WEBMASTER NOTE: This is the unedited transcript of the hedge fund hearings held on May 14-15, 2003, which we received directly from the court reporter. We are posting the transcript in this form to make it available as soon as possible. Staff will review this transcript and will correct any errors that may be contained in it. We will post on our website the corrected transcript, which will also be easier to view and to read, as soon as it is available. (This replaces the file posted May 22, 2003, which had technical defects.) -------------------------------------------------------------------------------------- 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION 2 3 In the Matter of: ) 4 ) File No. 05-007-03 5 HEDGE FUND ROUNDTABLE ) 6 PAGES: 1 through 264 7 PLACE: Securities and Exchange Commission 8 450 Fifth Street, N.W. 9 Washington, D.C. 10 DATE: Thursday, May 15, 2003 11 12 The above-entitled matter came on for hearing, pursuant 13 to notice, at 9:00 a.m. 14 15 BEFORE: 16 17 WILLIAM H. DONALDSON, Chairman 18 PAUL ATKINS, Commissioner 19 RAUL CAMPOS, Commissioner 20 CYNTHIA GLASSMAN, Commissioner 21 HARVEY GOLDSCHMID, Commissioner 22 23 24 Diversified Reporting Services, Inc. 25 (202) 467-9200 1 C O N T E N T S 2 PAGE 3 PANEL 5 - HEDGE FUND STRATEGIES AND MARKET 4 PARTICIPATION 9 5 6 MODERATOR: 7 ANNETTE L. NAZARETH 8 Director, Division of Market Regulation, Securities and 9 Exchange Commission 10 11 PANELISTS: 12 AFSANEH BESCHLOSS 13 CEO and Chief Investment Officer, Carlyle Asset 14 Management Group 15 16 PETER BORISH 17 Senior Managing Director of Business Development, 18 OneChicago, LLC 19 20 PETER BROWN 21 Executive Vice President, Renaissance Technologies 22 Corporation 23 24 JAMES CHANOS 25 President, Kynikos Associates, Ltd. 1 WILLIAM N. GOETZMANN 2 Edwin J. Beinecke Professor of Finance and Management 3 Studies and Director, International Center for Finance, 4 Yale School of Management 5 6 LAWRENCE E. HARRIS 7 Chief Economist and Director, Office of Economic 8 Analysis, Securities and Exchange Commission 9 10 WILLIAM HEYMAN 11 Executive Vice President and Chief Investment Officer, 12 The St. Paul Companies 13 14 ANDREW W. LO 15 Harris & Harris Group, Professor of Finance, Sloan 16 School of Management, Massachusetts Institute of 17 Technology 18 19 ROBERT STEEL 20 Vice Chairman, Goldman Sachs Group 21 22 MARK YUSKO 23 President and CEO, UNC Management Company, Inc. 24 25 1 PANEL 6 - ENFORCEMENT/FRAUD CONCERNS 89 2 3 MODERATOR: 4 CYNTHIA M. FORNELLI 5 Deputy Director, Division of Investment Management, 6 Securities and Exchange Commission 7 8 PANELISTS: 9 SCOTT BERMAN 10 Partner, Brown Rudnick Berlack Israels, LLP 11 12 STEPHEN M. CUTLER 13 Director, Division of Enforcement, Securities and 14 Exchange Commission 15 16 THOMAS FEDOREK 17 Senior Managing Director, Citigate Global Intelligence & 18 Security 19 20 KRISTINA L. KNEIP 21 Senior Staff Attorney/Examination, Supervisor, State of 22 Washington Department of Financial Institutions, 23 Securities Division 24 25 1 PATRICK J. McCARTY 2 General Counsel, Commodity Futures Trading Commission 3 4 PAMELA J. PARIZEK 5 Associate Managing Director, Kroll, Inc. 6 7 LOIS PELTZ 8 President and CEO, Infovest21 9 10 11 PANEL 7 - ASSESSMENT OF THE CURRENT REGULATORY 12 FRAMEWORK 147 13 14 MODERATOR: 15 PAUL F. ROYE 16 Director, Division of Investment Management, Securities 17 and Exchange Commission 18 19 PANELISTS: 20 MARK ANSON 21 Chief Investment Officer, CalPERS 22 23 ALAN BELLER 24 Director, Division of Corporation Finance, Securities 25 and Exchange Commission 1 ARMANDO BELLY 2 General Counsel, Soros Fund Management, LLC. 3 4 IAIN CULLEN 5 General Counsel, Alternative Investment Management 6 Association, partner, Simmons & Simmons 7 8 JEAN-CLAUDE DELESPAUL 9 Secretary General, Commission des Operations de Bourse, 10 France 11 12 JOHN G. GAINE 13 President, Managed Funds Association 14 15 FREDERICK C. "Rick" LAKE 16 Co-Chairman, Lake Partners, Inc. 17 18 SANDRA MANZKE 19 Founder & Co-Chief Executive Officer, Tremont Advisers 20 21 JOHN MARKESE 22 President and CEO, American Associatin of Individual 23 Investors 24 25 1 ANNETTE L. NAZARETH 2 Director, Division of Market Regulation, Securities and 3 Exchange Commission 4 5 ROBERT POZEN 6 John Olin Visiting Professor, Harvard Law School 7 8 PAUL N. ROTH 9 Partner, Schulte Roth & Zabel, LLP 10 11 DOUGLAS SCHEIDT 12 Associate Director and Chief Counsel, Division of 13 Investment Management, Securities and Exchange 14 Commission 15 16 CHRISTINA SINCLAIR 17 Head of Department, Business Standards, Financial 18 Services Authority, United Kingdom 19 20 JANE KANG THORPE 21 Director, Division of Clearing and Intermediary 22 Oversight, Commodity Futures Trading Commission 23 24 25 CLOSING REMARKS - Chairman Donaldson 260 1 P R O C E E D I N G S 2 MR. ROYE: Good morning. My name is Paul Roye, and 3 I'd like to welcome you back to the second day of our 4 roundtable on hedge funds. And I'd also like to welcome 5 those joining us by webcast. 6 As you can see from our agenda, just as yesterday, 7 today we have an impressive group of panelists to discuss a 8 variety of issues, and important issues, related to the hedge 9 fund industry. 10 We have a lot of ground to cover today. We're 11 going to start with the investment strategies and market 12 participation of hedge funds. We're going to talk about 13 enforcement and some fraud concerns that we have in the area, 14 as well as a broad discussion of the assessment of the 15 current regulatory framework that governs hedge funds. 16 So I invite all of you to sit back and enjoy the 17 discussions. We expect another lively set of discussions 18 today. 19 Again, just a few housekeeping matters. If you 20 leave the building, unfortunately you'll have to go through 21 our security procedures again, and we do urge you to turn off 22 your cell phones and we will have breaks during the panels so 23 you can make your phone calls. 24 With that, I'd like to turn over our program to 25 Annette Nazareth, our esteemed director of the division of 1 market regulation who is going to lead a discussion on hedge 2 fund strategies and market participation. 3 And on behalf of the SEC participants on the panel, 4 I'd just like to make the broad disclaimer for today that the 5 views that you hear from the SEC participants are their own 6 views and not necessarily the view of the Commission. 7 And with that, I will turn the program over to 8 Annette and her panel. 9 MS. NAZARETH: Thank you, Paul. Good morning. On 10 behalf of all of my colleagues on the staff, I'd like to 11 thank the panel members for taking the time to participate on 12 this panel dealing with hedge fund trading strategies and 13 market participation. 14 Clearly, this is a very ambitious topic and the 15 amount of time allocated to it is quite short so each of the 16 panelists have agreed to forego an opening statement so that 17 we will have more time for meaningful discussion. 18 First, though, I want to briefly introduce the 19 panel to you. I can only mention the highlights of their 20 very impressive resumes as they relate to the hedge fund 21 industry. Frankly, if I were to describe all of their 22 accomplishments, we'd have no time for discussion at all. 23 First, I'd like to start with Afsaneh Beschloss, 24 who is the chief executive officer and chief investment 25 officer of Caryle Asset Management Group and, prior to 1 joining CAMG, Afsaneh was the treasurer and chief investment 2 officer of the World Bank. 3 Next is Peter Borish, who is a senior managing 4 director of business development at OneChicago. OneChicago 5 is an exchange that trades single stock futures and narrow 6 based index futures, but Peter previously led a team of 7 researchers and traders at Tudor Investment Corporation. 8 Next is Peter Brown. He's executive vice president 9 of Renaissance Technologies Corp. where he develops 10 mathematical models for the financial market. Renaissance 11 Technologies is a general partner and investment advisor of 12 Medallion Funds, which is a hedge fund with approximately $5 13 billion in assets under management. 14 Next we have Jim Chanos, who is president and 15 founder of Kynikos Associates, which provides the investment 16 strategy of profiting from unhedged shortselling of 17 overvalued securities. Kynikos also manages the short 18 portfolios of Beta Hedge and Beta Hedge International for 19 domestic and offshore investors as well as The Opportunity 20 Fund which seeks to identify mispriced securities that are 21 both overvalued and undervalued. 22 Next we have Professor William Goetzmann, who is 23 the Edwin J. Beinecke Professor of finance and management 24 studies and the director of the International Center for 25 Finance at the Yale School of Management. Will is an expert 1 on a diverse range of investments, including stocks, mutual 2 funds, real estate and, even more interesting, paintings. 3 His research topics include global investing, forecasting 4 stock markets, selecting mutual fund managers, housing as 5 investment and the risk and return of art. 6 Next to me is Larry Harris, who is our chief 7 economist here at the Securities and Exchange Commission. 8 He's here on assignment from the Marshall School of Business 9 at the University of Southern California, where he holds the 10 Fred Keenan Chair in Finance. Very fortunate for us, having 11 Larry here. He's an expert on market microstructure, 12 investment management and the uses of transactions data in 13 financial research. 14 Next to Larry is Bill Heyman. He's executive vice 15 president and chief investment officer of The St. Paul 16 Companies, which is a major U.S. property and liability 17 insurance company and he is responsible for all of St. Paul's 18 public and private investment activities. Some highlights of 19 Bill's career -- and there are many -- include he was 20 chairman of CitiGroup Investments, Inc., he was head of the 21 private investment department of Salomon Brothers, Inc. and 22 of course, most impressive of all, he's a former director of 23 the SEC's division of market regulation. 24 Next is Andrew Lo. He's the Harris & Harris Group 25 Professor of Finance at the MIT Sloan School of Management 1 and he's a director of MIT's laboratory for financial 2 engineering. His interests are many. They include empirical 3 validation and implementation of financial asset pricing 4 models, the pricing of options and other derivative 5 securities, financial engineering and risk management, 6 trading technology and market microstructure and hedge fund 7 risk and return dynamics and risk transparency. So clearly 8 he has some very direct knowledge about our topics today. 9 Next to Andrew is Bob Steel. He's a vice chairman 10 of Goldman Sachs, Inc. and he's a member of the management 11 committee. At Goldman, Bob has held many important positions 12 including head of the firm's equities division, head of all 13 institutional equities in the United States and head of the 14 equities division in Europe. Bob is a member of the New York 15 Stock Exchange where he has served on various committees and 16 he's a member of the board of directors of the Securities 17 Industry Association. 18 And last, but not least, we have Mark Yusko. He's 19 chief investment officer of the University of North Carolina 20 at Chapel Hill. He's responsible for the management of 21 financial assets of the university and affiliated foundation 22 funds. Mark and his team founded the UNC Management Company 23 to provide comprehensive investment advisory services to the 24 university, including providing strategic and tactical asset 25 allocation recommendations to the board, investment 1 management selection, manager performance evaluation, 2 spending policy management and performance reporting. 3 And of course we also have again with us today -- 4 we're very fortunate to have all our commissioners and our 5 chairman with us this morning, so we're delighted to have 6 everyone here. 7 I'd like to begin by focusing first on -- directly 8 -- getting right to the topic on hedge fund trading 9 strategies and market impact. Hedge funds engage in a wide 10 variety of trading strategies ranging from strategies that 11 are market-neutral to those that are highly speculative. 12 This raises questions concerning the impact that these 13 strategies have on individual stocks and on the markets as a 14 whole. 15 So I thought I would begin by first calling on 16 Peter Brown to describe generally what these hedge fund 17 trading strategies are for the different types of investments 18 strategies that they engage in. 19 Peter, could we start with you? 20 MR. BROWN: Sure. Let me just say in very general 21 terms what all hedge funds that I know of do. They gather up 22 information and on the basis of this information, form an 23 opinion about what the true value or future value of some 24 financial instrument is. Then they notice if the market has 25 a different opinion and, if it does, they trade. That is 1 generally -- every hedge fund I know about, that's what they 2 do. 3 So, for example, an event-driven hedge fund may 4 think that the probability of some merger occurring is 5 greater than what they see in the market. Say if it's a 6 stock for stock merger, they'll buy the target -- the 7 acquiree and sell the acquirer, thereby driving the spread 8 between the two closer together. 9 Now, if the manager is right, the spread will 10 continue closer together and he'll turn a profit. Take 11 statistical arbitrage. That's the area I'm in. There, the 12 manager will form opinions on the relative value of all kinds 13 of instruments to one another and they will sell the 14 instruments they believe are overvalued relative to other 15 instruments and buy the instruments they believe are 16 undervalued relative to other instruments. 17 Again, look what happens. When they sell the 18 stocks or whatever the instruments are, the price of those 19 instruments will come down and the one they buy will go up. 20 If the manager is right, the stocks will continue to move in 21 the direction that they've nudged the market. 22 So in these cases and all other cases that I know 23 of, the impact of these trades -- I can give other examples. 24 Do you want me to run through a litany of kinds of hedge -- I 25 think it was discussed yesterday, but -- I'll give you one 1 other example. 2 Say convertible bond arbitrage. There, the manager 3 may believe that the volatility of a stock is underpriced so 4 he'll buy the convert which has an implicit option in it. He 5 doesn't want to take a position in the underlying so he'll 6 sell the stock to hedge out that exposure. 7 When he buys the convert, he increases the price 8 the marketplaces on the volatility and if he's right, the 9 same thing happens. He'll make money and the market will 10 continue to move in the direction which he's pushed the 11 price. 12 So in all these examples, what hedge funds do is 13 move the market in a direction that they believe the true 14 value of an instrument or pair of instruments ought to be. 15 And if they're successful, that is, if they make money, then 16 they'll make the market more efficient. 17 So when hedge funds trade in any strategy -- I'm 18 addressing now the market impact and going on to the next 19 issue -- I hope that's okay. When hedge funds trade, what 20 they do in any of these strategies is make the market more 21 efficient. So I think that trading by hedge funds is a good 22 thing. I want to make sure I get that in because I don't 23 know if you're going to call on me again. 24 Do you want me to go on with other strategies or -- 25 MS. NAZARETH: You can go on with a few more 1 strategies. 2 MR. BROWN: Can I instead go on and address other 3 aspects of -- okay, fine. 4 Let's look at volatility. There's been a concern 5 that hedge funds through their trading various strategies 6 affect the volatility of the market. Now, let's decompose 7 volatility into two components. One, that -- innovations in 8 news; in other words, new information coming in, and the 9 other, do -- let's call it noise. I don't necessarily mean 10 white noise but noise. 11 Now, you can't really do anything about innovations 12 in the news and you shouldn't really do anything there. But 13 the noise represents unwarranted risk to -- unnecessary risk 14 to all investors. And what a hedge fund does is trade out 15 the noise. All these strategies they trade out the noise. 16 So for example, if a stock takes a tumble for no 17 apparent reason, some hedge fund will be sitting there 18 waiting and buy the stock, thereby supporting the price and 19 reducing the volatility. So this is another way in which the 20 hedge fund trading is good for the market. 21 And I can go on to liquidity but I think maybe I'll 22 stop because you said talk for two or three minutes. 23 MS. NAZARETH: Bill, can you comment further on 24 both the types of techniques that hedge funds employ and the 25 instruments that are also used in hedge fund strategies? 1 MR. HEYMAN: Well, I could certainly continue the 2 litany of strategies. I don't know if that's productive. I 3 have one general observation that I had in reading these 4 questions which I thought were very good and it's probably 5 better made at the beginning of this discussion than at the 6 end. 7 As I read the press articles on hedge funds, which 8 describe them as unregulated, the exemptions under which they 9 operate are principally in the area of primary markets, 10 selling their own securities. In their secondary market 11 operations, hedge funds are subject to the same restrictions 12 as everybody else. 13 So a discussion of this nature is really less -- by 14 definition, has to be less a discussion of hedge funds than a 15 discussion of various trading strategies and how they affect 16 the market because in theory they could be executed by 17 anyone. 18 Now, as a matter of fact, hedge funds have a de 19 facto monopoly on many of these strategies, with some 20 competition, probably less than there used to be from 21 proprietary trading desks of regulated institutions. But 22 this discussion is to me more delicate than the other four or 23 five panels in that it involves consideration of tampering 24 with secondary markets which is always a delicate matter. 25 About six or seven years ago, in connection with a 1 NASDAQ settlement, the Commission, more or less by fiat, 2 restructured equity markets in the U.S. and only now are 3 people beginning to question certain elements of the scheme 4 that resulted. 5 The other day I recall that Chairman Donaldson 6 questioned whether decimalization was a good thing in all its 7 consequences, a question which would have been sacrilege five 8 years ago. 9 So I would simply say at the outset that as we 10 consider these things, we should understand that we're not 11 talking about entities, we're talking about strategies. 12 MS. NAZARETH: That's an excellent point. Jim, do 13 you have any thoughts that you want to add with respect to 14 techniques or strategies or the types of instruments again 15 that hedge funds employ in their trading strategy? 16 MR. BORISH: Well, I'm going to defer to my 17 colleagues on most of the aspects of variety of strategies. 18 I think I can focus a little bit on one particular strategy 19 which you highlight in your question, which is short selling, 20 market impact on short selling, whether or not it should be 21 regulated more than it already is. 22 I would point out that short selling is one 23 technique used by hedge funds. It's probably subject to the 24 most regulations in terms of needing to borrow shares, the 25 so-called uptick rule which has been in place for 70 years, 1 and a variety of other restrictions. 2 So we would comment that as it relates to that 3 market technique and trading approach, short sellers and 4 hedge fund managers who employ short selling are already 5 regulated more so than other traders or trading strategies. 6 Having said that, I think that it's worth exploring 7 some of the issues that short selling give rise to, and 8 certainly there's been, I know, increased interest, given the 9 last few years with market performance, on what is going on 10 on the short side and any way we can illuminate that would be 11 helpful hopefully for this panel. 12 MS. NAZARETH: I think we will spend a great deal 13 more time talking about short selling in the course of this 14 discussion. Maybe I'll ask Peter and Afsaneh to both see if 15 you can respond to the following question. In terms of risk, 16 can you sort of describe how hedge fund investments and 17 trading strategies differ from more traditional investments 18 through mutual funds and other similar products? 19 MS. BESCHLOSS: Sure. As someone who's been an 20 investor in hedge funds, both at the World Bank currently and 21 in various endowments, I was sort of listening to the other 22 panelists -- I have always looked at hedge funds essentially 23 as any other investable category except much more active, and 24 that has repercussions on what I'm going to say about risk. 25 So hedge funds are nothing but -- you know, some 1 people call them mutual funds on steroids or whatever you 2 want to call them, but essentially it's active strategies and 3 with the exception that they have access to many tools that 4 you do not have in traditional money management. 5 Now, what does that mean in terms of risk 6 management? Because they are much more active, because they 7 use many more tools, the risk management becomes a harder 8 job. Obviously, the risk management and the issues that we 9 may discuss later on transparency are very interrelated. On 10 the one hand, as an investor, you always want more 11 transparency, you want to understand exactly if you put your 12 money in something what's going on. 13 On the other side, there are certain strategies in 14 the hedge fund world in general, in investments, that require 15 some level of proprietary information, at least during 16 certain periods of time. Maybe not in the long run, but over 17 ceratin periods of time. 18 And one solution that we have come up with in the 19 past really four, five years, and it seems to be working, is 20 really working maybe with third parties in some form or other 21 so that the information from hedge fund managers could go to 22 third parties who have absolutely no connection with market 23 makers in any shape or form. They can process the 24 information and then as a user of information, as an 25 investor, you can then get that information in an aggregated 1 form, in a form that makes sense to you. 2 And obviously for some of the -- as I mentioned, 3 you know, some complex fixed income strategies, some complex 4 risk op strategies, it's very difficult to come up with 5 meaningful risk numbers. The second thing that is very 6 difficult is really aggregation of these different strategies 7 and you do have to make certain kinds of adjustments and 8 simplifications to be able to do that. 9 But my assumption has always been more risk 10 management is better than less risk management and if you are 11 -- especially right now as more investors are getting 12 invested in this sector, very important to have the risk 13 management. And obviously we can talk later about the role 14 of prime brokers and other entities in risk management. 15 But it is something I think which is key to both 16 the trading where both people who are trading the strategies 17 should understand the underlying risks of what they're doing 18 and the investors in the business should spend more time on 19 aggregation. 20 I'll just make one other point. The other thing 21 that I think as an investor that is extremely important is 22 hedge funds are generally a part of your portfolio, not the 23 totality of your portfolio. I think another very important 24 task is being able to aggregate the risk of your hedge fund 25 portfolio, whatever strategies are in there, together with 1 the rest of your portfolio which is generally a traditional 2 portfolio and I think that's one of the things that needs 3 more work in this area. 4 MS. NAZARETH: Do you think that this lack of 5 transparency with respect to risk has a negative impact on 6 market efficiency as a whole and do you think that some of 7 the concerns that you read about in the press with respect to 8 the ability of hedge funds to move market sometimes in 9 strange ways in particular products is related to that? 10 MS. BESCHLOSS: I don't necessarily look at it that 11 way. I think you do need -- you know, we need to do risk 12 management. But the question is, do you need the information 13 on a daily basis? I'd say no, because as an investor, what 14 would you do with that information? There's nothing very 15 much you could do. 16 And it's the same thing really for your mutual fund 17 or your public traditional kinds of -- you know, if you got 18 information from your public managers you'd have the same 19 problem. So I don't look at it quite that way. I think 20 hedge funds take advantage of market inefficiencies and as we 21 find in many strategies like merger op, like some others, as 22 the strategies become more common, as people put money, they 23 become more efficient. 24 So hedge funds have -- I've seen them also have -- 25 play role in making certain kinds of markets more efficient 1 than less efficient. But every type of business, whether 2 it's traditional money management or hedge fund management, 3 hedge funds obviously because of lack of transparency, 4 there's room to take advantage in certain ways that none of 5 us would feel comfortable. 6 MS. NAZARETH: Thank you. How about Peter Borish 7 and then I think Peter Brown has some comments. 8 MR. BORISH: Thank you. Well, I think that hedge 9 funds and risk management, a lot of what they do is they take 10 conventional wisdom and you sort of have to turn it upside 11 down. So the normal concept of the greater the risk, the 12 greater the reward is actually the opposite with a hedge 13 fund. 14 A hedge fund is going to look at an opportunity 15 where they look at less risk and they're going to look at the 16 greater the reward, which is they're going to vary their size 17 with respect to the opportunity. So the greater the 18 perceived market inefficiency, the larger they can 19 participate in the marketplace. 20 A normal investment where somebody buys something, 21 the general risk management is time and that -- so in a hedge 22 fund where the difference is every position that is taken, 23 usually before you take that trade you have an exit point. 24 So you have an entry and an exit and you can measure that 25 risk. Most other types of investments that are long only, 1 you get in but you don't have a notion of where you're going 2 to get out. 3 So oftentimes it's perceived that hedge funds may 4 be more risky but the fact that they're taking risk 5 management by actually trading is actually the most effective 6 risk management strategy that there is because in the 7 investment world, if you live, you win. And so the key here 8 is not to have an ego but to say I've tried this position, it 9 hasn't worked, now I'm going to get out. 10 So you want to turn that upside down, versus if I 11 buy something and it goes down 15 or 20 percent, well, I 12 liked it there, it must be better here. That may be true. 13 And that all works great until the one time when it doesn't 14 work and then you lose all your money and then you're not in 15 business. 16 So that's why I say you want to spend your time 17 turning it upside down. 18 MR. BROWN: I think it's useful to compare hedge 19 funds to stocks. There are roughly 6,000 hedge funds and a 20 comparable number of exchange trade stocks. Now, I recently 21 looked at the median volatility of a hedge fund is and the 22 medium volatility of stock. By volatility, referring to 23 standard deviation here. 24 The median volatility of a hedge fund is half the 25 median volatility of a common stock. The volatility of a 1 fund to funds recently is more like a quarter of the 2 volatility of the S&P 500. So just in terms of an objective 3 measure of risk, hedge funds are significantly less risky. 4 They came out of the collapse of the dot com bubble 5 relatively unscathed and this explains why a number of 6 universities, institutions and even retail investors are now 7 eager to get into hedge funds. They've sort of woken up -- 8 back five years ago everybody was making money going long and 9 they've now woken up to the fact that risk matters. 10 And I suppose that's part of the reason there's 11 attention to hedge funds now because so many people want to 12 get into them. There's concern about hedge funds increasing 13 volatility in the market, causing things to be risky through 14 use of derivatives and shorting. 15 But the hedge funds that I know about, they use 16 these derivatives and short selling -- maybe not Jim here -- 17 to control risk and that strikes me as a good thing. 18 I think I'll stop there. 19 MS. NAZARETH: Larry? 20 MR. HARRIS: We've been talking about two different 21 types of risk this morning already. Talking about the risk 22 associated with investment in a hedge fund. We're also 23 talking about the risk associated with the strategies that 24 hedge funds employ and their impact upon the market as a 25 whole. I want to talk about that second type of risk and its 1 relationship to transparency. 2 Our fear -- not the SEC but sort of throughout the 3 economy -- is that there might arise a circumstance when 4 everybody decides to do the same thing but that people are 5 not aware that everybody else is trying to do the same thing. 6 So some circumstance arises where everybody wants 7 to get out of the market at the same time but they don't know 8 that everybody else wants to and that in trying to exercise 9 that strategy without the knowledge that other people are 10 going to do it as well, we're afraid that that would possibly 11 drive the market down in a way that wouldn't be acceptable 12 and certainly would not likely happen if everybody knew about 13 everybody else's strategy, since certainly if everybody knew 14 that everybody else was going to do it they'd realize that 15 they couldn't do it and that therefore they would arrange 16 their affairs differently. 17 That's something similar to the scenario that we 18 saw in the '87 crash and many people believe that that was a 19 significant determinant of the '87 crash. Now, the question 20 is what relation should our fears about that kind of scenario 21 have to do with hedge funds in general and the transparency 22 of their operations. 23 I'll note that the types of mistakes that I just 24 described are not likely made by the most sophisticated 25 traders in the markets. The most sophisticated traders in 1 the market spend a lot of time thinking about what other 2 people do because they profit only when other people make 3 mistakes. 4 And so when they're successful, they're successful 5 not only because they've got a good idea but they have a good 6 understanding about the mistakes that other people make. As 7 a consequence, the more sophisticated traders in the markets 8 try to be as aware as possible of what's happening so that 9 it's unlikely that hedge funds are going to be the ones who 10 are going to collectively fall into the mistake that I've 11 just described. 12 If there are mistakes like this where collective 13 action leads to problems that individuals wouldn't have 14 anticipated because they didn't take into account what other 15 people would do, it's more likely going to happen among 16 people who are less sophisticated. 17 To the extent that these things do happen, though, 18 there are tremendous opportunities to profit from it and the 19 hedge funds, among other sophisticated investors, are going 20 to be the first to stand on the opposite side of it and step 21 in. 22 Just the same, we do have concerns about 23 transparency that if there were only more transparency, it 24 might be easier for other people to see what other people 25 intend to do and then respond to it or plan their affairs 1 accordingly. My -- I'm a little bit concerned about imposing 2 too much transparency on informed traders of any type because 3 the effect of imposing transparency on their operations is to 4 ultimately make their operations less profitable. 5 Now, I'm not particularly interested in the profits 6 of informed traders in the sense that I care about them as 7 traders, but I do care a lot about the research that those 8 profits support. 9 The research that the informed traders undertake to 10 become well informed is the -- provides them with the 11 insights that allow us to -- allow them to understand what 12 valuations should be in the market. And as was described 13 very eloquently by Peter Brown, the acting on those insights 14 is what makes the prices more informative and informative 15 prices are the -- are essential to the efficient operation of 16 our economy. 17 So if we ask for more transparency, we may obtain 18 better control over the systemic risk that we've just talked 19 about, but the control won't be quite as effective as it 20 might be -- that is to say that the systemic risks that we're 21 concerned about have to do with the less informed traders 22 than the better informed, sophisticated traders. 23 But if we ask for too much transparency, we 24 decrease the profits that hedge funds and other sophisticated 25 traders can make. Most of those profits, in one form or 1 another, go to compensating the collection of information and 2 the collection of that information ultimately goes into 3 prices and produces more informative prices that are used 4 throughout economy to better manage the use of our resources 5 and ensure that resources are allocated to their highest use 6 to ensure that CEOs and CFOs are compensated in a way that is 7 proportionate to their contribution to the management process 8 and so forth. 9 That's an overview of some of the systemic issues. 10 MS. NAZARETH: Okay. Thank you. I think I'll call 11 on Bill Heyman next and then I'll Mark Yusko and Andrew Lo to 12 be thinking about whether they can comment both on explaining 13 to us so we can better understand why hedge funds can be less 14 volatile, which is certainly not their -- I think is commonly 15 understood and Andrew maybe you can talk about the risk and 16 return with hedge funds. 17 MR. HEYMAN: Following up on some of the things 18 Larry said, the issue that seems to be posed for this panel 19 is are hedge funds good or bad for the market. I don't like 20 to use words good or bad in describing markets but the press 21 seems to use it. 22 I think that issue can be discussed on a number of 23 levels. The first level I think is are hedge funds users or 24 providers of liquidity. I've seen literature that assumes 25 that anyone participating in a market is a provider of 1 liquidity. In fact, I saw a brief from the Justice 2 Department in the mid-'90s that suggested that traders were 3 providers of liquidity. 4 But in reality, there are two classes of market 5 participants; people who are net providers of liquidity and 6 net users of liquidity. And although it's a generalization, 7 I would say that most of the time for most of their 8 strategies, hedge funds are net providers of liquidity. In 9 merger arbitrage, in investing in distressed securities, they 10 are more or less the only buyers from natural holders of 11 securities which, by virtue of events, pass into those 12 spheres. And, indeed, when hedge funds in those areas turn 13 sellers, there are no natural buyers. 14 So, I recall cocktail parties in the '80s where I 15 tried with a straight face to discuss the social utility of 16 merger arbitrage since that's what I did then but in 17 hindsight, I shouldn't have been so bashful. And as Larry 18 said, if -- transparency can certainly be considered but it 19 will come at a cost and the cost will not rest where 20 regulators suspect it will rest. 21 In the end, providers of liquidity who are saddled 22 with increased costs will attempt to pass them on and they 23 will pass them on to natural investors and that's I think 24 something to consider as one parses through these questions. 25 MS. NAZARETH: Thank you. Mark? 1 MR. YUSKO: Well, I think a number of things 2 related to the whole construct of risk are important to 3 highlight. One is, it depends on your definition of risk how 4 risky these strategies are in a portfolio. If your 5 definition of risk is volatility of returns, then as Peter 6 said and as Andrew I'm sure will comment on, and others have 7 shown, these strategies are significantly less risky if you 8 just take strict volatility of returns. 9 And to me, the way we think about risk is risk is 10 like energy. It can change form but it can't be eliminated 11 so you can't say that there's less risk, per se. You just 12 change the form from market risk or beta risk to stock 13 selection or alpha risk. And when we look at investing -- 14 and roughly 55 percent of our endowment is invested in "hedge 15 funds". 16 I hate the term hedge funds, one, because A.W. 17 Jones had a D on the end, it was called hedged fund when he 18 formed it in 1949 and most managers today -- because -- 19 somebody said there were 6,000 funds. I claim there are 24 20 because we've met all 6,000. They're all in the top quartile 21 so somewhere -- the bad fund's out there but we've never met 22 any. 23 (Laughter.) 24 MR. YUSKO: So the issue is that a lot of the 25 strategies have nothing to do with hedging. They have to do 1 with arbitrage. They have to do with taking advantage of 2 market anomalies. Yet there are some strategies in our 3 portfolio where the exposure is a hedged, with a D, equity 4 exposure that has reduced the volatility and the risk of loss 5 and has allowed our fund to preserve capital over the last 3 6 years where the average endowment fund has lost 8 to 10 7 percent a year for 3 years. 8 So if you think of risk as risk of loss, so going 9 to zero, there is some additional risk in this world of 10 strategies because of another tool that's used, not because 11 of the strategy but because of the tool used of leverage. 12 Leverage can be very good and it can be very useful. And in 13 fact, leverage plus short selling actually reduces risk -- 14 back to A.W. Jones. 15 But leverage in its worst form -- let's take a 16 house today. Housing market. There are loans being made at 17 125 percent of value. Loan to value of 125 percent. Well, 18 if you then lost your job and were forced to sell, you've now 19 used leverage to take away 100 percent of your equity. 20 You've got a hundred percent loss. 21 And that can happen and has happened in this 22 business as funds have blown up, although the number of 23 blowups -- I find this kind of interesting -- compared to the 24 number of funds and the dollars in management is much lower 25 than the wealth that was destroyed by the money that flowed 1 into the mutual fund industry at the peak. 2 My favorite stat is 85 percent of all the money in 3 tech mutual funds came in after January 1, 2000. That's a 4 very bad statistic because it means most of that money was 5 taken away. So it really depends on how you think about 6 risk. We define risk as not being able to provide inter- 7 generational equity between current users of the funds that 8 we spend and future generations. 9 So if we can't earn a real rate of return and if 10 you turn a dollar into 70 cents over the last three years, it 11 will take you decades to get back. If you can preserve 12 capital in the difficult markets by using a hedged strategy, 13 then we think that you're way far ahead. 14 One last piece is that we really believe that this 15 is really just a democratization or a disintermediation of 16 proprietary trading due to technology. The fact that you can 17 take a PC, even a handheld today, and have as much computing 18 power as Wall Street had 20, 30, 40 years ago, you used to 19 have to sit inside a Wall Street proprietary trading desk in 20 order to do these strategies. 21 Goldman Sachs was built around risk for arbitrage a 22 hundred years ago, so this strategy has been going on a long 23 time. It's not new, they're not novel and you have to focus 24 on the exposure as opposed to calling this an asset class. 25 It's the exposure, stocks and bonds and maybe some derivative 1 exposure. 2 MS. NAZARETH: I'll ask Andrew and then Bob Steel 3 to tell us about the Goldman experience. 4 Go ahead, Andrew. 5 MR. LO: I guess I'd like to start by pointing out 6 that there are two aspects of risk that need to be focused on 7 and I think they're distinct aspects. One has to do with 8 risks associated with the hedge fund investments themselves, 9 and I'll talk about that in a minute, and then the second has 10 to do with systemic risks that hedge funds in general impose 11 on the financial system. I think those are different and 12 need to be looked at somewhat separately. 13 With regard to the first kind of risk, I think it's 14 pretty clear from the comments from the other panelists that 15 in fact there are many different kinds of risks, that risk is 16 not a univariate concept. And that's part of the problem 17 with dealing with hedge funds is that there are so many 18 different types of risks. 19 I want to go back to a question that was posed by 20 Commissioner Campos yesterday. He asked I think quite 21 perceptively if it's the case that hedge funds are less risky 22 and have higher returns, why shouldn't we let everybody have 23 access to them? And I don't think that there was an adequate 24 answer given. I think a number of people tried to make 25 arguments about why you might not want to let other retail 1 investors have access, but I think there's a very simple 2 answer. 3 The answer is that hedge funds are more risky. I 4 know that that sounds rather surprising to some but the fact 5 -- if there's one lesson that we've learned from modern 6 financial economics it's that there's usually a relationship 7 between risk and expected return. And we know that hedge 8 funds have yielded higher expected returns than many other 9 investments. As a result, you would expect that they would 10 have higher risk in one form or another. 11 Now, I do agree with Peter and Mark that looking at 12 volatility as a measure of risk, for most hedge funds 13 volatility is quite low. But the same can be said for lots 14 of other things that we would all regard as risky. For 15 example, think about an insurance company that insures 16 earthquakes. If you take a look at the returns on those 17 kinds of companies, you'd find that they have very low 18 volatility, very high sharp ratios except every once in a 19 while, in the parlance of Wall Street, you have your face 20 ripped off. 21 (Laughter.) 22 MR. LO: Now, there's nothing wrong with that kind 23 of risk and there are many investors who are perfectly 24 capable, interested and delighted to take on those risks, 25 thank goodness. But the fact is it's a different kind of 1 risk that's not adequately measured by volatility. 2 And so with all of the various different hedge fund 3 styles that we've spoken about, each one of these styles 4 carries its own unique kind of risk that can't adequately be 5 measured by volatility. Now, if you think about trying to 6 explain that to unsophisticated investors, you quickly see 7 the problem. 8 Most people have a hard time figuring out how to 9 get the blinking 12:00 to stop on their VCRs. 10 (Laughter.) 