    [House Hearing, 110 Congress]
    [From the U.S. Government Publishing Office]

     AFTER BLACKSTONE: SHOULD SMALL INVESTORS BE EXPOSED TO RISKS OF HEDGE
                                     FUNDS?

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

                                    HEARING

                                   before the

                        SUBCOMMITTEE ON DOMESTIC POLICY

                                     of the

                             COMMITTEE ON OVERSIGHT
                             AND GOVERNMENT REFORM

                            HOUSE OF REPRESENTATIVES

                           ONE HUNDRED TENTH CONGRESS

                                 FIRST SESSION

                                   __________

                                 JULY 11, 2007

                                   __________

                               Serial No. 110-42

                                   __________

    Printed for the use of the Committee on Oversight and Government Reform

      Available via the World Wide Web: http://www.gpoaccess.gov/congress/
                                   index.html
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                 COMMITTEE ON OVERSISGHT AND GOVERNMENT REFORM

                     HENRY A. WAXMAN, California, Chairman
    TOM LANTOS, California               TOM DAVIS, Virginia
    EDOLPHUS TOWNS, New York             DAN BURTON, Indiana
    PAUL E. KANJORSKI, Pennsylvania      CHRISTOPHER SHAYS, Connecticut
    CAROLYN B. MALONEY, New York         JOHN M. McHUGH, New York
    ELIJAH E. CUMMINGS, Maryland         JOHN L. MICA, Florida
    DENNIS J. KUCINICH, Ohio             MARK E. SOUDER, Indiana
    DANNY K. DAVIS, Illinois             TODD RUSSELL PLATTS, Pennsylvania
    JOHN F. TIERNEY, Massachusetts       CHRIS CANNON, Utah
    WM. LACY CLAY, Missouri              JOHN J. DUNCAN, Jr., Tennessee
    DIANE E. WATSON, California          MICHAEL R. TURNER, Ohio
    STEPHEN F. LYNCH, Massachusetts      DARRELL E. ISSA, California
    BRIAN HIGGINS, New York              KENNY MARCHANT, Texas
    JOHN A. YARMUTH, Kentucky            LYNN A. WESTMORELAND, Georgia
    BRUCE L. BRALEY, Iowa                PATRICK T. McHENRY, North Carolina
    ELEANOR HOLMES NORTON, District of   VIRGINIA FOXX, North Carolina
        Columbia                         BRIAN P. BILBRAY, California
    BETTY McCOLLUM, Minnesota            BILL SALI, Idaho
    JIM COOPER, Tennessee                JIM JORDAN, Ohio
    CHRIS VAN HOLLEN, Maryland
    PAUL W. HODES, New Hampshire
    CHRISTOPHER S. MURPHY, Connecticut
    JOHN P. SARBANES, Maryland
    PETER WELCH, Vermont

                         Phil Schiliro, Chief of Staff
                          Phil Barnett, Staff Director
                           Earley Green, Chief Clerk
                      David Marin, Minority Staff Director

                        Subcommittee on Domestic Policy

                       DENNIS J. KUCINICH, Ohio, Chairman
    TOM LANTOS, California               DARRELL E. ISSA, California
    ELIJAH E. CUMMINGS, Maryland         DAN BURTON, Indiana
    DIANE E. WATSON, California          CHRISTOPHER SHAYS, Connecticut
    CHRISTOPHER S. MURPHY, Connecticut   JOHN L. MICA, Florida
    DANNY K. DAVIS, Illinois             MARK E. SOUDER, Indiana
    JOHN F. TIERNEY, Massachusetts       CHRIS CANNON, Utah
    BRIAN HIGGINS, New York              BRIAN P. BILBRAY, California
    BRUCE L. BRALEY, Iowa
                        Jaron R. Bourke, Staff Director

                                C O N T E N T S

                                  ----------
                                                                       Page
    Hearing held on July 11, 2007....................................     1
    Statement of:
        Bullard, Mercer E., University of Mississippi Law School;
          John C. Coffee, Jr., Columbia Law School; Joseph P. Borg,
          president of the Board of Directors of the North American
          Securities Administrators Association; and Peter J. Tanous,
          president and CEO, Lynx Investment Advisory, LLC...........    40
            Borg, Joseph P...........................................   100
            Bullard, Mercer E........................................    40
            Coffee, John C., Jr......................................    85
            Tanous, Peter J..........................................   111
        Donahue, Andrew J. ``Buddy'', Director of the Division of
          Investment Management, Securities and Exchange Commission..    19
    Letters, statements, etc., submitted for the record by:
        Borg, Joseph P., president of the Board of Directors of the
          North American Securities Administrators Association,
          prepared statement of......................................   103
        Bullard, Mercer E., University of Mississippi Law School,
          prepared statement of......................................    43
        Coffee, John C., Jr., Columbia Law School, prepared statement
          of.........................................................    88
        Donahue, Andrew J. ``Buddy'', Director of the Division of
          Investment Management, Securities and Exchange Commission,
          prepared statement of......................................    22
        Issa, Hon. Darrell E., a Representative in Congress from the
          State of California, prepared statement of.................    11
        Kucinich, Hon. Dennis J., a Representative in Congress from
          the State of Ohio, prepared statement of...................     4
        Tanous, Peter J., president and CEO, Lynx Investment
          Advisory, LLC, prepared statement of.......................   113

     AFTER BLACKSTONE: SHOULD SMALL INVESTORS BE EXPOSED TO RISKS OF HEDGE
                                     FUNDS?

                                  ----------

                            WEDNESDAY, JULY 11, 2007

                      House of Representatives,
                       Subcommittee on Domestic Policy,
                  Committee on Oversight and Government Reform,
                                                        Washington, DC.
        The subcommittee met, pursuant to notice, at 1 p.m., in
    room 2154, Rayburn House Office Building, Hon. Dennis J.
    Kucinich (chairman of the subcommittee) presiding.
        Present: Representatives Cummings, Kucinich, Davis of
    Illinois, Tierney, Watson, Braley, Cannon, Issa, and Bilbray.
        Also present: Representative Hodes.
        Staff present: Jaron Bourke, staff director; Charles Honig,
    counsel; Jean Gosa, clerk; Evan Schlom, intern; Natalie Laber,
    press secretary, Office of Congressman Dennis J. Kucinich;
    Leneal Scott, information systems manager; and David Marin,
    minority staff director.
        Mr. Kucinich. Good afternoon. The Subcommittee on Domestic
    Policy of the Committee of Oversight and Government Reform will
    now come to order.
        Today's hearing will take a closer look at loosened initial
    public offerings of hedge funds and private equity funds and
    the risks they pose to small investors.
        Without objection, the Chair and ranking minority member
    will have 5 minutes to make opening statements, followed by
    opening statements not to exceed 2 minutes by any other Member
    who seeks recognition.
        Without objection, Members and witnesses may have 5
    legislative days to submit a written statement or extraneous
    materials for the record.
        Without objection, we will be joined on the dias by Members
    not on our committee for the purposes of participating in this
    hearing and asking questions of our witnesses.
        Good afternoon. This hearing's purpose is to shed light on
    a serious challenge to America's decades-long commitment to
    protecting small investors, brought to public attention by the
    recent public offering of Blackstone LP. Hedge funds and
    private equity funds are risky, and they operate under
    exemptions from traditional investor protections.
        Under current law, hedge funds and private equity funds may
    not be sold to small investors. They deploy investment
    strategies that are otherwise prohibited, and they possess the
    potential for rich rewards. But at the same time, they are
    characterized by real potential risks of callosal failure,
    illustrated by the collapse of two Bear Sterns hedge funds just
    2 weeks ago, and the collapse of Amaranth Partners and Long
    Term Capital some years ago.
        The public offering of Blackstone LP 2 weeks ago and the
    offering of the Fortress Investment Group that preceded it
    marked the attempt to mainstream a new financial arrangement
    that effectively presents small investors with the ability to
    invest in the management of hedge funds and private equity
    funds. I am concerned that the effect is to expose small
    investors to risks that heretofore have been permitted only for
    large institutional investors and wealthy individuals.
        Blackstone is the latest and by far the largest family of
    hedge funds and private equity funds that have devised a way to
    be traded publicly without compliance with the Investment
    Company Act of 1940, but it by no means will be the last. The
    Kohlberg, Kravis, Roberts private equity group and the Och-Ziff
    Capital hedge funds have already filed with the SEC to make
    their management companies public following Fortress and
    Blackstone models, and news reports indicated that other funds,
    such as the Carlyle Group and Apollo may not be far behind.
        The subject of this hearing is this: has the SEC adequately
    used its existing authority to protect small investors with
    regard to the initial public offering of these arrangements? Is
    the existing law adequate to the task of protecting investors
    in the face of the desire and resourcefulness of hedge fund and
    private equity fund managers to go public? What are the new
    risks to small investors posed by these new financial
    arrangements?
        I want to be clear that this hearing is not about the
    abolition or even the further regulation of private equity and
    hedge funds, nor is this hearing biased toward forbidding
    future offerings like Blackstone LP. The bias, if there is one,
    is toward the protection of small investors and how best
    regulation may accomplish that goal; in other words, what steps
    all actors in the broader regulatory system, including
    Congress, can and should take to militate against the risk of
    these novel investment vehicles.
        The backbone of our financial system, one that makes it the
    envy of the world and an efficient machine to balance risk and
    reward, is our strong system of regulating public offerings.
    The Securities and Exchange Commission has attempted to
    institute some regulation of hedge funds for even sophisticated
    and wealthy investors. All of the witnesses that you will hear
    from today think that when small investors are allowed access
    to hedge funds and private equity funds there needs to be
    regulation. The question is: what type of regulation is both
    necessary and reasonable to strengthen our financial system?
        Blackstone LP provides the point of departure. This
    subcommittee wrote the SEC on June 21st out of concern that
    insufficient time an opportunity had been allotted to examine
    those new risks and the soundness of the new financial
    arrangements. Chairman Waxman and I felt that the stakes were
    high, since a careful reading of Blackstone's registration
    statements by our staff revealed that public investors in the
    IPO would be assuming risks without the traditional investor
    protections of corporate governance that allow investor control
    and without transparency and the disclosure of what is being
    invested in. Those risks include excessive compensation
    arrangements, management of self-dealing transactions with
    affiliates, use of substantial leverage, no diversification
    requirements, difficult-to-value investments, illiquid
    investments, no independent board members, no substantive
    voting rights, few fiduciary duties on management.
        Eagerness by Blackstone to launch this IPO and to stymie
    Congress' examination of these questions is unfortunate. It
    should be noted that Blackstone moved up its offering date by a
    week, precisely when we and several other Members of Congress
    asked the SEC to scrutinize further the offerings. They could
    have allowed the inquiry to take place, and I believe it was
    unfortunate they didn't. But if Blackstone was able to market a
    black box to ordinary investors by gaming their offering date,
    others that follow will not.
        The alternative to oversight is not pretty: it is to wait
    for something bad to happen; for the failure of one or several
    of these management complaints; and for, as in the Enron
    debacle, ordinary investors to lose everything, including their
    retirement income, and to allow the legal and economic fallout
    to be resolved through protracted and expensive litigation. You
    know, this just isn't acceptable.
        So our hearing today is timely and, we hope, helpful to the
    cause of protecting ordinary investors. These are individuals
    and families who are saving for college or retirement through
    IRAs and 527s, mutual funds, and online trading houses. They
    depend upon the SEC and Congress to afford them the
    opportunities of our market system with protections from
    excessive risks and dangers which can otherwise ruin and defeat
    the American dream.
        We will examine today, with the help of some of the
    Nation's leading experts, if we are living up to that challenge
    and if we are responsibly or irresponsibly exposing small
    investors to excessive risk and danger.
        Thank you very much.
        [The prepared statement of Hon. Dennis J. Kucinich
    follows:]

