[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
THE LONG AND SHORT OF HEDGE FUNDS:
EFFECTS OF STRATEGIES FOR MANAGING
MARKET RISK
=======================================================================
HEARING
BEFORE THE
SUBCOMMITTEE ON
CAPITAL MARKETS, INSURANCE, AND
GOVERNMENT SPONSORED ENTERPRISES
OF THE
COMMITTEE ON
FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
__________
MAY 22, 2003
__________
Printed for the use of the Committee on Financial Services
Serial No. 108-30
89-633 U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 2003
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512�091800
Fax: (202) 512�092250 Mail: Stop SSOP, Washington, DC 20402�090001
HOUSE COMMITTEE ON FINANCIAL SERVICES
MICHAEL G. OXLEY, Ohio, Chairman
JAMES A. LEACH, Iowa BARNEY FRANK, Massachusetts
DOUG BEREUTER, Nebraska PAUL E. KANJORSKI, Pennsylvania
RICHARD H. BAKER, Louisiana MAXINE WATERS, California
SPENCER BACHUS, Alabama CAROLYN B. MALONEY, New York
MICHAEL N. CASTLE, Delaware LUIS V. GUTIERREZ, Illinois
PETER T. KING, New York NYDIA M. VELAZQUEZ, New York
EDWARD R. ROYCE, California MELVIN L. WATT, North Carolina
FRANK D. LUCAS, Oklahoma GARY L. ACKERMAN, New York
ROBERT W. NEY, Ohio DARLENE HOOLEY, Oregon
SUE W. KELLY, New York, Vice JULIA CARSON, Indiana
Chairman BRAD SHERMAN, California
RON PAUL, Texas GREGORY W. MEEKS, New York
PAUL E. GILLMOR, Ohio BARBARA LEE, California
JIM RYUN, Kansas JAY INSLEE, Washington
STEVEN C. LaTOURETTE, Ohio DENNIS MOORE, Kansas
DONALD A. MANZULLO, Illinois CHARLES A. GONZALEZ, Texas
WALTER B. JONES, Jr., North MICHAEL E. CAPUANO, Massachusetts
Carolina HAROLD E. FORD, Jr., Tennessee
DOUG OSE, California RUBEN HINOJOSA, Texas
JUDY BIGGERT, Illinois KEN LUCAS, Kentucky
MARK GREEN, Wisconsin JOSEPH CROWLEY, New York
PATRICK J. TOOMEY, Pennsylvania WM. LACY CLAY, Missouri
CHRISTOPHER SHAYS, Connecticut STEVE ISRAEL, New York
JOHN B. SHADEGG, Arizona MIKE ROSS, Arkansas
VITO FOSELLA, New York CAROLYN McCARTHY, New York
GARY G. MILLER, California JOE BACA, California
MELISSA A. HART, Pennsylvania JIM MATHESON, Utah
SHELLEY MOORE CAPITO, West Virginia STEPHEN F. LYNCH, Massachusetts
PATRICK J. TIBERI, Ohio BRAD MILLER, North Carolina
MARK R. KENNEDY, Minnesota RAHM EMANUEL, Illinois
TOM FEENEY, Florida DAVID SCOTT, Georgia
JEB HENSARLING, Texas ARTUR DAVIS, Alabama
SCOTT GARRETT, New Jersey
TIM MURPHY, Pennsylvania BERNARD SANDERS, Vermont
GINNY BROWN-WAITE, Florida
J. GRESHAM BARRETT, South Carolina
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
Robert U. Foster, III, Staff Director
Subcommittee on Capital Markets, Insurance, and
Government Sponsored Enterprises
RICHARD H. BAKER, Louisiana, Chairman
DOUG OSE, California, Vice Chairman PAUL E. KANJORSKI, Pennsylvania
CHRISTOPHER SHAYS, Connecticut GARY L. ACKERMAN, New York
PAUL E. GILLMOR, Ohio DARLENE HOOLEY, Oregon
SPENCER BACHUS, Alabama BRAD SHERMAN, California
MICHAEL N. CASTLE, Delaware GREGORY W. MEEKS, New York
PETER T. KING, New York JAY INSLEE, Washington
FRANK D. LUCAS, Oklahoma DENNIS MOORE, Kansas
EDWARD R. ROYCE, California CHARLES A. GONZALEZ, Texas
DONALD A. MANZULLO, Illinois MICHAEL E. CAPUANO, Massachusetts
SUE W. KELLY, New York HAROLD E. FORD, Jr., Tennessee
ROBERT W. NEY, Ohio RUBEN HINOJOSA, Texas
JOHN B. SHADEGG, Arizona KEN LUCAS, Kentucky
JIM RYUN, Kansas JOSEPH CROWLEY, New York
VITO FOSSELLA, New York STEVE ISRAEL, New York
JUDY BIGGERT, Illinois MIKE ROSS, Arkansas
MARK GREEN, Wisconsin WM. LACY CLAY, Missouri
GARY G. MILLER, California CAROLYN McCARTHY, New York
PATRICK J. TOOMEY, Pennsylvania JOE BACA, California
SHELLEY MOORE CAPITO, West Virginia JIM MATHESON, Utah
MELISSA A. HART, Pennsylvania STEPHEN F. LYNCH, Massachusetts
MARK R. KENNEDY, Minnesota BRAD MILLER, North Carolina
PATRICK J. TIBERI, Ohio RAHM EMANUEL, Illinois
GINNY BROWN-WAITE, Florida DAVID SCOTT, Georgia
KATHERINE HARRIS, Florida
RICK RENZI, Arizona
C O N T E N T S
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Page
Hearing held on:
May 22, 2003................................................. 1
Appendix:
May 22, 2003................................................. 51
WITNESSES
Thursday, May 22, 2003
Donaldson, Hon. William H., Chairman, U.S. Securities and
Exchange Commission............................................ 7
Kamenar, Paul, Senior Executive Counsel, Washington Legal
Foundation..................................................... 28
Lamont, Owen, Associate Professor of Finance, Graduate School of
Business, University of Chicago................................ 33
Lenzner, Terry F., Chairman, Investigative Group International... 30
Mauldin, John, President, Millennium Wave Investments............ 25
Rocker, David A., General Partner, Rocker Partners, LP........... 35
APPENDIX
Prepared Statements:
Oxley, Hon. Michael G........................................ 52
Clay, Hon. Wm. Lacy.......................................... 54
Emanuel, Hon. Rahm........................................... 55
Kanjorski, Hon. Paul E....................................... 57
Donaldson, Hon. William H.................................... 59
Kamenar, Paul................................................ 88
Lamont, Owen................................................. 109
Lenzner, Terry F............................................. 121
Mauldin, John................................................ 134
Rocker, David A. (with attachments).......................... 159
Additional Material Submitted for the Record
Managed Funds Association, prepared statement.................... 173
THE LONG AND SHORT OF HEDGE FUNDS:
EFFECTS OF STRATEGIES FOR MANAGING
MARKET RISK
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Thursday, May 22, 2003
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance,
And Government Sponsored Enterprises
Committee on Financial Services,
Washington, D.C.
The subcommittee met, pursuant to call, at 10:06 a.m., in
Room 2128, Rayburn House Office Building, Hon. Richard Baker
[Chairman of the subcommittee] presiding.
Present: Representatives Baker, Ose, Gillmor, Bachus, Oxley
(ex officio), Kelly, Fossella, Biggert, Toomey, Hart, Tiberi,
Kanjorski, Inslee, Capuano, Ford, Clay, Matheson, Miller,
Emanuel and Scott.
Chairman Baker. [Presiding.] This meeting of the Capital
Markets Subcommittee will come to order.This morning, we are
here to examine not a new market mechanism, but one which has
exhibited extraordinary growth over recent years, the hedge
fund. To start with, there is not even a clear definition of
what constitutes a hedge fund. Although hedge funds perform
amazingly well, they are not necessarily linked to overall
market performance. Hedge funds have demonstrated an ability to
generate positive cash flow in a down or up market, which is a
good thing. Hedge funds have also generated significant
liquidity and helped to be a counterbalance to the risk
prevalent in ordinary market functions, which is a good thing.
So our purpose here today is not to condemn the hedge fund
concept, but merely to continue the committee's ongoing
examination of all aspects of market function, which began
almost three years ago. There is some expressed concern as
innovation proceeds that the fund of funds becomes a
methodology for the retailization of hedge fund risk, which
certainly leads us to examine suitability requirements and the
necessary transparency of disclosure of the risk undertaken by
hedge funds so that even the sophisticated investor may
properly examine the risk they are assuming with their
investment. Beyond the initial disclosures made at the time of
investment decisions, it is apparent to me that a continuing
disclosure regime would also be advisable, given the nature of
the hedge fund's changing its risk profile. Certainly, there
should be examination of the standards for the management of
the hedge fund. With the extraordinary growth not only in the
nominal dollar amount, but in the numbers of hedge funds, as
best we can determine what they are, there is certainly an
increased level of anxiety about the adequacy of management not
only in disclosure, but in day-to-day governance of the risk
assumed by their operation.
We also need to examine the current regulatory requirements
for registration. Since the manager of a single hedge fund is
not required under current rule to become a registered
compliant entity with the SEC, therefore the manager of up to
14 hedge funds perhaps could not be subject to SEC oversight
and examination, and whether that regime is appropriate in
today's environment.
Having listed a number of concerns, certainly the function
of hedge funds in today's market is a positive addition. We
should do nothing that would bring, or at least in my opinion,
hedge funds under day to day governmental regulation where we
have someone from the SEC sitting on the board of every hedge
fund. But I do believe it is appropriate to examine the risk
they potentially could present, given their enormity, to
systemic risk developments, and to further examine whether the
individual investor truly understands the risks they may be
assuming and whether the continued explosion of funds and the
potential retailization brings those into the market who really
should not be there.
I certainly appreciate those who will participate in the
hearing this morning. I have read Chairman Donaldson's
statement. I find it most helpful to the committee, and look
forward to hearing from other witnesses who will come before us
on the second panel.
At this time, I recognize Mr. Kanjorski for any statement
he may choose to make.
Mr. Kanjorski. Mr. Chairman, we meet today for the first
time since our subcommittee considered legislation in 2000 in
response to the collapse of Long-Term Capital Management, to
explore the issue of hedge funds. Created more than five
decades ago, hedge funds have largely operated on the periphery
of our nation's capitalistic system, with limited regulatory
oversight, restricted investor access, and little public
disclosure. Nevertheless, hedge funds, in my view, have played
an important and crucial role in the ongoing success of our
capital markets.
Before we hear from the witnesses, it is important to
review some basic facts about the size and scope of the hedge
fund industry. Today, experts estimate that there are between
6,000 and 7,000 hedge funds operating in the United States. The
hedge fund industry has grown substantially in recent years.
According to several estimates, hedge funds managed $50 billion
in 1990, $300 billion in 2000, and $650 billion in 2003.
Moreover, although hedge fund holdings represent about 4
percent of the value of the stock market, the Wall Street
Journal recently reported that hedge fund trading accounts are
nearly one-quarter of the daily volume.
As our capital markets have continued to evolve in dramatic
ways during the last decade, hedge funds have attracted the
attention of many of our nation's investors, particularly those
who want to earn higher returns in today's chaotic markets.
Because of their entrepreneurial investment strategies and
their independence of the legal requirements applied to other
securities products, hedge funds can generate positive returns
even during bear markets. Additionally, hedge funds have
attracted the attention of our regulators.
In February, for example, the National Association of
Securities Dealers issued a notice to brokers reminding them of
their obligations when selling hedge funds. Last year, the
Securities and Exchange Commission also began comprehensive
review of a number of issues related to hedge funds, including
their recent growth, trading strategies, regulatory oversight,
and transparency.
In its investigations, the commission has also worked to
examine the retailization of hedge funds. As my colleagues
know, investor protection is a top priority of mine. From my
perspective, a hedge fund is a very sophisticated securities
instrument. As a result, only very sophisticated individuals
with adequate resources and sufficient diversification should
purchase this type of product for their portfolios.
Hedge funds have also successfully operated with little
regulatory scrutiny for many years, and we should not now add
additional layers of unnecessary regulation in order to further
protect those investors who are truly qualified to make these
investments and already fully understand the risks involved.
As we consider these issues, I would further encourage my
colleagues on both sides of the aisle not to make quick
judgments about changing the statutory and regulatory
structures governing the hedge fund industry. Unless we
identify something wrong, something that endangers our capital
markets, something that poses a systemic threat to our
financial institutions, or something that represents bad public
policy, we should defer action in this area and await the
recommendations of the experts at the Securities Exchange
Commission and elsewhere. We additionally must move forward
prudently and carefully in our regulation in these matters, in
order to ensure that we do not cause further disturbances in an
already turbulent capital market.
Finally, later this morning I expect that we will hear
complaints about short-selling, a strategy used by a number of
successful hedge funds managers. I believe that this practice
provides investors with an opportunity to use the information
that they have about a particular company, industry or
financial instrument to make money. This practice, in my view,
is therefore a useful investment technique. It also helps to
provide needed liquidity in our capital markets. Furthermore,
it is perfectly legal. In short, when fairly practiced, short
selling is an important offshoot of capitalism and we should
not necessarily limit the practice.
Mr. Chairman, I want to commend you for bringing these
matters to our attention. I look forward to hearing from the
witnesses, especially Chairman Donaldson, who is testifying
before us for the first time since he took over the helm of the
SEC. I look forward to his valuable insights and leadership,
and congratulate you for having these hearings, Mr. Chairman.
[The prepared statement of Hon. Paul E. Kanjorski can be
found on page 57 in the appendix.]
Chairman Baker. Thank you, Mr. Kanjorski.Chairman Oxley?
Mr. Oxley. Thank you, Chairman Baker, and welcome, Chairman
Donaldson, to the hearing. We are pleased to have him and
certainly pleased to have him on board at the SEC.
The growth of the hedge fund industry makes it incumbent
upon this committee to examine whether there are sufficient
investor protections currently in place. Pursuant to the
committee's ongoing efforts to restore investor confidence, we
are reviewing the financial products in our marketplace to
ensure that investors are being treated fairly and
appropriately. Some have argued that hedge funds are not an
appropriate investment for retail investors. Others suggest
that all Americans should be given access. Some have raised
concerns about the lack of transparency in this industry, given
its size, scope and impact on the markets.
Our review of this industry will help us determine whether
additional regulatory scrutiny is warranted, or whether
additional regulations would actually harm investors and the
markets. Indeed, hedge funds have served their investors well
throughout the recent bear market. The average hedge fund has
recorded impressive gains in these difficult markets, and done
so with less risk than the average mutual fund. The industry
has experienced considerable growth over the past decade,
increasing in size from approximately $50 billion in assets to
about $600 billion today.
In just the past five years, the number of funds has
doubled, with about 3,500 new hedge funds opening for business.
This explosion in growth has been fueled by good performance
and a growing interest from large institutional investors,
pension funds, charitable foundations and university
endowments.
Concerns have been raised that many financial services
companies trying to capitalize on the exceptional performance
of hedge funds have begun to market portfolios of hedge funds
to retail investors. These funds of hedge funds are registered
investment companies that typically invest in 20 to 30 hedge
funds. They usually require lower minimum investments than
traditional hedge funds. It is my understanding that these
financial products available to institutional investors for
some time are only being sold to investors who meet the income
or net worth requirements of traditional hedge funds.
While hedge funds are currently being sold only to
accredited investors, it is my understanding that the funds of
funds are only doing so because they do not wish to sell to
retail investors. There may be a concern that, given the lack
of a statutory restriction, they could in the future change
their guidelines and sell to retail investors. I look forward
to learning from Chairman Donaldson what the commission has
found thus far regarding the access to hedge funds by these
investors.
Some question why retail investors are being denied access
to these important financial risk-balancing tools simply
because they are not wealthy. Today's panel will help
illuminate this debate. Some have raised concerns about short-
selling and its potential use to manipulate the market. I am
pleased that the commission is examining these issues in its
ongoing review of hedge funds in the markets, and look forward
to hearing the views of Chairman Donaldson and our other
witnesses on the effectiveness of existing laws prohibiting
such activity.
I applaud the SEC's year-long review of hedge funds, and
eagerly await the forthcoming staff report. There are many
important investor protections and capital formation issues to
be addressed. This committee and the commission must proceed
with an abundance of caution as we examine this industry which
has served its investors well and provides important benefits
to the markets. I am pleased, Mr. Chairman, to have this
hearing and look forward to participating. I yield back.
