[Senate Hearing 108-396]
[From the U.S. Government Printing Office]



                                                        S. Hrg. 108-396


                   RECENT DEVELOPMENTS IN HEDGE FUNDS

=======================================================================

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED EIGHTH CONGRESS

                             FIRST SESSION

                                   ON

THE RECENT DEVELOPMENTS IN HEDGE FUNDS (AN INVESTMENT COMPANY THAT USES 
HIGH-RISK TECHNIQUES, SUCH AS BORROWING MONEY AND SELLING SHORT, IN AN 
   EFFORT TO MAKE EXTRAORDINARY CAPITAL GAINS), FOCUSING ON INVESTOR 
                              PROTECTION 
   IMPLICATIONS, THE DIFFERENCES BETWEEN HEDGE FUNDS AND INVESTMENT 
 COMPANIES, REGULATION UNDER FEDERAL SECURITIES LAWS, AND CONFLICTS OF 
                                INTEREST

                               __________

                             APRIL 10, 2003

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


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                            WASHINGTON : 2003
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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire        THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina       DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island      JON S. CORZINE, New Jersey

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

                  Doug Nappi, Republican Chief Counsel

                   Dean Shahinian, Democratic Counsel

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                  (ii)
?

                            C O N T E N T S

                              ----------                              

                        THURSDAY, APRIL 10, 2003

                                                                   Page

Opening statement of Chairman Shelby.............................     1

Opening statements, comments, or prepared statements of:
    Senator Sarbanes.............................................     2
    Senator Sununu...............................................     5
    Senator Corzine..............................................     5
        Prepared statement.......................................    31
    Senator Dole.................................................     6
        Prepared statement.......................................    31
    Senator Dodd.................................................     6
    Senator Hagel................................................     6
    Senator Allard...............................................     6
        Prepared statement.......................................    32
    Senator Carper...............................................    18
    Senator Schumer..............................................    23

                                WITNESS

William H. Donaldson, Chairman, U.S. Securities and Exchange 
  Commission.....................................................     7
    Prepared statement...........................................    32
    Response to written questions of:
        Senator Shelby...........................................    40
        Senator Sarbanes.........................................    53
        Senator Sununu...........................................    63

                                 (iii)

 
                   RECENT DEVELOPMENTS IN HEDGE FUNDS

                              ----------                              


                        THURSDAY, APRIL 10, 2003

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 10 a.m., in room SD-538 of the Dirksen 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The Committee will come to order.
    Today, the Committee will be hearing from the SEC Chairman 
William Donaldson regarding the hedge fund industry. The 
immediate reason for this hearing is to get a progress report 
on the ongoing SEC oversight investigation of the hedge fund 
industry. I hope that this hearing will shed some light on 
developments within an industry that has been the subject of a 
great deal of surmise and opinion, but much less in the way of 
objective analysis.
    Despite the recent bear market, America remains a Nation of 

investors. The Internet, cable, satellite TV, and a host of 
other technological innovations have made information regarding 
the marketplace available just about anywhere at any time. We 
are all familiar with the trappings of Wall Street. But at a 
time when the floor of the New York Stock Exchange doubles as a 
set for a television show, and market analysts are TV 
personalities, hedge funds remain the last frontier, an 
uncharted area of our capital markets.
    Historically, hedge funds have been an outlier in the world 
of functional regulation. These investment pools have been, to 
borrow Winston Churchill's words regarding Russia, ``A riddle 
wrapped in a mystery inside an enigma.'' Hedge funds are not 
household names, and their managers have usually gone to great 
lengths to avoid public attention. Hedge funds operate in 
relative obscurity because they are limited partnerships, 
financed through private placements. Like all market 
participants, hedge funds are subject to the antifraud 
provisions of the Federal securities laws. However, they are 
exempt from a regulatory regime like that applied to broker-
dealers, investment-advisers, or publicly traded companies.
    Most businesses are focused on their public image and 
branding; but hedge funds have not only avoided publicity, as 
privately placed offerings, but they are also prohibited from 
advertising to the public. As private placements, hedge funds 
are the domain of extremely wealthy individuals and 
institutional investors. The securities laws deem that such 
investors have the acumen and the negotiating power to fend for 
themselves to a degree that the ordinary investor cannot. This 
is not a hedge fund-specific exemption.
    Events of the recent past have attracted unwanted attention 
to these funds. The 1998 collapse of Long-Term Capital 
Management put hedge funds on the front pages of the business 
news. In the intervening years, hedge funds have continued to 
attract media attention. Since the beginning of the recent bear 
market, much of that attention has focused on the 
``retailization'' of hedge funds, the explosive growth in the 
number of hedge funds, and an equally explosive growth in the 
number of hedge fund closings.
    During the recent bear market it appears that hedge funds 
have had positive, if not spectacular, results. However, 
positive returns have been enough to attract a flight of 
capital from more traditional market investments. And the 
generous fees that hedge fund managers earn has been enough to 
attract many of the best money managers. The desire to retain 
talent has led many mutual funds to establish affiliated hedge 
funds.
    As we consider these issues today, I believe it is 
important to remain mindful of the important role that hedge 
funds continue to play in our capital markets. Hedge funds are 
a liquidity source that permits capital to seek higher rewards, 
regardless of the overall market environment. They can provide 
expert management for patient capital that understands, and can 
bear the risks associated with seeking higher returns. However, 
when these funds are made available to less sophisticated 
investors through mutual funds, investor protection concerns 
arise that deserve careful consideration. These so-called 
``funds of funds'' must provide sufficient transparency and 
protection for their customers.
    The growth of an indirect retail market and other recent 
trends in the industry pose a number of investor protection 
issues. For instance, are retail investors receiving sufficient 
disclosure regarding their investments in so-called ``funds of 
funds.'' Is the conflict posed by comanagement of hedge funds 
and mutual funds being properly managed? Are any hedge funds 
using the opaqueness of the private placement to misuse or 
mismanage funds entrusted to them? The Committee looks forward 
to answers to this and other questions.
    I commend the SEC for its efforts to undertake this 
important and timely review of the hedge fund industry and look 
forward to Chairman Donaldson's testimony before the Committee 
today.
    Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Mr. Chairman. I want 
to commend you for holding this morning's important hearing on 
hedge funds. I join with others in welcoming Bill Donaldson, 
the Chairman of the SEC.
    I think this is your first opportunity to come back and 
testify before the Committee since your confirmation.
    Chairman Donaldson. It is, indeed.
    Senator Sarbanes. So let me extend a warm welcome to you, 
Mr. Chairman.
    I also want to note that just yesterday, the Senate 
approved the SEC Civil Enforcement Act, which was incorporated 
into the Care Act of 2003. This Civil Enforcement Act will 
strengthen the SEC's authority to prosecute securities fraud 
violations and will augment investor protection. Chairman 
Donaldson was very strongly in support of it, and we appreciate 
that strong support.
    This is legislation that the SEC's Enforcement Division has 
sought and it will contribute to their holding securities law 
violators accountable for their actions. We look forward to 
working it through the balance of the legislative process and 
providing those additional civil enforcement tools to the SEC.
    Mr. Chairman, in September 1998, the collapse of Long-Term 
Capital Management drew international attention to hedge funds. 
The Economist called it, ``One of the greatest financial 
failures of all time. The hedge fund's losses were spectacular: 
around $4 billion in 5 weeks. . . . The fund's implosion came 
perilously close to causing a catastrophic failure of the 
global financial system.'' That is The Economist, a staid, 
responsible magazine. Obviously, the collapse of Long-Term 
Capital Management raised very important issues of systemic 
risk and excessive leverage.
    Since that time, hedge funds actually have grown 
tremendously. Industry sources reported that, ``Since the turn 
of the century, the hedge fund industry has grown by 82 
percent, from $324 billion to $592 billion,'' and, in the last 
10 years, the number of hedge funds has grown from about 1,100 
to 5,700. Fortune reported that Warren Buffet has said, ``Hedge 
funds have become the latest Holy Grail.'' At the same time, 
according to The Financial Times, ``Fifty percent of all new 
hedge funds closed down within about 3 years of starting up.'' 
The growth in the industry has been accompanied by an increase 
in fraud and in the number of SEC enforcement actions.
    Hedge funds used to be investments for the very wealthy. 
Hedge fund managers sold only to, ``accredited investors,'' 
those who earned more than $200,000 per year, or had more than 
one million dollars in assets, which enabled them to take 
advantage of an exemption in the securities laws.
    However, the market for hedge funds has greatly expanded 
and spawned funds of funds. Fortune reported that, ``Funds that 
make investments in hedge funds are peddling themselves to less 
accredited investors as well--dentists, school principals, and 
the like--for minimum stakes, as low as $25,000. What is more, 
a huge group of shareholders may be in hedge funds and not even 
know it--America's retirees, through their retirement plans.''
    This raises some concerns about investor protection. 
Chairman Donaldson, at his confirmation hearing before this 
Committee on February 5--and we keep going back to that 
transcript, Chairman Donaldson, as our reference text as we 
deal with the SEC--referred to ``A distressing move toward what 
I would call the retailization of hedge funds, making them 
available to smaller and smaller investors . . . less 
sophisticated investors not realizing the risks inherent in the 
vehicle.'' And Chairman Donaldson went on to note that hedge 
funds are ``pretty much totally unregulated.''
    The SEC and other Federal regulators have been looking at 
these issues for some time. In 1999, the President's Working 
Group on Financial Markets issued a report titled, ``Hedge 
Funds, Leverage, and the Lessons of Long-Term Capital 
Management.'' In that report, the Working Group recommended 
that: First, hedge funds be required to ``disclose additional, 
more up-to-date information to the public'' through periodic 
reports. Second, public companies should publicly disclose 
``summaries of direct material exposures to significantly 
leveraged financial institutions.'' And third, financial 
regulators, including the SEC, should encourage improvements in 
the risk-management systems of securities firms.
    More recently, the Commission initiated a major 
investigation into the hedge fund industry. And I appreciate 
and commend the attention and interest that Chairman Donaldson 
is now devoting to this area.
    I gather that the SEC, in the middle of next month, is 
going to be holding a series of like roundtable discussions 
with respect to hedge funds.
    Let me just note, there are many important issues to 
consider, particularly as they relate to retail investors. 
These include: The suitability of offers and sales of hedge 
funds to retail investors. The adequacy of information 
available to such investors about their investments and their 
fund managers. Regulation of hedge funds offered to retail 
investors. Conflicts of interest that may arise where a firm 
manages both mutual funds and hedge funds. Conflicts of 
interest that may result with the higher fees charged to 
investors in hedge funds.
    There have been a number of articles about the problem with 
this, when you do both mutual funds and hedge funds and how, on 
the part of the managers, that raises important conflict 
questions.
    Other issues which have been consistently raised by 
commentators include: The valuation of hedge funds and the 
reporting of fund performance. The leverage associated with 
hedge funds. The potential systemic risks associated with the 
failure of a large hedge fund. To go back to the Long-Term 
Capital Management situation, the adequacy of market 
surveillance to protect against potential market manipulation 
by hedge funds, again, I think an interesting and important 
question. The lack of information about the size and activities 
of the hedge fund industry, including the rate and causes of 
hedge fund failures. Possible preferential treatment that 
brokerage firms give hedge funds. And whether the minimum 
wealth levels of the exemption for sophisticated investors 
should be revised. And I think this is only the beginning of 
the questions that need to be asked.
    Regarding the importance of hedge fund markets, Fortune 
magazine in a recent article entitled, ``Where The Money Is 
Really Made,'' stated that, ``The hedge fund boom has sweeping 
implications, not just for Wall Street traders and a few 
thousand well-heeled investors, but, increasingly, for every 
American business person, investor, and retiree.''
    We look forward to hearing and learning more about these 
potential ``sweeping implications.''
    Mr. Chairman, I want to commend you again for scheduling 
this hearing and launching the Committee on oversight with 
respect to this important issue.
    I simply close by going back to The Economist's description 
of the implications of the collapse of Long-Term Capital 
Management. We have to be alert to the risks that might occur 
on our watch. The Economist, said then, talking about Long-Term 
Capital Management, which they regarded as one of the greatest 
financial failures of all time--``The fund's implosion came 
perilously close to causing a catastrophic failure of the 
global financial system.''
    And of course, it is the responsibility of all of us, the 
Commission, this Committee, and other financial regulators, to 
make sure that we are not at risk of such consequences.
    Thank you very much.
    Chairman Shelby. Senator Sununu.

               COMMENTS OF SENATOR JOHN E. SUNUNU

    Senator Sununu. Thank you, Chairman Shelby. I just want to 
thank you for holding this very important hearing. I have no 
opening statement, Mr. Chairman. I am anxious to hear the 
Chairman's testimony.
    Chairman Shelby. Senator Corzine.

              STATEMENT OF SENATOR JON S. CORZINE

    Senator Corzine. Thank you, Mr. Chairman. I have a formal 
statement for the record.
    Chairman Shelby. It will be made part of the record in its 
entirety, without objection.
    Senator Corzine. Thank you. Let me express my appreciation 
for your holding this hearing. And particularly, let me thank 
Chairman Donaldson for his attention to an issue that I think 
all of us would be well served to have an oversight and 
understanding of as it fits into our economic system.
    As one that has benefited and participated along with an 
industry called the hedge fund industry, and seen its evolution 
from a pretty straightforward long/short structure of investing 
to maybe some of the most complicated elements of investing 
that have ever been put together, say as Long-Term Capital has 
been noted, this is really something that I think we need to 
understand in the context of our economic system today, the 
$600 billion number cited, the number of funds, the 
proliferation is really quite substantial.
    And I think there are a number of issues that--and I heard 
Senator Sarbanes talk about investor protection issues, 
investor suitability, the retailization, funds of funds 
structure really changing the whole nature, fee structures on 
top of fee structures, that may or may not be understood by 
some of those that participate, market integrity issues, 
conflicts of interest that can come from mutual funds and hedge 
funds being managed by the same people.
    Maybe one of the most serious issues is there is no 
standardization of evaluation. So how is it easy to compare one 
fund to another that I think deserve consideration and some 
transparency of discussion about.
    We talked about market stability and potential for systemic 
risk. Anybody that was seriously close to the Long-Term Capital 
situation has to know that the derivative position really takes 
that $600 billion number and explodes it into an extraordinary 
amount of potential impact for markets.
    If you looked at the notional amount, not necessarily the 
only way to look at exposures and financial systems. But when 
you add the notional amount of some of the derivative positions 
associated with a cash position of $600 billion, you are really 
talking in the trillions of dollars of impact in the 
marketplace in a realistic sense.
    And I do not think that we can have such an important 
element of our financial system completely outside of some 
oversight and understanding by those that provide protection 
for the system.
    I think this is a very useful beginning and the kinds of 
things that the SEC is doing with its roundtable discussion, 
are important. Getting the right balance so that we do not 
damage our system is equally important.
    But we no longer have a very narrow, single-dimensional 
element in our hedge fund community. I am not exactly sure how 
you even define a hedge fund these days. And I think we need to 
have a better understanding of how they operate and their 
impact on the market.
    I look forward to this hearing and continued discussion on 
improving the safety and soundness of our system. And I 
congratulate having this hearing and, again, Chairman Donaldson 
for his efforts along these lines as well.
    Chairman Shelby. Senator Dole.

               COMMENT OF SENATOR ELIZABETH DOLE

    Senator Dole. Mr. Chairman, in the interest of time, I will 
submit my written statement for the record.
    Chairman Shelby. Your statement will be made a part of the 
record, without objection.
    Senator Dodd.

            COMMENTS OF SENATOR CHRISTOPHER J. DODD

    Senator Dodd. Mr. Chairman, let me, just to move things 
along, apologize for racing in here. Let me catch my breath and 
ask for uninamous consent to add my statement to the record.
    Chairman Shelby. Without objection, it is so ordered.
    Senator Hagel.

                COMMENTS OF SENATOR CHUCK HAGEL

    Senator Hagel. Mr. Chairman, thank you. I have no statement 
at this time.
    Welcome, Chairman Donaldson.
    Chairman Shelby. Senator Allard.

                COMMENTS OF SENATOR WAYNE ALLARD

    Senator Allard. Mr. Chairman, I do have a statement that I 
would like to make a part of the record.
    Chairman Shelby. Without objection, it is so ordered.
    Senator Allard. I would just comment that hedge funds have 
a specific purpose in controlling risk. But once we get beyond 
that and they are looked at as more of an investment portfolio, 
then I have some real concerns. It takes someone really 
knowledgeable to manage these sorts of derivatives.
    I want to thank you for holding this hearing. It is very 
timely.
    Chairman Shelby. Senator Dodd.
    Senator Dodd. Mr. Chairman, just a couple of comments.
    I think it is important with the schedules that we all keep 
around here, people coming and going, and we may not get the 
chance to express some of our general thoughts and comments on 
this. So, I thought I would take a minute, if I could, with the 
Committee's indulgence, just to share a couple of thoughts on 
the subject matter.
    I want to thank you, Mr. Chairman, for doing this. This is 
exactly the kind of hearing that we should be holding and you 
are to be commended for placing this as high on the agenda and 
as early in the year as you have, and I thank you for doing 
that. It is tremendously helpful. We have to stay in touch with 
all of these critical issues. And this is a critical component 
of our financial markets, and so it is extremely important that 
we look at it.
    I also want to thank Chairman Donaldson. This is your first 
appearance since your confirmation hearing before this 
Committee, and we thank you for being here with us today.
    It is going to be appropriate and important for us to 
review our securities laws, including the various exceptions to 
those laws that are operating. And that is what we are going to 
be talking to you about today, in no small measure.
    Hedge funds, as has been noted, play a very important role 
in our capital markets and I think all of us would agree with 
that. But given the unsupervised nature of the industry, it is 
necessary I think to closely examine two very important 
features.
    First, is it possible for hedge funds to become so highly 
leveraged, to the point that they can create systemic risk? Or 
has the market and the regulators learned lessons from previous 
events?
    Second, are hedge funds, which were intended to be used by 
the most sophisticated of investors, being inappropriately 
marketed to those who do not understand the nature of the risks 
associated with hedge funds?
    While we want markets to continue to be creative and 
entrepreneurial, we at the same time bear a responsibility to 
protect the unsophisticated investors not only from fraud and 
deception, but also unsuitable financial investments. That is a 
difficult standard to meet, but certainly one that we should 
debate and discuss.
    While there are other aspects of hedge funds that should be 
reviewed, I would urge the Chairman, in his ongoing examination 
of hedge funds, to pay particular attention to these points, at 
least from my perspective.
    So with those points in mind, Mr. Chairman, I thank you 
again for doing this today. It is extremely worthwhile and 
important.
    Chairman Shelby. Chairman Donaldson, we again welcome you 
to the Committee and we believe that you will be coming back 
and helping us along on other issues.
    Please proceed as you wish. Your written statement will be 
made a part of the record in its entirety.