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        Mr. Kucinich. With that I recognize the Honorable ranking
    minority member, Mr. Issa of California.
        Mr. Issa. Thank you, Mr. Chairman. I think you did a great
    job of characterizing the majority opinion on today's hearing,
    and Ido want to thank you very sincerely for holding this. I
    believe that there is a need for this Congress to view changes
    in the market, and view them with the kind of doubt that, by
    definition, helps protect investors large and small.
        I do believe that we are holding two hearings here today.
    We are holding on that seems to be all about Blackstone. This
    IPO was not a private equity, in fact, public offering, but
    rather the management of a private equity. But we are also here
    today, without a doubt, dealing with questions of hedge funds
    and private equity that are being dealt with in Congress as we
    speak and that are being, in some cases, vilified.
        So little is known about private equity industry it is easy
    to mischaracterize the role they play in our economy. My
    comments today are directed primarily at private equity funds.
    I am concerned that we in Congress are lumping equity and hedge
    funds together and looking at them as interchangeable. They are
    different entities and should be seen differently.
        Frequently we have heard individuals such as Steve
    Schwartzman of Blackstone or Lew Gerstner of the Carlyle Group
    characterized as Masters of the Universe, invoking images of
    robber barons or captains of industry, to explain the business
    model. What is more, in every article concerning Blackstone's
    IPO, there were also descriptions of CEO's lavish lifestyle.
    These notions have led Members of Congress to advocate for
    increasing taxes associated with the private equity model.
        Included today I put some charts up--and I have more--that
    specifically make it clear that one of the major recipients of
    both hedge funds and private equity are, in fact, both public
    and private entities such as union pension funds, public
    pension funds, and, in fact, corporate pension funds typically
    having between 1 and 15 percent of their portfolio in these
    types of investments. These investments have done well for
    future retirees throughout the country, running as much as 22,
    23 percent return on investment year over year over year.
        So it is very clear that the most sophisticated buyers, the
    most sophisticated buyers, these large, multi-billion-dollar
    pension funds with all of their professional management, have
    made a decision that favors a certain percentage of these
    investments.
        It is also clear that if, not as this chairman, but as
    chairmen of some other committees, have been advocating, if, in
    fact, we choose to add a level of taxation to this process at
    any point, we are not going to take it out of the people and
    the companies that produce these profits; we are going to take
    it out of the pass-along to these entities. That is one of my
    concerns here today.
        Perhaps as a proud Republican, perhaps simply as a
    taxpayer, I find little doubt in my mind that we are taxed
    sufficiently. I am not here today to advocate for a tax
    increase. In fact, my opinion is that we, as Americans, are
    fully taxed and need not look for additional tax revenue by
    adding to a group to vilify in order to raise their taxes.
        Also, too often securities legislation has been the product
    of congressional hothouses. This follows closely on financial
    scandals or disasters. It is no coincidence that Congress
    passed the Security Exchange Act of 1933 or created the
    Securities and Exchange Commission in 1934 following the dark
    days of the 1929 crash and the Depression that followed.
        In recent history, Congress passed during my tenure
    Sarbanes-Oxley Act on the heels of Enron and WorldCom
    disasters. Oddly enough, Sarbanes-Oxley did little to prevent
    that from happening again, but has added billions of dollars of
    legal and accounting costs to public companies, thus reducing
    what they can pay in dividends to the small investor that we
    are here today to talk of.
        It is very clear that we are not here today to pass
    legislation in a hurry. It is clear that we should not. There
    has not been a disaster. There has not been some sort of an
    episode, including this public offering, that should cause us
    to hastily go to legislation. Just the opposite. I believe
    hearing from the Securities and Exchange Commission and from
    career investors and other people knowledgeable in this
    industry today, we will have a better opportunity to see what
    is right, what is more right in this country than any other
    country on the face of the Earth, and then perhaps what could
    be done. Perhaps we could start talking about rolling back some
    of the mistakes of Sarbanes-Oxley.
        Thankfully, the debate about Blackstone IPO will not result
    in a public scandal. It will and has resulted in small
    investors able to participate in just a few thousand dollars, a
    few hundred shares, if they choose to, in fact, the management
    team of a company that has been wildly successful.
        Full disclosure, not just by the SEC but also, and I think
    more importantly, by the public media has made it very clear
    that this is a unique first event and that investors should
    make sure that they are not over-weighted in this or any other
    investment.
        Mr. Chairman, not to be overly colorful, but because I am a
    believer that America's competitiveness depends on private
    equity, I am going to close and put the rest in for the record
    and just tilt up one example. I used wine with Chairman Waxman
    not too long ago, but Dunkin Donuts, a small public company
    that went private, in my opening statement I characterize they
    have made it very clear that their success today, in fact, the
    fact that they are doing a very good job against their best-
    known rival, Krispy Kreme--since I am putting out public names
    of which I own none--they, in fact, could not have reorganized
    and come out a much more successful company if they didn't have
    the ability to come out of the daily quarterly grind, make the
    kinds of investments that often we on the dais complain are
    short-sighted, the I have to make this quarter, the next
    quarter that public companies often do. But instead, they were
    able to put together a long-term plan, come out, and, in fact--
    and the odor is absolutely wonderful--produce a product that
    now is selling dramatically better than it did just a few years
    ago.
        Mr. Chairman, I will put the rest in for the record and
    make the donuts available to all of our guests. [Laughter.]
        I will yield back.
        [The prepared statement of Hon. Darrell E. Issa follows:]

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        Mr. Kucinich. I want to thank my friend for his
    presentation and say that we shall proceed in the spirit of
    keeping our eye on the donut and not on the hole. [Laughter.]
        I am a vegan. I don't eat that stuff.
        The Chair will recognize the distinguished Member of
    Congress from New Hampshire, Mr. Hodes, who is a guest at our
    committee.
        We welcome you.
        Mr. Hodes. Thank you, Mr. Chairman. I appreciate your
    allowing me to sit as a guest member of the subcommittee. I am
    a member of the Oversight and Government Reform Committee and
    also a member of the Financial Services Committee, and am
    especially interested in the Blackstone matter.
        I had a pleasure, as a member of the Financial Services
    Committee, Mr. Donahue, to question Chairman Cox and the
    Commissioners of the SEC about the Blackstone IPO because of
    some particular concerns I had.
        Now, I am not here to argue between tempe and tofu or one
    wine or the other, and I understand that the SEC has held that
    the Blackstone IPO did not have to comply with the Investment
    Company Act of 1940.
        My concern remains, however, and I suppose that reasonable
    minds could differ on the SEC's conclusion, and reasonable
    minds do, and the courts could take it up, and they may. But my
    question really--and I am hoping you will address this--is that
    it is a public policy question. The SEC's mission is to protect
    investors; maintain fair, orderly, and efficient markets; and
    facilitate capital formation.
        We are now in a new world in which a private equity firm,
    Blackstone, probably very different than a traditional, if such
    can be applied to the word hedge fund, has now gone public.
    They have made the transition from the private equity entity
    into the public markets.
        In that light, according to their S-1 filing and what is
    generally recognized in the way they are formed, they have
    disclaimed fiduciary duties in general to their unit holders,
    they have limited voting rights to their unit holders, and they
    have asserted the right to act with limited disclosure as to
    important elements of their strategy and the way they operate
    which would otherwise, in the ordinary course of a public
    offering which did comply with the Investment Company Act of
    1940, be available to their shareholders or unit holders.
        I think significant public policy questions are raised, and
    it is not too early, given the size and complexity of the
    Blackstone IPO and other private equity firms which appear to
    be coming to the market, to ask the question whether or not, in
    view of this new entity, the Investment Company Act of 1940 is
    up to date, and whether or not amendments need to be made to
    respond to the new situation in the markets in order to protect
    investors, because for the life of me I cannot see who is
    protecting the investors in the Blackstone IPO if they are
    allowed to disclaim their fiduciary duties, and how and by what
    mechanism that will happen.
        I understand that the SEC is moving on some elements to
    deal with fraud provisions that might relate, but it strikes
    me, as a matter of public policy, that we may have to address
    the Investment Company Act of 1940, and I look forward to
    hearing from you your thoughts on the advisability of doing
    that.
        Thank you very much.
        Thank you, Mr. Chairman.
        Mr. Kucinich. I thank the gentleman for joining us.
        If there are no additional opening statements, this
    subcommittee will now receive testimony from the witnesses
    before us today.
        I want to start by introducing the gentleman who will be
    making the first presentation, Mr. Andrew Donahue. Mr. Donahue
    has been the Director of the Division of Investment Management
    at the Securities and Exchange Commission since May 2006.
        Welcome, Mr. Donahue.
        As Director, Mr. Donahue is responsible for developing
    regulatory policy and administering the Federal securities laws
    applicable to mutual funds, exchange-traded funds, closed-end
    funds, variable insurance products, unit investment trust, and
    investment advisors. You can see that we have the right person
    here to talk to about this.
        Prior to the SEC, Mr. Donahue was global General Counsel
    for Merrill Lynch Investment Managers and chairman of the
    firm's Global Risk Oversight Committee. Prior to his time at
    Merrill Lynch, Mr. Donahue was a securities lawyer and
    executive vice president and general counsel, director, and
    member of the Executive Committee for Oppenheimer Funds.
        Mr. Donahue, it is the policy of the Committee on Oversight
    and Government Reform to swear in all witnesses before they
    testify, and I would ask if at this time you would kindly rise
    and raise your right hand.
        [Witness sworn.]
        Mr. Kucinich. The record will reflect that the witness
    answered in the affirmative.
        I ask the gentleman to give a brief summary of his
    testimony. Keep this summary, if you would, under 5 minutes in
    duration. I want you to bear in mind that your complete
    statement and anything you want to attach to it will be
    included in the hearing record.
        The gentleman is recognized. Again, thank you for your
    presence here today.
        You may proceed.

       STATEMENT OF ANDREW J. ``BUDDY'' DONAHUE, DIRECTOR OF THE
      DIVISION OF INVESTMENT MANAGEMENT, SECURITIES AND EXCHANGE
                               COMMISSION

