds could be several trillion 21 dollars in short order. The amounts keep growing, and there 22 is much troubling evidence of fraudulent activity. 23 It is clear that hedge funds are not doing business 24 in a vacuum, and it is not the case, in my view, of a few 25 rich people playing by themselves in a corner. No one can 112 1 seriously argue that hedge funds do not impact, directly, or 2 indirectly, public funds -- mutual funds, as demonstrated by 3 the timing and the late trading cases and through -- pension 4 funds have been affected, and may be affected in the future 5 by the activities of hedge fund managers. 6 Clearly, there is smoke, and there is danger, and 7 light needs to be shed on a dark corner. To ignore this 8 situation, it seems to me, would be irresponsible in my view, 9 both to investors, and to the industry. 10 Essentially, the industry and many commenters have 11 proposed one simple idea, with several variations. The idea 12 seems to be create a registry of some sort, and require 13 annual audited reports. 14 So to put it in the simplest context, what we have 15 had, in terms of alternatives, when one filters out all the 16 different comments, and the different commentary that we 17 received, we have a registry versus registration under the 18 Investment Advisers Act. 19 I certainly respect the views of the practitioners, 20 and their associations and counsel. However, I do not 21 believe that the registry idea and its variations would be 22 sufficient, given the problems that we have discerned. 23 Obtaining information is an important part of our objective, 24 but it’s not the exclusive goal. 25 Again, I have a hard time seeing the argument that 113 1 having examination and compliance procedures in place doesn't 2 offer deterrence. It's simply the wrong paradigm. 3 Would anyone suggest that registration under the 4 '34 Act should be abolished because we can't foresee, or we 5 can't detect every item of fraud? Would anyone argue that 6 cops on the beat make a difference, or that tax audits keep 7 individuals who are tempted to cheat from doing so? 8 Registration under the Advisers Act provides, 9 among other things, for clear standards under developed case 10 law of fiduciary to its investors. Books and records 11 requirements. A compliance system to be established by the 12 fund manager, and the right of our agency to conduct 13 examinations. 14 Now, having said that, a very important part of our 15 agency's obligation, in my view, is to discuss fully with the 16 regulated community, and with commenters. The agency 17 historically has always sought to have the regulated industry 18 help design the right regulation and oversight. 19 During this process, I've tried to be a part of 20 that. I have sought to keep an open mind, and to listen, and 21 to discuss with all who had opinions on this matter. Late 22 last week I promoted, I arranged and participated in meetings 23 with industry representatives of the Managed Funds 24 Association, and our senior staff. I listened, the staff 25 listened, and our Chairman and his staff listened. 114 1 Although so many quibble or argue that the agency 2 did not listen enough or read enough of the commentary, I 3 believe that this final rule has significant accommodations 4 to the industry, and these particular accommodations have 5 helped me to support it. 6 First of all, I want to point out that the 7 effective date of this particular final rule is over a year 8 away, in 2006. This allows great flexibility to the 9 industry. 10 There are technical rules that allow 11 grandfathering, so certain individual investors who may not 12 qualify after the effectiveness, can qualify. Planning can 13 occur. Significantly, the industry and their advisers will 14 have more time to point out problems to our staff. 15 Items that are unclear in the rulemaking can be 16 brought to light, and I am confident, and I know that our 17 staff will welcome those kind of inputs, and will work with 18 the industry and their advisers. I can't emphasize how 19 important I think that is. 20 One of the areas that concerned me greatly was the 21 so-called barrier-to-entry problem. I believe, again, that 22 much has been done in the final rule to help with that 23 particular problem. 24 Essentially -- and I think it's important to 25 emphasize this -- insiders and executives, and significantly, 115 1 partners, including passive partners, will not have their 2 contributions counted against the $25 million limit. As I 3 understand the way it will work, a passive partner to a hedge 4 fund adviser would not have his or her investment count 5 against the limit, so this would allow managing substantially 6 above the $25 million limit, and not be registered. 