[Federal Register Volume 69, Number 237 (Friday, December 10, 2004)]
[Rules and Regulations]
[Pages 72054-72098]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-26879]



[[Page 72053]]

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Part IV





Securities and Exchange Commission





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17 CFR Parts 275 and 279



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

  Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / 
Rules and Regulations  

[[Page 72054]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 275 and 279

[Release No. IA-2333; 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'' or 
``SEC'').

ACTION: Final rule.

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SUMMARY: The Commission is adopting a new rule and rule amendments 
under the Investment Advisers Act of 1940. The new rule and amendments 
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: Effective Dates: February 10, 2005, except for the amendments to 
Sec.  275.206(4)-2 [rule 206(4)-2] and Sec.  279.1 [Form ADV], which 
will become effective January 10, 2005.
    Compliance Dates: Advisers that will be required to register under 
the new rule and rule amendments must do so by February 1, 2006. 
Advisers must respond to the amended items of Form ADV in their next 
ADV filing after March 8, 2005. Section III of this Release contains 
more information on the effective and compliance dates.

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 adopting new rule 
203(b)(3)-2 [17 CFR 275.203(b)(3)-2], amendments to rules 203(b)(3)-1 
[17 CFR 275.203(b)(3)-1], 203A-3 [17 CFR 275.203A-3], 204-2 [17 CFR 
275.204-2], 205-3 [17 CFR 275.205-3], 206(4)-2 [17 CFR 275.206(4)-2], 
and 222-2 [17 CFR 275.222-2], and Form ADV [17 CFR 279.1] under the 
Investment Advisers Act of 1940 [15 U.S.C. 80b] (the ``Advisers Act'' 
or ``Act'').

Table of Contents

I. Background
    A. Growth of Hedge Funds
    B. Growth in Hedge Fund Fraud
    C. Broader Exposure to Hedge Funds
II. Discussion
    A. Need for Commission Action
    B. Matters Considered by the Commission
    C. Our Legal Authority Under the Advisers Act
    D. Rule 203(b)(3)-2
    E. Definition of ``Private Fund''
    F. Other Amendments to Rule 203(b)(3)-1
    G. Amendments to Rule 204-2
    H. Amendments to Rule 205-3
    I. Amendments to Rule 206(4)-2
    J. Amendments to Rule 222-2 and Rule 203A-3
    K. Amendments to Form ADV
III. Effective and Compliance Dates
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 Rule, Rule Amendments and Form Amendments

I. Background

    The Commission regulates investment advisers--persons and firms who 
advise others about securities--under the Investment Advisers Act of 
1940. The Act contains a few basic requirements, such as registration 
with the Commission, maintenance of certain business records, and 
delivery to clients 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.\1\ 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 material 
conflicts the adviser has with its clients,\2\ to seek best execution 
for client transactions,\3\ and to have a reasonable basis for client 
recommendations.\4\ The Advisers Act does not impose a detailed 
regulatory regime.
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    \1\ 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).
    \2\ See Capital Gains, supra note 1, at 191-194.
    \3\ 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).
    \4\ See supra note 3.
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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 twelve 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.\5\ Advisers taking 
advantage of this ``private adviser exemption'' must nonetheless comply 
with the Act's antifraud provisions,\6\ 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 examinations of 
advisers exempt from the Act's registration requirements.\7\
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    \5\ 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)]).
    \6\ 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].
    \7\ Section 204 of the Advisers Act [15 U.S.C. 80b-4] authorizes 
the Commission to conduct examinations of all records of investment 
advisers. Records of 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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    The private adviser exemption was not intended to exempt advisers 
to wealthy or sophisticated clients.\8\ It appears to reflect Congress' 
view that there is no federal interest in regulating advisers that have 
only a small number of clients and whose activities are unlikely to 
affect national securities markets.\9\ Today, however, a growing number 
of investment advisers take advantage of the private adviser exemption 
to operate large investment advisory firms without being registered 
with the Commission. Instead of managing client money directly, these 
advisers pool client assets by creating limited partnerships, business 
trusts or corporations in which clients invest. In 1985, we adopted a 
rule that permitted advisers to count each partnership, trust

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or corporation as a single client, which today permits advisers to 
avoid registration even though they manage large amounts of client 
assets and, indirectly, have a large number of clients.\10\
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    \8\ See discussion, infra, in Section II.B.8. of this Release.
    \9\ Id.; see also infra Section II.C of this Release.
    \10\ 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)] (``Rule 203(b)(3)-1 Adopting Release''). 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)] (``NSMIA 
Implementing Release''). Under rule 203(b)(3)-1(a)(2)(i)[17 CFR 
275.203(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(s) of the 
legal organization. Rule 203(b)(3)-1(b)(3)[17 CFR 275.203(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.'' As discussed in more detail below, infra note 157, 
until we adopted this rule there was considerable uncertainty 
whether advisers to unregistered investment pools were required to 
look through the pools to count each investor as a client, or could 
count each pool as a single client.
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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.\11\ 
Advisers organize and operate hedge funds in a manner that avoids 
regulation as investment companies under the Investment Company Act of 
1940, and hedge funds do not make public offerings of their 
securities.\12\
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    \11\ See William Fung and David A. Hsieh, A Primer on Hedge 
Funds, 6 J. of Empirical Fin. 309-31(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 Oct. 24, 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 Oct. 24, 2004). See also Gregory 
Zuckerman, Hedge Funds Grab More In Fees As Their Popularity 
Increases, Wall St. J., Oct.8, 2004, at A1 (noting that some of the 
best-performing hedge fund advisers now receive between 30 and 50 
percent of their funds' profits). 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).
    \12\ 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.\13\ 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.\14\ Many are very active traders of 
securities.\15\
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    \13\ See Carol J. Loomis, Hard Times Come To The Hedge Funds, 
Fortune, Jan. 1970, at 10.
    \14\ 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 * * 
*''). See also Citigroup Asset Management, Strategic Thinking: 
What's In A Hedge Fund? Toward A Better Understanding Of Sources Of 
Returns (Apr. 2004) (examining 12 hedge fund strategies and 
challenging the view that hedge funds are all designed to deliver 
absolute returns).
    \15\ 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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    In 2002, we requested that our staff investigate 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.\16\ 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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    \16\ See Douglas W. Hawes, Hedge Funds--Investment Clubs for the 
Rich, 23 Business Lawyer 576 (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 that we 
subsequently received from interested persons, contributed greatly to 
the staff's investigation and our understanding of hedge funds and 
hedge fund advisers as we developed our proposals.\17\
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    \17\ Transcripts of the Roundtable participants' presentations 
(``Roundtable Transcript'') and comments submitted in connection 
with the Roundtable are available at http://www.sec.gov/spotlight/hedgefunds.htm. Staff of the Commodity Futures Trading Commission 
(``CFTC''), the Commission des Operations de Bourse of France (COB), 
and the Financial Services Authority of the United Kingdom (FSA), 
participated in our Roundtable. In addition, Commission staff met 
with CFTC staff, staff of the Board of Governors of the Federal 
Reserve, staff of the Department of the Treasury, state securities 
officials, and staff of the FSA to discuss issues relating to hedge 
funds, their advisers, and their oversight.
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    In September 2003, the staff published a report entitled 
Implications of the Growth of Hedge Funds.\18\ The 2003 Staff Hedge 
Fund Report describes 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. 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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    \18\ 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

    It is difficult to estimate precisely the size of the hedge fund 
industry because neither we nor any other governmental agency collects 
data specifically about hedge funds. It is estimated that there are now 
approximately $870 billion of assets \19\ in approximately 7000 
funds.\20\ What is remarkable is the growth of the hedge funds. In the 
last five years alone, hedge fund assets have grown 260 percent, and in 
the last year, hedge fund assets have grown over 30 percent.\21\ Some 
predict the amount of hedge fund

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assets will exceed $1 trillion by the end of the year.\22\ Hedge fund 
assets are growing faster than mutual fund assets and already equal 
just over one fifth of the assets of mutual funds that invest in equity 
securities.\23\
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    \19\ See, e.g., Hedge Funds Grab More In Fees As Their 
Popularity Increases, supra note 11; Alistair Bair, Pension Funds 
Seen Boosting Hedge-Fund Allocations, CBS MarketWatch, Sept. 13, 
2004.
    \20\ See Hennessee Group LLC, 10th Annual Manager Survey (2004).
    \21\ Id. (Hennessee Group estimates that the 34 percent growth 
of hedge funds in 2003 was due to both performance (20 percent) and 
new capital (14 percent)). See also Sanford C. Bernstein & Co., 
Hedge Fund Industry Update `` One Year Later, The Song Remains The 
Same, Bernstein Research Call (July 28, 2004) (hedge fund assets 
grew globally by approximately 31 percent in calendar year 2003 with 
aggregate assets reaching $870 billion in March 2004) (``Bernstein 
2004 Report''). Hedge fund inflows have also continued to set 
records. See Chris Clair, Hedge Fund Inflows Set Another Record, 
HedgeWorld/Inside Edge, Aug. 16, 2004 (second quarter 2004 inflows 
of $43.3 billion bested the record set in the first quarter); Too 
Much Money Chasing Too Few Real Stars, Financial Times, July 22, 
2004 (first quarter 2004 inflows were $38.2 billion, following 
record 2003 inflows of $72 billion).
    \22\ Some estimate that hedge fund assets are already at or near 
$1 trillion. See Boom Or Bust? Banks And Hedge Funds, The Economist 
(Oct. 9, 2004); Daniel Kadlec, Will Hedge Funds Take A Dive?, Time, 
Oct. 4, 2004; Amey Stone, Hedge Funds Are Everyone's Problem, 
BUSINESSWEEK, Aug. 6, 2004.
    \23\ As of the end of August 2004, equity mutual funds' assets 
were $3.8 trillion. At $870 billion, hedge funds' assets were equal 
to 22.9 percent of this figure. See Investment Company Institute, 
Trends in Mutual Fund Investing: August 2004, News Release 
(available at http://www.ici.org, visited on Oct. 13, 2004).
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    As a result, hedge fund advisers have become significant 
participants in the securities markets, both as managers of assets and 
traders of securities. One report estimates that hedge funds represent 
approximately ten to twenty percent of equity trading volume in the 
United States.\24\ One article portrayed a single hedge fund adviser as 
responsible for an average of five percent of the daily trading volume 
of the New York Stock Exchange.\25\ Another reported that hedge funds 
dominate the market for convertible bonds.\26\
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    \24\ Sanford C. Bernstein & Co., The Hedge Fund Industry--
Products, Services, or Capabilities, Bernstein Research Call (May 
19, 2003), at 5 (``Bernstein 2003 Report'').
    \25\ Marcia Vickers, The Most Powerful Trader on Wall Street 
You've Never Heard of, BusinessWeek, July 21, 2003, at 66.
    \26\ See Henny Sender, Hedge Funds Skid on Convertible Bonds, 
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.\27\ In the last five years, the Commission has brought 51 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 $1.1 billion.\28\
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    \27\ We are not alone in our concerns regarding hedge fund 
frauds. In a recent study, over 50 percent of respondents identified 
hedge funds as ``most likely to be at the centre of an investment 
controversy'' in the next five years. Bank of New York, RESTORING 
BROKEN TRUST (July 2004).
    \28\ This reflects five cases in addition to those we cited in 
Registration Under the Advisers Act of Certain Hedge Fund Advisers, 
Investment Advisers Act Release No. 2266 (July 20, 2004) [69 FR 
45171 (July 28, 2004)] (``Proposing Release''). Some commenters have 
suggested that the cases we cited in the Proposing Release did not 
support the need for hedge fund adviser registration because some of 
the hedge funds had less than $30 million in assets and advisers 
with less than $30 million in assets under management are not 
required to register under the Act. First, while staff estimates 
that approximately half the advisers in these cases managed assets 
in excess of $30 million or were otherwise subject to registration, 
it was cases involving these larger advisers that comprise the bulk 
of the estimated losses, representing more than $1 billion of total 
$1.1 billion of estimated losses. Second, regardless of whether any 
particular adviser would be required to register with us, these 
cases demonstrate the increased prevalence of fraud associated with 
hedge funds. We note that whether a particular hedge fund adviser 
will be required to register with us will turn not solely on the 
amount of assets of a particular hedge fund it advises, but on the 
total amount of assets the adviser has under management, including 
those of other clients. See section 203A(a)(1)(A) of the Advisers 
Act [15 U.S. 80b-3a(a)(1)(A)].
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    Although most of our hedge fund fraud cases have involved hedge 
fund advisers that defrauded their investors, we now too frequently see 
instances in which hedge funds have been used to defraud other market 
participants. Most disturbing is that hedge fund advisers have been key 
participants in the recent scandals involving late trading and 
inappropriate market timing of mutual fund shares.\29\ Many of our 
enforcement cases involved hedge fund advisers that sought to exploit 
mutual fund investors for their funds' and their own gain. Some hedge 
fund advisers entered into arrangements with mutual fund advisers under 
which the mutual fund advisers

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waived restrictions on market timing in return for receipt of the hedge 
fund advisers' ``sticky assets,'' i.e., placement of other assets in 
other funds managed by the mutual fund adviser. Other hedge fund 
advisers sought ways to avoid detection by mutual fund personnel by 
conspiring with intermediaries to conceal the identity of their hedge 
funds. While our investigation is ongoing, the frequency with which 
hedge funds and their advisers appear in these cases and continue to 
turn up in the investigations is alarming. Our staff counts almost 400 
hedge funds (and at least 87 hedge fund advisers) involved in these 
cases and others under investigation.\30\
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    \29\ In the past year, we have sanctioned persons charged with 
late trading of mutual fund shares on behalf of groups of hedge 
funds, and mutual fund advisers or principals for permitting hedge 
funds' market timing. In the Matter of Invesco Funds Group, Inc., 
AIM Advisors, Inc., and AIM Distributors, Inc., Investment Advisers 
Act Release No. 2311 (Oct. 8, 2004) (Commission found that mutual 
fund adviser entered into an undisclosed arrangement permitting 
hedge funds to market time the adviser's mutual funds in a manner 
inconsistent with the mutual funds' prospectuses); SEC v. PIMCO 
Advisors Fund Management, LLC, Investment Advisers Act Release No. 
2292 (Sept. 13, 2004) (Commission found that mutual fund adviser 
entered into a market timing arrangement permitting over 100 mutual 
fund market timing transactions by hedge funds in exchange for hedge 
funds' investment in adviser's other investment vehicles; mutual 
fund adviser also provided hedge funds with material nonpublic 
portfolio information concerning four of the adviser's mutual 
funds); In the Matter of Banc One Investment Advisors Corporation 
and Mark A. Beeson, Investment Advisers Act Release No. 2254 (June 
29, 2004) (Commission found that investment adviser permitted Canary 
hedge fund manager Edward Stern 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 Stern 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 and prolonged 
short-term trading of several mutual funds and that one of its 
executives provided material nonpublic portfolio information to a 
broker-dealer, which passed it on to its hedge fund customers); In 
the Matter of Strong Capital Management, Inc., et al., Investment 
Advisers Act Release No. 2239 (May 20, 2004) (Commission found that 
investment adviser disclosed material nonpublic information about 
mutual fund portfolio holdings to Canary hedge funds, and permitted 
Canary and the adviser's own chairman 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 facilitating late 
trades and market timing by affiliated 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). 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 Canary hedge funds, 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 known market timer, including at least one hedge fund). We 
have also sanctioned mutual fund advisers for permitting certain 
investors to engage in undisclosed market timing of their funds; 
hedge funds were among the market timers in these cases. In the 
Matter of RS Investment Management, Investment Advisers Act Release 
No. 2310 (Oct. 6, 2004); In the Matter of Janus Capital Management, 
LLC, Investment Advisers Act Release No. 2277 (Aug. 18, 2004). In 
addition, we have sanctioned insurance companies for facilitating 
undisclosed market timing of mutual funds through variable annuity 
products marketed and sold to market timers including hedge funds. 
In the Matter of CIHC, Inc., Conseco Services, LLC, and Conseco 
Equity Sales, Inc., Investment Company Act Release No. 26526 (Aug. 
9, 2004) and In the Matter of Inviva, Inc. and Jefferson National 
Life Insurance Company, Investment Company Act Release No. 26527 
(Aug. 9, 2004).
    We are continuing to pursue several similar cases. To date, we 
have instituted six enforcement actions (in addition to the 12 
settled actions discussed above). See SEC v. Geek Securities, Inc., 
Litigation Release No. 18738 (June 4, 2004) (alleging that broker-
dealer engaged in late trading of mutual funds on behalf of several 
hedge fund customers, and facilitated hedge funds' market timing 
transactions in numerous mutual funds by evading the mutual funds' 
attempts to restrict the transactions); SEC v. Columbia Management 
Advisors, Inc., Litigation Release No. 18590 (Feb. 24, 2004) 
(alleging mutual fund wholesaler entered into, and adviser approved, 
arrangements allowing hedge funds to engage in market timing 
transactions in nine mutual 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. 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 the Matter of Theodore Charles Sihpol, III, Securities 
Exchange Act Release No. 48493 (Sept. 16, 2003) (charging former 
broker with playing a key role in enabling Canary hedge fund 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).
    \30\ Our Proposing Release reported only 40 hedge funds involved 
in these cases. Our staff has continued its investigation of late 
trading and market timing of mutual fund shares and, at our request, 
conducted a more detailed review. Staff has identified 389 different 
hedge funds, but in light of the continuing nature of staff's 
investigations, this number may be incomplete. Advisers registered 
with the Commission advised some of the 389 hedge funds.
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C. Broader Exposure to 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 this 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.\31\ 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 some hedge 
funds'' minimum investment requirements have decreased over time.\32\ 
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.\33\
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    \31\ 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; Hanna 
Shaw Grove and Russ Alan Prince, Let Us In, Registered Rep., Mar. 
2004; 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. See also Jenna Gottlieb, Hedge Fund Deal Raises Product's Bank 
Profile, American Banker, Oct. 14, 2004 (one fund of hedge funds 
adviser stated that hedge funds are becoming mainstream and are 
marketed to the mass affluent).
    \32\ See 2003 Staff Hedge Fund Report, supra note 18, at 81.
    \33\ 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. See, e.g., Robert Murray, Vega To 
Target Smaller Investors, Alternative Investment News, Aug 20, 2004 
(Spanish hedge fund adviser plans to offer a fund of its hedge funds 
to U.S. investors). 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 http://www.fsa.gov.uk/pubs/policy/04_07.pdf (visited on Oct. 25, 2004). 
The media recently reported that the FSA was examining whether it 
should lift the ban on letting ordinary members of the public invest 
in hedge funds. See FSA May Lift Ban on Hedge Fund Retail Investors, 
Reuters, Sept. 29, 2004, available at http://www.reuters.co.uk 
(visited on Sept. 29, 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, 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 
Oct. 25, 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 Oct. 25, 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 Oct. 25, 
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 Oct. 25, 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. The media recently reported that 
in Luxembourg, changes to regulation have allowed offshore hedge 
funds to list in Luxembourg since September 2004. See Phil Davis, 
Special Report Luxembourg: Hedge Fund Tide May Be About to Turn, 
Financial Times, Oct. 18, 2004.
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    Second, the development of ``funds of hedge funds'' has made hedge 
funds more broadly available to investors.\34\ Today there are 52 
registered funds of hedge funds that offer or plan to offer their 
shares publicly.\35\ Most funds of hedge funds are today offered only 
to institutional investors, but there are no statutory limitations on 
the public offering of these funds. Funds of hedge funds today 
represent approximately twenty percent of hedge fund capital,\36\ and 
are the fastest growing source of capital for hedge funds today.\37\
---------------------------------------------------------------------------

    \34\ The Street's Latest Lure: Some One Is Going to Mint Money 
With the New Hedge Funds For Smaller Investors, supra note 31; Going 
Mainstream, supra note 31; 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.
    \35\ An additional 51 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.
    \36\ Bernstein 2003 Report, supra note 24, at 18.
    \37\ Hennessee Group LLC, 10th Annual Manager Survey, supra note 
20 (``funds of funds continue to be the fastest growing source of 
capital for hedge funds, increasing 50 percent since January 1997 
(from 16 percent to 24 percent)''). See also Pauline Skypala, Hedge 
Funds of Funds Booming, FT.com, Sept. 26, 2004 (Morgan Stanley 
research estimates that over two-thirds of hedge fund inflows are 
coming through funds of funds).
---------------------------------------------------------------------------

    Finally, and perhaps most significantly, in the last few years, a 
growing number of public and private pension funds,\38\ as well as 
universities,

[[Page 72058]]

endowments, foundations, and other charitable organizations, have begun 
to invest in hedge funds or have increased their allocations to hedge 
funds.\39\ More of these institutions have also recently begun to 
consider these alternative investments.\40\ Institutional investments 
may increase in the next four years to $300 billion.\41\ Investors that 
have not been traditional hedge fund investors, including pension plans 
that have millions of beneficiaries, are thus today purchasing hedge 
funds. As a result of the participation by these entities in hedge 
funds, the assets of these entities are exposed to the risks of hedge 
fund investing. Losses resulting from hedge fund investing and hedge 
fund frauds may affect the entities' ability to satisfy their 
obligations to their beneficiaries or pursue other intended purposes.
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    \38\ 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. Bernstein Research 
reports that, among the top 200 U.S. defined benefit plans, at least 
15 percent have allocated a portion of their assets to hedge funds. 
Bernstein 2003 Report, supra note 24 at 13. 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, 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 Oct. 13, 
2004); Hennessee Group LLC, 10th Annual Manager Survey, supra note 
20. 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).
    \39\ 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 Sept. 18, 2004). Others estimate 
the average allocation to be 12 percent, see Bank of New York and 
Casey, Quirk & Acito, Institutional Demand for Hedge Funds: New 
Opportunities and New Standards, (Sept. 2004) (``BONY Report'') or 
as high as 17 percent of assets. See Hennessee Group, 2004 Hennessee 
Hedge Fund Survey of Foundations and Endowments (reporting that an 
average commitment of 17 percent of assets, and a projected 
commitment of 19 percent by 2005) (``Hennessee Foundation and 
Endowment Survey''). See also 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.
    \40\ Since we issued our Proposing Release, industry observers 
have seen smaller foundations expressing growing interest in hedge 
funds. Family Foundations Move Towards Hedge Funds, Fundfire, Oct. 
11, 2004 (family foundation consultant notes many family 
foundations, run by family members with limited investment 
knowledge, pursuing hedge fund investments). Also, in our Proposing 
Release, we identified a large number of pension plans that were 
investing or looking to invest in hedge funds. Since then, a number 
of additional pension plans have sought, or are seeking, hedge fund 
investment, according to one trade newsletter. Cincy Fund Will 
Weight Alts, Alternative Investment News, Oct. 8, 2004 (Cincinnati 
Retirement System will consider alternative investments in 2005); 
U.S. Pensions Examine Hedge Funds, Alternative Investment News, Oct. 
8, 2004 (pension plans sponsored by the General Conference of 
Seventh Day Adventists, Tulare County (CA) Employees' Retirement 
Association, and City of Laredo (TX) Firefighters Retirement System 
are considering investment in hedge funds); Colorado Guns & Hoses 
Makes Overlay Play, Alternative Investment News, Oct. 1, 2004 
(Colorado fire and police pension fund allocated $75 million to two 
hedge fund of funds managers); Service Employees Likely To Seek 
Hedge Fund of Funds, Alternative Investment News, Sept. 10, 2004 
(Service Employees International Union pension fund may seek to 
invest up to 5 percent of its $1.5 billion in assets to hedge funds 
of funds); New Hampshire Eyes Hedge Funds, Alternative Investment 
News, Sept. 10, 2004 (New Hampshire Retirement System is considering 
allocating up to $100 million to one or more hedge fund of funds 
managers); San Bernardino Pension Picks AIG, Benchmark Plus, 
Alternative Investment News, Aug. 13, 2004 (San Bernardino County 
(CA) Employees Retirement Association allocated $100 million to each 
of two hedge fund of fund managers); L.A. Water Dept. To Consider 
Hedge Funds, Alternative Investment News, July 30, 2004 (defined 
benefit plan to consider its first allocation to hedge funds early 
in 2005).
    \41\ BONY Report, supra note 39, at 1. See also Lewis Knox, The 
Hedge Fund: Institutional Money is Swelling the Coffers of the 
World's Largest Hedge Fund Managers, supra note 39.
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    In response to these developments, and after extensive consultation 
with participants in the hedge fund industry in connection with our 
staff's investigation, we proposed in July of 2004 a new rule that 
would require hedge fund advisers to count each investor in a hedge 
fund, rather than only the hedge fund itself, as a client for purposes 
of the private adviser exemption.\42\ As a result, most hedge fund 
advisers would have to register with the Commission and would be 
subject to SEC oversight. The rule and rule amendments were 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.\43\
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    \42\ Proposing Release, supra note 28.
    \43\ In 1999, the President's Working Group on Financial 
Markets, in the wake of the near-collapse of Long Term Capital 
Management, Inc., (``LTCM''), published a series of recommendations 
that did not include registration of hedge fund advisers under the 
Advisers Act. 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 Board of Governors of the Federal Reserve 
System and the Commodity Futures Trading Commission (Apr. 1999). The 
principal concerns of the President's Working Group report were 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. The focus of 
the Advisers Act is different, and includes such concerns as the 
prevention of frauds on investors. Since the issuance of the 
President's Working Group report, the size of the hedge fund 
industry has doubled, the exposure of investors to hedge funds has 
broadened, and the incidence of fraud we discover involving hedge 
fund advisers has increased. The Commission is the only member of 
the President's Working Group with responsibility for the protection 
of investors and the oversight of our nation's securities markets.
---------------------------------------------------------------------------

    We received letters from 161 commenters, including investors, hedge 
fund advisers, other investment advisers, trade associations, and law 
firms.\44\ Forty-two commenters did not express a view on whether we 
should or should not require hedge fund advisers to register, but asked 
us to consider particular issues or concerns if we adopted the 
rule.\45\ Thirty-six commenters supported the rule proposal and our 
efforts to improve our oversight of hedge fund advisers.\46\ Several 
investors and other commenters hailed the proposal as an important step 
towards protecting investors and the overall securities markets.\47\ 
They pointed out that while registering hedge fund advisers would not 
eliminate fraud, it would allow the Commission to address potential 
opportunities for fraud. These commenters also noted that registration 
may help the hedge fund industry to the extent it discourages persons 
intent on committing fraud from entering the industry and damaging the 
reputation of the legitimate managers.\48\ They also cautioned that the 
Commission should

[[Page 72059]]

not wait until the next crisis before taking measures of protection 
against potential fraud.\49\ Some hedge fund advisers and other 
advisers already registered with the SEC also welcomed the proposal. 
They used their own experiences to illustrate that registration would 
not overburden a firm's operation, and that benefits of being a 
registered adviser more than compensated for the costs.\50\
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    \44\ These letters are available on the Internet at http://www.sec.gov/rules/proposed/s73004.shtml.
    \45\ See, e.g., Comment Letter of Van Hedge Fund Advisors (Sept. 
15, 2004) (``Van Hedge Letter'').
    \46\ Hennessee Group also submitted the results of a survey of 
foundations and endowments, Hennessee Foundation and Endowment 
Survey, supra note 39. Nearly twice as many respondents to the 
Hennessee Foundation and Endowment Survey favored the proposal (59 
percent) as opposed it (30 percent).
    \47\ See, e.g., Comment Letter of Ohio Public Employees 
Retirement System, (Aug. 6, 2004) (``Ohio PERS Letter''); Comment 
Letter of New Jersey State Investment Council (Sept. 17, 2004) 
(``New Jersey State Investment Council Letter''); Comment Letter of 
Pennsylvania Securities Commission (July 26, 2004) (``Pennsylvania 
Securities Commission Letter''); Comment Letter of CFA Institute 
(Sept. 30, 2004) (``CFA Institute Letter''); Comment Letter of 
Investment Counsel Association of America (Sept. 14, 2004) (``ICAA 
Letter''); Comment Letter of Alternative Investment Group Services, 
LP (Aug. 20, 2004) (``Alternative Investment Group Letter''); 
Comment Letter of Lyn Batty (July 14, 2004) (``Lyn Batty Letter'').
    \48\ See, e.g., Comment Letter of Investment Company Institute 
(Sept. 15, 2004) (``ICI Letter''); Ohio PERS Letter, supra note 47; 
Comment Letter of Investment Management Consultants Association 
(Sept. 14, 2004) (``IMCA Letter''); Alternative Investment Group 
Letter, supra note 47; Comment Letter of David Patch (July 24, 2004) 
(``Patch Letter A'').
    \49\ See, e.g., Comment Letter of B. H. Bigg (July 23, 2004) 
(``Bigg Letter''); Comment Letter of Ralph S. Saul (Aug. 18, 2004) 
(``Saul Letter'').
    \50\ See, e.g., Comment Letter of Vantis Capital Management LLC 
(Aug. 6, 2004) (``Vantis August Letter''); Alternative Investment 
Group Letter, supra note 47.
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    Eighty-three commenters, including many unregistered hedge fund 
advisers, their attorneys, and trade associations, however, argued 
strongly against the proposal. They expressed concerns about the costs 
of compliance under the new rule,\51\ and raised questions about our 
effectiveness in preventing hedge fund fraud,\52\ and the potential 
intrusiveness of our oversight of hedge fund managers.\53\ Some hedge 
fund investors were concerned that their advisers might pass the costs 
of registration to them and increase management fees.\54\
---------------------------------------------------------------------------

    \51\ See, e.g., Comment Letter of Managed Funds Association 
(Sept. 15, 2004) (``MFA Letter''); Comment Letter of Madison Capital 
Management, LLC (Sept. 15, 2004)(``Madison Capital Letter''); 
Comment Letter of Proskauer Rose LLP (Aug. 31, 2004) (``Proskauer 
Letter''); Comment Letter of Schulte Roth & Zabel LLP (Sept. 15, 
2004) (``Schulte Roth Letter''); Comment Letter of Keith Black (July 
30, 2004) (``Black Letter''); Comment Letter of Guy Lander (Sept. 
15, 2004) (``Lander Letter''); Comment Letter of Sidley Austin Brown 
& Wood, LLP (Sept. 14, 2004) (``Sidley Austin Letter''); Comment 
Letter of Joseph LaRocco (Aug. 26, 2004) (``LaRocco Letter); Comment 
Letter of Superior Capital Management LLC (Sept. 8, 2004) 
(``Superior Capital Letter'').
    \52\ See, e.g., MFA Letter, supra note 51; Comment Letter of 
Chamber of Commerce of the United States of America (Sept. 15, 2004) 
(``Chamber of Commerce Letter''); Comment Letter of International 
Swaps and Derivatives Association (Sept. 15, 2004) (``ISDA 
Letter''); Comment Letter of David Patch (Sept. 10, 2004) (``Patch 
Letter B''); Comment Letter of Rodney Pitts (Sept. 15, 2004) 
(``Rodney Pitts Letter''); Comment Letter of Blanco Partners LP 
(Sept. 13, 2004) (``Blanco Partners Letter''); Comment Letter of 
Mark Acquino (Aug. 8, 2004)(``Acquino Letter'').
    \53\ See, e.g., MFA Letter, supra note 51; Chamber of Commerce 
Letter, supra note 52; ISDA Letter, supra note 52; Comment Letter of 
Financial Services Roundtable (Sept. 9, 2004) (``Financial Services 
Roundtable Letter''); Black Letter, supra note 51; Comment Letter of 
Tudor Investment Corporation (Sept. 15, 2004) (``Tudor Letter''); 
Comment Letter of David Thayer (Sept. 15, 2004) (``David Thayer 
Letter''); Lander Letter, supra note 51.
    \54\ See, e.g., Comment Letter of John Waller (July 31, 2004) 
(``John Waller Letter''); Acquino Letter, supra note 52; Comment 
Letter of Melissa Kadiri (Sept. 15, 2004) (``Melissa Kadiri 
Letter'').
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II. Discussion

    We have carefully considered all of the comments we received.\55\ 
For the reasons discussed below and in the Proposing Release, we are 
adopting rule 203(b)(3)-2 and related amendments to rule 203(b)(3)-1 
and Form ADV, which would require most hedge fund advisers to register 
with us under the Act.\56\
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    \55\ During and after the comment period, our staff has 
continued to have discussions in the President's Working Group with 
other regulators relating to hedge fund adviser regulation. See 
Letter from Congressman Richard H. Baker to John W. Snow, Secretary, 
U.S. Department of the Treasury (Oct. 7, 2004) (available in File 
S7-30-04).
    \56\ As discussed below, we are also adopting amendments to 
rules 203A-3, 204-2, 205-3, 206(4)-2, and 222-2. Unless otherwise 
noted, when we refer to rules 203(b)(3)-1, 203A-3, 204-2, 205-3, 
206(4)-2, 222-2, or any paragraph of the rules, we are referring to 
17 CFR 275.203(b)(3)-1, 275.203A-3, 275.204-2, 275.205-3, 
275.206(4)-2, and 275.222-2 of the Code of Federal Regulations in 
which the rules are published.
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A. Need for Commission Action

    The Commission is the federal agency with principal responsibility 
for the enforcement and administration of the federal securities laws 
and the supervision of the securities markets. The federal securities 
laws seek to protect investors by providing for the transparency of 
markets, by prohibiting fraud, and by imposing fiduciary 
obligations.\57\ They encourage the formation and efficient allocation 
of capital and the participation of investors in the capital 
markets.\58\ Our obligations under these laws as well as our commitment 
to protect investors require us to respond to important market 
developments, and the authority provided us by those laws permits us to 
adopt rules and interpret the statutes in order to preserve fair and 
honest markets.\59\
---------------------------------------------------------------------------

    \57\ See Capital Gains, supra note 1.
    \58\ See, e.g., AUSA Life Insurance Co. v. Ernst & Young, 206 
F.3d 202 (2nd Cir. 2000) at 217. ``During the Great Depression, 
Congress enacted the 1933 and 1934 [Securities] Acts to promote 
investor confidence in the United States securities markets and 
thereby to encourage the investment necessary for capital formation, 
economic growth, and job creation.'' Private Securities Litigation 
Reform Act of 1995, Pub. L. 104-67, S.Rep. No. 104-98 (June 19, 
1995), reprinted in 1995 U.S.C.C.A.N. 679, 683.
    \59\ See American Trucking Assns., Inc. v. Atchison, Topeka & 
Santa Fe Ry Co., 387 U.S. 397, 415 (1967) (``Regulatory agencies do 
not establish rules of conduct to last forever; they are supposed, 
within the limits of the law and of fair and prudent administration, 
to adapt their rules and practices to the Nation's needs in a 
volatile, changing economy. They are neither required nor supposed 
to regulate the present and the future within the inflexible limits 
of yesterday.'').
---------------------------------------------------------------------------

    We believe that, in light of the growth of hedge funds, the 
broadening exposure of investors to hedge fund risk, and the growing 
number of instances of malfeasance by hedge fund advisers, our current 
regulatory program for hedge fund advisers is inadequate. We do not 
have an effective program that would provide us with the ability to 
deter or detect fraud by unregistered hedge fund advisers. We currently 
rely almost entirely on enforcement actions brought after fraud has 
occurred and investor assets are gone. 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.\60\
---------------------------------------------------------------------------

    \60\ William Fung and David Hsieh, Measuring the Market Impact 
of Hedge Funds, 7 J. of Empirical Fin. 1 (2000) (``There are varying 
estimates of the size of the hedge fund industry.''); Hedg-matics: 
How Many Funds Exist? 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 http://www.ici.org (visited 
on Oct. 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 (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).
---------------------------------------------------------------------------

    Requiring hedge fund advisers to register under the Advisers Act 
will give us the ability to oversee hedge fund advisers without 
imposing burdens on the legitimate investment activities of hedge 
funds. We understand the important role that hedge funds play in our 
financial markets, and we appreciate that the lack of regulatory 
constraints on hedge funds has been a factor in the growth and success 
of hedge funds. But commenters have not persuaded us that requiring 
hedge fund advisers to register under the Act, requiring them to 
develop a compliance infrastructure, or subjecting them to our 
examination authority will impose undue burdens on them or interfere 
significantly with their operations.\61\

[[Page 72060]]

Indeed, the large number of hedge fund advisers currently registered 
under the Act--many of whom voluntarily register--provides a powerful 
refutation of the assertions made by commenters who opposed the rule on 
these grounds.\62\ We presume these hedge fund advisers would take 
steps to avoid registration under the Act if the consequences of 
registration were as dire as some commenters have asserted.\63\ 
Comments we received from hedge fund advisers that are registered under 
the Act provide persuasive testimonials that confirm our 
conclusion.\64\
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    \61\ CFA Institute agreed that the fact that many registered 
advisers are small firms ``argues strongly that such registration is 
not overly burdensome.'' CFA Institute Letter, supra note 47.
    \62\ We estimated, in the Proposing Release, that 40-50 percent 
of hedge fund advisers are registered under the Act. See Section V. 
of the Proposing Release. See also Hennessee Group LLC, 10th Annual 
Manager Survey, supra note 20 (39 percent of hedge fund managers 
surveyed were registered under the Advisers Act).
    \63\ Moreover, many hedge fund advisers that are not registered 
with us have indicated that they conform their operations to those 
of registered advisers. See 2003 Staff Hedge Fund Report, supra note 
18, at 314.
    \64\ See Vantis August Letter, supra note 50 (``While there are 
incremental costs associated with registration [under the Advisers 
Act], the burdens are not excessive for any serious investment firm, 
which is committed to timely and accurate reporting.'') and 
Alternative Investment Group Letter, supra note 47 (``We believe 
that the compliance costs will be minimal to the well-managed 
advisor.'').
---------------------------------------------------------------------------

