WEBMASTER NOTE: This is the unedited transcript of the hedge fund hearings held 
      on May 14-15, 2003, which we received directly from the court reporter.  We are 
      posting the transcript in this form to make it available as soon as possible.  
      Staff will review this transcript and will correct any errors that may be 
      contained in it. We will post on our website the corrected transcript, which 
      will also be easier to view and to read, as soon as it is available.
      (This replaces the file posted May 22, 2003, which had technical defects.)
--------------------------------------------------------------------------------------
             1   UNITED STATES SECURITIES AND EXCHANGE COMMISSION

             2

             3   In the Matter of:       )

             4                           )  File No. 05-007-03

             5   HEDGE FUND ROUNDTABLE   ) 

             6   PAGES:    1 through 264

             7   PLACE:    Securities and Exchange Commission

             8             450 Fifth Street, N.W.

             9             Washington, D.C.

            10   DATE:     Thursday, May 15, 2003

            11

            12        The above-entitled matter came on for hearing, pursuant

            13   to notice, at 9:00 a.m.

            14

            15   BEFORE:

            16

            17        WILLIAM H. DONALDSON, Chairman

            18        PAUL ATKINS, Commissioner

            19        RAUL CAMPOS, Commissioner

            20        CYNTHIA GLASSMAN, Commissioner

            21        HARVEY GOLDSCHMID, Commissioner

            22

            23

            24                Diversified Reporting Services, Inc.

            25                           (202) 467-9200




             1                          C O N T E N T S

             2                                                            PAGE

             3   PANEL 5 - HEDGE FUND STRATEGIES AND MARKET 

             4   PARTICIPATION                                              9 

             5

             6   MODERATOR:

             7        ANNETTE L. NAZARETH

             8        Director, Division of Market Regulation, Securities and

             9        Exchange Commission

            10

            11   PANELISTS:

            12        AFSANEH BESCHLOSS

            13        CEO and Chief Investment Officer, Carlyle Asset

            14        Management Group

            15

            16        PETER BORISH

            17        Senior Managing Director of Business Development,

            18        OneChicago, LLC

            19

            20        PETER BROWN

            21        Executive Vice President, Renaissance Technologies

            22        Corporation

            23

            24        JAMES CHANOS

            25        President, Kynikos Associates, Ltd.





             1        WILLIAM N. GOETZMANN

             2        Edwin J. Beinecke Professor of Finance and Management

             3        Studies and Director, International Center for Finance,

             4        Yale School of Management

             5

             6        LAWRENCE E. HARRIS

             7        Chief Economist and Director, Office of Economic

             8        Analysis, Securities and Exchange Commission

             9

            10        WILLIAM HEYMAN

            11        Executive Vice President and Chief Investment Officer,

            12        The St. Paul Companies

            13

            14        ANDREW W. LO

            15        Harris & Harris Group, Professor of Finance, Sloan

            16        School of Management, Massachusetts Institute of

            17        Technology

            18

            19        ROBERT STEEL

            20        Vice Chairman, Goldman Sachs Group

            21

            22        MARK YUSKO

            23        President and CEO, UNC Management Company, Inc.

            24

            25





             1   PANEL 6 - ENFORCEMENT/FRAUD CONCERNS                      89 

             2

             3   MODERATOR:

             4        CYNTHIA M. FORNELLI

             5        Deputy Director, Division of Investment Management, 

             6        Securities and Exchange Commission

             7

             8   PANELISTS:

             9        SCOTT BERMAN

            10        Partner, Brown Rudnick Berlack Israels, LLP

            11

            12        STEPHEN M. CUTLER

            13        Director, Division of Enforcement, Securities and

            14        Exchange Commission

            15

            16        THOMAS FEDOREK

            17        Senior Managing Director, Citigate Global Intelligence &

            18        Security

            19

            20        KRISTINA L. KNEIP

            21        Senior Staff Attorney/Examination, Supervisor, State of

            22        Washington Department of Financial Institutions,

            23        Securities Division

            24

            25





             1        PATRICK J. McCARTY

             2        General Counsel, Commodity Futures Trading Commission

             3

             4        PAMELA J. PARIZEK

             5        Associate Managing Director, Kroll, Inc.

             6

             7        LOIS PELTZ

             8        President and CEO, Infovest21

             9

            10

            11   PANEL 7 - ASSESSMENT OF THE CURRENT REGULATORY 

            12   FRAMEWORK                                                147 

            13

            14   MODERATOR:

            15        PAUL F. ROYE

            16        Director, Division of Investment Management, Securities

            17        and Exchange Commission

            18

            19   PANELISTS:

            20        MARK ANSON

            21        Chief Investment Officer, CalPERS

            22

            23        ALAN BELLER

            24        Director, Division of Corporation Finance, Securities

            25        and Exchange Commission





             1        ARMANDO BELLY

             2        General Counsel, Soros Fund Management, LLC.

             3

             4        IAIN CULLEN

             5        General Counsel, Alternative Investment Management

             6        Association, partner, Simmons & Simmons

             7

             8        JEAN-CLAUDE DELESPAUL

             9        Secretary General, Commission des Operations de Bourse,

            10        France

            11

            12        JOHN G. GAINE

            13        President, Managed Funds Association

            14

            15        FREDERICK C. "Rick" LAKE

            16        Co-Chairman, Lake Partners, Inc.

            17

            18        SANDRA MANZKE

            19        Founder & Co-Chief Executive Officer, Tremont Advisers

            20

            21        JOHN MARKESE

            22        President and CEO, American Associatin of Individual

            23        Investors

            24

            25





             1        ANNETTE L. NAZARETH

             2        Director, Division of Market Regulation, Securities and

             3        Exchange Commission

             4

             5        ROBERT POZEN

             6        John Olin Visiting Professor, Harvard Law School

             7

             8        PAUL N. ROTH

             9        Partner, Schulte Roth & Zabel, LLP

            10

            11        DOUGLAS SCHEIDT

            12        Associate Director and Chief Counsel, Division of

            13        Investment Management, Securities and Exchange

            14        Commission

            15

            16        CHRISTINA SINCLAIR

            17        Head of Department, Business Standards, Financial

            18        Services Authority, United Kingdom

            19

            20        JANE KANG THORPE

            21        Director, Division of Clearing and Intermediary

            22        Oversight, Commodity Futures Trading Commission

            23

            24

            25   CLOSING REMARKS - Chairman Donaldson                     260 





             1                       P R O C E E D I N G S

             2             MR. ROYE:  Good morning.  My name is Paul Roye, and

             3   I'd like to welcome you back to the second day of our

             4   roundtable on hedge funds.  And I'd also like to welcome

             5   those joining us by webcast.

             6             As you can see from our agenda, just as yesterday,

             7   today we have an impressive group of panelists to discuss a

             8   variety of issues, and important issues, related to the hedge

             9   fund industry.

            10             We have a lot of ground to cover today.  We're

            11   going to start with the investment strategies and market

            12   participation of hedge funds.  We're going to talk about

            13   enforcement and some fraud concerns that we have in the area,

            14   as well as a broad discussion of the assessment of the

            15   current regulatory framework that governs hedge funds.

            16             So I invite all of you to sit back and enjoy the

            17   discussions.  We expect another lively set of discussions

            18   today.

            19             Again, just a few housekeeping matters.  If you

            20   leave the building, unfortunately you'll have to go through

            21   our security procedures again, and we do urge you to turn off

            22   your cell phones and we will have breaks during the panels so

            23   you can make your phone calls.

            24             With that, I'd like to turn over our program to

            25   Annette Nazareth, our esteemed director of the division of





             1   market regulation who is going to lead a discussion on hedge

             2   fund strategies and market participation.

             3             And on behalf of the SEC participants on the panel,

             4   I'd just like to make the broad disclaimer for today that the

             5   views that you hear from the SEC participants are their own

             6   views and not necessarily the view of the Commission.

             7             And with that, I will turn the program over to

             8   Annette and her panel.

             9             MS. NAZARETH:  Thank you, Paul.  Good morning.  On

            10   behalf of all of my colleagues on the staff, I'd like to

            11   thank the panel members for taking the time to participate on

            12   this panel dealing with hedge fund trading strategies and

            13   market participation.

            14             Clearly, this is a very ambitious topic and the

            15   amount of time allocated to it is quite short so each of the

            16   panelists have agreed to forego an opening statement so that

            17   we will have more time for meaningful discussion.

            18             First, though, I want to briefly introduce the

            19   panel to you.  I can only mention the highlights of their

            20   very impressive resumes as they relate to the hedge fund

            21   industry.  Frankly, if I were to describe all of their

            22   accomplishments, we'd have no time for discussion at all.

            23             First, I'd like to start with Afsaneh Beschloss,

            24   who is the chief executive officer and chief investment

            25   officer of Caryle Asset Management Group and, prior to





             1   joining CAMG, Afsaneh was the treasurer and chief investment

             2   officer of the World Bank.

             3             Next is Peter Borish, who is a senior managing

             4   director of business development at OneChicago.  OneChicago

             5   is an exchange that trades single stock futures and narrow

             6   based index futures, but Peter previously led a team of

             7   researchers and traders at Tudor Investment Corporation.

             8             Next is Peter Brown.  He's executive vice president

             9   of Renaissance Technologies Corp. where he develops

            10   mathematical models for the financial market.  Renaissance

            11   Technologies is a general partner and investment advisor of

            12   Medallion Funds, which is a hedge fund with approximately $5

            13   billion in assets under management.

            14             Next we have Jim Chanos, who is president and

            15   founder of Kynikos Associates, which provides the investment

            16   strategy of profiting from unhedged shortselling of

            17   overvalued securities.  Kynikos also manages the short

            18   portfolios of Beta Hedge and Beta Hedge International for

            19   domestic and offshore investors as well as The Opportunity

            20   Fund which seeks to identify mispriced securities that are

            21   both overvalued and undervalued.

            22             Next we have Professor William Goetzmann, who is

            23   the Edwin J. Beinecke Professor of finance and management

            24   studies and the director of the International Center for

            25   Finance at the Yale School of Management.  Will is an expert





             1   on a diverse range of investments, including stocks, mutual

             2   funds, real estate and, even more interesting, paintings. 

             3   His research topics include global investing, forecasting

             4   stock markets, selecting mutual fund managers, housing as

             5   investment and the risk and return of art.

             6             Next to me is Larry Harris, who is our chief

             7   economist here at the Securities and Exchange Commission. 

             8   He's here on assignment from the Marshall School of Business

             9   at the University of Southern California, where he holds the

            10   Fred Keenan Chair in Finance.  Very fortunate for us, having

            11   Larry here.  He's an expert on market microstructure,

            12   investment management and the uses of transactions data in

            13   financial research.

            14             Next to Larry is Bill Heyman.  He's executive vice

            15   president and chief investment officer of The St. Paul

            16   Companies, which is a major U.S. property and liability

            17   insurance company and he is responsible for all of St. Paul's

            18   public and private investment activities.  Some highlights of

            19   Bill's career -- and there are many -- include he was

            20   chairman of CitiGroup Investments, Inc., he was head of the

            21   private investment department of Salomon Brothers, Inc. and

            22   of course, most impressive of all, he's a former director of

            23   the SEC's division of market regulation.

            24             Next is Andrew Lo.  He's the Harris & Harris Group

            25   Professor of Finance at the MIT Sloan School of Management





             1   and he's a director of MIT's laboratory for financial

             2   engineering.  His interests are many.  They include empirical

             3   validation and implementation of financial asset pricing

             4   models, the pricing of options and other derivative

             5   securities, financial engineering and risk management,

             6   trading technology and market microstructure and hedge fund

             7   risk and return dynamics and risk transparency.  So clearly

             8   he has some very direct knowledge about our topics today.

             9             Next to Andrew is Bob Steel.  He's a vice chairman

            10   of Goldman Sachs, Inc. and he's a member of the management

            11   committee.  At Goldman, Bob has held many important positions

            12   including head of the firm's equities division, head of all

            13   institutional equities in the United States and head of the

            14   equities division in Europe.  Bob is a member of the New York

            15   Stock Exchange where he has served on various committees and

            16   he's a member of the board of directors of the Securities

            17   Industry Association.

            18             And last, but not least, we have Mark Yusko.  He's

            19   chief investment officer of the University of North Carolina

            20   at Chapel Hill.  He's responsible for the management of

            21   financial assets of the university and affiliated foundation

            22   funds.  Mark and his team founded the UNC Management Company

            23   to provide comprehensive investment advisory services to the

            24   university, including providing strategic and tactical asset

            25   allocation recommendations to the board, investment





             1   management selection, manager performance evaluation,

             2   spending policy management and performance reporting.

             3             And of course we also have again with us today --

             4   we're very fortunate to have all our commissioners and our

             5   chairman with us this morning, so we're delighted to have

             6   everyone here.

             7             I'd like to begin by focusing first on -- directly

             8   -- getting right to the topic on hedge fund trading

             9   strategies and market impact.  Hedge funds engage in a wide

            10   variety of trading strategies ranging from strategies that

            11   are market-neutral to those that are highly speculative. 

            12   This raises questions concerning the impact that these

            13   strategies have on individual stocks and on the markets as a

            14   whole.

            15             So I thought I would begin by first calling on

            16   Peter Brown to describe generally what these hedge fund

            17   trading strategies are for the different types of investments

            18   strategies that they engage in.

            19             Peter, could we start with you?

            20             MR. BROWN:  Sure.  Let me just say in very general

            21   terms what all hedge funds that I know of do.  They gather up

            22   information and on the basis of this information, form an

            23   opinion about what the true value or future value of some

            24   financial instrument is.  Then they notice if the market has

            25   a different opinion and, if it does, they trade.  That is





             1   generally -- every hedge fund I know about, that's what they

             2   do.

             3             So, for example, an event-driven hedge fund may

             4   think that the probability of some merger occurring is

             5   greater than what they see in the market.  Say if it's a

             6   stock for stock merger, they'll buy the target -- the

             7   acquiree and sell the acquirer, thereby driving the spread

             8   between the two closer together.

             9             Now, if the manager is right, the spread will

            10   continue closer together and he'll turn a profit.  Take

            11   statistical arbitrage.  That's the area I'm in.  There, the

            12   manager will form opinions on the relative value of all kinds

            13   of instruments to one another and they will sell the

            14   instruments they believe are overvalued relative to other

            15   instruments and buy the instruments they believe are

            16   undervalued relative to other instruments.

            17             Again, look what happens.  When they sell the

            18   stocks or whatever the instruments are, the price of those

            19   instruments will come down and the one they buy will go up. 

            20   If the manager is right, the stocks will continue to move in

            21   the direction that they've nudged the market.

            22             So in these cases and all other cases that I know

            23   of, the impact of these trades -- I can give other examples. 

            24   Do you want me to run through a litany of kinds of hedge -- I

            25   think it was discussed yesterday, but -- I'll give you one





             1   other example.

             2             Say convertible bond arbitrage.  There, the manager

             3   may believe that the volatility of a stock is underpriced so

             4   he'll buy the convert which has an implicit option in it.  He

             5   doesn't want to take a position in the underlying so he'll

             6   sell the stock to hedge out that exposure.

             7             When he buys the convert, he increases the price

             8   the marketplaces on the volatility and if he's right, the

             9   same thing happens.  He'll make money and the market will

            10   continue to move in the direction which he's pushed the

            11   price.

            12             So in all these examples, what hedge funds do is

            13   move the market in a direction that they believe the true

            14   value of an instrument or pair of instruments ought to be. 

            15   And if they're successful, that is, if they make money, then

            16   they'll make the market more efficient.

            17             So when hedge funds trade in any strategy -- I'm

            18   addressing now the market impact and going on to the next

            19   issue -- I hope that's okay.  When hedge funds trade, what

            20   they do in any of these strategies is make the market more

            21   efficient.  So I think that trading by hedge funds is a good

            22   thing.  I want to make sure I get that in because I don't

            23   know if you're going to call on me again.

            24             Do you want me to go on with other strategies or --

            25             MS. NAZARETH:  You can go on with a few more





             1   strategies.

             2             MR. BROWN:  Can I instead go on and address other

             3   aspects of -- okay, fine.

             4             Let's look at volatility.  There's been a concern

             5   that hedge funds through their trading various strategies

             6   affect the volatility of the market.  Now, let's decompose

             7   volatility into two components.  One, that -- innovations in

             8   news; in other words, new information coming in, and the

             9   other, do -- let's call it noise.  I don't necessarily mean

            10   white noise but noise.

            11             Now, you can't really do anything about innovations

            12   in the news and you shouldn't really do anything there.  But

            13   the noise represents unwarranted risk to -- unnecessary risk

            14   to all investors.  And what a hedge fund does is trade out

            15   the noise.  All these strategies they trade out the noise.

            16             So for example, if a stock takes a tumble for no

            17   apparent reason, some hedge fund will be sitting there

            18   waiting and buy the stock, thereby supporting the price and

            19   reducing the volatility.  So this is another way in which the

            20   hedge fund trading is good for the market.

            21             And I can go on to liquidity but I think maybe I'll

            22   stop because you said talk for two or three minutes.

            23             MS. NAZARETH:  Bill, can you comment further on

            24   both the types of techniques that hedge funds employ and the

            25   instruments that are also used in hedge fund strategies?





             1             MR. HEYMAN:  Well, I could certainly continue the

             2   litany of strategies.  I don't know if that's productive.  I

             3   have one general observation that I had in reading these

             4   questions which I thought were very good and it's probably

             5   better made at the beginning of this discussion than at the

             6   end.

             7             As I read the press articles on hedge funds, which

             8   describe them as unregulated, the exemptions under which they

             9   operate are principally in the area of primary markets,

            10   selling their own securities.  In their secondary market

            11   operations, hedge funds are subject to the same restrictions

            12   as everybody else.

            13             So a discussion of this nature is really less -- by

            14   definition, has to be less a discussion of hedge funds than a

            15   discussion of various trading strategies and how they affect

            16   the market because in theory they could be executed by

            17   anyone.

            18             Now, as a matter of fact, hedge funds have a de

            19   facto monopoly on many of these strategies, with some

            20   competition, probably less than there used to be from

            21   proprietary trading desks of regulated institutions.  But

            22   this discussion is to me more delicate than the other four or

            23   five panels in that it involves consideration of tampering

            24   with secondary markets which is always a delicate matter.

            25             About six or seven years ago, in connection with a





             1   NASDAQ settlement, the Commission, more or less by fiat,

             2   restructured equity markets in the U.S. and only now are

             3   people beginning to question certain elements of the scheme

             4   that resulted.

             5             The other day I recall that Chairman Donaldson

             6   questioned whether decimalization was a good thing in all its

             7   consequences, a question which would have been sacrilege five

             8   years ago.

             9             So I would simply say at the outset that as we

            10   consider these things, we should understand that we're not

            11   talking about entities, we're talking about strategies.

            12             MS. NAZARETH:  That's an excellent point.  Jim, do

            13   you have any thoughts that you want to add with respect to

            14   techniques or strategies or the types of instruments again

            15   that hedge funds employ in their trading strategy?

            16             MR. BORISH:  Well, I'm going to defer to my

            17   colleagues on most of the aspects of variety of strategies. 

            18   I think I can focus a little bit on one particular strategy

            19   which you highlight in your question, which is short selling,

            20   market impact on short selling, whether or not it should be

            21   regulated more than it already is.

            22             I would point out that short selling is one

            23   technique used by hedge funds.  It's probably subject to the

            24   most regulations in terms of needing to borrow shares, the

            25   so-called uptick rule which has been in place for 70 years,





             1   and a variety of other restrictions.

             2             So we would comment that as it relates to that

             3   market technique and trading approach, short sellers and

             4   hedge fund managers who employ short selling are already

             5   regulated more so than other traders or trading strategies.

             6             Having said that, I think that it's worth exploring

             7   some of the issues that short selling give rise to, and

             8   certainly there's been, I know, increased interest, given the

             9   last few years with market performance, on what is going on

            10   on the short side and any way we can illuminate that would be

            11   helpful hopefully for this panel.

            12             MS. NAZARETH:  I think we will spend a great deal

            13   more time talking about short selling in the course of this

            14   discussion.  Maybe I'll ask Peter and Afsaneh to both see if

            15   you can respond to the following question.  In terms of risk,

            16   can you sort of describe how hedge fund investments and

            17   trading strategies differ from more traditional investments

            18   through mutual funds and other similar products?

            19             MS. BESCHLOSS:  Sure.  As someone who's been an

            20   investor in hedge funds, both at the World Bank currently and

            21   in various endowments, I was sort of listening to the other

            22   panelists -- I have always looked at hedge funds essentially

            23   as any other investable category except much more active, and

            24   that has repercussions on what I'm going to say about risk.

            25             So hedge funds are nothing but -- you know, some





             1   people call them mutual funds on steroids or whatever you

             2   want to call them, but essentially it's active strategies and

             3   with the exception that they have access to many tools that

             4   you do not have in traditional money management.

             5             Now, what does that mean in terms of risk

             6   management?  Because they are much more active, because they

             7   use many more tools, the risk management becomes a harder

             8   job.  Obviously, the risk management and the issues that we

             9   may discuss later on transparency are very interrelated.  On

            10   the one hand, as an investor, you always want more

            11   transparency, you want to understand exactly if you put your

            12   money in something what's going on.

            13             On the other side, there are certain strategies in

            14   the hedge fund world in general, in investments, that require

            15   some level of proprietary information, at least during

            16   certain periods of time.  Maybe not in the long run, but over

            17   ceratin periods of time.

            18             And one solution that we have come up with in the

            19   past really four, five years, and it seems to be working, is

            20   really working maybe with third parties in some form or other

            21   so that the information from hedge fund managers could go to

            22   third parties who have absolutely no connection with market

            23   makers in any shape or form.  They can process the

            24   information and then as a user of information, as an

            25   investor, you can then get that information in an aggregated





             1   form, in a form that makes sense to you.

             2             And obviously for some of the -- as I mentioned,

             3   you know, some complex fixed income strategies, some complex

             4   risk op strategies, it's very difficult to come up with

             5   meaningful risk numbers.  The second thing that is very

             6   difficult is really aggregation of these different strategies

             7   and you do have to make certain kinds of adjustments and

             8   simplifications to be able to do that.  

             9             But my assumption has always been more risk

            10   management is better than less risk management and if you are

            11   -- especially right now as more investors are getting

            12   invested in this sector, very important to have the risk

            13   management.  And obviously we can talk later about the role

            14   of prime brokers and other entities in risk management.

            15             But it is something I think which is key to both

            16   the trading where both people who are trading the strategies

            17   should understand the underlying risks of what they're doing

            18   and the investors in the business should spend more time on

            19   aggregation.

            20             I'll just make one other point.  The other thing

            21   that I think as an investor that is extremely important is

            22   hedge funds are generally a part of your portfolio, not the

            23   totality of your portfolio.  I think another very important

            24   task is being able to aggregate the risk of your hedge fund

            25   portfolio, whatever strategies are in there, together with





             1   the rest of your portfolio which is generally a traditional

             2   portfolio and I think that's one of the things that needs

             3   more work in this area.

             4             MS. NAZARETH:  Do you think that this lack of

             5   transparency with respect to risk has a negative impact on

             6   market efficiency as a whole and do you think that some of

             7   the concerns that you read about in the press with respect to

             8   the ability of hedge funds to move market sometimes in

             9   strange ways in particular products is related to that?

            10             MS. BESCHLOSS:  I don't necessarily look at it that

            11   way.  I think you do need -- you know, we need to do risk

            12   management.  But the question is, do you need the information

            13   on a daily basis?  I'd say no, because as an investor, what

            14   would you do with that information?  There's nothing very

            15   much you could do.

            16             And it's the same thing really for your mutual fund

            17   or your public traditional kinds of -- you know, if you got

            18   information from your public managers you'd have the same

            19   problem.  So I don't look at it quite that way.  I think

            20   hedge funds take advantage of market inefficiencies and as we

            21   find in many strategies like merger op, like some others, as

            22   the strategies become more common, as people put money, they

            23   become more efficient.

            24             So hedge funds have -- I've seen them also have --

            25   play role in making certain kinds of markets more efficient





             1   than less efficient.  But every type of business, whether

             2   it's traditional money management or hedge fund management,

             3   hedge funds obviously because of lack of transparency,

             4   there's room to take advantage in certain ways that none of

             5   us would feel comfortable.

             6             MS. NAZARETH:  Thank you.  How about Peter Borish

             7   and then I think Peter Brown has some comments.

             8             MR. BORISH:  Thank you.  Well, I think that hedge

             9   funds and risk management, a lot of what they do is they take

            10   conventional wisdom and you sort of have to turn it upside

            11   down.  So the normal concept of the greater the risk, the

            12   greater the reward is actually the opposite with a hedge

            13   fund.

            14             A hedge fund is going to look at an opportunity

            15   where they look at less risk and they're going to look at the

            16   greater the reward, which is they're going to vary their size

            17   with respect to the opportunity.  So the greater the

            18   perceived market inefficiency, the larger they can

            19   participate in the marketplace. 

            20             A normal investment where somebody buys something,

            21   the general risk management is time and that -- so in a hedge

            22   fund where the difference is every position that is taken,

            23   usually before you take that trade you have an exit point. 

            24   So you have an entry and an exit and you can measure that

            25   risk.  Most other types of investments that are long only,





             1   you get in but you don't have a notion of where you're going

             2   to get out.

             3             So oftentimes it's perceived that hedge funds may

             4   be more risky but the fact that they're taking risk

             5   management by actually trading is actually the most effective

             6   risk management strategy that there is because in the

             7   investment world, if you live, you win.  And so the key here

             8   is not to have an ego but to say I've tried this position, it

             9   hasn't worked, now I'm going to get out.  

            10             So you want to turn that upside down, versus if I

            11   buy something and it goes down 15 or 20 percent, well, I

            12   liked it there, it must be better here.  That may be true. 

            13   And that all works great until the one time when it doesn't

            14   work and then you lose all your money and then you're not in

            15   business.  

            16             So that's why I say you want to spend your time

            17   turning it upside down.

            18             MR. BROWN:  I think it's useful to compare hedge

            19   funds to stocks.  There are roughly 6,000 hedge funds and a

            20   comparable number of exchange trade stocks.  Now, I recently

            21   looked at the median volatility of a hedge fund is and the

            22   medium volatility of stock.  By volatility, referring to

            23   standard deviation here.

            24             The median volatility of a hedge fund is half the

            25   median volatility of a common stock.  The volatility of a





             1   fund to funds recently is more like a quarter of the

             2   volatility of the S&P 500.  So just in terms of an objective

             3   measure of risk, hedge funds are significantly less risky.

             4             They came out of the collapse of the dot com bubble

             5   relatively unscathed and this explains why a number of

             6   universities, institutions and even retail investors are now

             7   eager to get into hedge funds.  They've sort of woken up --

             8   back five years ago everybody was making money going long and

             9   they've now woken up to the fact that risk matters.

            10             And I suppose that's part of the reason there's

            11   attention to hedge funds now because so many people want to

            12   get into them.  There's concern about hedge funds increasing

            13   volatility in the market, causing things to be risky through

            14   use of derivatives and shorting.

            15             But the hedge funds that I know about, they use

            16   these derivatives and short selling -- maybe not Jim here --

            17   to control risk and that strikes me as a good thing.

            18             I think I'll stop there.

            19             MS. NAZARETH:  Larry?

            20             MR. HARRIS:  We've been talking about two different

            21   types of risk this morning already.  Talking about the risk

            22   associated with investment in a hedge fund.  We're also

            23   talking about the risk associated with the strategies that

            24   hedge funds employ and their impact upon the market as a

            25   whole.  I want to talk about that second type of risk and its





             1   relationship to transparency.

             2             Our fear -- not the SEC but sort of throughout the

             3   economy -- is that there might arise a circumstance when

             4   everybody decides to do the same thing but that people are

             5   not aware that everybody else is trying to do the same thing.

             6             So some circumstance arises where everybody wants

             7   to get out of the market at the same time but they don't know

             8   that everybody else wants to and that in trying to exercise

             9   that strategy without the knowledge that other people are

            10   going to do it as well, we're afraid that that would possibly

            11   drive the market down in a way that wouldn't be acceptable

            12   and certainly would not likely happen if everybody knew about

            13   everybody else's strategy, since certainly if everybody knew

            14   that everybody else was going to do it they'd realize that

            15   they couldn't do it and that therefore they would arrange

            16   their affairs differently.

            17             That's something similar to the scenario that we

            18   saw in the '87 crash and many people believe that that was a

            19   significant determinant of the '87 crash.  Now, the question

            20   is what relation should our fears about that kind of scenario

            21   have to do with hedge funds in general and the transparency

            22   of their operations.

            23             I'll note that the types of mistakes that I just

            24   described are not likely made by the most sophisticated

            25   traders in the markets.  The most sophisticated traders in





             1   the market spend a lot of time thinking about what other

             2   people do because they profit only when other people make

             3   mistakes.

             4             And so when they're successful, they're successful

             5   not only because they've got a good idea but they have a good

             6   understanding about the mistakes that other people make.  As

             7   a consequence, the more sophisticated traders in the markets

             8   try to be as aware as possible of what's happening so that

             9   it's unlikely that hedge funds are going to be the ones who

            10   are going to collectively fall into the mistake that I've

            11   just described.

            12             If there are mistakes like this where collective

            13   action leads to problems that individuals wouldn't have

            14   anticipated because they didn't take into account what other

            15   people would do, it's more likely going to happen among

            16   people who are less sophisticated.

            17             To the extent that these things do happen, though,

            18   there are tremendous opportunities to profit from it and the

            19   hedge funds, among other sophisticated investors, are going

            20   to be the first to stand on the opposite side of it and step

            21   in.

            22             Just the same, we do have concerns about

            23   transparency that if there were only more transparency, it

            24   might be easier for other people to see what other people

            25   intend to do and then respond to it or plan their affairs





             1   accordingly.  My -- I'm a little bit concerned about imposing

             2   too much transparency on informed traders of any type because

             3   the effect of imposing transparency on their operations is to

             4   ultimately make their operations less profitable.

             5             Now, I'm not particularly interested in the profits

             6   of informed traders in the sense that I care about them as

             7   traders, but I do care a lot about the research that those

             8   profits support.

             9             The research that the informed traders undertake to

            10   become well informed is the -- provides them with the

            11   insights that allow us to -- allow them to understand what

            12   valuations should be in the market.  And as was described

            13   very eloquently by Peter Brown, the acting on those insights

            14   is what makes the prices more informative and informative

            15   prices are the -- are essential to the efficient operation of

            16   our economy.

            17             So if we ask for more transparency, we may obtain

            18   better control over the systemic risk that we've just talked

            19   about, but the control won't be quite as effective as it

            20   might be -- that is to say that the systemic risks that we're

            21   concerned about have to do with the less informed traders

            22   than the better informed, sophisticated traders.

            23             But if we ask for too much transparency, we

            24   decrease the profits that hedge funds and other sophisticated

            25   traders can make.  Most of those profits, in one form or





             1   another, go to compensating the collection of information and

             2   the collection of that information ultimately goes into

             3   prices and produces more informative prices that are used

             4   throughout economy to better manage the use of our resources

             5   and ensure that resources are allocated to their highest use

             6   to ensure that CEOs and CFOs are compensated in a way that is

             7   proportionate to their contribution to the management process

             8   and so forth.

             9             That's an overview of some of the systemic issues.

            10             MS. NAZARETH:  Okay.  Thank you.  I think I'll call

            11   on Bill Heyman next and then I'll Mark Yusko and Andrew Lo to

            12   be thinking about whether they can comment both on explaining

            13   to us so we can better understand why hedge funds can be less

            14   volatile, which is certainly not their -- I think is commonly

            15   understood and Andrew maybe you can talk about the risk and

            16   return with hedge funds.