11 MR. LO: How do you explain to them the various 12 subtle kinds of risks that different kinds of hedge fund 13 strategies pose? I think this is an area where the SEC can 14 actually have a very big impact in the area of risk 15 disclosure and investor education. And one of the main 16 thrusts that I think that the SEC might consider is gathering 17 data. 18 One of the most important aspects of any kind of 19 research effort at understanding risk is to start with the 20 data. One of the reasons that there's been so much academic 21 research over the past few years in hedge funds is because we 22 now relatively recently have had access to hedge fund data. 23 The SEC chief economist Larry Harris's pioneering work on 24 market microstructure would have been impossible without 25 data. 1 And so I think that the SEC is in a unique position 2 to put together a data set that currently doesn't exist, data 3 that will not be generally and publicly available, but data 4 that will allow the SEC to get a much better handle on the 5 kind of risks for each of the hedge fund styles that we see. 6 COMMISSIONER GLASSMAN: Can I interrupt with a 7 question? Yesterday I asked a question about rate of failure 8 and the answer was essentially -- my understanding was there 9 really aren't that many hedge funds that fail. There are a 10 number that close but with no loss of principal. So what I'm 11 hearing you say is there are some spectacular failures. Are 12 there very few of them but they're just spectacular? Is that 13 what's -- 14 MR. LO: Exactly. I think that gets to my second 15 point about the systemic risk that hedge funds pose to the 16 financial system. 17 The fact is that it's true. There are very, very 18 few spectacular failures but then, again, there are very, 19 very few spectacular earthquakes. Each one of them is fairly 20 significant and I think we can learn a great deal from these 21 kinds of failures. 22 So this gets to my next point. I guess when a 23 hedge fund fails -- in fact, in 1998 when LTCM failed, one of 24 my colleagues said well, let's see -- you know, we had a 25 whole bunch of rich investors that lost their money. So 1 what? Who cares? 2 The who cares part is the fact that the failure or 3 the near-collapse of LTCM at least at that time seemed to 4 have threatened the integrity of the financial system and 5 that's an externality that I think the SEC is also in a prime 6 position to address. And I guess what I would suggest maybe, 7 an interesting alternative to the way that these kinds of 8 failures are handled right now, is to take the path that the 9 federal government is taking with respect to airplane 10 crashes. 11 In particular, we have an organization called the 12 National Transportation Safety Board that's charged with 13 responsibility for investigating every crash that occurs. 14 These are the folks that end up at the crash site, they look 15 for the black box, which may be appropriate for hedge funds 16 as well, they collect data, they analyze the data, and 17 ultimately they file a report that describes what happened 18 and makes recommendations as to how to improve the system. 19 Since 1967 when the NTSB started, they've 20 investigated 114,000 incidents in aviation alone. Now, there 21 haven't been 114,000 airplane crashes but any accident they 22 investigate they file a public report. And just to bring 23 home the point, I think many of you are probably aware that 24 icing on the wings of airplanes is not such a good thing. 25 Well, the reason that you know this, the reason 1 that we're aware of this is because on October 31, 1994, an 2 American Eagle flight 4184 crashed and the NTSB filed a 3 report shortly thereafter observing that ice accretion was 4 responsible for the crash. 5 And so the hope is that with systemic risks, 6 although those risks are very rare and not something that 7 fills our daily attention, that's the kind of thing that I 8 think the SEC is prime to be able to collect the data and be 9 able to analyze. 10 MS. NAZARETH: Thank you. Bob? 11 MR. STEEL: Thanks, Annette. It's great to be here 12 in the middle. I've learned that Gus Levy was recognized 13 today as having built our firm on risk arbitrage, which he'd 14 be pleased to know, and also I found out that you can change 15 the 12:00 on your VCR, which I didn't know. 16 (Laughter.) 17 MR. STEEL: I guess, Annette, that there are a 18 couple of things that I'd add to the conversation, I hope. 19 One is that I think something that maybe hasn't been said 20 clearly is that there is risk of the strategy when you invest 21 in hedge funds but by nature the limited partnership has 22 certain characteristics, too, that are of a risk that people 23 choose to accept or not accept. 24 There's less liquidity, there's the potential to 25 lose all your capital, and so that's a different form of 1 risk. Especially someone like Mark who basically is 2 investing in perpetuity as an endowment or he's really 3 investing for future generations and the goal is to protect 4 the purchasing power, but there isn't the near-term liquidity 5 needs. 6 The fact that he can be comfortable putting 55 7 percent of his portfolio, as I understood, into limited 8 partnership-type investing is consistent with his ambition 9 but it isn't for everyone else. And so I think that's a 10 different type of risk that you have to think about. I think 11 it steers into another issue that you'll get to later in 12 terms of appropriateness of investing and I just would like o 13 make that point. 14 To add to something Bill said, I think when you sit 15 inside our firm, what's fascinating to me is when there's a 16 sudden change in the nature of a security, which Bill alluded 17 to. And that is that on Monday a stock closes at 20 and 18 people are valuing it because of the long-term prospects. At 19 4:15, someone makes a bid for the security at 30 and the 20 stock opens on Tuesday morning at a new price. 21 It isn't a stock trading at 20 being valued on its 22 long-term fundamentals. It's a security that's valued at 27 23 where professionals are estimating what the odds of closing 24 are, what the antitrust issues are, and how long it will take 25 and whether you can borrow the security and set up the hedge. 1 And all of a sudden, the nature of investor changes 2 instantly and the arbitrager who comes in provides liquidity 3 to the people who previously owned the security at 20 with a 4 long-term ambition and have stepped into new shoes that have 5 new risks and new characteristics of risks. And that orderly 6 transfer of holders, given the change in the security or the 7 change in the situation, is something that occurs every day 8 and I can't imagine how that would happen -- and that the 9 previous holder would then be assuming risk they weren't 10 qualified or prepared to understand or to take into those 11 shoes. 12 And so I just thought of that and wanted to add 13 that to a point Bill was making. 14 I think to comment maybe briefly on Larry's point 15 -- well, on Andrew's points more, that looking into this 16 issue of systemic risk, at Goldman Sachs we have a business 17 of prime brokerage where we have about $125 billion of hedge 18 fund equity and so we look at this very carefully and we can 19 talk about how we look at it maybe later. 20 But I think that when we look at the amount of 21 different strategies going on and the amount of correlation, 22 I think the thing that is pleasing to us and would be 23 systemically is the fact that it seems as though there's not 24 much and that people are all doing different things, they're 25 all looking at all the different information and pursuing 1 different strategies that we don't see as much correlation as 2 you might think. 3 Andrew is correct that there is that earthquake 4 opportunity that we sure think about when we analyze the 5 securities because those are the equities off which we loan 6 money and we're the first line of defense. I think the issue 7 that Andrew raised -- he mentioned the other day when we were 8 discussing the panel -- of the transportation analogy is a 9 good one and I think that is something that I would encourage 10 us to think about. 11 The idea of a regulator stepping into the shoes to 12 decide and to analyze, quantify and then potentially make 13 decisions about the systemic risk as it builds, ebbs, flows 14 seems to be a tricky slope to start on but I would be 15 interested in other people's comments on that point. 16 MS. NAZARETH: Could I ask you about -- and perhaps 17 others here have some experience as well -- whether you think 18 that the practices in the industry after long-term capital 19 management improved in any way? I mean, obviously there were 20 some lessons learned. 21 We may not have had the kind of post mortem that 22 you would with a plane crash, but there certainly was a fair 23 amount of work done including work by the President's working 24 group and the counter-party risk management policy group I 25 thought had some very important recommendations. 1 Do you think that there have been improvements in 2 risk management by counter-parties since that experience? 3 MR. STEEL: I think the good news is that if you 4 look at the work and the 20 suggestions that came from the 5 counter-party risk management group, that there have been 6 lots of improvements. 7 I think the bad news is that not everybody -- there 8 isn't kind of a way of measuring who is getting in line and 9 who isn't on that and so everybody is applying these things 10 at their own speed in their own way. They are 11 recommendations and so I think from our perspective, I know 12 we sure take them seriously at the different levels where we 13 analyze our risk. 14 But I think the challenge is to -- we sometimes 15 have the tendency, we've seen in lots of situations, where 16 the lowest common denominator seeks a commercial advantage 17 and that would be systemically challenging. 18 So the answer would be successful articulation and 19 some degree of improvement but we could always do more. 20 MS. NAZARETH: I want to call on Will but I also 21 want -- I'm sure you have a number of things to say. One of 22 the things I was curious about as well was, again, following 23 up on something Bob said. 24 You know, when you're managing risk, one of the 25 issues again that I think came up in long-term capital 1 management was the sense that an awful lot of people were 2 sort of on the similar side of the market, there was a sort 3 of -- you worry about this herd mentality and that unwinding 4 positions can sometimes be substantially more difficult than 5 you anticipated if, again, everybody has got the similar 6 hedges and you can have more impact on the market than you 7 may otherwise have expected. 8 So it looks like that remark has inspired some 9 comments so let me call on Will and then I'll ask Bill to 10 respond to that as well. 11 MR. GOETZMANN: I could actually respond briefly to 12 that. You know, we're talking about events, systemic events 13 and so forth maybe caused by opinions, driven by models that 14 value securities but also we should consider systemic events 15 that are related to the institutions themselves. 16 Bob's firm, if it has 125 billion in hedge fund 17 capital flowing through it, is part of a system that can be 18 sensitive to interest rate shocks and the availability of 19 credit and other kinds of things, so that as we have -- as 20 the industry has moved from what almost seems a series of 21 little shops to a broader more -- something with real 22 foundations in the largest financial institutions, we should 23 consider the broader system beyond the hedge funds themselves 24 and the trading itself to the institutions that support them. 25 The point I wanted to make is that hedge funds are 1 absolutely vital to the operation of the markets. You 2 couldn't have markets without people serving in the role that 3 a hedge fund serves in terms of arbitraging these 4 opportunities. But they are marginal in two important 5 senses. 6 Hedge funds will never be the dominant form of 7 investment in a market. Mark's fund will never put 90 8 percent of its investment in what we would think of as a 9 hedge fund that seeks to exploit mis-pricings in a market. 10 As hedge funds have grown, especially because the returns 11 look attractive, we have to ask why these strategies have 12 attracted money and how can they continue to attract money. 13 Hedge funds -- their profits are driven by subtle 14 and fleeting mis-pricings that are captured by really bright 15 people working full-time to build sophisticated models to 16 measure them. And as such, they can't be sustained in a 17 market like ours, which is relatively efficient. 18 So inevitably, hedge funds are going to -- in some 19 sense, they contain the seeds of their own demise, especially 20 strategies such as M&A arbitrage and convertible bond 21 arbitrage where the returns have been a great challenge to 22 sustain over the last few years. 23 I think that's a good thing that this marginal 24 force in the economy has been there to serve us and step in 25 to support prices, step in to assert, if you will, 1 intelligently developed models of what securities should be 2 worth, but also it really shouldn't be considered a large and 3 dominating factor in an investment portfolio. So -- there 4 are limits to scale is the point I guess I'm making. 5 Now, the second sense of the marginality is 6 something that we've also talked about today which is hedge 7 funds being a marginal investor. That is, the investor that 8 effectively sets the price for a security and does so by 9 committing capital to an opinion about what the security is 10 worth. 11 It's very helpful to have a marginal investor that 12 is taking a stand with capital on a belief in the valuation 13 of the security and that's quite helpful to us. But as a 14 marginal investor, if the investor steps back -- if it 15 withdraws capital or has an abrupt change in the opinion of 16 what the value of the security might be, then the price will 17 change. 18 So inevitably, as hedge funds have served us as 19 marginal investors, they are bound to have some relationship 20 to price fluctuations. To the extent that they are trading 21 on important information, they will always move in price and 22 that can be helpful. And the few cases where it will not be 23 helpful are either if all the models are wrong at the same 24 time and everybody is trading on an idea that is just not 25 economically valid or if they're driven by expediency to 1 withdraw capital from a market and -- an example, a credit 2 crunch. 3 So those are the two times when the marginal 4 investor -- having these marginal investors can be a risk -- 5 systemic risk to the economy. 6 MS. NAZARETH: Thank you. 7 MR. HEYMAN: In discussing whether hedge funds make 8 the market a more dangerous or less fair place for other 9 investors, a couple people have alluded to the phenomenon 10 that occasionally everybody gets on the same side of the 11 boat. 12 I think there's a limit to which government ought 13 to worry about that; not that it shouldn't worry at all. 14 When I began in business, information basically seeped into 15 the market on a very unequal and probably an unfair basis, 16 and the result was less volatility and a better balance 17 between people wanting to buy and people wanting to sell. 18 In a fairer and more volatile world of instant 19 news, it is inevitable that there will be many times in which 20 everyone has the same opinion at once and there are quantum 21 shifts in investor preferences. 22 Government should not be concerned when that 23 happens unless it happens with such magnitude that it 24 threatens the systemic seizure and that is generally the 25 result of really outsized exposures which had all parties had 1 information, might not have happened. In the case of long- 2 term capital, what emerged -- and there really was a post 3 mortem in the press. 4 And in fact, in most large hedge fund blowups, 5 there are post mortem in the press. They may not have a 6 uniform style but everyone ends up knowing what happened. In 7 long-term capital, credit was being extended by a number of 8 regulated institutions. I think few knew what the others 9 were doing. The firm itself was able to receive this credit 10 without showing its own hand, something that probably 11 couldn't happen today. 12 So I think government's concern is legitimate at 13 the boundaries but to the extent that people say hedge funds 14 or any market participant make the market more volatile, 15 unless there's some inequity to which one can point, I think 16 government more or less has to watch that. 17 MR. LO: I'd just like to respond to a couple of 18 those points. The first is that I think volatility is a good 19 thing. I mean, in fact, typically when we teach about market 20 efficiency we argue that having a market that's volatile 21 means that there's a lot of price discovery information 22 transmission going on. 23 So the point is not to get rid of volatility. I 24 think that there's a distinction between market volatility 25 and the systemic risks that are posed by very, very large 1 catastrophic failures of a particular financial institution. 2 While I agree with you that there was a very 3 detailed post mortem, the President's working group on LTCM, 4 the fact is that that working group didn't really generate 5 any data for other people to study. It generated a few 6 recommendations, which were only recommendations. And this 7 was an unusual event that generated this kind of a post 8 mortem. There are lots of other events that I don't think 9 generate nearly the amount of post mortem. 10 Getting back to the NTSB example, I think one of 11 the reasons that people are so keen to learn from every 12 airplane crash is because the kind of information that we 13 glean from it has been paid for by the lives of the people 14 that are lost. And if we take that analogy to the financial 15 markets, many investors have given billions of dollars in 16 lost capital for what? I think what we'd like to be able to 17 do is to learn from it. 18 For example, while I think everybody is familiar 19 with LTCM and the facts surrounding that case, how many 20 people in the audience know the facts surrounding Laser 21 Advisors, Gotham Investment Management, Haifuku, Paramount 22 Partners? Each one of these cases contains a lesson and some 23 very important information for improving the financial system 24 and it seems to me that we ought to spend some time focusing 25 on those kinds of issues as well. 1 MR. YUSKO: Annette, one thing that -- I wish I had 2 a dollar for every time long-term capital was used in the 3 same sentence as hedge funds. And it's very frustrating 4 actually because actually I wouldn't have to work if that 5 were true and mostly it's very frustrating because long-term 6 capital was one of thousands of funds. And it was -- if you 7 actually go through the post mortem, 85 percent of the 8 investors in long-term capital made money. Only 15 percent 9 lost money. 10 Had they not given their equity capital back a 11 couple months before the widening of the spreads based on a 12 catastrophic event in Russian default, they would have been 13 able to meet their margin call and we wouldn't be having this 14 discussion. 15 So I think there's this overemphasis, particularly 16 in the financial press, on blowups which, if you actually 17 calculate the number of mutual funds that have gone out of 18 business since January 1, 2000, it's significantly, a 19 multiple of the number of hedge funds that have gone out of 20 business since January 1, 2000. 21 So I think there is this negative bias placed 22 around this industry that's really undeserved and if you keep 23 focusing on that and keep marginalizing the other issues and 24 the other risks -- for example, GE has been called the 25 biggest hedge fund in the world. Ford Motor Credit has 1 issues. GM Credit. There are lots of big European insurance 2 companies right now with much bigger prop books than most 3 hedge funds that are in desperate need of capital or 4 something bad is going to happen. Japanese banking system, 5 if we actually had the mark to market, what kind of mess 6 would that create? 7 So I think the size of this negative part of the 8 hedge fund business gets a disproportionate amount of press 9 and a disproportionate amount of commentary and I wish we 10 could talk about the Lone Pines and the Blue Ridges and the 11 Mavericks of the world instead of talking about long-term 12 capital. 13 COMMISSIONER GOLDSCHMID: Annette, let me ask a 14 question. How important is leverage to the hedge fund 15 strategy today, the various strategies? 16 MS. NAZARETH: Afsaneh? 17 MR. BORISH: I was going to mention another point 18 but on the leverage -- I'm sure others have a lot to say. 19 Really, I think what Peter said earlier, there are so many 20 different strategies -- there are some strategies when I was 21 at the World Bank, for example -- you know, I traded hedge 22 fund strategies myself which were totally unleveraged so you 23 could be trading totally unleveraged. 24 You could have -- there is a fund today which has 25 the same amount of leverage as long-term capital if you want 1 to call it like, you know, 400 times, and fixed income. But 2 it is very, very strategy-specific and also in certain kinds 3 of strategies it makes sense to have a certain level of 4 leverage, once, two times, three times, and others where, you 5 know, this particular fund says it's okay to have 400, 500 6 times. 7 Now, you know, we could debate that but essentially 8 they're saying they're really not leveraged because 9 everything is hedged against some other position. The 10 question is if something goes wrong in the documentation, 11 something goes wrong in the swap documents, well, yeah, the 12 systemic risk issues, which are really not hedge fund issues. 13 They are instrument related -- you know, that's a derivative 14 issue but I'm sure others have a lot more to say on this and 15 then maybe Annette will let me say something else. 16 MS. NAZARETH: You want to talk about the leverage 17 and then we'll get back to Afsaneh? 18 MR. BORISH: I'd like to respond to three speakers 19 briefly, if I might. On leverage, it's very important to 20 look at what you're leverage. I believe that an unleveraged 21 position in almost any dot com is more risky than a highly 22 leveraged position, say, in an indexed arbitrage trade. 23 Now, I also want to agree with Mark Yusko and 24 disagree with Andrew Lo. Too much emphasis is put on the 25 failure. If you look at stocks -- again, let's make the 1 analogy with stocks. Far -- even leaving aside WorldCom and 2 Enron, far more money has been lost in stocks that have gone 3 completely -- where everything has been lost, completely 4 bankrupt, than in hedge fund failures. Any hedge fund with 5 the return profile of the NASDAQ 100 would be out of business 6 today. 7 I also want to support Will Goetzmann where he said 8 that hedge funds contain the seeds of their own destruction. 9 Empirically you can see this. In the 1970s, a trained monkey 10 who happened to know the Black Shoal's formula could have 11 made a fortune betting on the mispriced options. 12 (Laughter.) 13 MR. BORISH: A couple decades ago, anybody who bet 14 that if a commodity goes up today it will go up tomorrow, 15 would have been living on the beach today. Another example 16 is index arbitrage. It's largely traded out. Any of these 17 strategies, very hard to make much money today because the 18 hedge funds and others have traded out these inefficiencies. 19 Today you have to concentrate on much more difficult to find 20 inefficiencies. 21 MS. NAZARETH: Afsaneh? 22 MS. BESCHLOSS: The other points I wanted to make 23 related to some of the things Peter just said and others have 24 said a little earlier. And I think one thing that's actually 25 interesting, we talked about risk, we talked about volatility 1 today. As Peter said earlier, volatility in many hedge fund 2 strategies is actually lower at the hedge fund level and then 3 if you take a fund to fund, which is diversified, even lower. 4 So in fact if you look for investors at the risk -- 5 you know, they went into hedge funds with a certain 6 understanding of how much risk they wanted to take overall in 7 their portfolio. In most cases, you'll find that that risk, 8 if measured by volatility, is actually lower. I think 9 something that is going on, which is interesting in hedge 10 fund industries, hedge fund managers themselves are measuring 11 their own risks better but at the same time maybe becoming 12 risk averse. 13 I mean, it's something that I would throw in this 14 debate. Are hedge fund managers taking the risks that they 15 are paid to take? 16 MR. BORISH: They have their money. 17 MS. BESCHLOSS: Exactly. They have their money, as 18 Peter said, in there. The other thing I think is that again, 19 when we go sort of at the microlevel and we look at risk, 20 you're really looking at -- when you're putting together a 21 portfolio of traditional managers and hedge fund managers and 22 how uncorrelated these hedge fund managers are to the rest of 23 your portfolio, and at the end of the day, most of the 24 portfolios I've been familiar with, hedge funds strategies 25 have reduced risk by being uncorrelated to the stocks and 1 bonds as Peter was saying. 2 The other thing is, again, when we talk 6,000 hedge 3 funds, and you asked are there lots of failures -- are they 4 small failures, I go back again to Peter's example. Just 5 like with stocks, just like with really any other instrument, 6 when we say 6,000, it's sort of a meaningless number because 7 in that data there are a lot of people who come in and out 8 with one or two million, they don't survive, they don't blow 9 up, they don't destroy anyone else's money. They just go in 10 and out of that sample. 11 And when I look at samples, it's more like a 12 thousand -- you know -- between 500 and a thousand that you 13 sort of take seriously in this industry and I think it goes 14 back to the subject which is really being discussed yesterday 15 and today. Investors, especially I think when it gets to 16 retail investors, do they really understand the risks and do 17 they understand the strategies? 18 If you don't understand broadly what the strategies 19 and broadly -- not in great detail -- what the risks are, 20 should you be investing at the retail level, which goes back 21 to the issue of whether you need to be the more sophisticated 22 endowment or public pension fund or sophisticated individual 23 to be able to invest in this. 24 But I think the most important point at least for 25 me is what Robert Steel said. Coming back to the prime 1 broker issue, at the end of the day, if we look at any 2 systemic risk issue, you know, I think a lot of us in this 3 room have gone through all the -- years and years of 4 discussing systemic risks and derivatives. I think there 5 were all the committees, I was involved in them and at some 6 point huge amounts of discussion went into systemic risks of 7 derivatives and how they would block markets and we would, 8 you know, all die. 9 (Laughter.) 10 MS. BESCHLOSS: And I think we're still alive. But 11 the issues go -- I think it would be interesting in the hedge 12 fund industry to look at that issue of systemic risk as we 13 studied it with regard to derivatives and I think when you 14 come down to it, it was the banks who provided credit to, 15 let's say, real estate. Had we done a better job at looking 16 at the risk at the level of prime brokers, I think the LTCM 17 issue might have been handled slightly differently. 18 So I would go back and say, number one, that maybe 19 what we need to be doing, one is what level of government 20 regulation you need but I think more importantly, what should 21 the prime brokers be doing, singly, as individual prime 22 brokers, jointly as a group. 23 And then I would add to that. If we put a lot of 24 extra regulation on U.S. prime brokers, what is that going to 25 do? The business will go offshore over which we have no 1 control. So if there is a way to have some sort of 2 understanding with prime brokers groups not just with U.S. 3 banks but across the board where this -- any kind of risk -- 4 hedge funds are really not particular -- where anything that 5 we want to be looking at is controlled where it should be 6 controlled and is aggregated where it should be aggregated. 7 MR. BORISH: If I could just have one point, 8 talking about risk, most hedge fund documents have a self- 9 preservation criteria in there which is if you lose 50 10 percent of your capital, they close or they stop trading or 11 they give the investors an opportunity to redeem their 12 capital. 13 So unlike a situation where if you buy a stock and 14 you get paralyzed and you don't know what to do and you hold 15 it and then it goes bankrupt or you lose everything, almost 16 hedge fund document I know has a point at which if you lose 17 money they stop trading. And some it's 35, 40 percent but 18 generally it's 50. 19 CHAIRMAN DONALDSON: Annette, I'd like to ask a 20 general question of this particular panel, and it goes 21 something like this. There are, as we all know, well 22 advertised figure of $600 billion of hedge fund money out 23 there. You just have to sit here for a few hours and listen 24 to all the knowledge that is resident and the people that 25 have been talking about it. 1 My question is there's a cost-benefit analysis from 2 the point of view of the SEC as to how much cost do we 3 possibly incur to the hedge fund industry in order to deliver 4 for us the right to go in and continually monitor and follow. 5 Is it worth it? How much cost are we willing to put onto 6 this industry, to a $600 billion industry, in order for us to 7 be able to have the right to go in and continually monitor 8 it? 9 Is there any view on this? Can this industry 10 sustain the cost in order for the greater good of the public 11 knowledge base of this agency? 12 MR. BROWN: I have one brief comment. I believe 13 that the SEC and regulators benefit enormously. If you just 14 look at what hedge funds pay in Section 31 fees, it dwarfs 15 the cost of the regulation. So I think the SEC and the 16 government is coming out way ahead on a cost-benefit 17 analysis. 18 (Laughter.) 19 MR. GOETZMANN: I'd be happy to answer that since I 20 have nothing at stake whatsoever in this issue except as a 21 taxpayer. I think that the process is underway now of 22 generating information and costly information but that 23 process is being separated. The big funds are doing one 24 thing and the small funds are not doing it. 25 And the process involves increasing auditing of the 1 procedures. You know, we talked a little bit about blowups 2 and how safe the hedge fund industry really is, but most of 3 the blowups in the hedge fund industry have been operational 4 catastrophes that probably would have been avoided had there 5 been more auditor attention and auditor ability to 6 investigate the procedures for trading that were used. 7 So I think that that's money well spent. And it 8 may not be money that -- it's certainly money that the major 9 hedge funds are investing in at this point, not just in terms 10 of engaging auditors and in seeking to comply with the 11 requests but also developing statistical systems, however 12 imperfect, to try and gauge their own measures of risk. 13 So I think that one of the dangers for the SEC is 14 that you would achieve rapid and total transparency and you 15 would have truckloads of paper being backed up to the doors 16 here full of all the trades and so forth, so it's a cost both 17 ways, not just for the funds but for us to go through and try 18 to reconstruct the activities. 19 But relying on this intermediary, the accounting 20 profession to provide some risk control measures without 21 disclosure of strategies to the public I think is a helpful 22 direction to go in. 23 COMMISSIONER CAMPOS: Moreover, we were told 24 yesterday that 70 percent of hedge fund managers are already 25 registered investment advisors so we already have a large 1 stake, apparently. Granted, that doesn't give us all the 2 compliance and examination that we might otherwise but it 3 seems to me we as an agency are already well into that and we 4 were told that that's attractive to be a registered 5 investment advisor if you want institutional moneys as a 6 manager. 7 So there's already an economic incentive at least 8 to exceed and to allow a certain amount of regulation. 9 Now, I have another question if we're in a position 10 to go forward on that, and we can come back to it. 11 It seems to me that -- we've had a tremendously 12 sophisticated discussion about risk and alphas and betas and 13 the moving -- the opportunity costs and all that. And then 14 there seems to be a gee, you know, sort of patting ourselves 15 on the back where we're the smart people of the world and 16 it's really difficult for those out there on Main Street to 17 understand risk and understand how complicated all this is. 18 And, you know, it's easy to do that when we get 19 together with highly educated people and people who 20 understand their professions that well. But I ask myself -- 21 and in terms of the risk aspects of it, how clear is it to 22 the retail investor the risk that they're taking when they go 23 long and naked without any amount of -- I mean, is that risk 24 being appropriately communicated and indicated to people? 25 And instead, what we have is we seem to have a two 1 class system. We seem to have those who have access to your 2 intelligence, your professional research and so forth, who at 3 least hedge or have hedged situations as was said a minute 4 ago. And we have the retail public that doesn't seem to have 5 access to these sorts of strategies, whether it be through 6 your industry or through existing mutual fund industry. 7 So, as an agency, should we care about that? I 8 mean, is it simply a caveat emptor world, and let the guy who 9 doesn't know any better be long on a big cap fund and 10 whatever happens happens? And even if they apply the 11 existing mantras of diversification in these last three 12 years, they're still going to lose because, you know, they're 13 30 percent in equities and you're 70 percent in fixed income 14 and you're losing 30 percent in your equities, you're not 15 going to make money, you know. 16 And then there's a time cycle. There's not enough 17 time for some of these people to come back and ride whenever 18 the next bull market comes. 19 MR. HEYMAN: Can I try that one? First, whether 20 it's clear to -- whether the risks of going along are clear 21 to retail investors, I'm sure they're a lot clearer than they 22 were a few years ago. 23 (Laughter.) 24 MR. HEYMAN: With respect to the second question, I 25 think it's a very simple question to the debate before this 1 two-day session. Certainly hedge fund strategies, again, 2 generalizing, over the last four or five years in which a lot 3 of equity values were destroyed, delivered on a significant 4 part of their promise and that was the promise that they 5 could preserve capital in poor climates for financial assets. 6 Obviously, some in the industry would support going 7 in the direction of raising the bar in terms of 8 qualifications of investments as a tradeoff against less 9 regulation. On the other hand, that does have the effect of 10 government saying to investors who can't meet that bar, the 11 new bar or the previous bar, that we're going to make it more 12 difficult or perhaps even impossible for you to accomplish 13 something that would have provided you with great protection. 14 Now, who knows going forward how true any of that 15 will be? We always fight the last war but in terms of 16 equity, for the conclusion to be reached that the solution -- 17 if there's a problem that needs a solution, which can be 18 debated -- is to simply prevent hedge fund strategies from 19 being accessible at lower ends of the food chain is probably 20 not a fair result. 21 MR. ROYE: I couldn't agree more. In fact, this is 22 one of the central issues that we think about all the time 23 and we've been approached by our alumni, by others who look 24 at the performance of the fund, particularly the low 25 volatility of the fund are attracted to it. 1 And I hope that this is not too offensive to too 2 many wealthy people but wealth is not an indicator of 3 investment intelligence. Usually that wealth was created in 4 many other capacities and I find it very frustrating as an 5 individual investor who just barely made it to qualified 6 status a couple years ago -- 7 (Laughter.) 8 MR. HEYMAN: Still there? 9 MR. ROYE: Yeah, still there. Cash. Cash is a 10 good thing. 11 (Laughter.) 12 MR. ROYE: And it's been very frustrating to watch 13 the best strategies, the best managers, who have migrated out 14 of the traditional world. Real story. Group at Putnam, 15 Putnam International Voyager, had an investment in there, in 16 a 403(b), was doing great. Last August it started to go 17 down, didn't think much of it, everything was going down. 18 So I met these two guys at a hedge fund conference 19 in January and we got chatting and they talked about what 20 they were doing, starting a hedge fund and where were you, 21 we're at Putnam, well, what did you manage? We managed the 22 Putnam International Voyager Fund. When did you leave? In 23 August. Who replaced you? A 29-year-old that had worked for 24 them for a couple years. And nothing against 29-year-olds; I 25 was one not too long ago. 1 (Laughter.) 2 MR. ROYE: It really does matter to me, I think, 3 that the perception of risk has blocked access to the people 4 who need it most. The perception was if you had a lot of 5 money, you could afford to be in risky strategies where 6 there's risk of loss. What I think we've seen now in the 7 bear market is that it's the exact opposite. If you don't 8 have time to get that money back, that you're in real 9 trouble. 10 And making these strategies accessible to others I 11 think will be very, very positive. In fact, if you look at 12 Richard Thayler's work, the problem in investing, 13 particularly in the defined contribution area which is 14 another whole bottle of worms or can of worms I don't want to 15 open up too much, but it's awful. 16 If there are seven options in your 401(k) or 17 403(b), five are stock and two are bond. The average 18 investor will have five-sevenths in stocks and two-sevenths 19 in bonds. If it's five bond and two stocks, they'll have 20 five-sevenths in bonds. And the elections they make on the 21 day they sign up in the HR office with nobody giving them any 22 advice are the same options they'll have forever. They don't 23 change. 24 So if you could have an arbitrage strategy which is 25 lower volatility, if you could have a long/short strategy 1 which is going to provide good upside in good markets and 2 protection in down markets, you'll decrease the volatility of 3 the overall portfolio. 4 And there's a great slide that I use with all of 5 our constitutes which shows that if you took the return on 6 the market of the last 30 years, about 13.2 percent, with 16 7 percent volatility, it turns a dollar into about four-and-a- 8 half dollars. 9 If you just reduce the volatility, don't increase 10 the return but take that volatility from 16 down to 8, you 11 end up with 7 in cumulative wealth. The reduction of 12 volatility is what matters, not increasing return. And these 13 strategies are all about getting rich slowly and compounding 14 wealth. So pushing that down as far as we can get it, 15 particularly because of the diversification benefits of a 16 thing like a fund to funds I think is critical. 17 MS. NAZARETH: Jim, do you have a comment? 18 MR. CHANOS: Yeah. I'd like to interject into this 19 argument the observation from my vantage point, running a 20 fund primarily from the short side gives a sort of unique 21 perspective to see people who are coming in to try to hedge 22 their portfolios. 23 And what I could respond to Commissioner Campos's 24 question, it really is almost a blunt answer but investors 25 almost, no matter what their sophistication, chase returns. 1 That has been our experience. We can talk a lot about risk 2 management, lowered volatility. I've seen it all and heard 3 it all from investors coming into my shop for 20 years. 4 But they chase returns and they will justify 5 putting money with you based on whatever model they want to 6 use. And I think to some extent retail investors have chased 7 returns more than perhaps more sophisticated investors, but 8 I've seen a lot of bonehead moves from sophisticated 9 investors at the top and bottoms of markets from our 10 perspective. So we're not going to save people from 11 themselves when fear and greed run rampant at various market 12 turning points. 13 Having said that, we recently have seen a number of 14 mutual fund companies come into our shop and talk to us about 15 partnering up, perhaps doing a joint venture. And I think 16 the interest is there and growing now to try to avail 17 themselves to various different techniques to hedge 18 portfolios. I'm not so sure it's going to be successful. 19 My sense is that one of their concerns is the PR 20 factor, for example, of taking short positions. We haven't 21 touched upon that in this panel yet but, you know, there are 22 some uneconomic arguments that people make about 23 shortselling, whether it's index arbitrage, whether it's 24 directional shortselling, whether it's fundamental 25 shortselling, that I think is keeping back some people in the 1 mutual funds complex from aggressively pursuing this or 2 rolling out products that are hedged. And maybe rightly so. 3 I don't know. We haven't discussed it yet. 4 But the point is that I think that intellectually 5 there is a sense afoot in that community that it needs to do 6 more and perhaps should do more with different strategies. I 7 think it's just beginning, however, and they're a little 8 uncertain. 9 MS. NAZARETH: Mike? 10 MR. LO: I just want to follow up on a couple of 11 comments that Mark made. I think it was a few years ago that 12 the former Treasury Secretary, Larry Summers, was giving a 13 lecture and somebody in the audience said if you're so smart, 14 how come you're not rich? And Larry retorted in his usual 15 way, if you're so rich, how come you're not smart? 16 (Laughter.) 17 MR. LO: And I think that -- so I would agree with 18 Mark that there really -- there isn't necessarily a 19 correlation between having a high net worth and having 20 investment intelligence. But the reason that high net worth 21 is part of the qualified investor's criterion is because if 22 you have a high net worth you can afford to lose a fair 23 amount of money. 24 So I guess what I would suggest, getting back to 25 Commissioner Campos's point, is that in changing the 1 suitability requirements, we might consider, in addition to 2 the high net worth criterion, to have some kind of an 3 educational criterion where investor education is I think the 4 ultimate answer. 5 I agree that it's important to have these kinds of 6 hedged products available to individuals, particularly for 7 retirement planning and building long-term wealth a little 8 bit at a time is exactly the right thing to do but getting 9 individual investors to do that and to feel good about doing 10 that is a very difficult task where investor education I 11 think comes in. So I think that's a really important issue. 12 MR. HARRIS: There's no question that there's an 13 element of paternalism associated with the qualified investor 14 status and that raises some philosophic problems. On the one 15 hand we say that, gee, who are we to be paternal? Let people 16 decide for themselves and they'll learn. On the other hand, 17 the history of this agency is one that P.T. Barnum would have 18 appreciated. Our commissioners every day, or twice or three 19 times a week, sit in enforcement meetings hearing cases of 20 situations that Jesse Livermore recognized from the turn of 21 the century. 22 How do we reconcile that? One way to reconcile is 23 to recognize that learning is very expensive and if we're to 24 say that people can go out and learn by themselves from 25 experience, that that's all we need to properly regulate the 1 market, so they get burned once, that's fine, that runs 2 counter to the notion that, gee, after you've learned, at 3 some point you're going to end up dying and your children are 4 not going to figure this out except by themselves. 