        Mr. Donahue. Chairman Kucinich, Ranking Member Issa, and
    members of the subcommittee, I am pleased to be here today to
    discuss the Securities and Exchange Commission's perspective
    with respect to initial public offerings of investment advisory
    firms that, among other things, manage hedge and private equity
    funds.
        As the head of the Commission's Division of Investment
    Management, I have responsibilities for overseeing and
    regulating nearly 1,000 investment company complexes with over
    $11 trillion in assets, and more than 10,000 investment
    advisors that manage more than $37 trillion in assets.
        A number of issues have been raised about the recent IPOs
    of Fortress Investment Group and the Blackstone Group. I am
    pleased to be able to offer the committee my knowledge and
    expertise, especially as it relates to the question of whether
    Fortress and Blackstone are investment companies and thus
    subject to the substantive provisions of the Investment Company
    Act of 1940.
        Congress enacted the Investment Company Act to provide a
    separate and different regulatory structure for investment
    companies as compared to industrial or operating companies.
    Among Congress' stated goals was to minimize the risk that an
    investment company might be managed in the interest of its
    managers or certain shareholders rather than for the benefit of
    all shareholders.
        The Investment Company Act provides important protections
    to investment company investors. I have great respect for the
    Investment Company Act and the role that it has had in
    affording America's investors an opportunity to invest in our
    Nation's securities markets through a vehicle subject to
    meaningful oversight and protection. As a result, I believe
    investment companies' status to be a critical determination.
        The staff reviewed the Fortress and Blackstone registration
    statements in the normal course and consistent with past review
    practices and Commission precedent. Applying tests established
    by Congress and the Investment Company Act, the staff concluded
    that Fortress and Blackstone do not appear to be investment
    companies.
        First, under the orthodox investment company test, Fortress
    and Blackstone are primarily engaged and hold themselves out as
    being primarily engaged in the business of managing money for
    others, not themselves. Their assets, sources of income,
    officer and employee activities, historical development, and
    public statements are consistent with those of an operating
    company, not an investment company.
        Second, in applying the inadvertent investment company
    test, Fortress and Blackstone did not appear to have 40 percent
    of their assets in investment securities.
        In addition to other assets, the primary assets of Fortress
    and Blackstone are their general partnership interests and the
    underlying funds they manage. These general partnership
    interests raise two questions relevant to the investment
    company status determinations. First, are they securities or
    investment securities? Second, what is their value?
        Under existing law, general partnership interests are not
    securities if the profits relating to those interests generally
    come from the efforts of the general partners, as opposed to
    the efforts of others. In the case of Fortress and Blackstone,
    the issue is maintained control over the day-to-day management
    of the underlying funds, with senior employees exercising such
    management through wholly owned subsidiaries.
        The profits to the general partnership interest result from
    the efforts of the general partnership managers, not others;
    thus, the general partnership interest would not constitute
    securities or investment securities.
        With respect to valuation, the Investment Company Act
    requires an issuer to assign a fair value to general
    partnership interests like those at issue in Fortress and
    Blackstone filings. In determining a fair value, the right to
    carried interest in underlying funds may be considered, because
    such rights are inexorably linked to the general partnership
    interest.
        Applying these principles, neither Fortress nor Blackstone
    appears to hold investment securities with a value exceeding 40
    percent of total assets.
        Put another way, in the context of both Fortress and
    Blackstone, the value of the assets that are not investment
    securities--the general partnership interests, including the
    right to receive carried interest in the underlying funds--is
    more than 60 percent of total assets.
        This asset composition is indicative of an operating
    company business rather than an investment company business.
        When conducting an investment company status analysis, the
    staff considers the status to the relevant entity prior to the
    offering, as well as giving effect to the offering. They also
    monitor the investment company status of certain companies on
    an ongoing basis. In some cases, the staff may disagree with
    the investment company's status analysis and request that it
    either register as an investment company or restructure its
    business or securities holdings so as to no longer be an
    investment company. The Commission will bring an enforcement
    action against a company in appropriate circumstances.
        Our staff did not object to the investment company status
    conclusion in the Fortress and Blackstone registration
    statements. As noted in the required legends on all registered
    public offerings, the Commission does not approve or disapprove
    of the securities offered, nor does it pass upon the adequacy
    or accuracy of the disclosures. Fortress and Blackstone remain
    liable for the statements contained in their registration
    statements.
        Finally, it is important to consider that the public
    investors in Fortress and Blackstone are buying an interest in
    an ongoing business which, among other things, manages some
    underlying funds. While the value of their investment in
    Fortress or Blackstone may be related to how well Fortress or
    Blackstone do at managing those underlying funds, as well as
    how well Fortress and Blackstone are operating their business,
    investors are not acquiring a share in any underlying fund.
        Thank you for this opportunity to appear before the
    committee. I would be happy to answer any questions you may
    have.
        [The prepared statement of Mr. Donahue follows:]

