[Federal Register Volume 69, Number 144 (Wednesday, July 28, 2004)]
[Proposed Rules]
[Pages 45172-45200]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-16888]



[[Page 45171]]

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Part III





Securities and Exchange Commission





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17 CFR Parts 275 and 279



Registration Under the Advisers Act of Certain Hedge Fund Advisers; 
Proposed Rule

  Federal Register / Vol. 69, No. 144 / Wednesday, July 28, 2004 / 
Proposed Rules  

[[Page 45172]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 275 and 279

[Release No. IA-2266; File No. S7-30-04]
RIN 3235-AJ25


Registration Under the Advisers Act of Certain Hedge Fund 
Advisers

AGENCY: Securities and Exchange Commission (the ``Commission'').

ACTION: Proposed rule.

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SUMMARY: The Commission is proposing for comment a new rule and rule 
amendments under the Investment Advisers Act of 1940. The proposed new 
rule and amendments would require advisers to certain private 
investment pools (``hedge funds'') to register with the Commission 
under the Advisers Act. The rule and rule amendments are designed to 
provide the protections afforded by the Advisers Act to investors in 
hedge funds, and to enhance the Commission's ability to protect our 
nation's securities markets.

DATES: Comments should be received on or before September 15, 2004.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to [email protected]. Please include 
File Number S7-30-04 on the subject line; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609.
    All submissions should refer to File Number S7-30-04. This file 
number should be included on the subject line if e-mail is used. To 
help us process and review your comments more efficiently, please use 
only one method. The Commission will post all comments on the 
Commission's Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments are also available for public inspection and 
copying in the Commission's Public Reference Room, 450 Fifth Street, 
NW., Washington, DC 20549. All comments received will be posted without 
change; we do not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
available publicly.

FOR FURTHER INFORMATION CONTACT: Vivien Liu, Senior Counsel, Jamey 
Basham, Branch Chief, or Jennifer L. Sawin, Assistant Director, at 202-
942-0719 or [email protected], Office of Investment Adviser Regulation, 
Division of Investment Management, Securities and Exchange Commission, 
450 Fifth Street, NW., Washington, DC 20549-0506.

SUPPLEMENTARY INFORMATION: The Commission is requesting public comment 
on proposed new rule 203(b)(3)-2 [17 CFR 275.203(b)(3)-2], proposed 
amendments to rules 203(b)(3)-1 [17 CFR 275.203(b)(3)-1], 204-2 [17 CFR 
275.204-2], 205-3 [17 CFR 275.205-3], and 206(4)-2 [17 CFR 275.206(4)-
2],\1\ and Form ADV [17 CFR 279.1] under the Investment Advisers Act of 
1940 [15 U.S.C. 80b] (the ``Advisers Act'' or ``Act'').
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    \1\ Unless otherwise noted, when we refer to rules 203(b)(3)-1, 
204-2, 205-3, 206(4)-2, or any paragraph of the rules, we are 
referring to 17 CFR 275.203(b)(3)-1, 275.204-2, 275.205-3, and 
275.206(4)-2 of the Code of Federal Regulations in which the rules 
are published.
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Table of Contents

I. Background
    A. Growth of Hedge Funds
    B. Growth in Hedge Fund Fraud
    C. ``Retailization'' of Hedge Funds
II. Discussion
    A. Need for Regulatory Action
    B. Matters Considered by the Commission
    C. Proposed Rule 203(b)(3)-2
    D. Definition of ``Private Fund''
    E. Amendments to Rule 203(b)(3)-1
    F. Amendments to Rule 204-2
    G. Amendments to Rule 205-3
    H. Amendments to Rule 206(4)-2
    I. Amendments to Form ADV
    J. Compliance Period
III. General Request for Comment
IV. Cost-Benefit Analysis
V. Effects on Commission Examination Resources
VI. Paperwork Reduction Act
VII. Effects on Competition, Efficiency and Capital Formation
VIII. Regulatory Flexibility Act
IX. Statutory Authority
Text of Proposed Rule, Rule Amendments and Form Amendments

I. Background

    The Commission regulates the nation's money managers under the 
Investment Advisers Act of 1940. These include investment advisers to 
mutual funds, pension funds, private funds, corporations, trusts, 
endowments, charities, as well as advisers to individuals and families. 
The approximately 8,000 investment advisers registered with us under 
the Advisers Act manage more than $23 trillion of client assets.\2\
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    \2\ Based on information filed with us on Form ADV, the adviser 
registration form, as of May 1, 2004, investment advisers registered 
with the Commission managed approximately $21 trillion in 
discretionary accounts and managed an additional $2.3 trillion on a 
non-discretionary basis.
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    Advisers registered with us engage in a wide variety of asset 
management styles. They represent perhaps every different view and 
approach to managing money, including indexing, quantitative analysis, 
and numerous styles of fundamental analysis. Some assemble simple 
portfolios of stocks and bonds. Others employ sophisticated hedging 
strategies that seek to reduce volatility or other risks. Still others 
use futures contracts or derivatives to leverage client holdings in 
hopes that, by assuming greater risk, they will capture greater 
profits. Some manage cash holdings that provide safety and liquidity 
for a portion of client portfolios while others help clients speculate 
in distressed securities, options, merger arbitrage or other risky 
investment strategies. Many do not manage money at all but, instead, 
provide financial planning services.
    The clients of these advisers include small investors and the 
largest of national and international financial institutions. A number 
of advisers registered with us manage client portfolios through mutual 
funds or other collective investment vehicles organized as 
corporations, trusts, limited partnerships or limited liability 
companies.\3\ Many advise only individual accounts,\4\ while others 
report to us that they advise only institutional or high net worth 
individuals.\5\
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    \3\ Based on information filed with us on Form ADV as of May 1, 
2004, 1,483 or 18 percent of advisers registered with us managed one 
or more investment companies and 1,912 or 23 percent of advisers 
registered with us managed other types of pooled investment 
vehicles.
    \4\ Based on information filed with us on Form ADV as of May 1, 
2004, 672 or 8 percent of advisers registered with us managed 
individual accounts only.
    \5\ Based on information filed with us on Form ADV as of May 1, 
2004.
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    There may be few areas of the financial services industry more 
diverse than the Commission's registered investment advisers.\6\ Yet 
the Advisers Act accommodates them all. Instead of prescribing a set of 
detailed rules, the Act contains a few basic requirements,

[[Page 45173]]

such as registration with the Commission, maintenance of business 
records, and delivery of a disclosure statement (``brochure''). Most 
significant is a provision of the Act that prohibits advisers from 
defrauding their clients, a provision that the Supreme Court has 
construed as imposing on advisers a fiduciary obligation to their 
clients.\7\ This fiduciary duty requires advisers to manage their 
clients' portfolios in the best interest of clients, but not in any 
prescribed manner. A number of obligations to clients flow from this 
fiduciary duty, including the duty to fully disclose any conflicts the 
adviser has with clients,\8\ to seek best execution for client 
transactions,\9\ and to have a reasonable basis for client 
recommendations.\10\
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    \6\ In addition to varying substantially in their approach to 
money management and their clientele, these investment advisers also 
vary widely in their organizational size. Our data indicate that the 
sizes of the 8,275 advisers registered with us range from 1 employee 
to exceeding 1,000 employees, with 4,132 having 1-5 employees and 96 
having more than 1,000 employees.
    \7\ See SEC v. Capital Gains Research Bureau, Inc., et al., 375 
U.S. 180 (1963) (``Capital Gains''). See also Transamerica Mortgage 
Advisors, Inc., (TAMA) v. Lewis, 444 U.S. 11 (1979); Santa Fe 
Industries, Inc. v. Green, 430 U.S. 462, 471, n 11 (1977).
    \8\ See Capital Gains, supra note 7, at 191-194.
    \9\ See In the Matter of Kidder, Peabody & Co., Incorporated, 
Edward B. Goodnow, Investment Advisers Act Release No. 232 (Oct. 16, 
1968); In the Matter of Mark Bailey & Co., and Mark Bailey, 
Investment Advisers Act Release No. 1105 (Feb. 24, 1988); In the 
Matter of Jamison, Eaton & Wood, Inc., Investment Advisers Act 
Release No. 2129 (May 15, 2003).
    \10\ See supra note 9.
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    Not all advisers must register with the Commission. The Act exempts 
an adviser from registration if it (i) has had fewer than fifteen 
clients during the preceding 12 months, (ii) does not hold itself out 
generally to the public as an investment adviser, and (iii) is not an 
adviser to any registered investment company.\11\ Advisers taking 
advantage of this ``private adviser exemption'' must nonetheless comply 
with the Act's antifraud provisions,\12\ but do not file registration 
forms with us identifying who they are, do not have to maintain 
business records in accordance with our rules, do not have to adopt or 
implement compliance programs or codes of ethics, and are not subject 
to Commission oversight. We lack authority to conduct regular 
examinations of advisers exempt from the Act's registration 
requirements.\13\
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    \11\ Section 203(b)(3) [15 U.S.C. 80b-3(b)(3)]. The Act also 
provides several other registration exemptions, which have much more 
limited application. Registration exemptions are provided to 
advisers that have only intrastate business and do not give advice 
on exchange-listed securities (section 203(b)(1) [15 U.S.C. 80b-
3(b)(1)]); to advisers whose only clients are insurance companies 
(section 203(b)(2) [15 U.S.C. 80b-3(b)(2)]); to charitable 
organizations and their officials (section 203(b)(4) [15 U.S.C. 80b-
3(b)(4)]); to church plans (section 203(b)(5) [15 U.S.C. 80b-
3(b)(5)]); and to commodity trading advisors registered with the 
Commodity Futures Trading Commission (``CFTC'') whose business does 
not consist primarily of acting as investment advisers (section 
203(b)(6) [15 U.S.C. 80b-3(b)(6)]).
    \12\ They are also subject to antifraud provisions of other 
federal securities laws, including rule 10b-5 under the Securities 
Exchange Act of 1934 [17 CFR 240.10b-5].
    \13\ Section 204 of the Advisers Act [15 U.S.C. 80b-4] 
authorizes the Commission to conduct examinations of all records of 
investment advisers. Advisers exempted from registration pursuant to 
section 203(b) of the Act [15 U.S.C. 80b-3(b)] are specifically 
excluded from being subject to these examinations.
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    There is no legislative history that explains why the private 
adviser exemption was enacted. We do know, however, that it was not 
intended to exempt advisers to wealthy or sophisticated clients. They 
were the primary clients of many advisers in 1940 when the provision 
was included in the Act.\14\ While provisions of the Securities Act 
(and its rules) provide exemptions from registration under that Act for 
securities transactions with persons, including institutions, that have 
such knowledge and experience that they are considered capable of 
fending for themselves and thus do not need the protections of the 
applicable registration provisions,\15\ the Advisers Act does not. When 
a client--even one who is highly sophisticated in financial matters--
seeks the services of an investment adviser, he acknowledges he needs 
the assistance of an expert. The client may be unfamiliar with 
investing or the type of strategy employed by the adviser, or may 
simply not have the time to manage his financial affairs. The Advisers 
Act is intended to protect all types of investors who have entrusted 
their assets to a professional investment adviser. Today, thirty-nine 
percent of advisers registered with us report that they advise only 
institutional and wealthy clients.\16\
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    \14\ The Commission's 1939 Investment Trust study to Congress, 
which preceded enactment of the Advisers Act, found that the average 
size of individual clients' accounts managed by advisers surveyed in 
1936 was $281,000, which equals $3.8 million in today's value. 
Individual clients represented about 83 percent of these advisers' 
client base. See SEC, Investment Trusts and Investment Companies, 
H.R. Doc. No. 279, 76th Cong., 1st Sess., pt. 2 at 8-9 (1940).
    \15\ See e.g., sections 4(2) and 4(6) of the Securities Act of 
1933 [15 U.S.C. 77d(2) and 77d(6)] and Regulation D [17 CFR 230.501 
et seq.] and rule 144A [17 CFR 230.144A]; SEC v. Ralston Purina Co., 
346 U.S. 119 (1953).
    \16\ Based on information filed with us on Form ADV as of June 
30, 2004.
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    The private adviser exemption appears to reflect Congress' view 
that there is no federal interest in regulating advisers with only a 
small number of clients, many of whom are likely to be friends and 
family members.\17\ Today, however, a growing number of investment 
advisers take advantage of the private adviser exemption to operate 
large investment advisory firms without Commission oversight. Instead 
of managing client money directly, these advisers pool client assets by 
creating limited partnerships, business trusts or corporations in which 
clients invest. Because our rules generally have permitted advisers to 
count each partnership, trust or corporation as a single client, many 
of these advisers have been able to avoid our oversight even though 
they manage large amounts of client assets and, indirectly, have a 
large number of clients.\18\
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    \17\ The legislative history of section 3(c)(1) of the 
Investment Company Act of 1940 [15 U.S.C. 80a-3(c)(1)], a parallel 
section to section 203(b)(3) that was enacted at the same time, 
reflects Congress' view that privately placed investment companies, 
owned by a limited number of investors likely to be drawn from 
persons with personal, familial, or similar ties, do not rise to the 
level of federal interest. See Investment Trusts and Investment 
Companies: Hearings on S.3580 before a Subcomm. of the Senate Comm. 
On Banking and Currency, 76th Cong. 3d. Sess. 179 (1940).
    \18\ Rule 203(b)(3)-1(a)(2)(i) generally permits a corporation, 
general partnership, limited partnership, limited liability company, 
trust, or other legal organization to be counted as a single client. 
Rule 203(b)(3)-1(b)(3) states that ``[a]' limited partnership is a 
client of any general partner or other person acting as investment 
adviser to the partnership.''
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    One significant group of these advisers provides investment advice 
through a type of pooled investment vehicle commonly known as a ``hedge 
fund.'' There is no statutory or regulatory definition of hedge fund, 
although many have several characteristics in common. Hedge funds are 
organized by professional investment managers who frequently have a 
significant stake in the funds they manage and receive a management fee 
that includes a substantial share of the performance of the fund.\19\ 
Advisers organize and operate hedge funds in a manner that avoids 
regulation as mutual funds under the Investment Company

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Act of 1940, and they do not make public offerings of their 
securities.\20\
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    \19\ See William Fung and David A. Hsieh, A Primer on Hedge 
Funds, Journal of Empirical Finance 6 (1999), at 310; David W. 
Frederick, Institute of Certified Financial Planners, Hedge Funds: 
Only the Wealthy Need Apply, Jan. 30, 1998, at http://www.yourretirement.com/fidlquest_22.htm (visited on May 20, 2004); 
Roy Kouwenberg, Erasmus University Rotterdam & William T. Ziemba, 
Sauder School of Business, Vancouver and Swiss Banking Institute, 
University of Zurich, Incentives and Risk Taking in Hedge Funds, 
July 17, 2003, at http://www.few.eur.nl/few / people/kouwenberg/
incentives3.pdf (visited on May 20, 2004). Not all hedge funds, 
however, are managed by legitimate investment professionals. See SEC 
v. Ryan J. Fontaine and Simpleton Holdings Corporation a/k/a 
Signature Investments Hedge Fund, Litigation Release No. 18254 (July 
28, 2003) (22 year-old college student purportedly acted as 
Signature's portfolio manager and made numerous false claims to 
investors and prospective investors).
    \20\ See sections 3(c)(1) and 3(c)(7) of the Investment Company 
Act of 1940 [15 U.S.C. 80a-3(c)(1) and 3(c)(7)].
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    Hedge funds were originally designed to invest in equity securities 
and use leverage and short selling to ``hedge'' the portfolio's 
exposure to movements of the equity markets.\21\ Today, however, 
advisers to hedge funds utilize a wide variety of investment strategies 
and techniques designed to maximize the returns for investors in the 
hedge funds they sponsor.\22\ Many are very active traders of 
securities.\23\
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    \21\ See Carol J. Loomis, Hard Times Come To The Hedge Funds, 
Fortune (Jan. 1970) at 10.
    \22\ Bernstein Wealth Management Research, Hedge Fund Myths and 
Realities (Oct. 2002) at 3 (``[H]edge funds vary in many ways, 
including the broad array of strategies they employ, the manager's 
skill at implementing those strategies and the risks they take * * 
*.'').
    \23\ Ted Caldwell, Introduction: The Model for Superior 
Performance, in HEDGE FUNDS, INVESTMENT AND PORTFOLIO STRATEGIES FOR 
THE INSTITUTIONAL INVESTORS, (Jess Lederman & Robert A. Klein eds., 
1995); Julie Rohrer, The Red-Hot World of Julian Robertson, 
Institutional Investor, May 1986, at 86.
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    The Commission has long been concerned about hedge funds and their 
managers, and the impact their investment activities can have on 
investors and the securities markets. As early as 1969, the Commission 
investigated hedge funds, responding to their rapid growth and concerns 
about their use of trading techniques such as leverage and short 
selling.\24\ In 1971 we conducted an economic study of institutional 
investors in which we described the activities of hedge funds, noted 
the serious conflicts of interest that hedge fund advisers have, and 
noted their growth.\25\ In 1992, in response to a Congressional 
inquiry, the Commission developed and provided to Congress detailed 
information about the regulatory treatment of hedge funds under the 
federal securities laws.\26\ Seven years later we participated in the 
President's Working Group on Financial Markets in the wake of the near-
collapse of Long Term Capital Management, Inc., (``LTCM'').\27\ LTCM 
was a large, highly leveraged hedge fund the unraveling of which 
threatened the stability of international capital markets.\28\ 
Recently, our staff assisted officials of the Treasury Department to 
prepare proposed rules that would require hedge funds to implement 
anti-money laundering programs.\29\
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    \24\ See The 35th Annual Report, Securities and Exchange 
Commission (1969), at 18.
    \25\ SEC, Institutional Investor Study Report, H.R. Doc. No. 92-
64, 92 Cong., 2d Sess., p. xv.
    \26\ See Letter from Richard C. Breeden, Chairman, U.S. 
Securities and Exchange Commission, to Edward J. Markey, Chairman, 
Subcommittee on Telecommunications and Finance, Committee on Energy 
and Commerce, U.S. House of Representatives (June 12, 1992), 
available at SEC's public reference room under file no. S7-30-04. 
See also Protecting Investors: A Half Century of Investment Company 
Regulation, Division of Investment Management of the U.S. Securities 
and Exchange Commission (May 1992).
    \27\ See Hedge Funds, Leverage, and the Lessons of Long-Term 
Capital Management--Report of the President's Working Group on 
Financial Markets, by representatives from the Commission, the 
Treasury Department, the Federal Reserve and the Commodity Futures 
Trading Commission (Apr. 1999) (``PWG LTCM Report'').
    \28\ Id.
    \29\ See Financial Crimes Enforcement Network; Anti-Money 
Laundering Programs for Unregistered Investment Companies, 
Department of the Treasury Release [67 FR 60617 (Sept. 26, 2002)].
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    In 2002, we requested that our staff again examine the activities 
of hedge funds and hedge fund advisers. First, we were aware that the 
number and size of hedge funds were rapidly growing and that this 
growth could have broad consequences for the securities markets for 
which we are responsible. Second, we were bringing a growing number of 
enforcement cases in which hedge fund advisers defrauded hedge fund 
investors, who typically were able to recover few of their assets. 
Third, we were concerned that the activities of hedge funds today might 
affect a broader group of persons than the relatively few wealthy 
individuals and families who had historically invested in hedge 
funds.\30\ We directed the staff to develop information for us on a 
number of related topics, and advise us whether we should exercise 
greater regulatory authority over the hedge fund industry.
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    \30\ See Douglas W. Hawes, Hedge Funds--Investment Clubs for the 
Rich, The Business Lawyer (Jan. 1968).
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    In connection with the staff investigation, we held a Hedge Fund 
Roundtable on May 14 and 15, 2003, and invited a broad spectrum of 
hedge fund industry participants to participate. Information developed 
at the Roundtable, and a large number of additional submissions we 
subsequently received from interested persons, contributed greatly to 
the staff's investigation and our understanding of hedge funds and 
hedge fund advisers.\31\
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    \31\ Transcripts of the Roundtable participants' presentations 
and comments submitted in connection with the Roundtable are 
available at http://www.sec.gov/spotlight/hedgefunds.htm.
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    In September 2003, the staff published a report entitled 
Implications of the Growth of Hedge Funds.\32\ The 2003 Staff Hedge 
Fund Report describes in detail the operation of hedge funds and raises 
a number of important public policy concerns. The report focused on 
investor protection concerns raised by the growth of hedge funds. In 
contrast, the principal focus of the President's Working Group's 1999 
report was the stability of financial markets and the exposure of banks 
and other financial institutions to the counterparty risks of dealing 
with highly leveraged entities such as the LTCM hedge fund. Because the 
two reports had different purposes, the recommendations of the two 
reports are also quite different. The 2003 Staff Hedge Fund Report 
confirmed and further developed several of our concerns regarding hedge 
funds and hedge fund advisers.
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    \32\ Implications of the Growth of Hedge Funds, Staff Report to 
the United States Securities and Exchange Commission, (``2003 Staff 
Hedge Fund Report''), available at http://www.sec.gov/spotlight/hedgefunds.htm.
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A. Growth of Hedge Funds

    Since 1993, the estimated assets in U.S. hedge funds have increased 
fifteenfold to at least $795 billion,\33\ and the number of hedge funds 
has increased more than fivefold to 7,000.\34\ Although hedge funds 
remain a relatively small portion of the U.S. financial markets,\35\ 
the rate of growth of hedge funds has been substantially greater than 
that of other sectors,\36\ and

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hedge fund assets have been projected to grow to over a trillion 
dollars by the end of 2004.\37\ In addition, hedge funds play a growing 
role in our securities markets as large and frequent traders of 
securities. One recent article portrayed a single hedge fund manager as 
responsible for an average of five percent of the daily trading volume 
of the New York Stock Exchange.\38\ Another reported hedge funds 
dominate the market for convertible bonds.\39\
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    \33\ The estimated total assets of hedge funds in the U.S. were 
$50 billion in January 1993. See Charles J. Gradante, Comments of 
Hennessee Group LLC for the U.S. Securities and Exchange Commission 
Roundtable on Hedge Funds, May 14-15, 2003 at 5 (available at http://www.sec.gov/spotlight/hedgefunds/hedge-parts.htm).). The Hennessee 
Group recently reported that total hedge fund assets in the U.S. 
have reached $795 billion. See Testimony of Charles J. Gradante, 
Managing Principal, the Hennessee Group LLC, Before the Senate 
Committee on Banking, Housing, and Urban Affairs, available at 
http://banking.senate.gov/_files/gradante.pdf (visited on July 20, 
2004). Hedge Fund Research, a research/consulting firm, recently put 
the figure at $800 billion. See Forbes News Release, Hedge Funds Are 
Robbing Investors, According to Forbes, May 5, 2004, available at 
www.forbesinc.com/newsroom/ releases/editorial/Forbes052404.doc 
(visited on May 20, 2004). Moreover, data indicated that the rate of 
new money invested in hedge funds may be accelerating. See Fund 
Briefs, Pensions and Investments (Mar. 22, 2004) (TASS estimates 
that the total amount of hedge fund inflows for 2003 was 4 times the 
amount of inflows for 2002). Industry experts predict world's total 
hedge fund assets may grow to $2-4 trillion by the end of the 
decade. See Is Two Trillion Dollars Too Little? AIMA Journal (June 
2004).
    \34\ The estimated total number of hedge funds in the U.S. grew 
from 1,100 in January 1993 to 5,700 in January 2003. See Charles J. 
Gradante, Comments for the Roundtable on Hedge Funds, supra note 33. 
The Hennessee Group recently reported that total number of hedge 
funds has grown to 7,000. See Testimony of Charles J. Gradante, 
supra note 33.
    \35\ For example, the total market value of corporate equities 
in the U.S. stock market at the end of 2003 was $15,497.9 billion. 
See Federal Reserve Statistical Release Z.1, Flow of Funds Accounts 
of the United States--Flows and Outstandings, First Quarter 2004.
    \36\ During the same period (1993-2003), the number of mutual 
fund portfolios barely doubled and their assets increased by 2.5 
times; assets of insurance companies and commercial banks doubled; 
and deposits of commercial banks barely doubled. Sources: ICI 
Factbook 2003 and ``Trends in Mutual Fund Investing, January 2004'' 
at www.ici.org; Federal Reserve Statistical Release Z.1, Flow of 
Funds Accounts of the United States--Flows and Outstandings, First 
Quarter 2004; Federal Reserve Statistical Release H.8, Assets and 
Liabilities of Commercial Banks in the United States, Dec. 1993 
through Dec. 2003.
    \37\ The total asset inflows into hedge funds for 2003 reached 
$72.2 billion according to TASS Research. See Tremont's TASS 
Research Reports Record $72.2 Billion in Net Inflow for 2003, Record 
Fourth Quarter Inflow of $26.8 Billion, Feb. 19, 2004, available at 
http://www.tremontinvestment.com/tass_estimate_021904.htm (visited 
on May 20, 2004). Hedge Fund Research, an alternative investments 
research and consulting firm, predicts that investors will put $100 
billion into hedge funds in 2004. See Neil Weinberg and Bernard 
Condon, The Sleaziest Show on Earth, Forbes (May 24, 2004), at 110. 
Financial Research Corp., a financial research firm, predicts the 
hedge fund industry will reach $1 trillion by year-end. See Hanna 
Shaw Grove and Russ Alan Prince, Let Us In, Registered Rep. (Mar. 
2004).
    \38\ Marcia Vickers, The Most Powerful Trader On Wall Street 
You've Never Heard Of, BusinessWeek (July 21, 2003), at 66.
    \39\ See Henny Sender, Hedge Funds Skid on Convertible Bonds, 
The Wall St. J., June 30, 2004, at C4 (hedge funds account for about 
95% of all trading in convertible bonds).
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B. Growth in Hedge Fund Fraud

    The growth in hedge funds has been accompanied by a substantial and 
troubling growth in the number of our hedge fund fraud enforcement 
cases. In the last five years, the Commission has brought 46 cases in 
which we have asserted that hedge fund advisers have defrauded hedge 
fund investors or used the fund to defraud others in amounts our staff 
estimates to exceed $1 billion. These frauds involved advisers that:
     For years grossly overstated the performance of their 
hedge funds to investors who were actually incurring tens or hundreds 
of millions of dollars in losses on their investments in the funds; 
\40\
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    \40\ SEC v. Edward Thomas Jung, et al., Litigation Release No. 
17417 (Mar. 15, 2002) (Commission found unregistered adviser caused 
investor losses of approximately $20 million); SEC v. David M. 
Mobley, Sr., et al., Litigation Release No. 18150 (May 20, 2003) 
(Commission found unregistered adviser caused investor losses of 
approximately $60 million); SEC v. Michael W. Berger, Manhattan 
Capital Management Inc., Litigation Release No. 17230 (Nov. 13, 
2001) (Commission obtained judgment in case against unregistered 
adviser who caused investor losses of approximately $400 million). 
We have also filed civil actions alleging the same types of fraud. 
SEC v. Michael Lauer, Lancer Management Group, LLC, and Lancer 
Management Group II, LLC, Litigation Release No. 18247 (July 23, 
2003) (charging unregistered hedge fund adviser with manipulating 
thinly-traded portfolio securities to fraudulently inflate fund 
values by hundreds of millions of dollars); SEC v. Ashbury Capital 
Partners, L.P., Ashbury Capital Management, L.L.C., and Mark 
Yagalla, Litigation Release No. 16770 (Oct. 17, 2000) (charging 
unregistered hedge fund adviser with misappropriating millions of 
dollars in client assets). See also SEC v. Beacon Hill Asset 
Management LLC, et al., Litigation Release No. 18745A (June 16, 
2004) (charging unregistered hedge fund adviser with understating 
losses by hundreds of millions of dollars for at least three months, 
and causing the hedge fund to purchase securities from the adviser's 
managed account clients at inflated prices to prop up the 
performance of the managed accounts; principals of the adviser were 
also charged with causing the hedge fund to trade with the 
principals' personal account at erroneous prices that benefited the 
principals).
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     Caused hedge funds to pay unnecessary and undisclosed 
commissions; \41\ and
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    \41\ In the Matter of Portfolio Advisory Services, LLC and Cedd 
L. Moses, Investment Advisers Act Release No. 2038 (June 20, 2002) 
(registered adviser caused its hedge funds to pay nearly $2 million 
in unnecessary and undisclosed commission costs, above markups 
already paid, to broker that had no role in executing trades, as 
reward for referring investors to the hedge funds).
---------------------------------------------------------------------------

     Used parallel unregistered advisory firms and hedge funds 
as vehicles to misappropriate client assets.\42\
---------------------------------------------------------------------------

    \42\ SEC v. Hoover and Hoover Capital Management, Inc., 
Litigation Release No. 17487 (Apr. 24, 2002), Litigation Release No. 
17981 (Feb. 11, 2003) (principal of registered adviser who, after 
becoming aware of Commission investigation of its misappropriation 
of client assets, established a hedge fund and parallel unregistered 
advisory firm to continue the fraud).
---------------------------------------------------------------------------