            17             MR. HEYMAN:  Following up on some of the things

            18   Larry said, the issue that seems to be posed for this panel

            19   is are hedge funds good or bad for the market.  I don't like

            20   to use words good or bad in describing markets but the press

            21   seems to use it.

            22             I think that issue can be discussed on a number of

            23   levels.  The first level I think is are hedge funds users or

            24   providers of liquidity.  I've seen literature that assumes

            25   that anyone participating in a market is a provider of





             1   liquidity.  In fact, I saw a brief from the Justice

             2   Department in the mid-'90s that suggested that traders were

             3   providers of liquidity.

             4             But in reality, there are two classes of market

             5   participants; people who are net providers of liquidity and

             6   net users of liquidity.  And although it's a generalization,

             7   I would say that most of the time for most of their

             8   strategies, hedge funds are net providers of liquidity.  In

             9   merger arbitrage, in investing in distressed securities, they

            10   are more or less the only buyers from natural holders of

            11   securities which, by virtue of events, pass into those

            12   spheres.  And, indeed, when hedge funds in those areas turn

            13   sellers, there are no natural buyers.

            14             So, I recall cocktail parties in the '80s where I

            15   tried with a straight face to discuss the social utility of

            16   merger arbitrage since that's what I did then but in

            17   hindsight, I shouldn't have been so bashful.  And as Larry

            18   said, if -- transparency can certainly be considered but it

            19   will come at a cost and the cost will not rest where

            20   regulators suspect it will rest.

            21             In the end, providers of liquidity who are saddled

            22   with increased costs will attempt to pass them on and they

            23   will pass them on to natural investors and that's I think

            24   something to consider as one parses through these questions.

            25             MS. NAZARETH:  Thank you.  Mark?





             1             MR. YUSKO:  Well, I think a number of things

             2   related to the whole construct of risk are important to

             3   highlight.  One is, it depends on your definition of risk how

             4   risky these strategies are in a portfolio.  If your

             5   definition of risk is volatility of returns, then as Peter

             6   said and as Andrew I'm sure will comment on, and others have

             7   shown, these strategies are significantly less risky if you

             8   just take strict volatility of returns.

             9             And to me, the way we think about risk is risk is

            10   like energy.  It can change form but it can't be eliminated

            11   so you can't say that there's less risk, per se.  You just

            12   change the form from market risk or beta risk to stock

            13   selection or alpha risk.  And when we look at investing --

            14   and roughly 55 percent of our endowment is invested in "hedge

            15   funds".

            16             I hate the term hedge funds, one, because A.W.

            17   Jones had a D on the end, it was called hedged fund when he

            18   formed it in 1949 and most managers today -- because --

            19   somebody said there were 6,000 funds.  I claim there are 24

            20   because we've met all 6,000.  They're all in the top quartile

            21   so somewhere -- the bad fund's out there but we've never met

            22   any.

            23             (Laughter.)

            24             MR. YUSKO:  So the issue is that a lot of the

            25   strategies have nothing to do with hedging.  They have to do





             1   with arbitrage.  They have to do with taking advantage of

             2   market anomalies.  Yet there are some strategies in our

             3   portfolio where the exposure is a hedged, with a D, equity

             4   exposure that has reduced the volatility and the risk of loss

             5   and has allowed our fund to preserve capital over the last 3

             6   years where the average endowment fund has lost 8 to 10

             7   percent a year for 3 years.

             8             So if you think of risk as risk of loss, so going

             9   to zero, there is some additional risk in this world of

            10   strategies because of another tool that's used, not because

            11   of the strategy but because of the tool used of leverage. 

            12   Leverage can be very good and it can be very useful.  And in

            13   fact, leverage plus short selling actually reduces risk --

            14   back to A.W. Jones.

            15             But leverage in its worst form -- let's take a

            16   house today.  Housing market.  There are loans being made at

            17   125 percent of value.  Loan to value of 125 percent.  Well,

            18   if you then lost your job and were forced to sell, you've now

            19   used leverage to take away 100 percent of your equity. 

            20   You've got a hundred percent loss.  

            21             And that can happen and has happened in this

            22   business as funds have blown up, although the number of

            23   blowups -- I find this kind of interesting -- compared to the

            24   number of funds and the dollars in management is much lower

            25   than the wealth that was destroyed by the money that flowed





             1   into the mutual fund industry at the peak.

             2             My favorite stat is 85 percent of all the money in

             3   tech mutual funds came in after January 1, 2000.  That's a

             4   very bad statistic because it means most of that money was

             5   taken away.  So it really depends on how you think about

             6   risk.  We define risk as not being able to provide inter-

             7   generational equity between current users of the funds that

             8   we spend and future generations.  

             9             So if we can't earn a real rate of return and if

            10   you turn a dollar into 70 cents over the last three years, it

            11   will take you decades to get back.  If you can preserve

            12   capital in the difficult markets by using a hedged strategy,

            13   then we think that you're way far ahead.

            14             One last piece is that we really believe that this

            15   is really just a democratization or a disintermediation of

            16   proprietary trading due to technology.  The fact that you can

            17   take a PC, even a handheld today, and have as much computing

            18   power as Wall Street had 20, 30, 40 years ago, you used to

            19   have to sit inside a Wall Street proprietary trading desk in

            20   order to do these strategies.

            21             Goldman Sachs was built around risk for arbitrage a

            22   hundred years ago, so this strategy has been going on a long

            23   time.  It's not new, they're not novel and you have to focus

            24   on the exposure as opposed to calling this an asset class. 

            25   It's the exposure, stocks and bonds and maybe some derivative





             1   exposure.

             2             MS. NAZARETH:  I'll ask Andrew and then Bob Steel

             3   to tell us about the Goldman experience.

             4             Go ahead, Andrew.

             5             MR. LO:  I guess I'd like to start by pointing out

             6   that there are two aspects of risk that need to be focused on

             7   and I think they're distinct aspects.  One has to do with

             8   risks associated with the hedge fund investments themselves,

             9   and I'll talk about that in a minute, and then the second has

            10   to do with systemic risks that hedge funds in general impose

            11   on the financial system.  I think those are different and

            12   need to be looked at somewhat separately.

            13             With regard to the first kind of risk, I think it's

            14   pretty clear from the comments from the other panelists that

            15   in fact there are many different kinds of risks, that risk is

            16   not a univariate concept.  And that's part of the problem

            17   with dealing with hedge funds is that there are so many

            18   different types of risks.

            19             I want to go back to a question that was posed by

            20   Commissioner Campos yesterday.  He asked I think quite

            21   perceptively if it's the case that hedge funds are less risky

            22   and have higher returns, why shouldn't we let everybody have

            23   access to them?  And I don't think that there was an adequate

            24   answer given.  I think a number of people tried to make

            25   arguments about why you might not want to let other retail





             1   investors have access, but I think there's a very simple

             2   answer.

             3             The answer is that hedge funds are more risky.  I

             4   know that that sounds rather surprising to some but the fact

             5   -- if there's one lesson that we've learned from modern

             6   financial economics it's that there's usually a relationship

             7   between risk and expected return.  And we know that hedge

             8   funds have yielded higher expected returns than many other

             9   investments.  As a result, you would expect that they would

            10   have higher risk in one form or another.

            11             Now, I do agree with Peter and Mark that looking at

            12   volatility as a measure of risk, for most hedge funds

            13   volatility is quite low.  But the same can be said for lots

            14   of other things that we would all regard as risky.  For

            15   example, think about an insurance company that insures

            16   earthquakes.  If you take a look at the returns on those

            17   kinds of companies, you'd find that they have very low

            18   volatility, very high sharp ratios except every once in a

            19   while, in the parlance of Wall Street, you have your face

            20   ripped off.

            21             (Laughter.)

            22             MR. LO:  Now, there's nothing wrong with that kind

            23   of risk and there are many investors who are perfectly

            24   capable, interested and delighted to take on those risks,

            25   thank goodness.  But the fact is it's a different kind of





             1   risk that's not adequately measured by volatility.

             2             And so with all of the various different hedge fund

             3   styles that we've spoken about, each one of these styles

             4   carries its own unique kind of risk that can't adequately be

             5   measured by volatility.  Now, if you think about trying to

             6   explain that to unsophisticated investors, you quickly see

             7   the problem.

             8             Most people have a hard time figuring out how to

             9   get the blinking 12:00 to stop on their VCRs.

            10             (Laughter.)

            11             MR. LO:  How do you explain to them the various

            12   subtle kinds of risks that different kinds of hedge fund

            13   strategies pose?  I think this is an area where the SEC can

            14   actually have a very big impact in the area of risk

            15   disclosure and investor education.  And one of the main

            16   thrusts that I think that the SEC might consider is gathering

            17   data.

            18             One of the most important aspects of any kind of

            19   research effort at understanding risk is to start with the

            20   data.  One of the reasons that there's been so much academic

            21   research over the past few years in hedge funds is because we

            22   now relatively recently have had access to hedge fund data. 

            23   The SEC chief economist Larry Harris's pioneering work on

            24   market microstructure would have been impossible without

            25   data.





             1             And so I think that the SEC is in a unique position

             2   to put together a data set that currently doesn't exist, data

             3   that will not be generally and publicly available, but data

             4   that will allow the SEC to get a much better handle on the

             5   kind of risks for each of the hedge fund styles that we see.

             6             COMMISSIONER GLASSMAN:  Can I interrupt with a

             7   question?  Yesterday I asked a question about rate of failure

             8   and the answer was essentially -- my understanding was there

             9   really aren't that many hedge funds that fail.  There are a

            10   number that close but with no loss of principal.  So what I'm

            11   hearing you say is there are some spectacular failures.  Are

            12   there very few of them but they're just spectacular?  Is that

            13   what's --

            14             MR. LO:  Exactly.  I think that gets to my second

            15   point about the systemic risk that hedge funds pose to the

            16   financial system.

            17             The fact is that it's true.  There are very, very

            18   few spectacular failures but then, again, there are very,

            19   very few spectacular earthquakes.  Each one of them is fairly

            20   significant and I think we can learn a great deal from these

            21   kinds of failures.

            22             So this gets to my next point.  I guess when a

            23   hedge fund fails -- in fact, in 1998 when LTCM failed, one of

            24   my colleagues said well, let's see -- you know, we had a

            25   whole bunch of rich investors that lost their money.  So





             1   what?  Who cares?

             2             The who cares part is the fact that the failure or

             3   the near-collapse of LTCM at least at that time seemed to

             4   have threatened the integrity of the financial system and

             5   that's an externality that I think the SEC is also in a prime

             6   position to address.  And I guess what I would suggest maybe,

             7   an interesting alternative to the way that these kinds of

             8   failures are handled right now, is to take the path that the

             9   federal government is taking with respect to airplane

            10   crashes.

            11             In particular, we have an organization called the

            12   National Transportation Safety Board that's charged with

            13   responsibility for investigating every crash that occurs. 

            14   These are the folks that end up at the crash site, they look

            15   for the black box, which may be appropriate for hedge funds

            16   as well, they collect data, they analyze the data, and

            17   ultimately they file a report that describes what happened

            18   and makes recommendations as to how to improve the system.

            19             Since 1967 when the NTSB started, they've

            20   investigated 114,000 incidents in aviation alone.  Now, there

            21   haven't been 114,000 airplane crashes but any accident they

            22   investigate they file a public report.  And just to bring

            23   home the point, I think many of you are probably aware that

            24   icing on the wings of airplanes is not such a good thing.

            25             Well, the reason that you know this, the reason





             1   that we're aware of this is because on October 31, 1994, an

             2   American Eagle flight 4184 crashed and the NTSB filed a

             3   report shortly thereafter observing that ice accretion was

             4   responsible for the crash.

             5             And so the hope is that with systemic risks,

             6   although those risks are very rare and not something that

             7   fills our daily attention, that's the kind of thing that I

             8   think the SEC is prime to be able to collect the data and be

             9   able to analyze.

            10             MS. NAZARETH:  Thank you.  Bob?

            11             MR. STEEL:  Thanks, Annette.  It's great to be here

            12   in the middle.  I've learned that Gus Levy was recognized

            13   today as having built our firm on risk arbitrage, which he'd

            14   be pleased to know, and also I found out that you can change

            15   the 12:00 on your VCR, which I didn't know.

            16             (Laughter.)

            17             MR. STEEL:  I guess, Annette, that there are a

            18   couple of things that I'd add to the conversation, I hope. 

            19   One is that I think something that maybe hasn't been said

            20   clearly is that there is risk of the strategy when you invest

            21   in hedge funds but by nature the limited partnership has

            22   certain characteristics, too, that are of a risk that people

            23   choose to accept or not accept.

            24             There's less liquidity, there's the potential to

            25   lose all your capital, and so that's a different form of





             1   risk.  Especially someone like Mark who basically is

             2   investing in perpetuity as an endowment or he's really

             3   investing for future generations and the goal is to protect

             4   the purchasing power, but there isn't the near-term liquidity

             5   needs.

             6             The fact that he can be comfortable putting 55

             7   percent of his portfolio, as I understood, into limited

             8   partnership-type investing is consistent with his ambition

             9   but it isn't for everyone else.  And so I think that's a

            10   different type of risk that you have to think about.  I think

            11   it steers into another issue that you'll get to later in

            12   terms of appropriateness of investing and I just would like o

            13   make that point.

            14             To add to something Bill said, I think when you sit

            15   inside our firm, what's fascinating to me is when there's a

            16   sudden change in the nature of a security, which Bill alluded

            17   to.  And that is that on Monday a stock closes at 20 and

            18   people are valuing it because of the long-term prospects.  At

            19   4:15, someone makes a bid for the security at 30 and the

            20   stock opens on Tuesday morning at a new price.

            21             It isn't a stock trading at 20 being valued on its

            22   long-term fundamentals.  It's a security that's valued at 27

            23   where professionals are estimating what the odds of closing

            24   are, what the antitrust issues are, and how long it will take

            25   and whether you can borrow the security and set up the hedge.





             1             And all of a sudden, the nature of investor changes

             2   instantly and the arbitrager who comes in provides liquidity

             3   to the people who previously owned the security at 20 with a

             4   long-term ambition and have stepped into new shoes that have

             5   new risks and new characteristics of risks.  And that orderly

             6   transfer of holders, given the change in the security or the

             7   change in the situation, is something that occurs every day

             8   and I can't imagine how that would happen -- and that the

             9   previous holder would then be assuming risk they weren't

            10   qualified or prepared to understand or to take into those

            11   shoes.

            12             And so I just thought of that and wanted to add

            13   that to a point Bill was making.

            14             I think to comment maybe briefly on Larry's point 

            15   -- well, on Andrew's points more, that looking into this

            16   issue of systemic risk, at Goldman Sachs we have a business

            17   of prime brokerage where we have about $125 billion of hedge

            18   fund equity and so we look at this very carefully and we can

            19   talk about how we look at it maybe later.

            20             But I think that when we look at the amount of

            21   different strategies going on and the amount of correlation,

            22   I think the thing that is pleasing to us and would be

            23   systemically is the fact that it seems as though there's not

            24   much and that people are all doing different things, they're

            25   all looking at all the different information and pursuing





             1   different strategies that we don't see as much correlation as

             2   you might think.

             3             Andrew is correct that there is that earthquake

             4   opportunity that we sure think about when we analyze the

             5   securities because those are the equities off which we loan

             6   money and we're the first line of defense.  I think the issue

             7   that Andrew raised -- he mentioned the other day when we were

             8   discussing the panel -- of the transportation analogy is a

             9   good one and I think that is something that I would encourage

            10   us to think about.

            11             The idea of a regulator stepping into the shoes to

            12   decide and to analyze, quantify and then potentially make

            13   decisions about the systemic risk as it builds, ebbs, flows

            14   seems to be a tricky slope to start on but I would be

            15   interested in other people's comments on that point.

            16             MS. NAZARETH:  Could I ask you about -- and perhaps

            17   others here have some experience as well -- whether you think

            18   that the practices in the industry after long-term capital

            19   management improved in any way?  I mean, obviously there were

            20   some lessons learned.  

            21             We may not have had the kind of post mortem that

            22   you would with a plane crash, but there certainly was a fair

            23   amount of work done including work by the President's working

            24   group and the counter-party risk management policy group I

            25   thought had some very important recommendations.





             1             Do you think that there have been improvements in

             2   risk management by counter-parties since that experience?

             3             MR. STEEL:  I think the good news is that if you

             4   look at the work and the 20 suggestions that came from the

             5   counter-party risk management group, that there have been

             6   lots of improvements.

             7             I think the bad news is that not everybody -- there

             8   isn't kind of a way of measuring who is getting in line and

             9   who isn't on that and so everybody is applying these things

            10   at their own speed in their own way.  They are

            11   recommendations and so I think from our perspective, I know

            12   we sure take them seriously at the different levels where we

            13   analyze our risk.  

            14             But I think the challenge is to -- we sometimes

            15   have the tendency, we've seen in lots of situations, where

            16   the lowest common denominator seeks a commercial advantage

            17   and that would be systemically challenging.

            18             So the answer would be successful articulation and

            19   some degree of improvement but we could always do more.

            20             MS. NAZARETH:  I want to call on Will but I also

            21   want -- I'm sure you have a number of things to say.  One of

            22   the things I was curious about as well was, again, following

            23   up on something Bob said.  

            24             You know, when you're managing risk, one of the

            25   issues again that I think came up in long-term capital





             1   management was the sense that an awful lot of people were

             2   sort of on the similar side of the market, there was a sort

             3   of -- you worry about this herd mentality and that unwinding

             4   positions can sometimes be substantially more difficult than

             5   you anticipated if, again, everybody has got the similar

             6   hedges and you can have more impact on the market than you

             7   may otherwise have expected.

             8             So it looks like that remark has inspired some

             9   comments so let me call on Will and then I'll ask Bill to

            10   respond to that as well.

            11             MR. GOETZMANN:  I could actually respond briefly to

            12   that.  You know, we're talking about events, systemic events

            13   and so forth maybe caused by opinions, driven by models that

            14   value securities but also we should consider systemic events

            15   that are related to the institutions themselves.

            16             Bob's firm, if it has 125 billion in hedge fund

            17   capital flowing through it, is part of a system that can be

            18   sensitive to interest rate shocks and the availability of

            19   credit and other kinds of things, so that as we have -- as

            20   the industry has moved from what almost seems a series of

            21   little shops to a broader more -- something with real

            22   foundations in the largest financial institutions, we should

            23   consider the broader system beyond the hedge funds themselves

            24   and the trading itself to the institutions that support them.

            25             The point I wanted to make is that hedge funds are





             1   absolutely vital to the operation of the markets.  You

             2   couldn't have markets without people serving in the role that

             3   a hedge fund serves in terms of arbitraging these

             4   opportunities.  But they are marginal in two important

             5   senses.

             6             Hedge funds will never be the dominant form of

             7   investment in a market.  Mark's fund will never put 90

             8   percent of its investment in what we would think of as a

             9   hedge fund that seeks to exploit mis-pricings in a market. 

            10   As hedge funds have grown, especially because the returns

            11   look attractive, we have to ask why these strategies have

            12   attracted money and how can they continue to attract money.

            13             Hedge funds -- their profits are driven by subtle

            14   and fleeting mis-pricings that are captured by really bright

            15   people working full-time to build sophisticated models to

            16   measure them.  And as such, they can't be sustained in a

            17   market like ours, which is relatively efficient.  

            18             So inevitably, hedge funds are going to -- in some

            19   sense, they contain the seeds of their own demise, especially

            20   strategies such as M&A arbitrage and convertible bond

            21   arbitrage where the returns have been a great challenge to

            22   sustain over the last few years.

            23             I think that's a good thing that this marginal

            24   force in the economy has been there to serve us and step in

            25   to support prices, step in to assert, if you will,





             1   intelligently developed models of what securities should be

             2   worth, but also it really shouldn't be considered a large and

             3   dominating factor in an investment portfolio.  So -- there

             4   are limits to scale is the point I guess I'm making.

             5             Now, the second sense of the marginality is

             6   something that we've also talked about today which is hedge

             7   funds being a marginal investor.  That is, the investor that

             8   effectively sets the price for a security and does so by

             9   committing capital to an opinion about what the security is

            10   worth.

            11             It's very helpful to have a marginal investor that

            12   is taking a stand with capital on a belief in the valuation

            13   of the security and that's quite helpful to us.  But as a

            14   marginal investor, if the investor steps back -- if it

            15   withdraws capital or has an abrupt change in the opinion of

            16   what the value of the security might be, then the price will

            17   change.

            18             So inevitably, as hedge funds have served us as

            19   marginal investors, they are bound to have some relationship

            20   to price fluctuations.  To the extent that they are trading

            21   on important information, they will always move in price and

            22   that can be helpful.  And the few cases where it will not be

            23   helpful are either if all the models are wrong at the same

            24   time and everybody is trading on an idea that is just not

            25   economically valid or if they're driven by expediency to





             1   withdraw capital from a market and -- an example, a credit

             2   crunch.

             3             So those are the two times when the marginal

             4   investor -- having these marginal investors can be a risk --

             5   systemic risk to the economy.

             6             MS. NAZARETH:  Thank you.

             7             MR. HEYMAN:  In discussing whether hedge funds make

             8   the market a more dangerous or less fair place for other

             9   investors, a couple people have alluded to the phenomenon

            10   that occasionally everybody gets on the same side of the

            11   boat.

            12             I think there's a limit to which government ought

            13   to worry about that; not that it shouldn't worry at all. 

            14   When I began in business, information basically seeped into

            15   the market on a very unequal and probably an unfair basis,

            16   and the result was less volatility and a better balance

            17   between people wanting to buy and people wanting to sell.

            18             In a fairer and more volatile world of instant

            19   news, it is inevitable that there will be many times in which

            20   everyone has the same opinion at once and there are quantum

            21   shifts in investor preferences.

            22             Government should not be concerned when that

            23   happens unless it happens with such magnitude that it

            24   threatens the systemic seizure and that is generally the

            25   result of really outsized exposures which had all parties had





             1   information, might not have happened.  In the case of long-

             2   term capital, what emerged -- and there really was a post

             3   mortem in the press.

             4             And in fact, in most large hedge fund blowups,

             5   there are post mortem in the press.  They may not have a

             6   uniform style but everyone ends up knowing what happened.  In

             7   long-term capital, credit was being extended by a number of

             8   regulated institutions.  I think few knew what the others

             9   were doing.  The firm itself was able to receive this credit

            10   without showing its own hand, something that probably

            11   couldn't happen today.

            12             So I think government's concern is legitimate at

            13   the boundaries but to the extent that people say hedge funds

            14   or any market participant make the market more volatile,

            15   unless there's some inequity to which one can point, I think

            16   government more or less has to watch that.

            17             MR. LO:  I'd just like to respond to a couple of

            18   those points.  The first is that I think volatility is a good

            19   thing.  I mean, in fact, typically when we teach about market

            20   efficiency we argue that having a market that's volatile

            21   means that there's a lot of price discovery information

            22   transmission going on.

            23             So the point is not to get rid of volatility.  I

            24   think that there's a distinction between market volatility

            25   and the systemic risks that are posed by very, very large





             1   catastrophic failures of a particular financial institution.

             2             While I agree with you that there was a very

             3   detailed post mortem, the President's working group on LTCM,

             4   the fact is that that working group didn't really generate

             5   any data for other people to study.  It generated a few

             6   recommendations, which were only recommendations.  And this

             7   was an unusual event that generated this kind of a post

             8   mortem.  There are lots of other events that I don't think

             9   generate nearly the amount of post mortem.

            10             Getting back to the NTSB example, I think one of

            11   the reasons that people are so keen to learn from every

            12   airplane crash is because the kind of information that we

            13   glean from it has been paid for by the lives of the people

            14   that are lost.  And if we take that analogy to the financial

            15   markets, many investors have given billions of dollars in

            16   lost capital for what?  I think what we'd like to be able to

            17   do is to learn from it.

            18             For example, while I think everybody is familiar

            19   with LTCM and the facts surrounding that case, how many

            20   people in the audience know the facts surrounding Laser

            21   Advisors, Gotham Investment Management, Haifuku, Paramount

            22   Partners?  Each one of these cases contains a lesson and some

            23   very important information for improving the financial system

            24   and it seems to me that we ought to spend some time focusing

            25   on those kinds of issues as well.





             1             MR. YUSKO:  Annette, one thing that -- I wish I had

             2   a dollar for every time long-term capital was used in the

             3   same sentence as hedge funds.  And it's very frustrating

             4   actually because actually I wouldn't have to work if that

             5   were true and mostly it's very frustrating because long-term

             6   capital was one of thousands of funds.  And it was -- if you

             7   actually go through the post mortem, 85 percent of the

             8   investors in long-term capital made money.  Only 15 percent

             9   lost money.

            10             Had they not given their equity capital back a

            11   couple months before the widening of the spreads based on a

            12   catastrophic event in Russian default, they would have been

            13   able to meet their margin call and we wouldn't be having this

            14   discussion.

            15             So I think there's this overemphasis, particularly

            16   in the financial press, on blowups which, if you actually

            17   calculate the number of mutual funds that have gone out of

            18   business since January 1, 2000, it's significantly, a

            19   multiple of the number of hedge funds that have gone out of

            20   business since January 1, 2000.

            21             So I think there is this negative bias placed

            22   around this industry that's really undeserved and if you keep

            23   focusing on that and keep marginalizing the other issues and

            24   the other risks -- for example, GE has been called the

            25   biggest hedge fund in the world.  Ford Motor Credit has





             1   issues.  GM Credit.  There are lots of big European insurance

             2   companies right now with much bigger prop books than most

             3   hedge funds that are in desperate need of capital or

             4   something bad is going to happen.  Japanese banking system,

             5   if we actually had the mark to market, what kind of mess

             6   would that create?

             7             So I think the size of this negative part of the

             8   hedge fund business gets a disproportionate amount of press

             9   and a disproportionate amount of commentary and I wish we

            10   could talk about the Lone Pines and the Blue Ridges and the

            11   Mavericks of the world instead of talking about long-term

            12   capital.

            13             COMMISSIONER GOLDSCHMID:  Annette, let me ask a

            14   question.  How important is leverage to the hedge fund

            15   strategy today, the various strategies?

            16             MS. NAZARETH:  Afsaneh?

            17             MR. BORISH:  I was going to mention another point

            18   but on the leverage -- I'm sure others have a lot to say. 

            19   Really, I think what Peter said earlier, there are so many

            20   different strategies -- there are some strategies when I was

            21   at the World Bank, for example -- you know, I traded hedge

            22   fund strategies myself which were totally unleveraged so you

            23   could be trading totally unleveraged.  

            24             You could have -- there is a fund today which has

            25   the same amount of leverage as long-term capital if you want





             1   to call it like, you know, 400 times, and fixed income.  But

             2   it is very, very strategy-specific and also in certain kinds

             3   of strategies it makes sense to have a certain level of

             4   leverage, once, two times, three times, and others where, you

             5   know, this particular fund says it's okay to have 400, 500

             6   times.

             7             Now, you know, we could debate that but essentially

             8   they're saying they're really not leveraged because

             9   everything is hedged against some other position.  The

            10   question is if something goes wrong in the documentation,

            11   something goes wrong in the swap documents, well, yeah, the

            12   systemic risk issues, which are really not hedge fund issues. 

            13   They are instrument related -- you know, that's a derivative

            14   issue but I'm sure others have a lot more to say on this and

            15   then maybe Annette will let me say something else.

            16             MS. NAZARETH:  You want to talk about the leverage

            17   and then we'll get back to Afsaneh?

            18             MR. BORISH:  I'd like to respond to three speakers

            19   briefly, if I might.  On leverage, it's very important to

            20   look at what you're leverage.  I believe that an unleveraged

            21   position in almost any dot com is more risky than a highly

            22   leveraged position, say, in an indexed arbitrage trade.

            23             Now, I also want to agree with Mark Yusko and

            24   disagree with Andrew Lo.  Too much emphasis is put on the

            25   failure.  If you look at stocks -- again, let's make the





             1   analogy with stocks.  Far -- even leaving aside WorldCom and

             2   Enron, far more money has been lost in stocks that have gone

             3   completely -- where everything has been lost, completely

             4   bankrupt, than in hedge fund failures.  Any hedge fund with

             5   the return profile of the NASDAQ 100 would be out of business

             6   today.  

             7             I also want to support Will Goetzmann where he said

             8   that hedge funds contain the seeds of their own destruction. 

             9   Empirically you can see this.  In the 1970s, a trained monkey

            10   who happened to know the Black Shoal's formula could have

            11   made a fortune betting on the mispriced options.

            12             (Laughter.)

            13             MR. BORISH:  A couple decades ago, anybody who bet

            14   that if a commodity goes up today it will go up tomorrow,

            15   would have been living on the beach today.  Another example

            16   is index arbitrage.  It's largely traded out.  Any of these

            17   strategies, very hard to make much money today because the

            18   hedge funds and others have traded out these inefficiencies. 

            19   Today you have to concentrate on much more difficult to find

            20   inefficiencies.

            21             MS. NAZARETH:  Afsaneh?

            22             MS. BESCHLOSS:  The other points I wanted to make

            23   related to some of the things Peter just said and others have

            24   said a little earlier.  And I think one thing that's actually

            25   interesting, we talked about risk, we talked about volatility





             1   today.  As Peter said earlier, volatility in many hedge fund

             2   strategies is actually lower at the hedge fund level and then

             3   if you take a fund to fund, which is diversified, even lower.

             4             So in fact if you look for investors at the risk --

             5   you know, they went into hedge funds with a certain

             6   understanding of how much risk they wanted to take overall in

             7   their portfolio.  In most cases, you'll find that that risk,

             8   if measured by volatility, is actually lower.  I think

             9   something that is going on, which is interesting in hedge

            10   fund industries, hedge fund managers themselves are measuring

            11   their own risks better but at the same time maybe becoming

            12   risk averse.  

            13             I mean, it's something that I would throw in this

            14   debate.  Are hedge fund managers taking the risks that they

            15   are paid to take?

            16             MR. BORISH:  They have their money.

            17             MS. BESCHLOSS:  Exactly.  They have their money, as

            18   Peter said, in there.  The other thing I think is that again,

            19   when we go sort of at the microlevel and we look at risk,

            20   you're really looking at -- when you're putting together a

            21   portfolio of traditional managers and hedge fund managers and

            22   how uncorrelated these hedge fund managers are to the rest of

            23   your portfolio, and at the end of the day, most of the

            24   portfolios I've been familiar with, hedge funds strategies

            25   have reduced risk by being uncorrelated to the stocks and





             1   bonds as Peter was saying.

             2             The other thing is, again, when we talk 6,000 hedge

             3   funds, and you asked are there lots of failures -- are they

             4   small failures, I go back again to Peter's example.  Just

             5   like with stocks, just like with really any other instrument,

             6   when we say 6,000, it's sort of a meaningless number because

             7   in that data there are a lot of people who come in and out

             8   with one or two million, they don't survive, they don't blow

             9   up, they don't destroy anyone else's money.  They just go in

            10   and out of that sample.

            11             And when I look at samples, it's more like a

            12   thousand -- you know -- between 500 and a thousand that you

            13   sort of take seriously in this industry and I think it goes

            14   back to the subject which is really being discussed yesterday

            15   and today.  Investors, especially I think when it gets to

            16   retail investors, do they really understand the risks and do

            17   they understand the strategies?  

            18             If you don't understand broadly what the strategies

            19   and broadly -- not in great detail -- what the risks are,

            20   should you be investing at the retail level, which goes back

            21   to the issue of whether you need to be the more sophisticated

            22   endowment or public pension fund or sophisticated individual

            23   to be able to invest in this.