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        Mr. Kucinich. I thank the gentleman.
        I would like to start out by asking you, sir, can you tell
    the committee what are some of the investor protections that
    follow if an offering is determined by the SEC to be an
    investment company?
        Mr. Donahue. There is a broad array of investor protection
    built into the 1940 act. There are limits on the composition of
    the board of directors, there are certain approvals that must
    be made by the board of directors of the investment company.
    There are provisions that cover the valuation of the assets
    that are owned by the investment company. There are limits on
    borrowing, senior securities, and leverage. There are limits on
    what the capital structure can be. There are limits on
    affiliate transactions. There are limits on where assets can be
    custodied. And there are very specific requirements with
    respect to who the advisor and who the officers and employees
    can be for the investment company.
        Mr. Kucinich. Thank you. Now, in view of the Securities and
    Exchange Commission determination that Blackstone LP was not an
    investment company, what investor protections exist now?
        Mr. Donahue. The investor protections that exist now for
    investors investing in Blackstone and in Fortress are those
    that are available to investors in securities that are
    registered with the Securities and Exchange Commission that are
    not investment companies.
        Mr. Kucinich. Let me be more specific, if I may. Under this
    determination that Blackstone LP was not an investment company,
    do investors have a right to an independent board of directors?
        Mr. Donahue. The composition of the board of directors for
    that entity, same as for other 1933 Act companies, would be
    determined by a combination of State law and the listing
    requirements of the exchange that they are traded on.
        Mr. Kucinich. So you can't answer yes or no? Is that what
    you are saying?
        Mr. Donahue. I believe in the case of Blackstone that three
    of their seven directors will be independent. That is my
    understanding.
        Mr. Kucinich. OK. Three of seven. Do they have guaranteed
    voting rights under this?
        Mr. Donahue. They have the voting rights that are afforded
    to them under their governing documents and State law and
    Exchange rules, same voting rights as any other 1933 Act
    company, same limitations.
        Mr. Kucinich. Do they have protections against self-
    interested transactions with affiliates?
        Mr. Donahue. Not under the Investment Company Act, but they
    would have the same protections that might be afforded to other
    registered companies.
        Mr. Kucinich. Do they have the guarantee of protections of
    the traditional range of fiduciary duties owed by management to
    shareholders in a corporation such as a duty of loyalty?
        Mr. Donahue. They would have the duty that is determined
    under State law.
        Mr. Kucinich. Now, may I ask you, are hedge funds and
    private funds sold today to ordinary investors? If not, why
    not?
        Mr. Donahue. The hedge funds and private pools of capital,
    private funds, can be sold currently to investors, provided
    that they are done in accordance with the--generally they use
    Regulation D, and in order to avoid registration under the
    Investment Company Act they generally comply with the exception
    under either 3(c)(1), where there are under 100 investors, or
    3(c)(7), where there is unlimited number of investors that all
    meet the $5 million or higher test for investments.
        Mr. Kucinich. Does the case law in applying the Securities
    and Investment Company Act generally support the principle that
    function trumps form, or the converse?
        Mr. Donahue. As I look at our responsibilities in
    administering the securities laws, we are mindful of the
    statutory framework within which we have been charged to
    operate by Congress, and determinations that have been made by
    courts with respect to interpretations. If there is anybody
    that felt that this was an investment company in our area, the
    protection of investors, we would have sought to see whether or
    not there was a way. If we felt that this had been constructed
    in a way to evade the Investment Company Act, we certainly
    would have taken, I wouldn't say a different look at it, but
    you can't evade the Investment Company Act. We did not feel
    that was the case here.
        Mr. Kucinich. I am going to ask one more question and then
    we will probably need to go another round. Will a significant
    portion of the value of the units of shares offered to the
    public in the Fortress or Blackstone LP deals ultimately be
    determined by the returns garnered under the underlying hedge
    fund and private equity fund portfolios and move in unison with
    the fund portfolios?
        Mr. Donahue. I would start off by saying I believe in the
    case of Blackstone that they have over 100 underlying
    investment funds that it is managing. I would think that the
    stock price of Blackstone is going to be driven by a variety of
    forces. One certainly I would hope would be how well they would
    manage their businesses and how well they are managing their
    underlying funds.
        It is true that, as currently constituted, a fair amount of
    their earnings are derived from how well they manage those
    underlying funds, but they are not parting company. They can go
    into other businesses. They can create new funds. So going
    forward, a lot is dependent not just on their current
    investments, the funds that they are managing, but also on how
    well they run their management, how well they manage their
    company.
        Mr. Kucinich. OK. Thank you very much, Mr. Donahue.
        The Chair recognizes Mr. Issa. Thank you.
        Mr. Issa. Thank you. I want to continue along the line the
    chairman was doing. I find this very interesting.
        If for a moment, instead of the IPO being about Blackstone
    Group, LP, if you were, in fact, investing in Dunkin Donuts,
    Hilton Hotels, Linens and Things, as typically people have,
    they are investing as limited partners, normally, correct?
        Mr. Donahue. I am not familiar with----
        Mr. Issa. Their underlying funds are, in fact, typically
    Blackstone's----
        Mr. Donahue. The underlying funds are typically set up as
    limited partnerships.
        Mr. Issa. Right.
        Mr. Donahue. Yes.
        Mr. Issa. And these are sophisticated buyers, usually, if
    there are more than 100 of them, and they go in with a portion
    of their otherwise high net worth. Many of them, of course, are
    public entities and pension funds. And they go in knowing that
    they will have absolutely no control; isn't that true? That
    limited partners are just what it says, they are limited, they
    are in for the ride and for the most part are delineated with
    relatively little control, virtually none of the protections
    that the chairman talked about?
        Mr. Donahue. I would hope they appreciate that.
        Mr. Issa. OK. So that wasn't what was offered by the SEC or
    reviewed by the SEC. You were reviewing something that had
    comparatively a little more protection; would that be fair to
    say?
        Mr. Donahue. I would say it had considerable disclosure
    with respect to the entity that was being----
        Mr. Issa. Thank you. I stand corrected. That really is more
    accurate, better disclosure. However, in the public disclosure
    it was made clear that 78 percent of the interest in this
    entity belongs to the partners of Blackstone, the managers, the
    people who have made this a successful entity, and only 22
    percent was being offered to the public, and of that, half was
    going to one investor, China. The other half, 11 percent of
    this interest, was going to the public. Is that roughly right,
    as you recall?
        Mr. Donahue. As I understand it, yes, sir.
        Mr. Issa. So there is inherently a, ``We are going to give
    you 11 percent of what we get, and the 78 percent is going to
    go to us, the managers, and we are going to be in it with what
    they like to call in the industry our skin, because we are
    going to try to maximize our profits.'' Is that essentially
    what this offering was all about?
        Mr. Donahue. I don't want to characterize what the offering
    was all about, but certainly the sale of the units to public
    investors was enabling the public investors to share in the
    success of the operating company that they had.
        Mr. Issa. Now I am going to call your attention to those
    things that you can't possibly read over there, even though we
    made them as large as possible.
        Mr. Kucinich. Would the gentleman yield? Is there a way, if
    you have those on a transparency, maybe we could put them up.
        Mr. Issa. We will make it available. I will just
    characterize it until they get it up on the slide.
        Public entities such as the Ohio Teachers Retirement,
    California's PERS and STERS, both the teachers and the public
    employees, they are typically running from 5 to 15 percent of
    their portfolio in private equity. For purposes of, I think,
    the public and Members here today, those percentages show that,
    in fact, private equity is something that you might want to
    have some of, but you wouldn't want to necessarily have only
    that. Is that fair to say, from your experience, because I am
    calling on your private life in addition to your current job.
        Mr. Donahue. If I could answer from my prior life and not
    my current responsibility----
        Mr. Issa. Your prior life would be fine. You are an expert
    in that area.
        Mr. Donahue. Well, I don't know that I would characterize
    myself as an expert, but certainly certain asset classes--and I
    think private equity is in there--for purposes of
    diversification, having a portion of your investments in those
    types of investments may be appropriate for you, depending on
    your circumstances.
        Mr. Issa. And I am going to need a second round, too, but I
    will just do one more on this round and then we will come back
    to some of the other details.
        When Goldman Sachs went public, Senator Corzine, now
    Governor Corzine, or, as we call him Seatbelt Corzine around
    here--he is going to be an advocate for seatbelt safety, I am
    sure--made at least $233 million on that public offering. Would
    you, for our edification, characterize why Goldman Sachs was
    one type of entity, why Blackstone is another type, and how, if
    you are familiar with both of these, how you would deal with
    it. I realize that you were a Merrill Lynch guy, but you may
    have looked over your shoulder at Goldman Sachs at some point.
    I think that will help us in understanding what an investment
    company is, etc.
        Mr. Donahue. This is based on imperfect knowledge. I would
    first say that many indeed would have loved to have been at
    Goldman Sachs when they went public, but the businesses of
    Goldman Sachs--investment banking, global market trading, asset
    management, and brokerage--are businesses that are traditional
    investment banking brokerage type businesses. A portion of what
    they do would be in the realm of what Blackstone and Fortress
    do, so they would have units that would do similar things, but
    it wouldn't be, obviously, as much of the particular entity as
    exists in a Blackstone case, the way I would characterize the
    differences there.
        Mr. Issa. OK. And that was where the 40 percent threshold
    and these other considerations makes it black and white as to
    how you would deal with an entity like Goldman Sachs, even if
    they were not a corporation, but Goldman Sachs versus
    Blackstone.
        Mr. Donahue. With respect to Goldman Sachs, I truly believe
    that the status determination would have been simpler,
    obviously, than Blackstone or Fortress.
        Mr. Issa. OK. Thank you.
        Mr. Chairman, I look forward to a second round.
        Mr. Kucinich. Thank you very much.
        The Chair recognizes Mr. Hodes.
        Mr. Hodes. Thank you, Mr. Chairman.
        Mr. Donahue, thank you for that testimony. I marvel at your
    skill and the careful distinctions you made when answering
    Chairman Kucinich's question in referring to the rights that
    Blackstone would have under, say, the law of Delaware under
    which they are organized.
        It is my understanding that in significant instances the
    law of Delaware also allows those registered under its laws to,
    by contract, essentially disclaim various of their obligations.
        For instance, in this case Blackstone has limited voting
    rights and giving its investors no rights to elect board
    members, according to its S-1 filing with the SEC. This is a
    restriction and all of these are restrictions of rights
    generally available to shareholders of what we will call normal
    publicly traded companies. They have disclaimed their fiduciary
    duty to investors and limited the remedies available. They have
    required a super majority vote to remove general partners. They
    prohibit shareholders who own more than 20 percent of
    outstanding common units from voting on any matter. They limit
    the unit holders rights of appraisal if Blackstone is
    reorganized. And approval from Blackstone's Conflicts Committee
    will be conclusive, despite Delaware law stating that this
    approval will simply shift the burden to a plaintiff to show a
    conflict of interest.
        They go on. There are other disclaimers. I have just listed
    a partial listing of the disclaimers that Blackstone makes. So
    they have disclosed the multitude of ways in which they limit
    the rights of those who are investing in their company.
        I would like you to change baseball caps for a moment to
    your far-sighted view as a regulator with vast experience and
    far better than I to look forward.
        Do you agree or disagree that when a company such as
    Blackstone or any company sells its shares to the public, that
    there is a public policy implication that kicks in to provide
    or that should provide protection for the investors who are now
    no longer limited to those millionaires and multi-millionaires
    who are qualified investors, whether at a $1 million or $5
    million level, but are not Ma and Pa, my constituents in New
    Hampshire investing in various ways who do not read SEC
    disclosure statements, who do not know what Blackstone is, and
    who are now trying to invest? Do you think the public policy
    kicks in and that we need to protect those investors?
        Mr. Donahue. Protection of investors is certainly key to
    the responsibilities that the Securities and Exchange
    Commission has. Traditionally, for non-investment companies and
    33 Act registered companies, those types of issues have been
    left to State law and left to the listing exchanges for their
    determinations. And the 1933 Act is a disclosure statute. It
    is, for the very reason that you could state all of those what
    you might characterize as non-protections, is what the 1933 Act
    is about, which is to make those material disclosures to
    investors so that investors can make an informed judgment about
    whether or not to make those investments.
        We are not in the 1933 Act context; we are in the 1940 Act
    context, really merit regulators or disclosure regulators. That
    is the context within which we review and allow registration
    statements to go to the light.
        Now, whether I have concerns about investor issues within
    certain companies and about remedies that might be to
    investors, of course I do.
        Mr. Hodes. Understanding your role as the SEC regulator on
    the disclosure requirements, do you have concerns on behalf of
    the investors in the Blackstone offering?
        Mr. Donahue. In the Blackstone context, I believe that the
    review that was done by my brethren in the Corporate Finance
    Division, that they felt that all the material disclosures were
    made. They had no reason to believe that the information was
    not out there for investors and their advisors to make a choice
    of whether or not this is an investment that they should want
    to make.
        Mr. Hodes. Thank you. I see my time is up. Thank you, Mr.
    Chairman.
        Mr. Kucinich. The Chair will recognize Mr. Braley.
        Mr. Braley. Thank you, Mr. Chairman.
        Mr. Donahue, I want to talk to you a little bit about the
    SEC's mandating of Blackstone's disclosure questions. Does the
    SEC's judgment about whether Blackstone LP is an investment
    company make that determination binding upon courts who are
    interpreting the legal implications of such a determination?
        Mr. Donahue. My answer to that would be no, that courts
    have at times disagreed with determinations that we have made.
        Mr. Braley. And, in fact, isn't it true that just last year
    the 7th Circuit Court of Appeals disagreed with the SEC's
    interpretation of the Investment Company Act determination?
        Mr. Donahue. I assume you are referring to the National
    Presto case?
        Mr. Braley. Yes.
        Mr. Donahue. The SEC believed that National Presto was an
    investment company under both the traditional test, the
    orthodox test, and the inadvertent test, and the court did
    disagree with us.
        Mr. Braley. Could you share with us the practical impact of
    the ability of Blackstone LP to conduct its business and the
    value of the units offered to the public if a court determined
    that Blackstone was an investment company?
        Mr. Donahue. It is a difficult question for me to answer in
    my current role, but the structure they have, the way that they
    operate would not be, in my judgment, practical under the 1940
    Act.
        Mr. Braley. Would it be possible that it would impose a
    substantial obstacle to the ability of the company to conduct
    its business?
        Mr. Donahue. In my judgment it most likely would.
        Mr. Braley. Could cause the value to fall precipitously?
        Mr. Donahue. I am sorry?
        Mr. Braley. Could it cause the value to fall precipitously?
        Mr. Donahue. That is beyond my expertise.
        Mr. Braley. All right. Did SEC staff request further
    explanations from Blackstone regarding its finances, including
    the partnership asset composition, in order to make a
    determination whether Blackstone LP was an investment company?
        Mr. Donahue. If you don't mind, I will expand a little bit
    on it, because this is really an important determination. We
    didn't take the registration statement, the information
    contained on it, and from that just say, OK, the company says
    they are not an investment company. There was much back and
    forth between us trying to get more information about exactly
    what the various components were, really how the assets were
    being determined, and how they reached their determination that
    they did not believe they were investment companies.
        It is difficult to, picking up a registration statement, on
    its face, to be able to tell that without getting more of the
    detailed information from the company about the valuations and
    a number of other things that go into that determination.
        Mr. Braley. Did the SEC view the information as being
    material in making its decision on the Investment Company Act?
        Mr. Donahue. The information supplied to us by the
    companies was critical for us to be able to determine that
    their determination of the status was not accurate, yes.
        Mr. Braley. And was this further information about its
    asset composition disclosed to the public before the IPO became
    effective?
        Mr. Donahue. There were some aspects of that information
    that was in the registration statement, and there was a certain
    amount of that was sent to us with a request to keep it
    confidential, so it was not in the registration statement.
        Mr. Braley. Well, can you quantify for us, in terms of the
    volume of information that was supplied that was actually made
    public?
        Mr. Donahue. Well, the first thing I would like to point
    out is we have a registration statement that is available, but
    the correspondence that goes back and forth between the
    registrant and the SEC are made public unless there is an
    appropriate request for confidential treatment.
        Mr. Braley. When you say they are made public, in what
    format are those made available to potential investors?
        Mr. Donahue. The actual letters are available on the EDGAR