    Since the staff report, a new species of hedge fund fraud has been 
uncovered. Advisers to hedge funds have been key participants in the 
recent scandals involving mutual fund late trading and inappropriate 
market timing.\43\ Many of our enforcement cases involved hedge funds 
that sought to exploit mutual fund investors for their own gain. Some 
entered into arrangements with mutual fund advisers under which the 
advisers waived restrictions on market timing in return for receipt of 
``sticky assets'' from the hedge fund, i.e., placement of other assets 
in other funds managed by the mutual fund adviser. Others sought ways 
to avoid detection by mutual fund personnel by conspiring with 
intermediaries to conceal the identity of the hedge funds. While our 
investigation is ongoing, the frequency

[[Page 45176]]

with which hedge funds appear in these cases and continue to turn up in 
the investigations is alarming. Our staff counts as many as forty 
different hedge funds involved in these cases, including hedge funds 
managed by Canary Investment Management, LLC.\44\
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    \43\ We recently sanctioned persons charged with late trading of 
mutual fund shares on behalf of groups of hedge funds, and against 
mutual fund advisers or principals for permitting hedge funds' 
market timing. In the Matter of Banc One Investment Advisers 
Corporation and Mark A. Beeson, Investment Advisers Act Release No. 
2254 (June 29, 2004) (Commission found that investment adviser 
permitted hedge fund manager to time the adviser's mutual funds, 
contrary to the funds' prospectuses; helped arrange financing for 
the timing trades; failed to disclose the timing arrangements; and 
provided the hedge fund manager with nonpublic portfolio 
information); In the Matter of Pilgrim Baxter & Associates, Ltd., 
Investment Advisers Act Release No. 2251 (June 21, 2004) (Commission 
found that mutual fund adviser permitted a hedge fund, in which one 
of its executives had a substantial financial interest, to engage in 
repeated short-term trading of several mutual funds and that one of 
its executives provided nonpublic portfolio information to a broker-
dealer, which passed it on to its customers); In the Matter of 
Strong Capital Management, Inc., Investment Advisers Act Release No. 
2239 (May 20, 2004) (Commission found that adviser disclosed 
material nonpublic information about mutual fund portfolio holdings 
to hedge fund, and permitted own chairman and hedge fund to engage 
in undisclosed market timing of mutual funds managed by adviser); 
SEC v. Security Trust Co., N.A., Litigation Release No. 18653 (Apr. 
1, 2004) (consent to judgment by trust company charged with 
accepting late trades from several hedge funds over at least a 
three-year period); In the Matter of Stephen B. Markovitz, 
Administrative Proceedings Release No. 33-8298 (Oct. 2, 2003) 
(Commission found that Markovitz engaged in late trading on behalf 
of hedge funds spanning four years). See also In the Matter of 
Alliance Capital Management, L.P., Investment Advisers Act Release 
No. 2205 (Dec. 18, 2003) (Commission found that investment adviser 
permitted known market timers, including at least one hedge fund, to 
market time its mutual funds, in exchange for the timers' 
investments in Alliance's investment vehicles); In the Matter of 
James Patrick Connelly, Jr., Investment Advisers Act Release No. 
2183 (Oct. 16, 2003) (Commission found that vice chairman of mutual 
fund adviser permitted market timing by hedge funds).
    We are continuing to pursue several similar cases. To date, we 
have instituted seven enforcement actions (in addition to the seven 
settled actions discussed above). See SEC v. PIMCO Advisors Fund 
Management, LLC, Litigation Release No. 18697 (May 6, 2004) 
(alleging that mutual fund adviser entered into a market timing 
arrangement permitting over 100 mutual fund market timing 
transactions by a hedge fund); SEC v. Columbia Management Advisors, 
Inc., Litigation Release No. 18590 (Feb. 24, 2004) (alleging mutual 
fund adviser entered into arrangements allowing hedge funds to 
engage in market timing transactions in nine funds, including one 
aimed at young investors); SEC v. Mutuals.com, Inc., Litigation 
Release No. 18489 (Dec. 4, 2003) (alleging that dually registered 
broker-dealer and investment adviser, three of its executives, and 
two affiliated broker-dealers assisted hedge fund brokerage 
customers in carrying out and concealing thousands of market timing 
trades and illegal late trades in shares of hundreds of mutual 
funds); SEC v. Invesco Funds Group, Litigation Release No. 18482 
(Dec. 2, 2003) (alleging that mutual fund adviser, with approval of 
its president and chief executive officer, entered into market 
timing arrangements with hedge funds); SEC v. Druffner, Litigation 
Release No. 18444 (Nov. 4, 2003) (alleging that five brokers, with 
the assistance of their branch office manager, evaded attempts to 
restrict their trading and assisted several hedge funds in 
conducting thousands of market timing trades in numerous mutual 
funds); In re Sihpol, Securities Exchange Act Release No. 48493 
(Sept. 16, 2003) (charging former broker with playing a key role in 
enabling hedge fund customers to engage in late trading in mutual 
fund shares over a three-year period). See also In the Matter of 
Paul A. Flynn, Securities Exchange Act Release No. 49177 (Feb. 3, 
2004) (alleging Flynn assisted numerous hedge funds in obtaining 
bank financing to fund late trading and deceptive market timing of 
mutual fund shares).
    \44\ Because the advisers to these hedge funds were 
unregistered, our examination staff had no opportunity to review 
their trading activities in the mutual funds.
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    In a lawsuit against Canary, the New York Attorney General has 
alleged that Canary obtained its late trading and market timing 
``capacity'' from mutual fund managers and intermediaries.\45\ In 
return, Canary often would leave millions of dollars in the fund 
managers' selected funds on a long-term basis as ``sticky assets.'' 
\46\ Canary borrowed from the parent companies of the fund managers or 
intermediaries to finance its late trading and market timing schemes. 
As a result, Canary reaped tens of millions of dollars in profits from 
these schemes,\47\ the fund managers collected lucrative management 
fees from the ``sticky assets,'' the intermediaries received huge 
commissions,\48\ and parent companies of the fund managers or 
intermediaries acting as lenders earned interest at a significant 
premium, while long-term investors in the mutual funds targeted by 
Canary lost tens of millions of dollars.\49\
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    \45\ See State of New York Complaint Against Canary Capital 
Partners, LLC, Canary Investment Management, LLC, Canary Capital 
Partners, LTD and Edward J. Stern, Sept. 3, 2003, available at 
www.oag.state.ny.us/press/2003/sep/canary_complaint.pdf (visited on 
May 26, 2004).
    \46\ Id.
    \47\ See, e.g., SEC v. Security Trust Co., N.A., supra note 43 
(as a result of its late trading and market timing assisted by 
Security Trust Co., Canary realized a profit of $85 million).
    \48\ See, e.g., SEC v. Security Trust Co., N.A., supra note 43 
(Security Trust Co. received over $5.8 million in direct 
compensation from Canary).
    \49\ See supra note 45.
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C. ``Retailization'' of Hedge Funds

    The third development of significant concern is the growing 
exposure of smaller investors, pensioners, and other market 
participants, directly or indirectly, to hedge funds. Hedge fund 
investors are no longer limited to the very wealthy. We note three 
developments that we have observed that contribute to our concern.
    First, some hedge funds today are expanding their marketing 
activities to attract investors who may not previously have 
participated in these types of risky investments.\50\ Many hedge funds 
maintain very high minimum requirements, and many of the hedge fund 
participants at our Roundtable expressed no interest in attracting 
``retail investors.'' Our staff observed, however, that many hedge 
funds'' minimum investment requirements have decreased over time.\51\ 
In developed markets outside the United States, hedge funds have sought 
to market themselves to smaller investors, and we can expect similar 
market pressures to develop in the United States as more hedge funds 
enter our markets.\52\
---------------------------------------------------------------------------

    \50\ See Harriet Johnson Brackey, New Class of Hedge Funds 
Reaches Beyond the Wealthy, San Jose Mercury News, Mar. 23, 2003; 
Pam Black, Going Mainstream, Registered Rep. (Mar. 1, 2004); Let Us 
In, Registered Rep., supra note 37; Jane Bryant Quinn and Temma 
Ehrenfeld, The Street's Latest Lure: Some One Is Going to Mint Money 
With the New Hedge Funds For Smaller Investors, Newsweek (May 26, 
2003). See also two recent articles discussing hedge funds in 
publications for physicians. John J. Grande, Alternative Investment 
Strategies Can Offer Significant ROI, Ophthalmology Times (May 15, 
2002); Leslie Kane, Where to Put Your Money: Four Experts Tell 
Whether You Should Expect Happy Days for Stocks, and How to Invest 
Your Money, Medical Economics (Jan. 9, 2004).
    \51\ See supra note 32, at 81.
    \52\ Any sales in the United States would, of course, be subject 
to the registration requirements of the Securities Act, and the 
hedge fund itself may be subject to the Investment Company Act, 
unless exemptions were available. The UK recently introduced a new 
type of vehicle which will be available only to sophisticated 
investors, but will still be authorized by the FSA, as a ``half way 
house'' between retail funds (fully regulated) and wholly 
unregulated funds. See Financial Services Authority, The CIS 
Sourcebook--A New Approach, Feedback on CP185 and Made Text, Mar. 
2004, available at www.fsa.gov.uk/pubs/policy/04--07.pdf (visited on 
May 11, 2004). Starting Jan. 2004, funds of hedge funds may sell 
their shares to smaller investors in Germany subject to certain 
regulations and procedures. See Silvia Ascarelli and David Reilly, 
Hedge Funds Are Coming to the Masses, The Wall St. J., Apr. 15, 
2004; EU Financial Services Group Briefing, Wilmer, Cutler & 
Pickering, Hedge Funds in Germany--German Parliament Opens the 
Market for Alternative Investment Products, Dec. 5, 2003, available 
at http://www.wilmer.com/pubs/results.aspx? iPractice (visited on 
May 11, 2004). Since April 2003, funds of hedge funds may sell their 
shares to smaller investors in France, subject to certain 
regulations and procedures. See Commission des Operations de Bourse 
(France), Regulating Alternative Multi-Management Investments, News 
Release (Apr. 1, 2003) (available in File No. S7-30-04); Alain 
Gauvin and Guillaume Eliet, Capital Markets Dept., Coudert Freres, 
Regulating Alternative Multi-Management Investments, 2003, available 
at http://www.coudert. com (visited on May 17, 2004). In Ireland, 
funds of hedge funds may sell their shares to smaller investors 
subject to certain regulations and procedures. See Matheson Ormsby 
Prentice, Establishing a Hedge Fund in Ireland, 2003, available at 
http://www.mop.ie/fileupload/ publications (visited on May 17, 
2004). In Asia, both Hong Kong and Singapore permit authorized hedge 
funds to sell their shares to investors subject to certain minimum 
subscription thresholds and regulations. See Donald E. Lacey, Jr., 
Democratizing the Hedge Fund: Considering the Advent of Retail Hedge 
Funds, Apr. 2003, (International Finance Seminar at Harvard Law 
School), available at http://www.law.harvard.edu/ programs/pifs/
pdfs/donald-- lacey.pdf (visited on May 17, 2004); Mattew Harrison, 
Fund Management in Hong Kong and Singapore, CSU Research and Policy, 
Jan. 6, 2003. In South Africa, regulators and trade associations 
recently issued a joint discussion paper to develop an acceptable 
regulated environment in which existing and new hedge funds can 
operate (including consideration of whether to permit certain hedge 
fund products to be marketed to the public). See The Financial 
Services Board, Association of Collective Investments and 
Alternative Investment Management Association, The Regulatory 
Position of Hedge Funds in South Africa--A Joint Discussion Paper 
(Mar. 9, 2004). See also Carla Fiford, South African Hedge Fund 
Industry Grows by Stealth, AIMA Journal (Feb. 2004).
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    Second, the development of ``funds of hedge funds'' has made hedge 
funds more broadly available to investors.\53\ Today there are 40 
registered funds of hedge funds that offer or plan to offer their 
shares publicly.\54\ Most funds of hedge funds are today offered only 
to institutional investors, but there are no limitations on the public 
offering of these funds.
---------------------------------------------------------------------------

    \53\ The Street's Latest Lure: Some One Is Going to Mint Money 
With the New Hedge Funds For Smaller Investors, supra note 50; Going 
Mainstream, supra note 50; Jessica Toonkel, Firms Take Pause Before 
Launching Hedge Funds of Funds for Mass Affluent; Hold Your Horses! 
Fund Action (Apr. 21, 2003); Michael P. Malloy and Jim Strangroom, 
Registered Funds of Hedge Funds, MFA Reporter (2002); Fool's Gold, 
The Economist (Sept. 1, 2001); Kimberly Hill, Investors Need Help 
With Hedge Funds, Fundfire, May 14, 2004.
    \54\ An additional 47 funds of hedge funds are registered with 
the Commission as investment companies but can be sold only through 
private offerings. The Commission does not have data on the number 
of additional funds of hedge funds that exist but are not registered 
with the Commission.
---------------------------------------------------------------------------

    Finally, and perhaps most significantly, in the last few years, a 
growing number of public and private pension funds,\55\ as well as 
universities, endowments, foundations, and other charitable 
organizations, have begun to invest in hedge funds or have increased 
their allocations to hedge funds.\56\ Press

[[Page 45177]]

reports indicate that more of these institutions have also recently 
begun to consider these alternative investments.\57\ Hedge funds are 
thus today being purchased by entities that are not traditional hedge 
fund investors, including pension plans that have millions of 
beneficiaries. As a result of the participation by these entities in 
hedge funds, as well as other sophisticated investment strategies, the 
assets of these entities are exposed to the risks of the hedge fund. 
Losses resulting from hedge fund investments, as with any other 
investment loss, may affect the entities' ability to satisfy their 
obligations to their beneficiaries or pursue other intended purposes.
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    \55\ According to Greenwich Associates, about 20 percent of 
corporate and public plans in the United States were investing in 
hedge funds in 2002, up from 15 percent in 2001. See BIM Alternative 
Investments SGR, Odd Blend May Be a Match, available at http://www.bimalternativesgr.it/ italiano/hedge--funds/ news/2003/
20030624--ticker--magazine (visited on May 18, 2004); RMF Investment 
Management, RMF Investment Letter, available at http://www.rmf.ch/rmf_ investment-- letter--June--2003.pdf (visited on May 18, 2004). 
Hennessee Group data indicate that pensions' investments in hedge 
funds increased from $13 billion in 1997 to $72 billion in 2004. See 
Testimony of Charles J. Gradante, supra note 33. See also Hedge 
Funds Gaining Acceptance Among Pension Funds, Morningstar Web site, 
June 27, 2003; Chris Clair, `Unprecedented Pressure': Public Plans 
Race to Embrace Hedge Funds; This Time They Are Leading, Not 
Following, Their Corporate Counterparts, Pensions and Investments, 
July 8, 2002, at 2; Alaska Pension Allocates to Hedge Fund, 
Alternative Investment News, July 1, 2004 (the Alaska State Pension 
Investment Board has chosen three firms to manage its first $300 
million hedge fund allocation).
    \56\ Median strategic allocation to hedge funds by endowments 
and foundations was 11 percent in 2001, 10 percent in 2003 and 
forecast at 12.3 percent in 2005. See Goldman Sachs International 
and Russell Investment Group, Report on Alternative Investing by 
Tax-Exempt Organizations 2003, available at http://www.russell.com/II/Research_and Resources/Informative--Articles /Goldman-- 
Russell-- Survey.asp (visited on May 18, 2004). Lewis Knox, The 
Hedge Fund: Institutional Money is Swelling the Coffers of the 
World's Largest Hedge Fund Managers, 28 Institutional Investor 
(International Edition) 53 (June 1, 2003); Dan Neel, Michigan Preps 
For Hedge, Real Estate, Investment Management Weekly, Apr. 28, 2003; 
Virginia Exposure Soars to 60%, Financial News (Daily), Apr. 27, 
2003 (University of Virginia has invested 50 percent of its 
portfolio in hedge funds, and plans to increase its exposure to 60 
percent of its total portfolio); Chris Clair, Allocation Goal: 25%--
UTIMCO Joins Billion-Dollar Hedge Fund Club, Pensions and 
Investments, Apr. 14, 2003, at 3; Chidem Kurdas, Hedge Funds 
Continue to Gain in Endowments' Alternative Investments, HedgeWorld 
Daily News, Apr. 7, 2003; Behind the Money Section; University of 
Wisconsin Searching for Hedge Funds, 4 Alternative Investment News, 
Feb. 1, 2003, at 20 ($300 million University of Wisconsin endowment 
will allocate up to 10 percent, or $25-30 million, to a fund of 
funds manager); Baylor University; Inside The Buyside; Increases 
Hedge Fund Activity by $20-25 Million, 4 Alternative Investment 
News, Feb. 1, 2003 at 6; Susan L. Barreto, Hedge Funds Become Saving 
Grace for Endowments in Tough Times, HedgeWorld Daily News, Apr. 4, 
2002.
    \57\ Philly to Embrace Hedge Funds, Alternative Investment News, 
June 21, 2004 (the $4.1 billion City of Philadelphia Board of 
Pension & Retirement system has carved out a 5 percent allocation to 
hedge funds--its first to the asset class); Texas Plan to Search for 
Hedge Funds, 6 Alternative Investment News, June 2004, at 6 ($1.5 
billion San Antonio Fire and Police Retirement Fund expects to carve 
out a $75 million allocation to hedge funds); Updated Searches 
Section, 6 Alternative Investment News, June 2004, at 12 (Illinois 
State Board of Investment will issue an RFP in early fall for four 
funds of hedge funds to handle between $500-550 million for the 
pension plans under its oversight); Auburn to Seek Alternatives 
Managers, Alternative Investment News, June 10, 2004 (Auburn 
University will hire a few funds of hedge funds firms to fill its 
newly-created 20 percent allocation to absolute return strategies); 
US Pension Plan Looks to Hedge Fund, Financial Times (London), June 
26, 2003, at Global Investing 21 (Virginia Retirement System plans 
to invest $1 billion in hedge funds); NYC Fund Eyes Maiden Hedge 
Fund of Funds Investment, 4 Alternative Investments, June 1, 2003, 
at 19 (Manhattan & Bronx Surface Transit Operating Authority 
Retirement Fund considers investment in hedge funds); Florida Plan 
to Search for Funds of Funds, 4 Alternative Investment News, Apr. 1, 
2003, at 19 (Gainesville, Florida General Employees Pension Plan 
searches for hedge fund manager); Indiana University Eyeing Single-
Manager Hedge Funds, 6 Foundation & Money Management, Mar. 1, 2003, 
at 1; Kern County Seeks Hedge Funds, 4 Alternative Investment News, 
Mar. 1, 2003, at 19 ($1.5 billion Kern County, California Employees 
Retirement Association will make a maiden foray into hedge funds 
with a $45 million search for multiple managers); MassPRIM to 
Consider Hedge Funds in Review, 4 Alternative Investment News, Feb. 
1, 2003, at 19 ($27 billion Massachusetts Pension Reserves 
Investment Management Board is considering adding its first hedge 
funds this year).
---------------------------------------------------------------------------

II. Discussion

A. Need for Regulatory Action

    Our responsibilities to protect investors and the nation's 
securities markets do not permit us to ignore these developments. Our 
current regulatory program for hedge funds and hedge fund advisers is 
inadequate--it relies almost entirely on enforcement actions brought 
after the fraud has occurred and investor assets are gone.\58\ We have 
no oversight program that would provide us with the ability to deter or 
detect fraud by unregistered hedge fund advisers at an early stage. We 
lack basic information about hedge fund advisers and the hedge fund 
industry, and must rely on third party data that often conflict and may 
be unreliable.\59\
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    \58\ Robert Lenzner and Michael Maiello, The Money Vanishes, 
Forbes, Aug. 6, 2001 at 70 (``What does it mean to say that hedge 
funds are unregulated? It means that if there is mischief, the 
Securities and Exchange Commission will find out about it too 
late.'').
    \59\ William Fung and David Hsieh, Measuring the Market Impact 
of Hedge Funds, 7 Journal of Empirical Finance 1 (2000) (``There are 
varying estimates of the size of the hedge fund industry.''); Hedg-
matics: How Many Funds Exist? The Wall St. J., May 22, 2003, at C5 
(``Just how big is the hedge-fund industry? This simple question has 
been debated because the data on hedge funds are spotty.''); Letter 
from Craig S. Tyle, General Counsel of the Investment Company 
Institute, to Jonathan G. Katz, Secretary, U.S. Securities and 
Exchange Commission, July 2, 2003, available at www.ici.org (visited 
on Feb. 10, 2004) (``There is currently no universal database that 
contains records of all hedge funds, both those currently operating 
and those that have ceased operating.''); Gaurav S. Amin and Harry 
M. Kat, Hedge Fund Performance 1990-2000: Do the ``Money Machines'' 
Really Add Value?, 38 Journal of Financial and Quantitative Analysis 
2 (June 1, 2003) (``Due to its private nature, it is difficult to 
estimate the current size of the hedge fund industry.''). See also 
Bing Liang, Hedge Funds: The Living and the Dead, 35 Journal of 
Financial and Quantitative Analysis 309-326 (2000) (study of 
statistical inconsistencies in two major hedge fund databases, 
noting hedge funds ``are basically not regulated. They report their 
fund information only on a voluntary basis. Therefore, the 
reliability of hedge fund data is an open question and is critical 
for hedge fund research and the investment community.''); Harry M. 
Kat, 10 Things That Investors Should Know About Hedge Funds, 
Institutional Investor (Spring 2003) (noting that hedge fund 
databases are of low quality, that each database covers only a 
subset of the hedge fund universe, that all present survivorship 
bias, and that researchers attempting to analyze the hedge fund 
industry or fund performance may perceive matters very differently 
depending on the database or index they use).
---------------------------------------------------------------------------

    Hedge fund growth and the evolution of hedge fund ownership have 
resulted in both more significant and broader market and investor 
protection concerns, and have convinced us that we should consider 
taking steps to provide for greater oversight of hedge fund advisers. 
As the 2003 Staff Hedge Fund Report outlines, numerous institutions on 
which individual investors, savers, and pensioners depend today have a 
substantial exposure to the risks of hedge funds and the activities of 
hedge fund advisers. One survey reports that pension fund exposure to 
hedge funds has grown from $13 billion in 1997 to $72 billion today, an 
increase of 450 percent.\60\ Hardly a week passes in which industry 
publications do not announce a decision by a public pension plan, 
endowment, foundation or other charitable organization to invest in 
hedge funds.\61\ The growing demand for hedge funds has resulted in 
asymmetries of information: even institutional investors are often 
unable to acquire information on an ongoing basis about the hedge fund 
adviser, its operations and conflicts.\62\
---------------------------------------------------------------------------

    \60\ See supra note 55.
    \61\ See supra notes 55-57.
    \62\ See Roundtable Transcript of May 14 at 167-70 (statement of 
David Swensen) (private placement memoranda as disclosure documents 
are ``not particularly useful''); Roundtable Transcript of May 15 at 
190 (statement of Sandra Manzke) (``[I]t would make my life a lot 
easier to have mandated disclosures * * * [I]t's very difficult to 
get answers out of managers, and they hold all the keys right now. 
If you want to get into a good fund, and you ask some difficult 
questions, you may not get that answer. Sure, there is a lot of 
access, to get online and do background checks, and hire firms * * * 
But that's expensive. And can the retail investor do it? No. Firms 
like ours, we spend a lot of money, we have a lot more people 
working for us now to uncover these types of situations.'').
---------------------------------------------------------------------------

    The recent rapid growth of hedge fund investments also concerns us 
because of its potential impact on the behavior of hedge fund advisers. 
As substantial inflows chase absolute returns, hedge fund managers will 
have powerful incentives to pursue riskier strategies in order to 
generate substantial absolute returns under all market conditions. The 
capacity of hedge fund advisers to generate large absolute returns is 
limited because the use of similar financial strategies by other hedge 
fund advisers narrows spreads and decreases profitability.\63\

[[Page 45178]]

We are also concerned that some hedge fund advisers may be pursuing 
strategies that may be inconsistent with disclosures provided regarding 
the advisers, or may be improper or unlawful, as we have seen with 
hedge funds pursuing late trading and market timing strategies.
---------------------------------------------------------------------------

    \63\ See David Reilly, Hot Hedge Fund Vega Grapples With Growth: 
Global/Macro Style of Investing May Provide Room to Maneuver, But a 
Door Is Closed to New Cash, The Wall St. J., June 4, 2004, at C1 (as 
hedge funds' assets explode, difficulties in finding winning 
strategies raises the specter of diminished returns and 
concentrations of investment risk that are difficult to unwind in a 
crisis); Mara Der Hovanesian, Will Hedge Funds Be Overrun By All The 
Traffic?, BusinessWeek, Mar. 11, 2002 (some hedge fund strategies 
are becoming less effective as the capacity of managers to generate 
high absolute returns diminishes when investment portfolios are too 
large). See also Alexander M. Ineichen, ABSOLUTE RETURNS (2003) at 
47 (falling barriers to entry for new hedge fund advisers are 
causing a dilution of the talent pool, making adviser selection more 
difficult).
---------------------------------------------------------------------------

    Hedge funds present unique risks to the securities markets and 
investors that concern us and should concern all market participants. 
Unregistered hedge fund advisers operate largely in the shadows, with 
little oversight, are subject to the pressures of performance fee 
arrangements,\64\ and in many cases are expected to generate positive 
returns even in down markets. While these conditions can stimulate a 
tremendous amount of investment creativity and profit, they are also a 
perfect medium for the germination and growth of frauds. As we have 
seen, hedge fund advisers are capable of serious transgressions that 
can harm ordinary citizens who in many cases are now their ultimate 
beneficiaries.
---------------------------------------------------------------------------

    \64\ See William Goetzmann, et al., High-Water Marks and Hedge 
Fund Management Contracts, Yale International Center for Finance 
(Apr. 18, 2001).
---------------------------------------------------------------------------

    Our concern is and must be the protection of investors and the 
suppression of fraud. But we must also recognize the important role 
that hedge funds play in our markets. Hedge funds contribute to market 
efficiency and liquidity.\65\ They play an important role in allocating 
investment risks by serving as counterparties to investors who seek to 
hedge risks.\66\ They provide their investors with greater 
diversification of risk by offering them exposure uncorrelated with 
market movements.\67\ Therefore, in evaluating alternative courses we 
might take, we have paid particular attention to the extent to which 
our actions might encumber the operation of hedge funds and thus damage 
the very markets we seek to protect.
---------------------------------------------------------------------------

    \65\ ``[M]any of the things which [hedge funds] do * * * tend to 
refine the pricing system in the United States and elsewhere. And it 
is that really exceptional and increasingly sophisticated pricing 
system which is one of the reasons why the use of capital in this 
country is so efficient * * * there is an economic value here which 
we should not merely dismiss * * *. I do think it is important to 
remember that [hedge funds] * * * by what they do, they do make a 
contribution to this country.'' Testimony of Alan Greenspan, 
Chairman of the Board of Governors of the Federal Reserve, Before 
the House Committee on Banking and Finance (Oct. 1, 1998).
    \66\ See A Primer on Hedge Funds, supra note 19. See also PWG 
LTCM Report, supra note 27; 2003 Staff Hedge Fund Report, supra note 
32, at 4.
    \67\ See A Primer on Hedge Funds, supra note 19. See also PWG 
LTCM Report, supra note 27; 2003 Staff Hedge Fund Report, supra note 
32, at 4.
---------------------------------------------------------------------------

B. Matters Considered by the Commission

    We are proposing a new rule the effect of which would be to require 
hedge fund advisers to register under the Advisers Act. Registration 
under the Act would address several of our concerns described above 
while imposing only minimal burdens on hedge fund advisers.
1. Census Information
    Hedge fund adviser registration would provide the Commission with 
important information about this growing segment of the U.S. financial 
system. Collecting information about the nation's investment advisers 
has been one aim of the Advisers Act since it was enacted in 1940.\68\ 
However, just as data on all advisers was lacking before 1940, today 
there are no comprehensive data on hedge fund advisers currently 
available.\69\ We have only limited indirect information about these 
firms and their trading practices, and we are hampered in our ability 
to develop regulatory policy regarding hedge fund advisers and their 
funds. Registering hedge fund advisers would permit us to collect 
information about the number of hedge funds that advisers manage, the 
amount of assets in hedge funds, the number of employees and types of 
clients these advisers have, other business activities they conduct, 
and the identity of persons that control or are affiliated with the 
firm.\70\
---------------------------------------------------------------------------

    \68\ Although the primary objective of the Advisers Act is the 
protection of advisory clients, the Act also serves as ``a 
continuing census of the Nation's investment advisers.'' H.R. Rep. 
No. 1760, 86th Cong., 2d Sess. 2 (1960). In 1940, Congress noted 
that it was difficult to ascertain the number of investment advisers 
in operation or the amount of funds under their influence and 
control. H.R. Rep. No. 1775, 76th Cong., 3d Sess. 21 (1940).
    \69\ See 2003 Staff Hedge Fund Report, supra note 32.
    \70\ Much of this information is currently collected from hedge 
fund advisers that are registered with the Commission. A registered 
adviser that is the general partner of a hedge fund must report that 
it advises a ``pooled vehicle'' in response to Item 5.D (6) of Part 
1A of Form ADV, list each pooled vehicle on Schedule D (Section 
7.B.) and disclose the amount of assets in the fund and the minimum 
amount of capital investment per investor.
---------------------------------------------------------------------------

    Although there may be other piecemeal sources for some of the 
information the Commission would obtain when a hedge fund adviser files 
Form ADV, much of the information is not readily available without 
substantial forensic efforts on the part of our staff. We need 
information that is reliable, current, and complete, and we need it in 
a format easily susceptible to analysis by our staff.
2. Deterrence and Early Discovery of Fraud
    Registration under the Advisers Act gives us authority to conduct 
examinations of the adviser's hedge fund activities.\71\ Our 
examinations permit us to identify compliance problems at an early 
stage, identify practices that may be harmful to investors, and provide 
a deterrent to unlawful conduct.\72\ They are a key part of our 
investor protection program.
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    \71\ See supra note 13.
    \72\ Other protections of the Advisers Act would also act as 
deterrents to unlawful conduct by serving as a check on the 
advisers' control of assets in funds they advise and contribute to 
the protection of investors in those funds. Our custody rule, for 
example, requires the adviser to maintain fund assets with a 
qualified custodian. See rule 206(4)-2 under the Advisers Act.
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    The prospect of an SEC examination increases the risk of getting 
caught, and thus will deter wrongdoers.\73\ During an examination, our 
staff reviews the advisory firm's internal controls and procedures; 
they examine the adequacy of procedures for valuing client assets, for 
placing and allocating trades, and for arranging for custody of client 
funds and securities. Examination staff also review the adviser's 
performance claims and delivery of its client disclosure brochure. Each 
of these operational areas presents a greater opportunity for 
misconduct if it is not open to examination. Our examinations bring 
limited sunlight to advisory activities that are kept from sight from 
clients for competitive and other reasons. Examinations may be a 
particularly appropriate form of sunlight because of the highly 
proprietary nature of many hedge fund advisers' activities.\74\
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    \73\ The facts of the action against Stevin R. Hoover and Hoover 
Capital Management, Inc. are instructive on this question. See SEC 
v. Hoover and Hoover Capital Management, Inc., (Second Amended 
Complaint of the SEC), (available at www.sec.gov/litigation/complr17487.htm). Hoover was involved in a scheme to defraud clients 
of his advisory firm by, among other things, misappropriating assets 
and overbilling expenses. When Hoover became aware that the 
Commission staff was investigating his firm, he established a 
separate, unregistered advisory firm and perpetuated his fraud 
through use of a hedge fund he created and controlled.
    \74\ We are not proposing to require, nor have we ever required, 
investment advisers to disclose their clients' securities positions. 
Indeed, we recently declined requests to require advisers to 
publicly disclose how they voted client proxies out of a concern 
that they would thereby divulge client securities positions. Proxy 
Voting by Investment Advisers, Investment Advisers Act Release No. 
2106 (Jan. 31, 2003) [68 FR 6585 (Feb. 7, 2003)]. The Advisers Act 
requires us to maintain as confidential information obtained by our 
examiners in the course of an examination. See sections 210(b) and 
210A of the Act. [15 U.S.C. 80b-210(b) and 210A].