Chairman Baker. Thank you, Mr. Chairman. We appreciate your
participation.Mr. Emanuel?
Mr. Emanuel. Thank you, Mr. Chairman. I want to commend you
for holding this important hearing on the role of hedge funds
and their role in the financial markets. I would also like to
thank Chairman Donaldson and our other distinguished witnesses.
I have had a longstanding interest in this subject of today's
hearings, going back to my service in the White House when the
Long-Term Capital crisis occurred, and subsequently as an
investment banker in the private sector. Last week, I had the
opportunity to attend the SEC's roundtable on hedge funds.
Chairman Donaldson and his team put together an excellent
program by gathering a wide spectrum of the industry's
participants and observers. We in the Congress also have a
responsibility.
As Chairman Donaldson said, take a long hard look at hedge
funds, especially in view of the industry's rapid growth, the
increase in hedge funds' share of overall market trading
volume, a spike in fraud cases, and the retailization of hedge
fund products.
As this committee begins to gather information on the hedge
fund industry, there are some fundamental questions we need to
have addressed and begin to think about: to what extent is
retailization of hedge funds a real problem; should the SEC
require clear disclosure that address certain basic investor
protections such as conflicts of interest, valuation,
performance reporting, relations with crime brokers, and other
service providers; should Congress and the SEC be focused on
distinctions between accredited investors and ordinary
investors; is the recent spike in hedge fund fraud cases the
result of a few bad actors or is this a sign of widespread
abuse.
Finally, I would like to hear from the panel on systematic
risk issues. As hedge funds' share of the market's overall
trading volume increases, now more than 25 percent of all
trades, what unique risks are posed? Additionally, has market
surveillance by regulators and counter-parties improved enough
since Long-Term Capital? Clearly, many hedge funds and fund of
hedge funds have historically served their investors well and
have made positive contributions to the market. Many hedge
funds are non-correlated with equity markets and thus reduce
portfolio risk while providing diversification. But it is
critical that investors, particular retail investors and
pension funds, receive the information they need to be able to
assess risk, make informed decisions, and evaluate their
investments on an ongoing basis.
I have the largest number of Illinois police, firefighters
and teachers from the Chicago police, firefighters and
teachers, and I am concerned that the current disclosure scheme
may not be providing pension managers with adequate
information. This is especially important in light of the fact
that many pension funds now invest upwards of 5 percent of
their capital in hedge funds. With the prolonged downturn in
the market, we also have retail investors flocking to hedge
funds to try to make up for lost returns.
Therefore, if hedge funds are going to be accessible to
retail investors and pension funds, and are going to be
marketed to those parties, it seems to me that we seem to set
some standards, not necessarily to restrict investor access,
but to provide information in plain English to help people make
good decisions.
I also think that hedge fund managers should be held to the
same lock-up periods and trading restrictions as funds of other
investors. I am eager to continue working with my colleagues
and the SEC to ensure that investors receive the information
they need to make informed investment decisions. Thank you, Mr.
Chairman.
Chairman Baker. Thank you, sir.Mr. Toomey?
Mr. Toomey. Thank you, Mr. Chairman. I would like to just
briefly observe, I think it is useful to think of hedge funds
as an asset class unto itself; one that allows investors to
diversify their portfolio, and certainly historically earn
superior returns relative to the risk that they take. It is
also important to note that the nature of the trading and
investment strategies of many hedge funds actually adds a
refinement to the pricing mechanism in the marketplace, and
makes financial markets in particular more efficient. To
achieve those things, they often employ confidential and
proprietary trading strategies which are a necessary part of
the business and entirely appropriate.
So I would just hope that as we explore this industry and
learn more about its growth and the implications of that
growth, that we bear in mind the significant benefits that this
industry provides to investors, as well as to the efficiency of
the marketplace.I yield the balance of my time.
Chairman Baker. Thank you, Mr. Toomey. Mr. Scott?
Mr. Scott. Thank you very much, Mr. Chairman. I want to
thank Chairman Baker and Ranking Member Kanjorski, and
certainly welcome you, Chairman Donaldson, to this hearing
today on hedge funds.Because hedge funds do not typically
register with the government, the data on the industry is not
entirely precise. For the past year, the Securities and
Exchange Commission has conducted an investigation of the hedge
fund industry, and the commission's report will be released
later this year. I certainly look forward to today's hearing as
a good learning opportunity that may show or may not show the
need for greater disclosure by hedge fund investors.
I do think that we must move with caution. We do have to
determine what measure of oversight is needed, what is the
level of investment risk. I think there should be questions
possibly on possible conflicts of interest. There certainly
have been questions raised about questionable marketing
tactics. My understanding is that the Securities and Exchange
Commission has brought 26 enforcement actions since 1998.
However, 12 of those actions have been in the last year.
I think there may be some questions on the economics of the
buyers, whether they have to have a certain amount of minimum
wealth; should that be stated and regulated. I think it is an
understanding that those who buy in the hedge funds should have
certainly a minimum of $1 million in assets, or certainly at
least $200,000 that have been accumulated in income each year.
I think that raises a question, is this only a wealthy person's
game? Is there room for more players at various levels of the
economic spectrum, and if that a wise thing for them to do.
I think also that one in five hedge firms have closed,
certainly, in the last year after losing money through possibly
poor decisions. But according to a recent study, 15 percent of
those were due to sort of scam operations. So I think that
there is evidence in dealing with hedge funds that we certainly
need to look at them. They have certainly been very positive in
many areas, but it is certainly an excellent opportunity for us
to take a good look at them and hear from you to determine what
recommendations you might offer this committee as we move
forward.
I certainly want to thank this panel for your testimony
today, and thank you, Mr. Chairman, for having this hearing.
Chairman Baker. Thank you, Mr. Scott.Mr. Bachus?
Mr. Bachus. Secretary Donaldson, I want to praise you on
another matter. You recently criticized the inclusion in the
new bankruptcy act of watering down the disinterested rule as
it pertains to prohibiting former investment bankers from
acting as advisers to the bankruptcy trustee. That is a
safeguard we have had since 1938, and I appreciate your
testimony in the Senate saying that this is not the time to
start watering down conflict of interest rules. I just want to
commend you for that.
I had actually offered an amendment here in the House to
strike that provision. To reinforce what you said, the national
bankruptcy review commission unanimously agrees with you that
that would be unwise. It certainly would not restore integrity
to the markets or confidence in the markets. I commend you for
taking that position.
Chairman Baker. Thank you, Mr. Bachus.If there are no
further members desiring to make opening statements, at this
time it is my distinct pleasure to formally welcome the
Chairman to our committee. I am certain that over the coming
months and years, we will have a very beneficial working
relationship. I am particularly pleased by your already-
demonstrated leadership skills. So it is my pleasure to welcome
to Capital Markets Subcommittee the Honorable William H.
Donaldson to make whatever comments he may choose to make.
Welcome, sir.
STATEMENT OF HON. WILLIAM H. DONALDSON, CHAIRMAN, U.S.
SECURITIES AND EXCHANGE COMMISSION
Mr. Donaldson. Chairmen Baker and Oxley, and Ranking Member
Kanjorski and members of the subcommittee, thanks very much for
inviting me to testify to discuss hedge funds generally and the
Securities and Exchange Commission's ongoing fact-finding
review of hedge funds.
As you all know, last week the commission hosted a two-day
roundtable on hedge funds. The event was a great success, in
our view, and proved to be very informative and very lively.
There was a great public interest in the event, both in the
number of people who attended and those that listened on the
Web cast. This public interest highlights just how important
hedge funds have become. The roundtable was an excellent
example, in my view, of how the SEC can operate as an effective
regulator.
By assembling a highly knowledgeable group of experts
representing a variety of viewpoints, we were able to
facilitate a debate on the important issues facing hedge funds,
many of which you have alluded to just a few moments ago. I
appreciate having the opportunity to discuss the roundtable and
our fact-finding review of hedge funds with you today.
As you know, the commission embarked on a fact-finding
mission last year to look into hedge funds. The commission's
division of investment management, alongside of our office of
compliance, inspections and examinations, has been gathering
information on a variety of investor protection issues
associated with hedge funds. The staff obtained and reviewed
documents and information from many different hedge fund
managers representing over 650 different hedge funds and
approximately $162 billion under management. The staff also
visited and engaged in discussions with a number of different
hedge fund managers. To complement our inquiries directed to
specific hedge funds, the staff has met with a variety of
experts, consultants, academics, and observers of the industry
to seek their perspective. Participating in last week's
roundtable were hedge fund managers, consultants, service
providers such as auditors and attorneys, academics, prime
brokers, investment bankers, investors and foreign and U.S.
regulators.
These experts discussed key aspects of hedge fund
operations, how they are structured and marketed, investment
strategies that they use, how they impact our markets, now they
are regulated, and whether the regulatory framework should be
modified. Specifically, we had discussions that addressed,
number one, the growth of hedge funds; number two, the hedge
fund trading strategies and market impact; number three, trends
in the hedge fund industry; four, the differences between hedge
fund and registered investment companies; five, hedge fund
fraud; and six, the regulatory framework applicable to hedge
funds; and seven, investor education.
Many people have asked why the commission determined to
embark on its fact-finding mission at this particular moment.
One of the primary reasons is because of the tremendous growth
of the funds. Over the past few years, the number of hedge
funds and their assets under management has continued to
increase. As was reiterated last week at the roundtable, there
are no precise figures, which is an indicator itself of a lack
of knowledge available regarding the number, size and assets of
the funds.
This is due in part to the fact, and this I think is an
important point, that there is no industry-wide definition of a
hedge fund, in part because those that track hedge fund data
rely on self-reporting by hedge funds, and in part because
hedge funds generally do not register with the SEC. So we
cannot independently track the data. Nevertheless, during our
roundtable, knowledgeable sources confirmed their belief that
there are between 6,000 and 7,000 hedge funds. I read in this
morning's paper that another person thought that there were
somewhat fewer than that; another expert source. The 6,000 to
7,000 have roughly $650 billion under management. Over the past
few years, the panelists estimated that there have been on
average $25 billion a year in new assets invested in hedge
funds. One panelist estimated that in the next decade, assets
under management in hedge funds will top $1 trillion.
Institutional investor money, be it from pension funds,
endowment, or foundations or other sources, account for an
increasingly large percentage of these assets.
The commission has made significant progress in its hedge
fund fact-finding mission, and we will continue to proceed with
a focus on how to best protect investors and our securities
markets. Additionally, we have called for public comment on the
issues surrounding hedge funds. The public comment period will
close approximately 45 days from today, on July 7. I view this
as an important next step, as we will need to hear from all
segments of the hedge fund industry, including those not
represented at the roundtable, as well as those of the
investing public. While we had many distinguished, thoughtful
and helpful panelists, I am mindful that in such a public forum
as a roundtable, we may have heard a guarded version of the
state of the industry. It is our duty as the investor's
advocate to ensure that we have all of the relevant information
as we formulate a course of action.
So while the roundtable was not the culmination of our fact
gathering, and though we have not yet reached any conclusions,
I have asked the SEC's staff to prepare a report to the
commission on the current results of our various fact-finding
efforts. The report will be delivered to the commission and I
intend to make it publicly available shortly thereafter. I
anticipate the report will address the key issues that have
been a focus of our inquiry, including hedge fund trading
strategies and market impact, the increased availability of
hedge fund exposure to retail investors, the disclosures
investors receive when investing in hedge funds, and on an
ongoing basis the difference between hedge funds and registered
investment companies, conflicts of interest including those
created by the fee structures of hedge funds and funds of hedge
funds, the role of primary brokers, hedge fund fraud, the
regulatory framework applicable to hedge funds, and last and
certainly not least, investor education.
I have asked the staff to include in its report any
recommendations for change in the regulatory framework
governing hedge funds. I look forward to reviewing this report,
analyzing the recommendations, and sharing the report with you.
Thanks again for the opportunity to be here this morning. I
would be more than happy to answer any questions you might
have. Thank you.
[The prepared statement of Hon. William H. Donaldson can be
found on page 59 in the appendix.]
Chairman Baker. Thank you, Mr. Chairman. I took time to
carefully review your written testimony, which I found to be
very helpful. The point upon which I have set most attention is
that the management of the hedge fund may count a hedge fund as
a single client, and under current rule until you have more
than 15 clients, you are not required to register. Therefore,
you do not really have the regulatory ability today to tell us
who are these people that have entered into the market within
the last few years, and their level of expertise in the
management of these funds, which is cause for two further
observations. One, with regard to the issue of retailization,
which I still believe is minimal at this juncture, given the
$200,000 income rule for two years, and a net worth of $1
million. That may need to be reviewed, and whether or not we
are really seeing unsophisticated investors move into this
market niche.
But secondly, on a broader national scale, whether the
significant growth in numbers and in assets under management,
which you reference at this point and estimate at about $650
billion with an eye toward $1 trillion; the potential systemic
risk, given inappropriate or sideways movement in these
markets, without prior knowledge by the regulatory community.
That is of significant concern to me.
Another notch down on the scale, but still of significant
concern, are those statements where short-selling activities
appear not to be under the same regulatory scrutiny in the
hedge fund world as it would be in the equities market, and the
potential adverse volatility consequences that may bring about
to the orderly function of the markets.
Do you think it now advisable based upon the work to date
that we at least ought to have management get a driver's
license? We may not regulate how big a truck or how much
horsepower, or how fast they drive or where they go, but at
least shouldn't we know who they are so if we do need to find
them, we have got that information? How do we bridge not
getting in the business, with having adequate information to
assess the risks for the public good?
Mr. Donaldson. Right. Well, let me say a couple of things.
First of all, I do not want to pre-judge the vast amount of
data that we are bringing to bear on the subject right now. I
do not want to speak for the commission, if you will, because
ultimately the responsibility will rest there. But let me try
and answer your question. Whether it is 6,000 or 7,000 or
whether it is $600 million or $600 billion, that is a lot of
money.
Chairman Baker. It is a lot.
Mr. Donaldson. And it is too much money for us to know as
little as we know now about what is going on. I mean,
fundamentally I would say that. Secondly, the regulations that
are currently in force are confusing, and I will not bore you
by going through all of them, but the funds are operating most
of them under exclusions under the Investment Company Act and
other exemptions under the 1933 and 1934 Acts. It gets
confusing in terms of which exemption or which exclusion they
are operating under. I think it says to us that we have got to
take a hard look at these exclusions.
If I can step back from that, and say that there are two
trends going on here that were brought out at our conference
and we are very much mindful of. First is that by and large, we
have regulated hedge funds in so far as we have been able to
regulate the registered ones, based on the assets and earning
power of the purchaser. I think that calls into question
whether that is the correct measure, because if you step back
from the fluctuations that we have had in the marketplace,
there is a perception, and it is probably more than a
perception, that the hedge funds have fared better generally
than our markets have, and generally than stocks have. There
are a lot of ``retail investors'' out there who are pretty
sophisticated, and who want to own hedge funds. So you have
that on the one hand, and the statement is, why should only
wealthy people have access to investment vehicles such as this?
On the other hand, you have the counter-trend which is that
the exceptions under which the hedge funds have been operating
do not reflect if we were to measure them by current dollars,
there are an awful lot of ``retail investors,'' if you will, or
smaller investors who have moved up into this category. The
question is, should the category be even higher in terms of
exclusion, if that is going to be the criteria by which you let
people in or out of hedge funds? So those two trends open
Pandora's box in terms of what we should do about it.
And then the arrival of the fund of funds concept; the fund
of hedge funds concept brings now, and that is a reflection of
a demand in the marketplace. You have now registered vehicles,
or vehicles seeking to be registered who themselves invest in
hedge funds. Although they are voluntarily urged by us,
restricting the kind of retail investor that can invest. In
other words, that they are applying voluntarily, although they
do not have to, because the parent company is registered
doesn't have the exclusion, that they are basically voluntarily
now limiting the size of an investment in these kinds of fund
of funds. The problem is that the underlying investments, the
underlying hedge funds themselves, most of them are not
registered. We have no access to them. We cannot get inside of
them. That is bothersome.
I do not know whether that answers your question, and I do
not want to pre-judge exactly what the commission will be doing
in this area.
Chairman Baker. If I may, because my time has expired, it
is clear to say that we need to know more. We are just not in a
position today to establish what should be on the list to be
identified in the way of detailed information until we do more
examination.