            24             But I think the most important point at least for

            25   me is what Robert Steel said.  Coming back to the prime





             1   broker issue, at the end of the day, if we look at any

             2   systemic risk issue, you know, I think a lot of us in this

             3   room have gone through all the -- years and years of

             4   discussing systemic risks and derivatives.  I think there

             5   were all the committees, I was involved in them and at some

             6   point huge amounts of discussion went into systemic risks of

             7   derivatives and how they would block markets and we would,

             8   you know, all die.  

             9             (Laughter.)

            10             MS. BESCHLOSS:  And I think we're still alive.  But

            11   the issues go -- I think it would be interesting in the hedge

            12   fund industry to look at that issue of systemic risk as we

            13   studied it with regard to derivatives and I think when you

            14   come down to it, it was the banks who provided credit to,

            15   let's say, real estate.  Had we done a better job at looking

            16   at the risk at the level of prime brokers, I think the LTCM

            17   issue might have been handled slightly differently.

            18             So I would go back and say, number one, that maybe

            19   what we need to be doing, one is what level of government

            20   regulation you need but I think more importantly, what should

            21   the prime brokers be doing, singly, as individual prime

            22   brokers, jointly as a group.  

            23             And then I would add to that.  If we put a lot of

            24   extra regulation on U.S. prime brokers, what is that going to

            25   do?  The business will go offshore over which we have no





             1   control.  So if there is a way to have some sort of

             2   understanding with prime brokers groups not just with U.S.

             3   banks but across the board where this -- any kind of risk --

             4   hedge funds are really not particular -- where anything that

             5   we want to be looking at is controlled where it should be

             6   controlled and is aggregated where it should be aggregated.

             7             MR. BORISH:  If I could just have one point,

             8   talking about risk, most hedge fund documents have a self-

             9   preservation criteria in there which is if you lose 50

            10   percent of your capital, they close or they stop trading or

            11   they give the investors an opportunity to redeem their

            12   capital.

            13             So unlike a situation where if you buy a stock and

            14   you get paralyzed and you don't know what to do and you hold

            15   it and then it goes bankrupt or you lose everything, almost

            16   hedge fund document I know has a point at which if you lose

            17   money they stop trading.  And some it's 35, 40 percent but

            18   generally it's 50.

            19             CHAIRMAN DONALDSON:  Annette, I'd like to ask a

            20   general question of this particular panel, and it goes

            21   something like this.  There are, as we all know, well

            22   advertised figure of $600 billion of hedge fund money out

            23   there.  You just have to sit here for a few hours and listen

            24   to all the knowledge that is resident and the people that

            25   have been talking about it.





             1             My question is there's a cost-benefit analysis from

             2   the point of view of the SEC as to how much cost do we

             3   possibly incur to the hedge fund industry in order to deliver

             4   for us the right to go in and continually monitor and follow. 

             5   Is it worth it?  How much cost are we willing to put onto

             6   this industry, to a $600 billion industry, in order for us to

             7   be able to have the right to go in and continually monitor

             8   it?  

             9             Is there any view on this?  Can this industry

            10   sustain the cost in order for the greater good of the public

            11   knowledge base of this agency?

            12             MR. BROWN:  I have one brief comment.  I believe

            13   that the SEC and regulators benefit enormously.  If you just

            14   look at what hedge funds pay in Section 31 fees, it dwarfs

            15   the cost of the regulation.  So I think the SEC and the

            16   government is coming out way ahead on a cost-benefit

            17   analysis.

            18             (Laughter.)

            19             MR. GOETZMANN:  I'd be happy to answer that since I

            20   have nothing at stake whatsoever in this issue except as a

            21   taxpayer.  I think that the process is underway now of

            22   generating information and costly information but that

            23   process is being separated.  The big funds are doing one

            24   thing and the small funds are not doing it.

            25             And the process involves increasing auditing of the





             1   procedures.  You know, we talked a little bit about blowups

             2   and how safe the hedge fund industry really is, but most of

             3   the blowups in the hedge fund industry have been operational

             4   catastrophes that probably would have been avoided had there

             5   been more auditor attention and auditor ability to

             6   investigate the procedures for trading that were used.

             7             So I think that that's money well spent.  And it

             8   may not be money that -- it's certainly money that the major

             9   hedge funds are investing in at this point, not just in terms

            10   of engaging auditors and in seeking to comply with the

            11   requests but also developing statistical systems, however

            12   imperfect, to try and gauge their own measures of risk.

            13             So I think that one of the dangers for the SEC is

            14   that you would achieve rapid and total transparency and you

            15   would have truckloads of paper being backed up to the doors

            16   here full of all the trades and so forth, so it's a cost both

            17   ways, not just for the funds but for us to go through and try

            18   to reconstruct the activities.

            19             But relying on this intermediary, the accounting

            20   profession to provide some risk control measures without

            21   disclosure of strategies to the public I think is a helpful

            22   direction to go in.

            23             COMMISSIONER CAMPOS:  Moreover, we were told

            24   yesterday that 70 percent of hedge fund managers are already

            25   registered investment advisors so we already have a large





             1   stake, apparently.  Granted, that doesn't give us all the

             2   compliance and examination that we might otherwise but it

             3   seems to me we as an agency are already well into that and we

             4   were told that that's attractive to be a registered

             5   investment advisor if you want institutional moneys as a

             6   manager.

             7             So there's already an economic incentive at least

             8   to exceed and to allow a certain amount of regulation.

             9             Now, I have another question if we're in a position

            10   to go forward on that, and we can come back to it.

            11             It seems to me that -- we've had a tremendously

            12   sophisticated discussion about risk and alphas and betas and

            13   the moving -- the opportunity costs and all that.  And then

            14   there seems to be a gee, you know, sort of patting ourselves

            15   on the back where we're the smart people of the world and

            16   it's really difficult for those out there on Main Street to

            17   understand risk and understand how complicated all this is.

            18             And, you know, it's easy to do that when we get

            19   together with highly educated people and people who

            20   understand their professions that well.  But I ask myself --

            21   and in terms of the risk aspects of it, how clear is it to

            22   the retail investor the risk that they're taking when they go

            23   long and naked without any amount of -- I mean, is that risk

            24   being appropriately communicated and indicated to people?

            25             And instead, what we have is we seem to have a two





             1   class system.  We seem to have those who have access to your

             2   intelligence, your professional research and so forth, who at

             3   least hedge or have hedged situations as was said a minute

             4   ago.  And we have the retail public that doesn't seem to have

             5   access to these sorts of strategies, whether it be through

             6   your industry or through existing mutual fund industry.

             7             So, as an agency, should we care about that?  I

             8   mean, is it simply a caveat emptor world, and let the guy who

             9   doesn't know any better be long on a big cap fund and

            10   whatever happens happens?  And even if they apply the

            11   existing mantras of diversification in these last three

            12   years, they're still going to lose because, you know, they're

            13   30 percent in equities and you're 70 percent in fixed income

            14   and you're losing 30 percent in your equities, you're not

            15   going to make money, you know.  

            16             And then there's a time cycle.  There's not enough

            17   time for some of these people to come back and ride whenever

            18   the next bull market comes.

            19             MR. HEYMAN:  Can I try that one?  First, whether

            20   it's clear to -- whether the risks of going along are clear

            21   to retail investors, I'm sure they're a lot clearer than they

            22   were a few years ago.

            23             (Laughter.)

            24             MR. HEYMAN:  With respect to the second question, I

            25   think it's a very simple question to the debate before this





             1   two-day session.  Certainly hedge fund strategies, again,

             2   generalizing, over the last four or five years in which a lot

             3   of equity values were destroyed, delivered on a significant

             4   part of their promise and that was the promise that they

             5   could preserve capital in poor climates for financial assets.

             6             Obviously, some in the industry would support going

             7   in the direction of raising the bar in terms of

             8   qualifications of investments as a tradeoff against less

             9   regulation.  On the other hand, that does have the effect of

            10   government saying to investors who can't meet that bar, the

            11   new bar or the previous bar, that we're going to make it more

            12   difficult or perhaps even impossible for you to accomplish

            13   something that would have provided you with great protection.

            14             Now, who knows going forward how true any of that

            15   will be?  We always fight the last war but in terms of

            16   equity, for the conclusion to be reached that the solution --

            17   if there's a problem that needs a solution, which can be

            18   debated -- is to simply prevent hedge fund strategies from

            19   being accessible at lower ends of the food chain is probably

            20   not a fair result.

            21             MR. ROYE:  I couldn't agree more.  In fact, this is

            22   one of the central issues that we think about all the time

            23   and we've been approached by our alumni, by others who look

            24   at the performance of the fund, particularly the low

            25   volatility of the fund are attracted to it.  





             1             And I hope that this is not too offensive to too

             2   many wealthy people but wealth is not an indicator of

             3   investment intelligence.  Usually that wealth was created in

             4   many other capacities and I find it very frustrating as an

             5   individual investor who just barely made it to qualified

             6   status a couple years ago --

             7             (Laughter.)

             8             MR. HEYMAN:  Still there?

             9             MR. ROYE:  Yeah, still there.  Cash.  Cash is a

            10   good thing.

            11             (Laughter.)

            12             MR. ROYE:  And it's been very frustrating to watch

            13   the best strategies, the best managers, who have migrated out

            14   of the traditional world.  Real story.  Group at Putnam,

            15   Putnam International Voyager, had an investment in there, in

            16   a 403(b), was doing great.  Last August it started to go

            17   down, didn't think much of it, everything was going down.  

            18             So I met these two guys at a hedge fund conference

            19   in January and we got chatting and they talked about what

            20   they were doing, starting a hedge fund and where were you,

            21   we're at Putnam, well, what did you manage?  We managed the

            22   Putnam International Voyager Fund.  When did you leave?  In

            23   August.  Who replaced you?  A 29-year-old that had worked for

            24   them for a couple years.  And nothing against 29-year-olds; I

            25   was one not too long ago.





             1             (Laughter.)

             2             MR. ROYE:  It really does matter to me, I think,

             3   that the perception of risk has blocked access to the people

             4   who need it most.  The perception was if you had a lot of

             5   money, you could afford to be in risky strategies where

             6   there's risk of loss.  What I think we've seen now in the

             7   bear market is that it's the exact opposite.  If you don't

             8   have time to get that money back, that you're in real

             9   trouble.

            10             And making these strategies accessible to others I

            11   think will be very, very positive.  In fact, if you look at

            12   Richard Thayler's work, the problem in investing,

            13   particularly in the defined contribution area which is

            14   another whole bottle of worms or can of worms I don't want to

            15   open up too much, but it's awful.  

            16             If there are seven options in your 401(k) or

            17   403(b), five are stock and two are bond.  The average

            18   investor will have five-sevenths in stocks and two-sevenths

            19   in bonds.  If it's five bond and two stocks, they'll have

            20   five-sevenths in bonds.  And the elections they make on the

            21   day they sign up in the HR office with nobody giving them any

            22   advice are the same options they'll have forever.  They don't

            23   change.

            24             So if you could have an arbitrage strategy which is

            25   lower volatility, if you could have a long/short strategy





             1   which is going to provide good upside in good markets and

             2   protection in down markets, you'll decrease the volatility of

             3   the overall portfolio.

             4             And there's a great slide that I use with all of

             5   our constitutes which shows that if you took the return on

             6   the market of the last 30 years, about 13.2 percent, with 16

             7   percent volatility, it turns a dollar into about four-and-a-

             8   half dollars.

             9             If you just reduce the volatility, don't increase

            10   the return but take that volatility from 16 down to 8, you

            11   end up with 7 in cumulative wealth.  The reduction of

            12   volatility is what matters, not increasing return.  And these

            13   strategies are all about getting rich slowly and compounding

            14   wealth.  So pushing that down as far as we can get it,

            15   particularly because of the diversification benefits of a

            16   thing like a fund to funds I think is critical.

            17             MS. NAZARETH:  Jim, do you have a comment?

            18             MR. CHANOS:  Yeah.  I'd like to interject into this

            19   argument the observation from my vantage point, running a

            20   fund primarily from the short side gives a sort of unique

            21   perspective to see people who are coming in to try to hedge

            22   their portfolios.

            23             And what I could respond to Commissioner Campos's

            24   question, it really is almost a blunt answer but investors

            25   almost, no matter what their sophistication, chase returns. 





             1   That has been our experience.  We can talk a lot about risk

             2   management, lowered volatility.  I've seen it all and heard

             3   it all from investors coming into my shop for 20 years.

             4             But they chase returns and they will justify

             5   putting money with you based on whatever model they want to

             6   use.  And I think to some extent retail investors have chased

             7   returns more than perhaps more sophisticated investors, but

             8   I've seen a lot of bonehead moves from sophisticated

             9   investors at the top and bottoms of markets from our

            10   perspective.  So we're not going to save people from

            11   themselves when fear and greed run rampant at various market

            12   turning points.

            13             Having said that, we recently have seen a number of

            14   mutual fund companies come into our shop and talk to us about

            15   partnering up, perhaps doing a joint venture.  And I think

            16   the interest is there and growing now to try to avail

            17   themselves to various different techniques to hedge

            18   portfolios.  I'm not so sure it's going to be successful.

            19             My sense is that one of their concerns is the PR

            20   factor, for example, of taking short positions.  We haven't

            21   touched upon that in this panel yet but, you know, there are

            22   some uneconomic arguments that people make about

            23   shortselling, whether it's index arbitrage, whether it's

            24   directional shortselling, whether it's fundamental

            25   shortselling, that I think is keeping back some people in the





             1   mutual funds complex from aggressively pursuing this or

             2   rolling out products that are hedged.  And maybe rightly so. 

             3   I don't know.  We haven't discussed it yet.

             4             But the point is that I think that intellectually

             5   there is a sense afoot in that community that it needs to do

             6   more and perhaps should do more with different strategies.  I

             7   think it's just beginning, however, and they're a little

             8   uncertain.

             9             MS. NAZARETH:  Mike?

            10             MR. LO:  I just want to follow up on a couple of

            11   comments that Mark made.  I think it was a few years ago that

            12   the former Treasury Secretary, Larry Summers, was giving a

            13   lecture and somebody in the audience said if you're so smart,

            14   how come you're not rich?  And Larry retorted in his usual

            15   way, if you're so rich, how come you're not smart?

            16             (Laughter.)

            17             MR. LO:  And I think that -- so I would agree with

            18   Mark that there really -- there isn't necessarily a

            19   correlation between having a high net worth and having

            20   investment intelligence.  But the reason that high net worth

            21   is part of the qualified investor's criterion is because if

            22   you have a high net worth you can afford to lose a fair

            23   amount of money.

            24             So I guess what I would suggest, getting back to

            25   Commissioner Campos's point, is that in changing the





             1   suitability requirements, we might consider, in addition to

             2   the high net worth criterion, to have some kind of an

             3   educational criterion where investor education is I think the

             4   ultimate answer.

             5             I agree that it's important to have these kinds of

             6   hedged products available to individuals, particularly for

             7   retirement planning and building long-term wealth a little

             8   bit at a time is exactly the right thing to do but getting

             9   individual investors to do that and to feel good about doing

            10   that is a very difficult task where investor education I

            11   think comes in.  So I think that's a really important issue.

            12             MR. HARRIS:  There's no question that there's an

            13   element of paternalism associated with the qualified investor

            14   status and that raises some philosophic problems.  On the one

            15   hand we say that, gee, who are we to be paternal?  Let people

            16   decide for themselves and they'll learn.  On the other hand,

            17   the history of this agency is one that P.T. Barnum would have

            18   appreciated.  Our commissioners every day, or twice or three

            19   times a week, sit in enforcement meetings hearing cases of

            20   situations that Jesse Livermore recognized from the turn of

            21   the century.

            22             How do we reconcile that?  One way to reconcile is

            23   to recognize that learning is very expensive and if we're to

            24   say that people can go out and learn by themselves from

            25   experience, that that's all we need to properly regulate the





             1   market, so they get burned once, that's fine, that runs

             2   counter to the notion that, gee, after you've learned, at

             3   some point you're going to end up dying and your children are

             4   not going to figure this out except by themselves.

             5             And so I think there is some room for -- I don't

             6   want to use the word paternalism but for benevolent care to

             7   recognize that the cost of learning is very high.  Now,

             8   Andy's suggestion is very good but we want to do everything

             9   we can to lower the cost of learning.

            10             Let me give you an example of a very simple

            11   situation that comes up in hedge funds that requires a fair

            12   amount of sophistication to understand and folks that are

            13   chasing returns, as Jim suggested, are not likely to have it. 

            14   So here's a problem that we learned yesterday.

            15             We learned yesterday that the management and

            16   contract in hedge funds is extremely important for aligning

            17   people's interest.  It rewards them for performing well. 

            18   There's 20 percent.

            19             Many of you know -- and if you don't, you do need

            20   to know this -- that if the manager of the hedge fund doesn't

            21   have his own finger in the guillotine in the presence of

            22   these contracts -- by finger in the guillotine I mean co-

            23   participation -- that the optimal strategy for the manager,

            24   who is not particularly concerned about the -- running down

            25   their reputation -- the optimal strategy is to take as much





             1   leverage possible because leverage produces volatility and

             2   volatility gives you a 50/50 chance with these compensation

             3   contracts of getting extraordinarily rich or walking away a

             4   loser.

             5             Now, if you're in a business that P.T. Barnum

             6   recognizes and understands that there's a sucker born every

             7   minute and that people will not be able to follow your

             8   reputation if you're a good marketing person, then what we've

             9   created is a situation that's very, very unattractive.  So

            10   the important message that people need to know is that it's

            11   not acceptable to have these types of management contracts

            12   without the co-participation.

            13             So that was explained very clearly yesterday, but I

            14   venture to say that if you grab people at random among the

            15   investing population, very few people will first of all

            16   recognize that the management contract will get us fantastic

            17   incentives to take leverage to increase volatility in the

            18   absence of the co-participation and that -- and very few

            19   people -- even if they recognize that, very few people will

            20   recognize the importance of co-participation. 

            21             So we have to educate people to this issue.  But in

            22   the end, we get back to the fact that as cheap as we make

            23   education, it's still very expensive and do we want to live

            24   in a world where we can allow a fringe to develop where

            25   people who have great marketing skills can have access to a





             1   sucker who is born every minute.  And those are the types of

             2   issues that the Commission undoubtedly will consider.

             3             MS. NAZARETH:  Harvey, did you have a comment?

             4             COMMISSIONER GOLDSCHMID:  Yeah, I -- following up

             5   on that a bit, though, enlarging it, one concern about risk

             6   for me in this area is the premise of hedge funds, if I

             7   understand them, the unifying premise is to find market mis-

             8   pricing, there have got to be only a limited number of

             9   targets of opportunity.

            10             As the Chairman indicated, as you've grown to 600

            11   billion with maybe more coming, the targets of opportunity

            12   have got to be limited, and is there risk that you're going

            13   to reach too far in order to keep producing numbers you've

            14   produced in a world where you just won't have the

            15   opportunities out there?

            16             MS. NAZARETH:  Peter, do you have an answer?

            17             MR. BORISH:  Well, one point when people talk about

            18   the growth of assets, and if you look at the relative amount

            19   of assets in the hedge fund world relative to the long only

            20   world and you look at targets of opportunity, you can make

            21   the same argument that part of the reason was that there was

            22   so much money coming into the long only strategy that there

            23   was very few targets of opportunities and they were trying to

            24   put a lot of money into that funnel.

            25             So I find that over time growth in almost every





             1   strategy continues to take place and that you will have good

             2   managers and you will have bad managers, and that certain

             3   strategies, as arbitrage and technology becomes more

             4   efficient, the mean return will decline and that will

             5   naturally take assets out of that strategy and move it into

             6   another strategy.

             7             But I think as the U.S. economy continues to grow

             8   and the long only strategies continue to grow and fixed

             9   income grows and real estate, there's much, much more

            10   opportunity for this realm to grow as well.  It's only a

            11   problem if this area grows and every other area does not.

            12             MR. HARRIS:  Commissioner Goldschmid, the profits

            13   that the hedge fund industry can make are limited as you

            14   mentioned.  They come from two sources.  The first source is

            15   the profits that they can make as well-informed speculators. 

            16   Those profits are determined by the mistakes that other

            17   speculators and investors make and by the demands that other

            18   people make on liquidity.  And those are finite and of course

            19   those are decreasing as people become better educated.  The

            20   good news for the hedge fund managers again are that there

            21   are new people in the market all the time who are not as well

            22   educated.

            23             They are also limited by the extent to which people

            24   can fall into bad products, as I just described, and

            25   hopefully want to limit it.





             1             The Chairman asked what's the capacity of this

             2   industry for carrying regulation and the answer is given that

             3   the -- if you ignore the profits that are associated with

             4   exploiting foolish people and only look at the profits

             5   associated with the stated line of business, any costs

             6   imposed upon this industry will reduce those profits because

             7   they're finite and they're limited.  

             8             And the reduction of those profits ultimately will

             9   have some impact, not necessarily measurable or identifiable,

            10   on market efficiency.  And so we weigh those costs against --

            11   in doing the cost benefit analysis, we'll weigh those costs

            12   against the benefits of trying to -- of taking a paternal

            13   line in some sense for investors and also possibly the

            14   benefits associated with systematic risks, of which frankly

            15   I'm not particularly concerned but I do think that we do have

            16   to pay close attention to them.

            17             MS. NAZARETH:  Bill?

            18             MR. HEYMAN:  If I may, your question may be even

            19   more pertinent than you know, although the answer may not be

            20   a matter for regulatory notice.

            21             There was a recent piece written by Steven

            22   Galbraith at Morgan Stanley, with which I have no

            23   affiliation, in which he gave the results of a study of the

            24   performance of equities over the last four or five years. 

            25   And he concluded that in the last year or so, the difference





             1   between the best performing equities and the mean and the

             2   worst performing equities and the mean had narrowed.  And it

             3   is that difference which is the alpha that all these

             4   long/short funds, which are the principal new entrants into

             5   the field, is seeking to capture.

             6             So there is a phenomenon out there with a

             7   geometrically increasing number of participants with more and

             8   more capital trying to capture a pie of alpha, which appears

             9   form all statistical evidence to be shrinking.  I don't know

            10   whether -- that may be a market condition that government

            11   simply can't recognize, but it is out there.

            12             COMMISSIONER GOLDSCHMID:  I take it one way of

            13   trying to keep up in this world would be to leverage and that

            14   may create its own problems.

            15             MR. HEYMAN:  That's possible.

            16             MS. NAZARETH:  I'd like to ask one more question on

            17   risk, following up on a number of points that people made and

            18   then, if possible, quickly move on to short selling because I

            19   know that's always of great interest.

            20             Again, following up on a number of thoughts, we've

            21   talked about managing both individual counter-party exposures

            22   as well as concerns about systemic risk and it seems to me

            23   that there were a couple of points made.  

            24             One was Afsaneh's suggestion that there's an

            25   importance in having gatekeepers such as prime brokers, which





             1   I'm sure Bob could talk about, they have the window of

             2   knowledge with respect to what these hedge funds are doing

             3   and what role can they play in ensuring some market integrity

             4   here.

             5             And also, the Chairman asked about the greater

             6   regulation -- some have suggested that simply greater

             7   transparency of some sort may again be better for the

             8   markets.  Others have suggested that that again could inhibit

             9   the ability of hedge funds to effectively trade.

            10             So I'd like people to if you can quickly address

            11   those issues.  Bob, do you want to address the prime

            12   brokerage question?

            13             MR. STEEL:  Sure, I can start and I think maybe

            14   some of my comments will reflect on some of the questions

            15   you've raised because it plugs in.  And when we think about

            16   the prime brokerage business, we're in the business of

            17   lending money and -- keeping securities and lending money

            18   against securities to finance people's strategies.

            19             I think to ask about the leverage -- we watch that

            20   all the time.  We look at aggregate numbers which are

            21   interesting but not very informative, to be honest, because

            22   you have to drill down and look at each strategy.  The

            23   current descriptors would suggest that people are not very

            24   leveraged today and I think that's in part consistent with

            25   the description that you made, that opportunities are not





             1   very robust right now.

             2             But when we think about it, we really go through

             3   three screens, if you will.  The first is really a business

             4   issue.  Do we know the people, do we understand their

             5   business model, do we like their documents, do they have the

             6   right auditors and things like that.  And so that's really

             7   done at one business selection model because we choose who

             8   we'll take prime broker and we choose who we won't just as

             9   we're taking them on to lend them money.

            10             The second really is at a supra level from the top

            11   of the firm where we have our credit people look at it and

            12   watch it at the macro level all the time, and then we go down

            13   to the day-to-day risk management applying margin that gets

            14   individual positions.  We only lend against positions we have

            15   in-house.

            16             We try our best to make sure we're watching all

            17   their positions to the best of our ability, and then as

            18   Andrew pointed out when he ran through the array of the four

            19   firms that have had challenges, in one of those we were very

            20   involved and it's a matter of managing through a process as

            21   it became apparent to us that the partnership had

            22   concentrated positions and as a result of moves in those

            23   concentrated positions, then we basically tried to manage

            24   through what I would describe as a lending business the

            25   recollection and repossession of collateral so as to let the





             1   air out slowly and manage the situation so as to protect

             2   ourselves as the person that was lending in that case.

             3             I think that the system seems to work well from our

             4   perspective.  We watch this business.  Our losses would be an

             5   expense against our revenue and, to be honest, if we were not

             6   good at the lending part of it, we could quickly wipe out the

             7   revenues that we receive given the amount of leverage there

             8   is in the system if there's any leverage like anything when

             9   you're lending against the principal in relatively large

            10   amounts.  So that's how we think about it.  

            11             I think an issue raised that you have to be careful

            12   about -- and I'm sorry I forgot who made the point -- is that

            13   this group of people, the most portable asset in the world is

            14   cash and these people can choose to organize in all kinds of

            15   places and so excessive regulation or requirements which you

            16   talk about, this balance, the price of regulation versus the

            17   benefit, that if the expense of regulation becomes too great

            18   relative to reducing opportunities, then I think you'll see

            19   people seek other locations or jurisdictions which would be

            20   not good and not a good outcome, either, to be honest, in my

            21   thinking.

            22             MS. NAZARETH:  Thank you.  Does anybody else want

            23   to address the question of additional transparency either

            24   through position reporting or some sort of risk reporting? 

            25   Afsaneh, you had mentioned it earlier.  Do you have specific





             1   thoughts on where additional transparency might help?

             2             MS. BESCHLOSS:  I think it goes back to sort of the

             3   point we discussed in the beginning of the session which is

             4   for different strategies, you can obtain different levels of

             5   risk transparency and it will not affect the business.  There

             6   are some strategies for which you can get detailed levels of

             7   transparency and it will not affect that business.  There are

             8   other strategies whereby insisting on getting position level

             9   on a realtime basis, you could affect that business, in

            10   effect.  

            11             So I think you need to be realistic about it if you

            12   want to continue making money out of the strategies and

            13   essentially have a two-pronged approach, for instance, where

            14   you just get exposure level transparency and look at what you

            15   need to do in terms of what are your minimum requirements as

            16   an investor or as any other player in the market and others

            17   where there's not a problem in getting position level and

            18   where the hedge funds do not have that level of sensitivity.

            19             I think the other thing is really educating the

            20   hedge fund managers in the sense that I think it's a process

            21   by which many hedge fund managers, when they realize who is

            22   using the information, who has access to the information,

            23   what they're going to do with that information, if there is a

            24   way to protect them against misusing that information, you

            25   can get a lot more transparency a lot more easily.





             1             MS. NAZARETH:  Andrew?

             2             MR. LO:  Well, I guess in the interest of full

             3   disclosure let me mention that in addition to being an

             4   academic, I'm also a principal in a hedge fund and so I have

             5   an interest in seeing this industry grow and prosper.  but I

             6   think that the way to do it, the way to create sustainable

             7   growth -- and I do think that the hedge fund industry is

             8   poised for some spectacular growth given the interest by

             9   institutional investors and possibly retail investors -- the

            10   way to create sustainable growth is to provide additional

            11   disclosure and transparency but not position transparency.

            12             I think that's a very important distinction.  I

            13   think several other panelists mentioned that providing

            14   position transparency will all but eliminate the value that

            15   hedge fund managers bring to the process.  Instead, what I

            16   think is necessary is risk transparency; that is, being able

            17   to provide specific risk statistics to investors so that they

            18   can interpret the risk.  

            19             In fact, I would argue this is sort of the best of

            20   all possible worlds in the sense that managers don't want to

            21   give out positions and frankly, investors can't possibly make

            22   use of all these positions.  They wouldn't know how to

            23   interpret it and particularly for the very active hedge

            24   funds, positions on a monthly basis will tell you very little

            25   about the risks that are going on in the fund.





             1             What I think is necessary is a number of risk

             2   statistics that would provide investors with the kind of

             3   comfort that they're getting into exactly what they expect in

             4   terms of the risks that they are willing and able and

             5   interested in taking on.

             6             MR. YUSKO:  And Annette, I think that the biggest

             7   issue really is in any business, the business spends money to

             8   create proprietary capital, whether it's proprietary capital

             9   in the manufacturing process.  We don't require Coca-Cola to

            10   give away the secret formula.  We don't require a mutual fund

            11   to give away the internal research that they do.

            12             Edge or proprietary information is what

            13   incentivizes these groups to stay small, to keep their money

            14   invested side by side.  The thing that makes me the most

            15   happy is the bulk of our assets are invested where the

            16   principal wakes up everyday and more than 100 percent of his

            17   net worth is invested next to mine.  In the mutual fund

            18   industry, we're lucky if $10,000 is invested of their own

            19   money in a $20 billion fund.

            20             So forcing someone to give away that proprietary

            21   research I think is a terrible idea.

            22             MS. NAZARETH:  Again, we are running out of time

            23   but since there's always a lot of interest in short selling,

            24   I thought that we would turn to that for a minute.

            25             Obviously, we discussed the fact that hedge funds





             1   often employ the technique of short selling and, among other

             2   things, there certainly have been concerns raised in the past

             3   about the possibility of manipulative activity with short

             4   selling and I don't think that that would necessarily be

             5   exclusive to hedge funds.

             6             But I wanted to discuss in general or have some of

             7   you talk to us a bit more about the short selling strategies,

             8   are they market neutral, are they aggressive, you know, the

             9   concerns over manipulation and the like.

            10             Jim, would you start us off?

            11             MR. CHANOS:  I'll take a stab at it, Annette. 

            12   First of all, the concerns about manipulative activities as

            13   it relates to short selling, I'm always a little confused

            14   about that because short sellers operate with the same rules

            15   and, as I mentioned, actually some extra rules that other

            16   investors don't have.  But let's be clear on an issue, that

            17   anyone engaging in behavior in which he or she is purchasing

            18   or selling stocks, inducing others to do the same or

            19   disseminating information on a basis where that information

            20   is known to be false is subject to action, whether you're a

            21   bull, a bear, a long or a short.

            22             I'd like to say end of story because I know it's

            23   emotionally more charged than that, but in fact that is the

            24   case.  And I know from a practice point of view, not only do

            25   short sellers deal with the so-called uptick rule, but it's





             1   monitored very, very closely on a realtime basis.  

             2             When our traders enter an order on the short side,

             3   the broker on the other end of the phone immediately asks a

             4   series of questions.  Have you borrowed the shares?  It's

             5   then verified.  Is this a short sale subject to the uptick

             6   rule?  Yes, it is.  And then following, if the trade is

             7   executed, you have a whole series of follow-on procedures the

             8   very next day to reconfirm all these issues.