5 And so I think there is some room for -- I don't 6 want to use the word paternalism but for benevolent care to 7 recognize that the cost of learning is very high. Now, 8 Andy's suggestion is very good but we want to do everything 9 we can to lower the cost of learning. 10 Let me give you an example of a very simple 11 situation that comes up in hedge funds that requires a fair 12 amount of sophistication to understand and folks that are 13 chasing returns, as Jim suggested, are not likely to have it. 14 So here's a problem that we learned yesterday. 15 We learned yesterday that the management and 16 contract in hedge funds is extremely important for aligning 17 people's interest. It rewards them for performing well. 18 There's 20 percent. 19 Many of you know -- and if you don't, you do need 20 to know this -- that if the manager of the hedge fund doesn't 21 have his own finger in the guillotine in the presence of 22 these contracts -- by finger in the guillotine I mean co- 23 participation -- that the optimal strategy for the manager, 24 who is not particularly concerned about the -- running down 25 their reputation -- the optimal strategy is to take as much 1 leverage possible because leverage produces volatility and 2 volatility gives you a 50/50 chance with these compensation 3 contracts of getting extraordinarily rich or walking away a 4 loser. 5 Now, if you're in a business that P.T. Barnum 6 recognizes and understands that there's a sucker born every 7 minute and that people will not be able to follow your 8 reputation if you're a good marketing person, then what we've 9 created is a situation that's very, very unattractive. So 10 the important message that people need to know is that it's 11 not acceptable to have these types of management contracts 12 without the co-participation. 13 So that was explained very clearly yesterday, but I 14 venture to say that if you grab people at random among the 15 investing population, very few people will first of all 16 recognize that the management contract will get us fantastic 17 incentives to take leverage to increase volatility in the 18 absence of the co-participation and that -- and very few 19 people -- even if they recognize that, very few people will 20 recognize the importance of co-participation. 21 So we have to educate people to this issue. But in 22 the end, we get back to the fact that as cheap as we make 23 education, it's still very expensive and do we want to live 24 in a world where we can allow a fringe to develop where 25 people who have great marketing skills can have access to a 1 sucker who is born every minute. And those are the types of 2 issues that the Commission undoubtedly will consider. 3 MS. NAZARETH: Harvey, did you have a comment? 4 COMMISSIONER GOLDSCHMID: Yeah, I -- following up 5 on that a bit, though, enlarging it, one concern about risk 6 for me in this area is the premise of hedge funds, if I 7 understand them, the unifying premise is to find market mis- 8 pricing, there have got to be only a limited number of 9 targets of opportunity. 10 As the Chairman indicated, as you've grown to 600 11 billion with maybe more coming, the targets of opportunity 12 have got to be limited, and is there risk that you're going 13 to reach too far in order to keep producing numbers you've 14 produced in a world where you just won't have the 15 opportunities out there? 16 MS. NAZARETH: Peter, do you have an answer? 17 MR. BORISH: Well, one point when people talk about 18 the growth of assets, and if you look at the relative amount 19 of assets in the hedge fund world relative to the long only 20 world and you look at targets of opportunity, you can make 21 the same argument that part of the reason was that there was 22 so much money coming into the long only strategy that there 23 was very few targets of opportunities and they were trying to 24 put a lot of money into that funnel. 25 So I find that over time growth in almost every 1 strategy continues to take place and that you will have good 2 managers and you will have bad managers, and that certain 3 strategies, as arbitrage and technology becomes more 4 efficient, the mean return will decline and that will 5 naturally take assets out of that strategy and move it into 6 another strategy. 7 But I think as the U.S. economy continues to grow 8 and the long only strategies continue to grow and fixed 9 income grows and real estate, there's much, much more 10 opportunity for this realm to grow as well. It's only a 11 problem if this area grows and every other area does not. 12 MR. HARRIS: Commissioner Goldschmid, the profits 13 that the hedge fund industry can make are limited as you 14 mentioned. They come from two sources. The first source is 15 the profits that they can make as well-informed speculators. 16 Those profits are determined by the mistakes that other 17 speculators and investors make and by the demands that other 18 people make on liquidity. And those are finite and of course 19 those are decreasing as people become better educated. The 20 good news for the hedge fund managers again are that there 21 are new people in the market all the time who are not as well 22 educated. 23 They are also limited by the extent to which people 24 can fall into bad products, as I just described, and 25 hopefully want to limit it. 1 The Chairman asked what's the capacity of this 2 industry for carrying regulation and the answer is given that 3 the -- if you ignore the profits that are associated with 4 exploiting foolish people and only look at the profits 5 associated with the stated line of business, any costs 6 imposed upon this industry will reduce those profits because 7 they're finite and they're limited. 8 And the reduction of those profits ultimately will 9 have some impact, not necessarily measurable or identifiable, 10 on market efficiency. And so we weigh those costs against -- 11 in doing the cost benefit analysis, we'll weigh those costs 12 against the benefits of trying to -- of taking a paternal 13 line in some sense for investors and also possibly the 14 benefits associated with systematic risks, of which frankly 15 I'm not particularly concerned but I do think that we do have 16 to pay close attention to them. 17 MS. NAZARETH: Bill? 18 MR. HEYMAN: If I may, your question may be even 19 more pertinent than you know, although the answer may not be 20 a matter for regulatory notice. 21 There was a recent piece written by Steven 22 Galbraith at Morgan Stanley, with which I have no 23 affiliation, in which he gave the results of a study of the 24 performance of equities over the last four or five years. 25 And he concluded that in the last year or so, the difference 1 between the best performing equities and the mean and the 2 worst performing equities and the mean had narrowed. And it 3 is that difference which is the alpha that all these 4 long/short funds, which are the principal new entrants into 5 the field, is seeking to capture. 6 So there is a phenomenon out there with a 7 geometrically increasing number of participants with more and 8 more capital trying to capture a pie of alpha, which appears 9 form all statistical evidence to be shrinking. I don't know 10 whether -- that may be a market condition that government 11 simply can't recognize, but it is out there. 12 COMMISSIONER GOLDSCHMID: I take it one way of 13 trying to keep up in this world would be to leverage and that 14 may create its own problems. 15 MR. HEYMAN: That's possible. 16 MS. NAZARETH: I'd like to ask one more question on 17 risk, following up on a number of points that people made and 18 then, if possible, quickly move on to short selling because I 19 know that's always of great interest. 20 Again, following up on a number of thoughts, we've 21 talked about managing both individual counter-party exposures 22 as well as concerns about systemic risk and it seems to me 23 that there were a couple of points made. 24 One was Afsaneh's suggestion that there's an 25 importance in having gatekeepers such as prime brokers, which 1 I'm sure Bob could talk about, they have the window of 2 knowledge with respect to what these hedge funds are doing 3 and what role can they play in ensuring some market integrity 4 here. 5 And also, the Chairman asked about the greater 6 regulation -- some have suggested that simply greater 7 transparency of some sort may again be better for the 8 markets. Others have suggested that that again could inhibit 9 the ability of hedge funds to effectively trade. 10 So I'd like people to if you can quickly address 11 those issues. Bob, do you want to address the prime 12 brokerage question? 13 MR. STEEL: Sure, I can start and I think maybe 14 some of my comments will reflect on some of the questions 15 you've raised because it plugs in. And when we think about 16 the prime brokerage business, we're in the business of 17 lending money and -- keeping securities and lending money 18 against securities to finance people's strategies. 19 I think to ask about the leverage -- we watch that 20 all the time. We look at aggregate numbers which are 21 interesting but not very informative, to be honest, because 22 you have to drill down and look at each strategy. The 23 current descriptors would suggest that people are not very 24 leveraged today and I think that's in part consistent with 25 the description that you made, that opportunities are not 1 very robust right now. 2 But when we think about it, we really go through 3 three screens, if you will. The first is really a business 4 issue. Do we know the people, do we understand their 5 business model, do we like their documents, do they have the 6 right auditors and things like that. And so that's really 7 done at one business selection model because we choose who 8 we'll take prime broker and we choose who we won't just as 9 we're taking them on to lend them money. 10 The second really is at a supra level from the top 11 of the firm where we have our credit people look at it and 12 watch it at the macro level all the time, and then we go down 13 to the day-to-day risk management applying margin that gets 14 individual positions. We only lend against positions we have 15 in-house. 16 We try our best to make sure we're watching all 17 their positions to the best of our ability, and then as 18 Andrew pointed out when he ran through the array of the four 19 firms that have had challenges, in one of those we were very 20 involved and it's a matter of managing through a process as 21 it became apparent to us that the partnership had 22 concentrated positions and as a result of moves in those 23 concentrated positions, then we basically tried to manage 24 through what I would describe as a lending business the 25 recollection and repossession of collateral so as to let the 1 air out slowly and manage the situation so as to protect 2 ourselves as the person that was lending in that case. 3 I think that the system seems to work well from our 4 perspective. We watch this business. Our losses would be an 5 expense against our revenue and, to be honest, if we were not 6 good at the lending part of it, we could quickly wipe out the 7 revenues that we receive given the amount of leverage there 8 is in the system if there's any leverage like anything when 9 you're lending against the principal in relatively large 10 amounts. So that's how we think about it. 11 I think an issue raised that you have to be careful 12 about -- and I'm sorry I forgot who made the point -- is that 13 this group of people, the most portable asset in the world is 14 cash and these people can choose to organize in all kinds of 15 places and so excessive regulation or requirements which you 16 talk about, this balance, the price of regulation versus the 17 benefit, that if the expense of regulation becomes too great 18 relative to reducing opportunities, then I think you'll see 19 people seek other locations or jurisdictions which would be 20 not good and not a good outcome, either, to be honest, in my 21 thinking. 22 MS. NAZARETH: Thank you. Does anybody else want 23 to address the question of additional transparency either 24 through position reporting or some sort of risk reporting? 25 Afsaneh, you had mentioned it earlier. Do you have specific 1 thoughts on where additional transparency might help? 2 MS. BESCHLOSS: I think it goes back to sort of the 3 point we discussed in the beginning of the session which is 4 for different strategies, you can obtain different levels of 5 risk transparency and it will not affect the business. There 6 are some strategies for which you can get detailed levels of 7 transparency and it will not affect that business. There are 8 other strategies whereby insisting on getting position level 9 on a realtime basis, you could affect that business, in 10 effect. 11 So I think you need to be realistic about it if you 12 want to continue making money out of the strategies and 13 essentially have a two-pronged approach, for instance, where 14 you just get exposure level transparency and look at what you 15 need to do in terms of what are your minimum requirements as 16 an investor or as any other player in the market and others 17 where there's not a problem in getting position level and 18 where the hedge funds do not have that level of sensitivity. 19 I think the other thing is really educating the 20 hedge fund managers in the sense that I think it's a process 21 by which many hedge fund managers, when they realize who is 22 using the information, who has access to the information, 23 what they're going to do with that information, if there is a 24 way to protect them against misusing that information, you 25 can get a lot more transparency a lot more easily. 1 MS. NAZARETH: Andrew? 2 MR. LO: Well, I guess in the interest of full 3 disclosure let me mention that in addition to being an 4 academic, I'm also a principal in a hedge fund and so I have 5 an interest in seeing this industry grow and prosper. but I 6 think that the way to do it, the way to create sustainable 7 growth -- and I do think that the hedge fund industry is 8 poised for some spectacular growth given the interest by 9 institutional investors and possibly retail investors -- the 10 way to create sustainable growth is to provide additional 11 disclosure and transparency but not position transparency. 12 I think that's a very important distinction. I 13 think several other panelists mentioned that providing 14 position transparency will all but eliminate the value that 15 hedge fund managers bring to the process. Instead, what I 16 think is necessary is risk transparency; that is, being able 17 to provide specific risk statistics to investors so that they 18 can interpret the risk. 19 In fact, I would argue this is sort of the best of 20 all possible worlds in the sense that managers don't want to 21 give out positions and frankly, investors can't possibly make 22 use of all these positions. They wouldn't know how to 23 interpret it and particularly for the very active hedge 24 funds, positions on a monthly basis will tell you very little 25 about the risks that are going on in the fund. 1 What I think is necessary is a number of risk 2 statistics that would provide investors with the kind of 3 comfort that they're getting into exactly what they expect in 4 terms of the risks that they are willing and able and 5 interested in taking on. 6 MR. YUSKO: And Annette, I think that the biggest 7 issue really is in any business, the business spends money to 8 create proprietary capital, whether it's proprietary capital 9 in the manufacturing process. We don't require Coca-Cola to 10 give away the secret formula. We don't require a mutual fund 11 to give away the internal research that they do. 12 Edge or proprietary information is what 13 incentivizes these groups to stay small, to keep their money 14 invested side by side. The thing that makes me the most 15 happy is the bulk of our assets are invested where the 16 principal wakes up everyday and more than 100 percent of his 17 net worth is invested next to mine. In the mutual fund 18 industry, we're lucky if $10,000 is invested of their own 19 money in a $20 billion fund. 20 So forcing someone to give away that proprietary 21 research I think is a terrible idea. 22 MS. NAZARETH: Again, we are running out of time 23 but since there's always a lot of interest in short selling, 24 I thought that we would turn to that for a minute. 25 Obviously, we discussed the fact that hedge funds 1 often employ the technique of short selling and, among other 2 things, there certainly have been concerns raised in the past 3 about the possibility of manipulative activity with short 4 selling and I don't think that that would necessarily be 5 exclusive to hedge funds. 6 But I wanted to discuss in general or have some of 7 you talk to us a bit more about the short selling strategies, 8 are they market neutral, are they aggressive, you know, the 9 concerns over manipulation and the like. 10 Jim, would you start us off? 11 MR. CHANOS: I'll take a stab at it, Annette. 12 First of all, the concerns about manipulative activities as 13 it relates to short selling, I'm always a little confused 14 about that because short sellers operate with the same rules 15 and, as I mentioned, actually some extra rules that other 16 investors don't have. But let's be clear on an issue, that 17 anyone engaging in behavior in which he or she is purchasing 18 or selling stocks, inducing others to do the same or 19 disseminating information on a basis where that information 20 is known to be false is subject to action, whether you're a 21 bull, a bear, a long or a short. 22 I'd like to say end of story because I know it's 23 emotionally more charged than that, but in fact that is the 24 case. And I know from a practice point of view, not only do 25 short sellers deal with the so-called uptick rule, but it's 1 monitored very, very closely on a realtime basis. 2 When our traders enter an order on the short side, 3 the broker on the other end of the phone immediately asks a 4 series of questions. Have you borrowed the shares? It's 5 then verified. Is this a short sale subject to the uptick 6 rule? Yes, it is. And then following, if the trade is 7 executed, you have a whole series of follow-on procedures the 8 very next day to reconfirm all these issues. 9 So it is very, very difficult in realtime to do 10 this. And I know the secondary concern is amongst issuers, 11 primarily, and market participants, are short sellers, to 12 further their interests, issuing false reports and trading in 13 front of them, concurrent with them and -- and if they are, 14 and if those reports are knowingly false, it's actionable. 15 We have rules, regulations and laws against that. As I say, 16 these things tend to be a little bit more emotionally charged 17 during and at the end of bear markets when people have lost a 18 lot of money and are looking around for reasons as to why 19 they lost money. 20 But if we look at the actors on the stage of say 21 the last 6 years, when I -- may I just make an observation 22 that if we were looking for wrongdoers or knaves, if you 23 will, in the investment world, I think you'd be hard pressed 24 to put short sellers in that group in the past handful of 25 years based on what's happened. 1 In fact, a lot of the more interesting work that 2 was done in the marketplace, some of the price discovery 3 mechanism that we talked about academically, was done by 4 people on the short side and in the hedge fund community, 5 things like Enron, Tyco, WorldCom. I could go on and on and 6 on with situations the short sellers were talking about for 7 many cases months or years before the problems became very 8 apparent to the marketplace. 9 So it's not something I think you want to quash in 10 a zeal to regulate this part of the marketplace that is 11 already pretty heavily regulated. 12 MR. YUSKO: Just one issue. Is there a difference 13 between a report issued by someone who is short in a stock 14 and having people react to that? One of my questions is why 15 would anyone react to an unnamed source that they read in a 16 chatroom or get over the Internet? Consider the source is 17 always a really good thing to do before you act on something, 18 yet plenty of investors make investment decisions based on 19 information that they have no idea where it came from. 20 But the second thing is, is that action any 21 different than the very common practice of people who take a 22 13(d) filing, it gets announced, it's in Barron's, and then 23 they're selling into it on the other side? That happens in 24 the long business all the time where there's a lot of press 25 about you have a large position, you had the large position 1 because you made money in it over time and now it's time to 2 sell because it's overvalued. You can't help that you have 3 that press. You didn't intend to have that press but it 4 happened. 5 So I don't see that being any different, and we 6 don't regulate that side. 7 MR. HARRIS: Issuers don't like short selling 8 because it tends to lower their stock prices. 9 (Laughter.) 10 MR. HARRIS: That of course raises their cost of 11 capital and may also decrease the compensation of the chief 12 executives. Owen LaMont in Chicago did a study of what 13 happened to stock prices of firms a year after the first time 14 they complained about short selling. So he looked at the 15 newspapers and got a record of the first complaint by issuers 16 of short selling in their stock and then went a full year 17 after that to see what had happened to stock prices between 18 that date and the year later date, and found that stock 19 prices had dropped by 25 percent. 20 That suggests to me that -- since we know that the 21 markets generally are pretty information efficient -- pretty 22 informative, it suggests that those stocks were overvalued 23 for who knows what reason, but if those stocks were 24 overvalued, perhaps it's because management wasn't doing a 25 good job and people didn't recognize it. Upon recognizing 1 it, their cost to capital increased. 2 It's appropriate that the cost to capital for those 3 firms increased. Apparently their business opportunities -- 4 either their ideas weren't good enough or their management 5 wasn't good enough. On average, those business opportunities 6 didn't warrant the flow of new capital. 7 And that's the whole purpose of having informative 8 prices, is that it ensures that capital flows to the best 9 ideas and that to the extent that we use stock prices to 10 motivate managers, it ensures that managers are compensated 11 for doing good and that directors are given very clear 12 signals for getting rid of managers who can't do well. 13 While undoubtedly there will be some manipulation, 14 our efforts to regulate short selling to prevent their 15 manipulations have an unsavory impact upon the other type of 16 manipulation, which is the pump and dump. By regulating 17 short selling and making it difficult, we make it difficult 18 for well-informed traders to take the opposite side when 19 people are trying to push up prices in ways that can equally 20 well hurt investors. 21 And in fact, it's far more likely that the people 22 who are hurt in the markets are going to be on the long side 23 than on the short side. The reason being is that it's much 24 easier to fool people to jumping into a stock on the long 25 side than to convince them to take a short position or to 1 sell a position they already have in the stock if you're 2 trying to do a bear manipulation. 3 The reason, of course, is that to convince people 4 to join, you can get anybody to join a manipulation on the 5 long side but to get people to sell, they have to be short 6 sellers and everybody knows that's extremely difficult, most 7 people don't understand it, they're afraid of it and many 8 people aren't even qualified to do it. I mean, literally, 9 their brokers won't let them do it. 10 And of course, the people in the stock -- it's hard 11 to get people in the stock to sell because, after all, they 12 believe in the stock; that's why they bought it. And if 13 you're trying to get people in the stock to buy more, that's 14 pretty easy because of course they already believe in it. So 15 the further regulation of short selling only disadvantages 16 our efforts to put a cap on pump and dump manipulations, all 17 of this in the name of preventing bear rates, which we should 18 try to do so but in fact we have mechanisms already to 19 protect against those. 20 MS. NAZARETH: Peter Brown. 21 MR. BROWN: I don't believe that short selling 22 drives stocks down. There is the initial impact of the sale 23 which will drive the stock down but beyond that, I don't 24 believe it drives it down any further. 25 We have about 75 Ph.D.s in math and physics who 1 looked at a very detailed models of the market and we take it 2 as axiomatic that you just cannot wring the market in that 3 way. 4 Secondly, one thing that people miss is that they 5 think all the short selling is driving the market down but in 6 order to recognize a profit on a short sale, you have to buy 7 the stock back. So the net result is you have as much buying 8 as selling. 9 Thirdly, by inhibiting short selling, you're going 10 got end up with stocks being slightly overpriced. And as 11 Larry just said, this is just as bad for an investor as being 12 underpriced because it means when my mother goes to buy a 13 stock, she's going to pay too much for it and later lose 14 money. 15 So I think that inhibiting short selling is very 16 bad for the markets. 17 MR. GOETZMANN: Just a brief sort of historical 18 view and geographical view. The Amsterdam Stock Exchange 19 opened in about 1607 and 1609 was the first short sale 20 scandal and 1610 was the first constraint on short sales. 21 This is a very old question. 22 (Laughter.) 23 MR. GOETZMANN: And so one way to approach this 24 that in fact was inspired by Owen LaMont's work was to take a 25 look at the short sales constraints all around the world and 1 ask a question is price discovery -- is the efficiency of the 2 price, which is really something we believe is important -- 3 is it better in markets where short sales are allowed or not? 4 And the answer is a very strong yes, so that -- so the 5 constraints on short sales appear to make things like a kind 6 of a bubble based on poor information more likely than not. 7 So on balance, it seems to have some benefits in 8 terms of price discovery. 9 MR. STEEL: Annette, I could just add that in our 10 experience, and when you look at the prime brokerage 11 business, probably two-thirds to three-quarters of our short 12 sales are accompanied by buys so that you're basically 13 creating a buy. I don't hear anyone complaining about the 14 purchase that came in with the sale. And so basically two- 15 thirds to three-quarters would be hedge strategies as opposed 16 to outright sales. 17 MS. NAZARETH: Peter, very quickly. 18 MR. BORISH: If you facilitate a two-sided market 19 at the margin you're going to end up having less volatility. 20 If you look at most markets, bonds, currencies, which are 21 larger in aggregate where it's equally easy to buy and sell, 22 the volatility is significantly less, however, you want to 23 measure it, than it is on an individual equity basis, and so 24 I think that it's very important to have a liquid two-sided 25 market. 1 MS. NAZARETH: Last word. 2 MR. HARRIS: Here's an amusing but absolutely 3 sincere, very simple economic analysis. If indeed short 4 selling leads to higher equity prices, that lowers the price 5 of capital and that's wonderful for capitalists. Lower costs 6 of capital means that economically throughout the economy 7 businesses will shift towards capital and away from labor. 8 Shifting away from labor cost U.S. jobs, an aspect 9 of this regulation that nobody has ever thought carefully 10 about. This is what we mean about the importance of 11 efficiency. It's not that we want to subsidize jobs or cost 12 jobs or subsidize capital or otherwise. We'd just like to 13 have all resources in the economy used as efficiently as 14 possible and short selling, if it indeed causes prices -- 15 capital to be higher, probably also cost U.S. labor jobs. 16 MS. NAZARETH: I'd like to thank our panelists. 17 Obviously we've run over a little bit but hopefully it was 18 time well spent. I certainly think so. 19 Thank you very much. 20 (Applause.) 21 (A brief recess was taken.) 22 MS. FORNELLI: Good morning. I think I can still 23 say good morning for a little while yet. 24 My name is Cindy Fornelli, and I'd like to welcome 25 you to Panel 6 of our second day of roundtable discussions. 1 Today we're going to talk about enforcement and fraud 2 concerns and I have of course a very distinguished panel here 3 with me that I'd like to introduce to you. 4 On my far left, I have Steve Cutler who is the 5 director of the SEC's division of enforcement. Steve, prior 6 to being the director, was the deputy director of enforcement 7 and he came to the SEC in January of 1999. Prior to that, 8 Steve was a partner at Wilmer, Cutler & Pickering here in 9 Washington, D.C., specializing in securities enforcement and 10 broker-dealer compliance and litigation. 11 Next to Steve is Pam Parizek. Pam is associate 12 managing director and a forensic accountant at Kroll Inc., a 13 global risk management consulting firm specializing in 14 business intelligence, internal investigations and forensic 15 accounting. And in Pam's prior life, she also worked at the 16 enforcement division here at the SEC. 17 On my immediate left is Scott Berman, a partner at 18 Brown Rudnick. Scott's practice focuses on complex 19 securities litigation including hedge fund cases in federal 20 and state courts and arbitrations across the country. 21 On my right we're pleased to have Kristina Kneip, a 22 senior staff attorney in examinations and a supervisor with 23 the State of Washington Department of Financial Institutions 24 in their securities division. Kristina has served in various 25 capacities with the North American Securities Administrators 1 Association or NASAA, and brings to our panel not only 2 familiarity with the State of Washington but also with issues 3 that hedge funds raise at the state level across the country. 4 To Kristina's right is Tom Fedorek, the senior 5 managing director in the New York headquarters of Citigate 6 Global Intelligence & Security, which is a provider of 7 corporate investigations and business intelligence. In 8 recent years, he's conducted due diligence investigations on 9 a number of hedge fund managers so he brings that experience 10 to the table. 11 Next to Tom is Lois Peltz, the president and CEO of 12 Infovest21. Infovest21 is an information provider to the 13 hedge fund industry. And last but not least is Patrick 14 McCarty, the general counsel of the CFTC and prior to joining 15 the CFTC, Pat was general counsel and executive vice 16 president for legislative and regulatory affairs of the 17 Managed Funds Association. 18 So I'd like to welcome all of you in the audience, 19 on the webcast and all the panelists, including Chairman 20 Donaldson and the Commissioners. 21 We're going to focus on three broad areas today. 22 We're going to look at enforcement actions by both the SEC 23 and the other regulatory panelists that we have here. We're 24 also going to look at examination and disclosure issues and 25 the third broad area we're going to focus on is due 1 diligence. 2 I know we started a little late and I know people 3 have schedules to keep, so we'll try to keep on time but we 4 might go just a little over. 5 So our first area that we're going to focus on, as 6 I said, is enforcement actions. Because the hedge funds 7 aren't generally regulated or registered with the SEC, our 8 main form of regulation over them is under the antifraud 9 provisions of the federal securities laws. 10 Other regulators have different regulatory schemes 11 so I'd like to open the panel by having each of our 12 regulatory panelists briefly outline their regulatory 13 programs and the types of cases they've been seeing with 14 respect to hedge funds. 15 So I'll start here at the SEC with Steve. 16 MR. CUTLER: I noticed that you put me way over 17 here and a vast separation between me and everyone else which 18 I don't quite understand. 19 In the last five years or so, the Commission has 20 brought roughly 30 enforcement actions relating to hedge 21 funds and in the last 3 or 4 years, we've seen a steep 22 increase in the number of hedge fund related enforcement 23 cases. 24 We brought two in 1999, six in 2000, seven in 2001 25 and twelve in 2002. And while there certainly are a number 1 of very complex issues associated with hedge funds, whether 2 they should be regulated, how they're structured, et cetera, 3 in the enforcement arena, and in particular in the cases that 4 we've brought, what we have seen is rather basic blatant 5 fraud. 6 The overwhelming number of cases we've brought 7 concern past or present -- I should say material 8 misrepresentations about past or present performance of 9 funds, the value of investors' holdings, the use of 10 investors' funds and the qualifications of the fund manager's 11 experience or the fund manager's experience. 12 In a very significant number of cases, we've simply 13 charged advisors or their associated persons with outright 14 theft, with misappropriating investor funds. In a couple of 15 cases, we've charged advisors with employing Ponzi-like 16 schemes, that is repaying exiting investors with funds 17 contributed by new investors to continue their fraud. 18 And, as I think we'll get to later on, we've also 19 brought a number of cases relating to mis-pricing schemes or 20 manipulations. And that's essentially the essence of where 21 we've been. I don't know if that's a complete reflection of 22 where we will go but certainly that's historically where 23 we've been in the hedge fund area and in SEC enforcement. 24 MS. FORNELLI: Pat, do you want to talk briefly 25 about the CFTC's enforcement program? 1 MR. McCARTY: Well, as the general counsel I'm not 2 usually the enforcement guy but I've been helped by my 3 enforcement friends. And I think our view of this is 4 basically that we've seen about 10 cases a year, hedge fund 5 fraud. Now, we've actually been maybe a little overinclusive 6 in terms of adding particular funds in. But anybody who is 7 basically committing a fraud and indicating that it's a hedge 8 fund-type entity, we included that. 9 You've had 30 cases in I guess four years, five 10 years. We've had 10 about a year so we have about 54. In 11 the context of enforcement cases, though, it's not a huge 12 part of our program and I've actually put together some 13 materials here just to sort of figure out where this stands. 14 15 Our -- I guess combined SEC and CFTC enforcement 16 actions total somewhere around 3,300 over the last five years 17 and I believe the total number of cases -- enforcement cases 18 brought in that 5-year period against entities who are saying 19 that they're hedge funds is about 80. So it's somewhere on 20 the order of magnitude of about 2 percent of all cases, maybe 21 3. But that -- to give some perspective as to where things 22 are. 23 I don't want to monopolize the time. The CFTC has 24 a significant presence I guess in the hedge fund industry but 25 I'll get into that a little later so I don't monopolize the 1 time here. 2 MS. FORNELLI: Kristina, do you want to talk about 3 what you've seen at the State of Washington? 4 MS. KNEIP: Sure. I'm going to actually give a 5 really brief overview on the states in general because I 6 think it's really important to know that many of the states 7 actually require hedge fund managers to register as 8 investment advisors and I don't know what that count is. 9 Given that 75 percent of hedge fund managers that we know are 10 registered as advisors, I don't know how many of those are 11 state advisors and how many are federal. But obviously, that 12 overlay makes a huge difference in the way that we approach 13 enforcement actions. 14 Presently, in the State of Washington we have 4 15 actions going. Two really have come from examination and are 16 really on a workout-type basis. They have to do with 17 advertising and making sort of performance review claims 18 regularly in news columns and kind of that sort of thing, 19 which isn't really fraud in any sense of the word. 20 However, nationwide, I've gotten numbers from the 21 other states and right now there are about 9 cases across the 22 country. Roughly half of those involve some serious kind of 23 fraud, generally with unregistered funds, so these aren't the 24 ones who are registered with the states as investment 25 advisors but they are looking a lot like what the SEC is 1 finding as far as Ponzi schemes. That's probably the biggest 2 thing that the states are finding in the fraudulent area. 3 But again, those are with the unregistered advisors that are 4 managing hedge funds with us. 5 We have a few cases of theft. We actually got 6 sentencing I think it was a couple weeks ago on one in 7 Washington, but it looks so much just like outright fraud and 8 theft that it's hard to really even associate what they were 9 doing sometimes with the hedge fund industry as it's been 10 represented here. 11 And I think that's because state registered or even 12 small state funds are maybe 3 to 10 million, although we have 13 some that are a lot bigger, they're just not doing the kind 14 of sophisticated strategy. So we see things a little bit 15 differently than I think maybe what the Commission sees or 16 definitely differently than what the CFTC sees. 17 MS. FORNELLI: I'm curious to know from our 18 panelists how you find what the sources of fraud are, fraud 19 cases. At the SEC, we don't do examinations so we don't 20 detect fraud through our examination program. 21 Steve, can you talk a little bit about the sources 22 that we have? 23 MR. CUTLER: Yeah, and I think that's actually an 24 important point because we're not -- at least in the case of 25 unregistered advisors, we're not going to be the 1 beneficiaries of an examination that's going to have 2 identified a problem, brought it to our attention in the form 3 of an enforcement referral. So a lot of what we end up 4 seeing in the hedge fund area is after the train wreck has 5 already happened. We will get a complaint from an investor 6 that finds that he's been wiped out. 7 Now, there have been cases, including in the 8 unregistered area, where we've gotten information from, for 9 example, a prime broker that said, gee, you know, our records 10 are showing this, we know that the hedge fund has been 11 advertising returns of substantially more than that, 12 something doesn't compute here. And we certainly have been 13 the beneficiaries of a couple of referrals frankly from the 14 industry. But those are, as you can imagine, fairly rare. 15 And for the most part we are relying on complainants to bring 16 hedge fund cases to our attention. 17 MS. FORNELLI: Pat, your experience at the CFTC is 18 different because, as I think you alluded to earlier, a lot 19 of the -- your regulated entities may be examined because 20 they're part of your program and a lot of the hedge funds are 21 registered with you in one form or another. 22 Do you see a lot of enforcement cases arising from 23 your examination program? 24 MR. McCARTY: Actually, the 54 cases we brought in 25 the last five years, about 10 or 11 a year, 78 percent of the 1 cases that we brought are against unregistered pools. We 2 find that the registered funds are really not the ones that 3 are usually the problem, and in fact I'll echo what Kristina 4 had to say there. 5 A lot of the ones in those 54 that we're counting 6 are -- it's not clear whether in fact people are intent upon 7 committing fraud and are using I guess the hedge fund name as 8 the mechanism or not. So I would say that most of the pool 9 cases that we've brought in the last five years we get 10 through complaints, not through our examination process. 11 Our examination process, which the NFA handles for 12 us, they see every one of our commodity pool operators every 13 two-and-a-half to three years and the number of problems that 14 come out of our registered pools is actually very, very, very 15 small. The number of complaints we get is about 10 a year on 16 commodity pools, and that's kind of phenomenal when you think 17 we have up close to 2,500 commodity pools out there. 18 MS. FORNELLI: Kristina, what about Washington? 19 MS. KNEIP: It's really -- it sounds like I'm 20 partnering with the CFTC here. I think that probably at 21 least 75 percent of our cases probably more come from 22 complaints. 23 The examination process I think brings some of the 24 -- not really transparency in the same way you're thinking of 25 it in markets but certainly gives the public some assurance 1 that when we go in on examination and the hedge funds are 2 expecting us at some time, we generally see them on about a 3 3-year cycle, but anywhere between two to seven years and 4 across the states probably about a five-year cycle for states 5 that actually examine hedge funds. 6 And I think that's a deterrent. Just having sort 7 of the cop on the beat there, as the states like to say we 8 are, when you're out there and people know you're coming in, 9 they tend to either hide it really well -- and maybe we just 10 haven't found it. I'd hate to think that was going on, but 11 certainly people tend to keep everything cleaner. 12 MS. FORNELLI: I'm curious to know -- in our last 13 panel they talked a little bit about short selling. We heard 14 yesterday about the types of conflicts of interest that can 15 arise that are unique with hedge funds when they're run side 16 by side, allocation issues. 17 I'm curious from all of our panelists, the types of 18 hedge fund fraud that we've seen, are there types of fraud 19 that are unique to hedge funds or is it the same types of 20 fraud that we see with other types of products? Steve? 21 MR. CUTLER: I guess my view is that it tends to be 22 similar. I mean, it's certainly a different forum for fraud 23 but fraud is fraud is fraud and I guess my sense is as the 24 hedge fund community is growing, that puts more pressure on 25 some of the things that we haven't seen. 1 And in particular I'm thinking about things like 2 conflicts of interest that can arise when a dealer or anyone 3 else sells a fund. What other interest does a dealer have in 4 that fund? Is that dealer doing, for example, brokerage 5 business with the fund and when the dealer is then selling 6 interest in the fund or introducing the fund to customers, 7 are customers aware that the dealer has an interest in the 8 success of that fund, either by virtue, for example, again, 9 doing brokerage business or by virtue of having its own 10 investment in the fund? 11 And I think those are some of the issues that I 12 think as hedge funds burgeon that we have to begin to deal 13 with. 14 MS. FORNELLI: Now, it's interesting because those 15 are conflicts of interest that obviously are of interest to a 16 regulator in terms of monitoring for fraud and detecting and 17 preventing fraud but I'm curious if any of the panelists have 18 a thought of whether or not those conflicts are adequately 19 disclosed to investors in the PPMs, in the documents. 20 You know, the SEC doesn't go in and examine, at 21 least with the unregistered advisors, the offering documents. 22 Do you see, Pat, anything like that, that the conflicts are 23 disclosed adequately, these potential conflicts when people 24 have various relationships? 25 MR. McCARTY: Well, I guess at the CFTC the vast 1 majority of the pools that are subject to our jurisdiction 2 are all private -- virtually all private placements. I mean, 3 we only have -- I think of the 2,400 funds, we have roughly 4 40 which are public offerings so the rest of them are private 5 placements. 6 The disclosure document review that's done is I 7 guess split depending upon whether it's a fund that's going 8 to restrict themselves to qualified eligible participants, 9 which is kind of like the qualified purchaser standard. 