Mr. Donaldson. My instinct, my personal instinct based on
everything that I have heard is that we need to one way or
another know more about this phenomena, if you will.
Chairman Baker. Thank you, Mr. Chairman. Mr. Kanjorski?
Mr. Kanjorski. Have you seen any indications of fraud or
abuse of any large amounts that would warrant the Federal
government getting involved further in this issue? Or is it
just curiosity on the part of the commission?
Mr. Donaldson. Which issue, congressman?
Mr. Kanjorski. On hedge funds; the activities, who is in
them, what they are investing in, what they are doing.
Mr. Donaldson. Again, there are, as was mentioned earlier,
we have brought enforcement actions, and although they are
relatively few; I mean, there are 25 or so enforcement actions
that have been brought over the last three or four years; but
over half of those have been brought in the year 2002. Those
enforcement actions cover a range of things; hedge funds cannot
advertise under our current laws; there are all sorts of things
that these people were doing that we have brought action.
However, if you look at the total number of hedge funds, 25
actions is not that much. If you look at the number of actions,
if you will, that we bring in the whole mutual fund industry,
and imputed that to this industry, you would say that there
were more actions out there that needed to be taken. That is a
leap of judgment on my part, and we need to know more about
what is going on inside some of these funds.
Mr. Kanjorski. What time frame do you see arriving at a
definition of what a hedge fund is? It seems to me quite a
challenge.
Mr. Donaldson. I am not sure we will ever come up with a
definition that is broad enough or meaningful enough. As you
know, the whole hedge fund concept started many years ago, and
it was quite simple. They are quite simple, and the idea was
that instead of just buying and going along with stocks that
you liked, why not at the same time sell stocks short that you
did not like. That spreads your research effort, if you will.
You go down a pike and look at a company you decide you do not
like, and as a matter of fact you think it is overpriced, why
not short that at the same time you are buying something that
you like. That was a pure hedged vehicle, and the combination
of being made sort of market-neutral, if you will, where no
matter where the market went, you were balanced here with a
long and short position, allowed borrowing to be inserted on
top of that; leverage.
Now, as time has gone on, the term ``hedge fund'' applies
to all sorts of investment techniques; macro techniques to
commodity funds to pools of capital that are doing all sorts of
things. I think that too often the word ``hedge fund'' is
applied to a freestanding pool of capital that is not hedged at
all; that is doing lots of different things. I think we need to
know more about what those things are. We get at that, and this
is probably a subject that you may want to get into, if there
is some sort of market manipulation, if you will, associated
with those techniques, we have the right right now to go at
market manipulation and fraud in the marketplace. If it is out
there, some of it is out there outside of hedge funds.
It is not a new phenomenon that people try to manipulate
the market. Hopefully as our human resources increase at the
SEC, we are going to be able to be much more broadly involved
in uncovering that.
Mr. Kanjorski. You are interested in that issue, I assume,
Mr. Donaldson?
Mr. Donaldson. Absolutely.
Mr. Kanjorski. Do you think the Congress should get off its
duff and act as soon as possible to give you that authority to
get more people?
Mr. Donaldson. To go one step further, the modern age we
live in, and in particular the Internet, ups our challenge
many-fold in terms of, you know, there are prohibitions on
hedge funds from advertising, as long as they are operating
under the exemption. A part of the exemption is they cannot
advertise. There are obviously prohibitions on market
manipulation. However, we have the Internet out there, and we
have a whole new communications media, and we have a special
group of people in the SEC now that are looking at the Internet
as a source of possible market manipulation. But it broadens
the scope of what we have to look at.
Mr. Kanjorski. Just one other question; myself, I will sort
of go with the rule that the we get the least involved we can,
except for either trying to protect against systemic risk or
fraud and activities that may be going on that we discover, but
apparently, we have not discovered that to a large extent. I am
worried about the insured institutions that are providing some
of the lending to these hedge funds. Have you had adequate
reporting and has the regulators of these insured institutions
received sufficient information to have a pretty good handle on
just how much of the insured deposits are being placed and used
by hedge funds? I guess another way of asking the question, are
the $650 billion; what portion of that is coming out of the
banking system or the insured system?
Mr. Donaldson. I think that, you know, if the question you
are asking is, do we have adequate resources now, human
resources, inspection resources and so forth; I think we are
headed toward that, if we can implement the authority that has
been given to us and add the people that we want to add. I
think that the evidence so far is that we do not see the broad
gauge manipulation as the image is out there.
That is not to say that it is not there, and I do not want
to make a judgment on that. As I said earlier, and I want to
emphasize this, that if you took the general tenor of the
conference we had a week ago, it was rather reassuring as far
as I was concerned. Just trying to make an overall judgment, it
was rather reassuring. On the other hand, we did not expect
people that were possibly doing things that we think violate
the law to come and talk about that in an open forum. So I want
to assure you all that we are not stopping with just the two-
day forum we had.
Mr. Kanjorski. When your report is concluded, would you
recommend that the committee have another hearing to receive
your report, your analysis and conclusions on it, and any
recommendations you may have for legislation?
Mr. Donaldson. We would be absolutely delighted to sit down
with you all and as a first step give you what we have. We will
give you what we have with our recommendations, and I have no
idea what those recommendations will be, but we certainly would
want to explore them in any forum that you think makes sense,
particularly this one.
Mr. Kanjorski. Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mr. Kanjorski.Chairman Oxley?
Mr. Oxley. Thank you, Mr. Chairman. By the way, happy
birthday to the Chairman. Our crack staff gave me that
information. I assume it is accurate.
Chairman Baker. I am taking it regardless.
Mr. Oxley. Okay.
[LAUGHTER]
Chairman Donaldson, the recent changes in the law in the
Congress as well as at the SEC and the SROs have dealt with the
manner in which analysts are evaluated and compensated in order
to eliminate conflicts of interest between their desire to
serve two masters; the corporate clients and retail investors.
I think we are making some progress on that issue.
If an analyst were to issue a research report that does not
reflect his own personal views of the covered security, that
would be indeed a violation of the recent rules, is that
correct? We have heard concerns that some analysts have been
pressured to downgrade companies in order to curry favor with
short-selling hedge funds that happened to be an important
client for the analyst's firm, generating millions of dollars
in revenues. That also would be a violation of the current laws
and regulations, is that true?
Mr. Donaldson. Yes, it would.
Mr. Oxley. Could you tell me, is there any effort by the
commission to investigate and take action against this type of
abuse?
Mr. Donaldson. We are particularly interested right now on
the follow-up to the settlement. Okay? We have put some rules
and regulations in and we are not going to just let it sit
there. We are out in the field and making sure that there is
conformity. Obviously, one of the aspects of the settlement and
so forth has been the signing of the analyst's report and the
analyst pledging that this is his or her view. The instance
that you bring up has not been brought to my attention. That
does not mean that we are no looking at it, but we would
respectfully request that any sort of information like that be
brought to our attention and we will do something about it. I
just want to assure you that that would be a fraudulent act;
what you cite there.
Mr. Oxley. And that would be in the province of your
enforcement division?
Mr. Donaldson. Yes.
Mr. Oxley. Thank you. In light of yesterday's press
accounts, I would like to get your views on the practice of
revenue sharing, whereby brokerage firms are paid by mutual
funds for distribution. Without commenting on whether the
agency is currently investigating this practice, I would like
to have your views on the following: whether these payments are
appropriate; whether you think investors are aware of this
practice; and whether such payments should be disclosed to
investors.
Mr. Donaldson. Right. Let me just go back to your prior
question, and just clarify that we would pick up what you
talked about in terms of an analyst not performing according to
the law. We would pick it up on the inspection side of the SEC.
If we found evidence of that, we would turn it over to our
enforcement people, but we would have our inspection people
especially aware of the possibility of it. In terms of the
mutual fund question you bring up, we are currently looking at
the sales practices of mutual funds within the broker-dealer
community to begin with.
What we are concerned with is there are laws that govern
special incentives that are not disclosed to the sellers of
mutual funds. We are concerned and therefore out investigating
as I speak now the various practices and whether these
practices are either violating the laws that exist now or
violating the spirit of the laws that exist now. Our bottom
line goal is to assure that a potential mutual fund investor
through an investment banking firm is aware of all the
compensation or inducements that are being paid to the broker
that is selling them, not only to the broker, but to the
broker's manager.
Mr. Oxley. How much of that is currently revealed?
Mr. Donaldson. I am sorry?
Mr. Oxley. How much of that information today is currently
revealed to the shareholder?
Mr. Donaldson. I would say not enough. I would say that the
average; there is disclosure, but I think that there are more
subtle ways of incenting brokers to sell particular funds that
the purchaser does not know. I am leaping ahead of the work we
are doing now to document that, but that is my own personal
opinion and the reason for us being out in the field right now
examining that.
Mr. Oxley. Do you think a revenue-sharing arrangement is a
conflict of interest on its face?
Mr. Donaldson. What kind of----
Mr. Oxley. The revenue-sharing agreement; would you
consider that to be a conflict of interest simply on its face?
Mr. Donaldson. At the very least, it is a piece of
information that a prospective buyer has a right to know. A
prospective buyer, in my view, has a right to know what
incentives lie behind a recommendation. I believe that that is
what we are after.
Mr. Oxley. Thank you. Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mr. Chairman. Mr. Scott?
Mr. Scott. I would like to kind of carry that thought just
a little further, and talk about mutual funds and the hedge
funds. I think it is true that brokers, prime brokers and
advisers can manage both hedge funds and mutual funds. I would
like to ask you to respond to that in terms of whether that is
a possible area of conflict, particularly in view of the fact
that over the last period of time, I think there has been an 11
percent increase in the profits accrued from hedge funds, and
almost an identical 11 percent loss in the return on mutual
funds. That in relationship to the conflict of interest; I
mean, that almost begs for some examination. Then I have a
follow-up question, but I would like you to respond to that one
first.
Mr. Donaldson. It is a very good question, and I think that
clearly the hedged vehicles generally speaking have done better
than unhedged vehicles, long-only mutual funds during a period
of market decline. That is not to say all hedge funds have done
better, but on average they have done better than on average
what mutual funds have done. This creates an environment in
which I would imagine there is considerable pressure in certain
mutual fund organizations to have a line of products of hedge
funds.
There is consumer demand out there. The conflict, if I
understood your question correctly, there is always a potential
conflict in a mutual fund family as between the various funds
they are running, in terms of who buys first and that sort of
stuff. That is pretty darn well regulated right now. But if in
fact the laws were changed to allow the fund of funds concept
to move into the mutual fund family, that again opens up a
potential for conflict. So you would not do that quickly, but
as I said earlier, I think there is a demand for hedge funds,
and that is quite natural that it is coming at a time when
long-only equity investing has been through such a difficult
period.
Mr. Scott. Do you think that, if I am correct, that they
have the right, the managers, to manage both of those funds and
yet also operate under privacy? Do you feel stripping them of
that privacy right would open up and make it----
Mr. Donaldson. I think what you are asking, I think, is I
think we need to know more than we do about what is going on in
the general area of hedge funds. I think the place where one
would question whether we should go to, and I would have
personally serious questions, is whether the funds are under an
obligation to disclose exactly what they are doing, because
that is a proprietary competitive fact. I think any attempt to
display that would be counter to principles of people being
able to build a business based on a special expertise. This is
where I think we have to be very careful in terms of regulating
the actual techniques being used.
Mr. Scott. Let me ask you this other question. Do you
believe that smaller investors will be able to participate in
similar activities in the future of hedge funds? Do you believe
that hedge funds will remain what it is right now, essentially
an investment tool for more wealthy individuals? Is it possible
or are there efforts to try to open it up so that more middle
class Americans would be able to benefit from this?
Mr. Donaldson. I would say two things. One is I think there
is a definite need to examine how hedge funds, properly run and
properly disclosed, can be allowed to be purchased by retail
investors, number one. I think number two is that there is a
danger here that because of the particular market circumstances
that we have had, and the relative performance of the stock
market long-only mutual funds versus the hedge funds, that a
tremendous new amount of money comes in, and as the new money
comes in, the opportunities to operate in that niche profitably
probably become less and less, so that the hedge fund returns,
perhaps, are not quite as great as they have been in the past,
or won't be. I think we have to guard against that in terms of
the rapidity with which we examine opening funds up to lesser
investors, to retail investors.
Chairman Baker. Can you wrap up?
Mr. Scott. Thank you.
Chairman Baker. Thank you, Mr. Scott.Mr. Toomey?
Mr. Toomey. Thank you, Mr. Chairman. Chairman Donaldson, I
guess my question has to do with the additional information
that I understand you to be suggesting I think intuitively that
you feel you ought to have. My question is, you know, since we
have an industry here where there is limited access, really it
is by and large for the most part it is high net worth
individuals. We have got very few cases of fraud. We have got
an industry that is contributing to market efficiencies and
providing superior returns to investors. Since there is a cost
of complying with any new regulatory regime, there is a cost to
providing information, I guess I am wondering what is the harm
that is being done that warrants demanding more information or
regulation, or what is the danger that you are worried about
that would justify creating a new demand on an industry, which
would of course have to pass that cost on to its investors?
Mr. Donaldson. Yes, it is the old cost-benefit analysis
that needs to be done. Clearly, I think what I am suggesting,
and again this is my own personal view, is that the minimal
level of gaining a right to examine hedge funds is not that
costly, and the benefit to our society would justify that. It
is what comes from that that is the big question. I make no
judgment. All I can say is that we just do not know now what we
do not know, if you will. I think that if what you are
suggesting is do we need a huge new overlay of regulation, I
just do not know. I doubt it right now, but we need to get the
information to see whether we do.
Mr. Toomey. I guess that leads to another question, then.
What kinds of things would you want to know that would be
useful in terms of; I guess there is a concern that maybe
something we do not know is out there that poses some kind of
systemic risk to our markets or some significant risks that
investors do not understand. I think most investors know that
there is inherent risk in this kind of investment. I am trying
to figure out what kinds of information would help in
preventing those sorts of things, without undermining what you
I think quite rightly recognize as the necessarily proprietary
nature of the investment strategies.
Mr. Donaldson. There are, again, for a large portion of
hedge funds, we do not have the right to go in and take a look
at what they are doing. So what would we be looking for when we
go in and look at what they are doing? We would be looking at
their books and records; we would be looking at the way they
value securities. Again, if I am running a fund of funds and I
have in my portfolio a hedge fund, and that hedge fund has to
be valued on a quarterly basis or a monthly basis, how are
those valuations being made? Those are the kinds of information
that I think we need to take a look at. Books and records and
the way the hedge fund is organized; all of these things we
just do not know and we do not have the right right now to go
in and look.
Mr. Toomey. Now, financial institutions that extend credit
to these funds, they do undertake that kind of analysis. Or do
you think that they do an inadequate job of understanding the
answers to those very questions, so that they can make an
informed credit judgment about the hedge fund?
Mr. Donaldson. I think there has been substantial
improvement in the responsibility and oversight of the prime
brokers. They have a vested interest in that. They are lending
money and so forth and so on. On the other hand, the funds are
very good customers of theirs. So it is hard to tell exactly
what is going on inside some of these funds. We had one of the
largest investors at our conference, a major investor who one
would think, who is a large purchase of hedge funds, and the
question was asked, you must have buying power so that you can
get inside some of these funds and ask questions that even a
regulator cannot before you make an investment. The answer was,
we have difficulty getting the information from a lot of these
funds. Again, my supposition here is that the funds with very
good records, that is the one that a fund of funds would want
to buy, but everybody wants to buy it and so the fund says, we
are not going to tell you. You can buy our fund or not. That
forces the investor, the institutional investor to go to lesser
funds with lesser records.
I guess what I am trying to say is that even those who have
the market power to demand more knowledge about what is going
on in funds that they want to buy are having trouble getting
that; at least that is the partial evidence that we are getting
right now.
Mr. Toomey. Thank you.
Chairman Baker. Thank you, Mr. Toomey.Mr. Emanuel?
Mr. Emanuel. Thank you, Mr. Chairman. I, too, want to wish
you a happy birthday, just so it is bipartisan in its approach.
Chairman Baker. I take it in that spirit. Thank you.
[LAUGHTER]
Mr. Emanuel. To try to follow up on what my colleague was
asking, but from a different side, we have mentioned that hedge
funds have about $600 billion now in the market, and you can
estimate somewhere between 6,000 to 7,000 hedge funds exist.