             9             So it is very, very difficult in realtime to do

            10   this.  And I know the secondary concern is amongst issuers,

            11   primarily, and market participants, are short sellers, to

            12   further their interests, issuing false reports and trading in

            13   front of them, concurrent with them and -- and if they are,

            14   and if those reports are knowingly false, it's actionable. 

            15   We have rules, regulations and laws against that.  As I say,

            16   these things tend to be a little bit more emotionally charged

            17   during and at the end of bear markets when people have lost a

            18   lot of money and are looking around for reasons as to why

            19   they lost money.

            20             But if we look at the actors on the stage of say

            21   the last 6 years, when I -- may I just make an observation

            22   that if we were looking for wrongdoers or knaves, if you

            23   will, in the investment world, I think you'd be hard pressed

            24   to put short sellers in that group in the past handful of

            25   years based on what's happened.  





             1             In fact, a lot of the more interesting work that

             2   was done in the marketplace, some of the price discovery

             3   mechanism that we talked about academically, was done by

             4   people on the short side and in the hedge fund community,

             5   things like Enron, Tyco, WorldCom.  I could go on and on and

             6   on with situations the short sellers were talking about for

             7   many cases months or years before the problems became very

             8   apparent to the marketplace.

             9             So it's not something I think you want to quash in

            10   a zeal to regulate this part of the marketplace that is

            11   already pretty heavily regulated.

            12             MR. YUSKO:  Just one issue.  Is there a difference

            13   between a report issued by someone who is short in a stock

            14   and having people react to that?  One of my questions is why

            15   would anyone react to an unnamed source that they read in a

            16   chatroom or get over the Internet?  Consider the source is

            17   always a really good thing to do before you act on something,

            18   yet plenty of investors make investment decisions based on

            19   information that they have no idea where it came from.

            20             But the second thing is, is that action any

            21   different than the very common practice of people who take a

            22   13(d) filing, it gets announced, it's in Barron's, and then

            23   they're selling into it on the other side?  That happens in

            24   the long business all the time where there's a lot of press

            25   about you have a large position, you had the large position





             1   because you made money in it over time and now it's time to

             2   sell because it's overvalued.  You can't help that you have

             3   that press.  You didn't intend to have that press but it

             4   happened.

             5             So I don't see that being any different, and we

             6   don't regulate that side.

             7             MR. HARRIS:  Issuers don't like short selling

             8   because it tends to lower their stock prices.

             9             (Laughter.)

            10             MR. HARRIS:  That of course raises their cost of

            11   capital and may also decrease the compensation of the chief

            12   executives.  Owen LaMont in Chicago did a study of what

            13   happened to stock prices of firms a year after the first time

            14   they complained about short selling.  So he looked at the

            15   newspapers and got a record of the first complaint by issuers

            16   of short selling in their stock and then went a full year

            17   after that to see what had happened to stock prices between

            18   that date and the year later date, and found that stock

            19   prices had dropped by 25 percent.

            20             That suggests to me that -- since we know that the

            21   markets generally are pretty information efficient -- pretty

            22   informative, it suggests that those stocks were overvalued

            23   for who knows what reason, but if those stocks were

            24   overvalued, perhaps it's because management wasn't doing a

            25   good job and people didn't recognize it.  Upon recognizing





             1   it, their cost to capital increased.

             2             It's appropriate that the cost to capital for those

             3   firms increased.  Apparently their business opportunities --

             4   either their ideas weren't good enough or their management

             5   wasn't good enough.  On average, those business opportunities

             6   didn't warrant the flow of new capital.  

             7             And that's the whole purpose of having informative

             8   prices, is that it ensures that capital flows to the best

             9   ideas and that to the extent that we use stock prices to

            10   motivate managers, it ensures that managers are compensated

            11   for doing good and that directors are given very clear

            12   signals for getting rid of managers who can't do well.

            13             While undoubtedly there will be some manipulation,

            14   our efforts to regulate short selling to prevent their

            15   manipulations have an unsavory impact upon the other type of

            16   manipulation, which is the pump and dump.  By regulating

            17   short selling and making it difficult, we make it difficult

            18   for well-informed traders to take the opposite side when 

            19   people are trying to push up prices in ways that can equally

            20   well hurt investors.

            21             And in fact, it's far more likely that the people

            22   who are hurt in the markets are going to be on the long side

            23   than on the short side.  The reason being is that it's much

            24   easier to fool people to jumping into a stock on the long

            25   side than to convince them to take a short position or to





             1   sell a position they already have in the stock if you're

             2   trying to do a bear manipulation.  

             3             The reason, of course, is that to convince people

             4   to join, you can get anybody to join a manipulation on the

             5   long side but to get people to sell, they have to be short

             6   sellers and everybody knows that's extremely difficult, most

             7   people don't understand it, they're afraid of it and many

             8   people aren't even qualified to do it.  I mean, literally,

             9   their brokers won't let them do it.

            10             And of course, the people in the stock -- it's hard

            11   to get people in the stock to sell because, after all, they

            12   believe in the stock; that's why they bought it.  And if

            13   you're trying to get people in the stock to buy more, that's

            14   pretty easy because of course they already believe in it.  So

            15   the further regulation of short selling only disadvantages 

            16   our efforts to put a cap on pump and dump manipulations, all

            17   of this in the name of preventing bear rates, which we should

            18   try to do so but in fact we have mechanisms already to

            19   protect against those.

            20             MS. NAZARETH:  Peter Brown.

            21             MR. BROWN:  I don't believe that short selling

            22   drives stocks down.  There is the initial impact of the sale

            23   which will drive the stock down but beyond that, I don't

            24   believe it drives it down any further.

            25             We have about 75 Ph.D.s in math and physics who





             1   looked at a very detailed models of the market and we take it

             2   as axiomatic that you just cannot wring the market in that

             3   way.

             4             Secondly, one thing that people miss is that they

             5   think all the short selling is driving the market down but in

             6   order to recognize a profit on a short sale, you have to buy

             7   the stock back.  So the net result is you have as much buying

             8   as selling.  

             9             Thirdly, by inhibiting short selling, you're going

            10   got end up with stocks being slightly overpriced.  And as

            11   Larry just said, this is just as bad for an investor as being

            12   underpriced because it means when my mother goes to buy a

            13   stock, she's going to pay too much for it and later lose

            14   money.

            15             So I think that inhibiting short selling is very

            16   bad for the markets.

            17             MR. GOETZMANN:  Just a brief sort of historical

            18   view and geographical view.  The Amsterdam Stock Exchange

            19   opened in about 1607 and 1609 was the first short sale

            20   scandal and 1610 was the first constraint on short sales. 

            21   This is a very old question.

            22             (Laughter.)

            23             MR. GOETZMANN:  And so one way to approach this

            24   that in fact was inspired by Owen LaMont's work was to take a

            25   look at the short sales constraints all around the world and





             1   ask a question is price discovery -- is the efficiency of the

             2   price, which is really something we believe is important  --

             3   is it better in markets where short sales are allowed or not? 

             4   And the answer is a very strong yes, so that -- so the

             5   constraints on short sales appear to make things like a kind

             6   of a bubble based on poor information more likely than not.

             7             So on balance, it seems to have some benefits in

             8   terms of price discovery.

             9             MR. STEEL:  Annette, I could just add that in our

            10   experience, and when you look at the prime brokerage

            11   business, probably two-thirds to three-quarters of our short

            12   sales are accompanied by buys so that you're basically

            13   creating a buy.  I don't hear anyone complaining about the

            14   purchase that came in with the sale.  And so basically two-

            15   thirds to three-quarters would be hedge strategies as opposed

            16   to outright sales.

            17             MS. NAZARETH:  Peter, very quickly.

            18             MR. BORISH:  If you facilitate a two-sided market

            19   at the margin you're going to end up having less volatility. 

            20   If you look at most markets, bonds, currencies, which are

            21   larger in aggregate where it's equally easy to buy and sell,

            22   the volatility is significantly less, however, you want to

            23   measure it, than it is on an individual equity basis, and so

            24   I think that it's very important to have a liquid two-sided

            25   market.





             1             MS. NAZARETH:  Last word.

             2             MR. HARRIS:  Here's an amusing but absolutely

             3   sincere, very simple economic analysis.  If indeed short

             4   selling leads to higher equity prices, that lowers the price

             5   of capital and that's wonderful for capitalists.  Lower costs

             6   of capital means that economically throughout the economy

             7   businesses will shift towards capital and away from labor.

             8             Shifting away from labor cost U.S. jobs, an aspect

             9   of this regulation that nobody has ever thought carefully

            10   about.  This is what we mean about the importance of

            11   efficiency.  It's not that we want to subsidize jobs or cost

            12   jobs or subsidize capital or otherwise.  We'd just like to

            13   have all resources in the economy used as efficiently as

            14   possible and short selling, if it indeed causes prices --

            15   capital to be higher, probably also cost U.S. labor jobs.

            16             MS. NAZARETH:  I'd like to thank our panelists. 

            17   Obviously we've run over a little bit but hopefully it was

            18   time well spent.  I certainly think so.

            19             Thank you very much.

            20             (Applause.)

            21             (A brief recess was taken.)

            22             MS. FORNELLI:  Good morning.  I think I can still

            23   say good morning for a little while yet.

            24             My name is Cindy Fornelli, and I'd like to welcome

            25   you to Panel 6 of our second day of roundtable discussions. 





             1   Today we're going to talk about enforcement and fraud

             2   concerns and I have of course a very distinguished panel here

             3   with me that I'd like to introduce to you.

             4             On my far left, I have Steve Cutler who is the

             5   director of the SEC's division of enforcement.  Steve, prior

             6   to being the director, was the deputy director of enforcement

             7   and he came to the SEC in January of 1999.  Prior to that,

             8   Steve was a partner at Wilmer, Cutler & Pickering here in

             9   Washington, D.C., specializing in securities enforcement and

            10   broker-dealer compliance and litigation.

            11             Next to Steve is Pam Parizek.  Pam is associate

            12   managing director and a forensic accountant at Kroll Inc., a

            13   global risk management consulting firm specializing in

            14   business intelligence, internal investigations and forensic

            15   accounting.  And in Pam's prior life, she also worked at the

            16   enforcement division here at the SEC.

            17             On my immediate left is Scott Berman, a partner at

            18   Brown Rudnick.  Scott's practice focuses on complex

            19   securities litigation including hedge fund cases in federal

            20   and state courts and arbitrations across the country.

            21             On my right we're pleased to have Kristina Kneip, a

            22   senior staff attorney in examinations and a supervisor with

            23   the State of Washington Department of Financial Institutions

            24   in their securities division.  Kristina has served in various

            25   capacities with the North American Securities Administrators





             1   Association or NASAA, and brings to our panel not only

             2   familiarity with the State of Washington but also with issues

             3   that hedge funds raise at the state level across the country.

             4             To Kristina's right is Tom Fedorek, the senior

             5   managing director in the New York headquarters of Citigate

             6   Global Intelligence & Security, which is a provider of

             7   corporate investigations and business intelligence.  In

             8   recent years, he's conducted due diligence investigations on

             9   a number of hedge fund managers so he brings that experience

            10   to the table.

            11             Next to Tom is Lois Peltz, the president and CEO of

            12   Infovest21.  Infovest21 is an information provider to the

            13   hedge fund industry.  And last but not least is Patrick

            14   McCarty, the general counsel of the CFTC and prior to joining

            15   the CFTC, Pat was general counsel and executive vice

            16   president for legislative and regulatory affairs of the

            17   Managed Funds Association.

            18             So I'd like to welcome all of you in the audience,

            19   on the webcast and all the panelists, including Chairman

            20   Donaldson and the Commissioners.

            21             We're going to focus on three broad areas today. 

            22   We're going to look at enforcement actions by both the SEC

            23   and the other regulatory panelists that we have here.  We're

            24   also going to look at examination and disclosure issues and

            25   the third broad area we're going to focus on is due





             1   diligence.

             2             I know we started a little late and I know people

             3   have schedules to keep, so we'll try to keep on time but we

             4   might go just a little over.

             5             So our first area that we're going to focus on, as

             6   I said, is enforcement actions.  Because the hedge funds

             7   aren't generally regulated or registered with the SEC, our

             8   main form of regulation over them is under the antifraud

             9   provisions of the federal securities laws.  

            10             Other regulators have different regulatory schemes

            11   so I'd like to open the panel by having each of our

            12   regulatory panelists briefly outline their regulatory

            13   programs and the types of cases they've been seeing with

            14   respect to hedge funds.

            15             So I'll start here at the SEC with Steve. 

            16             MR. CUTLER:  I noticed that you put me way over

            17   here and a vast separation between me and everyone else which

            18   I don't quite understand.

            19             In the last five years or so, the Commission has

            20   brought roughly 30 enforcement actions relating to hedge

            21   funds and in the last 3 or 4 years, we've seen a steep

            22   increase in the number of hedge fund related enforcement

            23   cases.

            24             We brought two in 1999, six in 2000, seven in 2001

            25   and twelve in 2002.  And while there certainly are a number





             1   of very complex issues associated with hedge funds, whether

             2   they should be regulated, how they're structured, et cetera,

             3   in the enforcement arena, and in particular in the cases that

             4   we've brought, what we have seen is rather basic blatant

             5   fraud.

             6             The overwhelming number of cases we've brought

             7   concern past or present -- I should say material

             8   misrepresentations about past or present performance of

             9   funds, the value of investors' holdings, the use of

            10   investors' funds and the qualifications of the fund manager's

            11   experience or the fund manager's experience.

            12             In a very significant number of cases, we've simply

            13   charged advisors or their associated persons with outright

            14   theft, with misappropriating investor funds.  In a couple of

            15   cases, we've charged advisors with employing Ponzi-like

            16   schemes, that is repaying exiting investors with funds

            17   contributed by new investors to continue their fraud.

            18             And, as I think we'll get to later on, we've also

            19   brought a number of cases relating to mis-pricing schemes or

            20   manipulations.  And that's essentially the essence of where

            21   we've been.  I don't know if that's a complete reflection of

            22   where we will go but certainly that's historically where

            23   we've been in the hedge fund area and in SEC enforcement.

            24             MS. FORNELLI:  Pat, do you want to talk briefly

            25   about the CFTC's enforcement program?





             1             MR. McCARTY:  Well, as the general counsel I'm not

             2   usually the enforcement guy but I've been helped by my

             3   enforcement friends.  And I think our view of this is

             4   basically that we've seen about 10 cases a year, hedge fund

             5   fraud.  Now, we've actually been maybe a little overinclusive

             6   in terms of adding particular funds in.  But anybody who is

             7   basically committing a fraud and indicating that it's a hedge

             8   fund-type entity, we included that.

             9             You've had 30 cases in I guess four years, five

            10   years.  We've had 10 about a year so we have about 54.  In

            11   the context of enforcement cases, though, it's not a huge

            12   part of our program and I've actually put together some

            13   materials here just to sort of figure out where this stands. 

            14

            15             Our -- I guess combined SEC and CFTC enforcement

            16   actions total somewhere around 3,300 over the last five years

            17   and I believe the total number of cases -- enforcement cases

            18   brought in that 5-year period against entities who are saying

            19   that they're hedge funds is about 80.  So it's somewhere on

            20   the order of magnitude of about 2 percent of all cases, maybe

            21   3.  But that -- to give some perspective as to where things

            22   are.

            23             I don't want to monopolize the time.  The CFTC has

            24   a significant presence I guess in the hedge fund industry but

            25   I'll get into that a little later so I don't monopolize the





             1   time here.

             2             MS. FORNELLI:  Kristina, do you want to talk about

             3   what you've seen at the State of Washington?

             4             MS. KNEIP:  Sure.  I'm going to actually give a

             5   really brief overview on the states in general because I

             6   think it's really important to know that many of the states

             7   actually require hedge fund managers to register as

             8   investment advisors and I don't know what that count is. 

             9   Given that 75 percent of hedge fund managers that we know are

            10   registered as advisors, I don't know how many of those are

            11   state advisors and how many are federal.  But obviously, that

            12   overlay makes a huge difference in the way that we approach

            13   enforcement  actions.

            14             Presently, in the State of Washington we have 4

            15   actions going.  Two really have come from examination and are

            16   really on a workout-type basis.  They have to do with

            17   advertising and making sort of performance review claims

            18   regularly in news columns and kind of that sort of thing,

            19   which isn't really fraud in any sense of the word.  

            20             However, nationwide, I've gotten numbers from the

            21   other states and right now there are about 9 cases across the

            22   country.  Roughly half of those involve some serious kind of

            23   fraud, generally with unregistered funds, so these aren't the

            24   ones who are registered with the states as investment

            25   advisors but they are looking a lot like what the SEC is





             1   finding as far as Ponzi schemes.  That's probably the biggest

             2   thing that the states are finding in the fraudulent area. 

             3   But again, those are with the unregistered advisors that are

             4   managing hedge funds with us.

             5             We have a few cases of theft.  We actually got

             6   sentencing I think it was a couple weeks ago on one in

             7   Washington, but it looks so much just like outright fraud and

             8   theft that it's hard to really even associate what they were

             9   doing sometimes with the hedge fund industry as it's been

            10   represented here.  

            11             And I think that's because state registered or even

            12   small state funds are maybe 3 to 10 million, although we have

            13   some that are a lot bigger, they're just not doing the kind

            14   of sophisticated strategy.  So we see things a little bit

            15   differently than I think maybe what the Commission sees or

            16   definitely differently than what the CFTC sees.

            17             MS. FORNELLI:  I'm curious to know from our

            18   panelists how you find what the sources of fraud are, fraud

            19   cases.  At the SEC, we don't do examinations so we don't

            20   detect fraud through our examination program.

            21             Steve, can you talk a little bit about the sources

            22   that we have?

            23             MR. CUTLER:  Yeah, and I think that's actually an

            24   important point because we're not -- at least in the case of

            25   unregistered advisors, we're not going to be the





             1   beneficiaries of an examination that's going to have

             2   identified a problem, brought it to our attention in the form

             3   of an enforcement referral.  So a lot of what we end up

             4   seeing in the hedge fund area is after the train wreck has

             5   already happened.  We will get a complaint from an investor

             6   that finds that he's been wiped out.

             7             Now, there have been cases, including in the

             8   unregistered area, where we've gotten information from, for

             9   example, a prime broker that said, gee, you know, our records

            10   are showing this, we know that the hedge fund has been

            11   advertising returns of substantially more than that,

            12   something doesn't compute here.  And we certainly have been

            13   the beneficiaries of a couple of referrals frankly from the

            14   industry.  But those are, as you can imagine, fairly rare. 

            15   And for the most part we are relying on complainants to bring

            16   hedge fund cases to our attention.

            17             MS. FORNELLI:  Pat, your experience at the CFTC is

            18   different because, as I think you alluded to earlier, a lot

            19   of the -- your regulated entities may be examined because

            20   they're part of your program and a lot of the hedge funds are

            21   registered with you in one form or another.

            22             Do you see a lot of enforcement cases arising from

            23   your examination program?

            24             MR. McCARTY:  Actually, the 54 cases we brought in

            25   the last five years, about 10 or 11 a year, 78 percent of the





             1   cases that we brought are against unregistered pools.  We

             2   find that the registered funds are really not the ones that

             3   are usually the problem, and in fact I'll echo what Kristina

             4   had to say there.

             5             A lot of the ones in those 54 that we're counting

             6   are -- it's not clear whether in fact people are intent upon

             7   committing fraud and are using I guess the hedge fund name as

             8   the mechanism or not.  So I would say that most of the pool

             9   cases that we've brought in the last five years we get

            10   through complaints, not through our examination process.

            11             Our examination process, which the NFA handles for

            12   us, they see every one of our commodity pool operators every

            13   two-and-a-half to three years and the number of problems that

            14   come out of our registered pools is actually very, very, very

            15   small.  The number of complaints we get is about 10 a year on

            16   commodity pools, and that's kind of phenomenal when you think

            17   we have up close to 2,500 commodity pools out there.

            18             MS. FORNELLI:  Kristina, what about Washington?

            19             MS. KNEIP:  It's really -- it sounds like I'm

            20   partnering with the CFTC here.  I think that probably at

            21   least 75 percent of our cases probably more come from

            22   complaints.  

            23             The examination process I think brings some of the

            24   -- not really transparency in the same way you're thinking of

            25   it in markets but certainly gives the public some assurance





             1   that when we go in on examination and the hedge funds are

             2   expecting us at some time, we generally see them on about a

             3   3-year cycle, but anywhere between two to seven years and

             4   across the states probably about a five-year cycle for states

             5   that actually examine hedge funds.  

             6             And I think that's a deterrent.  Just having sort

             7   of the cop on the beat there, as the states like to say we

             8   are, when you're out there and people know you're coming in,

             9   they tend to either hide it really well -- and maybe we just

            10   haven't found it.  I'd hate to think that was going on, but

            11   certainly people tend to keep everything cleaner.

            12             MS. FORNELLI:  I'm curious to know -- in our last

            13   panel they talked a little bit about short selling.  We heard

            14   yesterday about the types of conflicts of interest that can

            15   arise that are unique with hedge funds when they're run side

            16   by side, allocation issues.

            17             I'm curious from all of our panelists, the types of

            18   hedge fund fraud that we've seen, are there types of fraud

            19   that are unique to hedge funds or is it the same types of

            20   fraud that we see with other types of products?  Steve?

            21             MR. CUTLER:  I guess my view is that it tends to be

            22   similar.  I mean, it's certainly a different forum for fraud

            23   but fraud is fraud is fraud and I guess my sense is as the

            24   hedge fund community is growing, that puts more pressure on

            25   some of the things that we haven't seen.  





             1             And in particular I'm thinking about things like

             2   conflicts of interest that can arise when a dealer or anyone

             3   else sells a fund.  What other interest does a dealer have in

             4   that fund?  Is that dealer doing, for example, brokerage

             5   business with the fund and when the dealer is then selling

             6   interest in the fund or introducing the fund to customers,

             7   are customers aware that the dealer has an interest in the

             8   success of that fund, either by virtue, for example, again,

             9   doing brokerage business or by virtue of having its own

            10   investment in the fund?

            11             And I think those are some of the issues that I

            12   think as hedge funds burgeon that we have to begin to deal

            13   with.

            14             MS. FORNELLI:  Now, it's interesting because those

            15   are conflicts of interest that obviously are of interest to a

            16   regulator in terms of monitoring for fraud and detecting and

            17   preventing fraud but I'm curious if any of the panelists have

            18   a thought of whether or not those conflicts are adequately

            19   disclosed to investors in the PPMs, in the documents.

            20             You know, the SEC doesn't go in and examine, at

            21   least with the unregistered advisors, the offering documents. 

            22   Do you see, Pat, anything like that, that the conflicts are

            23   disclosed adequately, these potential conflicts when people

            24   have various relationships?

            25             MR. McCARTY:  Well, I guess at the CFTC the vast





             1   majority of the pools that are subject to our jurisdiction

             2   are all private -- virtually all private placements.  I mean,

             3   we only have -- I think of the 2,400 funds, we have roughly

             4   40 which are public offerings so the rest of them are private

             5   placements.

             6             The disclosure document review that's done is I

             7   guess split depending upon whether it's a fund that's going

             8   to restrict themselves to qualified eligible participants,

             9   which is kind of like the qualified purchaser standard.  

            10             We do not review those documents to see what the

            11   level of disclosure is regarding conflicts.  They're subject

            12   to the antifraud provisions and so, like Steve was saying

            13   earlier, a lot of times you're there after the fact when

            14   people have complained.  But I think -- what I would just

            15   reassert is that the enforcement cases we've had and the

            16   complaints that we receive, this area is not one which is

            17   large.  

            18             In fact, it's -- you know -- I guess of our

            19   enforcement actions in 10 years, 17 percent of our cases are

            20   against commodity pools and I think something like 11 -- more

            21   than 50 percent of those actions are against the unregistered

            22   ones who I think may be just intent upon fraud to start with. 

            23   I'm not really sure that they're actually hedge funds. 

            24   They're just fraudsters. 

            25             So I don't know whether -- I couldn't tell you





             1   whether the disclosure of conflicts is adequate in a PPM that

             2   a person setting out to commit fraud is.

             3             MS. KNEIP:  No.  And this has been probably the key

             4   issue that the states have been going off on for a long time. 

             5   At least, since NISMIA was passed and we stopped reviewing

             6   the 506 offerings, the disclosure just isn't there.  It's not

             7   there in a whole lot of areas.

             8             Now, I can temper my no with of course everybody

             9   who is an RIA with the State of Washington, they're

            10   disclosing all kinds of conflicts of interests because they

            11   have to in the ADV Part 2 and that's what we're missing in

            12   this process for the unregistered funds is that the 506s are

            13   just filed and they go into this great bank of filings here

            14   and they're not reviewed or anything until there's a problem

            15   and I really hope that maybe that's one of the solutions that

            16   at least the commission can look into more is can that issue

            17   be tackled.  

            18             Can we put even a little check box on the Reg D 506

            19   form that says yeah, I'm a hedge fund.  At least we know to

            20   ask then for the PPM or something, that there's some extra

            21   level of review that might be done that might not be very

            22   invasive for the industry and allow them to keep doing what

            23   they want to do but giving the investor some kind of level of

            24   protection.

            25             So the disclosure is just not there right now.





             1             MS. FORNELLI:  Lois, yesterday we talked a lot

             2   about the private offering and not holding yourself out and

             3   not having general advertising which then by necessity means

             4   that there's a lot of confidentiality around hedge funds not

             5   only with respect to their trading strategies, which I think

             6   is a different reason, but regulatorily there are

             7   prohibitions.

             8             Do you have any sense as to whether or not that

             9   kind of confidentiality impedes our ability to detect fraud?

            10             MS. PELTZ:  Well, there's no such thing as a secret

            11   and I think there are lots of checks and balances out there

            12   and a lot of this goes back to I guess the customer

            13   complaints and educating the investor so he knows what to

            14   look for.  

            15             Most things that a manager says, an investor can

            16   check.  For example, if it's asset size, the investor can

            17   check this with either the prime broker or the administrator. 

            18   He can also verify what the manager says his performance

            19   numbers are.  He can go back into monthly reports.  If he

            20   sees some spectacular numbers, maybe that should be a cause

            21   of concern and raise a red flag.

            22             I think one thing that investors don't do well is

            23   that they don't do ongoing due diligence of their managers. 

            24   They do initially when they select, but afterwards it's just

            25   as important.  Go visit that manager, check what the turnover





             1   is of his staff, what the change is in his portfolio mixes

             2   and visit him on a regular basis.

             3             There's lots of information out there that

             4   investors can check as well.  There are a lot of performance

             5   databases.  If an investor receives in his monthly report a

             6   number and in some other database it looks different, well,

             7   that's another cause of concern.  And similarly, there are

             8   many news services out there that carry information on

             9   managers and all these are sources of information that

            10   investors should look into.

            11             I think there are a lot of red flags.  If a manager

            12   promises great things and -- if it sounds too good to be

            13   true, it probably is.  If a manager doesn't have an audit, I

            14   think that's a big concern.  If you've never heard of the

            15   auditing firm or the administrator, again, another red flag. 

            16   If the audit late or an auditor has an issue, these are all

            17   things that investors should start to take note of.

            18             There's excessive employee turnover, another cause

            19   for concern.  Illiquid securities as we've discussed before,

            20   again, it's an area of concern that leads to more questions. 

            21   Same thing with leverage.  So I think there are many things

            22   that investors can do and should be aware of, and there's no

            23   such thing as a secret.

            24             COMMISSIONER GLASSMAN:  Could I just interrupt for

            25   a moment?  How much of what you just described could





             1   reasonably be done by a retail-type investor?

             2             MS. PELTZ:  Well, it goes back to the issue of

             3   sophisticated investor and who the hedge fund investor

             4   initially was and who he's going to be.  These sources are

             5   available and I think it's true for any investment you make. 

             6   You should know what you're getting into and you should be

             7   knowledgeable.

             8             MS. FORNELLI:  To follow up on that, I was

             9   interested to hear you say that an investor could check asset

            10   size, for instance, or assets under management with a prime

            11   broker.  I'm not sure that a prime broker would give that

            12   information up to an investor.  Does any of the panelists

            13   have any experience with that?  Is that something that Carl

            14   could get?

            15             MS. PARIZEK:  I think it's unlikely.  Someone on

            16   the due diligence panel yesterday mentioned -- and this was

            17   very encouraging to hear, frankly -- that there tends to be

            18   more of a focus these days on qualitative due diligence, you

            19   know, what is the reputation, character, integrity of the

            20   hedge fund manager.

            21             While there is a great deal of information that's

            22   available in the public domain, and we'll go into that a

            23   little bit later on this panel, things like reputation and

            24   integrity is not generally going to be available and

            25   frequently we are called upon to get that type of information





             1   for many of our investors.

             2             We frequently do this on behalf of larger

             3   institutions.  I would say about 70 percent of our work is on

             4   behalf of fund to fund managers and perhaps 30 percent is

             5   done for institutional investors and for fund managers.  So

             6   it's not the type of work that is generally performed for

             7   retail investors, to answer your question. 

             8             MS. FORNELLI:  Kristina, Lois also mentioned

             9   administrators.  That was one of the things that's come out

            10   in the roundtable, that foreign jurisdictions have third

            11   party administrators that act as a gatekeeper or a check. 

            12   That's something we typically don't see here, at least on the

            13   federal level.  Does the State of Washington have any

            14   experience with that?

            15             MS. KNEIP:  We see it a little bit differently at

            16   the state level because most of our hedge fund advisors

            17   actually have custody, they're in the situation where -- and

            18   especially because they're small -- they may not want to put

            19   up the capital necessary and so they're going to get out from

            20   under the custody rule by using a third party administrator.

            21             And that may be a reason that we don't see as much

            22   fraud, also.  I don't know, but certainly it puts a big check

            23   on where that money can go because you've got to get

            24   permission to pay yourself, to move funds in and out, and so

            25   we find that it really helps.





             1             I also want to just briefly address Commissioner

             2   Glassman's question if I could.  Essentially, even if you

             3   could get the position information from the prime broker,

             4   without a sophisticated software program to do the

             5   performance numbers, you're not going to be able to do it.  

             6             As the head of our exam team, I know we struggle

             7   with teaching all of our new examiners are you going to use

             8   modified dates, what are you going to do, how are we going to

             9   get everybody on the same page, what did the advisor use when

            10   they actually calculated their performance and if we

            11   calculate performance using a different method, it's not

            12   going to come out the same.  What's the acceptable

            13   difference, two basis points or less?

            14             The problems for an individual investor to actually

            15   verify, even if they could get the information, I think would

            16   be very difficult unless they're really truly sophisticated

            17   and could afford a separate investment advisor to run the

            18   programs for them.

            19             MR. CUTLER:  Could I just interject here?  I mean,

            20   one of the things that I'm concerned about, and I don't know

            21   enough about the regulation of hedge funds as opposed to

            22   enforcing the laws when they break it, but we've seen cases

            23   of funds and Lois had mentioned audits of hedge funds, where

            24   auditors come in, audit hedge funds but one of the things

            25   they don't do in that process is confirm with the customers





             1   what it is that the customers are being told their

             2   investments are worth in the hedge funds.

             3             And it seems to me that in the same way that

             4   auditors of public companies send confirms to suppliers and

             5   send confirms to customers, one of the things that might be

             6   done in this area to prevent the kinds of valuation frauds

             7   that we see so frequently is to do regular confirms with

             8   customers, what are you being told, and matching that against

             9   what the auditor is finding within the hedge fund.

            10             MR. McCARTY:  I'd like to chime in on that.  I

            11   think you're right on that.  I guess most of the time that --

            12   the 54 cases we've brought in the last five years, there's a

            13   high incidence of basically false statements being sent out

            14   to the customers.  I mean, they end up with a statement

            15   saying things are good, you made 10 percent last year, when

            16   in fact they lost 30 percent or something along that line.