               STATEMENT OF WILLIAM H. DONALDSON

       CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION

    Chairman Donaldson. Chairman Shelby, Ranking Member 
Sarbanes, and Members of the Committee, I would like to make 
just a brief statement here and then get to a number of the 
questions that have been implied.
    I just want to thank you, first of all, for inviting me to 
discuss some of the investor protection implications of hedge 
funds and the Securities and Exchange Commission's ongoing 
fact-finding investigation into this area. I appreciate the 
opportunity to discuss this 
important subject with you.
    Over the past few years, hedge funds have become more 
prominent and more popular. It is estimated that there are 
close to 5,700 hedge funds operating in the United States 
today, managing approximately $600 billion in assets. In 
contrast, in 1990, only about $50 billion was under management. 
There are frequent reports of high returns for hedge funds. 
Just as frequently, these reports highlight possible areas of 
concern, such as the potential conflicts of interest, valuation 
concerns, questionable marketing techniques, including, as you 
mentioned, the possible retailization of hedge funds, prime 
brokers, possible fraud in the hedge fund industry, and the 
market impact of hedge fund strategies.
    Since June 2002, the SEC staff has been engaged in a review 
and investigation of the structure and practices of hedge 
funds. The Commission is still at the fact-gathering stage and 
have yet to reach any conclusions. But I want to report that I 
have ordered us to move to the next stage of our investigation, 
and we will be holding, as you noted, important public 
roundtables on May 14 and 15.
    A little bit of history. Hedge funds have been around in 
some form since the establishment of the Jones Hedge Fund in 
1949. The term ``hedge fund'' is undefined, including in the 
Federal securities laws. Indeed, there is no commonly accepted 
universal meaning. As hedge funds have gained stature and 
prominence, the term ``hedge fund'' has developed as a catch-
all classification for many unregistered, privately managed 
pools of capital. These pools of capital may or may not utilize 
the sophisticated hedging and arbitrage strategies that 
traditional hedge funds employ, and many appear to engage in 
relatively simple equity strategies. Basically, many hedge 
funds are not actually hedged, and the term has become a 
misnomer in many cases.
    The last time the Commission took a really good look at the 
hedge fund industry was in 1998, when, as you mentioned, the 
Connecticut-based hedge fund, Long-Term Capital Management, 
nearly collapsed.
    Senator Dodd. You had to say Connecticut, didn't you.
    [Laughter.]
    Chairman Donaldson. Sorry, Senator.
    [Laughter.]
    There are lots in other States.
    After that incident, the Commission, along with the 
Treasury 
Department, the Federal Reserve, and the Commodity Futures 
Trading Commission, as part of the President's Working Group on 
Financial Markets, issued a report on the risk management and 
transparency issues raised by Long-Term Capital Management, in 
particular, and by highly leveraged institutions in general. 
The President's Working Group looked at such issues as the 
firms' adherence to their own stated policies, their margin and 
collateral requirements, their use of leverage, and whether it 
was excessive, and how well their risk models functioned. The 
report made serious recommendations that were intended to 
improve how firms functioned in these areas; and, based on our 
examination of the major brokerage houses that service hedge 
funds, many institutions extending leverage to hedge funds seem 
to have taken these recommendations to heart.
    In addition to this examination of the risk management and 
transparency issues, the Commission staff actively supported 
the work of the Multidisciplinary Working Group on Enhanced 
Disclosure and the subsequent Joint Forum Working Group on 
Enhanced Disclosure, which the Commission chairs, and is 
ongoing. Both groups address issues of enhanced disclosure for 
financial intermediaries, such as banks, securities firms, 
insurance companies, and hedge funds. We believe that many in 
the hedge fund industry are considering the recommendations of 
these two groups and contining to explore ways to improve some 
of their practices.
    Nevertheless, the markets have continued to evolve, and I 
believe the time has come for us--the SEC and the President's 
Working Group, of which the SEC is a part--again to review 
these risk management, transparency, and public disclosure 
issues. As part of the SEC's ongoing investigation into the 
operations of hedge funds, we are also addressing issues from 
the perspective of investor protection and looking into other 
issues related to the overall market impact of hedge fund 
practices.
    Our current investigation is proceeding. The SEC staff have 
obtained and reviewed documents and information from 67 
different hedge fund managers representing over 650 different 
hedge funds and approximately $162 billion under management.
    The staff has spoken to brokerage, compliance, risk 
management, legal, and other operational personnel of 
multibillion-dollar complexes with dozens of employees, as well 
as to their portfolio managers. And, at the other end of the 
scale, the staff has visited hedge funds where one employee 
serves as the marketer, the portfolio manager, the trader, the 
operations officer, and the risk manager.
    Aside from our inquiries directed to the specific hedge 
funds, the staff has met with a variety of experts in their 
respective fields to get their perspectives on the hedge fund 
industry. In addition to the legal and accounting experts, the 
staff has spoken with chief investment officers, risk managers, 
prime brokers, representatives from foreign regulators, trade 
industry representatives, and hedge fund consultants. Also, a 
number of foreign jurisdictions are revisiting their approaches 
to hedge funds, and we continue to benefit from discussions 
with our foreign counterparts.
    In conclusion, let me just assure you that our goal in this 
exercise is to determine how we can better protect investors 
and our securities markets. By working together, I believe that 
we can achieve this goal.
    And I want to thank you again for inviting me to speak on 
behalf of the Commission. It is a subject that interests me 
considerably, and I would be happy to answer any questions you 
have.
    Thank you.
    Chairman Shelby. Thank you, Mr. Chairman.
    Chairman Donaldson, your investigation at the SEC is 
looking at investment managers who handle both hedge funds and 
mutual funds. How common is it for managers to have both types 
of funds under their control?
    Chairman Donaldson. I think there is an increasing number 
of registered advisers who manage mutual fund complexes and so 
forth getting into the hedge fund industry in one form or 
another.
    I do not think that that was particularly prevalent as 
recently as 5 or 6 years ago. But, as a number of trends have 
come into view, particularly the competition from the hedge 
fund industry with the mutual fund industry, I think that they 
have been forced to go into that business.
    Chairman Shelby. What type of disclosure do these 
investment firms typically make to investors in the mutual 
funds?
    Chairman Donaldson. Well, I am going to go to a few--if I 
can find it in my little book here----
    Chairman Shelby. Take your time.
    Chairman Donaldson. --the regulations. And I do not want to 
get into too much detail. But let me just try and categorize 
for you.
    The hedge funds basically avoid regulation by meeting 
criteria that are laid out in four general exclusions or 
exceptions.
    We have the Investment Company Act of 1940, and there is an 
exclusion there. And some of the managers that you are talking 
about, mutual fund managers, come under that Act. But there is 
an exclusion for the hedge fund part. There is an exemption 
from the registration under the Securities Act of 1933. There 
is an exception from registration by the hedge fund manager 
under the Investment Advisers Act. And there is an exception 
from reporting requirements under the Securities and Exchange 
Act of 1934.
    Under each one of those categories, there are different 
ways that hedge fund managers can get themselves out from being 
regulated. I can go into more detail if you want, but it gets a 
little complex in terms of the numbers.
    Chairman Shelby. Sure, it does.
    Chairman Donaldson. But under Section 3(c)(1) of the 
Investment Company Act of 1940, there is an exclusion if a fund 
has no more than 100 investors and there is no public offering. 
If you can keep your number of investors under 100 and there is 
no public offering, you are excluded from regulation under that 
Act.
    Another section of the Investment Company Act, 3(c)(7) has 
been more recently passed. There is no limit on the number of 
investors up to a practical level of about 500. But investors 
must be qualified purchasers, and they must be high net-worth 
individuals. And under Section 3(c)(7), only high net-worth 
individuals, generally individuals who own certain specific 
investments worth at least $5 million in investments may 
invest; and again, there can be no public offering.
    Then there is the exemption under the Securities Act of 
1933. And under that exclusion or exemption, hedge funds 
generally can sell their securities only to those who qualify 
as accredited investors; individuals, as you mentioned earlier, 
with a minimum of $200,000 annual income, or $300,000 taken 
into consideration with spouses, and a minimum of $1 million in 
net assets.
    Might I add that, as time has gone on, those criteria which 
were set up a long time ago have moved a lot of people into 
those categories, if you will, who weren't there before.
    Chairman Shelby. Sure.
    Chairman Donaldson. Under the Investment Advisers Act, 
hedge fund managers, because they are providing advice about 
securities of others, fit into the definition of an investment 
adviser. However, an adviser with fewer than 15 clients and 
that does not publicize itself generally as an investment 
adviser is not required to register with the Commission. And 
that has the effect under our rules that the hedge fund itself 
counts as one client and not the number of investors in the 
fund.
    So, you can have quite a few investors in that fund.
    Chairman Shelby. Mr. Chairman, are mutual fund investors 
apprised of the existence of a hedge fund affiliate? Are there 
existing requirements for this kind of disclosure under the 
securities laws?
    Chairman Donaldson. I do not want to give a definite answer 
to that.
    Chairman Shelby. Do you want to do it for the record?
    Chairman Donaldson. I would like to come back to you and 
give you an answer on that. I think that if it is there, it is 
pretty spotty.
    Chairman Shelby. Spotty, at best.
    Chairman Donaldson. Spotty.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. Thank you very much, Mr. Chairman.
    I have to say as I listen to Chairman Donaldson run through 
the litany of the various securities legislations and the 
exemptions and exceptions that exist, you have this uneasy 
sense of people laying these statutes out in front of them and 
then charting their course through the exemptions and the 
exceptions, and leaving us all with an uneasy feeling that 
there are ticking timebombs out there.
    Therefore, again, I underscore the timeliness of this 
hearing. And I want to commend Chairman Shelby because he is 
obviously operating under the old adage that an ounce of 
prevention is worth a pound of cure. And I think we have to be 
very mindful of that in this instance.
    Chairman Donaldson, USA Today, just in January, only a few 
months ago, reported that Harry Edelman, the CEO of Farmer Mac, 
had talked about possible market manipulation. He said, ``We 
have no problem with the publication of legitimate research. 
But when short-sellers publish misinformation for the purpose 
of enhancing their positions, we find that objectionable.'' And 
he went on to accuse certain hedge funds of orchestrating a 
disinformation campaign.
    The Wall Street Journal, in an article about the same date, 
entitled, ``Regulators Review Complaints About Hedge Funds,'' 
identified additional companies which have complained that 
various hedge funds were working in concert to spread negative 
information about their stock.
    What is the Commission doing to detect and to prevent 
market manipulation by hedge funds and other market 
participants?
    Chairman Donaldson. Under our Market Regulation Division 
and the Enforcement Division, we are constantly looking at 
allegations of market manipulation.
    I think that the issue before the House today is how the 
market can be manipulated--there are cases of market 
manipulation obviously going on all the time, and I think we 
are on top of those.
    The question is, how much of that can be attributed to the 
specific vehicle, the hedge fund? And as I have indicated, 
there is a pretty broad spectrum that we are talking about. I 
think the investigation we are doing now, and the focus that 
will come from our seminars and roundtables and so forth, will 
give us a lot better feel for how much can be attributed to 
hedge fund techniques.
    Senator Sarbanes. Are the roundtables the concluding step 
with respect to your study that can then lead to 
recommendations and action?
    Chairman Donaldson. We are certainly not having them to put 
into the volumes and put on the shelf. I think it is very 
important that we give an opportunity to all sorts of people 
who are involved in this business to talk about the way that 
they are operating their funds.
    This is, I think you will see, a mix of people that we are 
bringing together. Some will be critical of the hedge fund 
industry. Some will be very defensive of their records. And we 
are trying to sort that out, and I think we are trying to get 
at that--and we do not expect that anybody will come before us 
and talk a lot about how they manipulate the market. So, we are 
going to have to depend upon our own investigative powers to 
get at whether hedge funds are manipulating the market.
    Senator Sarbanes. The NASD only a couple of months ago 
issued a Notice to Members entitled, ``NASD Reminds Members Of 
Obligations When Selling Hedge Funds.''
    And they went on to say in that Notice: ``As a result of a 
recent review of members that sell hedge funds and registered 
products, closed-end funds that invest in hedge funds, so-
called funds of hedge funds, NASD staff is concerned that 
members may not be fulfilling their sales practice obligations 
when selling these instruments, especially to retail 
customers.''
    Now what was the conduct by stock brokers that led the NASD 
to issue this Notice? And what is the SEC doing about more 
closely monitoring sales practices, or taking other appropriate 
actions?
    Chairman Donaldson. As you know, an entire division of the 
SEC is charged with monitoring and reviewing the sales 
practices of registered broker-dealers.
    I do not know of that specific instance that you referred 
to there, but I think we probably discovered evidence--or the 
NASD did--that made them feel that they should investigate and 
then caution.
    I do feel that we are watching very closely--with an 
adherence to the regulations I just mentioned--to make sure 
that people who are not registered are properly taking 
advantage of those various exclusions.
    Having said that, the ability to combine smaller and 
smaller investors into these pools has been enhanced. And I 
think that is right on point here; practices used to sell hedge 
fund investments to a less sophisticated person. You can get 
down to a pretty small amount of money--a relatively small 
amount of money--and still get into one of these funds.
    Senator Sarbanes. My time is expired. I presume we will 
have a second round.
    Chairman Shelby. We will.
    Senator Sarbanes. But just on this final point, I think we 
may have to close the door on some of those exceptions or 
exclusions, or define them in such a way that they accommodate 
what needs to be accommodated, but aren't utilized or 
manipulated for other purposes that may endanger the stability 
of our markets.
    Presumably, the Commission is taking a look at that.
    Chairman Donaldson. I think you are absolutely correct that 
we have to reexamine the various levels and parameters of 
exclusions.
    I will say that I believe we have to be careful in terms of 
the word risk because you can meet hedge fund managers who will 
explain to you why their hedging techniques accomplish just the 
opposite, how the risk parameters of what they are doing makes 
them less risky, let's say, than a common stock or a mutual 
fund.
    Chairman Shelby. But you cannot take the risk out of the 
marketplace, not all of it, anyway, can you?
    Chairman Donaldson. No. But in theory--and I am going to 
show my age now--I remember Mr. Jones way back in that period 
of time when he started the first hedge fund. His thought was 
that, if you are going out and analyzing companies and you find 
good companies to invest in, but, during that process, you find 
companies you think are not so good, if you put equal amounts 
of money into both sides and insulate yourself from overall 
market risk. And then added to that was leverage, and it took 
it on from there. But the idea was risk minimization, not risk 
acceptance.
    Chairman Shelby. But not elimination of risk.
    Chairman Donaldson. No. And, as we have seen in Long-Term 
Capital Management and so forth, the risk has been enhanced 
through leverage on that end of the spectrum.
    Chairman Shelby. Thank you.
    Senator Sununu.
    Senator Sununu. Thank you, Mr. Chairman.
    Mr. Chairman, it seems to me there are two broad concerns 
here. The first involves Long-Term Capital Management and what 
came out of that crisis. They were able to leverage themselves 
to a very large degree with the cooperation of public 
institutions. And there is a lot of discussion about the 
systematic risk that may or may not have come from their 
collapse.
    But to the degree that there was systematic risk or 
potential for systematic risk, it was because they were allowed 
to leverage themselves up to such a high level with the 
cooperation of those public institutions and what their 
collapse might mean to the public institutions.
    And the second is another set of issues that we have also 
been talking about, which is the degree to which retail 
investors, uninformed investors, ``unsophisticated investors'' 
described by the statutes, are being exposed to the risks that 
are inherent in some of these funds inherent to the markets, 
and that is what the Chairman was talking about.
    These are both important issues to discuss and to 
understand, but I see them as somewhat distinct.
    First, let me touch on the issue that grew out of Long-Term 
Capital Management. This was a case where we had not just some 
large Wall Street firms, but the largest, most prestigious, 
most well-regarded Wall Street firms providing a tremendous 
amount of leverage, a tremendous amount of debt to a fund 
manager. So, you could argue that these were the most 
sophisticated investors under any statute, and yet, they made 
some extremely poor business decisions with regard to leverage.
    It seems to me that the one thing, or maybe the most 
important thing that came out of this was I guess the 
recognition that just because you have a Nobel Prize in 
economics or you have earned a lot of money on Wall Street, you 
are not going to necessarily make good investment or policy 
decisions no matter where you are working.
    Second, the OCC then did take steps to establish guidelines 
for lending of financial institutions. Is that correct? And can 
you describe the guidelines that came out of this issue? I 
think they were posted in 1999.
    Chairman Donaldson. Yes, I think that, on the end of the 
spectrum that you are talking about, a great deal of progress 
has been made as a result of Long-Term Capital's near-demise 
and the work that was done after that by the President's 
Working Group.
    I think that we feel that the firms, the investment banking 
firms and banks which supply leverage, if you will, have much 
tighter restrictions now.
    Senator Sununu. And could I ask you to provide some 
description of those new guidelines that were put forward by 
the OCC for the record?
    Chairman Donaldson. Sure.
    Senator Sununu. Just so that we have them in all of their 
glory.
    With regard to the individual investors or smaller 
investors, however we want to describe them, I think it is 
important to frame this discussion as understanding that there 
are existing regulations.
    There is the 1940 Act and we talk about exemption from 
regulation. But what we are really providing is a different set 
of regulations, regulations having to do with limits on income, 
the $200,000 threshold, limits on the assets, the million-
dollar threshold.
    I think, like anyone else on this Committee, as you were 
going through the different cases, when you have fewer than 
100, fewer than 500, it is quite complicated. Perhaps too 
complicated. And that may be one of the problems, when you have 
so many different sets of circumstances, each with their own 
set of guidelines as to who is sophisticated and who is not 
sophisticated, yes, good minds, whether here in Washington or 
on Wall Street, will find a way to utilize those different 
rules effectively to arbitrage the regulations and to find a 
way to fit into the cracks.
    I would hope that, to the extent that you are looking at 
these rules in a comprehensive way, we look at ways that we 
might simplify them so that you can apply them more 
consistently and more effectively.
    One specific question about the million-dollar net worth 
provision that is covered under the Act of 1940. When was that 
million-dollar threshold established? Was that part of the 
original Act in 1940, or was it revised since then? I assume it 
was revised. But how old is that threshold?
    Chairman Donaldson. Much more recently 1982.
    Senator Sununu. So, 1982. Which is important because, at 
least in terms of the framers of the statute, a million dollars 
in 1982----
    Chairman Donaldson. That is a long time.
    Senator Sununu. I have never had a million dollars. Some 
Members of this Committee have had a million dollars. Some 
Members still have a million dollars.
    [Laughter.]
    But I do know enough to understand that a million dollars 
the year I graduated from high school is not the same as a 
million dollars today. So, I do think that that may bear some 
evaluation or consideration as you go through this process.
    Last, in the reading that I have done, some of these hedge 
funds or partnerships, are registering with the SEC, which I 
was interested to find. By registering with the SEC, they are 
covered by yet another set of regulations. And I understand 
registering with the SEC actually allows them to accept an even 
lower contribution and reduces the income thresholds for 
investors even further. That seemed counterintuitive to me to 
go in and register with a regulatory body. But somehow, that 
allows you to become involved with investors. That actually 
increases the concerns or makes you have a greater exposure to 
some of the concerns that we just talked about.
    What does registering a hedge fund with the SEC mean, and 
what does it get you if you are a fund manager?
    Chairman Donaldson. I think principally what it does is 
allow us, the SEC, to get inside the techniques that are being 
used. In other words, it opens the front door for us and allows 
us to come in and examine exactly what it is going on. It also 
puts disclosure parameters on those funds. In other words, 
disclosure of what their techniques are to the public. What 
they are doing, how they are doing it.
    Senator Sununu. There is a firm public reporting 
requirement associated with that registration.
    Chairman Donaldson. That is generally what it allows us to 
do. And as a matter of fact, that probably is something that we 
must really examine in terms of the whole industry. Again, we 
have a lot of work to do on this, and I do not want to get 
ahead of the Commission or ahead of the staff. But I will say 
that, at the end of the day, we need to know more about what is 
going on in these institutions.
    Senator Sununu. And I appreciate the concern for 
information. But I do believe that, at a certain level, the 
sophisticated investors, where you are talking about a limited 
partnership, the investment managers are selling their internal 
knowledge, their expertise, their investment capability.
    To the extent that they have to disclose daily, weekly, 
even monthly, what their positions are, that takes away from 
the value of the advice that they are providing. Also, it can 
be counterproductive. And to that end, I ask a simple question. 
That is, with all of this discussion of manipulation, we 
usually go after the short-sellers. If you force everyone to 
disclose today their short positions in every stock that they 
held, every short position that they held, do you think that 
that would increase or decrease the likelihood of market 
manipulation? That is a yes or no.
    Chairman Donaldson. The kind of disclosure that I am 
referring to, in response to your earlier question, was and is 
that it allows us in the front door.
    Senator Sununu. I understand that. And I am not suggesting 
that you support making everyone disclose their short position. 
However, my point is, I believe it makes the market more 
subject to manipulation. The point is disclosure does not 
always make for a better, more coherent market with a greater 
level of integrity, because exposing every player's position at 
a particular time can make them and the markets more subject to 
manipulation.
    Chairman Donaldson. I could not agree with you more.
    Senator Sununu. Thank you, Mr. Chairman.
    Chairman Donaldson. Thank you.
    Chairman Shelby. Senator Corzine.
    Senator Corzine. Thank you, Mr. Chairman. I am actually not 
aware of any rule that requires even registered broker-dealers 
to disclose their short position. I do not think that that is 
the kind of disclosure that is in the realm of the various 
degrees of what one could consider with regard to whatever the 
term regulation means. But I guess that is a point for a 
different time.
    What oversight, what perspective does the SEC have at all 
with those companies that have, as Senator Sarbanes said, 
weaned their way through that maze of four or five regulation 
exclusions?
    What is the SEC's ability to look into the activities? Or 
do you have to have a perceived or charged fraud to be able to 
take a look at the books and records? Are there any audit 
trails? What kind of authority does the SEC have today?
    Chairman Donaldson. Well, I would say, generally speaking, 
we do not have as broad authority as we would like. However, we 
have total authority in instances of fraud and manipulation and 
external manifestations of market manipulation, et cetera, to 
go in and do something about it.
    Senator Corzine. And how would you----
    Chairman Donaldson. What we do not have authority over in 
many instances is the accounting that is used in hedge funds, 
the way they are organized, the whole panoply of other things.
    Senator Corzine. Hedge funds required to maintain an audit 
trail, so that when you go in----
    Chairman Donaldson. We do not have the authority to audit 
or examine the audit of hedge funds under these exemptions, 
unless we can prove some fraud on investors.
    Senator Corzine. How do you, in a first instance, is it 
word of mouth that there is a potential fraud? Or how would you 
recognize it, that a fraud was taking place?
    Chairman Donaldson. There are a lot of different ways.
    Clearly, we monitor the markets. The self-regulatory 
agencies monitor the markets. We are constantly on the look-out 
for market manipulation. People write or call the SEC. People 
complain all the time and we examine and follow-up those 
complaints of alleged manipulation. So, we have many, many 
sources, not unlike the sources we have on potential problems 
outside of the hedge fund industry.
    Senator Corzine. And within the regimen of the regulated 
elements of the industry, you are suggesting that that is the 
same way you find market manipulation or fraud? Or is it more 
likely to be done through the audit process, either of the 
self-regulatory agencies or the Agency?
    Chairman Donaldson. There are all sorts of definitions of 
manipulation. You are focusing in now on market manipulation. 
But there is the possibility that the accounting techniques 
that are used to value securities in a hedge fund----
    Senator Corzine. Is there a standard for----
    Chairman Donaldson. We do not have the authority now to get 
at that, unless from some other source we have been told that 
there has been fraudulent accounting being used in this 
investment vehicle. Then we can go after it.
    Senator Corzine. One final question. I am a little unclear 
on what the term, retailization, which I have used myself on 
occasion, what does that mean?
    Chairman Donaldson. Very catchy. What that means is, it 
analogizes large institutional investors investing in hedge 
funds to a wholesale market. It says that there is a retail 
market also, and that refers to people with lesser assets.
    And what we are seeing through the more recent changes in 
the rules is the ability to package and register hedge funds 
for smaller investors.
    Senator Corzine. Can you give us some dimension of what you 
might think people have been able to access retail----
    Chairman Donaldson. These are still, I suspect, fairly 
large amounts of money to most people in America. Twenty-five 
thousand dollar participation is a lot of money to a lot of 
people. That may be retail to Wall Street, but it is a lot of 
money. So, you are still at that level. You are not down in the 
real mass market of $1,000, $5,000 investment.
    Senator Corzine. But well below $1 million set in the 1933 
Act.
    Chairman Donaldson. Well below, yes.
    Senator Corzine. Or the $5 million set in--I think it was 
actually the 1996 Act.
    Chairman Donaldson. Yes.
    Senator Corzine. Thank you.
    Chairman Shelby. Senator Dole.
    Senator Dole. Mr. Chairman, has the SEC done any studies as 
to the extent to which retail investors are investing in 
registered investment companies which are investing in hedge 
funds? To what extent has any work been done to tell us the 
extent of this?
    Chairman Donaldson. Well, we are gradually getting a handle 
on it. The statistics have a tendency of being repeated over 
and over again as being true.
    I use the statistic that there are 5,700 hedge funds out 
there. I am not sure that that is an exact figure. And so, we 
are zeroing in on that, and we are going to zero in, as best we 
can, with the resources we have, on just how much retail 
investment is either there or about to be there.
    Senator Dole. Okay. And how can these registered investment 
companies calculate valuations which are not required by the 
underlying hedge fund? Has this presented a problem for 
registered investment companies?
    Chairman Donaldson. I think that this is a real issue, 
which is, as I mentioned before, looking at the valuation 
techniques that are being used.
    Again, you may have a fund of funds, a fund of hedge funds, 
if you will; and, within that fund of funds, there may be a 
spread of hedge funds from some very large ones with a lot of 
history into the more speculative end of the spectrum. 
Depending upon what kind of investments the more speculative 
end is making, the valuation aspect becomes increasingly 
important.
    We have seen this in the derivatives market. We see that 
the issue of how you value what you own is a huge issue because 
it is in many ways in the eye of the beholder. If you own a 
huge amount of stock, and the last sale is $50 of that stock 
and you have a zillion dollars' worth of it, is it worth $50 
for purposes of your statement or is it worth something below 
that if you had to sell it all at once? I think that is an 
issue that we see in the valuation of these more sophisticated 
instruments, not just common stocks.
    Senator Dole. Right. And some have argued that if subject 
to regulation, hedge funds would quickly ``move'' offshore. 
They would move out of U.S. markets. What is your view on that? 
And what do you believe the removal of hedge funds would mean 
to our securities markets?
    Chairman Donaldson. Well, I think that is an issue that 
gets brought up. I think I would go back to the fact that most 
of these hedge funds have their investors in the United States 
and they are investing in U.S. securities, and we have a good 
reach into that.
    Insofar as the investments are made in offshore, non-U.S.-
regulated companies, and, insofar as the investors are not U.S. 
citizens, we have no reach there, unless they somehow come into 
our markets and use our markets and buy and sell U.S. 
securities.
    But I think that it is an issue that we have to be careful 
about because I think that what we need is more information. We 
need to remember, and I am not talking about the retail end of 
this, that some investors want to accept more risk. It is very 
hard to make a universal rule as to how you run a hedge fund 
because you defeat the very purpose of the fund.
    So, we have to remember that there is a market out there 
for a riskier and potentially higher potential return 
investment. And getting at just exactly how we come out of all 
of this, I think we will be very mindful of what you are 
saying.
    We do not want to drive the business out of this country.
    Senator Dole. Okay. Thank you, Mr. Chairman.
    Chairman Shelby. Senator Carper.