But all the recent articles and studies I have read show that
close to about $2 trillion over the next five years will be
involved in hedge funds. Today, a little less than a quarter of
the trades are done by hedge funds.
That will grow to over one-third to bordering up near 40
percent. Two other events, I think, raise the proper concern
why you had the two-day conference, why are having this
hearing, the first hearing by Congress since Long-Term Capital,
which is this is an instrument used by wealthy investors that
is now being exposed to a larger audience; what we normally
call retailization. That is one trend; not a negative or a
positive. It is just a trend.
The second is that we have a lot of new entrants in the
area managing funds who have never gone through the Long-Term
Capital experience. So you have a retailization, new entrants
managing funds, and a market unlike mutual funds or anywhere
else like on the street, it is the only area where people do
not have to register, do not have to give any information about
how they trade, how they perform, any transparency. There is no
other instrument like that; no other fund like that.
This is the only one that exists, and you have two events
happening simultaneously in the market that raise questions.We
have tried many ways, and I compliment you; you have obviously
adapted well to Washington since nobody can get you to go on
the record or comment on your views or what happened during
those two days, and your estimate, so you have done very well
at adapting to Washington; no answers to any questions yet. But
if I can at least get you to comment on after the hearing,
Commissioners Glassman and Campos commented that retailization
is not a concern in the hedge fund industry.
At least what I have heard you; you have not said you are
not not concerned; that is a double-negative; but do you at
least have some comments about the other commissioners'
comments that they are not concerned about retailization. Do
you see any kind of flashing yellow light that exists to the
retailization of hedge funds, an instrument prior to this point
being solely that for high net-worth individuals?
There are about four questions in there. Go ahead and pick
any one of them.
Mr. Donaldson. In the spirit of the openness of our two-day
conference, I think that both of those commissioners were
reacting to, perhaps making a statement to see if it would be
challenged by the audience. In other words, I think they were
in a learning process, as we all were. I think that I would
revert back to what I said earlier, which is that there is a
market demand for retailization, and that brings into question
whether the relative sophistication of the ``retail'' customer
or client, and I would submit that there are lots of people who
do not have the assets that are currently required for an
exclusion, that are very savvy investors, and perhaps should
have a right to participate in these vehicles. If that is true,
then we have got to somehow take a look at how we can make
whatever the risks are inherent in these funds readily
available to a less sophisticated retail investor. That is the
problem. That is the opportunity here, and there are strong
arguments. Again, I am giving my own personal opinion in terms
of the trend here.
There are also hedge funds being set up all the time. Some
are large and sophisticated and run by experienced people; some
are small, new groups breaking off from, maybe they were in the
research department somewhere on Wall Street or they were
somewhere else and they said, let us go start a hedge fund, and
they are getting into the business. I am concerned about that.
I am concerned about the proliferation of hedge funds, and I
think we have to take a look.
Mr. Emanuel. Do I have time for one more or not?
Chairman Baker. One short one, please, sir.
Mr. Emanuel. Okay. The last question is, the requirements
under the accredited investor, do you think those requirements
are still at the right place? Would you make any changes to
them?
Mr. Donaldson. I am not prepared to comment on that yet. I
really, again, and I would love to. I do not want to read in
the record and bore anybody here with the various exclusions
and exemptions and so forth. I would say that we have to take a
hard look at the current exemptions and so forth.
Mr. Emanuel. Thank you.
Chairman Baker. Ms. Biggert?
Mrs. Biggert. Thank you, Mr. Chairman, and welcome Mr.
Chairman also. Some have suggested requiring that the hedge
fund advisers be required to register under the Investment
Advisers Act. If the advisers of Long-Term Capital Management
had so registered, do you think that that would have prevented
the bankruptcy of that hedge fund?
Mr. Donaldson. I think that Long-Term Capital, again, was a
very special sort of hedge fund which had a very special area
of operation, which used large, huge amounts of leverage. I
think that the approach by the President's working group which
brought together not only the SEC, but the Treasury and the
Federal Reserve, got at the multi-dimensional aspect of Long-
Term Capital. I think that the oversight now into the counter-
parties and the lenders and so forth, which extends beyond the
SEC's purview in certain cases, has been pretty well closed. It
is in a lot better shape today than it ever was before. So I am
not; I think that is in pretty good shape; that kind of
spectacular----
Mrs. Biggert. I guess to me, or looking whether there would
be mandatory registration of any of the hedge funds, and if
there was that registration somehow would it be presumed by
investors that these hedge funds are less risky because of
having SEC registered status as their adviser?
Mr. Donaldson. Again, the use of the word
``registration''--there are all sorts of different levels of
registration, as you know. The simplest level is the
registration of the manager, if you will, as opposed to the
fund itself. Clearly, registrations of the funds under the 1933
and 1934 Acts is a vast and very costly thing. The simple
registration of the manager, if you will, which is a relatively
inexpensive thing to do, and it opens the door for the
regulators to get in and look and see what is happening.
Mrs. Biggert. I think that some of our witnesses later on
are going to suggest or believe that retail investors then
should not be denied the ability to invest in these funds.
Somehow we seem to be talking about that hedge funds are risky,
and yet if we have an open policy, their proprietary interests
are looked at and will actually make the hedge funds go down,
as far as the amount of money that can be returned, because
other people will get into what they are doing. So do you think
that the funds that if the retailers got into, and I think you
suggested earlier that these funds would help to reduce the
risk in an investor's portfolio, and yet we think of them as
the high risk funds.
Mr. Donaldson. Again, if you listen to the successful hedge
fund managers and if you listen to many academics and so forth,
that they would challenge the risk aspect. They would say, with
some conviction, that these funds because they have broader
powers than long-only mutual funds, that they can reduce the
risk; that they can make money in any kind of a market, is what
they would say, and that in fact the risk is not as great as
somebody that has invested in a fund that has to just invest in
common stocks. So I think there are other kinds of risk. There
is risk of leverage and there is the risk of records and books
and an honest operation. Those are all part of the risk
package, and I think we need to be able to take a harder look
than we can right now at those risks. I think what comes out of
that remains to be seen in terms of how far it is advisable to
go to allow ``retail'' investors to invest in these funds.
The bottom line is that we have got to somehow make
investment opportunities available to everybody in this country
that wants to invest. We cannot put a fence around a particular
investment vehicle, but at the same time we have got to be sure
that the investors understand the risks inherent in doing that.
Mrs. Biggert. Thank you very much.Thank you, Mr. Chairman.
Chairman Baker. Thank you, Ms. Biggert.Mr. Capuano?
Mr. Capuano. Thank you, Mr. Chairman. Chairman Donaldson,
first of all I actually like most of what I have heard today,
though as to be expected I have to pass through a fair amount
of it. That is okay; that is expected. I apologize for asking
what might be a simple question, but when do you expect to have
the report finalized? Is there any time frame at all?
Mr. Donaldson. As I said, we are going out; 45 days from
today we will put a cut-off on comments coming from either
those who were at our conference, who have read about it or saw
it on the Web and so forth. We also hope to complete our
further investigation outside of the conference, and I would
hope that sooner rather than later we will have a report to
you. If I were to put a; if you do not hold me to it exactly,
but to give you a parameter, I would hope that sometime in the
early fall, by the end of the summer and early fall that we
will be back to you. That is our thinking.
Mr. Capuano. Thank you. Just a couple of comments before I
get a question. I would disagree that you have the ability at
the moment to regulate hedge funds if you chose too. Everyone
looks to the SEC. I know you have some general powers to
basically regulate the trading system, to oversee the trading
system, and I would throw hedge funds into that. That is my
interpretation, not necessarily yours.
In response, I would have liked to have heard a stronger
response as to why you think it needs to be regulated. Anyone
who trades at 25 percent of the trades going on deserves to be
overseen by somebody. The degree of that oversight might be
subject to debate, and that is fair, but somebody should be
looking at what they are doing. I guess for me, I am reasonably
satisfied with the direction things are going. I am not
satisfied with the speed, but that is the normal situation in a
large government.
I guess for me, one of my concerns is, I am hoping that
whatever you are thinking about doing, you are also doing in
coordination with other regulatory agencies, and particularly
those of financial institutions. And I would hope that; is that
an accurate commentary or am I off on that?
Mr. Donaldson. I keep getting back to the various
exclusions and exemptions and so forth in terms of our powers,
if you will, to regulate, or to even stop short of that; our
powers to get inside and know what is going on. That is, I
think, a minimal level that this amount of money, $600 billion
and growing rapidly, requires. I do not want to pre-judge what
we are going to find here. I do not want to pre-judge what the
balanced judgment will be coming out of all the work that we
have done.
But I think it is just a simple statement that if somebody,
if we use this figure; 6,000 to 7,000 hedge funds; $600
billion; and somebody who has spent days and days and hours
analyzing it, and a report in the paper today that there are
really only 3,000 funds out there, or whatever; it simply
illustrates that we do not know.
Mr. Capuano. Fair enough, Mr. Chairman. But my concern has
never been for the wealthy investor who is very knowledgeable
about what he is doing. My concern has always been the impact
of these hedge funds on other investors. The last time, through
Long-Term Capital, my concern was not for the individuals who
may or may not have lost money. My concern honestly in that
situation was who allowed the bankers and the other financial
institutions to make investments without ever telling anyone
that they had done it. Not an SEC problem so much, but a
problem with other regulatory agencies, because they were
jeopardizing my money investing in a bank, as opposed to if I
go into a hedge fund, I know what I am into, so be it. My
interest in regulation is really not so much regulation in the
classic sense, as much as transparency. Again, not so much for
if it is going to be limited, but as hedge funds open their
doors; which they are doing; you know it; you have said it; we
all understand that as they open their doors, they bring in
less sophisticated investors and they also broaden their
ability to move that market.
It is the transparency. If you know what you are getting
into, if you know your money is at risk, well, fine. You are
entitled to make that risk. For me, it is the transparency that
is the most important thing. In this particular situation, one
question I have for you is right now, even with the limits that
are there, a million dollars net worth in today's society in
places like New York and San Francisco and Boston and
Philadelphia is your house, that you might have bought 20 years
ago.
And who is sitting there right now telling me or telling
you that they are adhering to those limits? My house might have
been worth $1 million last week, but with the current economy
maybe it is only worth $700,000. Can you sit here today, or can
anyone tell me today, that even with those lowered limits, that
we are not actually getting investors in? I have seen
advertisements for hedge funds in various financial papers. If
that is the case, who is telling me; who is making sure that
those less sophisticated investors are not being welcomed in?
Who is sitting there guarding the gates?
Chairman Baker. That will have to be the gentleman's final
question.
Mr. Donaldson. I want to draw a distinction between the
desire to have more information about what is going on in the
hedge fund, as opposed to our existing laws which allow us to
get after fraud and manipulation no matter where it comes from.
So we do not need any further powers to do that.
In terms of the issue of financial viability as a criteria;
net worth and earning power and so forth; as I tried to
explain, I think that that may not be the only criteria that
should be out there. Again, you get to the issue of suitability
and you get to the issue of transparency and suitability, and
there are laws on the books about that, too, in terms of what
you are talking about. I am not prepared sitting here today to
give you a prescription. That is what we are trying to get at;
exactly the question you are talking about and a lot of the
other questions. We are trying to understand it ourselves, and
we are trying to make some measured judgments based on data and
based on the testimony and the investigation that we are doing.
Chairman Baker. Thank you, sir. Ms. Kelly?
Mrs. Kelly. Thank you very much for holding this hearing.
Mr. Donaldson, we come from the same home town. I am just
delighted to have you here, proud to have one of my
constituents in your position. We all cheered when we heard you
were appointed. So I am glad to have you here.
Sir, we know today that significant long positions in
securities have to be disclosed, while significant short
positions are not subject to the same kind of disclosure. In
your testimony, you mentioned that you believe that the current
level of disclosure provides some information on both long and
short security positions.
I am wondering if you think that there should not be some
kind of a significant short position disclosure whether by a
hedge fund or any other investor, trying to figure out what is
going on, that parallels the treatment of disclosure with
respect to long positions.
Mr. Donaldson. There is, as you know, on the long side of
the market, there is a 5 percent level of disclosure. If you go
over 5 percent, you have to disclose it on the long side. In
fact, the evidence that we have is that the short positions of
hedge funds and others do not come anywhere near that 5 percent
level in terms of 5 percent of the total capitalization. That
is number one.Number two is that the self-regulatory
organizations; the NASD and the New York Stock Exchange; in
particular have requirements where short positions are
published on a monthly basis. I believe it is monthly.
So they do know in a gross way the long-short position in a
wide range of stocks. If you are suggesting that there needs to
be a public disclosure fund-by-fund of exactly how much money
they have in a short position, and the name of the stock and so
forth, and publish that, I think we have to take a look at
that.
Mrs. Kelly. I am glad to hear you say that, sir, because I
analogized this for the investors as being somebody who went on
vacation and accidentally dropped their essential glasses in a
lake. And they are looking down in that lake and it is slightly
murky. They can see the glasses on the bottom of the lake, and
they really want to get those glasses. They want to get into
the lake, but they are not sure if there is an alligator in the
lake. That is what I view some information as being. I think if
we are going to build investor information and investor
confidence in this market, we have got to make sure that you
tell them through transparency and other ways that there is no
alligator in the lake and they can get in and do what they want
to do.
That being said, I have got one more question, and that is,
last August, the NASD issued an investor alert that was
entitled Funds of Hedge Funds: High Costs and Risks for Higher
Potential Returns. As pooled investments, these funds of funds
are described as pooled investments in several unregistered
hedge funds. The funds of hedge funds can have a minimum of
$25,000 and have an unlimited number of investors. I am
wondering if you feel that these funds of hedge funds could
represent a danger to less sophisticated investors and what you
think we should do about that.
Mr. Donaldson. The fund of funds that are invested in hedge
funds; the vehicles, the parent company are registered vehicles
and have to conform to our existing laws. The issue as far as I
am concerned is the underlying investments; the hedge funds
that they are investing in. Here, as I said before, we do not
have enough information and I am not sure that some of the
funds of funds have enough information about what is going on
inside these units. And this becomes particularly pertinent in
terms of evaluation of these investments in the hedge funds. In
other words, if somebody is putting their own price on what
their performance is without some oversight there, there is
room for abuse. So I think as a first step, we just have to
know more about what is going on.
Mrs. Kelly. Thank you. Mr. Chairman, I just want to offer
one more comment. I want to thank the SEC for the Web site. I
think it is laudable that you have already set up the GRDI Web
site; the Guaranteed Returns Diversified Incorporated. That is
a wonderful way to do outreach to educate investors. I am very
hopeful that more; you say in your testimony that you have had
80,000 hits on it. That is terrific. Investor information,
investor education is again one of the ways that I believe we
can help people understand what they are getting into, and then
they will get in and they will be in the market. Thank you,
sir, for appearing. Thank you, Mr. Chairman.
Chairman Baker. I thank the gentlelady.
Just be advised, if you are on vacation in Louisiana and
drop your glasses in the lake, there is an alligator in every
one of them.
[LAUGHTER]
I almost overlooked my distinguished vice Chairman, who has
returned from other duties to join us today. Welcome, sir. I
know. I was trying to overlook you, but I forgot.
[LAUGHTER]
Mr. Ose. Thank you, Mr. Chairman. Chairman Donaldson, I
have asked this question at every meeting regardless of
subject, and I am going to ask it again today. What is the
status of the application of Nasdaq for exchange status?
Mr. Donaldson. The issue of Nasdaq becoming an exchange,
registered as an exchange, has very broad implications to it.
There are bits and pieces of market structure now that need
care in terms of how we resolve them. I think that the
application of Nasdaq has to be viewed in the context of the
overall market structure. That is exactly what we are doing. We
are talking to the Nasdaq people in terms of trying to resolve
some of the obvious objections we might have to the way they
are set up now. More importantly, I think we see this as part
of an overall market structure issue, and we have that under
review right now.
Mr. Ose. Has the application been deemed complete?
Mr. Donaldson. I think too often we have taken market
structure issues and solved them piece by piece without knowing
exactly where we are going. I think that the time has come to
take an overview of the entire situation and see what the
central marketplace should look like. I think we are trying to
do that. I want to assure you that we are not just sitting on
that application. We are working very hard to have an overall
view of how this total market is evolving.