7 I've also asked many questions, and I am confident 8 that the marketplace will adjust and mitigate the cost of 9 compliance. As has been said, there does not need to be 10 hired an individual to separately take on the position of 11 compliance officer. There are business models, there are 12 prime brokers who are sponsoring hedge fund advisers, and I 13 believe that that and other arrangements will work out, and 14 will mitigate those costs. 15 Now, I would like to take a moment to address one 16 of the most controversial aspects of the proposal, and that 17 is the compliance oversight by the Commission. Even those 18 opponents who support some type of information exchange 19 consistently have argued against the examination requirement. 20 They contend that the Commission staff lacks resources, 21 experience, and structure -- essentially, a justifiable and 22 well-modeled plan. 23 Although I believe some of these concerns stem from 24 our own, or from their own prior experiences with our OCIE, 25 which, by the way, the Commission and the OCIE are working 116 1 hard to rectify, some of these concerns seem to be rhetoric 2 that miss the point. The heart of the argument, the heart of 3 this particular argument, nonetheless, does resonate with me. 4 Accordingly, I took this problem to the Chairman, 5 and I mentioned to him that I was concerned that our 6 particular oversight was not sufficiently developed, and that 7 I was concerned, also, about our ability within the 8 resources. I am pleased to report that he also had similar 9 reservations, and that he also has given this much thought. 10 In response to these concerns, I'm pleased to say 11 that Chairman Donaldson has directed the formation of a task 12 force of SEC staff members, to be responsible for the 13 development of processes by which Commission examinations of 14 registered investment advisers will become truly risk- 15 filtered and risk-based. 16 Headed by Charles Fishkin, our director of the 17 Commission's Office of Risk Assessment, this task force is 18 comprised of staff members from the Office of Compliance, 19 Inspection and Examinations, OCIE; the Division of Investment 20 Management; the General -- or, I'm sorry, the Office of 21 General Counsel; the Office of Economic Analysis; and the 22 Office of Information Technology. 23 The staff group will begin meeting immediately, 24 following the Commission's approval of final rules, should 25 they be approved, requiring the registration of hedge fund 117 1 advisers. Their goal is to have a risk-based inspection 2 program operational by February 1, 2006. 3 Although we anticipate that the group's initial 4 deliberations will be internal to the Commission staff, it is 5 our expectation -- my expectation -- that the group will seek 6 input from investment advisers that are currently registered 7 with the Commission, as well as those investment advisers who 8 will be required to become registered as a result of the 9 hedge fund initiative. 10 We anticipate that by the time this new compliance 11 inspection regime has been fully developed, it will reflect 12 significant input, and further comment from the regulated 13 community. Again, this is one of the reasons I'm so pleased 14 to see a long period before the effective date for today's 15 rules. 16 So on two tracks, consultation with the industry 17 and their advisers will continue. Our staff will continue to 18 receive comments, and meet as they customarily do, with the 19 industry, with respect to the rules that are being finalized 20 today. At the same time, the new task force will study very 21 carefully what it is that our agency can do, given our 22 resources, and given what we can do with respect to our 23 examination procedures. 24 Again, we are now studying, and our particular 25 agency is interested in looking at risk-based examinations, 118 1 and studying particular problems that may be discerned. I 2 support the adoption of the proposal, and now I'd like to ask 3 a few questions, if I might. 4 As we all know, Paul and Bob, the Commission has 5 received a good deal of comment on aspects of the rule that 6 will affect the operation of hedge funds, and I know that the 7 staff has made a number of changes and clarifications that 8 address some of these comments, and produce a much clearer 9 definition and set of rules. 10 As I've said before, the changes have, in my mind, 11 significantly reduced barriers to entry, and I want to explore 12 that a little bit, or I also believe, address some of the 13 limits on innovation that others have been concerned about. 14 So, let me ask a few questions in that area. 15 One of the concerns is that we do not disrupt the 16 relationship between the hedge fund manager and the pool, so 17 as to raise questions about whether hedge fund investors are 18 clients for other purposes, and if there are special duties to 19 them that would be inconsistent with managing a pooled vehicle. 