    Web site, which is the official Web site for the SEC.
        Mr. Braley. So is that something that a potential investor
    could easily access as part of their own due diligence?
        Mr. Donahue. That would not work well for the due diligence
    that an investor might do in participating in the initial
    public offering, because the initial public offering will have
    already concluded by the time that correspondence is up.
        Mr. Braley. Thank you. Those are all the questions I have.
        Mr. Kucinich. I thank the gentleman.
        The Chair recognizes Ms. Watson.
        Ms. Watson. Mr. Chairman, I missed the first part of the
    testimony, so I am going to kind of work backward to inform
    myself, but, Mr. Donahue, in the Senate Finance hearing this
    morning, Congressional Budget Director Peter Orszag testified
    directly before your testimony and said that he viewed carried
    interest as partly compensation for return on capital and
    partly compensation for services rendered.
        In his testimony, he also referred to a large body of
    academic literature discussing the issue, and other witnesses
    testified that carried interest differed from earnings based on
    service.
        Do you agree with this conclusion, with Mr. Orszag's
    conclusion?
        Mr. Donahue. I haven't had an opportunity to look at the
    academic studies that he was referring to. I would note that
    his testimony was being given, I believe, in the context of a
    hearing relative to the appropriate tax treatment of carried
    interest, so I don't have a view toward that.
        Ms. Watson. Well, the SEC, as I understand, has determined
    that Blackstone is a carried investment or carried interest and
    doesn't come under the Investment Company Act. Can you comment
    on that?
        Mr. Donahue. I think the carried interest winds up to be an
    element in our determination of whether or not the nature of
    its investments, whether it meets the definition of an
    investment company. The carried interest analysis goes into the
    carried interest being part of the general partnership
    interest. Whether the carried interest entitles the general
    partner to receive income or whether it entitles the general
    partner to receive it in another form, it is tied in to the
    general partnership interest, I don't believe our analysis
    would differ, and particularly not based on the appropriate tax
    treatment of it.
        Ms. Watson. Well, if Blackstone is selling publicly, there
    are some things that are of concern to me, and this is an area
    that I don't have a lot of expertise, but looking at it from
    afar, at least if it conformed to the Investment Company Act it
    would have to keep the investors well informed, it would have
    to compensate or have returns on their dollars a little
    differently, and also what would the protection of the
    investors be like without coming under the act.
        That is a concern to me. The investors cannot vote. I guess
    there are no public meetings once a year. Therefore, they can
    do whatever they want with management, they can raise their
    salaries, they can give them huge bonuses, and they don't have
    to give them full reimbursement for their investments.
        So I am wondering what your view is, having them determined
    as being a direct investment group and not under the act.
        Mr. Donahue. I would like to start my response by saying
    that I am a great fan of the Investment Company Act. I think it
    provides great investments for investors. Our analysis that we
    start off with recognizing those great benefits, the key
    question that we first have is: is this an investment company?
    If it is not, then we don't move to push it into the investment
    company framework in order to get those benefits.
        The threshold question is, and the charge we have gotten
    from Congress, is to determine whether or not these are
    investment companies. If they are, they are in the investment
    company structure, for better or worse with respect to what it
    is going to do with respect to how their business operates. And
    if they are not, then they are not investment companies and are
    not entitled to the protections of the Investment Company Act.
        Ms. Watson. Well, what are you going to determine on your
    way to making a decision? Can you give us a heads-up?
        Mr. Donahue. On the two determinations----
        Ms. Watson. Yes.
        Mr. Donahue [continuing]. With respect to Fortress? We will
    look at what their real business is, how they characterize
    their business, what the nature of their assets are, where the
    five factors that are really set up and are extraordinarily old
    paced, and these are asset management companies. They happen to
    be managing alternative type investments, but these are asset
    management companies.
        If you look at Blackstone, I believe Blackstone has over
    100 different investment vehicles that they are managing. I
    believe if you look at Fortress, has over 20 different
    investment vehicles that it is managing. They are in the
    business of managing other peoples' money, not in the business
    of managing their own money. Now, their success may very well
    be related to how well they do at their business of managing
    other peoples' money.
        Ms. Watson. Well, if you walk like a duck and you quack
    like a duck, most people think you are a duck, so I would be
    interested----
        Mr. Donahue. Am I a duck?
        Ms. Watson. I would be interested in your determination. I
    will look forward to a hearing about that.
        Thank you so much, Mr. Chairman. I yield back my time.
        Mr. Kucinich. I thank the gentlelady.
        The Chair recognizes Mr. Cannon.
        Mr. Cannon. I thank you, Mr. Chairman. I apologize. We have
    another hearing going on in Judiciary next door and I am a
    member of that panel, so I apologize for not having been here
    for your testimony prior to this.
        Pursuing this investment question, how many comments did
    the SEC receive regarding the classification of Blackstone as
    an investment company? And how did the SEC respond to the views
    of these comments?
        Mr. Donahue. I am aware of two letters we received from one
    entity raising questions regarding the status determination,
    and also aware of a letter or two that we actually received
    from Congress asking us questions relating to those
    determinations. I took those seriously. If we get
    correspondence coming in to us that raises questions about
    whether or not we are analyzing something appropriately,
    whether or not we are taking into account the right
    circumstances, whether or not we might have it wrong, I take
    those seriously. I want to get it right, and so we do take them
    seriously.
        Mr. Cannon. So did you evaluate those letters and the
    claims in light of the statute and, I take it, determined that
    it is not an investment company?
        Mr. Donahue. When we got those, one of the first things
    that I did with them was to send those letters to my
    professional staff, the senior staff that actually were the
    main people that were looking into the appropriate treatment of
    the status of these two entities, Blackstone in particular, so
    that they were aware, and told them that I, you know, want them
    to take it into account and to be in a position to discuss with
    me why our analysis might differ, and, if so, why we are
    correct.
        Mr. Cannon. So you have a statutory decision about what an
    investment company is, with some exemptions. I take it these
    letters didn't lead you to believe or your staff to believe
    that the exemption should qualify and that this should not be
    an investment company?
        Mr. Donahue. It didn't lead us to believe that Blackstone
    or Fortress, although I don't believe we got comments on
    Fortress, that either one would require an exemption from the
    SEC to qualify as not being an investment company.
        Mr. Cannon. Let me just see if I understand it right. Even
    if your analysis had determined that Blackstone was an
    investment company, it would still likely have fallen under the
    statutory exemptions to an investing company? Have I gotten
    that correct?
        Mr. Donahue. If the determination had been that Blackstone
    met either the orthodox investment company test or the
    inadvertent investment company, then they would have had to
    search for a reason why those analyses wind up being
    overridden. There is an analysis that they could do under a
    different section that their primary business is not that and
    is else, or they could apply for an exemption from the SEC from
    or determination that they are not an exempted. They did not
    seek a determination that they were not.
        Mr. Cannon. And they didn't need to because you had already
    made the determination that they are not?
        Mr. Donahue. We concluded that they were not an investment
    company.
        Mr. Cannon. Could you explain the key distinguishing
    characteristics between a mutual fund and an organization like
    Blackstone LP?
        Mr. Donahue. Well, simply I would start off by saying that
    an investment company is in the business of managing its money,
    money that comes from individual investors, and in the
    investment company framework their capital structure is very
    simple. You wind up generally with one class of shares, similar
    rights, and the assets are valued under net asset value, and
    that determines what you get for your shares if you buy them or
    sell them, if it is an open-end fund. And there are a lot of
    controls built around how that money can be managed, what
    affiliated transactions can take place, and a lot of things.
        In the case of Blackstone and in the case of Fortress, they
    were not investing their money. They were managing other
    peoples' money. They were more akin to the investment advisor
    to a mutual fund than they were to a mutual fund. In fact,
    Blackstone I believe was the investment advisor to two closed-
    end funds as part of its business.
        Mr. Cannon. Thank you.
        Mr. Chairman, may I ask how much time I have remaining? It
    seems like the clock is running very long.
        Mr. Kucinich. Take another minute. Go ahead.
        Mr. Cannon. Thanks. I would be happy to yield.
        Mr. Kucinich. Go ahead.
        Mr. Cannon. I yield that minute to Mr. Issa.
        Mr. Issa. Perhaps I can bring some clarity through a
    question. If we look at an architectural firm and they take on
    huge jobs like building the new center here, the new visitors'
    center at the Capitol, and they derive revenue from it, and
    maybe even a bonus if they do a good job and it comes in under
    time and under budget, which is not true of our visitors'
    center, as you know--there will be no bonus earned there--but,
    in fact, if that partnership chose to go public, it would be
    akin to Blackstone. It drives its revenues by its management or
    activities of its team, and you are investing in that team, in
    the revenue stream that team earns.
        Is that a fair similarity, so that we get off of the model
    of are you a mutual fund or are you this other? Isn't that
    really akin to, if you were evaluating that architectural firm
    with all kinds of activities, including land acquisition on
    behalf of clients and lots of stuff, it makes it look complex,
    but ultimately you are investing in the management team; isn't
    that right?
        Mr. Donahue. I think that is a correct analysis. From your
    description, it sounds like an operating company. I would need
    to know, to make that determination--and this is, you know, the
    process that we wind up going through--I would need to know
    what degree of investments they might have. By way of example,
    if they had considerable amount of investments that were in
    investment securities, even though they are also in this other
    business they may be treated as an investment company.
        Mr. Issa. Right. And I will yield back, but the reason I
    asked that question is you seem to have the tools to make this
    evaluation of Blackstone like other companies, and these tools
    have served the SEC well for many, many years, and Blackstone
    is no exception; is that right?
        Mr. Donahue. That is correct.
        Mr. Issa. Thank you.
        I yield back.
        Mr. Kucinich. The Chair recognizes Mr. Tierney.
        Mr. Tierney. Thank you, Mr. Chairman. I would like to just
    claim my time for the purposes of yielding to Mr. Kucinich.
        Mr. Kucinich. I thank the gentleman.
        Mr. Donahue, in his written testimony Professor Coffee
    recommends that, in light of the Blackstone LP offering, the
    Securities and Exchange Commission used its influence to
    pressure the New York Stock Exchange and NASDAQ to change its
    listing requirement to require that publicly traded
    partnerships provide the same basic corporate governance
    protections for public investors that are demanded of public
    corporations. Do you support this recommendation?
        Mr. Donahue. I thought it was a very thoughtful analysis
    and appreciation for the position that the SEC is in. I have
    not had an opportunity to discuss Professor Coffee's
    recommendation with the chairman or with any of the
    Commissioners.
        Mr. Kucinich. Thank you. Now, with your broad jurisdiction
    in investor protection, as a matter of policy does the SEC have
    a problem that investors in these funds are denied basic
    corporate governance protection, such as being owed fiduciary
    duties, an independent board, and meaningful voting rights?
        Mr. Donahue. First I would like to note that the investors
    are the investors in the operating company, and I think I am
    not aware of any particular problems that have arisen yet with
    respect to this, and I will discuss the issue with my brethren
    over in corporate finance that oversee public companies and see
    whether or not there have been issues in similar companies.
        Mr. Kucinich. Doesn't the Securities and Exchange
    Commission have a regulatory role beyond that of simply
    enforcing the Securities Act and the Investment Company Act?
        Mr. Donahue. Well, our primary role is in enforcing the
    securities laws.
        Mr. Kucinich. Do you want to elaborate on that a little
    bit?
        Mr. Donahue. We, as an agency, you know, should be
    enforcing the Federal securities laws to the best of our
    ability to protect investors. With respect to other issues, and
    some issues that might arise under State laws, some remedies
    that people may have contractually, that is not necessarily in
    our mandate unless there is fraud taking place. We have broad
    authority, but, once again, that is pursuant to the Federal
    securities laws.
        Mr. Kucinich. The reason why I ask that, of course, is, I
    am sure you remember Chairman Levitt, who believed that it was
    a proper role when he, you know, created the discussion about
    the exchanges on corporate governance requirements. I am just
    trying to see how the SEC currently----
        Mr. Donahue. That is a distinction there, I think, and I
    wasn't at the SEC when the event being referred to taking place
    occurred, but, having heard the characterization of it, I would
    look at that as the SEC taking a leadership role with respect
    to going to others that had responsibility and could, you know,
    implement changes, and suggesting that, for the protection of
    investors, change might be necessary.
        Mr. Kucinich. Would you agree that it is a significant
    question, though, whether or not the Securities and Exchange
    Commission sees itself as having a regulatory role in addition
    to enforcing the Securities Act and Investment Company Act?
        Mr. Donahue. I view us as protecting investors, among other
    things. We have a mandate. Part of it is protecting investors.
    Others is to promote capital formation and provide for orderly
    markets, so we have a broad mandate and we do exercise it.
        Mr. Kucinich. Thank you.
        First of all, I want to thank you for your participation.
    It is very helpful, a little bit more of a discussion. I know
    we are going to get into some of these issues even more in
    depth in the next panel, but it is important to have you here
    and we want to thank you for the service that you give to our
    country. Thank you very much.
        Mr. Donahue. Thank you for inviting me.
        Mr. Kucinich. You bet.
        We are going to go to the next panel.
        Mr. Issa. As the next panel is coming up, please give our
    best to our former colleague, Mr. Cox, when you see him.
        Mr. Donahue. I certainly will.
        Mr. Kucinich. We are going to begin the second panel. I
    want to welcome all of the witnesses.
        It is the policy of our subcommittee and the full committee
    to swear in all witnesses.
        [Witnesses sworn.]
        Mr. Kucinich. Let the record show that the witnesses
    individually answered in the affirmative.
        I would like to make the introduction of the first witness.
    We will go from my left to right.
        Professor Mercer Bullard is assistant professor of law at
    the University of Mississippi School of Law, where he has been
    since 2002. He specializes in the areas of securities and
    banking regulation, corporate finance, and contracts, and he is
    recognized as one of the Nation's leading advocates for mutual
    fund shareholders.
        In January 2000, Professor Bullard founded Fund Democracy,
    a nonprofit membership organization that serves as an advocate
    and information source for mutual fund shareholders and their
    advisors. Fund Democracy publishes articles that address mutual
    fund practices, policies and rules that may be harmful to fund
    shareholders, and by lobbying legislators and regulators on
    mutual fund reform issues.
        Prior to founding Fund Democracy, Professor Bullard was
    Assistant Chief Counsel in the Securities and Exchange
    Commission's Division of Investment Management for 4 years,
    where he was responsible for a wide range of matters involving
    mutual funds and investment advisors.
        Professor John Coffee is Adolph A. Berle professor of law
    at Columbia Law School, where he has been a member of the
    faculty since 1980. As one of the Nation's preeminent security
    and corporate law experts, Professor Coffee has served as a
    member of many influential financial advisory boards and
    commissions, including the New York Stock Exchange, NASDAQ, and
    the Securities and Exchange Commission. He has testified
    numerous times before congressional committees. He has co-
    authored a number of textbooks on securities and corporate law,
    and the National Law Journal has named him 1 of the 100 most
    influential lawyers in the United States.
        Next, Mr. Joseph Borg is president of the North American
    Security Administrators Association, which represents 67 State,
    provincial, and territorial securities administrators. He has
    been a Director of the Alabama Securities Commission since
    1994.
        The NASAA member agencies work to protect consumers who
    purchase securities or investment advice, and regulate a wide
    variety of issuers and intermediaries who sell securities to
    the public.
        Prior to his career in public service, Mr. Borg was in-
    house corporate counsel to First Alabama Bank, practiced in law
    firms in Montgomery, AL, and New York City. He also served as
    an adjunct professor of law at Faulkner University Jones School
    of Law.
        Finally on the panel, Mr. Peter J. Tanous. Mr. Tanous is
    president and CEO of Lynx Investment Advisory, LLC, which he
    founded in 1992. Lynx Investment Advisory is an independent
    investment consulting firm specializing in asset allocation,
    risk management, and customized portfolio design. Lynx has over
    $1.4 billion under advisement, and on behalf of both nonprofit
    and for-profit institutions and affluent individuals worldwide.
        Previously Mr. Tanous was executive vice president of Bank
    Audi in New York City, Chairman of Petra Capital Corp., and
    first vice president and international regional director with
    Smith Barney.
        Mr. Tanous is the author of Investment Gurus: the Wealth
    Equation, and his latest book, Investment Visionaries.
        I want to thank all the members of this panel for their
    presence, their participation.
        Let us proceed with Professor Bullard.
        I also want to welcome Mr. Danny Davis and also Mr. Bilbray
    to our committee. Thank you.
        Let us proceed. Thank you. You may proceed.