    The Act does not require an adviser to follow or avoid 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, and will be furthered by the registration requirement.\65\ No 
commenter identified any provision of the Act that would provide an 
impediment to an adviser's successful operation of a hedge fund.\66\ 
Arguments by some that registration would somehow inhibit hedge fund 
advisers' willingness to engage in complex or innovative strategies 
because they would be second-guessed by our examination staff are 
baseless. They are refuted by the experience of registered hedge fund 
advisers.\67\ One commenter familiar with the obligations of registered 
advisers noted that registration would not require hedge fund advisers 
to reveal their trading strategies or disclose their portfolio 
holdings, and would not interfere with their ability to leverage their 
portfolios, and that our proposal would not restrict the ability of 
hedge funds to provide liquidity to the markets.\68\
---------------------------------------------------------------------------

    \65\ 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 [15 U.S.C. 
80b-4] (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. Thus, although unregistered advisers are subject 
to the antifraud provisions of the Act, our ability to enforce those 
provisions is hampered because in the absence of a registration 
requirement we cannot identify and examine these advisers.
    \66\ 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 13; Lawrence J. Berkowitz, 
Regulation of Hedge Funds, 2 Rev. of Securities Reg. (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)]. Further, we 
proposed to grandfather hedge fund advisers' existing investors that 
would otherwise not qualify to pay performance fees. See Section 
II.G. of the Proposing Release. No hedge fund industry participant 
with whom our staff spoke during their year-long investigation 
indicated that section 205 or the qualified client criteria in rule 
205-3 would present any concerns to hedge funds.
    \67\ See, e.g., ICI Letter, supra note 48 (``Many of our 
investment adviser members--all of whom are registered with the 
Commission--currently operate hedge funds and have found that 
registration is not overly burdensome and does not interfere with 
their investment activities.'').
    \68\ Id. Nor does the Act restrict the ability of advisers to 
engage in short-selling. Moreover, nothing in the Act or our rules 
requires any investment adviser to disclose its 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-10(b) and 10a].
---------------------------------------------------------------------------

    We are not aware of any evidence that suggests that registration 
under the Advisers Act has impeded investment advisers' performance, 
and commenters did not suggest that registration would have such an 
effect. Moreover, a recent study, while not conclusive, found that 
there were no significant differences between performance of hedge 
funds managed by registered advisers and those managed by unregistered 
advisers.\69\ Five of the ten largest (and presumably most successful) 
hedge fund advisers are today registered with us under the Advisers 
Act.\70\
---------------------------------------------------------------------------

    \69\ Bids and Offers, Wall St. J., July 23, 2004 at C4. In the 
study, Hedge Fund Research, Inc., an alternative investments 
research and consulting firm, examined the performance of 
approximately 2,200 single-strategy hedge funds. Id. However, the 
extent of cross-sectional variability in hedge fund returns makes it 
difficult to ascertain differences in performance statistically.
    \70\ See The Hedge Fund 100, Institutional Investor, May 2004.
---------------------------------------------------------------------------

    The bare assertions of adverse consequences of registration under 
the Advisers Act offered by many commenters opposed to our proposed 
rule, and the anecdotal evidence offered by others, simply do not stand 
up to scrutiny. There has been no suggestion that hedge funds managed 
by registered advisers play a diminished role in the financial markets 
compared to hedge funds managed by unregistered advisers. The empirical 
evidence we have seen, and the information collected informally by our 
staff,\71\ suggests that registration under the Advisers Act has no 
adverse effect on the legitimate market activities of hedge funds.
---------------------------------------------------------------------------

    \71\ In its investigation of hedge funds, see supra Section I of 
this Release, our staff conducted reviews of registered and 
unregistered hedge fund advisers, had on-site discussions with them, 
and met or spoke with a variety of experts to get their perspectives 
on the hedge fund industry. 2003 Staff Hedge Fund Report, supra note 
18, at 2.
---------------------------------------------------------------------------

    More than 8,500 advisory firms that collectively manage over $23 
trillion dollars of assets are today registered under the Advisers Act. 
We have seen no credible evidence that the Act has in any way impeded 
their ability to employ successful investment strategies, or to 
effectively compete with other financial institutions that manage 
securities portfolios here or abroad.
    Some commenters also expressed concerns about what the Commission 
might in the future do that could adversely affect the operation of 
hedge funds.\72\ Such inchoate fears, however, do not provide reason 
for our not going forward with this important rulemaking. Our record of 
64 years of administering the Advisers Act provides no basis for such 
fears.\73\ Our regulatory efforts to

[[Page 72061]]

date that relate specifically to hedge fund advisers have been to 
modify our rules to accommodate these advisers.\74\ Indeed, our 
proposals, and the rules we are adopting today, include additional 
regulatory relief to accommodate the needs of funds of hedge funds.\75\
---------------------------------------------------------------------------

    \72\ See, e.g., Chamber of Commerce Letter, supra note 52.
    \73\ Many of the fears concerning Commission oversight expressed 
by hedge fund advisers today are very similar to those expressed in 
1940 by opponents to enactment of the Advisers Act. See, e.g., 
Investment Trusts and Investment Companies: Hearings on S.3580 
Before the Senate Comm. on Banking and Currency, 76th Cong., 3d. 
Sess. (Apr. 22-23, 1940) (``1940 Senate Hearings'') (testimony of 
James N. White, Scudder, Stevens & Clark, (``We just feel that 
registration leads to investigation, and that investigation leads to 
regulation; and it is possible for a good deal of controversial 
theory on economics to creep into regulation.'')), (testimony of 
Dwight C. Rose, President, Investment Counsel Association of 
America, (``* * *all activities and recommendations of a cautious 
investment counselor would first have to be subjected to the 
question of whether or not at some time such activities or 
recommendations might involve difficulties for him in connection 
with the statute as enacted or with such future rulings as the 
Commission might take.'')), (testimony of Charles M. O'Hearn, 
Clarke, Sinsabaugh & Co., (``In addition, we should like to reaffirm 
our belief that we should be forced to take this position [against 
adviser registration] in the interests of our profession, even if we 
believed some Federal regulation was desirable, because of the broad 
and unqualified discretion given to the Securities and Exchange 
Commission to determine conditions which are vital not only to the 
convenience but to the very existence of our operations.'')). 
Registration, however, clearly has not impeded the growth of the 
investment advisory industry--in 1940, investment advisers managed 
only $4 billion (approximately $50 billion in today's dollars), but 
assets managed by advisers subject to registration under the 
Advisers Act have grown to over $23 trillion today.
    \74\ See Sections II.F. through II.H. of the Proposing Release.
    \75\ See Section II.I. of this Release.
---------------------------------------------------------------------------

B. Matters Considered by the Commission

    In the Proposing Release, we identified a series of considerations 
that led us to propose rule 203(b)(3)-2. These considerations have now 
led us to adopt the rule. These considerations explain what we intended 
to achieve by the proposed rule, why we believed some alternative 
approaches would not be effective, and why we believed our proposed 
rule reflected the proper administration of the Advisers Act. Many of 
the commenters discussed these considerations extensively. Those 
supporting the proposal tended to agree with the considerations we set 
out; those opposing the proposal challenged them. Below, we discuss 
each of the considerations set out in the Proposing Release, as well as 
others raised by commenters. For each, we address our considerations, 
the principal arguments commenters made against our adoption of the 
rule, and why we found those arguments to be unpersuasive.\76\
---------------------------------------------------------------------------

    \76\ One of these considerations--imposition of minimal 
burdens--is discussed above.
---------------------------------------------------------------------------

1. Census Information
    Registration under the Advisers Act provides the Commission with 
the ability to collect important information that we now lack about 
this growing segment of the U.S. financial system.\77\ Registered 
advisers must file Form ADV with us, the data from which will provide 
us with information we need to better understand the operation of hedge 
fund advisers, to plan examinations, to better develop regulatory 
policy, and to provide data and information to members of Congress and 
other government agencies. This includes information about the number 
of hedge funds managed by advisers, the amount of assets in hedge 
funds, the number of employees and types of other clients these 
advisers have, other business activities they conduct, and the identity 
of persons that control or are affiliated with the firm.\78\
---------------------------------------------------------------------------

    \77\ Collecting information about the nation's investment 
advisers has been one aim of the Advisers Act since it was enacted 
in 1940. 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, at 2 (1960). Just as data on all advisers was lacking 
before 1940, there has been no comprehensive data on hedge fund 
advisers available. See supra note 60.
    \78\ 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 pooled vehicle and 
the minimum amount of capital investment per investor.
---------------------------------------------------------------------------

    Currently, neither we nor any other government agency has any 
reliable data on even the number of hedge funds or the amount of their 
assets. We must rely on third-party surveys and reports, which often 
conflict and may be unreliable.\79\ Many commenters acknowledged this 
as a concern, and several agreed that the Commission needs reliable, 
current and in-depth information about hedge fund advisers.\80\ Some 
commenters, however, urged that, instead of registering advisers and 
obtaining information on Form ADV, we rely on a coordinated collection 
of filings and transaction reports currently made by hedge funds, their 
advisers, or broker-dealers with various government agencies or self-
regulatory organizations.\81\ We have considered this alternative, but 
believe that it would lead our staff to engage in a time-consuming 
forensic exercise to extract a composite of largely transactional 
information that would ultimately result in an incomplete picture of 
each hedge fund adviser and an incomplete picture of the hedge fund 
industry.\82\ We still would not know, for example, how many hedge 
funds, or hedge fund advisers, operate in the United States or their 
aggregate assets. As we explained in the Proposing Release, we need 
information that is reliable, current, and complete, and we need it in 
a format reasonably susceptible of analysis by our staff.
---------------------------------------------------------------------------

    \79\ See Bernstein 2004 Report, supra note 21, at 2 (``In 
general, there are very wide discrepancies in market size and 
performance estimates from different sources. As an example, we 
found that among three leading hedge fund data providers only 
approximately 15 percent of funds were included in all three 
databases.''); see also supra note 60.
    \80\ Even commenters that disagreed with our proposal to 
register hedge fund advisers agreed that the Commission needs 
information about them. See, e.g., Comment Letter of Kynikos 
Associates LP (Sept. 15, 2004) (``Kynikos Letter'').
    \81\ See, e.g., Chamber of Commerce Letter, supra note 52; MFA 
Letter, supra note 51.
    \82\ One commenter agreed with our concerns and the inadequacy 
of alternative approaches to collecting information about hedge fund 
managers. See Comment Letter of Long Trail Capital, LLC (Sept. 14, 
2004) (Monitoring prime broker information is no substitute for 
registration of hedge fund advisers because (1) funds use multiple 
prime brokers, complicating efforts to monitor a fund; (2) the 
transactional picture is not complete since funds may hold private 
equity, real estate, or derivatives not cleared by the prime broker; 
(3) brokers have an incentive to profit from the client relationship 
with the fund, and not to expend resources trying to oversee its 
activities; fund advisers should instead be accountable to an 
overseer with a primary mission to protect investors.)
---------------------------------------------------------------------------

2. Deterrence of Fraud
    Registration under the Advisers Act enables us to conduct 
examinations of the hedge fund adviser.\83\ Our examinations permit us 
to identify compliance problems at an early stage,\84\ identify 
practices that may be harmful to investors, and provide a deterrent to 
unlawful conduct.\85\ They are a key part of our investor protection 
program, and a key reason we are adopting rule 203(b)(3)-2.\86\
---------------------------------------------------------------------------

    \83\ See supra note 7.
    \84\ One registered hedge fund adviser commented that it 
benefits from our examination process. See Vantis August Letter, 
supra note 50 (``[T]he examiner provides an extra set of critical 
eyes to review our systems and identify any deficiencies. If we were 
to have deficiencies, we would want to promptly correct them.'')
    \85\ During an examination, our staff may review the advisory 
firm's internal controls and procedures; they may 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 may 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.
    \86\ 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.
---------------------------------------------------------------------------

    We are not suggesting that registration under the Advisers Act will 
result in our eliminating, or even identifying, every fraud. The 
prospect of a Commission examination, however, increases the risk of 
getting caught, and thus will deter wrongdoers.\87\ This risk

[[Page 72062]]

should alter hedge fund advisers' behavior by forcing them to account 
for the consequences of a compliance examination that, like a tax 
audit, may not occur with great frequency.\88\ Hedge fund advisers each 
day make decisions based on risk analysis of alternative investments, 
and should be particularly sensitive to the consequences of getting 
caught if their conduct is unlawful. The consequences may involve 
paying fines, disgorgement and other penalties, including industry 
suspensions or bars, as well as loss of reputation. This sensitivity, 
which may be reflected in the strength of the opposition among some 
hedge fund advisers to this rulemaking, suggests that the benefits of 
our oversight may be substantial.
---------------------------------------------------------------------------

    \87\ 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 http://www.sec.gov/litigation/complaints /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.
    \88\ Several studies examine the impact of deterrence on the 
decision to commit crimes in different contexts. The seminal paper 
in this area is Gary Becker, Crime and Punishment: An Economic 
Approach, 76 J. Political Econ. 169 (1968). Another influential 
paper is Isaac Ehrlich, Participation in Illegitimate Activities: A 
Theoretical and Empirical Investigation, 81 J. Political Econ. 521 
(1973). The deterrence hypothesis is also discussed in Robert Cooter 
and Thomas Ulen, Law and Economics, ch.11-12 (1988).
---------------------------------------------------------------------------

    Economic theories of monitoring and deterrence based on principal-
agent models have been used to examine regulatory issues related to tax 
fraud. See Jennifer F. Reinganum and Louis L. Wilde, Income Tax 
Compliance in a Principal-Agent Framework, 26 J. Pub. Econ. 1 (Feb. 
1985); Jennifer F. Reinganum and Louis L. Wilde, A Note On Enforcement 
Uncertainty and Taxpayer Compliance, 103(4) Quarterly J. Econ. 793 
(Nov. 1988). These papers suggest that randomized monitoring is 
sufficient to generate a deterrent effect. If the magnitude of 
deterrence is sufficient, randomized monitoring could create a net 
economic benefit.
    Commenters opposing the rule challenged our concerns regarding 
fraud on two grounds. Some asserted that there was an inadequate record 
of fraud by hedge fund advisers to support requiring hedge fund 
advisers to register. They asserted that the 46 cases we cited in the 
Proposing Release represented only two percent of our enforcement cases 
over the applicable five-year period.\89\ We note, however, that these 
cases, which have now grown to 51, represented over ten percent of our 
cases against investment advisers during the same period.
---------------------------------------------------------------------------

    \89\ See, e.g., MFA Letter, supra note 51; ISDA Letter, supra 
note 52; Chamber of Commerce Letter, supra note 52; Schulte Roth 
Letter, supra note 51, Black Letter, supra note 51, David Thayer 
Letter, supra note 53; Comment Letter of Sheila C. Bair (Sept. 15, 
2004) (``Sheila Bair Letter'').
---------------------------------------------------------------------------

    Some commenters cited to us a sentence from the 2003 Staff Hedge 
Fund Report that indicated that there was no evidence that hedge fund 
advisers engaged disproportionately in fraudulent activity.\90\ The 
2003 Staff Hedge Fund Report was issued before the discoveries of hedge 
fund involvement in late trading and inappropriate market timing of 
mutual fund shares.\91\ In addition, implicit in these commenters' 
arguments is that the Commission should wait to act until hedge fund 
frauds do comprise a disproportionate amount of fraudulent activity. We 
reject such arguments. In the face of trends that we now observe, 
including the potential impact of hedge fund fraud on a growing and 
broadening number of direct and indirect investors in hedge funds, we 
believe that waiting would be irresponsible.
---------------------------------------------------------------------------

    \90\ 2003 Staff Hedge Fund Report, supra note 18, at 72.
    \91\ Some of these hedge fund managers may have been part of a 
scheme to defraud mutual fund investors and aided and abetted others 
in defrauding them, in violation of federal securities laws.
---------------------------------------------------------------------------

    Second, some commenters asserted that the Commission would be 
unsuccessful at detecting fraud by hedge fund advisers, pointing to 
frauds that have occurred involving mutual funds.\92\ Such an assertion 
amounts to a generalized attack on the Commission's ability to deter 
and detect fraud in general, and on the premise of statutes that 
provide us with authority to examine investment advisers.\93\ This 
assertion is unsupported by any empirical data, and is as illogical as 
an assertion that because police officers are unable to prevent or 
detect all crime, they should be removed from their beats. Our 
examination staff uncovered, during routine or sweep exams, five of the 
eight cases we brought against registered hedge fund advisers,\94\ and 
two of the cases involving unregistered advisers originated out of 
examinations of related persons that were registered with us.\95\
---------------------------------------------------------------------------

    \92\ See, e.g., Comment Letter of Millrace Asset Group (Sept. 
15, 2004) (``Millrace Letter'').
    \93\ See S. Rep. No. 1760, at 3 (1960) (recommending amendments 
to the Advisers Act that gave Commission examination authority, 
explaining that ``[t]he prospect of an unannounced visit of a 
Government inspector is an effective stimulus for honesty and 
bookkeeping veracity.'').
    \94\ Eight of the 51 cases involved registered hedge fund 
advisers, and routine or sweep exams were the source of five of 
those eight cases. In the Matter of Alliance Capital Management, 
L.P., supra note 29 (Commission found that investment adviser to 
hedge fund and mutual funds permitted market timing of the mutual 
funds in exchange for the timers' agreements to invest in the hedge 
fund); 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) (charging hedge fund adviser with 
misallocating favorable investment opportunities); In the Matter of 
Zion Capital Management LLC, and Ricky A. Lang, Investment Advisers 
Act Release No. 2200 (Dec. 11, 2003) (charging hedge fund adviser 
with misallocating investment opportunities to the adviser's 
personal account); SEC v. Schwendiman Partners, LLC, Gary 
Schwendiman, and Todd G. Schwendiman, Investment Advisers Act 
Release No. 2043 (July 11, 2002) (charging hedge fund adviser with 
usurping favorable investment opportunities, for the benefit of the 
adviser); In the Matter of Portfolio Advisory Services, LLC and Cedd 
L. Moses, Investment Advisers Act Release No. 2038 (June 20, 2002) 
(Commission found hedge fund 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).
    \95\ SEC v. KS Advisors, Inc., et al., Litigation Release No. 
18600 (Feb. 27, 2004) (asserting hedge fund advisers misrepresented 
performance and net asset value of two hedge funds to conceal 
massive trading losses); SEC v. James S. Saltzman, Litigation 
Release No. 17158 (Sept. 27, 2001) (asserting hedge fund adviser 
diverted significant amounts of fund assets to personal use).
---------------------------------------------------------------------------

    Finally, some commenters suggested that hedge fund advisers are 
different from other advisers and that our examiners would be unable to 
fully understand their trading strategies and investments.\96\ This 
argument does not acknowledge that we are today responsible for the 
oversight of significant number of registered hedge fund advisers (not 
all of which are engaged in complex trading strategies), as well as 
many other advisers (some of which are engaged in complex trading 
strategies). In our experience, 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,\97\ portfolio

[[Page 72063]]

pumping,\98\ misrepresentation of portfolio performance,\99\ 
falsification of experience, credentials and past returns,\100\ 
misleading disclosure regarding claimed trading strategies \101\ and 
improper valuation of assets.\102\
---------------------------------------------------------------------------

    \96\ See, e.g., Schulte Roth Letter, supra note 51; Sidley 
Austin Letter, supra note 51.
    \97\ 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., Litigation Release No. 18150 (May 
20, 2003); SEC v. Vestron Financial Corp., et al., Litigation 
Release No. 18065 (Apr. 2, 2003); SEC v. Hoover and Hoover Capital 
Management, Inc., Litigation Release No. 17487 (Apr. 24, 2002); SEC 
v. Beacon Hill Asset Management LLC, et al., Litigation Release No. 
18745A (June 16, 2004); 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., 
Litigation Release No. 17417 (Mar. 15, 2002); 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, Litigation Release No. 16770 (Oct. 17, 2000).
    \98\ SEC v. Michael Lauer, Lancer Management Group, LLC, and 
Lancer Management Group II, LLC, Litigation Release No. 18247 (July 
23, 2003); SEC v. Burton G. Friedlander, Litigation Rel. No. 18426 
(Oct. 24, 2003).
    \99\ 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 97; SEC v. David M. 
Mobley, Sr., et al., supra note 97; SEC v. Hoover and Hoover Capital 
Management, Inc., supra note 97; SEC v. Beacon Hill Asset Management 
LLC, et al., supra note 97; SEC v. Edward Thomas Jung, et al., supra 
note 97; SEC v. Michael W. Berger, Manhattan Capital Management 
Inc., Litigation Release No. 17230 (Nov. 3, 2001); 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 97.
    \100\ 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 97; SEC v. Peter W. Chabot, Chabot 
Investments, Inc., Sirens Synergy and the Synergy Fund, LLC, supra 
note 97; SEC v. Vestron Financial Corp., et al., supra note 97; SEC 
v. House Asset Management, L.L.C., House Edge, L.P., Paul J. House, 
and Brandon R. Moore, supra note 97; SEC v. Evelyn Litwok & Dalia 
Eilat, supra note 97; SEC v. Ashbury Capital Partners, L.P., Ashbury 
Capital Management, L.L.C., and Mark Yagalla, supra note 97.
    \101\ SEC v. Peter W. Chabot, Chabot Investments, Inc., Sirens 
Synergy and the Synergy Fund, LLC, supra note 97; SEC v. David M. 
Mobley, Sr., et al., supra note 97; SEC v. Edward Thomas Jung, et 
al., supra note 97; SEC v. Ashbury Capital Partners, L.P., Ashbury 
Capital Management, L.L.C., and Mark Yagalla, supra note 97.
    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, supra note 94; 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, supra note 94; 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, supra note 94; 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 94. We have no reason to believe that unregistered advisers may 
not be perpetrating the same types of frauds, beyond our detection.
    \102\ SEC v. Global Money Management, L.P., Litigation Release 
No. 18666 (Apr. 12, 2004); SEC v. Burton G. Friedlander, supra note 
98; SEC v. Michael Lauer, Lancer Management Group, LLC, and Lancer 
Management Group II, LLC, supra note 98; SEC v. David M. Mobley, 
Sr., et al., supra note 97; SEC v. Beacon Hill Asset Management LLC, 
et al., supra note 97; SEC v. Edward Thomas Jung, et al., supra note 
97; In the Matter of Charles K. Seavey and Alexander Lushtak, supra 
note 99; In the Matter of Michael T. Higgins, supra note 99.
---------------------------------------------------------------------------

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.\103\ We intend to use this authority to help keep 
fraudsters, scam artists and others out of the hedge fund 
industry.\104\
---------------------------------------------------------------------------

    \103\ 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)]. 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. The Commission's screening, 
however, 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.
    \104\ See, e.g., SEC v. J. Scott Eskind, supra note (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 
hedge fund investors of approximately $700,000).
---------------------------------------------------------------------------

    Several of the frauds we have seen 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.'' \105\ We have been concerned that these individuals 
may have been attracted to hedge funds because they could operate 
without regulatory scrutiny of their past activities.\106\ 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.\107\
---------------------------------------------------------------------------

    \105\ SEC v. Jean Baptiste Jean Pierre, Gabriel Toks Pearse and 
Darius L. Lee, supra note (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 97 (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).
    \106\ Comment Letter of Vantis Capital Management LLC (July 14, 
2004) (``Vantis July Letter'') (registered hedge fund adviser stated 
that the lack of scrutiny of hedge fund advisers has led to the 
industry attracting ``unsavory characters'').
    \107\ 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, many prospective investors may insist that 
newly-formed 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 will require hedge fund 
advisers to adopt policies and procedures designed to prevent violation 
of the Advisers Act, and to designate a chief compliance officer.\108\ 
Hedge fund advisers that have not already done so must develop and 
implement a compliance infrastructure. We adopted this requirement last 
year for all advisers registered with us in recognition that advisers 
have the primary obligation to ensure compliance with the securities 
laws, and to foster more effective compliance practices.\109\ Our 
examination staff resources are limited, and 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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    \108\ Rule 206(4)-7 [17 CFR 275.206(4)-7].
    \109\ 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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    Comment letters opposing registration of hedge fund advisers did 
not challenge the benefits of compliance programs; rather, they 
complained of the costs of developing a compliance infrastructure, and 
of submitting to our compliance examinations.\110\ They asserted that 
these costs would make them less competitive, and would impose barriers 
to entry preventing new hedge fund advisers from starting their own 
hedge funds.\111\ We acknowledge that development and maintenance of 
compliance controls involves costs,\112\

[[Page 72064]]

but these are costs that today all advisers registered with us must 
bear, including advisers that are much smaller and have substantially 
fewer resources than many hedge fund advisers.\113\
---------------------------------------------------------------------------

    \110\ See, e.g., MFA Letter, supra note 51; Madison Capital 
Letter, supra note 51; Sidley Austin Letter, supra note 51.
    \111\ See Comment Letter of Seward & Kissel LLP (Sept. 15, 2004) 
(``Seward & Kissel Letter''); Comment Letter of Bryan Cave LLP (Aug. 
16, 2004) (``Bryan Cave Letter'').
    \112\ In the Proposing Release, we estimated that the new 
registrants would need to spend $20,000 in professional fees and 
$25,000 in internal costs, including staff time, to develop the 
compliance infrastructure required of a registered investment 
adviser. These estimates were based on our discussions with 
industry, including attorneys whose practice involved counseling 
registered and unregistered investment advisers. Commenters argued 
that their costs would be higher. We discuss the benefits and costs 
of our rulemaking in Section IV. of this Release.
    \113\ See ICAA Letter, supra note 47. As of September 30, 2004, 
of the 8,535 advisers registered with the Commission, 2,758 reported 
on their Form ADV that they were managing less than $50 million in 
client assets.
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    Our 2003 Staff Hedge Fund Report noted that, while 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.\114\ These lack of controls 
concern not only us, but also hedge fund investors. A recent survey of 
institutional investors reported that the adequacy of operational 
controls at hedge fund advisory firms was one of most frequently 
mentioned concerns.\115\ While these investors can request to see a 
hedge fund manager's compliance policies and procedures, we are in a 
position to determine whether the hedge fund adviser's operations seem 
to be in accordance with those policies and procedures.
---------------------------------------------------------------------------

    \114\ See 2003 Staff Hedge Fund Report, supra note 18 at section 
VII.A.1.b.
    \115\ BONY Report, supra note 39, at 15-16.
---------------------------------------------------------------------------

    Application of our recent rule requiring more formalized compliance 
policies administered by an employee designated as a chief compliance 
officer will serve to better protect hedge fund investors.\116\ We also 
believe it will well serve hedge fund advisers that, for business 
reasons alone, should have a compliance infrastructure commensurate 
with the nature of their operations and the risks involved.\117\ These 
costs appear small relative to the scale of the industry.\118\ The 
typical hedge fund fee structure, which involves both a management fee 
of two percent or more and a performance fee of twenty percent or more 
provides hedge fund advisers with a substantial cash flow.\119\ Today 
there are many investment advisers registered with us that manage a 
comparable amount of assets, charge substantially lower fees, and bear 
these same compliance costs. One recent study estimated that ``in 1999, 
with $450 billion in assets under management, hedge funds'' fee 
revenues were higher than those of the whole U.S. equity mutual fund 
industry.'' \120\
---------------------------------------------------------------------------

    \116\ Rule 206(4)-7. 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.
    \117\ One hedge fund adviser agreed: ``Benefits [of 
registration] include * * * the structure it provides for advisers'' 
policies and procedures, the value of having an additional layer of 
oversight of advisers' compliance programs.'' Vantis August Letter, 
supra note 50.
    \118\ In concluding that registration would impose substantial 
burdens on a hedge fund adviser, several commenters mistakenly 
assumed that compliance with rule 206(4)-7(c) would require them to 
hire a new chief compliance officer. The rule requires all 
registered advisers to ``designate'' an individual as chief 
compliance officer, which could be an individual currently employed 
by the adviser who has similar responsibilities.
    \119\ Some hedge fund advisers charge up to four percent in 
asset-based fees, and others take between 30 and 50 percent of their 
funds' profits. See Hedge Funds Grab More In Fees As Their 
Popularity Increases, supra note 11.
    \120\ See Bernstein 2003 Report, supra note 24, at 4.
---------------------------------------------------------------------------

    There are today ``[e]xtremely low barriers to entry and tremendous 
monetary and non-monetary incentives for hedge fund [advisers],'' \121\ 
and thus the cost of compliance with these rules should not present 
significant additional barriers to entry for new hedge fund advisers. 
Indeed some have suggested that our regulatory initiative may ``play a 
positive role of increasing confidence in hedge fund use by further 
demystifying them.'' \122\
---------------------------------------------------------------------------

    \121\ Id. at 15. See also Vantis July Letter, supra note 106 
(``there are presently too few barriers to entry'' in the hedge fund 
industry).
    \122\ Bernstein 2003 Report, supra note 24, at 14. Regulatory 
oversight to deter frauds may forestall erosion of investor 
confidence in this growing industry. See, e.g., Vantis July Letter, 
supra note 106 (mandatory registration will improve the image of the 
hedge fund industry); Hennessee Foundation and Endowment Survey, 
supra note 39 (survey participant remark that registration ``lends 
creditability to the field''); Comment Letter of North American 
Securities Administrators Association, Inc. (Oct. 18, 2004) (SEC 
registration will increase investor confidence, thereby benefiting 
hedge fund advisers).
---------------------------------------------------------------------------

5. Limitation on Retailization
    Registration under the Advisers Act will have the salutary effect 
of resulting in all direct investors in most hedge funds meeting 
minimum standards of rule 205-3 under the Advisers Act, because hedge 
fund advisers typically charge performance fees.\123\ Rule 205-3 
requires that each investor, in a private investment company that pays 
a performance fee, generally have a net worth of at least $1.5 million 
or have at least $750,000 of assets under management with the 
adviser.\124\ Many hedge fund advisers will rely on rule 205-3 to 
continue charging a performance fee to the funds they manage.
---------------------------------------------------------------------------

    \123\ See supra note 119.
    \124\ Hedge funds in the United States are generally organized 
to avoid regulation under the Investment Company Act by qualifying 
for an exclusion, from the definition of ``investment company,'' 
under section 3(c)(1) [15 U.S.C. 80a-3(c)(1)] or 3(c)(7) [15 U.S.C. 
80a-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 advisers to 3(c)(1) funds to consider each investor in the 
fund as a client for purposes of charging a performance fee.
---------------------------------------------------------------------------

    Most commenters did not address this effect of registration under 
the Act, except with respect to expressing their support for the 
transitional rule we also proposed, and which we discuss later in this 
Release.\125\ Some argued that we should, instead, raise the 
``accredited investor'' standards applicable to private offerings 
pursuant to Regulation D, which may have a similar effect on limiting 
direct investments in hedge funds.\126\ Raising the accredited investor 
standards would not address the broader concerns, discussed above, of 
the indirect exposure to hedge funds by an increasingly large number of 
persons who are beneficiaries of pensions plans or invest through other 
intermediaries that are likely to meet any higher standards.
---------------------------------------------------------------------------

    \125\ See infra Section II.H of this Release.
    \126\ Regulation D [17 CFR 230.501 through 508] exempts from 
registration under the Securities Act of 1933 offerings and sales of 
securities that satisfy certain conditions, including certain sales 
to ``accredited investors.'' As noted in the 2003 Staff Hedge Fund 
Report, supra note 18, at 313, our approach of leaving eligibility 
requirements for accredited investors unchanged also allows small 
businesses to continue to seek capital from historical sources.
---------------------------------------------------------------------------

6. CFTC Regulation
    Several commenters suggested that the Commission exempt from 
registration hedge fund advisers that are registered with the CFTC as 
commodity pool operators in order to avoid duplicative 
registration.\127\ In 2000 Congress addressed this concern by adding 
section 203(b)(6) to the Advisers Act, which exempts any CFTC-
registered commodity trading advisor from investment adviser 
registration if its business does not consist primarily

[[Page 72065]]

of acting as an investment adviser.\128\ A hedge fund adviser that 
qualifies for this statutory exemption is not required to register with 
us.
---------------------------------------------------------------------------

    \127\ Comment Letter of Denali Asset Management LLLP (Aug. 27, 
2004) (``Denali Letter''); Comment Letter of Willkie Farr & 
Gallagher LLP (Sept. 13, 2004) (``Willkie Farr Letter''); Comment 
Letter of National Futures Association (Sept. 14, 2004) (``NFA 
Letter''); ICAA Letter, supra note 47; Comment Letter of Katten 
Muchin Zavis Rosenman (Sept. 14, 2004) (``Katten Muchin Letter''); 
Tudor Letter, supra note 53; Financial Services Roundtable Letter, 
supra note 53; Jeffrey R. Neufeld (Sept. 15, 2004) (``Neufeld 
Letter''); Kynikos Letter, supra note 80; Comment Letter of the 
Association of the Bar of the City of New York Committee on Futures 
Regulation (Sept. 15, 2004) (``NYC Bar Futures Committee Letter''); 
Comment Letter of the U.S. Commodity Futures Trading Commission 
(Oct. 22, 2004) (``CFTC Letter'').
    \128\ 15 U.S.C. 80b-203(b)(6). Congress enacted section 
203(b)(6) as part of the Commodity Futures Modernization Act of 
2000, Pub. L. 106-554, 114 Stat. 2763 (2000) (codified in scattered 
sections of the United States Code). A parallel provision was added 
simultaneously to the Commodity Exchange Act. Section 4m of the 
Commodity Exchange Act [7 U.S.C. 6m]. The exemption in section 
203(b)(6) is not available if the firm acts as an adviser to a 
registered investment company or to a company that has elected to be 
a business development company under section 54 of the Investment 
Company Act [15 U.S.C. 80a-53].
---------------------------------------------------------------------------

    We disagree that our oversight of hedge fund advisers that are also 
commodity pool operators would be duplicative. Most hedge fund 
portfolios consist primarily of securities, and the CFTC's oversight 
necessarily focuses more on the area of futures trading, which is the 
activity of most concern to the CFTC.\129\ It would be inconsistent 
with principles of functional regulation and contrary to the design and 
purpose of the 2000 amendments to the Advisers Act for the Commission 
not to oversee hedge fund advisers whose primary business is acting as 
an investment adviser.\130\
---------------------------------------------------------------------------

    \129\ Roundtable Transcript of May 15 at 236-37, supra note 
(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'').
    \130\ We note that the frequency with which hedge fund advisers 
may also be registered with the CFTC as commodity pool operators 
(``CPOs'') may diminish substantially in the future. The CFTC 
recently adopted rules that may permit most hedge fund advisers to 
now avoid registering as CPOs or commodity trading advisors 
(``CTAs''). See 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). See also Susan Ervin, Downsizing 
Commodity Pool Regulation: The CFTC's New Initiative, Futures 
Industry, 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 
expect our staff will consult with the staff of the CFTC to discuss 
a variety of matters regarding examinations of hedge fund advisers, 
including the extent to which examinations should be coordinated or 
results shared.
---------------------------------------------------------------------------

7. Moral Hazard Implications
    Some commenters urged us not to adopt the rule because Commission 
oversight of hedge fund advisers might tend to cause hedge fund 
investors to rely on that oversight instead of performing appropriate 
due diligence before making an investment in a hedge fund.\131\ Such an 
argument, if accepted, would support withdrawal of the Commission's 
oversight of all advisers, particularly of those advisers whose clients 
are less sophisticated and who might be less likely to appreciate the 
limitations of regulatory oversight.\132\ Congress addressed such 
arguments in 1940 when it passed the Advisers Act by including a 
provision in the Act that makes it unlawful for any investment adviser 
to ``represent or imply in any manner whatsoever that [the adviser] has 
been sponsored, recommended, or approved, or that his abilities or 
qualifications have in any respect been passed upon by the United 
States or any agency or officer thereof.'' \133\
---------------------------------------------------------------------------

    \131\ We note, however, that without the new rule requiring 
registration, a hedge fund adviser can now choose to register under 
the Advisers Act but then withdraw its registration, for example, at 
the prospect of an examination. Thus, without the new rule, any 
moral hazard would already exist, but without necessarily providing 
hedge fund investors the benefit of our oversight of their advisers.
    \132\ See, e.g., 1940 Senate Hearings, supra note (testimony of 
Dwight C. Rose, President, Investment Counsel Association of 
America, (``Many incompetents would be permitted to register and 
describe themselves as registered or licensed investment counsel. 
This badge of registration and apparent approval by the Federal 
Government might, therefore, in spite of any express provision 
denying such approval in the act itself, give to the unsophisticated 
investor a mistaken and completely underserved impression of 
qualification and standing.'')). Indeed, such an argument could be 
made against Commission regulation of any broker-dealer, transfer 
agent, or investment company.
    \133\ Section 208(a) of the Act [15 U.S.C. 80b-8(a)]. A 
registered adviser may refer to itself as ``registered'' so long as 
the effect of registration is not misrepresented. Section 208(b) [15 
U.S.C. 80b-8(b)].
---------------------------------------------------------------------------

8. Proper Administration of the Advisers Act
    In adopting rule 203(b)(3)-2, an important consideration for us has 
been our dissatisfaction with the operation of the existing safe harbor 
because it permits advisers, without registering under the Act, to 
manage large amounts of securities indirectly through hedge funds that 
may have, collectively, hundreds of investors.\134\ We believe that the 
safe harbor has become inconsistent with the underlying purpose of the 
registration exemption in Section 203(b)(3), which was designed to 
exempt advisers whose business activities are too limited to warrant 
federal attention. Commenters have not persuaded us otherwise. Our 
actions today withdraw that safe harbor and require advisers to 
``private funds''--which will include most hedge funds--to ``look 
through'' the funds to count the number of investors as ``clients'' for 
purposes of the private adviser exemption.
---------------------------------------------------------------------------

    \134\ Practically speaking, a single hedge fund can have up to 
499 investors; beyond this limit, the fund faces potential 
obligations to register under section 12 of the Exchange Act [15 
U.S.C. 78h] and rule 12g-1 [17 CFR 240.12g-1], generally requiring 
registration of any issue with 500 holders of record of a class of 
equity securities and assets in excess of $10 million. Since rule 
203(b)(3)-1 has generally allowed an adviser to count each hedge 
fund as one client, a hedge fund adviser could have 14 funds with 
499 investors in each, or a total of 6,986 investors.
---------------------------------------------------------------------------