Mr. Ose. So their submittal is complete or it is not
complete? In other words, the requests that SEC has made of
them and they responded and given you everything that you have
asked for in terms of submittals?
Mr. Donaldson. I think that, as I say, the issue of
Nasdaq's registration, the thing that is before us, the whole
issue of public ownership of markets, of where regulation fits;
these are big issues and I think we have to look at them as
part of a whole, and not piecemeal address things that come
into us unless we understand what impact that has on the whole.
Mr. Ose. So how much time is it going to be before we come
to a conclusion on this matter?
Mr. Donaldson. I do not want to put a timetable on it. I
will say that some of the market issues and market structure
issues have been around for quite a while. I think that we are
seeing enough pressure now in terms of new markets, of
electronic markets, ECNs, internalization; a whole series of
things going on in the marketplace to know that there has to be
an overall structure here, and that we cannot just address this
thing in an ad hoc way.
Mr. Ose. So there is no time frame in which you are
planning to get to an answer?
Mr. Donaldson. It is a very high priority for us. Let me
put it that way.
Mr. Ose. We have been at this; I believe they actually
initially filed two years ago.
Mr. Donaldson. Yes, I have only been at it for three
months.
Mr. Ose. I understand that. And you have not fixed it, and
I am just appalled.
[LAUGHTER]
But I do appreciate you looking at it. It is a subject that
I find timely, given our needs to have markets of some form or
another operative in the event of an incident.
Mr. Donaldson. Right.
Mr. Ose. So next time I see you, I am going to ask you the
same question. I am sorry to bring it up in the context of
hedge funds, but I asked your assistant when we did the last
hearing; mutual funds, thank you; so I am interested in seeing
you come to a conclusion on that particular application.
Thank you, Mr. Chairman.
Chairman Baker. Thank you, Mr. Ose.
I am making sure no one else is waiting. I do appreciate
your appearance here today. It has been helpful to the
committee. I would express a deep interest by all members of
the committee in the advantage of the study and report which
the agency is generating on this matter. We would certainly
want to return for a public discussion of those findings,
specifically if there are recommendations that would require
any action on our part.
In the meantime, we perhaps will proffer our own questions
for inclusion in the public comment period on issues raised
today by many members concerning the transparency and adequacy
of the current regulatory structure. We look forward to working
with you on this and many other matters of interest in the
coming months.
Mr. Donaldson. Terrific.
Chairman Baker. Thank you, Mr. Chairman.
Mr. Donaldson. Thank you.
Chairman Baker. I would also invite our second panel
forward at this time. I would like to welcome the members of
our second panel. I would like to request each member if
possible to constrain your remarks to five minutes. We will
make the full written testimony part of our official record for
further evaluation by the committee. We welcome each of you
here. First, Mr. John Mauldin, President of Millennium Wave
Investments. Welcome, Mr. Mauldin.
STATEMENT OF JOHN MAUDLIN, PRESIDENT, MILLENIUM WAVE
INVESTMENTS
Mr. Mauldin. Thank you, Chairman Baker. I thank you for
allowing me to share some thoughts on the important matter of
who should be allowed to invest in hedge funds. My name is John
Mauldin. I am President of Millennium Wave Investments. I have
been involved in the alternative investment world since 1989. I
speak at investment conferences on a wide variety of topics on
hedge funds, and I write a weekly letter that goes to two
million readers each week.
Let me summarize quickly my written testimony. It is my
contention that the positive values that hedge funds offer to
rich investors should also be offered to the middle class,
within appropriate and proper regulatory structure. The current
two-class structure limits the investment choices of average
Americans and makes the pursuit of affordable retirement more
difficult than it should be. The rich have a considerable
example in growing assets for retirement in that they simply
have more assets to begin with. They should not also have an
advantage in better investment choices.
Specifically, why should 95 percent of Americans simply
because they have less than $1 million be precluded from the
same choices as the rich? Why do we assume that those with less
than $1 million to be sophisticated enough to understand the
risk in stocks, which have lost trillions of investor dollars;
stock options, the majority of which expire worthless; futures,
where 95 percent of retail investors lose money; mutual funds,
80 percent of which under-perform the market; and a whole host
of very high-risk investments, yet are deemed to be incapable
of understanding the risk of hedge funds.
Indeed, if hedge funds had performed as mutual funds have
done in the last three years, hedge funds would be out of
business. The current state of the hedge fund industry is the
result of laws that were written in the 1930s and 1940s, long
before anyone ever thought of a hedge fund. The path that we
have come down is not one of deliberate forethought, but a
response on the part of entrepreneurial investment managers to
improve investment returns for clients within the current
regulatory framework. It is as if we were still driving the
cars of today on dirt roads built for the 1930s.
The first hedge fund was formed by Alfred Jones in 1952. It
was a simple long-short fund, but it was revolutionary. Due to
limitations imposed by Federal securities laws, the only
available legal vehicle for him at that time was a private
limited partnership. Thus, he was forced by the rules of
decades past to not advertise or publicly solicit investors,
creating the aura of secrecy. This became the pattern from
which future hedge funds were cut. As an aside, hedge fund
investors were subject to strict suitability requirements, thus
women were the persons most often rejected as investors as they
were deemed unsuitable. That was in 1969.
The early hedge funds had a fairly limited range of
strategies. As time wore on, different pioneers thought of new
ways to earn absolute returns instead of the relative returns
of the market. By absolute returns, I mean actual profits at
the end of the day. Investors in hedge funds do not want to
hear the siren song of relative returns; we are a good fund;
the market is down 30 percent, and you are only down 25
percent. The reason hedge funds have grown to the extent they
have done is a very simple reason. It is returns. If high net-
worth investors and institutions could get the same returns as
hedge funds by simply investing in stocks, bonds or mutual
funds, why would they choose hedge funds which have higher
fees, are hard to find and evaluate, and need more scrutiny?
The answer is they would not. The demonstrably observable
higher risk-adjusted returns make the effort worth it.
Some hedge funds are very volatile and extremely risky, as
are some mutual funds and stocks and futures. Some hedge funds
are fairly stable and boring. Lumping all hedge fund styles
into the same category can be very misleading. Simply because a
person is a member of Congress does not mean they think and act
alike. But just as voters get to choose the type of
congressional representative they want, so too should investors
be able to choose the type of funds and risks that they or
their advisers feel appropriate.
What I would suggest is that we need a new hedge fund
investment company. Let me just briefly describe what that
would do. A hedge fund should be allowed to register with the
SEC or the CFTC as a hedge fund investment company. They would
be required to have an annual independent audit, at least
quarterly independent evaluations of their assets, and
independent administrators, plus they would be subject to SEC
or CFTC advertising rules. There would be few, if any limits on
the strategies the fund could employ and they could charge a
management fee and an incentive fee. They would have to fully
disclose not only the relevant risk, but full disclosure of
information on their strategies, personnel and management
experience. As with mutual funds, there would be no limits on
the number of investors. They would be allowed to advertise
within current regulatory guidelines, and with certain
restrictions, they should be able to take on non-accredited or
average investors. Would hedge funds register under such a
situation? My belief is that they will.Looking at the
situation, we should ask ourselves three questions about
opening up the hedge funds to average investors. Number one, is
it appropriate? The premise of modern portfolio theory is that
you should diversify your portfolio into non-correlated
investment asset classes. Many hedge fund styles by any
reasonable assessment are highly uncorrelated with the stock
and bond markets. High net-worth individuals and institutions
are taking advantage of this fact by diversifying a part of
their portfolio into hedge funds. This reasonable
diversification should be made available to smaller investors
as well. No one would suggest that all or even a significant
portion of an investor's portfolio should be in hedge funds,
but a reasonable diversification is appropriate. There is no
real reason to believe that smaller investors cannot understand
hedge fund strategies. If investors can be assumed to
understand the risk involved with individual U.S. stocks,
foreign stocks, commodity futures, currencies, options, mutual
funds and real estate, not to mention a host of Reg D
offerings, then how could anyone suggest that hedge fund
strategies are beyond the ken of investors? A hedge fund is a
business generally with a straightforward premise.
It is no more and often far less difficult to understand
the risk of a hedge fund than that of a public offering of a
bio-tech or a technology company.
The second thing we need to ask, is it the right thing to
do? Most hedge funds have an offshore version with lower
minimums. The reality is that investors from Botswana have more
and better investment choices than do U.S. citizens from Baton
Rouge, Louisiana. The only people who benefit from limiting
investor choices are those who have a vested interest in not
facing the competition from hedge funds. As they seek to
protect their turf, they have lost sight of the interests of
those whom they should be serving. Those who oppose allowing
average investors to have the same choices as the rich must
tell us why smaller net-worth investors are less intelligent or
are less deserving of options. They should show why average
investors should only be allowed funds which are one-way bets
on an uncertain future.
I believe that investors would tell you that not allowing
them the same choices as the rich is a kind of government
protection that they do not need.
Finally, we need to ask, is it fair and just? It would
behoove us to remember that the small investor is not even
allowed a hedge fund crumb from the rich man's table. The focus
of future regulation should be to make sure there is an honest
game on an even playing field, not to exclude certain classes
of citizens. To put it simply, it is a matter of choice, it is
a matter of equal access, it is a matter of equal opportunity.
I believe it is time to change a system where 95 percent of
Americans are relegated to second-class status based solely on
their income and wealth, and not on their abilities. It is
wrong to deny a person equal opportunity and access to what
they feel are the best managers in the world based upon old
rules designed for a different time and a different purpose. I
hope that someday this committee will see to it that the small
investor is invited to sit at the table as equals with the
rich. Thank you, Mr. Chairman. I am open for questions.
[The prepared statement of John Mauldin can be found on
page 134 in the appendix.]
Chairman Baker. Thank you, sir. Our next to be heard is Mr.
Paul Kamenar, Senior Executive Counsel, the Washington Legal
Foundation. Welcome, sir.
STATEMENT OF PAUL KAMENAR, SENIOR EXECUTIVE COUNSEL, WASHINGTON
LEGAL FOUNDATION
Mr. Kamenar. Thank you, Mr. Chairman. Mr. Chairman and
members of the committee, my name is Paul Kamenar, Senior
Executive Counsel of the Washington Legal Foundation. On behalf
of our foundation, I would like to thank the chair and the
committee for inviting us to testify on this important aspect
of hedge fund regulation, namely the relationship between trial
attorneys and short sellers. We applaud the committee and its
staff for its interest in this important aspect of the hedge
fund issue, and urge the committee to exercise its oversight
function and ensure that the SEC addresses this issue as well.
Briefly, WLF is a nonprofit public interest law and policy
center based here in Washington, D.C. We advocate free
enterprise principles, responsible government, property rights,
strong national security defense, and civil justice reform.
Earlier this year, WLF launched its investor protection program
to protect the stock markets from manipulation; to protect
employees, consumers, pensioners and investors from stock
losses caused by abusive litigation practices; to encourage
congressional regulatory oversight of the conduct of the
plaintiff's bar with the securities industry; and to restore
investor confidence in the financial markets through regulatory
and judicial reform measures.
We also regularly oppose excessive attorneys' fees in class
action cases on behalf of consumers, and we also filed comments
with the SEC last week on their hedge fund roundtable.
As part of our investor protection program, we filed a
complaint with the SEC earlier this year; gave copies to the
committee here and on the Senate side, as well as at the
Department of Justice, calling on the commission to conduct a
formal investigation into the short-selling of J.C. Penney
stock that occurred shortly before and after a major class
action lawsuit was filed against Eckerd Drug Stores, which is
owned by J.C. Penney. We think the J.C. Penney case is just the
tip of the iceberg, and is a good illustration of the problem,
and therefore I would like to focus on it in my remaining time.
Details of the questionable contacts between the lawyers
and the short-sellers is recounted in a January 7 issue of the
Wall Street Journal, a copy of which is appended to our written
statement. The headline of that article says it all, ``Suit
Batters Penney Shares, but Serves Short Sellers Well.'' In a
nutshell, evidence suggests that trial attorneys may be tipping
off short-sellers or hedge fund operators as to what major
class action lawsuits against publicly traded companies will be
filed with the court.
Armed with this material non-public information short
positions are able to be taken in the stock of the targeted
company. When the suit is filed, the price of the stock in the
company falls, and short-sellers stand to gain by the price
drop. The U.S. Chamber of Commerce has called upon the SEC to
order an informal investigation into our complaint.
According to the Journal article, there are plenty of
questions that remain unanswered that the SEC needs to ask, and
here are just a few. In the first place, it is questionable who
the plaintiff was in this case. It was filed on behalf of a 77-
year-old widow named Shirley Minsky of Fort Lauderdale,
Florida, who alleged that Eckerd Drugs overcharged consumers
for certain liquid medications. There is only one problem. Mrs.
Minsky did not authorize the filing of the suit. She learned it
from her next door neighbor who read the news the day after the
suit was filed. The attorneys claim she authorized the suit.
She angrily denied it, saying ``they made up the whole damn
story.''
The lawyers scrambled to find another lead plaintiff who
was substituted for Mrs. Minsky. More troubling than the
selection of the plaintiff is the sequence of events and the
communications that led up to the filing of the suit. According
to the Journal article, Don Reilly, an Eckerd pharmacist, had
complained to Federal and State authorities that he believed
Eckerd was overcharging its drugs. He was repeatedly contacted
by Clifford Murray, a doctor turned analyst with the Boca Raton
office of KSH Investment Group. According to Mr. Reilly, Dr.
Murray contacted him some 30 to 40 times to update Mr. Reilly
on the timing of the class action suit against Eckerd.
According to Mr. Reilly, Dr. Murray was communicating with the
lead plaintiff's attorney in the suit before it was filed. In
the article, Dr. Murray's office denies that he had advance
knowledge of the suit and claims he did not talk to the lead
attorney until after the suit was filed. The SEC needs to find
out the truth of this assertion.
Interestingly, the lawsuit was date-stamped 3:59 p.m. on
Friday, February 1, 2002, which is just one minute before the
close of the market for the week. Jeff Sultan, head of the
local KSH, claimed that neither he nor his firm sold Penney
stock short, but when asked why in this case Dr. Murray spent
so much time talking to the pharmacist and whether the broker-
dealer had been advising clients to short the stock, Mr. Sultan
did not respond. The SEC needs to get Mr. Sultan to respond to
those questions.
By the time the suit was filed and amended in April, 2002,
J.C. Penney stock dropped a total of 32 percent since mid-
November, 2001. Short-selling activity in the stock rose 43
percent between January 15 and February 15. A subsequent
investigation by the Florida Attorney General's office
concluded that Eckerd did not overcharge for its drugs. We do
note that the aggregate figures of the short-selling was only
in a monthly report, and we think that weekly and daily reports
may be better, as suggested by Representative Kelly. Indeed,
the Committee on Government Operations recommended such a thing
in 1991.
Finally, we think that if the SEC says there is no
violation that has occurred here, whether it is a 10b-5 under
the misappropriation theory under O'Hagan, that may be fine,
but it is important for the public and this committee to know
that, because the next question would be whether new SEC
regulations should be promulgated to curb this practice, or
whether remedial legislation is warranted.
Thank you very much, Mr. Chairman, for the opportunity to
give this testimony, and I am open to any questions.
[The prepared statement of Paul Kamenar can be found on
page 88 in the appendix.]
Chairman Baker. Thank you, Mr. Kamenar. Our next witness is
Mr. Terry F. Lenzner, Chairman, Investigative Group
International. Welcome, sir.
STATEMENT OF TERRY LENZER, CHAIRMAN, INVESTIGATIVE GROUP
INTERNATIONAL
Mr. Lenzner. Thank you, Mr. Chairman. I appreciate the
Chairman and this committee and this committee staff looking at
a number of activities and issues that I believe have been
flying below the regulatory radar screen to the detriment of a
number of American companies.
These activities are abusive tactics by short-sellers,
exacerbated by the lack of information on the short selling
positions, which was brought up by a congresswoman earlier
today, and a behind the scenes an unholy alliance we now know
between the short sellers and the plaintiffs bar. The result of
these activities that have not been on the radar screen is the
loss of jobs, loss of value to shareholders, loss of access to
the capital markets by American corporations, and overall loss
to the gross national products estimated at about 2 percent for
the last year. I want to quickly add that I am not against the
hedge funds per se. I am simply against those funds that
conduct abusive activities.