20 How have we dealt with that? 21 MR. PLAZE: Well, we've included a sentence in the 22 draft release, making it absolutely clear that the rulemaking 23 is solely limited to the method of counting clients for 24 purposes of Section 203(b)(3), and doesn't alter the duties 25 or obligations owed by hedge fund advisers to clients, or 119 1 investors in any respect. 2 COMMISSIONER CAMPOS: As far as counting clients, 3 under the rule, or actually the current rule, off-shore 4 advisers only have to count clients that are U.S. persons. 5 Commenters were concerned about the definition of U.S. 6 person, and whether it works for hedge funds. Could you 7 explain how that is addressed in the rule? 8 MR. PLAZE: Yes. The issue arises with respect to 9 an offshore adviser. Since an offshore adviser only has to 10 count U.S. clients in order to determine whether they have a 11 registration obligation -- whether they have more than 14 12 clients, the question is how do you determine whether 13 somebody is a U.S. client? The Advisers Act rule looks -- 14 the Advisers Act looks consistently to the residence of a -- 15 of a U.S. person. 16 But the commenters raised the question, well what 17 if the client is -- is under this rule, and the investor and 18 the hedge fund is a corporation, or a trust, or a managed 19 account, what -- what are we going to use -- they don't have 20 residences, and so, we've clarified that in the case of a -- 21 a corporation or a business entity -- it's the place of 22 organization. A trust, it's the location of the trustee. 23 And so, we've made -- we've made those issues -- we've 24 answered those questions. They've never been asked before, 25 which was surprising to us when we got the comment letters 120 1 before, because these rules have been on the books for quite 2 a number of year now. 3 COMMISSIONER CAMPOS: It just seems to me there was 4 a lot of concern about that, and -- and this is -- these are 5 very helpful. Just on another technical item, when -- when a 6 non-U.S. person is -- invests in a hedge fund, and later 7 moves to the United States, does that person then become a 8 U.S. person, thus forcing the hedge fund manager to register? 9 MR. PLAZE: That's -- that was a new issue, too, 10 because in a normal advisory relationship, when someone moves 11 to the United States, you would expect them to be a U.S. 12 person, and we would not change that. Commenters 13 persuasively argued that with a pooled investment vehicle, it's 14 a different -- one needs to take a different approach. And 15 we were persuaded, and under the rules, as we recommend that 16 you adopt today, you would look to the -- the residency, or 17 the place of organization of the person at the time he or she 18 invests in the pool. 19 COMMISSIONER CAMPOS: I mentioned this in my 20 statement, but have you clarified -- or maybe you can make 21 sure that I'm correct, here -- regarding a hedge fund manager 22 himself as a client, and what about the family of the advisers, 23 and other key employees? 24 MR. PLAZE: Well, this is actually one of the most 25 significant changes from the proposal, and an idea that came 121 1 about by commenters, again, persuading us. And so, there are 2 some significant changes, particularly for small hedge funds. 3 Under the -- under the rules we recommend you adopt today, 4 you would exclude in counting employees to the 14 -- key 5 executives, partners, key employees of the advisory firm. 6 And this is important for your small firms, because 7 typically, you start with a group of -- of partners, or 8 insiders, who put together the capital. 9 And you'd only -- you would exclude those people 10 who -- who would be typically involved in the start-up of a 11 small hedge fund. Members of the family, your partners -- 12 even passive partners in the advisory firm itself. Those are 13 people you're going into business with. The Advisers Act is 14 not about protecting people you're in business with. The 15 Advisers Act is about protecting people whose professional 16 services you are offering, and those would be the outside 17 investors, when they eventually come into the pool. 18 And you would be able to exclude many of those, also, 19 from -- from the assets -- the proprietary assets of the firm 20 would not be counted, in terms of the $25 million threshold. 21 And the practical effect of that is that firms are going to 22 be able to conduct business for a longer period of time than 23 you might have thought, given the 14 client and the $30 24 million threshold before they come into registration with the 25 SEC. 122 1 COMMISSIONER CAMPOS: Again, I mentioned, and I'm 2 drawing a lot of comfort form the fact that there's a year 3 period before the effective date. Can you comment about how 4 that will work? 5 MR. PLAZE: Well, that -- that's an important 6 period, because we understand that some firms are going to 7 have to examine their business operations, and are going to 8 have to hire advisers, and we have given plenty of time for 9 new firms to come into compliance with our compliance rule, 10 and we've given similar time for firms. Let me give you some 11 transition areas during this period that's very important. 