    Many commenters who opposed the rule urged us to maintain the safe 
harbor because it operated to exempt advisers to hedge funds in which 
only wealthy and sophisticated investors participated.\135\ This 
argument implicitly concedes that the Commission should look to the 
investors in the hedge fund (rather than the hedge fund itself) to 
determine whether the adviser should be required to register, but 
concludes that we should continue to exempt the adviser from 
registration because the ultimate advisory clients are wealthy or 
sophisticated.
---------------------------------------------------------------------------

    \135\ See, e.g., Chamber of Commerce Letter, supra note 52; MFA 
Letter, supra note 51. Opponents of the Advisers Act made this same 
argument to Congress in 1940 without success. See, e.g., 1940 Senate 
Hearings, supra note (testimony of Charles O'Hearn, Clarke, 
Sinsabaugh & Co., (``Regulation of this profession by the Securities 
and Exchange Commission is not necessary for the protection of 
small, uninformed investors, since they do not use investment 
counsel service. There is a marked difference between the owners of 
investment trust securities and our clients. While investment trusts 
sell securities in amounts sufficiently small so that even the 
poorest may buy, our services are designed for and limited to a 
group of persons who are a minority in the community. We do not deal 
with the general public. Our clients represent substantial amounts 
of capital and have adequate means to inform themselves about us 
through their banking and legal affiliations.'')).
---------------------------------------------------------------------------

    Section 203(b)(3) was not intended to exempt advisers to wealthy or 
sophisticated clients. First, they were the primary clients of many 
advisers in 1940 when the provision was included in the Act.\136\ 
Second, it would make no sense for Congress to have imposed a limit on 
the number of wealthy or sophisticated clients an adviser could have 
before it had to register under the Act. Surely, the fifteenth wealthy 
or sophisticated client would not trigger the need for registration. 
Other

[[Page 72066]]

provisions in the federal securities laws designed to exempt 
transactions or relationships with wealthy or sophisticated investors 
contain no such limitations.\137\
---------------------------------------------------------------------------

    \136\ 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).
    \137\ See, e.g., section 3(c)(7) [15 U.S.C. 80a-3(c)(7)] of the 
Investment Company Act.
---------------------------------------------------------------------------

    The intent of Congress in enacting section 203(b)(3) appears to 
have been to create a limited exemption for advisers whose activities 
were not national in scope \138\ and who provided advice to only a 
small number of clients, many of whom are likely to be friends and 
family members.\139\ These advisers are unlikely to significantly 
affect investors and the securities markets generally.\140\ 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,\141\ 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.
---------------------------------------------------------------------------

    \138\ See section 201 of the Act [15 U.S. 80b-1] (activities of 
investment advisers are of national concern because they 
substantially affect national securities exchanges and the national 
economy).
    \139\ 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 1940 Senate Hearings, supra note 73.
    \140\ See section 201 of the Act.
    \141\ 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 and rule 144A 
[17 CFR 230.144A]; SEC v. Ralston Purina Co., 346 U.S. 119 (1953).
---------------------------------------------------------------------------

    Several commenters opposing the rule pointed to legislation enacted 
in 1996 that created a new exclusion from the definition of 
``investment company'' under the Investment Company Act for pools of 
securities offered exclusively to ``qualified purchasers'' as evidence 
that Congress intended that hedge fund advisers be left unregulated by 
the Advisers Act as well as the Investment Company Act.\142\ These 
commenters offered no support for this proposition.
---------------------------------------------------------------------------

    \142\ See, e.g., Comment Letter of Wilmer Cutler Pickering Hale 
and Dorr LLP (Sept. 8, 2004) (``Wilmer Cutler Letter'').
---------------------------------------------------------------------------

    The 1996 National Securities Markets Improvement Act (NSMIA) 
exempted these qualified purchaser funds from only the Investment 
Company Act.\143\ Its legislative history explains only that Congress 
believed the protections afforded by the Investment Company Act were 
unnecessary for financially sophisticated investors.\144\ Moreover, the 
current safe harbor, which can result in hedge fund advisers with 
hundreds of millions of dollars of assets being registered with one or 
more state regulators, is inconsistent with the policy and purposes of 
NSMIA, which allocated oversight responsibility for larger advisers to 
the Commission.\145\
---------------------------------------------------------------------------

    \143\ Pub L. No. 104-290, 110 Stat. 3416 (1996) (codified in 
scattered sections of the United States Code).
    \144\ S.Rep. No. 104-293, at 10 (1996).
    \145\ Title III of NSMIA amended the Advisers Act to allocate 
regulatory responsibility over advisers between the Commission and 
state securities authorities. It gave the Commission responsibility 
for advisers with more than $25 million of assets under management, 
and preempted state registration and other requirements for advisers 
registered with the Commission. These are firms that Congress 
concluded were ``[l]arger advisers, with national businesses [that] 
should be registered with the Commission and be subject to national 
rules.'' S. Rep. No. 293, 104th Cong., 2d Sess. (1996) at 3-4.
---------------------------------------------------------------------------

    The legislative record of NSMIA, in fact, suggests that Congress 
may have expected the Commission to regulate the activities of advisers 
to hedge funds eligible for the new Investment Company Act exclusion. 
NSMIA amended section 205 of the Advisers Act to exempt qualified 
purchaser funds from restrictions on performance fees. Section 205 of 
the Act does not apply to advisers ``exempt from registration pursuant 
to Section 203(b),'' and thus affects only funds advised by investment 
advisers registered with the Commission. Thus, Congress understood that 
at least some of these qualified purchaser pools would be advised by 
registered advisers, and chose to exempt these advisers only from the 
restrictions on performance fees.
9. Alternatives Submitted
    Several commenters submitted alternative approaches for our 
consideration. These alternatives included provisions aimed at 
addressing several of the considerations that led us to propose rule 
203(b)(3)-2, such as the need for information about hedge fund advisers 
and the broadening exposure of investors to hedge funds. We have 
considered these alternatives. However, as discussed below, the 
alternatives each involve partial responses to our concerns, and all 
would deny us the ability to examine the activities of hedge fund 
advisers, and would not, in our judgment, accomplish the goals of this 
rulemaking.
    Some commenters suggested we except hedge fund advisers from the 
adviser registration requirement if all investors in their hedge funds 
meet ``qualified purchaser'' standards under section 3(c)(7) of the 
Investment Company Act.\146\ Others suggested that in lieu of requiring 
hedge fund adviser registration, we should increase the current 
``accredited investor'' standards for private securities offerings 
under Regulation D.\147\ These alternatives would address one aspect of 
our concern about the prospect of direct ownership of hedge funds by 
investors who may not previously have participated in these types of 
risky investments, but would not permit us to protect the interests of 
those whose exposure is through intermediaries such as funds of funds 
and pension funds.\148\ Moreover, as discussed earlier, the Advisers 
Act does not exempt an adviser from registration merely because its 
clients may be wealthy or sophisticated.\149\
---------------------------------------------------------------------------

    \146\ See, e.g., Financial Services Roundtable Letter, supra 
note 53; Tudor Letter, supra note 53. Another commenter suggested 
that the investments of the hedge fund adviser's insiders be 
excluded in applying the registration requirements. Comment Letter 
of Alex M. Paul (July 21, 2004). We are adopting a provision that 
allows an adviser to exclude certain knowledgeable insiders when 
counting its clients. See infra Section II.D.2 of this Release.
    \147\ See, e.g., Chamber of Commerce Letter, supra note 52; 
Neufeld Letter, supra note 127 (increase accreditation standards, 
with exemptions for family members of advisory firms' employees). 
See also MFA Letter, supra note 51 (suggesting creation of investor 
accreditation standards under the Advisers Act for hedge fund 
investors).
    \148\ Other commenters suggested variations with special rules 
for funds of funds or pension plans. Regardless of the extent to 
which these alternatives might limit indirect participation in hedge 
funds advised by unregistered advisers, these alternatives would not 
permit us to examine unregistered hedge fund advisers. See, e.g., 
Bryan Cave Letter, supra note 111 (apply investor accreditation 
standards to funds of funds on a look-through basis); Comment Letter 
of Leon M. Metzger (Sept. 15, 2004) (``Metzger Letter'') (require 
fund of funds whose investors do not meet accreditation standards to 
invest only in funds with registered advisers; coordinate with 
Department of Labor to prohibit pension fund investments in hedge 
funds with unregistered advisers); Madison Capital Letter, supra 
note 51 (apply the look-through for purposes of counting up to 15 
clients, but the only investors that would be counted towards the 
limit would be (i) investors that did not meet 3(c)(7) ``qualified 
purchaser'' standards, (ii) pension funds, and (iii) registered 
investment companies).
    \149\ See supra Section II.B.8 of this Release.
---------------------------------------------------------------------------

    Other commenters offered alternatives based on amending our Form D 
to

[[Page 72067]]

require hedge funds to provide certain information about their 
advisers.\150\ Some suggested that hedge fund advisers whose funds 
submitted this information be excepted from adviser registration 
requirements,\151\ while others suggested it be an alternative to 
registration.\152\ Some commenters further suggested that these 
information requirements be combined with limited application of 
specific rules that apply only to registered advisers, such as the 
custody rule or the compliance rule.\153\ None of these alternatives, 
however, would provide us with examination authority.\154\
---------------------------------------------------------------------------

    \150\ Form D [17 CFR 239.500] is the form filed with the 
Commission by issuers (including many hedge funds) that make private 
securities offerings in reliance on Regulation D. Other commenters 
suggested informational filing requirements but did not focus on 
Form D in particular. See, e.g., Comment Letter of the American Bar 
Association Section of Business Law (Sept. 28, 2004) (``ABA 
Letter''); MFA Letter, supra note 51 (informational filing coupled 
with certification that insiders of the adviser or its funds did not 
have disciplinary history that would be reportable under Form ADV, 
and adviser's agreement to provide certain additional information to 
the Commission on ``special call'' in limited circumstances).
    \151\ These commenters suggested registration carve-outs apply 
to hedge fund advisers whose funds submitted the expanded Form D 
information and accepted investments only from persons meeting 
``accredited investor'' or ``qualified client'' criteria. See, e.g., 
Bryan Cave Letter, supra note 111; Seward & Kissel Letter, supra 
note 111. Bryan Cave also suggested that hedge funds be covered 
under revised and expanded Suspicious Activity Reports (``SARs''), 
and any information reported be shared with the Commission to aid 
enforcement efforts. The Financial Crimes Enforcement Network 
requires banks, brokers, and other financial institutions to file 
SARs if the institution observes suspected or potential financial 
crimes. We believe this kind of monitoring of hedge funds' financial 
transactions with third parties would provide us only with partial 
information about hedge fund advisers' activities.
    \152\ See, e.g., Comment Letter of Coudert Brothers LLP (Sept. 
15, 2004) (``Coudert Letter''); Katten Muchin Letter, supra note 
127.
    \153\ See, e.g., Bryan Cave Letter, supra note 111; MFA Letter, 
supra note 51; Kynikos Letter, supra note 80. Kynikos suggested that 
each adviser certify its compliance with the custody, compliance, 
and code of ethics rules and its adherence to investor qualification 
standards, as well as provide investors with special disclosures of 
key valuation and allocation standards, and distribute quarterly 
unaudited and annual audited financial statements to investors. 
Other commenters similarly included audit requirements as part of 
their alternatives. See, e.g., Madison Capital Letter, supra note 51 
(suggesting annual audit requirement (with results delivered to 
investors and the Commission) and expanded Form D information 
reporting); Willkie Farr Letter, supra note 127 (suggesting self-
executing exemptive application procedure for advisers whose funds 
distribute audited financials and special valuation disclosures to 
investors). We have previously requested comment on alternatives 
that would incorporate private audits into our oversight of 
investment advisers. Compliance Programs of Investment Companies and 
Investment Advisers, Investment Advisers Act Release No. 2017 (Feb. 
5, 2003) [68 FR 7038 (Feb. 11, 2003)]. However, as commenters in 
that inquiry noted, reliance on auditors can be problematic, since 
their reviews are not necessarily designed to address all the issues 
addressed by our oversight program, and audit personnel do not 
necessarily have an in-depth knowledge of the Advisers Act. See, 
e.g., Comment Letter of the Council of Institutional Investors 
(April 10, 2003), available at http://www.sec.gov/rules/proposed/s70303/cii041003.htm.
    \154\ Further, under this alternative, hedge fund advisers could 
not use Investment Adviser Registration Depository system 
(``IARD''), the electronic filing system that investment advisers 
use to make filings with us. Thus, information about investment 
advisers to hedge funds would not be integrated with information 
about other investment advisers, it would not be included in the 
data reports available to our staff, and disciplinary and other 
important information about hedge fund advisers would not be 
available to the public through the Investment Adviser Public 
Disclosure system, which draws data from the IARD.
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    Finally, some commenters suggested that, instead of registering 
hedge fund advisers, we gather information about them from a variety of 
regulatory filings currently made by hedge funds, their advisers, and 
broker-dealers.\155\ We have considered this alternative, but the 
reports and information currently available would provide at best a 
partial, inadequate view of the activities of hedge fund advisers. 
While some of the reports emphasized by these commenters might provide 
us with basic identifying information about hedge funds advisers that 
are registered as broker-dealers or commodity pool operators, many are 
not registered in either capacity. These commenters also focus on 
several existing transactional reporting requirements, arguing they 
contain a wealth of information about hedge funds. However, as 
discussed above, making use of this information would require 
substantial effort on the part of our staff to extract a composite of 
information about any particular hedge fund, yielding limited 
information about its assets instead of any useful information about 
whether its adviser is fulfilling its fiduciary duties. As we stated in 
the Proposing Release, we need information that is reliable, current, 
and complete, and we need it in a format reasonably susceptible to 
analysis by our staff.
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    \155\ See, e.g., MFA Letter, supra note 51; Tudor Letter, supra 
note 53.
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C. Our Legal Authority Under the Advisers Act

    A few commenters challenged our legal authority to adopt rule 
203(b)(3)-2, asserting that the approach of the rule, which requires an 
adviser to ``look through'' a hedge fund to determine whether it is 
eligible for the private adviser exemption, is contrary to the Act. For 
the reasons discussed below, we believe we have broad authority to 
adopt the rule. We start our discussion with the statutory language.
    Section 203(b)(3) of the Act provides an exemption from 
registration for certain investment advisers. To qualify for the 
exemption, Congress provided two specific tests, each of which an 
adviser must satisfy. First, the adviser must not advise fifteen or 
more clients and, second, the adviser must not hold itself out to the 
public as an investment adviser. In enacting this provision, Congress 
exempted from the registration requirements a category of advisers 
whose activities were not sufficiently large or national in scope, 
e.g., advisers to family or friends, to implicate the policy objectives 
identified in section 201 of the Act.\156\
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    \156\ See also supra notes 138-140 and accompanying text.
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    Congress did not appear to have addressed or considered whether an 
adviser must count an investor in a pooled investment vehicle as a 
client for purposes of section 203(b)(3). Nevertheless, it has long 
been recognized that determining whether the exemption applies could 
not be limited to a formalistic assessment of whether the adviser 
provided investment advice to a single legal entity, but instead 
requires consideration of the surrounding circumstances of the advisory 
arrangement, which, in appropriate cases, might call for ``looking 
through'' the advised entity.\157\
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    \157\ Before the Commission adopted the safe harbor in 1985, the 
staff issued numerous no-action letters that required an investment 
adviser to look through an entity and count each individual advisee 
or member as a separate client. See Ruth Levine, SEC Staff No-Action 
Letter (Dec. 15, 1976); David Shilling, SEC Staff No-Action Letter 
(Apr. 3, 1976); B.J. Smith, SEC Staff No-Action Letter (Dec. 25, 
1975); S.S. Program Limited, SEC Staff No-Action Letter (Oct. 17, 
1974); Wofsey, Rosen, Kweskin & Kuriansky, SEC Staff No-Action 
Letter (Apr. 25, 1974); Hawkeye Bancorporation, SEC Staff No-Action 
Letter (June 11, 1971). Ambiguity with respect to this issue was 
fueled in part by Abrahamson v. Fleschner, 568 F.2d 862 (2d Cir. 
1977), cert. denied, 436 U.S. 913 (1978), overruled on other grounds 
by TransAmerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11 
(1979), in which the Second Circuit 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. For a discussion, see 
Robert Hacker and Ronald Rotunda, SEC Registration of Private 
Investment Partnerships after Abrahamson v. Fleschner, 78 Colum. L. 
Rev. 1471, 1477 (1978).
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    For purposes of counting clients, ``looking through'' the advised 
entity in appropriate circumstances is fully consistent with the broad 
remedial purposes of the Advisers Act and the exemptive provisions of 
section

[[Page 72068]]

203(b)(3).\158\ The Act's objectives would be substantially undermined 
if an adviser with more than fifteen clients could evade its 
registration obligation through the simple expedient of having those 
clients invest in a limited partnership or similar fund vehicle--which 
the adviser would thereafter count as a single client. This concern is 
amplified where the adviser solicits investments directly in the fund 
vehicle based on the adviser's investment management skills, and offers 
investors the ability to redeem their assets on a short-term basis, as 
they would be permitted to do if they opened an account directly with 
the adviser.
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    \158\ 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). We note, also, that other regulators have required a look-
through approach in similar circumstances. Various states look 
through investment vehicles to count the investors as ``clients'' of 
the adviser. See Comment Letter of North American Securities 
Administrators Association (Oct. 18, 2004) (``NASAA Letter''). In 
addition, section 4m(1) of the Commodity Exchange Act [7 U.S.C. 
6m(1)] provides an exemption from CTA registration that parallels 
the exemption in section 203(b)(3) of the Advisers Act, and until 
recently, the CFTC looked through legal organizations to count 
owners for purposes of determining whether a person had provided 
commodity trading advice to more than 15 persons in the preceding 12 
months. See Additional Registration and Other Regulatory Relief for 
Commodity Pool Operators and Commodity Trading Advisors, (Mar. 10, 
2003) [68 FR 12622 (Mar. 17, 2003)] (proposing new rule 4.14(a)(10) 
to treat legal organizations as single clients).
---------------------------------------------------------------------------

    The legislative and regulatory history of the Advisers Act since 
its enactment in 1940 is consistent with the understanding that the 
statute in appropriate cases may require ``looking through'' the entity 
for purposes of counting clients. Congressional action involving 
section 203(b)(3), the Commission's rulemaking under the provision, and 
staff no-action letters \159\ evidence the longstanding recognition 
that the exemption does not require a rigid approach to counting 
clients without consideration of the surrounding circumstances.
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    \159\ See supra note 157.
---------------------------------------------------------------------------

    First, the amendment to section 203(b)(3) in 1980 confirmed that 
the exemption could be read to require an adviser to ``look through'' a 
legal entity and count its investors. In 1980, Congress amended the 
section to provide that, in the case of a business development company, 
``no shareholder, partner, or beneficial owner * * * shall be deemed to 
be a client of such investment adviser unless such person is a client 
of such investment adviser separate and apart from his status as a 
shareholder, partner or beneficial owner.'' The language of this 
provision would have been superfluous absent a recognition that, in 
some cases, a shareholder, partner, or beneficial owner, could be 
counted for purposes of the exemption. Further, the legislative history 
indicates that Congress deliberately left open the question of how to 
count clients for entities other than business development 
companies.\160\
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    \160\ See H.R. Rep. No. 96-1341, at 62-63 (1980) (``with respect 
to persons or firms which do not advise business development 
companies, [this amendment] is not intended to suggest that each 
shareholder, partner or beneficial owner of a company advised by 
such a person or firm should or should not be regarded as a client 
of that person or firm''), and S.Rep. No. 96-958 at 41.
---------------------------------------------------------------------------

    Second, the Commission's creation of the existing safe harbor in 
current rule 203(b)(3)-1 would have been entirely unnecessary if there 
had not been a substantial concern, at that time, that an adviser to a 
hedge fund might, in some cases, either be required to ``look through'' 
the fund for counting purposes or to view itself as having violated the 
``holding out'' limitation set out in the statutory exemption.
    When adopting the safe harbor in 1985, we determined to resolve the 
uncertainty regarding when advisers to hedge funds must register by 
expressly exempting them from registration.\161\ At that time, when 
advisers to hedge funds played a far less significant role in the 
national markets than they do today, we did not consider it 
inconsistent with the legislative objectives embedded in the statutory 
exemption to exempt those advisers from registration. However, as we 
stated when we proposed the safe harbor, ``a different approach could 
be followed in counting clients.'' \162\ In light of the developments 
regarding hedge funds and their advisers, we are now taking a different 
approach.
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    \161\ Rule 203(b)(3)-1 Adopting Release, supra note 10 (by 
providing a safe harbor, rule 203(b)(3)-1 will provide greater 
certainty regarding when advisers can rely on section 203(b)(3)). 
Commenters did not challenge our authority to withdraw the safe 
harbor of rule 203(b)(3)-1(a)(2)(i) with respect to private funds.
    \162\ Definition of ``Client'' for Purposes Relating to Limited 
Partnerships, Investment Advisers Act Release No. 956 (Feb. 25, 
1985) [50 FR 8740 (Mar. 5, 1985)] (proposed rule [203(b)(3)-1] is 
intended to provide investment advisers to limited partnerships with 
greater certainty in determining the circumstances under which they 
may rely on section 203(b)(3)).
---------------------------------------------------------------------------

    As discussed above, in the intervening two decades and particularly 
in recent years, much has changed in our capital markets. The growth of 
hedge funds, their market activity and their trading volume has been 
dramatic, and as a result they now have a substantial effect on 
national securities markets and on the national economy. This growth, 
together with the increase in fraud involving hedge fund advisers, 
fully justifies a reexamination of whether it is consistent with the 
Act to continue to provide an across-the-board registration exemption 
for all advisers to hedge funds. The amendments adopted by the 
Commission today recognize those changed circumstances and constitute 
an appropriate use of the Commission's rulemaking authority under the 
Act.
    The Commission has broad rulemaking authority under section 211(a) 
of the Act, which states that the Commission may adopt rules 
``necessary or appropriate to the exercise of the functions and powers 
conferred upon the Commission elsewhere in this title * * *'' and ``may 
classify persons and matters within its jurisdiction and prescribe 
different requirements for different classes of persons or matters.'' 
\163\ Section 206(4) of the Act provides us with authority to adopt 
rules ``that define, and prescribe means reasonably designed to prevent 
such acts, practices, and courses of business as are fraudulent, 
deceptive or manipulative.'' \164\ Once these advisers are registered, 
the Commission will be able to carry out its regulatory function with 
respect to them, such as conducting inspections and examinations,\165\ 
and implementing other provisions, discussed elsewhere in this Release, 
to further investor protection.
---------------------------------------------------------------------------

    \163\ 15 U.S.C. 80b-11(a). See also section 202(a)(17) of the 
Act [15 U.S.C. 80(b)-2(a)(17)] (``The Commission may by rules and 
regulations classify, for the purposes of any portion or portions of 
this title, persons, including employees controlled by an investment 
adviser.'').
    \164\ 15 U.S.C. 80b-6(4). The Supreme Court has upheld, in a 
similar context, our broad authority to prohibit acts not themselves 
fraudulent in order to prevent fraudulent or manipulative conduct. 
See U.S. v. O'Hagan, 521 U.S. 642, 672-73 (1997).
    \165\ See section 204 of the Act [15 U.S.C. 80b-4] (inspection 
and examination authority).
---------------------------------------------------------------------------

    The amendments we adopt today implement our rulemaking authority in 
a manner specifically targeted to those advisers whose activities 
involving ``private funds'' most directly suggest the need for 
registration. As discussed in more detail below,\166\ first, a private 
fund will be one that is excepted from the definition of investment 
company under section 3(c)(1) or 3(c)(7) of the Investment Company Act 
of 1940. By definition, these funds engage in significant securities 
related activities in a context where they deal privately with

[[Page 72069]]

each of their investors (since under sections 3(c)(1) and 3(c)(7) they 
may not engage in a public offering).\167\ Second, the term ``private 
funds'' is limited to investment pools with redemption features that 
offer investors a short-term right to withdraw their assets from 
management, based on their individual liquidity needs and other 
preferences, in a manner similar to clients that directly open an 
account with an adviser. This condition will ensure that the definition 
does not inadvertently include private equity funds, venture capital 
funds, or other funds that require long-term commitment of capital. 
Third, the term is limited to those funds that are marketed based on 
the skills, ability, and expertise of the adviser to the fund, thereby 
confirming the direct link between the adviser's management services 
and the investors. These investors thus not only expect to receive, but 
are solicited explicitly on the basis of, the investment management 
ability of the adviser. Under the definition of private fund, an 
adviser will only need to look through for purposes of counting clients 
where some affirmative steps have been taken to make fifteen or more 
potential clients aware of the ability to obtain the adviser's services 
through the fund vehicle.\168\ Based on this definition of private 
fund, we believe registration of these advisers will advance the 
objectives of the Advisers Act.
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    \166\ See infra Section II.E of this Release.
    \167\ See sections 3(a) and 3(b) of the Investment Company Act 
[15 U.S.C. 80a-3(a) and 80a-3(b)].
    \168\ Although rule 203(b)(3)-1(c) provides that an adviser will 
not be deemed to be holding itself out generally to the public as an 
investment adviser solely as a result of participating in a non-
public offering of limited partnership interests, there may be 
circumstances where the marketing activities of a hedge fund adviser 
go beyond the scope of this safe harbor.
---------------------------------------------------------------------------

    Some commenters argued that the Commission lacks authority because 
the new rule and rule amendments contradict the ``unambiguous'' intent 
of Congress expressed in section 203(b)(3).\169\ However, as discussed 
above, the intent of Congress appears to have been to create a limited 
exemption for advisers whose activities were not national in scope and 
who provided advice to family members or friends. Further, since hedge 
funds did not exist until 1949,\170\ it is unclear whether Congress 
would have viewed a hedge fund or the hedge fund's investors as the 
client.\171\ Moreover, the term ``client'' is not defined in the Act, 
nor does the word have one clear meaning.\172\ To the extent section 
203 is unclear, the Commission has authority to interpret an exemption 
and to adopt a rule that is reasonably related to the statutory 
purpose.\173\ As we have explained above, rule 203(b)(3)-2 is such a 
rule.\174\
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    \169\ See, e.g., Wilmer Cutler Letter, supra note 142. See also 
Comment Letter of Managed Funds Association (Oct. 12, 2004).
    \170\ See Hard Times Come To The Hedge Funds, supra note 13 at 
10.
    \171\ The original version of section 203(b) in 1940 also 
exempted from registration any adviser ``whose only clients are 
investment companies.'' Investment Advisers Act, Section 203(b), 
Pub. L. No. 76-768, 54 Stat. 847, 850 (1940). This language does 
not, as some commenters have asserted, undermine the Commission's 
interpretation of section 203(b)(3) with respect to counting the 
number of clients in a hedge fund. See, e.g., Wilmer Cutler Letter, 
supra note 142. Even if Congress in 1940 clearly intended, with 
respect to investment companies, that a legal entity be the client, 
that does not mean that Congress must have intended the same result 
with respect to entities--such as hedge funds--that are not 
investment companies. Moreover, Congress may have included this 
provision because it believed that, absent an express exemption for 
investment companies, individual investors might be counted as 
clients, or may have simply concluded that advisers to entities 
subject to Title I of the statute they were considering (the 
Investment Company Act) would not be subject to Title II (the 
Advisers Act). Title I of the legislation established a new 
comprehensive scheme for the regulation of investment companies, and 
Congress may have determined that the investment advisory 
relationship between an adviser and an investment company would be 
governed by the new Investment Company Act. See 1940 Senate 
Hearings, supra note 73, (statement of Senator Boren (``there is a 
distinct separation of investment advisers under the two different 
sections of the bill'')).
    \172\ Although commenters argue, citing certain dictionaries, 
that ``client'' has a plain meaning that cannot include passive 
investors in an entity who are not being advised individually, 
resort to dictionary definitions is inconclusive. See Webster's 
Unabridged Dictionary (2nd ed. 1934) (``client'' means ``one who 
consults a legal adviser in order to obtain his professional advice 
or assistance, or submits his cause to his management'' (emphasis 
added.)).
    \173\ Chevron U.S.A. v. NRDC, 467 U.S. 837, 843-44 (1984). 
Because the Commission has the inherent authority to interpret the 
ambiguous language used in section 203(b)(3), the absence of a 
specific grant of authority in the Advisers Act to define terms 
(such as is found in the Investment Company Act and other securities 
statutes) does not limit the scope of our authority. Nor is our 
authority undermined by the fact that, as explained in the Proposing 
Release, we are changing our interpretation of the statutory 
exemption from registration created by section 203(b)(3), as it 
applies to hedge funds, in light of changed circumstances resulting 
from the growth of hedge funds. Courts have recognized that agencies 
have clear authority to change a prior position in light of changed 
circumstances. See, e.g., American Trucking Assns., Inc. v. 
Atchison, Topeka & Santa Fe Ry Co., supra note 59; United Video Inc. 
v. FCC, 890 F.2d 1173, 1181-82 (D.C. Cir. 1989).
    \174\ Some commenters assert that the method for counting 
clients of a private fund set forth in rule 203(b)(3)-2 would be 
inconsistent with the Supreme Court's view of the scope of the 
Advisers Act expressed in Lowe v. SEC, 472 U.S. 181 (1985). However, 
Lowe involved a different issue and a different statutory 
provision--the meaning of the exclusion from the definition of 
investment adviser in section 202(a)(11)(D) for ``the publisher of 
any bona fide newspaper, news magazine or business of financial 
publication of general and regular circulation.'' 15 U.S.C. 80b-
2(11)(d).
---------------------------------------------------------------------------

    Although Congress in 1940 may not have anticipated the client 
counting questions that arose from the development of hedge funds and 
other pooled investment vehicles, by 1960 it clearly anticipated that, 
in certain cases, enforcement of the Act may require the Commission or 
courts to ``look through'' legal artifices to address the substance of 
a transaction or relationship.\175\ Section 208(d), added in 1960, made 
it unlawful for any person ``to indirectly, through or by any other 
person to do any act or thing which it would be unlawful for such 
person to do directly under the provisions of this [Act], or any rule 
or regulation thereunder.'' \176\
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    \175\ See supra note 158.
    \176\ 15 U.S.C. 80b-8d. Congress added section 208(d) to the 
Advisers Act in 1960, Investment Advisers Act of 1940, Amendment, 
Pub. L. 86-750, 54 Stat. 847 (1960).
---------------------------------------------------------------------------

    Today, an adviser with, for example, 15 clients and $100 million in 
assets under management can take those client assets, move them into a 
hedge fund it advises and, because the adviser now has but one client, 
withdraw its Advisers Act registration.\177\ If those clients' assets 
had been managed similarly or identically (and today in many cases they 
are),\178\ nothing will have changed, except that the clients will have 
lost the protection of our oversight. Advisers to hedge funds market 
their services based on the skills, ability and expertise of the 
persons who will make the fund's investment decisions. Thus, the 
clients will still rely exclusively on the efforts and skill of the 
investment adviser, and any new investors will be attracted to the 
hedge fund as a means to obtain the asset management services of the 
adviser. The clients will periodically receive reports from the adviser 
about the hedge fund, and their decisions whether or not to withdraw 
their assets from the fund will necessarily rely heavily on those 
reports.\179\
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    \177\ See, e.g., SEC v. Gary A Smith, 1995 Lexis 22352 (S.D. 
Mich. 1995) (adviser persuaded client to place accounts in trusts to 
try to avoid Advisers Act regulation).
    \178\ See Status of Investment Advisory Programs Under the 
Investment Company Act of 1940, Investment Company Act Release No. 
22579 (Mar. 24, 1997) [62 FR 15098 (Mar. 31, 1997)] (adopting rule 
providing safe harbor from investment company registration for 
similarly managed accounts).
    \179\ Similar factors led the Second Circuit to conclude that 
limited partners of an investment partnership were clients of the 
general partner/investment adviser for purposes of section 206 of 
the Act. See Abrahamson v. Fleschner, supra note 157, at 869-70.
---------------------------------------------------------------------------

    A hedge fund adviser may not treat all of its hedge fund investors 
the same. Some investors may have greater access to risk and portfolio 
information,\180\

[[Page 72070]]

different lock-up periods may be provided,\181\ and some investors may 
be able to negotiate lower fees.\182\ ``Side pockets,'' in which assets 
are segregated, may operate to provide different investors with 
different investment experiences.\183\ Thus, today each account of a 
hedge fund investor may bear many of the characteristics of separate 
investment accounts, which, of course, must be counted as separate 
clients for purposes of section 203(b)(3). Our rule closes this 
loophole.
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    \180\ See, e.g., Roundtable Transcript of May 14 at 171, supra 
note (statement of Robert Bernard, Chief of Administration and 
Finance, RiskMetrics Group) (some investors have the market power to 
receive full portfolio position disclosure); id. at 177-78 
(statement of Robert Bernard). See also Roundtable Transcript of May 
15 at 108-09, supra note 17, (statement of Patrick McCarty) (an 
investor with $25 or $30 million in a fund will have more access 
than someone investing a small amount).
    \181\ Ron S. Geffner, Deals on the Side, HEDGEFUNDMANAGER, (US 
East Coast 2005).
    \182\ See, e.g., Roundtable Transcript of May 14 at 167, supra 
note (statement of David Swensen, Chief Investment Officer, Yale 
University) (Yale sometimes negotiates ``deal structures'' that 
differ from the terms set forth in the offering documents); id. at 
211-12 (same).
    \183\ See id. at 68 (statement of Joel Press, Senior Partner, 
Ernst & Young). See also id. at 56 (statement of Joel Press) (hedge 
funds may establish separate share classes by type of investor in 
order to track each investor's return separately). We also note that 
on June 13, 2002, the Commission issued a Formal Order of Private 
Investigation in the matter of Investor Protection Implications of 
Private Investment Fund Growth. In the course of their 
investigation, our staff reviewed materials that appear to indicate 
that different investors in a hedge fund may have different 
investment experiences or may receive different disclosure. Under 
one limited partnership agreement, for example, limited partners can 
elect not to participate in the fund's purchase of illiquid assets, 
which are kept apart from the majority of the fund's assets. Under 
another limited partnership agreement, as much as 20 percent of the 
fund's yearly profits, including profits from ``hot issue'' 
accounts, could be reallocated to certain limited partners. 
Marketing material for a third hedge fund stated that investors 
investing over a certain amount in the fund are provided with 
additional information about the fund's portfolio holdings.
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D. Rule 203(b)(3)-2

    Rule 203(b)(3)-2 requires investment advisers to count each owner 
of a ``private fund'' towards the threshold of 14 clients for purposes 
of determining the availability of the private adviser exemption of 
section 203(b)(3) of the Act.\184\ As a result, an adviser to a 
``private fund,'' which is defined in rule 203(b)(3)-1 and discussed 
below, can no longer rely on the private adviser exemption if the 
adviser, during the course of the preceding twelve months, has advised 
private funds that had more than fourteen investors.\185\ Furthermore, 
an adviser that advises individual clients directly must count those 
clients together with the investors in any private fund it advises in 
determining its total number of clients for purposes of section 
203(b)(3).\186\ If the total number of individual clients and investors 
in private funds exceeds fourteen, the adviser is not eligible for the 
private adviser exemption and must register with us, assuming it meets 
our minimum requirements for assets under management.
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    \184\ For convenience, we will use the terms ``adviser to a 
private fund'' and ``hedge fund adviser'' interchangeably. As 
proposed, rule 203(b)(3)-2 was titled ``definition of client for 
certain private funds.'' The rule is now titled ``methods for 
counting clients in certain private funds.'' This change does not 
alter the substance of the rule but is meant to clarify the rule's 
scope.
    \185\ As discussed in Section III of this Release, we are 
implementing a special transition period for the new rule so that 
advisers to private funds need not look back for the 12-month period 
when determining their registration obligations as of the compliance 
date of the new rule.
    \186\ Commenters asked us to provide further clarification on 
how hedge fund advisers should count investors when looking through 
private funds. Comment Letter of Tannenbaum Helpern Syracuse & 
Hirschtritt LLP (Sept. 14, 2004) (``Tannenbaum Helpern Letter''). If 
an adviser manages private funds that have, in the aggregate, more 
than 14 investors, it must register. Thus, an adviser to two private 
funds, each of which has eight investors, will need to register. 
Similarly, an adviser must register if it advises a private fund 
that has 10 investors, and also manages five other portfolios that 
are not private funds. For counting purposes, an adviser that is 
required to count the investors in a private fund need not also 
count the private fund itself.
---------------------------------------------------------------------------

    The new rule is designed to amend the method of counting that hedge 
fund advisers use for purposes of applying the private adviser 
exemption. It is not intended to alter the duties or obligations owed 
by an investment adviser to its clients.\187\
---------------------------------------------------------------------------

    \187\ We remind advisers, however, that, independent of this new 
rule, the antifraud provisions of the Advisers Act apply to the 
adviser's relationship with the fund's limited partners. See 
Abrahamson v. Fleschner, supra note 157.
---------------------------------------------------------------------------