10 We do not review those documents to see what the 11 level of disclosure is regarding conflicts. They're subject 12 to the antifraud provisions and so, like Steve was saying 13 earlier, a lot of times you're there after the fact when 14 people have complained. But I think -- what I would just 15 reassert is that the enforcement cases we've had and the 16 complaints that we receive, this area is not one which is 17 large. 18 In fact, it's -- you know -- I guess of our 19 enforcement actions in 10 years, 17 percent of our cases are 20 against commodity pools and I think something like 11 -- more 21 than 50 percent of those actions are against the unregistered 22 ones who I think may be just intent upon fraud to start with. 23 I'm not really sure that they're actually hedge funds. 24 They're just fraudsters. 25 So I don't know whether -- I couldn't tell you 1 whether the disclosure of conflicts is adequate in a PPM that 2 a person setting out to commit fraud is. 3 MS. KNEIP: No. And this has been probably the key 4 issue that the states have been going off on for a long time. 5 At least, since NISMIA was passed and we stopped reviewing 6 the 506 offerings, the disclosure just isn't there. It's not 7 there in a whole lot of areas. 8 Now, I can temper my no with of course everybody 9 who is an RIA with the State of Washington, they're 10 disclosing all kinds of conflicts of interests because they 11 have to in the ADV Part 2 and that's what we're missing in 12 this process for the unregistered funds is that the 506s are 13 just filed and they go into this great bank of filings here 14 and they're not reviewed or anything until there's a problem 15 and I really hope that maybe that's one of the solutions that 16 at least the commission can look into more is can that issue 17 be tackled. 18 Can we put even a little check box on the Reg D 506 19 form that says yeah, I'm a hedge fund. At least we know to 20 ask then for the PPM or something, that there's some extra 21 level of review that might be done that might not be very 22 invasive for the industry and allow them to keep doing what 23 they want to do but giving the investor some kind of level of 24 protection. 25 So the disclosure is just not there right now. 1 MS. FORNELLI: Lois, yesterday we talked a lot 2 about the private offering and not holding yourself out and 3 not having general advertising which then by necessity means 4 that there's a lot of confidentiality around hedge funds not 5 only with respect to their trading strategies, which I think 6 is a different reason, but regulatorily there are 7 prohibitions. 8 Do you have any sense as to whether or not that 9 kind of confidentiality impedes our ability to detect fraud? 10 MS. PELTZ: Well, there's no such thing as a secret 11 and I think there are lots of checks and balances out there 12 and a lot of this goes back to I guess the customer 13 complaints and educating the investor so he knows what to 14 look for. 15 Most things that a manager says, an investor can 16 check. For example, if it's asset size, the investor can 17 check this with either the prime broker or the administrator. 18 He can also verify what the manager says his performance 19 numbers are. He can go back into monthly reports. If he 20 sees some spectacular numbers, maybe that should be a cause 21 of concern and raise a red flag. 22 I think one thing that investors don't do well is 23 that they don't do ongoing due diligence of their managers. 24 They do initially when they select, but afterwards it's just 25 as important. Go visit that manager, check what the turnover 1 is of his staff, what the change is in his portfolio mixes 2 and visit him on a regular basis. 3 There's lots of information out there that 4 investors can check as well. There are a lot of performance 5 databases. If an investor receives in his monthly report a 6 number and in some other database it looks different, well, 7 that's another cause of concern. And similarly, there are 8 many news services out there that carry information on 9 managers and all these are sources of information that 10 investors should look into. 11 I think there are a lot of red flags. If a manager 12 promises great things and -- if it sounds too good to be 13 true, it probably is. If a manager doesn't have an audit, I 14 think that's a big concern. If you've never heard of the 15 auditing firm or the administrator, again, another red flag. 16 If the audit late or an auditor has an issue, these are all 17 things that investors should start to take note of. 18 There's excessive employee turnover, another cause 19 for concern. Illiquid securities as we've discussed before, 20 again, it's an area of concern that leads to more questions. 21 Same thing with leverage. So I think there are many things 22 that investors can do and should be aware of, and there's no 23 such thing as a secret. 24 COMMISSIONER GLASSMAN: Could I just interrupt for 25 a moment? How much of what you just described could 1 reasonably be done by a retail-type investor? 2 MS. PELTZ: Well, it goes back to the issue of 3 sophisticated investor and who the hedge fund investor 4 initially was and who he's going to be. These sources are 5 available and I think it's true for any investment you make. 6 You should know what you're getting into and you should be 7 knowledgeable. 8 MS. FORNELLI: To follow up on that, I was 9 interested to hear you say that an investor could check asset 10 size, for instance, or assets under management with a prime 11 broker. I'm not sure that a prime broker would give that 12 information up to an investor. Does any of the panelists 13 have any experience with that? Is that something that Carl 14 could get? 15 MS. PARIZEK: I think it's unlikely. Someone on 16 the due diligence panel yesterday mentioned -- and this was 17 very encouraging to hear, frankly -- that there tends to be 18 more of a focus these days on qualitative due diligence, you 19 know, what is the reputation, character, integrity of the 20 hedge fund manager. 21 While there is a great deal of information that's 22 available in the public domain, and we'll go into that a 23 little bit later on this panel, things like reputation and 24 integrity is not generally going to be available and 25 frequently we are called upon to get that type of information 1 for many of our investors. 2 We frequently do this on behalf of larger 3 institutions. I would say about 70 percent of our work is on 4 behalf of fund to fund managers and perhaps 30 percent is 5 done for institutional investors and for fund managers. So 6 it's not the type of work that is generally performed for 7 retail investors, to answer your question. 8 MS. FORNELLI: Kristina, Lois also mentioned 9 administrators. That was one of the things that's come out 10 in the roundtable, that foreign jurisdictions have third 11 party administrators that act as a gatekeeper or a check. 12 That's something we typically don't see here, at least on the 13 federal level. Does the State of Washington have any 14 experience with that? 15 MS. KNEIP: We see it a little bit differently at 16 the state level because most of our hedge fund advisors 17 actually have custody, they're in the situation where -- and 18 especially because they're small -- they may not want to put 19 up the capital necessary and so they're going to get out from 20 under the custody rule by using a third party administrator. 21 And that may be a reason that we don't see as much 22 fraud, also. I don't know, but certainly it puts a big check 23 on where that money can go because you've got to get 24 permission to pay yourself, to move funds in and out, and so 25 we find that it really helps. 1 I also want to just briefly address Commissioner 2 Glassman's question if I could. Essentially, even if you 3 could get the position information from the prime broker, 4 without a sophisticated software program to do the 5 performance numbers, you're not going to be able to do it. 6 As the head of our exam team, I know we struggle 7 with teaching all of our new examiners are you going to use 8 modified dates, what are you going to do, how are we going to 9 get everybody on the same page, what did the advisor use when 10 they actually calculated their performance and if we 11 calculate performance using a different method, it's not 12 going to come out the same. What's the acceptable 13 difference, two basis points or less? 14 The problems for an individual investor to actually 15 verify, even if they could get the information, I think would 16 be very difficult unless they're really truly sophisticated 17 and could afford a separate investment advisor to run the 18 programs for them. 19 MR. CUTLER: Could I just interject here? I mean, 20 one of the things that I'm concerned about, and I don't know 21 enough about the regulation of hedge funds as opposed to 22 enforcing the laws when they break it, but we've seen cases 23 of funds and Lois had mentioned audits of hedge funds, where 24 auditors come in, audit hedge funds but one of the things 25 they don't do in that process is confirm with the customers 1 what it is that the customers are being told their 2 investments are worth in the hedge funds. 3 And it seems to me that in the same way that 4 auditors of public companies send confirms to suppliers and 5 send confirms to customers, one of the things that might be 6 done in this area to prevent the kinds of valuation frauds 7 that we see so frequently is to do regular confirms with 8 customers, what are you being told, and matching that against 9 what the auditor is finding within the hedge fund. 10 MR. McCARTY: I'd like to chime in on that. I 11 think you're right on that. I guess most of the time that -- 12 the 54 cases we've brought in the last five years, there's a 13 high incidence of basically false statements being sent out 14 to the customers. I mean, they end up with a statement 15 saying things are good, you made 10 percent last year, when 16 in fact they lost 30 percent or something along that line. 17 And that -- you're absolutely right. I mean, 18 that's the vast majority of situations where we see this and 19 that's the kind of fraud that is pervasive in that small 20 group of cases that we see. 21 Now, I'm not quite sure how frequently this occurs 22 and since this market is really not a market for retail 23 investors, at least at this point in time, it may be the case 24 that the institutional investors and high net worth 25 individuals have more experience with that or actually as I 1 understand it, they have some communications directly with an 2 awful lot of the managers on this. If they have a stake of 3 25, $30 million in the fund, they have more access than 4 someone who has $5,000 in the fund. 5 MS. PARIZEK: But I think the access is still 6 limited and we've had clients unfortunately -- you know, most 7 of our work is on the front end but we do have maybe 10 8 percent of our work in the back end where we've got very 9 sophisticated clients who were relying upon audited financial 10 statements. But a lot of that information is done after the 11 fact and they were told all along, hey, you know, your money 12 is in a very safe, carefully contemplated derivative 13 instrument that has very stable returns when in fact the 14 money was being put into Ponzi schemes, bad port -- credit 15 card receivable portfolios and other very risky instruments. 16 And it wasn't until after the fact that they realized that 17 tens of millions of dollars had disappeared when all along 18 they were told, you know, as you said, things are just fine, 19 we have very steady returns. so it's very challenging to get 20 out that information. 21 Now, in the defense of the hedge fund managers, I 22 think that there are very legitimate concerns about the 23 proprietary nature of that information because, let's face 24 it, I mean, that's what the funds are all about. And you 25 need to have some protection so that other people don't have 1 access and especially if you're dealing with a fund to fund 2 who is looking into managers, there are some legitimate 3 concerns about sharing the information concerning their 4 strategy, so it's a delicate balance that has to be struck 5 someplace. 6 MR. McCARTY: The valuation issue I think is really 7 important. To the extent that hedge funds invest in illiquid 8 investments, illiquid securities and/or things like 9 derivatives where it's hard to put a mark on them, the 10 question is whether in fact you've got a accurate pricing of 11 that particular security or position. And in some situations 12 where there really is trading only by appointment with 13 respect to that security, I think that it's almost -- even if 14 you have a third party service provider do the marks, which 15 probably is a good idea, it's sometimes 20/20 hindsight. 16 Several months later, whatever you said it was worth is now 17 half or a third because something didn't happen. 18 And I think that's one of those things where people 19 seem to need to sort distinguish the valuation problem from 20 the valuation fraud because I think in a lot of situations 21 you're going to have people trying to make a good faith 22 estimate as to what an illiquid security is worth but time 23 proves them wrong. 24 MS. PARIZEK: Pat, you're exactly right and that's 25 one of the reasons that we recommend due diligence not only 1 on the fund managers but also on the third party service 2 providers. Who are your administrators? Who are your 3 lawyers? For that matter, who are the accountants? And 4 that's something that certainly can help in preventing some 5 of the frauds that have occurred. 6 MS. FORNELLI: Scott, do you have something? 7 MR. BERMAN: Valuation fraud -- yes, thank you. 8 I've been trying. This panel is very aggressive. Feels like 9 we're in court. 10 MS. FORNELLI: Yes, you have to be assertive. 11 MR. BERMAN: Valuation fraud, which is the example 12 of big fraud that I see most frequently, almost can never be 13 accomplished just by the hedge fund manager. I mean, the 14 hedge fund manager with typically illiquid securities such as 15 microcaps or CMOs or the like, is not likely to show his 16 portfolio and, absent some regulation, will not show his 17 portfolio, but by himself or herself can't commit the fraud. 18 Typically what happens is in the PPM there are 19 requirements for third party verification or third party 20 participation in the marks so that in the Granite hedge fund 21 fraud case, for example, the hedge fund manager made up his 22 own marks but he did it with the willing cooperation of the 23 dealers who sold him the CMOs. 24 How did he do that? Because he would go every 25 month to the dealers and say please give me marks. They'd 1 give him marks. Then he'd call them back and say thank you 2 very much but I'd like another set of marks and they'd give 3 it to him because he was buying the toxic stock that nobody 4 else wanted and he was driving -- he, being the hedge fund 5 manager, David Askin -- these huge deals. 6 So, could he have done this by himself? No. He 7 was telling his investors that the dealers are giving me 8 marks and, in fact, the dealers were giving him marks which 9 were being confirmed to the auditors so that the blame here 10 when there is fraud is almost never just the hedge fund 11 manager. There is almost always third parties involved. 12 Let me touch on the auditors for a moment, too, if 13 I can. When you're auditing a hedge fund, there's only two 14 things I think you need to do. Make sure that the 15 instruments exist and they're properly valued. There's not 16 much else to do. And it's amazing to me that those two -- 17 what you would think are relatively simple things don't get 18 done right in these hedge fund cases. 19 Kids get put on these things or don't know how to 20 audit the hedge funds, don't properly confirm that the 21 positions exist, such as in the Manhattan case, or don't do 22 the proper testing for valuation which is why, since I sue 23 the street and accountants in connection with hedge fund 24 blowups, I'm able to do it because either they are knowing 25 participants in the fraud or they've acted very recklessly, 1 grossly negligently or recklessly in performing the services 2 that they're supposed to be performing to give investors the 3 feeling that at least somebody besides the hedge fund manager 4 is minding the store. 5 MS. FORNELLI: Well, then I'd lie to turn it over 6 to Tom and kind of talk about then examinations because it 7 sounds like if the hedge fund manager wants to commit fraud 8 by mis-pricing securities or puffing up performance and the 9 third party administrator or the third party auditor will 10 conspire with the hedge fund manager to falsify those 11 records, what's an investor to do? Do we need inspections? 12 Would that be a deterrent to these types of activities if we 13 had frequent regular inspections of hedge funds? 14 MR. FEDOREK: That's a very touch question. The 15 investor is generally, unless they are an institutional 16 investor with a very big investment, they're probably not 17 going to get full access to all the books and records they 18 would need to make that determination. And as Scott pointed 19 out, many hedge fund frauds involve an extraordinarily high 20 level of deception and are complex in that they involve 21 several different parties to the transaction. 22 As we were talking about the auditors, I was 23 reminded of how Michael Berger in the Manhattan fraud which 24 has been already mentioned just completely pulled the wool 25 over the eyes of his auditors by rigging up a fax machine and 1 sending the trade information directly to the auditors. It 2 was supposed to go through the administrator, but he rigged 3 up the fax machine so that when it came off the fax machine 4 at the auditor's office, it had a header that indicated it 5 came from the administrator's office when it fact it came 6 from Michael Berger himself. 7 What's an investor to do and do we need more 8 examination and inspection by agencies like the SEC? Let me 9 just turn that over to the panel because I don't really have 10 an answer. 11 COMMISSIONER GLASSMAN: Can I just interrupt, Tom, 12 and ask you in your experience what percentage of hedge funds 13 have problems that the market should be worried about? 14 MR. FEDOREK: As Pam said, in our business, in the 15 private investigations business, we tend much more often to 16 be involved on the front end of the transaction in helping 17 investors do their due diligence before an investment is 18 made. We do get involved on the back end when a fraud occurs 19 but by that time the damage is done and if we can get access 20 to the books and records, we can help with forensic 21 accounting services. 22 The -- I actually once -- I've done between 100 and 23 150 due diligence investigations of hedge fund managers and I 24 actually once did a tally of my cases and flagged the ones 25 where we surfaced something that we thought we needed to 1 bring to the attention of the investor, and it was 2 approximately 25 percent of the due diligence cases we did 3 surfaced some kind of issue which we thought important enough 4 to bring to our investors' attention. 5 And the two basic things we do in a due diligence 6 investigation would be to first take the information that the 7 hedge fund manager has provided to the potential investor and 8 we'll go line by line through that information, what the 9 educational credentials are, what the employment history is, 10 what the professional credentials are, and we'll verify that. 11 We'll see if it's true. 12 We'll also do independent research to see if there 13 let's call them sins of omission. And in 25 percent of the 14 cases, we found that there was some kind of inaccuracy in 15 that information, an exaggeration, an error or an omission. 16 Now, ADP is in the resume-checking business and 17 they have a company that checks about two million resumes a 18 year and they did a study last year that found that more than 19 40 percent of the resumes they tried to verify had some kind 20 of inaccuracy so by comparison, the hedge fund industry is 21 doing very well. 22 But in 5 to 10 percent of the cases, we found 23 something that was a deal killer and that would be like an 24 undisclosed criminal conviction, a regulatory problem, or 25 some kind of serious personal financial issue like a recent 1 bankruptcy filing, judgments and liens that you find when 2 somebody is having a severe cash flow problem. 3 MS. PARIZEK: Our number are, you know, pretty 4 consistent with that. I would say that we probably do front 5 end due diligence, as I mentioned previously, about 90 6 percent of the time. In the last five years we've done, you 7 know, roughly -- I'm not sure -- 3 to 400 background 8 investigations. Now they're classified a little bit 9 differently. They used to be just background investigations. 10 Now they're hedge fund fraud investigations, so I'm not 11 exactly sure where that number falls. 12 But to give you some sense of what the numbers are 13 for those of you who read last month's issue of the MFA 14 Report, you may have seen that we estimate that roughly 10 to 15 15 percent of the time there is some indication of a red 16 flag. That doesn't mean necessarily that there is fraud but 17 there is something that really should be looked at a little 18 bit more carefully. 19 Now, within that pool, about 80 percent of the time 20 there's some sort of a misrepresentation concerning the 21 background of the fund manager and about 20 percent of the 22 time it might have to do with undisclosed relationships, 23 questions about the use of proceeds or other contingent 24 liabilities. 25 COMMISSIONER GLASSMAN: Cindy, are these the kinds 1 of things that we would find if we were doing inspections? 2 MS. FORNELLI: Well, that's one of the things I'd 3 like the panel to explore a little further. Pat, I know that 4 you have both registered and unregistered. Do you see on the 5 examinations -- are your fraud cases -- is there a 6 distinction between the registered and the unregistered when 7 you bring fraud cases? 8 MR. McCARTY: Oh, yeah. As I said before, about 9 70, almost 80 percent of the cases that we bring which you 10 could call a hedge fund case, and we erred on the side of 11 basically being overinclusive, that 80 percent of those cases 12 are against unregistered entities. Now, the thing is though 13 that number is small and I just want people to keep these 14 things in perspective, is that if we bring 54 cases in the 15 last five years and 80 percent of those cases are against 16 unregistered entities, then we're talking about bringing 40 17 cases. 18 And I have to tell you that we have -- of the -- it 19 depends upon how you define hedge fund I guess is kind of -- 20 what does the CFTC see in hedge funds when we examine them? 21 Well, it depends upon what you consider to be a hedge fund. 22 I put some statistics in my materials here. 23 If you count in commodity pools that have over $100 24 million in assets as being hedge funds, and I think for 25 purposes of talking about fraud I'm counting everybody down 1 to $100,000, the 628 commodity pools that have over 100 2 million in assets, we see maybe two complaints a year. 3 MS. PARIZEK: I should probably qualify my prior 4 remarks to make it clear that I was talking about 5 predominantly unregistered advisors because typically that's 6 what we're called upon to look at. It's places where there 7 is not a good deal of information available and people want 8 more information about some of the smaller lesser known 9 managers. 10 Now, I should further qualify that by saying we're 11 in the business of investigations, not statistics, so I can't 12 tell you whether this is isolated or systemic and I think 13 that's something that really deserves further inquiry. 14 MS. FORNELLI: Well, maybe I've done the panel and 15 the audience a disservice by asking the question as to 16 whether or not we'd catch more fraud if we did examinations. 17 Maybe the question is what other benefits are there to 18 examinations, not just catching fraud. Kristina, do you have 19 a thought on that? 20 MS. KNEIP: I think certainly examinations leads to 21 a lot more disclosure that's available to the public in the 22 end. If the Commission were to register investment advisors 23 that advised hedge funds, they could go in under exam power 24 on the IA rules and presumably you'd want to draft it broad 25 enough that they could go into the third party administrator 1 so that they could look at pricing issues if they were there 2 but certainly on top of that temper it with a risk rating 3 sort of thing that I know the Commission has gone to and 4 we've gone to in the State of Washing that says okay, if they 5 use a third party administrator and we've got these people -- 6 we've got surprise audits being done by their CPA firms and 7 that sort of thing, then they're probably way lower on the 8 risk rating scale for us than a hedge fund who doesn't use a 9 third party administrator and those folks we probably want to 10 go in and do a lot more thorough checking of every single 11 pricing issue. 12 So I think we could get to pricing but you would 13 have to make ti broad enough to get to the third party 14 administrators or whomever else is doing that other work for 15 them. 16 MS. FORNELLI: Tom, do you have a sense of whether 17 or not registration would get more information out to 18 investors? 19 MR. FEDOREK: Yeah. I think there's a real 20 opportunity here for the SEC to be not just a cop but to be 21 what it is, actually, to a large extent already, an 22 information provider. I mean, there's not a day that goes by 23 that I don't dial into one of the SEC's databases to get 24 information to help me in the research that I do in my 25 investigations, whether it's EDGAR or some of the other 1 databases that you have. 2 You could effectively put Pam and myself out of the 3 hedge fund manager due diligence business by requiring 4 anybody who runs money for somebody else to credential 5 themselves with the SEC. It would be okay with me and Pam 6 because the bad guys would just go operate some other 7 business and we'd just go chase them there. 8 MS. FORNELLI: Scott, would that put you out of 9 business? 10 MR. BERMAN: No. Clever fraudsters always find a 11 way to get it done and I think that the more transparency 12 there is, the better off everybody will be but there will 13 always be fraud and there will always be a place for it. But 14 as long as -- I was thinking in addition to examination, if 15 you want to give a better -- an additional tool to fighting 16 fraud, and it's a fairly radical thought, but Section 10(b) 17 of the 34 Act and rule 10(b)(5) allow me to sue for 18 securities fraud in connection with the purchase or sale of a 19 security but as Lois pointed out a few moments ago, investors 20 fall down many times in doing their due diligence after the 21 initial investment and in fact many times the fraud occurs 22 years later after the purchase of the instrument or the 23 purchase of the investment interest in the hedge fund has 24 occurred. 25 So what happens is when you have a fraud that 1 occurs later on, you have a problem with the -- in connection 2 with the purchase or sale of a security requirement under 3 Section 10(b) and Blue Chip, which is the Supreme Court case 4 on -- in connection with the purchase or sale of securities 5 requirement. 6 So what I do, at least in New York, is when New 7 York law governs, there is a common law claim for fraudulent 8 maintenance which I use. That claim does not exist in all 9 jurisdictions. That claim does not necessarily exist if you 10 have to apply the law of a foreign jurisdiction, if it's an 11 offshore hedge fund, s that to me a very valuable tool in 12 combating fraud would be to federalize the fraudulent 13 maintenance theory. 14 In other words, take out the in connection with the 15 purchase or sale requirement. It's radical. You know, lots 16 of people are not going to like that, but to me that would be 17 a very, very valuable tool in combating fraud. 18 MR. CUTLER: It's so radical we actually have it in 19 the Investment Advisors Act, right, because under 206 we 20 don't need a purchase or sale and indeed a lot of our cases 21 are brought under Section 206 of the Investment Advisors Act 22 which allows us to go after fraud whether it occurs in 23 connection with a purchase or fraud or not. 24 MR. BERMAN: But that's you, not me, and that -- 25 (Laughter.) 1 MR. BERMAN: And the problem is, as we all know, 2 the SEC has limited manpower and in many of these cases where 3 the SEC leaves off, I begin. That's the Manhattan case, 4 that's the Granite case, and that's what happens. And if I 5 have and other private litigants have those tools, we will 6 all be able to combat fraud better. 7 MR. McCARTY: I have a question for Tom and Pam 8 which I was kind of interested in. Cindy's question was 9 basically will you put us out of business if all these people 10 have to register, then you don't have to do the private 11 investigation. You're always looking at the SEC's web site 12 for information. 13 Do you look at the NFA's database? Because quite 14 frankly -- and you see it in the materials here -- we have at 15 the CFTC -- most of the large hedge funds are registered with 16 us or at least a majority of the large hedge funds are 17 registered with us as CPOs. There's an awful lot of data in 18 that database and in fact I'd note that I think at least 19 foour or five of the participants at this hedge fund 20 roundtable are registrants. I mean, they are hedge funds but 21 they are registered with the CFTC. 22 So there's data and I'm not quite sure if that is 23 getting out to people that in fact if they're going to 24 invest, they ought to be looking not only at the SEC's 25 database and the NASD's but also at the NFA's. And is that 1 one way to basically get more information out? 2 MR. FEDOREK: Yeah. Pat, I'm really glad you made 3 that point because this actually came up on the preliminary 4 call we had and somebody made a point and I think you made 5 this point and I thought it was such a good one, I wanted to 6 make sure it got out that yes, the NFA is an excellent place 7 to go looking and hedge fund managers will be registered. 8 There's the NFA database, there's a CRD database which is put 9 together by NASD and NASAA and then there's the investor 10 advisor database that you get through the SEC web site and 11 hedge fund managers will be -- you can get information about 12 them, some, all or none of the above. 13 And perhaps what there's a need for, thinking once 14 again along the lines of the regulatory agency as also being 15 an information provider, a need to make it easy to -- one 16 stop shopping for investors who need information because the 17 information is there but as Pat points out, many people are 18 just not even aware of the existence of the NFA database and 19 I myself forgot to mention it. 20 COMMISSIONER GLASSMAN: I just have a quick 21 question for context. What percentage of the hedge funds are 22 registered versus unregistered? 23 MS. FORNELLI: Well, at the SEC we think about, 24 what, 35 of the 100 largest hedge funds were registered with 25 us? 1 MR. ROYE: Well, in terms of investment managers, 2 I'm glad you asked the question because I've heard the number 3 75 percent of hedge fund managers being registered with the 4 SEC and our data shows that it's about a third. And it's 5 also confirmed by the fact that if you look at the 100 6 largest hedge fund managers, according to one service, we did 7 a double-check against who was registered with us. Again, it 8 was about a third. 9 MS. FORNELLI: And I think OC this exam as part of 10 this fact-finding mission for those numbers out, too. 11 MR. McCARTY: I'd also just to chime in, in my 12 materials there, we checked the institutional investors study 13 from last year and 18 of the top 25 hedge funds, and I guess 14 that's the large ones, are operated by CPOs or registered 15 with the CFTC and then 55 of the hundred are registered with 16 us and 44 of them are actually registered as CTAs, commodity 17 trading advisors. 18 I'd also note that those numbers may change. The 19 CFTC is considering some proposals to provide additional 20 exemptions from registration and I think that some of the 21 data that we have here related to hedge fund fraud basically 22 indicate that there's been very little hedge fund fraud, at 23 least as far as we can see, with our registrants and that's 24 one reason why we're considering that. 25 I'd also note that one of the exemptions we're 1 considering is basically providing a de minimus test for 2 basically registration. Prior to I guess this rulemaking, if 3 you traded one futures contract you had to register with the 4 CFTC. The Commission is now deciding whether they should 5 actually say that it should be a certain percentage of your 6 assets or futures to justify them having to register with us. 7 But today, at this point in time, 55 of the top 8 100, at least according to institutional investor, are 9 registered with the CFTC as commodity pool operators and we 10 examine them through the NFA every two-and-a-half to three 11 years, and our experience has actually been incredibly good. 12 MS. FORNELLI: Commissioner Glassman, your question 13 I think touches on an issue which we probably should flag, 14 and that is if it's true that only a third -- approximately a 15 third of hedge fund managers are registered with us, if the 16 SEC were determined to register investment advisors we would 17 have to consider as an agency -- you would have to consider 18 as an agency the resources that it would take to perform 19 those examinations and I know that's something that Lori and 20 our OC program has to worry about, too, what kind of 21 resources that would take to keep on our exam cycle and 22 examine all of those. 23 MR. CUTLER: Well, I think also -- I think -- 24 sorry. 25 COMMISSIONER GLASSMAN: I have one follow-up 1 question about the data and this may not be the right panel, 2 but the data that you gave us shows that the unregistered 3 hedge funds seem to perform better than the registered. This 4 may not be the right panel but if it is, does anybody know 5 why that would be? Is there something related to the 6 registration or is it just something else? 7 MR. CUTLER: Maybe they're reporting fraudulent 8 numbers. 9 (Laughter.) 10 MR. CUTLER: No, I really did mean that 11 facetiously. 12 COMMISSIONER GLASSMAN: I certainly hope so. 13 MR. ROYE: I don't think we really know the reason 14 for the difference but you're right. In terms of looking at 15 -- I mean, we looked at a number of hedge funds. It was a 16 fairly significant number of hedge funds so whether or not 17 it's representative of registered managers versus 18 unregistered, can't really say and couldn't really say what's 19 driving it. Maybe you can talk to Larry Harris about that. 20 But I do want to ask Pat one question about -- you 21 know, you indicated that in terms of your enforcement cases 22 you see problems in the unregistered area, not in the 23 registered area. The CFTC seems to be moving away and is 24 going to allow more hedge funds to be unregistered. To what 25 extent do you see the examination program as having been a 1 deterrent because of the registration to fraud in the area 2 where you say in the registered area you don't see it but you 3 seem to be moving in the opposite direction. 4 MR. McCARTY: That's a good question, one I guess 5 the Commission itself will have to decide. We've gotten 6 comments on the exemption proposals and the commissioners 7 will have to make a decision on that I guess in the next two 8 months as to whether they'll go with the proposed exemptions 9 or some modified approach. 10 What has the examination procedure done to cut off 11 fraud? I guess the -- all I can say is basically the vast 12 majority of our cases are against unregistered pools and I 13 think that we will probably -- and continue to bring the 14 majority of our cases against unregistered pools. 15 I'm not sure whether in fact -- I think the exam 16 process probably does help but we really don't get many cases 17 from our exam process. I think that you've got to consider 18 whether in fact the industry -- the people who register and 19 who are running this as a business are in a business and they 20 are going to be doing the right thing and so I'm not sure 21 we're really going to find -- we'll find a lot of fraud with 22 the registered entities. 23 That's at least what our experience has been. I 24 mean, these people are in it for the long run in terms of 25 investment management and alternatives. It's not clear to me 1 what will occur. Part of me seems to think that in fact part 2 of the increased fraud that you may be seeing is that hedge 3 funds are a hot issue. 4 I mean, people aren't looking to do prime bank note 5 schemes and they're not looking to do the next hot Internet 6 idea or the next biotech. Seems to me that that may be one 7 of the reasons why there's this bump up in hedge fund fraud 8 cases because you've got people who want to do fraud. 9 It's not to say that there aren't hedge funds who 10 have engaged in fraud. It's just I'm not sure that this is 11 -- we're getting -- we have an accurate sample or 12 understanding as to whether this is a real problem or not. 13 And the statistics we have seem to indicate that the number 14 of cases is pretty consistent year in, year out and that it's 15 typically a very small friends and family fraud that's being 16 done, under 50 participants, you're probably usually talking 17 about under $5 million. 18 It's kind of like what the State of Washington is 19 seeing. And I'm not quite sure if it's just -- you know, 20 whether it's a hedge -- hedge funds are more prone to fraud 21 or whether in fact fraudsters are prone to use hot investment 22 ideas to attract people. I think it's the latter. 23 MS. FORNELLI: Commissioner Atkins. 24 COMMISSIONER ATKINS: Yeah. I wanted to along 25 those same lines ask Mr. Cutler a couple of questions about 1 the -- sort of put you on the spot there on the -- 2 MR. CUTLER: You can call me Steve. 3 COMMISSIONER ATKINS: Okay. 4 MS. FORNELLI: That's when you know he's going to 5 ask you a tough question, Steve, when he calls you Mr. 6 Cutler. 7 COMMISSIONER ATKINS: With respect to the 12 that 8 you cited, I mean, that's not a very big number but just what 9 sort of cases those were and then to compare to the question 10 that you had regarding the -- how an examination program 11 might bring up cases, I was wondering on our registered 12 investment advisor side, what sort of percentage of real true 13 fraud is uncovered through the examination program versus 14 what comes in through the press and through complaints from 15 customers and things like that. It just occurs to me most of 16 the fraud we see around the table at the commission meetings 17 tend to be the latter rather than through the examination 18 process. 19 MR. CUTLER: Yeah. I don't have a great sense of 20 it. And actually, just to address the last question first, I 21 mean, I guess I -- my view of a successful examination 22 program is not at the end of the day that it's produced so 23 many enforcement cases. It's sort of like being a good 24 umpire. You -- the sign of a good empire is that you don't 25 notice him and the sign of a good examination program is that 1 it effectively deters misconduct. And so I don't know what 2 the answer is. 3 Anecdotally, my sense is probably even in the 4 registered community we get as many tips if you will from 5 complainants as we do from referrals, but I'm not sure that 6 necessarily answers the question as to what the utility of 7 the exam program is because it may well be not producing 8 referrals because it is deterring misconduct in the first 9 place. 10 MR. ROYE: We should have probably had Lori 11 Richards on this panel. Lori is sitting here. She says that 12 about 80 percent of the examinations result in a deficiency 13 letter of registered investment advisors and of 80 percent, 14 about 7 percent result in enforcement action. 15 MR. CUTLER: I did look at the 12 actions, to get 16 to your first question, Commissioner, and of those, 3 were 17 follow-on AP's that we brought against registered entities. 18 So if you exclude those, we've got 9 left and of those, 8 19 involved unregistered investment advisors and only a single 20 one involved a registered investment advisor. 21 But again, the numbers are too small probably to 22 draw any significant conclusions from them. 23 MS. PARIZEK: I think as a former regulator I can 24 tell you that, you know, registration is great in theory. 25 Now that I've moved to the private sector of course our 1 clients have enlightened me a little bit about their other 2 views and legitimate concerns. But in terms of registration, 3 yes, of course, there are certain cases that the SEC may have 4 an ability to detect because remember, you know, our clients 5 come to us and say we want you to look at XYZ fund manager 6 because -- you know, unless you have registration, then the 7 SEC won't have that opportunity. 8 But on the other hand, remember that this 9 information is self-reported and with respect to fund 10 managers who are fiduciaries, you can't just rely on the 11 information that's filed in a PPM because you need to look a 12 little bit deeper perhaps and as I mentioned earlier, to 13 learn more about the integrity of the manager you do need to 14 do a little bit of due diligence. 15 So I don't think that registration would put us out 16 of business. But with respect to the inspection component, 17 yeah, again, in theory, that's a great idea. If you have 18 some sort of a concern that you're going to have your books 19 inspected without notice, then theoretically, yes, that makes 20 sense but realistically how much can you do? Because if 21 you've got 6,000 funds, I think I heard the numbers were 22 maybe 1 inspection every five years, that's not going to be a 23 deterrent to the people who intend to commit fraud. 24 I mean, they're going to go where the money is and 25 let's face it, the money is in the hedge fund industry and 1 with $600 billion in assets under management its susceptible. 2 MS. KNEIP: There's another way that you can use 3 exam programs to really get at fraud especially so when 4 complaints come in the door, the way we do it in Washington 5 is we have a fraud unit that are examiners and those people 6 are deployed in as rapid fashion as we can out to where the 7 problems are. And if the Commission were given the resources 8 to be able to do a similar thing, then while you're chasing 9 it it would certainly help build enforcement cases faster. 10 And just being able to put somebody in an office 11 where fraud or anything else bad has been reported on a 12 complaint rather than doing the whole subpoena power and all 13 that, if you had exam power, you have a different way to 14 investigate problems than you have going through the entire 15 Commission situation that you have to do before you can even 16 start giving out subpoenas here. 17 So you have that added advantage of being able to 18 do for cause exams very rapidly and hopefully save investors 19 from losing more money by getting in faster. 20 MS. PARIZEK: But if you're relying on the 21 antifraud provisions, do you need registration to do that, 22 and I guess that's the question. I guess the bottom line -- 23 and this is a question and answer that I'm not going to touch 24 -- but the question is should retail investors really be in 25 this business and, if so, to what extent? And are there more 1 moderate proposals like changing the standards for credit 2 investors that might accomplish the same objectives and not 3 impair the ability to do periodic inspections if you get a 4 complaint through the investor hotline. 