            17             And that -- you're absolutely right.  I mean,

            18   that's the vast majority of situations where we see this and

            19   that's the kind of fraud that is pervasive in that small

            20   group of cases that we see.

            21             Now, I'm not quite sure how frequently this occurs

            22   and since this market is really not a market for retail

            23   investors, at least at this point in time, it may be the case

            24   that the institutional investors and high net worth

            25   individuals have more experience with that or actually as I





             1   understand it, they have some communications directly with an

             2   awful lot of the managers on this.  If they have a stake of

             3   25, $30 million in the fund, they have more access than

             4   someone who has $5,000 in the fund.

             5             MS. PARIZEK:  But I think the access is still

             6   limited and we've had clients unfortunately -- you know, most

             7   of our work is on the front end but we do have maybe 10

             8   percent of our work in the back end where we've got very

             9   sophisticated clients who were relying upon audited financial

            10   statements.  But a lot of that information is done after the

            11   fact and they were told all along, hey, you know, your money

            12   is in a very safe, carefully contemplated derivative

            13   instrument that has very stable returns when in fact the

            14   money was being put into Ponzi schemes, bad port -- credit

            15   card receivable portfolios and other very risky instruments. 

            16   And it wasn't until after the fact that they realized that

            17   tens of millions of dollars had disappeared when all along

            18   they were told, you know, as you said, things are just fine,

            19   we have very steady returns.  so it's very challenging to get

            20   out that information.

            21             Now, in the defense of the hedge fund managers, I

            22   think that there are very legitimate concerns about the

            23   proprietary nature of that information because, let's face

            24   it, I mean, that's what the funds are all about.  And you

            25   need to have some protection so that other people don't have





             1   access and especially if you're dealing with a fund to fund

             2   who is looking into managers, there are some legitimate

             3   concerns about sharing the information concerning their

             4   strategy, so it's a delicate balance that has to be struck

             5   someplace.

             6             MR. McCARTY:  The valuation issue I think is really

             7   important.  To the extent that hedge funds invest in illiquid

             8   investments, illiquid securities and/or things like

             9   derivatives where it's hard to put a mark on them, the

            10   question is whether in fact you've got a accurate pricing of

            11   that particular security or position.  And in some situations

            12   where there really is trading only by appointment with

            13   respect to that security, I think that it's almost -- even if

            14   you have a third party service provider do the marks, which

            15   probably is a good idea, it's sometimes 20/20 hindsight. 

            16   Several months later, whatever you said it was worth is now

            17   half or a third because something didn't happen.

            18             And I think that's one of those things where people

            19   seem to need to sort distinguish the valuation problem from

            20   the valuation fraud because I think in a lot of situations

            21   you're going to have people trying to make a good faith

            22   estimate as to what an illiquid security is worth but time

            23   proves them wrong.

            24             MS. PARIZEK:  Pat, you're exactly right and that's

            25   one of the reasons that we recommend due diligence not only





             1   on the fund managers but also on the third party service

             2   providers.  Who are your administrators?  Who are your

             3   lawyers?  For that matter, who are the accountants?  And

             4   that's something that certainly can help in preventing some

             5   of the frauds that have occurred.

             6             MS. FORNELLI:  Scott, do you have something?

             7             MR. BERMAN:  Valuation fraud -- yes, thank you. 

             8   I've been trying.  This panel is very aggressive.  Feels like

             9   we're in court.

            10             MS. FORNELLI:  Yes, you have to be assertive.

            11             MR. BERMAN:  Valuation fraud, which is the example

            12   of big fraud that I see most frequently, almost can never be

            13   accomplished just by the hedge fund manager.  I mean, the

            14   hedge fund manager with typically illiquid securities such as

            15   microcaps or CMOs or the like, is not likely to show his

            16   portfolio and, absent some regulation, will not show his

            17   portfolio, but by himself or herself can't commit the fraud.

            18             Typically what happens is in the PPM there are

            19   requirements for third party verification or third party

            20   participation in the marks so that in the Granite hedge fund

            21   fraud case, for example, the hedge fund manager made up his

            22   own marks but he did it with the willing cooperation of the

            23   dealers who sold him the CMOs.

            24             How did he do that?  Because he would go every

            25   month to the dealers and say please give me marks.  They'd





             1   give him marks.  Then he'd call them back and say thank you

             2   very much but I'd like another set of marks and they'd give

             3   it to him because he was buying the toxic stock that nobody

             4   else wanted and he was driving -- he, being the hedge fund

             5   manager, David Askin -- these huge deals.

             6             So, could he have done this by himself?  No.  He

             7   was telling his investors that the dealers are giving me

             8   marks and, in fact, the dealers were giving him marks which

             9   were being confirmed to the auditors so that the blame here

            10   when there is fraud is almost never just the hedge fund

            11   manager.  There is almost always third parties involved.

            12             Let me touch on the auditors for a moment, too, if

            13   I can.  When you're auditing a hedge fund, there's only two

            14   things I think you need to do.  Make sure that the

            15   instruments exist and they're properly valued.  There's not

            16   much else to do.  And it's amazing to me that those two --

            17   what you would think are relatively simple things don't get

            18   done right in these hedge fund cases.

            19             Kids get put on these things or don't know how to

            20   audit the hedge funds, don't properly confirm that the

            21   positions exist, such as in the Manhattan case, or don't do

            22   the proper testing for valuation which is why, since I sue

            23   the street and accountants in connection with hedge fund

            24   blowups, I'm able to do it because either they are knowing

            25   participants in the fraud or they've acted very recklessly,





             1   grossly negligently or recklessly in performing the services

             2   that they're supposed to be performing to give investors the

             3   feeling that at least somebody besides the hedge fund manager

             4   is minding the store.

             5             MS. FORNELLI:  Well, then I'd lie to turn it over

             6   to Tom and kind of talk about then examinations because it

             7   sounds like if the hedge fund manager wants to commit fraud

             8   by mis-pricing securities or puffing up performance and the

             9   third party administrator or the third party auditor will

            10   conspire with the hedge fund manager to falsify those

            11   records, what's an investor to do?  Do we need inspections? 

            12   Would that be a deterrent to these types of activities if we

            13   had frequent regular inspections of hedge funds?

            14             MR. FEDOREK:  That's a very touch question.  The

            15   investor is generally, unless they are an institutional

            16   investor with a very big investment, they're probably not

            17   going to get full access to all the books and records they

            18   would need to make that determination.  And as Scott pointed

            19   out, many hedge fund frauds involve an extraordinarily high

            20   level of deception and are complex in that they involve

            21   several different parties to the transaction.

            22             As we were talking about the auditors, I was

            23   reminded of how Michael Berger in the Manhattan fraud which

            24   has been already mentioned just completely pulled the wool

            25   over the eyes of his auditors by rigging up a fax machine and





             1   sending the trade information directly to the auditors.  It

             2   was supposed to go through the administrator, but he rigged

             3   up the fax machine so that when it came off the fax machine

             4   at the auditor's office, it had a header that indicated it

             5   came from the administrator's office when it fact it came

             6   from Michael Berger himself.

             7             What's an investor to do and do we need more

             8   examination and inspection by agencies like the SEC?  Let me

             9   just turn that over to the panel because I don't really have

            10   an answer.

            11             COMMISSIONER GLASSMAN:  Can I just interrupt, Tom,

            12   and ask you in your experience what percentage of hedge funds

            13   have problems that the market should be worried about?

            14             MR. FEDOREK:  As Pam said, in our business, in the

            15   private investigations business, we tend much more often to

            16   be involved on the front end of the transaction in helping

            17   investors do their due diligence before an investment is

            18   made.  We do get involved on the back end when a fraud occurs

            19   but by that time the damage is done and if we can get access

            20   to the books and records, we can help with forensic

            21   accounting services.

            22             The -- I actually once -- I've done between 100 and

            23   150 due diligence investigations of hedge fund managers and I

            24   actually once did a tally of my cases and flagged the ones

            25   where we surfaced something that we thought we needed to





             1   bring to the attention of the investor, and it was

             2   approximately 25 percent of the due diligence cases we did

             3   surfaced some kind of issue which we thought important enough

             4   to bring to our investors' attention.

             5             And the two basic things we do in a due diligence

             6   investigation would be to first take the information that the

             7   hedge fund manager has provided to the potential investor and

             8   we'll go line by line through that information, what the

             9   educational credentials are, what the employment history is,

            10   what the professional credentials are, and we'll verify that. 

            11   We'll see if it's true.

            12             We'll also do independent research to see if there

            13   let's call them sins of omission.  And in 25 percent of the

            14   cases, we found that there was some kind of inaccuracy in

            15   that information, an exaggeration, an error or an omission.

            16             Now, ADP is in the resume-checking business and

            17   they have a company that checks about two million resumes a

            18   year and they did a study last year that found that more than

            19   40 percent of the resumes they tried to verify had some kind

            20   of inaccuracy so by comparison, the hedge fund industry is

            21   doing very well.

            22             But in 5 to 10 percent of the cases, we found

            23   something that was a deal killer and that would be like an

            24   undisclosed criminal conviction, a regulatory problem, or

            25   some kind of serious personal financial issue like a recent





             1   bankruptcy filing, judgments and liens that you find when

             2   somebody is having a severe cash flow problem.

             3             MS. PARIZEK:  Our number are, you know, pretty

             4   consistent with that.  I would say that we probably do front

             5   end due diligence, as I mentioned previously, about 90

             6   percent of the time.  In the last five years we've done, you

             7   know, roughly -- I'm not sure -- 3 to 400 background

             8   investigations.  Now they're classified a little bit

             9   differently.  They used to be just background investigations. 

            10   Now they're hedge fund fraud investigations, so I'm not

            11   exactly sure where that number falls.

            12             But to give you some sense of what the numbers are

            13   for those of you who read last month's issue of the MFA

            14   Report, you may have seen that we estimate that roughly 10 to

            15   15 percent of the time there is some indication of a red

            16   flag.  That doesn't mean necessarily that there is fraud but

            17   there is something that really should be looked at a little

            18   bit more carefully.

            19             Now, within that pool, about 80 percent of the time

            20   there's some sort of a misrepresentation concerning the

            21   background of the fund manager and about 20 percent of the

            22   time it might have to do with undisclosed relationships,

            23   questions about the use of proceeds or other contingent

            24   liabilities.

            25             COMMISSIONER GLASSMAN:  Cindy, are these the kinds





             1   of things that we would find if we were doing inspections?

             2             MS. FORNELLI:  Well, that's one of the things I'd

             3   like the panel to explore a little further.  Pat, I know that

             4   you have both registered and unregistered.  Do you see on the

             5   examinations -- are your fraud cases -- is there a

             6   distinction between the registered and the unregistered when

             7   you bring fraud cases?

             8             MR. McCARTY:  Oh, yeah.  As I said before, about

             9   70, almost 80 percent of the cases that we bring which you

            10   could call a hedge fund case, and we erred on the side of

            11   basically being overinclusive, that 80 percent of those cases

            12   are against unregistered entities.  Now, the thing is though

            13   that number is small and I just want people to keep these

            14   things in perspective, is that if we bring 54 cases in the

            15   last five years and 80 percent of those cases are against

            16   unregistered entities, then we're talking about bringing 40

            17   cases.  

            18             And I have to tell you that we have -- of the -- it

            19   depends upon how you define hedge fund I guess is kind of --

            20   what does the CFTC see in hedge funds when we examine them? 

            21   Well, it depends upon what you consider to be a hedge fund. 

            22   I put some statistics in my materials here.  

            23             If you count in commodity pools that have over $100

            24   million in assets as being hedge funds, and I think for

            25   purposes of talking about fraud I'm counting everybody down





             1   to $100,000, the 628 commodity pools that have over 100

             2   million in assets, we see maybe two complaints a year.

             3             MS. PARIZEK:  I should probably qualify my prior

             4   remarks to make it clear that I was talking about

             5   predominantly unregistered advisors because typically that's

             6   what we're called upon to look at.  It's places where there

             7   is not a good deal of information available and people want

             8   more information about some of the smaller lesser known

             9   managers.

            10             Now, I should further qualify that by saying we're

            11   in the business of investigations, not statistics, so I can't

            12   tell you whether this is isolated or systemic and I think

            13   that's something that really deserves further inquiry.

            14             MS. FORNELLI:  Well, maybe I've done the panel and

            15   the audience a disservice by asking the question as to

            16   whether or not we'd catch more fraud if we did examinations. 

            17   Maybe the question is what other benefits are there to

            18   examinations, not just catching fraud.  Kristina, do you have

            19   a thought on that?

            20             MS. KNEIP:  I think certainly examinations leads to

            21   a lot more disclosure that's available to the public in the

            22   end.  If the Commission were to register investment advisors

            23   that advised hedge funds, they could go in under exam power

            24   on the IA rules and presumably you'd want to draft it broad

            25   enough that they could go into the third party administrator





             1   so that they could look at pricing issues if they were there

             2   but certainly on top of that temper it with a risk rating

             3   sort of thing that I know the Commission has gone to and

             4   we've gone to in the State of Washing that says okay, if they

             5   use a third party administrator and we've got these people --

             6   we've got surprise audits being done by their CPA firms and

             7   that sort of thing, then they're probably way lower on the

             8   risk rating scale for us than a hedge fund who doesn't use a

             9   third party administrator and those folks we probably want to

            10   go in and do a lot more thorough checking of every single

            11   pricing issue.

            12             So I think we could get to pricing but you would

            13   have to make ti broad enough to get to the third party

            14   administrators or whomever else is doing that other work for

            15   them.

            16             MS. FORNELLI:  Tom, do you have a sense of whether

            17   or not registration would get more information out to

            18   investors?

            19             MR. FEDOREK:  Yeah.  I think there's a real

            20   opportunity here for the SEC to be not just a cop but to be

            21   what it is, actually, to a large extent already, an

            22   information provider.  I mean, there's not a day that goes by

            23   that I don't dial into one of the SEC's databases to get

            24   information to help me in the research that I do in my

            25   investigations, whether it's EDGAR or some of the other





             1   databases that you have.

             2             You could effectively put Pam and myself out of the

             3   hedge fund manager due diligence business by requiring

             4   anybody who runs money for somebody else to credential

             5   themselves with the SEC.  It would be okay with me and Pam

             6   because the bad guys would just go operate some other

             7   business and we'd just go chase them there.

             8             MS. FORNELLI:  Scott, would that put you out of

             9   business?

            10             MR. BERMAN:  No.  Clever fraudsters always find a

            11   way to get it done and I think that the more transparency

            12   there is, the better off everybody will be but there will

            13   always be fraud and there will always be a place for it.  But

            14   as long as -- I was thinking in addition to examination, if

            15   you want to give a better -- an additional tool to fighting

            16   fraud, and it's a fairly radical thought, but Section 10(b)

            17   of the 34 Act and rule 10(b)(5) allow me to sue for

            18   securities fraud in connection with the purchase or sale of a

            19   security but as Lois pointed out a few moments ago, investors

            20   fall down many times in doing their due diligence after the

            21   initial investment and in fact many times the fraud occurs

            22   years later after the purchase of the instrument or the

            23   purchase of the investment interest in the hedge fund has

            24   occurred.

            25             So what happens is when you have a fraud that





             1   occurs later on, you have a problem with the -- in connection

             2   with the purchase or sale of a security requirement under

             3   Section 10(b) and Blue Chip, which is the Supreme Court case

             4   on -- in connection with the purchase or sale of securities

             5   requirement.

             6             So what I do, at least in New York, is when New

             7   York law governs, there is a common law claim for fraudulent

             8   maintenance which I use.  That claim does not exist in all

             9   jurisdictions.  That claim does not necessarily exist if you

            10   have to apply the law of a foreign jurisdiction, if it's an

            11   offshore hedge fund, s that to me a very valuable tool in

            12   combating fraud would be to federalize the fraudulent

            13   maintenance theory.

            14             In other words, take out the in connection with the

            15   purchase or sale requirement.  It's radical.  You know, lots

            16   of people are not going to like that, but to me that would be

            17   a very, very valuable tool in combating fraud.

            18             MR. CUTLER:  It's so radical we actually have it in

            19   the Investment Advisors Act, right, because under 206 we

            20   don't need a purchase or sale and indeed a lot of our cases

            21   are brought under Section 206 of the Investment Advisors Act

            22   which allows us to go after fraud whether it occurs in

            23   connection with a purchase or fraud or not.

            24             MR. BERMAN:  But that's you, not me, and that --

            25             (Laughter.)





             1             MR. BERMAN:  And the problem is, as we all know,

             2   the SEC has limited manpower and in many of these cases where

             3   the SEC leaves off, I begin.  That's the Manhattan case,

             4   that's the Granite case, and that's what happens.  And if I

             5   have and other private litigants have those tools, we will

             6   all be able to combat fraud better.

             7             MR. McCARTY:  I have a question for Tom and Pam

             8   which I was kind of interested in.  Cindy's question was

             9   basically will you put us out of business if all these people

            10   have to register, then you don't have to do the private

            11   investigation.  You're always looking at the SEC's web site

            12   for information.

            13             Do you look at the NFA's database?  Because quite

            14   frankly -- and you see it in the materials here -- we have at

            15   the CFTC -- most of the large hedge funds are registered with

            16   us or at least a majority of the large hedge funds are

            17   registered with us as CPOs.  There's an awful lot of data in

            18   that database and in fact I'd note that I think at least

            19   foour or five of the participants at this hedge fund

            20   roundtable are registrants.  I mean, they are hedge funds but

            21   they are registered with the CFTC.

            22             So there's data and I'm not quite sure if that is

            23   getting out to people that in fact if they're going to

            24   invest, they ought to be looking not only at the SEC's

            25   database and the NASD's but also at the NFA's.  And is that





             1   one way to basically get more information out?

             2             MR. FEDOREK:  Yeah.  Pat, I'm really glad you made

             3   that point because this actually came up on the preliminary

             4   call we had and somebody made a point and I think you made

             5   this point and I thought it was such a good one, I wanted to

             6   make sure it got out that yes, the NFA is an excellent place

             7   to go looking and hedge fund managers will be registered. 

             8   There's the NFA database, there's a CRD database which is put

             9   together by NASD and NASAA and then there's the investor

            10   advisor database that you get through the SEC web site and

            11   hedge fund managers will be -- you can get information about

            12   them, some, all or none of the above.

            13             And perhaps what there's a need for, thinking once

            14   again along the lines of the regulatory agency as also being

            15   an information provider, a need to make it easy to -- one

            16   stop shopping for investors who need information because the

            17   information is there but as Pat points out, many people are

            18   just not even aware of the existence of the NFA database and

            19   I myself forgot to mention it.

            20             COMMISSIONER GLASSMAN:  I just have a quick

            21   question for context.  What percentage of the hedge funds are

            22   registered versus unregistered?

            23             MS. FORNELLI:  Well, at the SEC we think about,

            24   what, 35 of the 100 largest hedge funds were registered with

            25   us?





             1             MR. ROYE:  Well, in terms of investment managers,

             2   I'm glad you asked the question because I've heard the number

             3   75 percent of hedge fund managers being registered with the

             4   SEC and our data shows that it's about a third.  And it's

             5   also confirmed by the fact that if you look at the 100

             6   largest hedge fund managers, according to one service, we did

             7   a double-check against who was registered with us.  Again, it

             8   was about a third.

             9             MS. FORNELLI:  And I think OC this exam as part of

            10   this fact-finding mission for those numbers out, too.

            11             MR. McCARTY:  I'd also just to chime in, in my

            12   materials there, we checked the institutional investors study

            13   from last year and 18 of the top 25 hedge funds, and I guess

            14   that's the large ones, are operated by CPOs or registered

            15   with the CFTC and then 55 of the hundred are registered with

            16   us and 44 of them are actually registered as CTAs, commodity

            17   trading advisors.

            18             I'd also note that those numbers may change.  The

            19   CFTC is considering some proposals to provide additional

            20   exemptions from registration and I think that some of the

            21   data that we have here related to hedge fund fraud basically

            22   indicate that there's been very little hedge fund fraud, at

            23   least as far as we can see, with our registrants and that's

            24   one reason why we're considering that.

            25             I'd also note that one of the exemptions we're





             1   considering is basically providing a de minimus test for

             2   basically registration.  Prior to I guess this rulemaking, if

             3   you traded one futures contract you had to register with the

             4   CFTC.  The Commission is now deciding whether they should

             5   actually say that it should be a certain percentage of your

             6   assets or futures to justify them having to register with us.

             7             But today, at this point in time, 55 of the top

             8   100, at least according to institutional investor, are

             9   registered with the CFTC as commodity pool operators and we

            10   examine them through the NFA every two-and-a-half to three

            11   years, and our experience has actually been incredibly good.

            12             MS. FORNELLI:  Commissioner Glassman, your question

            13   I think touches on an issue which we probably should flag,

            14   and that is if it's true that only a third -- approximately a

            15   third of hedge fund managers are registered with us, if the

            16   SEC were determined to register investment advisors we would

            17   have to consider as an agency -- you would have to consider

            18   as an agency the resources that it would take to perform

            19   those examinations and I know that's something that Lori and

            20   our OC program has to worry about, too, what kind of

            21   resources that would take to keep on our exam cycle and

            22   examine all of those.

            23             MR. CUTLER:  Well, I think also -- I think --

            24   sorry.

            25             COMMISSIONER GLASSMAN:  I have one follow-up





             1   question about the data and this may not be the right panel,

             2   but the data that you gave us shows that the unregistered

             3   hedge funds seem to perform better than the registered.  This

             4   may not be the right panel but if it is, does anybody know

             5   why that would be?  Is there something related to the

             6   registration or is it just something else?

             7             MR. CUTLER:  Maybe they're reporting fraudulent

             8   numbers.

             9             (Laughter.)

            10             MR. CUTLER:  No, I really did mean that

            11   facetiously.

            12             COMMISSIONER GLASSMAN:  I certainly hope so.

            13             MR. ROYE:  I don't think we really know the reason

            14   for the difference but you're right.  In terms of looking at

            15   -- I mean, we looked at a number of hedge funds.  It was a

            16   fairly significant number of hedge funds so whether or not

            17   it's representative of registered managers versus

            18   unregistered, can't really say and couldn't really say what's

            19   driving it.  Maybe you can talk to Larry Harris about that.

            20             But I do want to ask Pat one question about -- you

            21   know, you indicated that in terms of your enforcement cases

            22   you see problems in the unregistered area, not in the

            23   registered area.  The CFTC seems to be moving away and is

            24   going to allow more hedge funds to be unregistered.  To what

            25   extent do you see the examination program as having been a





             1   deterrent because of the registration to fraud in the area

             2   where you say in the registered area you don't see it but you

             3   seem to be moving in the opposite direction.

             4             MR. McCARTY:  That's a good question, one I guess

             5   the Commission itself will have to decide.  We've gotten

             6   comments on the exemption proposals and the commissioners

             7   will have to make a decision on that I guess in the next two

             8   months as to whether they'll go with the proposed exemptions

             9   or some modified approach.

            10             What has the examination procedure done to cut off

            11   fraud?  I guess the -- all I can say is basically the vast

            12   majority of our cases are against unregistered pools and I

            13   think that we will probably -- and continue to bring the

            14   majority of our cases against unregistered pools.

            15             I'm not sure whether in fact -- I think the exam

            16   process probably does help but we really don't get many cases

            17   from our exam process.  I think that you've got to consider

            18   whether in fact the industry -- the people who register and

            19   who are running this as a business are in a business and they

            20   are going to be doing the right thing and so I'm not sure

            21   we're really going to find -- we'll find a lot of fraud with

            22   the registered entities.

            23             That's at least what our experience has been.  I

            24   mean, these people are in it for the long run in terms of

            25   investment management and alternatives.  It's not clear to me





             1   what will occur.  Part of me seems to think that in fact part

             2   of the increased fraud that you may be seeing is that hedge

             3   funds are a hot issue.  

             4             I mean, people aren't looking to do prime bank note

             5   schemes and they're not looking to do the next hot Internet

             6   idea or the next biotech.  Seems to me that that may be one

             7   of the reasons why there's this bump up in hedge fund fraud

             8   cases because you've got people who want to do fraud.

             9             It's not to say that there aren't hedge funds who

            10   have engaged in fraud.  It's just I'm not sure that this is 

            11   -- we're getting -- we have an accurate sample or

            12   understanding as to whether this is a real problem or not. 

            13   And the statistics we have seem to indicate that the number

            14   of cases is pretty consistent year in, year out and that it's

            15   typically a very small friends and family fraud that's being

            16   done, under 50 participants, you're probably usually talking

            17   about under $5 million.  

            18             It's kind of like what the State of Washington is

            19   seeing.  And I'm not quite sure if it's just -- you know,

            20   whether it's a hedge -- hedge funds are more prone to fraud

            21   or whether in fact fraudsters are prone to use hot investment

            22   ideas to attract people.  I think it's the latter.

            23             MS. FORNELLI:  Commissioner Atkins.

            24             COMMISSIONER ATKINS:  Yeah.  I wanted to along

            25   those same lines ask Mr. Cutler a couple of questions about





             1   the -- sort of put you on the spot there on the --

             2             MR. CUTLER:  You can call me Steve.

             3             COMMISSIONER ATKINS:  Okay.

             4             MS. FORNELLI:  That's when you know he's going to

             5   ask you a tough question, Steve, when he calls you Mr.

             6   Cutler.

             7             COMMISSIONER ATKINS:  With respect to the 12 that

             8   you cited, I mean, that's not a very big number but just what

             9   sort of cases those were and then to compare to the question

            10   that you had regarding the -- how an examination program

            11   might bring up cases, I was wondering on our registered

            12   investment advisor side, what sort of percentage of real true

            13   fraud is uncovered through the examination program versus

            14   what comes in through the press and through complaints from

            15   customers and things like that.  It just occurs to me most of

            16   the fraud we see around the table at the commission meetings

            17   tend to be the latter rather than through the examination

            18   process.

            19             MR. CUTLER:  Yeah.  I don't have a great sense of

            20   it.  And actually, just to address the last question first, I

            21   mean, I guess I -- my view of a successful examination

            22   program is not at the end of the day that it's produced so

            23   many enforcement cases.  It's sort of like being a good

            24   umpire.  You -- the sign of a good empire is that you don't

            25   notice him and the sign of a good examination program is that





             1   it effectively deters misconduct.  And so I don't know what

             2   the answer is.

             3             Anecdotally, my sense is probably even in the

             4   registered community we get as many tips if you will from

             5   complainants as we do from referrals, but I'm not sure that

             6   necessarily answers the question as to what the utility of

             7   the exam program is because it may well be not producing

             8   referrals because it is deterring misconduct in the first

             9   place.

            10             MR. ROYE:  We should have probably had Lori

            11   Richards on this panel.  Lori is sitting here.  She says that

            12   about 80 percent of the examinations result in a deficiency

            13   letter of registered investment advisors and of 80 percent,

            14   about 7 percent result in enforcement action.

            15             MR. CUTLER:  I did look at the 12 actions, to get

            16   to your first question, Commissioner, and of those, 3 were

            17   follow-on AP's that we brought against registered entities. 

            18   So if you exclude those, we've got 9 left and of those, 8

            19   involved unregistered investment advisors and only a single

            20   one involved a registered investment advisor.

            21             But again, the numbers are too small probably to

            22   draw any significant conclusions from them.

            23             MS. PARIZEK:  I think as a former regulator I can

            24   tell you that, you know, registration is great in theory. 

            25   Now that I've moved to the private sector of course our





             1   clients have enlightened me a little bit about their other

             2   views and legitimate concerns.  But in terms of registration,

             3   yes, of course, there are certain cases that the SEC may have

             4   an ability to detect because remember, you know, our clients

             5   come to us and say we want you to look at XYZ fund manager

             6   because -- you know, unless you have registration, then the

             7   SEC won't have that opportunity.

             8             But on the other hand, remember that this

             9   information is self-reported and with respect to fund

            10   managers who are fiduciaries, you can't just rely on the

            11   information that's filed in a PPM because you need to look a

            12   little bit deeper perhaps and as I mentioned earlier, to

            13   learn more about the integrity of the manager you do need to

            14   do a little bit of due diligence.

            15             So I don't think that registration would put us out

            16   of business.  But with respect to the inspection component,

            17   yeah, again, in theory, that's a great idea.  If you have

            18   some sort of a concern that you're going to have your books

            19   inspected without notice, then theoretically, yes, that makes

            20   sense but realistically how much can you do?  Because if

            21   you've got 6,000 funds, I think I heard the numbers were

            22   maybe 1 inspection every five years, that's not going to be a

            23   deterrent to the people who intend to commit fraud.  

            24             I mean, they're going to go where the money is and

            25   let's face it, the money is in the hedge fund industry and





             1   with $600 billion in assets under management its susceptible.

             2             MS. KNEIP:  There's another way that you can use

             3   exam programs to really get at fraud especially so when

             4   complaints come in the door, the way we do it in Washington

             5   is we have a fraud unit that are examiners and those people

             6   are deployed in as rapid fashion as we can out to where the

             7   problems are.  And if the Commission were given the resources

             8   to be able to do a similar thing, then while you're chasing

             9   it it would certainly help build enforcement cases faster.

            10             And just being able to put somebody in an office

            11   where fraud or anything else bad has been reported on a

            12   complaint rather than doing the whole subpoena power and all

            13   that, if you had exam power, you have a different way to

            14   investigate problems than you have going through the entire

            15   Commission situation that you have to do before you can even

            16   start giving out subpoenas here.

            17             So you have that added advantage of being able to

            18   do for cause exams very rapidly and hopefully save investors

            19   from losing more money by getting in faster.

            20             MS. PARIZEK:  But if you're relying on the

            21   antifraud provisions, do you need registration to do that,

            22   and I guess that's the question.  I guess the bottom line --

            23   and this is a question and answer that I'm not going to touch

            24   -- but the question is should retail investors really be in

            25   this business and, if so, to what extent?  And are there more





             1   moderate proposals like changing the standards for credit

             2   investors that might accomplish the same objectives and not

             3   impair the ability to do periodic inspections if you get a

             4   complaint through the investor hotline.

             5             MR. CUTLER:  Well, in that regard, Pam and Tom, I

             6   mean, I'd be curious -- you guys have said you've done what,

             7   I don't know, 400 due diligence-type inquiries over the last

             8   few years.  How many of those have been commissioned by

             9   anything other than a huge institution who can afford

            10   essentially to do the kind of due diligence that -- I mean,

            11   your firms aren't cheap.

            12             MS. FORNELLI:  Well, I want to take the question a

            13   little bit, too, on that because I've been hearing that --

            14   throughout the whole roundtable I've been hearing of the

            15   dichotomy between the pressure that an institutional investor

            16   can bring to bear, that there's more information and an

            17   institutional investor can really go out and get the

            18   information, that they have that clout as more and more

            19   institutional investors go into the hedge funds as

            20   alternative investments.

            21             And then we've heard a lot about the retailization

            22   and how the investment minimums have lowered and how

            23   individual investors are now having more and more access. 

            24   And so I do want to expand on Steve's point about what can an

            25   individual investor do.





             1             Yesterday the Yale Endowment speaker noted that for

             2   him, when he's making an investment determination, the

             3   integrity and character of the portfolio manager was key. 

             4   How does an individual investor get that information?  Can

             5   they replicate the type of information that, Tom, you and Pam

             6   give to your big institutional client?

             7             MS. PARIZEK:  I suppose to some extent certain

             8   things can be done.  I mean, listen, the SEC has a very good

             9   investor education program with direct links to the state

            10   securities regulators, to the NASD database.  The SEC also

            11   has a very vibrant complaint line that it's actively used.  I

            12   think that Pat has some statistics in his presentation that I

            13   believe is available that shows there are an awful lot of

            14   complaints that are filed.