In the past, about 15 years ago, Mr. Chairman, when I
started looking at short sellers, they were using a very
laborious process to put out false inflammatory information
about particular companies. A few real examples; a short seller
calls up the FBI, and I know the Chairman of the committee is a
former FBI agent, and tells the FBI that company X is an
organized crime front and is involved in money laundering. They
then call the press to tell them that the FBI is investigating
the company. The press then calls the FBI and the FBI can
neither confirm nor deny that allegation, and the press runs
with the story and damages instantaneously the reputation of
that company.
I have seen examples in the past where they acted as Wall
Street Journal reporters to get false information to vendors,
clients, customers, and regulatory authorities that the company
was about to be indicted; that the company was about to go
bankrupt; the company was about to lose its permit or a major
contract; again, with the intent of depressing the stock price.
With the growth of the Internet, and the Chairman noted
this earlier, and the use of pseudonyms on the Internet, there
has been a virtual explosion of inexpensive instantaneous
communications that have been used to damage companies'
reputations and depress the stock price. One of the most
dramatic examples is the CareMark Corporation where a short
seller went on the Internet, posed as the Chairman of the
company, predicted that the fourth quarter results were going
to be 50 percent less than what the company and the street had
anticipated, and the company lost $400 million in net worth in
less than two weeks. And the Allied Capital case; an individual
by the name of David Einhorn from Greenlight Capital gave a
talk at a charity event and named Allied Capital as a company
with dubious accounting.
The day after that, the company was hit with a deluge of
lawsuits by the plaintiffs bar and the co-head of the class
action became Milberg Weiss; you will hear about them later.
The allegation was that the valuation of assets was over-
inflated and that Arthur Andersen had at one-time been their
auditor. The company fought back. They mounted a vigorous
campaign.
They fought back against the lawsuits, and very recently a
judge ruled in their favor and dismissed the case on the
grounds that there was simply no basis on which to infer that
Allied's evaluation of its investments were in fact incorrect
or inflated, and thus no basis to infer that Allied's
accounting policies resulted in fraudulent over-valuation.
Since Allied's actual valuation policies were public, as was
all adverse information about the companies in which Allied had
invested, plaintiffs have not alleged that Allied concealed any
facts from its investors. I might say that the gentleman to my
left, Mr. Lamont, in a public statement that I have recently
seen, criticized the company for fighting back.
My conclusion is had the company not fought back while its
stock suffered, it would have been battered far worse if it had
not responded, as is its right, to that attack.
We also had another individual who comments frequently on
short sellers, Herb Greenberg, Onthestreet.com, echoed Mr.
Einhorn's remarks, and I do not know if Mr. Rocker shorted the
stock, but Mr. Rocker owns 10 percent of Onthestreet.com, and I
think at some point the SEC ought to look at whether there is
any kind of communication between analysts and the short
sellers.
What is missing is the information. Companies and the
public and regulatory authorities get aggregate amounts of
short positions every 30 days. Recently, I was watching the
Moore Corporation and on February 15 it had 900,000 shares
short, and on March 15 it had 14 million shares short. No
information in between, and as a result if I was Chairman or
CEO of that company, I would have been alarmed when I picked up
a newspaper on the 15th of March and saw that my short position
had grown so immensely.
The other questions, I was glad to see the Chairman
announce today that 13d, the 5 percent reporting requirement,
does apply to short sellers, because I have asked a number of
senior SEC officials and security lawyers if 13d applied and
nobody seems to know. In fact, nobody seems to know why there
is so little information published about the short positions.
The Chairman did say 13d applied, but he said they had looked
and had not seen any holdings in excess of 5 percent. The
question I would suggest is, as in the long positions, has the
SEC looked to see if there are concert parties, that is to say
a number of short sellers who are shorting the stock at the
same time in concert with each other, that exceeds 5 percent.
If it does, then they do have to file under 13d. We have seen
enough patterns of communications and coordination between
short sellers in cases like Allied Capital to think that that
does exist and the SEC ought to take a look at it.
Now, the relationship between the plaintiffs bar and the
hedge funds; you do not have to go any farther than the Hedge
Fund Association. If you click on their Web site, and most of
the short sellers are represented by the Hedge Fund
Association, one of their members of the board of directors is
Randall Steinmeyer of the Milberg Weiss firm. If you click on
his name, you get instant access to the Milberg Weiss Web site.
So that if you are a short seller or a plaintiff looking for a
law firm, it would be very easy to find them.Now, I just want
to talk briefly about the Dynegy case, because it kind of wraps
up all the issues that I have been talking about, including Mr.
Steinmeyer. An individual by the name of Ted Beatty became
unhappy and concerned about Dynegy's accounting practices. He
thought they were wash transactions and they had a banking
relationship that they called Project Alpha. He gave this
information to a short seller who immediately shorted the
stock. He also gave that information to the Wall Street
Journal, who published an article on April 3, 2002.
Unfortunately for the short sellers who had taken positions in
anticipation of this article, the price went up and not down,
and they panicked, and they called Mr. Beatty and said, can you
give us more information to make the stock go down? He said, at
this point I had been threatened with a lawsuit from the
company that he had now left, and I want a lawyer. They said
just give us the documents, and we will get you a lawyer, and
we want you to be the front man and we want you to talk to the
newspapers about Dynegy, talk to the regulators about it, and
talk to the credit rating agencies about it. Indeed, he did do
all of that and Moody's lowered their rating based on what he
told them.
The next thing he heard was that Mr. Steinmeyer had been
approached by the short sellers to represent Mr. Beatty. Mr.
Steinmeyer called Mr. Beatty on April 15, upset, frustrated and
unhappy that the Wall Street Journal had not depressed the
stock, but rather the stock had gone up, and insisted as part
of his legal representation that Beatty send him materials that
he took from Dynegy immediately. Ultimately, Beatty did and
Steinmeyer turned around and used them to file a lawsuit
against Dynegy. Steinmeyer never represented Beatty, never gave
him a single piece of advice, and never talked to him about any
of the issues that were of concern to him.
And the stock did then decline. But when Steinmeyer, the
lawyer, went to Beatty and told him, I am upset that the stock
price had not fallen during that period of time, it inferred to
me that Steinmeyer was working closely with the short sellers.
Indeed, when Beatty told the Wall Street Journal that, that
Steinmeyer had told him not only was he working closely with
the short sellers, but the short sellers had made $150 million
on shorting Dynegy stock between April and May, Steinmeyer
called from Europe to the Beattys and said if that is printed,
we no longer represent you. He was extremely upset and told
them that if was off the record, when he told them about his
relationship with the short sellers.
Chairman Baker. Can you begin to wrap up for me, sir?
Mr. Lenzner. So in conclusion, what I am suggesting is this
is a clear plan of the relationship between these two groups,
whose major interest is to drive prices down. I believe if the
commission and this committee looks further into this, you will
see a very profound historical pattern of the same kind of
activity.Thank you.
[The prepared statement of Terry F. Lenzer can be found on
page 121 in the appendix.]
Chairman Baker. Thank you, sir, for your comments. Our next
witness is Mr. Owen Lamont, Associate Professor of Finance,
Graduate School of Business, University of Chicago. Welcome,
Mr. Lamont.
STATEMENT OF OWEN LAMONT, ASSOCIATE PROFESSOR OF FINANCE,
GRADUATE SCHOOL OF BUSINESS, UNIVERSITY OF CHICAGO
Mr. Lamont. Thank you, Mr. Chairman. I am pleased to have
this opportunity to testify about the state of the hedge fund
industry and the role of short sellers in capital markets, and
I thank you, Mr. Chairman and the members of the committee, for
this opportunity.As an economist, I am concerned with prices.
We need to get the prices right. To get the prices right, we
need to get all information, negative and positive, into the
market. When security prices are wrong, resources are wasted
and investors are hurt. One way to get negative information
into the market is through short sellers. Without short
sellers, stock prices can be too high. Stocks can get
overpriced, as only optimistic opinions are reflected in the
stock price.
Our current financial system is not set up to encourage
short selling. We have well-developed institutions such as
long-only mutual funds to encourage investors to go long, but
we do not have many institutions to encourage them to go short.
As events of the past few years have made clear, the
infrastructure of our system; the analysts, the underwriters,
the issuing firms, the accounting firms, and some elements of
the media; have an overly optimistic bias. In addition to this
optimistic bias, there are technical issues about short
selling. Sometimes it is difficult to short, or impossible to
short certain stocks for technical reasons. Simply put, our
system is not set up to facilitate short selling.
A variety of evidence suggests that when stocks are
difficult to short, they get overpriced. One example I have
studied is battles between short sellers and firms. We have
heard about some current battles. I have studied battles in
history. Firms do not like it when someone shorts their stock,
and sometimes they take actions against short sellers. An
example is Solv-Ex, a firm that in 1996 claimed to have
technology for economically extracting crude oil from tar-laden
sand. In 1996, Solv-Ex took some anti-shorting actions. It
attempted to organize a short squeeze, and it later filed suit
against short sellers, claiming the short sellers had illegally
spread false information. But in this case, it was Solv-Ex that
was engaged in illegal activities, not the short sellers.
Subsequent to this anti-shorting action, Solv-Ex de-listed, the
SEC investigated, and the court ruled in 2000 that the firm had
indeed defrauded investors.It turns out, based on the
historical record, that Solv-Ex is a typical case. The evidence
shows that when you have these fights against short sellers and
firms, short sellers are usually vindicated by subsequent
events. Firms that take anti-shorting actions tend to have
falling prices in the following years, suggesting that they
were overpriced to begin with, perhaps due to fraud by
management; perhaps just due to excessively optimistic investor
expectations.
Short sellers are good at detecting and publicizing fraud
on the part of firms. Again, recent events of the past few
years have shown that we need more whistleblowers and we need
to encourage people to be whistleblowers. The SEC and the
regulators cannot be our only line of defense against corporate
fraud. To protect investors, we need a vibrant short selling
community.
Even absent corporate fraud, though, short sellers play an
important role in protecting individual investors from
overpriced stocks. When informed traders are not able to go
short, it will tend to be the small investors who unwittingly
buy the overpriced stocks and the smart money stays away. For
example, during the tech stock mania in 2000, there were some
stocks that were identifiably overpriced, but they were not
shortable for technical reasons. The victims in this case were
the individual investors who bought those stocks and later
suffered substantial losses.
In my opinion, therefore, we should change the current
lopsided system which discourages short selling. First, in the
narrow technical arena, we need to find ways to make the equity
lending system work better. It seems particularly unhelpful
that firms are sometimes able to abuse various aspects of the
system in order to prevent short selling. Second, in the
broader arena, we need to continue to encourage the development
of institutions that channel investor capital into short
selling. It would benefit both the efficiency of prices and the
welfare of investors if more capital were allocated to
strategies involving short selling; for example market-neutral
long-short funds. This goal could be accomplished through
increased investment in hedge funds, retailization of hedge
funds, or it could be accomplished through mutual funds that
employ long-short strategies.
What we should avoid is a set of new regulations that limit
the freedom of hedge funds to exploit and correct mis-pricing.
I fear that such new regulation might have the unintended
consequence of making short selling harder than it already is.
There is a natural tendency to feel that short selling is
somehow inherently malevolent and un-American. To the contrary,
nothing is more beneficial to our economy than detecting fraud
and correcting overpricing. If we are going to have liquid
markets that properly reflect available information, investors
must be able to both buy and sell.
Of course, it is appropriate for the SEC and other
authorities to investigate possible cases of market
manipulation, but the big story of the past few years has been
malfeasance on the part of the long side; the issuing firms,
the analysts, the accounting firms, and the underwriters. The
short sellers have been the heroes of the past few years,
alerting the public and the authorities to corporate fraud.
Congress and the SEC will continue to hear complaints about
short selling from firms, and we have heard some today. As I
mentioned earlier, the evidence shows that when companies and
short sellers fight, it is the short sellers who are usually
vindicated by subsequent events. For example, in 1989 before
this House, the House Committee on Government Operations, the
Commerce, Consumer and Monetary Affairs Subcommittee, held
hearings about the alleged evils of short selling featuring
testimony from supposedly victimized firms. Officials from
three firms testified. Subsequent to this testimony, the
Presidents of two out of these three firms were charged with
fraud by the SEC. So when you hear companies complain, keep in
mind that short sellers are often the good guys.
Thank you for this opportunity to testify, and I would be
delighted to answer any questions.
[The prepared statement of Owen Lamont can be found on page
109 in the appendix.]
Chairman Baker. Thank you, Mr. Lamont. Our last panelist
today is Mr. David A. Rocker, General Partner, Rocker Partners.
Welcome, sir
STATEMENT OF DAVID A. ROCKER, GENERAL PARTNER, ROCKER PARTNERS,
LP
Mr. Rocker. Thank you, sir. I am honored to have this
opportunity to address the House Subcommittee on Capital
Markets to offer my views on hedge funds, short selling, and
the appropriateness, of additional regulation.
Rocker Partners is an 18-year-old firm with a contrarian
style. While we maintain both long and short positions, we have
focused our research efforts most heavily in recent years on
short selling because we have identified more stocks which we
have felt were overvalued than those which we felt were
attractive. We are generally viewed as a specialized manager,
and our investors, primarily wealthy families and individuals
and institutions such as universities, hospitals and
endowments, often use us as a risk-reducing hedge against their
long-biased investments.
Hedge funds have grown rapidly because they have served
both of their constituencies, investors and their managers,
better than more conventional alternatives. Over the last six
years, which encompassed both the expansion of the biggest
equity bubble this country has ever seen, and its subsequent
deflation, an investment in the average-performing mutual fund
would have remained essentially unchanged, but the same
investment in the average-performing hedge fund would have
appreciated approximately 75 percent, and would have done so
with lesser volatility.
Investors have also been attracted to hedge funds because
of the greater identity of interests between the fund manager
and the investor. Substantial personal assets of the hedge fund
manager and their families are typically co-invested alongside
limited partners, and such investments typically represent a
much higher percentage of total assets under management than is
the case in mutual funds.
Hedge funds frequently provide a more attractive financial
opportunity for successful managers, and a broader investment
flexibility available in the hedge fund structure has also
proven appealing. As a result, many former mutual fund managers
have joined or started hedge funds in recent years. While there
is considerable discussion as to whether hedge funds require
greater regulation, it is important to recognize that even
unregulated funds are already subject to a substantial degree
of oversight.
Sophisticated investors, especially in mature funds such as
ours, impose tremendous demands on managers with whom they
choose to invest, including among other things that the fund
has formal compliance policies, appropriate restrictions on
employee trading, investment transparency, operational
efficiency, risk management techniques and a host of other
protective requirements. Those managers that do not or cannot
provide these protections to the investor marketplace generally
do not succeed or survive. There are lots of choices.
Additionally, the co-investment of the hedge fund manager's
personal and family assets help serve as a self-governing
mechanism.
The highly publicized hedge fund blowups in recent years
must be placed in perspective. Such funds have represented
fewer than one-quarter of one percent of the industry, and the
superior investment results cited earlier include the losses
from these entities. As the present structure has served
investors well during both rising and falling markets, I
believe that additional regulation is neither necessary nor
desirable. Existing regulations effectively applied, coupled
with the extensive due diligence and operational requirements
of investors, have proven sufficient to date. Anyone willing to
commit fraud will not be deterred from doing so by a
registration statement. With few notable exceptions, hedge
funds have proven less risky, so the present focus on them in
this context is somewhat puzzling.
I am not going to comment on retailization, as it is not an
area of expertise and time is short. I would like now to turn
my attention to short selling and the important role I believe
it plays in creating more liquid, balanced and fair markets.
Short sellers already operate in a field tilted sharply against
them, and considerable restrictions and risks relate
specifically and often uniquely to this strategy.
Unlike a long investor who can buy a stock at any price or
repeatedly at ever-higher prices intra-day, the short seller
must initiate his or her position only on an uptick; a price
above the preceding trading price. Buyers do not have to wait
for downticks.In contrast to a long position, in which only the
initial investment can be lost, there is a risk of potentially
unlimited loss in short positions. The short seller is
obligated to pay dividends to the holder from whom he borrows
stock, and most especially there is the potential loss of one's
ability to determine when a short position is purchased or
covered. If the supply of borrowable stock dries up, the short
seller may be involuntarily bought in by his broker in what is
generally known as a short squeeze.
