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By Mark J. Astarita, Esq.
The SEC has now decided to require registration of certain hedge fund advisers under the Investment Adviser Act of 1940.
The new rules, trumpeted by a few (but not all) of the Commissioners, is being touted as a method to stop Hedge Fund Fraud, and to control the hedge fund industry. The question is however, is there any significant hedge fund fraud, and does the industry need control? Further, does the SEC have the funds or staffing to control or oversee the industry, and what makes anyone believe that they can do so in an effective manner. Or finally, is this just another bureaucratic blunder that will cost the regulated more time and money without any significant benefit to the investing public.
The SEC has put forward an argument that since hedge fund investing has gone mainstream, it needs to be regulated, and that since there are an increasing number of frauds in the hedge fund sector, there is an urgent need for such regulation.
While the Commission may have its heart in the right place, as one who has followed this issue from the beginning, and has been involved in securities regulation for over 20 years, the justifications do not support the concept of registration. In fact, most of the justifications for these new regulations are simply untrue.
The SECs rationale is based on questionable reasoning, is contradicted by the Commissions own research and studies, and is simply not supported by any evidence or data.
The SEC believes that if hedge fund managers are registered, it will be able to better prevent fraud by those managers. Putting aside the question of whether there is any significant fraud by hedge fund managers (there is no evidence that there is) we question whether there is any significant effect of SEC registration on preventing or detecting fraud.
Looking back, the defendants in the research scandal were registered with the SEC, the defendants in the market timing scandal were registered with the SEC, Enron, Tyco and the defendants in the corporate accounting scandals were all registered with the SEC.
The SEC did not prevent, nor even detect, any of those frauds, and there is no reason to believe that the additional regulatory burden on another industry segment will result in the detection or prevention of any supposed fraud in that industry segment.
The Rule Change
The SECs release on the rule change is available at their web site, in a notice entitled Registration Under the Advisers Act of Certain Hedge Fund Advisers. It might make interesting reading for some of you, and if you do read it, please make sure to read the Dissent of Commissioners Cynthia A. Glassman and Paul S. Atkins. For those of you who are really interested, the original proposal is also available, and is titled Registration Under the Advisers Act of Certain Hedge Fund Advisers File No.: S7-30-04. The document is quite lengthy, as the Commission attempts to justify this rule proposal. There is also a significant Dissent by Commissioners Cynthia A. Glassman and Paul S. Atkins to the original proposal, which merits a careful reading.
The rule change itself is relatively simple, and merely changes how the number of clients are counted for purposes of determining whether an investment adviser is required to register with the Commission. However, the rule change is designed to limit the exemption, and require hedge fund operators to register.
Traditionally, hedge fund managers were not required to register as Investment advisers because of an exemption in the registration statutes, which exempted from registration any adviser with less than 15 clients. Since the Act counted partnerships and corporations as one client, regardless of how many shareholders or partners were involved, a hedge fund adviser, running one hedge fund, only had one client.
The rule would require investment advisers to count as "clients" limited partners and shareholders of certain unregistered investment funds for which they provide investment advice. That is, every investor in the hedge fund itself now becomes a client for purposes of the exemption.
The effect of the rule is to require registration of advisers of hedge funds that have more than 15 investors which is undoubtedly most, if not all, hedge funds.
The proposed rule contains special provisions for advisers located outside the United States that are designed to limit the extraterritorial application of the Advisers Act to non-U.S. Advisers of offshore funds that have U.S. investors.
The Current Rule
Under the current version of Section 203(b)(3) of the Advisers Act and the rules thereunder, an investment adviser is not required to register with the SEC if:
(i) it has fewer than 15 advisory clients in any 12- month period;
(ii) does not hold itself out to the public as an investment adviser; and
(iii) has $25 million or more in assets under management.
Rule 203(b)(3) under the Act currently permits investment advisers to count an investment fund as one client and does not require advisers to look through a fund and count investors in the fund as clients when determining whether they have 15 or more clients. Most hedge fund advisers rely on that rule to avoid SEC registration.
The rule change will therefore require most hedge fund advisers to register, as most hedge funds have more than 15 investors, and thus, more than 15 clients for purposes of the rule.
The Underlying Rationale for the Change
First, even the casual observer of the securities regulation structure understands that the SEC does not prevent fraud, it does not have the manpower or budget to properly enforce the regulations that are currently in effect, and the SEC does nothing to obtain money for investors who are the subject of fraud.