              COMMENTS OF SENATOR THOMAS R. CARPER

    Senator Carper. Thanks, Mr. Chairman.
    Chairman Donaldson, welcome. How are you holding up in your 
new job?
    [Laughter.]
    Chairman Donaldson. Sipping from the fire hose, as they 
say.
    [Laughter.]
    Senator Carper. I have sipped from a few of those myself. 
It is not much fun. Hopefully, the volume will come down a 
little bit.
    Thanks for your willingness to serve and we wish you well. 
What do we need to be doing here to help you in your job? You 
have been there a while. What more do we need to be doing to 
help you do your job well?
    Chairman Donaldson. That is a very good question. I 
appreciate this Committee's interest. I appreciate the 
opportunity that it gives us now, and I hope in the future to 
speak in a public forum about exactly what we are doing.
    I think that to have this hearing is a good start for us, 
to give you a baseline as to where we are. And I think once we 
get done with our seminars and have a chance to continue the 
work that has been going on, I think we will be able to come 
back to you with the thoughts we have. And you can take it from 
there in terms of whether you like our thoughts and whether you 
might give us whatever we need to implement whatever we 
conclude.
    Senator Carper. How many weeks have you been on the 
payroll?
    Chairman Donaldson. Pardon.
    Senator Carper. How many weeks have you been on the payroll 
now at the SEC?
    Chairman Donaldson. Eight weeks and 2 days.
    [Laughter.]
    Senator Carper. All right. But who's counting?
    [Laughter.]
    Senator Sarbanes. Hours and minutes, too.
    [Laughter.]
    Senator Carper. What have you learned so far that has 
surprised you?
    Chairman Donaldson. I am sorry, I did not hear you.
    Senator Carper. What have you learned so far that maybe 
surprised you a little bit?
    Chairman Donaldson. On the hedge fund side of things?
    Senator Carper. No, no, just broadly. More broadly.
    [Laughter.]
    Chairman Donaldson. Have you got a few minutes, Senator.
    Senator Carper. About five.
    [Laughter.]
    Chairman Donaldson. Well, I am constantly amazed and 
interested in the number of cases, enforcement cases that come 
before the Commission at the lowest level in terms of scams, 
manipulations, pyramid schemes, all things, involving large 
amounts of money perpetrated on unexpected investors.
    I am amazed. Having been in the business all my life, I 
find it hard to recognize that that is out there, and it 
continues to be out there. You cut off the head of one and 
something pops up over here.
    I think the Commission is doing an outstanding job of 
getting at that. And, if I might thank you, we are going to 
have more resources to do that.
    Senator Carper. I was going to ask, in terms of the 
resources that you need and what you are getting, is the 
balance getting better in terms of what your needs are for 
resources to go after some of those frauds?
    Chairman Donaldson. Do we need the resources?
    Senator Carper. No. Are you getting more of what you need?
    Chairman Donaldson. Yes, we are. We are moving ahead on our 
new authorizations. Our trick, if you will, or challenge, is to 
make sure that we hire well, that we put people in the right 
spots, that we look at our organization, and that we just do 
not go out and add a lot of people.
    We are before another committee here, if I can put in a 
plug, trying very hard to get authorization so that we can hire 
accountants faster than we can right now.
    Under an exception to the rule, we can hire lawyers 
immediately. Accountants, we are really slowed down. And we 
have had an agreement with our union. We have put it before the 
House Committee, and it will come before the Senate Committee. 
We hope that we will get a rule changed that will allow us to 
hire accountants and economists and so forth, faster than we 
are right now able to do.
    Senator Carper. When we created the new Department of 
Homeland Security, we included in it provisions authored by 
Senators Voinovich and Akaka which deal not just with personnel 
issues, accommodations for that new Department, but also more 
broadly.
    I would just urge that you make sure that the people who 
work for you in the personnel area, the human resources area, 
are mindful of the kind of flexibilities that are provided for 
all agencies, including your own.
    Let me ask one specific question, if I could, about hedge 
funds.
    We spent a lot of time last year under the leadership of 
Senator Sarbanes trying to develop legislation that we now call 
Sarbanes-Oxley, that is designed, among other things, to make 
sure that investors have a better idea what they are buying.
    When an investment analyst says buy, they mean buy. When 
they say sell, they mean sell. And when they say hold, they 
mean hold. When we read financial information from companies, 
publicly traded companies, they would not just take the money 
to the bank, but actually rely on the information being 
provided to us.
    In a related area, how much information is currently 
available for hedge fund investors regarding the hedge fund 
managers, the people actually managing these funds? What do the 
investors know about the professional backgrounds of the hedge 
fund managers? What do they know about whether there have been 
any securities-related problems in the past with these hedge 
funds managers? And finally, does the SEC have, do you people 
have the sufficient information that you need about these fund 
managers?
    Chairman Donaldson. I think that the situation is rapidly 
changing. I think that because of some of the new exceptions 
that are allowed and the fact that we are seeing more funds 
registering voluntarily, if you will, there is more information 
coming down the pike in a certain segment.
    On the other hand, I think a number of professional 
investors, large institutions, are going to demand a lot more 
information from people who are trying to get them to invest in 
their hedge funds.
    I think you are going to find that some of the big pension 
funds and other professional investors who may have bought a 
hedge fund 10 years ago are going to demand now that they know 
a lot more about what is going on inside that hedge fund. That 
is a sign of a healthy market.
    Senator Carper. All right. Well, I hope that that demand 
will be met by supply in terms of information that investors 
need to make wise decisions.
    Thank you, Mr. Chairman.
    Chairman Shelby. Chairman Donaldson, you referenced some 
legislation. We are going to move that as fast as we can. We 
are going to give you the resources at the Securities and 
Exchange Commission under your leadership to do the job that 
has to be done in America.
    Mr. Chairman, before we go to the second round, I also want 
to say that we appreciate that your investigation is ongoing, 
that many of the questions that we are perhaps asking you may 
not be answerable in great detail until you complete your 
study. You mentioned this earlier.
    We would, at the proper time, after the study is complete, 
like for you to return to the Committee, and I hope you will.
    But your interim report today on your progress and the 
issues you are considering in balance has been very helpful, I 
believe even today, looking at it as an interim report.
    Having said that, I have some other questions as we start 
the second round.
    Chairman Donaldson. Sure.
    [Laughter.]
    Chairman Shelby. In your discussion of the Long-Term 
Capital Management report's recommendations regarding margin, 
collateral leverage, and risk management, and I believe that in 
your written testimony, you stated that many institutions 
extending leverage to hedge funds seem to have taken these 
recommendations to heart. Some of us are concerned by the use 
of qualifying words like many and seem.
    Should we read this testimony as indicating that the 
lessons of LTCM have been lost on some of the institutions that 
extend credit to hedge funds?
    Chairman Donaldson. Yes, I think that that is cautionary 
language. I think that we would hesitate to say that it has 
been solved across the board.
    On the other hand, that cautionary language comes from the 
fact that we are zeroing in on areas where we think they 
haven't done what they should do. And I might add, our ability 
to do that is a resource-based thing in terms of our staff time 
and so forth.
    I think the general trend is in the right direction. I 
believe that the very fact that you are having this hearing, 
the very fact that it has become such a prominent subject, 
heightens the awareness.
    Chairman Shelby. Absolutely. In the collapse of Long-Term 
Capital Management, as we look back at it, banks were willing 
to lend money with little information and basically no 
collateral.
    Given the recent surge in hedge fund investment, what can 
you tell us about the lending practices of Wall Street and 
commercial banks to hedge funds? Is there any caution out there 
now?
    Chairman Donaldson. I am not going to cop out on that 
question. I am going to say that the lending practices of Wall 
Street investment banking firms clearly fall in our purview. 
The lending practices of commercial banks do not.
    Chairman Shelby. Absolutely. But how do the banking 
regulators and the SEC that you chair interact in terms of 
monitoring this type of activity? And if they do not, how could 
you?
    Chairman Donaldson. That is an excellent question, and it 
is a question that is of concern.
    I think our President's Working Group has helped us in 
terms of talking to the other regulators. As you might know, 
and I am sure you do, as a result of Gramm-Leach-Bliley and the 
new authority that commercial banks have, there is a tension, a 
jurisdictional tension, as to who is regulating what part of 
the bank.
    And I think we are having some very constructive 
conversations about that with the Federal Reserve and with the 
Treasury.
    Chairman Shelby. Chairman Donaldson, just to lay the 
predicate, hedge funds leverage, as we know. That is part of 
their deal.
    How much they borrow compared to their capital allows them 
to earn greater returns, yet also increases the risk. What is 
the typical leverage position of hedge funds or the range of 
the leverage positions that the SEC has observed in its 
investigation?
    Chairman Donaldson. I think it is a difficult question to 
answer because the leverage borrowing, or rather, the danger of 
the borrowing, would depend upon how much hedging has been 
done. In other words, if you have a single security and you 
borrow against that versus a portfolio that is both long and 
short, perhaps you can borrow more against that than you might 
against a single security.
    And it varies tremendously in terms of the focus of the 
hedge fund itself. In a Long-Term Capital situation, they were 
dealing with debt instruments, with all sorts of derivative 
instruments on top of that, as opposed to dealing with common 
stocks or something else, and their borrowings were very high.
    Chairman Shelby. In other words, is leverage in the hedge 
fund industry, and it is all about leverage, still a concern to 
the SEC? Are there sufficient safeguards against systemic risk 
here?
    Chairman Donaldson. I think we are feeling relatively 
better about the Long-Term Capital end of the scale, if I can 
say that. And I think we need to know a lot more about the 
middle ground as to whether we are concerned.
    Chairman Shelby. Investor protection, do these funds 
receive adequate information to protect the interests of their 
investors? Do you perceive that they are having trouble 
assessing all the information that they need? In other words, 
why would a fund of funds manager invest with a hedge fund that 
would not provide all of the information needed for due 
diligence purposes? Is it just because they are hoping for the 
greater return?
    Chairman Donaldson. I think that, personally, and I do not 
speak for the Commission now, there is a need for more 
information in terms of those funds that are using the 
exemptions, that are not registering and so forth. I think 
there is a need for more information. The market will demand 
it. In other words, as we have gone through a bad stock market 
and you put your money in a hedge fund and after a couple of 
years, you have lost a lot of money, you are going to be 
demanding that you have more information as to how that money 
was lost and what are you doing now than has been true in the 
past. In a bull market, people do not really care what you are 
doing, so long as you are making money for them.
    Chairman Shelby. Sure. Mr. Chairman, are these funds of 
funds subject to the same reporting and other requirements as a 
typical mutual fund?
    Chairman Donaldson. By and large, yes, they are in terms of 
reporting. Not restrictions as to the diversification and that 
sort of thing. But in terms of reporting, yes.
    Chairman Shelby. These funds are charged fees at the hedge 
fund level and at the fund of funds level. How are fees 
disclosed by these funds?
    Chairman Donaldson. That is a major issue. You do have fees 
upon fees.
    Chairman Shelby. Sure.
    Chairman Donaldson. And whether that is properly disclosed, 
I will be able to tell you a lot better as we get into this 
thing.
    Chairman Shelby. As you finish your study, yes.
    Senator Sarbanes.
    Senator Sarbanes. Senator Schumer hasn't had his first 
round.
    Chairman Shelby. Excuse me. He slipped in over there.
    Senator Schumer.
    Senator Schumer. Quiet as a little mouse, as usual.
    [Laughter.]
    Chairman Shelby. Do you have a statement, Senator Schumer?

             COMMENTS OF SENATOR CHARLES E. SCHUMER

    Senator Schumer. Thank you, Mr. Chairman. I will be brief. 
I just have two questions and I thank you for your testimony.
    The first question is this. The record of hedge funds in 
terms of performance has been better than the general mutual 
fund market. You hear comments from average investors who do 
not meet the threshold saying they would like to be able to 
take advantage. At the same time, you want to make sure that 
they have protections so that people aren't taken advantage of. 
And it is opposite sides of the same coin.
    Do you have any thoughts, Mr. Chairman, on how we can 
extend hedge funds to be available to more average investors, 
less wealthy investors, but at the same time make sure that 
they are protected?
    Chairman Donaldson. Well, I think that is the bottom-line 
question--how do you get at what you are talking about? And how 
do you do that in a way that doesn't impede the free 
determination of what the investment objective of the fund 
would be?
    And as I said earlier before you came, there is a market 
out there for people who want to take more risk to earn more. I 
think we have to be very careful that we do not come up with 
legislation that prescribes exactly how a fund can invest.
    I think the first level here is a level of disclosure, a 
level of our having the ability to get inside these funds and 
find out what they are doing, and, if they are being sold to 
the public, that the disclosure is intelligible. And that is 
again something that we will come back to.
    Senator Schumer. Now, my second question relates to the USA 
PATRIOT Act.
    You know that there is an antimoney-laundering provision in 
the PATRIOT Act at Section 352. And can you tell us how you are 
working with the industry and other agencies to make sure that 
hedge funds are complying with the antimoney-laundering 
guidelines to make sure that someone is not figuring out, here 
is an unregulated area. Here is a way that I can get money to 
places that the law would prohibit.
    Chairman Donaldson. Yes. It is a matter of real concern.
    As you know, there have been a number of laws that target 
pure laundering of money. And those laws originally pertained 
to the banking industry, commercial banking industry and the 
financial institutions where it is pretty obvious that there 
are big cashflows in and out, readily identifiable.
    As we have moved in after September 11, I think there has 
been more thinking about other kinds of funds, where it is not 
so obvious where the money comes from and where it is going to, 
as it might be in a bank.
    I think we are making good progress. The President's 
Working Group--the Chairman of the SEC, the Chairman of the 
Federal Reserve, the Secretary of the Treasury, the Chairman of 
the Commodities Future Corporation, and our staffs--is working 
on this.
    Senator Schumer. Just one comment. This is not related to 
the hedge funds.
    I know that yesterday, a white paper came out between the 
SEC, the FED, and the OCC about New York City and the location 
of alternative sites. I thought it was thoughtful, mindful of 
New York City's position as the financial capital of the world. 
I appreciate the change in course.
    As you know, we have talked about it, as I have with 
Chairman Greenspan and the head of the OCC. I just hope when we 
do the second white paper, it will have the same thoughtful 
nature to it, mindful of New York's centrality as the world's 
financial capital. To undo that by some kind of regulation 
would not only hurt New York City--obviously, it would--but 
also the whole country.
    Chairman Donaldson. Thank you.
    Senator Schumer. So, I appreciate your careful and 
thoughtful revisions there.
    Chairman Donaldson. Thank you.
    Senator Schumer. Thank you, Mr. Chairman.
    Senator Sarbanes. Thank you, Senator Schumer.
    Chairman Donaldson, I wanted to ask about how you address 
the assertion that there is an inherent conflict of interest 
with firms running both mutual funds and hedge funds, that the 
different fee and compensation structures for portfolio 
managers, analysts, and traders provide incentives for them to 
act differently when they are managing hedge funds alongside of 
mutual funds. We have gotten a number of comments from people 
about the problems in these areas. What is your view of that?
    Chairman Donaldson. I think there is the potential for 
people who are running pools of money in one investment 
organization--on the one hand, you have regular fees, mutual 
fund kind of fees. On the other hand, you have 20 percent of 
the profits and so on. And there is certainly the theoretical 
temptation to favor one side versus the other.
    I think that any substantial investment institution that 
gives into that temptation and doesn't monitor it and doesn't 
have rules and regulations of a self-regulatory nature, it 
won't be in business very long. And if we have the right to go 
in and inspect, we check for it, and if we find it, we will 
take action against them.
    I do not want to say any more than that, other than that we 
are aware of that potential conflict and it certainly is on our 
checklist, if you will.
    Senator Sarbanes. Mr. Chairman, to sharpen the issue, let 
me just read to you some of the communications we have 
received.

    One of the most important issues is firms that run hedge 
funds and mutual funds together. Many asset management firms 
have started hedge funds in the last few years due to the much 
higher fees and less stringent regulations, but run them side-
by-side with mutual funds. They are often run by the same 
portfolio managers.
    The main reason mutual fund firms start hedge funds is to 
keep their star portfolio managers from leaving to set up their 
own fund. Some of the biggest mutual fund companies in the 
country are doing this. This practice presents incredible 
conflicts.
    Some firms use the visibility of their mutual funds on Wall 
Street to gain access to research, ideas, IPO's, et cetera, 
from the brokerage houses, but use the benefits in 
disproportion for their higher-fee hedge funds.

