Speech by SEC Commissioner:
Remarks Before the New York City Bar Association
by
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
New York, New York
May 5, 2006
Thank you, Nora and Chris, for laying a nice foundation for my remarks and thank you all for the opportunity to be with you here today. Before I begin, you should know that the views that I express here are my own and do not necessarily represent those of the Securities and Exchange Commission or my fellow commissioners.
As the last speaker after three plus hours of technical discussion about hedge fund registration, I am taking a bit of a risk. Rest assured, you have my empathy. I have had to talk a lot more in the past couple of years about hedge funds than I would have liked.
As you know, in October of 2004, one week before the 2004 elections, the Commission adopted the hedge fund registration mandate over my objections and those of my colleague, Commissioner Glassman. Since then, we have seen more than one thousand new hedge fund advisor registrants, and the Commission has been sued for adopting the rule.
The newly registered hedge fund advisors have approximately doubled the pool of hedge fund registrants. Reportedly, quite a few hedge fund advisors have not registered. Some advisors, quite understandably, shifted to a two-year lockup period to avoid the application of the rule. Large, well-established advisors were most able to take advantage of this route of escape from registration. This entirely predictable reaction to a wholly arbitrary line of demarcation is not a good result for investors. I would venture a guess that most investors would gladly exchange the protections afforded to them by registration for the opportunity to have their money locked up for less than two years so that they can vote with their feet when they feel that something is amiss.
Some foreign advisors have simply shut their doors to U.S. investors — another entirely predictable reaction to the rule that also is not a good result for investors. The adopting release acknowledged that "as a practical matter, U.S. investors may be precluded from an investment opportunity in offshore funds if their participation resulted in the full application of the Advisers Act and our rules." But foreign advisors could reasonably be scared off even by the "registration light" approach that was embodied in the final rule, under which our books and records requirements apply and the prospect of a time-consuming, costly SEC examination looms.
Even some domestic advisors have ceased accepting new investments. Some of these advisors are waiting for the resolution of Phillip Goldstein's legal challenge to the registration requirement that is currently pending in the D.C. Circuit. Perhaps the Commission's recent defeat in the same court in the fund governance case has increased the resolve of some of these advisors to wait it out. I cannot really blame them. A heated oral argument took place last December, so I expect that a decision should be forthcoming any day now.
It is no wonder that the rule, with its ad hoc and internally inconsistent definition of "client," attracted a legal challenge. The majority, in adopting the registration mandate, abandoned the common-sense notion that the client is the person for whom the advice is tailored. The final rule redefined "client" solely for advisors to hedge funds and then only to determine their eligibility to rely on the fifteen client exemption from registration. The new definition demands that advisors look through their hedge funds and count investors as clients.
Regardless of how the Court decides the case, the challenge has already served to remind us of the danger of undergoing regulatory contortions to achieve a questionable objective. Ironically, some states have taken this opportunity to tell out-of-state advisors that the Commission's look-through approach is also the right way to determine whether a hedge fund advisor has in-state clients and therefore needs to register its investment advisor representatives in that state.
One of the issues that Commissioner Glassman and I raised when we dissented from the hedge fund rule was the opportunity cost to the Commission, which will result from diverting resources from overseeing mutual funds to overseeing hedge fund advisors. After all, there are more than 90 million mutual fund investors, compared to an estimated 100,000 to 200,000 hedge fund investors.
The so-called retailization of hedge funds does not change this calculus. The notion that there is an influx of unprotected retail investors is simply unfounded. A study by the SEC staff published in September 2003 discounted this notion of reutilization. When challenged with these findings, the proponents of the rule focused on the growing pension fund investments in hedge funds as evidence of realization. After all, they argued, the proverbial Joe Six Pack is thus exposed to hedge fund risk through the investments of his pension fund. Quite frankly, this is nothing but transparent demagoguery. Sophisticated fiduciaries stand between pensioners and hedge funds. Even if the fiduciaries are not "sophisticated" in the true sense of knowing what they are doing — let's just assume that they are the dumbest investors on earth, ERISA laws and the mechanics of the marketplace essentially drive these fiduciaries to hire people who know something about investing to help them manage the money with which they are entrusted. In fact, the biggest twist of irony regarding this argument is that ERISA law and pension fund investing in hedge funds have encouraged voluntary SEC registration of hedge funds, even before the SEC adopted the rule.
For the most part, it seems that U.S. hedge fund advisors are simply not looking to attract direct investments by retail investors. As you all know, hedge fund investors are generally either experienced, or can hire someone who is, to assess and compare hedge fund advisors. The same cannot be said for mutual fund investors, who are drawn from a cross-section of the public.