1. Minimum Assets Under Management
    Rule 203(b)(3)-2 does not alter the minimum amount of assets under 
management that an investment adviser generally must have in order to 
register with the Commission. A hedge fund adviser whose principal 
office and place of business is in the United States cannot (subject to 
certain exceptions) register with the Commission unless it manages at 
least $25 million.\188\ A hedge fund adviser whose principal office and 
place of business is outside the United States (an ``offshore 
adviser'') must register with the Commission if it has more than 
fourteen clients who are resident in the United States regardless of 
the amount of assets the adviser has under management. We are not 
applying the $25 million threshold to offshore advisers, as urged by 
some commenters,\189\ because that threshold is premised on regulation 
of the unregistered adviser by one or more states in which the adviser 
has its principal office and place of business.\190\
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    \188\ See section 203A(a)(1)(A) [15 U.S.C. 80b-3a(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 [15 U.S.C. 80b-3a] 
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).
    \189\ See Seward & Kissel Letter, supra note 111, Comment Letter 
of the European Commission (Sept. 15, 2004) (``European Commission 
Letter''); Comment Letter of the Alternative Investment Management 
Association Limited (Sept. 15, 2004) (``AIMA Letter''); ABA Letter, 
supra note 150. Seward & Kissel suggested we apply a $100 million 
threshold to offshore advisers.
    \190\ Any adviser whose principal office and place of business 
is in a state that has enacted an investment adviser statute is 
subject to this statutory minimum. Any investment adviser whose 
principal office and place of business is outside the United States, 
or in Wyoming (the only U.S. state that does not have an adviser 
statute), is not subject to this minimum and must register with us 
regardless of the amount of assets it manages. See NSMIA 
Implementing Release, supra note 10 at Section II.E.
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    In determining the amount of assets it has under management, a 
hedge fund adviser whose principal office and place of business is in 
the United States must include the total value of securities portfolios 
in its assets under management. That is, it may not reduce the value of 
those assets by amounts borrowed to acquire them. An adviser may 
exclude proprietary assets invested in the fund, and need not include 
the value of assets attributable to non-U.S. investors.\191\
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    \191\ Instruction 5(b) to Part 1 of Form ADV [17 CFR 279.1]
---------------------------------------------------------------------------

2. Counting ``Owners''
    Rule 203(b)(3)-2 requires investment advisers to count each owner 
of a private fund towards the threshold of fourteen clients, that is, 
each shareholder, limited partner, member, or beneficiary of the 
private fund.\192\ In response to suggestions by several commenters we 
have revised the rule. First, we have added a provision clarifying that 
an adviser does not have to count itself as a client regardless of the 
form its ownership in the pool takes.\193\ Second, we permit a hedge 
fund adviser to exclude certain knowledgeable advisory personnel who 
are ``qualified clients'' (i.e., who are ``insiders'') that may be 
charged a

[[Page 72071]]

performance fee.\194\ An adviser to a private fund may also exclude the 
value of these insiders' interests in the private fund when calculating 
the firm's assets under management for purposes of the $25 million 
registration threshold.\195\
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    \192\ Rule 203(b)(3)-2(a).
    \193\ Id.
    \194\ Rule 203(b)(3)-2(a). Rule 205-3(d)(1)(iii) under the 
Advisers Act permits certain knowledgeable personnel of an 
investment adviser to pay a performance or incentive fee to the 
adviser without meeting the net worth or invested assets 
requirements that would otherwise apply. Similarly, rule 3c-5 under 
the Investment Company Act [17 CFR 270.3c-5] provides that 
``knowledgeable employees'' of a private investment pool or of its 
adviser need not be counted in determining the number of beneficial 
owners of the pool (for 3(c)(1) pools) or in determining whether all 
investors in the pool are ``qualified purchasers'' (for 3(c)(7) 
pools). An adviser could not, however, make a private fund investor 
a partner in the advisory firm to avoid counting the investor for 
purposes of the private adviser exemption. See section 208(d) of the 
Advisers Act.
    \195\ An adviser is permitted, but not required, to include the 
value of its family and proprietary securities portfolios in 
calculating its assets under management under Instruction 5.b(1)(a) 
to Part 1A of Form ADV. A hedge fund adviser may construe the 
investments of these inside personnel and their families as 
proprietary or family assets for purposes of calculating its assets 
under management. This does not, however, alter the fiduciary 
obligations of the adviser with respect to those accounts.
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3. Funds of Hedge Funds
    Under rule 203(b)(3)-2, a hedge fund adviser whose investors 
include a fund of funds that is itself a ``private fund'' must apply 
the general provisions of the new rule, which compel looking through 
that ``top tier'' private fund and counting its investors as clients 
for purposes of the private adviser exemption.\196\ If the fund of 
funds is a registered investment company, rule 203(b)(3)-2(b) requires 
the adviser to an underlying private fund to look through the 
investment company and to count its investors as clients for purposes 
of the exemption. Without the look-through requirement, an adviser 
could provide its services through fourteen or fewer top tier funds and 
continue to indirectly manage the assets of hundreds or, in the case of 
registered funds of hedge funds, thousands of investors, without 
registering or being subject to the Commission's oversight.\197\
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    \196\ The new rule does not require the adviser to the 
underlying fund to receive information as to the identities of the 
top tier investors, and does not specify when or how often the 
underlying hedge fund adviser must assess whether the number of 
investors in the top tier funds exceeds 14. The underlying adviser 
need not necessarily receive information as to the precise number of 
the top tier investors, so long as the underlying adviser can 
determine, on a periodic ongoing basis, its own registration 
obligations. Although some commenters expressed concern that 
advisers to funds of funds would face uncertainty as to their 
registration obligations, we believe it would be exceedingly rare 
for the top tier funds to have 14 or fewer investors. Most advisers 
to underlying hedge funds will not be eligible to rely on the 
private adviser exemption, absent facts and circumstances that 
provide assurances to the underlying adviser that no more than 14 
investors, in the aggregate, are being served.
    \197\ Commenters suggested that the adviser to an underlying 
hedge fund be required to look through its top tier funds only under 
limited circumstances, such as when the top tier fund holds more 
than ten percent of the underlying fund. See, e.g., Comment Letter 
of Dechert LLP (Sept. 15, 2004) (``Dechert Letter''), Comment Letter 
of Davis Polk & Wardwell (Sept. 15, 2004) (``Davis Polk Letter''); 
ABA Letter, supra note 150. Such an approach would, however, permit 
hedge fund managers to avoid registration simply by providing their 
services to a multitude of investors through, for example, 12 funds 
of funds, each of which owned eight percent of the underlying fund.
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4. Offshore Advisers
    Some commenters suggested that advisers located offshore \198\ be 
exempted from regulation under the Advisers Act if they are subject to 
regulation in their home jurisdiction.\199\ The Commission has not 
chosen to take such an approach. The Commission's primary concern when 
developing regulatory policy that has implications for foreign 
participants in our markets is to ensure that U.S. investors are 
protected and that there is a level playing field for all market 
participants. In this regard, a single set of rules provides greater 
transparency to investors, who can be confident that they will receive 
the same level of protection with respect to their investments 
regardless of the country of origin of their investment adviser. 
Similarly, a single set of rules assures a level playing field for both 
U.S. and foreign participants in our markets. Our approach to offshore 
advisers to offshore funds with U.S. investors, discussed below, 
represents an accommodation and not a fundamental change of policy in 
this regard.
---------------------------------------------------------------------------

    \198\ Whether an adviser is ``offshore'' depends on the location 
of the adviser's principal office and place of business. See rule 
203(b)(3)-1(b)(5).
    \199\ See, e.g., Financial Services Roundtable Letter, supra 
note 53; Tannenbaum Helpern Letter, supra note 186. Some commenters 
raised concerns that regulation under the Advisers Act would 
conflict with regulations in offshore advisers' home jurisdictions. 
See Financial Services Roundtable Letter, supra note 53. According 
to one law firm's analysis, however, registration under the Advisers 
Act will 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.
---------------------------------------------------------------------------

    Acceptance of home jurisdictional regulatory protections or 
``mutual recognition'' may be a compelling alternative for participants 
in a common regulatory and statutory framework, such as the European 
Union. However, the absence of such a framework would require us to 
determine regulatory equivalence of hundreds of potential home 
jurisdictions. Such an effort would tax our resources. Moreover, 
regulatory systems that may be equivalent today may diverge in a matter 
of a few years, thus the evaluation would have to occur on an ongoing 
basis.\200\
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    \200\ So that our oversight of offshore advisers can be 
conducted effectively and efficiently in light of potential overlap 
with foreign regimes, we have asked our Division of Investment 
Management, our Office of Compliance Inspections and Examinations, 
and our Office of International Affairs to explore ways to obtain 
and share information with foreign authorities with oversight of 
hedge advisers that may register with the SEC.
---------------------------------------------------------------------------

a. Counting Clients of Offshore Advisers
    The final rules impose the same counting requirements on offshore 
advisers to hedge funds as offshore advisers providing advice directly 
to U.S. clients. Thus, for purposes of eligibility for the private 
adviser exemption, an offshore hedge fund adviser must look through 
each private fund it advises, whether or not those funds are also 
located offshore, and count each investor that is a U.S. resident as a 
client.\201\ An offshore adviser to any hedge fund that, in the course 
of the preceding twelve months, has more than fourteen investors (or 
other advisory clients) that are U.S.

[[Page 72072]]

residents generally must register under the Advisers Act.\202\
---------------------------------------------------------------------------

    \201\ As discussed in Section II.F. of this Release, new rule 
203(b)(3)-2 and rule 203(b)(3)-1 are designed to work together. Once 
the offshore adviser looks through the private fund as required 
under rule 203(b)(3)-2, rule 203(b)(3)-1(b)(5) provides that only 
U.S. clients must be counted towards the private adviser exemption.
    Commenters asked that, because rule 203(b)(3)-1 speaks only to 
residents, we provide further guidance on when a client, 
particularly a client that is not a natural person, should be 
considered a U.S. client. Several commenters suggested that the 
Advisers Act should look to the definition of ``U.S. person'' in 
Regulation S under the Securities Act of 1933. See 17 CFR 230.902. 
Regulation S is designed for use in transactions, not ongoing 
advisory relationships, and its use in this context raises larger 
issues that we cannot address in this rulemaking. Until the 
Commission reconsiders this question, however, we would not object 
if advisers looked (i) in the case of individuals to their 
residence, (ii) in the case of corporations and other business 
entities to their principal office and place of business, (iii) in 
the case of personal trusts and estates to the rules set out in 
Regulation S, and (iv) in the case of discretionary or non-
discretionary accounts managed by another investment adviser to the 
location of the person for whose benefit the account is held.
    \202\ The offshore adviser would not have to register, however, 
if it were eligible for some other exemption from registration.
---------------------------------------------------------------------------

    At the suggestion of commenters, we are adopting a provision that 
allows an adviser to a private fund to determine whether an investor is 
a U.S. client or a non-U.S. client at the time of the investment in the 
private fund.\203\ If an investor is a non-U.S. client at the time of 
that investment, the adviser may continue to count the investor as a 
non-U.S. client even if the investor subsequently relocates to the 
United States.
---------------------------------------------------------------------------

    \203\ Rule 203(b)(3)-1(b)(7). If, however, a non-U.S. investor 
transfers his interest to a U.S. investor, the adviser should count 
the transferee as a U.S. client.
---------------------------------------------------------------------------

    Several commenters suggested that offshore advisers be required to 
look through their private funds only if more than 25 percent of the 
fund was held by U.S. investors.\204\ We believe that this suggestion 
would result in most offshore advisers that serve U.S. investors being 
exempt from registration, and we are not adopting it.\205\
---------------------------------------------------------------------------

    \204\ Comment Letter of International Bar Association (Sept. 14, 
2004) (``International Bar Letter''), ABA Letter, supra note 150, 
AIMA Letter, supra note 189.
    \205\ Commenters pointed out that, because of provisions in the 
U.S. tax laws, U.S. investors in offshore hedge funds are likely to 
be tax-exempt investors such as pension and benefit plans subject to 
the Employee Retirement Income Security Act of 1974 (``ERISA'') [ 29 
U.S.C. 1001 et seq.]. Many hedge funds permit no more than 25 
percent of the fund's assets to be held by pension plans subject to 
ERISA in order to prevent the assets of the fund from being deemed 
``plan assets'' under ERISA. See 29 CFR 2510.3-101 (Department of 
Labor regulation deems participation by plan investors of 25 percent 
or more in the unregistered securities of an entity to be 
significant which would then trigger certain ERISA limitations on 
the hedge fund). Accordingly, it may be unusual for these funds to 
have more than 25 percent U.S. ownership.
---------------------------------------------------------------------------

b. Advisers to Offshore Publicly Offered Funds
    The final rule includes 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 in a country outside the United States, and is regulated as 
a public investment company under the laws of the country other than 
the United States.\206\ Absent this provision, advisers to offshore 
publicly offered mutual funds or closed-end funds might be required to 
register with us simply because more than fourteen of their investors 
are now residents in the United States.\207\ The exception applies to 
any type of publicly offered fund, whether in corporate, trust, 
contractual or other form,\208\ so long as the fund is authorized for 
sale in the same jurisdiction in which it is regulated as a public 
investment company.\209\
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    \206\ Rule 203(b)(3)-1(d)(3). Commenters supported this 
exception.
    \207\ Section 7(d) of the Investment Company Act [15 U.S.C. 80a-
7(d)] generally prohibits a foreign investment company from publicly 
offering its securities in the United States unless registered with 
us. That provision does not preclude these 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)]. See also Touche 
Remnant & Co., SEC Staff No-Action Letter (Aug. 27, 1984); Goodwin, 
Procter & Hoar, SEC Staff No-Action Letter (Feb. 28, 1997). Our 
staff has also provided no-action relief to address circumstances 
where U.S. persons are 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).
    \208\ This clarification responds to an issue raised by the 
European Commission. See European Commission Letter, supra note 189. 
Some commenters asked whether all funds listed on an offshore 
securities exchange were offshore public funds. See AIMA Letter, 
supra note 189; Coudert Letter, supra note 152. We note that listing 
criteria in some jurisdictions may be distinct from criteria for 
public offerings, and we cannot provide guidance in this area at 
this time. The European Commission also pointed out that some 
offshore public funds may be authorized for public sale in multiple 
countries pursuant to harmonized regulations, while others may be 
sold publicly only in individual countries. A fund would qualify for 
this exception so long as it is regulated as a public investment 
company in at least one of the jurisdictions in which it may be 
offered to the public.
    \209\ We are aware that, in some jurisdictions, hedge funds may 
be publicly offered. Such funds would not be public investment 
companies for purposes of this rule. Whether a particular fund is a 
public investment company will turn on, among other things, how it 
is known in those other jurisdictions.
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c. Advisers to Offshore Privately Offered Funds
    Rule 203(b)(3)-2 limits the extraterritorial application of the 
Advisers Act that would otherwise occur as a result of the new rule, by 
providing that an offshore adviser to an offshore private fund may 
treat the fund (and not the investors) as its client for most purposes 
under the Act.\210\ Because we do not apply most of the substantive 
provisions of the Act to the non-U.S. clients of an offshore 
adviser,\211\ and because the offshore fund would be a non-U.S. 
client,\212\ the substantive provisions of the Act generally would not 
apply to the offshore adviser's dealings with the offshore fund.\213\
---------------------------------------------------------------------------

    \210\ Rule 203(b)(3)-2(c). This provision applies in the case of 
an adviser whose principal office and place of business is outside 
the United States, if the fund is organized under the laws of a 
country other than the United States. The proposal looked instead to 
the principal office and place of business of the fund, but as one 
commenter noted, a fund as a passive vehicle typically has no 
offices. ABA Letter, supra note 150.
    \211\ 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'').
    \212\ It has been estimated that 70 percent of hedge funds are 
organized offshore. See Bernstein 2003 Report, supra note at 11.
    \213\ 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. See Offshore Offers and 
Sales, Securities Act Release No. 6863 (Apr. 24, 1990) [55 FR 18306 
(May 2, 1990)]. Moreover, as a practical matter, U.S. investors 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.
---------------------------------------------------------------------------

    Commenters supported this aspect of the rule, but also requested 
that we clarify how we would apply the Advisers Act to offshore 
advisers relying on it.\214\ The offshore adviser will be required 
(unless eligible for an exemption) to register under the Act \215\ and 
to keep certain books and records as required by our rules,\216\ and 
will

[[Page 72073]]

remain subject to examinations by our staff.\217\ Other requirements, 
including the Act's compliance rule,\218\ custody rule,\219\ and proxy 
voting rule,\220\ would not apply to the registered offshore adviser, 
assuming it has no U.S. clients other than for counting purposes under 
the private adviser exemption.\221\ The registered offshore adviser 
without U.S. clients (other than for counting purposes) will not be 
required to adopt a code of ethics but must retain its access persons' 
personal securities reports that would otherwise be required under such 
a code.\222\
---------------------------------------------------------------------------

    \214\ Dechert Letter, supra note 197, Comment Letter of White & 
Case LLP (Aug. 31, 2004) (``White & Case Letter''); Comment Letter 
of Jonathan Baird (Aug. 11, 2004) (`` Baird Letter''); ICI Letter, 
supra note 48; Tannenbaum Helpern Letter, supra note 186, European 
Commission Letter, supra note 189, Davis Polk Letter, supra note 
197, AIMA Letter, supra note 189; Comment Letter of the Association 
of the Bar of the City of New York Committee on Private Investment 
Funds (Sept. 15, 2004) (``NYC Bar Private Funds Letter''); ABA 
Letter, supra note 150.
    \215\ One commenter asked whether we would view it as misleading 
for an offshore adviser to represent itself as registered with the 
Commission under the Advisers Act, given that it is not required 
under the rule to comply with many provisions of the Act with 
respect to its offshore clients. NYC Bar Private Funds Letter, supra 
note 214. We note that offshore advisers seeking no-action relief 
from our staff have undertaken not to represent themselves to 
offshore clients as registered with us. E.g., Royal Bank of Canada, 
SEC Staff No-Action Letter (June 3, 1998). We are not, at this time, 
prohibiting offshore advisers from representing themselves as SEC-
registered advisers, but we remind them that they remain subject to 
the Act's antifraud provisions and that substantial clarification 
and disclosure may be necessary to make the representation not 
misleading.
    \216\ Our staff has provided guidance, in a series of no-action 
letters, regarding the recordkeeping obligations of registered 
advisers that are located offshore. Under that analysis, the 
registered adviser must, in order to rely on the no-action relief, 
comply with our recordkeeping rules, other than (1) rules 204-
2(a)(3) and (7) with respect to transactions involving offshore 
clients that do not relate to advisory services performed by the 
registered adviser on behalf of United States clients or related 
securities transactions; and (2) rules 204-2(a)(8), (9), (10), (11), 
(14), (15) and (16) and 204-2(b) with respect to transactions 
involving, or representations or disclosures made to, offshore 
clients. See, e.g., Royal Bank of Canada, supra note 215. In the 
context of rule 203(b)(3)-2, an offshore adviser to an offshore 
private fund would treat the fund as its offshore client for 
purposes of its recordkeeping requirements.
    \217\ During an examination, the registered offshore adviser 
must provide to our staff any and all records required to be kept 
under our rules as well as any records the adviser keeps under 
foreign law. Id. Section 204 of the Act [15 U.S.C. 80b-4] authorizes 
us to examine all records of any registered adviser.
    \218\ 17 CFR 275.206(4)-7.
    \219\ 17 CFR 275.206(4)-2.
    \220\ 17 CFR 275.206(4)-6.
    \221\ In addition, we would not require an offshore adviser to 
deliver a written disclosure brochure to its offshore clients (or to 
any investors in an offshore private fund it advises) under rule 
204-3 [17 CFR 275.204-3], although the adviser does have a fiduciary 
duty to provide those clients with full and fair disclosure of 
conflicts of interest. We would not require an offshore adviser's 
contracts with its offshore clients, including an offshore private 
fund, to include certain provisions that would otherwise be required 
by section 205. Moreover, with respect to an offshore fund, an 
adviser, whether located within or without the United States, is not 
subject to the prohibition on performance fees contained in section 
205; section 205(b)(5) makes that prohibition inapplicable to an 
advisory contract with a person that is not a resident of the United 
States. [15 U.S.C. 80b-5]. Thus, a registered adviser can charge 
performance fees to an offshore fund regardless of whether the fund 
has U.S. investors. We would not apply section 206(3)'s restrictions 
to an offshore adviser's principal transactions with offshore 
clients. [15 U.S.C. 80b-6(3)]. We would also not subject an offshore 
adviser to our rules governing adviser advertising [17 CFR 
275.206(4)-1], or cash solicitations [17 CFR 275.206(4)-3] with 
respect to offshore clients.
    A registered offshore adviser must, of course, comply with all 
of the Advisers Act and our rules with respect to any U.S. clients 
it may have.
    \222\ 17 CFR 275.204A-1.
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E. Definition of ``Private Fund''

    Because our concern is focused on hedge fund advisers and their 
oversight, we did not propose to require advisers to ``look through'' 
every business or other legal organization they advised for purposes of 
determining the availability of the ``private adviser'' exemption. Our 
proposal included a definition of ``private fund'' in order to identify 
those legal organizations that advisers would be required to look 
through.\223\ We proposed to define a ``private fund'' by reference to 
three characteristics shared by virtually all hedge funds, and that 
differentiate hedge funds from other pooled investment vehicles such as 
private equity funds \224\ or venture capital funds.\225\ In our 
amendments to rule 203(b)(3)-1, we are adopting the definition 
substantially as proposed, and we discuss each of the characteristics 
of a private fund below.
---------------------------------------------------------------------------

    \223\ 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. See 
Financial Crimes Enforcement Network; Anti-Money Laundering Programs 
for Unregistered Investment Companies, Department of the Treasury 
Release [67 FR 60617 (Sept. 26, 2002)]. Like the Treasury 
Department, we have tried to keep the definition simple, and provide 
a ``bright line'' indicator of when an adviser must look through a 
client that is a legal organization.
    \224\ Private equity funds concentrate their investments in 
unregistered (and typically illiquid) securities. They typically are 
long-term investments providing for liquidation at the end of a term 
specified in the fund's governing documents. 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.
    \225\ 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 the 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.
    A few commenters suggested that the rule distinguish hedge funds 
from other privately offered investment pools on the basis of their 
investment strategies or portfolio composition. See, e.g., Madison 
Capital Letter, supra note 51. We have not adopted such an approach 
because we are concerned that it could serve to chill advisers' use 
of certain investment strategies solely in order to avoid 
registration under the Advisers Act, and might possibly negatively 
affect the markets.
---------------------------------------------------------------------------

1. Section 3(c)(1) and 3(c)(7)
    First, a fund will not be a ``private fund'' unless it is a company 
that would be subject to regulation under the Investment Company Act 
but for the exception, from the definition of ``investment company,'' 
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.\226\ Thus, advisers are not 
required to ``look through'' most clients that are business 
organizations, including insurance companies, broker-dealers, and 
banks, but are required to look through many types of pooled investment 
vehicles investing in securities, including hedge funds.\227\
---------------------------------------------------------------------------

    \226\ Rule 203(b)(3)-1(d)(1)(i). Section 3(c)(1) excepts from 
the definition of investment company, an issuer the securities 
(other than short-term paper) of which are beneficially owned by not 
more than 100 persons and that is not making or proposing to make a 
public offering of its securities. An issuer that is organized in a 
country other than the United States is not subject to the 100-
investor limitation of section 3(c)(1) with respect to its 
beneficial owners who are non-U.S. persons. Section 3(c)(7) excepts 
from the definition of investment company, an issuer the outstanding 
securities of which are owned exclusively by persons who, at the 
time of acquisition of such securities, are qualified purchasers and 
that is not making or proposing to make a public offering of its 
securities. An issuer that is organized in a country other than the 
United States is not subject to the qualified purchaser limitation 
of section 3(c)(7) with respect to its owners who are non-U.S. 
persons. Under certain conditions, an issuer organized in a country 
other than the United States may make a private placement in the 
U.S. in accordance with Regulation D concurrently with an offering 
in another country in accordance with Regulation S under the 
Securities Act of 1933 without integrating the two offerings for 
purposes of determining whether the issuer complies with section 
3(c)(1) or 3(c)(7) or has made a public offering in contravention of 
section 7(d) of the Investment Company Act (prohibiting investment 
companies organized outside of the United States from making a 
public offering). Statement of the Commission Regarding Use of 
Internet Web Sites to Offer Securities, Solicit Securities 
Transactions or Advertise Investment Services Offshore, Securities 
Act Release No. 7516 (Mar. 23, 1998); See also Touche Remnant & Co., 
SEC Staff No-Action Letter (Aug. 27, 1984) and Goodwin, Proctor & 
Hoar, SEC Staff No-Action Letter (Feb. 28, 1997) (addressing public 
offerings for purposes of section 7(d)). Cf. Resale of Restricted 
Securities; Changes to Method of Determining Holding Period of 
Restricted Securities Under Rules 144 and 145, Securities Act 
Release No. 33-6862 (Apr. 30, 1990), at Section II.F. Our staff's 
no-action letter, The France Growth Fund, Inc., SEC Staff No-Action 
Letter (July 15, 2003), is superseded to the extent that it is 
inconsistent with this Release.
    An offshore hedge fund in which U.S. persons invest will 
ordinarily be a section 3(c)(1) or 3(c)(7) issuer because it makes a 
private offering (if any) in the U.S., and has 100 or fewer 
beneficial owners that are U.S. persons or requires all of its 
owners who are U.S. persons to be qualified purchasers, 
respectively.
    \227\ These companies, as opposed to other entities, by 
definition, engage in significant securities related activities. See 
sections 3(a) and 3(b) of the Investment Company Act. Moreover, 
3(c)(1) and 3(c)(7) funds invest in the context in which they deal 
privately with investors because both provisions require that the 
fund not engage in a public offering.
    Commenters asked whether the rule would require a U.S. adviser 
to look through an offshore pooled investment vehicle whose 
investors are all non-U.S. persons. If interests in the pool are 
offered only to non-U.S. investors, it is unlikely that the pool 
would be relying on the exceptions in either section 3(c)(1) or 
section 3(c)(7). If the pool does not rely on one of those 
exceptions, the pool is not a private fund under the rule, and thus 
only the pool itself would count as a single client.
    Many offshore hedge funds are organized as master-feeder 
structures in which an offshore adviser organizes a ``master'' fund 
interests in which are purchased by multiple ``feeder funds.'' The 
feeder funds seek to achieve their investment objectives solely by 
investing in the master fund and thus the feeder is a conduit that 
provides different investors access to the master fund. One feeder 
fund may be organized as a corporation and offered solely to non-
U.S. investors, while another may be organized as a limited 
partnership in a foreign jurisdiction offering its shares 
exclusively to more than 14 U.S. investors. See Thomas P. Lemke et 
al, Hedge Funds and Other Private Funds: Regulation and Compliance 
(2004-05) at 19. The feeder fund is a private fund under rule 
203(b)(3)-1(d); interests in the feeder are sold directly to U.S. 
investors, and thus the feeder must rely on either section 3(c)(1) 
or 3(c)(7) to avoid being subject to the Investment Company Act. The 
adviser to the master fund must look through the master fund as well 
as the feeder in order to count U.S. investors as clients, so that 
it is not violating section 208(d) of the Act by doing indirectly 
through the master what it could not do if it provided its advice 
directly to the feeder fund. See discussion supra note 176.

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[[Page 72074]]

    Several commenters suggested that the definition of private fund 
exclude 3(c)(7) funds because investors in a 3(c)(7) fund must all be 
qualified purchasers and can be presumed to have a certain level of 
financial sophistication.\228\ We have considered these comments but 
believe such an exclusion would not be consistent with the purpose and 
scope of the private adviser exemption. As we discussed above, the 
Advisers Act does not exempt from registration advisers whose clients 
are all financially sophisticated, and indeed a client's decision to 
engage a professional adviser acknowledges that the client needs an 
expert's assistance.\229\
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    \228\ Comment Letter of David Schroll (July 27, 2004) (``Schroll 
Letter''); Proskauer Letter, supra note 51; Comment Letter of Guy 
Judkowski (July 27, 2004) (``Judkowski Letter''); Seward & Kissel 
Letter, supra note 111; Madison Capital Letter, supra note 51; Tudor 
Letter, supra note 53; Davis Polk Letter, supra note 197; Financial 
Services Roundtable Letter, supra note 53; Comment Letter of 
Kleinberg, Kaplan, Wolff & Cohen, P.C. (Sept. 15, 2004) (``Kleinberg 
Letter'').
    \229\ See supra Section II.B.8 of this Release. Further, 
Congress chose to not to exempt 3(c)(7) fund advisers from the 
Advisers Act. An adviser that manages more than fourteen 3(c)(7) 
funds is required to register and is subject to all provisions of 
the Advisers Act, yet the investors in those funds are no less 
sophisticated than other 3(c)(7) fund investors. Also, Congress 
excepted 3(c)(7) fund advisers from performance fee restrictions 
under section 205 of the Act, which applies only to advisers who are 
not otherwise exempt from registration under section 203(b). See 
section 205(b)(4) [15 U.S.C. 80b-5(b)(4)].
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2. Redemption Within Two Years
    Second, a company will be a private fund only if it permits 
investors to redeem their interests in the fund within two years of 
purchasing them.\230\ The provision applies to each interest purchased 
or amount of capital contributed to the fund.\231\ Hedge funds 
typically offer their investors liquidity access \232\ following an 
initial ``lock-up'' period, which is typically for less than two 
years.\233\ Thus, this provision will include most hedge fund advisers, 
but will exclude advisers that manage only private equity funds, 
venture capital funds, and similar funds that require investors to make 
long-term commitments of capital.\234\ These other funds are similar to 
hedge funds in some respects, but the Commission has not encountered 
significant enforcement problems with advisers with respect to their 
management of private equity or venture capital 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,\235\ which in some cases 
was used to induce a false sense of security for investors when they 
might otherwise have exercised their redemption rights.\236\ Because 
hedge funds are where we have seen a recent growth in fraud enforcement 
actions, we will focus our examination resources on their advisers, 
rather than on advisers to private equity or venture capital funds, at 
this time.\237\ Most commenters who spoke to the issue supported 
drawing this distinction between hedge funds, on the one hand, and 
private equity and venture capital funds, on the other.\238\
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    \230\ Rule 203(b)(3)-1(d)(1)(ii). Two commenters suggested we 
shorten the period while another suggested it be longer. See AIMA 
Letter, supra note 189; Seward & Kissel Letter, supra note 111; 
Comment Letter of UnFarallon Coalition (Sept. 14, 2004) 
(``UnFarallon Letter''). Research has shown that hedge funds' 
average lock-up period is 12 months. Bernstein 2003 Report, supra 
note 24, at 5. We believe a two-year period, therefore, would 
include most hedge funds as private funds, and we are adopting a 
redemption test of two years as proposed.
    \231\ Funds could use a ``first in, first out'' for determining 
the age of purchases and capital contributions.
    \232\ Private funds operate in this respect similarly to an 
account an investor maintains with an adviser.
    \233\ Hedge funds generally offer semi-annual, quarterly, or 
monthly liquidity terms to their investors. 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); Ron S. Geffner, Deals on the 
Side, HEDGEFUNDMANAGER, U.S. East Coast 2005, at 22-23. An 
investment pool cannot use side letters to bypass the two-year 
redemption test. That is, if the pool uses side letters to provide 
some, but not all, investors the opportunity to redeem shares within 
two years, the pool would meet the definition of a private fund.
    \234\ This provision is also designed to prevent certain 
structured finance vehicles from being included as ``private 
funds.'' See, e.g., rule 3a-7(a) under the Investment Company Act 
[17 CFR 270.3a-7(a)] (exemption from Investment Company Act is not 
available to structured finance vehicle issuing redeemable 
securities); see also Comment Letter of Chapman and Cutler LLP 
(Sept. 15, 2004) (expressing concerns that some structured finance 
vehicles would inappropriately be deemed to be private funds).
    \235\ 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 97; In the Matter of Michael T. Higgins, supra 
note 99; SEC v. David M. Mobley, Sr., et al., supra note 99; SEC v. 
Michael W. Berger, Manhattan Capital Management Inc., supra note 99; 
SEC v. Todd Hansen and Nicholas Lobue, Litigation Release No. 17299 
(Jan. 9, 2002).
    \236\ We are currently pursuing actions in which we allege hedge 
fund advisers lulled investors into keeping their assets in the 
hedge fund. See, e.g., SEC v Anthony P. Postiglione, Jr., et al., 
Litigation Release No. 18824 (Aug. 9, 2004).
    \237\ Moreover, periodic redemption rights offered by hedge 
funds 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. The ability to 
terminate the relationship with an adviser and choose a new one, or 
to withdraw a portion of one's investment after a relatively short 
time period, is consistent with the notion that hedge fund advisers 
are effectively providing advisory services to the fund's investors. 
As a result, the redeemability feature of the definition of private 
fund will promote the purposes of the Act by applying the rule to 
those relationships that the Act was designed to address.
    \238\ E.g., NYC Bar Private Funds Letter, supra note 214. Some 
commenters expressed concern that hedge fund advisers would extend 
their lock-up periods beyond two years in order to avoid 
registration. E.g., Comment Letter of the Greenwich Roundtable 
(Sept. 15, 2004). Others felt that the two-year test drew an 
appropriate line between hedge funds and private equity or venture 
capital funds. See Comment Letter of National Venture Capital 
Association (Sept. 15, 2004) (``NVCA Letter'') (``As a practical 
means of exempting venture capital from the proposed rule's 
definition of `private fund,' two years is appropriate.''). We will 
continue to monitor developments regarding this aspect of the new 
rule and whether it continues effectively to distinguish hedge funds 
from private equity and venture capital funds.
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    The rule permits a fund to offer redemption rights under 
extraordinary circumstances without being considered a private fund 
under the rule.\239\ Private equity and venture capital funds may offer 
redemption rights under extraordinary circumstances, and these 
extraordinary redemptions do not change the basic character of the 
investment pool into a hedge fund. We are omitting the proposed 
requirement that such circumstances be ``unforeseeable.'' Commenters 
suggested that to the extent an investor negotiated for the right to 
redeem its interest in extraordinary circumstances, the circumstances 
could be viewed as ``foreseeable.'' \240\ The redemption test

[[Page 72075]]

also does not restrict the general partner or investment adviser from 
initiating distributions payable to all owners, or a class of owners, 
in accordance with the fund's governing documents.\241\ The rule also 
provides an exception to the two-year redemption test for interests 
acquired through reinvestment of distributed capital gains or 
income.\242\
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    \239\ Rule 203(b)(3)-1(d)(2)(i).
    \240\ See Davis Polk Letter, supra note 214, NYC Bar Private 
Funds Letter, supra note 150, ABA Letter, supra note 150. Many 
partnership agreements provide the investor the opportunity to 
redeem part or all of its investment, for example, in the event 
continuing to hold the investment became impractical or illegal, in 
the event of an owner's death or total disability, in the event key 
personnel at the fund adviser die, become incapacitated, or cease to 
be involved in the management of the fund for an extended period of 
time, in the event of a merger or reorganization of the fund, or in 
order to avoid a materially adverse tax or regulatory outcome. 
Similarly, some investment pools may offer redemption rights that 
can be exercised only in order to keep the pool's assets from being 
considered ``plan assets'' under ERISA. Offering redemption rights 
that apply only in these types of circumstances will not make the 
fund a ``private fund'' under the new rule.
    \241\ These are distributions, as distinguished from redemptions 
initiated by the investor. Similarly, an investor's transfer of his 
interest to, for example, a new limited partner in a secondary 
market transaction will not be considered a redemption.
    \242\ Proposed rule 203(b)(3)-1(d)(2)(ii). Though we proposed 
this exception only for interests acquired with reinvested 
dividends, commenters noted that venture capital and private equity 
funds are more likely to distribute capital gains than declare 
dividends.
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3. Advisory Skills, Ability, or Expertise
    Third, a company will be a private fund only if interests in it are 
offered based on the investment advisory skills, ability or expertise 
of the investment adviser.\243\ As we discussed in the Proposing 
Release, a hedge fund adviser's history, experience, past performance, 
strategies, and disciplinary record are likely important to investors, 
who rely on the adviser for their investment's success, in deciding 
whether to invest in a particular hedge fund.\244\ Accordingly, hedge 
fund advisers often emphasize the portfolio manager's record when 
marketing their fund, and provide prospective investors with 
information about the adviser and individual manager. This reliance by 
hedge fund investors implicates the need for the protections that 
Advisers Act registration offers.\245\
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    \243\ If interests in an investment pool are offered based on 
the investment advisory skills, ability or expertise of the pool's 
investment adviser, then the pool is a private fund and all advisers 
to the pool, including subadvisers, must look through it to count 
owners as clients for purposes of the private adviser exemption. 
Advisers may not circumvent the rule by delegating the advisory 
function to subadvisers, including subadvisers that might not be 
identified in the fund's offering materials, or by establishing a 
``manager of managers'' structure.
    \244\ See also Roundtable Transcript of May 14 at 167-68, supra 
note 17 (statement of David Swensen, Chief Investment Officer, Yale 
University) (investor looks for ``the character, the intelligence, 
the integrity, the creativity, and market savvy'' of the fund 
adviser, and the most important criterion when making an investment 
decision is the character and quality of the investment adviser).
    \245\ This is particularly true when this attribute is combined 
with the redeemability feature discussed earlier, such that an 
investment in a hedge fund more closely resembles an advisory 
account. It is also worth noting in this regard that section 
203(b)(3) of the Advisers Act [15 U.S.C. 80b-3(b)(3)] 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.
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F. Other Amendments to Rule 203(b)(3)-1

    We are amending rule 203(b)(3)-1 to clarify that investment 
advisers may not count hedge funds as single clients under that safe 
harbor.\246\ As discussed earlier, many hedge fund advisers have 
avoided Advisers Act registration in the past by relying on paragraph 
(a)(2)(i) of this rule, which we adopted in 1985 in order to permit 
advisers to count a legal organization, rather than its owners, as a 
single client.\247\ Advisers to private funds may, however, continue to 
rely on the other paragraphs of rule 203(b)(3)-1 when determining the 
number of their clients for purposes of the private client 
exemption.\248\ We have designed new rule 203(b)(3)-2 to be used in 
conjunction with rule 203(b)(3)-1.\249\ The adviser to a private fund 
must, under rule 203(b)(3)-2, look through the fund to its investors, 
but may rely on the safe harbor of rule 203(b)(3)-1 to determine 
whether each investor must count as a separate client or whether a 
``single client'' may include more than one investor.\250\
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    \246\ Rule 203(b)(3)-1(b)(6). We are also adopting, as proposed, 
non-substantive changes to the wording of several other paragraphs 
of rule 203(b)(3)-1 to clarify those sections.
    \247\ Rule 203(b)(3)-1(a)(2)(i).
    \248\ For example, particularly paragraph (a)(1) of rule 
203(b)(3)-1 allows a ``single client'' to encompass (i) a natural 
person, (ii) his or her minor children, (iii) his or her relatives, 
spouse, and relatives of spouse who share the same principal 
residence, as well as (iv) any accounts or trusts of which the only 
primary beneficiaries are the foregoing persons. In addition, if a 
given individual invests in two private funds advised by the same 
adviser, that individual need be counted only once towards the 14-
client threshold.
    \249\ Several commenters suggested that new rule 203(b)(3)-2 
contain a special provision for limited partnerships owned or 
controlled primarily by members of a single family. See Comment 
Letter of Paul, Hastings, Janofsky & Walker LLP (Sept. 10, 2004) 
(``Paul Hastings Letter''); Comment Letter of Skadden, Arps (Sept. 
14, 2004) (``Skadden Letter''), Kynikos Letter, supra note 80, ABA 
Letter, supra note 150. Others suggested we adopt a provision 
declaring that interests in family limited partnerships are not 
offered based on the expertise of the adviser. See Davis Polk 
Letter, supra note 197, Comment Letter of William S. McGinness, Jr. 
(July 26, 2004). This latter suggestion may be true in some 
circumstances, but there may be other cases in which, for example, a 
family group has engaged an outside adviser and interests in the 
family vehicle are offered to family members based on the expertise 
of the adviser. We believe that rule 203(b)(3)-1(a)(1) already 
affords family office advisers considerable flexibility before they 
reach fifteen clients. We also note that we have granted exemptive 
relief, on application, to a number of family office advisers. E.g., 
Bear Creek Inc., Investment Advisers Act Release No. 1931 (Mar. 9, 
2001) [66 FR 15150 (Mar. 15, 2001)] (notice); Moreland Management 
Co., Investment Advisers Act Release No. 1700 (Feb. 12, 1998) [63 FR 
8710 (Feb. 20, 1998)] (notice). A further exception for family 
limited partnerships is outside the scope of this rulemaking.
    \250\ An adviser to a hedge fund underlying a fund of funds 
must, as discussed earlier, apply new rule 203(b)(3)-2 to look 
through the top tier fund and count that fund's investors as clients 
for purposes of the private adviser exemption. Once the underlying 
adviser has looked through the layers of private funds, however, it 
may then apply the provisions of rule 203(b)(3)-1(a)(1) to those 
investors for counting purposes.
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G. Amendments to Rule 204-2

    We are adopting two amendments to the adviser recordkeeping rule. 
The first of these amendments permits hedge fund advisers that are 
required to register with us under new rule 203(b)(3)-2 to market their 
performance from periods prior to their registration with us, even if 
they have not kept documentation that our rules would otherwise 
require.\251\ This exception applies not only to the adviser's private 
funds (as proposed), but also to other accounts.\252\ Hedge fund 
advisers are required to retain whatever records they do have that 
support the performance they earned prior to their registration with 
us, but are excused from our recordkeeping rule to the extent that 
those records are incomplete or otherwise do not meet the requirements 
of rule 204-2.\253\
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    \251\ Under rule 204-2(a)(16), a registered investment adviser 
that makes claims concerning its performance track record must 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.'' The supporting records must be retained for a 
period of five years after the performance information is last used. 
Rule 204-2(e)(3). 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.
    \252\ Rule 204-2(e)(3)(ii). Commenters pointed out that hedge 
fund advisers may manage other clients' assets.
    \253\ Commenters generally supported this transitional exemption 
for hedge fund advisers' past performance records, in order to avoid 
placing these new registrants at a competitive disadvantage in 
promoting the returns they have earned, in some cases over many 
years. See Comment Letter of Cumberland Associates LLC (Sept. 9, 
2004) (``Cumberland Letter''), Comment Letter of James E. Mitchell 
(Sept. 1, 2004) (``Mitchell Letter''), ICAA Letter, supra note 47, 
Davis Polk Letter, supra note 197; ABA Letter, supra note 150. Three 
commenters suggested that we require hedge fund advisers to place a 
legend on any marketing materials that contained performance claims 
for which the adviser did not maintain all required records. CFA 
Institute Letter, supra note 47; ICAA Letter, supra note 47, 
UnFarallon Letter, supra note 230. The final rule does not impose 
such a requirement, but we caution hedge fund advisers that they 
remain, as they were prior to their registration, subject to the 
Advisers Act's antifraud provisions with respect to their marketing 
materials. One commenter opposed the exemption.

