[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) 512ï¿½091800  
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                 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

                              ----------                              
                                                                   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

                              ----------                              


                         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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