            15             Are there things people can do?  Yeah.  I mean,

            16   they can make phone calls.  We've had cases where there are

            17   just blatant frauds, where people have indicated that they

            18   have received commendations from NASA, Harvard, the Air

            19   Force.  And you look back at the bio and make a few phone

            20   calls and this kid was a teenager at the time that those

            21   commendations were allegedly made.  Could an individual

            22   investor make that phone call?  Could they do a little bit of

            23   due diligence in that respect?  Yes.

            24             Will it tell you about the reputation, integrity

            25   and performance?  Not necessarily.  But the question is would





             1   registration do that?  I think the answer is no.

             2             MS. PELTZ:  There are other sources that an

             3   investor can go to.  I mean, they can talk to other investors

             4   at that firm, they can talk to people who left that firm.

             5             MS. FORNELLI:  Let me just interject for a second,

             6   and I don't mean to be naive but can an individual investor

             7   go to a hedge fund manager and say can I please speak to

             8   other investors in this fund?  Can I please speak to

             9   employees who have left?

            10             MS. PELTZ:  Well, you can get a list of references. 

            11   I would think any business person would provide that and you

            12   can just build your own network of other investors even if

            13   they are small investors.  And just talk about these things,

            14   share information.

            15             MR. McCARTY:  If I could jump in here, there's a

            16   bit of confusion in my mind here.  Steve and Cindy, you're

            17   talking about retail investors, the people who want to put in

            18   $10,000 or $5,000 and I guess that's if hedge funds become

            19   retail products.  But they're not.

            20             MS. FORNELLI:  I'm even talking about the

            21   accredited investor who has $500,000 in annual income so that

            22   he meets the accredited investor standard, has $100,000 to

            23   invest, can he or she get that information as an individual?

            24             MR. BERMAN:  Can I add something?  The vehicle to

            25   do that -- the best vehicle I think is to find a good fund of





             1   fund manager who will do that due diligence for you, even

             2   though it adds a layer of cost.  To me, that's the better way

             3   for a $500,000 investor to be dipping his toes into this

             4   water.

             5             MR. CUTLER:  And who's going to be doing the due

             6   diligence on the fund to fund manager?

             7             MR. BERMAN:  The fund to fund manager, the $500,000

             8   person is going to have to do that, but if the fund to fund

             9   manager, if his strategy is to diversify over 30, 40, 50

            10   whatever different alternative investment strategies, the

            11   likelihood that there is going to be fund of fund fraud is

            12   far less likely than hedge fund fraud and in fact, I have yet

            13   to be confronted with a big case of fund of fund fraud. 

            14   Never seen one.

            15             MS. KNEIP:  If I can jump in here, retailization

            16   isn't occurring at the big funds and most of the people who

            17   are here at the roundtable and I've heard the discussions

            18   from big fund managers, we have some over a hundred million

            19   in Washington that are actually under our purview and they

            20   don't have the 35 unaccredited investors but everybody is

            21   forgetting that you can have those people.

            22             And most of the advisors that we have that are

            23   running these really small funds, they're your neighbor. 

            24   Maybe not everybody in this room but they are somebody who is

            25   a former Microsoft millionaire -- no offense to Microsoft;





             1   that will probably get me in trouble -- but they've decided

             2   to become a day trader.  During the market downturn they

             3   learned a lot about short selling, they made all this money,

             4   they turned around, they form a 506 and get all their

             5   neighbors into it and none of those people are really

             6   accredited or if they are, it's only because their home value

             7   is now $2.5 million and they just want to get in.

             8             And that's what we're seeing.  Is it large scale? 

             9   No, but those are the people complaining and they're losing

            10   all their money because these people don't have a track

            11   record, they're not the people the big hedge funds are ever

            12   going to hire to manage their money and there is nowhere you

            13   can go to check out these people.  And they're your neighbor

            14   and probably their wife or husband, somebody watches your

            15   kids during the day or something so you're just not going to

            16   do it if you're the standard retail investor.

            17             MR. McCARTY:  And you can't.  I think that -- I

            18   mean, that's probably Steve's point, that the individual

            19   investor can't but I guess in the hedge fund world today,

            20   depends on what you want to define as hedge fund, that

            21   institutional investors -- the high net worth or the family

            22   office guys, the endowments, have the ability to go to Tom

            23   and to Pam and to say do some due diligence on this, are they

            24   registered with the CFTC or the ISAC, what's their track

            25   record, who do they report to, this, that and the other





             1   thing.

             2             You know, are hedge funds a good idea for retail

             3   investors, people who are not accredited investors?  Probably

             4   not.  And in fact, I think the hedge fund industry would

             5   probably say we'd give up all 35 non-accredited investors,

             6   you know.  That's fine.  In fact, we don't want them I think

             7   is what they would tell you.

             8             But getting back to --

             9             MS. FORNELLI:  That's -- a lot of hedge funds will

            10   say that but a newer hedge fund that we've heard a lot about,

            11   the 25-year-old entrepreneurial guy who leaves -- the broker-

            12   dealer, who leaves the trading desk and goes out and starts

            13   his or her own hedge fund, they might want that smaller

            14   client, might they not?

            15             MR. McCARTY:  Well, they might.  In fact, I was

            16   just going to say I had looked at our statistics from 1999

            17   where we brought theoretically 15 pool cases.  We had 12

            18   cases, 12 of those 15 were under a million dollars collected,

            19   and that's I think the kind of fraud you're talking about.  I

            20   mean, 14 of them were under $5 million.  

            21             So these things do happen.  Are they hedge funds? 

            22   I'm not sure whether they -- the friends and family

            23   investment company?  I'm don't know what you would call it,

            24   but it depends upon how you want -- are you going to treat

            25   the entire industry the same way?  Are the large funds that





             1   have million dollar investment minimums going to be treated

             2   the same as the ones who go out and get their money in $5,000

             3   increments?  And I think that's a real issue that people have

             4   to think about.  

             5             The funds that are here at the SEC today, the

             6   registered hedge fund of funds, all of them, 56 or so, the

             7   minimum investment I guess is 25,000 and there's only handful

             8   at that.  Most of them are 50 or 75 or 100,000.  And all of

             9   them are at either the accredited investor level but more

            10   likely than not the qualified client level.

            11             So it's not the case that these registered hedge

            12   fund of funds are really for retail investors, at least yet. 

            13   I mean, retail --

            14             MS. FORNELLI:  That's what I was going to say, yet.

            15             MR. McCARTY:  But the idea -- I mean, this concept

            16   of retailization of the hedge fund industry seems to be I

            17   guess equalized with the dropping minimums.  It doesn't seem

            18   as if hedge funds are actually selling to anybody other than

            19   accredited investors, which is -- I mean, maybe there's a

            20   disconnect here but it seemed to me what we're worried about

            21   or at least the cases we're bringing that we see is really

            22   the small people, the retail investors who are getting ripped

            23   off by friends and family.

            24             MS. FORNELLI:  Well, I think that we as regulators

            25   have to be concerned, because I think one of the reasons that





             1   you're seeing an increase in the fund of funds and the

             2   lowering of the minimums is because there is an appetite, an

             3   investor appetite for that.  It's not -- it's kind of the

             4   chicken and the egg problem.  It's not necessarily the hedge

             5   funds going out after these people.  You've said that the

             6   large hedge funds would gladly give those people away.

             7             But I think as there's more and more of an appetite

             8   by the smaller investor to get into these types of vehicles,

             9   you're going to see an increase in that and so I think

            10   that --

            11             COMMISSIONER GOLDSCHMID:  Cindy -- I'm sorry.  Can

            12   I ask for a bottom line from the panel on this?  Common

            13   ground seems to be that enhanced auditing may make some sense

            14   and auditing standards. Is there anything else that ought to

            15   be done in the view of the panel?

            16             MS. FORNELLI:  We'll start with our non-regulators. 

            17   Lois?

            18             MS. PELTZ:  I think that there needs to be clearer

            19   definitions and classifications exactly of what this industry

            20   is.  I mean, even if you take the word hedge fund, everyone

            21   has their own definition --

            22             COMMISSIONER GOLDSCHMID:  Well, take hedge out of

            23   it and fund and they invest.  What do you want to do, if

            24   anything?

            25             MS. PELTZ:  Well, I think there needs to be clearer





             1   definitions.  I mean, these strategies, everyone calls them

             2   something different and if the people in the industry have

             3   all this blurred confusion, well investors are going to be

             4   blurred, too.  So I just think there need to be clearer

             5   definitions of what it is we're talking about, what these

             6   strategies are and once you have that, you can also develop

             7   risk profiles and what a manager of this type would look like

             8   so it's investor education so an investor would understand

             9   what the strategy is and what the risks are.

            10             So I'm for investor education and clarification.

            11             COMMISSIONER GOLDSCHMID:  Well, is it just

            12   education or should we impose disclosure and risk and

            13   strategy technique and such?

            14             MS. PELTZ:  I think you could start with investor

            15   education and see where that goes and clarify what these

            16   strategies are, what are the risks involved, and take it from

            17   that end.

            18             MS. FORNELLI:  I don't want to go -- did you want

            19   to go --

            20             MS. PELTZ:  Go ahead.

            21             MS. PARIZEK:  I think you have to think through

            22   what the  long-term consequences of that would be.  I mean,

            23   the exemptions were designed for a reason and there were

            24   certain thresholds that were put into place and as this

            25   investment vehicle has become more popular, I'm not sure that





             1   the existing standards are really set at the right thresholds

             2   anymore.  And maybe we need to consider a little bit more

             3   carefully what the thresholds are, whether they're

             4   appropriate and whether they should be changed.

             5             MR. BERMAN:  I think that the SEC should be taking

             6   a long, hard look in each of these hedge fund fraud cases at

             7   what the service providers are doing and not doing, the

             8   broker dealers, the auditors and the administrators.  Because

             9   typically the enforcement actions focus on the manager and

            10   the fund, they do not focus on the service providers.

            11             I think if you did that, there would be a terrific

            12   deterrent effect to some of the things that have gone on and

            13   that I think would be the single biggest area in which

            14   perhaps fraud could be deterred.

            15             MR. FEDOREK:  A credentialing agency that would --

            16   for anybody who is going to manage money on behalf of another

            17   party, which would ensure the investor that the manager has

            18   passed some kind of basic smell test and keep the major

            19   malefactors and the fraud recidivists out of the field.

            20             As I said before, they'll just go elsewhere and it

            21   won't completely solve the problem because some of these

            22   frauds seem to be crimes of opportunity that arose as -- and

            23   perhaps they didn't start out planning to commit a fraud but

            24   as the returns went south, there was an opportunity to

            25   falsify financial statements perhaps with the intent of





             1   making it up later and that never happened.

             2             MS. FORNELLI:  Pat?

             3             MR. McCARTY:  I'm -- I guess -- I think I agree

             4   with Pam in terms of I think the accredited investor

             5   standards.  Probably the SEC should consider whether in fact,

             6   since they haven't been changed since 1982, maybe it's time

             7   to increase that level.

             8             It's a totally different situation if you're going

             9   to let retail investors into this product and I think the

            10   level of regulation should be commensurate with the type of

            11   investors who are going to be in the product and I quite

            12   frankly think that that's the way the SEC has approached it

            13   in the past and I think it's the way it should be in the

            14   future.

            15             The amount of fraud cases that we have seen, and I

            16   guess that the SEC has seen, does not seem to be sufficient

            17   to indicate the need for a huge sea change here.  That would

            18   be my view.  If we're average 10 a year, and it looks like

            19   we're including in those 10 a year things which may not even

            20   really be classified as a hedge fund, I'm not sure when you

            21   think about it -- I know that Steve is very busy and he

            22   brings about 500 and some odd cases a year --

            23             COMMISSIONER GOLDSCHMID:  We were at 600 this year,

            24   Pat.

            25             MR. McCARTY:  Well, there you go.  Productivity is





             1   up.  I hope you got a bonus for that.

             2             (Laughter.)

             3             MR. McCARTY:  Hey, pay parity.  That's the one.  I

             4   guess the thing is shouldn't -- this industry -- I mean, the

             5   financial services industry in the United States is probably

             6   one of the shining beacons and I think the thing is we should

             7   think long and hard about I guess possibly doing something to

             8   a segment of that industry that has actually been very, very

             9   successful and so I would wander in slowly.

            10             Part of me would also say that to the extent that

            11   the CFTC actually has an entity, one of these hedge funds

            12   registered with us as a CPO or a CTA, I would think that

            13   there's not a need for the SEC to require them to be

            14   registered over here because we currently do have them

            15   registered and we do examine them.  

            16             Our point of view in terms of the type of

            17   regulation is probably a little different but I think we both

            18   are against fraud and take quick action and I know that our

            19   enforcement group coordinates with Steve's group on this.  So

            20   I'm very -- I think that's what I would believe is the

            21   appropriate approach.

            22             MS. FORNELLI:  Kristina?

            23             MS. KNEIP:  I have a laundry list here.  The first

            24   idea is if you can come up with a new exemption vehicle other

            25   than the 506, then we don't have to revamp 506.  But I





             1   suppose all this takes Congress to act on.  But that would be

             2   my first thing, is just to make a different kind of an

             3   exemption rather than using a 506, something else that we

             4   know it's a hedge fund, you file the documents, people can

             5   get at them, we've done a great job up front and then maybe

             6   we don't have to do anything else.

             7             If we can't do that, then I'd really like to see

             8   the SEC get the folks registered as investment advisors and

             9   have the exam power with it and of course no double

            10   regulation.  I'm not into that.  So we take the small ones

            11   like we do at the states, the Commission takes the big ones

            12   and the CFTC takes all the ones registered with them so

            13   people aren't forced to go through several examinations.

            14             Lose the 35 non-accredited investor standard, raise

            15   it, index it and investor add always.  The states are trying

            16   to be really active on that and maybe we could do something

            17   with the Commission.  I don't know if the Commissioners have

            18   nay plans to go out on the road again but if it continues to

            19   be a hot topic, maybe that should be included in there and

            20   maybe the states and the CFTC and the Commission could all

            21   get together and kind of do a road show around telling

            22   investors this is the deal with hedge funds and watch out for

            23   your neighbor who is selling to you.

            24             MS. FORNELLI:  Steve, do you want to chime in or is

            25   that putting you on the spot?





             1             MR. CUTLER:  It is putting me on the spot but I'll

             2   chime in.  I guess I'm struck from an enforcement perspective

             3   and that's really the only perspective I'm semi-qualified to

             4   give here, is that we ought to be trying to put more pressure

             5   on the gatekeepers here.  I mean, this is an area where there

             6   are gatekeepers as well and you've identified one set of

             7   them, the third party services and I think the auditors, but

             8   also at the point of sale.

             9             And I think particularly as we see more of this,

            10   the trend toward the retailization of hedge funds, we ought

            11   to be looking harder at who is selling them and what they're

            12   saying when they sell them.

            13             Steve recently brought a case involving sales

            14   literature that accompanied sales pitches related to hedge

            15   fund investments and I think that's an area where the

            16   regulators ought to be putting pressure to ensure that any

            17   sales effected through those venues are done properly.

            18             MS. PARIZEK:  I just wanted to make a few comments

            19   on the idea of credentialing.  Our chairman, Mr. Kroll, has

            20   been thinking about this for the last couple of years.  In

            21   fact, I think Tom and I met when Tom was at Kroll when we

            22   were talking about well, if we were to come up with some sort

            23   of a credential, what would it look like.

            24             Subsequent to that time we actually did develop a

            25   product that would be a "certification" or verification that





             1   managers complied with certain fundamental things like the

             2   managers are who they say they are, background due diligence,

             3   but also had a financial component as well as an operational

             4   component.

             5             There was a little bit of resistance from the

             6   industry on opening up their books to third parties who would

             7   come in just to take a look and make sure that everything is

             8   as they say it is.  I think the response was why should we

             9   lift our kimonos if we don't have to.  So we have considered

            10   other alternatives and there may very well be some.

            11             MS. FORNELLI:  I guess in ending I'll put myself on

            12   the spot and say that I think that we can draw from a lot of

            13   ideas and there might not be one single answer to your

            14   question, Commissioner Goldschmid, but that all of these

            15   ideas bear further examination.

            16             So what that, I will say goodbye and thank you very

            17   much to our panelists.  It's time for lunch.  Don't forget

            18   you have to go back through security.

            19             (Whereupon, a lunch recess was taken.)

            20                 A F T E R N O O N   S E S S I O N

            21             MR. ROYE:  I would like to welcome everyone back

            22   for our latest panel.  We are just going to focus on the

            23   current regulatory framework governing hedge funds.  And to

            24   some extent, we will touch on some of the issues and

            25   questions that came up in our earlier panels.





             1             I have been asked on behalf of our panelists here -

             2   - we have a distinguished panel -- really, to indicate that -

             3   - as unless they indicate otherwise, the views that they

             4   express are their own personal opinions, and not necessarily

             5   the views of the organizations that they represent.

             6             So, let me introduce our distinguished panel.  To

             7   my far right is Mark Anson.  Mark is the chief investment

             8   officer of CalPERS, the California Public Employees

             9   Retirement System.  He is also a member of the International

            10   Association of Financial Engineers, and he serves on their

            11   investor risk committee.  And he has authored several books

            12   on the financial markets, including one called, "The Handbook

            13   of Alternative Assets."

            14             Next to Mark is Alan Beller, our distinguished

            15   direct of the division of corporation finance, who you met

            16   yesterday on our marketing and distribution panel.  Next to

            17   Alan is Jean-Claude Delespaul.  

            18             Jean-Claude is the secretary general of France's

            19   security regulator, known as the COB.  He has also served in

            20   the ministry of finance, and is a financial counselor to the

            21   French embassy in Tokyo, and he also has been generous with

            22   his time with us at the SEC, and he participated last year,

            23   near the end of the year, in a roundtable on auditor

            24   independence and the lawyer rules.  He has been involved in

            25   the COB's consideration of hedge fund and fund of hedge fund





             1   issues.

             2             And then next to him is Bob Pozen.  Bob is the John

             3   Olin visiting professor at the Harvard Law School.  He is the

             4   former president of Fidelity Investments, and he also, in his

             5   career, was the associate general counsel of the SEC.

             6             Next to Bob is Rick Lake.  Rick is the co-founder

             7   and co-chairman of Lake Partners.  Lake Partners is a

             8   registered investment advisor that offers multi-manager

             9   investment programs, primarily hedge funds.  And he manages

            10   the firm's portfolio of hedged funds.

            11             Next to Rick is Sandra Manzke.  She is the co-

            12   founder and co-CEO of Tremont Advisors, Inc.  Tremont engages

            13   in hedge fund consulting services, database sales, and

            14   information services, as well as investment product

            15   development.

            16             Next to Sandra is Iain Cullen.  Iain is the general

            17   counsel of the Alternative Investment Management Association. 

            18   It's a UK-based trade association for hedge funds throughout

            19   the world.  And he is also a partner in the London office of

            20   the law firm of Simmons & Simmons, and heads the firm's hedge

            21   fund practice.

            22             We also, fortunately, have with us Jane Thorpe, of

            23   the CFTC.  Jane is the director of the CFTC's division of

            24   clearing and intermediary oversight, and that's the division

            25   that oversees the commodity trading advisors and commodity





             1   pool operators.

             2             To my immediate left is John Markese.  He is the

             3   president and CEO of the American Association of Individual

             4   Investors, and that's a non-profit organization that is

             5   formed for the purpose of assisting individuals in becoming

             6   effective managers of their own assets through a variety of

             7   educational information programs, and they engage in a

             8   variety of research activities on behalf of individual

             9   investors.

            10             Next to John is Armando Belly.  Armando is general

            11   counsel, and a member of the management committee of Soros

            12   Fund Management.  He also serves as a hearing committee

            13   member of the National Futures Association, and is on the

            14   arbitration committee of the New York Mercantile Exchange.

            15             Next is no stranger.  Annette Nazareth, again, is

            16   our director of market regulation.  It's also noteworthy that

            17   Annette is our representation on the financial stability

            18   forum, which was convened in April of 1999 to promote

            19   international financial stability through information

            20   exchange and cooperation and financial supervision and

            21   surveillance among regulators.

            22             Next to Annette is Paul Roth.  Paul is the founding

            23   partner of Schulte Roth & Zabel in New York, a law firm where

            24   he coordinates the firm's corporate practice, and heads the

            25   firm's private investment funds practice, and he has over 30





             1   years experience in the private funds area.

             2             Next to Paul is Christina Sinclair, of the

             3   Financial Services Authority in the United Kingdom, their

             4   principal financial services regulator.  She heads up the

             5   business standards department, and worked on the FSA's recent

             6   papers regarding hedge funds.  And the department's main

             7   portfolio is really focusing on business standard policies

             8   across the markets in retail sectors in the UK.

             9             And then is our chief counsel, Doug Scheidt.  He

            10   moderated our panel yesterday on evaluation and other issues.

            11             And then last, but not least, is Jack Gaine.  Jack

            12   is the president of the Managed Funds Association, and it's a

            13   U.S.-based association of investment professionals that

            14   manage hedge funds and engage in alternative investments.  I

            15   should point out that earlier in his career he was general

            16   counsel of the commodities futures trading commission.

            17             We thought, to begin the discussion in this area,

            18   it would be useful to kind of focus on how other regulators

            19   view hedge funds and fund of hedge fund issues, how they

            20   focus on hedge fund managers, their approach to regulation. 

            21   And I thought we would start with Jean-Claude, to talk about

            22   how you approach the regulation of hedge funds and managers

            23   in France.

            24             ME. DELESPAUL:  I will try to do that.  I will try

            25   to do it briefly, although I need some minutes to explain.





             1             First of all, I would like to say I am delighted to

             2   be here, and to present some varying views.  I am expecting

             3   and hoping that it will help in a better understanding of

             4   perhaps diverging or completing ideas.

             5             As you know, Mr. Roye, the COB has been, for the,

             6   probably, past five years, a strong advocate among the

             7   regulators of some reflections to be put at the international

             8   level on hedge funds, and on the effect and inference of

             9   hedge funds on the labor market.  And consequently, some work

            10   has been done within the IOSCO, Internal Organization of

            11   Securities Commission, on that question.  So, we considered

            12   it important, in the COB, to be here today to express our

            13   views.

            14             I would just like to say a word to ask you to be,

            15   please, very kind to the only person in the room to whom

            16   English is not a natural language.

            17             (Laughter.)

            18             ME. DELESPAUL:  Concerning France, I will try to

            19   explain briefly where we stood a few years ago -- say, about

            20   three years ago -- what we intended to do, what has been done

            21   so far, and what we consider, as regulator, remains to be

            22   done, in terms of hedge funds.

            23             First where were we, say, two to three years ago? 

            24   We have in the French law a general provision which has

            25   existed for almost 100 years, which totally prohibits any





             1   commercialization in France of foreign financial products

             2   which haven't been approved or recognized by the French

             3   minister of finance and COB's recommendation.  

             4             Recognized means that we can accept completely what

             5   we call in Europe the coordinated collective investment

             6   scheme following the European directives, which means that

             7   there is a possibility to commercialize in France other

             8   European collective investment schemes and products.

             9             In what I said, the term "commercialization"

            10   implies an active role of the promoter to approach customer

            11   and to convince them to invest.  It doesn't mean that the

            12   sale of such products is forbidden.  And we knew perfectly

            13   that some portfolio managers or third-party asset managers

            14   had been shopping around to add some hedge funds investments

            15   to their assets.  But that was tolerated, because it remained

            16   very marginal until the end of the 1990s.

            17             We had also in our regulation, a few specific

            18   products of a more risky nature corresponding to the needs

            19   and the qualification of affluent investors under strict

            20   condition, and with the specific agreement by the COB.  So,

            21   at the beginning of the 1990s -- I will not describe them

            22   into details, but you could find probably the reference for

            23   the regulation -- at the beginning of the 1990s, we had

            24   introduced something called -- specific funds operating on

            25   futures and options, so created at the beginning of the





             1   1990s.

             2             In the mid-1990s, simplified procedure restricted

             3   to qualified investors.  They have in common precise rules

             4   for their management, for instance, higher requirements

             5   concerning the qualification of managers, and the technical

             6   means used by the management.  And they are qualified by a

             7   special warning which has to be read and accepted by the

             8   investors.

             9             These funds are approved and registered by the COB,

            10   and are under the surveillance of the French regulator.  The

            11   -- part of that is that they can operate more freely in terms

            12   of leverage, and in terms of operation.

            13             That was the point -- the situation two to three

            14   years ago.  What did we intend to do?  At the end of -- we

            15   observed that the rapid development abroad of hedge funds was

            16   meeting precisely the appetite of French investors and of

            17   fund managers to obtain, in one case, and to propose, in a

            18   manager's case, higher yields, or at least yields higher than

            19   the average market indexes and bench marks.  And we noticed

            20   an increase in their investment in hedge funds.

            21             Again, this is still a marginal phenomenon.  It --

            22   our figures show that they are probably, by the end of 2002,

            23   about 5 billion of Euro invested in hedge fund by about 140

            24   funds in France.  And these, probably in addition to a

            25   slightly higher amount -- 6.5 billion, I suppose, Euro --





             1   under direct management by the funds which I described

             2   earlier.

             3             So, all together, and compared to the total amount

             4   of assets managed under collective investment schemes, this

             5   is very limited.  Nevertheless, it shows a real and rapid

             6   increase over the past two to three years.

             7             In addition to that, we consider that there was

             8   some risk of intra-European -- I hesitate to use the

             9   "competition," -- but intra-European leaks, we could say,

            10   which might push French investors to find products more

            11   easily in some other of our neighboring countries.

            12             So, the commission decided to address the issue,

            13   and made it within a very close relation and discussion with

            14   the profession and the industry, giving a high priority to

            15   the protection of investors.  And it appeared rapidly, that

            16   the best approach was to try to repatriate those investments

            17   under the French regulation as much as possible, and to put

            18   clear conditions on the possibility for funds to invest into

            19   hedge funds.  Of course, it's out of question that we

            20   regulate, directly, hedge funds.

            21             So, the process undertaken is a process from

            22   tolerance, which was the previous situation, to drafting some

            23   framework.  It has taken about two years of intense work,

            24   very strong discussions, and sometimes very conflicting views

            25   between the industry and the regulator, before the commission





             1   could approve a set of decisions which were approved earlier

             2   this year, and presented publicly this year concerning what

             3   we decided to call alternative multi-management investments.

             4             I should say that in parallel, and during the same

             5   period of time, we had a specific working group under the

             6   chairmanship of one of the members of the commission working

             7   on management fees and charges and commissions, and that this

             8   group produced recommendations, which were sometimes also

             9   semi-conflictual, at the end of 2002.

            10             Now, I come to what has been decided by the French

            11   commission.  Decisions have been taken concerning the actors,

            12   concerning the products, and concerning the customers. 

            13   Concerning the operators, the portfolio management companies

            14   who invest, or were willing to invest in foreign non-

            15   coordinated funds -- you could say in hedge funds -- have to

            16   produce or to adjust -- produce, if it's a project for new

            17   management companies, or to adjust if it's an existing

            18   management company -- specific programme d'activite.  

            19             That's the document which is produced to the COB

            20   before licensing, before registration, and which describes,

            21   as precisely as possible, all elements of the management

            22   company and the -- not only the business plan, but giving a

            23   complete description of all what will be the operations.  So,

            24   even existing portfolio management companies will have to

            25   adjust their programme d'activite and submit it to the COB. 





             1   And this, as soon as they intend to invest from the first

             2   Euro into hedge funds.

             3             Five points have been clearly underlined as

             4   important to the regulator.  One is the expertise and

             5   experience of the team to select funds and to master the

             6   management techniques related to -- relating to hedge funds. 

             7   A second point is the ability to follow the investments which

             8   are made.  A third one is the existence of the specific risk

             9   control structure in the management company.  Another one is

            10   the existence of technical means adapted to the complexity of

            11   the financial techniques used.  And the fifth one, relating

            12   to the customers, is relating to information and

            13   commercialization procedures.

            14             The -- still concerning the operators, the

            15   depository is fully responsible for the conversation of the

            16   assets.  The management company keeps full responsibility for

            17   the management.  And when they are delegations or services

            18   provided by some other companies, it has to be clearly and

            19   precisely monitored and described.  In addition to that, the

            20   industry itself has accepted to prepare an code of conduct

            21   for such investments.

            22             Concerning now the products.  The -- one of the

            23   requirements is that the shares of the target funds acquired

            24   can be qualified as stocks, in terms of legal requirements. 

            25   I don't -- that means that there is clear transferability,





             1   that there are equal rights between the different

             2   shareholders, that the responsibility rules are clear, that

             3   there is an audit of the accounts, that there are

             4   prospectuses, and so on.

             5             Secondly, we, the commission -- and this has been a

             6   point of long discussions within the industry -- the

             7   commissioners decided that, as a rule, we wouldn't accept

             8   three levels of investment.  Clearly, funds of funds -- funds

             9   of hedge funds -- are possible, but not funds of funds of

            10   funds, except of course, in the case of master -- funds where

            11   there is an exception.  

            12             Also has been a point of strong and long

            13   discussions, the traditional classical rules which we apply

            14   to diversification and to the disbursion of risks are to be

            15   applied to these funds of funds.  As a counterpart of that,

            16   we accept more relaxed rules in terms of leverage, in terms

            17   of -- which characterizes the management of the hedge fund.

            18             Now, the protections for investors -- and again, I

            19   stress that the starting point of the process was the

            20   protection of investors -- we would have the commission

            21   specific control over the commercialization.  The brochures

            22   and promotional documents will be presented to the COB.  The

            23   idea is that it should explain as clearly and simply as

            24   possible what is exactly contained in the investment proposed

            25   to the investor.





             1             In terms of limit to the investment, the COB's

             2   suggestion is that it should cover initial subscription of at

             3   least 10,000 Euro, which is not a very high level, but we

             4   consider that the other rules and requirements should give

             5   sufficient protection to the small retail investor. 

             6             Now, this is what has been decided this year. and

             7   what comes now into publication.  So, a few things that still

             8   have to be done.  Part of that has to be translated into

             9   regulation, which hasn't been made so far, and which might,

            10   for some elements, take time, since, at the same time, we

            11   have, as many other European countries, to transpose into

            12   French regulation, the principles of the new usage directives

            13   in -- decided in Brussels within the union.

            14             We will create, before the end of this year,

            15   special category of usage, which would be called funds of

            16   alternative management, and this would be the implementation

            17   of those decisions presented earlier.

            18             And in addition to that, a law which is presently

            19   being discussed in the French parliament proposes to create a

            20   new concept of contractual funds which would be -- I

            21   shouldn't say French hedge funds, because this probably is

            22   not the case -- but which would be very liberated funds, with

            23   a reinforced mechanism of surveillance by the regulator, a

            24   high level of initial investment -- probably 500,000 Euro --

            25   and a strict control by the COB under the commercialization





             1   and distribution.  So, this would be a fund reserved to

             2   professional investors, and with very relaxed rules of

             3   management.  

             4             So, this is point now concerning the present

             5   situation in France relating to hedge funds, and their

             6   commercialization.  Thank you.

             7             ME. ROYE:  Thank you, Jean-Claude.  It sounds like

             8   in your regime, the manager will have to be qualified, and

             9   you're going to permit fund of hedge funds, investors are

            10   going to invest a certain threshold.  You're going to put

            11   qualification standards, in terms of how they can be sold,

            12   and then it looks like you're moving toward -- well, it

            13   sounds like the equivalent of our sort of 3C7-type hedge fund

            14   for investors who can make significant investments into the

            15   fund, and providing more flexibility there.