12 One is that we have statements in the release that 13 the staff stands prepared to deal and assist with technical 14 issues that came up. About seven or eight years ago, we 15 adopted a set of rules under 3(c)(7) of the Investment 16 Company Act that dealt with hedge funds. And during the 17 implementation period, the staff issued quite a lengthy 18 interpretive letter, issuing -- explaining issues that we 19 hadn't fully seen, and ones that Congress left open when it 20 did its statute. It stands ready to provide similar guidance 21 here. 22 But in addition, the transition period contains a 23 number of -- of -- of transitional rules that are important. 24 Would you like me to go through those transition rules, also? 25 COMMISSIONER CAMPOS: I think that'd be useful. 123 1 Sure. 2 MR. PLAZE: One is that all current investors in 3 hedge funds are grandfathered, as are other clients of hedge 4 fund advisers. Therefore, no one is going to have to leave 5 the hedge fund who perhaps wouldn't be eligible to be in the 6 hedge fund in the future, as a result of the effect of the 7 performance fee rules. Under the performance fee rules, a 8 client -- you look through the fund, and you require clients 9 to have a certain amount of wealth or sophistication in order 10 to be in that fund. Those are essentially waived for all 11 clients in the fund -- already in the fund, as of the day of 12 the compliance date, which is -- we mentioned is in February 13 of 2006. 14 And secondly, in measuring 14 clients, under the 15 statute, you look back 12 months. So let's say if you only 16 have one client today, but indeed, if cumulatively you had 14 17 clients over the past 12 months, you might have a 18 registration obligation. And indeed, you could certainly see 19 a situation with the hedge fund, that it had a number of 20 investors six months ago, but it doesn't today. Some have 21 left for whatever reason. 22 Now, what we would do is, we would modify the 23 measure of -- of look-backs, so that the look-back begins on 24 the compliance date in February 2006, so that you wouldn't 25 have retroactive registration obligations on hedge funds who 124 1 would perhaps have gotten smaller -- hedge fund advisers have 2 gotten smaller, or because they've rearranged their business 3 arrangements to avoid registration. So, we avoid the -- the 4 “I gotcha” application of that statutory provision. 5 And secondly, the two-year redemption limitation. 6 That is, if you have redemption -- if the fund offers 7 redemption rights of more than -- two years, if it offers 8 redemption rights for investments that have been in the fund 9 less than two years, it's going to have to register. It's 10 going to be a private fund. We would not make that 11 retroactive. We'd only apply that to securities that are 12 offered -- interests in the hedge fund that are offered after 13 the compliance date. So, funds that have entered into 14 business arrangements with a certain expected set of rules, 15 are not going to be -- have those retroactively applied. 16 And finally, we have our 17 recordkeeping requirements dealing with performance 18 information, which have to be substantiated 19 back from the first day of that performance period. We would 20 relax those for these hedge fund advisers of course, they would 21 still be subject to the anti-fraud provisions, which really 22 weren't on notice that they were required to keep those -- 23 those records, having not had a registration obligation. So 24 these are important, I think, transition provisions that will 25 really alleviate the impact of these rules on -- on hedge 125 1 fund managers that have heretofore been operating under a 2 separate set of rules. 3 COMMISSIONER CAMPOS: Thank you, that -- that is at 4 least reassuring to me. Mr. Chairman, I hope that it is 5 clear from this statement, and from our particular release 6 that the industry understands that the agency is seeking to 7 work with it, to make these rules realistic and not overly 8 burdensome, and that we will continue to do so. We certainly 9 -- the door is open, and the invitation is there, and I know 10 that you are supportive of that -- of that particular 11 approach. And I -- and I do hope that -- that those out 12 there will not let themselves get into this tailspin of -- of 13 a toxic environment, and instead, come in, work with us, have 14 these rules be effective, and -- and appropriately designed, 15 as we have already. But again, we -- we have the structure 16 now, and -- and I think it's something that can be very -- 17 very palatable to the industry. 