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[[Page 45179]]

    Examination of hedge fund advisers should serve the same deterrent 
role that it does with respect to other types of advisers.\75\ There is 
nothing unique about hedge fund advisers or the types of frauds they 
have committed that suggests that our examination program would not or 
could not play the same effective role. The fraud actions we have 
brought against unregistered hedge fund advisers have been similar to 
the types of fraud actions we have brought against other types of 
advisers, including misappropriation of assets,\76\ portfolio 
pumping,\77\ misrepresentation of portfolio performance,\78\ 
falsification of experience, credentials and past returns,\79\ 
misleading disclosure regarding claimed trading strategies \80\ and 
improper valuation of assets.\81\
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    \75\ Of course, we are not suggesting our examination program 
would reduce investment risks. Our examination program is designed 
to uncover poor controls and to deter and expose misconduct. It is 
not designed to evaluate advisers' investment and trading strategies 
or to prevent losses that may result from legitimate investment 
risks.
    \76\ SEC v. Jean Baptiste Jean Pierre, Gabriel Toks Pearse and 
Darius L. Lee, Litigation Release No. 18216 (July 7, 2003); SEC v. 
Peter W. Chabot, Chabot Investments, Inc., Sirens Synergy and the 
Synergy Fund, LLC, Litigation Release No. 18214 (July 3, 2003); SEC 
v. David M. Mobley, Sr., et al., supra note 40; SEC v. Vestron 
Financial Corp., et al., Litigation Release No. 18065 (Apr. 2, 
2003); SEC v. Hoover and Hoover Capital Management, Inc., supra note 
42; SEC v. Beacon Hill Asset Management LLC, et al., supra note 40; 
SEC v. House Asset Management, L.L.C., House Edge, L.P., Paul J. 
House, and Brandon R. Moore, Litigation Release No. 17583 (June 24, 
2002); SEC v. Edward Thomas Jung, et al., supra note 40; SEC v. 
Evelyn Litwok & Dalia Eilat, Litigation Release No. 16843 (Dec. 27, 
2000); SEC v. Ashbury Capital Partners, L.P., Ashbury Capital 
Management, L.L.C., and Mark Yagalla, supra note 40.
    \77\ SEC v. Michael Lauer, Lancer Management Group, LLC, and 
Lancer Management Group II, LLC, supra note 40; SEC v. Burton G. 
Friedlander, Litigation Rel. No. 18426 (Oct. 24, 2003).
    \78\ In the Matter of Samer M. El Bizri and Bizri Capital 
Partners, Inc., Admin Proc. File No. 3-11521 (June 16, 2004); SEC v. 
Millennium Capital Hedge Fund, Litigation Release No. 18362 (Sept. 
25, 2003); SEC v. Peter W. Chabot, Chabot Investments, Inc., Sirens 
Synergy and the Synergy Fund, LLC, supra note 76; SEC v. David M. 
Mobley, Sr., et al., supra note 40; SEC v. Hoover and Hoover Capital 
Management, Inc., supra note 42; SEC v. Beacon Hill Asset Management 
LLC, et al., supra note 40; SEC v. Edward Thomas Jung, et al., supra 
note 40; SEC v. Michael W. Berger, Manhattan Capital Management 
Inc., supra note 40; In the Matter of Charles K. Seavey and 
Alexander Lushtak, Investment Advisers Act Release No. 1968 (Aug. 
15, 2001); In the Matter of Michael T. Higgins, Investment Advisers 
Act Release No. 1947 (June 1, 2001); SEC v. Ashbury Capital 
Partners, L.P., Ashbury Capital Management, L.L.C., and Mark 
Yagalla, supra note 40.
    \79\ SEC v. J. Scott Eskind, Litigation Release No. 18558 (Jan. 
29, 2004); SEC v. Jean Baptiste Jean Pierre, Gabriel Toks Pearse and 
Darius L. Lee, supra note 76; SEC v. Peter W. Chabot, Chabot 
Investments, Inc., Sirens Synergy and the Synergy Fund, LLC, supra 
note 76; SEC v. Vestron Financial Corp., et al., supra note 76; SEC 
v. House Asset Management, L.L.C., House Edge, L.P., Paul J. House, 
and Brandon R. Moore, supra note 76; SEC v. Evelyn Litwok & Dalia 
Eilat, supra note 76; SEC v. Ashbury Capital Partners, L.P., Ashbury 
Capital Management, L.L.C., and Mark Yagalla, supra note 40.
    \80\ SEC v. Peter W. Chabot, Chabot Investments, Inc., Sirens 
Synergy and the Synergy Fund, LLC, supra note 76; SEC v. David M. 
Mobley, Sr., et al., supra note 40; SEC v. Edward Thomas Jung, et 
al., supra note 40; SEC v. Ashbury Capital Partners, L.P., Ashbury 
Capital Management, L.L.C., and Mark Yagalla, supra note 40.
    \81\ SEC v. Global Money Management, L.P., Litigation Release 
No. 18666 (Apr. 12, 2004); SEC v. Burton G. Friedlander, supra note 
77; SEC v. Michael Lauer, Lancer Management Group, LLC, and Lancer 
Management Group II, LLC, supra note 40; SEC v. David M. Mobley, 
Sr., et al., supra note 40; SEC v. Beacon Hill Asset Management LLC, 
et al., supra note 40; SEC v. Edward Thomas Jung, et al., supra note 
40; In the Matter of Charles K. Seavey and Alexander Lushtak, supra 
note 78; In the Matter of Michael T. Higgins, supra note 78.
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    We have also charged registered hedge fund advisers with other 
types of fraud, including: misallocating favorable investment 
opportunities to a hedge fund, to the detriment of the adviser's other 
clients, In the Matter of Nevis Capital Management, LLC, David R. 
Wilmerding, III and Jon C. Baker, Investment Advisers Act Release No. 
2214 (Feb. 9, 2004); misallocating investment opportunities to the 
personal account of a hedge fund adviser, to the detriment of the hedge 
fund, In the Matter of Zion Capital Management LLC, and Ricky A. Lang, 
Investment Advisers Act Release No. 2200 (Dec. 11, 2003); usurping a 
profitable, low-risk investment opportunity available to a hedge fund 
and taking it for the personal benefit of a hedge fund adviser, SEC v. 
Schwendiman Partners, LLC, Gary Schwendiman, and Todd G. Schwendiman, 
Investment Advisers Act Release No. 2043 (July 11, 2002); and causing 
hedge funds to pay commissions to a broker that had no role in 
executing trades, as reward for referring investors to the adviser's 
hedge funds, In the Matter of Portfolio Advisory Services, LLC and Cedd 
L. Moses, supra note 41. We have no reason to believe that unregistered 
advisers may not be perpetrating the same types of frauds, beyond our 
detection.
    Improper valuation of hedge fund assets by hedge fund advisers is a 
matter of serious concern to us. A recent study of hedge funds 
identified valuation problems as playing a primary or contributing role 
in 35 percent of hedge fund failures, and fraud as the underlying cause 
for more than half of them.\82\ The authors attribute these failures, 
in part, to a lack of regulatory oversight: ``Put these natural, 
inherent difficulties in pricing complex or illiquid investments [in 
which hedge funds invest] together with a powerful financial incentive 
[on the part of the adviser] to show (or hide weak) performance, and 
then situate these factors in an environment with minimal regulatory 
oversight, or without strict discipline and internal controls (still 
far too typical in the hedge fund industry), and there is potential for 
trouble.'' \83\
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    \82\ Christopher Kundro and Stuart Feffer, Valuation Issues and 
Operational Risk in Hedge Funds, Capco White Paper (Dec. 2003) 
(valuation problems played a role in 35 percent of studied hedge 
fund failures, and 57 percent of those valuation problems were 
caused by fraud or misrepresentation) (available at http://www.capco.com/pdf/j10art06.pdf) (visited on July 12, 2004). See also 
Proceed With Caution, Investment Adviser, Apr. 12, 2004 
(``Unreliable pricing of securities in a hedge fund manager's 
portfolio remains the single most significant cause of blow-ups in 
the industry * * *.''); Mara Der Hovanesian, Hedge Fund Values: Stop 
the Fudging, BusinessWeek, May 10, 2004, at 106.
    \83\ Kundro & Feffer, supra note 82 at 4.
---------------------------------------------------------------------------

    Valuation problems arise in many cases when hedge fund advisers 
overstate assets in order to cover trading losses or to ``buy time'' 
until performance improves.\84\ Registered investment advisers are not 
required to follow any particular valuation methodology, but our 
examiners consider whether the adviser's procedures for valuing the 
managed assets are effective, whether the adviser's actual practices in 
valuing client assets follow the procedures they have established, and 
how the adviser discloses, mitigates and manages the conflicts of 
interest that can arise with respect to valuation.\85\
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    \84\ See, e.g., SEC v. Michael W. Berger, Manhattan Capital 
Management Inc., supra note 40; SEC v. Edward Thomas Jung, et al., 
supra note 40.
    \85\ Examinations of Investment Companies and Investment 
Advisers, SEC Staff Report (Mar. 2004) at 19, available at http://www.sec.gov/news/extra/apx-ts031004lar.pdf. One simple check our 
examiners perform is to determine the extent to which the sale price 
of fund securities deviates substantially from the price at which 
the securities are valued.
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3. Keeping Unfit Persons From Using Hedge Funds To Perpetrate Frauds
    Registration with the Commission permits us to screen individuals 
associated with the adviser, and to deny registration if they have been 
convicted of a felony or had a disciplinary record subjecting them to 
disqualification.\86\

[[Page 45180]]

Several of the hedge fund frauds appear to have been perpetrated by 
unscrupulous persons using the hedge fund as a vehicle to defraud 
investors. These persons appear to never have intended to establish a 
legitimate hedge fund, but used the allure of a hedge fund to attract 
their ``marks.'' \87\
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    \86\ See, e.g., SEC v. J. Scott Eskind, supra note 79 (Eskind, 
already barred by the Commission from association with any 
investment adviser, raised more than $3 million from investors for a 
purported hedge fund, and simply misappropriated it); SEC v. Sanjay 
Saxena, Litigation Release No. 16206 (July 8, 1999) (Saxena, already 
barred by the Commission from the securities industry, defrauded 
fund investors of approximately $700,000). Item 11 of Part 1 of Form 
ADV requires applicants for registration as an investment adviser to 
report felonies and other disciplinary events occurring during the 
last 10 years. Section 203(c)(2) of the Advisers Act [15 U.S.C. 80b-
3(c)(2)] permits the Commission, after notice and opportunity for a 
hearing, to deny registration to an adviser that is subject to 
disqualification under Section 203(e) [15 U.S.C. 80b-3(e)]. The 
Commission's screening does not rely exclusively on an applicant's 
self-reporting of violations; our staff checks applicants against a 
large database of securities violators to determine whether there 
are any unreported disciplinary events.
    \87\ SEC v. Jean Baptiste Jean Pierre, Gabriel Toks Pearse and 
Darius L. Lee, supra note 76 (defendants raised nearly half a 
million dollars, the majority of which were simply misappropriated 
by Jean Pierre); SEC v. Peter W. Chabot, Chabot Investments, Inc., 
Sirens Synergy and the Synergy Fund, LLC, supra note 76 (Chabot 
raised over $1.2 million for an alleged hedge fund but did not buy 
any stocks or other securities with the funds, instead using the 
money for his personal expenses).
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    We are concerned that these individuals may have been attracted to 
hedge funds because they could operate without regulatory scrutiny of 
their past activities. Our lack of oversight may have contributed to 
the belief that their frauds would not be exposed. Our ability to 
screen individuals and, in some cases, to block their entrance into the 
advisory profession should serve to discourage unscrupulous persons 
from using hedge funds as vehicles for fraud.\88\
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    \88\ We acknowledge that many new sponsors of hedge funds may 
not have $25 million of assets under management and thus may not be 
required to register with us. See section 203A(a)(1) of the Act [15 
U.S. 80b-3a(a)(1)] (prohibiting certain advisers having less than 
$25 million from registering with the Commission). It is likely that 
if we adopt this rule, prospective investors will insist that hedge 
fund advisers be registered with the Commission. These advisers will 
apply for registration pursuant to our rule 203A-2(d) [17 CFR 
275.203A-2(d)], which permits an adviser with less than $25 million 
of assets under management to register with us if the adviser has a 
reasonable expectation that it will be eligible to register within 
120 days.
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4. Adoption of Compliance Controls
    Registration under the Advisers Act would require hedge fund 
advisers to adopt policies and procedures designed to prevent violation 
of the Advisers Act, and to designate a chief compliance officer.\89\ 
Because our examination staff resources are limited, we cannot be at 
the office of every adviser at all times. Compliance officers serve as 
the front line watch for violations of securities laws, and provide 
protection against conflicts of interests.
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    \89\ Rule 206(4)-7 [17 CFR 275.206(4)-7].
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    Hedge fund advisers have substantial conflicts of interest, both 
with their hedge funds and with their investors. These conflicts arise 
from management strategies, fee structures, use of fund brokerage and 
other aspects of hedge fund management. To protect against the adverse 
consequences of these conflicts, a hedge fund adviser must make 
compliance considerations a part of its business plan. While the 2003 
Hedge Fund Staff Report indicated that many unregistered hedge fund 
managers had strong compliance controls, others had very informal 
procedures that appeared to be inadequate for the amount of assets 
under their management.\90\ Application of our recent rule requiring 
more formalized compliance policies administered by an employee 
designated as a chief compliance officer should serve to better protect 
hedge fund investors.\91\
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    \90\ See section VII.A.1.b. of the 2003 Staff Hedge Fund Report, 
supra note 32.
    \91\ See Compliance Programs of Investment Companies and 
Investment Advisers, Investment Advisers Act Release No. 2204 (Dec. 
17, 2003) [68 FR 74714 (Dec. 24, 2003)].
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5. Limitation on Retailization
    Registration under the Advisers Act would have the salutary effect 
of requiring all direct investors in most hedge funds to meet minimum 
standards of rule 205-3 under the Advisers Act.\92\ Rule 205-3 requires 
that each investor generally have a net worth of at least $1.5 million 
or have at least $750,000 of assets under management with the 
adviser.\93\ Many hedge fund advisers will rely on rule 205-3 to 
continue charging a ``performance fee'' to the funds they manage.
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    \92\ Most hedge fund advisers charge performance fees. Rule 205-
3 permits registered investment advisers to charge performance fees 
only to ``qualified clients'' that have a net worth of at least $1.5 
million or have at least $750,000 of assets under management with 
the adviser.
    \93\ Hedge funds in the United States are generally organized to 
avoid regulation under the Investment Company Act by qualifying for 
an exemption under section 3(c)(1) or 3(c)(7) of that Act. There are 
no performance fee restrictions on 3(c)(7) funds, but each investor 
in the fund must be a ``qualified purchaser,'' which for natural 
persons generally means having investments of at least $5 million. 
See section 2(a)(51) of the Investment Company Act [15 U.S.C. 80a-
2(a)(51)]. Rule 205-3 requires that each advisory client subject to 
a performance fee have $1.5 million in net worth or $750,000 under 
management with the investment adviser, and requires advisers to 
3(c)(1) funds to consider each investor as a client.
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6. Imposition of Minimal Burdens
    While it furthers these five important objectives, registration 
under the Advisers Act would meet another important objective of the 
Commission by imposing only minimal additional burdens on hedge fund 
advisers. As we discussed above, the Act does not require or prohibit 
an adviser to follow any particular investment strategies, nor does it 
require or prohibit specific investments. Its most significant 
provision, which requires full disclosure of conflicts of interest and 
prohibits fraud against clients, applies regardless of whether the 
adviser is registered under the Act.\94\
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    \94\ The antifraud prohibitions of section 206 [15 U.S.C. 80b-
6], including provisions restricting an adviser's ability to engage 
in principal trades and agency cross-transactions with clients, 
apply to any investment adviser that makes use of the mails or any 
means of interstate commerce. In contrast, section 204 (authorizing 
the Commission to require advisers to issue reports and maintain 
books and records) applies to all advisers other than those 
specifically exempted from registration by section 203(b) of the 
Act.
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    Many advisers registered with us today currently advise hedge 
funds,\95\ and none has reported to us that registration made their 
hedge funds less competitive with other hedge funds.\96\ Although some 
panelists on our Roundtable argued against requiring hedge fund 
advisers to register under the Act, none identified any impediment 
under the Advisers Act to managing a hedge fund.\97\ Thus, registration 
under the Advisers Act should not interfere with the important 
functions that hedge funds play in our financial markets.
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    \95\ 95 Our data show that as of May 1, 2004 1,912 advisers 
reported in their Form ADVs that they provide advice to pooled 
investment vehicles other than investment companies, pension and 
profit sharing plans. Our staff's inspection experience indicates 
that a large percentage of these pools are hedge funds or funds of 
hedge funds.
    \96\ Five of the ten world's largest hedge fund managers (ranked 
by total assets under management) are currently registered with us. 
See The Hedge Fund 100, Institutional Investor (May 2004).
    \97\ In the past, hedge fund industry participants cited the 
restrictions on registered advisers charging performance-based 
compensation in section 205(a)(1) of the Act [15 U.S.C. 80b-5(a)(1)] 
as being incompatible with the operation of hedge funds. See Hard 
Times Come to the Hedge Funds, supra note 21; Lawrence J. Berkowitz, 
Regulation of Hedge Funds, 2 Rev. of Securities Reg. (Jan. 17, 
1969). In 1998, however, the Commission eliminated this concern by 
adopting amendments to rule 205-3. Exemption to Allow Investment 
Advisers to Charge Fees Based Upon a Share of Capital Gains Upon or 
Capital Appreciation of a Client's Account, Investment Advisers Act 
Release No. 1731 (July 15, 1998) [63 FR 39022 (July 21, 1998)]. No 
hedge fund industry participant with whom our staff spoke indicated 
that section 205 or the qualified client criteria in rule 205-3 
present any concerns to hedge funds. See Section II. G. of this 
Release.
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    We request comment on the burdens our proposal would impose, and 
whether those burdens could be alleviated in some manner that also 
meets our objectives in proposing these rules.

[[Page 45181]]

     Many hedge fund advisers voluntarily register under the 
Advisers Act in order to meet client needs or requirements.\98\ We 
infer from these decisions that, in practice, advisers do not consider 
registration burdensome. Is this inference warranted?
---------------------------------------------------------------------------

    \98\ See Jeff Benjamin, Oversight Concerns Aren't Registering 
With Hedge Funds, InvestmentNews, Apr. 19, 2004 (between 30 percent 
and 50 percent of all U.S.-based hedge fund managers are already 
registered as investment advisers).
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     We specifically request comment from hedge fund advisers 
that are registered under the Act. Do they believe that registration 
has imposed undue burdens on them? Has registration impaired their 
ability to compete for investors with other hedge fund managers? Has 
registration affected their choices of management strategies or 
investments?
     Recently, we amended our rule governing the safekeeping of 
client assets by advisers that have custody of those assets.\99\ Those 
rule amendments specifically accommodated the needs of hedge fund 
advisers,\100\ which usually have custody of client assets.\101\ Are 
there similar accommodations that could be made to other of our rules 
or forms that might make them work better for hedge fund advisers? Are 
there changes that should be made to our other rules or forms to tailor 
them to advisers to hedge funds? Should we further narrow or expand any 
of them when applied to hedge fund advisers? If so, how?
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    \99\ See Custody of Funds or Securities of Clients by Investment 
Advisers, Investment Advisers Act Release No. 2176 (Sept. 25, 2003) 
[68 FR 56692 (Oct. 1, 2003)].
    \100\ See rule 206(4)-2(b)(3). We are proposing additional 
amendments to accommodate advisers to funds of hedge funds. See 
Section II. H. of this Release.
    \101\ Our custody rule makes it clear that an adviser acting as 
general partner to a pooled investment vehicle it manages has 
custody of the pool's assets. Rule 206(4)-2(c)(1)(iii).
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     Some have suggested that hedge fund advisers may move 
their operations offshore, i.e., to other countries, in order to avoid 
registration under the Advisers Act.\102\ Is that a likely result? 
Under the proposed rule, which we describe below, an adviser would not 
only have to persuade valuable employees to live abroad, it would also 
have to forgo capital from U.S. investors.\103\
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    \102\ See Letter from John G. Gaine, Managed Funds Association, 
to William Donaldson, Chairman, U.S. Securities and Exchange 
Commission (Nov. 21, 2003), available in File No. S7-30-04. Managed 
Funds Association raised the concern that ``the burdens associated 
with mandatory registration might lead certain hedge fund advisers 
to relocate offshore, making existing regulation less effective.''
    \103\ Under rule 203(b)(3)-1(b)(5), an adviser with its 
principal place of business in another country must count each U.S. 
client to determine whether it is eligible for the private adviser 
exemption. Thus, under the proposed rule, a hedge fund adviser could 
not admit more than 14 U.S. residents into its hedge funds. At least 
one hedge fund consultant has suggested that for this reason hedge 
fund advisers are unlikely to move offshore. Ron Orol, Firmly 
Rooted, Daily Deal, July 14, 2003 (citing Arthur Bell of Arthur Bell 
& Associates as stating that U.S. investors would be ``virtually 
impossible to replace'').
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     Many of the advisers registered with us are smaller firms 
with less than $50 million of assets under management.\104\ Many of 
them are likely to have markedly less cash flow than hedge fund 
advisers, many of which have a substantial amount of assets under 
management and charge a customary fee of one to two percent of assets 
plus 20 percent of gains.\105\ We infer from this that the Advisers Act 
does not impose an undue burden on smaller advisory firms, and that 
hedge fund advisers are in a position to bear that burden. Is our 
inference warranted? We request comment on this question particularly 
from smaller firms such as financial planners.
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    \104\ As of May 1, 2004, of the 8,275 advisers registered with 
the Commission, 2,640 reported on their Form ADV that they were 
managing less than $50 million in client assets.
    \105\ See 2003 Staff Hedge Fund Report, supra note 32, at ix.
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7. CFTC Regulation
    Some have argued that registering hedge fund advisers under the 
Advisers Act is unnecessary because many may already be registered with 
the Commodity Futures Trading Commission (``CFTC'') as commodity pool 
operators (``CPOs'') and examined by the National Futures Association 
(``NFA''), a self-regulatory organization.\106\ These examinations, 
however, necessarily focus more on the area of futures trading--that 
is, the activities of most concern to the CFTC and NFA.\107\ Moreover, 
the CFTC is withdrawing its oversight of certain hedge fund advisers. 
The CFTC recently adopted rules that may permit most hedge fund 
advisers to now avoid registering as CPOs or commodity trading advisors 
(``CTAs'').\108\ New entrants to the industry have an opportunity to 
structure their activities so as to avoid CFTC registration, and 
existing hedge fund advisers may deregister with the CFTC.\109\
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    \106\ Roundtable Transcript of May 14 at 279 (statement of 
Anthony Artabane, Partner, Pricewaterhouse Coopers, LLP) (regulation 
should not be overlapping); Roundtable Transcript of May 15 at 144 
(statement of Patrick J. McCarty, General Counsel, Commodity Futures 
Trading Commission) (to the extent the hedge fund adviser is 
registered with CFTC as a CPO or CTA, there is no need for SEC 
registration), and 231 (statement of Armando Belly, General Counsel, 
Soros Fund Management, LLC) (SEC registration is not worthwhile if 
the firm is already registered with the CFTC).
    \107\ Roundtable Transcript of May 15 at 236-37 (statement of 
Jane Thorpe that ``NFA certainly has the ability to go in and 
inspect vehicles that may not directly be trading in futures but 
based on a risk-based approach is going to focus on those areas that 
obviously it has the most and we have the most interest in.'').
    \108\ Additional Registration and Other Regulatory Relief for 
Commodity Pool Operators and Commodity Trading Advisors; Past 
Performance Issues (Aug. 1, 2003) [68 FR 47221 (Aug. 8, 2003)] 
(``CFTC 2003 Exemptive Release'') (adopting new rule 4.13(a)(3), 
which exempts CPOs from registration if the pool is sold only to 
accredited investors and engages in limited trading of commodity 
interests, new rule 4.13(a)(4), which exempts CPOs from registration 
if the pool is offered only to persons reasonably believed to be 
``qualified eligible persons,'' and new rule 4.14(a)(10), which 
exempts CTAs who during the preceding 12 months provide advice to 
fewer than 15 legal entities).
    \109\ See Susan Ervin, Downsizing Commodity Pool Regulation: The 
CFTC's New Initiative, Futures Industry 36 (May/June 2003) (The CFTC 
has embarked upon a fundamental change in its regulatory program, 
which would free very sizable portions of the industry from CFTC 
regulation. Many new entrants would not need to register with the 
CFTC and many currently registered persons may elect to withdraw 
from registration.).
    We are not, however, seeking to require Advisers Act 
registration of hedge fund advisers whose business consists 
primarily of advising others with respect to investments in futures. 
Hedge fund advisers that are registered as CTAs with the CFTC may 
qualify for a separate exemption from SEC registration if their 
business does not consist primarily of acting as an investment 
adviser. See section 203(b)(6) of the Advisers Act.
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8. Proper Administration of the Advisers Act
    As we discussed above, many hedge fund advisers currently avoid 
registration under the Advisers Act by qualifying for the ``private 
adviser'' exemption that section 203(b)(3) provides to advisers that 
have had fourteen or fewer clients during the preceding twelve months 
and that do not hold themselves out generally to the public as 
investment advisers. The Act does not define the term ``client,'' and 
for many years it was unclear whether the Act required an adviser that 
served as a general partner to a limited partnership holding investment 
securities to count each limited partner as a client, because the 
pooled investment vehicle served primarily as a vehicle through which 
the adviser/general partner provided investment advice.\110\ If 
advisers to hedge funds