5 MR. CUTLER: Well, in that regard, Pam and Tom, I 6 mean, I'd be curious -- you guys have said you've done what, 7 I don't know, 400 due diligence-type inquiries over the last 8 few years. How many of those have been commissioned by 9 anything other than a huge institution who can afford 10 essentially to do the kind of due diligence that -- I mean, 11 your firms aren't cheap. 12 MS. FORNELLI: Well, I want to take the question a 13 little bit, too, on that because I've been hearing that -- 14 throughout the whole roundtable I've been hearing of the 15 dichotomy between the pressure that an institutional investor 16 can bring to bear, that there's more information and an 17 institutional investor can really go out and get the 18 information, that they have that clout as more and more 19 institutional investors go into the hedge funds as 20 alternative investments. 21 And then we've heard a lot about the retailization 22 and how the investment minimums have lowered and how 23 individual investors are now having more and more access. 24 And so I do want to expand on Steve's point about what can an 25 individual investor do. 1 Yesterday the Yale Endowment speaker noted that for 2 him, when he's making an investment determination, the 3 integrity and character of the portfolio manager was key. 4 How does an individual investor get that information? Can 5 they replicate the type of information that, Tom, you and Pam 6 give to your big institutional client? 7 MS. PARIZEK: I suppose to some extent certain 8 things can be done. I mean, listen, the SEC has a very good 9 investor education program with direct links to the state 10 securities regulators, to the NASD database. The SEC also 11 has a very vibrant complaint line that it's actively used. I 12 think that Pat has some statistics in his presentation that I 13 believe is available that shows there are an awful lot of 14 complaints that are filed. 15 Are there things people can do? Yeah. I mean, 16 they can make phone calls. We've had cases where there are 17 just blatant frauds, where people have indicated that they 18 have received commendations from NASA, Harvard, the Air 19 Force. And you look back at the bio and make a few phone 20 calls and this kid was a teenager at the time that those 21 commendations were allegedly made. Could an individual 22 investor make that phone call? Could they do a little bit of 23 due diligence in that respect? Yes. 24 Will it tell you about the reputation, integrity 25 and performance? Not necessarily. But the question is would 1 registration do that? I think the answer is no. 2 MS. PELTZ: There are other sources that an 3 investor can go to. I mean, they can talk to other investors 4 at that firm, they can talk to people who left that firm. 5 MS. FORNELLI: Let me just interject for a second, 6 and I don't mean to be naive but can an individual investor 7 go to a hedge fund manager and say can I please speak to 8 other investors in this fund? Can I please speak to 9 employees who have left? 10 MS. PELTZ: Well, you can get a list of references. 11 I would think any business person would provide that and you 12 can just build your own network of other investors even if 13 they are small investors. And just talk about these things, 14 share information. 15 MR. McCARTY: If I could jump in here, there's a 16 bit of confusion in my mind here. Steve and Cindy, you're 17 talking about retail investors, the people who want to put in 18 $10,000 or $5,000 and I guess that's if hedge funds become 19 retail products. But they're not. 20 MS. FORNELLI: I'm even talking about the 21 accredited investor who has $500,000 in annual income so that 22 he meets the accredited investor standard, has $100,000 to 23 invest, can he or she get that information as an individual? 24 MR. BERMAN: Can I add something? The vehicle to 25 do that -- the best vehicle I think is to find a good fund of 1 fund manager who will do that due diligence for you, even 2 though it adds a layer of cost. To me, that's the better way 3 for a $500,000 investor to be dipping his toes into this 4 water. 5 MR. CUTLER: And who's going to be doing the due 6 diligence on the fund to fund manager? 7 MR. BERMAN: The fund to fund manager, the $500,000 8 person is going to have to do that, but if the fund to fund 9 manager, if his strategy is to diversify over 30, 40, 50 10 whatever different alternative investment strategies, the 11 likelihood that there is going to be fund of fund fraud is 12 far less likely than hedge fund fraud and in fact, I have yet 13 to be confronted with a big case of fund of fund fraud. 14 Never seen one. 15 MS. KNEIP: If I can jump in here, retailization 16 isn't occurring at the big funds and most of the people who 17 are here at the roundtable and I've heard the discussions 18 from big fund managers, we have some over a hundred million 19 in Washington that are actually under our purview and they 20 don't have the 35 unaccredited investors but everybody is 21 forgetting that you can have those people. 22 And most of the advisors that we have that are 23 running these really small funds, they're your neighbor. 24 Maybe not everybody in this room but they are somebody who is 25 a former Microsoft millionaire -- no offense to Microsoft; 1 that will probably get me in trouble -- but they've decided 2 to become a day trader. During the market downturn they 3 learned a lot about short selling, they made all this money, 4 they turned around, they form a 506 and get all their 5 neighbors into it and none of those people are really 6 accredited or if they are, it's only because their home value 7 is now $2.5 million and they just want to get in. 8 And that's what we're seeing. Is it large scale? 9 No, but those are the people complaining and they're losing 10 all their money because these people don't have a track 11 record, they're not the people the big hedge funds are ever 12 going to hire to manage their money and there is nowhere you 13 can go to check out these people. And they're your neighbor 14 and probably their wife or husband, somebody watches your 15 kids during the day or something so you're just not going to 16 do it if you're the standard retail investor. 17 MR. McCARTY: And you can't. I think that -- I 18 mean, that's probably Steve's point, that the individual 19 investor can't but I guess in the hedge fund world today, 20 depends on what you want to define as hedge fund, that 21 institutional investors -- the high net worth or the family 22 office guys, the endowments, have the ability to go to Tom 23 and to Pam and to say do some due diligence on this, are they 24 registered with the CFTC or the ISAC, what's their track 25 record, who do they report to, this, that and the other 1 thing. 2 You know, are hedge funds a good idea for retail 3 investors, people who are not accredited investors? Probably 4 not. And in fact, I think the hedge fund industry would 5 probably say we'd give up all 35 non-accredited investors, 6 you know. That's fine. In fact, we don't want them I think 7 is what they would tell you. 8 But getting back to -- 9 MS. FORNELLI: That's -- a lot of hedge funds will 10 say that but a newer hedge fund that we've heard a lot about, 11 the 25-year-old entrepreneurial guy who leaves -- the broker- 12 dealer, who leaves the trading desk and goes out and starts 13 his or her own hedge fund, they might want that smaller 14 client, might they not? 15 MR. McCARTY: Well, they might. In fact, I was 16 just going to say I had looked at our statistics from 1999 17 where we brought theoretically 15 pool cases. We had 12 18 cases, 12 of those 15 were under a million dollars collected, 19 and that's I think the kind of fraud you're talking about. I 20 mean, 14 of them were under $5 million. 21 So these things do happen. Are they hedge funds? 22 I'm not sure whether they -- the friends and family 23 investment company? I'm don't know what you would call it, 24 but it depends upon how you want -- are you going to treat 25 the entire industry the same way? Are the large funds that 1 have million dollar investment minimums going to be treated 2 the same as the ones who go out and get their money in $5,000 3 increments? And I think that's a real issue that people have 4 to think about. 5 The funds that are here at the SEC today, the 6 registered hedge fund of funds, all of them, 56 or so, the 7 minimum investment I guess is 25,000 and there's only handful 8 at that. Most of them are 50 or 75 or 100,000. And all of 9 them are at either the accredited investor level but more 10 likely than not the qualified client level. 11 So it's not the case that these registered hedge 12 fund of funds are really for retail investors, at least yet. 13 I mean, retail -- 14 MS. FORNELLI: That's what I was going to say, yet. 15 MR. McCARTY: But the idea -- I mean, this concept 16 of retailization of the hedge fund industry seems to be I 17 guess equalized with the dropping minimums. It doesn't seem 18 as if hedge funds are actually selling to anybody other than 19 accredited investors, which is -- I mean, maybe there's a 20 disconnect here but it seemed to me what we're worried about 21 or at least the cases we're bringing that we see is really 22 the small people, the retail investors who are getting ripped 23 off by friends and family. 24 MS. FORNELLI: Well, I think that we as regulators 25 have to be concerned, because I think one of the reasons that 1 you're seeing an increase in the fund of funds and the 2 lowering of the minimums is because there is an appetite, an 3 investor appetite for that. It's not -- it's kind of the 4 chicken and the egg problem. It's not necessarily the hedge 5 funds going out after these people. You've said that the 6 large hedge funds would gladly give those people away. 7 But I think as there's more and more of an appetite 8 by the smaller investor to get into these types of vehicles, 9 you're going to see an increase in that and so I think 10 that -- 11 COMMISSIONER GOLDSCHMID: Cindy -- I'm sorry. Can 12 I ask for a bottom line from the panel on this? Common 13 ground seems to be that enhanced auditing may make some sense 14 and auditing standards. Is there anything else that ought to 15 be done in the view of the panel? 16 MS. FORNELLI: We'll start with our non-regulators. 17 Lois? 18 MS. PELTZ: I think that there needs to be clearer 19 definitions and classifications exactly of what this industry 20 is. I mean, even if you take the word hedge fund, everyone 21 has their own definition -- 22 COMMISSIONER GOLDSCHMID: Well, take hedge out of 23 it and fund and they invest. What do you want to do, if 24 anything? 25 MS. PELTZ: Well, I think there needs to be clearer 1 definitions. I mean, these strategies, everyone calls them 2 something different and if the people in the industry have 3 all this blurred confusion, well investors are going to be 4 blurred, too. So I just think there need to be clearer 5 definitions of what it is we're talking about, what these 6 strategies are and once you have that, you can also develop 7 risk profiles and what a manager of this type would look like 8 so it's investor education so an investor would understand 9 what the strategy is and what the risks are. 10 So I'm for investor education and clarification. 11 COMMISSIONER GOLDSCHMID: Well, is it just 12 education or should we impose disclosure and risk and 13 strategy technique and such? 14 MS. PELTZ: I think you could start with investor 15 education and see where that goes and clarify what these 16 strategies are, what are the risks involved, and take it from 17 that end. 18 MS. FORNELLI: I don't want to go -- did you want 19 to go -- 20 MS. PELTZ: Go ahead. 21 MS. PARIZEK: I think you have to think through 22 what the long-term consequences of that would be. I mean, 23 the exemptions were designed for a reason and there were 24 certain thresholds that were put into place and as this 25 investment vehicle has become more popular, I'm not sure that 1 the existing standards are really set at the right thresholds 2 anymore. And maybe we need to consider a little bit more 3 carefully what the thresholds are, whether they're 4 appropriate and whether they should be changed. 5 MR. BERMAN: I think that the SEC should be taking 6 a long, hard look in each of these hedge fund fraud cases at 7 what the service providers are doing and not doing, the 8 broker dealers, the auditors and the administrators. Because 9 typically the enforcement actions focus on the manager and 10 the fund, they do not focus on the service providers. 11 I think if you did that, there would be a terrific 12 deterrent effect to some of the things that have gone on and 13 that I think would be the single biggest area in which 14 perhaps fraud could be deterred. 15 MR. FEDOREK: A credentialing agency that would -- 16 for anybody who is going to manage money on behalf of another 17 party, which would ensure the investor that the manager has 18 passed some kind of basic smell test and keep the major 19 malefactors and the fraud recidivists out of the field. 20 As I said before, they'll just go elsewhere and it 21 won't completely solve the problem because some of these 22 frauds seem to be crimes of opportunity that arose as -- and 23 perhaps they didn't start out planning to commit a fraud but 24 as the returns went south, there was an opportunity to 25 falsify financial statements perhaps with the intent of 1 making it up later and that never happened. 2 MS. FORNELLI: Pat? 3 MR. McCARTY: I'm -- I guess -- I think I agree 4 with Pam in terms of I think the accredited investor 5 standards. Probably the SEC should consider whether in fact, 6 since they haven't been changed since 1982, maybe it's time 7 to increase that level. 8 It's a totally different situation if you're going 9 to let retail investors into this product and I think the 10 level of regulation should be commensurate with the type of 11 investors who are going to be in the product and I quite 12 frankly think that that's the way the SEC has approached it 13 in the past and I think it's the way it should be in the 14 future. 15 The amount of fraud cases that we have seen, and I 16 guess that the SEC has seen, does not seem to be sufficient 17 to indicate the need for a huge sea change here. That would 18 be my view. If we're average 10 a year, and it looks like 19 we're including in those 10 a year things which may not even 20 really be classified as a hedge fund, I'm not sure when you 21 think about it -- I know that Steve is very busy and he 22 brings about 500 and some odd cases a year -- 23 COMMISSIONER GOLDSCHMID: We were at 600 this year, 24 Pat. 25 MR. McCARTY: Well, there you go. Productivity is 1 up. I hope you got a bonus for that. 2 (Laughter.) 3 MR. McCARTY: Hey, pay parity. That's the one. I 4 guess the thing is shouldn't -- this industry -- I mean, the 5 financial services industry in the United States is probably 6 one of the shining beacons and I think the thing is we should 7 think long and hard about I guess possibly doing something to 8 a segment of that industry that has actually been very, very 9 successful and so I would wander in slowly. 10 Part of me would also say that to the extent that 11 the CFTC actually has an entity, one of these hedge funds 12 registered with us as a CPO or a CTA, I would think that 13 there's not a need for the SEC to require them to be 14 registered over here because we currently do have them 15 registered and we do examine them. 16 Our point of view in terms of the type of 17 regulation is probably a little different but I think we both 18 are against fraud and take quick action and I know that our 19 enforcement group coordinates with Steve's group on this. So 20 I'm very -- I think that's what I would believe is the 21 appropriate approach. 22 MS. FORNELLI: Kristina? 23 MS. KNEIP: I have a laundry list here. The first 24 idea is if you can come up with a new exemption vehicle other 25 than the 506, then we don't have to revamp 506. But I 1 suppose all this takes Congress to act on. But that would be 2 my first thing, is just to make a different kind of an 3 exemption rather than using a 506, something else that we 4 know it's a hedge fund, you file the documents, people can 5 get at them, we've done a great job up front and then maybe 6 we don't have to do anything else. 7 If we can't do that, then I'd really like to see 8 the SEC get the folks registered as investment advisors and 9 have the exam power with it and of course no double 10 regulation. I'm not into that. So we take the small ones 11 like we do at the states, the Commission takes the big ones 12 and the CFTC takes all the ones registered with them so 13 people aren't forced to go through several examinations. 14 Lose the 35 non-accredited investor standard, raise 15 it, index it and investor add always. The states are trying 16 to be really active on that and maybe we could do something 17 with the Commission. I don't know if the Commissioners have 18 nay plans to go out on the road again but if it continues to 19 be a hot topic, maybe that should be included in there and 20 maybe the states and the CFTC and the Commission could all 21 get together and kind of do a road show around telling 22 investors this is the deal with hedge funds and watch out for 23 your neighbor who is selling to you. 24 MS. FORNELLI: Steve, do you want to chime in or is 25 that putting you on the spot? 1 MR. CUTLER: It is putting me on the spot but I'll 2 chime in. I guess I'm struck from an enforcement perspective 3 and that's really the only perspective I'm semi-qualified to 4 give here, is that we ought to be trying to put more pressure 5 on the gatekeepers here. I mean, this is an area where there 6 are gatekeepers as well and you've identified one set of 7 them, the third party services and I think the auditors, but 8 also at the point of sale. 9 And I think particularly as we see more of this, 10 the trend toward the retailization of hedge funds, we ought 11 to be looking harder at who is selling them and what they're 12 saying when they sell them. 13 Steve recently brought a case involving sales 14 literature that accompanied sales pitches related to hedge 15 fund investments and I think that's an area where the 16 regulators ought to be putting pressure to ensure that any 17 sales effected through those venues are done properly. 18 MS. PARIZEK: I just wanted to make a few comments 19 on the idea of credentialing. Our chairman, Mr. Kroll, has 20 been thinking about this for the last couple of years. In 21 fact, I think Tom and I met when Tom was at Kroll when we 22 were talking about well, if we were to come up with some sort 23 of a credential, what would it look like. 24 Subsequent to that time we actually did develop a 25 product that would be a "certification" or verification that 1 managers complied with certain fundamental things like the 2 managers are who they say they are, background due diligence, 3 but also had a financial component as well as an operational 4 component. 5 There was a little bit of resistance from the 6 industry on opening up their books to third parties who would 7 come in just to take a look and make sure that everything is 8 as they say it is. I think the response was why should we 9 lift our kimonos if we don't have to. So we have considered 10 other alternatives and there may very well be some. 11 MS. FORNELLI: I guess in ending I'll put myself on 12 the spot and say that I think that we can draw from a lot of 13 ideas and there might not be one single answer to your 14 question, Commissioner Goldschmid, but that all of these 15 ideas bear further examination. 16 So what that, I will say goodbye and thank you very 17 much to our panelists. It's time for lunch. Don't forget 18 you have to go back through security. 19 (Whereupon, a lunch recess was taken.) 20 A F T E R N O O N S E S S I O N 21 MR. ROYE: I would like to welcome everyone back 22 for our latest panel. We are just going to focus on the 23 current regulatory framework governing hedge funds. And to 24 some extent, we will touch on some of the issues and 25 questions that came up in our earlier panels. 1 I have been asked on behalf of our panelists here - 2 - we have a distinguished panel -- really, to indicate that - 3 - as unless they indicate otherwise, the views that they 4 express are their own personal opinions, and not necessarily 5 the views of the organizations that they represent. 6 So, let me introduce our distinguished panel. To 7 my far right is Mark Anson. Mark is the chief investment 8 officer of CalPERS, the California Public Employees 9 Retirement System. He is also a member of the International 10 Association of Financial Engineers, and he serves on their 11 investor risk committee. And he has authored several books 12 on the financial markets, including one called, "The Handbook 13 of Alternative Assets." 14 Next to Mark is Alan Beller, our distinguished 15 direct of the division of corporation finance, who you met 16 yesterday on our marketing and distribution panel. Next to 17 Alan is Jean-Claude Delespaul. 18 Jean-Claude is the secretary general of France's 19 security regulator, known as the COB. He has also served in 20 the ministry of finance, and is a financial counselor to the 21 French embassy in Tokyo, and he also has been generous with 22 his time with us at the SEC, and he participated last year, 23 near the end of the year, in a roundtable on auditor 24 independence and the lawyer rules. He has been involved in 25 the COB's consideration of hedge fund and fund of hedge fund 1 issues. 2 And then next to him is Bob Pozen. Bob is the John 3 Olin visiting professor at the Harvard Law School. He is the 4 former president of Fidelity Investments, and he also, in his 5 career, was the associate general counsel of the SEC. 6 Next to Bob is Rick Lake. Rick is the co-founder 7 and co-chairman of Lake Partners. Lake Partners is a 8 registered investment advisor that offers multi-manager 9 investment programs, primarily hedge funds. And he manages 10 the firm's portfolio of hedged funds. 11 Next to Rick is Sandra Manzke. She is the co- 12 founder and co-CEO of Tremont Advisors, Inc. Tremont engages 13 in hedge fund consulting services, database sales, and 14 information services, as well as investment product 15 development. 16 Next to Sandra is Iain Cullen. Iain is the general 17 counsel of the Alternative Investment Management Association. 18 It's a UK-based trade association for hedge funds throughout 19 the world. And he is also a partner in the London office of 20 the law firm of Simmons & Simmons, and heads the firm's hedge 21 fund practice. 22 We also, fortunately, have with us Jane Thorpe, of 23 the CFTC. Jane is the director of the CFTC's division of 24 clearing and intermediary oversight, and that's the division 25 that oversees the commodity trading advisors and commodity 1 pool operators. 2 To my immediate left is John Markese. He is the 3 president and CEO of the American Association of Individual 4 Investors, and that's a non-profit organization that is 5 formed for the purpose of assisting individuals in becoming 6 effective managers of their own assets through a variety of 7 educational information programs, and they engage in a 8 variety of research activities on behalf of individual 9 investors. 10 Next to John is Armando Belly. Armando is general 11 counsel, and a member of the management committee of Soros 12 Fund Management. He also serves as a hearing committee 13 member of the National Futures Association, and is on the 14 arbitration committee of the New York Mercantile Exchange. 15 Next is no stranger. Annette Nazareth, again, is 16 our director of market regulation. It's also noteworthy that 17 Annette is our representation on the financial stability 18 forum, which was convened in April of 1999 to promote 19 international financial stability through information 20 exchange and cooperation and financial supervision and 21 surveillance among regulators. 22 Next to Annette is Paul Roth. Paul is the founding 23 partner of Schulte Roth & Zabel in New York, a law firm where 24 he coordinates the firm's corporate practice, and heads the 25 firm's private investment funds practice, and he has over 30 1 years experience in the private funds area. 2 Next to Paul is Christina Sinclair, of the 3 Financial Services Authority in the United Kingdom, their 4 principal financial services regulator. She heads up the 5 business standards department, and worked on the FSA's recent 6 papers regarding hedge funds. And the department's main 7 portfolio is really focusing on business standard policies 8 across the markets in retail sectors in the UK. 9 And then is our chief counsel, Doug Scheidt. He 10 moderated our panel yesterday on evaluation and other issues. 11 And then last, but not least, is Jack Gaine. Jack 12 is the president of the Managed Funds Association, and it's a 13 U.S.-based association of investment professionals that 14 manage hedge funds and engage in alternative investments. I 15 should point out that earlier in his career he was general 16 counsel of the commodities futures trading commission. 17 We thought, to begin the discussion in this area, 18 it would be useful to kind of focus on how other regulators 19 view hedge funds and fund of hedge fund issues, how they 20 focus on hedge fund managers, their approach to regulation. 21 And I thought we would start with Jean-Claude, to talk about 22 how you approach the regulation of hedge funds and managers 23 in France. 24 ME. DELESPAUL: I will try to do that. I will try 25 to do it briefly, although I need some minutes to explain. 1 First of all, I would like to say I am delighted to 2 be here, and to present some varying views. I am expecting 3 and hoping that it will help in a better understanding of 4 perhaps diverging or completing ideas. 5 As you know, Mr. Roye, the COB has been, for the, 6 probably, past five years, a strong advocate among the 7 regulators of some reflections to be put at the international 8 level on hedge funds, and on the effect and inference of 9 hedge funds on the labor market. And consequently, some work 10 has been done within the IOSCO, Internal Organization of 11 Securities Commission, on that question. So, we considered 12 it important, in the COB, to be here today to express our 13 views. 14 I would just like to say a word to ask you to be, 15 please, very kind to the only person in the room to whom 16 English is not a natural language. 17 (Laughter.) 18 ME. DELESPAUL: Concerning France, I will try to 19 explain briefly where we stood a few years ago -- say, about 20 three years ago -- what we intended to do, what has been done 21 so far, and what we consider, as regulator, remains to be 22 done, in terms of hedge funds. 23 First where were we, say, two to three years ago? 24 We have in the French law a general provision which has 25 existed for almost 100 years, which totally prohibits any 1 commercialization in France of foreign financial products 2 which haven't been approved or recognized by the French 3 minister of finance and COB's recommendation. 4 Recognized means that we can accept completely what 5 we call in Europe the coordinated collective investment 6 scheme following the European directives, which means that 7 there is a possibility to commercialize in France other 8 European collective investment schemes and products. 9 In what I said, the term "commercialization" 10 implies an active role of the promoter to approach customer 11 and to convince them to invest. It doesn't mean that the 12 sale of such products is forbidden. And we knew perfectly 13 that some portfolio managers or third-party asset managers 14 had been shopping around to add some hedge funds investments 15 to their assets. But that was tolerated, because it remained 16 very marginal until the end of the 1990s. 17 We had also in our regulation, a few specific 18 products of a more risky nature corresponding to the needs 19 and the qualification of affluent investors under strict 20 condition, and with the specific agreement by the COB. So, 21 at the beginning of the 1990s -- I will not describe them 22 into details, but you could find probably the reference for 23 the regulation -- at the beginning of the 1990s, we had 24 introduced something called -- specific funds operating on 25 futures and options, so created at the beginning of the 1 1990s. 2 In the mid-1990s, simplified procedure restricted 3 to qualified investors. They have in common precise rules 4 for their management, for instance, higher requirements 5 concerning the qualification of managers, and the technical 6 means used by the management. And they are qualified by a 7 special warning which has to be read and accepted by the 8 investors. 9 These funds are approved and registered by the COB, 10 and are under the surveillance of the French regulator. The 11 -- part of that is that they can operate more freely in terms 12 of leverage, and in terms of operation. 13 That was the point -- the situation two to three 14 years ago. What did we intend to do? At the end of -- we 15 observed that the rapid development abroad of hedge funds was 16 meeting precisely the appetite of French investors and of 17 fund managers to obtain, in one case, and to propose, in a 18 manager's case, higher yields, or at least yields higher than 19 the average market indexes and bench marks. And we noticed 20 an increase in their investment in hedge funds. 21 Again, this is still a marginal phenomenon. It -- 22 our figures show that they are probably, by the end of 2002, 23 about 5 billion of Euro invested in hedge fund by about 140 24 funds in France. And these, probably in addition to a 25 slightly higher amount -- 6.5 billion, I suppose, Euro -- 1 under direct management by the funds which I described 2 earlier. 3 So, all together, and compared to the total amount 4 of assets managed under collective investment schemes, this 5 is very limited. Nevertheless, it shows a real and rapid 6 increase over the past two to three years. 7 In addition to that, we consider that there was 8 some risk of intra-European -- I hesitate to use the 9 "competition," -- but intra-European leaks, we could say, 10 which might push French investors to find products more 11 easily in some other of our neighboring countries. 12 So, the commission decided to address the issue, 13 and made it within a very close relation and discussion with 14 the profession and the industry, giving a high priority to 15 the protection of investors. And it appeared rapidly, that 16 the best approach was to try to repatriate those investments 17 under the French regulation as much as possible, and to put 18 clear conditions on the possibility for funds to invest into 19 hedge funds. Of course, it's out of question that we 20 regulate, directly, hedge funds. 21 So, the process undertaken is a process from 22 tolerance, which was the previous situation, to drafting some 23 framework. It has taken about two years of intense work, 24 very strong discussions, and sometimes very conflicting views 25 between the industry and the regulator, before the commission 1 could approve a set of decisions which were approved earlier 2 this year, and presented publicly this year concerning what 3 we decided to call alternative multi-management investments. 4 I should say that in parallel, and during the same 5 period of time, we had a specific working group under the 6 chairmanship of one of the members of the commission working 7 on management fees and charges and commissions, and that this 8 group produced recommendations, which were sometimes also 9 semi-conflictual, at the end of 2002. 10 Now, I come to what has been decided by the French 11 commission. Decisions have been taken concerning the actors, 12 concerning the products, and concerning the customers. 13 Concerning the operators, the portfolio management companies 14 who invest, or were willing to invest in foreign non- 15 coordinated funds -- you could say in hedge funds -- have to 16 produce or to adjust -- produce, if it's a project for new 17 management companies, or to adjust if it's an existing 18 management company -- specific programme d'activite. 19 That's the document which is produced to the COB 20 before licensing, before registration, and which describes, 21 as precisely as possible, all elements of the management 22 company and the -- not only the business plan, but giving a 23 complete description of all what will be the operations. So, 24 even existing portfolio management companies will have to 25 adjust their programme d'activite and submit it to the COB. 1 And this, as soon as they intend to invest from the first 2 Euro into hedge funds. 3 Five points have been clearly underlined as 4 important to the regulator. One is the expertise and 5 experience of the team to select funds and to master the 6 management techniques related to -- relating to hedge funds. 7 A second point is the ability to follow the investments which 8 are made. A third one is the existence of the specific risk 9 control structure in the management company. Another one is 10 the existence of technical means adapted to the complexity of 11 the financial techniques used. And the fifth one, relating 12 to the customers, is relating to information and 13 commercialization procedures. 14 The -- still concerning the operators, the 15 depository is fully responsible for the conversation of the 16 assets. The management company keeps full responsibility for 17 the management. And when they are delegations or services 18 provided by some other companies, it has to be clearly and 19 precisely monitored and described. In addition to that, the 20 industry itself has accepted to prepare an code of conduct 21 for such investments. 22 Concerning now the products. The -- one of the 23 requirements is that the shares of the target funds acquired 24 can be qualified as stocks, in terms of legal requirements. 25 I don't -- that means that there is clear transferability, 1 that there are equal rights between the different 2 shareholders, that the responsibility rules are clear, that 3 there is an audit of the accounts, that there are 4 prospectuses, and so on. 5 Secondly, we, the commission -- and this has been a 6 point of long discussions within the industry -- the 7 commissioners decided that, as a rule, we wouldn't accept 8 three levels of investment. Clearly, funds of funds -- funds 9 of hedge funds -- are possible, but not funds of funds of 10 funds, except of course, in the case of master -- funds where 11 there is an exception. 12 Also has been a point of strong and long 13 discussions, the traditional classical rules which we apply 14 to diversification and to the disbursion of risks are to be 15 applied to these funds of funds. As a counterpart of that, 16 we accept more relaxed rules in terms of leverage, in terms 17 of -- which characterizes the management of the hedge fund. 18 Now, the protections for investors -- and again, I 19 stress that the starting point of the process was the 20 protection of investors -- we would have the commission 21 specific control over the commercialization. The brochures 22 and promotional documents will be presented to the COB. The 23 idea is that it should explain as clearly and simply as 24 possible what is exactly contained in the investment proposed 25 to the investor. 1 In terms of limit to the investment, the COB's 2 suggestion is that it should cover initial subscription of at 3 least 10,000 Euro, which is not a very high level, but we 4 consider that the other rules and requirements should give 5 sufficient protection to the small retail investor. 6 Now, this is what has been decided this year. and 7 what comes now into publication. So, a few things that still 8 have to be done. Part of that has to be translated into 9 regulation, which hasn't been made so far, and which might, 10 for some elements, take time, since, at the same time, we 11 have, as many other European countries, to transpose into 12 French regulation, the principles of the new usage directives 13 in -- decided in Brussels within the union. 14 We will create, before the end of this year, 15 special category of usage, which would be called funds of 16 alternative management, and this would be the implementation 17 of those decisions presented earlier. 18 And in addition to that, a law which is presently 19 being discussed in the French parliament proposes to create a 20 new concept of contractual funds which would be -- I 21 shouldn't say French hedge funds, because this probably is 22 not the case -- but which would be very liberated funds, with 23 a reinforced mechanism of surveillance by the regulator, a 24 high level of initial investment -- probably 500,000 Euro -- 25 and a strict control by the COB under the commercialization 1 and distribution. So, this would be a fund reserved to 2 professional investors, and with very relaxed rules of 3 management. 4 So, this is point now concerning the present 5 situation in France relating to hedge funds, and their 6 commercialization. Thank you. 7 ME. ROYE: Thank you, Jean-Claude. It sounds like 8 in your regime, the manager will have to be qualified, and 9 you're going to permit fund of hedge funds, investors are 10 going to invest a certain threshold. You're going to put 11 qualification standards, in terms of how they can be sold, 12 and then it looks like you're moving toward -- well, it 13 sounds like the equivalent of our sort of 3C7-type hedge fund 14 for investors who can make significant investments into the 15 fund, and providing more flexibility there. 16 ME. DELESPAUL: Right, that's it. 17 ME. BELLER: Paul, I had one quick question. The 18 programme d'activite, which is filed with the COB, is that 19 also publicly available? 20 ME. DELESPAUL: Yes, it is. 21 ME. ROYE: Christina, in the UK, you have also 22 taken a recent look at hedge funds and whether or not they 23 should be opened up to retail investors, looking at how the 24 hedge fund managers themselves should be regulated, and 25 whether or not that should be changed or modified. Could you 1 give us an outline of what you guys just recently went 2 through, and where you came out? 3 MS. SINCLAIR: Yes. Yes, I can do that, thank you. 4 But perhaps I might first make a couple of comments about the 5 way we regulate hedge funds in the UK, and that will make 6 some of the comments about how we went about our discussion 7 paper a little clearer. 8 First of all, regulation in the UK, we do not have 9 a special regime for hedge funds. We apply our ordinary 10 regime in a variated way, to catch what we do for hedge 11 funds. And I think I could say there are really regulation 12 attachers in two ways. First of all, to the products, and 13 secondly, by virtue of a person conducting some sort of 14 activity, which may be advising, promoting, managing, or 15 selling, and you can see how those two things might attach to 16 hedge funds. 17 So, looking first at products, hedge funds can be 18 either unincorporated vehicles or collective investment 19 schemes. And in the UK, that means that they could be 20 regulated or unregulated. Now, hedge funds do not generally 21 come in a shape and size that would enable them to be 22 regulated under our existing regime. So they exist as 23 unregulated schemes. And in that case, that means that we, 24 generally speaking, allow them to exist as an unregulated 25 scheme. 1 Now, I mention at this stage that the tax treatment 2 of these entities in the UK is not necessarily attractive, 3 and so they are not -- the UK is not a domicile of choice for 4 funds. So our experience with products is limited. 5 The second way a hedge fund might exist is in a 6 corporate vehicle. And very similar to -- as you have over 7 here, they can be public, in which case they may be listed, 8 or they can be private. And our ordinary regulation will 9 attach to each of those. 10 Now, for listed funds, they are currently -- the UK 11 listing authority has taken the view that, as investment 12 companies, hedge funds do not meet the required criteria for 13 spreading of risk. And so they are ineligible to be listed. 14 And one of the things that we did talk about in our 15 discussion paper was whether or not we needed to modify that 16 to allow our companies to be listed. As private companies, 17 of course, there are no such restrictions, and they could, if 18 they wished, be -- exist as private companies under UK law. 19 Just going back, then, to the activities, those who 20 engage in those activities that I mentioned before -- 21 promoting, advising, selling, or managing -- need to be 22 authorized under our regime. So, if you wanted to be a hedge 23 fund manager, you would need to be authorized. Similarly, if 24 you wanted to promote or sell hedge funds to people in the 25 UK, you would need to be authorized. 1 There are some exemptions to those particular 2 rules, but I think I will just plow on, as though you have 3 come within the ordinary category of required to be 4 authorized. To get authorized, you need to come through our 5 threshold conditions, which focus primarily on honesty, 6 integrity, and competence in order to do your job, and that 7 is a broad category that attaches to whether or not you're 8 doing a hedge fund, or whether you're setting up an insurance 9 company, really. 10 And so, it's very broad in general, but it needs to 11 be interpreted specifically for the permitted activity that 12 you want to do. So, of course, if you wish to manage a hedge 13 fund, we would look at what that means in relation to the 14 activities that you were actually proposing to undertake. 15 The authorization process is just the beginning. 16 When you become authorized, of course, you then become 17 subject to the FSA's supervision and oversight regime. And 18 in the first instance, of course, that means you need to 19 comply with our rules. 20 And our rules -- we operate a principles-based 21 regime, and we have high-level principles of business that 22 apply to all businesses conducting any sort of activity, and 23 they are very general and relate to such things as, in the 24 first instance, that senior management need to take 25 responsibility, they need to have appropriate systems and 1 controls, they need to treat their customers fairly, and they 2 need to conduct their business so as to preserve market 3 integrity. There are a number of those principles, but I 4 think you get the picture. 5 We have detailed rules underneath those principles, 6 and those detailed rules are tailored more specifically to 7 the nature of particular activities. And of course, there 8 are a number of rules that relate to the activity of 9 investment management, and they would apply to a hedge fund 10 manager in the same way as they would apply to any other 11 investment manager. 12 In particular, there are training and competence 13 requirements. And of course, again, they are backed up with 14 more detailed provisions relating to systems and controls for 15 the business. 16 What do we do, as the FSA? It's not just that we 17 have rules, we also have supervision. And I think anyone who 18 has come in contact with the UK system of regulation will 19 know that the financial services authority adopts a risk- 20 based approach to supervision, and what that means is that we 21 tailor or supervisory activities according to what we 22 perceive to be activities that present the greatest risk to 23 our statutory objectives. And two particular statutory 24 objectives are our objective of maintaining confidence in the 25 UK financial market, and protecting investors. 1 And so we look at hedge funds in this way. We say 2 this is a category of the market that, by and large, provides 3 services to a sophisticated vehicle, which is a hedge fund, 4 which, in many cases, is located offshore. The fact that 5 it's located offshore does not stop our rules biding on our 6 managers. 