    STATEMENTS OF MERCER E. BULLARD, UNIVERSITY OF MISSISSIPPI LAW
      SCHOOL; JOHN C. COFFEE, JR., COLUMBIA LAW SCHOOL; JOSEPH P.
    BORG, PRESIDENT OF THE BOARD OF DIRECTORS OF THE NORTH AMERICAN
      SECURITIES ADMINISTRATORS ASSOCIATION; AND PETER J. TANOUS,
            PRESIDENT AND CEO, LYNX INVESTMENT ADVISORY, LLC

                     STATEMENT OF MERCER E. BULLARD

        Mr. Bullard. Chairman Kucinich, members of the
    subcommittee, thank you for the opportunity to appear today
    before you to discuss the public offering of interest and hedge
    fund managers. It is an honor and a privilege to appear before
    this subcommittee today.
        The question for today's hearing, Should investors be
    exposed to the risks of hedge funds, is answered by current law
    in the negative. Only sophisticated persons are permitted to
    invest in hedge funds. I believe that the answer should be the
    same for hedge fund managers that are the functional equivalent
    of hedge funds. There appears to be substantial agreement on
    this point. Virtually every commentator on the Blackstone IPO
    had described the firm's future prospects as depending directly
    on the performance of its funds. The financial press has
    suggested that the Blackstone offering, for example, provides a
    way for small investors to access the previously forbidden
    world of hedge funds.
        It is worth noting that no one views the future prospects
    of pure asset managers such as T. Rowe Price as depending
    directly on the performance of their funds, and firms such as
    T. Rowe Price accordingly have traded at a tiny fraction of
    their assets under management, whereas hedge fund managers have
    traded at 20 or 30 times that fraction.
        The markets recognize that hedge fund managers are the
    economic equivalent of hedge funds, and we should respect the
    market's judgment. The market's judgment is confirmed by the
    structure of hedge fund managers, as illustrated by Blackstone.
        A majority of Blackstone's assets are investment
    securities. Of its $7.2 billion in assets on its March 31st
    balance sheet, $5.2 billion are investments in its funds and
    funds portfolio companies, another $4.1 billion are carried
    interest, which substantially exceeds 50 percent of its total
    assets. I note that includes a denominator that includes assets
    that have virtually nothing to do with any business activity,
    such as its goodwill, deferred tax assets, and cash. If you
    eliminate those assets, virtually all of the meaningful assets
    held by Blackstone are investment securities.
        There is disagreement as to whether Blackstone's carried
    interest or investment securities under the Investment Company
    Act. I am not aware of any disagreement that carried interest
    are the economic equivalent of a leveraged bet on Blackstone's
    funds. Someone suggested that carried interest should be viewed
    as compensation. Professor Coffee, for example, suggests that
    carried interest are more like compensation on the ground that
    investors and hedge fund manager do not share the funds'
    ``downside'' because they will ``simply not receive their share
    of the nonexistent profits from that fund.''
        I must respectfully disagree. Blackstone's $4.1 billion in
    carried interest are exactly what investors in Blackstone are
    buying, and that figure is based on the current value of those
    carried interests. If Blackstone's funds take a turn for the
    worse, Blackstone's investors will lose billions of dollars.
    The severity of those losses will actually exceed
    proportionately the decline in the funds because a carried
    interest skims profits off the top of a fund's performance. A
    slight decline in a fund's annualized performance has a
    multiplier effect on the value of a carried interest.
        I would refer you to this morning's hearing on the Senate
    side, during which this point was made repeatedly by every one
    of the persons testifying at that hearing.
        Professor Coffee's position is correct as to the Blackstone
    manager who sees a carried interest that started as a zero
    value and goes up and returns to zero, but it is incorrect as
    to the purchaser of a carried interest in the middle of a
    fund's life. When a Blackstone manager sells his carried
    interest at that point, he is effectively cashing out his part
    of the carried interest before its value has been realized and
    leaving public investors holding the bag in the event of the
    fund's performance declining.
        Professor Coffee further suggests that reading the ICA to
    include carried interest in the definition of investment
    security reads the definition too broadly because it would mean
    that every business' ``actively managed subsidiary would thus
    become an investment security. At this point, the ICA applies
    to everything.''
        That would be a fair observation but for the fact that the
    securities issued by subsidiaries would be investment
    securities under the Investment Company Act if Congress had not
    specifically excluded from the definition. The ICA defines
    investment security to exclude all securities, to include all
    securities except securities issued by majority-owned
    subsidiaries.
        I mentioned Professor Coffee's comments not only out of my
    high regard for his opinions on securities law issues, but also
    because I believe that we are substantially in agreement on the
    critical policy question for this subcommittee. Although I have
    stated that public investors should not be allowed to assume
    the risk of hedge funds and Professor Coffee argues that they
    should, he uses risk in an economic sense and I use it in a
    broader functional sense. If risk were to include the risk of
    inadequate corporate governance, which I include in the concept
    of risk, Professor Coffee and many others would agree that
    public investors should not be exposed to such risk.
        Professor Coffee describes Blackstone's corporate
    governance as pathological and recommends reforms notably that
    would apply if Blackstone were treated as an investment company
    under the Investment Company Act.
        In conclusion, the ICA's regulatory framework and exemptive
    provisions are ideally suited to address the regulatory
    shortcomings that have been exposed by the Blackstone offering.
    It is unfortunate that the SEC has decided not to take
    advantage of this efficient, proven approach to regulation, and
    I strongly recommend that Congress, assuming continued SEC
    inaction, take steps to ensure the appropriate regulation of
    hedge fund managers.
        Thank you very much.
        [The prepared statement of Mr. Bullard follows:]

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        Mr. Kucinich. I thank the gentleman.
        Professor Coffee, you may proceed.

                    STATEMENT OF JOHN C. COFFEE, JR.

        Mr. Coffee. Thank you, Chairman and members of the
    committee, for inviting me to be here.
        My message is simple. This is the Oversight Committee, and
    the Blackstone approach to going public needs a great deal of
    oversight. I am not recommending legislation, and I, in my
    comments, urge the committee and regulators to always use the
    least drastic means available to realize the regulatory
    objective. I also happen to be a supporter. I believe that
    private equity funds and hedge funds are among the most
    successful, dynamic performers in our financial services
    industry, but I do think there is a problem. The Blackstone
    offering has established a template for future offerings by
    managers of private equity funds and hedge funds. Already
    others are lining up and there is a race to rush to the window
    before it closes.
        Unfortunately, that template has three elements that
    represent the worst imaginable corporate governance. As has
    already been pointed out, there are no meaningful voting
    rights. Beyond that, the founders of the firm have the right to
    remove any of the directors at any time if they act together
    jointly.
        Second, there is no independent board. Indeed, there is
    neither a nominating committee nor a compensation committee
    that has any independence. That to me is totally against the
    trend which the business community, itself, has come to and
    accepted that independent directors are necessary for publicly
    held investments because that is where the ultimate protection
    and the legitimacy enterprise comes from, oversight by
    independent directors.
        Finally, there is no meaningful fiduciary duties owed to
    the investors because the partnership agreement has exploited
    all the potential under Delaware law to cancel the normal
    fiduciary duties. That is because Delaware law regards a
    partnership agreement as really a private contract among a
    small, limited number of people, not a mechanism by which
    thousands of investors are asked to trust other people's money,
    in effect, to financial managers who do face significant
    conflicts of interest.
        Thus, voiceless, voteless, and stripped of legal remedies,
    Blackstone's investors must remain passive. There is not even
    the usual possibility of a control contest, because no one can
    vote more than 20 percent.
        Now, how did this unique and I have said pathological
    governance structure arise? You can attribute it to one of two
    things: one, that the company is deemed to be exempt from the
    Investment Company Act. I would like to get this committee's
    attention beyond the Investment Company Act. I think we are a
    little too obsessed with just the Investment Company Act. The
    problem here is basically one of corporate governance. There is
    little transparency and no accountability under the governance
    structure that Blackstone has put in place and that others are
    rushing to copy.
        The other reason why there is this pathological structure
    is that Blackstone was not subject to the usual corporate
    governance standards required by the New York Stock Exchange
    and NASDAQ because it went public as a limited partnership, not
    as a corporation. While the critics have all focused on the
    Investment Company Act, I think the Investment Company Act,
    frankly, is a remedy that can sometimes be worse than the
    disease when it is applied to those entities that are at least
    at the margin of its possible coverage.
        You could make this an investment company and then exempt
    Blackstone from most of the rules under the Investment Company
    Act. That would work. But I think it is much simpler and more
    direct to focus on what we want to achieve. I believe what we
    want to achieve is greater accountability, greater
    transparency, and that can be done by simpler ways than
    imposing the investment company straightjacket on this
    particular entity.
        Now, how do we get to this goal of greater accountability
    and greater transparency? I think the simple problem here is
    that partnerships are never subjected to normal corporate
    governance standards because in the past partnerships very
    seldom went public. When we have seen publicly held
    partnerships, they were used basically to hold passive pools of
    investments--real estate, oil and gas, timber. There aren't
    serious corporate governance problems there. But Blackstone is
    an operating company that is basically restructuring companies,
    not holding a passive pool of investments; therefore, what
    should we do?
        Well, besides State law the other mechanism by which
    corporate governance standards are imposed on publicly listed
    companies are the rules of the stock exchanges, both New York
    and NASDAQ today. The New York Stock Exchange since its
    inception has had minimum corporate governance standards, but
    it has had no reason to apply them to partnerships because they
    were a tiny aspect, probably no more than 1 or 2 percent of all
    listed companies.
        The New York Stock Exchange, under influence of Congress,
    under the oversight of Congress, did move to adopt strong
    independence standards requiring an independent board, and it
    is a majority independent board; entirely independent
    nominating, audit, and compensation committees; and a lead
    director and a process for annual evaluation of the chief
    executive officer. All of that is in the interest of
    investigators. The business community does not resist this.
        The typical American public corporation today has 10.4
    directors and over 8 of them are independent. That is not the
    law; that is the norms established by the business community
    and respected by them. But a partnership is exempt from that.
        This didn't arise by any conscious decision to exempt
    partnerships; it arose by the unconscious design, the
    unconscious fact that there was no need to develop governance
    rules for partnerships. Today there is. I think this is a
    process that needs oversight.
        I think in the past we have seen the SEC, under Chairman
    Arthur Levitt, go to the exchanges and ask them to upgrade
    their governance standards. He did that with respect to the
    one-share/one-vote rules, where the court struck down the
    mandatory rule but Chairman Levitt was able, through diplomacy,
    to convince the exchanges to adopt minimum rules to protect
    shareholders' voting rights.
        I think the exchanges should be invited before this
    committee to explain whether they are satisfied with the idea
    that shareholders would have no independent voting rights; no
    right to a majority of independent directors; no compensation,
    audit, or nominating committee that was independent; and no
    other rights that are traditionally associated with publicly
    held companies.
        I think that is in the long-term national interest because
    the market works best when we have the oversight of independent
    directors. That is the least drastic means, and I think we
    should move in the direction of trying to implement that
    particular remedy.
        Thank you.
        [The prepared statement of Mr. Coffee, Jr., follows:]
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        Mr. Kucinich. I want to say to Professor Coffee I think
    that you have made a worthwhile suggestion here to the
    committee with respect to asking the New York Stock Exchange
    and NASDAQ questions such as the ones that you have raised.
    Thank you, sir.
        Mr. Borg.