We have slightly over 400 '40 Act examiners. Adding another thousand registrants to their bailiwick is a significant drain on their time. The Government Accountability Office expressed a similar concern about the resource allocation issue in a recent report. The report cited the hedge fund rule as an "oversight challenge facing the SEC's mutual fund examination program" and questioned the "SEC's capacity to effectively monitor the hedge fund industry … given the tradeoffs that the agency has had to make in overseeing the mutual fund industry."1
I am encouraged, however, and I think that you should be also, that it does not seem that hedge fund advisors are being singled out as targets for examination. The use of a risk-based approach means that we should not be focusing all of our attention on advisors to hedge funds. The Office of Compliance Inspections and Examinations is assessing hedge fund advisors, like all other advisors, through a risk-based lens. Before the adoption of the hedge fund registration mandate, in an effort to rationalize our examination resources, OCIE moved to a risk-based approach to monitoring investment advisors. This approach, a departure from the five-year exam cycle that was previously in place, is intended to focus our resources on those areas that seem particularly susceptible to investor harm and other trouble.
Of course, a problem with this approach is that some firms deemed to be low-risk could go unexamined for years since OCIE will randomly select for examination only ten percent of these low-risk firms each year. As the GAO observed, our "inability to conduct examinations of all mutual funds within a reasonable period may limit [our] capacity to accurately distinguish relatively higher risk funds from lower risk funds and effectively conduct routine examinations of higher risk funds."2
Risk ratings, which are derived through an assessment of Form ADV data, form the starting point for decisions about which firms to examine. Not surprisingly, OCIE conducts a risk assessment for new registrants. Only a portion will get examined right away, but because of the recent influx of hedge fund advisors into the registrant pool, it may turn out that hedge fund advisors may be disproportionately represented in this year's examination numbers. This might cause them to feel under siege. In fact, some of the parameters by which our staff weighs risk may point them more towards examining hedge funds. However, from what I have seen so far, hedge fund advisors seem to be represented among those advisors being examined in the same proportion as they bear to the overall population of advisors. Encouraging your clients to strengthen their compliance measures is the most constructive way to respond to their concerns about the burdens of regulatory oversight. Strong internal compliance programs lower risk and make our examiners focus their attention elsewhere.
I am also encouraged, and you should be too, by the extensive training that our examination staff has been undergoing to prepare them better for hedge fund examinations. Staff are midway through twenty-two training sessions taught with the assistance of seasoned professionals and practitioners like you. A knowledgeable, well-prepared examiner is much more likely to take a reasonable approach and to reject a one-size-fits-all compliance model. Some aspects of hedge fund advisors are common to any asset management firm: conflicts of interest, custody, performance advertising, recordkeeping, truthfulness of disclosure. But many other aspects are much more complex, such as intricate holding structures, the high volume of trades, the use of leverage, structured products, and valuation issues.
One determinant of how well we will achieve our objectives is whether we can work with other regulators. We did not make serious efforts to reach out to other regulators before we adopted the hedge fund rule. Before embarking down the regulatory path, we should have worked with our counterparts to assess the already-available collective data about hedge fund advisors. At the meeting adopting the rule, Commissioner Glassman famously asked the staff if they had talked to the other regulators regarding alternatives to our registration requirement. Upon getting the response that yes, they had, she asked: "Well, did you listen to what they had to say?"
It is not too late for us to start listening. Now that the rule is in place, we should coordinate closely with the CFTC, Treasury, the Federal Reserve, the Department of Labor and others domestically to determine how best to parcel out our regulatory responsibilities. We also should work with foreign regulators to gain a better understanding about the interaction of our requirements with foreign regulatory frameworks. Systemic concerns about hedge funds should be handled at the level of the President's Working Group, which is made up of the heads of the Treasury, the Federal Reserve, the CFTC, and the SEC.
It is true that the rule's proponents have an incentive to find problems in order to show how necessary the rule was in the first place. I anticipate a bandying about of hedge fund fraud statistics as evidence that the registration mandate was long overdue. My experience with hedge fund fraud statistics before the adoption of the rule means that I will look at such statistics with a skeptical eye. As Commissioner Glassman's and my analysis of the cases that were cited in support the rule revealed, lots of types of cases get labeled as hedge fund cases. The 51 cases that were cited in the Adopting Release as evidence of a, "troubling growth in the number of our hedge fund fraud enforcement cases" largely implicated advisors who would have been too small to be registered with the Commission, were already registered in some capacity, should have been registered, or were simply garden-variety fraudsters. The cynic in me wonders whether, if the Commission decides to turn its attention to venture capital and private equity funds, the "hedge fund" cases will get relabeled.
In saying this, I am not discounting the seriousness with which the Commission must approach hedge fund fraud. We cannot tolerate fraud, market manipulation, insider trading, misappropriation of client funds, cherry picking, misvaluation, and favoritism in allocation (just to name a few) from registered or unregistered advisors. However, we did not need registration as a hook to pursue fraud — we have broad authority already under the securities laws. Advisors, whether registered or not, are subject to the antifraud provisions of the Act. In addition, it is no secret that the Commission's subpoena power extends beyond its registrants.