[[Page 45182]]

were viewed as providing investment advice to one client--the fund--
then they would not be required to register under the Act (assuming 
they advised no more than fourteen funds and did not hold themselves 
out to the public as investment advisers). If they were viewed as 
advising each partner of a partnership having more than fourteen 
partners, they would be required to register (assuming no other 
exemption were available).
---------------------------------------------------------------------------

    \110\ See Robert C. Hacker and Ronald D. Rotunda, SEC 
Registration of Private Partnerships after Abrahamson v. Fleschner, 
78 Colum. L. Rev. 1471, 1478 (1978). It was also unclear whether the 
general partner was an adviser who gave advice to ``others'' within 
the meaning of section 202(a)(11) of the Act. That issue was 
resolved by the Second Circuit in Abrahamson v. Fleschner, 568 F.2d 
862 (2d Cir. 1977), cert. denied, 436 U.S. 913 (1978), which held 
that general partners of limited partnerships investing in 
securities were investment advisers. The Second Circuit originally 
characterized the individual limited partners as the ``clients'' of 
the general partner, (1976-77) Fed.Sec.L.Rep. (CCH) ] 95,889, at 
91,282 n. 16, but later withdrew this characterization, 568 F. 2d at 
872 n. 16, leaving unanswered the issue of whether the partnership, 
or each of the partners, should be counted as a client. See 
Definition of ``Client'' of an Investment Adviser for Certain 
Purposes Relating to Limited Partnerships, Investment Advisers Act 
Release No. 956 (Feb. 25, 1985) [50 FR 8740 (Mar. 5 1985)]. See also 
Hacker and Rotunda, supra, at 1484.
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    In 1985, the Commission addressed this issue by adopting rule 
203(b)(3)-1, which permits an adviser to treat a limited partnership as 
the ``client'' for purposes of the private adviser exemption if, among 
other things, the advice provided to the limited partnership is based 
on the investment objectives of the partnership rather than those of 
the various limited partners.\111\ When we adopted rule 203(b)(3)-1, we 
concluded that when an adviser manages a group of client accounts on 
the basis of the investment objectives of the pool, it would be 
appropriate to view the pool (rather than each participant in the pool) 
as the client.\112\ We acknowledged, however, that a different approach 
could be followed.\113\
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    \111\ See Definition of ``Client'' of an Investment Adviser for 
Certain Purposes Relating to Limited Partnerships, Investment 
Advisers Act Release No. 983 (July 12, 1985) [50 FR 29206 (July 18, 
1985)]. In 1997, we expanded the rule to cover other types of legal 
entities that advisers use to pool client assets. See Rules 
Implementing Amendments to the Investment Advisers Act of 1940, 
Investment Advisers Act Release No. 1633 (May 15, 1997) [62 FR 28112 
(May 22, 1997)]. Under rule 203(b)(3)-1(a)(2)(i), an investment 
adviser may count a legal organization as a single client so long as 
the investment advice is provided based on the objectives of the 
legal organization rather than the individual investment objectives 
of any owner of the legal organization.
    \112\ See Definition of ``Client'' of an Investment Adviser for 
Certain Purposes Relating to Limited Partnerships, supra note 111. 
In other circumstances, we look through pools to the investors 
themselves in specifying advisers' obligations under the Advisers 
Act. See, e.g., rule 205-3(b) (requiring each investor in a private 
investment company to meet qualified client criteria if the adviser 
charges the private investment company a performance fee); rule 
206(4)-2(a)(3)(iii) (requiring that custody account statements for 
funds and securities of limited partnerships for which the adviser 
acts as general partner be delivered to each limited partner); 
Electronic Filing by Investment Advisers; Proposed Amendments to 
Form ADV, Investment Advisers Act Release No. 1862 (Apr. 5, 2000) 
[65 FR 20524 (Apr. 17, 2000)] at n.117 and accompanying text 
(clarifying that an adviser acting as general partner of a limited 
partnership must provide Form ADV disclosures to each limited 
partner).
    \113\ See Definition of ``Client'' of an Investment Adviser for 
Certain Purposes Relating to Limited Partnerships, supra note 111. 
Until recently, the CFTC interpreted a similar provision of the 
Commodities Exchange Act (``CEA'') to require a commodity trading 
advisor to register by ``looking through'' a client that was not a 
natural person, e.g., a limited partnership, to count the number of 
participants. Section 4m(1) of the CEA provides an exemption from 
registration for a commodity trading advisor that has not furnished 
commodity trading advice to more than 15 persons during the 
preceding 12 months and does not hold itself out to the public as a 
commodity trading advisor. When queried about its interpretation of 
``person'' in the context of non-natural persons, the CFTC 
historically took the position that a commodity trading advisor 
providing advice to such entities would look through and count the 
individual participants for purposes of tabulating the number of 
persons it advises. See, e.g., CFTC Interpretive Letter 95-39 (Dec. 
5, 1994) (each partner in a limited partnership counts as a person) 
and CFTC Interpretive Letter 96-43 (May 15, 1996) (each shareholder 
in a corporation counts as a person ). In 2003, the CFTC adopted new 
rule 4.14(a)(10) [17 CFR 4.14(a)(10)] that reversed its look-through 
interpretation by permitting commodity trading advisors to count 
legal entities, such as corporations or limited partnerships, as a 
single person. The rule is patterned after Advisers Act rule 
203(b)(3)-1, and in the adopting release the CFTC confirmed that 
``it intends to follow interpretations of rule 203(b)(3)-1 issued by 
the SEC and its staff.'' See CFTC 2003 Exemptive Release, supra note 
91.
---------------------------------------------------------------------------

    But since 1985, circumstances have changed. Hedge fund assets have 
continued to grow,\114\ the number of hedge funds has increased, the 
types of investors have changed and funds of hedge funds have emerged. 
Moreover, this growth has occurred in an environment where hedge fund 
advisers have not been required to register. Commensurate with this 
growth, fraud in the hedge fund industry has increased. It is clear 
that the implications of our 1985 decision have also grown. Today, 
advisers to hedge funds manage multiple hedge funds having hundreds of 
investors, and tens of millions of dollars of assets, without 
registering with the Commission. We are concerned that rule 203(b)(3)-1 
may no longer be consistent with the underlying purposes of section 
203(b)(3), which, as we noted above, seems intended to exempt from 
registration advisers that have only a few clients and whose clients 
are likely to be friends, associates or family members.\115\
---------------------------------------------------------------------------

    \114\ See supra notes 33 and 34.
    \115\ See supra note 17.
---------------------------------------------------------------------------

    In 1996, Congress amended the Advisers Act to allocate regulatory 
responsibility over advisers between the SEC and state regulatory 
authorities.\116\ In doing so, Congress established a threshold for 
federal interest in advisers by requiring advisers to register with the 
Commission (unless they were otherwise exempt) if they have more than 
$25 million of assets under management.\117\ While such a later 
amendment of the Act would not serve to expand or contract the scope of 
section 203(b)(3),\118\ we believe it should inform our administration 
of the section. In this regard, rule 203(b)(3)-1 may provide too broad 
a safe harbor in light of the 1996 Congressional determination that 
there is a federal interest in the oversight of advisers that manage 
significant amounts of client assets.
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    \116\ Pub L. No. 104-290, 110 Stat. 3416 (1996) (codified in 
scattered sections of the United States Code). Hedge fund advisers 
that avail themselves of the registration exemption under section 
203(b)(3) may nevertheless be required to register as investment 
advisers with one or more states.
    \117\ Section 203A of the Advisers Act [15 U.S.C. 80b-3A].
    \118\ See Capital Gains, supra note 7, at 286-87 (declining to 
narrow construction of the Advisers Act as adopted in 1940 by 
reference to amendments enacted in 1960, stating ``[o]pinions 
attributed to a Congress twenty years after the event cannot be 
considered evidence of the Congress of 1940.'' (internal citations 
omitted)).
---------------------------------------------------------------------------

    In suggesting this conclusion, we are mindful of section 208(d) of 
the Act, which prohibits advisers from doing indirectly, or through or 
by another person, what they are prohibited from doing directly.\119\ 
Rule 203(b)(3)-1 may thus be viewed to permit advisers to manage assets 
for more than fourteen clients ``through or by'' a hedge fund and 
remain unregistered.
---------------------------------------------------------------------------

    \119\ 15 U.S.C. 80b-8(d). We note that neither the Advisers Act 
nor the Commission's 1985 release (see supra note 111), in our view, 
should be construed to provide an exemption for an adviser with 
greater than 14 clients merely because the adviser did not provide 
individualized advice to each of those clients.
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C. Proposed Rule 203(b)(3)-2

    Proposed rule 203(b)(3)-2 would require investment advisers to 
count each owner of a ``private fund'' as a client for purposes of 
determining the availability of the private adviser exemption of 
section 203(b)(3) of the Act. As a result, an adviser to a ``private 
fund,'' which is defined in the rule and discussed below, could no 
longer rely on the private adviser exemption if the adviser, during the 
course of the preceding twelve months, advised a private fund that had 
more than fourteen investors. And an adviser that advised individual 
clients directly would have to count those clients together with the 
investors in any private fund it advised in determining its total 
number of clients.
1. Minimum Assets Under Management
    The new rule would not alter the minimum assets under management 
that an investment adviser must have in order to be eligible to 
register with the

[[Page 45183]]

Commission.\120\ Thus, hedge fund advisers with assets under management 
of less than $25 million would continue generally not to be eligible 
for Commission registration (unless they also advise a registered 
investment company or qualify for registration under one of our 
exemptive rules).\121\ Hedge fund advisers with assets under management 
between $25 and $30 million would be eligible, but not required, to 
register with the Commission.\122\
---------------------------------------------------------------------------

    \120\ See section 203A(a)(1)(A). The National Securities Markets 
Improvement Act of 1996 amended the Advisers Act to divide the 
responsibility for regulating investment advisers between the 
Commission and the state securities authorities. Section 203A of the 
Advisers Act effects this division by generally prohibiting 
investment advisers from registering with us unless they have at 
least $25 million of assets under management or advise a registered 
investment company, and preempting most state regulatory 
requirements with respect to SEC-registered advisers. See Pub. L. 
104-290, 110 Stat. 3416 (1996) (codified in scattered sections of 
the United States Code).
    \121\ See rule 203A-2 [17 CFR 275.203A-2].
    \122\ See rule 203A-1 [17 CFR 275.203A-1].
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     We request comment on the applicability of the minimum 
asset thresholds to hedge fund advisers. Should they be higher? Should 
they be lower given that some of the frauds we have uncovered involved 
hedge fund advisers that never had $25 million of assets under 
management? \123\
---------------------------------------------------------------------------

    \123\ See Securities and Exchange Commission v. J. Scott Eskind, 
Lorus Investments, Inc., and Capital Management Fund, Limited 
Partnership, supra note 79; SEC v. Hoover and Hoover Capital 
Management, Inc., supra note 42.
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2. Funds of Hedge Funds
    The new rule would contain a special provision for advisers to 
hedge funds in which a registered investment company invests.\124\ 
Hedge fund advisers would be required to count the investors in the 
registered fund as clients.\125\ Without this provision, a hedge fund 
adviser could provide its services to thousands of mutual fund 
investors through fourteen or fewer mutual funds, each of which could 
invest in the private fund, and each of which would count as a single 
client.
---------------------------------------------------------------------------

    \124\ Proposed rule 203(b)(3)-2(b).
    \125\ An adviser to a fund underlying an unregistered fund of 
hedge funds would also count the investors in the top-tier fund as 
clients. However, where the top-tier fund is itself a ``private 
fund'' under the rule, the general provisions of the rule would 
compel looking through the top-tier fund and no special provision is 
needed. Our proposal would not require the adviser to the underlying 
fund to receive information as to the precise number or identities 
of the top-tier investors--it would be sufficient if the adviser to 
the top-tier fund confirms to the underlying adviser that the top-
tier fund has more than 14 owners.
---------------------------------------------------------------------------

     We request comment on our ``look through'' approach with 
respect to registered investment companies investing in hedge funds. 
Are its terms clear?
     Have we provided detailed enough guidance on how advisers 
should count clients? Or, are there points on which further guidance is 
needed?
3. Offshore Advisers
    a. Counting Clients of Offshore Advisers. The proposal would 
require hedge fund advisers located offshore to look through the funds 
they manage, whether or not those funds are also located offshore, and 
count investors that are U.S. residents as clients. An adviser to any 
hedge fund that, in the course of the previous twelve months, has more 
than fourteen investors (or other advisory clients) that are U.S. 
residents would generally have to register under the Advisers Act.\126\ 
Offshore advisers to hedge funds would, therefore, be treated in the 
same manner as any other type of offshore adviser providing advice to 
U.S. residents.\127\
---------------------------------------------------------------------------

    \126\ Rule 203(b)(3)-1(b)(5) (adviser with principal place of 
business not in the United States need count only clients that are 
U.S. residents). The offshore adviser would not have to register, 
however, if it were eligible for some other exemption from 
registration. Absent the availability of an exemption, offshore 
advisers would be required to register regardless of the amount of 
assets managed by the adviser because the $25 million threshold does 
not apply to an adviser that does not have its principal place of 
business in the United States. See Rules Implementing Amendments to 
the Investment Advisers Act of 1940, supra note 111, at section 
II.E.
    \127\ See supra note 126.
---------------------------------------------------------------------------

     Should offshore advisers be required to look through their 
offshore funds only if assets attributable to U.S. residents comprise 
more than a threshold percentage? If we impose a threshold, what should 
it be? Should the threshold apply to the cumulative assets of all 
offshore funds advised by the offshore adviser?
     Would registration present difficulties for offshore 
advisers because of conflicts with the laws of their home jurisdiction? 
\128\ Approximately 350 non-U.S. advisers are currently registered with 
us, and we are unaware of any conflicts that create problems for those 
dual registrants. Do offshore hedge fund advisers present different 
concerns or face different burdens? If so, what are they and how should 
we address them?
---------------------------------------------------------------------------

    \128\ According to one law firm's analysis, registration under 
the Advisers Act would have little impact on most non-U.S. hedge 
fund managers: ``For unregistered non-U.S. investment managers, it 
is likely that the impact will be less significant because in most 
jurisdictions where hedge fund managers are concentrated, including, 
for example, London, Paris and Frankfurt and other European Union 
jurisdictions, management of third party assets is generally an 
activity which requires registration with local regulators and 
ongoing compliance with minimum operational standards, regardless of 
the number of 'clients' for whom these services are provided. It is 
likely therefore that most major non-U.S. hedge fund managers that 
will be affected by the SEC's recommendations will already be 
complying in their home jurisdictions with broadly similar 
requirements to those the Staff now seeks to impose.'' See Shearman 
& Sterling, SEC Report: Implications of the Growth of Hedge Funds, 
Jan. 2004, available in File No. S7-30-04.
---------------------------------------------------------------------------

    b. Advisers to Offshore Publicly Offered Funds. We do not want to 
require advisers to offshore publicly offered mutual funds or closed-
end funds to register with us simply because more than fourteen of 
their investors are now resident in the United States.\129\ Therefore, 
we have included in the proposed rule an exception to the definition of 
``private fund'' for a company that has its principal office and place 
of business outside the United States, makes a public offering of its 
securities outside the United States, and is regulated as a public 
investment company under the laws of a country other than the United 
States.\130\
---------------------------------------------------------------------------

    \129\ Section 7(d) of the Investment Company Act [15 U.S.C. 80a-
7(d)] generally prohibits an unregistered foreign investment company 
from publicly offering its securities in the United States. That 
provision does not preclude unregistered foreign investment 
companies from making private offerings in the United States. Resale 
of Restricted Securities, Investment Company Act Release No. 17452 
(Apr. 23, 1990) [55 FR 17933 (Apr. 30, 1990)]. Nor does it prevent 
U.S. persons from being shareholders of foreign investment companies 
as a result of, for example, relocating to the United States. See, 
e.g., Investment Funds Institute of Canada, SEC Staff No-Action 
Letter (Mar. 4, 1996).
    \130\ 130 Proposed rule 203(b)(3)-2(d)(3).
---------------------------------------------------------------------------

     Is the scope of this exception too broad or too narrow?
     Are there any other types of companies or entities that 
need to be included in the exception?
     Is there a significant concern that some hedge fund 
advisers would seek to use this exception to evade the requirements of 
the Act?
     Hedge funds may be offered publicly in some countries. 
Would our proposed rule exempt these hedge funds from the definition of 
``private fund''? Should it?
    c. Advisers to Offshore Private Funds. We are also proposing to 
limit the extraterritorial application of the Advisers Act that would 
otherwise occur as a result of these amendments. We do not apply most 
of the substantive provisions of the Act to the non-U.S. clients of an 
offshore adviser.\131\ As a result, offshore advisers registered with 
us must, for example, comply with our rules regarding the safekeeping 
of client assets only with respect to assets of their

[[Page 45184]]

U.S. clients.\132\ If those client assets are pooled and held, for 
example, in a hedge fund, our custody rule would, as a practical 
matter, require the adviser to meet many of the requirements of the 
rule with respect to all assets of the fund even if most of the fund 
investors are not U.S. residents.
---------------------------------------------------------------------------

    \131\ This policy was first set forth in a staff letter from our 
Division of Investment Management, in which Division staff stated 
that they would not recommend to the Commission enforcement action 
against an offshore fund adviser under such circumstances. See Uniao 
de Banco de Brasileiros S.A., SEC Staff No-Action Letter (July 28, 
1992) (``Unibanco letter'').
    \132\ Rule 206(4)-2.
---------------------------------------------------------------------------

    It is not uncommon for U.S. investors to acquire interests in an 
offshore hedge fund that has few connections to the United States other 
than the investors (or the securities in which they invest). The laws 
governing such a fund would likely be those of the country in which it 
is organized or those of the country in which the adviser has its 
principal place of business. U.S. investors in such a fund generally 
would not have reasons to expect the full protection of the U.S. 
securities laws.\133\ Moreover, as a practical matter, they may be 
precluded from an investment opportunity in offshore funds if their 
participation resulted in the full application of the Advisers Act and 
our rules.
---------------------------------------------------------------------------

    \133\ See Offshore Offers and Sales, Securities Act Release No. 
6863 (Apr. 24, 1990) [55 FR 18306 (May 2, 1990)].
---------------------------------------------------------------------------

    Therefore, we propose to permit an offshore adviser to an offshore 
fund to treat the fund as its client (and not the investors) for all 
purposes under the Act, other than (i) determining the availability of 
the private adviser exemption (section 203(b)(3)), and (ii) those 
provisions prohibiting fraud (sections 206(1) and 206(2)).\134\ Such an 
adviser would register with us, but because the fund would not be a 
U.S. client, most of the substantive provisions of the Advisers Act 
would not apply to the adviser's dealings with the fund or other of its 
non-U.S. clients.\135\ We request comment on this provision.
---------------------------------------------------------------------------

    \134\ Proposed rule 203(b)(3)-2(c). Because the fund would not 
be a U.S. client of the adviser, the substantive provisions of the 
Act generally would not apply to the adviser's dealings with the 
fund under general principles first outlined in the Unibanco letter, 
supra note 131.
    \135\ See supra note 134.
---------------------------------------------------------------------------

     Is this exception a reasonable limitation on the 
extraterritorial application of the Advisers Act?
     Is there a significant concern that some U.S. hedge fund 
advisers would seek to use this exception to evade the requirements of 
the Act? An unregistered adviser could not establish a shell subsidiary 
in a foreign country through which to manage offshore hedge funds 
without violating section 208(d) of the Act, which prohibits any person 
from doing indirectly, or through or by any other person, anything it 
would be unlawful for the person to do directly.\136\ Are there other 
means of evading the requirements of the Act that ought to concern us?
---------------------------------------------------------------------------

    \136\ See supra note 119. See also Richard Ellis, Inc., SEC 
Staff No-Action Letter (Sept. 17, 1981).
---------------------------------------------------------------------------

     Would it be sufficient to warn advisers seeking to 
circumvent the substantive provisions of the rule of the potential 
applicability of section 208(d)?
     As proposed, this exception would apply to an offshore 
adviser that advised an offshore hedge fund owned entirely by U.S. 
residents. Should we apply the substantive provisions of the Act to 
such an adviser? Should the exception be available to advisers only 
with respect to private funds owned primarily by non-U.S. 
residents?\137\ If so, what should be the appropriate threshold?
---------------------------------------------------------------------------

    \137\ See, e.g., rule 14d-1(c)(1) [17 CFR 240.14(d)(c)(1)] 
(exempting securities of foreign private issuers from most 
provisions of the Securities Exchange Act of 1934 [15 U.S.C. 77a-
77aa] and rules governing tender offers when U.S. security holders 
hold 10 percent or less of the subject securities).
---------------------------------------------------------------------------

D. Definition of ``Private Fund''

    Advisers have many types of clients, some of which may be legal 
organizations such as trusts, partnerships, or corporations that have 
beneficial owners, e.g., beneficiaries, limited partners, or 
shareholders. It would not serve the purpose of this regulatory 
initiative or of the Act if we were to require advisers to ``look 
through'' each and every business or other legal organization they 
advised for purposes of determining the availability of the ``private 
adviser'' exemption. To identify those legal organizations whose 
advisers would be required to look through, the rule would contain a 
definition of ``private fund.''
    Our rule would define a ``private fund'' by reference to three 
characteristics shared by virtually all hedge funds. First, the private 
fund would be limited to a company that would be subject to regulation 
under the Investment Company Act of 1940 (the ``Investment Company 
Act'') but for the exception provided in either section 3(c)(1) (a 
``3(c)(1) fund'') or section 3(c)(7) (a ``3(c)(7) fund'') of such 
Act.\138\ By limiting the scope of the look-through provision to those 
entities relying on these two sections of the Investment Company Act, 
we would exclude advisers to most business organizations, including 
insurance companies, broker-dealers, and banks, and include advisers to 
many types of pooled investment vehicles investing in securities, 
including hedge funds.\139\
---------------------------------------------------------------------------

    \138\ Proposed rule 203(b)(3)-2(d)(1)(i). Section 3(c)(1) 
exempts issuers with fewer than 100 shareholders from the definition 
of ``investment company'' under the Investment Company Act and 
section 3(c)(7) exempts issuers whose shareholders are exclusively 
``qualified purchasers'' from that definition. See section 3(c)(1) 
and section 3(c)(7) of the Investment Company Act.
    \139\ It would also exclude, of course, advisers to registered 
investment companies. This exclusion would, however, have no effect 
on these advisers, which are not eligible for the private adviser 
exemption. See section 203(b)(3).
---------------------------------------------------------------------------

    Second, a company would be a private fund only if it permits 
investors to redeem their interests in the fund (i.e., sell them back 
to the fund) within two years of purchasing them.\140\ Hedge funds 
typically offer their investors liquidity access following an initial 
``lock-up'' period,\141\ and thus most hedge fund advisers would be 
included within the rules. This ``redeemability'' requirement would, 
however, exclude persons who advise private equity funds,\142\ venture 
capital funds,\143\ and similar funds that require investors to make 
long-term commitments of capital. These funds are similar to hedge 
funds in some respects, but we have not encountered significant 
enforcement problems with advisers with respect to their management of 
these types of

[[Page 45185]]

funds. In contrast, the Commission has developed a substantial record 
of frauds associated with hedge funds. A key element of hedge fund 
advisers' fraud in most of our recent enforcement cases has been the 
advisers' misrepresentation of their funds' performance to current 
investors,\144\ which in some cases was used to induce a false sense of 
security for investors when they might otherwise have exercised their 
redemption rights. Because hedge funds are where we have seen a recent 
growth in fraud enforcement actions, that is where we propose to focus 
our examination resources at this time.
---------------------------------------------------------------------------

    \140\ Proposed rule 203(b)(3)-2(d)(1)(ii). Private equity and 
venture capital funds may offer redemption rights under 
extraordinary circumstances. These extraordinary redemptions do not 
change the basic character of the investment pool into a hedge fund. 
Accordingly, an investment pool could offer redemption rights in 
extraordinary and unforeseeable situations, such as an owner's death 
or total disability, or circumstances that make it illegal or 
impractical for the investor to continue to own the interest in the 
fund, without becoming a ``private fund'' under the new rule. 
Proposed rule 203(b)(3)-2(d)(2)(i). The proposed new rule would also 
provide an exception to the two-year redemption test for interests 
acquired with reinvested dividends. Proposed rule 203(b)(3)-
2(d)(2)(ii). The two-year redemption test would apply to each 
investment in the fund, not only the investor's initial investment, 
and could be used on a ``first in, first out'' basis.
    \141\ Hedge funds often offer semi-annual, quarterly, or monthly 
liquidity terms to their investors. We understand that, because 
liquidity is important to hedge fund investors, some hedge fund 
advisers offer certain investors ``side letter agreements'' to 
provide shorter liquidity terms than other investors in the same 
fund may receive. See Alexander M. Ineichen, Funds of Hedge Funds: 
Industry Overview, 4 J. WEALTH MGMT. 47 (Mar. 22, 2002).
    \142\ Private equity funds concentrate their investments in 
unregistered (and typically illiquid) securities. Private equity 
investors typically commit to invest a certain amount of money with 
the fund over the life of the fund, and make their contributions in 
response to ``capital calls'' from the fund's general partner. 
Private equity funds offer little, if any, opportunity for investors 
to redeem their investments.
    \143\ Venture capital funds are generally organized to invest in 
the start-up or early stages of a company. Venture capital funds 
have the same features that distinguish private equity funds 
generally from hedge funds, such as capital contributions over the 
life of the fund and long-term nature of the investment. A venture 
capital fund typically seeks to liquidate its investment once the 
value of the company increases above the value of the investment.
    \144\ See, e.g., SEC v. Jean Baptiste Jean Pierre, Gabriel Toks 
Pearse and Darius L. Lee, Litigation Release No. 17303 (Jan. 10, 
2002) and supra note 76; In the Matter of Michael T. Higgins, supra 
note 78; SEC v. David M. Mobley, Sr., et al., Investment Advisers 
Act Release No. 2131 (May 20, 2003); SEC v. Michael W. Berger, 
Manhattan Capital Management Inc., supra note 40; SEC v. Todd Hansen 
and Nicholas Lobue, Litigation Release No. 17299 (Jan. 9, 2002).
---------------------------------------------------------------------------

    In addition, as the staff discussed in its 2003 Staff Hedge Fund 
Report, private equity funds typically are long-term investments 
providing for liquidation at the end of a term specified in the fund's 
governing documents. They provide for little or no opportunity for 
investors to redeem their investments,\145\ and moreover typically 
require investors to commit to invest an amount of money over the life 
of the fund, and make contributions in response to ``capital calls.'' 
Periodic redemption rights offered by hedge funds, however, provide the 
hedge fund investors with a level of liquidity that allows the investor 
to withdraw a portion of his or her assets, controlled by the adviser, 
or to terminate the relationship with the hedge fund adviser and choose 
a new adviser. Given the association between these redeemability 
features and potential abuses that could harm investors in the fund, 
this element of the private fund definition will help promote the 
purposes of the Act.
---------------------------------------------------------------------------

    \145\ See supra note 142.
---------------------------------------------------------------------------

    Third, interests in a private fund would be based on the ongoing 
investment advisory skills, ability or expertise of the investment 
adviser. In deciding whether to invest in a particular hedge fund, the 
adviser's history, experience, past performance with this or other 
client accounts, strategies, and disciplinary record, are likely 
important to investors, who rely on the adviser for the success of 
their investment. In that regard, hedge fund advisers emphasize the 
record of the manager and often provide prospective investors with 
information about the adviser and individual manager. This reliance by 
hedge fund investors implicates the need for the protections that the 
Advisers Act offers.\146\
---------------------------------------------------------------------------

    \146\ It is worth noting in this regard that section 203(b)(3) 
of the Advisers Act specifically excludes an adviser from relying on 
the exemption, even if it has fewer than 15 clients, if it holds 
itself out generally to the public as an investment adviser.
---------------------------------------------------------------------------

    Our approach to defining the scope of rule 203(b)(3)-2 is similar 
to that taken recently by the Department of Treasury in defining the 
scope of its proposed rule requiring ``private investment companies'' 
to adopt anti-money laundering programs.\147\ Like the Treasury 
Department, we have tried to keep the definition simple, and provide a 
``bright line'' indicator of when an adviser must look though a client 
that is a legal organization. We have avoided alternative approaches 
that would turn on the nature of the investments made by the pooled 
investment vehicle because we do not want registration concerns to 
affect investment decisions of the adviser.
---------------------------------------------------------------------------

    \147\ See supra note 29.
---------------------------------------------------------------------------

    We request comment on the proposal:
     Should we narrow the rule? If so, how?
     Should ``private fund'' include private equity, venture 
capital, and other investment pools that are not hedge funds? If so, 
how should we broaden the rule?
     Do the three characteristics used in the rule effectively 
distinguish hedge funds from these other types of funds? If not, what 
specific tests should apply?
     Is two years an appropriate time period for redemptions? 
If not, should it be longer or shorter, and why?
     Are there any other circumstances prompting redemptions 
that need to be excepted from the two-year test?