                      STATEMENT OF JOSEPH P. BORG

        Mr. Borg. Thank you. Chairman Kucinich, members of the
    subcommittee, I appreciate the opportunity to testify today on
    an issue of importance to retail investors.
        State securities regulators have a special appreciation for
    the plight of everyday investors who are confronted with a
    bewildering array of new and complex investment products. We
    are the only securities regulators who interact with and
    advocate for individual investors on a personal basis each and
    every day. In short, we are uniquely qualified to address the
    potential impact of making alternative investments such as
    hedge funds widely available to the average individual
    investor.
        My remarks should not suggest to you that I believe the
    retail investing public is unable to properly evaluate
    investments, nor am I suggesting that regulators should adopt a
    paternalistic approach and withhold alternative investments
    from the average retail investor.
        What I do suggest to you today is the following: new
    investments with highly complex structures, opaque investment
    strategies, and dubious profitability have arrived on Main
    Street. Precisely because of this trend, the investigator
    protections afforded by statutes like the Investment Company
    Act are more important than ever.
        Due to a nearly complete lack of transparency, the level of
    individual and systemic risk attached to these instruments
    remains unknown to the individual investor. Their fee
    structures and lack of full disclosures obscure real returns.
        The structure of these new instruments places investors in
    a vulnerable position subject to the whims of controlling
    persons and literally without recourse. In light of the
    complexity and uncertainty surrounding these instruments,
    allowing them to be offered to the public without appropriate
    regulatory protections poses serious risks to the investors.
        As a threshold matter, we believe that public offerings by
    private equity firms or hedge funds must provide full
    transparency and investor rights and protections. More
    particularly, we believe that private equity firms engaging in
    public offerings, when structured as Blackstone is, should be
    subject to the requirements of the Investment Company Act of
    1940.
        While the Securities Acts of 1933 and the Securities and
    Exchange Commission Act of 1934 protected investors from
    potential abuse by corporate managers and financial
    intermediaries, they could not adequately protect investors
    from abuses by organizers of pooled instrument vehicles.
    Congress enacted the ICA to impose additional layers of
    protection for investors, including independent boards,
    fiduciary duties, shareholder rights, heightened disclosures,
    restrictions on permissible investments, and even limits on
    fees and loads.
        Offerings such as the Blackstone IPO circumvent the
    governance protections that the ICA mandates, even though it is
    no longer a private investment company. For example, under the
    ICA a fund must have independent directors who represent the
    interests of public investors. Additionally, investors are
    protected by the fiduciary duty that attaches to officers and
    directors. Neither is the case with Blackstone.
        We must remember that the securities laws favor substance
    over form and disdain structures whose only purpose is to evade
    their reach. In reality, both pre-and post-IPO, Blackstone
    functions as an investment company that earns its income
    through investments. From an investor protection standpoint, we
    are puzzled by the exclusion Blackstone enjoys from the
    safeguards mandated under the ICA.
        The SEC has viewed this type of structure broadly and
    flexibly since the enactment of ICA. My written testimony cites
    a number of legal opinions where the SEC recognized that even
    funds engaged to a significant degree in ``special
    situations,'' as is Blackstone, qualify as investment
    companies. For decades, the SEC has been guided by ``In re:
    Tonopah Mining Company,'' which set forth five factors to
    determine whether a company was operating as an investment
    company: the company's history, its public representations, the
    activities of its officers and directors, the nature of its
    assets, and the sources of its income, all of which serve as a
    proxy for what a reasonable investor would believe to be an
    investment company.
        Tonopah identified the most important factor as whether the
    nature of the assets and income of the company was such as to
    lead investors to believe that the principle activity of the
    company was trading and investing in securities. We believe
    that Blackstone meets this test. The Blackstone structure, now
    being copied by others seeking to ``go retail'' appeals to mask
    the nature of the assets and income of the company in order to
    avoid the strictures of the ICA and to allow its continued
    operation as a de facto private company. Neither goal serves
    the interest of investors or marketplace.
        The new entities attempted to escape the conclusion that
    they are investing companies through a purely structural
    maneuver: adding a new layer in its corporate form, Blackstone
    LP, and then selling units in Blackstone LP to the public. But
    measured by the true nature of its activities and its
    investment holdings, the Blackstone structured entities should
    be regulated as investment companies.
        The prospectus makes it clear to investors that they will
    share in the rewards and bear the risks of Blackstone's
    investment activities. The point is further reinforced through
    the identification of the carried interest as a significant
    source of potential gain for investors.
        Presumably, Blackstone would suggest that their offering
    poses no undue threat to investors because, while it may be
    risky, those risks are disclosed. The public policy issue is:
    how much risk, even when disclosed, should be transferred to
    the general public? In a perfect world a careful financial
    advisor will say Blackstone type entities are too risky, too
    opaque, too conflicted, so we won't invest. However, the real
    world operates much differently. Securities salespersons sell
    whatever their firms tell them to sell. They are not likely to
    delve deeply into disclosed risks with the customer sitting
    across the kitchen table.
        The IPO disclosures come dangerously close to an
    affirmative statement by Blackstone that it will conduct its
    business in whatever way it chooses, and that the investors
    must waive any rights or remedies for such conduct. It is
    precisely for these reasons that Congress enacted the ICA, not
    just to ensure disclosure, but to impose affirmative duties on
    such companies and to delineate boundaries in the operation of
    these inherently risky enterprises.
        In the Blackstone IPO, which apparently now will be
    followed by KKR, Och-Ziff Capital, and others, a fundamental
    purpose of the ICA is imperiled. That purpose is the protection
    of the investing public from the potential risks of investment
    pools. When private speculators turn to the public markets for
    capital, what Justice Brandeis called ``other people's money,''
    they cannot continue to operate as if they were still a private
    concern.
        In conclusion, I want to emphasize that NASAA does not
    object to access to alternative investigations by retail
    investors so long as they are accompanied by all appropriate
    and necessary investor protections, rights, and remedies. This
    can only be accomplished by ensuring such investments are
    offered pursuant to the appropriate act.
        Your constituents, America's retail investors, are not
    accustomed to the realities of alternative investments,
    portfolios of illiquid securities, the use of substantial
    leverage, concentration of investments, and excessive
    compensation arrangements detrimental to their interest.
    Congress sought to eliminate these elements of alternative
    investments from the public marketplace. Surely, your and our
    constituents are still deserving of the protections so wisely
    provided to them.
        Thank you, Mr. Chairman.
        [The prepared statement of Mr. Borg follows:]

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        Mr. Kucinich. Thank you very much, Mr. Borg.
        Mr. Tanous.

                      STATEMENT OF PETER J. TANOUS

        Mr. Tanous. Thank you, Chairman Kucinich and Ranking Member
    Issa, for allowing me to appear before you today.
        Let me make several points relative to the discussion
    today. The first was made by Congressman Issa earlier, which is
    the difference between private equity firms and hedge funds.
    They are in very different businesses, and I won't belabor that
    point. They have two things in common. One is that they both
    charge very high fees, and the other is that their liquidity is
    very limited. In the case of private equity firms, you are
    basically investing for a number of years.
        Now, what are the risks in owning shares of Blackstone,
    because that is on the table today? We shouldn't confuse the
    risk of owning the Blackstone management company, we should
    call it, with the risk of investing in Blackstone funds. They
    are very different. The people who bought the Blackstone shares
    are basically buying into a stream of income from the fees that
    Blackstone earns. That is arguably not very different from the
    risk any investor takes when an investor buys a company that is
    competing in the marketplace and is subject to whatever the
    competitive factors are.
        Now, it also has been pointed out that the unit
    shareholders of Blackstone do not have the same rights as most
    stockholders do. I don't particularly like that, but the fact
    is that when an investor decides to invest in it, the investor
    knows or should know what those limitations are.
        I might also point out that there are other examples, such
    as in the newspaper industry where you have two classes of
    stocks, and most of the investors have very limited rights with
    respect to electing the board and other rights.
        Are hedge funds safe for the average investor? There is a
    wide gamut of hedge fund activities and philosophies, and,
    frankly, they run from very safe to very risky. In our
    business, though, because they are not at all transparent, we
    do not want our investors, even very wealthy ones, to take the
    risk of buying a single hedge fund. We all remember last year
    the case of Amaranth. This is a case of a hedge fund that was
    very highly regarded, a lot of very smart people had money with
    them, and they bragged about how good their controls were, and
    yet a 32-year-old trader made a big bet on natural gas and lost
    $5 billion in 1 week and the fund subsequently folded.
        For those who are interested in hedge funds, small or large
    investors, we think they should use funds of funds where the
    risk is spread out over 20, 30, or 50 separate hedge funds.
        Finally, should private equity firms and hedge funds be
    regulated by the SEC, which seems to be the major topic today?
    The SEC was created to protect investors, and the American
    capital systems are the envy of the world as a result of the
    honesty and integrity of our systems. My firm is registered
    with the SEC. We file a form ADV once a year, sometimes even
    more frequently, and we have to disclose lots of things in that
    form. We have to disclose our board of directors, our
    shareholders, the nature of our clients, and what not.
        Now, I heard--forgive me for characterizing it this way--
    the legal mumbo-jumbo about why Blackstone is not subject to
    SEC rules, and I would rather apply a simpler test that was
    alluded to earlier in this hearing. If it looks like a duck and
    acts like a duck and quacks like a duck, it is a duck. I
    suggest that, to me, Fortress and Blackstone are investment
    ducks, and if my firm is regulated by the SEC I can think of a
    lot of reasons why they should be, as well.
        Thank you, Mr. Chairman.
        [The prepared statement of Mr. Tanous follows:]