7 They are small -- although the sums are large -- 8 they are small in relation to the number of pounds involved 9 in that particular activity across the whole financial 10 services industry in the UK. And the number of retail 11 consumers that are likely to be affected by problems in that 12 industry, because -- by virtue of our other rules and 13 regulations is small. And in that case, we, generally 14 speaking, put hedge funds in a category of risk as being 15 rather low. 16 Now, that doesn't mean that investment managers 17 need to not comply with our rules, but what it means is that 18 we do not spend a large proportion of our supervisory time 19 crawling all over their business, and we are more likely to 20 expend supervisory effort through a themed approach, where we 21 look at particular risks that those businesses may pose. 22 And in that sense, some of the risks that we would 23 be sensitive to are risks that might arise out of leverage, 24 excessive leverage. And of course, we have mentioned that 25 before, that was one of the things that came up in the 1 president's working group. We will be looking at highly- 2 leveraged institutions, and we look, in particular, at the 3 counter-party exposure to hedge funds, because we have other 4 financial institutions who are providing a range of services 5 in the UK who may have exposures in that context. So, just 6 to sum up on that, we think our supervision of hedge fund 7 managers is probably light touch. 8 Now, just briefly going back, then, on investor 9 protection, we have a number of rules that prohibit marketing 10 and promotion to retail investors of hedge funds. And that, 11 I think, is enough background to lead me into a quick 12 discussion of what we did in DP 16. What we are very 13 conscious of is that we regulate the managers, we do not 14 regulate the funds. Where the funds are not incorporated in 15 the UK, our regular treatment does not extend to them. But 16 we do cover the managers. 17 We were concerned that somehow, the fact that 18 managers could advertise themselves as being authorized, may 19 lead investors in funds to believe that somehow they received 20 a greater degree of regulatory protection than may be the 21 case. And we thought that we would want to think about that, 22 and what the implications of that were. 23 Secondly, we were also concerned that there was an 24 appetite for hedge funds to be marketed to retail investors, 25 and that retail investors were clamoring to get into hedge 1 funds, particularly in the downturn of the market, there was 2 very much a sense that retail investors were aware that hedge 3 funds had not suffered drops in performance as much as 4 conventional funds, and with an appetite for them to have a 5 piece of the action. 6 In DP 16, therefore, we said two things. First of 7 all, we wanted to ensure that there was awareness out there 8 that our regulatory remittance scope extended only so far. 9 And in particular, that although we looked at the managers, 10 we were not regulating the funds. And secondly, we wanted to 11 ask the industry whether or not there was an appetite for us 12 to change our rules on marketing of hedge funds to retail. 13 As a part B of that question, we also said, "And 14 would there be an appetite for us to relax our restrictions 15 and rules on establishing hedge funds in the UK?" In other 16 words, perhaps a relaxing of our listing rules, such as I 17 mentioned before, or setting up a new category of collective 18 investment scheme that would allow hedge funds to be 19 established in the UK. 20 We published a feedback statement. We received a 21 number of responses to our consultation paper. And very 22 interestingly, the responses that we received showed -- quite 23 hearteningly, for us -- that perception and understanding of 24 the limit of our regulatory remit was high. And in 25 particular, we were concerned about some of the clients of 1 hedge funds, or investors of hedge funds that we may not 2 automatically say are necessarily sophisticated investors. 3 And by this, we mean things like charities or trust funds, 4 who, although they had reasonable chunks of money, would not 5 automatically be savvy, in financial services terms. 6 And our results showed that, yes, they were well 7 aware of the limitations of our scope, they understood what a 8 hedge fund was, they understood, when a fund was established 9 offshore, what that meant. 10 Secondly, in relation to the retail issue, we 11 actually received quite an interesting response from industry 12 which said they were very sensitive to the issues that 13 allowing higher retail involvement in funds would bring. And 14 many of these are some of the things that we have talked 15 about before. Ought there to be higher standards of public 16 oversight through auditing or through valuation controls? 17 Through investment controls? All of those sorts of areas 18 where we can see that lax standards can lead to problems in 19 the industry. 20 Now, the industry said they could see that there 21 was an argument that they would, perhaps, need to be higher, 22 where you had retail investors. And therefore, in many 23 cases, they did not think that they were worth taking on 24 those particular rules was worth it, and they would rather 25 stick with the regime as it was. The one exception to this 1 was in the fund of funds area, where we did see some appetite 2 for perhaps allowing more retail in. But I mention that 3 funds of funds, in any event, can be listed in the UK under 4 our rules, in any event. 5 So, we published our feedback, and we took the 6 decision that we were not going to change the regime, 7 although we were going to keep it under watch, to see if 8 there was an appetite for new changes to our rules. 9 Now, just to back up, what Jean-Claude has said in 10 response to some of the European developments in relation to 11 the European directive that relates to collective investment 12 schemes, we have been reviewing whether or not there is scope 13 to expand the category of collective investment scheme to 14 encompass things that would allow hedge funds in there, but 15 only if these were available to institutional investors. 16 And we have recently published a CP of collective 17 investment schemes which raises that possibility. I think 18 that's probably enough. 19 ME. ROYE: Thank you, Christina. One thing that is 20 striking about, you know, when you went through the 21 qualifications, and how you regulate a manager, it sounds 22 like it's more of a merit review that you do, in terms of 23 qualifying the manager, allowing the manager to register, 24 whereas in the U.S., it's a regime where if you, you know, 25 you file the registration document, you make the disclosures, 1 we're not going to scrutinize whether or not you have the 2 appropriate qualifications. As long as you haven't maybe 3 been convicted of certain crimes or disciplinary history, you 4 can be an investment advisor registered with the SEC. 5 And it sounds like you go into a much more in-depth 6 analysis of the qualifications, background, et cetera, of the 7 manager. 8 MS. SINCLAIR: We do. We look at what is the 9 permission that is sought. And if the permission says, "We 10 want to do this," then, yes, we would look and see what sort 11 of qualifications you would have to do that, yes. 12 ME. ROYE: All right. Doug, you work with the 13 International Organizations of Securities Regulators, and 14 have been in discussions with other regulators about how they 15 approached hedge fund regulation, hedge fund managers. And 16 we have just heard two regulators talk about their 17 approaches. 18 Can you give us a sense of how other countries are 19 approaching hedge fund regulation, a regulation of managers? 20 And I guess my sense is that we are one of the few countries 21 that doesn't at least require the manager to be registered 22 with the regulatory authority. 23 ME. SCHEIDT: Your sense is generally correct. We 24 are also one of the few countries that, in your words, 25 doesn't give merit review to those managers who do register, 1 or seek authorization from the regulatory authorities. 2 I usually put this in stark contrast, and say that 3 my three-and-a-half-year-old daughter could register with the 4 SEC as an investment advisor within 45 days of filing the 5 advisor registration document. And the point usually comes 6 across pretty well. But most -- 7 ME. ROYE: It would be a legal capacity issue 8 there, but -- 9 ME. SCHEIDT: Yes. But most jurisdictions are like 10 the UK and the U.S., in that they permit hedge funds to be 11 privately sold and marketed to sophisticated investors and 12 institutional investors without requiring the fund to be 13 licensed, or registered with the regulatory authority. 14 Some jurisdictions -- and I will get into more 15 detail about this -- do permit the sale of hedge funds to the 16 retail investor. And many, many jurisdictions allow funds of 17 hedge funds to be marketed to retail investors. I am going 18 to focus on three countries. 19 The one that has been in the business the longest, 20 I would say, is Switzerland. Since 1994, they have had 21 legislation that permits the sale of hedge funds and funds of 22 hedge funds to the public in Switzerland. There are -- they 23 created a category of fund called "other funds with special 24 risks," that cannot call themselves hedge funds, but they 25 must prominently disclose this designation in the prospectus. 1 There are several requirements that are similar 2 across the three countries that I will focus on, but: 3 special prospectus disclosure; minimum manager experience and 4 capital; sometimes they require expertise of the auditor for 5 the hedge fund; operating restrictions, such as restrictions 6 on leverage; and a thorough assessment, similar to the merit- 7 based approach, to the manager, that may also go to the fund, 8 itself. 9 So, in Switzerland, there is special prospectus 10 disclosure of all special risks. It must specifically 11 disclose redemption and valuation methodologies and 12 procedures. The managers must have five years, at a minimum, 13 of experience, and a minimum capital of about $750,000. The 14 external auditors must have -- must demonstrate expertise in 15 auditing hedge funds, or that type of hedge fund. Redemption 16 must be available at least four times a year. Borrowing is 17 restricted to 25 percent of the fund's assets. They have no 18 minimum investment amount, but we are told that they never 19 had an investment below a certain relatively low level, 20 $10,000. 21 And then there are additional requirements for 22 funds of hedge funds. They define a fund of hedge funds as 23 any fund that has more than 10 percent of its assets invested 24 in a hedge fund. No more than 30 percent of the fund's 25 assets can be invested in any fund offered by the same 1 manager. And the prospectus disclosure in the fund of hedge 2 funds must say that you could lose 100 percent of your money. 3 Hong Kong, more recently, permitted sale of hedge 4 funds to retail investors. They have minimum investment 5 requirements that's $50,000 for a single hedge fund, and in a 6 fund of hedge fund it's as low as $10,000. The manager must 7 have expertise in a certain -- must have at least $100 8 million in management -- in hedge fund strategy, and five 9 years of experience in managing hedge funds, or hedge fund 10 strategies, and two years in the strategy that's going to be 11 employed by the fund. 12 The prospectus must disclose the extent of 13 diversification, the leverage, risks, et cetera. They 14 require that the performance fee charged by the hedge fund 15 must be on a high watermark basis. They require valuation by 16 an independent valuation agent, and they require valuation on 17 at least a monthly basis. And they also require quarterly 18 reports by the hedge fund. 19 Singapore -- I guess I won't go into detail too 20 much on Singapore -- but Singapore has a similar approach as 21 to -- as Hong Kong does. 22 ME. ROYE: But you have situations where, you know, 23 even where they're opening the door to retail investors, they 24 are still, in effect, limiting who can be a hedge fund 25 manager. I mean, they are scrutinizing qualifications, 1 background, and only letting what they view as a suitable 2 manager run a hedge fund. But they can be offered to retail 3 investors. 4 ME. SCHEIDT: Yes, similar in the U.S., to the 5 extent that we permit registered funds of hedge funds. There 6 is an awful reliance, if you will, on the top-tier manager, 7 his expertise, on behalf of the investors in the fund in 8 picking suitable hedge funds, if you will. 9 But we don't impose any requirements on those 10 managers. We don't require experience, we don't require 11 demonstrated abilities. We don't get involved in that 12 process. The foreign jurisdictions that permit funds of 13 hedge funds, and retail investment in hedge funds do 14 thoroughly assess the fitness of the manager to provide those 15 services, the educational background and experience. 16 ME. ROYE: I guess I would just open it up to the 17 other panelists, maybe Iain, in particular. Any observations 18 on how regulators, other than the U.S., approach the 19 regulations of hedge funds, funds of hedge funds, hedge fund 20 managers? 21 ME. CULLEN: I don't have a lot to say. I think 22 it's been said, principally by Christina and by Jean-Claude. 23 I think you do have to remember that the European and Far 24 Eastern systems grew up entirely differently from yours, and 25 these are different times. Simply looking at what other 1 people have done in other parts of the world and saying, 2 "Maybe this is the way to go," ignores the fact that they 3 have grown up under different circumstances. 4 I make no comment about whether it's right or not 5 to look as closely as we do -- and, indeed, as many other 6 European jurisdictions do about the underlying experience of 7 the managers. I think the only -- 8 ME. ROYE: We probably bring a lot more enforcement 9 cases than you see in Europe as a result of -- 10 ME. CULLEN: Your system is very different. As 11 somebody said in one of this morning's panels, the SEC tends 12 to be the cop, whereas most of the European regulators have 13 grown up working not so much as cop, but rather with their 14 constituencies. It's not seen as an us and them scenario. 15 And I don't think you can just graft other jurisdiction's 16 ways of doing things on to yours, and say, "Well, theirs is 17 better, and this is the way we should do it." 18 I think the only other point that I would make in 19 relation to funds of hedge funds, in particular, is that not 20 just Switzerland, Hong Kong, and Singapore, in the process of 21 bringing out rules for domestic funds of hedge funds, but 22 Italy has done it some time ago, Germany has expressed its 23 intention to do so. I think the UK will get there, sooner, 24 rather than later. And the FSA just needs a bit of a push. 25 And I think that Ireland and Luxembourg -- Ireland 1 has just come out with specific rules for funds of hedge 2 funds. One tends to think of Ireland and Luxembourg, in the 3 same breath, as being jurisdictions that provide product to 4 be sold elsewhere, because they are so small, in themselves. 5 But clearly, there is a move outside the U.S., as 6 well, towards regulating, in one shape or form, funds of 7 hedge funds, at least. And I think it will continue, rather 8 than contract, particularly if you think in terms of the 9 extra bit that -- in relation to at least Hong Kong and 10 Singapore, which is that if you have a guaranteed fund of 11 hedge funds -- or, indeed, actually a guaranteed single 12 manager fund -- although I don't think there are any -- there 13 is no minimum investment, whatsoever. You can have a minimum 14 investment as low as five dollars -- local dollars, rather 15 than U.S. dollars. 16 ME. ROYE: Thank you. Why don't we move from how 17 foreign regulators approach the regulation of hedge funds and 18 their managers to the CFTC. I mean, as we pointed out, I 19 think largely, hedge funds aren't registered with the SEC. 20 They are off our radar screen, but they are on the CFTC's 21 radar screen. 22 Jane, if you could, you know, outline how you 23 regulate and oversee hedge funds for us. 24 MS. THORPE: Thank you, Paul. Hedge funds is not a 25 term that is defined in the Commodity Exchange Act, or the 1 rules of the CFTC. But if a hedge fund happens to exchange 2 trade a derivatives, then the operator of that vehicle that 3 invests in futures must -- is subject to regulation. 4 So, even though, Paul, we are in the United States 5 and not outside the United States, we do scrutinize the 6 manager, and it is the manager that we regulate, and not the 7 vehicle itself. Those managers are required to be registered 8 with the commission as commodity pool operators. There is no 9 general relief for privately offered funds, comparable to 10 that under the securities laws. If a CPO relies on an 11 external advisor, that advisor must be registered as a 12 commodity trading advisor. As of April 2003, there were 13 approximately 1,800 active CPOs and about 800 active CTAs. 14 In terms of our regulatory framework, it's really 15 based on investor protection. It's designed to protect 16 investors against fraud and trading abuses. Registration and 17 other requirements are intended to ensure the fitness and 18 properness of the manager. The disclosures include 19 information on the investment program, principal risk 20 factors, past performance, fees and expenses, conflicts of 21 interest. And these disclosures must be updated every nine 22 months and be provided to an investor before it opens an 23 account. 24 In addition, the pool operator must also provide 25 periodic account statements, as well as an annual audited 1 financial statement. Further, they are also required to 2 comply with sales practice requirements, as well as various 3 record-keeping and reporting requirements. CPOs and CTAs are 4 subject to requirements in anti-fraud and anti-manipulation. 5 With respect to compliance, it really is a 6 responsibility that we have given to the National Futures 7 Association and Industry Self-Regulatory Organization. And 8 in practice, we have delegated many of these functions to 9 NFA, including the registration processing function for CPOs, 10 CTAs, as well as most of our other registrants. In addition, 11 review the annual financial statements for compliance with 12 GAAP, and a disclosure document review for compliance with 13 the standards in our rules. 14 NFA conducts routine periodic examinations of CPOs 15 and CTAs for compliance with both CFTC and NFA rules. And 16 then we, in turn, review NFA's review of these entities. 17 CPOs and CTAs are conducted on a three-year audit cycle by 18 NFA. 19 As far as current regulatory relief that is 20 available under the Commodity Exchange Act, I think the most 21 prominent one to mention is that there is no broad-based 22 registration relief for entities that are hedge fund-like, as 23 I mentioned. 24 But there is a significant relief for entities that 25 are 4.7 qualified, that, to the extent they have 1 sophisticated investors, they are required to be registered 2 as commodity pool operators, but they are exempt from any 3 disclosure, record-keeping and reporting requirements. And 4 approximately 50 percent of the registered CPOs have filed 5 4.7 notices, so that is a significant number. 6 The Commodities Exchange Act does not require the 7 CFTC to insure the safety and soundness of either the 8 commodity pool operator, or the pool that it operates, and it 9 does not restrict the types of products that a pool can trade 10 in. 11 However, pools are customers, and their accounts 12 must be carried by a futures commission merchant, which is 13 supervised for capital requirements. Also, pools are 14 customers on markets. And as such, they are subject to large 15 trader reporting requirements and speculative trading 16 restrictions. 17 If you want me to touch upon the proposal that we 18 have outstanding, Paul, I can do that now, or I can do that 19 later. 20 ME. ROYE: Yes, I was just going to ask you, you 21 know, that you're proposing to reshape the regime. Pat 22 McCarty alluded to that in one of the earlier panels. And I 23 guess it's going to provide additional exemptions for hedge 24 fund operators, I guess, or hedge fund advisors. 25 And I just wondered the theory behind that, you 1 know, why are you moving in that direction, and if you have 2 any estimates of what that's going to mean, in terms of hedge 3 funds moving off your radar screen, or advisors moving off 4 your radar screen. 5 MS. THORPE: Right. Well, since passage of the 6 Commodity Futures Modernization Act of 2000, the commission 7 has been reviewing the regulatory framework to identify 8 further areas for modernization of our approach to 9 regulation. And within the past year, we have done quite a 10 lot of work in the area of intermediary regulation. Pool 11 operators and trading advisors are, obviously, included in 12 intermediary regulation. 13 And in that regard, the core concern under the CFMA 14 is to ascertain whether the level of regulation is 15 appropriate to the risk posed by the activity and the 16 customers involved. What we have proposed to do in March of 17 this year is to expand the category of those persons that are 18 eligible for exemption from the CPO and CTA registration 19 requirement. 20 And again, let me emphasize that what we have 21 proposed is a registration exemption. It is not anything 22 that would result in our losing jurisdiction over these 23 entities. And they would remain subject to our anti-fraud 24 jurisdiction. 25 In March, we proposed, essentially -- it would have 1 two prongs to it for exemption from registration. One prong 2 would be based on diminimous amount of futures and options 3 trading by the pool, where the participation is restricted to 4 accredited investors, as defined under SEC rules and 5 regulations. 6 The other prong would be based on higher 7 sophistication tests, but because of the higher 8 sophistication of participants, there would be no restriction 9 on the amount of futures that the vehicle could engage in. 10 Because our investor qualification requirements 11 basically track the SEC's definition of sophisticated 12 persons, if the SEC were to increase or lower its standards 13 or rules on exemptions, then the proposal, similarly, would 14 go up and down. 15 One of the reasons why we felt comfortable 16 proposing the rules in this regard is that the commission and 17 NFA staff have reviewed the audits of rule 4.7 pool 18 operators, and found out the deficiencies in those vehicles 19 rarely rose to a level that really warranted any disciplinary 20 action. I believe NFA receives only two to three customer 21 complaints per year regarding 4.7 CPOs. And although the 22 number of 4.7 CPOs has increased by approximately 480 percent 23 in the last 10 years, NFA has brought only 2 disciplinary 24 actions involving the activities of these 4.7 pools. 25 The comment period has closed; we received 31 1 comment letters. They were overwhelmingly favorable, and 2 many urged the commission to adopt final rules, with various 3 proposed modifications, as soon as possible. 4 And so, where we are today is that with respect to 5 these 4.7 entities, we have a regime where we have exempted 6 them because of the sophistication of the participants from 7 many of the requirements: disclosure, reporting, and record- 8 keeping. But we still require registration, and we still 9 require examination of these managers. 10 And I think the ultimate question for the 11 commission is whether the continuation of the current 12 registration and inspection regime adds material value to 13 investor protection, fraud prevention, or limitation of 14 market abuse. 15 ME. ROYE: A lot of the pools that you're talking 16 about, I guess, understand that they are really privately 17 offered, and there is only -- I think Pat mentioned -- maybe 18 30 or so publicly-offered commodity pools. 19 MS. THORPE: None of the pools that I mentioned 20 that would be eligible to be 4.7 qualified, and therefore, 21 also be eligible for the additional registration exemption 22 that we have proposed could be publicly-offered pools. The 23 exemptions, both under 4.7 and what we have proposed would 24 require that, at a minimum, the customers invest via credited 25 investors. 1 ME. ROYE: And so, when you have the 1,800 2 commodity pools, I think you said 800 -- maybe I have that 3 wrong -- in terms of commodity trading advisors. 4 MS. THORPE: Mm-hmm. 5 ME. ROYE: What will the rules do to those numbers, 6 in terms of registration? Any sense of -- 7 MS. THORPE: Well, it is interesting, and it 8 remains to be seen. If the proposal is adopted -- as I 9 mentioned, approximately half of the 1,800 registered pool 10 operators are 4.7-qualified. That would mean that, 11 potentially, all of those 50 percent -- those CPOs would be 12 eligible to claim one of the two exemptions, either the 13 diminimous, because they do limited futures trading, or 14 because of the higher sophistication, unlimited trading. 15 So, there is no question that we would be 16 potentially creating a situation where a significant number 17 of entities that are currently registered with us could 18 actually deregister. 19 We do have some interesting statistics. As part of 20 our proposed rule-making, the commission actually, in the 21 proposal, embedded a no-action position that basically 22 permitted pools that had accredited investors as a minimum, 23 and restricted their trading in futures to filing notice with 24 us, and trade in futures products. 25 And the data is actually quite revealing, that as 1 of May of this year, we have received 340 notices claiming no 2 action relief in the embedded rule-making. And of those, 290 3 involve commodity pool registration relief. So, it is quite 4 clear that our current registration requirements for these 5 "hedge funds" has kept out participants who would otherwise 6 have come in. 7 ME. ROYE: And I guess, consistent with what Pat 8 said earlier, a lot of this movement is driven by the fact 9 that, as Pat pointed out, we have seen very little fraud in 10 this area. 11 MS. THORPE: Both by the commission's own 12 enforcement activities, as well as by NFA, which is the 13 entity that has responsibility for compliance and inspections 14 of these entities. Yes, that's right, Paul. 15 ME. GAINE: Paul, if I might say -- 16 ME. ROYE: Mm-hmm. 17 ME. GAINE: What Jane said is absolutely correct. 18 The drive at the CFTC flows from the CFMA, which was trying 19 to match the level of protection versus the level of 20 sophistication, and balance those two. 21 We are very strong supporters of the -- MFA is very 22 strong supporters of the current proposal of the CFTC, and 23 they are actually premised on the success, their internal 24 success, of lack of customer complaints, but also, the 3C1 25 3C7 analogy over under your act where you're lessening the 1 level of protection because of the nature of the investors. 2 And it was modeled after those -- at least in my mind -- when 3 we put together. And as you know, as well, the CFTC is 4 reconsidering its 203B31 failure to consider a fund as the 5 one customer, and looking through to them as part of this 6 same package. 7 So, a lot of what -- I think these proposals mirror 8 what the existing securities laws are. 9 ME. ROYE: Well, why don't we move to the 10 securities laws? You know, largely, the disclosure, you 11 know, by hedge funds, I think, is driven by the applicability 12 of the anti-fraud provisions of the federal securities laws. 13 And I guess a fundamental question is whether or not that 14 leads to an appropriate level of disclosure by hedge funds. 15 And I guess I would go to Mark Anson first, as a 16 large investor in hedge funds. What's your perception of the 17 disclosure that you see in the hedge fund area? Is it 18 adequate? Do you think there are areas where disclosure 19 could be improved? Disclosure should be mandated? What's 20 your perspective on that? 21 ME. ANSON: To answer the question simply, yes. 22 Disclosure can be improved. Let me talk about the fraud that 23 concerns me, as an investor, particularly since we're talking 24 about the anti-fraud provisions of the SEC laws. 25 As an investor, when I look at hedge funds, there 1 are really two types of frauds that worry me. The first is 2 that, to begin with, the trading strategy of the hedge fund 3 is a sham, to begin with. It doesn't exist. 4 But this type of fraud can be ferreted out through 5 solid due diligence: the audit trail of trade tickets; 6 speaking to the hedge fund manager's prime broker; 7 interviewing other investors in the fund; the reasonableness 8 of the track record giving economic circumstances. Through 9 pretty basic and solid due diligence, you can ferret out 10 whether a hedge fund manager has a legitimate track record or 11 not, and unearth the fraud if it exists. 12 The second type of fraud that I would like to talk 13 about is the one that concerns me more, as an investor. And 14 that's the failure to disclose losses in a hedge fund in a 15 timely manner. 16 I think the recent example of Beacon Hill is a 17 great case, where that seems pretty clear there were losses 18 that were parceled out over time, and were not disclosed to 19 investors in a timely manner. In fact, there are two recent 20 papers, academic papers, both published in the Journal of 21 Portfolio Management, that demonstrate, in fact, that hedge 22 fund managers smooth their returns. They parcel out their 23 gains and losses over time. 24 And while the anti-fraud provisions can deter 25 fraud, they really can't prevent it. And most particularly, 1 it's the second type of fraud, where hedge fund managers 2 don't disclose their losses immediately, and in fact, they 3 parcel them out over time, that's the one that's most 4 worrisome to me, because once the fraud is uncovered, and the 5 anti-fraud provisions kick in, and action can be taken, well, 6 by that time, the losses have already occurred. And it's 7 difficult for investors to get their money back. 8 I think it noted here on the syllabus, one of the 9 questions that you posed to me is, "Should there be 10 additional regulation, or regulatory requirements for hedge 11 funds and their managers?" I guess that's what we're all 12 here to answer today. 13 You also ask whether there should be more 14 regulation regarding disclosure, and whether we should leave 15 it the industry practice, the negotiation of terms between 16 hedge fund managers and their investors. Well, I would like 17 to note that leaving disclosure to industry practice and 18 negotiation right now, well, the power remains with the hedge 19 fund managers. I will give you two good examples. 20 One, there are far more attorneys out there 21 representing hedge fund managers than representing investors 22 in hedge funds. So when you get down to negotiating the 23 nitty gritty, generally you're sitting across the table from 24 a hedge fund manager who has better legal representation than 25 you do, as an investor. 1 Second, there is the issue of capacity constraints. 2 The best hedge fund managers close their hedge funds. Or, if 3 they open them, they open them for a very small period of 4 time, and it's basically a take it or leave it. "You want 5 into my fund? Here are the terms that you get." The 6 bargaining and leverage remains with the best hedge fund 7 managers. 8 In my opinion -- and again, I am expressing my own 9 personal opinion, and not that of CalPERS -- in my opinion, 10 more disclosure is needed. But there also must be a balance. 11 If there is a public disclosure of the hedge fund manager's 12 trading positions, well, that may reveal that hedge fund 13 manager's competitive advantage. And as an investor, that 14 doesn't help me, that's just going to erode my returns. 15 So, as we talk about the anti-fraud provisions, I 16 think, one, the concern -- the greater concern -- I have is 17 with regard to hedge fund managers that don't reveal or 18 disclose their losses in a timely manner, and second, with 19 regard to better disclosure provision, yes. There can be 20 better disclosure. Certainly there should be some basic -- a 21 minimum disclosure. Right now, it's all over the board. 22 And in terms of revealing a hedge fund manager's 23 trading positions to the public, well, you're just going to 24 force hedge fund managers offshore, and furthermore, that's 25 going to erode their returns, which is not going to help me, 1 as an investor. 2 I think at that point, I would probably stop and 3 see where we take this discussion on questions. 4 ME. ROYE: Well, it is interesting that you, as one 5 of the largest institutional investors probably in the world, 6 is saying there is a problem in terms of accessing 7 information. And I guess I would have thought that, in your 8 position, you would be able to get all the information you 9 needed. 10 And I guess I would be worried about maybe the 11 smaller investors being able to access information. But 12 you're saying that you have problems. 13 ME. ANSON: I think you have to be smart enough and 14 sophisticated enough to ask the right questions. If you ask 15 the right questions of the hedge fund managers, you will get 16 the right answers. But you have got to know what questions 17 to ask, to begin with. Part of that just comes from being a 18 knowledgeable investor, and part of it just comes from the 19 education of hard knocks, learning from your mistakes. 20 ME. ROYE: I guess I would ask Sandra to -- who 21 follows the industry very closely, and is interested in a lot 22 of these disclosures, what is your sense of the disclosure 23 question? 24 MS. MANZKE: Well, first of all, I think that, in 25 my own personal opinion, it would make my life a lot easier 1 to have mandated disclosures. I agree, it's very difficult 2 to get answers out of managers, and they hold all the keys 3 right now. If you want to get into a good fund, and you ask 4 some difficult questions, you may not get that answer. 5 Sure, there is a lot of access, to get online and 6 do background checks, and hire firms such as the last panel. 7 But that's expensive. And can the retail investor do it? 8 No. Firms like ours, we spend a lot of money, we have a lot 9 more people working for us now to uncover these types of 10 situations. 11 I would also like to state that I, personally, 12 would like to see more prosecution. We also looked at people 13 -- in the last panel, they mentioned David Askin. One year 14 after David Askin had lost all the money for his investors, 15 he was the keynote speaker at a major conference that was 16 attended by over 700 people. I listened to the Q&A, there 17 was not one harsh question that was asked of him, he spent 18 not the day in jail, and basically has a lot of money today. 19 I can go through a list of managers that have 20 created fraud situations, and it seems to me that it's okay 21 to steal in this country from rich people -- and you probably 22 will get a better, lighter prison sentence -- than the person 23 who burglarized your house. 24 I think that there isn't any reason today, if 25 managers -- it used to be that you only had 100 investor 1 limitations. When the regulation was passed that opened up 2 hedge fund investors to 500 or more, and the 3C7, perhaps at 3 that time they should have mandated some registration. 4 We talked about the retail investor trying to get 5 any of this information. Wouldn't it be nice to have a 6 Morningstar database of hedge fund managers? You know, we 7 have a database, but I can tell you, managers stop reporting 8 for several reasons. The obvious one is they don't want 9 their negative numbers shown to investors. But second is 10 that they are not taking any new money. It also becomes very 11 difficult to get a real definition of this industry, when 12 some of the largest hedge fund managers refuse to report 13 performance or size. 14 So, I think some of the regulatory issues today, 15 with the size of the industry and the newcomers coming in to 16 this, we shouldn't just say because you have $5 million, that 17 you're sophisticated. It's not true. It's very difficult, 18 even for somebody who might have that money, to be able to do 19 this due diligence. 20 So, the information that I would like to see is, 21 you know, their background, who their auditors are, has there 22 been change in that auditing firm -- that's another, you 23 know, sometimes auditors resign because they don't like 24 working with those managers -- their previous experience, and 25 be able to trail some of the people that are in this 1 industry. 2 I also do find it a bit odd that in this country 3 you have to take a test to be a broker, and pass, and get 4 certain licenses to run a brokerage firm. You have to take 5 exams and pass licenses. And to sell insurance, you have to 6 take an exam in order to be an insurance salesman. But as 7 you said, to be an investment manager, you just fill out the 8 form, and 45 days later, you're an investment manager. So, 9 even some of the qualifications to be a manager, I think, 10 should be upheld. And that would eliminate a lot of the 11 fraud on the smaller people. 12 The very big hedge funds, I don't see any problems 13 with them. They are usually stand-up people, they have their 14 own capital at risk. But where we are seeing the problems 15 are the people that are going out and being able to raise $1 16 million to $5 million from smaller investors, and 17 essentially, duping them. 18 ME. ROYE: Well, there have to be some differing 19 views at the table. 20 (Laughter.) 21 ME. ROYE: Jack? 22 ME. GAINE: Yes, I do disagree. I think -- I will 23 take your question in the context of the traditional hedge 24 fund, not retail -- a small one -- and just point out that, 25 as most people in this room know, that the anti-fraud 1 provisions of the 33 Act and the 34 Act, and the Advisors 2 Act, all apply to the hedge fund manager and the advisor. 3 And they cover fraud, and they offer in sales of securities, 4 purchase of securities, insider trading, and fraud and the 5 advisory relationship. 6 I think if you had sat through here for the two 7 days, you would come to realize the variegated -- if that's a 8 word, but anyway -- very diversified kinds of hedge funds, 9 what disclosures -- I'm sure Mark Anson knows what the right 10 questions are to ask, and has asked them, and has invested in 11 some large hedge funds, and not in some others. 12 I agree with Sandra, there probably should be more 13 prosecutions, or at least there should be prosecutions of 14 those persons who ought to be prosecuted. And my good 15 friend, since his name is now Steve, he obviously is doing a 16 good job at that. I think that is a great answer to this. 17 But Mark also mentioned the risk of going offshore. 18 This is a very delicate area of what is it, the role of the 19 federal government? What could they do to prescribe here in 20 Washington that would provide someone in Mark's position, or 21 a comparable position, information that they wouldn't be able 22 to get themselves? And if they don't get it themselves 23 satisfactorily, given the private nature, the private 24 offering nature, the private contractual relationship of a 25 hedge fund to their investors, the investor is free to walk 1 away. And I would say that that would be the answer. 2 These are not public products. They are privately 3 offered products. No one is forcing anyone to buy them. 4 They are not advertised. And I think the bargaining position 5 of the investor should be enough to get what he needs to 6 know. And if he doesn't, he should look elsewhere. 7 ME. ROYE: Paul, you draft these documents. But 8 you -- 9 ME. ROTH: Yes, I would like to say something on 10 behalf of the much-aligned private offering memorandum. 11 (Laughter.) 12 ME. ROTH: I sat on my hands yesterday when it was 13 maligned, and I'm glad that I'm up here with a microphone to 14 say something about it today. I can only speak about the 15 ones that we draft. But we use, as a starting gate, a format 16 of what is the required disclosure for a registered 17 investment company. 18 We also look at what is required for a 33 Act 19 filing. And we put together that kind of information, which 20 is required under both of those situations, to put together 21 an offering memorandum. 22 Now, I will be the first to say sometimes it is 23 something that you might want to take, when you're having 24 trouble sleeping, to bed with you. But that's because, I 25 think, not that it is so difficult to understand, but because 1 the risk factors are repeated so many times. We had a 2 summary in which the risk factors are set forth. We do 3 encourage, strongly encourage, all of our clients to set 4 forth what their investment program is, because what we tell 5 people is the place where you get sued is where there has 6 been an expectation gap. 7 If you follow the investment program that you have 8 told your investors that you were going to follow, and you 9 lose money, they understand that. If you lose money 10 following an investment program that you haven't said you're 11 going to follow, or that they didn't understand you were 12 going to do because you have so muddied up the waters of 13 saying anything, watch out. You're going to have a problem. 14 And so, personally, I don't want to issue a 15 challenge or anything, but if we were to read the private 16 offering memoranda of the hedge funds as against the public 17 documentation of the registered mutual fund, or even the 33 18 Act companies, I'm not sure which comes in first, second, and 19 third in that network sweepstakes. 20 ME. ROYE: Or last, or next to last, or next to 21 next to last. 22 ME. ROTH: Right. So -- 23 MR. ROYE: No one comes in first. 24 ME. ROTH: The second thing I would like to say is 25 that we have across the table from Mark Anson, and I don't 1 think he lacks adequate legal representation, or 2 sophistication. We have learned that the hard way. And 3 sophisticated investors know the questions that they want to 4 ask. And this is like anything else. It's a learning 5 process. 6 I remember the first time somebody said to me, "We 7 would like to do a hedge fund." Unfortunately for me, that 8 was back in 1967, and I said, "What's that?" I learned, and 9 I have been doing hedge funds since that period. 10 And I must say, I think the statistics about the 11 number of fraud cases that have been brought are remarkably 12 low, considering the demographics of the industry. I think 13 that the learning of the CFTC is very instructive, in terms 14 of what they have seen, with respect to the hedge fund 15 industry. And of course, it's not all one way or the other. 16 There is going to be some balance in this. 17 But by and large, this is an industry that is very 18 well run. The large players are subject to a great deal of 19 supervision from their prime brokers, from their lenders. 20 The lessons, I think, of long-term capital management, 21 hopefully, will not be forgotten. But they have been 22 learned, and the amount of leverage in the system is far 23 different. 24 And you know, I think the system is working fairly 25 well, in terms of disclosure. And there is -- I would not, 1 personally, invest in a fund that would not answer questions 2 that I had. I don't know why anybody else would. Every one 3 of our offering documents gives the background of the 4 manager. Every one of our offering documents tells who the 5 auditor is, who the lawyers are, and what the education and 6 sophistication is of the people who are working on the 7 strategy. 8 So, let me just stop there with a plug for the 9 offering document. Bob Pozen? 10 MR. POZEN: I think there are two different 11 disclosures involved here. One is the disclosure to the 12 marketplace for other institutional investors who are 13 obviously now all required to disclose their positions and 14 they want to know who else is trading, they want to know 15 what's happening in the marketplace, especially if there's a 16 leverage vehicle. 17 And I don't think if there was a requirement, say, 18 for a quarterly disclosure by hedge funds that was lagged 30 19 to 45 days, that there would be a tremendous disruption in 20 their trading strategies. But that's what all the rest of 21 the institutional investors have to do and they don't have 22 the trading volume that the hedge funds do. So there's some 23 medium ground there. 