            16             ME. DELESPAUL:  Right, that's it.

            17             ME. BELLER:  Paul, I had one quick question.  The

            18   programme d'activite, which is filed with the COB, is that

            19   also publicly available?

            20             ME. DELESPAUL:  Yes, it is.  

            21             ME. ROYE:  Christina, in the UK, you have also

            22   taken a recent look at hedge funds and whether or not they

            23   should be opened up to retail investors, looking at how the

            24   hedge fund managers themselves should be regulated, and

            25   whether or not that should be changed or modified.  Could you





             1   give us an outline of what you guys just recently went

             2   through, and where you came out?

             3             MS. SINCLAIR:  Yes.  Yes, I can do that, thank you. 

             4   But perhaps I might first make a couple of comments about the

             5   way we regulate hedge funds in the UK, and that will make

             6   some of the comments about how we went about our discussion

             7   paper a little clearer.

             8             First of all, regulation in the UK, we do not have

             9   a special regime for hedge funds.  We apply our ordinary

            10   regime in a variated way, to catch what we do for hedge

            11   funds.  And I think I could say there are really regulation

            12   attachers in two ways.  First of all, to the products, and

            13   secondly, by virtue of a person conducting some sort of

            14   activity, which may be advising, promoting, managing, or

            15   selling, and you can see how those two things might attach to

            16   hedge funds.

            17             So, looking first at products, hedge funds can be

            18   either unincorporated vehicles or collective investment

            19   schemes.  And in the UK, that means that they could be

            20   regulated or unregulated.  Now, hedge funds do not generally

            21   come in a shape and size that would enable them to be

            22   regulated under our existing regime.  So they exist as

            23   unregulated schemes.  And in that case, that means that we,

            24   generally speaking, allow them to exist as an unregulated

            25   scheme.





             1             Now, I mention at this stage that the tax treatment

             2   of these entities in the UK is not necessarily attractive,

             3   and so they are not -- the UK is not a domicile of choice for

             4   funds.  So our experience with products is limited.

             5             The second way a hedge fund might exist is in a

             6   corporate vehicle.  And very similar to -- as you have over

             7   here, they can be public, in which case they may be listed,

             8   or they can be private.  And our ordinary regulation will

             9   attach to each of those.  

            10             Now, for listed funds, they are currently -- the UK

            11   listing authority has taken the view that, as investment

            12   companies, hedge funds do not meet the required criteria for

            13   spreading of risk.  And so they are ineligible to be listed. 

            14   And one of the things that we did talk about in our

            15   discussion paper was whether or not we needed to modify that

            16   to allow our companies to be listed.  As private companies,

            17   of course, there are no such restrictions, and they could, if

            18   they wished, be -- exist as private companies under UK law.  

            19             Just going back, then, to the activities, those who

            20   engage in those activities that I mentioned before --

            21   promoting, advising, selling, or managing -- need to be

            22   authorized under our regime.  So, if you wanted to be a hedge

            23   fund manager, you would need to be authorized.  Similarly, if

            24   you wanted to promote or sell hedge funds to people in the

            25   UK, you would need to be authorized.





             1             There are some exemptions to those particular

             2   rules, but I think I will just plow on, as though you have

             3   come within the ordinary category of required to be

             4   authorized.  To get authorized, you need to come through our

             5   threshold conditions, which focus primarily on honesty,

             6   integrity, and competence in order to do your job, and that

             7   is a broad category that attaches to whether or not you're

             8   doing a hedge fund, or whether you're setting up an insurance

             9   company, really.

            10             And so, it's very broad in general, but it needs to

            11   be interpreted specifically for the permitted activity that

            12   you want to do.  So, of course, if you wish to manage a hedge

            13   fund, we would look at what that means in relation to the

            14   activities that you were actually proposing to undertake.

            15             The authorization process is just the beginning. 

            16   When you become authorized, of course, you then become

            17   subject to the FSA's supervision and oversight regime.  And

            18   in the first instance, of course, that means you need to

            19   comply with our rules.  

            20             And our rules -- we operate a principles-based

            21   regime, and we have high-level principles of business that

            22   apply to all businesses conducting any sort of activity, and

            23   they are very general and relate to such things as, in the

            24   first instance, that senior management need to take

            25   responsibility, they need to have appropriate systems and





             1   controls, they need to treat their customers fairly, and they

             2   need to conduct their business so as to preserve market

             3   integrity.  There are a number of those principles, but I

             4   think you get the picture.

             5             We have detailed rules underneath those principles,

             6   and those detailed rules are tailored more specifically to

             7   the nature of particular activities.  And of course, there

             8   are a number of rules that relate to the activity of

             9   investment management, and they would apply to a hedge fund

            10   manager in the same way as they would apply to any other

            11   investment manager.

            12             In particular, there are training and competence

            13   requirements.  And of course, again, they are backed up with

            14   more detailed provisions relating to systems and controls for

            15   the business.

            16             What do we do, as the FSA?  It's not just that we

            17   have rules, we also have supervision.  And I think anyone who

            18   has come in contact with the UK system of regulation will

            19   know that the financial services authority adopts a risk-

            20   based approach to supervision, and what that means is that we

            21   tailor or supervisory activities according to what we

            22   perceive to be activities that present the greatest risk to

            23   our statutory objectives.  And two particular statutory

            24   objectives are our objective of maintaining confidence in the

            25   UK financial market, and protecting investors.  





             1             And so we look at hedge funds in this way.  We say

             2   this is a category of the market that, by and large, provides

             3   services to a sophisticated vehicle, which is a hedge fund,

             4   which, in many cases, is located offshore.  The fact that

             5   it's located offshore does not stop our rules biding on our

             6   managers.  

             7             They are small -- although the sums are large --

             8   they are small in relation to the number of pounds involved

             9   in that particular activity across the whole financial

            10   services industry in the UK.  And the number of retail

            11   consumers that are likely to be affected by problems in that

            12   industry, because -- by virtue of our other rules and

            13   regulations is small.  And in that case, we, generally

            14   speaking, put hedge funds in a category of risk as being

            15   rather low.

            16             Now, that doesn't mean that investment managers

            17   need to not comply with our rules, but what it means is that

            18   we do not spend a large proportion of our supervisory time

            19   crawling all over their business, and we are more likely to

            20   expend supervisory effort through a themed approach, where we

            21   look at particular risks that those businesses may pose.  

            22             And in that sense, some of the risks that we would

            23   be sensitive to are risks that might arise out of leverage,

            24   excessive leverage.  And of course, we have mentioned that

            25   before, that was one of the things that came up in the





             1   president's working group.  We will be looking at highly-

             2   leveraged institutions, and we look, in particular, at the

             3   counter-party exposure to hedge funds, because we have other

             4   financial institutions who are providing a range of services

             5   in the UK who may have exposures in that context.  So, just

             6   to sum up on that, we think our supervision of hedge fund

             7   managers is probably light touch.  

             8             Now, just briefly going back, then, on investor

             9   protection, we have a number of rules that prohibit marketing

            10   and promotion to retail investors of hedge funds.  And that,

            11   I think, is enough background to lead me into a quick

            12   discussion of what we did in DP 16.  What we are very

            13   conscious of is that we regulate the managers, we do not

            14   regulate the funds.  Where the funds are not incorporated in

            15   the UK, our regular treatment does not extend to them.  But

            16   we do cover the managers.

            17             We were concerned that somehow, the fact that

            18   managers could advertise themselves as being authorized, may

            19   lead investors in funds to believe that somehow they received

            20   a greater degree of regulatory protection than may be the

            21   case.  And we thought that we would want to think about that,

            22   and what the implications of that were.

            23             Secondly, we were also concerned that there was an

            24   appetite for hedge funds to be marketed to retail investors,

            25   and that retail investors were clamoring to get into hedge





             1   funds, particularly in the downturn of the market, there was

             2   very much a sense that retail investors were aware that hedge

             3   funds had not suffered drops in performance as much as

             4   conventional funds, and with an appetite for them to have a

             5   piece of the action.

             6             In DP 16, therefore, we said two things.  First of

             7   all, we wanted to ensure that there was awareness out there

             8   that our regulatory remittance scope extended only so far. 

             9   And in particular, that although we looked at the managers,

            10   we were not regulating the funds.  And secondly, we wanted to

            11   ask the industry whether or not there was an appetite for us

            12   to change our rules on marketing of hedge funds to retail.

            13             As a part B of that question, we also said, "And

            14   would there be an appetite for us to relax our restrictions

            15   and rules on establishing hedge funds in the UK?"  In other

            16   words, perhaps a  relaxing of our listing rules, such as I

            17   mentioned before, or setting up a new category of collective

            18   investment scheme that would allow hedge funds to be

            19   established in the UK.

            20             We published a feedback statement.  We received a

            21   number of responses to our consultation paper.  And very

            22   interestingly, the responses that we received showed -- quite

            23   hearteningly, for us -- that perception and understanding of

            24   the limit of our regulatory remit was high.  And in

            25   particular, we were concerned about some of the clients of





             1   hedge funds, or investors of hedge funds that we may not

             2   automatically say are necessarily sophisticated investors. 

             3   And by this, we mean things like charities or trust funds,

             4   who, although they had reasonable chunks of money, would not

             5   automatically be savvy, in financial services terms.

             6             And our results showed that, yes, they were well

             7   aware of the limitations of our scope, they understood what a

             8   hedge fund was, they understood, when a fund was established

             9   offshore, what that meant.

            10             Secondly, in relation to the retail issue, we

            11   actually received quite an interesting response from industry

            12   which said they were very sensitive to the issues that

            13   allowing higher retail involvement in funds would bring.  And

            14   many of these are some of the things that we have talked

            15   about before.  Ought there to be higher standards of public

            16   oversight through auditing or through valuation controls? 

            17   Through investment controls?  All of those sorts of areas

            18   where we can see that lax standards can lead to problems in

            19   the industry.

            20             Now, the industry said they could see that there

            21   was an argument that they would, perhaps, need to be higher,

            22   where you had retail investors.  And therefore, in many

            23   cases, they did not think that they were worth taking on

            24   those particular rules was worth it, and they would rather

            25   stick with the regime as it was.  The one exception to this





             1   was in the fund of funds area, where we did see some appetite

             2   for perhaps allowing more retail in.  But I mention that

             3   funds of funds, in any event, can be listed in the UK under

             4   our rules, in any event.

             5             So, we published our feedback, and we took the

             6   decision that we were not going to change the regime,

             7   although we were going to keep it under watch, to see if

             8   there was an appetite for new changes to our rules.

             9             Now, just to back up, what Jean-Claude has said in

            10   response to some of the European developments in relation to

            11   the European directive that relates to collective investment

            12   schemes, we have been reviewing whether or not there is scope

            13   to expand the category of collective investment scheme to

            14   encompass things that would allow hedge funds in there, but

            15   only if these were available to institutional investors.

            16             And we have recently published a CP of collective

            17   investment schemes which raises that possibility.  I think

            18   that's probably enough.

            19             ME. ROYE:  Thank you, Christina.  One thing that is

            20   striking about, you know, when you went through the

            21   qualifications, and how you regulate a manager, it sounds

            22   like it's more of a merit review that you do, in terms of

            23   qualifying the manager, allowing the manager to register,

            24   whereas in the U.S., it's a regime where if you, you know,

            25   you file the registration document, you make the disclosures,





             1   we're not going to scrutinize whether or not you have the

             2   appropriate qualifications.  As long as you haven't maybe

             3   been convicted of certain crimes or disciplinary history, you

             4   can be an investment advisor registered with the SEC. 

             5             And it sounds like you go into a much more in-depth

             6   analysis of the qualifications, background, et cetera, of the

             7   manager.

             8             MS. SINCLAIR:  We do.  We look at what is the

             9   permission that is sought.  And if the permission says, "We

            10   want to do this," then, yes, we would look and see what sort

            11   of qualifications you would have to do that, yes.

            12             ME. ROYE:  All right.  Doug, you work with the

            13   International Organizations of Securities Regulators, and

            14   have been in discussions with other regulators about how they

            15   approached hedge fund regulation, hedge fund managers.  And

            16   we have just heard two regulators talk about their

            17   approaches.  

            18             Can you give us a sense of how other countries are

            19   approaching hedge fund regulation, a regulation of managers? 

            20   And I guess my sense is that we are one of the few countries

            21   that doesn't at least require the manager to be registered

            22   with the regulatory authority.

            23             ME. SCHEIDT:  Your sense is generally correct.  We

            24   are also one of the few countries that, in your words,

            25   doesn't give merit review to those managers who do register,





             1   or seek authorization from the regulatory authorities.  

             2             I usually put this in stark contrast, and say that

             3   my three-and-a-half-year-old daughter could register with the

             4   SEC as an investment advisor within 45 days of filing the

             5   advisor registration document.  And the point usually comes

             6   across pretty well.  But most --

             7             ME. ROYE:  It would be a legal capacity issue

             8   there, but --

             9             ME. SCHEIDT:  Yes.  But most jurisdictions are like

            10   the UK and the U.S., in that they permit hedge funds to be

            11   privately sold and marketed to sophisticated investors and

            12   institutional investors without requiring the fund to be

            13   licensed, or registered with the regulatory authority.

            14             Some jurisdictions -- and I will get into more

            15   detail about this -- do permit the sale of hedge funds to the

            16   retail investor.  And many, many jurisdictions allow funds of

            17   hedge funds to be marketed to retail investors.  I am going

            18   to focus on three countries. 

            19             The one that has been in the business the longest,

            20   I would say, is Switzerland.  Since 1994, they have had

            21   legislation that permits the sale of hedge funds and funds of

            22   hedge funds to the public in Switzerland.  There are -- they

            23   created a category of fund called "other funds with special

            24   risks," that cannot call themselves hedge funds, but they

            25   must prominently disclose this designation in the prospectus.





             1             There are several requirements that are similar

             2   across the three countries that I will focus on, but: 

             3   special prospectus disclosure; minimum manager experience and

             4   capital; sometimes they require expertise of the auditor for

             5   the hedge fund; operating restrictions, such as restrictions

             6   on leverage; and a thorough assessment, similar to the merit-

             7   based approach, to the manager, that may also go to the fund,

             8   itself.

             9             So, in Switzerland, there is special prospectus

            10   disclosure of all special risks.  It must specifically

            11   disclose redemption and valuation methodologies and

            12   procedures.  The managers must have five years, at a minimum,

            13   of experience, and a minimum capital of about $750,000.  The

            14   external auditors must have -- must demonstrate expertise in

            15   auditing hedge funds, or that type of hedge fund.  Redemption

            16   must be available at least four times a year.  Borrowing is

            17   restricted to 25 percent of the fund's assets.  They have no

            18   minimum investment amount, but we are told that they never

            19   had an investment below a certain relatively low level,

            20   $10,000.

            21             And then there are additional requirements for

            22   funds of hedge funds.  They define a fund of hedge funds as

            23   any fund that has more than 10 percent of its assets invested

            24   in a hedge fund.  No more than 30 percent of the fund's

            25   assets can be invested in any fund offered by the same





             1   manager.  And the prospectus disclosure in the fund of hedge

             2   funds must say that you could lose 100 percent of your money.

             3             Hong Kong, more recently, permitted sale of hedge

             4   funds to retail investors.  They have minimum investment

             5   requirements that's $50,000 for a single hedge fund, and in a

             6   fund of hedge fund it's as low as $10,000.  The manager must

             7   have expertise in a certain -- must have at least $100

             8   million in management -- in hedge fund strategy, and five

             9   years of experience in managing hedge funds, or hedge fund

            10   strategies, and two years in the strategy that's going to be

            11   employed by the fund.

            12             The prospectus must disclose the extent of

            13   diversification, the leverage, risks, et cetera.  They

            14   require that the performance fee charged by the hedge fund

            15   must be on a high watermark basis.  They require valuation by

            16   an independent valuation agent, and they require valuation on

            17   at least a monthly basis.  And they also require quarterly

            18   reports by the hedge fund.

            19             Singapore -- I guess I won't go into detail too

            20   much on Singapore -- but Singapore has a similar approach as

            21   to -- as Hong Kong does.

            22             ME. ROYE:  But you have situations where, you know,

            23   even where they're opening the door to retail investors, they

            24   are still, in effect, limiting who can be a hedge fund

            25   manager.  I mean, they are scrutinizing qualifications,





             1   background, and only letting what they view as a suitable

             2   manager run a hedge fund.  But they can be offered to retail

             3   investors.

             4             ME. SCHEIDT:  Yes, similar in the U.S., to the

             5   extent that we permit registered funds of hedge funds.  There

             6   is an awful reliance, if you will, on the top-tier manager,

             7   his expertise, on behalf of the investors in the fund in

             8   picking suitable hedge funds, if you will.

             9             But we don't impose any requirements on those

            10   managers.  We don't require experience, we don't require

            11   demonstrated abilities.  We don't get involved in that

            12   process.  The foreign jurisdictions that permit funds of

            13   hedge funds, and retail investment in hedge funds do

            14   thoroughly assess the fitness of the manager to provide those

            15   services, the educational background and experience.

            16             ME. ROYE:  I guess I would just open it up to the

            17   other panelists, maybe Iain, in particular.  Any observations

            18   on how regulators, other than the U.S., approach the

            19   regulations of hedge funds, funds of hedge funds, hedge fund

            20   managers?

            21             ME. CULLEN:  I don't have a lot to say.  I think

            22   it's been said, principally by Christina and by Jean-Claude. 

            23   I think you do have to remember that the European and Far

            24   Eastern systems grew up entirely differently from yours, and

            25   these are different times.  Simply looking at what other





             1   people have done in other parts of the world and saying,

             2   "Maybe this is the way to go," ignores the fact that they

             3   have grown up under different circumstances.

             4             I make no comment about whether it's right or not

             5   to look as closely as we do -- and, indeed, as many other

             6   European jurisdictions do about the underlying experience of

             7   the managers.  I think the only --

             8             ME. ROYE:  We probably bring a lot more enforcement

             9   cases than you see in Europe as a result of -- 

            10             ME. CULLEN:  Your system is very different.  As

            11   somebody said in one of this morning's panels, the SEC tends

            12   to be the cop, whereas most of the European regulators have

            13   grown up working not so much as cop, but rather with their

            14   constituencies.  It's not seen as an us and them scenario. 

            15   And I don't think you can just graft other jurisdiction's

            16   ways of doing things on to yours, and say, "Well, theirs is

            17   better, and this is the way we should do it."

            18             I think the only other point that I would make in

            19   relation to funds of hedge funds, in particular, is that not

            20   just Switzerland, Hong Kong, and Singapore, in the process of

            21   bringing out rules for domestic funds of hedge funds, but

            22   Italy has done it some time ago, Germany has expressed its

            23   intention to do so.  I think the UK will get there, sooner,

            24   rather than later.  And the FSA just needs a bit of a push.

            25             And I think that Ireland and Luxembourg -- Ireland





             1   has just come out with specific rules for funds of hedge

             2   funds.  One tends to think of Ireland and Luxembourg, in the

             3   same breath, as being jurisdictions that provide product to

             4   be sold elsewhere, because they are so small, in themselves. 

             5             But clearly, there is a move outside the U.S., as

             6   well, towards regulating, in one shape or form, funds of

             7   hedge funds, at least.  And I think it will continue, rather

             8   than contract, particularly if you think in terms of the

             9   extra bit that -- in relation to at least Hong Kong and

            10   Singapore, which is that if you have a guaranteed fund of

            11   hedge funds -- or, indeed, actually a guaranteed single

            12   manager fund -- although I don't think there are any -- there

            13   is no minimum investment, whatsoever.  You can have a minimum

            14   investment as low as five dollars --  local dollars, rather

            15   than U.S. dollars.

            16             ME. ROYE:  Thank you.  Why don't we move from how

            17   foreign regulators approach the regulation of hedge funds and

            18   their managers to the CFTC.  I mean, as we pointed out, I

            19   think largely, hedge funds aren't registered with the SEC. 

            20   They are off our radar screen, but they are on the CFTC's

            21   radar screen. 

            22             Jane, if you could, you know, outline how you

            23   regulate and oversee hedge funds for us.

            24             MS. THORPE:  Thank you, Paul.  Hedge funds is not a

            25   term that is defined in the Commodity Exchange Act, or the





             1   rules of the CFTC.  But if a hedge fund happens to exchange

             2   trade a derivatives, then the operator of that vehicle that

             3   invests in futures must -- is subject to regulation.

             4             So, even though, Paul, we are in the United States

             5   and not outside the United States, we do scrutinize the

             6   manager, and it is the manager that we regulate, and not the

             7   vehicle itself.  Those managers are required to be registered

             8   with the commission as commodity pool operators.  There is no

             9   general relief for privately offered funds, comparable to

            10   that under the securities laws.  If a CPO relies on an

            11   external advisor, that advisor must be registered as a

            12   commodity trading advisor.  As of April 2003, there were

            13   approximately 1,800 active CPOs and about 800 active CTAs.  

            14             In terms of our regulatory framework, it's really

            15   based on investor protection.  It's designed to protect

            16   investors against fraud and trading abuses.  Registration and

            17   other requirements are intended to ensure the fitness and

            18   properness of the manager.  The disclosures include

            19   information on the investment program, principal risk

            20   factors, past performance, fees and expenses, conflicts of

            21   interest.  And these disclosures must be updated every nine

            22   months and be provided to an investor before it opens an

            23   account.

            24             In addition, the pool operator must also provide

            25   periodic account statements, as well as an annual audited





             1   financial statement.  Further, they are also required to

             2   comply with sales practice requirements, as well as various

             3   record-keeping and reporting requirements.  CPOs and CTAs are

             4   subject to requirements in anti-fraud and anti-manipulation.

             5             With respect to compliance, it really is a

             6   responsibility that we have given to the National Futures

             7   Association and Industry Self-Regulatory Organization.  And

             8   in practice, we have delegated many of these functions to

             9   NFA, including the registration processing function for CPOs,

            10   CTAs, as well as most of our other registrants.  In addition,

            11   review the annual financial statements for compliance with

            12   GAAP, and a disclosure document review for compliance with

            13   the standards in our rules.

            14             NFA conducts routine periodic examinations of CPOs

            15   and CTAs for compliance with both CFTC and NFA rules.  And

            16   then we, in turn, review NFA's review of these entities. 

            17   CPOs and CTAs are conducted on a three-year audit cycle by

            18   NFA.

            19             As far as current regulatory relief that is

            20   available under the Commodity Exchange Act, I think the most

            21   prominent one to mention is that there is no broad-based

            22   registration relief for entities that are hedge fund-like, as

            23   I mentioned.  

            24             But there is a significant relief for entities that

            25   are 4.7 qualified, that, to the extent they have





             1   sophisticated investors, they are required to be registered

             2   as commodity pool operators, but they are exempt from any

             3   disclosure, record-keeping and reporting requirements.  And

             4   approximately 50 percent of the registered CPOs have filed

             5   4.7 notices, so that is a significant number.

             6             The Commodities Exchange Act does not require the

             7   CFTC to insure the safety and soundness of either the

             8   commodity pool operator, or the pool that it operates, and it

             9   does not restrict the types of products that a pool can trade

            10   in. 

            11             However, pools are customers, and their accounts

            12   must be carried by a futures commission merchant, which is

            13   supervised for capital requirements.  Also, pools are

            14   customers on markets.  And as such, they are subject to large

            15   trader reporting requirements and speculative trading

            16   restrictions.

            17             If you want me to touch upon the proposal that we

            18   have outstanding, Paul, I can do that now, or I can do that

            19   later.

            20             ME. ROYE:  Yes, I was just going to ask you, you

            21   know, that you're proposing to reshape the regime.  Pat

            22   McCarty alluded to that in one of the earlier panels.  And I

            23   guess it's going to provide additional exemptions for hedge

            24   fund operators, I guess, or hedge fund advisors.

            25             And I just wondered the theory behind that, you





             1   know, why are you moving in that direction, and if you have

             2   any estimates of what that's going to mean, in terms of hedge

             3   funds moving off your radar screen, or advisors moving off

             4   your radar screen.

             5             MS. THORPE:  Right.  Well, since passage of the

             6   Commodity Futures Modernization Act of 2000, the commission

             7   has been reviewing the regulatory framework to identify

             8   further areas for modernization of our approach to

             9   regulation.  And within the past year, we have done quite a

            10   lot of work in the area of intermediary regulation.  Pool

            11   operators and trading advisors are, obviously, included in

            12   intermediary regulation.

            13             And in that regard, the core concern under the CFMA

            14   is to ascertain whether the level of regulation is

            15   appropriate to the risk posed by the activity and the

            16   customers involved.  What we have proposed to do in March of

            17   this year is to expand the category of those persons that are

            18   eligible for exemption from the CPO and CTA registration

            19   requirement. 

            20             And again, let me emphasize that what we have

            21   proposed is a registration exemption.  It is not anything

            22   that would result in our losing jurisdiction over these

            23   entities.  And they would remain subject to our anti-fraud

            24   jurisdiction.

            25             In March, we proposed, essentially -- it would have





             1   two prongs to it for exemption from registration.  One prong

             2   would be based on diminimous amount of futures and options

             3   trading by the pool, where the participation is restricted to

             4   accredited investors, as defined under SEC rules and

             5   regulations.

             6             The other prong would be based on higher

             7   sophistication tests, but because of the higher

             8   sophistication of participants, there would be no restriction

             9   on the amount of futures that the vehicle could engage in.

            10             Because our investor qualification requirements

            11   basically track the SEC's definition of sophisticated

            12   persons, if the SEC were to increase or lower its standards

            13   or rules on exemptions, then the proposal, similarly, would

            14   go up and down.

            15             One of the reasons why we felt comfortable

            16   proposing the rules in this regard is that the commission and

            17   NFA staff have reviewed the audits of rule 4.7 pool

            18   operators, and found out the deficiencies in those vehicles

            19   rarely rose to a level that really warranted any disciplinary

            20   action.  I believe NFA receives only two to three customer

            21   complaints per year regarding 4.7 CPOs.  And although the

            22   number of 4.7 CPOs has increased by approximately 480 percent

            23   in the last 10 years, NFA has brought only 2 disciplinary

            24   actions involving the activities of these 4.7 pools.

            25             The comment period has closed; we received 31





             1   comment letters.  They were overwhelmingly favorable, and

             2   many urged the commission to adopt final rules, with various

             3   proposed modifications, as soon as possible. 

             4             And so, where we are today is that with respect to

             5   these 4.7 entities, we have a regime where we have exempted

             6   them because of the sophistication of the participants from

             7   many of the requirements:  disclosure, reporting, and record-

             8   keeping.  But we still require registration, and we still

             9   require examination of these managers.  

            10             And I think the ultimate question for the

            11   commission is whether the continuation of the current

            12   registration and inspection regime adds material value to

            13   investor protection, fraud prevention, or limitation of

            14   market abuse.  

            15             ME. ROYE:  A lot of the pools that you're talking

            16   about, I guess, understand that they are really privately

            17   offered, and there is only -- I think Pat mentioned -- maybe

            18   30 or so publicly-offered commodity pools.

            19             MS. THORPE:  None of the pools that I mentioned

            20   that would be eligible to be 4.7 qualified, and therefore,

            21   also be eligible for the additional registration exemption

            22   that we have proposed could be publicly-offered pools.  The

            23   exemptions, both under 4.7 and what we have proposed would

            24   require that, at a minimum, the customers invest via credited

            25   investors.





             1             ME. ROYE:  And so, when you have the 1,800

             2   commodity pools, I think you said 800 -- maybe I have that

             3   wrong -- in terms of commodity trading advisors. 

             4             MS. THORPE:  Mm-hmm.

             5             ME. ROYE:  What will the rules do to those numbers,

             6   in terms of registration?  Any sense of --

             7             MS. THORPE:  Well, it is interesting, and it

             8   remains to be seen.  If the proposal is adopted -- as I

             9   mentioned, approximately half of the 1,800 registered pool

            10   operators are 4.7-qualified.  That would mean that,

            11   potentially, all of those 50 percent -- those CPOs would be

            12   eligible to claim one of the two exemptions, either the

            13   diminimous, because they do limited futures trading, or

            14   because of the higher sophistication, unlimited trading. 

            15             So, there is no question that we would be

            16   potentially creating a situation where a significant number

            17   of entities that are currently registered with us could

            18   actually deregister.

            19             We do have some interesting statistics.  As part of

            20   our proposed rule-making, the commission actually, in the

            21   proposal, embedded a no-action position that basically

            22   permitted pools that had accredited investors as a minimum,

            23   and restricted their trading in futures to filing notice with

            24   us, and trade in futures products.

            25             And the data is actually quite revealing, that as





             1   of May of this year, we have received 340 notices claiming no

             2   action relief in the embedded rule-making.  And of those, 290

             3   involve commodity pool registration relief.  So, it is quite

             4   clear that our current registration requirements for these

             5   "hedge funds" has kept out participants who would otherwise

             6   have come in.

             7             ME. ROYE:  And I guess, consistent with what Pat

             8   said earlier, a lot of this movement is driven by the fact

             9   that, as Pat pointed out, we have seen very little fraud in

            10   this area.

            11             MS. THORPE:  Both by the commission's own

            12   enforcement activities, as well as by NFA, which is the

            13   entity that has responsibility for compliance and inspections

            14   of these entities.  Yes, that's right, Paul.

            15             ME. GAINE:  Paul, if I might say --

            16             ME. ROYE:  Mm-hmm.

            17             ME. GAINE:  What Jane said is absolutely correct. 

            18   The drive at the CFTC flows from the CFMA, which was trying

            19   to match the level of protection versus the level of

            20   sophistication, and balance those two.

            21             We are very strong supporters of the -- MFA is very

            22   strong supporters of the current proposal of the CFTC, and

            23   they are actually premised on the success, their internal

            24   success, of lack of customer complaints, but also, the 3C1

            25   3C7 analogy over under your act where you're lessening the





             1   level of protection because of the nature of the investors. 

             2   And it was modeled after those -- at least in my mind -- when

             3   we put together.  And as you know, as well, the CFTC is

             4   reconsidering its 203B31 failure to consider a fund as the

             5   one customer, and looking through to them as part of this

             6   same package.  

             7             So, a lot of what -- I think these proposals mirror

             8   what the existing securities laws are.

             9             ME. ROYE:  Well, why don't we move to the

            10   securities laws?  You know, largely, the disclosure, you

            11   know, by hedge funds, I think, is driven by the applicability

            12   of the anti-fraud provisions of the federal securities laws. 

            13   And I guess a fundamental question is whether or not that

            14   leads to an appropriate level of disclosure by hedge funds.  

            15             And I guess I would go to Mark Anson first, as a

            16   large investor in hedge funds.  What's your perception of the

            17   disclosure that you see in the hedge fund area?  Is it

            18   adequate?  Do you think there are areas where disclosure

            19   could be improved?  Disclosure should be mandated?  What's

            20   your perspective on that?

            21             ME. ANSON:  To answer the question simply, yes. 

            22   Disclosure can be improved.  Let me talk about the fraud that

            23   concerns me, as an investor, particularly since we're talking

            24   about the anti-fraud provisions of the SEC laws.

            25             As an investor, when I look at hedge funds, there





             1   are really two types of frauds that worry me.  The first is

             2   that, to begin with, the trading strategy of the hedge fund

             3   is a sham, to begin with.  It doesn't exist.  

             4             But this type of fraud can be ferreted out through

             5   solid due diligence: the audit trail of trade tickets;

             6   speaking to the hedge fund manager's prime broker;

             7   interviewing other investors in the fund; the reasonableness

             8   of the track record giving economic circumstances.  Through

             9   pretty basic and solid due diligence, you can ferret out

            10   whether a hedge fund manager has a legitimate track record or

            11   not, and unearth the fraud if it exists.