The short seller has no control over when the stock is
bought in or the price at which it is executed. The situation
is clearly distinct from that of the long holder, who cannot be
forced into an involuntary sale.
The contribution of the short seller to more efficient
markets can be best evaluated in the context of the stock
market in the last six years. An equity bubble of extraordinary
proportions developed in the late 1990s, peaking in early 2000.
The Internet mania was just the most visible part of this
general hysteria. Since the peak, the bubble has deflated,
costing investors some $7 trillion. By the way, I would
encourage you to read an article that I wrote for Barron's ``A
Crowded Trade,'' which is part of the package that I included,
and it covers some of the structural issues that have made it
so.
The goal of regulatory policy must be to establish fair and
safe markets for investors. In considering what if any
regulatory changes are appropriate, I believe it is important
to reflect on the forces that created the bubble, as well as
those which have led to its demise. In that connection, it is
important to understand the structural bullish bias of the
market. Shareholders, of course, want their stocks rising.
Corporate officers desire higher prices, as this serves both as
their report card and, thanks to the liberal use of options
which should be treated as expenses, the key to enormous
personal wealth. Higher stock prices also provide inexpensive
acquisition currency. Security analysts clearly want stocks
higher to validate their recommendations. For every
transaction, there must be both a seller and a buyer.
Thus, it is interesting to note that while 50 percent of
stock transactions are, by definition, sales, purchase
recommendations by analysts are 10 to 20 times more numerous
than sale recommendations.The recent Wall Street settlement has
focused on the pressure placed on analysts from internal
investment banking. The pressures from clients and corporate
executives have received much less attention. Analysts who
recommend the sale of stock risk the ire of the clients who own
it. These clients complain to research directors, and can
withhold favorable votes and reviews important to an analyst's
compensation.
Similarly, corporate executives frequently react in a
hostile manner to anyone who downgrades their stock,
restricting his or her contact with the company and thereby
making future analysis of the company more difficult.
Collectively, these factors, coupled with a cheerleading
media, created the bubble. Anyone challenging the valuation of
a company or the integrity of its financial statements was most
unwelcome in this environment. Analysts and market strategists
who either warned of overvaluation or were insufficiently
bullish were pushed aside and replaced by those who went along
with the irrational exuberance.
Short sellers, through their research and public
skepticism, provide a much-needed counterpoint to the bullish
bias. They are willing to ask touch questions of management in
meetings and on conference calls, thereby providing a more
balanced view for listeners. Investors benefit by getting both
sides of the story when the views of short sellers appear in
the media. Several articles I have written are enclosed as part
of this presentation.
Short sellers have helped uncover many frauds and
accounting abuses in recent years, including Tyco, Enron,
Conseco, AOL, Boston Chicken, Network Associates and Lernout
and Hauspie, among a host of others. Short sellers serve as
unpaid, albeit self-interested, detectives who willingly share
their findings with the SEC, which has acknowledged the
usefulness of these inputs. Although there have been occasional
instances in which short sellers have been accused of
circulating misleading stories, these instances are dwarfed
both in number and magnitude by the misleading stories
circulated by long holders and the issuers themselves. Because
of the greater risk in short selling, research done by short
sellers has tended to be more careful and more accurate than
most.
As Gretchen Morgenson of the New York Times recently
reported, and I quote, ``if you own shares in a company that
declares war on short sellers, there is only one thing to do:
sell your stake. That is the message of a new study by Owen
Lamont, associate professor of finance at the University of
Chicago's graduate school of business. That study, which covers
1977 to 2002, shows not only that the stocks of companies who
try to thwart short sellers are generally overpriced, but often
that the short sellers are dead right.''
The value of short selling as a means for creating greater
liquidity and orderly markets is well understood. Specialists
of the major exchanges are required to sell short to help
offset an imbalance of orders. Trading desks at brokerage firms
do so as well to facilitate customer orders. It is also
important to note that over two-thirds of short selling is
simply related to arbitrage activities.
So when you see the short interest figures in the papers,
it is important to put them in this context.
Any effort to further restrict short selling should be
rejected. While short sellers seem to attract a
disproportionate amount of attention, usually from companies
with questionable accounting or flawed business models who do
not welcome scrutiny, the number of short biased firms are few
in number and are actually shrinking. Many short sellers were
driven out of business during the bubble, and even today they
represent the only sub-category of hedge funds that has seen
net redemptions in recent years. Of nearly 6,000 hedge funds,
short biased hedge funds with asset bases of $100 million or
more number fewer than 10; 10 out of 6,000; and the total
assets managed by these entities is well under 1 percent of the
total assets managed by all hedge funds. That few managers have
chosen this strategy or have been able to survive suggests that
there are easier ways to make a living.
The short interest in each stock is reported monthly, yet
there are proposals circulating, most visibly from the Full
Disclosure Coalition now in formation, by the Washington law
firm Patton Boggs, which would seek to have individual short
sellers detail their short positions in periodic filings. The
claim being made is that this would level the playing field,
but as we discussed earlier, the playing field is already
tilted sharply against the short seller. Such disclosure
requirements would serve only to make targets of individual
short sellers and likely drive them out of business. Some
publications are designed specifically for the purpose of
creating short squeezes which can be exploited by traders and
mutual funds who know that short sellers cannot defend
themselves from escalating prices by selling on downticks. Most
companies simply ignore short sellers, recognizing that there
are differences of opinion in free markets, and go about their
business.
Chairman Baker. Can you wrap up?
Mr. Rocker. In light of Mr. Lamont's findings, it is
interesting to see which companies will be part of this
coalition. I am just about finished.
The reason the Williams Act requires the filing of a 13D is
to alert a company that someone is accumulating more than 5
percent of their shares and may be attempting a creeping
tender. There is no such threat from a short position, as being
short does not give anyone any vote or any authority
whatsoever.
Given the positive contribution by short sellers and the
evident shrinkage in their number, it is hoped that
consideration should be given to truly leveling the playing
field by modifying the uptick rule to make is less restrictive.
This would contribute to greater stability in today's
electronically-driven markets. Short selling plays an important
role in public capital markets. Any additional bias in favor of
long investors will further erode this important counterweight.
Short selling is an important investment tool as part of a
proper risk reduction investment strategy. The marketplace not
only understands the benefit of short selling, in fact it
requires it. I thank you for your time and your attention. I
would be happy to answer questions.
[The prepared statement of David A. Rocker can be found on
page 159 in the appendix.]
Chairman Baker. Thank you, sir. Mr. Lamont and Mr. Rocker,
from your testimony it would appear that you view the short
selling world different and distinctly in character from that
of the equity side. Is it not sort of a logical thing that you
follow the money; that when the analysts were trumpeting the
longside to drive prices up, there was a reason for that. Is it
your view that the same manipulative forces do not work on the
short side of the ledger as well? That reporting of information
adverse to a corporate outlook has financial consequences of
value to those engaged in that activity.
Let me characterize the question properly. I see
extraordinary value in short selling. I think it performs a
market function that we should foster and encourage, but the
reasons for the disparity in reporting of the historic
misconduct is a democratization on the side of equities, with
the limitations on the number of people who can successfully
participate in the hedge fund activity, and a view by some that
if rich people lose money, so what. So the Chairman appeared
here today of the SEC and indicated we do not even know how
many of these funds there are, much less what they are doing.
In the absence of that information, how can we then draw the
conclusion that one side is good and the other is bad. Can you
respond to that?
Mr. Lamont. As a theoretical matter, of course, you might
expect manipulation to take place on the long side and the
short side. Certainly, there is manipulation that takes place
on the short side, it is just rare given that so few people
ever short and it is so hard to short, and given that the firms
really control information; you know, if you are Enron you
control the flow of information going out of Enron.
Historically, it has been the long side that has done the
manipulation and has done the fraud.
Chairman Baker. But that has been the result of
expectations by the broad consumer group wanting to get in on
what was perceived to be the 15 to 20 percent rate of return.
You threw money and did not ask the questions. That was because
it was open to the smallest of investor and the lowest dollar
denomination possible. Whereas on the other side, it is a much
more restrictive world in which the losers are folks of
considerable assets, generally speaking. So I am just trying to
frame it. You may be absolutely right, but it would appear on
the statistical data available we have not sufficient sampling
on the short side to really know how equitably or efficiently
it works as related to the volume of information available on
the long side. Is that fair?
Mr. Lamont. You are thinking about manipulation, right?
Chairman Baker. Those activities which are not conducive to
good public policy.
Mr. Lamont. The SEC and the other regulatory bodies, the
NYSE and the NASD, do have full powers; they have the power to
investigate manipulation and they do investigate manipulation
on the short side. As Mr. Rocker mentioned, there are all kinds
of limitations. There are many extra limitations on short
selling that are not true on going long.
Chairman Baker. On overt misrepresentation of fact or
manipulation of corporate performance which is known not to be
accurate, certainly. I think the Chairman spoke rather at
length this morning, though, to the veil that appears to be
between him and his agency and understanding what really is
happening in that sector of the market. I am not picking
arbitrarily on you two guys, but we do not have enough
information, at least in my perspective, to make those absolute
clear determinations between the two sectors of the market. I
think both are extraordinarily important for our overall
economic vitality.
Let me jump to the other side, because we have been here
awhile, and I certainly want to get to Mr. Kanjorski as well.
Mr. Mauldin, following your logic about the openness of the
market to all who choose to come, that would lead me to the
next question. What about suitability requirements period? I
mean, why don't we let everybody; the young person cutting
grass for three bucks an hour; invest his money wherever he
sees fit. Is that the logical end conclusion of not having some
criteria for investing?
Mr. Mauldin. The answer is yes. But under the framework
that I am proposing, and I have got it in my written statement,
what I would suggest is that opening up hedge funds to the
average investor does pose some risks. The primary risk that it
poses is that investors look at the great returns and jump into
the funds not understanding and having no background for that.
I think there ought to be a period of about seven to ten
years where average investors could only invest in this new
hedge fund investment company if they passed some program
showing that they were suitable; showing that they could
understand hedge funds; or if they went through a broker or an
investment adviser who passed appropriate tests showing that
they understood hedge funds. So you give that seven to ten year
period to allow investors to begin to get used to the different
types of risk that hedge funds pose.
It is not a matter of risk or no risk. Every market has
risk. It is just you get to choose which risk you want. So as
investors become aware of it and understand those risks, they
say yes, I want that risk as opposed to the risk in stocks or
bonds.
Chairman Baker. So you would suggest we proceed, but
proceed with caution.
Mr. Mauldin. Absolutely. Hedge funds are not investment
nirvana. They have got all sorts of risks. I spend a great
portion of my day every day investigating hedge funds trying to
find out where the risks are. Some of them are very scary. I
would not for a minute suggest that they are not. But you
choose your risk. That is why investors now have a 401k that is
a 201K. They had very limited options.
Chairman Baker. We have a dilemma in the sense that hedge
fund information is generally deemed as proprietary, and if we
disclose what we do our competitors will then encroach on our
market diminishing our profitability.
Mr. Mauldin. I am sorry to interrupt, but I think that is
kind of a false idea. It is amazing how much information; you
can go on my Web site. I have got a due diligence document with
well over 100 questions that I ask a hedge fund when I go in.
It is amazing what they will tell you.
Chairman Baker. But it is also amazing what they won't.
LTCM said give me a million dollars and go away for a few years
and do not call me.
Mr. Mauldin. If you invested in LTCM, you got what you
deserved.
Chairman Baker. Yes, but you could not get behind the
screen to determine what you were buying.
Mr. Mauldin. But the point is that under a hedge fund
investment company that I would open up to the public, you do
not allow companies that do not open up in. You require the
disclosures. You require the transparency.
Chairman Baker. Even sophisticated lenders; insured
depositories; were throwing money at them because they had
three years of back-to-back successful investment activities
without a two-day back-to-back trading loss until the demise.
Mr. Mauldin. Let us look at what happened to Long-Term
Capital. You had very smart managers who took highly
concentrated positions in markets that they could not easily
exit. That is the same thing that happened in the mutual fund
Janus 20, where investors lost $10 billion as they had
technology stocks that they could not get out of. It is not a
matter of risk or no risk. It is a matter of choosing your
risk. You still have to have transparency and disclosure; you
absolutely have to have that.
Chairman Baker. I am not disagreeing with you. I am
pressing you because it just begs the question perhaps, but it
is alright for everyone to defend their home; it is another
thing to give a loaded hand-gun to a six-year-old. I think that
is where we are trying to balance the equities. When do you
understand the risk you are taking, and when is it advisable
for us to require more information to be made available so that
an educated person can take the risk that is advisable for
them?
Mr. Mauldin. I think that part of the cure here is to
require disclosure and to require more information. I would do
that within the context of the hedge fund investment company.
You allow the hedge funds to disclose. Here is what we do. Most
hedge funds, they are businesses. They have very
straightforward premises; we do this; we are seeking this type
of return; and this is the way we go about it. It is not more
difficult to understand than a Cisco or a General Motors or a
GE.
You just simply give the investors, the individuals the
opportunity. To simply say that somebody; I mean, I have people
who have MBAs in finance. I cannot tell them about hedge funds
because they do not have $1 million. Most of the members of
this committee, I could not talk to you about the hedge funds
that you are overseeing because the laws say that I am not
allowed to tell you about these funds because you are not
sophisticated enough. These are very strange rules.
Chairman Baker. But I agree with that rule.
[LAUGHTER]
Mr. Kanjorski?
Mr. Kanjorski. You can tell us about it. We just cannot
engage in it.
Mr. Mauldin. I cannot. No, sir.
Mr. Kanjorski. You mean you cannot even tell me what you
do?
Mr. Mauldin. I can tell you what I do, but I cannot talk to
you about a specific fund.
Mr. Kanjorski. No, not to recommend that we get into it
because I am not a qualified investor.
Mr. Mauldin. I am not even supposed to discuss a specific
fund or a specific investment with somebody who is not an
accredited investor, and not deemed suitable for that
investment.
Mr. Kanjorski. Yes, carrying your logic to a further
extent, maybe this committee should pass a law barring Bill
Bennett from casinos.
Mr. Mauldin. It could happen.
Mr. Kanjorski. The question I have, we are not in the
business of guaranteeing people a return or protection on their
investment. We should be in the business of making sure there
is not fraud and abuse.
Mr. Mauldin. Absolutely.
Mr. Kanjorski. And that hopefully opening up markets to
qualified individuals, but this whole idea of giving a test;
are you serious? I mean, you don't give anybody a test when
they walk into a casino, and yet 90 percent of them lose money
when they walk into a casino. I have sat at card tables and
have been absolutely awed when people will split two tens. Any
book you read on it will mathematically tell you that is a
stupid bet, but people have a right to make a stupid bet.
People have the right to buy stupid things.
Mr. Mauldin. If this committee decided that we should open
up the investment world and wanted to allow anybody in without
having some deemed suitability, that would be the committee's
decision. There are a number of courses that are offered by
independent academic institutions that would prepare somebody
to be able to analyze the risk in hedge funds. I personally
think they should do that before they buy stocks, but that is a
different story.
Mr. Kanjorski. Going to the retailization of this whole
thing; isn't there enough money in the hedge funds now, $650
billion, a growth of 10 times in 10 years? Isn't that enough
money? Why are we worried about encouraging or opening the
market to more people or more money?
Mr. Mauldin. It is not about how much money is in the hedge
funds. It is about the fairness of the situation. This is all a
matter of equity. Why should a rich person have an advantage
that a less-richer person does not? Why do the rich get the
best deals?
Mr. Kanjorski. Rich people who derive their riches from
financial transactions are usually smarter people, too, aren't
they? I mean, there is some correlation there.
Mr. Mauldin. I deal with a lot of those people and I am not
certain that is true; except for my clients, of course.
[LAUGHTER]
Mr. Kanjorski. It may not be true, but they are rich enough
to pay the tuition to lose.
Mr. Mauldin. That is correct. Investors are rich enough to
pay a tuition to get in their 401K and put it in an index fund
that drops 40 percent.
Mr. Kanjorski. From the experiences I have heard before
this committee for the last several years, all of us seem to
brag about how many more people are in the equity markets. I am
not certain that that is something we should be bragging about.
I am not certain that more than 50 percent of the people have
the financial sophistication to be in the equity markets. But I
am not going to bar them from being there. I think that is the
marketplace. They lose, that is their tuition.