The casual observer may not be aware that there is no increase in securities fraud by hedge funds, and that current rules and regulations prevent every type of fraud that the SEC expresses concern over.
The Alleged Retailization of Hedge Funds
The first leg of support for registration of hedge fund advisers is the Commissions belief that there is an increased Retailization of mutual funds. That is, the Commission claims that mutual funds are being sold to the masses.
Well, the simple fact is, that if the SEC were enforcing current regulations, retailization would be impossible. Current regulations prohibit the marketing of hedge funds. It is illegal to do so.
Second, hedge funds, for the most part, do not accept investors who are not accredited investors that is, earn over $200,000 a year or have a net worth in excess of $1 million.
The masses are hardly involved in the hedge fund industry. They cannot be, since the regulations prohibit them from being involved. Perhaps we need to adjust the definition of accredited investor or qualified client, but the masses are not involved.
In this same proposal, the SEC acknowledges that the small investor is not involved in hedge funds. When discussing the impact of the proposal on non qualified clients, the SEC stated Accordingly, there may be some small number of investors in hedge funds that are not qualified clients. A qualified client is generally defined as an investor who has $750,000 under a particular adviser's management or has a net worth of $1.5 million. There are not too many individuals in this country who have a net worth in excess of 1.5 million dollars, and even less who have a single investment that is in excess of $750,000.
And if they are involved, it is because the SEC is not enforcing current regulations. And if they are not enforcing current regulations, why are they looking to have more regulations that they cannot enforce?
The SEC points to a study which found that the minimum investment requirement for many hedge funds has decreased over the years, and concludes that funds are now reaching for the smaller investor. That may or may not be true, but the simple fact is that a fund will not accept an investor who is not an accredited investor, and cannot charge a performance fee to an investor who is not a qualified client. Simply enforce the existing rules and regulations and every small investor would be out of the hedge fund investment. Simple, easy, and involves no additional paperwork
The masses are not investing in hedge funds, and hedge funds have not become retailized. If the foregoing were not enough to convince you of this fact, I submit this quotation for your review The 2003 Staff Hedge Fund Report found no retailization and no significant increase in fraud. These conclusions were consistent with the views expressed at the Commission's May 2003 roundtable, at which 60 panelists, including representatives of federal, state and foreign government regulators, securities industry professionals, and academics testified.
The quotation is from the dissent of the two commissioners who oppose the rule. If the SECs Staff Report found no increase in retailization, then where is the factual basis for support the majoritys conclusion? It is simply galling to learn that the commission spends hundreds of thousands of dollars conducting a study, and then simply ignores the study when it does not support their required conclusion.
There is simply no evidence of the average investor becoming involved in hedge funds. The 2003 Staff Hedge Fund Report found no retailization and no significant increase in fraud. These conclusions were consistent with the views expressed at the Commission's May 2003 roundtable, at which 60 panelists, including representatives of federal, state and foreign government regulators, securities industry professionals, and academics testified.
A careful review of the statement in support provides the explanation the Commission has no support for its conclusion.
In the footnotes to the report, we learn that while the Commission says that hedge funds are marketing to investors who have not invested in hedge funds before, that statement does not suggest that it is inappropriate many wealthy individuals have not invested in hedge funds. The support for the argument that the marketing is going on is not from the Commissions years of study and testimony; the supporting references are to newspaper articles!
Yes, the Commission is relying on newspaper articles to support this conclusion, a conclusion that its own staff found to be untrue.
The footnotes in support cite to an article in the San Jose Mercury News and another in Newsweek Magazine; two notable publications, but since when does the United States Government rely on a news reporters for support for major regulatory changes when the Commissions own staff, which conducted years of study reached a different conclusion?
The Commission also relies on two other articles in professional publications. One in a story in Registered Representative Magazine, a publication for stock brokers. The second is in Ophthalmology Times and Medical Economics - two publications aimed at the wealthiest investors doctors and surgeons which suggest hedge funds as alternative investments for these wealthy individuals. Hardly support for the proposition that the hedge fund industry is reaching out to small or unsophisticated investors. If anything, it is evidence that hedge funds are of interest as investment choices for our wealthiest professionals.
For further support, in a lengthy footnote, the commission points to the regulations of other countries that permit average individuals to invest in hedge funds. My immediate response is so what; OUR regulations do not permit such investments; whether France or Germany permit those investments is completely irrelevant to the issue of changing our securities regulations, which already prohibit such investments.