    I am very much concerned about this--``Some firms have been 
known to short a stock in the hedge fund, hold on to it in 
their mutual funds because they are not allowed to sell short, 
and then sell the mutual fund position at a later date, thus, 
causing downward pressure on the stock price and making the 
short position more valuable. ''
    Then they go on about the use of soft dollars to pay for 
research and information service and skewing that to the hedge 
fund. What about this short position and the implications of 
that?
    Chairman Donaldson. You know, you bring a number of issues 
up there.
    Let me just say this. On our regular inspections, under the 
Investment Advisers Act, we look at the allocation of stock 
purchases.
    In other words, if a fund group buys a huge block of stock, 
we look at how they distribute that stock into the various 
funds that they are managing. And if we see something that is 
fraudulent about that, or favoring one account over another, we 
get on that.
    I think that the same thing is true now as the hedge funds 
are in mutual fund groups. This is an age-old concern that is 
not just pertinent to hedge funds, an age-old concern of are 
you being fair in the allocation of your purchases.
    Now on the shorting side, again, I cannot react to that 
specific allegation, but we are sure hearing you. And you can 
be sure that, if that is true, we will do something about it.
    Senator Sarbanes. Presumably, part of the problem is this 
explosive growth in the hedge fund industry at a time when the 
SEC's ability to monitor was not keeping pace because of the 
shortage of resources.
    Now, you have gotten a very hefty boost in your budget this 
year and we hope for a further substantial increase next year. 
I know you testified before the Appropriations Committees on 
the budget, which would take you to about, I think, $842 
million from $468 in a fairly short period of time.
    So, we are very encouraged that we can deliver that for the 
Commission. I want to just echo Chairman Shelby's statement 
that I know the House is working on that legislation on the 
hiring process. And as soon as it comes over here, I am sure we 
will be ready to move it ahead.
    Chairman Shelby. Absolutely.
    Senator Sarbanes. How are you doing on the pay parity 
issue? I will leave aside the hiring of new people because I 
know that is related in part to the legislation.
    Chairman Donaldson. Right.
    Senator Sarbanes. But you have the authority and now you 
have the money to do pay parity for your existing employees. 
And that is important I think for morale and for not losing 
good people, and also the money to upgrade the information 
technology.
    Chairman Donaldson. Right.
    Senator Sarbanes. How are you doing on those fronts?
    Chairman Donaldson. Okay.
    Senator Sarbanes. After 8 weeks, 2 days, and--I do not know 
if I begin your day at 8 a.m.----
    Chairman Shelby. Twenty-seven minutes.
    [Laughter.]
    Senator Sarbanes. Three hours and 37 minutes, yes.
    [Laughter.]
    Chairman Donaldson. On the pay parity side, I think the 
news is good in terms of our turnover, of people we are losing. 
I forget the exact figures, but before pay parity, we were 
losing people with something like a 20-percent attrition rate. 
Since pay parity has come in, our attrition rate is down to 
about 4 percent. That may not be exact.
    Senator Sarbanes. Now, you are encompassing parity on 
benefits as well as just salaries, aren't you, in your concept 
of pay parity?
    Chairman Donaldson. Yes, I believe that is so.
    Senator Sarbanes. I certainly hope it is so because 
benefits are a very important part of the compensation package. 
I think if you do not include that in, there is still going to 
be a significant discrepancy between what the SEC is doing and 
what other Federal financial regulatory agencies are doing.
    This is only pay parity between Federal regulatory 
agencies. It doesn't even touch the issue of how much more the 
private sector can offer. But, of course, we have always had to 
contend with that. You should not be losing people to other 
Government agencies because they have been authorized to give 
pay parity and the SEC has not delivered on it.
    Chairman Donaldson. No. I think pay parity has helped a 
lot. I might add that perhaps the economy's softness makes it 
not quite as easy to leave, or desirable to leave, in terms of 
trying to be realistic about this.
    On the other hand, I think the challenges facing the SEC 
now are such that that heightens the public service instinct of 
a lot of very good people out there who want to come to work in 
an agency that is doing something good. I think we are seeing 
that, and we definitely are seeing it on the legal side in 
terms of the caliber of people that are available to us now.
    This gets back to the fact that we want to hire people and 
not just all lawyers. We want to hire these other disciplines. 
And there we are at the competitive disadvantage because we 
cannot move swiftly. And so we need some help there.
    But I think, clearly, that pay parity has helped a lot.
    Senator Sarbanes. I will just close with this.
    I think I am encouraged to hear that. I think you, as 
Chairman, should seize on the opportunity in terms of 
attracting talent of, I do not know, maybe visiting law schools 
and Ph.D. programs and saying, it is a new day at the SEC. Look 
at what the Congress has done for our budget.
    I even had a hearing the other day before the Senate 
Appropriations Subcommittee that deals with my budget and the 
Chairman of the Subcommittee said to me, the check is in the 
bank.
    [Laughter.]
    I hope he's right. We will see.
    Chairman Donaldson. I heard that. I did hear that.
    Senator Sarbanes. Yes. Well, it was a nice thing to hear.
    And so you can say to them, we are doing very exciting 
things at the SEC. There is a real challenge. And if you really 
want to serve the public interest and strengthen the American 
economy and the integrity of our markets, which has been such 
an important part of our economic strength, here is an 
opportunity for you to come to a refurbished, dynamic SEC and 
make an important contribution.
    I think you, as the new Chairman, are in a position to 
really make that case and really enhance the attractiveness of 
the SEC to people. So, on the one hand, you strengthen the 
context for the people you have, which of course, I relate very 
much to pay parity, and on the other, the new leadership being 
provided, and then reach out in terms of attracting new people 
to the Commission.
    I wish you the very best in that endeavor.
    Chairman Donaldson. Thank you.
    Senator Sarbanes. Thank you, Mr. Chairman.
    Chairman Shelby. Mr. Chairman, I want to add before I 
recognize Senator Sununu again, I appreciate how you are 
asserting the authority you and your staff of the SEC that had 
been, a lot of us thought, abdicated in recent years, and I 
commend you for that.
    Chairman Donaldson. Thank you.
    Chairman Shelby. Because if you are not assertive, somebody 
else will assert the authority and fill the vacuum, as I am 
sure you well know.
    Senator Sarbanes. Mr. Chairman, I may leave. Could I just 
say, as I understand it, you indicated to Chairman Donaldson 
that when they complete the study that is underway----
    Chairman Shelby. We will have him back.
    Senator Sarbanes.We want him to come back and present the 
findings to the Committee.
    Chairman Shelby. Absolutely.
    Senator Sarbanes. Is that correct?
    Chairman Shelby. Well, we would. We would like that, Mr. 
Chairman.
    Chairman Donaldson. I would be delighted to come back.
    Chairman Shelby. I think that that would be in order.
    Thank you, Senator Sarbanes.
    Senator Sununu.
    Senator Sununu. Thank you.
    Chairman Donaldson, I very much want you to succeed and 
want you to be able to retain good people and I am willing to 
do a lot of things in order to help you achieve that goal. But 
depressing the economy is not one of them. We will fund you, we 
will encourage your organization, but I think we are all 
rooting for a strong economy. I know you are.
    On these registered investment companies, I want to be 
clear, I understand what that term means. How many of them are 
there in total, registered investment companies, if I may use 
that term?
    Chairman Donaldson. Registered hedge funds or registered 
investment companies?
    Senator Sununu. Feel free to make the distinction and give 
me the number of both.
    Chairman Donaldson. Six thousand registered investment 
companies and 60 registered funds of hedge funds.
    Senator Sununu. Sixty?
    Chairman Donaldson. Six thousand and 60. Sixty registered 
funds of hedge funds.
    Senator Sununu. Six zero. Sixty registered funds of hedge 
funds?
    Chairman Donaldson. Yes.
    Senator Sununu. Sixty hedge funds that are registered 
investment companies. And we have been talking a lot about 
funds of funds. Do they need to be registered investment 
companies?
    Chairman Donaldson. Yes. Generally speaking, most of them, 
I suspect, are registering now.
    I think that the companies that are promoting funds of 
funds and so forth, are generally financial institutions that 
will register before----
    Senator Sununu. And have registered the funds, one of the 
60.
    Chairman Donaldson. Yes.
    Senator Sununu. What is the minimum investment for one of 
these registered hedge funds or for a registered investment 
company? Is it the same thing?
    Chairman Donaldson. Well, it varies. In terms of the 
minimum investment, I am told, in some of the more recent ones, 
you can get down as low as $25,000, I think.
    Senator Sununu. Is there any limitation put on someone's 
salary or net worth for investing in one of these registered 
hedge funds?
    Chairman Donaldson. Again, we have to be specific because 
there are so many different levels of qualification.
    Senator Sununu. You have only 60 hedge funds, though.
    Chairman Donaldson. There are 60 funds of hedge funds that 
are registered.
    Senator Sununu. There is no minimum contribution. No 
minimum salary requirement. No minimum asset requirement.
    Chairman Donaldson. Excuse me.
    Senator Sununu. Sure. Take your time.
    [Pause.]
    Chairman Donaldson. There is no, at this point, regulatory 
minimum. But some of the fund groups have their own minimum.
    Senator Sununu. Sure. They elect a minimum. But I am 
talking about the regulations. Those that aren't registered, 
unless I have misheard the testimony, if you are not 
registered, you have a salary minimum of $200,000 per year and 
an asset minimum of a million dollars.
    Chairman Donaldson. That is in terms of your ability to 
invest.
    Senator Sununu. Yes.
    Chairman Donaldson. But that does not address how much 
money you can invest. And how much money you can invest would 
be a minimum that would be set by the fund itself.
    Senator Sununu. I understand. But what is the salary and 
the asset threshold for a registered hedge fund? Again, the 
answer that I think I heard was zero.
    Chairman Donaldson. None. None right now.
    Senator Sununu. I think that is an important distinction to 
make because a lot of the concerns--again, we get back to these 
concerns that the Chairman and the Ranking Member and others 
have shared about these investment vehicles. And to the extent 
that we are not providing enough information and retailizing--I 
appreciated Senator Corzine's question because that was a 
question I had myself. What does that really mean?
    To the extent that these concerns are prevalent, it seems 
to me they are most prevalent in the one area where, in theory, 
we have the greatest regulatory leverage, which is those firms 
that are registered. And that seems to me to be a very great 
paradox, not that we should be surprised. Where the Federal 
Government is concerned, we have these kinds of unexpected 
consequences or problems that are sometimes created by our 
effort to do good.
    So, I think that that is an important distinction to make. 
And I know from your previous answers that is one of the things 
you are going to be addressing in your review.
    Did you want to make an additional comment?
    Chairman Donaldson. No. I think that, generally speaking, 
some of the funds that have been around the longest are ones 
that are getting on the cutting edge of voluntarily 
registering.
    I think that some of the funds that are being started 
within the context of existing banks or mutual fund complexes 
or whatever, are going to register. I do not believe they can 
run an unregistered fund side-by-side in a big investment fund 
complex. So, I think there is voluntary and accepted 
registration going on.
    Senator Sununu. I guess to conclude my point on this topic, 
I would want to make sure as a policymaker, and as you come out 
with your report, that registering is a good thing for 
consumers. And to be blunt, I haven't been convinced that it is 
a good thing for consumers at this point because they are 
registering, which may give you more access to information as 
you go about your job as a regulator within the SEC regarding 
disclosure.
    But there may not be--may not be--protections or 
information provided to consumers. They are not necessarily 
seeing any direct advantage of the registration process.
    My final question. Do you have to be a registered 
investment adviser to manage a mutual fund?
    Chairman Donaldson. Yes.
    Senator Sununu. And do you have to be a registered 
investment adviser to manage a hedge fund?
    Chairman Donaldson. No.
    Senator Sununu. Even if the hedge fund is a registered 
investment company?
    Chairman Donaldson. If it is registered, you do.
    Senator Sununu. So if it is a registered investment 
company, you do. But otherwise, you do not.
    Thank you.
    Thank you very much, Mr. Chairman.
    Chairman Shelby. Chairman Donaldson, we appreciate your 
appearance today. We look forward to working with you and we 
look forward to this report when it is finished.
    Chairman Donaldson. Thank you.
    Chairman Shelby. Mr. Chairman, thank you.
    The hearing is adjourned.
    [Whereupon, at 11:48 a.m., the hearing was adjourned.]
    [Prepared statements and responses to written questions 
supplied for the record follow:]
              PREPARED STATEMENT OF SENATOR JON S. CORZINE
    Mr. Chairman, thank you very much for holding this important 
hearing. Chairman Donaldson, I thank you for joining us today, and let 
me commend you for what has been, by all accounts, a successful early 
tenure at the SEC.
    The hedge fund industry has changed dramatically since A.W. Jones 
created the first hedge fund in 1949. Originally created by Jones as an 
alternative investment strategy, hedge funds today represent a $600 
billion industry that employs a wide variety of complex and often risky 
investment strategies. When one considers the use of leveraging and 
derivative instruments, the actual impact of hedge funds on our 
financial markets and on underlying commodities is potentially huge.
    In recent years, the importance of hedge funds has grown 
substantially as a much broader range of investors have sought out 
these funds, largely because their average returns have exceeded those 
of the S&P, the Dow, and the Nasdaq.
    Once the exclusive domain of wealthy, and presumed highly 
sophisticated investors, today's hedge fund investors include teachers, 
firefighters, nurses and retirees, as well as public and private 
pensions funds, universities, and endowment funds.
    Yet while hedge funds promise higher returns, the pursuit of those 
rewards also comes with increased risks. As hedge funds have grown, so 
too have hedge fund 
closures. In addition, we have seen an increase in hedge fund fraud.
    The retailization of hedge funds and the increasing impact of hedge 
funds on our financial markets make it important that we carefully 
examine this industry and the many public policy issues at stake.
    The SEC has begun such an examination, and I commend Chairman 
Donaldson for his interest in this matter. This Committee also has an 
important responsibility to address these issues, and I commend Senator 
Shelby for holding this hearing.
    We need to consider a host of issues.
    What does the growth of the hedge fund industry mean for investors 
and financial markets? Do those who invest in these funds have 
sufficient information to evaluate their risks? What challenges do the 
practices of hedge funds and fund managers pose to those charged with 
ensuring the integrity of our markets? And, 5 years after the collapse 
of Long-Term Capital Management, what has been learned--and, more 
importantly, done--to mitigate the systemic risks posed by these funds?
    It is my sense that the current system of hedge fund regulation is 
inadequate given the rapid change this industry has undergone. Some 
improvements may be able to occur through administrative action. 
Others, however, may well require legislation. Hopefully, the report 
that comes out of the SEC investigation will shed light on the areas of 
most urgent need.
    Chairman Donaldson and Chairman Shelby, I am committed to working 
with both of you to ensure that the SEC has the tools it needs to 
protect investors and our financial markets, while promoting the 
continued growth of this industry.
    I look forward to today's testimony, and again thank you, Chairman 
Donaldson, for joining us.

                               ----------
              PREPARED STATEMENT OF SENATOR ELIZABETH DOLE

    I would like to express my appreciation to you for holding this 
hearing on recent developments in hedge funds. Approximately $600 
billion is currently invested in hedge funds. The hedge fund industry 
represents both an important component to the capital market structure 
and a useful investment option. In addition, the industry provides 
important liquidity to the organized exchanges as well as the over-the-
counter and less liquid markets.
    Back in 1998, we all gained a quick education about the perils of 
hedge funds when Long-Term Capital Management created a market crisis 
that wound up affecting all sorts of people with no previous knowledge 
of hedge funds. Long-Term Capital Management was run by an unusually 
distinguished group of money managers, from long-time Wall Street 
professionals to Nobel Prize-winning academics. The end result showed 
that regardless of knowledge or skill, many have overestimated their 
understanding of the markets and paid the price. However, we were 
fortunate that major Wall Street firms were convinced to act together 
so as to minimize further detrimental impacts on the financial markets.
    Hedge funds are in many ways the opposite of mutual funds. While 
hedge funds are limited to those wealthy and sophisticated in the 
market, many investors of different incomes can invest in a mutual 
fund. While many mutual funds are very large billion dollar operations, 
hedge funds are known to be smaller. Mutual funds have investment 
limitations, disclosure requirements, and allow investors to move their 
money in and out as they choose. Hedge funds, on the other hand, have 
very little--if any--disclosure features, and require investors to keep 
their money with the fund for a specified period.
    Because of the requirements in the securities laws that hedge fund 
investors be ``sophisticated,'' the people whose money is at risk in 
these funds are not the people I worry about in our economy. However, 
one recent trend of concern is registered investment companies which 
invest in hedge funds. These investment companies do not require the 
investor to be ``sophisticated'' or necessarily wealthy. It is the less 
sophisticated or lower income investors whom we should be concerned 
about since they cannot afford to lose their investment, and they may 
not understand the risks which hedge funds can take. I believe it is 
this trend that Chairman Donaldson spoke about at his February 5 
confirmation hearing when he cited, ``A distressing move toward the 
`retailization' of hedge funds.''
    I am pleased that Chairman Donaldson has taken time out of his busy 
schedule to join us here today and share his thoughts and views on this 
subject. I look forward to hearing his testimony and discussing these 
issues with him.
    Thank you.

                               ----------
               PREPARED STATEMENT OF SENATOR WAYNE ALLARD

    I would like to thank Chairman Shelby for holding this important 
hearing to learn about the recent developments in the Securities and 
Exchange Commission's Hedge Fund Study.
    The ability to produce positive returns despite the condition of 
the market makes the practice of hedging a unique tool for asset growth 
in the United States. In the past, hedge funds have proven to be an 
extremely successful vehicle for the well-educated, advanced investor. 
Recently, the search for capital and promising investment vehicles have 
increased the retailing of hedge fund products, and similarly, 
increased the participation of investors with smaller portfolios.
    This growth of hedge fund participation raises potential concerns 
for the protection of the investor and the impact of hedge funds on 
U.S. markets. The Securities and Exchange Commission has a difficult 
task before them in determining their role in regulating the industry 
and educating the investor.
    Thank you, Chairman Donaldson, for coming before the Committee 
today to discuss what will be an issue of increasing importance in the 
U.S. financial markets. I look forward to your testimony.

                               ----------
               PREPARED STATEMENT OF WILLIAM H. DONALDSON
           Chairman, U.S. Securities and Exchange Commission
                             April 10, 2003

    Chairman Shelby, Ranking Member Sarbanes, and distinguished Members 
of the Committee, thank you for inviting me to testify today to discuss 
hedge funds generally and the Securities and Exchange Commission's 
ongoing fact-finding investigation into hedge funds. I appreciate 
having the opportunity to discuss this important subject with you.
    Over the past few years, hedge funds have become more prominent and 
more popular. Sources have estimated that there are close to 5,700 
hedge funds operating in the United States today with approximately 
$600 billion under management. To put this number in perspective, today 
there are approximately $6.3 trillion of assets under management in the 
mutual fund industry. In 1990, it is estimated that only $50 billion 
was under management in hedge funds, demonstrating the rapid increase 
in a relatively short period of time. There have been frequent reports 
of high returns of hedge funds that outperform registered investment 
companies. But, just as frequently, these reports highlight possible 
areas of concern, such as potential conflicts of interest, questionable 
marketing techniques, valuation concerns, and market impact of hedge 
fund strategies.
    As you know, the SEC staff has been engaged in an investigation of 
the structure and practices of hedge funds since June 2002. Because 
hedge funds continue to grow in status and increase the ranks of their 
investors, our investigation grows more 
important every day. We at the Commission are still at the fact-
gathering stage and have yet to reach any conclusions. But I want to 
report that we are moving to the next stage of our investigation. As 
part of the investigation's advancement, the 
Commission will be holding public roundtables on May 14 and 15. As I 
said before this Committee at my confirmation hearing, I believe there 
are many unanswered questions related to hedge funds, and I am anxious 
to take a deeper look at both their risks and rewards.
    Hedge funds have been around in some form since the establishment 
of the Jones Hedge Fund in 1949. The term ``hedge fund'' is undefined, 
including in the Federal securities laws. Indeed, there is no commonly 
accepted universal meaning. As hedge funds have gained stature and 
prominence, though, ``hedge fund'' has developed into a catch-all 
classification for many unregistered privately managed pools of 
capital. These pools of capital may or may not utilize the 
sophisticated hedging and arbitrage strategies that traditional hedge 
funds employ, and many appear to engage in relatively simple equity 
strategies. Basically, many ``hedge funds'' are not actually hedged, 
and the term has become a misnomer in many cases.
    The last time the Commission took a good look at hedge funds was in 
1998, when Long-Term Capital Management nearly collapsed. As you may 
recall, LTCM was a Connecticut-based hedge fund whose investment 
strategy employed a tremendous amount of borrowed money, or leverage. 
This strategy caused it to suffer approximately $1.8 billion in losses 
in August 1998, when Russia devalued the ruble.
    After LTCM's near collapse, the Commission, along with the Treasury 
Department, the Federal Reserve, and the Commodity Futures Trading 
Commission, as part of the President's Working Group on Financial 
Markets, issued a report on the risk management and transparency issues 
raised by LTCM in particular and of ``highly leveraged institutions'' 
in general.\1\ The President's Working Group looked at such issues as 
firms' adherence to their own stated policies, their margin and 
collateral requirements, their use of leverage and whether it was 
excessive, and how well their risk models functioned. The report made 
serious recommendations that were intended to improve how firms 
functioned in these areas; and, based on our examination of the major 
brokerage houses that service hedge funds, many institutions extending 
leverage to hedge funds seem to have taken these recommendations to 
heart.
---------------------------------------------------------------------------
    \1\ ``Hedge Funds, Leverage, and the Lessons of Long-Term Capital 
Management,'' April 1999.
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    In addition to this examination of the risk management and 
transparency issues, the Commission staff actively supported the work 
of the Multidisciplinary Working Group on Enhanced Disclosure (MWGED). 
The MWGED and the subsequent Joint Forum Working Group on Enhanced 
Disclosure (JFWGED), which the Commission chairs, both address issues 
of enhanced disclosure for financial intermediaries (i.e., banks, 
securities firms, insurance companies, and hedge funds). The MWGED 
issued its report in April 2001, and the work of the JFWGED is ongoing, 
but we believe many in the hedge fund industry are considering the 
recommendations of these two groups and continuing to explore ways to 
improve some of their practices.
    Nonetheless, the markets have continued to evolve, and I believe 
the time has come for us--the SEC and the President's Working Group--
again to review these risk management, transparency, and public 
disclosure issues.\2\ As part of the SEC's ongoing investigation into 
the operations of hedge funds, we are also addressing issues from the 
perspective of investor protection. These issues include the recent 
growth of the industry; the ``retailization'' of hedge funds--meaning 
the increasing availability of these products and how and to whom they 
are available; an apparent increase in reported fraud involving hedge 
funds; and conflicts of interests. Additionally, I am interested in 
looking into other issues related to the overall market impact of hedge 
fund practices.
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    \2\ Certainly, we must be cognizant of how the lack of public 
information about hedge funds also plays a critical part in a hedge 
fund's investment strategy. Many hedge funds are concerned about third 
parties uncovering their strategies. For example, an investor knowing 
that a hedge fund holds a large short position in a security could use 
that information to the detriment of the hedge fund by trading against 
that short position.
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    The Commission also has been very active in working with our 
colleagues at Treasury, the Federal Reserve, and other financial 
regulators to explore and address the potential use of hedge funds as 
vehicles for money laundering and terrorist 
financing. As mandated by the USA PATRIOT Act, Treasury, the Federal 
Reserve, and the SEC issued a report to Congress that addressed the 
regulation of investment companies, including hedge funds, as it 
related to money laundering.\3\ Additionally, Treasury, in coordination 
with the CFTC, the Federal Reserve, and the SEC, has proposed 
regulations that would require certain unregistered investment 
companies, including hedge funds, to establish anti-money laundering 
programs.\4\
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    \3\ ``A Report to Congress in Accordance with Section 356(c) of the 
Uniting and Strengthening America by Providing Appropriate Tools 
Required to Intercept and Obstruct Terrorism Act of 2001 (USA PATRIOT 
Act),'' December 31, 2002.
    \4\ The proposed regulation was issued September 26, 2002 [67 FR 
60617].
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Differences Between Hedge Funds and Investment Companies
    In order to fully understand the many questions associated with 
hedge funds, we must first examine the characteristics that distinguish 
them from registered investment companies. Unlike registered investment 
companies, investors in hedge funds usually must commit their money to 
hedge funds for extended periods of time and cannot redeem an 
investment without prior notice. In fact, some hedge funds permit 
investors to redeem only once or twice per year. Moreover, hedge funds 
are not subject to the diversification requirements imposed on 
registered investment companies and, therefore, may concentrate their 
portfolios in a handful of investments, thereby increasing their 
potential exposure to market fluctuations.
    Hedge funds typically do not have boards of directors. Hedge funds 
also do not have to report their results in a standardized format. And 
while registered investment companies generally pay an advisory fee 
based on a percentage of assets under management, hedge funds typically 
pay both an asset-based fee (typically one to two percent of assets) as 
well as a performance fee. The performance fee is typically 20 percent 
or more of the hedge fund's annual profits (realized or not) but often 
may be paid only if the hedge fund's performance exceeds a benchmark 
set forth in the fund's offering documents.
    Hedge funds are not subject to borrowing and leverage restrictions 
that apply to registered investment companies. Thus, a hedge fund may 
leverage its portfolio beyond the extent that a registered investment 
company may do so. On the other hand, many hedge funds employ 
investment strategies with limited or no leverage.
    One of the most significant differences between hedge funds and 
registered investment companies, for our purposes, is that because hedge 
funds typically are not registered with the Commission, they are not 
directly subject to examination and inspection by the Commission.
Regulation of Hedge Funds Under the Federal Securities Laws
    The exclusions from registration under the Federal securities laws 
that apply to hedge funds and their securities offerings are central to 
the questions that currently surround hedge funds. The exclusions 
define the investment strategies that hedge funds may pursue, the types 
of investors who generally may invest in hedge funds, and how hedge 
fund securities may be sold. Hedge funds are able to avoid regulation 
by meeting criteria that are laid out in four general exclusions or 
exceptions: (1) the exclusion from registration of the fund under the 
Investment Company Act of 1940, (2) the exemption from registration of 
the fund's securities under the Securities Act of 1933, (3) the 
exception from registration of the hedge fund manager under the 
Investment Advisers Act of 1940, and (4) the exception from reporting 
requirements under the Securities Exchange Act of 1934.
Exclusion from Registration Under the Investment Company Act of 1940
    Hedge funds typically do not register with the SEC. They rely on 
one of two exclusions under the Investment Company Act of 1940 to avoid 
registration. The first exclusion under Section 3(c)(1) of the 
Investment Company Act limits investors in the hedge fund to 100 
persons, while the second exclusion under Section 3(c)(7) of the 
Investment Company Act, which was added to the Investment Company Act 
in 1996, imposes no numerical limit on the number of investors.\5\ 
Instead, it generally looks to the size and nature of the investments 
of an individual. Thus, investors in funds that utilize the 3(c)(7) 
exemption generally must be ``qualified purchasers.'' Qualified 
purchasers are defined to include high net worth individuals (generally 
individuals who own certain specified investments worth at least $5 
million) and certain companies. The theory is that wealthy investors do 
not need the full protections of the registration provisions of the 
Federal securities laws.
---------------------------------------------------------------------------
    \5\ Although there is no specific numeric limitation on the number 
of investors in a Section 3(c)(7) fund, the Federal securities laws 
generally require any issuer with 500 or more investors and $10 million 
of assets to register its securities and to file public reports with 
the Commission. Most hedge funds do not wish to register their 
securities, and therefore they stay below the 500 investor level.
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Exemption from Registration Under the Securities Act of 1933
    Importantly, both of these exclusions require hedge funds to sell 
their securities in non-public offerings. Thus, most hedge funds rely 
on one of a handful of exemptions under the Securities Act in order to 
avoid making a public offering. In order to be classified as a non-
public offering, the hedge fund securities may not be offered for sale 
using general solicitation or advertising. Additionally, hedge funds 
generally sell their securities only to those who qualify as 
``accredited investors.'' The term ``accredited investor'' includes 
individuals with a minimum of $200,000 in annual 
income or $300,000 in annual income with their spouses, or a minimum of 
$1,000,000 in net assets. It also includes most organized entities with 
over $5,000,000 in assets, including registered investment 
companies.\6\
---------------------------------------------------------------------------
    \6\ This exemption also permits a private issuer to sell to up to 
35 nonaccredited investors, but in that case, those investors must be 
``sophisticated'' persons--meaning that they must be capable of 
evaluating the merits and risks of their investment--and the issuer 
must provide disclosure to those investors comparable to that in public 
offerings.
---------------------------------------------------------------------------
    Because these limitations under the Securities Act apply at lower 
levels than the ``qualified purchaser'' exemption for 3(c)(7) funds, 
these 3(c)(7) funds may only be offered or sold to investors who are 
qualified purchasers, as well as accredited investors. Other hedge funds, 
that do not qualify as 3(c)(7) funds, may be offered 
and sold to accredited investors, whether or not they are also 
qualified purchasers. Finally, a fast-growing group of funds of hedge 
funds are registered under the Securities Act and may be publicly 
offered and sold.