18 At the end of the day, I believe that the industry 19 can win with this situation. This should provide deterrence, 20 and when one thinks about the reputational capital, and the 21 -- and the loss that could occur to the industry with -- with 22 a small hiccup -- with a small scandal, I think this kind of 23 system is worth having in place, and is worth the cost. 24 Thank you. 25 CHAIRMAN DONALDSON: Thank you. Do you -- any of the 126 1 Commissioners have any comments? We're getting close to the 2 conclusion, here. 3 COMMISSIONER GLASSMAN: I do. It will be short. 4 I'm glad Commissioner Campos mentioned the task force. As I 5 said in my remarks, I -- I think it will be useful to have 6 the task force. I would have preferred that the task force 7 do its work first, to determine the right model, and apply it 8 to the hedge funds. And I would point out that I asked the 9 Chairman to do such a thing over a year ago, to look at the 10 kind of information that we need from hedge funds, and the 11 best way to get it. And unfortunately, that hasn't been 12 done. Had it been done, we'd be in a very different place 13 today. 14 CHAIRMAN DONALDSON: Commissioner Atkins? 15 COMMISSIONER ATKINS: I think I've said my piece. 16 Thank you. 17 CHAIRMAN DONALDSON: I'm sorry. Took you out of 18 order. Commissioner Campos. 19 COMMISSIONER CAMPOS: I've said my piece, as well. 20 CHAIRMAN DONALDSON: Let me just make two remarks, 21 because I -- I believe that there have been -- I don't want 22 to rehash all that's been said. I think we've been over it, 23 and over it. There are two remarks that were made here that 24 I want to clarify. The first is the reference to the 25 President's Working Group. And I want to make sure that my 127 1 colleagues on that organization understand, and the people 2 sitting at this table in this room understand that the 3 President's Working Group does not -- I think the statement 4 was, we were proceeding without the concurrence of the 5 President's Working Group, and the President's Working Group 6 is not an organization that -- that has a concurrence to it. 7 It's an advisory group. Comments made by members of that 8 group are made in their own individual capacity, just as the 9 comments that I make are made in my capacity as Chairman of 10 this regulatory agency. The other gentlemen on that group 11 have different roles. I think that needs to be made clear. 12 I also want to just comment one moment on the issue 13 of -- of the task force, and the formation of the task force. 14 As all of us at this table know, we've been working since the 15 day I got here as Chairman of the Commission, to -- to put 16 together a risk-based approach to our entire method of 17 operation. And we've had to bring in the structure to do 18 that. We've had to bring in the people to chair the office. 19 We have now advanced to the point where we have a risk-based 20 approach throughout the entire agency, and we've now got a 21 special sub-group of something that's already going, that's 22 going to focus, and thank goodness they are, as Commissioner 23 Campos stated. 24 So, I just want to say that, you know, I've of 25 course given consideration to the discussion -- arguments pro 128 1 and con, and I fully support the staff's recommendation. In 2 connection with what Commissioner Campos said, I want to note 3 that a number of important issues were discussed this 4 morning, particularly in response to the questions of those 5 of other Commissioners, and I'd like to ask the Commission to 6 authorize the staff to make appropriate revisions to the 7 final release, to reflect the key points we've covered. 8 Subject, of course, to the approval of each of the 9 Commissioners who favor the rule. 10 However, before I officially call the question, I 11 just want to say a few words. I appreciate and welcome the 12 insights and observations that have been offered by all of my 13 colleagues this morning, and throughout this process. I've 14 said before, if all of the decisions we were asked to make were 15 easy, and self-evident, there'd be no need to have five 16 people sitting on this panel. And while we may not always 17 have agreed, disagreements are driven by the bedrock respect 18 we share for this institution that we serve. They provide 19 valuable evidence that the process works, and it works well. 20 To each of my colleagues, I extend my thanks and 21 congratulations. These are difficult decisions. The 22 rigorous debates that we've had have been crucial to the 23 development of this initiative. And with that, I will call 24 the question, do the Commissioners vote to approve the 25 staff's recommendation? 129 1 (Voice vote.) 2 CHAIRMAN DONALDSON: Okay. That -- that, then, is 3 an approval by a vote of three to two. Thank you all. And 4 that's the end of the meeting. Thanks. 5 (Whereupon, at 1:09 p.m., the meeting was 6 concluded.) 7 * * * * * 8 9 10 11 12