[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


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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.]

                                 
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