Realistically, it might not be long before the rule serves up its first major disappointment to its supporters. Yes, even registered hedge fund advisors will commit fraud. We will not find all of the fraudsters in time to prevent investor harm. We have seen time and again over the years just how difficult it is for any examiner or auditor to ferret out fraud at large and small retail-oriented investment advisors using straightforward long strategies. By their nature, fraudsters tend to be crafty and go to great lengths to hide their fraud. Needless to say, we did not find the late trading and market timing problems through our examinations of any of the many registered funds, registered advisors, and registered broker-dealers that were at fault. And, those who claim that hedge fund registration would have led us to discover the fraud through examination are engaging in wishful thinking. They don't understand the craftiness of people who engage in illicit activities. As we do now, we will have to rely heavily on disgruntled investors, former employees, and suspicious third parties, such as a prime broker, to alert us to problems.
It also might not be long before some of those who acquiesced blithely to the registration rule or even encouraged the Commission to adopt it start to shed their illusions that being registered would not prove to be particularly burdensome. As I mentioned, hedge fund advisors are not being singled out by our compliance folks, but those who are selected for routine exams might find that it is costly and time-consuming to respond to the routine, lengthy document requests and answer examiners' questions. They will face the same frustrations as other advisors in, for example, discerning the contours of the Commission's e-mail retention and production requirements, an issue to which the Commission should be turning its attention soon.
Even advisors who do not have hedge fund clients might be affected by the new rule if it spawns new requirements that apply to all advisors. One interesting upshot of the hedge fund rule is that it has highlighted the gaps in the existing Form ADV. Some have suggested that we look for new ways to get more data from advisors, such as requiring quarterly SEC filings. Others have suggested requiring a few more pieces of information. Advisors might be asked, for example, to identify their auditors and indicate whether they prepare their own account statements.
I remain convinced that the Commission erred in requiring hedge fund advisors to register. Investors lose out. Mutual fund investors will see examination resources being diverted. All hedge fund investors will end up paying for something that some of them did not want. Those who did view registration as worth the cost already had the option, before the rule went into effect, of investing in funds with registered advisors. Now that the rule is in place, hedge fund investors will still be able to choose unregistered hedge fund advisors, but to do so, they will have to agree to a lock-up period of more than two years.
Even if it were proper to make the protection of the small and sophisticated ranks of hedge fund investors a regulatory priority of the SEC, a registration requirement would not be the right approach. One-size-fits-all regulatory mandates, although generally well-intentioned, deprive investors of decision-making power that is rightfully theirs and may impose costs on investors that do not produce a proportionate return. Investors are best able to make this determination. If SEC-registration were perceived to be uniformly desirable, the market — meaning investors — would eventually lead all hedge fund advisers to register.
Some have argued that the SEC must try to look wherever it can for fraud, if only to discourage potential fraudsters from taking the risk of being caught. After all, the argument goes, police do not just completely ignore parts of their city and need to be on the look out for crime wherever it may occur. We know that hedge funds are not immune to fraud, so it is incumbent on us to at least turn over some of the rocks to look for the worms.
But, is this a fair comparison? Police departments would be rather derelict if they did not take some sort of risk-based approach to their job and the allocation of their resources. If one area of town is made up of estates with private security guards, the police force might be justified to rely on the occasional call reporting a burglary (rather than sending a patrol car driving through the neighborhood) and focus its attention on more densely populated areas known for high crime or for a large, unprotected population that is susceptible to being victimized. The SEC has broad jurisdiction over the financial markets, and regularly acts on tips with respect to parts of the markets that are unregistered. This applies not only to unregistered advisors and funds, but also to municipal securities, Rule 144A securities, and real estate and other scams that are really securities frauds. These areas are not regularly policed by the SEC, even though we have seen some egregious problems develop at least in some of them.
Since summer is almost here, I will put aside my usual ski slope analogy in favor of a beach analogy. One can compare the investment world to a beach, one end of which is open to all and staffed by a life guard, the other end of which is restricted to experienced swimmers and unguarded. It is simply not a good allocation of scarce lifeguard resources to make the guard spend half his time sitting on the restricted access beach. In those places, the signs that restrict access and say "No swimming" or "Riptides — Swim at Your Own Risk" must suffice.
As long as the rule is in on our books, however, I am hopeful that we at the Commission will administer it wisely and use it as best we can to assist us in our oversight of the securities markets. Chairman Cox takes a deliberate approach to regulation and a careful approach to the use of our enforcement authority. With the assistance of your insights, the SEC will assess the investor protection, regulatory, and business landscape very carefully before undertaking any additional hedge fund regulation.
In this vein, I look forward to hearing your thoughts about the SEC's actions with respect to hedge funds or any other areas of concern that you might have. Thank you all for your attention.
Endnotes
http://www.sec.gov/news/speech/2006/spch050506psa.htm