Exception from Registration Under the Investment Advisers Act of 1940
    Managers of hedge funds meet the definition of ``investment 
adviser'' under the Investment Advisers Act of 1940 because they are in 
the business of providing investment advice about securities to others. 
Under this Act, an investment adviser with fewer than 15 clients that 
does not publicize itself generally as an invest-
ment adviser is not required to register with the Commission. Because 
Commission regulations count each hedge fund, rather than each investor 
in the hedge fund, as one client, some hedge fund managers may not be 
required to register with the Commission.\7\ Unregistered advisers are 
not directly subject to the Commission's examination and inspection 
program. But it is important to note that all hedge fund managers--
whether registered as investment advisers or not--are subject to the 
antifraud provisions of the Investment Advisers Act.
---------------------------------------------------------------------------
    \7\ We understand that some hedge fund managers voluntarily 
register with the Commission because some investors, particularly many 
foreign investors, prefer their managers to be registered. Others 
register because they also advise registered investment companies, 
which are 
required to be advised only by registered investment advisers.
---------------------------------------------------------------------------
Exception from Reporting Requirements Under the Securities
Exchange Act of 1934
    Hedge funds generally are not subject to the reporting requirements 
of the Securities Exchange Act because they are operated so as not to 
trigger registration of their securities under that statute. However, 
if a hedge fund holds large public equity 
positions, the manager, like any other large institutional manager, 
must publicly disclose those positions. This disclosure, however, does 
not necessarily provide significant insight into any particular hedge 
fund's portfolios or strategies because the manager is permitted to 
aggregate all clients' holdings into one report. In addition, 
disclosure is not required of short and debt positions.

The Commission's Investigation of Hedge Funds
    Our investigation has been primarily focused on the investor 
protection implications of the growth in hedge funds. Once we have 
concluded that work, we plan to share our conclusions with other 
members of the President's Working Group so that we jointly can 
consider whether to review other market issues, including market 
impact, leverage, and counterparty risk. Furthermore, let me assure you 
that the SEC will continue to use the full extent of its authority to 
examine the risk assessment policies and procedures of broker-dealers, 
especially those of the larger firms, which are more likely to have 
counterparty exposure to hedge funds or otherwise be exposed to risk 
from hedge fund investments. Because many of these firms are affiliated 
with other types of financial institutions, such as banks, that may 
also have hedge fund exposure, firms' credit practices may also be 
subject to examination by other financial regulators. While our current 
investigation is not yet complete, I want to share with you some of the 
issues on which we have been focusing, including: (1) conflicts or 
interest, (2) retailization, (3) prime brokers, and (4) fraud.
Conflicts of Interest

Side-by-Side Products
    Investment advisers to registered investment companies increasingly 
are offering hedge fund investments to their clients--both to satisfy 
clients who are seeking 
alternative investments, and to provide opportunities for their most 
talented investment managers who otherwise might defect to higher 
paying positions with 
hedge funds. The result, that the advisers manage hedge funds alongside 
registered investment companies, raises the potential for conflicts of 
interests.
    For example, hedge fund managers often have large stakes in the 
hedge funds that they advise and/or they collect performance fees from 
their hedge fund clients. Consequently, there is the potential that a 
hedge fund manager may be tempted to favor its hedge fund clients over 
its registered investment company clients in allocating lucrative 
trades.
    Hedge fund investments may be managed differently than they are in 
a registered investment company. For performance and other reasons, a 
hedge fund manager may determine to sell a security short in a hedge 
fund's portfolio, while holding the same security long in a mutual 
fund's portfolio.
    I stress that these types of potential conflicts are the same as 
those that exist for any investment adviser that manages both 
registered investment companies and private client accounts.

Valuation
    Other potential conflicts of interest are inherent in hedge funds 
alone. Registered investment companies must price their portfolio 
securities at market or, if there is no market, at their current ``fair 
value''--determined in good faith by the fund's board of directors. 
Hedge funds are not subject to these requirements. Thus, for example, 
hedge funds may determine that the appropriate price of a security is 
its inherent price, a price that looks to the future. Or it may 
substitute its determination of the value of a security for a market 
price.
    These valuation determinations are, of course, subject to the 
antifraud provisions of the Federal securities laws, but otherwise they 
are permissible. Ultimately, it may be impossible for an investor to 
know the actual value of a hedge fund's portfolio securities.

``Retailization'' of Hedge Funds
    Another primary focus of our investigation involves the 
``retailization'' of hedge funds.
``Middle Class'' Hedge Funds
    I earlier mentioned the term ``accredited investor.'' This 
qualification is the standard measure used by some private hedge funds 
to determine who may invest in their offerings, and it is a hedge 
fund's basis for meeting the standards of one of the four general 
exemptions from registration. The monetary amounts used to determine 
accredited investor status essentially have remained the same since 
1982. With the sustained growth in incomes and wealth in the 1990's, 
however, more investors meet this standard, despite recent economic 
downturns. Although the Commission is not aware of any systematic 
investor losses or other failures caused by the current accredited 
investor standard, we could of course consider adjusting it, if 
appropriate. A global change to the standard, however, could impact 
significantly the availability of securities registration exemptions to 
other companies. In particular, we would carefully consider the effect 
of any adjustment to the standard on the opportunities for small 
business capital formation before proposing any change.
    In addition, the Internet has changed forever how companies 
communicate with their current and prospective investors. Just plugging 
the term ``hedge fund'' into any search engine will elicit hundreds of 
responses. If hedge fund sponsors fail to follow the law, every 
investor with access to the Internet could easily obtain materials that 
could constitute an offering of securities to the public, triggering 
registration and other requirements under the securities laws. 
Appropriate regulation of Internet offerings is a challenge for the 
Commission, as it is for other regulatory agencies. The Commission 
staff watches how the Internet is used to offer securities to the 
public, including offerings by hedge funds. Our policy goal is to 
strike a balance between encouraging use of the Internet for legitimate 
capital formation and at the same time preventing fraud and abuse. If 
we become concerned that our rules and guidelines need to be changed, 
or enforcement action needs to be taken, to prevent abuse by hedge 
funds or others engaged in purported capital formation activity, we 
will act accordingly.

Funds of Hedge Funds
    Registered investment companies that invest all, or substantially 
all, of their assets in an underlying pool of hedge funds are another 
means of increased availability of hedge funds to public investors. 
These funds are a recent phenomenon, evolving from the laws governing 
the structure of 3(c)(7) funds. The Commission's Division of Investment 
Management has seen a boom in these funds. In summer 2002, the first 
fund of hedge funds became eligible to sell its securities to the 
public. Subsequently, there have been 17 other funds of hedge funds 
cleared for the public market. All of these funds currently are subject 
to fund-specific minimum investment requirements of at least $25,000. 
However, there is now no Federal 
requirement for a minimum investment, and it is possible that funds 
might seek to lower this requirement making these types of funds 
available to a greater number of investors with even less capital. 
These possibilities also implicate the need to focus on suitability 
determinations and sales practices of those marketing hedge funds.
    Funds of hedge funds raise special concerns because they permit 
investors to invest indirectly in the very hedge funds in which they 
likely may not invest directly due to the legal restrictions. Because 
of the influence that accompanies the large size of their investment, 
registered funds of hedge funds can compel the underlying hedge funds 
to provide more information to investors than they would typically get. 
However, even funds of hedge funds do not get the same volume and 
frequency of information as investors in a registered investment 
company or mutual fund.

Prime Brokers
    The growth in the number of hedge funds has also highlighted 
another aspect of the hedge fund industry that we need to better 
understand. Hedge funds generally use one or more broker-dealers, known 
as ``prime brokers,'' to provide a wide variety of services.
    Prime brokerage is a system developed by full-service broker-
dealers to facilitate the clearance and settlement of securities trades 
for substantial retail and institutional customers who are active 
market participants. Prime brokerage involves three distinct parties: 
The prime broker, the executing broker, and the customer. The prime 
broker is the broker-dealer that clears and finances the customer 
trades executed by one or more executing broker-dealers at the behest 
of the customer. The prime broker is responsible for all applicable 
margin and Regulation T requirements for the customer.
    Generally, customers, such as hedge funds, believe a prime 
brokerage arrangement is advantageous because the prime broker acts as 
a clearing facility for the customer's securities transactions wherever 
executed, as well as a central custodian for all the customer's 
securities and funds.
    Prime brokers offer certain other services to hedge funds that are 
typically offered to other substantial customers such as margin loans 
and risk management services, but prime brokers may offer other 
services that are particularly directed to their hedge fund customers. 
For example, some prime brokers provide ``capital introduction'' 
services to hedge funds. These services, which range from sponsoring 
investor conferences to arranging individual meetings and preparing 
informational documents, are aimed at bringing hedge fund managers 
together with potential investors. We are looking into these services 
and the way they are disclosed to investors.

Hedge Fund Fraud
    Fraud is, of course, always a primary concern to us. I emphasize 
that I do not intend to imply that hedge funds or their managers 
generally engage in nefarious or illegal activities. I have no reason 
to believe that fraud is more prevalent in hedge funds than it is 
anywhere else. Nevertheless, there have been complaints by some issuers 
that hedge funds have acquired large short positions in their stocks 
and have then attempted to drive the share price down through the 
issuance of highly critical and allegedly inaccurate reports on their 
finances.
    The Division of Enforcement will continue to investigate 
allegations of manipulative short selling by hedge funds as it deems 
warranted. From a regulatory perspective, the Commission recognizes 
that, while short selling can add important benefits to the market, 
such as facilitating liquidity, hedging, and pricing efficiency, it 
also may be used as a tool for manipulation. In this regard, the 
Commission will consider amendments to existing short sale regulation, 
as necessary, to curb potential manipulation by all market 
participants, including hedge funds, without unnecessarily restricting 
liquidity.
    More generally, we have recently experienced a sharp increase in 
the number of hedge fund frauds that we have investigated and that have 
resulted in enforcement action. In fact, last year we instituted twice 
the number of enforcement actions against hedge funds or their managers 
than we instituted in any of the four previous years.
    Examples of charges filed by the Commission include: Making false 
or misleading statements in offering documents; misappropriating 
assets; market manipulation in a variety of guises; reporting false or 
misleading performance, including with respect to valuation of 
securities; insider trading; and fraudulently allocating investment 
opportunities.
    These charges generally are not unique to hedge funds. But hedge 
funds present us with a unique challenge. Because hedge funds typically 
are not registered with us, we are limited in our ability to detect 
problems before they result in harm to investors or the securities 
markets.

Market Impact
    In addition to the risk management and transparency issues 
addressed by the President's Working Group and the investor protection 
aspects that the Commission has been primarily focused on to this 
point, I believe the Commission's investigation should explore other 
market impact issues specifically in the context of hedge funds because 
of the substantial assets under their management. We would, of course, 
consider these market impact issues with other members of the 
President's Working Group. The Commission already aggressively enforces 
the anti-manipulation provisions of the Federal securities laws. It may 
be that there are other, more subtle or nuanced results of hedge fund 
activity that merit attention.
     Among the matters that I believe we should look at is the impact 
of hedge fund trading. There is nothing inherently nefarious about 
hedge fund trading strategies, including short selling. However, they 
may disproportionately affect the market or certain issuers. This is a 
special concern because we don't know enough about the activities of 
these hedge funds.
     I think we need to determine whether the information firewalls of 
hedge fund industry participants are adequate and whether information 
flow within or among hedge fund managers is an area that merits attention. 
Our understanding is that prime brokers' policies include strict 
information firewalls, but there may be other aspects of information 
flow that should be considered.
    The nature of managers' returns on hedge funds, either through 
investments in the funds or through carried interests, also may affect 
trading behavior. While some of the resulting issues relating to risk-
taking are properly issues of disclosure and investor protection, it is 
also possible that there are resulting market impacts that merit 
attention, and I believe our investigation should consider that 
possibility.

The Progress of the Investigation
    Our current investigation is proceeding well. The Commission's 
Division of Investment Management, alongside our Office of Compliance 
Inspections and Examinations, has been gathering information on 
investor protection issues to assist the Commission in its 
investigation and in preparation for the roundtables in May. The staff 
has obtained and reviewed documents and information from 67 different 
hedge fund managers representing over 650 different hedge funds and 
approximately $162 billion under management.
    The staff has also visited and engaged in discussions with a number 
of different hedge fund managers. When the staff visited these 
managers, they inquired into various aspects of their business, 
depending on their size and level of sophistication. The staff talked 
to brokerage, compliance, risk management, legal, and other operational 
personnel of multi-billion dollar complexes with dozens of employees, 
as well as to their portfolio managers. At the other end of the 
spectrum, the staff visited hedge funds where one employee serves as 
marketer, portfolio manager, trader, operations officer, and risk 
manager.
    Aside from our inquiries directed to specific hedge funds, the 
staff has met with a variety of experts in their respective fields to 
get their perspectives on the hedge fund industry. In addition to legal 
and accounting experts, the staff has spoken with chief investment 
officers, risk managers, prime brokers, representatives from foreign 
regulators, trade industry representatives, and hedge funds 
consultants. Also, a number of foreign jurisdictions are revisiting 
their approaches to hedge funds, and we continue to benefit from 
discussions with our foreign counterparts.

Hedge Fund Roundtable
    As you know, we are taking our investigation to the next step. As 
part of this we have scheduled two full days of hedge fund roundtable 
discussions to take place in Washington on May 14 and 15. These 
discussions will focus primarily on the investor protection issues 
mentioned earlier. Leading experts in the world of hedge funds will 
provide their views on hedge funds and the issues that concern us. In 
addition, we will solicit comments from the general public to secure 
their views. At the end of this process, my current goal is to produce 
a report that will summarize what we have found and where we should go. 
I believe we should make public what we have found and what conclusions 
we have reached.

Investor Education Efforts
    Before I close, I would like to tell you about efforts that we and 
others are making to provide the public with tools to help to evaluate 
the potential risks of hedge funds and funds of hedge funds. Since the 
creation of the Commission's website at www.sec.gov, we have used the 
website to educate and alert investors to issues relating to 
securities. Among other things, the website generally discusses hedge 
funds and funds of hedge funds. We have also used that website to 
provide investors with a laundry list of questions they should ask 
before investing in these products.
    In addition, Commission staff developed a website advertising a 
simulated hedge fund, Guaranteed Returns Diversified, Inc. (GRDI or 
greedy, for short). This website demonstrates how easy it is to be 
taken in by false statements and seeks to sensitize investors to their 
vulnerability. The Commission's website provides a link to the fake 
scam, although we have discovered that most are finding it by surfing 
the Internet looking for quick and easy returns. Since we launched this 
website on February 13, 2003, we have had over 70,000 hits on it!
     Finally, the NASD has increased its efforts to ensure that 
investors are not steered to unsuitable investments. At the beginning 
of this year, the NASD issued a Notice To Members that reminds broker-
dealers of their obligations when selling hedge funds and funds of 
hedge funds. These obligations include steps to ensure that proper 
disclosures are made to customers about these products and that broker-
dealers consider the suitability of these products for their customers.

Conclusion
    In conclusion, let me assure you that our goal in this exercise is 
to determine how we can better protect investors and our securities 
markets. By working together, I believe that we can achieve this goal.
    Thank you again for inviting me to speak on behalf of the 
Commission and the investing public. I would be happy to answer any 
questions that you may have.

        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY 
                   FROM WILLIAM H. DONALDSON

Q.1.a. Your investigation is looking at investment managers who 
handle both hedge funds and mutual funds. How many firms have 
personnel (that is, fund managers) that are responsible for 
both types of funds? How many individual managers have 
responsibility for both types of funds?

A.1.a. The Commission doesn't collect data on hedge funds. We 
do, however, collect data on advisers registered with the 
Commission, and we know that 1,431 advisers registered with the 
Commission advise both investment companies and some kind of an 
unregistered pooled investment vehicle, which would include 
funds typically referred to as hedge funds. This number 
represents just over 18 percent of all SEC-registered advisers 
and is based on the responses to Items 5D(4) and 5D(6) of Form 
ADV (the registration form advisers file with the Commission).
    We do not, however, ask advisers specific questions about 
their internal management activities with respect to hedge 
funds or other unregistered pooled investment vehicles. 
Consequently, we do not have data on the number of individuals 
employed by investment advisers who have responsibility for 
both registered and unregistered funds.

Q.1.b. What type of disclosure do these investment firms 
typically make to investors in the mutual fund?

A.1.b. Investment advisers to registered investment companies, 
including advisers to mutual funds, increasingly are offering 
hedge fund investment opportunities to their clients. When an 
adviser manages a hedge fund alongside a registered investment 
company, it raises potential conflicts of interests. Notably, 
however, the nature of these conflicts is similar to those for 
an adviser managing a registered investment company alongside a 
private client account or accounts--a practice which is 
relatively commonplace in the fund industry.
    The relevant registration forms do not expressly require 
that these potential conflicts be disclosed as a specific 
principal risk of investment in the fund. Put another way, the 
forms are not designed to mandate which specific risks must be 
disclosed. Rather, the forms require that all material risks be 
disclosed. The forms also set out where in the registration 
statement the more significant material risks must be 
disclosed.
    Most mutual fund managers, of course, do not also manage 
hedge funds. But when that is the case, the mutual fund must 
analyze the potential conflicts raised by that dual role and 
determine whether or not disclosure to fund shareholders is 
necessary. Disclosure might not be necessary, for example, 
where the particular mutual fund and hedge fund use very 
different investment strategies or are otherwise unlikely to 
make investment decisions regarding the same investments.
    The staff typically does not see mutual funds disclosing 
these potential conflicts as a specific material risk of 
investment. Investors, however, do receive important related 
information in connection with a fund's brokerage allocation 
procedures. The applicable registration forms for open- and 
closed-end funds expressly call for disclosure relating to the 
fund's brokerage allocation procedures in the fund's statement of 
additional information. Funds sometimes disclose securities 
allocation procedures involving the fund and other accounts of 
the adviser (whether those other accounts are private client 
accounts, other registered investment vehicles, or hedge funds).
    A mutual fund also must describe in its prospectus the 
adviser's experience, as well as the recent business experience 
of the portfolio manager. This disclosure would require general 
information regarding hedge funds managed.
    Finally, and regardless of any disclosure obligations, it 
is very important to note that an adviser to a mutual fund is 
subject to the antifraud provisions of the Investment Advisers 
Act of 1940, and has a fiduciary duty to treat all clients 
fairly pursuant to that Act. Accordingly, during our 
examinations of investment companies, we scrutinize the 
adviser's procedures in this area to ascertain whether the fund 
is being managed in an appropriate manner along with other 
accounts, including hedge funds, managed by the adviser.

Q.1.c. What safeguards do investment firms have in place to 
guard against preferential treatment of the hedge fund?

A.1.c. Advisers that manage hedge funds and other pools of 
assets or individual accounts have substantial conflicts of 
interest when a hedge fund pays a performance fee. Investment 
advisers, even those exempt from registration with the 
Commission, owe their clients fiduciary duties that prohibit 
the adviser from acting on such conflicts to harm clients. 
Although it is difficult to generalize across the industry, 
many investment advisers have also established the policies and 
procedures designed to prevent these types of conflicts from 
harming clients, including:

 Establishing written compliance policies that, among 
    other things, provide for the fair allocation of investment 
    opportunities among clients.
 Adopting written codes of ethics that proscribe 
    illegal, unethical, or inappropriate conduct by the 
    adviser's employees.
 Establishing supervisory procedures designed to 
    prevent em-
    ployees from causing the adviser to breach its fiduciary 
    duties by favoring hedge fund clients, including monitoring 
    for patterns of trading that, although effected in 
    accordance with compliance procedures, indicate a 
    possibility of abuse.
 Structuring portfolio manager compensation to 
    ameliorate incentives to act on conflicts.

    These are policies and procedures similar to those advisers 
use to guard against other types of conflicts of interest. Our 
experience is that larger advisory firms are more likely to 
have written, formal procedures than smaller organizations.

Q.2.a. The securities fraud laws that the SEC enforces apply to 
hedge funds. According to some press reports, the SEC has 
brought about two dozen cases against hedge funds since 1998. 
Have these all been antifraud cases?

