Securities and Exchange Commission Chairman William H. Donaldson has unveiled the SEC staff's report and recommendations on hedge funds.
The report, "The Implications of the Growth of Hedge Funds", contains a number of recommendations to improve the regulation and oversight of the hedge fund industry.
The SEC staff's primary recommendation is that the Commission consider revising its rules to require that hedge fund advisers register under the Investment Advisers Act.
Chairman Donaldson said, "Currently there is more than USD 600 billion invested in hedge funds. That figure is expected to exceed USD 1 trillion in the next five to 10 years. The substantial growth in hedge fund assets, and the Commission's lack of information about these investment pools, make the study released today particularly important."
The staff's most significant recommendations include the following:
The Commission should consider requiring hedge fund advisers to register as investment advisers under the Advisers Act, taking into account whether the benefits outweigh the burdens of registration. The staff recommends that the Commission consider revising its rules under the Advisers Act to require hedge fund advisers to register as investment advisers. The staff further recommends that Commission consider amending its rules to require that registered hedge fund advisers file with the Commission, and deliver to investors, a disclosure statement specifically designed for hedge fund investors.
The staff says registration of hedge fund advisers would have several benefits:
* registered hedge fund advisers would become subject to the Commission's regular inspections and examinations program. Effective Commission oversight could lead to earlier detection of actual and potential misconduct, help to deter fraud and encourage a culture of compliance and controls.
* the Commission would be authorized to collect basic and meaningful information about the activities of hedge fund advisers and hedge funds, which are becoming increasingly influential participants in the U.S. financial markets.
* Advisers Act registration would enable the Commission to require hedge fund advisers to disclose information about issues important to investors, such as conflicts arising from side-by-side management of hedge funds and other client accounts and hedge funds' relationships with their prime brokers.
* registration of hedge fund advisers under the Advisers Act also would effectively increase the minimum investment requirement for direct investments in some hedge funds because registered advisers are generally prohibited from charging performance fees unless investors have $750,000 invested with the adviser or have a net worth of $1.5 million.
In the Report, the staff notes that Advisers Act registration would not impede the manner in which a hedge fund adviser invests or operates a hedge fund. Registration would not place restrictions on a hedge fund adviser's ability to trade securities, use leverage, sell securities short or enter into derivative transactions. Registration also would not require the disclosure of hedge fund trading strategies and portfolio positions, nor would it result in the identification of the hedge fund's investors.
The Commission and its staff should address certain valuation and fee disclosure issues relating to registered funds of hedge funds ("FOHFs"). The staff also recommends that the Commission consider requiring, through rulemaking, that all registered investment companies that invest their assets in hedge funds, including registered FOHFs, have policies and procedures designed to ensure that funds and their boards value their interests in hedge funds in a manner consistent with the requirements of the Investment Company Act. To address concerns that registered FOHF investors do not understand the impact of multiple layers of fees, the staff recommends that the Commission adopt its proposed rulemaking to require all registered investment companies, including registered FOHFs, to disclose in their prospectus fee tables the estimated expenses of the company's underlying fund interests.
The Commission should consider permitting general solicitation in fund offerings limited to qualified purchasers. The staff recommends that the Commission consider eliminating the prohibition on general solicitation or advertising in offerings by hedge funds that rely on the exclusion from the definition of an investment company for hedge funds that permit investments only by highly sophisticated investors. Permitting pooled investment vehicles, including hedge funds, which limit their investors to this higher standard to engage in a general solicitation could assist funds in identifying such qualified purchasers, without raising significant investor protection concerns.
Other recommendations. The staff also recommended that:
* the staffs of the Commission and the NASD monitor closely capital introduction services provided by broker-dealers and watch closely for violations of broker-dealer suitability obligations with respect to the sale of FOHFs;
* the Commission encourage the hedge fund industry to embrace and further develop best practices;
* the Commission continue its efforts to improve investor education regarding hedge funds; and
* the Commission consider issuing a concept release to examine the wider use of hedge fund investment strategies in registered funds.
Chairman Donaldson said: "The staff has done a fine job of preparing the report and presenting the Commission with comprehensive recommendations. I, along with my fellow Commissioners, look forward to thoroughly reviewing this important work and the additional comments from all parties interested in the hedge fund industry to determine how we may wish to proceed."
The report follows a fact-finding investigation into the operations and practices of the hedge fund industry.
During its investigation, SEC staff reviewed documents and information from 65 hedge fund advisers managing more than 650 different hedge funds with over USD 160 billion of assets.
Staff also visited hedge fund advisers and prime brokers and conducted a series of examinations of registered funds of hedge funds. In addition, the staff met with a variety of hedge fund industry experts and observers.
Complementing the study, the Commission held a highly successful two-day Roundtable, during which a variety of experts discussed key aspects of hedge fund operations. The staff also analyzed approximately 80 comment letters that were received by the Commission on hedge fund issues following the Roundtable.
In its report, the SEC identifies a number of areas of concern regarding hedge funds:
* the trend toward "retailization" of hedge funds;
* the lack of Commission information about hedge funds and their advisers' activities;
* the lack of prescribed and uniform disclosure by hedge fund advisers;
* valuation and other conflict of interest issues; and
* the increased incidence of hedge fund fraud.
Many of these concerns arise from the unregulated status of hedge funds.
The staff's report can be found on the SEC's website at www.sec.gov .
Copyright Hedgeweek 2003