E. Amendments to Rule 203(b)(3)-1

    We propose to amend rule 203(b)(3)-1 to clarify that investment 
advisers may not count hedge funds as single clients under that safe 
harbor. As discussed earlier, many hedge fund advisers have avoided 
Advisers Act registration by relying on paragraph (a)(2)(i) of this 
rule, which permits advisers to count a legal organization, rather than 
its owners, as a single client.\148\ New paragraph (b)(6) would make it 
clear that advisers cannot rely on paragraph (a)(2)(i) with respect to 
private funds.\149\
---------------------------------------------------------------------------

    \148\ Rule 203(b)(3)-1(a)(2)(i).
    \149\ We are also proposing non-substantive changes to the 
wording of the preliminary note and paragraphs (a) (General), 
(a)(2)(i), (b)(1), (2), (3), (4) and (5), and (c) of rule 203(b)(3)-
1 to clarify those sections.
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F. Amendments to Rule 204-2

    We are proposing to provide relief from a recordkeeping requirement 
for hedge fund advisers that would be required to register with us 
under new rule 203(b)(3)-2. Under our rules, a registered investment 
adviser that makes claims concerning its performance ``track record'' 
must keep documentation supporting those performance claims.\150\ The 
supporting records must be retained for a period of five years after 
the performance information is last used.\151\ Thus, if a registered 
adviser promotes its 20-year performance record in 2004, it must 
continue to keep its supporting records for its 1984 performance 
through 2009--five years after the last time that 1984 performance is 
included.
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    \150\ Rule 204-2(a)(16) requires registered investment advisers 
to make and keep ``[a]ll accounts, books, internal working papers, 
and any other records or documents that are necessary to form the 
basis for or demonstrate the calculation of the performance or rate 
of return of any or all managed accounts or securities 
recommendations in any notice, circular, advertisement, newspaper 
article, investment letter, bulletin or other communication that the 
investment adviser circulates or distributes, directly or 
indirectly, to 10 or more persons (other than persons connected with 
such investment adviser); provided, however, that, with respect to 
the performance of managed accounts, the retention of all account 
statements, if they reflect all debits, credits, and other 
transactions in a client's account for the period of the statement, 
and all worksheets necessary to demonstrate the calculation of the 
performance or rate of return of all managed accounts shall be 
deemed to satisfy the requirements of this paragraph.''
    \151\ Rule 204-2(e)(3) specifies the retention period: ``Books 
and records required to be made under the provisions of paragraphs 
(a)(11) and (a)(16) of this rule shall be maintained and preserved 
in an easily accessible place for a period of not less than five 
years, the first two years in an appropriate office of the 
investment adviser, from the end of the fiscal year during which the 
investment adviser last published or otherwise disseminated, 
directly or indirectly, the notice, circular, advertisement, 
newspaper article, investment letter, bulletin or other 
communication.''
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    While it is important for our examiners to be able to substantiate 
an adviser's performance claims, we recognize that hedge fund advisers, 
like other investment firms, need to communicate their performance 
history to their clients and prospective clients. We question, however, 
whether advisers that were not previously subject to our rules will 
necessarily have retained adequate records from prior periods. It is 
not our intention to put these new registrants at a competitive 
disadvantage in promoting the returns they have earned, in some 
instances over many years. Accordingly, we would require these new 
registrants to retain whatever records they do have that support the 
performance they earned prior to their registration with us, but would 
excuse them from our recordkeeping rule to the extent that those 
records are incomplete or otherwise do not meet the

[[Page 45186]]

requirements of rule 204-2. Once a hedge fund adviser has registered 
with us, of course, it must comply with our recordkeeping rule going 
forward.
    We ask comment on this aspect of our proposal.
     Is this exemption necessary? Or, do hedge fund advisers 
already routinely retain documents substantiating their performance 
claims that comply with our recordkeeping rules?
    We are also proposing an amendment to rule 204-2 clarifying that, 
for purposes of section 204 of the Advisers Act, the books and records 
of a hedge fund adviser registered with us include records of the 
private funds for which the adviser acts as general partner, managing 
member, or in a similar capacity.\152\ Section 204 of the Act generally 
subjects records of investment advisers to examination by the 
Commission. To determine whether a hedge fund adviser is meeting its 
fiduciary obligations to a private fund under the Advisers Act and 
rules, our examiners require access to all records relating to the 
adviser's activities with respect to the fund, including records 
relating to the adviser's service as the fund's general partner. The 
general partners effectively control all the operations and assets of 
the hedge fund. Because many hedge fund advisers establish a separate 
special purpose vehicle to be named as the fund's general partner, the 
proposed amendment would also cover private funds for which a related 
person of the adviser (as defined in Form ADV) acts as general partner, 
managing member, or in a similar capacity.
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    \152\ Proposed rule 204-2(l).
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    We ask comment on this aspect of our proposal.
     Is the scope of this provision too narrow or too broad?
     Are there other entities we should include?

G. Amendments to Rule 205-3

    We are proposing to amend rule 205-3 under the Advisers Act to 
avoid requiring certain hedge fund investors to divest their current 
interests in the funds. Most hedge fund advisers charge a fee based on 
their fund's capital gains or appreciation--a ``performance fee.'' Rule 
205-3 permits registered investment advisers to charge performance fees 
only to ``qualified clients,'' and requires the adviser to a 3(c)(1) 
fund to look through the fund to determine whether all investors are 
qualified clients.\153\ Generally, to be a qualified client of a 
registered investment adviser an investor must place at least $750,000 
under that adviser's management or have a net worth of $1.5 
million.\154\ While many hedge fund advisers place these or even more 
stringent requirements on the investors in their funds, not all do so. 
Some hedge funds are marketed to ``accredited investors,'' \155\ and 
some may permit a small number of non-accredited investors.
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    \153\ Rule 205-3(a) and (b). Rule 205-3 permits registered 
advisers to charge performance fees that would otherwise be 
prohibited by section 205(a). [15 U.S.C. 80b-5(a)]. Registered 
advisers are not prohibited from charging performance fees to 
3(c)(7) funds, section 205(b)(4) [15 U.S.C. 80b-5(b)(4)], investors 
in which must all be ``qualified purchasers.'' See supra note 93.
    \154\ A ``qualified client'' under rule 205-3 is: (i) A natural 
person who or a company that immediately after entering into the 
contract has at least $750,000 under the management of the 
investment adviser; (ii) A natural person who or a company that the 
investment adviser entering into the contract (and any person acting 
on his behalf) reasonably believes, immediately prior to entering 
into the contract, either: (A) Has a net worth (together, in the 
case of a natural person, with assets held jointly with a spouse) of 
more than $1,500,000 at the time the contract is entered into; or 
(B) Is a qualified purchaser as defined in section 2(a)(51)(A) of 
the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(51)(A)) at 
the time the contract is entered into; or (iii) A natural person who 
immediately prior to entering into the contract is: (A) An executive 
officer, director, trustee, general partner, or person serving in a 
similar capacity, of the investment adviser; or (B) An employee of 
the investment adviser (other than an employee performing solely 
clerical, secretarial or administrative functions with regard to the 
investment adviser) who, in connection with his or her regular 
functions or duties, participates in the investment activities of 
such investment adviser, provided that such employee has been 
performing such functions and duties for or on behalf of the 
investment adviser, or substantially similar functions or duties for 
or on behalf of another company for at least 12 months.
    \155\ Regulation D under the Securities Act provides that an 
accredited investor includes certain institutional investors as well 
as any natural person whose individual net worth, or joint net worth 
with that person's spouse, at the time of his purchase exceeds 
$1,000,000 or who had an individual income in excess of $200,000 in 
each of the two most recent years or joint income with that person's 
spouse in excess of $300,000 in each of those years and has a 
reasonable expectation of reaching the same income level in the 
current year.
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    Accordingly, there may be some small number of investors in hedge 
funds that are not qualified clients. It may, therefore, be against our 
current rules for the adviser to continue receiving a performance fee 
from some current investors.\156\ While we would require hedge fund 
advisers to comply with our performance fee rules going forward, we do 
not believe it is necessary to disrupt existing arrangements with 
persons who have already invested in the hedge fund. Our proposed 
amendment to 205-3 would allow a hedge fund's current investors who are 
not qualified clients to retain their existing investment in that fund, 
and to add to that account. It would not give them an exemption to open 
new investment accounts in that hedge fund or other hedge funds.
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    \156\ In the absence of relief, the registered adviser would 
have to either force the non-qualified client out of the fund or 
restructure its fee so that the non-qualified client is not paying 
the performance-based component of the fee.
---------------------------------------------------------------------------

    We request comment on this aspect of our proposal:
     Is it appropriate to create this exemption for current 
investors? If not, should we require that investors who are not 
qualified clients exit the hedge funds, or should we require that they 
be carved out of paying the performance fee?
     Is the scope of the exemption appropriate? If it is too 
narrow, should we permit current investors to open new accounts or 
invest in other hedge funds managed by the same adviser? Alternatively, 
if it is too broad, should we prohibit current investors from adding to 
their investment?
     Are there other exceptions or exemptions we should create?

H. Amendments to Rule 206(4)-2

    We propose to amend rule 206(4)-2, the adviser custody rule, to 
accommodate advisers to funds of hedge funds. Our custody rule makes it 
clear that an adviser acting as general partner to a pooled investment 
vehicle it manages has custody of the pool's assets.\157\ Under the 
rule, advisers to pooled investment vehicles, including hedge funds, 
may satisfy their obligation to deliver custody account information to 
investors by distributing the pool's audited financial statements to 
investors within 120 days of the pool's fiscal year-end.\158\ Some 
advisers to funds of hedge funds have encountered difficulty in 
obtaining completion of their fund audits prior to completion of the 
audits for the underlying funds in which they invest, and as a 
practical matter will be prevented from complying with the 120-day 
deadline. We propose to extend the period for pooled investment 
vehicles to distribute their audited financial statements to their 
investors from 120 days to 180 days, so that advisers to funds of hedge 
funds may comply with the rule.\159\
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    \157\ Rule 206(4)-2(c)(1)(iii).
    \158\ Rule 206(4)-2(b)(3).
    \159\ Until the Commission takes action on this proposed 
amendment, the Division of Investment Management will not recommend 
that the Commission take any enforcement action against an adviser 
to a fund of funds that acts in accordance with the proposed 
amendment.
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    We request comments on the proposed amendments.
     Is the 180-day period too long?
     Would a 150-day period achieve the same goal?

[[Page 45187]]

     Should we keep the 120-day requirement for non-fund of 
hedge funds advisers?

I. Amendments to Form ADV

    We propose to amend Form ADV to identify advisers to hedge funds. 
The current Form ADV collects information about advisers to pooled 
investment vehicles without distinguishing hedge fund advisers from 
other advisers. We would amend Item 7B. of Part 1A and Section 7B. of 
Schedule D to require advisers to ``private funds'' as defined in the 
proposed rule to identify themselves as hedge fund advisers in Part 1A 
and Schedule D of Form ADV. We request comment on this aspect of our 
proposal.
     Are any other changes needed to Form ADV in connection 
with registering hedge fund advisers?

J. Compliance Period

    We request comment on the length of time hedge fund advisers would 
need in order to register and revise their compliance systems so as to 
meet the requirements under the Advisers Act. Although many hedge fund 
advisers may be able to transition easily, we recognize that some firms 
may need to develop control policies and procedures in a number of 
areas.
     Would six months be sufficient?
     Would hedge fund advisers require as long as one year?

III. General Request for Comment

    The Commission requests comment on the rule and amendments proposed 
in this Release, suggestions for other additions to the rule and 
amendments, and comment on other matters that might have an effect on 
the proposals contained in this Release. For purposes of the Small 
Business Regulatory Enforcement Fairness Act of 1996, the Commission 
also requests information regarding the potential impact of the 
proposed rule and amendments on the economy on an annual basis. 
Commenters should provide empirical data to support their views.

IV. Cost-Benefit Analysis

    We are sensitive to the costs and benefits that result from our 
rules. Proposed rule 203(b)(3)-2 would require certain hedge fund 
advisers to register with us under the Investment Advisers Act of 1940. 
We are also proposing related recordkeeping and performance fee 
amendments to facilitate a smooth transition for hedge fund advisers, 
and amendments to the custody rule designed to facilitate a smooth 
transition particularly for advisers to funds of hedge funds. We have 
identified certain costs and benefits, which are discussed below, that 
may result from the proposed rule and amendments. We request comment on 
the costs and benefits of the proposed rule and amendments. We 
encourage commenters to identify, discuss, analyze, and supply relevant 
data regarding these or any additional costs and benefits.

A. Benefits

1. Benefits To Hedge Fund Investors
    As discussed above in this Release, our proposal to require hedge 
fund advisers to register under the Advisers Act would benefit hedge 
fund investors, though these benefits are difficult to quantify.
    (a) Deter fraud and curtail losses. Our oversight may prevent or 
diminish losses hedge fund investors would otherwise experience as a 
result of hedge fund advisers' fraud. Registration would allow us to 
conduct regular examinations of hedge fund advisers, and our 
examinations provide a strong deterrent to advisers' fraud, identify 
practices that may harm investors, and lead to earlier discovery of 
fraud that does occur.\160\ Registration would also permit us to screen 
individuals seeking to advise hedge funds, and to deny entry to those 
with a history of disciplinary problems.\161\
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    \160\ See Section II.B.2 of this Release.
    \161\ See Section II.B.3 of this Release.
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    In the last five years, the Commission has brought 46 enforcement 
cases in which we assert hedge fund advisers have defrauded hedge fund 
investors or used the fund to defraud others. While 3 of these frauds 
were detected in time to prevent investor losses, this was the 
exception rather than the rule.\162\ In 35 of these cases, our staff 
estimates potential investor losses aggregate approximately $1.1 
billion.\163\ Staff cannot at this time estimate the amount of losses 
in the remaining eight cases.\164\ We are concerned that individuals 
have targeted hedge fund investors and chosen hedge funds as a vehicle 
for fraud because these individuals could operate their funds without 
regulatory scrutiny of their activities. Only eight of the 46 cases 
involve investment advisers registered with the Commission, with over 
$75.7 million in estimated aggregate investor losses.\165\ The

[[Page 45188]]

remaining 38 cases involve advisers that were not registered with us, 
with over $1 billion in estimated aggregate investor losses.\166\ While 
our regulatory oversight cannot guarantee hedge fund investors will 
never be defrauded, our oversight should reduce investor losses.\167\
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    \162\ SEC v. EPG Global Private Equity Fund, Litigation Release 
No. 18577 (Feb. 17, 2004); SEC v. Millennium Capital Hedge Fund, 
L.P., Millennium Capital Group, LLC, and Andreas F. Zybell, 
Litigation Release No. 18362 (Sept. 25, 2003); In the Matter of John 
Christopher McCamey and Sierra Equity Partners, LP, Securities 
Exchange Act Release No. 48917 (June 18, 2003).
    \163\ In the Matter of Samer M. El Bizri and Bizri Capital 
Partners, Inc., supra note 78; SEC v. Daniel D. Dyer and Oxbow 
Capital Partners, LLC, Litigation Release No. 18719 (May 19, 2004); 
SEC v. J. Robert Dobbins, Dobbins Capital Corp., Dobbins Offshore 
Capital LLC, Dobbins Partners, L.P., and Dobbins Offshore, Ltd., 
Litigation Release No. 18634 (Mar. 23, 2004); SEC v. Patrollers 
Capital Fund and Franklin S. Marone, Litigation Release No. 18601 
(Feb. 27, 2004); SEC v. Darren Silverman and Matthew Brenner, 
Litigation Release No. 18597 (Feb. 25, 2004); In the Matter of Nevis 
Capital Management, LLC, David R. Wilmerding, III and Jon C. Baker, 
supra note 80; In the Matter of Robert T. Littell and Wilfred 
Meckel, Investment Advisers Act Release No. 2203 (Dec. 15, 2003); 
SEC v. Koji Goto, Litigation Release No. 18456 (Nov. 14, 2003); SEC 
v. John F. Turant, Jr., Russ R. Luciano, JTI Group Fund, LP, J.T. 
Investment Group, Inc., Evergreen Investment Group, LP, and New 
Resource Investment Group, Inc., Litigation Release No. 18351 (Sept. 
15, 2003); SEC v. Michael Batterman, Randall B. Batterman III, and 
Dynasty Fund, Ltd., et al., Litigation Release No. 18299 (Aug. 20, 
2003); SEC v. Ryan J. Fontaine and Simpleton Holdings Corporation a/
k/a Signature Investments Hedge Fund, supra note 19; In the Matter 
of Ascend Capital, LLC, Malcolm P. Fairbairn, and Emily Wang 
Fairbairn, Investment Advisers Act Release No. 2150 (July 17, 2003); 
SEC v. Beacon Hill Asset Management LLC, et al., supra note 40; SEC 
v. J. Scott Eskind, Lorus Investments, Inc., and Capital Management 
Fund, Limited Partnership, supra note 79; SEC v. Michael L. Smirlock 
and LASER Advisers, Inc., Litigation Release No. 17630 (July 24, 
2002); SEC v. Schwendiman Partners, LLC, Gary Schwendiman, and Todd 
G. Schwendiman, supra note 80; SEC v. Von Christopher Cummings, 
Paramount Financial Partners, L.P., Paramount Capital Management, 
LLC, John A. Ryan, Kevin L. Grandy and James Curtis Conley, 
Litigation Release No. 17598 (July 3, 2002); SEC v. House Asset 
Management, L.L.C., House Edge, L.P., Paul J. House, and Brandon R. 
Moore, supra note 76; In the Matter of Portfolio Advisory Services, 
LLC and Cedd L. Moses, supra note 41; SEC v. Jean Baptiste Jean 
Pierre, Gabriel Toks Pearse and Darius L. Lee, supra note 76; In the 
Matter of Zion Capital Management LLC, and Ricky A. Lang, supra note 
80; SEC v. Peter W. Chabot, Chabot Investments, Inc., Sirens Synergy 
and the Synergy Fund, supra note 76; SEC v. Vestron Financial Corp., 
et al., supra note 76; SEC v. Edward Thomas Jung, et al., supra note 
40; SEC v. Burton G. Friedlander, supra note 77; SEC v. Hoover and 
Hoover Capital Management, Inc., supra note 42; SEC v. Evelyn Litwok 
& Dalia Eilat, supra note 76; SEC v. Ashbury Capital Partners, L.P., 
Ashbury Capital Management, L.L.C., and Mark Yagalla, supra note 40; 
SEC v. James S. Saltzman, Litigation Release No. 17158 (Sept. 27, 
2001); In the Matter of Stephen V. Burns, Investment Advisers Act 
Release No. 1910 (Nov. 17, 2002); In the Matter of Michael T. 
Higgins, supra note 78; SEC v. David M. Mobley, Sr., et al., supra 
note 40; SEC v. Michael W. Berger, Manhattan Capital Management 
Inc., supra note 78; In the Matter of Charles K. Seavey and 
Alexander Lushtak, supra note 78; SEC v. Todd Hansen and Nicholas 
Lobue, supra note 144.
    \164\ SEC v. Global Money Management, LP, LF Global Investments, 
LLC, and Marvin I. Friedman, Litigation Release No. 18666 (Apr. 12, 
2004); SEC v. KS Advisors, Inc. et al., Litigation Release No. 18600 
(Feb. 27, 2004); In the Matter of Alliance Capital Management, L.P., 
supra note 43; SEC v. Edward J. Strafaci, Litigation Release No. 
18432 (Oct. 29, 2003); In the Matter of Stephen B. Markovitz, supra 
note 43; Michael Lauer, Lancer Management Group, LLC, and Lancer 
Management Group II, LLC, supra note 40; In the Matter of Martin W. 
Smith and World Securities, Inc., Investment Advisers Act Release 
No. 2124 (Apr. 18, 2003); SEC v. Platinum Investment Corp. et al., 
Litigation Release No. 17643 (July 31, 2002).
    \165\ In the Matter of Alliance Capital Management, L.P., supra 
note 43; SEC v. Michael L. Smirlock, supra note 163; SEC v. Edward 
J. Strafaci, supra note 164; In the Matter of Nevis Capital 
Management, supra note 80; In the Matter of Martin W. Smith and 
World Securities, Inc., supra note 164; SEC v. Schwendiman Partners, 
LLC, Gary Schwendiman, and Todd G. Schwendiman, supra note 80; In 
the Matter of Portfolio Advisory Services, LLC and Cedd L. Moses, 
supra note 41; In the Matter of Zion Capital Management LLC, and 
Ricky A. Lang, supra note 80. Staff cannot estimate the amount of 
losses in 3 of these cases at this time.
    \166\ Staff cannot estimate the amount of losses in 5 of these 
cases at this time.
    \167\ This benefit may be particularly important to hedge fund 
investors in an environment where there is excess demand for hedge 
funds. As substantial inflows chase absolute returns, average hedge 
fund risk can be expected to increase as hedge fund advisers compete 
for investment opportunities. This pressure may give hedge fund 
advisers incentives to engage in strategies that may not be 
consistent with the funds' disclosure or may be unlawful. See supra 
note 63 and accompanying text. In the absence of Commission 
oversight as a deterrent, these incentives may tempt hedge fund 
advisers to engage in fraud.
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    (b) Provide basic information about hedge fund advisers. Form ADV 
information that hedge fund advisers would file in registering would 
aid hedge fund investors in evaluating potential managers.\168\ Filing 
Form ADV would require hedge fund advisers to disclose information 
about their business, affiliates and owners, and disciplinary history. 
Many investors currently lack good access to this information about 
their hedge fund managers.\169\ Although the information hedge fund 
advisers would provide on their Form ADV filings and to comply with our 
rules cannot substitute for an investor's due diligence, it would aid 
investors by providing a publicly accessible foundation of basic 
information.\170\
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    \168\ See supra note 62 and accompanying text.
    \169\ Id.
    \170\ Participants at our Hedge Fund Roundtable last year spoke 
of the difficulty and costs that investors face in obtaining 
information from hedge fund advisers. Roundtable Transcript, May 15 
(statement of Sandra Manzke) (``[I]t's very difficult to get answers 
out of managers, and they hold all the keys right now. If you want 
to get into a good fund, and you ask some difficult questions, you 
may not get that answer. Sure, there is a lot of access, to get 
online and do background checks, and hire firms * * *. But that's 
expensive. And can the retail investor do it? No. Firms like ours, 
we spend a lot of money, we have a lot more people working for us 
now to uncover these types of situations.'').
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    (c) Improve compliance controls. Hedge fund investors would benefit 
from their advisers' improved compliance controls. Once registered, 
hedge fund advisers would be required to have comprehensive compliance 
procedures and to designate a chief compliance officer.\171\ Specific 
procedures governing proxy voting \172\ and a code of ethics including 
requirements for personal securities reporting would also be 
required.\173\ In addition, our examinations and the obligation to 
commit to a program of compliance controls foster adherence to a 
culture of compliance by advisers.\174\ These compliance measures are 
the first line of defense in protecting investors against breaches of 
an adviser's fiduciary duties under the Act.
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    \171\ See Section II.B.4 of this Release.
    \172\ Rule 206(4)-6 [17 CFR 275.206(4)-6].
    \173\ Rule 204A-1 [17 CFR 275.204A-1].
    \174\ See Section II.B.2 of this Release.
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2. Benefits to Mutual Fund Investors
    Mutual fund investors would benefit from hedge fund adviser 
registration to the extent that Commission oversight deters hedge funds 
and their advisers from illegal conduct that exploits mutual funds. 
Many of the market timers and illegal late traders involved in recent 
mutual fund scandals have been hedge funds.\175\ The 46 enforcement 
cases discussed earlier do not include 12 other actions we have brought 
to date against persons charged with late trading of mutual fund shares 
on behalf of hedge fund groups, and against mutual fund advisers or 
principals for permitting hedge funds to market time mutual funds 
contrary to the mutual funds' prospectus disclosure.\176\ Hedge fund 
advisers reaped huge profits for their funds over an extended period 
while costing our nation's retail mutual fund investors hundreds of 
millions of dollars.\177\
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    \175\ See supra note 43.
    \176\ Id.
    \177\ Id.
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3. Benefits to Other Investors and Markets
    Other investors, and markets, would benefit from hedge fund adviser 
registration to the extent that SEC oversight eliminates opportunities 
for hedge funds and their advisers to engage in other types of unlawful 
conduct in the securities markets. The mutual fund scandals have shown 
us that hedge fund advisers' improper or illegal activities can cause 
harm beyond the hedge funds' own investors. There may be other 
fraudulent activities by hedge fund advisers of which we are unaware 
because we cannot examine these advisers regularly.\178\ Adviser 
registration, as discussed above, would lead to earlier discovery of 
fraudulent activities and thus would enhance protections to all 
investors in the securities markets.
---------------------------------------------------------------------------

    \178\ See, e.g., Michael Lauer, Lancer Management Group, LLC, 
and Lancer Management Group II, LLC, supra note 40 (Commission 
complaint asserting unregistered hedge fund adviser manipulated the 
market price of certain securities held by the hedge fund); SEC v. 
Burton G. Friedlander, supra note 77.
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4. Benefits to Regulatory Policy
    Registration of hedge fund advisers would benefit all investors and 
market participants by providing us and other policy makers with better 
data. Better data would help us to form and frame appropriate 
regulatory policies regarding the hedge fund industry and its advisers, 
and to evaluate the effect of our policies and programs on this sector. 
We have limited information about hedge fund advisers and the hedge 
fund industry, and much of what we do have is indirect information 
extrapolated from other data. This hampers our ability to develop 
regulatory policy for the protection of hedge fund investors and 
investors in general.\179\ Hedge fund adviser registration would 
provide the Congress, the Commission and other government agencies with 
important information about this rapidly growing segment of the U.S. 
financial system.\180\
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    \179\ See Section II.B.1. of this Release.
    \180\ In addition to the Commission, other federal and state 
government departments and agencies regulating the financial sectors 
of the country may need such information to form their regulatory 
policies. For example, the Commission was unable to provide the 
Department of Treasury with accurate information about the number of 
hedge funds for use in connection with its proposals to require 
hedge funds to adopt anti-money laundering programs. Financial 
Crimes Enforcement Network; Anti-Money Laundering Programs for 
Unregistered Investment Companies, supra note 29. Because there is 
no government source of information to identify or locate hedge 
funds, the Treasury Department proposed a rule under the USA Patriot 
Act that will require that hedge funds, among others, to file a 
brief notice with the Department with certain information about 
their operations. Id. at p. 60622. See also The President's Working 
Group Study on Hedge Funds: Hearing Before the House Comm. on 
Banking and Financial Services, 106th Cong. (1999), p. 4 (statement 
of Representative John LaFalce, Member, House Comm. on Banking and 
Financial Services) (``The message of LTCM is not so much that the 
Federal Reserve set the stage for extricating very big and 
sophisticated principals and their lenders from a tight situation. 
The real message is that we can no longer doubt that we have a new 
powerful kind of financial institution in our midst, the hedge fund, 
and that we know very little about them.''); PWG LTCM Report, supra 
note 27 at 1(``[I]t is difficult to estimate precisely the size of 
the [hedge fund] industry * * *.'').
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5. Benefits to Hedge Fund Advisers
    (a) Curtail competitive disparities. Mandatory registration would 
provide a level playing field for hedge fund advisers. Many hedge fund 
advisers have already registered with us,\181\ and

[[Page 45189]]

have organized their compliance procedures under the Advisers Act. 
Unregistered hedge fund advisers, however, vary substantially in their 
compliance practices.\182\ While many of them have adopted sound 
compliance practices, many others, against whom they and the registered 
advisers compete, have not allocated resources to implement an 
effective compliance infrastructure. Mandatory registration would 
ensure that all hedge fund advisers compete on the same basis in this 
regard.
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    \181\ Many advisers to hedge funds are required to register with 
us because of other advisory business they have. Still others have 
chosen to register with us because their investor clients require 
it. See Section II.B.6 of this Release. See also supra note 98.
    \182\ See Section VII.A.1.b. of the 2003 Staff Hedge Fund 
Report, supra note 32.
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    (b) Legitimize a growing and maturing industry. As discussed above, 
the hedge fund industry has been growing at an extraordinary pace in 
the past decade.\183\ Registration under the Advisers Act would bring 
hedge fund advisers to the same compliance level as other SEC-
registered advisers, thus legitimizing a growing and maturing industry 
that is currently perceived as operating in the shadows. In addition, 
without appropriate regulatory oversight to check growing hedge fund 
fraud, investors' confidence in hedge fund advisers and the hedge fund 
industry could eventually erode.
---------------------------------------------------------------------------