24 The second thing is in terms of disclosures -- 25 we're talking about non-registered entities to clients. It's 1 been my experience with registered investors that the hardest 2 thing to get people to do is to have standardized returns 3 including their losses. And even in the mutual fund industry 4 where people had these rules, people really struggled for 5 years about whether or not they were really getting 6 standardized returns and whether they were reporting losses 7 accurately. 8 So if you say what's -- one of your questions here 9 -- what would be sort of the signal or most important thing 10 if you were not to have a broad scheme of regulations but a 11 modest scheme of regulations, those seem to me the two 12 things. Some sort of disclosure to the marketplace on a lag 13 basis and some sort of systematic way of calculating fees and 14 disclosing returns and losses. 15 MR. ROYE: Sandra, do you have any perspective on 16 the standardization point getting all the hedge fund managers 17 to report their performance the same way? I mean, I know 18 they report in to you. 19 MS. MANZKE: Yeah. It is actually difficult. I 20 think that there's methods to get there. For a long time I 21 beat my head against the wall by asking for gross and net 22 returns. The industry has really settled on net returns. 23 But some of the statistics that you should be looking at, you 24 really want to do them on your gross returns because there's 25 a smoothing effect with your performance fee kicking in and 1 out on net returns. 2 Additionally, people come into these funds at 3 different times so if you came in in June as an investor you 4 probably don't have the same rate of -- you don't have the 5 same rate of return as the investor that's been in for the 6 full year or those that added. I think, you know, one way of 7 looking at it is to take returns of an investor that put a 8 million dollars in the fund at the beginning of the year and 9 see what the end return is rather than the full fund's 10 return. 11 So there's a lot of problems with getting 12 performance numbers and also the fee calculations. There is 13 an annual audit done once a year. We personally don't ever 14 invest with a manager until an audit has been done. But 15 again, those audits come out later and if you get your audit 16 in the end of April or by mid-April, that's a long time to 17 wait for a manager's first audit. 18 Again, I would love the industry to adopt some kind 19 of systematic methods of reporting and things that we need to 20 look at. I don't think positions really help you that much. 21 I don't really care what the managers and IBM record. I'd 22 like to know how many equity positions they have, I want to 23 know the amount of leverages in the portfolio, I want to see 24 exposures, I want to see the -- what I call benign 25 transparency. 1 Disclosing your short positions I think is death to 2 the industry for a variety of reasons but knowing what your 3 net exposures are is important. And again, there is no real 4 regulation that says you have to disclose your performance 5 numbers and I again get back to I think that that's something 6 that the industry would benefit from, the investors from the 7 fund would also be able to benefit from readily having 8 accessible data. 9 COMMISSIONER ATKINS: I want to throw in a question 10 in that vein. As far as AIMR goes, those sort of standards, 11 those sort of market-based approach, is there a growing from 12 a demand from some of the public punching plans and ERISA 13 plans, is there a growing demand for that on the part of 14 hedge fund managers? 15 MS. MANZKE: You can get that information from 16 managers that you want to put investments with. It's just 17 that there are no real complete standards. We go back and do 18 -- with all the managers that we have money with, once we get 19 the audited financials, we're able to go back and piece 20 whether or not the numbers that were reported were actually 21 the ones that were produced in the fund. 22 But until you get that audit, you know, you're 23 really relying on the manager to give you those interim 24 results. You can compare the offshore funds at least have an 25 independent third party so pricing and coming up with NAV and 1 so it's easier actually to use some of the offshore numbers 2 as a better indicator of what the performance of the managers 3 are. 4 MR. ROYE: Mark? 5 MR. ANSON: If I could just follow up on that. 6 It's interesting when you look -- when you mention AIMR, 7 whether hedge fund managers are AIMR compliant. I have seen 8 very few hedge fund documents that say they're AIMR compliant 9 whereas in the traditional investment world of long only 10 management, every manager is AIMR compliant. 11 Couple reasons for that. First, very few CFA 12 charter holders have gotten into the hedge fund industry but 13 as more get in, I suspect that you will see more AIMR 14 compliant performance data. Second, AIMR is still grappling 15 with the issue of leverage. How do you account for leverage 16 and how do you present performance results when you have 17 leverage embedded in the returns? 18 That's an issue that's unresolved at this time but 19 I suspect that once it does become resolved, given the amount 20 of leverage in hedge fund returns, you'll see more AIMR 21 compliant returns as a result. 22 MR. ROYE: Iain, you've worked on a set of best 23 practices for the European hedge fund industry and I guess I 24 wonder -- and I guess this is also to Jack -- are best 25 practices embraced in the hedge fund community and -- these 1 disclosure issues, standardization of performance? I notice 2 to some extent in your best practices you do go into 3 disclosure concerns and issues that you think hedge funds 4 ought to focus on. 5 Have these been embraced and are best practices a 6 solution to some of these issues? 7 MR. CULLEN: I think the first and most important 8 thing to say is that what we produced was a guide to sound 9 practices and I think there is a very big difference. And in 10 fact, in the introduction we made that point. 11 MR. ROYE: Excuse me. I'm sorry. I didn't -- 12 MR. CULLEN: We had a large debate before we 13 started on this as to whether this was sound practice. 14 MR. ROYE: These are the minimum standards or these 15 are what you see as appropriate standards but not necessarily 16 the best standards. 17 MR. CULLEN: And I think the point about best is 18 that best assumes that in a sense that you are selecting a 19 particular standard that is applicable to all and I don't 20 think you can be as -- we didn't -- this was a group 21 comprised of a large number of UK-based hedge fund managers, 22 prime brokers, accountants. My only involvement was to co- 23 review rather than to co-edit and to some extent what that 24 involved doing was taking out references to anything that 25 might be construed as a best practice. 1 And I think it's important to know the genesis of 2 this sound practices guide rather than the U.S. post long- 3 term sound practices guide which serves a different purpose. 4 The purpose of the guide which AIMR published, which is a 5 guide to sound practices for European hedge fund managers but 6 which is at the moment being extended to Asia with some 7 suggestion that it be extended to the U.S., but my personal 8 view is that that is a bit of a minefield. 9 It was actually the result of two linked things. 10 The first was the new rules published by the financial 11 services authority back in the tail end of 2001 where it 12 became apparent that under the new rules compliance in its 13 loosest sense was going to be something that the FSA was be 14 looking at more closely in relation to fund managers 15 generally and the existing hedge fund manager contingent 16 within the FSA, bearing in mind that all hedge fund managers 17 in the UK are regulated, concluded that it would be helpful 18 if they were all saying the same thing or just about the same 19 thing to the FSA if it came a-calling. 20 And so there was nothing at that point in writing 21 as to what was market practice, what was sound practice and 22 it was -- they concluded themselves that it would be a good 23 idea to produce something on the basis of which FSA, if it 24 wanted to, could test the way they were operating. 25 And in conjunction with that, they concluded that 1 it would also be a good idea to produce a guide for new 2 entrants to the industry. Many of them said at the time we 3 were working on this it would have been very helpful if we'd 4 had something like this when we started out, bearing in mind 5 that the UK hedge fund management industry is considerably 6 younger than the US. 7 And so what we ended up with is something which 8 says -- and if you'll forgive me, I'll cite it briefly, 9 whilst the intention has been to produce a resource for 10 general use, it should not be assumed that one size fits all. 11 The size, nature, jurisdiction of regulation and complexity 12 of a particular hedge fund manager's operations and 13 investment strategy may mean that some or all of the sound 14 practices set out in the guide are in fact inappropriate to 15 the business of a particular hedge fund manager. 16 So really as sound practices, it was accepted that 17 they would apply differently to different fund managers and 18 in different jurisdictions as well. Because whilst this is 19 inevitably, given the makeup of the working group, based on 20 UK operations and the way UK fund managers operate, it was 21 designed to be capable of being used as the hedge fund 22 manager industry expanded through Europe into places like 23 France and the like. 24 So it is only sound practices and it was a 25 recognition basically by the industry that it would be 1 helpful to them and to new entrants to have a document which 2 could be used as a sort of reference guide. 3 MR. ROYE: Is it your sense that these sound 4 practices have been generally embraced? 5 MR. CULLEN: I think it's too early to tell. It 6 reflected when it was published in August of last year the 7 way the hedge fund manager industry was operating. At that 8 time, clearly, we are not that far ahead and given the way 9 the markets have been playing out, there haven't been nearly 10 as many new startups in the hedge fund manager field as there 11 were perhaps in the 12 months or 24 months before August of 12 2002. 13 So there have not been, I would suspect, enough new 14 startups to be able to generate a really clear picture as 15 whether this is -- what sort of part this is going to play. 16 The fact, though, that it's being -- at the request of hedge 17 fund managers in Asia is being adapted to the Asian market, 18 to the extent that it needs to -- I mean, a lot of what's in 19 here is generic, it's not specific to the UK or Europe -- 20 suggests that at least in the developing market, if I can use 21 that expression in a slightly different way from the way in 22 which it's normally used, in the developing markets, be it 23 Asia, be it Australia, it is seen as a good thing I think. 24 Probably, as I said, to adapt this for the U.S. 25 would be using a document that was never intended for a 1 mature market. 2 MR. ROYE: Jack, do you have a sense that U.S. 3 managers are looking to this document and other documents -- 4 MR. GAINE: Well, they're not looking -- I can be 5 very quick on this if I can just do a little housekeeping 6 here. We prepared a submission, submitted on May 6 to the 7 SEC but I think because it was a hedge fund related thing it 8 came under the Lab Technology letter and it's not readily 9 available on the front of the web site and you have to dig 10 into the web site under the panel and then find our 11 submission next to my name. 12 And in that is I think a very good submission and 13 included in that are many references to what we called back 14 in February of 2000 sound practices for hedge fund managers. 15 We didn't limit it to any geographic area. 16 And in here, in this document, which is totally 17 different from Iain's, we discuss valuation, risk control, 18 funding liquidity risk, counter-party credit risk and 19 disclosure and transparency. And I think the valuation 20 provisions in here might even make Richard Phillips happy. 21 And this is widely cited in our document and you can get to 22 both of these things on our web site if you can't pass the 23 Lab Technology test and get to it here on the SEC site. 24 MR. ROYE: To what extent do your members, do you 25 think, adhere to those policies and embrace them? 1 MR. GAINE: I've not done any survey. I would say 2 that perhaps during the course of your investigation you 3 might have a feel for it. I would say a good percentage and 4 the valuation provisions are very, very similar to what I sat 5 in the audience yesterday and heard discussed. And there's a 6 disclosure to investors and disclosures to counterparties as 7 well as other issues discussed in there, but I don't have a 8 percentage number for you. 9 MR. ROYE: Well, we want to move on next to some of 10 the key issues in terms of how hedge funds are offered and 11 sold, the accredited investor standards and hear from some of 12 our own panelists. 13 I think we proposed that we take a break right 14 about now. but I assure you that we're going to get into some 15 very interesting issues when we come back and hear from some 16 of our other panelists. 17 We'll take, I guess, a 10-minute break or so and 18 then come back and resume. 19 (A brief recess was taken.) 20 MR. ROYE: As we've heard over the last couple of 21 days, hedge funds rely on several exemptions under the 22 Investment Company Act which are conditioned on not making a 23 public offering. And as we heard outlined, they typically 24 look to Reg D in terms of making the private offering. 25 I think we've heard some differing views with 1 regard to hedge funds, funds of hedge funds, opening them up 2 to retail investors. I think we've heard some people suggest 3 at least that retail investors ought to have access to these 4 vehicles, it shouldn't be just the providence of high net 5 worth individuals and institutions. 6 We've heard others suggest that the eligibility 7 standards in Reg D which haven't been modified in over 20 8 years are in need of adjusting. 9 And I guess I just wanted to get reactions from 10 folks on the panel, particularly Rick Lake and John Markese 11 about that issue. Are the standards at the appropriate place 12 from a Reg D standpoint in terms of offering hedge funds? 13 Should we throw them out? Should we start over? Are they 14 necessary? 15 MR. LAKE: Well, I'm flattered and honored to 16 answer this question. The real general question is who are 17 we trying to protect and from what. If we work our way 18 through the regulations starting with 3(c)(7), if a manager 19 is making an offering under that exemption he only wants 20 investors with 5 million and up so he can raise a lot of 21 funds. So we haven't touched the unaccredited investor yet. 22 If we go to 3(c)(1), the manager wants accredited 23 investors with 1 million or more. If he lets in a non- 24 accredited investor, my understanding, then he has to 25 increase the amount of paperwork and disclosure which is a 1 big disincentive because then he has to let in a small 2 investor and do a lot of work to do it. 3 So in terms of hedge funds working their way down 4 to unaccredited investors -- oh, I've been speaking to 5 myself. 6 (Laughter.) 7 MR. LAKE: I thought I rendered the room silent 8 with my discussion of 3(c)(7). I hope you heard all that. 9 Oh, good. 10 So, okay. So we've worked out way through 3(c)(7) 11 and 3(c)(1) and the unaccredited investor hasn't been touched 12 yet. So we work our way down to maybe the tiny state 13 offerings under 506, do I have this correct, and this, as 14 discussed earlier, was suggested might be the purview of 15 fraudsters who will take advantage of small local investors 16 whether it's an Internet deal, a hedge fund or a Broadway 17 show, what have you. 18 So then the policy question becomes does allowing 19 small investors into deals on the private placement exemption 20 facilitate capital formation on a microbasis or does it just 21 allow a easy tool for fraudsters to take advantage of smaller 22 investors. And I suspect the answer to that would be capital 23 formation on a small basis is probably encouraged by allowing 24 unaccredited investors into some types of funds. If the 25 investor protection issue becomes overwhelming, then it's 1 time for a change. 2 The next issue becomes how should small investors 3 be able to access on a democratic basis hedge fund strategies 4 and perhaps the best vehicle for that is the open end mutual 5 fund, and I suspect we'll be able to talk about that more 6 later. 7 MR. ROYE: John? 8 MR. MARKESE: Thanks, Paul. I represent the 9 individual investor, also known as the retail investor. I 10 feel a little outnumbered today, but what the heck. If we 11 can get an investor's attention, there's two things we want 12 to tattoo on the back of their hand if they'll stand still 13 long enough. One is to efficiently diversify and the second 14 one is to understand what you're investing in, the cost 15 structure, risks, expected returns, before you invest. 16 Let's look at Stan Beckham. I'm going to look at 17 the whole concept of hedge funds. If we believe the 18 marketing that has slipped out through the press and a lot of 19 the great stories that they can add to diversification -- and 20 I'm going to argue that probably there is a possibility they 21 could, even for a $100,000 investor who puts 10,000 into a 22 hedge fund. 23 So if you argue that way that perhaps they are a 24 useful vehicle for diversification, we run into the second 25 thing that I've had you tattoo on the back of your hand and 1 that's understanding your investment before you invest. 2 Let's look at these accreditation standards for 3 investors. How many of you know someone who has a salary of 4 $200,000 plus, maybe a million dollars net worth, that 5 doesn't know anything about investing and is in no way 6 sophisticated? My guess is that you could come up with a 7 pretty big list here of friends, family and acquaintances, 8 colleagues. 9 Let's face it. It's probably a poor proxy for the 10 ability to withstand loss. It's probably a poor proxy for 11 liquidity, but it is certainly not a proxy for financial 12 sophistication. I don't know that there is one around. 13 So let's not just raise this bar to a half a 14 million dollars and whatever in income and so forth. Let's 15 stand back and say we need disclosure, we in fact need to let 16 individual investors access this field, we need to have a 17 broad-based information flow. We of course have to have this 18 before we let the investors in and we have to allow them to 19 be able to independently form a judgment on this investment 20 called hedge funds. 21 I mean, obviously there's not one animal here. But 22 right now, even if you make that benchmark, you make that 23 accreditation standard which I will say is, in my opinion, 24 bankrupt as a sophistication standard. You still have to 25 deal with an intermediary. You still have to deal with 1 someone who is going to educate you on what is in this fund, 2 and for most investors, simply making it in the club, getting 3 in that club is what their final goal is. 4 And they're relying now not on independent judgment 5 having made this club, but in an intermediary or 6 representative explaining what perhaps is best for you in 7 that fund. 8 So I think we have it wrong. I'd like to throw out 9 the accreditation standards, I'd like to open it up, have 10 reporting of all registered funds. Let's face it, if there's 11 money to be made, fund of funds are going to grow and grow 12 and grow and now we don't have one black box, we have a fund 13 with probably 20 or 30 black boxes in there that again an 14 individual investor cannot form an independent knowledgeable 15 decision on what they are investing in. 16 Thank you. 17 MR. ROYE: Other perspectives on the accredited 18 investor standard? I think Jack -- you guys suggested it 19 ought to be -- we ought to reconsider the level? 20 MR. GAINE: I think just in the traditional hedge 21 fund context it was adopted in 1982, I think. It would 22 probably be worthwhile to open it up and take another look at 23 it. 24 MR. ROYE: How about the notion, the restrictions 25 in terms of general solicitation and no advertising? I guess 1 one of the questions I have is whether or not in this new 2 Internet age, information age where information is free 3 flowing, there's a lot of information out there about hedge 4 funds. 5 Are we really fooling ourselves when we try to 6 regulate the offering of a security as opposed to who it's 7 sold to? Do we need to step back and rethink the way we 8 approach these exemptions? I suppose this may even go 9 outside the hedge fund area but does anybody have any 10 reaction? 11 Paul, do you have any sense of whether or not we 12 have an antiquated framework in terms of how we regulate 13 private offerings? 14 MR. ROTH: Yes. I guess my reaction, Paul, would 15 be that right now it's very difficult for the practitioner 16 because we are talking about regulating private offerings in 17 a environment in which the Internet covers an awful lot of 18 what's going on in the hedge fund world, where you can pick 19 up Barron's and get a quarterly listing of the performance of 20 hedge funds that you think you're having a private offering 21 with respect to, where there is what used to be a cottage 22 industry and there is now an enormous growth industry in 23 terms of magazines and other publications that cover it and 24 where you have reporters for the Wall Street Journal, the New 25 York Times, the Financial Times, that are assigned to the 1 hedge fund beat. 2 And in that context, we find ourselves frequently 3 dealing with the problem of a manager who's conducting a 4 continuous offering who is being interviewed and asked a 5 question about his fund and it's almost a gotcha kind of 6 situation. On the one hand, if he answer the question, the 7 lawyers are sitting there saying well, maybe you really have 8 to suspend offering for a while because you made the wrong 9 comment with respect to your fund. 10 We're very sensitive to this issue because on the 11 one hand I don't believe that anybody in the hedge fund 12 industry is looking to advertise and take out advertisements. 13 There is some tension between the issue of if you go into 14 retailization and you have more information out there because 15 you're not restricting information with respect to offers, is 16 that conditioning the market with respect to retailization. 17 That seems to me a legitimate issue. But all in 18 all, I think that we would come down at recommending that in 19 this Internet age where there is an exchange of information 20 and there is so much literature going on out there, it would 21 be better -- and we would lose the issue of the press 22 constantly saying that they couldn't get a reaction to 23 somebody because he says his lawyer told him he can't answer 24 the question because of this continuous offering. 25 It would be better for the freer flow of 1 information and I don't think it would change the nature of 2 the risks involved in terms of the investors who can invest 3 to have the emphasis be on the sale rather than the offering. 4 MR. ROYE: Alan, do you have any reaction to 5 redoing the whole framework along those lines? 6 MR. BELLER: Yeah. I mean, this is a subject which 7 not just in the hedge fund or the investment fund area but in 8 terms of offerings generally has been bandied about for kind 9 of at least a decade at this point. I think I said yesterday 10 all the way back at least to the Wohlman commission which I 11 think is right, we have got lots of suggestions sitting 12 around both on your floor and on ours about the deregulation 13 of the offering process as opposed to sales. 14 We certainly live in an age of publicity and 15 information where the restrictions that the Securities Act 16 imposes on publicity are I guess I would say anachronistic 17 and there probably has to be some recognition of the new 18 environment with the Internet and with communications 19 technology and so forth and in investor interest in kind of 20 unlimited access to information that exists today. 21 I must say that balanced against that, so long as 22 you have a Reg D standard that is at the 200, 300,000 level 23 for income or a million for assets, having unlimited 24 publicity where that is your offering universe I do think is 25 a little bit troubling from an investor protection point of 1 view. 2 A number of panelists over the last two days have 3 said I think on both sides of the buy and sell that 4 ratcheting the accredited investor standard up somewhat -- it 5 won't change the problem that's been identified, which is 6 that it's not a good surrogate for sophistication but it 7 might be a good surrogate for things like liquidity and risk 8 of loss and so forth. 9 If you -- I'd be more comfortable in loosening up 10 the offering process if I thought we -- if we also at the 11 same time thought about what the accredited investor standard 12 was. And I have to say there, one of the questions that 13 there is is the point that Rick made, which is not just in 14 the fund area. I mean, the accredited investor standard and 15 Reg D have been used -- have been hugely important in the 16 capital formation process for small business in particular 17 generally and not just in the hedge fund or unregistered fund 18 area. 19 And I think that has been frankly the principal 20 obstacle whenever that issue of what the Reg D standards 21 should be has been revisited, that's always been the 22 principal obstacle in changing them. One thought -- one size 23 doesn't fit all and I'm not sure that you have to have the 24 same Reg D standard for direct small business investment that 25 you need to have for other purposes but I think we should be 1 open-minded about looking at the publicity and offering 2 issue. 3 MR. ROYE: I'd like to move to funds of hedge fund. 4 I think we heard from our regulators that there seems to be a 5 trend in terms of allowing greater offering or the ability to 6 register and offer various country's funds of hedge funds. 7 The Investment Company Act restricts the offering 8 of hedge funds directly, again in terms of private placements 9 and no public offering, but you have funds of hedge funds 10 that really allow investors theoretically to access a vehicle 11 that they could not access directly. And I guess I just 12 wanted to throw out to the panel, is this a good development, 13 a positive development? 14 Maybe Bob Pozen, you're in the business of 15 developing products for retail investors. Is this a good 16 product, bad product, good development? 17 MR. POZEN: Well, I would say that -- are we 18 talking about the registered fund of funds? 19 MR. ROYE: Yes. Yes. 20 MR. POZEN: I think if you look at the way 21 registered fund of funds are organized, you have a lot of 22 anomalies between funds that invest -- 3(c)(1) funds and 23 3(c)(7) funds so I think the Commission probably ought to 24 clean that all up. But ultimately you get to the question of 25 what sorts of fee structures and what's the board of the fund 1 of funds going to do. 2 If the board -- I mean, if you justify retail 3 investors being in a fund of funds, then you have to put a 4 lot of emphasis on the manager of the fund of funds and the 5 board of the fund of funds to really take care of the retail 6 investor. And if you can get comfortable with that, then you 7 should be able to be comfortable with fund of funds. 8 The second thing is what are the fees and how are 9 the fees going to be layered? A lot of these fund of funds 10 really wind up having quite a lot of fees and then if you get 11 a performance fee for the underlying fund and then you get a 12 performance fee for the fund of funds, you could do the math 13 and you could see that a lot of the return gets taken up. 14 So I think it can be a good product. It can be a 15 good product by providing investors good access to non-market 16 correlated funds but I think that you've got to make sure 17 that you put some real responsibilities on the managers and 18 the directors of the fund of funds and that you have some 19 limitations or a lot of disclosure about what the aggregate, 20 all the performance fees, all the fees are going to look 21 like. 22 MR. ROYE: Other perspectives on funds of hedge 23 funds? Jack? 24 MR. GAINE: Yeah. I think these two days have shed 25 a lot of light and knowledge about the hedge fund industry 1 and particularly in the retailization and we've established 2 that as of today, retailization, as at least I would 3 understand it, doesn't it but it might well exist at some 4 point. 5 I think there's -- 6 MR. ROYE: Some are saying that it should exist. 7 MR. GAINE: Well, some, yes, and getting to that, 8 which is what I think we're talking about here, there are a 9 class of investors who have been pounded for the last 3 or 4 10 years in long only strategies who want something else. And 11 if the something else is a registered fund of funds, I will 12 maybe throw this back into your court. I think within the 40 13 Act context, if you can have that appropriate disclosures of 14 the risks involved, et cetera, I think it's certainly 15 something that you should look at. 16 But I think Commissioner Campos raised that issue 17 kind of the other day and I've heard it in Europe, 18 particularly. There seems like a class warfare that the big 19 guys can get into something and the little fellow cannot. 20 I'm not sure all of those disclosures could be done 21 but I'm sure between you and your staff that you can get 22 working on it. 23 MR. POZEN: And I think the problem really grows 24 out of the fact that mutual funds are so constricted and 25 taking non-correlated positions. I mean, right now, to short 1 a mutual fund you either have to have a covered position, 2 which essentially you're not short, or you have to segregate 3 cash and mark to market daily. 4 So it's very difficult for a mutual fund that's a 5 registered mutual fund to go short. It's very difficult to 6 get leverage and I think when I computed the number of mutual 7 funds that had performance fees, it's less than one percent 8 of the industry because the rules are so difficult to meet. 9 So, I mean, you can view this from either way. 10 There clearly is an appetite for non-correlated investments, 11 especially given the last 3 or 4 years. You can either start 12 a whole new regime for retail fund of funds or what I would 13 think would be a useful way to think about it is to think 14 about why is it that the mutual fund industry has had so few 15 performance fees and has had so much difficulty in having 16 non-correlated investments. 17 And I think the answer is clearly that the 18 regulations are a significant barrier and I think we ought to 19 have some more flexibility on those and allow the traditional 20 mutual fund industry to provide a broader array of products. 21 MR. ROTH: Paul, I sort of first want to commend 22 the Staff in the approach that it's taken with respect to the 23 registered fund of funds, especially those that -- you got 24 two classes of them. One, fund of funds that are registered 25 under the 40 Act but generally are open only to sophisticated 1 investors and that can be qualified clients which have a net 2 worth of a million and a half dollars and up. Some of them 3 are offered to accredited investors but that's generally not 4 the case and they have very, very high minimums. 5 The new product, so to speak, is the fund of funds 6 for the retail investor. And I think there are a couple of 7 things that are noteworthy about that. One is this is not a 8 product really sponsored by the hedge fund industry. It's 9 not an outgrowth of what hedge funds want. It's basically 10 been a outgrowth of what is perceived to be a demand by Wall 11 Street institutions in terms of being able to market 12 something that people think there is a demand for. 13 The second thing I think is you've done a very good 14 job of going slow in terms of making sure that the boards of 15 directors of these funds have adopted procedures with respect 16 to valuation that are reasonable and that meet the standards 17 under the 40 Act and that up till now, notwithstanding the 18 matter in which the registration statements were originally 19 filed, they have not come out unless the sales are restricted 20 to either accredited investors or investors who are being 21 represented by a discretionary -- by an investment advisor 22 exercising discretion. 23 And I think that type of rollout of the product, of 24 seeing how it does, is an intelligent way to proceed. With 25 respect to this, I suppose I'm a democrat with a small D and 1 that is if it's a good product, it should be available and we 2 ought to be able to figure out how we can describe the risks 3 to the investing public. 4 MR. BELLER: Paul, are there any hedge funds or any 5 significant number of hedge funds who are saying no to fund 6 of funds buyers, fund of funds investors, who are saying we 7 don't want to sell our funds to that? 8 MR. ROTH: Yes, there are. What their reasons are, 9 I'm not quite sure but I've -- certainly some of them have 10 done a little bit of betting on whether or not let's say 11 advisors to hedge funds, underlying hedge funds or leveraged 12 investment companies to invest in them might someday be 13 required to be registered investment advisors and some of 14 them are taking that position. 15 Others are simply taking it on the basis of we're 16 not organized to sell to that class of investor and we're not 17 selling to that class of investor. For some reason or other, 18 they're looking at it differently. 19 I should say that there are some hedge funds that 20 will not permit funds of funds, private funds of funds to 21 invest in them as well and others, for ERISA purposes, 22 because of compliance with ERISA, don't have pension funds 23 investing with them. 24 So there's a whole panoply of reasons, business 25 reasons, that are involved. 1 MS. MANZKE: If I can just interject, too, though, 2 the funds that are out there first of all are still applying 3 the sophisticated accredited investor attestation but at the 4 same time there is a little bit of a benefit from these 5 funds. Your neighbor could start a fund of funds, as was 6 said, that he has expertise in this area. 7 When you're getting into these registered products, 8 they typically have your outside board of directors and also 9 the responsibility of those that are offering that is a much 10 heightened than if I was just taking my neighbor's money. 11 There is reputational risk here. If there is a problem 12 within these funds, these larger institutions are much better 13 equipped to pony up any of the mistakes that could occur than 14 the hedge fund fund of fund purveyor that's out there today. 15 Also, I should say that there is such a risk in 16 types of -- this type of offering that some of the issues 17 that are required -- for example, in the funds that we have, 18 the manager have to subscribe to Risk Metrics which is a 19 third party purveyor which gives us this benign transparency 20 because we won't take that type of risk in this type of 21 product. 22 MR. ROYE: Armando, would you guys sell to a fund 23 of funds or do you? 24 MR. BELLY: Well, the endowment fund is closed so 25 we don't have to face the issue. 1 MR. ROYE: Okay. Easy. 2 MS. MANZKE: But you did before. Years ago you 3 did. 4 MR. BELLY: I wasn't around, so I wouldn't know. 5 MR. ROYE: Okay. I want to turn to the 6 registration of the manager question. I think as was 7 highlighted, the US is one of the few jurisdictions where the 8 manager of a hedge fund is not required to be registered in 9 any manner and again, our registration regime I think as 10 juxtaposed against some of the other regimes in terms of 11 requirements and qualifications I believe is fairly -- is 12 certainly less stringent than a lot of regimes. 13 Views on whether or not we ought to move to 14 registration of hedge fund managers. Sandra? 15 MS. MANZKE: Well, I think without moving towards 16 registration, the industry actually is moving that way. 17 There is -- with the institutional investor coming in, they 18 are requiring that many of these managers have to register so 19 you're seeing much more of if you want the money, you will 20 register. That does mean that there will be managers that 21 don't register. 22 If you require, though, all the managers to be 23 registered, you run the risk that many of them will move to 24 another jurisdiction and therefore you're also once again 25 penalizing your US investors or they simply won't take you as 1 investors into their fund. 2 But there has to be some middle ground here where 3 there would be the opportunity to have more disclosures, 4 maybe you're not subject to the SEC coming in and doing their 5 audits. I mean, we are registered as an investment advisor, 6 have gone through several SEC audits. The first time it's 7 painful, the second time less so and it's actually kind of 8 informative because if you do find you're doing something 9 that isn't to the proper standards, you have that opportunity 10 to correct it. So I don't look at it as a policing function 11 but actually to keep us in compliance with all the 12 regulations. 13 No one wants to have an audit. If you -- sort of 14 like nobody wants cancer, but sometimes -- 15 (Laughter.) 16 MR. ROYE: Not that bad. 17 MS. MANZKE: But nevertheless, they think that -- 18 MR. ROYE: It's like going to the dentist. 19 MS. MANZKE: I really don't see any reason why a 20 manager would find it that onerous to register and I'd like 21 to see it to be more voluntary than to be mandatory. One of 22 the other reasons that I've also heard that managers are 23 against registration is while they're in compliance with all 24 the regulations today, who knows what new rule could come out 25 that also would be hinging on their ability to make money? 1 So in that case I can understand that. But again, 2 if there was some mandating of disclosure and information so 3 that the retail investor, so the large investor, we can all 4 have a standard, I think that would be more appropriate. 5 MR. ROYE: I guess I'd ask Paul whether or not 6 there's anything that you see in the Investment Advisors Act 7 regime that really is an impediment to running a hedge fund. 8 MR. ROTH: Well, maybe I could respond by starting 9 off by saying for close to 40 years I've been coming to this 10 building to ask for exemptions or requests or to explain to 11 the Staff why they've gotten something wrong. I think you 12 got it right the way it is right now. And I'm -- let me talk 13 about it in a way. 14 The way I look at it, the question is what's the 15 purpose served by registration? Is the purpose served 16 investor protection? Well, I think that there are three 17 different groups that you look at with respect to investor 18 protection. You can look at the -- on the retailization and 19 I think that in connection with retailization, people who 20 want to go the retail route should expect to have a higher 21 standard of regulation applied to them because you're going 22 through the Investment Company Act of 1940. 23 3(c)(7) investors, I really don't see any purpose 24 served by regulation of investment advisors with respect to 25 3(c)(7) investors. They are perfectly capable of ferreting 1 out for themselves the information that is necessary. 2 Now, many people who will become -- who are 3 advisors to 3(c)(7) investors, as Sandra said, will move in 4 fact to registration and that's because of business dictates. 5 You mentioned before and our office calculated as well that 6 35 of the top 100 of the institutional investors studied are 7 registered as investment advisors so that's the top hundred. 8 And I think that there may be a pressure business- 9 wise to do it but I see no regulatory purpose in requiring 10 it. 11 MR. ROYE: Let me ask you one question about that. 12 When you have a fund of hedge funds that's investing in a 13 3(c)(7) fund, with the fund of hedge funds potentially having 14 retail investors and exposed to the risk of the 3(c)(7) 15 funds, that doesn't change the calculation? 16 MR. ROTH: Well, as I said to you earlier, if a 17 fund wants to accept investors that is going to be a fund of 18 funds that is registered under the 40 Act, there may be a 19 difference in calculation that exists there. I'm not sure 20 there should be, but I can certainly understand the 21 Commission taking a very, very cautious approach with respect 22 to that in terms of -- you know, in some respects, one can 23 look at the underlying funds in these cases, maybe self- 24 advisors, to some extent, and require registration the way 25 you have with self-advisors. 1 Otherwise, you can look at it in terms of custody 2 requirements and otherwise. But I don't think in the absence 3 of that that there is a reason for registration with respect 4 to 3(c)(7) funds. And with respect to 3(c)(1) funds, I think 5 the issue is sort of less clear. I mean, in Alan's case, 6 maybe if you raise the accreditation standards that might be 7 the way to attack it rather than through registration. 8 My own view is you have an industry which is 9 extremely entrepreneurial, which is extremely innovative and 10 which fortunately thus far has stayed away from a lot of 11 problems and so the regulatory structure ought to understand 12 that. 13 There's a certain risk analysis or risk judgment 14 that is made with respect to hedge funds that kind of colors 15 the whole issue but the statistics that we have seen in the 16 last two days that have come out here, for example, hedge 17 funds of funds having less than 25 percent of the volatility 18 of the S&P and hedge funds in general having less than 50 19 percent of the volatility of the S&P. 20 I would be cautious only about the value judgment 21 that is involved with respect to whether or not hedge funds 22 are somehow riskier than oil and gas funds and real estate 23 investments that other things have -- that other investments 24 have had other limited liquidity and frankly are hard to 25 understand. 1 And if the requirement is that you can change the 2 12:00 blinking on your VCR, then there'd be a different 3 surrogate for investment and I guess I'm out of it then. 4 MR. ROYE: Armando, views on advisory registration? 5 MR. BELLY: Well, I think the way you have to look 6 at it is what is the cost and what is the benefit and just 7 who do you register? 8 I know that someone had mentioned is it burdensome 9 to be registered or is it onerous. I don't really think 10 that's the question, to put a word like onerous or 11 burdensome. Registration has costs. It costs money, it 12 costs time. And the question is whether it's really worth it 13 and from the point of the SEC -- because we may be 14 fiduciaries of our clients. The SEC, in essence, are 15 fiduciaries for the taxpayers so they have to watch out the 16 expenditure of what money they have. 17 If the SEC registers 2,500 or 3,000 hedge funds, 18 they're going to need auditors to audit these hedge funds. 19 Now, this is big building. Maybe there are 250 or 500 20 auditors walking around who don't have anything to do, but 21 I've had friends who work here and they work very hard and I 22 really doubt it. I think they're going to have to spend a 23 lot of money to hire these people. 24 And then there's going to have to be someplace 25 where they stay. They have to have an office. And I notice 1 there are a lot of lots around here that are sort of vacant. 2 Maybe they can build some buildings. It's going to be very 3 expensive. And the question is is it work it. Is it worth 4 it with respect to every unregistered investment advisor? 