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[[Page 72076]]

    As proposed, the exemption would have covered only the records 
supporting the performance of the adviser's private funds. Commenters 
pointed out that a hedge fund adviser may also manage other pools, such 
as private equity funds. The amendment as we are adopting it applies to 
records supporting any accounts managed by the hedge fund adviser.\254\
---------------------------------------------------------------------------

    \254\ Rule 204-2(e)(3)(ii).
---------------------------------------------------------------------------

    Our second amendment to the recordkeeping rule clarifies that, for 
purposes of section 204 of the Advisers Act,\255\ the books and records 
of a registered hedge fund adviser include records of the private funds 
for which the adviser acts as investment adviser and the adviser or a 
related person \256\ acts as general partner, managing member, or in a 
similar capacity.\257\ Our examiners require access to these records to 
determine whether a hedge fund adviser is meeting its fiduciary 
obligations to a private fund under the Advisers Act and rules.\258\
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    \255\ Section 204 of the Act [15 U.S.C. 80b-4] generally 
subjects records of registered investment advisers to examination by 
the Commission.
    \256\ We include private funds for which the adviser's related 
person (as defined in Form ADV) acts as general partner, managing 
member, or in a similar capacity, because many hedge fund advisers 
establish a separate special purpose vehicle to be named as the 
fund's general partner.
    \257\ Rule 204-2(l). One commenter described this amendment as a 
``necessary requirement.'' CFA Institute Letter, supra note 47. The 
rule does not require that the adviser maintain duplicate books and 
records for the funds, nor that a registered private fund adviser be 
the party to keep the books and records of the private funds in 
question. Because the private funds' records will be deemed to be 
records of the adviser, however, our examination staff will have 
access to them when they examine the adviser.
    \258\ The rule applies to related person general partners only 
when the adviser has an advisory relationship with the fund in 
question. It does not, as one commenter was concerned, apply to 
every related general partnership in a large financial complex.
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H. Amendments to Rule 205-3

    We are adding grandfathering provisions to rule 205-3 under the 
Advisers Act, the performance fee rule, to avoid disrupting existing 
arrangements between newly-registered hedge fund advisers and their 
current pool investors or separate account clients.\259\ Most hedge 
fund advisers charge a ``performance fee'' based on their fund's 
capital gains or appreciation. Our rules, however, permit registered 
investment advisers to charge performance fees only to ``qualified 
clients.'' \260\ Unregistered hedge fund advisers have not necessarily 
required all of their investors to meet this standard.\261\ We proposed 
(and commenters supported) an amendment to rule 205-3 grandfathering 
the existing equity accounts of hedge fund investors, and allowing 
these investors to add to their accounts.\262\ Commenters noted, 
however, that our proposal would disrupt performance fee agreements 
with other types of investment pools or separate accounts sometimes 
managed by hedge fund advisers.\263\ We have revised the coverage of 
the amendment to permit existing owners in any 3(c)(1) fund to retain 
their investment and to add to it,\264\ and to permit the newly-
registered advisers to continue in effect advisory contracts they may 
have with other clients that are not 3(c)(1) funds.
---------------------------------------------------------------------------

    \259\ 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, investors in which 
must all be ``qualified purchasers.'' Section 205(b)(4) [15 U.S.C. 
80b-5(b)(4)].
    \260\ Rule 205-3(a). The adviser to a 3(c)(1) fund must look 
through the fund to determine whether all investors are qualified 
clients. See rule 205-3(b). 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. Rule 
205-3(d)(1).
    \261\ In the absence of relief, the newly-registered adviser 
would have to either force the non-qualified client out of the 
3(c)(1) fund or restructure its fee so that the non-qualified client 
is not paying the performance-based component of the fee.
    \262\ Proposed rule 205-(3)(c)(2) (grandfathering investors in 
``private funds'').
    \263\ NYC Bar Private Funds Letter, supra note 214.
    \264\ One hedge fund adviser suggested that we also allow 
grandfathered investors to open new accounts in the hedge fund in 
which they were invested, and two other commenters suggested we also 
allow grandfathered investors to invest in new funds advised by the 
same hedge fund adviser. Davis Polk Letter, supra note 197, ABA 
Letter, supra note 150. These suggestions go significantly beyond 
our oxbjective in proposing the grandfathering provision, which was 
to avoid disrupting existing business arrangements.
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I. Amendments to Rule 206(4)-2

    We are amending rule 206(4)-2, the adviser custody rule, to allow 
additional time for completion of audit work on behalf of advisers to 
funds of hedge funds that choose to distribute audited fund financial 
statements to investors under the custody rule.\265\ The amendments 
extend from 120 to 180 days the time within which an adviser to a fund 
of funds may distribute the fund's audited financial statements. Some 
advisers to funds of funds are not able to comply with the current 120-
day deadline because they cannot obtain completion of their fund audits 
prior to completion of the audits for the underlying funds in which 
they invest. To be eligible for the extended deadline, a fund of funds 
must invest at least ten percent of it assets in other, unrelated, 
pooled investment vehicles.\266\ Commenters strongly supported the 
amendment, but persuaded us that our proposal to extend the period for 
all pooled investment vehicles (instead of just funds of funds) would 
lead to the underlying funds taking advantage of the extension 
themselves, leaving funds of funds in no better position to comply than 
they were previously.\267\
---------------------------------------------------------------------------

    \265\ An adviser acting as general partner to a pooled 
investment vehicle it manages, including a hedge fund, has custody 
of the pool's assets. Rule 206(4)-2(c)(1)(iii). The adviser may 
satisfy its obligation to deliver custody account information to 
investors by distributing the pool's audited financial statements to 
investors. Rule 206(4)-2(b)(3). The current rule gives advisers 120 
days from the pool's fiscal year-end to distribute the financial 
statements. Id.
    \266\ A ``fund of funds'' under the amended rule is any limited 
partnership (or limited liability company or other type of pooled 
investment vehicle) that invests at least 10 percent of its total 
assets in other pooled investment vehicles that are not related 
persons of the fund of funds, or related persons of the adviser or 
general partner of the fund of funds. Rule 206(4)-2(c)(4). Where the 
underlying funds are related to the fund of funds, the fund of funds 
should have ample opportunity to coordinate its audit with that of 
the underlying funds.
    \267\ Dechert Letter, supra note 197; Renaissance, Alternative 
Investment Group Letter, supra note 47; Comment Letter of Stroock/
Credit Suisse Union Bancaire (Sept. 2, 2004) (``Stroock Letter''); 
Katten Muchin Letter, supra note 127; Van Hedge Letter, supra note 
45; Coudert Letter, supra note 152; Comment Letter of Price Meadows 
(Sept. 15, 2004) (``Price Meadows Letter''); Comment Letter of 
Silver Creek (Sept. 15, 2004) (``Silver Creek Letter'').
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J. Amendments to Rule 222-2 and Rule 203A-3

    This rulemaking is designed to alter the method of counting clients 
that hedge fund advisers use for purposes of determining their 
registration

[[Page 72077]]

obligations with us. It is not our intention to amend advisers' method 
of counting clients for other purposes. Two commenters raised concerns 
about whether private fund investors must be counted as clients for 
purposes of applying the national ``de minimis'' standard for state 
adviser registration.\268\ One commenter also questioned whether 
advisers' supervised persons must count private fund investors as 
clients for purposes of the definition of ``investment adviser 
representative'' in rule 203A-3.\269\
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    \268\ The ABA Letter, supra note 150, and NYC Bar Private Funds 
Letter, supra note 214, both raised this specific concern. Section 
222(d) of the Advisers Act [15 U.S.C. 80b-18a(d)] provides that a 
state may not require an adviser to register with its state 
securities authority unless the adviser has a place of business 
located within the state or has had, during the preceding 12-month 
period, at least 6 clients who are residents of that state. Rule 
222-2 [17 CFR 275.222-2] provides that an adviser may rely on rule 
203(b)(3)-1 when counting clients for purposes of the de minimis 
standard.
    \269\ 17 CFR 275.203a-3. See NYC Bar Private Funds Letter, supra 
note 214.
---------------------------------------------------------------------------

    To respond to commenters' concerns, we are amending both rules 222-
2 and 203A-3 to clarify that advisers and supervised persons may, for 
purposes of those rules, count clients as provided in rule 203(b)(3)-1 
without giving regard to the look through requirements in rule 
203(b)(3)-2.\270\
---------------------------------------------------------------------------

    \270\ The amendment makes new rule 203(b)(3)-1(a)(6) 
inapplicable in the context of rules 203A-3 and 222-2. Because new 
rule 203(b)(3)-1(a)(6) does not apply, advisers are free to look to 
rule 203(b)(3)-1(a)(2)(i) with respect to private funds.
---------------------------------------------------------------------------

K. Amendments to Form ADV

    We proposed to amend Form ADV to require advisers to ``private 
funds'' as defined in the proposed rule to identify themselves as hedge 
fund advisers, and we are adopting this provision as proposed. One 
commenter spoke to these changes to say they were essential.\271\
---------------------------------------------------------------------------

    \271\ CFA Institute Letter, supra note 47. Because advisers' 
responses to Form ADV are made available to the investing public on 
the Internet through the Investment Adviser Public Disclosure 
system, one commenter asked that we confirm that hedge fund advisers 
would not be disqualified from relying on section 4(2) of the 
Securities Act of 1933 [15 U.S.C. 77d(2)] or on rule 506 [17 CFR 
230.506] thereunder, both of which are unavailable in the event of a 
public offering, solely as a result of the private fund being 
identified through the IAPD. See ABA letter, supra note 150. The 
mere identification of a private fund through the IAPD does not 
render section 4(2) or rule 506 unavailable. We note that Form ADV 
already calls for registered advisers to identify the private 
investment pools they manage; this information appears on the IAPD 
for the estimated 40 to 50 percent of hedge fund advisers that are 
already registered with us.
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III. Effective and Compliance Dates

    The effective date of the amendments to rule 206(4)-2 and Form ADV 
is January 10, 2005. The effective date of new rule 203(b)(3)-2 and 
amendments to rules 203(b)(3)-1, 203A-3, 204-2, 205-3, and 222-2 is 
February 10, 2005. Hedge fund advisers may elect to begin complying 
with the new rule and the rule amendments as of their effective date, 
but have until February 1, 2006 to come into compliance with rule 
203(b)(3)-2 and the amendments to rules 203(b)(3)-1, 203A-3, 204-2, 
205-3, 206(4)-2, and 222-2.\272\ We are providing hedge fund advisers 
with this long transition period so that they have time to work through 
any technical issues as they prepare for registration. Our staff will 
be available to work with these new registrants on resolving technical 
questions.
---------------------------------------------------------------------------

    \272\ Commenters expressing a view on the compliance period 
generally suggested hedge fund advisers would require one year to 
begin complying as registered advisers under the Advisers Act and 
its rules. Dechert Letter, supra note 197, Seward & Kissel Letter, 
supra note 111, Davis Polk Letter, supra note 197, AIMA Letter, 
supra note 189, Coudert Letter, supra note 152; NYC Bar Private 
Funds Letter, supra note 214, NYC Bar Futures Committee Letter, 
supra note 127, ABA Letter, supra note 150.
---------------------------------------------------------------------------

    By the compliance date, February 1, 2006, each adviser required to 
register under the new rule\273\ must have its registration effective, 
and must have in place all policies and procedures required under our 
rules.\274\ Each adviser must also have designated a chief compliance 
officer.\275\ Also by February 1, 2006, advisers must ensure that they 
are in compliance with our rule for custody of client funds and 
securities.\276\ We expect that most private funds are already subject 
to an annual audit and that advisers will elect to have the audit 
results distributed to investors within the appropriate time period 
under the custody rule. Some advisers, however, may need to either 
arrange for their private funds to be audited or for quarterly 
transaction statements to be distributed to the investors in lieu of 
audit results.
---------------------------------------------------------------------------

    \273\ The private adviser exemption requires that the adviser 
count all persons who have been clients at any time during the 
preceding 12 months. At the suggestion of a commenter, we will apply 
the new counting rule only prospectively, without regard to this 
``look back'' provision for the period leading up to the compliance 
date. Coudert Letter, supra note 152.
    \274\ Under the Advisers Act and our rules, registered 
investment advisers must, for example, have policies in place to 
ensure compliance with the Act and its rules (rule 206(4)-7), 
including policies to prevent misuse of material nonpublic 
information (section 204A [15 U.S.C. 80b-4a]) and policies to ensure 
that (if they vote client securities) client securities are voted in 
the best interest of the client (rule 206(4)-6). Registered advisers 
must also have in place a code of ethics applicable to their 
supervised persons, which code must require access persons to submit 
reports of personal securities transactions and holdings (rule 204A-
1). We understand that, in many advisory firms, access persons use 
their year-end brokerage statements to compile their securities 
holding reports; accordingly, we have set the compliance date for 
the new rules so as to allow sufficient time for hedge fund 
advisers' access persons to receive their brokerage statements for 
the period ended December 31, 2005 and to submit their securities 
holdings reports before the compliance date. For this reason, we are 
hereby extending the compliance date for rule 204A-1 from January 7, 
2005 to February 1, 2005. See Investment Adviser Codes of Ethics, 
Investment Advisers Act Release No. 2256 (July 2, 2004) [69 FR 41695 
(July 9, 2004)] at Section III.
    \275\ Rule 206(4)-7. Several commenters seemed to believe our 
rule would require them to hire a new executive to serve as chief 
compliance officer. As we have explained previously, the rule does 
not require an adviser to hire new staff, only to designate the 
person within the firm that is primarily responsible for compliance.
    \276\ Rule 206(4)-2.
---------------------------------------------------------------------------

    Once their registrations are effective, the new registrants must, 
of course, comply with the Advisers Act and all of our rules, including 
provisions applying to registered advisers such as the limitations on 
performance fees,\277\ our books and records requirements,\278\ and our 
rules governing advertising \279\ and cash solicitations.\280\
---------------------------------------------------------------------------

    \277\ Section 205(a)(1) and rule 205-3.
    \278\ Rule 204-2.
    \279\ Rule 206(4)-1.
    \280\ Rule 206(4)-3.
---------------------------------------------------------------------------

    Several commenters asked whether the two-year redemption test under 
the definition of private fund would apply to investments made prior to 
the effectiveness of the new rules. Advisers must apply the two-year 
redemption test to any investments made on or after February 1, 2006, 
whether those investments are made by new or existing investors, but 
need not apply this test to investments made prior to the compliance 
date.
    The IARD filing system will incorporate the amendments made to Form 
ADV on March 8, 2005. Registered advisers amending their Form ADV after 
the form has incorporated the amendments must respond to Item 7.B of 
Part 1A as amended \281\ and must in any event amend their Form ADV to 
respond to the revised item by February 1, 2006. By implementing these 
changes to the IARD system in March of 2005, we will allow most 
registered advisers to respond to the revised item in conjunction with 
their regular annual updating amendment, rather than requiring them to 
file an additional amendment. Implementing this change to the IARD 
system promptly will also ensure that our staff, as well as members of 
the investing public, can begin to

[[Page 72078]]

access information about advisers to private funds.
---------------------------------------------------------------------------

    \281\ Similarly, advisers applying for registration with the 
Commission after the form has incorporated the amendments must 
respond to Item 7.B of Part 1A as amended.
---------------------------------------------------------------------------

IV. Cost-Benefit Analysis

    We are sensitive to the costs and benefits that result from our 
rules. Rule 203(b)(3)-2 requires certain hedge fund advisers to 
register with us under the Investment Advisers Act of 1940. We are also 
adopting related rule amendments to facilitate a smooth transition for 
hedge fund advisers. In the Proposing Release, we identified possible 
costs and benefits of the rule and rule amendments and requested 
comment on our analysis. Many commenters supported the new rule,\282\ 
although many commenters, chiefly hedge fund advisers and a trade 
association, expressed reservations at the potential costs of the new 
rule.\283\
---------------------------------------------------------------------------

    \282\ See supra notes 46-50 and accompanying text.
    \283\ See supra note 51 and accompanying text.
---------------------------------------------------------------------------

A. Benefits

    As discussed above in this Release, we expect that hedge fund 
investors, advisory clients and advisers will benefit from the rule and 
rule amendments, although these benefits are difficult to quantify.
1. Benefits to Hedge Fund Investors
    (a) Deter fraud and curtail losses. Our oversight may prevent or 
diminish losses that hedge fund investors would otherwise experience as 
a result of hedge fund advisers' fraud. Registration allows us to 
conduct 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.\284\ Registration also permits us to screen individuals seeking 
to advise hedge funds, and to deny entry to those with a history of 
disciplinary problems.\285\
---------------------------------------------------------------------------

    \284\ See Section II.B.2 of this Release. We received comments 
specifically focusing on these benefits under the rule. See, e.g., 
ICAA Letter, supra note 47. One commenter asserted it may be 
impossible for the Commission to identify potentially harmful 
compliance problems at an early stage absent the ability to examine 
hedge fund advisers. ICI Letter, supra note 48.
    \285\ See Section II.B.3 of this Release. Commenters also viewed 
this screening function as an important benefit for investors. See, 
e.g., Vantis July Letter, supra note 106 (registered hedge fund 
adviser stated that lack of scrutiny of hedge fund advisers has led 
to the industry attracting ``unsavory characters''); Ohio PERS 
Letter, supra note 47; ICI Letter, supra note 48; IMCA Letter, supra 
note 48.
---------------------------------------------------------------------------

    In the last five years, the Commission has brought or authorized 51 
enforcement cases in which we assert hedge fund advisers have defrauded 
hedge fund investors or used the hedge fund to defraud others. While 
three of these frauds were detected in time to prevent investor losses, 
this was the exception rather than the rule.\286\ In 40 of these cases, 
our staff estimates potential investor losses aggregate approximately 
$1.1 billion.\287\ Staff cannot at this time estimate the amount of 
losses in the remaining eight cases.\288\ 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 51 cases involve investment advisers registered with the 
Commission, with over $75.7 million in estimated aggregate investor 
losses.\289\ The remaining 43 cases involve advisers that were not 
registered with us, with over $1 billion in estimated aggregate 
investor losses.\290\
---------------------------------------------------------------------------

    \286\ 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, supra 
note 99; In the Matter of John Christopher McCamey and Sierra Equity 
Partners, LP, Securities Exchange Act Release No. 48917 (June 18, 
2003).
    \287\ SEC v. Haligiannis, et al, Litigation Release No. 18853 
(Aug. 25, 2004); SEC v. Scott B. Kaye, et al., Litigation Release 
No. 18845 (Aug. 24, 2004); SEC v. Gary M. Kornman, Litigation 
Release No. 18836 (Aug. 18, 2004); SEC v. Anthony P. Postiglione, 
Jr., et al., supra note 236; In the Matter of Samer M. El Bizri and 
Bizri Capital Partners, Inc., supra note 99, 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 94; In the Matter of Robert T. Littell and 
Wilfred Meckel, Investment Advisers Act Release No. 2203 (Dec. 15, 
2003); SEC v. Adam G. Kruger and Kruger, Miller, and Tummillo, Inc., 
Litigation Release No. 18473 (Nov. 20, 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 11; 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 97; SEC v. J. 
Scott Eskind, Lorus Investments, Inc., and Capital Management Fund, 
Limited Partnership, supra note 100; 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 94; 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 97; In the Matter of Portfolio Advisory Services, 
LLC and Cedd L. Moses, supra note 94; SEC v. Jean Baptiste Jean 
Pierre, Gabriel Toks Pearse and Darius L. Lee, supra note 97; In the 
Matter of Zion Capital Management LLC, and Ricky A. Lang, supra note 
101; SEC v. Peter W. Chabot, Chabot Investments, Inc., Sirens 
Synergy and the Synergy Fund, supra note 97; SEC v. Vestron 
Financial Corp., et al., supra note 97; SEC v. Edward Thomas Jung, 
et al., supra note 97; SEC v. Burton G. Friedlander, supra note 98; 
SEC v. Hoover and Hoover Capital Management, Inc., supra note 97; 
SEC v. Evelyn Litwok & Dalia Eilat, supra note 97; SEC v. Ashbury 
Capital Partners, L.P., Ashbury Capital Management, L.L.C., and Mark 
Yagalla, supra note 97; SEC v. James S. Saltzman, supra note 95; 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 99; SEC v. David M. Mobley, Sr., et al., supra note 97; SEC v. 
Michael W. Berger, Manhattan Capital Management Inc., supra note 99; 
In the Matter of Charles K. Seavey and Alexander Lushtak, supra note 
99; SEC v. Todd Hansen and Nicholas Lobue, supra note 235.
    \288\ SEC v. Global Money Management, LP, LF Global Investments, 
LLC, and Marvin I. Friedman, supra note 102; SEC v. KS Advisors, 
Inc. et al., supra note 95; In the Matter of Alliance Capital 
Management, L.P., supra note 29; SEC v. Edward J. Strafaci, 
Litigation Release No. 18432 (Oct. 29, 2003); In the Matter of 
Stephen B. Markovitz, supra note 29; Michael Lauer, Lancer 
Management Group, LLC, and Lancer Management Group II, LLC, supra 
note 98; 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).
    \289\ In the Matter of Alliance Capital Management, L.P., supra 
note 29; SEC v. Michael L. Smirlock, supra note 287; SEC v. Edward 
J. Strafaci, supra note 288; In the Matter of Nevis Capital 
Management, supra note 94; In the Matter of Martin W. Smith and 
World Securities, Inc., supra note 288; SEC v. Schwendiman Partners, 
LLC, Gary Schwendiman, and Todd G. Schwendiman, supra note 94; In 
the Matter of Portfolio Advisory Services, LLC and Cedd L. Moses, 
supra note 94; In the Matter of Zion Capital Management LLC, and 
Ricky A. Lang, supra note 101. Staff cannot estimate the amount of 
losses in 3 of these cases at this time.
    \290\ Staff cannot estimate the amount of losses in 5 of these 
cases at this time.
---------------------------------------------------------------------------

    While our regulatory oversight cannot guarantee hedge fund 
investors will never be defrauded, we expect our oversight will reduce 
investor losses.\291\

[[Page 72079]]

Some commenters argued that registration of hedge fund advisers would 
not address the frauds evidenced by these enforcement cases, arguing 
the majority of the advisers in these fraud cases were too small to 
meet the $30 million threshold for registration under the Advisers Act 
or were registered already.\292\ We disagree with these commenters. 
Half of the advisers in these 51 cases appear to have managed more than 
$30 million or otherwise been eligible for registration with us, and it 
was these larger advisers who caused nearly all the investor losses, 
representing over $1 billion of the estimated total losses of $1.1 
billion. This strongly suggests that the Commission's registration 
requirement will affect an appropriate group of hedge fund advisers and 
serve as an effective response to combat hedge fund fraud.
---------------------------------------------------------------------------

    \291\ As substantial inflows chase absolute returns, there may 
be pressure for hedge fund advisers to engage in strategies that may 
not be consistent with the funds' disclosure or may be unlawful. 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). In the 
absence of Commission oversight as a deterrent, these incentives may 
tempt hedge fund advisers to engage in fraud.
    \292\ See, e.g., MFA Letter, supra note 51; LaRocco Letter, 
supra note 51; Chamber of Commerce Letter, supra note 52; ISDA 
Letter, supra note 52.
---------------------------------------------------------------------------

    In addition, these commenters argued that examination programs are 
unable to detect fraud, and that regulatory authorities must instead 
rely on ``tips'' to uncover misconduct. However, in 5 of the 8 cases 
against registered advisers, it was our examiners who uncovered the 
fraudulent conduct.\293\ These cases show that registered hedge fund 
advisers contemplating their chances of ``getting away'' with a breach 
of their fiduciary duty to their clients would be well advised to fear 
detection. We believe this has a genuine deterrent effect.\294\
---------------------------------------------------------------------------

    \293\ In addition, in two of the 43 cases against unregistered 
advisers, our examiners uncovered the fraud as a result of examining 
registered advisers who employed the principals of the hedge fund. 
See supra notes 94 and 95.
    \294\ Cf. Alternative Investment Group Letter, supra note 47 
(hedge fund managers will realize they are more likely to receive 
SEC scrutiny and will tighten their procedures toward a greater 
culture of compliance); Vantis August Letter, supra note 50 
(possibility of SEC exams on short notice creates an extra incentive 
for firm professionals to remain disciplined and keep files updated 
on a timely basis). In addition, as discussed above, examination of 
regulatory issues relating to the deterrent effect of unannounced 
government inspections, under economic theories of monitoring and 
deterrence based on principal-agent models, suggest that randomized 
monitoring is sufficient to generate a deterrent effect. See supra 
note 88.
---------------------------------------------------------------------------

    (b) Provide basic information about hedge fund advisers.
    Form ADV information that hedge fund advisers will file in 
registering will aid hedge fund investors in evaluating potential 
managers. Filing Form ADV will require hedge fund advisers to disclose 
information about their business, affiliates and owners, and 
disciplinary history. As commenters pointed out, many investors 
currently lack good access to this information about their hedge fund 
managers.\295\ Although the information hedge fund advisers will be 
required to provide on their Form ADV filings and to comply with our 
rules cannot substitute for an investor's due diligence, it should aid 
investors by providing a publicly accessible foundation of basic 
information.\296\
---------------------------------------------------------------------------

    \295\ UnFarallon Letter, supra note 230; Comment Letter of Gregg 
D. Caplitz (Aug. 9, 2004) (``Caplitz Letter''); Comment Letter of 
Rosalind D. Herman (August 10, 2004) (``Rosalind Herman Letter'').
    \296\ The difficulty many institutional investors have in 
obtaining information about hedge fund advisers is reflected in the 
Hennessee Group's survey clarifying the involvement of foundations 
and endowments in the hedge fund market. Among foundations and 
endowments responding to the survey, those supporting hedge fund 
adviser registration outnumbered its opponents by nearly 2 to 1. See 
Hennessee Foundation and Endowment Survey, supra note 39. 
Participants at our Hedge Fund Roundtable last year similarly 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.'').
---------------------------------------------------------------------------

    (c) Improve compliance controls.
    Hedge fund investors should benefit from their advisers' improved 
compliance controls. Several commenters confirmed this assessment in 
their comment letters.\297\ Once registered, hedge fund advisers will 
be required to have comprehensive compliance procedures and to 
designate a chief compliance officer.\298\ Specific procedures 
governing proxy voting \299\ and a code of ethics including 
requirements for personal securities reporting will also be 
required.\300\ In addition, the obligation to commit to a program of 
compliance controls combined with our examinations foster adherence to 
a culture of compliance by advisers.\301\ These compliance measures are 
the first line of defense in protecting investors against an adviser's 
misconduct.
---------------------------------------------------------------------------

    \297\ See, e.g., ICAA Letter, supra note 47, Alternative 
Investment Group Letter, supra note 47, Caplitz Letter, supra note 
295.
    \298\ Rule 206(4)-7.
    \299\ Rule 206(4)-6.
    \300\ Rule 204A-1.
    \301\ Some registered hedge fund advisers used their own 
experiences to support this conclusion. See, e.g., Vantis August 
Letter, supra note 50, Alternative Investment Group Letter, supra 
note 47.
---------------------------------------------------------------------------

2. Benefits to Mutual Fund Investors
    Mutual fund investors will 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 fund advisers.\302\ The 51 
enforcement cases discussed earlier do not include 18 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 fund advisers to 
market time mutual funds contrary to the mutual funds' prospectus 
disclosure.\303\ 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.\304\
---------------------------------------------------------------------------

    \302\ See supra note 29.
    \303\ Id.
    \304\ Id.
---------------------------------------------------------------------------

3. Benefits to Other Investors and Markets
    The registration of hedge fund advisers will benefit not only hedge 
fund investors but also other investors and the securities markets, to 
the extent that the Commission's oversight eliminates opportunities for 
hedge fund advisers to engage in other types of unlawful conduct in the 
securities markets. Commenters also saw this as a benefit to adviser 
registration.\305\ 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. Adviser registration, as discussed above, 
should lead to earlier discovery of fraudulent activities and thus 
enhance protections to all investors in the securities markets.
---------------------------------------------------------------------------

    \305\ See, e.g., ICAA Letter, supra note 47; Rosalind Herman 
Letter, supra note 295; Patch Letter A, supra note 48; Comment 
Letter of Joe Allebaugh (July 14, 2004) (``Allebaugh Letter''); 
Vantis August Letter, supra note 50; Saul Letter, supra note 49.
---------------------------------------------------------------------------

4. Benefits to Regulatory Policy
    Registration of hedge fund advisers will benefit all investors and 
market participants by providing us and other policy makers with better 
data. 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

[[Page 72080]]

investors in general.\306\ 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. While some commenters agreed with our assessment of 
this benefit,\307\ others suggested that, instead of registering hedge 
fund advisers, we compile information about them from a variety of 
scattered regulatory filings currently made by hedge funds, their 
advisers, and broker-dealers.\308\ We have considered this alternative, 
but the reports and information currently available would provide at 
best a partial and inadequate view of the activities of hedge fund 
advisers.\309\
---------------------------------------------------------------------------

    \306\ See Section II.B.1 of this Release.
    \307\ See, e.g., Ohio PERS Letter, supra note 47, ICAA Letter, 
supra note 47, ICI Letter, supra note 48, IMCA Letter, supra note 
48.
    \308\ See, e.g., MFA Letter, supra note 51, Tudor Letter, supra 
note 53.
    \309\ See Section II.B.9 of this Release.
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5. Benefits to Hedge Fund Advisers
    Mandatory registration will provide a level playing field for hedge 
fund advisers. Many hedge fund advisers have already registered with 
us, and have organized their compliance procedures under the Advisers 
Act. \310\ Unregistered hedge fund advisers, however, vary 
substantially in their compliance practices.\311\ 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. We received comments 
noting that mandatory registration would ensure that all hedge fund 
advisers compete on the same basis in this regard.\312\
---------------------------------------------------------------------------

    \310\ 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. Registered hedge fund advisers commented on the benefits of 
registration. See Vantis August Letter, supra note 50.
    \311\ See Section VII.A.1.b. of the 2003 Staff Hedge Fund 
Report, supra note 18.
    \312\ See, e.g., Saul Letter, supra note 49, Rosalind Herman 
Letter, supra note 295, Caplitz Letter, supra note 295.
---------------------------------------------------------------------------

    Registering hedge fund advisers may enhance investor confidence in 
a growing and maturing industry. As discussed above, the hedge fund 
industry has been growing at an extraordinary pace in the past 
decade.\313\ Registration under the Advisers Act will bring hedge fund 
advisers to the same compliance level as other SEC-registered advisers, 
thus providing hedge fund investors with additional protections with 
respect to conflicts of interest addressed by the funds' advisers.\314\
---------------------------------------------------------------------------

    \313\ See Section I.A. of this Release.
    \314\ See, e.g., Vantis July Letter, supra note 106 (mandatory 
registration will improve the image of the hedge fund industry); 
Hennessee Foundation and Endowment Survey, supra note 39 (survey 
participant remark that registration ``lends creditability to the 
field''); Comment Letter of North American Securities Administrators 
Association, Inc. (Oct. 18, 2004) (SEC registration will increase 
investor confidence, thereby benefiting hedge fund advisers).
---------------------------------------------------------------------------

    Some commenters, however, argued that registration would create a 
``moral hazard'' by providing hedge fund investors with a false sense 
of enhanced investor protection that might cause them to be less 
diligent in their own investigations.\315\ We disagree. Such argument 
could have been used against registration of any kind of investment 
adviser and against any regulation of the securities industry.\316\ In 
addition, without the new rule requiring registration, a hedge fund 
adviser can now choose to register under the Advisers Act but then 
withdraw its registration, for example, at the prospect of an 
examination. Thus, without a registration requirement, any ``moral 
hazard'' would already exist, but without necessarily providing hedge 
fund investors the benefit of our oversight of their advisers.
---------------------------------------------------------------------------

    \315\ See, e.g., MFA Letter, supra note 51, Chamber of Commerce 
Letter, supra note 52, ISDA Letter, supra note 52, David Thayer 
Letter, supra note 52.
    \316\ Furthermore, section 208(a) of the Act [15 U.S.C. 80b-
8(a)] expressly forbids registered advisers from implying that their 
services bear the imprimatur of the government. Section 208(b) of 
the Act permits a registered adviser to state that it is registered, 
but only if the effect of registration is not misrepresented.
---------------------------------------------------------------------------

B. Costs

    As we discussed in the Proposing Release, registration of hedge 
fund advisers under the Advisers Act would not impede hedge funds' 
operations. Comments from registered hedge fund advisers agreed.\317\ 
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.\318\
---------------------------------------------------------------------------

    \317\ Vantis August Letter, supra note 50, Alternative 
Investment Group Letter, supra note 47.
    \318\ See Hedge Funds, Leverage, and the Lessons of Long-Term 
Capital Management--Report of the President's Working Group on 
Financial Markets, supra note 43, 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. See 2003 
Staff Hedge Fund Report, supra note 18, at 4.
---------------------------------------------------------------------------

    Nevertheless, registration imposes certain costs. In the Proposing 
Release, we analyzed various costs that hedge fund advisers would incur 
in connection with registration. Commenters representing the views of 
unregistered hedge fund advisers generally challenged our cost 
estimates and predicted the costs of compliance would be 
burdensome.\319\ Comments from registered advisers generally 
characterized the costs as being significant, but reasonable in light 
of the nature of the advisory business.\320\ As we discussed in the 
Proposing Release, the costs of compliance for a new registrant can 
vary widely among firms depending on size, activities, and the 
sophistication of the existing compliance infrastructure. Investment 
advisers, whether registered with us or not, place the future of their 
business at peril if they do not establish a sound compliance 
infrastructure to fulfill their fiduciary duties towards their clients 
under the Act. Registered hedge fund advisers estimated that advisers 
with good compliance infrastructures in place would incur much less 
incremental cost than those that did not have good compliance 
infrastructures.\321\
---------------------------------------------------------------------------