A.2.a. From 1998 through 2002, the Commission has brought 
approximately 28 enforcement actions relating to hedge funds. 
All but one of these actions included charges of securities 
fraud; some of these actions alleged additional violations of 
other provisions of the Federal securities laws. The remaining 
enforcement action charged violations of the registration 
provisions of the Securities Act and the Investment Company 
Act, and of the books-and-records provision of the Investment 
Advisers Act.\1\
---------------------------------------------------------------------------
    \1\ See In the Matter of Prime Advisors, Inc., et al., Release No. 
7560, July 31, 1998.

---------------------------------------------------------------------------
Q.2.b. What was the nature of the fraud?

A.2.b. The fraud charges in these hedge fund cases were based 
primarily on allegations that the hedge funds and/or their 
advisers made misrepresentations concerning: (i) the past, 
present, or future performance of the fund; (ii) the risk 
associated with investing in the fund; (iii) the adviser's 
qualifications or experience; (iv) the current value of the 
fund or an investor's interest in it; (v) the fund's trading 
strategy; (vi) use of fund assets; and/or (vii) the extent of 
losses. In many of these cases, the fund or its adviser 
misappropriated investors' monies.

Q.2.c. How did the SEC become aware of the fraud?

A.2.c. While we cannot report how the fraud was learned of in 
each of these cases, the Commission frequently learns of frauds 
such as these from investors who have suffered losses or who 
are solicited to invest. We also may learn of hedge fund 
misconduct from a third-party that conducts business with the 
fund, such as a brokerage firm or auditor.

Q.2.d. Are we seeing evidence of more abuses in this industry 
or are we just seeing more cases because the industry has 
grown?

A.2.d. It is difficult to identify the cause (or causes) of the 
recent increase in cases relating to hedge funds. It may relate 
to the growth in the industry. It is also likely that as public 
awareness of hedge funds has increased, those intent upon 
defrauding investors are using the allure of hedge funds to 
attract victims. In these situations, the violators may have no 
intention of establishing a legitimate hedge fund, but simply 
market the fraudulent investment opportunity as a hedge fund.

Q.2.e. Given the ability of less sophisticated investors to 
access hedge funds, will the SEC be re-evaluating its 
enforcement 
program?

A.2.e. The Commission aggressively combats all types of fraud, 
including fraud relating to hedge funds. As the hedge fund 
industry continues to grow and hedge funds become more 
available to retail investors, the enforcement program's focus 
on hedge fund fraud will grow more acute.

Q.3.a. Hedge funds typically own assets that are difficult to 
value--either because they are not broadly traded or because of 
unique characteristics of the assets. What are the typical 
guidelines for valuation and reporting for hedge funds?

A.3.a. Valuation. The Federal securities laws generally do not 
require hedge funds to value their assets in any particular 
manner. Hedge funds, however, typically disclose to their 
investors how they value their assets.
    The manager of a hedge fund typically values the fund's 
assets. As a general matter, however, hedge funds ordinarily 
use: (a) market prices to value securities for which the market 
quotations are readily available, and (b) ``fair value'' to 
value securities and other assets for which market quotations 
are not readily available. Although there is no uniform 
methodology for determining fair value, fair value generally is 
the price that the fund might reasonably expect to receive for 
a security or other asset upon its current sale. Many hedge 
funds use pricing information from pricing services, such as 
Bloomberg, Reuters, and FT Interactive Data, to value their 
assets. Some hedge funds value the securities of nonpublicly 
traded companies at cost and generally do not revalue them 
until a public trading market exists for the securities or the 
issuer engages in a subsequent round of equity financing. Some 
hedge funds also utilize ``side pocket'' accounting, whereby 
illiquid assets are essentially not considered when determining 
the funds' net asset values (NAV) until the funds sell the 
assets.
    Hedge fund financial statements typically are prepared in 
accordance with generally accepted accounting principles 
(GAAP). GAAP generally requires the use of fair values when 
market prices are not readily available. Hedge funds, however, 
are not subject to the requirements of Regulation S-X under the 
Securities Act of 1933, which specifies the form and content of 
financial statements and standards concerning auditor 
independence.
    Independent public accountants typically audit the year-end 
financial statements of hedge funds. Most auditors attempt to 
verify the accuracy of hedge funds' securities valuations by 
comparing them with values they obtain from pricing services. 
For certain assets for which prices are not readily available, 
however, auditors generally review and assess the 
reasonableness of the hedge fund manager's valuation process; 
most auditors do not attempt to verify the actual prices of the 
assets.
    Reporting. The Federal securities laws generally do not 
require hedge funds to provide reports to the Commission or to 
their investors. Many hedge funds, however, provide their 
investors with quarterly, semi-annual, or annual reports. Hedge 
funds also commonly provide their investors with copies of 
their year-end audited financial statements. Some hedge funds 
also provide their investors with monthly or quarterly account 
statements. In addition, some hedge funds post performance and 
other information on password-protected websites that are 
available to their investors.

Q.3.b. Are intermediary ``funds of funds'' making sure that 
they receive fair valuations?

A.3.b. A small but growing number of funds of hedge funds 
(FOHF's) have registered with the Commission in the past 
several years. These funds are required by the Investment 
Company Act of 1940 to value their portfolio securities by 
using: (a) the market value of the securities when market 
quotations are ``readily available'' and (b) the fair value of 
the securities when market quota-
tions are not readily available. As there generally are no 
readily available market prices for interests in the underlying 
hedge funds in which registered FOHF's invest, the FOHF's are 
required to value such interests at their fair value.
    Registered FOHF's generally disclose to their investors how 
they value their interests in hedge funds. The disclosure 
typically sets forth the steps that the FOHF's and their 
managers take to ensure that they value their assets fairly. 
Registered FOHF's often disclose in their offering documents 
that, prior to investing in a hedge fund, their managers 
conduct due diligence reviews of the valuation methodologies 
used by the hedge fund. Such reviews typically include 
examining the hedge fund's offering documents and obtaining 
additional relevant information from the fund's manager. Many 
registered FOHF's rely on valuation information provided to 
them by the hedge funds in which they invest. Registered FOHF's 
also typically disclose that they generally lack access to the 
information that would be needed to confirm independently the 
accuracy of valuation information provided by the underlying 
hedge funds. In addition, registered FOHF's typically disclose 
that, in the event that they have information that causes them 
to question the valuation information reported by a hedge fund, 
they will fair value their interest in the hedge fund based on 
any relevant information, including the reported valuation 
information, available to them.
    The financial statements of registered FOHF's must be 
audited annually by independent public accountants, and the 
financial statements of many hedge funds also are audited 
annually by independent public accountants. These audits may 
provide some degree of assurance that registered FOHF's are 
valuing their assets appropriately. As noted above, auditors 
generally review and assess the reasonableness of a hedge 
fund's valuation process when auditing the fund's financial 
statements.

Q.3.c. If retail investors are involved in hedge funds, what 
can be done to ensure that the value of their investments is 
reported appropriately?

A.3.c. Retail investors generally may invest in FOHF's 
registered under the Investment Company Act and whose 
securities are registered under the Securities Act. Four 
elements can help to ensure the value of retail investors' 
investments in registered FOHF's are reported appropriately: 
(1) review by the Commission's staff of the funds' offering 
documents and financial statements; (2) examinations of FOHF's 
by the Commission's examination staff; (3) audits of the FOHFs' 
financial statements by independent public accountants; and (4) 
oversight by the FOHF independent directors of the valuation 
process.
    The Investment Company Act places the responsibility for 
fair value pricing of portfolio securities on the investment 
company's board of directors.\2\ Therefore, investment company 
directors should demand sufficient information to be 
comfortable that the valuations of underlying hedge fund 
investments are accurate.
---------------------------------------------------------------------------
    \2\ Section 2(a)(41) of the Investment Company Act.
---------------------------------------------------------------------------
    The Commission's staff closely reviews the offering 
documents of FOHF's seeking to register as investment companies 
to ensure that their valuation policies and procedures are 
fully consistent with regulatory requirements. Examinations by 
the Commission's staff of the actual valuation practices of 
registered FOHF's and their financial statements also should 
help to ensure registered FOHF's are valuing their portfolio 
securities in a manner consistent with regulatory requirements 
and their disclosures to investors.
    Finally, audits of the financial statements of registered 
FOHF's and hedge funds by independent public accountants should 
also provide some assurance that registered FOHF's and hedge 
funds are valuing and reporting their investments 
appropriately.

Q.3.d. Should there be a requirement for independent 
verification of the valuations?

A.3.d. Given our limited experience with these vehicles, it is 
difficult to determine, at this time, whether there should be a 
requirement for independent verification of hedge funds' 
valuations. We are aware that some FOHF's will invest only with 
underlying hedge funds that agree to provide information to an 
independent third party to value the hedge funds' assets and 
report to the FOHF. At least one jurisdiction, Hong Kong, 
generally requires independent verification of hedge funds' 
valuations. We are studying these recently adopted requirements 
and intend to consult with the Hong Kong Securities and Futures 
Commission concerning the operation of these requirements for 
hedge funds and FOHF's in Hong Kong.

Q.4.a. Hedge funds are well-known as an option for the 
sophisticated or ``accredited'' investor, currently defined as 
someone with $1 million in net worth or annual salary of 
$200,000. These values have not changed in many years. Do these 
levels need to be adjusted to accommodate changes in income and 
wealth since they were adopted?

A.4.a. The monetary amounts used to determine accredited 
investor status essentially have remained the same since 1982. 
With the sustained growth in incomes and wealth in the 1990's, 
however, more investors meet this standard, despite recent 
economic downturns. It may, therefore, be appropriate to 
consider whether the definition should be updated to increase 
the levels of income or net worth.
    The Commission would, of course, consider adjusting the 
``accredited investor'' definition, if appropriate. Before 
proposing any adjustments, the Commission must consider a 
number of factors. First, the Commission is not aware of any 
systematic investor losses or other failures caused by the 
current accredited investor standard. Second, the Commission 
may wish to reconsider using the definition as a surrogate for 
investor sophistication, and that concept also may be worthy of 
consideration. Third, a global change to the accredited 
investor standards, however, could impact significantly the 
availability of securities registration exemptions to other 
companies. In particular, the Commission would consider 
carefully the effect of any adjustment to the standard on the 
opportunities for small business capital formation before 
proposing any change.

Q.4.b. What is the current industry practice regarding minimum 
levels for investing in funds of funds?

A.4.b. Your inquiry raises two separate, but related, 
questions. First, has an industry practice developed around the 
minimum initial investment required by registered FOHF's? And, 
second, have investors in these funds been required to meet 
certain other investor eligibility requirements?
    All of the FOHF's registered with the Commission to date as 
investment companies have registered as closed-end funds under 
the Investment Company Act. Some also have registered their 
securities under the Securities Act. Notably, none of these 
registered FOHF's currently trades on an exchange.
    With regard to the first question, all of these registered 
FOHF's subject investors to fund-specific minimum initial 
investments of no less than $25,000. Some require a $25,000 
initial minimum, others $50,000, and a few impose much greater 
initial minimums (in some cases, $1 million). A few also 
disclose that they will reduce, or reserve the right to waive, 
the required minimum in limited circumstances, such as when the 
investor already is an existing client of the adviser with 
substantial assets under management, or when the investor is an 
officer or employee of the adviser.
    However, there is no Federal requirement that FOHF's impose 
any minimum initial investment.\3\ A registered FOHF, 
therefore, could lower its minimum initial investment so as to 
make itself available to a greater number of investors with 
less capital.\4\ The emergence of these products implicates the 
need to focus on the suitability determinations and sales 
practices of those marketing the registered FOHF's, as well as 
the underlying hedge funds.
---------------------------------------------------------------------------
    \3\ Some foreign jurisdictions, such as Hong Kong, France, and 
Australia, do require a minimum investment in the FOHF's they regulate.
    \4\ In fact, one FOHF whose registration statement is pending with 
the staff proposes to trade its shares on an exchange without any 
minimum initial investment requirement. That fund also would not impose 
other common investor eligibility standards, such as those we discuss 
later in this answer.
---------------------------------------------------------------------------
    With regard to the second question, as we noted above, the 
underlying hedge fund investments typically limit their U.S. 
investors to those who satisfy specific eligibility standards. 
All of the FOHF's currently registered with the Commission have 
imposed specific 
eligibility standards, regardless of whether those standards 
are required under Federal law. All of these registered FOHF's 
restrict their sales to investors that at least satisfy the 
``accredited investor'' standard, even those funds engaged in a 
public offering and thereby required to register their 
securities under the Securities Act and their funds under the 
Investment Company Act. In addition to certain institutional 
investors, ``accredited investors'' are defined generally as 
natural persons with individual or joint net worth of 
$1,000,000, or individual income in each of the last 2 years in 
excess of $200,000, or joint income for the same period in 
excess of $300,000.
    But those registered FOHF's charging a performance-based 
fee (that is, a fee based on the capital gains or capital 
appreciation of the fund or a client's account) are required to 
impose specific eligibility standards pursuant to the 
Investment Advisers Act. Such funds must limit their investors 
to ``qualified clients.'' That term generally is defined as 
investors with individual or joint net worth exceeding 
$1,500,000, or with assets under the adviser's management of at 
least $750,000, or investors who are ``qualified purchasers'' 
for purposes of the Investment Company Act (defined as, among 
other things, an investor with at least $5,000,000 in 
investments).
    Therefore, with respect to minimum initial investments, a 
FOHF need not impose any specific eligibility standards if it 
does not charge a performance-based fee or register its 
securities under the Securities Act. However, not imposing 
these standards voluntarily would raise suitability and sales 
practices concerns.

Q.4.c. Alternatively, should there be a floor set on the 
minimum level at which retail investors can buy into hedge 
funds through the ``funds of funds'' structure?

A.4.c. As noted above, there is no Federal requirement that 
registered FOHF's impose a minimum initial investment on 
investors. Further, investors in some of the currently offered 
FOHF's need not satisfy, as a matter of law, specific 
eligibility standards. Nevertheless, all current registered 
FOHF's voluntarily impose minimum initial investments and 
specific eligibility standards.\5\
---------------------------------------------------------------------------
    \5\ It the absence of a legal mandate, suitability and related 
considerations (discussed below) may be major factors in why these 
funds are adopting such policies.
---------------------------------------------------------------------------
    With respect to eligibility standards, this result 
primarily is due to changes made to the Federal securities laws 
in the National Securities Markets Improvement Act of 1996 
(NSMIA). Those changes provided greater leeway for the creation 
of registered FOHF's and expanded the kinds of hedge funds that 
could be offered (primarily through enactment of Section 
3(c)(7) of the Investment Company Act). Further, after NSMIA, a 
hedge fund in which a FOHF invests need not ``look through'' 
the FOHF, to its investors, to determine who is a ``qualified 
purchaser'' for purposes of Section 3(c)(7).\6\
---------------------------------------------------------------------------
    \6\ Put another way, the registered FOHF (or a mutual fund) would 
be the ``qualified purchaser'' for Section 3(c)(7) purposes in the 
unregistered hedge fund, regardless of the bona fides of the investors 
in that registered FOHF or mutual fund. However, Rule 2a51-3 under the 
Investment Company Act provides that a fund shall not be deemed to be a 
qualified purchaser if it was formed for the specific purpose of 
acquiring the securities of a 3(c)(7) fund, unless each of the top 
fund's beneficial owners is a qualified purchaser.
---------------------------------------------------------------------------
    In a FOHF, the adviser's expertise and sophistication, in 
effect, is substituted for that of each investor. The investors 
are protected through the purchase of a registered product. The 
adviser to a registered FOHF must register with the Commission 
and is subject to regulation under the Advisers Act. Investors 
also are protected through comprehensive regulation of the 
registered fund and Commission oversight under the Investment 
Company Act. Moreover, if the fund conducts a public offering 
and registers its securities under the Securities Act, 
additional statutory provisions protect the investors.
    As important, investment advisers and broker-dealers who 
recommend FOHF's must ensure that such recommendations are 
suitable for the particular investor. Advisers are fiduciaries 
owing their clients a duty to provide only suitable investment 
advice.\7\ To do this, advisers must make reasonable 
determinations that their advice is suitable for a particular 
client based on that client's financial situation and 
investment objectives. This duty is enforceable under Section 
206 of the Advisers Act.
---------------------------------------------------------------------------
    \7\ See Suitability of Investment Advice Provided by Investment 
Advisers, Investment Advisers Act Release No. 1406 (March 16, 1994).
---------------------------------------------------------------------------
    The Federal securities laws and the rules of various self-
regulatory organizations (SRO's) require a broker-dealer to 
have a reasonable basis for believing its recommendations are 
suitable for a particular investor. Recently, one SRO, the 
National Association of Securities Dealers, issued a Notice to 
Members reminding its broker-dealers of their suitability and 
sales practice obligations concerning the sale of FOHF's and 
hedge funds.\8\
---------------------------------------------------------------------------
    \8\ Notice to Members 03-07 (February 2003). This notice emphasized 
a broker-dealer's obli-
gation to: Provide a balanced disclosure in promotional efforts; 
perform a reasonable-basis 
suitability determination; perform a customer-specific suitability 
determination; and provide adequate training and supervision of persons 
selling these products.
---------------------------------------------------------------------------
    Investor net worth has long been a useful proxy for 
suitability and sophistication generally. For example, if a 
prospective investor in a FOHF has $750,000 invested elsewhere 
with an adviser, or has considerable other assets, those facts, 
though perhaps not dispositive, would be relevant to the 
investment's suitability and the investor's ability to 
withstand the loss of the entire investment in the FOHF. It is 
not so clear that a minimum initial investment 
requirement has the same efficacy as a proxy for suitability or 
sophistication. For example, an investor might seek to 
diversify his/her small investment portfolio with a small 
investment in a FOHF. The investor might not be terribly savvy 
or wealthy, since he/she might satisfy that fund's voluntarily 
imposed accredited investor eligibility standard primarily 
because of the net worth of the investor's house. Requiring 
that investor to make a $50,000 minimum initial investment 
would not seem to advance the cause of investor protection. 
Rather, imposition of such a minimum could have potentially 
perverse results--the loss of the entire investment likely 
would have dire consequences to the investor.
    We certainly are not opposed to funds imposing such 
minimums on their own initiative, nor are we opposed to 
investment advisers or broker-dealers looking to such minimums, 
in conjunction with all other relevant factors, in reaching a 
suitability determination in a given instance. However, we 
question whether investment minimums alone adequately protect 
less sophisticated investors.

Q.5.a. Britain's Financial Services Authority (FSA) does not 
allow hedge funds to be marketed to retail investors--although 
they are considering options for opening up hedge funds to 
retail investors. They are also trying to limit the amount that 
hedge funds can borrow in order to prevent any systemic risks. 
Is the SEC reviewing the FSA's work in this area?

A.5.a. The Commission is currently reviewing and considering 
how other jurisdictions, including the United Kingdom, regulate 
hedge funds. An examination of the regulation of hedge funds in 
other jurisdictions may assist the Commission in determining 
whether the U.S. regulatory regime for hedge funds and hedge 
fund managers should be amended.
    With respect to the FSA's work, hedge funds, as a general 
matter, currently may not be marketed and sold to retail 
investors in the United Kingdom. The FSA, however, recently 
solicited comments on whether hedge funds should be permitted 
to be marketed and sold to retail investors in light of 
considerable changes both to the hedge fund market and the 
structure of regulation in the United Kingdom.\9\ The comments 
received by the FSA generally indicated that hedge fund product 
providers and investment managers do not have a great desire to 
produce or to sell retail hedge fund products in the United 
Kingdom and there is no significant demand from retail 
investors for access to such products. After reviewing the 
comments, the FSA concluded that its current regulatory regime 
is appropriate and that no changes are required.\10\ The FSA 
stated that it would continue to monitor the hedge fund market 
to determine whether to amend the regulations for hedge 
funds.\11\
---------------------------------------------------------------------------
    \9\ FSA Discussion Paper 16 (August 2002), available at http://
www.fsa.gov.uk/pubs/discussion/16/.
    \10\ FSA Feedback Statement on DP 16 (March 2003), available at 
http://www.fsa.gov.uk/pubs/discussion/fs16/.
    \11\ The FSA noted that there were several significant obstacles to 
changing the regulatory regime to permit the marketing and sale of 
hedge funds to retail investors. For example, few hedge funds currently 
are established in the United Kingdom because the tax regime is 
unfavorable, especially compared to certain offshore jurisdictions. In 
addition, existing regulations would limit the type of hedge funds that 
could be authorized in the United Kingdom to those that meet certain 
key investor protections, such as risk spreading, independent 
depository, regular valuation, rights of redemption, limitations on 
borrowing, and disclosure.
---------------------------------------------------------------------------
    The FSA also requested comments on the appropriateness of 
its regulatory regime for hedge fund managers. Hedge fund 
managers based in the United Kingdom must be authorized by the 
FSA even if the funds that they manage are offshore. The 
comments received by the FSA generally indicated that the FSA's 
current regulatory regime for United Kingdom-based hedge fund 
managers is appropriate. The FSA concluded that it would not be 
appropriate to introduce rules specifically to regulate hedge 
fund managers. The FSA stated that it would continue to monitor 
the hedge fund market to determine whether to amend the 
regulations that apply to hedge fund managers.

Q.5.b. What have other countries with mature capital markets 
done?