    \183\ See Section I. A. of this Release.
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B. Costs

    Registration of hedge fund advisers under the Advisers Act would 
not impede hedge funds' operations. The Act does not prohibit any 
particular investment strategies, nor does it require or prohibit 
specific investments. Instead of imposing specific procedures on 
registrants, the Advisers Act is principally a disclosure statute that 
requires registrants to fully inform clients of conflicts so that those 
clients can determine whether to give their consent. For the same 
reasons, registering hedge fund advisers should not impair the ability 
of hedge funds to continue their important roles of providing price 
information and liquidity to our markets.\184\ Registration, however, 
imposes certain additional costs as discussed below.
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    \184\ See PGW LTCM Report supra note 27 at 2. The 2003 Staff 
Hedge Fund Report, also noted that hedge funds' trading brings price 
information to our securities markets, thus improving market 
efficiency, and hedge funds also provide liquidity to our capital 
markets. 2003 Staff Hedge Fund Report at 4, supra note 32.
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1. Registration Costs
    Hedge fund advisers would experience costs to register under the 
Advisers Act, but these costs would not be high. In order to register, 
advisers are required to file Part 1 of Form ADV (the registration form 
for advisers) electronically through the Investment Adviser 
Registration Depository (``IARD'') and pay initial filing fees and 
annual filing fees to the IARD system operator.\185\ In addition to 
these filing fees, hedge fund advisers would also incur internal costs 
in connection with preparing Part 1, but these costs should be low 
because Form ADV readily accommodates registration by hedge fund 
advisers. Part 1 requires advisers to answer basic questions about 
their business, their affiliates and their owners, and Part 1 can be 
completed using information readily available to hedge fund advisers. 
Numerous hedge fund advisers have already registered with the 
Commission using Part 1, and none has reported to us that their 
business model presents any difficulty in using the form.\186\ Advisers 
must also complete Part II of Form ADV and deliver a copy of Part II or 
a disclosure brochure containing the same information to clients.\187\ 
Part II requires disclosure of certain conflicts of interest. We expect 
that hedge fund advisers would face relatively small internal costs in 
preparing a Part II, and would be likely to include their Part II 
information as part of their private placement memoranda for their 
hedge funds, reducing their overall costs even further.
---------------------------------------------------------------------------

    \185\ The initial filing fee for advisers with $25 million to 
$100 million of assets under management is $800 and for advisers 
with $100 million or more of assets under management is $1,100. The 
annual filing fee for advisers with $25 million to $100 million of 
assets under management is $400 and for advisers with more than $100 
million of assets under management is $550. Available at 
www.sec.gov/division/investment/iard/iardfee.shtml.
    \186\ In fact, our proposal makes only one small change to Part 
1, to better identify which advisers' pooled investment vehicles are 
hedge funds. See Section II. I. of this Release.
    \187\ See rule 204-3 [17 CFR 275.204-3], the brochure delivery 
rule.
---------------------------------------------------------------------------

2. Compliance Infrastructure Costs
    New hedge fund adviser registrants would also face costs to bring 
their operations into conformity with the Advisers Act and the rules 
under the Act, and these costs would vary substantially across advisory 
firms. Registered advisers are required to comply with rules under the 
Advisers Act such as the books and records rule,\188\ the custody 
rule,\189\ the proxy voting rule,\190\ the compliance rule,\191\ and 
the code of ethics rule.\192\ Many unregistered hedge fund advisers 
have already built sound compliance infrastructure because their 
business compels it. These firms already have procedures designed to 
keep good records of all transactions, to keep their clients' assets 
safe, to provide fair and full disclosure of conflicts of interest, and 
to prevent their supervised persons from breaching fiduciary duties. 
These advisory firms would face little cost to modify their current 
compliance practices to comply with the Advisers Act rules. For other 
hedge fund advisers that have not yet established sound compliance 
programs, however, the costs would be higher.
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    \188\ Rule 204-2.
    \189\ Rule 206(4)-2.
    \190\ Rule 206(4)-6.
    \191\ Rule 206(4)-7.
    \192\ Rule 204A-1.
---------------------------------------------------------------------------

    Based on discussions with industry, we estimate the costs to 
establish the required compliance infrastructure would be $20,000 in 
professional fees and $25,000 in internal costs including staff 
time.\193\ These estimates are averages. As stated above, the costs 
would likely be less for new registrants that have already established 
sound compliance practices and more for new registrants that do not yet 
have good compliance procedures. These costs should not represent a 
barrier to entry for new hedge fund advisers. More than 2,500 smaller 
advisory firms are currently registered with us.\194\ These firms have 
absorbed these compliance costs, notwithstanding the fact that their 
revenues are likely to be smaller than those of a typical hedge fund 
adviser.\195\
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    \193\ Our staff has estimated that between 690 and 1,260 hedge 
fund advisers would be new Advisers Act registrants under the 
proposed rules. See infra text following note 198. Aggregate start-
up costs to establish required compliance infrastructure for all new 
registrants are therefore estimated to range from $31 to $57 
million.
    \194\ As of May 1, 2004, 2,640 advisers registered with us 
reported that they were managing less than $50 million in client 
assets. These advisers represent 32 percent of our registrant pool.
    \195\ In addition to asset-based investment management fees that 
are comparable to advisory fees charged by non-hedge fund advisory 
firms, hedge fund advisers also typically earn incentive 
compensation equaling 20 percent of the fund's net investment 
income.
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V. Effects on Commission Examination Resources

    The proposed rule would also increase the workload of the 
Commission's investment adviser examination program, which is operated 
by our Office of Compliance Inspections and Examinations (``OCIE''). 
OCIE's examination program already covers a number of advisers to hedge 
funds. These advisers have registered with the SEC, either because they 
advise non-hedge fund clients for whom registration is required, or 
because they

[[Page 45190]]

perceive SEC registration to be necessary to their business model. The 
proposed rule would increase the number of SEC-registered advisers by 
some amount, and increase our examination workload correspondingly.
    There are various options we could pursue to lessen the effect of 
this increase. Though OCIE's resources would be spread over an expanded 
pool of investment adviser registrants, we could develop risk 
assessment tools that enhance the efficiency of our examination 
program. In addition, we have recently adopted measures that require 
advisory personnel to be more accountable for the efficacy of 
compliance programs. By October of this year, advisers must comply with 
our new compliance rule, which requires all registered investment 
advisers to implement comprehensive policies and procedures for 
compliance with the Advisers Act, under the administration of a chief 
compliance officer.\196\ As advisers improve their own compliance 
regimes, we expect our examination program will enjoy increased 
efficiencies. Another option would be to increase the current threshold 
for SEC registration from $25 million of assets under management to a 
slightly higher amount, thereby reducing the number of smaller advisers 
overseen by the Commission (instead of state securities 
administrators). Or we could seek additional resources from Congress, 
if necessary.
---------------------------------------------------------------------------

    \196\ Rule 206(4)-7. See Compliance Programs of Investment 
Companies and Investment Advisers, supra note 91.
---------------------------------------------------------------------------

    Our ability to estimate the size of the increase in our workload 
has been hampered by the absence of any reliable and comprehensive 
database of hedge funds or advisers to hedge funds. Our staff 
tentatively estimates that the addition of new hedge fund advisers to 
our current registrant pool of 8,300 advisers could increase the total 
size of this pool by 8 to 15 percent.
    Based on a review of the limited information available, our staff 
estimates that there are probably between 2,300 and 3,500 hedge fund 
advisers in the industry, advising approximately 7,000 funds.\197\ 
After examining various private databases of hedge fund information, 
staff further estimates that approximately 60 percent of these firms 
are likely to have at least $25 million in assets under management, 
making them eligible to register with the Commission instead of the 
states. Staff further estimates that approximately 40 to 50 percent of 
those eligible advisers are already registered with the Commission, 
with registration rates likely to be higher for larger firms and lower 
for smaller firms.\198\ Based on these estimates and assumptions:
---------------------------------------------------------------------------

    \197\ Participants at our Hedge Fund Roundtable in May of 2003 
estimated that there were approximately 6,000 hedge funds in 
operation at that time. 2003 Staff Hedge Fund Report, supra note 32 
at n. 2. More recently, the Hennessee Group has estimated the total 
number of hedge funds at 7,000. See Testimony of Charles J. 
Gradante, supra note 33.
    No similar estimates exist of the number of advisers managing 
these hedge funds. Many hedge fund advisers manage two or four funds 
(one or two management styles, with a U.S. and an off-shore version 
of each), while other smaller hedge fund advisers manage only one 
and some of the largest advisers manage more than four. If, on 
average, each hedge fund advisory firm is managing approximately two 
to three funds, that equates to approximately 2,300 to 3,500 firms.
    \198\ In reaching this estimate, staff reviewed information 
contained in private databases of hedge fund information. Form ADV 
does not presently require SEC-registered advisers to indicate 
whether they advise hedge funds. As of April 2004, approximately 
1,900 advisers, representing 23 percent of all SEC-registered 
advisers, indicated on their Form ADV that they advised ``other 
pooled investment vehicles'' as clients, and approximately 600 out 
of the 1,900 indicated these pooled investment vehicles represented 
75 percent or more of their client base. While these ``other pooled 
investment vehicles'' include hedge funds, they also include a 
variety of other non-hedge fund pools, and therefore we cannot use 
these responses to estimate how many of these advisers manage hedge 
funds.
---------------------------------------------------------------------------

     If the industry is comprised of approximately 2,300 hedge 
fund advisers, then approximately 1,380 are likely eligible to register 
with the Commission under the $25 million registration threshold. Of 
these 1,380 firms, approximately 550 to 690 are likely already SEC-
registered, and the proposed rule would result in 690 to 830 new 
registrants.
     If the industry is comprised of approximately 3,500 hedge 
fund advisers, then approximately 2,100 are likely eligible to register 
with the Commission under the $25 million registration threshold. Of 
these 2,100 firms, approximately 840 to 1,050 are likely already SEC-
registered, and the proposed rule would result in 1,050 to 1,260 new 
registrants.
    We request comment on these estimates. We encourage commenters to 
identify, discuss, analyze, and supply relevant data regarding these or 
any alternative estimates.

VI. Paperwork Reduction Act

    Proposed rule 203(b)(3)-2 contains no new ``collection of 
information'' requirements within the meaning of the Paperwork 
Reduction Act of 1995 (44 U.S.C. 3501 to 3520). The rules proposed to 
be amended contain several collection of information requirements, but 
the proposed amendments do not change the burden per response from that 
under the current rules. Proposed rule 203(b)(3)-2 would have the 
effect of requiring advisers to hedge funds to register with the 
Commission under the Advisers Act and would therefore increase the 
number of respondents under several existing collections of 
information, and, correspondingly, increase the annual aggregate burden 
under those existing collections of information. The Commission has 
submitted, to the Office of Management and Budget (``OMB'') in 
accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11, the existing 
collections for information for which the annual aggregate burden would 
likely increase as a result of rule 203(b)(3)-2. The titles of the 
affected collections of information are: ``Form ADV,'' ``Form ADV-W and 
Rule 203-2,'' ``Rule 203-3 and Form ADV-H,'' ``Form ADV-NR,'' ``Rule 
204-2,'' ``Rule 204-3,'' ``Rule 204A-1,'' ``Rule 206(4)-2, Custody of 
Funds or Securities of Clients by Investment Advisers,'' ``Rule 206(4)-
3,'' ``Rule 206(4)-4,'' ``Rule 206(4)-6,'' and ``Rule 206(4)-7,'' all 
under the Advisers Act. The existing rules affected by rule 203(b)(3)-2 
contain currently approved collection of information numbers under OMB 
control numbers 3235-0049, 3235-0313, 3235-0538, 3235-0240, 3235-0278, 
3235-0047, 3235-0596, 3235-0241, 3253-0242, 3235-0345, 3235-0571 and 
3235-0585, respectively. An agency may not conduct or sponsor, and a 
person is not required to respond to, a collection of information 
unless it displays a currently valid control number. All of these 
collections of information are mandatory, and respondents in each case 
are investment advisers registered with us, except that (i) respondents 
to Form ADV are also investment advisers applying for registration with 
us; (ii) respondents to Form ADV-NR are non-resident general partners 
or managing agents of registered advisers; (iii) respondents to Rule 
204A-1 include ``access persons'' of an adviser registered with us, who 
must submit reports of their personal trading to their advisory firms; 
(iv) respondents to Rule 206(4)-2 are only those SEC-registered 
advisers that have custody of clients' funds or securities; (v) 
respondents to Rule 206(4)-3 are advisers who pay cash fees to persons 
who solicit clients for the adviser; (vi) respondents to Rule 204(4)-4 
are advisers with certain disciplinary histories or a financial 
condition that is reasonably likely to affect contractual commitments; 
and (vii) respondents to Rule 206(4)-6 are only those SEC-registered 
advisers that vote their clients' securities. Unless

[[Page 45191]]

otherwise noted below, responses are not kept confidential.
    We cannot estimate with precision the number of hedge fund advisers 
that would be new registrants with the Commission under the Advisers 
Act if proposed rule 203(b)(3)-2 is adopted. As discussed earlier, our 
staff has estimated that between 690 and 1,260 hedge fund advisers 
would be new Advisers Act registrants under the proposed rules.\199\ 
For purposes of estimating the increases in respondents to the existing 
collections of information, we have used the midpoint of this estimated 
range, or 975 new respondents. We request comment on the number of 
hedge fund advisers that would be subject to the proposed rule and to 
the applicable collections of information.
---------------------------------------------------------------------------

    \199\ See supra text following note 198.
---------------------------------------------------------------------------

A. Form ADV

    Form ADV is the investment adviser registration form. The 
collection of information under Form ADV is necessary to provide 
advisory clients, prospective clients, and the Commission with 
information about the adviser, its business, and its conflicts of 
interest. Rule 203-1 requires every person applying for investment 
adviser registration with the Commission to file Form ADV. Rule 204-1 
requires each registered adviser to file amendments to Form ADV at 
least annually, and requires advisers to submit electronic filings 
through the IARD. This collection of information is found at 17 CFR 
275.203-1, 275.204-1, and 279.1. The currently approved collection of 
information in Form ADV is 102,653 hours. We estimate that 975 new 
respondents would file one complete Form ADV and one amendment 
annually, and comply with Form ADV requirements relating to delivery of 
the code of ethics. Accordingly, we estimate the proposal would 
increase the annual aggregate information collection burden under Form 
ADV by 28,958 hours \200\ for a total of 131,611 hours.
---------------------------------------------------------------------------

    \200\ 975 filings of the complete form at 22.25 hours each, plus 
975 amendments at 0.75 hours each, plus 6.7 hours for each of the 
975 hedge fund advisers to deliver copies of their codes of ethics 
to 10 percent of their 670 clients annually who request it, at 0.1 
hours per response.
---------------------------------------------------------------------------

B. Form ADV-W and Rule 203-2

    Rule 203-2 requires every person withdrawing from investment 
adviser registration with the Commission to file Form ADV-W. The 
collection of information is necessary to apprise the Commission of 
advisers who are no longer operating as registered advisers. This 
collection of information is found at 17 CFR 275.203-2 and 17 CFR 
279.2. The currently approved collection of information in Form ADV-W 
is 500 hours. We estimate that 975 hedge fund advisers that would be 
new registrants would withdraw from SEC registration at a rate of 
approximately 16 percent per year, the same rate as other registered 
advisers, and would file for partial and full withdrawals at the same 
rates as other registered advisers, with approximately half of the 
filings being full withdrawals and half being partial withdrawals. 
Accordingly, we estimate the proposal would increase the annual 
aggregate information collection burden under Form ADV-W and rule 203-2 
by 78 hours \201\ for a total of 578 hours.
---------------------------------------------------------------------------

    \201\ 156 filings (975 x 0.16), consisting of 78 full 
withdrawals at 0.75 hours each and 78 partial withdrawals at 0.25 
hours each.
---------------------------------------------------------------------------

C. Rule 203-3 and Form ADV-H

    Rule 203-3 requires that advisers requesting either a temporary or 
continuing hardship exemption submit the request on Form ADV-H. An 
adviser requesting a temporary hardship exemption is required to file 
Form ADV-H, providing a brief explanation of the nature and extent of 
the temporary technical difficulties preventing it from submitting a 
required filing electronically. Form ADV-H requires an adviser 
requesting a continuing hardship exemption to indicate the reasons the 
adviser is unable to submit electronic filings without undue burden and 
expense. Continuing hardship exemptions are available only to advisers 
that are small entities. The collection of information is necessary to 
provide the Commission with information about the basis of the 
adviser's hardship. This collection of information is found at 17 CFR 
275.203-3, and 279.3. The currently approved collection of information 
in Form ADV-H is 10 hours. We estimate that the approximately 975 hedge 
fund advisers that would be new registrants would file for temporary 
hardship exemptions at approximately 0.1 percent per year, the same 
rate as other registered advisers.\202\ Accordingly, we estimate the 
proposal would increase the annual aggregate information collection 
burden under Form ADV-H and rule 203-3 by 1 hour \203\ for a total of 
11 hours.
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    \202\ We expect that no hedge fund advisers would be small 
advisers that would be eligible to file for a continuing hardship 
exemption.
    \203\ 1 filing (975 x 0.001) at 1 hour each.
---------------------------------------------------------------------------

D. Form ADV-NR

    Non-resident general partners or managing agents of SEC-registered 
investment advisers must make a one-time filing of Form ADV-NR with the 
Commission. Form ADV-NR requires these non-resident general partners or 
managing agents to furnish us with a written irrevocable consent and 
power of attorney that designates the Commission as an agent for 
service of process, and that stipulates and agrees that any civil suit 
or action against such person may be commenced by service of process on 
the Commission. The collection of information is necessary for us to 
obtain appropriate consent to permit the Commission and other parties 
to bring actions against non-resident partners or agents for violations 
of the federal securities laws. This collection of information is found 
at 17 CFR 279.4. The currently approved collection of information in 
Form ADV-NR is 15 hours. We estimate that the approximately 975 hedge 
fund advisers that would be new registrants would make these filings at 
the same rate (0.2 percent) as other registered advisers. Accordingly, 
we estimate the proposal would increase the annual aggregate 
information collection burden under Form ADV-NR by 2 hours \204\ for a 
total of 17 hours.
---------------------------------------------------------------------------

    \204\ 2 filings (975 x 0.002) at 1 hour each.
---------------------------------------------------------------------------

E. Rule 204-2

    Rule 204-2 requires SEC-registered investment advisers to maintain 
copies of certain books and records relating to their advisory 
business. The collection of information under rule 204-2 is necessary 
for the Commission staff to use in its examination and oversight 
program. Responses provided to the Commission in the context of its 
examination and oversight program are generally kept confidential.\205\ 
The records that an adviser must keep in accordance with rule 204-2 
must generally be retained for not less than five years.\206\ This 
collection of information is found at 17 CFR 275.204-2. The currently 
approved collection of information for rule 204-2 is 1,537,884 hours, 
or 191.78 hours per registered adviser. We estimate that all 975 
advisers that would be new registrants would maintain copies of records 
under the requirements of rule 204-2. Accordingly, we estimate the 
proposal would increase the annual aggregate information collection 
burden under rule 204-2 by 186,985.5 hours \207\ for a total of 
1,724,869.5 hours.
---------------------------------------------------------------------------

    \205\ See section 210(b) of the Advisers Act [15 U.S.C. 80b-
10(b)].
    \206\ See rule 204-2(e).
    \207\ 975 hedge fund advisers x 191.78 hours per adviser = 
186,985.5 hours.
---------------------------------------------------------------------------

F. Rule 204-3

    Rule 204-3, the ``brochure rule,'' requires an investment adviser 
to

[[Page 45192]]

deliver or offer to prospective clients a disclosure statement 
containing specified information as to the business practices and 
background of the adviser. Rule 204-3 also requires that an investment 
adviser deliver, or offer, its brochure on an annual basis to existing 
clients in order to provide them with current information about the 
adviser. The collection of information is necessary to assist clients 
in determining whether to retain, or continue employing, the adviser. 
This collection of information is found at 17 CFR 275.204-3. The 
currently approved collection of information for rule 204-3 is 
5,412,643 hours, or 694 hours per registered adviser, assuming each 
adviser has on average 670 clients. We estimate that all 975 advisers 
that would be new registrants would provide brochures to their clients 
as required by rule 204-3. Accordingly, we estimate the proposal would 
increase the annual aggregate information collection burden under rule 
204-3 by 676,650 hours \208\ for a total of 6,089,293 hours. We note 
that the average number of clients per adviser reflects a small number 
of advisers who have thousands of clients, while the typical SEC-
registered adviser has approximately 76 clients. We ask comment on the 
number of clients of the average hedge fund adviser.
---------------------------------------------------------------------------

    \208\ 975 hedge fund advisers times 694 hours per adviser.
---------------------------------------------------------------------------

G. Rule 204A-1

    Rule 204A-1 requires SEC-registered investment advisers to adopt 
codes of ethics setting forth standards of conduct expected of their 
advisory personnel and addressing conflicts that arise from personal 
securities trading by their personnel, and requiring advisers' ``access 
persons'' to report their personal securities transactions. The 
collection of information under rule 204A-1 is necessary to establish 
standards of business conduct for supervised persons of investment 
advisers and to facilitate investment advisers' efforts to prevent 
fraudulent personal trading by their supervised persons. This 
collection of information is found at 17 CFR 275.204A-1. The currently 
approved collection of information for rule 204A-1 is 945,841 hours, or 
117.95 hours per registered adviser. We estimate that all 975 advisers 
that would be new registrants would adopt codes of ethics under the 
requirements of rule 204A-1 and require personal securities transaction 
reporting by their ``access persons.'' Accordingly, we estimate the 
proposal would increase the annual aggregate information collection 
burden under rule 204A-1 by 115,001 hours \209\ for a total of 
1,060,842 hours.
---------------------------------------------------------------------------

    \209\ 975 hedge fund advisers at 117.95 hours per adviser 
annually.
---------------------------------------------------------------------------

H. Rule 206(4)-2

    Rule 206(4)-2 requires advisers with custody of their clients' 
funds and securities to maintain controls designed to protect those 
assets from being lost, misused, misappropriated, or subjected to 
financial reverses of the adviser. The collection of information under 
rule 206(4)-2 is necessary to ensure that clients' funds and securities 
in the custody of advisers are safeguarded, and information contained 
in the collections is used by staff of the Commission in its 
enforcement, regulatory, and examination programs. This collection of 
information is found at 17 CFR 275.206(4)-2. The currently approved 
collection of information for rule 206(4)-2 is 72,113 hours. We 
estimate that all 975 hedge fund advisers that would be new registrants 
would have custody. We are proposing to amend rule 206(4)-2 to make it 
easier for hedge fund advisers to distribute audited financial 
statements to their investors annually in lieu of quarterly account 
statements sent by either the adviser or a qualified custodian and we 
estimate that all 975 new respondents would use this approach and would 
not be required to undergo an annual surprise examination. Accordingly, 
we estimate the proposal would increase the annual aggregate 
information collection burden under rule 206(4)-2 by 326,625 hours 
\210\ for a total of 398,738 hours.
---------------------------------------------------------------------------

    \210\ 975 hedge fund advisers times 670 clients times 0.5 hours 
per annual financial statement distribution.
---------------------------------------------------------------------------

I. Rule 206(4)-3

    Rule 206(4)-3 requires advisers who pay cash fees to persons who 
solicit clients for the adviser to observe certain procedures in 
connection with solicitation activity. The collection of information 
under rule 206(4)-3 is necessary to inform advisory clients about the 
nature of a solicitor's financial interest in the recommendation of an 
investment adviser, so the client may consider the solicitor's 
potential bias, and to protect investors against solicitation 
activities being carried out in a manner inconsistent with the 
adviser's fiduciary duties. This collection of information is found at 
17 CFR 275.206(4)-3. The currently approved collection of information 
for rule 206(4)-3 is 10,982 hours. We estimate that approximately 20 
percent of the 975 hedge fund advisers that would be new registrants 
would be subject to the cash solicitation rule, the same rate as other 
registered advisers. Accordingly, we estimate the proposal would 
increase the annual aggregate information collection burden under rule 
206(4)-3 by 1,373 hours \211\ for a total of 12,355 hours.
---------------------------------------------------------------------------

    \211\ 195 respondents (975 x 0.2) at 7.04 hours annually per 
respondent.
---------------------------------------------------------------------------

J. Rule 206(4)-4

    Rule 206(4)-4 requires registered investment advisers to disclose 
to clients and prospective clients certain disciplinary history or a 
financial condition that is reasonably likely to affect contractual 
commitments. This collection of information is necessary for clients 
and prospective clients in choosing an adviser or continuing to employ 
an adviser. This collection of information is found at 17 CFR 
275.206(4)-4. The currently approved collection of information for rule 
206(4)-4 is 10,118 hours. We estimate that approximately 17.3 percent 
of the 975 hedge fund advisers that would be new registrants would be 
subject to rule 206(4)-4, the same rate as other registered advisers. 
Accordingly, we estimate the proposal would increase the annual 
aggregate information collection burden under rule 206(4)-4 by 1,265 
hours \212\ for a total of 11,383 hours.
---------------------------------------------------------------------------

    \212\ 169 respondents (975 x 0.173) at 7.5 hours annually per 
respondent.
---------------------------------------------------------------------------

K. Rule 206(4)-6

    Rule 206(4)-6 requires an investment adviser that votes client 
securities to adopt written policies reasonably designed to ensure that 
the adviser votes in the best interests of clients, and requires the 
adviser to disclose to clients information about those policies and 
procedures. This collection of information is necessary to permit 
advisory clients to assess their adviser's voting policies and 
procedures and to monitor the adviser's performance of its voting 
responsibilities. This collection of information is found at 17 CFR 
275.206(4)-6. The currently approved collection of information for rule 
206(4)-6 is 103,590 hours. We estimate that all 975 hedge fund advisers 
that would be new registrants would vote their clients' securities. 
Accordingly, we estimate the proposal would increase the annual 
aggregate information collection burden under rule 206(4)-6 by 16,283 
hours \213\ for a total of 119,873 hours.
---------------------------------------------------------------------------

    \213\ 975 hedge fund advisers would spend 10 hours each annually 
documenting their voting policies and procedures, and would provide 
copies of those policies and procedures to 10 percent of their 670 
clients annually at 0.1 hours per response.

---------------------------------------------------------------------------

[[Page 45193]]

L. Rule 206(4)-7

    Rule 206(4)-7 requires each registered investment adviser to adopt 
and implement written policies and procedures reasonably designed to 
prevent violations of the Advisers Act, review those policies and 
procedures annually, and designate an individual to serve as chief 
compliance officer. This collection of information under rule 206(4)-7 
is necessary to ensure that investment advisers maintain comprehensive 
internal programs that promote the advisers' compliance with the 
Advisers Act. This collection of information is found at 17 CFR 
275.206(4)-7. The currently approved collection of information for rule 
206(4)-7 is 623,200 hours, or 80 hours annually per registered adviser. 
We estimate all 975 advisers that would be new registrants would be 
required to maintain compliance programs under rule 206(4)-7. 
Accordingly, we estimate the proposal would increase the annual 
aggregate information collection burden under rule 206(4)-7 by 78,000 
hours \214\ for a total of 701,200 hours.
---------------------------------------------------------------------------

    \214\ 975 hedge fund advisers at 80 hours annually.
---------------------------------------------------------------------------

M. Request for Comment

    Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits 
comments to:
     Evaluate whether the proposed collections of information 
are necessary for the proper performance of the functions of the 
Commission, including whether the information will have practical 
utility;
     Evaluate the accuracy of the Commission's estimate of the 
burden of the proposed collections of information;
     Determine whether there are ways to enhance the quality, 
utility, and clarity of the information to be collected; and
     Determine whether there are ways to minimize the burden of 
the collections of information on those who are to respond, including 
through the use of automated collection techniques or other forms of 
information technology.
    Persons wishing to submit comments on the collection of information 
requirements should direct them to the Office of Management and Budget, 
Attention: Desk Officer for the Securities and Exchange Commission, 
Office of Information and Regulatory Affairs, Room 3208, Washington, DC 
20503, and also should send a copy to Jonathan G. Katz, Secretary, 
Securities and Exchange Commission, 450 Fifth Street, NW., Washington, 
DC 20549-0609 with reference to File No. S7-30-04. OMB is required to 
make a decision concerning the collections of information between 30 
and 60 days after publication, so a comment to OMB is best assured of 
having its full effect if OMB receives the comment within 30 days after 
publication of this release. Requests for materials submitted to OMB by 
the Commission with regard to these collections of information should 
be in writing, refer to File No. S7-30-04, and be submitted to the 
Securities and Exchange Commission, Records Management, Office of 
Filings and Information Services, 450 Fifth Street, NW., Washington, DC 
20549.