    \319\ See, e.g., Madison Capital Letter, supra note 51; Chamber 
of Commerce Letter, supra note 52; ISDA Letter, supra note 52; 
Blanco Partners, supra note 52; Millrace Letter, supra note 92.
    \320\ Vantis August Letter, supra note 50, Alternative 
Investment Group Letter, supra note 47, ICI Letter, supra note 48, 
ICAA Letter, supra note 47, CFA Institute Letter, supra note 47.
    \321\ See Vantis August Letter, supra note 50, Alternative 
Investment Group Letter, supra note 47.
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1. Registration Costs
    In our Proposing Release, we estimated that the costs of preparing 
adviser registration submissions, including preparation and submission 
of Part 1A of Form ADV, would not be high. Although one commenter 
suggested the costs of preparing a Part 1A submission can be quite 
high, we believe the commenter's example does not reflect the 
experience of other advisers, none of whom made similar comments.\322\ 
Part 1A requires advisers

[[Page 72081]]

to answer basic questions about their business, their affiliates and 
their owners, and Part 1A can be completed using information readily 
available to hedge fund advisers. Numerous hedge fund advisers have 
already registered with the Commission using Part 1A, and none has 
reported to us that its business model presents any difficulty in using 
the form.\323\ 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.\324\ Part II requires disclosure of certain 
conflicts of interest, which even unregistered advisers have a 
fiduciary duty to disclose to their clients. We expect that hedge fund 
advisers will face relatively small internal costs in preparing a Part 
II, and will be likely to include their Part II disclosure as part of 
their private placement memoranda for their hedge funds, reducing their 
overall costs even further. We received no comments to the contrary.
---------------------------------------------------------------------------

    \322\ The MFA stated that one of its members expended $75,000 of 
internal staff time in preparing its Form ADV filing. See MFA 
Letter, supra note 51. MFA's comments are also not reflective of 
other feedback we have received on revised Form ADV and the IARD 
electronic filing system, which were launched in 2001. See Letter 
from Karen Barr, General Counsel, Investment Counsel Association of 
America, to Paul F. Roye, Director, Division of Investment 
Management, U.S. Securities and Exchange Commission (May 16, 2001) 
(noting that ICAA members found the filing system easy to use and 
found the form instructions and staff responses to frequently-asked 
questions to provide useful guidance).
    \323\ In fact, our new rule makes only one small change to Part 
1A, to better identify which advisers' pooled investment vehicles 
are hedge funds. See Section II.K. of this Release.
    \324\ See rule 204-3, the brochure delivery rule.
---------------------------------------------------------------------------

2. Cost of Establishing a Compliance Infrastructure
    New hedge fund adviser registrants will also face costs to bring 
their operations into conformity with the Advisers Act and the rules 
under the Act. In the Proposing Release, we estimated the cost of 
establishing a compliance infrastructure would primarily consist of 
establishing procedures and systems that address rules under the 
Advisers Act such as the books and records rule,\325\ the custody 
rule,\326\ the proxy voting rule,\327\ the compliance rule,\328\ and 
the code of ethics rule.\329\ While some commenters also focused on 
these factors,\330\ others identified additional cost considerations, 
as we discuss below.
---------------------------------------------------------------------------

    \325\ Rule 204-2.
    \326\ Rule 206(4)-2.
    \327\ Rule 206(4)-6.
    \328\ Rule 206(4)-7.
    \329\ Rule 204A-1.
    \330\ See, e.g., Schulte Roth Letter, supra note 51; ICAA 
Letter, supra note 47.
---------------------------------------------------------------------------

    Many unregistered hedge fund advisers have already built sound 
compliance infrastructures 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.\331\ In the 
Proposing Release, we estimated these advisory firms should face little 
cost to modify their current compliance practices to comply with the 
Advisers Act rules. Comments from registered hedge fund advisers 
agreed.\332\ For other hedge fund advisers that have not yet 
established sound compliance programs, however, the costs will be 
higher.
---------------------------------------------------------------------------

    \331\ One private attorney commenting on the rule noted he knows 
of few hedge fund managers which do not already comply with the 
substantive provisions of the Advisers Act as a matter of best 
practice. Sidley Austin Letter, supra note 51.
    \332\ Alternative Investment Group Letter, supra note 47; Vantis 
August Letter, supra note 50.
---------------------------------------------------------------------------

    In the Proposing Release, we estimated the cost for hedge fund 
advisers to establish the required compliance infrastructure will be, 
on average, $20,000 in professional fees and $25,000 in internal costs 
including staff time.\333\ These estimates were prepared in 
consultation with private attorneys who, as part of their practice, 
counsel hedge fund advisers establishing their registrations with the 
SEC. The estimates are averages, premised on the understanding that the 
costs will 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. Several law firms and 
attorneys representing hedge fund advisers challenged these estimates 
as being too low, but these firms did not provide any estimates of 
their own.\334\ The ICAA, based on the experience of its adviser 
members generally, commented that the costs of a compliance 
infrastructure are considerable, but that they are justified, 
especially considering the relative risks of hedge fund activities as 
compared to many other investment advisory activities.
---------------------------------------------------------------------------

    \333\ Our staff has estimated that between 690 and 1,260 hedge 
fund advisers would be new Advisers Act registrants under the new 
rule and rule amendments. See infra Section V of this Release; 
Section V of the Proposing Release. Aggregate start-up costs to 
establish required compliance infrastructure for all new registrants 
are therefore estimated to range from $31 to $57 million.
    \334\ Schulte Roth Letter, supra note 51; Bryan Cave Letter, 
supra note 111; Davis Polk Letter, supra note 197.
---------------------------------------------------------------------------

    Several hedge fund advisers estimated the costs to be in the range 
of $300,000, but most or all of the cost was attributable to 
compensation costs for hiring a dedicated chief compliance officer 
(CCO).\335\ Our compliance rule does not require firms to hire a new 
individual to serve as a full-time CCO, and the question of whether an 
advisory firm can look to existing staff to fulfill the CCO requirement 
internally is firm-specific. Firms may consider factors such as the 
size of the firm, the complexity of its compliance environment, and the 
qualifications of current staff.
---------------------------------------------------------------------------

    \335\ Lander Letter, supra note 51, Madison Capital Letter, 
supra note 51, MFA Letter, supra note 51 (recounting the estimates 
of members, and noting larger firms' cost for a chief compliance 
officer can approach $500,000). Data from the SIA Report on 
Management and Professional Earnings in the Securities Industry 
2003, modified by the SEC staff for an 1800-hour work-year and with 
a 35 percent markup for overhead, however, suggest that the total 
cost for hiring a full-time chief compliance officer in New York 
City would be approximately $234,000.
---------------------------------------------------------------------------

    While we recognize some hedge fund advisers will need to designate 
someone to serve as CCO on a full-time basis, we expect these will be 
larger firms--those with many employees and a sizeable amount of 
investor assets under management. Because there is no currently-
available comprehensive database of hedge fund advisers, we cannot 
determine the number of these larger hedge fund firms in operation, but 
our staff estimates it is relatively few. Staff estimates approximately 
half of these hedge fund advisers are already registered with us, and 
have already designated a CCO. While the remaining, unregistered, 
larger hedge fund advisers may not have designated a CCO as such, many 
of these firms likely already have personnel who perform similar 
functions to a CCO, in order to address the firm's liability exposure 
and protect its reputation.
    In smaller hedge fund advisers, the designated CCO will likely also 
fill another function in the firm, and perform additional duties 
alongside compliance matters. Firms designating a CCO from existing 
staff may experience costs to the extent the individual is taking on 
additional compliance responsibilities or giving up other non-
compliance responsibilities. These costs may include costs of shifting 
responsibilities among employees, and might in some cases include 
additional compensation costs. Some of these firms may need to add 
compliance capacity to their staffs. Costs will vary from firm to firm, 
depending on the extent to which firm staff is already performing some 
or all of the requisite compliance functions, the extent to which the 
CCO's non-compliance responsibilities need to be lessened to permit 
allocation of more time to compliance responsibilities, and the value 
to the firm of the CCO's non-compliance responsibilities. We do not 
have access to information that would

[[Page 72082]]

allow us to determine these costs, and commenters did not provide 
estimates.
3. Ongoing Costs of Compliance and Examination
    Several comments on our Proposing Release identified additional 
cost considerations related to hedge fund advisers' ongoing, annual 
costs of compliance and the costs of undergoing examination by the 
Commission. There may be a number of unregistered hedge fund firms 
whose operations are already substantially in compliance with the 
Advisers Act and that would therefore experience only minimal 
incremental ongoing costs as a result of registration.\336\ There are 
other unregistered hedge fund advisers, however, who will face 
additional ongoing costs to conduct their operations in compliance with 
the Advisers Act. These costs may be significant for some hedge fund 
advisers.
---------------------------------------------------------------------------

    \336\ One law firm commented that it knew of few hedge fund 
advisers that are not already complying with the substantive 
provisions of the Advisers Act as a matter of best practices. Sidley 
Austin Letter, supra note 51. See also Superior Capital Letter, 
supra note 51 (noting that the Advisers Act compliance regulations 
would be ``redundant'' for this firm).
---------------------------------------------------------------------------

    We do not have access to information that would enable us to 
determine these additional ongoing costs, which are predominantly 
internal to the firms themselves. Incremental ongoing compliance costs 
will vary from firm to firm depending on factors such as the complexity 
of each firm's activities, the business decisions it makes in 
structuring its response to its compliance obligations, and the extent 
to which it is already conducting its operations in compliance with the 
Advisers Act.\337\ We received comments from small hedge fund advisers 
estimating that their annual compliance costs would be approximately 
$25,000 and could be as high as $50,000.\338\ These commenters and 
other small hedge fund advisers expressed concerns that compliance 
costs would be prohibitive in comparison to their management fee 
revenues.\339\ Other small hedge fund advisers commented that their 
existing staff could not accommodate the compliance responsibilities 
they would face as a result of registration.\340\ We also, however, 
received comments from investment advisory trade associations noting 
that thousands of small investment advisers currently operate under the 
same compliance burden.\341\ We note that more than 2,500 smaller 
advisory firms are currently registered with us.\342\ 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.\343\
---------------------------------------------------------------------------

    \337\ These underlying uncertainties surrounding these internal 
costs would introduce the same level of uncertainty to various 
alternatives that we might pursue in determining these costs. For 
example, advisory firms themselves are not likely to be able to 
provide reliable estimates for several reasons. First, experiences 
will vary across firms; second, few firms are likely to have 
allocated the internal resources necessary to assess which costs are 
a direct result of legal requirements and which arise from other 
factors; and third, firms' experience with some newer requirements 
(such as the adviser compliance rule and the adviser code of ethics 
rule) is still limited. Attempting to estimate the number of staff 
hours involved (and applying industry standard wage and benefit 
costs for the corresponding types of personnel) would entail the 
same uncertainties.
    \338\ Comment Letter of Joseph L. Vidich (Aug. 7, 2004) 
(``Vidich Letter'') (currently managing $10 million hedge fund); 
Comment Letter of Venkat Swarna (Sept. 14, 2004) (``Swarna Letter'') 
(anticipates managing $2 million hedge fund). Although these 
commenters would not be covered by our registration requirement, we 
have taken their cost estimates into consideration, because other 
small firms that will be covered did not provide us with quantified 
estimates.
    \339\ See Vidich Letter, supra note 338; Superior Capital 
Letter, supra note 51; LaRocco Letter, supra note 51; see also ISDA 
Letter, supra note 52.
    \340\ See, e.g., Millrace Letter, supra note 92; see also Seward 
& Kissel Letter, supra note 111; Blanco Partners Letter, supra note 
52.
    \341\ ICAA Letter, supra note 47, CFA Institute Letter, supra 
note 47.
    \342\ Some commenters suggested the threshold for hedge fund 
adviser registration should be $50 million, to address their 
concerns that the cost burden of adviser registration might be 
disproportionate for advisers managing lesser amounts of assets. 
See, e.g., LaRocco Letter, supra note 51. However, many currently-
registered firms, which presently comply with these same 
registration obligations, manage less than $50 million. As of 
September 30, 2004, 2,758 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. We also note 
that establishing a higher assets under management registration 
threshold for advisers to private funds would allow these other 
advisers to avoid registration merely by pooling some of their 
clients' assets into a private fund.
    \343\ 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. See supra note 11.
---------------------------------------------------------------------------

    Some commenters asserted that there would be substantial costs 
associated with hedge fund advisers' responses to our examinations. One 
hedge fund adviser reportedly estimated spending 160 hours of internal 
staff time during an SEC examination.\344\ We believe this does not 
reflect the typical experience of our registrants, with the possible 
exception of the very largest advisers, and few of the firms affected 
by the new rule are likely to be of this size.\345\ A law firm 
commented that two registered hedge fund advisers reportedly spent an 
estimated $300,000 to $500,000 in out-of-pocket costs preparing for and 
undergoing SEC examinations.\346\ We believe this also is not 
representative of our registrants' experiences, who do not typically 
find it necessary to involve private counsel in extensive pre-
examination review of their activities and records. Also, we note that 
one registered hedge fund adviser commented that the firm itself 
derived benefit from the examination process.\347\
---------------------------------------------------------------------------

    \344\ MFA Letter, supra note 51 (reporting experience of one 
registered hedge fund adviser).
    \345\ As we discuss elsewhere, the absence of a comprehensive 
database of hedge fund advisers makes it difficult to estimate the 
number or size of hedge fund advisory firms that will be affected by 
the new rule. However, staff estimates half or more of the larger 
hedge fund advisers are likely already registered with us. See also 
The Hedge Fund 100, supra note 70 (estimating that even the top 100 
hedge fund advisers manage in the range of $2 billion to $11.5 
billion).
    \346\ Sidley Austin Letter, supra note 51.
    \347\ Vantis August Letter, supra note 50 (review provides 
additional assurance that any deficiencies not already identified by 
internal or external audit are identified; exam staff offers helpful 
instruction in regulatory issues and assistance in developing 
policies and procedures).
---------------------------------------------------------------------------

V. Effects on Commission Examination Resources

    The new registration requirement will increase the number of 
investment adviser firms subject to Commission examinations. The 
examination program 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 Commission, either because they advise non-hedge fund clients 
for whom registration is required, or because they perceive 
registration with the Commission to be necessary to their business 
model. Implementation of rule 203(b)(3)-2 will increase the number of 
SEC-registered advisers by some amount.
    Several commenters expressed concerns about this increase.\348\ As 
stated in the Proposing Release, there are various options we could 
pursue to lessen the effect of this increase. Though OCIE's resources 
will be spread over an expanded pool of investment adviser registrants, 
we are developing risk assessment tools to enhance the efficiency of 
our examination program by allowing our staff to focus examination 
resources on the areas of greatest risk to investors. In addition, we 
have recently adopted measures that require advisory personnel to be 
more accountable for the efficacy of

[[Page 72083]]

compliance programs. As of October of this year, registered advisers 
have begun complying with our new compliance rule, which requires them 
to implement comprehensive policies and procedures for compliance with 
the Advisers Act, under the administration of a chief compliance 
officer.\349\ As advisers improve their own compliance regimes, we 
expect this will facilitate our examination of advisory firms. As 
discussed in the Proposing Release,\350\ 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. We are continuing to develop techniques to 
assess risk.
---------------------------------------------------------------------------

    \348\ See, e.g., Schulte Roth Letter, supra note 51, Davis Polk 
Letter, supra note 197, Rodney Pitts Letter, supra note 52, Sheila 
Bair Letter, supra note 89, Comment Letter of Alex Cook (Aug. 26, 
2004) (``Alex Cook Letter), Tudor Investment Letter, supra note 53.
    \349\ Rule 206(4)-7. See Compliance Programs of Investment 
Companies and Investment Advisers, supra note 109.
    \350\ See Section V. of the Proposing Release.
---------------------------------------------------------------------------

    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. In the Proposing 
Release, we described our staff's tentative estimates that the addition 
of new hedge fund advisers to our current registrant pool could 
increase the total size of this pool by 8 to 15 percent.\351\ We 
received no comment on these estimates.
---------------------------------------------------------------------------

    \351\ Staff estimated that between 690 and 1,260 hedge fund 
advisers will be new Advisers Act registrants under the new rule and 
rule amendments. See Section V. of the Proposing Release.
---------------------------------------------------------------------------

VI. Paperwork Reduction Act

    As we discussed in the Proposing Release, 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 rule 
amendments contain several collections of information requirements, but 
the amendments do not change the burden per response from that under 
the current rules. Rule 203(b)(3)-2 will have the effect of requiring 
most advisers to hedge funds to register with the Commission under the 
Advisers Act and will 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 of 
information for which the annual aggregate burden will 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 OMB 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 206(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 otherwise noted below, 
responses are not kept confidential.
    We cannot estimate with precision the number of hedge fund advisers 
that will be new registrants with the Commission under the Advisers Act 
after rule 203(b)(3)-2 is adopted. As discussed earlier, our staff has 
estimated that between 690 and 1,260 hedge fund advisers will be new 
Advisers Act registrants under the new rule and rule amendments.\352\ 
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 received no comments on these 
estimates.
---------------------------------------------------------------------------

    \352\ See Section V. of the Proposing Release.
---------------------------------------------------------------------------

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 will 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 new rule will increase the 
annual aggregate information collection burden under Form ADV by 28,958 
hours \353\ for a total of 131,611 hours.
---------------------------------------------------------------------------

    \353\ 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. (975 x 22.25) + (975 x 0.75) + (975 x (670 x 
0.1) x 0.1).
---------------------------------------------------------------------------

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 the 975 hedge fund advisers that will be 
new registrants will withdraw from SEC registration at a rate of 
approximately 16 percent per year, the same rate as other registered 
advisers, and will 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 new rule will increase the annual 
aggregate information collection burden

[[Page 72084]]

under Form ADV-W and rule 203-2 by 78 hours \354\ for a total of 578 
hours.
---------------------------------------------------------------------------

    \354\ 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 will be new registrants will file for temporary 
hardship exemptions at approximately 0.1 percent per year, the same 
rate as other registered advisers.\355\ Accordingly, we estimate the 
new rule will increase the annual aggregate information collection 
burden under Form ADV-H and rule 203-3 by 1 hour \356\ for a total of 
11 hours.
---------------------------------------------------------------------------

    \355\ We expect that no hedge fund advisers would be small 
advisers that would be eligible to file for a continuing hardship 
exemption.
    \356\ 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 will be new registrants will make these filings at 
the same rate (0.2 percent) as other registered advisers. Accordingly, 
we estimate the new rule will increase the annual aggregate information 
collection burden under Form ADV-NR by 2 hours \357\ for a total of 17 
hours.
---------------------------------------------------------------------------

    \357\ 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.\358\ 
The records that an adviser must keep in accordance with rule 204-2 
must generally be retained for not less than five years.\359\ 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 will be new registrants will maintain copies of records 
under the requirements of rule 204-2. Accordingly, we estimate the new 
rule will increase the annual aggregate information collection burden 
under rule 204-2 by 186,985.5 hours \360\ for a total of 1,724,869.5 
hours.
---------------------------------------------------------------------------

    \358\ See section 210(b) of the Advisers Act [15 U.S.C. 80b-
10(b)].
    \359\ See rule 204-2(e).
    \360\ 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 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 will be new registrants will provide brochures as required by rule 
204-3. Accordingly, we estimate the new rule will increase the annual 
aggregate information collection burden under rule 204-3 by 676,650 
hours \361\ 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 requested, but did not receive, comments 
on the number of clients of the average hedge fund adviser.
---------------------------------------------------------------------------

    \361\ 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 will be new registrants will 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 new 
rule will increase the annual aggregate information collection burden 
under rule 204A-1 by 115,001 hours \362\ for a total of 1,060,842 
hours.
---------------------------------------------------------------------------

    \362\ 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

[[Page 72085]]

custody of advisers are safeguarded, and staff of the Commission uses 
information contained in the collections 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 will be new registrants will have custody. 
Advisers to pooled investment vehicles such as hedge funds may 
distribute audited financial statements to their investors annually in 
lieu of quarterly account statements sent by either the adviser or a 
qualified custodian. We are amending rule 206(4)-2 to make it easier 
for advisers to funds of hedge funds to use this approach. We estimate 
that all 975 new respondents will use this approach and will not be 
required to undergo an annual surprise examination. Accordingly, we 
estimate the new rule will increase the annual aggregate information 
collection burden under rule 206(4)-2 by 326,625 hours \363\ for a 
total of 398,738 hours.
---------------------------------------------------------------------------

    \363\ 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 will be new registrants 
will be subject to the cash solicitation rule, the same rate as other 
registered advisers. Accordingly, we estimate the new rule will 
increase the annual aggregate information collection burden under rule 
206(4)-3 by 1,373 hours \364\ for a total of 12,355 hours.
---------------------------------------------------------------------------

    \364\ 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 will be new registrants will be 
subject to rule 206(4)-4, the same rate as other registered advisers. 
Accordingly, we estimate the new rule will increase the annual 
aggregate information collection burden under rule 206(4)-4 by 1,265 
hours \365\ for a total of 11,383 hours.
---------------------------------------------------------------------------

    \365\ 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 will be new registrants will vote their clients' securities. 
Accordingly, we estimate the new rule will increase the annual 
aggregate information collection burden under rule 206(4)-6 by 16,283 
hours \366\ for a total of 119,873 hours.
---------------------------------------------------------------------------

    \366\ We estimate that 975 hedge fund advisers will spend 10 
hours each annually documenting their voting policies and 
procedures, and will provide copies of those policies and procedures 
to 10 percent of their 670 clients annually at 0.1 hours per 
response.
---------------------------------------------------------------------------

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 will be new registrants will be 
required to maintain compliance programs under rule 206(4)-7. 
Accordingly, we estimate the new rule will increase the annual 
aggregate information collection burden under rule 206(4)-7 by 78,000 
hours \367\ for a total of 701,200 hours.
---------------------------------------------------------------------------

    \367\ 975 hedge fund advisers at 80 hours per adviser annually.
---------------------------------------------------------------------------

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.\368\
---------------------------------------------------------------------------

    \368\ 15 U.S.C. 80b-2(c).
---------------------------------------------------------------------------

    As discussed above, rule 203(b)(3)-2 will, in effect, require most 
hedge fund advisers to register with the Commission under the Advisers 
Act. The new 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 adopting rule amendments that will 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 new rule and rule amendments may indirectly increase efficiency for 
hedge fund investors. Hedge fund adviser registration will 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 new rule will introduce any 
competitive disadvantages. The new 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

[[Page 72086]]

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 will require that all hedge 
fund advisers compete with each other and with other investment 
advisers on the same basis in this regard. The 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 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.
    Some hedge fund advisers may elect to limit the number of investors 
in their funds, or limit their total assets under management in order 
to avoid registration under the Advisers Act. To the extent that 
certain hedge fund advisers choose not to expand their business, some 
investors may not be able to place their assets with particular 
advisers; on the other hand, a hedge fund adviser's decision not to 
expand its business may make it easier for other advisers to enter the 
market.
    The new 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.

VIII. Regulatory Flexibility Act

A. Certification

    Pursuant to section 605(b) of the Regulatory Flexibility Act,\369\ 
the Commission hereby certifies that rule 203(b)(3)-2 and the 
amendments to rules 203(b)(3)-1, 203A-3, 204-2, 205-3, 222-2 and Form 
ADV will not 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 million or more on the last day of its most 
recent fiscal year.\370\
---------------------------------------------------------------------------

    \369\ 5 U.S.C. 605(b)
    \370\ Rule 0-7(a) [17 CFR 275.0-7(a)].
---------------------------------------------------------------------------

    Rule 203(b)(3)-2 and the amendment to rule 203(b)(3)-1 will 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 new rule, 
investment advisers with assets under management of less than $25 
million will remain generally ineligible for registration with the 
Commission under section 203A of the Advisers Act.\371\ The amendments 
to rule 203A-3 and 222-2 clarify that advisers may continue to rely on 
rule 203(b)(3)-1's safe harbor when counting clients for purposes of 
rules that affect state licensing and registration. The amendments to 
rules 204-2 and 205-3 will allow advisers affected by the new rule to 
continue certain marketing practices and performance fees they now have 
in place. The amendment to Form ADV will require advisers to private 
funds to identify themselves as such. No other entities will incur 
obligations from the new rule and amendments. Accordingly, the 
Commission certifies that rule 203(b)(3)-2 and the amendments to rules 
203(b)(3)-1, 203A-3, 204-2, 205-3, 222-2, and Form ADV will not have a 
significant economic impact on a substantial number of small entities.
---------------------------------------------------------------------------

    \371\ 15 U.S.C. 80b-3A.
---------------------------------------------------------------------------

B. Amendment to Rule 206(4)-2

    The Commission has prepared the following Final Regulatory 
Flexibility Analysis (``FRFA'') regarding the amendment to rule 206(4)-
2 in accordance with section 3(a) of the Regulatory Flexibility 
Act.\372\
---------------------------------------------------------------------------

    \372\ 5 U.S.C. 603(a).
---------------------------------------------------------------------------

1. Reasons for Action
    We are amending rule 206(4)-2, the adviser custody rule, to 
accommodate advisers to private funds of funds, including funds of 
hedge funds.\373\ 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.\374\ 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 amended the rule to extend 
the period for funds of funds 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.\375\
---------------------------------------------------------------------------

    \373\ Rule 206(4)-2.
    \374\ Rule 206(4)-2(b)(3).
    \375\ We initially proposed to extend the period for all 
investment advisers. Commenters pointed out that such extension 
would leave the advisers to funds of funds in the same situation, 
i.e., the underlying hedge funds would use the entire 180-day 
period, and the advisers to the funds of funds would have no time to 
prepare financial statements for the funds of funds after they 
receive the financial statements from underlying hedge funds.
---------------------------------------------------------------------------

2. Objectives and Legal Basis
    The objective of the 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 amendment.
3. Small Entities Subject to Rule
    The Commission estimates that as of June 30, 2004,\376\ 
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.\377\
---------------------------------------------------------------------------

    \376\ This estimate is based on the information provided by SEC-
registered advisers in Form ADV, Part 1A.
    \377\ 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 amendment to rule 206(4)-2 is 
not limited to hedge fund advisers that would be subject to 
registration requirements under rule 203(b)(3)-2.
---------------------------------------------------------------------------

4. Reporting, Record-keeping, and Other Compliance Requirements
    The amendment will impose no new reporting, record-keeping or other 
compliance requirements. To the contrary, the amendment will provide 
all advisers, big or small, that advise funds of funds 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.

[[Page 72087]]

5. Duplicative, Overlapping, or Conflicting Federal Rules
    The Commission believes that there are no rules that duplicate, 
overlap, or conflict with the amendment.
6. Significant Alternatives
    The Regulatory Flexibility Act directs the Commission to consider 
significant alternatives that will accomplish the stated objective, 
while minimizing any significant adverse impact on small entities. In 
connection with the new 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 amendment is to decrease regulatory 
burdens on advisers; small advisers, as well as large ones, will 
benefit from the new rule. Moreover, the 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 amendment are unlikely to minimize any impact that 
the new 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 will deprive small 
entities of the burden relief provided by the amendment.

IX. Statutory Authority

    We are adopting new rule 203(b)(3)-2 and amendments to rule 
203(b)(3)-1, rule 203A-3, rule 204-2, rule 205-3, rule 206(4)-2, rule 
222-2 and Form ADV pursuant to our authority under section 19(a) of the 
Securities Act of 1933,\378\ sections 23(a) and 28(e)(2) of the 
Securities Exchange Act of 1934,\379\ section 319(a) of the Trust 
Indenture Act of 1939,\380\ section 38(a) of the Investment Company Act 
of 1940,\381\ and sections 202(a)(17), 203, 204, 205(e), 206(4), 206A, 
208(d) and 211(a) of the Advisers Act.\382\ 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.\383\ Our authority is described in more detail 
in Section II.C of this Release.
---------------------------------------------------------------------------

    \378\ 15 U.S.C. 77s(a).
    \379\ 15 U.S.C. 78w(a) and 78bb(e)(2).
    \380\ 15 U.S.C. 77sss(a).
    \381\ 15 U.S.C. 80a-37(a).
    \382\ 15 U.S.C. 80b-2(a)(17), 80b-3, 80b-4, 80b-6(4) and 80b-
11(a).
    \383\ 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 * * *.''
---------------------------------------------------------------------------

Text of Rule, Rule Amendments and Form Amendments

List of Subjects in 17 CFR Parts 275 and 279

    Investment Advisers, Reporting and recordkeeping requirements, 
Securities.

0
For reasons set forth in the preamble, Title 17, Chapter II of the Code 
of Federal Regulations is amended as follows:

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

0
1. The general authority citation for Part 275 continues 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.
* * * * *

0
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, 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 
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;
    (6) You may not rely on paragraph (a)(2)(i) of this section with 
respect to any private fund as defined in paragraph (d) of this 
section; and
    (7) For purposes of paragraph (b)(5) of this section, a client who 
is an owner of a private fund is a resident of the place at which the 
client resides at the time of the client's investment in the fund.
    (c) Holding out. If you are relying on this section, you shall not 
be deemed to be holding yourself out generally to the

[[Page 72088]]

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.
    (d) Private fund. (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
    (ii) Interests acquired through reinvestment of distributed capital 
gains or income.
    (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.

0
3. Section 275.203(b)(3)-2 is added to read as follows:


Sec.  275.203(b)(3)-2  Methods for counting clients in 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 as clients the shareholders, limited partners, 
members, or beneficiaries (any of which are referred to hereinafter as 
an ``owner'') of a private fund as defined in paragraph (d) of section 
275.203(b)(3)-1, unless such owner is your advisory firm or a person 
described in paragraph (d)(1)(iii) of section 275.205-3.
    (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 you have your principal office and place of business outside 
the United States, you may treat a private fund that is organized or 
incorporated under the laws of a country other than the United States 
as your client for all purposes under the Act, other than sections 203, 
204, 206(1) and 206(2) (15 U.S.C. 80b-3, 80b-4, 80b-6(1) and (2)).

0
4. Section 275.203A-3 is amended by revising paragraph (a)(4) to read 
as follows:


Sec.  275.203A-3  Definitions.

    (a) * * *
    (4) Supervised persons may rely on the definition of ``client'' in 
Sec.  275.203(b)(3)-1, without giving regard to paragraph (b)(6) of 
that section, to identify clients for purposes of paragraph (a)(1) of 
this section, except that supervised persons need not count clients 
that are not residents of the United States.
* * * * *

0
5. Section 275.204-2 is amended by:
0
(a) Redesignating paragraph (e)(3) as (e)(3)(i); and
0
(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)-1, and you were 
exempt from registration under section 203(b)(3) of the Act (15 U.S.C. 
80b-3(b)(3)) prior to February 10, 2005, 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 or other account you advise for any period ended prior to 
February 10, 2005, 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 or other account 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)-1), 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).
    6. 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 investment advisers.

* * * * *
    (c)(1) * * *
    (2) Advisers to private funds with non-qualified investors. 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)-1, and you 
were exempt from registration under section 203(b)(3) of the Act (15 
U.S.C. 80b-3(b)(3)) prior to February 10, 2005, paragraph (b) of this 
section will not apply to the existing account of any equity owner of a 
private investment company who was an equity owner of that company 
prior to February 10, 2005.
    (3) Advisers to private funds with non-qualified clients. 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)-1, and you 
were exempt from registration under section 203(b)(3) of the Act (15 
U.S.C. 80b-3(b)(3)) prior to February 10, 2005, section 205(a)(1) of 
the Act (15 U.S.C. 80b-5(a)(1)) will not apply to any investment 
advisory contract you entered into prior to February 10, 2005, 
provided, however, that this paragraph will not apply with respect to 
any contract to which a private investment company is a party, and 
provided further that section 205(a)(1) of the Act will apply with 
respect to any natural person or company who is not a party to the 
contract prior to and becomes a party to the contract on or after 
February 10, 2005.
* * * * *

0
7. Section 275.206(4)-2 is amended by revising paragraph (b)(3) and 
adding paragraph (c)(4) to read as follows:


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

[[Page 72089]]

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 120 
days of the end of its fiscal year, or in the case of a fund of funds 
within 180 days of the end of its fiscal year; and
* * * * *
    (c) * * *
    (4) Fund of funds means a limited partnership (or limited liability 
company, or another type of pooled investment vehicle) that invests 10 
percent or more of its total assets in other pooled investment vehicles 
that are not, and are not advised by, a related person (as defined in 
Form ADV (17 CFR 279.1)), of the limited partnership, its general 
partner, or its adviser.

0
8. Section 275.222-2 is revised to read as follows:


Sec.  275.222-2  Definition of ``client'' for purposes of the national 
de minimis standard.

    For purposes of section 222(d)(2) of the Act (15 U.S.C. 80b-
18a(d)(2)), an investment adviser may rely upon the definition of 
``client'' provided by section 275.203(b)(3)-1 without giving regard to 
paragraph (b)(6) of that section.

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

0
9. 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.

0
10. Form ADV (referenced in Sec.  279.1) is amended by:
0
a. In Part 1A, Item 7, revising Item 7B; and
0
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)-1? [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:
[squ] Add [squ] Delete [squ] 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)-1?
[squ] Yes [squ] No
    Are your clients solicited to invest in the limited partnership, 
limited liability company or other private fund?
[squ] Yes [squ] 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: December 2, 2004.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.

Dissent of Commissioners Cynthia A. Glassman and Paul S. Atkins to the 
Registration Under the Advisers Act of Certain Hedge Fund Advisers

    Four months ago, the majority proposed to regulate hedge fund 
advisers over our dissent.\1\ We were nevertheless hopeful that a 
careful review of commentary on the proposal would convince the 
majority, instead of taking further action on this proposal, to 
consider better alternatives. Our hope was fueled by the fact that 
many commenters offered excellent insights and recommendations to 
the Commission. We are disappointed that the majority, unmoved by 
the chorus of credible concerns from diverse voices,\2\ has 
determined to adopt the hedge fund registration rules largely as 
proposed.\3\ As discussed below, we continue to agree that we need 
more information on hedge funds, but we disagree with the majority's 
solution.
---------------------------------------------------------------------------

    \1\ Registration Under the Advisers Act of Certain Hedge Fund 
Advisers, Investment Advisers Act Release No. 2266 (July 20, 2004) 
[69 FR 45172 (July 28, 2004)] (``Proposing Release'').
    \2\ In addition to the many comments the Commission received, 
the diversity of voices is illustrated by the appearance of 
editorials opposing the rulemaking in the New York Times, Wall 
Street Journal, and Washington Post. See Hands off Hedge Funds, 
Wash. Post, B6, July 18, 2004; Reforming Hedge Funds, N.Y. Times, 
D12, June 27, 2004; The SEC's Expanding Empire, Wall St. J., A14, 
July 13, 2004.
    \3\ Registration Under the Advisers Act of Certain Hedge Fund 
Advisers, Investment Advisers Act Release No. 2333 ( Dec. 2, 2004) 
(``Adopting Release'').
---------------------------------------------------------------------------

    Our main concerns with this rulemaking can be broadly divided 
into the following categories:
     There are many viable alternatives to this rulemaking 
that should have been considered.
    The needed information about hedge funds can be obtained from 
other sources, including other regulators and market participants, 
as well as through a notice and filing requirement. The Commission 
should have collected and analyzed the existing information and 
determined what new information would be useful before imposing 
mandatory registration. Further, the Commission has failed to 
demonstrate that this is the least burdensome and most effective way 
to accomplish its objective.
     The pretext for the rule does not withstand scrutiny.
    Just last year, the staff found that fraud was not rampant in 
the hedge fund industry, and that retailization was not a concern. 
Nonetheless, the majority repeatedly asserts

[[Page 72090]]

that these issues justify imposition of the rulemaking. The fallacy 
of the majority's approach is apparent when one notes that 
registration of hedge fund advisers would not have prevented the 
enforcement cases cited by the majority, and the rulemaking will 
have the perverse effect of promoting, rather than inhibiting, 
retailization.
     The Commission's limited resources will be diverted.
    At the open meeting, Chairman Donaldson stated that a task force 
had been constituted to identify hedge fund risks and implied that 
the task force would develop a targeted examination model. However, 
the task force should have completed its work prior to the 
promulgation of this rulemaking, so that it could be specifically 
tailored to address actual, as opposed to hypothetical, concerns. 
Under this rulemaking, the Commission will have to allocate its 
limited resources to inspect more than 1,000 additional advisers. 
Our concerns about the misuse of resources were validated when, just 
two days after the open meeting, the staff stated that, if the 
Commission cannot undertake its new examination responsibilities, it 
has in its ``back pocket'' the ability to shift resources from 
oversight of small advisers.\4\ This possible shift should have been 
raised during the open meeting and weighed by the Commission in 
deciding whether to adopt the rule.
---------------------------------------------------------------------------

    \4\ See Robert Schmidt, Hedge Fund Rule May Cause SEC to Drop 
Smaller Firms, Roye Says, Bloomberg (Oct. 28, 2004).
---------------------------------------------------------------------------

    Our concerns are addressed in detail below.

