August 26, 2004
Investor Protection
I think the main purpose of any new regulatory proposal affecting hedge funds should be investor protection. Investor protection in the hedge fund arena can be better served by increasing investor awareness. After a little searching on the internet I noticed that both the SEC www.sec.gov/answers/hedge.htm and the NASD www.nasd.com/Investor/Alerts/alert_headgefunds.htm have addressed this idea with useful information on their websites. Although incidents of fraud by hedge funds have been minimal compared to fraudulent activities in other areas of the securities industry, more needs to be done to increase investor awareness regarding hedge funds. Fraud is difficult to prevent if the perpetrator is intent on carrying out his or her fraudulent plan, and whether the investment adviser to the hedge fund is registered or not, wont seem to make a bit of difference in preventing fraud from occurring. It should be pointed out, however, that the SEC has been doing a tremendous job in pursuing enforcement actions on the civil and criminal level. They should be commended for their work their enforcement actions have been swift and punitive and I believe will continue to be a better deterrent to fraud than registration. By way of analogy, the strict and detailed regulations for broker-dealers and their registered representatives do not prevent fraud in the stock market and stock price manipulation. As the dissent of SEC Commissioners Cynthia A. Glassman and Paul S. Atkins appropriately pointed out, . . .the SEC has brought 46 enforcement actions in the past five years in which hedge fund advisers have defrauded hedge fund investors or used a hedge fund to defraud others. By comparison, the Commission initiated approximately 2,600 enforcement actions during fiscal years 1999 through 2003. . . . Mandatory hedge fund registration would not add to the Commissions ability to combat these types of fraud.1
1 From footnote 15 of Dissent. In only 8 of the 46 cases the existence of the rule might have increased in the Commissions oversight. These 8 cases, however, do not justify the proposed rulemaking. Most involve valuation problems, which have been notoriously difficult for us to detect even if the adviser is registered. In addition, only perfectly timed inspections would have improved the Commissions detection of the frauds at issue. With respect to all advisers, registered or unregistered, tips from knowledgeable insiders or third parties are often the key to discovering the fraud. Indeed, tips pointed us to the fraud in 7 of the 8 remaining cases.
Registration
I believe the proposed rule change requiring the counting of individual investors in each fund is a drastic change that will affect many of the small investment advisers. Under the current rule an investment adviser could easily have 2 limited partnership funds with different strategies, 10 investors in each fund for a total of 20 investors and say 32,000,000 under management, yet be exempt from registration. Now that same investment adviser, if the current proposal is approved as is, will have to register. The compliance and record keeping requirements will greatly hinder these smaller funds. They will either struggle to survive and fail or pass the cost on to their investors. I suggest the following:
1 Use the proposed definition for counting of individual investors but increase it to 25 investors and increase the amount under management to 50 million for mandatory registration. The reason for increasing to 50 million is because those investment advisers will be better able to bear the cost of the compliance and record keeping requirements. This should also catch any investment advisers that manage pension fund money but are not registered assuming there are any, but alternatively, if the SEC feels that there are investment advisers that manage pension fund money that would still slip through the cracks, then simply add that any investment advisers that manage pension fund money must be registered.
2 Require all investment advisers of hedge funds whether registered or exempt from registration to provide their investors with annual audited financials. This one I cant stress enough and hopefully anyone else who comments after my letter or reads this and feels the same way will send in a sort comment letter supporting the need for annual audited financials. Investment advisers with only managed accounts would of course not be subject to this requirement. The reason for requiring audited financials is clear, it provides tremendous investor protection and investment adviser accountability and oversight. The example that comes to mind, involves the lawsuit the SEC brought against Michael Lauer of Lancer Management Group, LLC. I noticed from the litigation release that one of the first red flags was his refusal to provide audited financials for some of his investors.
3 Impose a statutory set of investor guidelines that all investment advisers must provide to prospective investors, which would include the links to the SEC and NASD websites concerning hedge funds which I list in the first paragraph of this letter. These guidelines should be set forth in all marketing materials and offering documents that are used by the investment adviser.
Thank you for your consideration of this comment letter. Please contact me if you have any questions regarding my comments.
Very truly yours,
Joseph B. LaRocco, Esq.
49 Locust Avenue
Suite 107
New Canaan, CT 06840
p 203-966-0566