VII. Effects on Competition, Efficiency and Capital Formation

    Section 202(c) of the Advisers Act mandates that the Commission, 
when engaging in rulemaking that requires it to consider or determine 
whether an action is necessary or appropriate in the public interest, 
to consider, in addition to the protection of investors, whether the 
action will promote efficiency, competition, and capital 
formation.\215\
---------------------------------------------------------------------------

    \215\ 15 U.S.C. 80b-2(c).
---------------------------------------------------------------------------

    As discussed above, proposed rule 203(b)(3)-2 would, in effect, 
require hedge fund advisers to register with the Commission under the 
Advisers Act. The proposed rule is designed to provide the protection 
afforded by the Advisers Act to investors in hedge funds, and to 
enhance the Commission's ability to protect our nation's securities 
markets. We are also proposing rule amendments that would facilitate 
hedge fund advisers' transition to registration and improve the 
Commission's ability to identify hedge fund advisers from information 
filed on their Form ADV. The proposed rule and rule amendments may 
indirectly increase efficiency for hedge fund investors. Hedge fund 
adviser registration would provide hedge fund investors and industry 
participants with better access to important basic information about 
hedge fund advisers and the hedge fund industry. This improved access 
may allow investors to investigate and select their advisers more 
efficiently.
    We do not anticipate that the proposed rule would introduce any 
competitive disadvantages. The proposed rule may provide a level 
playing field with respect to advisers' compliance infrastructures. 
Many hedge fund advisers are already registered with us, either because 
their investors demand it or because they have other advisory business 
that requires them to register. These registered advisers must adopt 
compliance procedures under the Advisers Act and must provide certain 
safeguards to their clients, including their hedge fund investors. 
While some unregistered hedge fund advisers have adopted sound 
comparable compliance procedures, others have not. Mandatory 
registration would require that all hedge fund advisers compete with 
each other and with other investment advisers on the same basis in this 
regard. The proposed amendment to rule 204-2 is designed to prevent 
newly-registered hedge fund advisers from being at a competitive 
disadvantage with respect to the promotion of their previous 
performance records, and the proposed amendment to rule 206(4)-2 is 
designed to allow advisers to funds of hedge funds to use the same 
approach under the adviser custody rule as do advisers to other pooled 
investment vehicles.
    The proposed rule is unlikely to have a substantial effect on 
capital formation. To the extent that registration and the prospect of 
Commission examinations improves the compliance culture at hedge fund 
advisory firms, it may bolster investor confidence and investors may be 
more likely to entrust hedge fund advisers with their assets for 
investment. However, these assets may be diverted from other 
investments in the capital markets.
    The Commission seeks comment regarding the impact of the proposed 
rules on efficiency, competition, and capital formation. Commenters are 
requested to provide empirical data to support their views.

VIII. Regulatory Flexibility Act

A. Certification

    Pursuant to section 605(b) of the Regulatory Flexibility Act,\216\ 
the Commission hereby certifies that proposed rule 203(b)(3)-2 and the 
proposed amendments to rules 203(b)(3)-1, 204-2, 205-3 and Form ADV 
would not, if adopted, have a significant economic impact on a 
substantial number of small entities. Under Commission rules, for the 
purposes of the Advisers Act and the Regulatory Flexibility Act, an 
investment adviser generally is a small entity if it: (i) Has assets 
under management having a total value of less than $25 million; (ii) 
did not have total assets of $5 million or more on the last day of its 
most recent fiscal year; and (iii) does not control, is not controlled 
by, and is not under common control with another investment adviser 
that has assets under management of $25 million or more, or any person 
(other than a natural person) that had $5

[[Page 45194]]

million or more on the last day of its most recent fiscal year.\217\
---------------------------------------------------------------------------

    \216\ 5 U.S.C. 605(b).
    \217\ Rule 0-7(a) [17 CFR 275.0-7(a)]
---------------------------------------------------------------------------

    Proposed rule 203(b)(3)-2 and the amendment to rule 203(b)(3)-1 
would remove a safe harbor and require certain advisers to private 
funds to register with the Commission under the Advisers Act by 
requiring them to count investors in the fund as clients for purposes 
of the Advisers Act ``de minimis'' exemption from registration. 
Notwithstanding the proposed rule, investment advisers with assets 
under management of less than $25 million would remain generally 
ineligible for registration with the Commission under section 203A of 
the Advisers Act.\218\ The proposed amendments to rules 204-2 and 205-3 
would allow advisers affected by the proposed new rule to continue 
certain marketing practices and performance fees they now have in 
place. The proposed amendment to Form ADV would require advisers to 
private funds to identify themselves as such. No other entities would 
incur obligations from the proposed rules and amendments. Accordingly, 
the Commission certifies that proposed rule 203(b)(3)-2 and the 
proposed amendments to rules 203(b)(3)-1, 204-2, 205-3 and Form ADV 
would not have a significant economic impact on a substantial number of 
small entities.
---------------------------------------------------------------------------

    \218\ 15 U.S.C. 80b-3A.
---------------------------------------------------------------------------

    The Commission requests written comments regarding this 
certification. The Commission requests that commenters describe the 
nature of any impact on small businesses and provide empirical data to 
support the extent of the impact.

B. Amendment to Rule 206(4)-2

    The Commission has prepared the following Initial Regulatory 
Flexibility Analysis (``IRFA'') regarding the proposed amendment to 
rule 206(4)-2 in accordance with section 3(a) of the Regulatory 
Flexibility Act.\219\
---------------------------------------------------------------------------

    \219\ 5 U.S.C. 603(a).
---------------------------------------------------------------------------

1. Reasons for Proposed Action
    We propose to amend rule 206(4)-2, the adviser custody rule, to 
accommodate advisers to private funds of funds, including funds of 
hedge funds.\220\ Under the rule, advisers to pooled investment 
vehicles may satisfy their obligation to deliver custody account 
information to investors by distributing the pool's audited financial 
statements to investors within 120 days of the pool's fiscal year-
end.\221\ Some advisers to private funds of funds (including funds of 
hedge funds) have encountered difficulty in obtaining completion of 
their fund audits prior to completion of the audits for the underlying 
funds in which they invest, and as a practical matter will be prevented 
from complying with the 120-day deadline. We propose to extend the 
period for pooled investment vehicles to distribute their audited 
financial statements to their investors from 120 days to 180 days, so 
that advisers to funds of hedge funds may comply with the rule.
---------------------------------------------------------------------------

    \220\ Rule 206(4)-2 [17 CFR 275.206(4)-2].
    \221\ Rule 206(4)-2(b)(3).
---------------------------------------------------------------------------

2. Objectives and Legal Basis
    The objective of the proposed amendment to rule 206(4)-2 is to make 
the rule requirements easier to comply with for advisers to private 
funds of funds such as funds of hedge funds. Section IX of this Release 
lists the statutory authority for the proposed amendment.
3. Small Entities Subject To Rule
    The Commission estimates that as of June 30, 2004,\222\ 
approximately 490 SEC-registered investment advisers that would be 
affected by the amendment to the rule were small entities for purposes 
of the Advisers Act and the Regulatory Flexibility Act.\223\
---------------------------------------------------------------------------

    \222\ This estimate is based on the information provided 
submitted by SEC-registered advisers in Form ADV, Part 1A [17 CFR 
279.1].
    \223\ See Section VIII.A. of this Release for the definition of 
a small entity. Unlike the other rules and amendments the Commission 
is proposing today, the scope of the proposed amendment to rule 
206(4)-2 is not limited to hedge fund advisers that would be subject 
to registration requirements under proposed rule 203(b)(3)-2.
---------------------------------------------------------------------------

4. Reporting, Recordkeeping, and Other Compliance Requirements
    The proposed amendment would impose no new reporting, recordkeeping 
or other compliance requirements. To the contrary, the proposed 
amendment would provide all advisers, big or small, that advise pooled 
investment vehicles with the opportunity to reduce the burdens they 
incur complying with the present rule's requirements to send pools' 
audited financial statements to their investors within 120 days.
5. Duplicative, Overlapping, or Conflicting Federal Rules
    The Commission believes that there are no rules that duplicate, 
overlap, or conflict with the proposed amendment.
6. Significant Alternatives
    The Regulatory Flexibility Act directs the Commission to consider 
significant alternatives that would accomplish the stated objective, 
while minimizing any significant adverse impact on small entities. In 
connection with the proposed rule, the Commission considered the 
following alternatives: (a) The establishment of differing compliance 
or reporting requirements or timetables that take into account the 
resources available to small entities; (b) the clarification, 
consolidation, or simplification of compliance and reporting 
requirements under the rule for such small entities; (c) the use of 
performance rather than design standards; and (d) an exemption from 
coverage of the amendment for such small entities.
    The overall impact of the proposed amendment is to decrease 
regulatory burdens on advisers, and small advisers, as well as large 
ones, will benefit from the proposed rule. Moreover, the proposed 
amendment achieves the rule's objectives through alternatives that are 
already consistent in large part with advisers' current custodial 
practices. For these reasons, alternatives to the proposed amendment 
are unlikely to minimize any impact that the proposed rule may have on 
small entities. The 180-day rule cannot be further clarified, or 
improved by the use of a performance standard. Regarding exemption from 
coverage of the rule amendment, or any part thereof, for small 
entities, such an exemption would deprive small entities of the burden 
relief provided by the amendment.
7. Solicitation of Comments
    We encourage written comments on matters discussed in this IRFA. 
Commenters are asked to describe the nature of any effect and provide 
empirical data supporting the extent of the effect.

IX. Statutory Authority

    We are proposing amendments to rule 203(b)(3)-1 and proposing rule 
203(b)(3)-2 pursuant to our authority under sections 202(a)(17),\224\ 
203, 204, 206(4) and 211(a) of the Advisers Act.\225\ Section 211(a) 
gives us authority to classify, by rule, persons and matters within our 
jurisdiction and to prescribe different requirements for different 
classes of persons, as necessary or appropriate to the exercise of our 
authority under the Act.\226\
---------------------------------------------------------------------------

    \224\ 15 U.S.C. 80b-2(a)(17).
    \225\ 15 U.S.C. 80b-3, 80b-4, 80b-6(4) and 80b-11(a).
    \226\ Section 211(a) also provides that ``the Commission shall 
have authority from time to time to make, issue, amend, and rescind 
such rules and regulations and such orders as are necessary or 
appropriate to the exercise of the functions and powers conferred 
upon the Commission * * *.''
---------------------------------------------------------------------------

    We are proposing amendments to rule 204-2 pursuant to our authority 
under

[[Page 45195]]

sections 204, 206(4), and 211(a) of the Advisers Act.
    We are proposing amendments to rule 205-3 pursuant to the authority 
set forth in section 205(e) and 206A of the Advisers Act.\227\
---------------------------------------------------------------------------

    \227\ 15 U.S.C. 80b-5(e) and 80b-6a.
---------------------------------------------------------------------------

    We are proposing amendments to rule 206(4)-2 pursuant to our 
authority set forth in sections 206(4) and 211(a) of the Advisers Act.
    We are proposing amendments to Form ADV under section 19(a) of the 
Securities Act of 1933,\228\ sections 23(a) and 28(e)(2) of the 
Securities Exchange Act of 1934,\229\ section 319(a) of the Trust 
Indenture Act of 1939,\230\ section 38(a) of the Investment Company Act 
of 1940,\231\ and sections 203(c)(1), 204, and 211(a) of the Investment 
Advisers Act of 1940.\232\
---------------------------------------------------------------------------

    \228\ 15 U.S.C. 77s(a).
    \229\ 15 U.S.C. 78w(a) and 78bb(e)(2).
    \230\ 15 U.S.C. 77sss(a).
    \231\ 15 U.S.C. 78a-37(a).
    \232\ 15 U.S.C. 80b-3(c)(1), 80b-4, and 80b-11(a).
---------------------------------------------------------------------------

Text of Proposed Rule, Rule Amendments and Form Amendments

List of Subjects in 17 CFR Parts 275 and 279

    Investment Advisers, Reporting and recordkeeping requirements, 
Securities.

    For reasons set forth in the preamble, title 17, chapter II of the 
Code of Federal Regulations is proposed to be amended as follows:

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

    1. The general authority citation for Part 275 is revised to read 
as follows:

    Authority: 15 U.S.C. 80b-2(a)(11)(F), 80b-2(a)(17), 80b-3, 80b-
4, 80b-4a, 80b-6(4), 80b-6a, and 80b-11, unless otherwise noted.
* * * * *
    2. Section 275.203(b)(3)-1 is revised to read as follows:


Sec.  275.203(b)(3)-1  Definition of ``client'' of an investment 
adviser.

    Preliminary Note to Sec.  275.203(b)(3)-1. This section is a 
safe harbor and is not intended to specify the exclusive method for 
determining who may be deemed a single client for purposes of 
section 203(b)(3) of the Act. Under paragraph (b)(6) of this 
section, the safe harbor is not available with respect to private 
funds.

    (a) General. You may deem the following to be a single client for 
purposes of section 203(b)(3) of the Act (15 U.S.C. 80b-3(b)(3)):
    (1) A natural person, and:
    (i) Any minor child of the natural person;
    (ii) Any relative, spouse, or relative of the spouse of the natural 
person who has the same principal residence;
    (iii) All accounts of which the natural person and/or the persons 
referred to in this paragraph (a)(1) are the only primary 
beneficiaries; and
    (iv) All trusts of which the natural person and/or the persons 
referred to in this paragraph (a)(1) are the only primary 
beneficiaries;
    (2) (i) A corporation, general partnership, limited partnership, 
limited liability company, trust (other than a trust referred to in 
paragraph (a)(1)(iv) of this section), or other legal organization (any 
of which are referred to hereinafter as a ``legal organization'') to 
which you provide investment advice based on its investment objectives 
rather than the individual investment objectives of its shareholders, 
partners, limited partners, members, other securityholders or 
beneficiaries (any of which are referred to hereinafter as an 
``owner''); and
    (ii) Two or more legal organizations referred to in paragraph 
(a)(2)(i) of this section that have identical owners.
    (b) Special rules. For purposes of this section:
    (1) You must count an owner as a client if you provide investment 
advisory services to the owner separate and apart from the investment 
advisory services you provide to the legal organization, provided, 
however, that the determination that an owner is a client will not 
affect the applicability of this section with regard to any other 
owner;
    (2) You are not required to count an owner as a client solely 
because you, on behalf of the legal organization, offer, promote, or 
sell interests in the legal organization to the owner, or report 
periodically to the owners as a group solely with respect to the 
performance of or plans for the legal organization's assets or similar 
matters;
    (3) A limited partnership or limited liability company is a client 
of any general partner, managing member or other person acting as 
investment adviser to the partnership or limited liability company;
    (4) You are not required to count as a client any person for whom 
you provide investment advisory services without compensation;
    (5) If you have your principal office and place of business outside 
of the United States, you are not required to count clients that are 
not United States residents, but if your principal office and place of 
business is in the United States, you must count all clients; and
    (6) You may not rely on paragraph (a)(2)(i) of this section with 
respect to any private fund as defined in Sec.  275.203(b)(3)-2(d).
    (c) Holding out. If you are relying on this section, you shall not 
be deemed to be holding yourself out generally to the public as an 
investment adviser, within the meaning of section 203(b)(3) of the Act 
(15 U.S.C. 80b-3(b)(3)), solely because you participate in a non-public 
offering of interests in a limited partnership under the Securities Act 
of 1933.
    3. Section 275.203(b)(3)-2 is added to read as follows:


Sec.  275.203(b)(3)-2  Definition of ``client'' for certain private 
funds.

    (a) For purposes of section 203(b)(3) of the Act (15 U.S.C. 80b-
3(b)(3)), you must count the shareholders, limited partners, members, 
other securityholders or beneficiaries (any of which are referred to 
hereinafter as an ``owner'') of a private fund as clients.
    (b) If you provide investment advisory services to a private fund 
in which an investment company registered under the Investment Company 
Act of 1940 (15 U.S.C. 80a-1 to 80a-64) is, directly or indirectly, an 
owner, you must count the owners of that investment company as clients 
for purposes of section 203(b)(3) of the Act (15 U.S.C. 80b-3(b)(3)).
    (c) If both you and the private fund have your principal offices 
and places of business outside the United States, you may treat the 
private fund as your client for all other purposes under the Act, other 
than sections 206(1) and 206(2) (15 U.S.C. 80b-6(1) and (2)).
    (d)(1) A private fund is a company:
    (i) That would be an investment company under section 3(a) of the 
Investment Company Act of 1940 (15 U.S.C. 80a-3(a)) but for the 
exception provided from that definition by either section 3(c)(1) or 
section 3(c)(7) of such Act (15 U.S.C. 80a-3(c)(1) or (7));
    (ii) That permits its owners to redeem any portion of their 
ownership interests within two years of the purchase of such interests; 
and
    (iii) Interests in which are or have been offered based on the 
investment advisory skills, ability or expertise of the investment 
adviser.
    (2) Notwithstanding paragraph (d)(1) of this section, a company is 
not a private fund if it permits its owners to redeem their ownership 
interests within two years of the purchase of such interests only in 
the case of:
    (i) Events you find after reasonable inquiry to be extraordinary 
and unforeseeable at the time the interest was issued; and
    (ii) Interests acquired with reinvested dividends.

[[Page 45196]]

    (3) Notwithstanding paragraph (d)(1) of this section, a company is 
not a private fund if it has its principal office and place of business 
outside the United States, makes a public offering of its securities in 
a country other than the United States, and is regulated as a public 
investment company under the laws of the country other than the United 
States.
    4. Section 275.204-2 is amended by:
    (a) Redesignating paragraph (e)(3) as (e)(3(i); and
    (b) Adding paragraphs (e)(3)(ii) and (l).
    The additions read as follows:


Sec.  275.204-2  Books and records to be maintained by investment 
advisers.

* * * * *
    (e) * * *
    (3)(i) * * *
    (ii) Transition rule. If you are an investment adviser to a private 
fund as that term is defined in Sec.  275.203(b)(3)-2, and you were 
exempt from registration under section 203(b)(3) of the Act (15 U.S.C. 
80b-3(b)(3)) prior to [insert effective date of the final Sec.  
275.203(b)(3)-2], paragraph (e)(3)(i) of this section does not require 
you to maintain or preserve books and records that would otherwise be 
required to be maintained or preserved under the provisions of 
paragraph (a)(16) of this section to the extent those books and records 
pertain to the performance or rate of return of such private fund for 
any period ended prior to [insert effective date of the final Sec.  
275.203(b)(3)-2], provided that you were not registered with the 
Commission as an investment adviser during such period, and provided 
further that you continue to preserve any books and records in your 
possession that pertain to the performance or rate of return of such 
private fund for such period.
* * * * *
    (1) Records of private funds. If an investment adviser subject to 
paragraph (a) of this section advises a private fund (as defined in 
Sec.  275.203(b)(3)-2(d)), and the adviser or any related person (as 
defined in Form ADV [17 CFR 279.1]) of the adviser acts as the private 
fund's general partner, managing member, or in a comparable capacity, 
the books and records of the private fund are records of the adviser 
for purposes of section 204 of the Act [15 U.S.C. 80b-4].
    5. Section 275.205-3 is amended by redesignating paragraph (c) as 
(c)(1) and adding paragraph (c)(2) to read as follows:


Sec.  275.205-3  Exemption from the compensation prohibition of section 
205(a)(1) for registered investment advisers.

* * * * *
    (c)(1) * * *
    (2) Private funds. If you are an investment adviser to a private 
investment company that is a private fund as that term is defined in 
Sec.  275.203(b)(3)-2, and you were exempt from registration under 
section 203(b)(3) of the Act [15 U.S.C. 80b-3(b)(3)] prior to [insert 
effective date of the final Sec.  275.203(b)(3)-2], paragraph (b) of 
this section will not apply to any equity owner of that company that 
was an equity owner of that company prior to [insert effective date of 
the final Sec.  275.203(b)(3)-2].
* * * * *
    6. Section 275.206(4)-2 is amended by revising paragraph (b)(3) to 
read as:


Sec.  275.206(4)-2  Custody of funds or securities of clients by 
investment advisers.

* * * * *
    (b) * * *
    (3) Limited partnerships subject to annual audit. You are not 
required to comply with paragraph (a)(3) of this section with respect 
to the account of a limited partnership (or limited liability company, 
or another type of pooled investment vehicle) that is subject to audit 
(as defined in section 2(d) of Article 1 of Regulation S-X (17 CFR 
210.1-02(d)) at least annually and distributes its audited financial 
statements prepared in accordance with generally accepted accounting 
principles to all limited partners (or members or other beneficial 
owners) within 180 days of the end of its fiscal year; and
* * * * *

PART 279--FORMS PRESCRIBED UNDER THE INVESTMENT ADVISERS ACT OF 
1940

    7. The authority citation for Part 279 continues to read as 
follows:

    Authority: The Investment Advisers Act of 1940, 15 U.S.C. 80b-1, 
et seq.

    8. Form ADV (referenced in Sec.  279.1) is amended by:
    a. In Part 1A, Item 7, revising Item 7B; and
    b. In Schedule D, revising Section 7.B.
    The revisions read as follows:

    Note: The text of Form ADV does not and this amendment will not 
appear in the Code of Federal Regulations.

Form ADV
* * * * *
Part 1A
* * * * *
Item 7 Financial Industry Affiliations
* * * * *
    B. Are you or any related person a general partner in an 
investment-related limited partnership or manager of an investment-
related limited liability company, or do you advise any other ``private 
fund,'' as defined under SEC rule 203(b)(3)-2?

[ballot] Yes [ballot] No

    If ``yes,'' for each limited partnership, limited liability 
company, or (if applicable) private fund, complete Section 7.B. of 
Schedule D. If, however, you are an SEC-registered adviser and you have 
related persons that are SEC-registered advisers who are the general 
partners of limited partnerships or the managers of limited liability 
companies, you do not have to complete Section 7.B. of Schedule D with 
respect to those related advisers' limited partnerships or limited 
liability companies.
    To use this alternative procedure, you must state in the 
Miscellaneous Section of Schedule D: (1) That you have related SEC-
registered investment advisers that manage limited partnerships or 
limited liability companies that are not listed in Section 7.B. of your 
Schedule D; (2) that complete and accurate information about those 
limited partnerships or limited liability companies is available in 
Section 7.B. of Schedule D of the Form ADVs of your related SEC-
registered advisers; and (3) whether your clients are solicited to 
invest in any of those limited partnerships or limited liability 
companies.
* * * * *
Schedule D
* * * * *
SECTION 7.B. Limited Partnership or Other Private Fund Participation
    You must complete a separate Schedule D Page 4 for each limited 
partnership in which you or a related person is a general partner, each 
limited liability company for which you or a related person is a 
manager, and each other private fund that you advise.
    Check only one box:
[ballot] Add [ballot] Delete [ballot] Amend
    Name of Limited Partnership, Limited Liability Company, or other 
Private Fund:
-----------------------------------------------------------------------

    Name of General Partner or Manager:
-----------------------------------------------------------------------

    If you are registered or registering with the SEC, is this a 
``private fund'' as defined under SEC rule 203(b)(3)-2?
[ballot] Yes [ballot] No

    Are your clients solicited to invest in the limited partnership, 
limited liability company or other private fund?


[[Page 45197]]


[ballot] Yes [ballot] No
    Approximately what percentage of your clients have invested in this 
limited partnership, limited liability company, or other private 
fund?------%
    Minimum investment commitment required of a limited partner, 
member, or other investor: $----------
    Current value of the total assets of the limited partnership, 
limited liability company, or other private fund: $----------


    Dated: July 20, 2004.

    By the Commission.
Jill M. Peterson,
Assistant Secretary.

Dissent of Commissioners Cynthia A. Glassman and Paul S. Atkins to 
Proposing Release No. IA-2266; Proposed Registration Under the Advisers 
Act of Certain Hedge Fund Advisers

    The majority proposes a new rule and rule amendments under the 
Investment Advisers Act of 1940 that would require advisers to all 
hedge funds to register with the Commission.\1\ We write jointly to 
dissent from this proposal. Our primary purpose in writing this 
dissent is to encourage commenters to respond to the issues 
discussed in the Proposing Release and to address the numerous 
issues that the release does not raise.
---------------------------------------------------------------------------

    \1\ The term ``hedge fund'' generally refers to an unregistered 
pooled investment, privately organized, not advertised, and 
administered by professional investment managers, whose securities 
are privately placed with wealthy individual and institutional 
investors. See generally Implications of the Growth of Hedge Funds, 
Staff Report to the United States Securities and Exchange 
Commission, at 3 (available at http://www.sec.gov/ spotlight/
hedgefunds.htm) (``2003 Staff Hedge Fund Report'').
---------------------------------------------------------------------------

    The majority proposes a solution to an ill-defined problem 
without having given proper consideration to viable alternative 
solutions in light of the limitations of our own capabilities. We 
acknowledge that the Commission does not know everything it would 
like to about hedge funds and hedge fund advisers. Mandatory 
registration of hedge fund advisers under the Advisers Act would not 
fill in these information gaps, but would significantly increase 
industry and Commission burdens. We are confident that there are 
other ways of obtaining information that would help us with our 
investor protection mission. However, before attempting a systematic 
collection of information, we must determine what information we 
want or need. We hope that commenters can provide us guidance about 
the types of useful information that would assist the Commission in 
discovering and deterring hedge fund fraud.