I. The Information That the Commission Needs can be Obtained From Other 
Sources

    We share the majority's objective of getting better information 
about hedge funds and would support alternative measures such as 
pooling of information from Commission registrants and other 
government agencies and self-regulatory organizations that collect 
data on hedge funds, enhanced oversight of existing registrants, a 
census of all hedge funds, and requiring additional periodic and 
systematic information to be filed with us. Although the majority 
anticipates without specificity that ``registration would provide 
the Congress, the Commission and other government agencies with 
important information,'' Form ADV is unlikely to provide the 
information that the Commission needs. Before taking an action of 
the magnitude of this final rule, the Commission should have 
determined the information that it needs and worked with its fellow 
regulators and affected parties to obtain this information. Instead, 
the process by which the rule was proposed and adopted discouraged a 
true exchange of ideas about the proposed approach and 
alternatives.\5\
---------------------------------------------------------------------------

    \5\ Such a major shift in the Commission's regulatory approach 
warranted a significantly longer comment and comment review period 
than we afforded it. The proposal appeared in the Federal Register 
on July 28, 2004, and comments were due by September 15, 2004. 
Concerned about the brevity of the comment period and its 
inopportune timing during the vacation month of August, ten 
commenters requested a reasonable extension, but no extension was 
granted.
    Moreover, once the comment period closed, the staff did not 
prepare a formal summary analyzing the issues raised by the more 
than 160 comment letters, most of which opposed the rule. Such 
summaries are standard procedure for rulemakings of this 
significance, because the summaries help ensure that the comments 
are considered by the commissioners and staff. The abbreviated 
discussion of the comment letters in the adopting release is not a 
sufficient substitute for a comment summary that is prepared before 
drafting the release to assist the Commission in deciding whether to 
adopt a proposed rulemaking and, if so, whether to make any changes.
    The majority seems to have concluded that it had already heard 
all perspectives at the Commission's roundtable on hedge funds in 
May of 2003 and through the subsequent staff study. See Securities 
and Exchange Commission, Hedge Fund Roundtable (May 14-15, 2003) 
(transcript and webcast available at: http://www.sec.gov/spotlight/hedgefunds.htm) (``Roundtable''); Implications of the Growth of 
Hedge Funds, Staff Report to the United States Securities and 
Exchange Commission (Sept. 2003) (available at: http://www.sec.gov/news/studies/hedgefunds0903.pdf) (``2003 Staff Hedge Fund Report''). 
However, the roundtable and staff study disproved the existence of 
the problems that some thought might be found in the hedge fund 
industry. Consequently, the public did not have sufficient notice 
that a rulemaking would be forthcoming, much less of the specifics 
of the proposed rulemaking.
---------------------------------------------------------------------------

A. Coordination With Other Regulators Should Have Been a 
Prerequisite to Unilateral Commission Action

    Before adopting this rulemaking, the Commission should have 
coordinated with other government entities to aggregate the 
information that is available. The majority correctly notes that 
such information is not gathered in one convenient place, but we 
could work with other regulators to improve our and other agencies' 
access to information.\6\ The Commission also could explore ways of 
expanding the form that the Department of Treasury has proposed to 
require all unregistered advisers to file as part of its anti-money 
laundering program for investment advisers.\7\
---------------------------------------------------------------------------

    \6\ The Commodity Futures Trading Commission (``CFTC''), for 
example, has offered to enter into an information-sharing 
arrangement with the Commission and other relevant agencies. See 
Comment Letter of the CFTC (Oct. 22, 2004). The National Futures 
Association, which is a self-regulatory organization for the futures 
industry, likewise offered to share the information that it collects 
about hedge funds. See Comment Letter of the National Futures 
Association (Sept. 14, 2004).
    \7\ Financial Crimes Enforcement Network; Anti-Money Laundering 
Programs for Investment Advisers, 68 FR 23646 (May 5, 2003). The 
proposed rule would apply to, among others, any adviser that has at 
least $30 million in assets under management and is exempt from 
registration under section 203(b)(3) of the Investment Advisers Act 
[15 U.S.C. 80b-3(b)(3)], unless it is otherwise required to have an 
anti-money laundering program and is subject to examination by a 
federal regulator. See section 103.50(a)(2) of the proposed rule. 
[31 CFR 103.50(a)(2)]. As proposed, the form is intended to identify 
unregistered advisers, but the Commission could work with the 
Department of Treasury to tailor the form to elicit the information 
that the Commission determines that it needs.
---------------------------------------------------------------------------

    The majority approved the rulemaking three weeks after 
Congressman Baker, Chairman of the House Subcommittee on Capital 
Markets, Insurance and Government Sponsored Enterprises, asked the 
President's Working Group on Financial Markets (``PWG'') \8\ to work 
out a data sharing agreement before the Commission proceeded with 
its rule.\9\ Because the regulation of hedge funds has broad market 
implications, any regulatory requirement would be more appropriately 
addressed as part of a collaborative effort among the members of the 
PWG, all of whom apparently have concerns with our proposal.\10\ In 
1999 after the near collapse of Long Term Capital Management, the 
PWG issued a report that concluded that ``requiring hedge fund 
managers to register as investment advisers would not seem to be an 
appropriate method to monitor hedge fund activity.'' \11\ We agree 
with Chairman Greenspan that nothing has changed since then to 
warrant a different conclusion.\12\
---------------------------------------------------------------------------

    \8\ The President's Working Group is made up the heads of the 
Treasury, the Federal Reserve Board, the CFTC, and the SEC.
    \9\ See Letter from Congressman Richard H. Baker to John Snow, 
Chairman of the President's Working Group on Financial Markets (Oct. 
7, 2004). Oddly, the majority cites this letter, the existence of 
which we learned about the day before the Open Meeting for this 
rulemaking, in support of the proposition that ``During and after 
the comment period, our staff has continued to have discussions with 
other regulators relating to hedge fund adviser regulation.'' 
Adopting Release at n. 55.
    \10\ See, e.g., Alan Greenspan, Chairman, Federal Reserve Board, 
Testimony before the Senate Banking, Housing and Urban Affairs 
Committee (July 20, 2004) (``My problem with the SEC's current 
initiative is that the initiative cannot accomplish what it seeks to 
accomplish. Fraud and market manipulation will be very difficult to 
detect from the information provided by registration under the 1940 
Act.''); Comment Letter of the CFTC (Oct. 22, 2004) (requesting 
exemption for CFTC-registered advisers that ``would be complemented 
by a formal information sharing agreement between the CFTC and SEC 
related to CFTC-registered CPOs and CTAs''); Judith Burns, Split SEC 
Set to Vote on Tighter Hedge Fund Oversight, Dow Jones News Service, 
Oct. 25, 2004 (``Federal Reserve Chairman Alan Greenspan and 
Treasury Secretary John Snow worry that more regulation won't 
prevent fraud and could reduce benefits that hedge funds bring to 
markets.'').
    \11\ Hedge Funds, Leverage, and the Lessons of Long-Term Capital 
Management--Report of the President's Working Group on Financial 
Markets, at B-16 (Apr. 1999) (available at: http://www.treas.gov/press/releases/reports/hedgfund.pdf) (the Council of Economic 
Advisers, the Federal Deposit Insurance Corporation, the National 
Economic Council, the Federal Reserve Bank of New York, the Office 
of the Comptroller of the Currency, and the Office of Thrift 
Supervision also participated in the study and supported its 
conclusions and recommendations). The majority contends that the 
report did not focus on issues relevant to the Commission's 
administration of the Advisers Act, but rather on ``the stability of 
financial markets and the exposure of banks and other financial 
institutions to the counterparty risks of dealing with highly 
leveraged entities.'' Adopting Release at n. 43. The Commission 
cannot protect the nation's securities markets without considering 
the effect of its rules on the stability of the financial markets.
    \12\ See Alan Greenspan, Chairman, Federal Reserve Board, 
Written Responses to Questions from Chairman Shelby in Connection 
with Testimony before the Senate Banking, Housing and Urban Affairs 
Committee, at 3 (July 20, 2004).
---------------------------------------------------------------------------

    The majority justifies going forward in the face of such 
opposition by arguing that the

[[Page 72091]]

Commission alone among the PWG members bears the ``responsibility 
for the protection of investors and the oversight of our nation's 
securities markets,'' \13\ but other regulators may be better suited 
to address some of the majority's specific areas of concern.\14\ The 
majority, for example, did not consult the Department of Labor, 
which has primary jurisdiction over private pension plan advisers, 
about this rulemaking even though one of its justifications for the 
rulemaking is pension fund investment in hedge funds. The CFTC, with 
which many hedge fund advisers or sponsors are already registered, 
expressed serious concerns about duplicative regulation by the SEC 
and recommended an exemption for CFTC registrants.\15\ Similarly, 
although the majority addressed a number of concerns raised with 
respect to offshore funds, they did not adequately address, through 
discussions with foreign regulators, commenters' concerns about 
potentially duplicative regulation.\16\
---------------------------------------------------------------------------

    \13\ Adopting Release at n. 43.
    \14\ As the Commission has explained elsewhere, the Commission's 
interest in a particular area does not preclude its working with 
other regulators. See, e.g., SEC, 2002 Annual Report 1 (available 
at: http://www.sec.gov/pdf/annrep02/ar02fm.pdf) (``Though it is the 
primary overseer and regulator of the U.S. securities markets, the 
SEC works closely with many other institutions * * *''). The 
Adopting Release notes that the staff met with staff of various 
fellow regulators, but because these meetings were not documented in 
the comment file, it is difficult to discern what occurred at those 
meetings. See Adopting Release at n. 17.
    \15\ See Comment Letter of the CFTC (Oct. 22, 2004) (``in the 
interest of good government and in order to avoid duplicative 
regulation, the CFTC respectfully requests that the SEC provide a 
registration exemption for these CFTC registrants that do not hold 
themselves out to the general public as investment advisers.''). 
Many other commenters also recommended an exemption for CFTC-
registered entities. The majority dismisses requests to exempt CFTC-
registered commodity pool operators by arguing that Congress already 
addressed this concern by adding section 203(b)(6) to the Advisers 
Act in 2000 [15 U.S.C. 80b-3(b)(6)], but that section covers only 
commodity trading advisers, not commodity pool operators. See 
Adopting Release at text accompanying n. 128. We share the 
majority's hope that the staff will consult with the CFTC staff 
regarding examinations, but staff discussions at the implementation 
stage cannot substitute for discussions about the Commission's 
proposal prior to adoption. See Adopting Release at n. 130.
    \16\ Many commenters recommended that the Commission should not 
require the registration of certain advisers that are subject to 
oversight by foreign authorities. See, e.g., Comment Letter of the 
European Commission (Sept. 15, 2004); Comment Letter of the 
F[eacute]d[eacute]ration Europ[eacute]enne des Fonds et 
Soci[eacute]t[eacute]s d'Investissement (Sept. 15, 2004); Comment 
Letter of the Financial Services Roundtable (Sept. 15, 2004); the 
International Bar Association (Sept. 14, 2004).
---------------------------------------------------------------------------

B. Before Proceeding With Registration, the Commission Should Have 
Enhanced Its Oversight of Existing Registrants

    Rather than adding to its stable of registrants, the Commission 
could have obtained useful information by monitoring transactions 
through its existing registrants. The Commission, for example, could 
enhance its oversight of prime brokers to detect and deter fraud by 
their hedge fund clients and obtain more information about hedge 
fund advisers.\17\ More generally, market surveillance is an 
effective, targeted way of finding fraud, and would allow us to 
leverage the knowledge and expertise of other self-regulatory 
organizations.\18\
---------------------------------------------------------------------------

    \17\ See, e.g., Alan Greenspan, Chairman, Federal Reserve Board, 
Written Responses to Questions from Chairman Shelby in Connection 
with Testimony before the Senate Banking, Housing and Urban Affairs 
Committee, (July 20, 2004) (``If there was a public policy reason to 
monitor hedge fund activity, the best method of doing so without 
raising liquidity concerns would be indirectly through oversight of 
those broker-dealers (so-called prime brokers) that clear, settle, 
and finance trades for hedge funds. Although the use of multiple 
prime brokers by the largest funds would complicate the monitoring 
of individual funds by this method, such monitoring could provide 
much useful information on the hedge funds sector as a whole.'').
    \18\ See, e.g., Alan Greenspan, Chairman, Federal Reserve Board, 
Written Responses to Questions from Chairman Shelby in Connection 
with Testimony before the Senate Banking, Housing and Urban Affairs 
Committee (July 20, 2004) (``Concerns about market manipulation, 
whether by hedge funds or others, can best be addressed by enhanced 
market surveillance.'').
---------------------------------------------------------------------------

C. Commenters Showed a Commendable Willingness To Help the 
Commission Obtain the Information We Need Through Mining Existing 
Information Resources or Developing New Ones

    The commenters, the vast majority of which opposed mandatory 
registration, suggested a number of alternatives for ensuring that 
the Commission has ample information about hedge funds. Among the 
suggestions was requiring investment advisers that are exempt under 
sections (3)(c)(1) or (3)(c)(7) of the Investment Company Act of 
1940 \19\ or rely on the safe harbor in rule 203(b)(3)-1 under the 
Advisers Act \20\ to file and annually update information statements 
with the Commission.\21\ These information statements could include 
information such as the names of all unregistered funds advised, the 
names and qualifications of the key owners and employees of the 
adviser, assets under management, other types of accounts managed, a 
list of the prime brokers used by the adviser, and performance data. 
The majority's footnote addressing this approach dismisses this as a 
variant of another suggested approach--expanded Form D 
reporting.\22\ The majority refused to consider either approach 
because both lack an examination component.\23\ For the reasons 
stated below, we do not believe that the examination aspect of hedge 
fund regulation will deliver the benefits that the majority believes 
it will and we are concerned with the diversion of resources that 
examination will entail.
---------------------------------------------------------------------------

    \19\ 15 U.S.C. 80a-3(c)(1) and 15 U.S.C. 80a-3(c)(7).
    \20\ 17 CFR 275.203(b)(3)-1.
    \21\ A number of commenters suggested this approach or a similar 
annual census form for hedge fund advisers. See, e.g., Comment 
Letter of the American Bar Association, Section of Business Law 
(Sept. 28, 2004); Comment Letter of Sheila C. Bair, Professor of 
Financial Regulatory Policy, University of Massachusetts--Amherst 
(Sept. 15, 2004); Comment Letter of the U.S. Chamber of Commerce 
(Sept. 15, 2004); Comment Letter of Kynikos Associates (Sept. 15, 
2004); Comment Letter of the Managed Funds Association (Sept. 15, 
2004); Comment Letter of Seward & Kissell LLP (Sept. 15, 2004); 
Comment Letter of Schulte Roth & Zabel, LLP (Sept. 15, 2004); 
Comment Letter of Tudor Investment Corp. (Sept. 15, 2004). Other 
commenters suggested requiring hedge fund advisers to file audited 
financial statements. See, e.g., Comment Letter of Madison Capital 
Management LLC (Sept. 15, 2004); Comment Letter of James E. Mitchell 
(Sept. 1, 2004); Comment Letter of Joseph L. Vidich (Aug. 7, 2004); 
Comment Letter of Willkie, Farr & Gallagher (Sept. 13, 2004) 
(recommending self-executing exemptive application procedure for 
advisers that provide investors with audited financials and 
valuation disclosures).
    \22\ See Adopting Release at n. 150.
    \23\ See Adopting Release at text accompanying n. 154. The 
majority also concluded that it was not worthwhile for the staff to 
try to make use of the information generated by existing 
transactional reporting requirements. See Adopting Release at text 
following n. 155. This seems to be a premature conclusion, 
particularly in light of commenters' suggestion to tailor current 
forms so that they meet the Commission's information needs. See, 
e.g., Comment Letter of Bryan Cave LLP (Aug. 16, 2004) (recommending 
extensive amendments to Regulation D and Form D and Suspicious 
Activity Reports); Comment Letter of Madison Capital Management LLC 
(Sept. 15, 2004); Comment Letter of Proskauer Rose LLP (Aug. 31, 
2004); Comment Letter of Tudor Investment Corp. (Sept. 15, 2004).
---------------------------------------------------------------------------

II. Mandatory Registration Does Not Address the Concerns Underlying the 
Rulemaking

    The majority cites three main bases for its action: the growth 
of hedge fund assets, the growth in hedge fund fraud, and the 
broader exposure to hedge funds. None of these justifies the 
majority's action.

A. The Commission Should Not Necessarily Increase Its Regulatory 
Requirements on an Industry Simply Because It Has Grown

    The majority points to the growth of the hedge fund industry as 
a concern underlying the action being taken. Given the industry's 
size,\24\ the Commission has a basis for wanting more information 
about it, but the Commission should not assume that a greater level 
of regulation is needed in a flourishing industry with a wealthy and 
sophisticated investor base.
---------------------------------------------------------------------------

    \24\ The majority estimates the hedge fund industry to be $870 
billion, which is dwarfed by the approximately $23 trillion under 
management by registered advisers. See Adopting Release at text 
accompanying n. 19 and following n. 71.
---------------------------------------------------------------------------

    In the Proposing Release, the majority argued that registration 
would ``legitimiz[e] a growing and maturing industry that is 
currently perceived as operating in the shadows.''\25\ The Adopting 
Release does not repeat this dramatic language, but the underlying 
belief that there is something improper about not registering 
voluntarily is evident.\26\ The Commission should not

[[Page 72092]]

encourage an adviser's registration status to be viewed as a proxy 
for the adviser's honesty. There are many legitimate reasons for a 
hedge fund adviser not to register.\27\
---------------------------------------------------------------------------

    \25\ Proposing Release, supra n. 1, at text following n. 183.
    \26\ This belief manifests itself in the perfunctory manner in 
which the majority dismisses legitimate concerns from opposing 
commenters by challenging the commenters' integrity. See, e.g., 
Adopting Release at text accompanying n. 87 (noting, that hedge fund 
advisers ``should be particularly sensitive to the consequences of 
getting caught if their conduct is unlawful. * * * This sensitivity, 
which may be reflected in the strength of the opposition among some 
hedge fund advisers to this rulemaking, suggests that the marginal 
benefits of our oversight may be substantial.''). See also William 
H. Donaldson, Chairman, SEC, Testimony before the Senate Banking 
Committee (July 15, 2004) (video testimony available at: http://banking.senate.gov/index.cfm?Fuseaction= 
Hearings.Detail&HearingID=122) (``I don't get much push back from 
people that are operating good funds. I don't get much push back 
from people who have nothing to hide.'').
    \27\ See, e.g., Comment Letter of Amaranth Advisors LLC (Sept. 
15, 2004) (hedge fund adviser explains that it does not operate in 
the shadows, but under the scrutiny of a number of regulators); 
Comment Letter of the Greenwich Roundtable (Sept. 15, 2004) (``The 
hedge fund industry is already a highly legitimate and professional 
industry. Sophisticated investors in the hedge fund community make 
significant allocation decisions based in large part on the rigorous 
due diligence examinations that they personally perform prior to 
making an investment.''); Comment Letter of the Managed Funds 
Association (Sept. 15, 2004) (detailing regulatory obligations to 
which hedge fund advisers are subject). The perception that hedge 
funds operate in the shadows might be attributable partially to the 
limitations to which hedge fund advisers are subject. See, e.g., 
Testimony of Michael Neus, Principal and Chief General Counsel, 
Andor Capital Management, LLC, at the Hedge Fund Roundtable, supra 
n. 5 (May 14, 2004) (``it's a highly professional, highly organized 
industry which, because of restrictions on advertising or holding 
yourself out to the public, we are not capable of sharing with the 
general public * * *'').
---------------------------------------------------------------------------

B. Registration Would Not Have Prevented the Violations in the 
Enforcement Cases Cited by the Majority

    While we acknowledge that hedge fund fraud exists and should be 
taken seriously, it appears, based on our knowledge, that the 
majority overstates its relative significance. The 2003 Staff Hedge 
Fund Report did not find disproportionate involvement of hedge funds 
or their advisers in fraud.\28\ We estimate that the cases cited by 
the majority during the past five years comprise less than two 
percent of total SEC cases in the same period. The CFTC similarly 
found that only three percent of all SEC and CFTC enforcement 
actions were against hedge funds or their advisers.\29\
---------------------------------------------------------------------------

    \28\ See 2003 Staff Hedge Fund Report, supra n. 5, at 73. The 
majority notes that it is ``not alone in [its] concerns regarding 
hedge fund frauds'' and cites the results of interviews with 
managers of European financial institutions about the state of the 
European Financial Market. See Adopting Release at n. 27 (citing 
Bank of New York, Restoring Broken Trust: A Pan European Study of 
the Causes of Declining Trust in the European Financial Services 
Industry and Analysis of the Actions Needed to Rebuild Investor 
Trust (July 2004). While interesting, the opinions expressed by 
these European managers are largely immaterial in the context of the 
U.S. industry, and it is not clear how today's rulemaking will 
address these concerns.
    \29\ See Testimony of Patrick J. McCarty, General Counsel of the 
CFTC, before the U.S. Senate Committee on Banking, Housing and Urban 
Affairs 1 (July 15, 2004). See also Comment Letter of the National 
Futures Association (Sept. 14, 2004) (NFA's experience with the 
hedge funds it oversees is ``consistent with the comparatively small 
number of CFTC and SEC enforcement actions involving commodity pool 
and hedge fund activities.'').
---------------------------------------------------------------------------

    Citing to forty-six cases in the Proposing Release and five 
additional cases in the Adopting Release, the majority is requiring 
advisers to the most sophisticated investors to register based on 
fraud cases, most of which were directed at the least sophisticated 
investors. These cases do not provide a justification for mandatory 
registration because, in most, the hedge fund advisers would have 
been too small to be registered under the new requirement,\30\ were 
already registered,\31\ or should have been registered.\32\ Many 
were garden-variety fraudsters who could as easily have called their 
schemes something other than ``hedge funds.'' The majority argues 
that registration with the Commission permits it to screen 
registrants and deny registration to anyone who has been convicted 
of a felony or otherwise has a disciplinary history that warrants 
disqualification. Many of those implicated in our cases would not 
even have sufficient assets to be eligible for registration.\33\ 
Others, whose sole objective was to defraud investors, likely would 
not even attempt to register, but would nevertheless perpetrate 
their frauds.\34\
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    \30\ Hedge fund advisers, like other advisers, generally will be 
required to register only if they have assets under management of 
$30 million or more and advisers with between $25 million and $30 
million will be permitted to register. See Investment Advisers Act 
section 203A(a)(1) [15 U.S. 80b-3a(a)(1)] and rule 203A-1 [17 CFR 
275.203A-1] thereunder.
    \31\ The majority states that ``[o]ur examination staff 
uncovered, during routine or sweep exams, five of the eight cases we 
brought against registered hedge fund advisers * * *.'' Adopting 
Release at n. 94 and accompanying text. One of those cases was 
uncovered during a sweep examination that was prompted by a civil 
complaint filed by the New York Attorney General. See In the Matter 
of Alliance Capital Management, L.P., Investment Advisers Act 
Release No. 2205 (Dec. 18, 2003). In another, the problem was not 
discovered until seven years after it began. See In the Matter of 
Portfolio Advisory Services, LLC and Cedd L. Moses, Investment 
Advisers Act Release No. 2038 (June 20, 2002). The Commission cannot 
rely on registration to unearth violations in a prompt and 
predictable manner.
    \32\ In our dissent to the Proposing Release, we discussed these 
46 cases in detail. See Proposing Release, supra n. 1, at 45197-98. 
The advisers implicated in the five newly-identified cases likely 
would fall outside the scope of the rulemaking. See SEC v. 
Haligiannis, et al, Litigation Release No. 18853 (Aug. 25, 2004) 
(having raised $27 million over eight years, the hedge fund's 
president and general partners likely would not have been required 
to register); SEC v. Scott B. Kaye, et al., Litigation Release No. 
18845 (Aug. 24, 2004) (having raised only $1.9 million, the adviser 
likely would not have been required to register); SEC v. Gary M. 
Kornman, Litigation Release No. 18836 (Aug. 18, 2004) (individual 
that used inside information to make trades on behalf of hedge funds 
was owner of broker-dealer registered with the Commission); SEC v. 
Anthony P. Postiglione, Jr., et al., Litigation Release No. 18824 
(Aug. 9, 2004) (having raised approximately $5 million, the adviser 
likely would not have been required to register); SEC v. Adam G. 
Kruger and Kruger, Miller, and Tummillo, Inc., Investment Advisers 
Act Release No. 2297 (Sept. 15, 2004) (having raised approximately 
$1 million, the adviser likely would not have been required to 
register).
    \33\ The majority anticipates that hedge fund investors will 
demand that even new hedge fund advisers register. These advisers 
will be able to register even before they have $25 million under 
management if they have a reasonable expectation of meeting the $25 
million threshold within 120 days. See rule 203A-2(d) [17 CFR 
275.203A-2(d)]. It is not realistic to assume that all new advisers 
would register. Reaching $25 million in assets under management 
within four months is likely to be an unrealistic goal for many.
    \34\ See also SEC v. Sanjay Saxena, Litigation Release No. 16641 
(Aug. 2, 2000) (having already been barred by the Commission from 
acting as an investment adviser, the defendant used his wife as a 
front for his advisory activity).
---------------------------------------------------------------------------

    The majority also points to the involvement of hedge funds in 
the recent market timing scandals as evidence of a need for 
registration. The illegal conduct occurred when advisers to mutual 
funds contravened their fund prospectuses by allowing hedge funds 
and others to engage in market timing. While the Commission also 
should pursue any securities law violations by hedge funds (and is 
doing so), it should not necessarily impugn hedge fund advisers for 
the legally permissible actions they took to enhance the performance 
of the hedge funds. Finally, to the extent hedge fund advisers 
committed illegal actions, it is difficult to believe that this 
rulemaking would have stopped them. Despite the Commission's 
examination authority over mutual fund advisers, all of whom must be 
registered under the Advisers Act, routine examinations did not 
uncover the illegal conduct. In addition, of the approximately 70 
hedge fund advisers involved in these cases, at least 20 were 
registered.
    In the hedge fund context, routine examinations will not be an 
effective tool for the Commission. The Commission already can invoke 
its subpoena power to investigate potential fraudulent abuses in 
hedge funds.\35\ Certainly a perfectly-timed routine examination 
could expose fraud, but with so many registrants and so few 
examiners, it is unrealistic to anticipate that this will happen 
very often. Moreover, because hedge fund advisers tend to employ 
more complex investment strategies than the typical registered 
adviser, the Commission will have to incur substantial training 
costs in order to understand and oversee the newly registered hedge 
fund advisers.\36\ Chairman Donaldson envisions being able ``to 
apply our manpower and expertise in an effective, risk-based system 
designed not only for this responsibility but ultimately as an 
underpinning for all examinations and

[[Page 72093]]

inspections conducted by the Commission.''\37\ However, the 
Commission has not yet demonstrated the effectiveness of this new 
approach.\38\ More specifically, the move towards risk-based 
oversight will not be effective if we have not identified relevant 
risk factors.\39\
---------------------------------------------------------------------------

    \35\ The Commission, for example, employed its subpoena power in 
order to impose a broad document request on unregistered hedge fund 
advisers to enable the staff to gather information for the 2003 
Staff Hedge Fund Report. See supra n. 5.
    \36\ See, e.g., Comment Letter of W. Hardy Callcott, Bingham 
McCutchen LLP (Sept. 15, 2004) (anticipating that addition of hedge 
fund advisers to examination pool could disproportionately slow the 
examination cycle for all advisers because ``it is likely to take a 
substantial amount of time and effort for [] examiners to understand 
what they are seeing--hedge fund trading strategies and operations 
are often far more complex than those at mutual funds and retail-
oriented investment advisers'').
    \37\ Chairman William H. Donaldson, Remarks at Open Meeting: 
Registration of Hedge Fund Advisers (Oct. 26, 2004).
    \38\ See Comment Letter of W. Hardy Callcott, Bingham McCutchen 
LLP (Sept. 15, 2004) (``The Commission should not rely on a risk 
assessment model to replace regular cycle examinations--certainly 
not until such a model has been rigorously tested and has a track 
record of effective implementation.'').
    \39\ As Chairman Greenspan noted: Even should SEC's proposed 
risk evaluation surveillance of hedge funds detect possible trading 
irregularities, which I doubt frankly, those irregularities will 
likely be idiosyncratic and of mainly historic interest, because by 
the time of detection, hedge funds would have long since moved on to 
different strategies.
    Alan Greenspan, Chairman, Federal Reserve Board, Testimony 
before the Senate Banking, Housing and Urban Affairs Committee (July 
20, 2004).
---------------------------------------------------------------------------

    The majority contends that, even if examinations do not 
routinely detect fraud, the threat of an examination will deter 
fraudulent activity by hedge fund advisers.\40\ Any deterrent 
effect, however, is muted by the fact that the Commission lacks the 
resources necessary to conduct frequent, comprehensive hedge fund 
adviser examinations, and our lack of resources is a matter of 
public record.\41\ The Chairman has publicly announced that the 
Commission is rethinking its inspection model, which historically 
has focused on site visits and information requests.\42\ The new 
approach will not be centered around routine inspections. Heavy 
sanctions for fraudulent behavior are a more effective and cheaper 
deterrent than the specter of an examination every several 
years.\43\ In making these observations, we are not questioning the 
need for a Commission examination program. Rather, we are suggesting 
that the Commission should not assume a task that is now handled by 
the market, particularly since it is a task the Commission is not 
equipped to perform.
---------------------------------------------------------------------------

    \40\ See Adopting Release at text accompanying nn. 87-88. 
Because examinations take place so infrequently, the marginal 
increase in the chance of getting caught will not change the 
fraudster's calculus significantly. Further, the majority, to be 
consistent in its deterrence analysis, should take into account the 
shift of resources away from other types of advisers and hence the 
resulting decrease in deterrence for those advisers, particularly 
because they see the Commission's focus on hedge fund advisers as an 
area of emerging risk.
    \41\ As Chairman Donaldson noted when testifying before Congress 
this year, the Commission has only 495 staff conducting examinations 
of approximately 8,000 mutual funds, managed in over 900 fund 
complexes, as well as more than 8,000 investment advisers. See 
Testimony of William H. Donaldson, Chairman, Securities and Exchange 
Commission, before the House Subcommittee on Commerce, Justice, 
State, and the Judiciary, Committee on Appropriations (Mar. 31, 
2004) (``During most of the period from 1998 to early 2003, the 
SEC's examination program for funds and advisers had approximately 
370 members on its staff (including examiners, supervisors, and 
support staff). Routine examinations were conducted every five 
years. In the last two years, program staffing was increased by one-
third, to approximately 495 employees. With this staffing increase, 
the SEC has increased the frequency of examinations of funds and 
advisers posing the greatest compliance risks, and is conducting 
more examinations targeted to areas of emerging compliance risk.'').
    \42\ Testimony of William H. Donaldson, Chairman, SEC, before 
the Senate Committee on Banking, Housing and Urban Affairs (July 15, 
2004) (``I have asked the staff to develop an enhanced risk-based 
approach to oversight and examination of our investment adviser 
registrants, including hedge fund advisers.'').
    \43\ Periodic examinations would likely have no deterrent effect 
on scam artists, who, under the guise of operating a hedge fund set 
out to steal money from unwitting investors, because these types of 
individuals will simply not register.
---------------------------------------------------------------------------

C. Retail Investors' Exposure to Hedge Funds Is Limited and They 
Can Be Protected Through More Effective Means Than Registration

    The majority speaks ominously of the ``retailization'' of hedge 
funds, i.e., their increasing accessibility through pension funds 
and funds of funds to unsophisticated investors of moderate means. 
The 2003 Staff Hedge Fund Report, however, found no 
retailization.\44\ Moreover, the Report's conclusion is 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.\45\ Hedge fund advisers appear willing to 
take steps to preclude retailization.\46\ Raising the accreditation 
standards for hedge fund investors, for example, would reduce the 
number of high net worth individual investors, which is estimated 
already at fewer than 200,000, to an even smaller universe of 
investors. Alternatively, we could require registration for funds 
that allow relatively small investments.
---------------------------------------------------------------------------

    \44\ 2003 Staff Hedge Fund Report, supra n. 5, at 80 (``To date, 
however, the staff has not uncovered evidence of significant numbers 
of retail investors in hedge funds.'').
    \45\ See, e.g., Testimony of Robert Schulman, Chairman and CEO, 
Tremont Asset Management, at the Roundtable, supra n. 5 (May 14, 
2004) (``It is not a massive flow of money from retail or high net 
worth investors using registered products. That's not what's fueled 
the growth here to date. It may come to be that, but that's not what 
it's been today.'').
    \46\ See, e.g., Comment Letter of the Managed Fund Association 
(Sept. 15, 2004) (noting the validity of the Commission's concern 
about the increased number of persons qualifying as individual 
investors and recommending an adjustment of the accredited investor 
standard); Comment Letter of Porter, Felleman, Inc. (Aug. 16, 2004); 
Comment Letter of Tudor Investment Corp. (Sept. 15, 2004). And if, 
as the majority notes, hedge fund inflows already are so rapid that 
hedge fund advisers have more to invest than they can handle, then 
they will not need to look to retail investors. See Adopting Release 
at n. 21 and accompanying text.
---------------------------------------------------------------------------

    Concern about the exposure of retirees through their pension 
funds, a cornerstone of the majority's retailization argument, is 
unwarranted. Although pension fund investment in hedge funds has 
grown in recent years, just one percent of the more than $6.4 
trillion invested in U.S. pension funds is currently invested in 
hedge funds.\47\ Pension fund investments are only eight percent of 
total hedge fund investments.\48\ For every pension fund dollar 
invested in hedge funds, approximately three pension fund dollars 
are invested in other private investment funds,\49\ yet the 
rulemaking carefully seeks to avoid reaching them. More generally, 
pension funds, as part of a risk diversification strategy, invest in 
hedge funds and other investments in which retirees might not be 
able to invest directly. Some of these investment vehicles, such as 
off-shore investment vehicles, venture capital funds, and real 
estate investment trusts, are not advised by advisers registered 
with the Commission.
---------------------------------------------------------------------------

    \47\ See Greenwich Associates, Press Release, Alternative 
Investments May Disappoint Dabblers (Jan. 21, 2004) (available at: 
http://www.greenwich.com).
    \48\ This assumes that $72 billion of pension money is invested 
in hedge funds, which are estimated to have total assets of $870 
billion. See Adopting Release at n. 38 and text accompanying n. 19. 
The majority does not tell us what proportion of pension fund 
investments are invested in hedge funds without registered advisers.
    \49\ See Hewitt Investment Group, In Brief: Immunization--Theory 
and Practice 5 (July 2004) (available at: http://www.hewittinvest.com/pdf/InBrief_Immunization.pdf) (citing 
Greenwich Associates Market Characteristics 2003 Report) (based on 
asset allocation of private pension funds). See also Comment Letter 
of the National Venture Capital Association (Sept. 15, 2004) (noting 
that pension funds, foundations and university endowments have long 
invested in venture capital funds).
---------------------------------------------------------------------------

    Pension funds, along with the universities and charitable 
organizations that the majority cites as contributors to the trend 
towards retailization, are managed by fiduciaries, who typically are 
highly-skilled.\50\ These fiduciaries are responsible for 
determining whether to invest in hedge funds, the types of hedge 
funds in which to invest, and how to weigh risk and transparency 
issues in making these determinations.\51\ Neither the information 
available on Form ADV nor the possibility that a particular hedge 
fund adviser will be subject to an inspection would substantially 
reduce these fiduciaries' due diligence obligations.
---------------------------------------------------------------------------

    \50\ The Department of Labor oversees the conduct of private 
pension plan advisers. In the public pension fund context, state law 
requires that the pension fund adviser, often an elected official, 
act for the benefit of the pensioners.
    \51\ See, e.g., Transcript of Chronicle of Higher Education 
Colloquy with John S. Griswold of the Commonfund Group, (May 27, 
2004) (available at: http://chronicle.com/colloquylive/2004/05/endowments/) (noting the role alternative investments, including 
hedge funds, play in diversifying endowment portfolios, reducing 
portfolio risk, and boosting returns).
---------------------------------------------------------------------------

    The majority also worries about retail investors' exposure to 
hedge funds through funds of hedge funds. Advisers so far have set 
investment minimums between $25,000 and $1 million.\52\ There are a 
number of ways aside from universal registration to address concerns 
about retail exposure to these funds. The Commission could require 
the funds of funds that are targeted to retail

[[Page 72094]]

investors, and all of their component funds, to have registered 
advisers.\53\ Alternatively, the Commission could prohibit these 
funds from being publicly offered or place heightened restrictions 
on investors.
---------------------------------------------------------------------------

    \52\ See 2003 Hedge Fund Report, supra n. 5, at 69.
    \53\ See, e.g., Comment Letter of Leon M. Metzger (Sept. 15, 
2004).
---------------------------------------------------------------------------

III. The Majority's Approach Will Have Detrimental Effects on 
Investors, Advisers, and the Markets

A. The New Rule Will Necessitate a Dangerous Diversion of Resources

    In order to administer the new requirement, the Commission will 
have to divert resources from the protection of unsophisticated 
investors, including more than 90 million mutual fund investors, to 
an estimated 200,000 individual and institutional hedge fund 
investors. This seems unwise so soon after we made the case that we 
did not have enough staff to oversee the existing pool of registered 
advisers and funds. In fact, just two days after the majority 
adopted this rulemaking, the Director of the Division of Investment 
Management reportedly said that an option that the Commission has in 
its ``back pocket'' is raising the threshold registration level to 
$40 million.\54\ If the majority was seriously contemplating raising 
the registration threshold in connection with the rulemaking, it 
should have sought specific comment on the implications of such a 
change.\55\
---------------------------------------------------------------------------

    \54\ See supra n. 1. Another option discussed in the Adopting 
Release is asking Congress for more funding, a request Congress 
might be loathe to fulfill absent assurances the new funds would not 
again be applied to expand our regulatory reach. See Adopting 
Release at Section V.
    \55\ Although both the Proposing and Adopting Releases mentioned 
raising the threshold for registration ``to a slightly higher 
amount'' as a possible way of compensating for the increase in 
registered advisers resulting from the rulemaking, the Proposing 
Release did not solicit comment on whether this was an appropriate 
reallocation of resources. See Proposing Release, supra n. 1, at 
section V and Adopting Release at section V.
---------------------------------------------------------------------------