Lastly, the Commission argues that about 20 percent of corporate and public pension plans in the United States were investing in hedge funds in 2002, up from 15 percent in 2001. The argument is that retail investors money is in those pension funds. This is true. What is equally true is that the amount of such money invested in hedge funds is less than 1% of all available pension funds. Less than 1%.
More to the point however, is that these pension funds are managed by professional money managers, not mom and pop; those pension fund managers are subject to very strict regulation and oversight by the federal government, and professional managers are managing the money. Professional money managers, who are regulated by the SEC, are investing less than 1% of their funds with hedge funds. This is a problem?
In short, the SECs own study did not find any evidence of retailization of the funds, and the Commissions desperation to find evidence or retailization in newspaper articles is demeaning, and unavailing. Clearly, there is no retailization of hedge funds, and existing regulations prevent such an event.
If mom and pop are investing in hedge funds, the SEC is not enforcing current regulations. Existing regulations cover all of this. Why is there is undying need to create new regulations everytime a perceived problem comes up? Enforce existing regulations and the problem goes away. Create new regulations and continue a non-enforcement problem and all you have are new regulations, and paperwork, and bureaucratic expense.
If the commission is concerned about individuals becoming investors, simply adjust the eligibility criteria, which would address about potential retailization more directly than hedge fund adviser registration, which does nothing to address such concerns.
Hedge Fund Fraud
The second justification hedge fund fraud is also a false argument. Again, the Commissions own report found no significant increase in fraud in the hedge fund sector, and no disproportionate fraud in the sector versus any of the regulated areas of the securities industry.
While there is no doubt that there is fraud in the hedge fund arena, fraud exists in all segments of the securities markets. In fact, fraud exists in all segments of society. The mere fact that there are fraud cases does not lead to the conclusion that more regulation will stop the fraud.
We need to remember one significant point. The SEC currently has jurisdiction over every hedge fund in this country which engages in securities fraud. Every person who commits securities fraud, from mom and pop, to Internet marketers to hedge funds to securities brokers, can be investigated and civilly prosecuted by the SEC. Hedge funds and their advisers enjoy an exemption from registration only they are still subjected to the United States securities fraud laws, as we all are.
The next question is there any evidence of a fraud problem in the hedge fund industry? Not according to the SEC. The SECs own study found that there is "no evidence indicating that hedge funds or their advisers engage disproportionately in fraudulent activity."
In the press release the SEC does not dispute its jurisdiction, and argues that fraud is increasing since in the last five years. The Commission points to the fact that it has brought 46 cases in which it has asserted that hedge fund advisers have defrauded hedge fund investors or used the fund to defraud others. Of course it has, and each of those cases were brought under existing laws, rules and regulations.
Further, a review of the cases cited leads to the conclusion that many of those fraud allegations did not occur with advisers who would be affected by this regulation. It appears, and I have not verified, that the Commissions hedge fund fraud cases involved hedge fund advisers with less than $25 million under management advisers who are NOT subject to this new regulation.
But we know that the SEC has commenced 46 cases under existing rules, and that registration of advisers will not create any new substantive rules. Securities fraud is being detected, and prosecuted, under current rules. No new rules are required for those cases. So, what is the justification? Incredibly, the SEC claims that registration of hedge fund advisers will help prevent fraud, since the SEC will be able to inspect advisers before they have a chance to commit a fraud.
Registration will Prevent Fraud
Given the SECs history of reacting to fraud, rather than preventing fraud, this justification is almost a joke. First, the SEC does not have the staff or budget to inspect the advisers that are currently registered, and for years, did not even bother to make those inspections. The reason? In the scope of the securities industry, fraud by investment advisers is not significant enough. Or alternatively, inspections do not do enough to uncover fraud. Either way, the SEC does not inspect the advisers it currently has under registration, and there is no reason to assume that it will inspect all of these new advisers.
Further, we KNOW that the SEC has an abymisal track record in preventing fraud, and the standard joke in the securities industry is that the SEC does a terrific job of locking, double locking the barn doors after the horses have escaped. Unfortunately, the SEC also inadvertently burns the barn down while trying to lock the doors, but that is the subject of latter commentary.
The SEC claims that registration of advisers will enable the SEC to
· collect and provide to the public basic information about hedge funds and hedge fund advisers, including the number of hedge funds operating in the U.S., the amount of hedge fund assets and the identities of their advisers;
· conduct examinations of advisers in order to identify compliance problems at an early stage, identify practices that may be harmful to investors, and provide a deterrent to unlawful conduct;
· screen individuals associated with the adviser, and to deny registration if they have been convicted of a felony or had a disciplinary record subjecting them to disqualification.