Hedge Funds Have Long Been the Subject of SEC Study

    As the Proposing Release points out, the Commission has been 
studying hedge funds since the 1960s.\2\ As recently as 1992, in 
response to a Congressional inquiry, the Commission's staff 
discussed the ``difficulties'' that unregulated advisers pose to our 
enforcement efforts.\3\ The report concluded ``the Commission has 
substantial powers to obtain information for enforcement purposes, 
including the power to compel testimony and document production.'' 
\4\ Further, the report noted that ``the purpose of regulation is to 
protect investors, not to simplify investigations'' and ``the 
potential need to obtain information from hedge funds for 
enforcement purposes would not seem to be an adequate reason for 
registration.'' \5\ Seven years later, the President's Working Group 
on Financial Markets, of which the Commission is a member, issued a 
report after the near collapse of Long Term Capital Management.\6\ 
This report concluded ``requiring hedge fund managers to register as 
investment advisers would not seem to be an appropriate method to 
monitor hedge fund activity.'' \7\
---------------------------------------------------------------------------

    \2\ See Proposing Release, at n. 24 and accompanying text.
    \3\ See Letter from Richard C. Breeden, Chairman, SEC, to Edward 
J. Markey, Chairman, Subcommittee on Telecommunications and Finance, 
Committee on Energy and Commerce, U.S. House of Representatives 
(June 12, 1992), transmitting Memorandum from William H. Heyman, 
Director, Division of Market Regulation, and Marianne K. Smythe, 
Director, Division of Investment Management, to Chairman Breeden, 
regarding Hedge Funds, at 10 (available at SEC's public reference 
room under file no. S7-30-04).
    \4\ Id. at 10.
    \5\ Id. at 10.
    \6\ See Hedge Funds, Leverage, and the Lessons of Long-Term 
Capital Management--Report of the President's Working Group on 
Financial Markets, by representatives from the Commission, the 
Treasury Department, the Federal Reserve and the Commodity Futures 
Trading Commission (Apr. 1999) (available at: http://www.treas.gov/press/releases/reports/hedgfund.pdf) (``PWG LTCM Report'').
    \7\ Id. at B-16.
---------------------------------------------------------------------------

    Last year, however, our staff, after conducting another study of 
the hedge fund industry, issued a report that recommended, among 
other things, that the Commission consider requiring hedge fund 
managers to register as investment advisers under the Advisers 
Act.\8\ This report was the culmination of a study that the 
Commission authorized the staff to conduct in June 2002 in order to 
determine the necessity of new rules or legislation for hedge 
funds.\9\ The Commission gave the staff subpoena power to ensure 
that it could obtain the information that it needed. Of particular 
concern was whether hedge funds were becoming ``retailized'' and 
whether the growth in hedge funds was accompanied by a 
disproportionate incidence of fraud.
---------------------------------------------------------------------------

    \8\ 2003 Staff Hedge Fund Report, supra note 1.
    \9\ The objective of the study was to aid the Commission in 
determining whether regulatory or legislative changes were necessary 
to respond to the growth in hedge funds. Commission staff reviewed 
documents and information from 65 hedge fund advisers managing more 
than 650 different hedge funds, visited hedge fund advisers and 
prime brokers, and conducted a series of examinations of registered 
funds of hedge funds. See 2003 Staff Hedge Fund Report, supra note 
1, at vii.
---------------------------------------------------------------------------

    The 2003 Staff Hedge Fund Report found no retailization and no 
significant increase in fraud. These conclusions were consistent 
with the views expressed at the Commission's May 2003 roundtable, at 
which 60 panelists, including representatives of Federal, State and 
foreign government regulators, securities industry professionals, 
and academics testified. Notwith-standing these findings, the staff 
recommended registering hedge fund advisers. The Proposing Release 
fails to make a convincing case that this change from the 
President's Working Group position, supported by the Commission four 
years earlier, is warranted. It dismisses the conclusion in the PWG 
LTCM Report on the basis that the Report and the Proposing Release 
serve ``different purposes.'' \10\ Nonetheless, the Proposing 
Release cites as a concern underlying the proposed rulemaking the 
very anomalies and marketplace risks that were a central focus of 
the PWG LTCM Report.\11\
---------------------------------------------------------------------------

    \10\ See Proposing Release at text following n. 32.
    \11\ See Proposing Release at text accompanying nn. 38 and 39. 
The majority speaks ominously of the fact that certain hedge fund 
managers are active traders, but this just indicates their important 
role in providing liquidity. See Proposing Release at n. 38 and 
accompanying text (citing Marcia Vickers, The Most Powerful Trader 
on Wall Street You've Never Heard Of, Business Week, July 21, 2003, 
at 66 (noting that SAC Capital Advisors ``routinely accounts for as 
much as 3% of the New York Stock Exchange's average daily trading, 
plus up to 1% of the NASDAQ's'')). Federal Reserve Chairman Alan 
Greenspan explained the important role hedge funds can play. Alan 
Greenspan, Chairman, Federal Reserve Board, Testimony before the 
Senate Banking, Housing And Urban Affairs Committee (Feb. 12, 2004) 
(``Greenspan Testimony'') (``The value that these institutions have 
is to create a very significant amount of liquidity in our system, 
and I think that while they have a reputation of being a sort of 
peculiar type of financial group, I think they've been very helpful 
to the liquidity and, hence, the international flexibility of our 
financial system.'').
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Registration Will Not Reduce Enforcement Actions

    In support of its proposal, the majority cites Commission 
enforcement actions. First, it notes that the Commission has brought 
46 enforcement actions in the past five years in which hedge fund 
advisers have defrauded hedge fund investors or used a hedge fund to 
defraud others. By comparison, the Commission initiated 
approximately 2,600 enforcement actions during fiscal years 1999 
through 2003.\12\ As the staff's 2003 Hedge Fund Report states, 
there is ``no evidence indicating that hedge funds or their advisers 
engage disproportionately in fraudulent activity.'' \13\
---------------------------------------------------------------------------

    \12\ See Securities and Exchange Commission, 2002 Annual Report 
at 2, and 2003 Annual Report at 17 (reporting number of civil 
injunctive actions and administrative proceedings initiated during 
fiscal years 1999 through 2003).
    \13\ See 2003 Staff Hedge Fund Report, supra note 1, at 73.
---------------------------------------------------------------------------

    Even assuming that the number of hedge fund cases is rising 
disproportionately, the nature of the cases suggests that 
registration of hedge fund advisers will not stem the increase. The 
46 cases suggest that the typical ``hedge fund'' fraud is 
perpetrated by an adviser that is too small to be registered with 
the Commission, was registered already with the Commission, or 
evaded registration

[[Page 45198]]

requirements.\14\ Mandatory hedge fund adviser registration would 
not add to the Commission's ability to combat these types of 
fraud.\15\ Importantly, the majority's recitation of these fraud 
cases illustrates the fact that hedge fund advisers are subject to 
the antifraud provisions regardless of their registration status.
---------------------------------------------------------------------------

    \14\ Specifically, 8 of these 46 cases involve hedge fund 
advisers who were already registered with the Commission. In 5 of 
the 46 cases, the fund should have been registered under the 
Investment Company Act, so their advisers already should have been 
registered under current rules. In 20 of the 46 cases, the hedge 
funds were too small to be covered by the proposed rulemaking. In 2 
cases, the fraud involved a principal of a registered broker-dealer 
or investment adviser, over whom we already had full regulatory 
oversight. Three of the 46 cases were garden-variety fraud designed 
to swindle investors, regardless of whether the vehicles were called 
hedge funds, venture capital funds, limited partnerships or prime 
banks. Registration might have deterred them from using the term 
``hedge fund,'' but would not have deterred the fraud itself.
    \15\ In only 8 of the 46 cases the existence of the rule might 
have increased in the Commission's oversight. These 8 cases, 
however, do not justify the proposed rulemaking. Most involve 
valuation problems, which have been notoriously difficult for us to 
detect even if the adviser is registered. In addition, only 
perfectly timed inspections would have improved the Commission's 
detection of the frauds at issue. With respect to all advisers, 
registered or unregistered, tips from knowledgeable insiders or 
third parties are often the key to discovering the fraud. Indeed, 
tips pointed us to the fraud in 7 of the 8 remaining cases.
---------------------------------------------------------------------------

    To substantiate requiring registration, the majority also points 
to the recent market timing and late trading scandal in the 
investment company industry in which some hedge funds were 
implicated. The majority posits that had our examiners been 
inspecting the hedge funds, they would have found these abuses 
sooner. But mutual funds and their advisers are registered, and 
examiners were inspecting the mutual funds involved in the scandals 
and did not find the abuses. We have been and are continuing to 
punish fund advisers and their employees for orchestrating these 
schemes.\16\ Although our enforcement actions have been targeted 
primarily at the regulated advisers of mutual funds, hedge fund 
advisers are also answerable--and will be punished--for their 
violations of the securities laws.\17\ In addition to our 
enforcement actions, we have adopted certain regulatory measures 
\18\ and are considering others to address any underlying, 
widespread problems.\19\ We should revisit our oversight methods 
rather than looking for more entities to inspect. For example, had 
we reviewed mutual funds' flow data and understood how to extract 
the relevant information, we might have discerned these abusive 
practices.
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    \16\ See, e.g., In the Matter of Alliance Capital Management, 
L.P., Investment Advisers Act Release No. 2205 (Dec. 18, 2003); In 
the Matter of Banc One Investment Advisors Corporation and Mark A. 
Beeson, Investment Advisers Act Release No. 2254 (June 29, 2004); In 
the Matter of James Patrick Connelly, Jr., Investment Advisers Act 
Release No. 2183 (Oct. 16, 2003); In the Matter of Pilgrim Baxter & 
Associates, Ltd., Investment Advisers Act Release No. 2251 (June 21, 
2004); In the Matter of Strong Capital Management, Inc., Investment 
Advisers Act Release No. 2239 (May 20, 2004); SEC v. Security Trust 
Co., N.A., Litigation Release No. 18653 (Apr. 1, 2004); In the 
Matter of Steven B. Markovitz, Release No. 33-8298 (Oct. 2, 2003).
    \17\ The Proposing Release states that the staff has identified 
up to 40 hedge funds that have been involved in the Commission's 
late trading and market timing actions. See Proposing Release at n. 
44 and accompanying text. The reliance on this information to 
substantiate the proposal is unwarranted. The majority never counted 
the number of hedge fund advisers, the entities it proposes to 
register. We estimate that the number of advisers involved with 
these funds would have been approximately half. In addition, it is 
unclear at this point how many of the advisers to these 40 funds 
actually violated the securities laws.
    \18\ See, e.g., Disclosure Regarding Market Timing and Selective 
Disclosure of Portfolio Holdings, Investment Company Act Release No. 
26418 (Apr. 16, 2004) [69 FR 22299 (Apr. 23, 2004)] and Compliance 
Programs of Investment Companies and Investment Advisers, Investment 
Advisers Act Release No. 2204 (Dec. 17, 2003) [68 FR 74713 (Dec. 24, 
2003)].
    \19\ See, e.g., Amendments to Rules Governing Pricing of Mutual 
Fund Shares, Investment Company Act Release No. 26288 (Dec. 11, 
2003) [68 FR 70387 (Dec. 17, 2003)].
---------------------------------------------------------------------------

Form ADV Does Not Meet the Information ``Needs'' Articulated by the 
Majority

    The majority believes that the information that hedge fund 
advisers will provide on Form ADV could otherwise only be obtained 
through ``substantial forensic efforts on the part of our staff.'' 
\20\ Without considerable further amendment, information filed on 
Form ADV will not provide the details about hedge fund advisers that 
the majority suggests it needs to assist the Commission in 
addressing the concerns that the majority refers to in the 
release.\21\ Part I of Form ADV yields little more than a census of 
name, address, and amount of assets under management. Part II of 
Form ADV, although more substantive, is unlikely to produce 
information that would prove useful to the Commission because hedge 
fund advisers will feel compelled to draft their disclosure to 
protect proprietary information. Perhaps it is proponents' 
realization that the Form ADV may not provide all the information 
they need that causes them to characterize the proposal to require 
hedge fund advisers to register as a modest first step. This begs 
the question of what this is a first step towards.\22\
---------------------------------------------------------------------------

    \20\ See Proposing Release at text following n. 70.
    \21\ Form ADV and its instructions are available at http://www.sec.gov/about/forms/formadv.pdf.
    \22\ The staff recommended one possible next step. See 2003 
Hedge Fund Staff Report, supra note 1, at 97 (recommending that 
Commission consider requiring advisers to provide a brochure 
specifically designed for hedge funds).
---------------------------------------------------------------------------

No Evidence of Significant Retailization

    The majority contends that the retailization of hedge funds is a 
growing problem. They assert that as more investors qualify as 
accredited investors, unsophisticated investors might be gaining 
inappropriate access to hedge funds. Adjustments to the eligibility 
criteria would address concerns about potential retailization more 
directly than hedge fund adviser registration.\23\
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    \23\ This would directly address the staff's concern that 
although it ``has not uncovered evidence of significant numbers of 
retail investors investing directly in hedge funds,'' 
``[n]evertheless, the increased number of retail investors 
qualifying as accredited investors raises our concern that hedge 
funds and broker-dealers might begin to seek out these investors as 
a new source of capital for hedge funds.'' See 2003 Staff Hedge Fund 
Report, supra note 1, at 80-81. If, as the majority suggests, there 
are an excess of investor dollars waiting to flow into hedge funds, 
then it is unclear why hedge funds would need to look to retail 
investors. See From Alpha to Omega; Hedge Funds, ECONOMIST, July 17, 
2004 (``[M]any of the oldest and best-known hedge funds will not 
accept any new money'' because ``[f]or many trading strategies * * * 
there is a limit to the amount of money that can be moved around 
cheaply and briskly. While punting large amounts on the highly 
liquid foreign-exchange or government-bond markets is easy, betting 
on illiquid corporate bonds or shares is far harder. And the larger 
the amounts, the more expensive the bets are.'').
---------------------------------------------------------------------------

    The majority also points to indirect retailization through 
pension fund investments in hedge funds.\24\ The proposing release 
cites an increase in pension investments and hedge funds from $13 
billion to $72 billion since 1997.\25\ This amount is approximately 
one percent of the total amount invested in private and public 
pension plans.\26\ Despite the small portion of pension assets 
invested in hedge funds, the Proposing Release assumes that pension 
plan participants' financial well-being depends on Commission 
protection. Pension plan participants rely on professional money 
managers, who are fiduciaries of the pension plans, to evaluate 
investment options on behalf of the plan. Further, pension funds 
fall under either the oversight of either the Department of Labor 
or, in the case of public funds, state oversight.
---------------------------------------------------------------------------

    \24\ The majority also expresses concern about an increase in 
hedge fund investment by universities, endowments, foundations, and 
other charitable organizations because ``[l]osses resulting from 
hedge fund investments, as with any other investment loss, may 
affect the entities' ability to satisfy their obligations to their 
beneficiaries or pursue other intended purposes.'' See Proposing 
Release at text following n. 57. We applaud the majority's concern 
for the nation's educational and charitable institutions, but these 
organizations hire experienced money managers to invest their money 
in a way that maximizes the ability of those organizations to carry 
out their objectives.
    \25\ See Proposing Release at text accompanying n. 60.
    \26\ See Board of Governors of the Federal Reserve System, 
Federal Reserve Statistical Release: Flow of Funds Accounts of the 
United States (June 10, 2004) (reporting for year 2003, $4.21 
trillion in private pension fund reserves and $2.21 trillion in 
public pension fund reserves).
---------------------------------------------------------------------------

    Similarly, the majority points to creeping retailization through 
publicly-offered funds of hedge funds, noting that currently ``there 
are 40 registered funds of hedge funds that offer or plan to offer 
their shares publicly.'' \27\ However, these publicly-offered funds 
must be managed by a registered investment adviser and the fund must 
also comply with the more prescriptive provisions of the Investment 
Company Act. The Commission is able to examine registered advisers 
to registered funds of hedge funds as often as it deems appropriate. 
The Commission may ask for additional information from a registered 
adviser. It is therefore unclear how mandatory hedge fund adviser 
registration

[[Page 45199]]

would be helpful in this context. However, if the Commission can 
demonstrate that publicly-offered funds of hedge funds pose real 
undisclosed risks to retail investors, the Commission could consider 
whether the problem can be addressed by reversing past regulatory 
actions that have permitted these funds of hedge funds to be 
publicly offered.
---------------------------------------------------------------------------

    \27\ See Proposing Release at text accompanying n. 54.
---------------------------------------------------------------------------

Scope of the Proposed Rule

    The majority's proposal would reach fund advisers that advise 
``private funds,'' which it defines as funds that: (1) Would be 
subject to regulation under the Investment Company Act of 1940 but 
for the exception provided in either section 3(c)(1) or section 
3(c)(7) of the Act; (2) permit investors to redeem their interests 
in the fund within two years of purchasing them; and (3) interests 
in which are or have been offered based on the investment advisory 
skills, ability or expertise of the investment adviser. We question 
whether the two year lock-up will simply cause hedge fund advisers 
to lengthen their redemption periods, which would not benefit 
investors. Further, the majority points to valuation as one of the 
problems that the proposed rulemaking would address.\28\ If 
valuation concerns are motivating the push for hedge fund 
registration, we should have the same concerns about private equity 
and venture capital funds.\29\
---------------------------------------------------------------------------

    \28\ The Proposing Release cites a recent study finding 
valuation problems in hedge funds, and noted that ``the authors 
attribute these failures, in part, to a lack of regulatory 
oversight.'' See Proposing Release at n. 83 and accompanying text 
(citing Christopher Kundro and Stuart Feffer, Valuation Issues and 
Operational Risk in Hedge Funds, Capco White Paper (Dec. 2003)). The 
article does not call for enhanced government regulation, but for 
more rigorous internal valuation procedures with adequate managerial 
supervision and, when necessary, utilization of third-party pricing 
services. See id. at 8-9.
    \29\ Probate and taxation of investors' estates, financing 
transactions based on balance sheet assets, marketing to investors 
of follow-on funds, and secondary sales of investment interests all 
raise potential valuation issues for private equity and venture 
funds.
---------------------------------------------------------------------------

Costs of Registration

    The proposing release seeks to minimize the burden of 
registration.\30\ It downplays the complexities involved in 
registering as an investment adviser. Although proponents seem to 
believe that, even under the current regulatory regime, Advisers Act 
registration is the only choice for legitimate advisers,\31\ there 
is no indication that advisers undertake the process of registration 
lightly.\32\ While the burden of this first step is likely to exceed 
the majority's expectations, future, more substantive regulation may 
bring even higher costs, such as the stifling of hedge funds' 
ability to carry out their business.\33\
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    \30\ The majority estimated filing fees of approximately $1,000 
in the first year and approximately $500 subsequently. In addition, 
the majority estimated average initial compliance costs of $20,000 
in professional fees and $25,000 in internal costs including staff 
time. See Proposing Release at Section IV.B. At the same time the 
majority characterizes the costs associated with hedge fund adviser 
registration as small, it contends that the proposal will level the 
playing field among hedge fund advisers. See Proposing Release at 
IV.A.5.a.. A level playing field already exists; hedge fund advisers 
can decide to register and, if registration is important to 
investors, the market will reward registered advisers. Others 
suggest that hedge funds have an unfair advantage over mutual funds. 
This is not the only area in which the Commission permits a mix of 
unregistered and registered products in order to enhance investors' 
options without compromising investor protection. Rule 144A [17 CFR 
230.144A] private offerings, for example, exist alongside public 
offerings.
    \31\ Indeed, underlying this proposal is an apparent belief that 
advisers that are willing to register are better than those who do 
not. See William Donaldson, Chairman, Securities and Exchange 
Commission, Testimony before the Senate Banking Committee (July 18, 
2004) (``I don't get much push back from people who are operating 
good funds,'' he said. ``I don't get much push back from people who 
have nothing to hide.'').
    \32\ Adviser registration already carries with it certain 
substantive requirements, including adherence to rule 206(4)-6 [17 
CFR 275.206(4)-6], the proxy voting rule, and rule 206(4)-7 [17 CFR 
275.206(4)-7], the compliance rule. More generally, as with any 
disclosure document, Forms ADV can serve as the basis for a 
litigation against an adviser, so they are prepared with great care 
and often costly legal advice.
    \33\ Federal Reserve Chairman Alan Greenspan warned of the 
likelihood of substantive regulation following registration. See 
Greenspan Testimony, supra note 11. (``I grant you that registering 
advisers in and of itself is not a problem. The question is: What is 
the purpose of that unless you're going to go further? And therefore 
I feel uncomfortable about that issue.'').
---------------------------------------------------------------------------

    It is far from certain that the oversight afforded through 
registration under the Advisers Act will reduce hedge fund investor 
fraud losses. By contrast, it is certain that fund investors will 
bear the cost of the additional regulations.\34\ The information 
collected on Form ADV will not be a sufficient basis for hedge fund 
advisers' investment decisions; hedge fund investors will continue 
to do their own research to supplement this information.
---------------------------------------------------------------------------

    \34\ The majority argues that all investors, regardless of their 
wealth, deserve the protection of the Investment Advisers Act. See 
Proposing Release at nn. 15-17. Wealthy investors might not want or 
need the same level of protection. They often employ well-trained 
professionals to select investments appropriate for them. If they 
desire the comfort afforded by a more rigorous regulatory regime, 
they may select mutual funds or other investments managed by 
advisers registered with the Commission or rely on a registered 
investment adviser to invest their money for them. Thus, the 
majority should view the benefit of enhanced protection for wealthy 
investors against the costs, including limitations on their 
investment options and potentially higher fees. See, Erik J. 
Greupner, Comment, Hedge Funds Are Headed Down-market: A Call for 
Increased Regulation?, 40 SAN DIEGO L. REV. 1555, 1578 (2003) 
(``[R]egulatory action aimed at eliminating every vestige of fraud 
in a given market would place such a heavy and costly burden of 
compliance upon issuers that investors would be safe but unable to 
achieve any meaningful return on their investments. The regulatory 
agency would also incur a high cost of enforcement. Carried to its 
logical end, investor protection as a sole reason for regulation, 
without also granting markets the freedom to reward those who take 
risk, ironically keeps investors safe and yet fails to fully protect 
the investors' sole interest in investing in the first instance: to 
achieve the highest return commensurate with their individual 
tolerance for risk.'').
---------------------------------------------------------------------------

    Even apart from the Form ADV discussion, the majority discounts 
the fact that registration implies inspection. Effective inspection 
of all hedge fund advisers will require the Commission to invest 
substantial resources and expertise that it does not yet have. 
Targeted exams will not necessarily be less burdensome than routine 
exams either for the Commission or for those advisers inspected. If 
we fail to devote adequate resources and develop the necessary 
expertise to carry out effective risk-based examinations, we are 
providing a false sense of security by suggesting to the marketplace 
that, through registration, we have bathed hedge funds in 
``sunlight.''
    The majority ignores the opportunity costs of its proposal. The 
Commission does not have unlimited resources. Resources we devote to 
regulating hedge fund advisers are resources that we could be 
devoting to other, perhaps higher, priorities. It is abundantly 
clear from recent events that we have more work to do in other, more 
traditional, areas under our jurisdiction.\35\ Would investors be 
better served if we devoted our additional resources to more 
effective regulation of mutual funds, the investment of choice for 
over ninety million Americans, as opposed to hedge funds, whose 
direct investors are limited to institutions and an estimated 
200,000 sophisticated high net worth investors? The Commission is 
moving away from routine inspections and towards a risk-based 
inspections system. The majority views hedge fund advisers as ideal 
candidates for the risk-based approach.\36\ As the Commission 
determines what it is looking for, hedge fund advisers may face 
repeated, ad-hoc requests for paper and electronic documents. Such 
an approach cannot be deemed to be ``modest.''
---------------------------------------------------------------------------

    \35\ The majority contends that hedge fund advisers fall within 
our traditional jurisdiction, but for the safe harbor provision in 
rule 203(b)(3)-1 [17 CFR 275.203(b)(3)-1 (``A limited partnership is 
a client of any general partner or other person acting as investment 
adviser to the partnership'')]. See Proposing Release at text 
accompanying n. 119. We disagree with the majority's suggestion that 
rule 203(b)(3)-1 conflicts with the spirit of section 208(d) of the 
Act, which prohibits a person from doing indirectly or through 
another person something that would be unlawful for the person to do 
directly. See Definition of ``Client'' of Investment Adviser for 
Certain Purposes Relating to Limited Partnerships, Investment 
Advisers Act Release No. 956 (Feb 22, 1985) (when the Commission 
proposed rule 203(b)(3)-1, it explained that the rule's availability 
is limited ``to situations where the general partner advises the 
partnership based on the investment objectives of the limited 
partners as a group'' to ``prevent a general partner, in 
contravention of section 208(d) of the Advisers Act, from using the 
partnership to do what it could not do directly itself, namely, 
provide individualized investment advice to 15 or more clients 
without registering as an investment adviser''). Hedge fund advisers 
provide advice to hedge fund investors as a group, not individually, 
and, therefore, they should not be deemed to be managing the assets 
of more than 14 persons in contravention of the Act.
    \36\ Absent clearly identified red flags, we are concerned that 
high performance will likely invite extra Commission scrutiny.
---------------------------------------------------------------------------

The Commission Should Explore Alternative Approaches

    Before making this proposal, the Commission should have 
undertaken a study that complements the descriptive overview of

[[Page 45200]]

hedge funds provided by the 2003 Staff Hedge Fund Report and focuses 
on identifying the qualitative and quantitative information that 
would raise red flags and provide systematic data on hedge fund 
trends and practices. Although speed of implementation seems to be 
of great concern to the majority, the Commission can defer 
consideration of adoption of the proposal pending the completion of 
such an analysis.
    This study would include a survey of hedge funds, hedge fund 
investors, prime brokers, bank lenders and auditors and other 
relevant sources. The Commission should also review the vast array 
of data that the Commission and other government agencies already 
receive.\37\ The Commission can glean additional information from 
investor complaints, examinations of prime brokers and registered 
hedge fund advisers, and in hedge fund enforcement cases. Another 
source of information may be hedge funds' filings under the USA 
Patriot Act.\38\ After completing such a study, we could consider 
whether to require hedge fund advisers to file periodically certain 
information, which we could then monitor for red flags and 
trends.\39\
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    \37\ Systemic risk issues are properly addressed jointly with 
the Treasury and the Federal Reserve. As Federal Reserve Chairman 
Alan Greenspan has stated, hedge funds have ``been very helpful to 
the liquidity and hence the international flexibility of our 
financial system.'' Greenspan testimony, supra note 11. If well-
meaning, but ineffective regulation inhibits hedge funds from 
performing their important function of lubricating our financial 
system, it could have a negative effect on our economy. The Chairman 
of the CFTC has expressed a desire for cooperation across agencies. 
See CFTC Chairman James Newsome, Financial Times, 5 April 2004 
(``But my concern is that before any regulatory agency drives 
specific rules, you have to remember that hedge funds run across 
multiple jurisdictions. So I would suggest that the [President's] 
working group is the appropriate mechanism because that group takes 
the broader context.'').
    \38\ See Anti-Money Laundering Programs for Unregistered 
Investment Companies, 67 FR 60617 (Sept. 26, 2002) (proposing to 
require, among other things, that unregistered investment companies 
file a notice containing certain basic information with the 
Department of Treasury's Financial Crimes Enforcement Network).
    \39\ Proponents tend to paint the proposed approach as little 
more than a notice filing approach. We suspect that many advisers 
already regulated under the Advisers Act would not share that view.
---------------------------------------------------------------------------

    If the data point us to specific problems with hedge funds, we 
may be able to work with prime brokers, which are already registered 
with the Commission, to develop solutions. The Proposing Release 
does not even ask any questions about the role that prime brokers 
can play, even though prime brokers have already helped us to 
identify some fraudulent activity at hedge funds.

Request for Comment

    We urge commenters to address the following questions and any 
other issues raised here and in the Proposing Release.
     What are the concerns with respect to hedge funds that 
we should be addressing through rulemaking?
     Would approaches other than hedge fund registration be 
effective in addressing the concerns raised by the majority? Should 
we, for example, adjust the eligibility criteria for hedge fund 
investors? If so, what should the revised criteria be? For example, 
should we devise another definition of ``accredited investor'' that 
differs from that we employ for Regulation D purposes? Would a 
notice filing and reporting regime be a better alternative to 
Advisers Act registration? Are there more effective ways of 
addressing valuation? What measures could we take to enlist prime 
brokers in identifying valuation problems, fraud, and other red 
flags at hedge funds?
     What effect will universal registration have on 
investor demand for hedge fund investment opportunities? Would the 
registration of all hedge fund advisers expand the universe of 
eligible hedge funds and encourage even more pension fund investment 
in hedge funds? Would universal registration lead to calls for a 
reduction in eligibility criteria for investors because of a belief 
that registration enhances safety? \40\
---------------------------------------------------------------------------

    \40\ As the Proposing Release points out, in some other 
countries, there is pressure to open up hedge funds, subject to 
certain regulations, to a wider range of investors. See Proposing 
Release at n. 52.
---------------------------------------------------------------------------

     Is there a justifiable basis for distinguishing between 
the advisers covered by the proposed rulemaking and advisers to 
venture capital and private equity funds? \41\ Are there risks that 
are peculiar to hedge fund advisers?
---------------------------------------------------------------------------

    \41\ The majority distinguishes them by noting that, despite 
similarities, ``we have not encountered significant enforcement 
problems with advisers with respect to their management of these 
types of funds.'' See Proposing Release at text accompanying notes 
142 through 144. The majority links the higher incidence of abuses 
to the relative ease with which hedge fund investments can be 
redeemed. See id. at text accompanying n. 145.
---------------------------------------------------------------------------

     If the Commission adopts the proposal, should it 
include an exemption for advisers that are registered with another 
government agency, e.g., the Commodity Futures Trading Commission?
     Would the proposed rulemaking conflict with the 
securities laws' traditional view that sophisticated investors do 
not need the full oversight of the Commission? \42\
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    \42\ See, e.g., section 4(2) of the Securities Act of 1933 [15 
U.S.C. 77d(2)], Regulation D [17 CFR 230.501-230.508] and rule 144A 
[17 CFR 230.144A] promulgated thereunder, and sections 3(c)(1) [15 
U.S.C. 80a-3(c)(1)] and 3(c)(7) [15 U.S.C. 80a-3(c)(7)] of the 
Investment Company Act.
---------------------------------------------------------------------------

     Is the information provided on Form ADV sufficient to 
address the majority's concerns about hedge funds? What effect would 
the availability of information on the Form ADV have on the costs 
investors incur in researching hedge funds? What effect would 
registration have on the due diligence performed by hedge fund 
investors and the professionals they hire?
     Are the majority's estimates of the costs of 
registration and the costs of maintaining a compliance program under 
rule 206(4)-2, and the costs of complying with other rules under the 
Advisers Act, accurate? What are the anticipated effects of this 
rule proposal on new entrants in the marketplace? Would fears about 
more substantive regulation of hedge fund activity, business models, 
and business practices drive hedge fund advisers offshore? What 
burdens will hedge fund advisers face in responding to targeted, 
time-sensitive document requests under the Commission's new risk-
based approach to oversight of registrants? What costs would 
investors bear as a result of the proposed rulemaking (including any 
reduction in the number of hedge fund offerings)?
    Although the proposal seems innocuous on its face, it may harm 
investors without helping us perform our role. We need to know more 
about hedge funds. Registration of hedge fund advisers is not the 
best way to learn more, and it is unlikely that the Commission will 
determine in the next sixty days what it needs to know. While we 
would not normally oppose issuing a rule proposal to solicit 
comment, we cannot support a proposing release that papers over the 
weaknesses of the approach it puts forward, overstates the purported 
benefits, and ignores the possibility that viable, and indeed 
preferable, alternative approaches may exist.
    For all of the foregoing reasons, we respectfully dissent.

Cynthia A. Glassman,
Commissioner.

Paul S. Atkins,
Commissioner.

[FR Doc. 04-16888 Filed 7-27-04; 8:45 am]
BILLING CODE 8010-01-P