    The majority argues that all investors, sophisticated and not, 
are entitled to protection under the Advisers Act. Indeed, all 
investors do enjoy the protection of the Act's antifraud provisions. 
But, as Congress recognized in 1996 in connection with the adoption 
of Investment Company Act section 3(c)(7), ``[financially 
sophisticated] investors can evaluate on their own behalf matters 
such as the level of a fund's management fees, governance 
provisions, transactions with affiliates, investment risk, leverage, 
and redemption rights.''\56\ In contrast to mutual fund investors, 
hedge fund investors have not been conditioned to rely on Commission 
oversight.\57\ They can perform due diligence (or hire someone else 
to do so for them), review audit reports or third-party internal 
control reports, and enlist help if they suspect fraud or 
malfeasance.\58\ By adopting the registration requirement, the 
Commission has upset the private-public balance and taken on a task 
that it might not have adequate resources to perform.\59\
---------------------------------------------------------------------------

    \56\ S.R. 104-293, at 10 (June 26, 1996).
    \57\ See, e.g., Comment Letter of the Greenwich Roundtable 
(Sept. 15, 2004) (nonprofit organization made up of private and 
institutional investors opposed the rulemaking), Comment Letter of 
Rodney C. Pitts (Sept. 15, 2004) (hedge fund investor suggesting 
that Commission resources should not be diverted to protect the 
relatively small number of hedge fund investors), Comment Letter of 
Myra Tatum, Pointer Management Co. (Aug. 26, 2004) (manager of fund 
of funds noting that mandatory registration will not benefit 
investors; fund of funds manager already conducts extensive due 
diligence and ongoing monitoring of hedge fund managers). The 
majority cites a survey conducted by the Hennessee Group in support 
of its rulemaking. See Hennessee Group, 2004 Hennessee Hedge Fund 
Survey of Foundations and Endowments (submitted as a comment letter 
for this rulemaking). While 59 percent of the 46 respondents 
supported the rulemaking, foundations and endowments opposing the 
rulemaking were larger, more heavily invested in hedge funds, and 
had more years of experience in hedge fund investment than entities 
that favored the rulemaking. See id.
    \58\ As one commenter pointed out, ``the 
``institutionalization'' of the hedge fund market has had many 
salutary effects on the industry [because] [m]ost such institutions 
require funds to complete voluminous questionnaires about 
management, investment procedures, and operational and risk 
controls.'' Comment Letter of Schulte, Roth & Zabel LLP (Sept. 15, 
2004). Moreover, reports by auditors are a commonly-used method of 
demonstrating the integrity of internal controls. See, e.g., 
Codification of Accounting Standards and Procedures, Statement on 
Auditing Standards No. 70, Service Organizations. See also Comment 
Letter of Blanco Partners LP (Sept. 13, 2004) (``We feel that having 
the highest quality attorneys, auditors and prime[] brokers is a 
selling point for our fund.''). In other contexts, the Commission 
views favorably the use of outside control reports. See, e.g., Fair 
Administration and Governance of Self-Regulatory Organizations; 
Disclosure and Regulatory Reporting by Self-Regulatory 
Organizations; Recordkeeping Requirements for Self-Regulatory 
Organizations; Ownership and Voting Limitations for Members of Self-
Regulatory Organizations; Ownership Reporting Requirements for 
Members of Self-Regulatory Organizations; Listing and Trading of 
Affiliated Securities by a Self-Regulatory Organization, Securities 
Exchange Act Release No. 50699 (Nov. 18, 2004).
    \59\ See, e.g., Comment Letter of Sheila C. Bair, Dean's 
Professor of Financial Regulatory Policy, University of 
Massachusetts-Amherst (Sept. 15, 2004) (``By promising a `culture of 
compliance' through registration, the SEC may be encouraging 
investors to take a `free ride', reducing the amount of due 
diligence they would otherwise conduct on their own. The first line 
of defense for sophisticated investors should be their own due 
diligence, not SEC compliance measures, which are already seriously 
strained.''); Comment Letter of W. Hardy Callcott, Bingham McCutchen 
LLP (Sept. 15, 2004) (``When not promised that the SEC will oversee 
the adviser, hedge fund investors have been able through private 
ordering to negotiate adequate protections for themselves--
protections apparently at least as effective as those provided by 
SEC registration and oversight.''), Comment Letter of the U.S. 
Chamber of Commerce (``[C]ounterparty surveillance (e.g., extended 
pre-investment due diligence by investors and discipline imposed by 
lenders) is today pervasive among institutions and other 
sophisticated [private investment fund] investors.''); Comment 
Letter of Price Meadows Inc. (Sept. 15, 2004) (noting that market 
pressures are enhancing investor protection as reflected in the 
increasing percentage of hedge funds that are audited or rely on 
third-party administration).
---------------------------------------------------------------------------

B. The Commission Has Failed To Demonstrate That This Is the Least 
Burdensome and Most Effective Way To Accomplish Its Objective

    In addition to being costly to the Commission, the new 
registration requirement will be costly to affected advisers, and 
these costs will be passed on to investors. The majority approaches 
the costs of its action with a remarkable casualness and tries to 
shift responsibility for the cost-benefit analysis to 
commenters.\60\ The majority accepts anecdotal evidence from those 
in support of the rulemaking, but rejects as complaints equivalent 
statements by those opposed.\61\ The majority treats cost estimates 
provided by commenters as overestimates.\62\ The majority failed to 
aggregate the initial costs associated with registration and did not 
estimate ongoing costs of compliance.\63\
---------------------------------------------------------------------------

    \60\ See, e.g., Adopting Release at text accompanying n. 61 
(``But commenters have not persuaded us that requiring hedge fund 
advisers to register under the Act, requiring them to develop a 
compliance infrastructure, or subjecting them to our examination 
authority will impose undue burdens on them or interfere 
significantly with their operations.''). The majority bolstered the 
cost-benefit analysis and the discussion of alternatives in the 
final release three weeks after the vote to approve the rulemaking. 
Such issues should have been thoroughly explored prior to the vote.
    \61\ Compare Adopting Release at n. 64 and accompanying text 
(relying on the ``persuasive testimonials'' of two commenters who 
did not provide empirical data to conclude that registration is not 
overly burdensome) with Adopting Release at text following n. 70 
(``The bare assertions of adverse consequences of registration under 
the Advisers Act offered by many commenters opposed to our proposed 
rule, and the anecdotal evidence offered by others, simply do not 
stand up to scrutiny.'').
    \62\ See, e.g., Adopting Release at nn. 344-46 and accompanying 
text.
    \63\ In fact, the only cost estimates offered by the majority in 
its cost-benefit analysis are per-firm costs of $20,000 for 
professional fees and $25,000 for internal costs that firms would 
incur in establishing the required compliance infrastructure and 
aggregate costs of $31 to $57 million. See Adopting Release at n. 
333 and accompanying text.
---------------------------------------------------------------------------

    The majority points to the fact that advisers that are already 
registered, including hedge fund advisers, are able to bear the 
costs associated with registration.\64\ Yet the majority also argues 
that its action will level the playing field between hedge fund 
advisers by imposing the costs on currently unregistered advisers 
that are borne now only by voluntary registrants. Costs of 
registration vary across firms.\65\ Currently, if the benefits of 
registration, such as wider appeal to pension funds and other 
investors, do not outweigh the costs, then hedge fund advisers do 
not register.\66\ Costs are likely to be

[[Page 72095]]

particularly onerous for small advisers.\67\ According to some, 
registration costs will be even more burdensome for small hedge fund 
advisers than they are for other small advisers.\68\
---------------------------------------------------------------------------

    \64\ See Adopting Release at text accompanying n. 320.
    \65\ See, e.g., Comment Letter of Proskauer Rose LLP (Aug. 31, 
2004) (``[F]or certain advisers the benefits of registration exceed 
the costs and for others the reverse is true, and [] the gulf can be 
substantial.''). If the majority is correct in its cost estimates, 
it should be satisfied in simply letting the trend of voluntary 
registration continue.
    \66\ Mandating across-the-board registration only serves to 
eliminate any benefit registered advisers enjoyed in being able to 
distinguish themselves from unregistered advisers.
    \67\ See, e.g., Comment Letters of Blanco Partners LP (Sept. 13, 
2004) (small advisers will be disproportionately burdened); Venkat 
Swarna (Sept. 14, 2004) (``We estimate the annual compliance costs 
of a state or federal registration to be in the range of 20,000 to 
25,000. These compliance costs would be prohibitive to a small 
advisor like ours, as these costs alone constitute a sizeable 
percentage of the portfolio of the fund we would be managing in our 
case more than 1[%]''); Joseph L. Vidich (Aug. 7, 2004) (``In a one 
or two person firm, with 10 million under management, the annual 
cost of compliance could easily fall between 25,000 and 50,000, 
which represents twenty five to fifty percent of the firms asset 
management fee.''). See also Hedge Fund Regulation May Force 
Consolidation, PipeLine 3 (June 15, 2003) (reporting study findings 
that registration would impose significant burdens on small hedge 
funds in the range of $50,000 to $100,000 annually) (citing Sanford 
C. Bernstein & Co., The Hedge Fund Industry--Products, Services, or 
Capabilities? (May 19, 2003); Arden Dale, Small Mutual-Fund Firms 
Cry Uncle--New Rules Protect Investors, but They Can be a Burden; 
Cost of a Compliance Cop, Wall St. J., C15, Sept. 13, 2004 
(reporting difficulty of mutual fund advisers that have less than a 
few billion dollars under management to bear the costs of regulatory 
requirements, including the Commission's compliance requirement).
    \68\ See, e.g., Comment Letter of Blanco Partners LP (Sept. 13, 
2004) (contending that registration will burden small hedge fund 
advisers more heavily than the average small adviser); Comment 
Letters of the International Swaps and Derivatives Association 
(Sept. 15, 2004) and Guy Judkowski, Hedgehog Capital (explaining 
that, in contrast to many other small advisers, some small hedge 
fund advisers deliberately remain small in order to effectively 
pursue a particular strategy).
---------------------------------------------------------------------------

    The majority's cost-benefit analysis does not provide a 
realistic assessment of the direct costs associated with 
registration.\69\ Even the Investment Counsel Association of America 
(``ICAA''), which supports the majority's action, took issue with 
the majority's minimization of costs.\70\ Advisers must file Form 
ADV, and are likely to seek the assistance of an attorney because it 
is a public disclosure form.\71\ Once registered, advisers face 
numerous substantive requirements, including recordkeeping, custody, 
and compliance requirements, all of which impose costs.\72\ The 
majority failed to offer any quantitative estimate for the costs 
associated with the requirement to have a chief compliance 
officer.\73\ Hosting a Commission examination team can be very 
costly, particularly in terms of the opportunity cost of those who 
must comply with increasingly burdensome document requests and stand 
ready to answer questions.\74\
---------------------------------------------------------------------------

    \69\ Even proponents of registration acknowledge that its costs 
will be significant enough to deter some advisers from entering the 
business. See, e.g., Ron Orol, Regulation? Bring it on, TheDeal.com, 
Oct. 11, 2004 (interview of Steven Holzman, the managing partner of 
Vantis Capital Management LLC, who wrote two comment letters cited 
repeatedly in support of registration) (Mr. Holzman predicted that 
registration would help his business by raising barriers to entry 
and anticipated that ``[w]ith registration, we will have half as 
many new funds starting up next year * * *.'' ). Nonetheless, the 
majority cites Mr. Holzman for the proposition that barriers to 
entry are low and concludes that ``thus the cost of compliance with 
these rules should not present significant additional barriers to 
entry for new hedge fund advisers.'' Adopting Release at nn. 121-22 
and accompanying text.
    \70\ See Comment Letter of the ICAA (Sept. 14, 2004) (``The fact 
is that investment adviser regulation and compliance have become 
increasingly complex and costly.''). See also Comment Letter of 
Davis, Polk & Wardwell (Sept. 15, 2004) (noting that the costs of 
registration and compliance are ``substantial and increasing'' and 
will be passed on to investors).
    \71\ See, e.g., Comment Letter of the Managed Funds Association 
(Sept. 15, 2004) (reporting that one MFA member incurred over 
$75,000 in staff time in connection with the preparation of Form 
ADV).
    \72\ See, e.g., Comment Letter of Guy P. Lander (Sept. 15, 2004) 
(reporting that client anticipates spending more than $300,000 in 
the first year to come into compliance with the rulemaking); Comment 
Letter of the Managed Funds Association (Sept. 15, 2004) (MFA 
members report incurring more than $300,000 in outside legal and 
other expenses associated with registration and compliance 
requirements); Comment Letter of C. Peter Marin, Superior Capital 
Management LLC (Sept. 8, 2004) (estimating that compliance costs 
will be 15-20% of revenues of adviser to small hedge fund); Comment 
Letter of Millrace Asset Group (Sept. 15, 2004) (hedge fund adviser 
anticipates having to increase staff from four to five to handle 
compliance under the rulemaking); Comment Letter of Seward & Kissel 
LLP (Sept. 15, 2004) (``To properly fulfill the breadth of 
compliance requirements under the Advisers Act, many advisers would 
be required to hire at least one additional professional at a cost 
far greater than the estimate provided.''). The majority did not 
attempt to estimate ongoing compliance and examination costs because 
of the difficulty of doing so, dismisses the estimates it received 
as ``not representative,'' and instead offers the observation that 
``one registered hedge fund adviser commented that the firm itself 
derived benefit from the examination process.'' Adopting Release at 
IV.B.3.
    \73\ The majority explains this failure and its rejection of 
commenters' estimates by noting that advisers are not required to 
hire someone to fill the role and the chief compliance officer can 
have responsibilities. See Adopting Release at text following n. 
335. The majority did not attempt to estimate the real, quantifiable 
cost of the requirement on firms, which must allocate at least a 
portion of an employee's time to handling the increased compliance 
functions. See Adopting Release at Section IV.B.2.
    \74\ See, e.g., David R. Sawyer (Sidley, Austin, Brown and Wood) 
(Sept. 14, 2004) (reporting that two clients, hedge fund advisers, 
spent between $300,000 and $500,000 preparing for and hosting 
examiners, without including opportunity costs).
---------------------------------------------------------------------------

    In addition to the direct costs of complying with Commission 
rules, there are likely to be indirect costs as hedge funds advisers 
are dissuaded from employing complex investment strategies that they 
cannot explain to Commission examiners. Questions about those 
strategies are likely since the majority believes there to be 
substantial conflicts related to ``management strategies, fee 
structures, use of fund brokerage and other aspects of hedge fund 
management.'' \75\ As one commenter explained, ``there is no doubt 
that hedge fund managers would abandon a lawful strategy that the 
Commission takes exception with rather than face the controversy and 
the associated distractions generated by the Commission's 
position.'' \76\ The effects might be felt by the market as a 
whole.\77\ Advisers might even limit their businesses in order to 
avoid registering.\78\
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    \75\ Adopting Release at n. 116. The staff, in its hedge fund 
report, noted: ``We are concerned about our inability to examine 
hedge fund advisers and evaluate the effect of the strategies used 
in managing hedge funds on our financial markets.'' 2003 Staff Hedge 
Fund Report, supra n., at 11. Certainly, then, hedge fund advisers 
can anticipate that the staff will be looking into, and perhaps 
regulating, such strategies.
    \76\ Comment Letter of Guy P. Lander (Sept. 15, 2004). See also 
Comment Letter of the U.S. Chamber of Commerce (Sept. 15, 2004) 
(advisers might avoid innovative strategies in order to avoid 
Commission scrutiny).
    \77\ See, e.g., Alan Greenspan, Chairman, Federal Reserve Board, 
Testimony before the Senate Banking, Housing and Urban Affairs 
Committee (July 20, 2004) (``Should the existing proposal fail in 
achieving its goal, pressure will become irresistible to expand 
SEC's regulatory reach in an endeavor to accomplish what it set out 
to do. Hedge fund arbitrageurs are required to move flexibly and 
expeditiously if they are to succeed. If placed under increasing 
restrictions, many will leave the industry, to the significant 
detriment of our economy.''). See also Comment Letter of the 
International Swaps and Derivatives Association (Sept. 15, 2004) 
(registration will reduce the number of entrants into the hedge fund 
industry and force others offshore, which will harm the derivatives 
industry and the market as a whole); Comment Letter of the Financial 
Services Roundtable (Sept. 15, 2004) (rulemaking might deter ``the 
types of innovative and active trading that serve the marketplace as 
a whole''); Comment Letter of the Managed Funds Association (Sept. 
15, 2004) (the rulemaking ``has the potential to create inefficiency 
and instability in our capital markets by stifling the willingness 
of hedge funds to act as shock absorbers and provide risk capital in 
times of market instability''); Comment Letter of Seward & Kissel 
LLP (Sept. 15, 2004) (rulemaking could raise barriers to entry for 
new advisers); Comment Letter of Tudor Investment Corp. (Sept. 15, 
2004). The majority, in faulting commenters opposing the rule for 
failing to demonstrate ``that hedge funds managed by registered 
advisers play a diminished role in the financial markets compared to 
hedge funds managed by unregistered advisers,'' fails to recognize 
that the effects of registration might be different for different 
advisers. Adopting Release at text accompanying n. 71.
    \78\ The majority's attempt to characterize this as a positive 
potential effect of the rulemaking is not persuasive. See Adopting 
Release at Section VII (acknowledging that investors might not be 
able to select the adviser of their choice, but noting that ``a 
hedge fund adviser's decision not to expand its business may make it 
easier for other advisers to enter the market.'').
---------------------------------------------------------------------------

    The majority reasons that the ``costs appear small relative to 
the scale of the industry.'' \79\ Further, the majority argues, 
hedge fund advisers' fees provide them with ``a

[[Page 72096]]

substantial cash flow.'' \80\ It is not the Commission's job to make 
value judgments regarding the propriety of hedge fund advisers' 
management fees, which investors have agreed to pay and which 
presumably reflect the risks of establishing a hedge fund and the 
high costs of attracting talented managers. Resources used to pay 
for compliance with new regulatory mandates cannot be used for other 
purposes, such as hiring new employees or purchasing outside 
research. Thus, unless the Commission determines that the benefits 
of imposing the requirements justify the costs, the Commission 
should not impose the costs.
---------------------------------------------------------------------------

    \79\ Adopting Release at text accompanying n. 118. It is 
difficult to discern how the majority made such a determination 
without making an estimate of the costs. The majority also argues 
that, absent registration, hedge fund advisers might not understand 
how beneficial a strong compliance program is to their business. See 
Adopting Release at text accompanying n. 117. Our intervention is 
unnecessary to solve this problem; the market will punish advisers 
who provide less compliance controls than investors want. See, e.g., 
Comment Letter of Leon M. Metzger (Sept. 15, 2004) (``the Commission 
may want to consider whether the growing movement toward voluntary 
registration will accomplish the goals of mandatory 
registration.'').
    \80\ Adopting Release at text accompanying n. 119.
---------------------------------------------------------------------------

C. The Rulemaking May Encourage Retailization

    The majority's proposal ironically may stimulate retailization. 
First, pension funds and other institutional investors, who 
indirectly invest in hedge funds on behalf of individuals, might 
invest more money in hedge funds as a result of the rulemaking. 
Because such investment vehicles tend to limit hedge fund 
investments to those with registered advisers, the mandatory 
registration would expand the potential universe and encourage even 
more investment in hedge funds, which the majority suggests puts 
retail investors at risk. Second, if all hedge fund advisers are 
registered, there is likely to be grassroots demand for access to 
hedge funds by retail investors.\81\ Section 208(a) of the Advisers 
Act prohibits advisers from representing or implying that they are 
``sponsored, recommended, or approved, or that their abilities or 
qualifications have in any respect been passed upon'' by the 
government.\82\ Registered advisers, however, may advertise 
themselves as SEC-registered (and anecdotal evidence suggests that 
they do). Those who are not familiar with the Commission's role 
likely will not understand how little this means, particularly 
because the majority has argued that registration will 
``legitimize'' hedge funds.
---------------------------------------------------------------------------

    \81\ See, e.g., Comment Letter of Madison Capital Management LLC 
(Sept. 15, 2004) (predicting that the rulemaking will have the 
effect of inducing hedge funds to admit retail investors).
    \82\ 15 U.S.C. 80b-8(a).
---------------------------------------------------------------------------

IV. The Majority's Approach Makes Arbitrary Distinctions Between Funds

A. The Definition of ``private funds'' Covered by the Rule Is 
Unsuitable

    ``Private funds'' are defined in the new rule on the basis of 
three characteristics. A ``private fund'' is a company: (1) That 
would be subject to regulation under the Investment Company Act but 
for the exception, from the definition of ``investment company'' 
provided in either section 3(c)(1) or 3(c)(7) of the Investment 
Company Act; (2) that permits investors to redeem their interests in 
the fund within two years of purchasing them; and (3) the interests 
of which are offered based on the investment advisory skills, 
ability or expertise of the investment adviser.\83\ This definition 
is arbitrary and not reflective of a relevant difference among 
different types of private investment companies.\84\
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    \83\ See amended rule 203(b)(3)-1(d).
    \84\ See, e.g., Comment Letter of the CFA Institute Center for 
Financial Market Integrity (Sept. 30, 2004) (noting that the two 
year redemption criterion ``would seem to us to be somewhat 
arbitrary''); Comment Letter of Madison Capital Management LLC 
(Sept. 15, 2004) (``the majority's `private fund' centered 
regulatory scheme creates an arbitrary distinction among funds''); 
Comment Letter of the North American Securities Administrators 
Association (``NASAA feels that the definition of `Private Fund' is 
ineffective at distinguishing hedge funds from private equity, 
venture capital and commodity pools.'').
---------------------------------------------------------------------------

    The redemption period is the only criterion that would 
distinguish most hedge funds from most other types of private 
funds.\85\ Even this criterion will pull into the rule other types 
of private investment funds, which the majority does not deem at 
this time to be in need of regulation.\86\ More generally, at a time 
when there is already a trend towards longer lock-ups, this 
criterion will encourage advisers to extend their redemption periods 
beyond two years in order to avoid registration.\87\ Therefore, it 
will be more difficult for investors, once they have made the 
decision to invest in a hedge fund, to ``vote'' on the quality and 
integrity of the hedge fund manager by leaving the fund.\88\ A 
definition that looked, for example, to portfolio content or 
frequency of trading rather than redemption period would likely be 
more precise.\89\
---------------------------------------------------------------------------

    \85\ See, e.g., Comment Letter of Gibson, Dunn & Crutcher LLP 
(Sept. 13, 2004) (``this component is the only factor in the Rule 
itself that can be relied upon to exempt traditional private equity 
and venture capital funds'').
    \86\ Comment Letter of the Financial Services Roundtable (Sept. 
15, 2004) (rule will reach some private equity and real estate fund 
advisers); Commenter Letter of Gunderson Dettmer Stough Villeneuve 
Franklin & Hachigian, LLP. (Sept. 15, 2004) (requesting narrower 
definition of ``Private fund'' to avoid including other types of 
investment vehicles).
    \87\ See, e.g., Comment Letter of Ellington Management Group LLC 
(Sept. 15, 2004) (``The industry `buzz'; is that, in fact, many 
hedge fund managers wishing to avoid registration will be trying to 
institute two-year lockups exactly for this purpose.''); Comment 
Letter of the Greenwich Roundtable (Sept. 15, 2004); Comment Letter 
of Jeffrey R. Neufeld (Sept. 15, 2004).
    \88\ The majority inappropriately looks to ease of redeemability 
as evidence that ``hedge fund advisers are effectively providing 
advisory services to the fund's investors.'' See Adopting Release at 
n. 237.
    \89\ See, e.g., Comment Letter of the Greenwich Roundtable 
(Sept. 15, 2004) (``If the intention of the Rule is to specifically 
exclude venture capital and private equity funds, then those funds 
can more easily be excluded without harming genuine hedge fund 
investors. We would suggest instead that the Rule apply a test that 
focuses on the marketability of a fund's holdings, rather than on an 
investor's willingness to lock-up an investment.''); Comment Letter 
of Kynikos Associates (Sept. 15, 2004) (recommending distinguishing 
funds on the basis of ``investment characteristics''); Comment 
Letter of the North American Securities Administrators Association 
(recommending a test based on frequency with which securities in 
fund are traded). See also Comment Letter of Ellington Management 
Group LLC (Sept. 15, 2004) (recommending distinguishing hedge funds 
from other types of private investment funds by looking at how the 
fund employs net asset value in determining management fees and 
setting purchase price and redemption fees). The majority explains 
that it rejected this approach in order to prevent advisers from 
altering their investment strategies to avoid registration. See 
Adopting Release at n. 225. It is much easier for advisers to alter 
their redemption period in order to avoid registration.
---------------------------------------------------------------------------

B. If the Majority's Rationale for Regulation of Hedge Fund 
Advisers Is Sound, Then It Applies Equally to Advisers to Private 
Equity and Venture Capital Funds

    We asked in our dissent to the proposal whether there was a 
basis for excluding advisers to venture capital and private equity 
funds. Valuation issues, for example, arise in the private equity 
and venture capital funds, just as they do in hedge funds.\90\ The 
National Venture Capital Association (``NVCA'') filed a comment 
letter that explained that, while there are meaningful bases upon 
which to distinguish venture capital funds from hedge funds, the 
grounds on which the majority distinguished them are not meaningful. 
Fearing that these same justifications could be used in the future 
to require venture capital advisers to register, the NVCA opposed 
the proposal.\91\ The majority continues to maintain that advisers 
to venture capital and private equity funds should remain beyond the 
scope of this rulemaking because they have not been implicated in as 
many enforcement actions as advisers to hedge funds have been.\92\ 
We share the NVCA's concern that the majority has not meaningfully 
differentiated between hedge funds and other private investment 
funds. Just as the majority's justifications do not support the 
registration of hedge funds, they do not compel registration of any 
other type of private investment fund.
---------------------------------------------------------------------------

    \90\ See, e.g., Comment Letter of Kynikos Associates (Sept. 15, 
2004) (noting that while venture capital and private equity funds 
are ``somewhat different'' from hedge funds, the Commission's 
concerns, including particularly valuation, are nevertheless 
applicable); Comment Letter of Leon M. Metzger (Sept. 15, 2004) 
(interim valuations matter for other types of private funds, e.g., 
for purposes of the valuation of a deceased investor's estate ); 
Comment Letter of the Committee on Private Investment Funds, The 
Association of the Bar of The City of New York (Sept. 15, 2004) 
(although of ``more limited relevance,'' in the venture capital and 
private equity context, valuation is important for purposes such as 
investor reporting, and marketing follow-on funds).
    \91\ Comment Letter of the National Venture Capital Association 
(Sept. 15, 2004) (``NVCA believes that the [proposing] Release and 
the proposed rule create a risk of future burdensome regulation on 
venture capital that outweighs any investor protection benefit that 
would come from the proposed rule.'').
    \92\ The majority also argues that the third prong of the 
definition, which limits ``private funds'' to those that are 
marketed based on the skills, ability, and expertise of the adviser, 
``confirm[] the direct link between the adviser's management 
services and the investors.'' Adopting Release at text preceding n. 
168. If this reasoning is sound with respect to hedge funds, the 
same link exists between investors in venture capital and private 
equity funds and the advisers of those funds.
---------------------------------------------------------------------------

V. In Taking This Action, the Majority Has Departed From Regulatory and 
Statutory Precedent

    In order to carve out hedge fund advisers as a subset of 
advisers to private investment

[[Page 72097]]

companies for registration, the majority has redefined ``client'' 
solely for this particular subset of advisers and then only to 
determine their eligibility to rely on section 203(b)(3). That 
section exempts from registration any adviser who during the past 
year has had fewer than fifteen clients and who does not hold 
himself out to the public as an investment adviser and does not act 
as an adviser to investment companies or business development 
companies.\93\ Traditionally, for purposes of section 203(b)(3), 
advisers counted the funds, not the investors in those funds, as 
clients. The safe harbor in rule 203(b)(3)-1, which deems ``the 
legal organization * * * that receives investment advice based on 
its investment objectives rather than the individual investment 
objectives of its [owners],'' confirms the propriety of this 
approach.\94\ The majority, however, has now (i) amended rule 
203(b)(3)-1 to deprive advisers to ``private funds'' of the safe 
harbor for counting clients afforded by that rule and (ii) added new 
rule 203(b)(3)-2 to require advisers to count each owner of a 
``private fund'' towards the threshold of 14 clients for purposes of 
determining the availability of the private adviser exemption of 
section 203(b)(3) of the Act.
---------------------------------------------------------------------------

    \93\ 15 U.S.C. 80b-3(b)(3). When Congress amended section 
203(b)(3) in 1980 to preclude looking through business development 
companies in counting clients for purposes of that section, Congress 
did not ``intend to affect adversely the status of investment 
advisers which are not registered under the Act.'' H.R. Rep. No. 96-
1341, at 62 (1980).
    \94\ The Commission explained that this safe harbor was ``not 
intended to specify the exclusive method for a limited partnership, 
rather than each limited partner, to be counted as a `client' for 
purposes of section 203(b)(3) of the Act.'' 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)].
---------------------------------------------------------------------------

    The majority's action marks a departure from the Commission's 
established approach of determining who an adviser's client is, 
namely by looking at whether or not the adviser is tailoring the 
advice to the financial situation and objectives of the individual 
investors or is simply providing advice to an entity in which 
individuals share the profits.\95\ The core of the advisory 
relationship is the provision of individualized advice tailored to 
the needs and financial situation of the client. Thus, in 1997, when 
the Commission created a safe harbor to enable investment advisers 
to group clients together, it included safeguards to ensure that the 
adviser continued to treat each investor, not the group, as a 
client.\96\ As the Commission explained:
---------------------------------------------------------------------------

    \95\ See, e.g., Definition of ``Client'' for Certain Purposes 
Relating to Limited Partnerships, Investment Advisers Act Release 
No. 956 (Feb. 25, 1985) [50 FR 8740 (Mar. 5, 1985)] (``Where an 
adviser to an investment pool manages the assets of the pool on the 
basis of the investment objectives of participants as a group, it 
appears appropriate to view the pool--rather than each participant--
as a client of the adviser.'').
    \96\ See Status of Investment Advisory Programs under the 
Investment Company Act of 1940, Investment Company Act Release No. 
22579 (Mar. 24, 1997) [62 FR 15098 (Mar. 31, 1997)] (adopting rule 
3a-4 under the Investment Company Act [17 CFR 270.3a-4(a)] to 
provide a nonexclusive safe harbor from the definition of investment 
company for certain programs under which investment advisory 
services are provided on a discretionary basis to a large number of 
advisory clients having relatively small amounts to invest). Among 
the safeguards in the rule is a requirement that the sponsor of the 
program must obtain sufficient information from each client to be 
able to provide individualized investment advice to the client and 
periodically update the information. See rule 3a-4(a)(2). The 
majority, in support of its approach, posits a situation in which a 
group of individual clients of an adviser is combined into a hedge 
fund in order to avoid application of the Advisers Act. The 
majority's hypothetical example does not tell us whether the 
investors continue to receive personalized advice. See Adopting 
Release at text accompanying nn. 177-78. If they do not, there is 
nothing inappropriate about the adviser's characterizing the group 
as an unregistered investment company; they should be characterized 
as such, so long as they meet the applicable criteria to be 
classified as a private investment company.
---------------------------------------------------------------------------

A client of an investment adviser typically is provided with 
individualized advice that is based on the client's financial 
situation and investment objectives. In contrast, the investment 
adviser of an investment company need not consider the individual 
needs of the company's shareholders when making investment 
decisions, and thus has no obligation to ensure that each security 
purchased for the company's portfolio is an appropriate investment 
for each shareholder.\97\
---------------------------------------------------------------------------

    \97\ Status of Investment Advisory Programs under the Investment 
Company Act of 1940, Investment Company Act Release No. 22579 (Mar. 
24, 1997) [62 FR 15098 (Mar. 31, 1997)].

An adviser to a hedge fund is not expected to tailor its advice to the 
needs of individual owners of the fund, who do not necessarily have 
identical financial situations or objectives.\98\
---------------------------------------------------------------------------

    \98\ In instances in which an entity is merely a legal artifice, 
advisers, of course, are prohibited from counting it, rather than 
its investors, as clients in order to avoid registration. See 
section 208(d) of the Advisers Act [15 U.S.C. 80b-8d] (making it 
``unlawful for any person indirectly * * * to do any act or thing 
which it would be unlawful for such person to do directly.''). This 
does not describe the hedge funds the advisers of which are the 
intended targets of the new rulemaking.
---------------------------------------------------------------------------

    Not only does the majority's action awkwardly depart from the 
established approach for identifying an adviser's clients, but the 
majority rejected compelling challenges to the Commission's statutory 
authority for this action.\99\ When Congress first adopted the 
Investment Advisers Act in 1940, it did not look through investment 
companies and treat the underlying shareholders as the client. Rather, 
the Advisers Act treated the company itself as the client.\100\ In this 
vein, section 203(b) of the Act as originally enacted exempted from 
registration ``any investment adviser whose only clients are investment 
companies and insurance companies.''\101\ In 1970, when Congress, 
acting on the Commission's recommendation, amended the Act to require 
advisers to investment companies to register, it determined that ``the 
shareholders of investment companies should have the same protections 
now provided for clients of investment advisers who obtain investment 
advice on an individual basis.''\102\ Advisers to privately placed 
investment companies, however, were not affected by the change. These 
advisers could still rely on the exemption from registration in section 
203(b)(3) for advisers who do not hold themselves out generally to the 
public as advisers and have fewer than 15 clients.
---------------------------------------------------------------------------

    \99\ See, e.g., Comment Letters of Schulte Roth & Zabel LLP 
(Sept. 15, 2004); U.S. Chamber of Commerce (Sept. 15, 2004); 
Willkie, Farr & Gallagher (Sept. 13, 2004), Wilmer Cutler Pickering 
Hale and Dorr, LLP (Sept. 8, 2004).
    \100\ The majority speculates that Congress might not have 
intended for the legal entity to be treated as the client in the 
hedge fund context as it is in the investment company context. See 
Adopting Release at n. 171. But for their ability to rely on 
statutory exemptions from the definition of ``investment company'' 
under the Investment Company Act, hedge funds generally would fit 
within the definition. The approach of treating the entity, not the 
investors, as the client is equally appropriate in both cases.
    \101\ Investment Advisers Act, Section 203(b), Pub. L. 76-768, 
54 Stat. 847, 850 (1940).
    \102\ See Investment Company Act Amendments of 1970, H.R. Rep. 
No. 91-1382, at 39 (1970).
---------------------------------------------------------------------------

    The Commission assumes that removing the exemption would simply 
effect Congress's unspoken intent that any adviser who manages a 
significantly large asset pool must register. The majority points for 
support to the legislative history of Investment Company Act section 
3(c)(1), which exempts investment companies with fewer than 100 
owners.\103\ But the legislative history of that section suggests that 
Congress understood that there would be asset pools, some of them 
large, that were not reached by the statute.\104\ Congress has not 
amended section 203(b)(3) to require hedge fund advisers to register 
despite being aware that many hedge fund advisers are advising large 
pools of money without being registered. In fact, just eight years ago, 
Congress, recognizing ``the important role that these pools can play in 
facilitating capital formation for U.S. companies,'' made the formation 
of large private pools easier.\105\ Congress

[[Page 72098]]

added section 3(c)(7) to the Investment Company Act to permit the 
formation of unregistered pools of an unlimited number of highly 
sophisticated investors.\106\ The Committee report faulted ``regulatory 
restrictions on these private pools'' for driving American investors 
offshore.\107\ The fact that many advisers to such pools were not 
registered under the Advisers Act was certainly known to Congress and 
allowing them to continue in their unregistered state was entirely 
consistent with Congress's objective of minimizing regulatory 
restrictions on such pools of assets.
---------------------------------------------------------------------------

    \103\ See Adopting Release at n. 139.
    \104\ Investment Trusts and Investment Companies: Hearings on S. 
3580 before a Subcommitteee of the Senate Committee on Banking and 
Currency, 76th Cong., 3d Sess. 179 (1940) (David Schenker, Chief 
Counsel of the Investment Trust Study, explained: ``The total assets 
play no part in the determination as to whether a company is a 
public investment company or a private investment company * * *.'').
    \105\ S. Rep. 104-293, at 10 (1996).
    \106\ 15 U.S.C. 80a-3(c)(7).
    \107\ S. Rep. 104-293, at 10 (1996).
---------------------------------------------------------------------------

VI. Conclusion

    When we dissented from this rulemaking at the proposal stage, we 
asked for comment on a wide range of issues. We were interested in 
exploring different ways of getting more information about hedge funds, 
including working with other regulators and enhancing Commission 
oversight of existing registrants. Commenters responded with legitimate 
concerns about the costs and unintended consequences and offered their 
cooperation and a number of more feasible alternatives for addressing 
the Commission's concerns.
    As the commenters pointed out, mandatory registration is an 
inappropriate response to the concerns underlying this rulemaking. The 
growth of the industry might support our call for more information, but 
it is not a valid justification for regulation. Registration is not 
likely to deter or lessen substantially the harm of fraudulent 
activities of the type cited by the majority. The majority has failed 
to demonstrate that retailization is a problem, let alone that 
mandatory, universal registration would be the appropriate solution. 
Not only is the majority's rulemaking a poor solution for the problems 
that the majority cites, but it gives rise to unintended consequences. 
Among these are the imposition of substantial direct and opportunity 
costs on hedge fund advisers and their investors, and increased 
retailization. Moreover, implementing the rulemaking diverts Commission 
resources from the protection of retail investors. The Commission, in 
carrying out its mission, should apply its limited resources towards 
their highest and best use.
    The majority also has failed to draw legitimate distinctions 
between hedge funds and other types of private investment pools that 
would justify different regulatory schemes. Questions about the wisdom 
of the majority's approach are compounded by questions about the 
propriety of this approach in light of legislative and regulatory 
precedent.
    We hoped that the Commission would accord serious consideration to 
objections to their proposal. Today's rulemaking, which is the wrong 
solution to an undefined problem, disappoints those hopes and leaves 
better solutions unexplored.
    For all of the foregoing reasons, we respectfully dissent.

    Dated: December 2, 2004.
Cynthia A. Glassman,
Commissioner.
Paul S. Atkins,
Commissioner.
[FR Doc. 04-26879 Filed 12-9-04; 8:45 am]
BILLING CODE 8010-01-P