5 Take our case. We're registered with the CFTC. 6 Why would we -- why would it make sense for us to be audited 7 in addition to the National Futures Association and the CFTC 8 has the ability to audit us as the prime regulator, what 9 would be gained by having us audited? 10 Remember, the SEC is a fiduciary for the American 11 taxpayer. What would the American taxpayer gain? And I 12 would agree with you. With respect to people, for example, 13 sophisticated investors, people who are in maybe 3(c)(7) 14 funds, what actually is gained? I mean, we're talking about 15 resources that may be limited. Maybe those resources should 16 be focused on where the problem is if there's a problem. 17 And I have to admit, I've been here, I've tried to 18 pay attention for two days. I think I have, and I'm still 19 trying to identify what it is the problem. But you all have 20 more evidence than I do on what the problem -- I mean, I see 21 our fund, which I haven't seen any problems with. 22 So I really would say that whatever we do with the 23 question of registration should be focused. It should be -- 24 the taxpayers' money should be spent only if the registration 25 of the particular investment advisor would serve some 1 purpose. And I don't know whether there are cases where that 2 will be shown. I really don't have an opinion on that. 3 But I don't think that if you're already registered 4 with the CFTC, that it's worth the taxpayers' money to have 5 you register again and be audited by another federal agency. 6 MR. ROYE: Well, do you think the CFTC is looking 7 for the same things that the SEC examiner is looking for? I 8 mean, they're not inspecting for compliance with the 9 antifraud provisions of the federal securities laws. Are 10 they looking at the same things? 11 MR. BELLY: Well, you know, I have never gone 12 through an SEC audit and frankly I hope I never do but we 13 just completed an NFA audit and I have to say it was very, 14 very thorough. They examined our books and records, they 15 interviewed people, they examined our practices. I don't 16 know if -- we don't have any fraud, I assume. They didn't 17 discover any. I don't know what -- we don't sell to anybody 18 at this point. I don't know what type of fraud your auditors 19 would be looking for that the NFA auditors would have missed, 20 or that you would have caught that the NFA auditors would 21 have missed. 22 MR. ROYE: Did they look at vehicles for which 23 there was no futures trading? 24 MR. BELLY: Well, we have our hedge fund -- there's 25 one hedge fund. I mean, I think really when you talk about 1 hedge funds, we're talking about -- so they looked at the 2 Quantum Endowment Fund and there are really two parts to 3 that, Quantum Partners and Quantum Emerging Growth. 4 MR. ROYE: So you may be a case where because of 5 your activity, they come in and maybe they look at the same 6 things we would look at but there can be other advisors where 7 it's futures trading or not futures trading, there are 8 different types of accounts and they have no reason to look 9 at those. 10 MR. BELLY: Well, as I said, I really don't have 11 the answer. I mean, I don't know -- maybe there really is a 12 problem with CFTC registrants who don't engage in fraud 13 relating to futures but engage in fraud in securities. I 14 don't know that one way or the other. 15 If there is a big problem on that and you come to 16 the conclusion that's the only way to deal with it, then I 17 could -- 18 MR. ROYE: I mean, my only point is that we 19 shouldn't be falling all over each other in terms of our 20 examinations but there very well may be legitimate reasons 21 given the nature of the operations why we come in and look at 22 different things and look at different vehicles, different 23 clients. 24 MR. BELLY: But I'm glad that you agree that we 25 don't need another examination so any rule that you apply 1 we're happy with. 2 (Laughter.) 3 MR. ROYE: Well, let me reserve on that point. 4 MR. GAINE: Quickly, I agree with what Paul and 5 Armando said but this cost benefit analysis is not -- I think 6 coming from us it might seem self-serving but I've heard it 7 from Chairman Donaldson, I've heard it from your deputy, Ms. 8 Fornelli, Professor Liang and Bob Steel actually referenced 9 it as well, that there could well be a movement offshore. 10 And I don't think per se -- I think you probably do 11 a very well audit and it's well done and it might produce 12 results but I think you have to establish the problem first. 13 This may not be popular as it was four or five years ago and 14 I guess I have to agree with Armando. 15 I tried to pay attention, probably with my advanced 16 age not nearly as well as he has, and I haven't seen the case 17 here on either the incidence of fraud and then some of Pat 18 McCarty's statistics, assuming they're accurate, that he 19 brought over with him. It's underwhelming, to put it mildly, 20 if that's the -- you know, if it's somehow to identify fraud 21 and given the host of problems that you all are facing -- and 22 I have not seen the 250 or 500 auditors wandering through 23 here; in fact, I think you're all probably very much 24 overworked. 25 If the industry drives people into it, if Mark 1 ANSON and Mark Yusko and Charles Swensen say if you register 2 we might invest with you, then maybe a hedge fund will listen 3 to that or if an ERISA for purposes -- register, but if it's 4 an industry-driven thing, that's fine but federally mandated 5 here, I don't know that the case is there to be made. In 6 fact, I don't think it's made here but then, again, as the 7 chairman pointed out on the opening day, we're only in the 8 middle of a fact-finding mission. 9 MR. ROYE: Doug? 10 MR. SCHEIDT: I think a case could be made. I 11 think that you've seen a large amount of money flow into the 12 industry which also attracts a large number of people who 13 want to provide services in the industry. So you have a big 14 change factually. You have an increase in the number of 15 enforcement actions and we only see the problems after they 16 occur. 17 I bet you that there wouldn't be that many 18 enforcement actions against registered investment advisors if 19 we didn't examine them. I think the exam program is a big 20 source of enforcement referrals and enforcement cases. If we 21 didn't conduct examinations, we wouldn't learn of many of the 22 fraudulent activities that occur until long after the fact, 23 if at all. 24 I think that you also, Armando, have to give us a 25 little bit of credit and I think the UK approach is part of 1 that. We have been operating under limited resources for a 2 long, long time. At one time, not too long ago, we had 3 30,000 registered investment advisors with us and we had far 4 fewer examiners than we do today. But we made intelligent 5 cuts on where to develop those resources. 6 We didn't and we couldn't hire additional resources 7 to do the job so we devoted our resources and directed them 8 at the areas that we thought presented the highest risk. 9 Now, we may have missed some problems but there was always 10 the threat that the SEC might come knocking on a registered 11 advisor's door. That deterrent effect that that has is a 12 positive one whether or not the exam ever happens. 13 And here with the larger amount of money in recent 14 years, the larger number of players, the apparent larger 15 number of enforcement cases involving frauds, I think that 16 really cries out for at a minimum giving the SEC authority to 17 examine advisors over a certain level or under certain 18 circumstances which we don't have right now. 19 I think the case has been made or the facts to make 20 that case are present and you've got to give us some credit 21 for -- give us some leeway that we aren't -- Congress isn't 22 going to give us the kind of money that would enable us to 23 conduct exams of advisors on a monthly basis or to put 24 someone in the manager's office like the bank regulators do. 25 It's just not going to happen. You've got to give us some 1 credit for using our limited resources in an intelligent way. 2 MS. THORPE: Paul, can I comment on the futures 3 side? 4 MR. ROYE: Sure. 5 MS. THORPE: Let me just go back and comment on 6 something Armando said and Jack said as well that when the 7 CFTC regulates the pool operator but not the underlying fund, 8 you cannot have a situation where the entity is out there 9 regulated by you, you're up at the plate responsible for its 10 propriety and the manner in which it acts and have it 11 engaging in completely fraudulent activities and other 12 similar types of pools that may not directly be trading in 13 futures. 14 As a consequence of that, NFA certainly has the 15 ability to go in and inspect vehicles that may not directly 16 be trading in futures but based on a risk-based approach is 17 going to focus on those areas that obviously it has the most 18 and we have the most interest in. I think there's a little 19 bit of concern with one of the suggestions that I heard at 20 the table, well, maybe you don't have to do inspections as 21 the SEC but you should at least register them. 22 And I think that's the most difficult for the 23 regulator that you actually have registered somebody and yet 24 you're not going in to do inspections. I think that that 25 creates certain problems and you can't say registration is 1 not expensive. It's not the registration that's the 2 burdensome part of supervising somebody. It's the actual 3 inspections and the compliance supervision that actually is 4 the cost that the industry has to bear. 5 MR. ROYE: I think that's an important point. I 6 mean, certainly you don't want to be in a position where you 7 create a false sense of security or you don't have the 8 resources to go in and do what you want to do in order to do 9 appropriate oversight. 10 I did want to return to the point that Bob Pozen 11 made about the mutual fund area and again I think what we've 12 heard is that you don't see mutual funds engaging in a lot of 13 the strategies that hedge funds engage in. Short selling, 14 use of leverage, there are constraints on performance fees 15 and I do want to see the panel react to whether or not those 16 are constraints that we ought to consider removing. 17 I mean, I would point out that there are mutual 18 funds out there that do use short selling strategies, use 19 leverage, particularly on the short sale and we don't see 20 very many funds that embrace those strategies. They have the 21 ability to do it and maybe some of the constraints that you 22 alluded to -- 23 MR. POZEN: I don't think I'm suggesting that there 24 ought not to be any restrictions on registered funds but the 25 restrictions that exist are pretty daunting. I mean, if you 1 sell short and you have to cover it with a security, then 2 you're not selling short, you're just doing a covered call or 3 something like that. And if you have to sell short and have 4 segregated cash -- and mark to market, so again, I don't 5 think we know whether -- if there is this -- I mean, what I 6 think -- what's the fund of funds all about? It's about an 7 appetite for less volatile investments. 8 And if you -- you have two approaches and concepts. 9 You can either open up the fund of funds more or you can let 10 mutual funds have a class of funds which you could identify 11 in some way as being somewhat different for which you would 12 have much more flexible rules on short selling and on 13 leverage but you don't have to have no rules. 14 And right now the rules are daunting and the rules 15 on performance fees -- I mean, if we have only 140 funds out 16 of 8,000 that have performance fees, that suggests that 17 regulation is preventing a lot of people who might otherwise 18 have performance fees which should generally be a good thing 19 because they align the interest of investors with managers. 20 So we should be encouraging performance fees. 21 If I may, there are two issues -- two big broad 22 issues to discuss in terms of mutual funds that do use 23 hedging strategies. One is what's gone on to date and the 24 other bigger issue is what is the public policy issue at 25 stake. And the public policy issue at stake is that the 1 country is about to face its largest generation of retirees 2 ever and they have 5 to $7 trillion of mutual funds, 3 depending how you calculate the size of the mutual fund 4 universe. 5 In the last year alone, mutual funds lost $600 6 billion of investor money. In the year before that, they lost 7 $500 billion of investor money. In they year before that, 8 they lost $400 billion of investor money. So if we were the 9 board of trustees of a retirement pool of $5 trillion and we 10 had to tell our colleagues we just lost one and a half 11 trillion because of the investment restrictions, I think we'd 12 start looking for other ways to try to incorporate 13 opportunities for return, opportunities for diversification 14 and tools for risk control. 15 So from a public policy point of view, maybe we 16 should be talking about the democratization of hedge funds 17 rather than the retailization of hedge funds as a commercial 18 objective. 19 In terms of mutual funds that do use hedging, there 20 is a small universe of them which began to grow after 21 Congress repealed the short short rule in '97, which was a 22 restriction that limited the amount of income a mutual fund 23 can derive from short selling or short term trading. And as 24 soon as that one tiny regulation which was a bit archaic was 25 released, a small group of hedge mutual funds began to 1 develop. And they did quite well during the bull and bear 2 market, outperforming the S&P when the markets were going up 3 and protecting investors really well when the market was 4 going down. 5 It was not Lake Woebegone as Doug Scheidt warned us 6 yesterday with all these hedge mutual funds doing well. They 7 did have to drink from the bitter brew of the bear market but 8 they were able to handle the bear market reasonably well. 9 So the next question becomes if we try to 10 incorporate alternative investments into the open end mutual 11 fund world, we would have to make a catalog of the 12 restrictions that impair them and then go through that 13 catalog and say what should be loosened up and what would be 14 appropriate in light of investor protection. So I think that 15 would be the issue in terms of hedging strategies within 16 mutual funds. 17 It would also have the dual effect of regulating 18 the hedge fund industry if the hedge fund private industry 19 had to compete with the public hedge fund industry. So I 20 think it would be interesting to explore that in more detail 21 at some future date. 22 MR. ROYE: Do you -- I mean, in a mutual fund, 23 money is flowing in and out on a daily basis. In the hedge 24 fund area, the money is locked up for at least a quarter. I 25 mean, you don't have to worry about meeting withdrawals, you 1 know, their intervals. Bob, do you see -- 2 MR. POZEN: What's interesting is one of the -- I 3 think Doug will notice it -- how many interval funds are -- 4 the Commission put out a rule a few years ago for interval 5 funds which were geared to be sort of periodic redemptions 6 rather than daily redemptions. To the best of my knowledge, 7 there are either none or very few interval funds. 8 So the 40 Act actually does have a mechanism and 9 one could think of a regulation where you said that if you 10 went short more than 10 percent of your fund, then you had to 11 go into the interval fund sort of regime but if you did just 12 a modest amount of shorting or hedging, it's different. And 13 I think we all know that hedge fund is a misnomer. 14 There are lots of hedge funds that don't hedge and 15 they have lots of different strategies but I think that 16 clearly rather than us sort of searching for how we can sort 17 of fit the fund of hedge funds into -- you know, a circle 18 into a square sort of a mold, we might think of sort of -- we 19 could think of two diff -- we could think of modest mutual 20 funds hedging, we could think of more -- and the interval 21 fund is a sort of concept that we really haven't used very 22 well. Maybe that's an appropriate concept to think about. 23 MR. ROYE: Would this also be an answer to 24 something that I know you've spoken about before? You 25 hijacked our roundtable on fund governance to talk about 1 hedge fund managers, mutual fund managers leaving to go start 2 hedge funds. If we were to revamp the compensation 3 structure, allow performance fees in a mutual fund framework, 4 would it solve this sort of what you view as a brain drain? 5 MR. POZEN: Well, there always will be managers of 6 mutual funds who will go off and want to do their own thing 7 and have their own shops but I do think that the huge 8 differential in compensation between hedge fund managers 9 who're getting 20 percent of the upside and then the downside 10 only limited to a high watermark is used. 11 So I think it would help mutual fund managers if 12 there could be more flexibility in their compensation 13 structures, and clearly this very strict symmetrical 14 requirement has led most mutual funds not to have performance 15 fees. In fact, I think if you -- I mean, you have Fidelity, 16 you have IDS and you have Vanguard only for its external 17 managers, not for its internal managers. Those are the only 18 three groups that have any performance fees of any 19 significance. 20 So I think it would help. It wouldn't solve the 21 problem but it surely would sort of move us to the situation 22 where managers could be compensated better in the mutual fund 23 context, which would be a positive thing. 24 MS. MANZKE: But so far that hasn't worked because 25 every good hedge fund manager that was part of a larger 1 institution, Lazard being the latest example, those managers, 2 once they have good numbers and maybe they're getting 60 3 percent of the upside, they're going to want a hundred, so 4 then they walk out the door. 5 And I think the other thing that on the mutual fund 6 side is this is not an un -- you can have trillions of 7 dollars in these types of strategies. There's only so many 8 convertibles that are out there. There's only so much stock 9 that you can lend in your portfolio and it really isn't -- 10 you're talking about revamping the entire mutual fund world 11 if you started having performance fees and all these to 12 alternative strategies. 13 It's a relative gain where the hedge funds is an 14 absolute return. Your investors are going to turn around and 15 say well, if you really don't have that good view of the 16 market and you started shorting and you started raising cash, 17 why didn't you call me and tell me to get out of your long 18 fund? 19 MR. POZEN: I think probably this wouldn't be a 20 situation which the whole mutual fund complex would go that 21 way. What you would have is a subset of funds that might be 22 offered to your higher net worth investors in mutual funds 23 and most mutual fund complexes have a difficulty satisfying 24 the needs of their higher net worth investors within the 25 mutual fund context. Some of them have done explicitly hedge 1 funds. So I think you wouldn't have -- in most big complexes 2 you wouldn't have this as the main theme. This would be a 3 small set of funds just like funds -- complexes now have a 4 small set of sector funds that are higher risk and higher 5 return funds. 6 MR. ROTH: I think there are -- for many of the 7 mutual fund companies there are cultural issues involved and 8 putting in whether the tail is going to wag the dog in terms 9 of compensation of a small number of their managers based on 10 a percentage of their profits as they would do in the hedge 11 fund world as contrasted to the way in which the vast 12 majority of the managers are compensated, certainly that has 13 been the major concern that we have heard as we have talked 14 to institutions that sponsor mutual funds, that they have a 15 grave concern as to the manner in which it will affect the 16 culture of the organization. 17 MR. POZEN: I think that is a valid concern. On 18 the other hand, we do have mutual fund complexes that have 19 hedge funds that run in a related trust company or something 20 like that some complexes have overcome the -- 21 MR. ROTH: Absolutely, but it has been a very big 22 sticking point for a lot of them. 23 MR. POZEN: I don't think what we're talking about 24 is requiring mutual funds to have this sort of hedge funds. 25 I think all we're saying is if we had some more flexibility 1 we would have some percentage of complexes in some probably 2 modest percentage of their funds that would do it. 3 MR. SCHEIDT: Aren't mutual fund managers making an 4 obscene amount of money as it is and why can't they just 5 divvy up some of those profits to their star managers -- 6 MR. POZEN: Well, everything is relative as 7 Einstein said and I think if you compare the -- what hedge 8 fund managers are making in an up market, there's nothing 9 that beats 1 or 2 percent base or 20 percent of the upside, 10 even if you are -- 11 MR. SCHEIDT: Well, I'll put it another way. 12 Aren't mutual fund investors already paying too much for 13 basically getting closet indexes that their managers are 14 trying to perform against an index rather than doing what 15 they could do which is trying to achieve absolute returns, 16 yet they closet index the funds and the performance, they 17 take in an awful lot of money and the mutual fund investors 18 are paying managed account fees for index funds? 19 MR. POZEN: Well, I would strongly disagree with 20 that characterization of what most maul fund managers do. I 21 think that you would find that most mutual fund managers are 22 actively managing their portfolio, they're researching their 23 stocks. If you have a very large fund, then it's maybe 24 constrained in terms of how much it can trade in or out but, 25 you know, I think that the fees of most mutual funds reflect 1 the active management and that all the index funds are, I 2 think in some sense, free riding off all that research that's 3 being done. So it's the relative efficiency of the market 4 that's produced by the active research that makes the index 5 funds able to exist. 6 MR. SCHEIDT: I don't understand how index funds 7 free ride off of the research of the managers. The index 8 funds are -- 9 MR. POZEN: Because index funds depend on an 10 efficient pricing of the market. The only way the market is 11 efficiently priced is because there are lots of analysts from 12 lots of active managers who are out there researching the 13 stocks and trading them all the time. 14 MR. SCHEIDT: Okay. Well, they're free riding on 15 more than just the fund manager. 16 MR. POZEN: If you had a universe in which you 17 prohibited in the theoretical sense active research, then the 18 pricing of index funds would be way off. So the only reason 19 why an index fund can exist is because it's taking advantage 20 of the efficient market which is being produced by all those 21 active analysts, not only in mutual fund complex but 22 throughout the securities industry. 23 MR. ROYE: Okay. To wrap this up, I thought we 24 would give each of our panelists the opportunity to give 25 their view on hedge funds and whether or not there are 1 things, issues the SEC ought to be focusing on, concerns, 2 approaches we ought to take, cautions, whatever, and I'll 3 start with Mark Anson. 4 MR. ANSON: I think I would make one final comment. 5 As we were talking about the registration of hedge funds, 6 whether it's Form ADV or some other format that the SEC would 7 design, from my perspective as an investor, that's just a 8 starting point for due diligence. 9 If a hedge fund manager is registered with the SEC 10 and does have a form ADV, great, but that's not where I'm 11 going to end my due diligence. That's really only a starting 12 point for me. There's much more work and analysis that's 13 going to go into my selection about a hedge fund manager. 14 The flip side of that is it does provide a starting 15 point for every investor in the market. We have some piece 16 of paper, some platform from which every person can begin. 17 But from there you have to rely on your own wits. You have 18 to know which questions to have. Paul, you have to have the 19 right legal representation. 20 MR. ROTH: It's available, Mark. 21 (Laughter.) 22 MR. ANSON: Well said. Well done. 23 MR. DELESPAUL: At a cost. 24 MR. ANSON: So registration of hedge fund managers, 25 yes, it gives you a starting point but that's all it is. A 1 lot of the work remains with the investor and we can never 2 forget that. Thank you. 3 MR. ROYE: Alan, I'll give you a pass. Jean- 4 Claude, any wisdom from abroad for us? 5 MR. DELESPAUL: Well, I don't know if it would be 6 wisdom. I suppose that through all these, the major question 7 is the willingness to protect the investors in the best 8 manner. I must say I was quite surprised with the 9 discussions I heard about registration or non-registration on 10 the managers. I come from a country where managing somebody 11 else's money requires necessarily that you be known by the 12 regulator and that you be registered in a way. At least you 13 are under surveillance. 14 Everything is possible. I mean, it's possible not 15 to contemplate any retailization of the hedge funds or any 16 change in the sector. What is important is to make sure that 17 whatever invests or easy to invest because information as we 18 said in this Internet age becomes very open, money in a 19 financial product be completely protected in terms of risk, 20 in terms of information and that the regulator make sure that 21 he is in a position to take good positions. 22 MR. ROYE: Bob? 23 MR. POZEN: I think that the reason we're all here 24 is because retail investors now have an appetite for downside 25 protection. That's what this is all about. That's why we're 1 here. Otherwise we wouldn't be here. And I think the 2 Commission has two choices. One is it can try to regulate 3 more hedge funds and hedge fund of hedge funds and I think it 4 will be limited both because it's not sensible to regulate 5 them more in certain ways and because if you push too hard, 6 they'll go offshore. 7 So again, I'd suggest that the Commission consider 8 another approach which is to loosen a little, not do away 9 with, some of the regulations you now have on short selling 10 and performance fees for your registered mutual funds as a 11 way to respond to what I think is basically what we're 12 hearing from investors. 13 MR. ROYE: Rick? 14 MR. LAKE: Well, I want to thank Professor Pozen 15 for saying what I wanted to say. But what's happening -- 16 MR. POZEN: You're welcome. I did it with my mike 17 on, though. 18 MR. LAKE: Well, technically you're a sophisticated 19 investor. I don't know how to use a microphone. 20 (Laughter.) 21 MR. LAKE: But all levity aside, we're all here 22 also because hedge funds have become part of the landscape. 23 Alternative investments are a key part of any portfolio so 24 once we know that, moving forward, the question is how do we 25 make sure alternative strategies can be available to everyone 1 and operate effectively for everyone within the context of 2 investor protection. 3 MS. MANZKE: Well, in the ideal world, not only 4 would you register in my opinion but you would also have 5 qualification standards to meet in order to become an 6 investment advisor. However, this isn't a perfect world and 7 I don't certainly want to kill the golden goose. Hedge funds 8 have been quite kind to me and we've been quite to all the 9 hedge fund industry because they've all made a lot of money. 10 I'd like to see this move to a voluntary 11 registration, which I think one day it will. If you want to 12 get money, your investors will someday say well, why aren't 13 you registered and if you're not registered, that will add 14 another question mark. 15 I don't think many of the -- if you regulate the 16 hedge fund managers requiring them to register, I don't think 17 that many will move offshore. I mean, it's not the greatest 18 place to live if you have to live in St. Croix the rest of 19 your life so if you live in the United States you still would 20 be subject to some of these industry demands. 21 In the meantime, before the industry moves into 22 this perfect direction, I think that disclosure and mandatory 23 disclosures about historical performance and some of the 24 industry -- their practices, how they allocate trades, et 25 cetera, all these important factors should be at some point 1 on a quarterly basis filed somewhere. 2 MR. ROYE: Iain? 3 MR. CULLEN: I think the one thing that I would ask 4 you to bear in mind in relation to whether or not to regulate 5 hedge fund managers is the offshore industry. 6 I think you will find that if the way you regulate 7 hedge fund managers is such that it causes non-U.S. hedge 8 fund managers or indeed non-U.S. investment advisors of any 9 sort without any presence in the U.S. to have to register 10 whilst already being regulated in their own jurisdiction in 11 order to offer a product to U.S. investors, then to cite a 12 comment I saw recently in relation to the proposed anti- 13 monitoring rules, you could find that there are a large 14 number of products and a large number of PPMs that come out 15 with a sticker on them saying something along the lines of 16 American investors not welcome. 17 MR. ROYE: Jane? Fellow regulator? Advice for us? 18 MS. THORPE: Well, we actually have it quite easy. 19 The Commodities Futures Modernization Act gave the CFTC a 20 blueprint for how we should regulate and that blueprint says 21 that one size does not fit all and don't cast a broad net to 22 address a one-all situation. 23 And so essentially it's the way we've been 24 proceeding in our new rule proposal which is identify the 25 risks that you believe the activity is presenting and second, 1 look at who the customers are and what level of protection 2 they need. 3 MR. ROYE: John, our individual investor 4 representative? 5 MR. MARKESE: The individual investor. You know, 6 if it's a viable product, which I think it is, it will help 7 diversification which we all support. I think we should make 8 it available and before we make it available, I think we 9 should have information. 10 Right now we have an information vacuum and the way 11 we've solved this information vacuum indirectly or obliquely 12 is to keep raising the bar and say we're going to have high 13 minimums and high income and net worth. 14 I'd like to essentially have registration, have 15 information, allow individual investors, even the smaller 16 individual investors who want to partake of this industry to 17 do so, but we obviously have to have registration 18 information, historic information, risk information so they 19 can make intelligent decisions independently on their own. 20 MR. ROYE: Armando. 21 MR. BELLY: I really just wanted to make sure that 22 everyone understood that I wasn't saying that there shouldn't 23 be registration. I was simply saying -- 24 MR. ROTH: For other people. 25 (Laughter.) 1 MR. BELLY: Right. Well, that's a very good point. 2 But if we have regulation or additional registration, that it 3 should be focused on the particular problem and be cost- 4 effective. 5 MS. SINCLAIR: I just want to make one sort of 6 final statement that I guess we didn't have too much time to 7 talk about here but with respect to short sales which we 8 talked about in the trading strategies panel, I think it is 9 important to reiterate that it seems that short selling and 10 hedge funds are often said in the same breath. It's 11 important to reiterate that certainly short selling is a 12 legitimate trading strategy. 13 I think there was a lot of conversation that went 14 to the point that it has actually helped to reduce volatility 15 with respect to these portfolios and certainly also 16 contributed to market efficiency. 17 I think another point to emphasize is that short 18 selling is not exclusively a tool used by hedge funds by any 19 means and finally to the extent that there has been talk of 20 manipulation, manipulation also is not exclusive to short 21 selling but it is something that we look at very closely and 22 put all of our enforcement tools to work to address and we 23 would continue to do that. 24 And I think that my own view is that that would be 25 the way to address the problems rather than to be overly 1 restrictive in the activity itself. 2 MR. ROYE: Paul? 3 MR. ROTH: Well, I think that the Commission and 4 the Staff have done an admirable job in recognizing that 5 there's been a huge growth in the assets in the hedge fund 6 area and therefore a study with respect to the industry which 7 is educational for the Commission as well as the participants 8 in the industry and those who want to invest is something 9 that is very, very worthwhile. So I think this is a helpful 10 process. 11 From my standpoint, I look at regulation as saying 12 it should cure some problem and I don't see thus far the 13 problem to be cured in connection with the hedge fund 14 industry as we've discussed it. The number of fraud cases, 15 while they have increased, are relatively small in terms of 16 the Commission's load and with respect to the CFTC and 17 certainly as a percentage of the number of hedge funds that 18 are out there. 19 It seems to me that there is a full panoply of 20 antifraud rules and regulations that the Commission has at 21 its beck and call to deal with fraud and fraud should be 22 dealt with, I think we all agree, in an intelligent manner 23 and by the enforcement division. 24 So I think that this is a good exercise but the net 25 result is that I think the industry is doing pretty well. 1 And one of the things that people say, well, what's the cost 2 of imposing regulation? I think in some sense that is 3 turning the question upside down by the cost potentially is 4 homogenization. 5 What people in the industry are concerned with is 6 that their investment techniques which are constantly on the 7 cutting edge and the innovative edge and dealing with 8 products that haven't been dealt with before, I'm not sure 9 your costs in terms of educating your examiners are going to 10 be just limited to how many you're going to have and where 11 you're going to house them, but the question of learning how 12 to evaluate those techniques is something that is a problem 13 as people move into new and different instruments. And 14 that's one of the concerns with respect to examination. 15 MR. ROYE: Christina? 16 MS. SINCLAIR: Yes. I'll make just a couple of 17 points. To pick up again on what Jean-Claude said, in our 18 jurisdiction it's already our law that you need to be 19 registered if you are going to manage other peoples' 20 investments and other people's money so registration is not a 21 big issue for us. 22 What is a much bigger issue for us is whether or 23 not these funds should be made available for retail and there 24 we come into very difficult issues and there's a tension 25 between allowing the freedom and the flexibility which we've 1 heard as being so important to some of the hedge funds there 2 balanced against the safeguards that are necessary for a 3 group of consumers for whom credit cards and mortgages can be 4 complicated products. Very difficult judgments there. 5 MR. SCHEIDT: I have four thoughts which for me may 6 be an all-time personal best. 7 MR. POZEN: On the high or the low side? 8 MR. SCHEIDT: On the high. 9 (Laughter.) 10 MR. SCHEIDT: You heard my views on hedge fund 11 manager registration but I'll add that I don't think the SEC 12 is qualified nor do I think it's an appropriate part of the 13 SEC's scope to evaluate the qualifications of hedge fund 14 managers or advisors in general. 15 It's more in my view a matter for the individual 16 investor to make a decision whether that person has the 17 experience and qualifications necessary to manage that 18 person's money and we shouldn't be in the -- stand in the way 19 of perhaps allowing a 16-year-old whiz kid to open up his own 20 business and manage money in a way that no one ever has 21 before just because he hasn't served an apprenticeship with 22 one of the big shops. It's not the American way. 23 I definitely think that we should change the 24 accredited investor standards. The current ones are not 25 representative of the sophistication whatsoever. I can't 1 think of another proxy other than net worth and income but 2 they should probably be doubled. 3 Two other thoughts. If you permit retail investors 4 to invest directly in hedge funds without requiring the hedge 5 funds to register, all of the abuses that the 40 Act is 6 addressed against are possible. You have principal trades 7 with the manager, you have joint arrangements, you have all 8 of the other abuses that were present before the 1940 Act was 9 adopted in a pooled vehicle and that makes investing in a 10 hedge fund a different thing from investing in an individual 11 risky security. Those additional elements of pooled 12 management and the abuses that the manager can engage in with 13 respect to the pool are elements that make retail investors 14 investing in a hedge fund different from a retail investor 15 investing in a risky instrument. 16 The fourth thing is that we should consider 17 allowing public offers by restricting sales to sophisticated 18 investors. I think currently -- the current system increases 19 the cost of capital formation. It decreases the amount of 20 information that's out there to investors to make intelligent 21 decisions and, for that matter, the financial press and the 22 financial advisory press, the more information that they can 23 distill and provide to investors, the better off we all will 24 be. And the current regulations have had the perverse effect 25 of limiting the amount of information available to people. 1 But I would also suggest that perhaps we get more 2 creative about this and perhaps if hedge funds themselves 3 were allowed, apart from any other kind of issuer to make 4 this kind of public offers but restricted to sophisticated 5 investors, we might want to attach some conditions that would 6 not change the nature of the hedge fund and how they operate 7 but that might attach some conditions in the sense that a 8 hedge fund might be permitted to make public offers but only 9 sophisticated sales on the condition that they have an annual 10 audit, that they get third party valuations and they provide 11 standardized returns and perhaps that they provide a minimum 12 amount of mandatory disclosure. 13 Think about -- just be creative in the process of 14 give here and take away a little bit here and give here but 15 add some investor protection aspects to it that might satisfy 16 the individual investor and might even satisfy the 17 sophisticated investor and might provide some additional 18 protections. 19 And, you know, for that matter, requiring an annual 20 audit probably just would codify what most funds do but it 21 might encourage those that don't have an audit who may have a 22 greater need to raise money in an easier less expensive way 23 to allow them to do that but with an additional investor 24 protection cost added to it. 25 MR. ROYE: Jack, last word. 1 MR. GAINE: You told me that the concession stands 2 would still be open when I finished and I don't think that's 3 true. 4 On a serious note and on a positive note I think 5 for the whole meeting, Annette, unless Rich Lindsay took the 6 only copy of that '99 concept release on short selling with 7 him, I would love to think that the discussions over the last 8 couple of days have resurrected that. We can get rid of the 9 uptick rule and put the U.S. markets on a level playing field 10 with other markets. 11 Secondly, on the merits of what we're talking about 12 today, I'll just agree with what Paul Roye had to say and 13 thirdly and finally, Bob Pozen, for your former colleagues, I 14 support a pay parity bill for the mutual fund manager. I 15 thank these four guys and Doug, I think you got a good 16 night's sleep because I loved 90 percent of what you just 17 said. 18 And thank you all very much. 19 MR. ROYE: We're going to turn it over to Chairman 20 Donaldson for some closing remarks, but on behalf of the 21 Staff, I'd like to thank all our panelists over the past two 22 days. I think we've learned a lot. We appreciate the time. 23 Many of you came great distances to be here and adjusted 24 schedules to be here and I think we're better off for it and 25 better informed. 1 Chairman Donaldson? 2 (Applause.) 3 CHAIRMAN DONALDSON: Thanks very much, Paul. This 4 brings to a close what I think we all can agree has been a 5 very informative and helpful and provocative two days of 6 discussion regarding all aspects of the mutual funds, how 7 they're structured, how they operate, how they're managed and 8 how they're currently regulated. We also I think identified 9 some areas of concern. As I believe the roundtable has 10 demonstrated, hedge funds play an important role in our 11 markets and offer investors legitimate and oftentimes 12 lucrative investment opportunities. 13 I believe that our discussions have also 14 demonstrated that it is an appropriate time to review hedge 15 funds and our regulation of them. 16 The next phase for the Commission and the staff is 17 to analyze what we've learned over the past two days at this 18 roundtable and through our previous fact-finding. Therefore, 19 I encourage all of you to submit comments to us as you 20 reflect on the past two days. 21 As I stated yesterday, I want to emphasize again, 22 the discussion does not end with the close of this 23 roundtable. This is perhaps the most critical phase yet 24 because it allows us to review the input from various experts 25 as well as the data we've collected so far. 1 Therefore I'm asking the staff to prepare a report 2 that will summarize our findings and include the 3 recommendations for any actions that should be taken, whether 4 legislative or regulatory, to ensure that the hedge fund 5 investors are adequately protected. 6 I look forward to the staff's report, which the 7 Commission will make public. 8 Before you go, I want to thank the group of 9 panelists. We've all benefitted from their participation 10 yesterday and today and I thank them for taking the time out 11 of their schedules to help us focus on the important issues 12 surrounding hedge funds. I think this is the way the SEC 13 should operate, in an open manner to bring all sorts of 14 points of view together, for the Commissioners to sit here 15 and listen, for the staff to sit here and listen. 16 I do want to thank the staff who put this together. 17 Though the list is long, I want to mention by name the staff 18 members who played the most significant roles. Paul, 19 beginning with you as our master of ceremonies -- 20 (Applause.) 21 CHAIRMAN DONALDSON: Will you hold your applause 22 until the end? 23 Cindy Fornelli, Jennifer McHugh, Bob Platz, Doug 24 Scheidt, Liz Osterman, Evan Gelzar, Rochelle Plessett, Martin 25 Kimmell, Steve Pax, Lily Chu, Wendy Friedlander and Jennifer 1 Berman, all of them from the division of investment 2 management. 3 From the office of compliance, inspections and 4 examinations, I'd like to thank Lori Richards, Jean Hogey, 5 Maryann Godzilla, Marvis Kelly, Brian Snively, Karen 6 Stevenson, Leslie Ward and all of the staff who worked on the 7 fact-finding stage of this endeavor. And of course, Alan 8 Beller, Steve Cutler, Annette Nazareth, our division 9 directors from corporation finance, enforcement and market 10 regulation, respectively. 11 I'm sure, absolutely sure that I left somebody out 12 and I know this group has played an instrumental role in 13 assisting the Commission in this important endeavor. 14 I close by thanking all of you again for coming 15 here, wishing you all a nice evening and safe travel to those 16 of you who are going to be dispersed in the winds. 17 Thanks for joining us. 18 (Applause.) 19 (Whereupon, at 5:19 p.m., the roundtable was 20 concluded.) 21 * * * * * 22 23 24 25