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        Mr. Kucinich. I thank the gentleman.
        We are going to go to questions from members of the panel.
    Mr. Tierney, would you like to go first?
        Mr. Tierney. Well, I think I fall in line with most of the
    public here. I am not sure that I understand all that I ought
    to understand about what seems to be a complex issue, but I
    look at it more from the standard of somebody that has worked
    all their life and put money into a pension fund, to have those
    pension fund managers turn around and invest in something like
    a Blackstone on that. So I guess my question would be: what
    protections do we have under the current system for those
    individuals? And what protections ought we have for them?
        Professor, we will start with you and just go left to
    right.
        Mr. Coffee. I think right now the only protection that a
    pension fund manager investing in Blackstone, the hedge fund
    manager, not the Blackstone funds, have would be rule 10(b)(5)
    in the law of fraud. I am not alleging in any way that there is
    any fraud, but you don't have the usual mechanisms. You don't
    get to vote. You don't get your right to information. You don't
    have independent directors owing you fiduciary duties. And
    there is no prospect that if this management is poor some other
    management will come in and buy them out and have a control
    fight. None of that can happen under the way this has been
    designed, and I think that is a very poor precedent for the
    future.
        My focus is not on Blackstone, but we are opening up a
    possibility of a whole new asset class, which could be over
    $100 billion in a few months or years, composed of entities
    that are in a business that is full of conflicts of interest
    and there is not any of the traditional mechanisms of corporate
    accountability applicable to them.
        Mr. Bullard. I would add to that I see your question in the
    context of it being publicly offered. My view is that if the
    pension fund were investing in a Blackstone, that by itself
    Blackstone should be able to do anything it wants and I
    wouldn't object to any of the provisions that Professor Coffee
    has mentioned.
        I think he is meaning in the context of a public offering,
    because no one questions it in today's context. A pension fund
    can invest. It can agree contractually to all of those onerous
    pathological provisions and I don't think anyone on this table
    objects to that. What is objectionable is when that vehicle
    becomes available in the public market.
        Mr. Coffee. I misunderstood your question. He has corrected
    me. I thought you were asking about investment in the public.
        Mr. Tierney. I probably wasn't as clear as I should be. As
    I said, I don't think I understand it as fully as I should.
    What is the harm to Blackstone if they go out and are treated
    as an investment company? What is the deal to them? I am
    telling you, from somebody on the other side that doesn't
    completely understand all of it, this thing just smells to high
    heaven. I am looking out there and saying, you know what, this
    is distasteful. This reminds me of a lot of things that have
    happened in our history where the small guy gets tucked and
    somebody else walks away with all the dough. They are taking
    care of themselves, as the gentleman at the end said, with a
    lot of mumbo-jumbo, and they are off and running.
        So why don't we just regulate them and make them do the
    things we reasonably make other people do? What is the harm?
        Mr. Coffee. If you were to subject Blackstone to the
    Investment Company Act, much of what they currently do could
    not be done without a new form of exemption. For example, that
    would include that there is a prohibition on incentive fees and
    that you right now are receiving very high incentive fees based
    on percentage of profits. That is regulated by a series of
    rules that treat mutual funds very differently than hedge
    funds, and they are very different animals. They are not that
    similar at all in terms of their behavior.
        There are restrictions on leverage, and it is the case that
    a true investment company can't have more than approximately 15
    percent of its assets in illiquid investments. All of what
    Blackstone owns is illiquid investments, so that they would
    have to have a very different portfolio. There could be
    exemptions given. I fully agree the SEC could call it an
    investment company and take 80 percent of it back, but that
    seems to me going up the hill and back down the hill and
    accomplishing very little along the way.
        My colleague here differs.
        Mr. Bullard. Well, I agree that they simply would not be
    able to function if they were subject to all the requirements
    of the Investment Company Act. That being said, I think I would
    go further than Professor Coffee in pointing out that the
    exemptive process is a longstanding tradition of the SEC. It
    has created numerous entities and allowed them to be publicly
    offered, subject to carefully tailored exemptions. For example,
    asset-backed securities have a virtually complete exemption
    from the act. Exchange traded funds exist only because of an
    exemption from the act. Even more, the multi-class funds with
    their A, B, and C shares are prohibited by the act. They exist
    because of an exemption. The 12(b)(1) fees are prohibited by
    the act. They exist only because of an exemption. Money market
    funds are prohibited by the act. The only reason that we have
    only $2 trillion in money market funds is the SEC exemptive
    authority, and that is a much more efficient way to regulate
    them than to go to the exchanges to obtain some kind of limited
    governance reform.
        Mr. Tierney. Mr. Tanous, I sympathize with what you were
    saying. If your firm has to register, why don't they? Would you
    put them under the Investment Act, or would you do some of the
    other more novel approaches of Professor Coffee?
        Mr. Tanous. Mr. Tierney, I would put them under the
    Investment Act, but make the exceptions that were enunciated
    here. That seems to be the best way to do it. The idea of
    putting them under the Investment Act and saying that now they
    are going to have to comply with all of the provisions that
    were written in 1940 obviously doesn't make much sense. But
    there is a simpler way and more practical way to do this, but
    they should be regulated.
        Mr. Tierney. Absolutely.
        Thank you all very, very much.
        Mr. Kucinich. Mr. Cannon.
        Mr. Cannon. Thank you again, Mr. Chairman. I apologize for
    going back and forth. We have a high level panel on clemency
    going on in the Judiciary Committee, which is just next door,
    and so Mr. Issa and I are both on both of these committees and
    are going back and forth. So, again, I apologize for the
    erratic presence.
        I do actually have some questions that I would like to go
    into with this panel.
        Mr. Tanous, could you explain for the committee the concept
    of investing in funds of hedge funds and what this type of
    investing does to insulate--I am sorry, we don't want to ask
    that question.
        Mr. Tanous. I would be happy to answer.
        Mr. Cannon. What I would rather ask is this: would you
    agree that organizations like Blackstone are nothing like Long-
    Term Capital Management, and therefore comparisons between the
    two are flawed?
        Mr. Tanous. Yes. I don't think they are anything like Long-
    Term Capital Management. The Long-Term Capital Management blow-
    up was largely an issue of very high leverage, and that, to my
    knowledge, is not at all the case with respect to Blackstone
    and the activities that they do.
        Mr. Cannon. And would you describe their activities, just
    in comparison?
        Mr. Tanous. Say that again?
        Mr. Cannon. Would you describe Blackstone's activities?
        Mr. Tanous. I am not an expert on Blackstone, but basically
    they have a number of different activities. The one that they
    are best known for is private equity. Essentially, they will
    buy a company out, improve it, sell it back on the market at a
    higher price, and make money for their fundholders and
    themselves.
        Mr. Cannon. Thank you.
        Now if I can shift to Mr. Borg--and maybe you can come back
    on this Mr. Tanous--the idea that you have private equity and
    that there is some risk involved--of course, with any
    investment you have some risk, but you also have these large
    investment funds, retirement funds. Those are run, Mr. Borg, by
    professionals, and, in fact, CALPERS has, like, $21 billion
    that is invested just in their investment portfolio in private
    equity, the California State Teachers Retirement System has $10
    billion in private equity, and apparently the Ohio Public
    Employees Retirement System has $600 million invested in
    private equity. These are among the most sophisticated managers
    of money on earth. No private individual could spend the kind
    of time and focus. Do we need to be worried about those people
    making decisions that are inappropriate, where the risk would
    be inconsistent with the return?
        Mr. Borg. As with any pension fund, as an institutional
    investor certainly they are different than the retail market
    that I was addressing. We are talking about the Mom and Pops in
    the kitchen trading stocks on the kitchen table. The pension
    funds, with their managerial experience, would qualify for even
    having Blackstone-like entities come and talk to them on a one-
    to-one basis and talk about details that a retail investor will
    never hear about. That is the first thing.
        Are there dangers with respect to the pension funds? Sure.
    There are a lot of pension funds that are under water because
    of changes in the market conditions, especially since the crash
    of 2000-2001. The bottom line, though, is retail investors who
    won't even know what an illiquid pool of investment is, the
    pension funds, with their expertise, can make a more informed
    judgment as to what their risk factors are. Plus, most pension
    funds--and I can speak for the pension fund that I am familiar
    with, which of course would be the State of Alabama--there are
    certain criteria where they cannot go over a certain amount of
    risk, as well.
        That is vastly different than asking somebody to take their
    retirement fund from their job and all of the sudden they have
    $30,000 or $50,000 in Blackstone with very little protections
    at all. In fact, even the big pension funds, the bigger they
    are the more they are going to be listened to, even if they
    don't have protections, to some extent, because they are a
    force to be reckoned with, not the retail investors.
        Mr. Cannon. Professor Coffee, would you like to comment on
    that?
        Mr. Coffee. I think I agree very much with what Joe Borg
    has just said. In the world of the private pension fund, the
    governance is really by contract. The pension fund sits down
    and contracts with the hedge fund manager and maybe will agree
    that you have the right to redeem after 6 months, 1 year. You
    have all kinds of provisions that you put in by contract. That
    is not feasible when we move into the world of public markets
    where little investors can't contract with the manager and
    where the small retail investor doesn't know to diversify.
        Intelligent pension funds are going to be diversified among
    a variety of different hedge fund and similar investments. The
    retail investor unfortunately chronically under-diversifies.
        Mr. Cannon. I might point out that is probably less the
    case since Enron collapsed and people are aware of the
    possibility, but over time it is probably clearly the case.
        Thank you, Mr. Chairman. I yield back. Do we have a vote?
        Mr. Kucinich. We do. I am going to try to get my questions.
    How much time is left on that vote? We are going to try to do
    this.
        I would like the members of the panel, in particular
    starting with Mr. Bullard and then Professor Coffee, assuming
    that Blackstone were regulated under the Investment Company
    Act, from what provisions would you grant or not grant
    exemptive relief?
        Mr. Bullard. I would probably subject them to virtually all
    of the corporate governance provisions. They would have an
    independent board. They would have to get shareholder approval
    for various fee issues, which would in this context be
    essentially executive compensation. I think on that point I
    would probably agree with Professor Coffee.
        Where I would disagree is I think that one thing the
    Investment Company Act provides that the exchanges cannot do,
    which is to limit affiliated transactions and provide that they
    only occur under certain circumstances, and the SEC has a long
    history of granting exemptions to business development
    companies where they have managed the problem of co-investments
    and other affiliated transactions for that purpose.
        Other than those two major categories, I think that
    virtually all of the other requirements of the Investment
    Company Act would be handled through better disclosure and some
    standardizing of the disclosure regarding volatility and risk.
        Mr. Kucinich. Professor Coffee.
        Mr. Coffee. To the extent that there is a debate or a
    dialog between Professor Bullard and I, it is really a debate
    about whether you apply the statute and then grant exemptions
    for 80 or 85 percent of it, because that is the order of
    magnitude we are talking about in terms of exemptions, or,
    alternatively, we say the simpler, more direct approach is to
    focus on that 15 percent of the statute that we think is
    relevant today and not make it applicable and then repeal it,
    but rather say what we want is better independent boards, we
    want better voting rights, we want fiduciary duties to apply,
    and I agree we want related party transaction to be restricted.
    But I do think that the SEC using its disclosure options can
    put a very strong oversight over affiliated transactions, and I
    don't think that really is the problem with Blackstone.
        Mr. Kucinich. Mr. Borg, did you want to weigh in on that?
        Mr. Borg. Very quickly. I think that there is a 1990 case--
    and I am going to defer to the professors--that says the SEC
    cannot apply those listing standards. I may be wrong on that.
        Mr. Coffee. You are talking about the Business Roundtable
    case----
        Mr. Borg. Yes.
        Mr. Coffee [continuing]. Which I do discuss. And I think
    this has to be done by diplomacy, but that is the least drastic
    means.
        Mr. Borg. I think this actually opens up the SEC to a
    possible lawsuit if they try and do that, even by a separate
    agreement, if there is a case law that says you can't do that.
    But I agree in general with the idea that those are the
    protections that need to be imposed. I only see at this point
    the existing law as the ICA as the one method available at this
    time.
        Mr. Kucinich. Mr. Tanous, did you want to add anything?
        Mr. Tanous. My only concern, Mr. Chairman, and perhaps one
    of the other panelists could address it if you want them to,
    but I worry about the slippery slope aspect of mandating or
    even legislating how the voting is going to take place in some
    of these firms, because the issue of the two classes of stocks
    in a number of corporations comes to mind where you have class
    A stock with one vote and class B stock with ten. Where do you
    draw the line in terms of voters' rights and prerogatives?
        Mr. Kucinich. Thank you. I just have one quick question. I
    would ask Professor Coffee to respond. If the exchanges were to
    adopt new rules for hedge fund managers, what should those
    rules be?
        Mr. Coffee. I think the first thing would be that there
    would be a majority independent board, or perhaps it could even
    be as high as the Investment Company Act may require in the
    future, and I think that there should be independent
    nominating, audit, and compensation committees.
        As to affiliated party transactions, both the exchanges and
    the SEC could require periodic disclosure that I think would
    focus on the danger of affiliated party transactions.
        Mr. Kucinich. I want to thank the panel. We have a vote on
    right now that I am going to have to go to, but I think we have
    covered the territory substantively in a relatively short
    amount of time.
        This has been a hearing of the Domestic Policy Subcommittee
    of the Oversight and Government Reform Committee. The topic of
    today's hearings has been: After Blackstone, Should small
    Investors Be Exposed to Risks of Hedge Funds? We have had a
    representative of the Securities and Exchange Commission
    testify, as well as experts in securities issues that relate to
    this pertinent matter.
        I want to thank very much all of the people who testified
    today.
        This committee stands adjourned.
        [Whereupon, at 3:07 p.m., the subcommittee was adjourned.]