That all sounds very grand, but the question is, will this help the SEC prevent fraud, or will it simply cause additional regulation for investment advisers, new burdens on investors, and serve to increase the burden of a bureaucracy that is already crushing an industry with is sheer size, weight and ineffectiveness?
The answer is clear, and all one needs to do is to look at the current fraud cases that the SEC claims provides a foundation for its registration proposal the mutual fund timing scandal.
The Commission trumpets the scandal as its prime example of hedge fund fraud and the need for regulation, in order to have early detection.
This is certainly a joke. First, the SEC did not discover the mutual fund timing scandal; the state securities commissioners did so.
Second, the state securities commissioners uncovered and investigated the fraud based on information from whistleblowers, not because the mutual funds were registered.
Third, the mutual fund timing frauds were in fact uncovered, without registration of the handful of hedge funds that were involved, without registration of those funds.
And fourth, the mutual fund timers were not the ones violating the securities laws in most instances. The timing violations occurred in large part because the mutual funds themselves, or the advisers to the mutual funds, violated the prospectus disclosures of the funds. Lets be clear here the violations of law that have been alleged in the timing scandal were violations by the mutual funds, and their advisers not by the timers.
And the mutual funds and their advisers are all registered with the SEC.
Lets recap = the SEC needs to register hedge fund advisers so that it can prevent frauds like the mutual fund scandals. However, the SEC did not detect the mutual fund scandals, which were perpetrated by SEC registered broker-dealers and mutual fund advisers.
The mutual fund scandal is not the only example of an ineffective SEC. The SEC missed Enron, Tyco and the entire corporate governance scandal. Each of those entities were regulated by the SEC all public companies make regular financial filings with the SEC, and prepare their financials in accordance with SEC guidelines. Either the SEC did not adequately review those financials, or could not review those financials, but it is clear registration and filing with the SEC did not prevent the scandals, and the SEC did not detect the scandals.
Yet another example is the research analyst scandal. Once again, heavily regulated persons and entities brokerage firms and research analysts and a few major firms breached their obligations to their clients, and violated existing securities laws, all right under the nose of the SEC. Each of the brokerage firms who were fined, and each analyst who admitted violating the securities laws, were duly licensed and registered with the SEC and/or its designees, the NASD and the NYSE. Again, registration and oversight by the SEC did nothing to prevent this massive fraud, and despite full, complete and unbridled access to the firms, the SEC did not detect, deter, or discover this fraud.
On what possible grounds could the SEC claim that registration of hedge fund managers will prevent fraud and enable early detection? They do not conduct meaningful inspections of existing registrants, they do not conduct any meaningful review of the documents that are currently filed with them, and they did not uncover the last three major frauds that were perpetrated on the securities markets!
Of course, the SEC already has this power and authority over every brokerage firm, and many hedge fund advisers. Clearly, the SEC has missed most of the significant securities frauds of the last decade, which were uncovered by private attorneys and the various state securities administrators. It is therefore unclear how the SEC is going to accomplish any of these goals without proper staffing, manpower and budgets.
There is certainly fraud in the hedge fund area, as there is in all segments of our society. The question is not whether fraud exists, but whether additional filings, paperwork and bureaucracy is going to protect investors, or prevent any fraud. Clearly the answer is no, and that the new rule proposal will simply mean more bureaucracy, without any benefit to the investing public.
In fact, some have suggested that the registration of select hedge fund managers will harm investors, as it will create the suggestion of additional oversight, and therefore safety, to unsuspecting investors.
The commission needs to remember that the financial professionals in this country who are running brokerage firms, hedge funds, and pension funds are more knowledgeable and experienced in investing than the commissions are. Those professionals are honest and diligent, and work for their investors. Adding additional restraints on their ability to perform hurts investors, it does not help them.
As you review the proposal, keep an old punchline in mind Hi, We are from the government and we are here to help you. Has the SEC done anything in the last 10 years to help investors and is there any reason to believe that new regulations will assist in the process?
Securities Law Blog
Nothing herein is intended as legal or financial advice. The law is different in different jurisdictions, and the facts of a particular matter can change the application of the law. Please consult an attorney or your financial advisor before acting upon the information contained in this article. SECLaw.com was created by and is sponsored by Mark J. Astarita, Esq., a securities attorney and partner in the law firm of Beam & Astarita, LLC, who represents financial professionals in a wide variety of matters. Mr. Astarita can be contacted by email at firstname.lastname@example.org.
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