A.5.b. Most jurisdictions permit hedge funds to be marketed and 
sold to sophisticated investors or institutional investors 
without requiring the hedge funds to be authorized by the 
securities regulator in the jurisdiction. Most jurisdictions, 
however, do not permit hedge funds to be marketed and sold to 
retail investors. A few jurisdictions, such as Hong Kong, 
Singapore, and Switzerland, do permit hedge funds to be 
marketed and sold to retail investors.
    In jurisdictions that permit hedge funds to be marketed and 
sold to retail investors, hedge funds are subject to various 
restrictions that are designed to address the retail investor 
protection issues. For example, each jurisdiction requires a 
minimum investment in a hedge fund.\12\ Each jurisdiction also 
requires specific disclosures in hedge fund prospectuses and 
marketing materials regarding fund policies, strategies, and 
risks.\13\ In two of the three jurisdictions, the prospectus 
also must contain information about the fund's valuation 
procedures.\14\ Hedge funds must have external audits by 
independent auditors in at least two jurisdictions.\15\ At 
least two jurisdictions require regular reports to 
investors.\16\ In addition, in all three jurisdictions, hedge 
fund managers must meet certain experience and expertise 
requirements.\17\
---------------------------------------------------------------------------
    \12\ Hong Kong, Singapore, and Switzerland require a minimum 
investment in a hedge fund of $50,000 (or, for a capital guaranteed 
hedge fund, with no minimum investment), approximately $58,000, and 
approximately $11,000 respectively.
    \13\ In Hong Kong, the prospectus must disclose the types of 
investment instruments permitted, the extent of diversification and 
leverage, and the risk implications to investors. The prospectus also 
must contain a disclaimer regarding the risk of price fluctuations 
during the payout period, which can last as long as 90 days. In 
Singapore, all marketing material must disclose fees and charges, refer 
to the risks of investing in the fund, and include disclaimers that: 
(1) investment in a hedge fund carries special risks and may not be 
suitable to investors averse to such risks; (2) if not a capital 
guaranteed fund, that investors may lose all or a large part of their 
investment; or if a capital guaranteed fund, that investors are subject 
to the credit risk of the guarantor or the default risk of the issuer; 
and (3) hedge funds may not be suitable for all types of investors and 
are not intended to be a complete investment strategy for any investor. 
In Switzerland, the prospectus must disclose all special risks, the 
redemption procedures, and include a glossary of terms.
    \14\ In Hong Kong, the prospectus must disclose the valuation 
methods, frequency of valuation and the identity and qualifications of 
the valuation agent, which must be independent. In Switzerland, the 
prospectus must disclose the valuation method.
    \15\ In Switzerland, the external auditors must demonstrate 
professional expertise in the area of alternative investments in which 
the hedge fund invests. In Hong Kong, an auditor that is independent of 
the management company and the trustee/custodian must audit the annual 
report of the fund.
    \16\ In Hong Kong, the hedge fund manager must issue a quarterly 
narrative report to holders on the fund activities during the reporting 
period. The report must be distributed within one month of the end of 
the period it covers. In Switzerland, an annual report must be issued 
discussing the development of the fund's investment style and strategy, 
as well as the valuation of any difficult-to-value investments.
    \17\ In Hong Kong, a hedge fund manager must have $100 million in 
assets under management that follows hedge fund strategies, 5 years of 
general experience in hedge fund strategies and 2 years of experience 
in the same strategy as that of the proposed hedge fund. In Singapore, 
a hedge fund manager must demonstrate expertise in managing hedge 
funds, and at least two executives of the manager must have 5 years of 
experience in hedge fund management. In Switzerland, a hedge fund 
manager must have 5 years of experience in the investment area 
concerned and have a minimum capital of approximately $755,590. In all 
of these jurisdictions, the regulator has the authority to prohibit the 
public offering of a hedge fund if the fund manager does not have the 
proper experience or expertise.
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    Many jurisdictions permit funds of hedge funds to be 
marketed and sold to retail investors.\18\ Funds of hedge funds 
are subject to various restrictions that are designed to 
address retail investor protection issues. In most 
jurisdictions that permit funds of hedge funds to be marketed 
and sold to retail investors, the prospectus and marketing 
material must contain information describing the risks of such 
an investment.\19\ In most, if not all, foreign jurisdictions 
that permit funds of hedge funds to be marketed and sold to 
retail investors, the regulator scrutinizes the experience and 
competence of a manager before authorizing that manager to 
manage a fund of hedge funds.\20\ Most jurisdictions that 
permit funds of hedge funds to be marketed and sold to retail 
investors require investors to make a minimum investment in a 
fund of hedge funds.\21\
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    \18\ Australia, Bermuda, Cayman Islands, Hong Kong, Ireland, Italy, 
Japan, Luxembourg, Singapore, Switzerland, and the United Kingdom. In 
the United Kingdom, funds of hedge funds that invest on a conventional 
long-only basis may be listed on exchanges. Germany currently does not 
permit funds of hedge funds to be marketed and sold to retail 
investors, but it is planning to allow such access in the future.
    \19\ In France, marketing material must contain a disclaimer that 
the fund is illiquid and intended only for investors who do not require 
immediate liquidity. In Hong Kong, funds of hedge funds must provide a 
disclaimer that some or all of the underlying funds and their fund 
managers are not subject to regulation by the securities regulator. In 
Ireland, a fund of hedge funds must disclose special information on 
risks including certain disclaimers, and the fund must disclose its 
diversification policies and information about the underlying funds and 
their fees. In Singapore, a fund of hedge funds must meet the same 
requirements as a hedge fund with regard to disclosure of risks and 
disclaimers. See supra footnote 13. In Switzerland, the prospectus of a 
fund of hedge funds must include a disclaimer that the fund can lose up 
to 100 percent of its investment in a single underlying fund.
    \20\ In Australia, fund of hedge fund managers must demonstrate 
expertise and experience as well as financial resources to be licensed. 
In Hong Kong, fund of hedge fund managers must: (1) be regulated in a 
jurisdiction with an acceptable regulatory regime; (2) have $100 
million in aggregate assets under management that follows hedge fund 
strategies; and (3) have 5 years of experience in managing hedge funds 
strategies and 2 years of experience managing funds of hedge funds. 
Fund of hedge fund managers must demonstrate appropriate expertise and 
provide information to the Central Bank of Ireland regarding 
appropriate controls to be authorized in Ireland. In Luxembourg, the 
regulator pays particular attention to expertise and financial standing 
of the managers of hedge funds when considering their applications for 
authorization. In Singapore, fund of hedge fund managers must have 
expertise in managing such funds.
    \21\ Luxembourg has no explicit minimum investment requirement, but 
the regulator may impose one if the fund of hedge funds is perceived to 
be risky. Minimum investments in Australia can be as low as $1-$2,000, 
while other jurisdictions (Hong Kong, Ireland, the Netherlands, 
Singapore, and Switzerland) generally require a minimum investment of 
$10-$15,000.

Q.5.c. To what extent is the SEC looking at how the 
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international community governs hedge funds?

A.5.c. The Commission has been a participant in the Financial 
Stability Forum (FSF) since it was convened in April 1999, to 
promote international financial stability through information 
exchange and international cooperation in financial supervision 
and surveillance. The FSF has been studying the implications 
for global economic stability of highly leveraged institutions 
(which include hedge funds).\22\ In addition, the Commission 
participates in meetings of the International Organization of 
Securities Commissions (IOSCO). Over the past few years, 
IOSCO's Technical Committee, as well as Standing Committee 5 on 
Investment Management have examined the regulations governing 
hedge funds in the international community.\23\ Most recently, 
the Commission hosted speakers from the United Kingdom and 
France at its Hedge Fund Roundtable in May 2003, which was 
convened to investigate the structure and practices of hedge 
funds. The Commission seeks to benefit from the experience of 
other jurisdictions in examining the issue of regulation of 
hedge funds.
---------------------------------------------------------------------------
    \22\ The FSF has published three papers: ``Recommendations and 
Concerns Raised by Highly Leveraged Institutions (HLI's): An 
Assessment'' (March 2002); ``Progress in Implementing the 
Recommendations of the Working Group on HLI's'' (May 2001); and 
``Working Group on Highly Leveraged Institutions'' (April 2000).
    \23\ For example, in 1999, IOSCO's Technical Committee issued a 
report entitled, ``Hedge Funds and Other Highly Leveraged 
Institutions,'' and in 2003, it published a paper entitled ``Regulatory 
and Investor Protection Issues Arising from the Participation by Retail 
Investors in (Funds of ) Hedge Funds.''

Q.6.a. Press Reports have focused a great deal of attention on 
hedge funds because of their extensive use of short selling, 
particularly in what has been a downward trending market. Does 
the SEC monitor short selling? How? Does the SEC monitor short 
---------------------------------------------------------------------------
selling by hedge funds? How?

A.6.a. As you are probably aware, short selling in itself is 
not an illegal activity, although there are rules in place 
governing the way in which short sales are carried out. For 
example, Rule 10a-1(a)(1) under the Securities Exchange Act of 
1934 (Exchange Act) provides that, subject to certain 
exceptions, an exchange-listed security may be sold short: (i) 
at a price above the price at which the immediately preceding 
sale was effected (plus tick), or (ii) at the last sale price 
if it is higher than the last different price (zero-plus tick). 
Conversely, short sales are not permitted on minus ticks or 
zero-minus ticks, subject to narrow exceptions. The operation 
of these provisions is commonly described as the ``tick test.'' 
A similar ``bid test'' applies to short sales effected in 
Nasdaq National Market 
Securities, and prohibits NASD members, subject to certain 
exceptions, from effecting short sales at or below the best bid 
when the best bid displayed is below the preceding best bid in 
a security.
    In addition, the self-regulatory organizations, such as the 
New York Stock Exchange and the National Association of 
Securities Dealers, have adopted rules to help ensure delivery 
of securities sold short by settlement date. These rules 
generally require that, prior to effecting short sales, member 
firms must affirm that they will receive delivery of the 
security from the customer, or that the firm can borrow the 
security on behalf of the customer or on its own behalf for 
delivery by settlement date. Short sellers are also subject to 
other costs, such as margin requirements, net capital 
requirements for broker-dealers, capital and risk management 
standards, and costs imposed by the equity lending market.
    The SRO's conduct surveillance regarding compliance with 
short sale regulation. In addition, the Commission's Office of 
Compliance Inspections and Examinations also conducts 
examinations for potential violations with respect to exchange-
listed securities. While a hedge fund that is not registered 
with the Commission as either a broker-dealer or investment 
company would not be subject to examination, the Commission 
could and does examine broker-dealers effecting short sales on 
behalf of hedge funds.

Q.6.b. Has the SEC discovered any evidence of the abuse of 
short selling?

A.6.b. There have been press reports documenting complaints by 
issuers that they were the victims of attacks by hedge funds. 
These issuers have alleged that the hedge funds accumulated 
large short positions in their stocks, and then sought to drive 
the share price down through the issuance of highly critical 
and allegedly inaccurate reports on their finances. The 
Commission has also recently investigated and brought actions 
against certain parties engaging in manipulative naked short 
selling as part of what is commonly called a ``death spiral'' 
scheme. In these schemes a party providing financing receives 
from a public company debentures that are later convertible 
into the stock of the issuer, typically at a discount to the 
current market price. The parties providing financing, which in 
some instances may be operating as hedge funds, and may engage 
in extensive, naked short selling designed to lower the price 
of the issuer's stock, thus realizing profits upon the 
conversion of the 
debentures.
    The Division of Enforcement will continue to investigate 
allegations of manipulative short selling by hedge funds as it 
deems warranted. From a regulatory perspective, the Commission 
recognizes that while short selling adds important benefits to 
the market, such as facilitating liquidity, hedging, and 
pricing efficiency, it also may be used as a tool for 
manipulation. In this regard, the Commission will consider 
amendments to existing short sale regulation, as necessary, to 
curb potential manipulation by all of the market participants, 
including hedge funds, without unnecessarily restricting 
liquidity.

Q.6.c. To what degree are some of the standard mutual funds, or 
other ``buy side'' market participants now using short selling?

A.6.c. As a general matter, mutual funds engage in short 
selling to a very limited extent. While many mutual funds 
reserve the right to engage in short selling as part of their 
overall investment strategies, many of these funds infrequently 
or never engage in short selling. Recent annual and semi-annual 
reports filed with the Commission indicate that, during a 
recent reporting period, approximately 230 mutual funds engaged 
in short sales, as did approximately 30 closed-end funds. The 
press also has reported that there are approximately 50 
specialized mutual funds with combined assets of $6 billion 
that consistently employ short selling and related hedging 
strategies.\24\ The NYSE and Nasdaq publicly disclose monthly 
open short interests for their listed companies.
---------------------------------------------------------------------------
    \24\ See ``Fund Trackers Mull Categories for Hedge Techniques,'' 
Ignites (www.ignites.com), May 28, 2003.

Q.7.a. In a down market environment, hedge funds are more 
attractive to pension fund investors who need the positive 
returns to meet their commitments. To what extent are the 
pension funds 
---------------------------------------------------------------------------
involved in the hedge fund market?

A.7.a. Press reports suggest that pension plans generally are 
not heavily invested in hedge funds, but that many plans are 
exploring the possibility of making investments in hedge funds. 
Because the Commission regulates neither pension plans nor 
hedge funds, we do not maintain data on the extent to which 
pension plans have invested in hedge funds.

Q.7.b. Do you believe that the pension fund managers are asking 
for and receiving the type of disclosure that they need to 
understand the risks involved?

A.7.b. We generally have insufficient information to determine 
whether pension plan managers are requesting and receiving the 
type of disclosure that they need to understand the risks 
involved in investing in hedge funds. Under ERISA, however, 
pension plan managers generally have a fiduciary duty to 
exercise prudence in investigating, evaluating, and making 
investments for their plans. As a result, we believe that 
pension plan managers should be asking for and receiving the 
information that they need to understand the risks involved in 
investing in particular hedge funds.

       RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES 
                   FROM WILLIAM H. DONALDSON

Q.1. In 1999, the President's Working Group on Financial 
Markets under the Clinton Administration issued a report 
titled, ``Hedge Funds, Leverage, and the Lessons of Long-Term 
Capital Management.'' In that report, the Working Group made a 
number of recommendations.
    Which of the 1999 Working Group's recommendations are 
currently supported by the SEC and by the Bush Administration's 
Working Group? Which of the regulatory recommendations of the 
1999 Working Group have been adopted? Which have not? Please be 
specific and give the rationale for any given regulation within 
the SEC's jurisdiction which has not been implemented.

A.1. The Commission continues to support the recommendations 
made by the President's Working Group on Financial Markets. As 
described below, the recommendations that fall within the 
jurisdiction of the Commission have been implemented or are the 
subject of further study in order to develop an implementation 
strategy that best furthers the goals of the President's 
Working Group.

Recommendation 1--Disclosure and Reporting
    The President's Working Group recommended that public 
companies be required to provide disclosures concerning their 
material exposures to significantly leveraged financial 
institutions.
    Since the report, Commission staff participated in the 
Multidisciplinary Working Group on Enhanced Disclosure also 
known as the Fisher Group (Fisher Group). The Fisher Group was 
established by the Basel Committee on Banking Supervision, the 
Committee on the Global Financial System of the G10 central 
banks, the Interna-
tional Association of Insurance Supervisors, and the Interna-
tional Organization of Securities Commissions. In April 2001, 
the Fisher Group issued a final report with recommendations for 
improving public disclosure practices of financial institutions 
and suggested that hedge funds be encouraged to make similar 
disclosures--when material--to investors, counterparties, and 
creditors. The recommended disclosures included intraperiod 
market risk exposures, qualitative discussions of funding 
liquidity risk with quantitative supporting information, and 
counterparty credit exposures categorized by business line, 
credit quality, and maturity. Public securities firms, in large 
part, are complying with the recommendations through the 
disclosures they make in their regulatory filings and annual 
reports. The Fisher Group also recommended that regulators and 
market participants collaborate further on improving market and 
counterparty credit risk disclosures. SEC staff currently is 
chairing a multinational group--the Joint Forum Working Group 
on Enhanced Disclosure--that is studying these issues as a 
follow up to the report and recommendations of the Fisher 
Group.

Recommendation 2--Supervisory Oversight
    The President's Working Group recommended that bank, 
securities, and futures regulators monitor and encourage 
improvements in the risk management systems of regulated 
entities.
    This recommendation is consistent with Commission practice. 
The Commission's Office of Compliance, Inspections and Exams 
(OCIE) conducts internal controls and risk management exams of 
broker-dealers. These reviews focus on a firm's systems, 
procedures, resources, and overall performance in the 
assessment, monitoring, and control of all risks at the firm. 
The examiners look for areas where a firm's controls are weak 
or inadequate and make findings as appropriate. OCIE also 
conducts targeted exams that focus on specific risks. For 
example, it currently is conducting a 
series of examinations of broker-dealers that are significantly 
involved in businesses and services related to hedge funds.
    In addition, the Commission's Division of Market Regulation 
has staff committed to a Risk Assessment Program (RAP), which 
focuses on broker-dealer holding companies. The RAP staff 
monitors the financial condition and operating results of 160 
broker-dealer holding companies. This includes obtaining 
quarterly reports that contain detailed information on the 
legal structure of the holding company and consolidating 
financials. This information is not routinely provided to other 
regulators and allows for analysis of the leverage, capital 
adequacy, risktaking, and business of each legal entity that is 
included in the holding company structure. The information 
provided by the reporting firms generally does not include 
external counterparty credit risk exposure.
    The RAP staff also meets monthly with the independent risk 
managers at the five independent broker-dealers most active as 
dealers in financial derivatives. It also meets quarterly with 
risk managers at several bank-owned broker-dealers that are 
significant participants in this area. Several of these firms 
also are among the dominant providers of prime brokerage 
services to hedge funds. The information provided at these 
meetings is the same information used by the firms internally 
to manage their market and counterparty credit risk exposures. 
These meetings give the RAP staff perspective on how securities 
firms manage these risks firmwide. They also provide the RAP 
staff with intra-period information on significant market and 
external counterparty credit risk exposures. The analysis of 
the risk exposures at these firms provides a unique perspective 
into market trends with respect to risk exposures and capital 
allocation. Although the meetings are voluntary, the 
participating firms have been very cooperative in helping the 
RAP staff understand their risks.
    In addition to these efforts, Commission staff members 
represent the Commission on a number of multinational working 
groups that have studied, or are studying, counterparty credit 
risk issues, including the aforementioned Joint Forum Working 
Group on Enhanced Disclosure and the Fisher Group, as well as 
the Financial Stability Forum (FSF).

Recommendation 3--Enhanced Private Sector Practices
for Counterparty Risk Management
    The President's Working Group recommended that financial 
institutions implement improved risk management procedures.
    Securities firms have implemented this recommendation. The 
market and counterparty credit risk procedures of the 
securities firms most involved with hedge funds have been 
substantially augmented and improved since 1998. These firms 
have devoted significant resources to hiring qualified risk 
managers. They also have purchased and developed highly 
innovative technological tools for measuring and aggregating 
risk, booking transactions, and tracking documentation. On the 
industry-wide level, they formed the Counterparty Risk 
Management Policy Group (CRMPG). In June 1999, CRMPG issued a 
report titled ``Improving Counterparty Risk Management 
Practices.'' The recommendations in this report have provided 
firms with useful guidance in improving counterparty credit 
risk procedures.

Recommendation 4--Capital Adequacy
    The President's Working Group has recommended that 
prudential supervisors and regulators promote the development 
of more risk-sensitive approaches to capital adequacy.
    The Commission has taken necessary steps toward making its 
broker-dealer capital rule more risk-sensitive. In 1997, the 
Commission adopted rules that allow securities firms to 
establish 
special broker-dealer affiliates that operate as over-the-
counter derivatives dealers. These firms are permitted to 
calculate market and credit risk charges using internal models. 
The Commission is drawing on this experience in implementing 
rules for investment bank holding companies under the Gramm-
Leach-Bliley Act.

Recommendation 5--Expanded Risk Assessment for the
Unregulated Affiliates of Broker-Dealers and Futures
Commission Merchants

    The President's Working Group recommended enhancing the 
current authority of the Commission to require financial 
information about the unregulated affiliates of broker-dealers.
    The Commission has authority to collect certain information 
about material affiliates of broker-dealers. This authority has 
been implemented through the RAP described above. The mandatory 
reporting required under the RAP generally does not include 
external counterparty credit risk exposures; it is limited to 
credit exposures among affiliates. On the other hand, the 
voluntary reporting by several of the largest securities firms 
provides RAP staff with in-
formation on firm-wide external counterparty credit exposures. 
Gramm-Leach-Bliley authorized the Commission to implement 
recordkeeping rules at the securities firm holding company 
level. However, firms would elect to be subject to these rules; 
they would not be mandatory. If the recommendation was 
implemented, it would enhance the Commission's authority to 
obtain information about market and external counterparty 
credit risk exposures at the broker-dealer holding company 
level. The voluntary disclosures made by the larger broker-
dealers at the monthly RAP meetings would serve as a valuable 
template for implementing such authority. The goal would be to 
limit the reporting to the most useful 
information for assessing systemic risk issues. This would 
entail a flexible approach and one that did not cause an influx 
of less relevant information.

Recommendation 6--Bankruptcy Code Issues
    The Working Group recommended changes to the U.S. 
bankruptcy code to improve close-out netting provisions.
    The proposed changes would expand the categories of 
financial contracts eligible for netting and permit netting 
across different types of contracts. The proposals also would 
clarify that a U.S. court could apply U.S. bankruptcy code 
protections in an ancillary proceeding. This would prevent a 
judicial stay from halting netting and liquidation rights 
recognized under U.S. law. Netting and liquidation rights are 
integral to prudent risk management by financial institutions. 
Accordingly, the Commission supports passage of a bill that 
accomplishes them.

Recommendation 7-- Offshore Financial Centers and
Tax Havens

    The Working Group recommended that the U.S. regulators work 
with foreign counterparts to encourage offshore financial 
centers to adopt internationally agreed upon standards to 
reduce the incentive for hedge funds to move their operations 
abroad.
    While some hedge funds may move offshore for regulatory 
purposes, their assets and the collateral they pledge generally 
remain in the United States. Therefore, locating offshore does 
not necessarily increase credit risk. However, international 
borders and secrecy havens, in particular, do further 
complicate the already limited ability of U.S. regulators to 
obtain access to hedge fund 
information and records. Therefore, removing incentives for 
hedge funds to move offshore is helpful. Commission staff 
efforts through IOSCO, the Financial Action Task Force and the 
FSF have contributed to a reduction in the number of incentives 
for a hedge fund to move offshore. In addition, through the G7 
and other political avenues, Commission staff encouraged a 
number of other jurisdictions to join in the effort to 
strengthen, among other things, the 
supervisory systems and standards of offshore financial 
centers. Multilateral initiatives have focused on removing the 
``opacity'' incentive for hedge funds to move operations to an 
offshore financial center or ``non-cooperative'' jurisdiction. 
Through the IOSCO, FATF, and FSF, Commission staff continues to 
encourage the implementation of laws, regulations, and 
practices that follow international standards. A majority of 
offshore financial centers have enhanced their regimes for 
regulatory oversight, including reporting, recordkeeping, and 
information sharing requirements.
    The President's Working Group specifically noted that the 
ability of offshore financial centers to join IOSCO and Basel-
sponsored working groups should be made contingent on progress 
toward implementation of international supervisory standards. 
This factor continues to be a membership criterion for IOSCO.

Q.2.a. It is my understanding that much of what is known about 
hedge funds is not precise. For example, it is not known 
exactly how many hedge funds there are; what is the size of the 
market, who are the investors, who are the managers; and how 
they impact the market. What information does the SEC routinely 
collect about hedge funds? How often is this information 
collected? Does the SEC have the authority it needs to collect 
adequate information to protect retail investors?