Hopefully they are smart enough that they only have to lose
one time. But if they want to play, I do not see the role of
government in all these things. What is our role that we have
to force very sophisticated organizations that have put
together a program to invest, and now we have got to force them
to tell the whole world what; I think that is what the Chairman
was getting at; what their thought process is and what they are
going to do and how they are going to it, so that their
competitor can read that. Is that our system?
Mr. Mauldin. That is not what I am suggesting. I am saying
that this is a voluntary thing. You would not require every
hedge fund to register. You would offer hedge funds that would
like to broaden their base the opportunity to register. I do
not want to disturb the status quo. I want to create a new
hedge fund investment company.
Mr. Kanjorski. I would suggest then the very sharp hedge
funds. They probably do not have a heck of a lot of difficulty
attracting capital if they are making a lot of money and they
have a long history record of being successful. I imagine
people are knocking on their doors hoping to qualify and let
them take their money and invest it and get a high return. Why
are we so interested in putting this in a retail business to
suggest that we want to bring a lot more money into hedge
funds, and why do we want to get a lot more less sophisticated
people into hedge funds as a government policy? I do not see
that is our role. I would rather build fences from people
jumping over cliffs, rather than paving roads to cliffs.
Mr. Mauldin. I still think is comes back to an issue of
fairness. Hedge funds have clearly out-performed mutual fund
stocks. There is no question about that. Why should a smaller
investor simply because he does not have $1 million, and the
real practical limit is $4 million to $5 million; it is not $1
million; why should smaller investors be prevented from sitting
at the same table as a rich person? Why shouldn't they have
access to the best managers in the world?
Mr. Kanjorski. Well, I just came back from my office and I
read a scam where eight of my constituents were scammed out of
about $1.2 million. When you read the scam, and you read the
level of sophistication of these people, you have no wonder why
they were scammed. To encourage them into what I would think is
the Ph.D area of investment, with the idea that instead of
getting a sounder return on a safer investment, they are going
to go out seeking the higher return with the idea that these
people; hedge funds do lose money, don't they?
Mr. Mauldin. Hedge funds do lose money.
Mr. Kanjorski. Some very wealthy people sometimes lose a
lot of money? They are not guaranteed to make money.
Mr. Mauldin. That is correct, but I think here again you
have the assumption that all hedge funds are equal. We have
lumped them into the same class. Some hedge fund are very, very
boring, very, very stable. My favorite styles of hedge funds
invest in bonds, and they have been able to take out the
direction risk of bonds and give their investors very stable
returns. You invest in them not because you want to shoot the
moon or you are wanting 15 or 20 percent, but because you want
a steady 7 or 8 percent. Why shouldn't investors be allowed to
do that?
Mr. Kanjorski. I am not sure it is the role of government
to make everything fall under the rule of egalitarianism. I do
not recognize that as a capitalistic concept. Generally,
capitalism is winners and losers and people that are shrewder
make shrewder investments, and they prove their way into the
market. I certainly do not want to encourage middle class
average families betting their retirement or their kids' funds
on a hedge fund because they can get 5 percent more return on
their money, possibly. I am not sure that is good public
policy.
Mr. Mauldin. I would reply that the government is already
involved. It is involved because it has excluded people from
the table. And the second thing is, all the academic studies
show that the choices that mom and pop have today for their
children's education funds are much riskier than hedge funds.
So you are only giving your constituents and voters; you are
giving them choices of more risky things. By opening them up to
some of the hedge fund strategies that are available to the
rich, you would actually be helping them improve their
retirements and their college education funds. Right now, they
have bad choices.
Mr. Kanjorski. You would recommend if there is ever a
success in privatizing Social Security, we allow these Social
Security people to take some of their money and put it in hedge
funds?
Mr. Mauldin. If you privatize it and you would allow them
to put their money in stocks or bonds or international stocks,
then hedge funds would be appropriate.
Mr. Kanjorski. So stocks or bonds are riskier than hedge
funds? Is that your view?
Mr. Mauldin. Clearly. Absolutely. I presented the evidence
in my statement. We compared bond funds to hedge fund
strategies. Again, you have got to be careful when you say
``hedge funds.'' There are dozens of different styles of hedge
funds, and some of them are very risky and I would not put
French money into them. Some of them are very, very stable,
well managed, well run funds.
Mr. Kanjorski. We just had the commissioner tell us he is
not sure he is going to be able to define what a hedge fund is.
Mr. Mauldin. That is a very good point.
Mr. Kanjorski. If you are going to have a hard time
defining it, we are going to have a hard time keeping people in
or out of whatever these 6,000 or 7,000 entities are. Until we
can define it, it seems to me we are not in a very strong
position to be able to regulate it in a reliable way. Just to
open them up for the benefit of allowing middle class people to
make a little bit more money; never become wealthy, but make a
little bit more money, contingent with how that may be on also
losing a great deal more money, I think it is a tough
proposition. We have some folks here who are opposed apparently
even to short selling. That is too risky.
Mr. Mauldin. I think short selling is a very risky
proposition. Mr. Rocker, I think, will tell you so.
Mr. Kanjorski. Well, it is risky, but does the government
belong in the world of saying you cannot do a risky thing? I
mean, it is risky for someone to take a cruise on a cruise
liner who cannot swim, but that is not for us to say you have
got to administer a test after you buy your ticket and prove
you can swim in case the liner goes down. That is a risk of
life. They have to be smart enough to protect themselves. Other
than that, we are going to have to hire an awful lot of
government people to walk around holding the hands of other
people who do not want to feel that they have to make these
decisions themselves; that it is up to the government to guide
them along the way to success or life.Yes?
Mr. Lenzner. We are not saying we want to eliminate short
selling. That is not even on the agenda. What we are saying is
that there has been a history and a pattern and practice of
abuses in the short selling industry, combined with their
alliance and working with the plaintiffs bar, which has
damaged----
Mr. Kanjorski. Do you have very clear evidence of that?
Mr. Lenzner. Yes, sir. We have very clear evidence. We have
several cases.
Mr. Kanjorski. How many plaintiffs bar have been disbarred
because of that conspiratorial action?
Mr. Lenzner. The plaintiffs bar firm I am talking about
today is currently under Federal investigation in the Los
Angeles U.S. Attorney's office.
Mr. Kanjorski. I would imagine anybody who made a statement
that there may be a conspiracy would cause a Federal
investigation. Investigations do not amount to anything unless
there is an indictment and conviction.
Mr. Lenzner. Yes, right, and they are still investigating
it.
Mr. Kanjorski. Yes, but don't hold up because, quote, they
are being investigated. Hell, we investigate all kinds of
things here. I would hate to conclude that everyone we talk
about or investigate is guilty of something improper, wrong,
immoral or illegal. That is not the case.
Mr. Lenzner. This practice conducted by the short sellers
with the plaintiffs bar has flown under the radar screen. There
are only monthly aggregate reports so people do not know
exactly what they are doing.
Mr. Kanjorski. You mean the exchanges and the regulators do
not have the authority to examine?
Mr. Lenzner. Of course they do, but my opening statement
was this process, these activities have flown under their
regulatory radar screen.
Mr. Kanjorski. Well, you are here now. You are in the
public. You are on the record. You have a Congressional Record
you can send to the New York Stock Exchange and say here is the
testimony I have given. I have incontrovertible evidence. I am
available as a witness to testify. I am sure there are some
Attorneys General at the State level or at the Federal level
that are anxious to make a reputation.
Mr. Lenzner. I hope that is right. I was appearing here
hoping to get the interest of the committee to have an
oversight relationship with the SEC on this issue because it
has gone below the radar screen so long, and because there are
numbers of American companies who have been very seriously
damaged by misinformation being put out about the company,
followed up by litigation which generally can be successful or
not successful. I am not defending the companies that have been
talked about before; Tyco and WorldCom.
I am talking about companies that are generally not given
information about the short sellers except on a monthly basis.
They are under short attack. They are not aware of it. They are
not aware of information being put out, and they are not aware
that the information may be coming from inside their own
corporation that is being disseminated outside. So my question
for the SEC is, if a short seller is gathering information from
a current employee and the information is material and non-
public, is that a violation of the inside information rule? I
have talked to several senior SEC lawyers.
Mr. Kanjorski. Is it correct information? Is it true?
Mr. Lenzner. Some of it could be true. Some of it----
Mr. Kanjorski. Now we are getting very close to First
Amendment and privacy rights and everything. I am not sure----
Mr. Lenzner. I do not understand that, congressman. If it
is a tip from inside the corporation, it is material non-public
information, why isn't that inside information being used to
trade and is in violation of----
Mr. Kanjorski. That is part of the free market methodology
of cleaning our markets in a way. I mean, we cannot depend that
government or regulators are always going to be able to keep
everybody on the top and narrow. But if there is a company out
there that is claiming it has product in warehouses and they
are empty warehouses, and one of their inside people tells
somebody, that is the market and will penalize that company
dearly. I am not sure that I would like to go and say no, we
are going to penalize the insider information and we are going
to allow that company to continue to have warehouses that have
no product that they are representing as product.
You tell which is worse. I think having companies that have
a gag rule on everything and can perpetuate all kinds of frauds
would be worse than having a short selling operation; I think
you have to worry. If you are a CEO and you are pulling some
gimmick, you better be darn certain how few people know about
it. If enough people know about it in your company and it is
going to leak out, and you are going to get raided in a short
sale, that is your problem. That is good enforcement. That is
the capitalist market. You got stuck. We did not have to spend
one cent for a prosecutor. We did not have to send the FBI
down. We did not have to do anything. You just got cleaned.
Mr. Lenzner. What is the difference between that and the
investigation of Martha Stewart for when she was on a long
position selling because she has heard the stock is going down?
Mr. Kanjorski. I do not have a lot of sympathy for the
crucifixion of Martha Stewart.
Mr. Lenzner. I am just saying, what is the difference
between investigating her for that and investigating a short
seller who does exactly the same thing?
Mr. Kanjorski. I doubt very seriously if her name were not
Martha Stewart there would have ever been an investigation.
Mr. Lenzner. All I am trying to do is show an example of an
investigation into somebody who traded on a long position; why
should that be any different than somebody who traded on a
short position?
Mr. Kanjorski. It should not be any different, but
unfortunately if you are; who is that crazy guy Jackson; you
know, you just have to do a crazy thing and put a mask on and
you make headlines. If I did the same thing he did the other
day, nobody would pay any attention to it. That is just; we
cannot get into regulating and controlling that. I hope we do
not, because we are going to need so many people working down
at the SEC there are going to be more employees at the SEC than
there are investors.
Chairman Baker. Let me jump in. Let me try to put all of
this into a basket and I will recognize you. I think it is
clear from the comments of the Chairman this morning, of the
SEC, we are operating in a fashion that is clearly handicapped.
We do not have enough information, I do not think, to make
decisive determinations about, one, whether additional
disclosure should be required; whether the regulatory
environment is or is not adequate; whether or not there are
manipulative forces at work on this side of the ledger. We have
not as a committee ever examined this subject before. Today's
hearing is not to reach an end determination, but to begin a
lengthy process of examination. While we await the SEC's
initial report, hopefully either before or just after the
August recess, at which time I think we need to really delve
into the issue of separating the hedge funds from the hedge
hogs. That is what this is all about.
There has been an enormous growth in the market. There are
significant growth in resources being invested. And there are
pension funds pouring money into these activities, which appear
to be somewhat veiled and if not transparent, they may be
translucent even to the smart, sophisticated investor, and we
have work to do. I do not dispute at all what Mr. Kanjorski is
saying. We do not want to be in the business of running hedge
funds as a SEC or as a Congress for sure. There is a vital role
for them, but we would have some action for our own
constituents to look at us rather caustically if we were not to
conduct this examination, given the enormity of their
appearance in the marketplace.Yes, Mr. Rocker?
Mr. Rocker. Yes, I would just like to say a couple of
things. The growth of hedge funds is not something that is
stimulated by hedge funds seeking clients, but conversely by
clients seeking hedge funds.
Chairman Baker. You make my point, and that was the same
reason for the growth in the equity market. It was not the fact
that the equity people were out there necessarily dialing up
everybody. You had lots of folks with cash in the bank or even
worse, borrowing money at 8 percent and investing it because
they did not want to miss the 20 percent rise.
Mr. Rocker. That is right.
Chairman Baker. What we want to ensure is that we have
enough knowledge that that same effect is in fact not occurring
on the other side of the ledger sheet.
Mr. Rocker. Right. I do want to state for the record that
there are a lot of things which are not subject to conjecture,
but are empirical fact. Hedge funds have out-performed mutual
funds. They have been more safe. They have in fact on a
collective basis had much lower volatility, and so perhaps the
smaller investor should have an opportunity to invest in hedge
funds in an appropriately regulated fashion, if that is
Congress' will. But there is not an issue of how they
performed. Number two, with respect to longs spreading false
rumors versus shorts spreading false rumors----
Chairman Baker. Let me jump back to that first conclusion.
There is no question that hedge funds are functioning properly.
In a broad, categorical statement, yes; as hedge fund to hedge
fund, there may be questions.
Mr. Rocker. For sure. But as far as not knowing what the
industry is or its size, there are large indices. For instance,
CS FirstBoston Tremont has an index which covers about 80
percent of the assets. Those are where the statistics are
coming from. So you may miss a little, but you certainly know
what is happening with most. It is as good as the Investment
Institute.
Shorts are a convenient scapegoat after a market has cost
investors $7 trillion. The point that I was trying to make in
my statement, and I wish to reiterate now, is that we should be
looking at what got us to the level from which people lost so
much money. The biases are entirely on the side of the bulls.
Regulations are in place which allow any fraudulent activity,
whether it be by a short seller or long, to be subject to
prosecution. They should be aggressively pursued. But the
record is clear, the prosecutions and more importantly the
findings of such has overwhelmingly been on the side of longs
pushing bogus stocks as opposed to shorts spreading bad
stories.
I would invite anybody who doubts this to look on the Web
sites and chat boards of the Street to find people who are
hiding behind anonymous names who, by the way, include
corporate officers spreading positive stories about their own
stocks. It is a wholly biased field. To the extent that you
further restrict the very few people who are willing to go at
risk, the short sellers, with their own capital, I believe you
would be making a great mistake and risking the public savings
of this nation to a greater degree.
Chairman Baker. Thank you, Mr. Rocker. Mr. Kamenar?
Mr. Kamenar. Mr. Chairman, I just wanted to make a point
about the transparency issue that was raised about information.
I think we all agree that transparency is a good thing. In
1991, the House Government Operations Committee, as I stated in
my written testimony, recommended that daily and weekly short
selling data activity and interest be obtained from broker
dealers and be made available electronically; daily and weekly
activity at a minimum.
This is in 1991 that the Government Operations Committee
recommended that. Yet today, it is a 30-day or monthly report,
and during that monthly period, as Mr. Lenzner testified, a lot
of short activity could be going on that the CEO or the company
and other investors do not know about. The committee also
issued a report in 1991 on short selling and agreed that the
SEC's uptick rule was valuable as a price stabilizing force,
and encouraged Nasdaq to adopt a similar restriction, which
they did in 1994.
So there are certain things that the committee and the
Congress can do that assists investors to stabilize the market
without necessarily being the nanny state for certain
unsophisticated investors.
Mr. Rocker. That is all part of the asymmetry of the
market. There is an uptick rule preventing sellers from selling
it down. There is not a downtick rule preventing buyers from
cascading stocks up, especially in today's electronic
marketplaces where you can use ECNs to sweep markets at various
levels. That is what got stocks to 130 times earnings for the
Nasdaq 100. That is when the mutual funds were sucking in a
tremendous amount of the savings of this nation which was
subsequently destroyed. That is what should be investigated.
Chairman Baker. You gentleman have raised a panoply of
issues which are going to take us some while to unwind, if it
is possible. Since we are talking about something we cannot
define that nobody seems to regulate, that nobody can explain
how they performed so well, for which so many dollars are
invested, we have got a lot of homework ahead of us.
Let me express my appreciation for your longstanding
patience in the hearing today. The bells have just gone off for
votes on the floor, but the committee would reserve the right
to forward additional questions, particularly in light of Mr.
Kanjorski's line of questioning on specifics of allegations
relating to activities that each of you might have raised from
different perspectives. We look forward to working with you in
the months ahead toward resolution of this important
matter.Thank you very much.
[Whereupon, at 1:02 p.m., the subcommittee was adjourned.]
A P P E N D I X
May 22, 2003
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