A.2.a. The Commission does not routinely collect any data about 
hedge funds. Because hedge funds typically qualify for 
exemptions from the Investment Company Act of 1940 and the 
periodic reporting requirements of the Securities Exchange Act 
of 1934, the Commission does not have authority to collect 
information from hedge funds under those statutes. The 
Commission does have authority to collect information about 
hedge funds from their advisers under the Investment Advisers 
Act of 1940, although most hedge fund 
advisers currently qualify for exemption from registration 
under Section 203(b)(3) of the Advisers Act because they manage 
fewer than fifteen funds and do not hold themselves out as an 
investment adviser. We believe that the Commission has 
administrative authority to require all hedge fund advisers to 
register under the Advisers Act, and thus could use this 
authority to collect information to protect hedge fund 
investors.

Q.2.b. It is my understanding that much of what is known about 
hedge funds is not precise. For example, it is not known 
exactly how many hedge funds there are; what is the size of the 
market, who are the investors, who are the managers; and how 
they impact the market. What information does the SEC routinely 
collect about hedge funds? How often is this information 
collected? Does the SEC have the authority it needs to collect 
adequate information to determine the impact of hedge fund 
trading activities on the securities markets?

A.2.b. Many hedge funds use broker-dealers to execute their 
securities transactions and maintain custody of their assets, 
and a few hedge funds are registered as broker-dealers. Also, 
the RAP staff monitors the counterparty credit risk exposures 
of the largest investment banks. Thus, the SEC, through its 
oversight and examination authority, can review hedge fund 
activities to the extent that they involve broker-dealers or 
registered investment advisers. However, as discussed above, 
the Commission does not have the authority to collect 
information directly from hedge funds or managers who are not 
registered with the Commission, except through subpoena. 
Accordingly, the Commission's ability to determine the impact 
of hedge fund trading on the securities markets is limited.

Q.3. With respect to funds of hedge funds, how are they valued? 
What is the frequency of such valuations? How reliable is the 
valuation? How does the SEC protect retail investors in funds 
of hedge funds from receiving inaccurate valuations of their 
shares?

A.3. A small but growing number of FOHF's have registered with 
the Commission in the past several years. These funds are 
required by the Investment Company Act of 1940 to value their 
portfolio 
securities by using: (a) the market value of the securities 
when market quotations are ``readily available,'' and (b) the 
fair value of the securities when market quotations are not 
readily available. As there generally are no readily available 
market prices for interests in the underlying hedge funds in 
which registered FOHF's invest, the FOHF's are required to 
value such interests at their fair value.
    Registered FOHF's generally disclose to their investors how 
they value their interests in hedge funds. The disclosure 
typically sets forth the steps that the FOHF's and their 
managers take to ensure that they value their assets fairly. 
Registered FOHF's often disclose in their offering documents 
that, prior to investing in a hedge fund, their managers 
conduct due diligence reviews of the valuation methodologies 
used by the hedge fund. Such reviews typically include 
examining the hedge fund's offering documents and obtaining 
additional relevant information from the fund's manager. Many 
registered FOHF's rely on valuation information provided to 
them by the hedge funds in which they invest. Registered FOHF's 
also typically disclose that they generally lack access to the 
information that would be needed to confirm independently the 
accuracy of valuation information provided by the underlying 
hedge funds. In addition, registered FOHF's typically disclose 
that, in the event that they have information that causes them 
to question the valuation information reported by a hedge fund, 
they will fair value their interest in the hedge fund based on 
any relevant information, including the reported valuation 
information, available to them.
    Registered FOHF's are required to provide a valuation of 
their assets at least semi-annually. Many registered FOHF's 
effect purchases and redemptions on a quarterly basis and, 
therefore, value their assets for those events. In addition, 
some registered FOHF's calculate their valuations more 
frequently, such as monthly, for purposes of calculation fees.
    The financial statements of registered FOHF's must be 
audited annually by independent public accountants, and the 
financial statements of many hedge funds also are audited 
annually by independent public accountants. These audits may 
provide some degree of assurance that registered FOHF's are 
valuing their assets appropriately. As noted above, auditors 
generally review and assess the reasonableness of a hedge 
fund's valuation process when auditing the fund's financial 
statements.
Q.4. Have the number of hedge fund related complaints received 
by the SEC increased over the past few years? What is the 
nature of these complaints? Please be as specific as possible.

A.4. Prior to this year, the SEC's Office of Investor Education 
and Assistance did not separately count how many investor 
contacts discussed hedge funds. Instead, our data system 
collected information about the nature of the conduct discussed 
in the investor's 
letter. Earlier this year, as hedge funds began to be marketed 
more heavily to retail investors, we added a code to track the 
number of investor contacts involving hedge funds. Our records 
show that 37 people, 7 of whom wished to remain anonymous, 
contacted the SEC this year (since January) concerning hedge 
funds. What follows are details about these contacts.
    Eighteen investors raised the possibility of fraud. Five of 
the eighteen expressed concern that their money may have been 
stolen, rather than put into a hedge fund. Six investors 
contacted the SEC because they had been unable to withdraw 
funds from hedge funds. Six investors alleged that various 
hedge funds were illegally shorting stocks, or otherwise 
manipulating the market. Two investors contacted the SEC to ask 
about the status of SEC investigations into hedge funds in 
which they were invested. One person forwarded an article that 
alleged insider trading in a hedge fund and asked that we 
investigate the matter. Whenever an investor raises credible 
allegations of fraud, our Office practice is to refer the 
matter to Enforcement.
    One investor complained to the SEC that a securities 
salesperson from a firm where she holds an account approached 
her and tried to get her to invest in a hedge fund that was too 
risky. Whenever an investor raises credible allegations of 
sales practice abuses, we refer the matter to Enforcement.
    Four investors suggested that the SEC needed to intensify 
regulation over hedge funds. Two asked that the SEC not 
regulate hedge funds further.
    One investor asked for a copy of materials referenced in 
the discussion during our roundtable on hedge funds held on May 
14 and 15, 2003.
    One person wrote to the SEC requesting the regulations and 
requirements governing the origin, funding, and operation of a 
hedge fund, plus any applications for registration and 
licensing as may be necessary.
    Three investors contacted our Office to check the 
backgrounds and/or addresses of particular hedge funds.

Q.5. In your surveillance of the securities markets have you 
considered identifying companies whose stocks have exhibited 
unusual trading patterns to determine whether hedge fund 
trading has played a prominent role in this trading activity?

A.5. There have been press reports documenting complaints by 
issuers that they were the victims of attacks by hedge funds. 
These issuers have alleged that the hedge funds accumulated 
large short positions in their stocks, and then sought to drive 
the share price down through the issuance of highly critical 
and allegedly inaccurate reports on their finances. The 
Commission has also recently investigated and brought actions 
against certain parties engaging in manipulative naked short 
selling as part of what is commonly called a ``death spiral'' 
scheme. In these schemes a party providing financing receives 
from a public company debentures that are later convertible 
into the stock of the issuer, typically at a discount to the 
current market price. The parties providing financing, which in 
some instances may be operating as hedge funds, may engage in 
extensive naked short selling designed to lower the price of 
issuer's stock, thus realizing profits upon conversion of the 
debentures.
    The Division of Enforcement will continue to investigate 
allegations of manipulative short selling by hedge funds as it 
deems warranted. From a regulatory perspective, the Commission 
recognizes that while short selling adds important benefits to 
the market, such as facilitating liquidity, hedging, and 
pricing efficiency, it also may be used as a tool for 
manipulation. In this regard, the Commission will consider 
amendments to existing short sale regulation, as necessary, to 
curb the potential manipulation by all market participants, 
including hedge funds, without unnecessarily restricting 
liquidity.

Q.6. At the Committee hearing, I read from one communication we 
have received regarding the conflicts that mutual funds appear 
to have when they also run hedge funds. According to another 
source:

    The conflicts are in several areas: (1) The different fee 
and compensation structures for portfolio managers, analysts, 
and traders incent them to act differently when managing hedge 
funds alongside mutual funds. Firms are not required to put up 
a Chinese wall between the two operations. It is often not 
feasible to do so due to expense constraints. This is 
compounded when mutual fund firms allow their portfolio 
managers to open hedge funds as a retention device to prevent 
them from leaving the firm. To maximize their compensation and 
that of their team, they tend to devote considerably more 
energy to managing the hedge fund than their mutual funds. (2) 
The ability to short stocks in a hedge fund also causes 
conflicts with investment teams running long only money. There 
are many instances where a decision to short a stock in a hedge 
fund is made simultaneously with a decision to sell in the long 
fund. The hedge fund investors naturally benefit when the 
mutual fund sales are done. (3) There is also the case where 
the benefits of running mutual funds, such as access to 
research through use of commission dollars from the mutual fund 
business, is transferred disproportionately to the hedge fund 
investor.

    Does the SEC probe these issues in their regular 
examinations? Has the SEC heard similar allegations and, if so, 
how is it addressing them?

A.6. When the Commission's examination staff conducts 
examinations of registered investment advisers that manage both 
mutual funds and hedge funds, the staff pays particular 
attention to the types of conflicts of interest to which this 
question refers. The Commission's ongoing investigation of the 
hedge fund industry also has focused on these conflicts of 
interest. These conflicts of interest, however, are not new, 
nor are they unique to side-by-side management of mutual funds 
and hedge funds. These types of conflicts may exist whenever an 
investment adviser: (i) manages accounts that pay performance-
based fees in addition to accounts that pay asset-based fees; 
and (ii) sells a security short on behalf of a client when 
another client sells a long position in that same security.
    The Commission's risk-based approach to examinations 
considers investment advisers that manage both mutual funds and 
hedge funds as posing a higher level of regulatory risk due to, 
among other things, the presence of conflicts of interest. Such 
entities can expect to be examined by the Commission's staff 
more frequently than lower-risk mutual funds and investment 
advisers. The Commission's examinations generally focus on how 
registered investment advisers manage these conflicts of 
interest, and whether the conflicts are disclosed to mutual 
fund boards of directors and mutual fund investors. For 
example, the examinations focus on the separation of duties 
(for example, the use of information barriers) and other 
internal controls that are designed to manage conflicts of 
interest in such entities. The examinations also focus on 
whether the investment advisers' conduct in relation to the 
mutual funds and hedge funds is consistent with their fiduciary 
duties and in compliance with their obligations under the 
Federal securities laws.
    The Commission also addresses conflicts of interest by 
instituting enforcement cases in appropriate instances when the 
conflicts of 
interest result in unlawful activity. For example, the 
Commission has instituted enforcement actions against 
investment advisers that preferred their performance fee-paying 
clients over their other clients in the allocation of ``hot'' 
initial public offerings.\1\
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    \1\ See In the Matter of F.W. Thompson Company, Ltd., Investment 
Advisers Act Release No. 1895 (September 7, 2000); In the Matter of 
McKenzie Walker Investment Management, Inc., 
Investment Advisers Act Release No. 1571 (July 16, 1996).
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    The Commission is continuing to explore what additional 
measures can be taken to isolate the conflicts of interest 
resulting from side-by-side management of mutual funds and 
hedge funds. The staff intends to address these and other 
issues in a report to the Commission, to be completed later 
this year, that will summarize the staff 's findings and make 
recommendations with respect to the investor protection 
implications of the growth in the hedge fund industry.

Q.7. In the Fortune article that was dated March 31, 2003 
``Where the Money's Really Made'' it stated, ``The hedge fund 
boom has sweeping implications not just for Wall Street traders 
and a few thousand well-heeled investors, but increasingly for 
every American businessperson, investor, and retiree.''
    Please comment on this statement and the potential 
``sweeping implications'' for retail investors that are raised.

A.7. The Fortune article states that the ``hedge fund boom'' 
has implications for many U.S. investors. We agree that the 
growth of the hedge fund industry has a number of implications 
for U.S. investors, including:

 Institutional investors that historically have not 
    invested in hedge funds, such as pension plans, may now be 
    investing in hedge funds. As a result, retirement and other 
    assets may be subject to the risks associated with hedge 
    funds.
 An increasing number of potentially less sophisticated 
    investors have become eligible to invest, and may be 
    investing, in hedge funds, subjecting themselves to the 
    risks associated with hedge funds.
 A small but growing number of registered investment 
    companies invest all or a significant portion of their 
    assets in hedge funds.\2\ Since these funds of hedge funds 
    are increasingly registering their securities under the 
    Securities Act, they can be sold to retail investors who 
    would then be subject to the risks associated with hedge 
    funds.
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    \2\ Following amendments to the Investment Company Act enacted in 
1996, certain hedge funds may sell their securities without regulation 
under the Federal securities laws to up to 499 qualified purchasers, 
including to most registered investment companies. Among other things, 
a qualified purchaser generally includes ``any person, acting for its 
own account or the accounts of other qualified purchasers, who in the 
aggregate owns and invests on a discretionary basis, not less than 
$25,000,000 in investments.'' Section 2(a)(51)(A)(iv) of the Investment 
Company Act.
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 More assets are invested in hedge funds, which are 
    generally not subject to the investor protection provisions 
    of the Federal securities laws, and the managers of many of 
    those hedge funds are not subject to the regulatory 
    oversight of the Commission.
 Hedge funds engage in strategies, such as short 
    selling, that may have a significant impact on the 
    financial markets.

    The Commission staff has been gathering, and is continuing 
to gather, information relating to the implications of hedge 
fund growth in the course of its ongoing investigation of the 
hedge fund industry. While we have reached no conclusions yet, 
the staff is considering these implications and will report to 
the Commission whether the existing regulatory framework 
continues to be appropriate in light of the growth of the hedge 
fund industry.

Q.8. I am aware that since June 2002, the SEC has been 
conducting an investigation of the hedge fund industry's 
structure and practices. What safeguards are in place to reduce 
the likelihood of another failure of the type of Long-Term 
Capital Management? What risks do large hedge funds pose to the 
financial system?

A.8. Since the near collapse of the LTCM in 1998, there have 
been significant changes in the hedge fund industry. The large 
macro hedge funds of the 1990's (Soros, Tiger) have scaled back 
or ceased operations. While assets under management at hedge 
funds have continued to grow, the majority of funds are 
relatively small entities. Broker-dealers that extend credit to 
hedge funds have substantially improved their counterparty 
credit risk management in light of the LTCM. Most exposures to 
hedge funds are fully collateralized, including excess 
collateral. Moreover, broker-dealer credit-risk departments 
have been upgraded and credit procedures strengthened and 
refined. In enhancing their procedures, broker-dealers have 
adopted recommendations of the CRMPG in its June 1999 report 
titled, ``Improving Counterparty Risk Management Practices.'' 
Nonetheless, there is still room for improvement. The CRMPG 
report recognized the difficulty in quantifying the credit risk 
associated with leveraged counterparties. In certain 
circumstances, large degrees of leverage may pose very little 
risk while a counterparty with little leverage may cause great 
exposure. Multinational working groups, such as the Fisher 
Group, continue to study the issue of counterparty credit risk 
exposure.
    The LTCM experience is helpful in analyzing the risks posed 
by a large hedge fund. The LTCM employed maximum leverage to 
profit on inefficiencies in the global financial markets. The 
LTCM used its market power to exact favorable transaction terms 
from its counterparties. In particular, it was able to enter 
into securities repurchase agreements with very little margin 
required. When the market value of the collateral dropped, 
counterparties called for additional collateral more quickly. 
In order to meet these collateral calls, the LTCM in many cases 
sold its most liquid assets first leaving the less liquid 
assets to meet future liquidity demands. The value of the less 
liquid assets dropped as the LTCM moved to liquidate them. This 
contributed to volatility, which put stress on other entities 
holding similar positions. Broker-dealers learned from this 
experience and generally no longer provide such favorable 
transaction terms to hedge funds. However, the business 
opportunities associated with a large hedge fund could put 
pressure on a financial institution's credit risk procedures.
    Also in the period just prior to its near collapse, the 
LTCM sold to other market participants large volumes of 
financial products that provided protection against adverse 
movements in various equity indices. To create these positions, 
the LTCM sold options to counterparties such as broker-dealers 
and banks, which used the options to hedge their own securities 
positions. At the time of its troubles, the LTCM essentially 
was the sole provider of these hedging tools. Accordingly, the 
LTCM experience demonstrates the danger of multiple major 
market participants establishing identical credit exposures 
with a single counterparty that is not subject to an effective 
disclosure regime.

        RESPONSE TO WRITTEN QUESTIONS OF SENATOR SUNUNU 
                   FROM WILLIAM H. DONALDSON

Q.1. For hedge funds that register as investment companies with 
the Securities and Exchange Commission, what disclosures 
regarding assets and liabilities are required? What other 
disclosure or audit requirements are these funds subject to?

A.1. All of the hedge funds currently registered as investment 
companies with the Commission have registered as closed-end 
funds. Like all other closed-end funds, these hedge funds are 
subject to numerous requirements designed to protect investors. 
A registered closed-end hedge fund must follow the reporting 
requirements of the Investment Company Act similar to those 
followed by other registered investment companies. For 
instance, the hedge fund must register on the form applicable 
to all other closed-end funds. That form does not distinguish 
between the disclosures--financial disclosures or otherwise--
required for a closed-end fund operating as a hedge fund, and 
for any other kind of closed-end fund.
    A closed-end fund's prospectus contains important 
information about: Its fees and expenses, investment objectives 
and strategies, risks, performance, valuation policies, and 
more. The fund's statement of additional information (SAI) 
includes information that is not necessarily needed by 
investors to make an informed decision, but that some investors 
find useful. The SAI generally includes information, or 
additional information, about: The fund's history and its 
policies; officers, directors, and persons controlling the 
fund; 
advisory and other services; brokerage commissions; and tax and 
other matters.
    The SAI also generally includes the fund's financial 
statements. In the initial registration statement, the fund's 
statement of assets and liabilities is commonly referred to as 
the ``seed balance sheet.'' Like any closed-end fund, the seed 
balance sheet for a registered hedge fund reflects the initial 
minimum of $100,000 contributed by the adviser to make the fund 
operational. It also reflects the hedge fund's assets and 
liabilities, and those are presented in the same manner as 
those for any other closed-end fund.
    After a registered hedge fund commences operations, it must 
file and provide to shareholders financial statements semi-
annually, just like other registered investment companies. The 
form and content of the financial statements of a registered 
hedge fund is the same as that of any registered closed-end 
fund. Financial reporting for publicly registered investment 
companies is governed by the rules of Regulation S-X.\1\
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    \1\ The initial balance sheet must be audited. The fund also must 
undergo an annual audit after each fiscal year end.
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    In the statement of assets and liabilities, a registered 
investment company typically reports investments in securities 
as the first asset because of their relative importance to 
total assets. Other assets reported include, among other 
things, receivables for securities sold, and dividends and 
subscriptions receivable from shareholders. Liabilities 
reported include, among other things, payables for various 
operational expenses, accrued liabilities for securities sold 
short, open option contracts written, and distributions payable 
to shareholders.
    Other financial statements and schedules that must be 
disclosed in a registered investment company's (registered 
hedge fund or otherwise) shareholder reports include:

 a schedule of investments--a detailed list of the 
    portfolio securities as of the latest period; \2\
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    \2\ Those ``funds of hedge funds'' that invest solely in other 
hedge funds only would report the underlying hedge funds in which they 
invested, not the underlying investments made by those underlying hedge 
funds.
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 a statement of operations--shows increase or decrease 
    in net assets resulting from investment activities by 
    reporting investment income from dividends, interest, and 
    other income less expenses, and the amount of gain or loss 
    from investment and foreign currency transactions;
 a statement of changes in net assets--summarizes 
    results from operations, dividends, and distributions to 
    shareholders, capital share transactions, and capital 
    contributions;
 financial highlights--contains per share operating 
    performance data for a typical share outstanding (for those 
    investment companies that are unitized), as well as total 
    investment return, analytical ratios, and other 
    supplemental data for a period of at least 5 years; and
 a statement of cash flow--explains changes in cash and 
    cash equivalents. The statement classifies cash receipts 
    and cash payments as resulting from operating, investing, 
    and financing activities and includes a reconciliation of 
    net cash provided by and used for operating activities to 
    net increase or decrease in net assets from operating 
    activities.\3\
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    \3\ A registered investment company need not include a statement of 
cash flows in its shareholder report if it meets certain criteria, 
including that the fund's net assets be made up of 
highly liquid investments throughout the period. Funds of hedge funds 
invariably have to supply a statement of cash flows because they do not 
meet this criterion.

    In addition to filing semi-annual reports, registered 
investment companies must file Form N-SAR semi-annually. The N-
SAR is a regulatory report used by the Commission to review 
whether the registered investment companies are in compliance 
with the Investment Company Act. It is not provided to 
shareholders but is publicly available.
    N-SAR includes similar information reported in the 
financial statements. A closed-end fund must provide the 
aggregate number of shares and net consideration paid for all 
repurchases of the fund's stock during the reporting period, 
and also must disclose rate schedules for fees paid to 
investment advisers. The fund also must provide, among other 
things, the top ten brokers with whom it executed commission 
and non-commission trades. In addition, the annual N-SAR 
includes an auditor's report on the fund's internal controls. 
In that report, the auditor must identify any material 
weaknesses in the fund's accounting system or in the fund's 
internal controls.

Q.2. Following the LTCM's collapse, the President's Working 
Group on Financial Markets issued a report addressing the 
excessive leveraging by hedge funds and banks lending to hedge 
funds. As part of this report, the Fed and the OCC issued new 
guidelines with instructions to banks lending to hedge funds. 
Please detail these guidelines, as well as the degree to which 
they have been implemented, and their effectiveness in limiting 
inappropriate leverage in financial institutions.

A.2. We must defer to the Fed and the OCC to provide a detailed 
response to this question. We can report that Commission staff 
members have worked alongside U.S. banking regulators in a 
number of groups that have examined issues related to highly 
leveraged institutions. For example, staff members participated 
in a Working Group on Highly Leveraged Institutions for the 
Financial Stability Forum. In the course of this work, U.S. 
banking regulators reported that a 2000 review found a decline 
in the aggregate level of U.S. national bank exposure to highly 
leveraged institutions and a decline in the number of 
institutions providing credit to that sector. The banking 
supervisors also report that the banks are doing a better job 
of due diligence and ongoing monitoring of hedge fund 
counterparties. Finally, they report that U.S. banks continue 
to work on improving the measurement of potential future 
exposure as part of their efforts to improve counterparty 
credit risk management.