            12             The second type of fraud that I would like to talk

            13   about is the one that concerns me more, as an investor.  And

            14   that's the failure to disclose losses in a hedge fund in a

            15   timely manner.  

            16             I think the recent example of Beacon Hill is a

            17   great case, where that seems pretty clear there were losses

            18   that were parceled out over time, and were not disclosed to

            19   investors in a timely manner.  In fact, there are two recent

            20   papers, academic papers, both published in the Journal of

            21   Portfolio Management, that demonstrate, in fact, that hedge

            22   fund managers smooth their returns.  They parcel out their

            23   gains and losses over time.

            24             And while the anti-fraud provisions can deter

            25   fraud, they really can't prevent it.  And most particularly,





             1   it's the second type of fraud, where hedge fund managers

             2   don't disclose their losses immediately, and in fact, they

             3   parcel them out over time, that's the one that's most

             4   worrisome to me, because once the fraud is uncovered, and the

             5   anti-fraud provisions kick in, and action can be taken, well,

             6   by that time, the losses have already occurred.  And it's

             7   difficult for investors to get their money back.

             8             I think it noted here on the syllabus, one of the

             9   questions that you posed to me is, "Should there be

            10   additional regulation, or regulatory requirements for hedge

            11   funds and their managers?"  I guess that's what we're all

            12   here to answer today.  

            13             You also ask whether there should be more

            14   regulation regarding disclosure, and whether we should leave

            15   it the industry practice, the negotiation of terms between

            16   hedge fund managers and their investors.  Well, I would like

            17   to note that leaving disclosure to industry practice and

            18   negotiation right now, well, the power remains with the hedge

            19   fund managers.  I will give you two good examples.  

            20             One, there are far more attorneys out there

            21   representing hedge fund managers than representing investors

            22   in hedge funds.  So when you get down to negotiating the

            23   nitty gritty, generally you're sitting across the table from

            24   a hedge fund manager who has better legal representation than

            25   you do, as an investor.





             1             Second, there is the issue of capacity constraints. 

             2   The best hedge fund managers close their hedge funds.  Or, if

             3   they open them, they open them for a very small period of

             4   time, and it's basically a take it or leave it.  "You want

             5   into my fund?  Here are the terms that you get."  The

             6   bargaining and leverage remains with the best hedge fund

             7   managers.

             8             In my opinion -- and again, I am expressing my own

             9   personal opinion, and not that of CalPERS -- in my opinion,

            10   more disclosure is needed.  But there also must be a balance. 

            11   If there is a public disclosure of the hedge fund manager's

            12   trading positions, well, that may reveal that hedge fund

            13   manager's competitive advantage.  And as an investor, that

            14   doesn't help me, that's just going to erode my returns.

            15             So, as we talk about the anti-fraud provisions, I

            16   think, one, the concern -- the greater concern -- I have is

            17   with regard to hedge fund managers that don't reveal or

            18   disclose their losses in a timely manner, and second, with

            19   regard to better disclosure provision, yes.  There can be

            20   better disclosure.  Certainly there should be some basic -- a

            21   minimum disclosure.  Right now, it's all over the board.

            22             And in terms of revealing a hedge fund manager's

            23   trading positions to the public, well, you're just going to

            24   force hedge fund managers offshore, and furthermore, that's

            25   going to erode their returns, which is not going to help me,





             1   as an investor.  

             2             I think at that point, I would probably stop and

             3   see where we take this discussion on questions.

             4             ME. ROYE:  Well, it is interesting that you, as one

             5   of the largest institutional investors probably in the world,

             6   is saying there is a problem in terms of accessing

             7   information.  And I guess I would have thought that, in your

             8   position, you would be able to get all the information you

             9   needed.

            10             And I guess I would be worried about maybe the

            11   smaller investors being able to access information.  But

            12   you're saying that you have problems.

            13             ME. ANSON:  I think you have to be smart enough and

            14   sophisticated enough to ask the right questions.  If you ask

            15   the right questions of the hedge fund managers, you will get

            16   the right answers.  But you have got to know what questions

            17   to ask, to begin with.  Part of that just comes from being a

            18   knowledgeable investor, and part of it just comes from the

            19   education of hard knocks, learning from your mistakes.

            20             ME. ROYE:  I guess I would ask Sandra to -- who

            21   follows the industry very closely, and is interested in a lot

            22   of these disclosures, what is your sense of the disclosure

            23   question?

            24             MS. MANZKE:  Well, first of all, I think that, in

            25   my own personal opinion, it would make my life a lot easier





             1   to have mandated disclosures.  I agree, it's very difficult

             2   to get answers out of managers, and they hold all the keys

             3   right now.  If you want to get into a good fund, and you ask

             4   some difficult questions, you may not get that answer.

             5             Sure, there is a lot of access, to get online and

             6   do background checks, and hire firms such as the last panel.  

             7   But that's expensive.  And can the retail investor do it? 

             8   No.  Firms like ours, we spend a lot of money, we have a lot

             9   more people working for us now to uncover these types of

            10   situations.

            11             I would also like to state that I, personally,

            12   would like to see more prosecution.  We also looked at people

            13   -- in the last panel, they mentioned David Askin.  One year

            14   after David Askin had lost all the money for his investors,

            15   he was the keynote speaker at a major conference that was

            16   attended by over 700 people.  I listened to the Q&A, there

            17   was not one harsh question that was asked of him, he spent

            18   not the day in jail, and basically has a lot of money today.

            19             I can go through a list of managers that have

            20   created fraud situations, and it seems to me that it's okay

            21   to steal in this country from rich people -- and you probably

            22   will get a better, lighter prison sentence -- than the person

            23   who burglarized your house.

            24             I think that there isn't any reason today, if

            25   managers -- it used to be that you only had 100 investor





             1   limitations.  When the regulation was passed that opened up

             2   hedge fund investors to 500 or more, and the 3C7, perhaps at

             3   that time they should have mandated some registration.

             4             We talked about the retail investor trying to get

             5   any of this information.  Wouldn't it be nice to have a

             6   Morningstar database of hedge fund managers?  You know, we

             7   have a database, but I can tell you, managers stop reporting

             8   for several reasons.  The obvious one is they don't want

             9   their negative numbers shown to investors.  But second is

            10   that they are not taking any new money.  It also becomes very

            11   difficult to get a real definition of this industry, when

            12   some of the largest hedge fund managers refuse to report

            13   performance or size.

            14             So, I think some of the regulatory issues today,

            15   with the size of the industry and the newcomers coming in to

            16   this, we shouldn't just say because you have $5 million, that

            17   you're sophisticated.  It's not true.  It's very difficult,

            18   even for somebody who might have that money, to be able to do

            19   this due diligence.

            20             So, the information that I would like to see is,

            21   you know, their background, who their auditors are, has there

            22   been change in that auditing firm -- that's another, you

            23   know, sometimes auditors resign because they don't like

            24   working with those managers -- their previous experience, and

            25   be able to trail some of the people that are in this





             1   industry.

             2             I also do find it a bit odd that in this country

             3   you have to take a test to be a broker, and pass, and get

             4   certain licenses to run a brokerage firm.  You have to take

             5   exams and pass licenses.  And to sell insurance, you have to

             6   take an exam in order to be an insurance salesman.  But as

             7   you said, to be an investment manager, you just fill out the

             8   form, and 45 days later, you're an investment manager.  So,

             9   even some of the qualifications to be a manager, I think,

            10   should be upheld.  And that would eliminate a lot of the

            11   fraud on the smaller people.  

            12             The very big hedge funds, I don't see any problems

            13   with them.  They are usually stand-up people, they have their

            14   own capital at risk.  But where we are seeing the problems

            15   are the people that are going out and being able to raise $1

            16   million to $5 million from smaller investors, and

            17   essentially, duping them.

            18             ME. ROYE:  Well, there have to be some differing

            19   views at the table.

            20             (Laughter.)

            21             ME. ROYE:  Jack?  

            22             ME. GAINE:  Yes, I do disagree.  I think -- I will

            23   take your question in the context of the traditional hedge

            24   fund, not retail -- a small one -- and just point out that,

            25   as most people in this room know, that the anti-fraud





             1   provisions of the 33 Act and the 34 Act, and the Advisors

             2   Act, all apply to the hedge fund manager and the advisor. 

             3   And they cover fraud, and they offer in sales of securities,

             4   purchase of securities, insider trading, and fraud and the

             5   advisory relationship. 

             6             I think if you had sat through here for the two

             7   days, you would come to realize the variegated -- if that's a

             8   word, but anyway -- very diversified kinds of hedge funds,

             9   what disclosures -- I'm sure Mark Anson knows what the right

            10   questions are to ask, and has asked them, and has invested in

            11   some large hedge funds, and not in some others.

            12             I agree with Sandra, there probably should be more

            13   prosecutions, or at least there should be prosecutions of

            14   those persons who ought to be prosecuted.  And my good

            15   friend, since his name is now Steve, he obviously is doing a

            16   good job at that.  I think that is a great answer to this.

            17             But Mark also mentioned the risk of going offshore. 

            18   This is a very delicate area of what is it, the role of the

            19   federal government?  What could they do to prescribe here in

            20   Washington that would provide someone in Mark's position, or

            21   a comparable position, information that they wouldn't be able

            22   to get themselves?  And if they don't get it themselves

            23   satisfactorily, given the private nature, the private

            24   offering nature, the private contractual relationship of a

            25   hedge fund to their investors, the investor is free to walk





             1   away.  And I would say that that would be the answer.

             2             These are not public products.  They are privately

             3   offered products.  No one is forcing anyone to buy them. 

             4   They are not advertised.  And I think the bargaining position

             5   of the investor should be enough to get what he needs to

             6   know.  And if he doesn't, he should look elsewhere.

             7             ME. ROYE:  Paul, you draft these documents.  But

             8   you --

             9             ME. ROTH:  Yes, I would like to say something on

            10   behalf of the much-aligned private offering memorandum.

            11             (Laughter.)

            12             ME. ROTH:  I sat on my hands yesterday when it was

            13   maligned, and I'm glad that I'm up here with a microphone to

            14   say something about it today.  I can only speak about the

            15   ones that we draft.  But we use, as a starting gate, a format

            16   of what is the required disclosure for a registered

            17   investment company.

            18             We also look at what is required for a 33 Act

            19   filing.  And we put together that kind of information, which

            20   is required under both of those situations, to put together

            21   an offering memorandum.

            22             Now, I will be the first to say sometimes it is

            23   something that you might want to take, when you're having

            24   trouble sleeping, to bed with you.  But that's because, I

            25   think, not that it is so difficult to understand, but because





             1   the risk factors are repeated so many times.  We had a

             2   summary in which the risk factors are set forth.  We do

             3   encourage, strongly encourage, all of our clients to set

             4   forth what their investment program is, because what we tell

             5   people is the place where you get sued is where there has

             6   been an expectation gap.

             7             If you follow the investment program that you have

             8   told your investors that you were going to follow, and you

             9   lose money, they understand that.  If you lose money

            10   following an investment program that you haven't said you're

            11   going to follow, or that they didn't understand you were

            12   going to do because you have so muddied up the waters of

            13   saying anything, watch out.  You're going to have a problem.

            14             And so, personally, I don't want to issue a

            15   challenge or anything, but if we were to read the private

            16   offering memoranda of the hedge funds as against the public

            17   documentation of the registered mutual fund, or even the 33

            18   Act companies, I'm not sure which comes in first, second, and

            19   third in that network sweepstakes.

            20             ME. ROYE:  Or last, or next to last, or next to

            21   next to last.

            22             ME. ROTH:  Right.  So --

            23             MR. ROYE:  No one comes in first.

            24             ME. ROTH:  The second thing I would like to say is

            25   that we have across the table from Mark Anson, and I don't





             1   think he lacks adequate legal representation, or

             2   sophistication.  We have learned that the hard way.  And 

             3   sophisticated investors know the questions that they want to

             4   ask.  And this is like anything else.  It's a learning

             5   process. 

             6             I remember the first time somebody said to me, "We

             7   would like to do a hedge fund."  Unfortunately for me, that

             8   was back in 1967, and I said, "What's that?"  I learned, and

             9   I have been doing hedge funds since that period.  

            10             And I must say, I think the statistics about the

            11   number of fraud cases that have been brought are remarkably

            12   low, considering the demographics of the industry.  I think

            13   that the learning of the CFTC is very instructive, in terms

            14   of what they have seen, with respect to the hedge fund

            15   industry.  And of course, it's not all one way or the other. 

            16   There is going to be some balance in this.  

            17             But by and large, this is an industry that is very

            18   well run.  The large players are subject to a great deal of

            19   supervision from their prime brokers, from their lenders. 

            20   The lessons, I think, of long-term capital management,

            21   hopefully, will not be forgotten.  But they have been

            22   learned, and the amount of leverage in the system is far

            23   different.

            24             And you know, I think the system is working fairly

            25   well, in terms of disclosure.  And there is -- I would not,





             1   personally, invest in a fund that would not answer questions

             2   that I had.  I don't know why anybody else would.  Every one

             3   of our offering documents gives the background of the

             4   manager.  Every one of our offering documents tells who the

             5   auditor is, who the lawyers are, and what the education and

             6   sophistication is of the people who are working on the

             7   strategy.

             8             So, let me just stop there with a plug for the

             9   offering document.  Bob Pozen?

            10             MR. POZEN:  I think there are two different

            11   disclosures involved here.  One is the disclosure to the

            12   marketplace for other institutional investors who are

            13   obviously now all required to disclose their positions and

            14   they want to know who else is trading, they want to know

            15   what's happening in the marketplace, especially if there's a

            16   leverage vehicle.

            17             And I don't think if there was a requirement, say,

            18   for a quarterly disclosure by hedge funds that was lagged 30

            19   to 45 days, that there would be a tremendous disruption in

            20   their trading strategies.  But that's what all the rest of

            21   the institutional investors have to do and they don't have

            22   the trading volume that the hedge funds do.  So there's some

            23   medium ground there.

            24             The second thing is in terms of disclosures --

            25   we're talking about non-registered entities to clients.  It's





             1   been my experience with registered investors that the hardest

             2   thing to get people to do is to have standardized returns

             3   including their losses.  And even in the mutual fund industry

             4   where people had these rules, people really struggled for

             5   years about whether or not they were really getting

             6   standardized returns and whether they were reporting losses

             7   accurately.

             8             So if you say what's -- one of your questions here

             9   -- what would be sort of the signal or most important thing

            10   if you were not to have a broad scheme of regulations but a

            11   modest scheme of regulations, those seem to me the two

            12   things.  Some sort of disclosure to the marketplace on a lag

            13   basis and some sort of systematic way of calculating fees and

            14   disclosing returns and losses.

            15             MR. ROYE:  Sandra, do you have any perspective on

            16   the standardization point getting all the hedge fund managers

            17   to report their performance the same way?  I mean, I know

            18   they report in to you.

            19             MS. MANZKE:  Yeah.  It is actually difficult.  I

            20   think that there's methods to get there.  For a long time I

            21   beat my head against the wall by asking for gross and net

            22   returns.  The industry has really settled on net returns. 

            23   But some of the statistics that you should be looking at, you

            24   really want to do them on your gross returns because there's

            25   a smoothing effect with your performance fee kicking in and





             1   out on net returns.

             2             Additionally, people come into these funds at

             3   different times so if you came in in June as an investor you

             4   probably don't have the same rate of -- you don't have the

             5   same rate of return as the investor that's been in for the

             6   full year or those that added.  I think, you know, one way of

             7   looking at it is to take returns of an investor that put a

             8   million dollars in the fund at the beginning of the year and

             9   see what the end return is rather than the full fund's

            10   return.

            11             So there's a lot of problems with getting

            12   performance numbers and also the fee calculations.  There is

            13   an annual audit done once a year.  We personally don't ever

            14   invest with a manager until an audit has been done.  But

            15   again, those audits come out later and if you get your audit

            16   in the end of April or by mid-April, that's a long time to

            17   wait for a manager's first audit.

            18             Again, I would love the industry to adopt some kind

            19   of systematic methods of reporting and things that we need to

            20   look at.  I don't think positions really help you that much. 

            21   I don't really care what the managers and IBM record.  I'd

            22   like to know how many equity positions they have, I want to

            23   know the amount of leverages in the portfolio, I want to see

            24   exposures, I want to see the -- what I call benign

            25   transparency.





             1             Disclosing your short positions I think is death to

             2   the industry for a variety of reasons but knowing what your

             3   net exposures are is important.  And again, there is no real

             4   regulation that says you have to disclose your performance

             5   numbers and I again get back to I think that that's something

             6   that the industry would benefit from, the investors from the

             7   fund would also be able to benefit from readily having

             8   accessible data.

             9             COMMISSIONER ATKINS:  I want to throw in a question

            10   in that vein.  As far as AIMR goes, those sort of standards,

            11   those sort of market-based approach, is there a growing from

            12   a demand from some of the public punching plans and ERISA

            13   plans, is there a  growing demand for that on the part of

            14   hedge fund managers?

            15             MS. MANZKE:  You can get that information from

            16   managers that you want to put investments with.  It's just

            17   that there are no real complete standards.  We go back and do

            18   -- with all the managers that we have money with, once we get

            19   the audited financials, we're able to go back and piece

            20   whether or not the numbers that were reported were actually

            21   the ones that were produced in the fund.  

            22             But until you get that audit, you know, you're

            23   really relying on the manager to give you those interim

            24   results.  You can compare the offshore funds at least have an

            25   independent third party so pricing and coming up with NAV and





             1   so it's easier actually to use some of the offshore numbers

             2   as a better indicator of what the performance of the managers

             3   are.

             4             MR. ROYE:  Mark?

             5             MR. ANSON:  If I could just follow up on that. 

             6   It's interesting when you look -- when you mention AIMR,

             7   whether hedge fund managers are AIMR compliant.  I have seen

             8   very few hedge fund documents that say they're AIMR compliant

             9   whereas in the traditional investment world of long only

            10   management, every manager is AIMR compliant.

            11             Couple reasons for that.  First, very few CFA

            12   charter holders have gotten into the hedge fund industry but

            13   as more get in, I suspect that you will see more AIMR

            14   compliant performance data.  Second, AIMR is still grappling

            15   with the issue of leverage.  How do you account for leverage

            16   and how do you present performance results when you have

            17   leverage embedded in the returns?

            18             That's an issue that's unresolved at this time but

            19   I suspect that once it does become resolved, given the amount

            20   of leverage in hedge fund returns, you'll see more AIMR

            21   compliant returns as a result.

            22             MR. ROYE:  Iain, you've worked on a set of best

            23   practices for the European hedge fund industry and I guess I

            24   wonder -- and I guess this is also to Jack -- are best

            25   practices embraced in the hedge fund community and -- these





             1   disclosure issues, standardization of performance?  I notice

             2   to some extent in your best practices you do go into

             3   disclosure concerns and issues that you think hedge funds

             4   ought to focus on.

             5             Have these been embraced and are best practices a

             6   solution to some of these issues?

             7             MR. CULLEN:  I think the first and most important

             8   thing to say is that what we produced was a guide to sound

             9   practices and I think there is a very big difference.  And in

            10   fact, in the introduction we made that point.

            11             MR. ROYE:  Excuse me.  I'm sorry.  I didn't --

            12             MR. CULLEN:  We had a large debate before we

            13   started on this as to whether this was sound practice.

            14             MR. ROYE:  These are the minimum standards or these

            15   are what you see as appropriate standards but not necessarily

            16   the best standards.

            17             MR. CULLEN:  And I think the point about best is

            18   that best assumes that in a sense that you are selecting a

            19   particular standard that is applicable to all and I don't

            20   think you can be as -- we didn't -- this was a group

            21   comprised of a large number of UK-based hedge fund managers,

            22   prime brokers, accountants.  My only involvement was to co-

            23   review rather than to co-edit and to some extent what that

            24   involved doing was taking out references to anything that

            25   might be construed as a best practice.





             1             And I think it's important to know the genesis of

             2   this sound practices guide rather than the U.S. post long-

             3   term sound practices guide which serves a different purpose. 

             4   The purpose of the guide which AIMR published, which is a

             5   guide to sound practices for European hedge fund managers but

             6   which is at the moment being extended to Asia with some

             7   suggestion that it be extended to the U.S., but my personal

             8   view is that that is a bit of a minefield.

             9             It was actually the result of two linked things. 

            10   The first was the new rules published by the financial

            11   services authority back in the tail end of 2001 where it

            12   became apparent that under the new rules compliance in its

            13   loosest sense was going to be something that the FSA was be

            14   looking at more closely in relation to fund managers

            15   generally and the existing hedge fund manager contingent

            16   within the FSA, bearing in mind that all hedge fund managers

            17   in the UK are regulated, concluded that it would be helpful

            18   if they were all saying the same thing or just about the same

            19   thing to the FSA if it came a-calling.

            20             And so there was nothing at that point in writing

            21   as to what was market practice, what was sound practice and

            22   it was -- they concluded themselves that it would be a good

            23   idea to produce something on the basis of which FSA, if it

            24   wanted to, could test the way they were operating.

            25             And in conjunction with that, they concluded that





             1   it would also be a good idea to produce a guide for new

             2   entrants to the industry.  Many of them said at the time we

             3   were working on this it would have been very helpful if we'd

             4   had something like this when we started out, bearing in mind

             5   that the UK hedge fund management industry is considerably

             6   younger than the US.

             7             And so what we ended up with is something which

             8   says -- and if you'll forgive me, I'll cite it briefly,

             9   whilst the intention has been to produce a resource for

            10   general use, it should not be assumed that one size fits all. 

            11   The size, nature, jurisdiction of regulation and complexity

            12   of a particular hedge fund manager's operations and

            13   investment strategy may mean that some or all of the sound

            14   practices set out in the guide are in fact inappropriate to

            15   the business of a particular hedge fund manager.

            16             So really as sound practices, it was accepted that

            17   they would apply differently to different fund managers and

            18   in different jurisdictions as well.  Because whilst this is

            19   inevitably, given the makeup of the working group, based on

            20   UK operations and the way UK fund managers operate, it was

            21   designed to be capable of being used as the hedge fund

            22   manager industry expanded through Europe into places like

            23   France and the like.

            24             So it is only sound practices and it was a

            25   recognition basically by the industry that it would be





             1   helpful to them and to new entrants to have a document which

             2   could be used as a sort of reference guide.

             3             MR. ROYE:  Is it your sense that these sound

             4   practices have been generally embraced?

             5             MR. CULLEN:  I think it's too early to tell.  It

             6   reflected when it was published in August of last year the

             7   way the hedge fund manager industry was operating.  At that

             8   time, clearly, we are not that far ahead and given the way

             9   the markets have been playing out, there haven't been nearly

            10   as many new startups in the hedge fund manager field as there

            11   were perhaps in the 12 months or 24 months before August of

            12   2002.

            13             So there have not been, I would suspect, enough new

            14   startups to be able to generate a really clear picture as

            15   whether this is -- what sort of part this is going to play. 

            16   The fact, though, that it's being -- at the request of hedge

            17   fund managers in Asia is being adapted to the Asian market,

            18   to the extent that it needs to -- I mean, a lot of what's in

            19   here is generic, it's not specific to the UK or Europe --

            20   suggests that at least in the developing market, if I can use

            21   that expression in a slightly different way from the way in

            22   which it's normally used, in the developing markets, be it

            23   Asia, be it Australia, it is seen as a good thing I think.

            24             Probably, as I said, to adapt this for the U.S.

            25   would be using a document that was never intended for a





             1   mature market.

             2             MR. ROYE:  Jack, do you have a sense that U.S.

             3   managers are looking to this document and other documents --

             4             MR. GAINE:  Well, they're not looking -- I can be

             5   very quick on this if I can just do a little housekeeping

             6   here.  We prepared a submission, submitted on May 6 to the

             7   SEC but I think because it was a hedge fund related thing it

             8   came under the Lab Technology letter and it's not readily

             9   available on the front of the web site and you have to dig

            10   into the web site under the panel and then find our

            11   submission next to my name.

            12             And in that is I think a very good submission and

            13   included in that are many references to what we called back

            14   in February of 2000 sound practices for hedge fund managers. 

            15   We didn't limit it to any geographic area.

            16             And in here, in this document, which is totally

            17   different from Iain's, we discuss valuation, risk control,

            18   funding liquidity risk, counter-party credit risk and

            19   disclosure and transparency.  And I think the valuation

            20   provisions in here might even make Richard Phillips happy. 

            21   And this is widely cited in our document and you can get to

            22   both of these things on our web site if you can't pass the

            23   Lab Technology test and get to it here on the SEC site.

            24             MR. ROYE:  To what extent do your members, do you

            25   think, adhere to those policies and embrace them?





             1             MR. GAINE:  I've not done any survey.  I would say

             2   that perhaps during the course of your investigation you

             3   might have a feel for it.  I would say a good percentage and

             4   the valuation provisions are very, very similar to what I sat

             5   in the audience yesterday and heard discussed.  And there's a

             6   disclosure to investors and disclosures to counterparties as

             7   well as other issues discussed in there, but I don't have a

             8   percentage number for you.

             9             MR. ROYE:  Well, we want to move on next to some of

            10   the key issues in terms of how hedge funds are offered and

            11   sold, the accredited investor standards and hear from some of

            12   our own panelists.

            13             I think we proposed that we take a break right

            14   about now. but I assure you that we're going to get into some

            15   very interesting issues when we come back and hear from some

            16   of our other panelists.

            17             We'll take, I guess, a 10-minute break or so and

            18   then come back and resume.

            19             (A brief recess was taken.)

            20             MR. ROYE:  As we've heard over the last couple of

            21   days, hedge funds rely on several exemptions under the

            22   Investment Company Act which are conditioned on not making a

            23   public offering.  And as we heard outlined, they typically

            24   look to Reg D in terms of making the private offering.

            25             I think we've heard some differing views with





             1   regard to hedge funds, funds of hedge funds, opening them up

             2   to retail investors.  I think we've heard some people suggest

             3   at least that retail investors ought to have access to these

             4   vehicles, it shouldn't be just the providence of high net

             5   worth individuals and institutions.

             6             We've heard others suggest that the eligibility

             7   standards in Reg D which haven't been modified in over 20

             8   years are in need of adjusting.

             9             And I guess I just wanted to get reactions from

            10   folks on the panel, particularly Rick Lake and John Markese

            11   about that issue.  Are the standards at the appropriate place

            12   from a Reg D standpoint in terms of offering hedge funds? 

            13   Should we throw them out?  Should we start over?  Are they

            14   necessary?

            15             MR. LAKE:  Well, I'm flattered and honored to

            16   answer this question.  The real general question is who are

            17   we trying to protect and from what.  If we work our way

            18   through the regulations starting with 3(c)(7), if a manager

            19   is making an offering under that exemption he only wants

            20   investors with 5 million and up so he can raise a lot of

            21   funds.  So we haven't touched the unaccredited investor yet.

            22             If we go to 3(c)(1), the manager wants accredited

            23   investors with 1 million or more.  If he lets in a non-

            24   accredited investor, my understanding, then he has to

            25   increase the amount of paperwork and disclosure which is a





             1   big disincentive because then he has to let in a small

             2   investor and do a lot of work to do it.

             3             So in terms of hedge funds working their way down

             4   to unaccredited investors -- oh, I've been speaking to

             5   myself.

             6             (Laughter.)

             7             MR. LAKE:  I thought I rendered the room silent

             8   with my discussion of 3(c)(7).  I hope you heard all that. 

             9   Oh, good.

            10             So, okay.  So we've worked out way through 3(c)(7)

            11   and 3(c)(1) and the unaccredited investor hasn't been touched

            12   yet.  So we work our way down to maybe the tiny state

            13   offerings under 506, do I have this correct, and this, as

            14   discussed earlier, was suggested might be the purview of

            15   fraudsters who will take advantage of small local investors

            16   whether it's an Internet deal, a hedge fund or a Broadway

            17   show, what have you.

            18             So then the policy question becomes does allowing

            19   small investors into deals on the private placement exemption

            20   facilitate capital formation on a microbasis or does it just

            21   allow a easy tool for fraudsters to take advantage of smaller

            22   investors.  And I suspect the answer to that would be capital

            23   formation on a small basis is probably encouraged by allowing

            24   unaccredited investors into some types of funds.  If the

            25   investor protection issue becomes overwhelming, then it's





             1   time for a change.

             2             The next issue becomes how should small investors

             3   be able to access on a democratic basis hedge fund strategies

             4   and perhaps the best vehicle for that is the open end mutual

             5   fund, and I suspect we'll be able to talk about that more

             6   later.

             7             MR. ROYE:  John?

             8             MR. MARKESE:  Thanks, Paul.  I represent the

             9   individual investor, also known as the retail investor.  I

            10   feel a little outnumbered today, but what the heck.  If we

            11   can get an investor's attention, there's two things we want

            12   to tattoo on the back of their hand if they'll stand still

            13   long enough.  One is to efficiently diversify and the second

            14   one is to understand what you're investing in, the cost

            15   structure, risks, expected returns, before you invest.

            16             Let's look at Stan Beckham.  I'm going to look at

            17   the whole concept of hedge funds.  If we believe the

            18   marketing that has slipped out through the press and a lot of

            19   the great stories that they can add to diversification -- and

            20   I'm going to argue that probably there is a possibility they

            21   could, even for a $100,000 investor who puts 10,000 into a

            22   hedge fund.

            23             So if you argue that way that perhaps they are a

            24   useful vehicle for diversification, we run into the second

            25   thing that I've had you tattoo on the back of your hand and





             1   that's understanding your investment before you invest.

             2             Let's look at these accreditation standards for

             3   investors.  How many of you know someone who has a salary of

             4   $200,000 plus, maybe a million dollars net worth, that

             5   doesn't know anything about investing and is in no way

             6   sophisticated?  My guess is that you could come up with a

             7   pretty big list here of friends, family and acquaintances,

             8   colleagues.

             9             Let's face it.  It's probably a poor proxy for the

            10   ability to withstand loss.  It's probably a poor proxy for

            11   liquidity, but it is certainly not a proxy for financial

            12   sophistication.  I don't know that there is one around.  

            13             So let's not just raise this bar to a half a

            14   million dollars and whatever in income and so forth.  Let's

            15   stand back and say we need disclosure, we in fact need to let

            16   individual investors access this field, we need to have a

            17   broad-based information flow.  We of course have to have this

            18   before we let the investors in and we have to allow them to

            19   be able to independently form a judgment on this investment

            20   called hedge funds.

            21             I mean, obviously there's not one animal here.  But

            22   right now, even if you make that benchmark, you make that

            23   accreditation standard which I will say is, in my opinion,

            24   bankrupt as a sophistication standard.  You still have to

            25   deal with an intermediary.  You still have to deal with





             1   someone who is going to educate you on what is in this fund,

             2   and for most investors, simply making it in the club, getting

             3   in that club is what their final goal is.

             4             And they're relying now not on independent judgment

             5   having made this club, but in an intermediary or

             6   representative explaining what perhaps is best for you in

             7   that fund.  

             8             So I think we have it wrong.  I'd like to throw out

             9   the accreditation standards, I'd like to open it up, have

            10   reporting of all registered funds.  Let's face it, if there's

            11   money to be made, fund of funds are going to grow and grow

            12   and grow and now we don't have one black box, we have a fund

            13   with probably 20 or 30 black boxes in there that again an

            14   individual investor cannot form an independent knowledgeable

            15   decision on what they are investing in.

            16             Thank you.

            17             MR. ROYE:  Other perspectives on the accredited

            18   investor standard?  I think Jack -- you guys suggested it

            19   ought to be -- we ought to reconsider the level?

            20             MR. GAINE:  I think just in the traditional hedge

            21   fund context it was adopted in 1982, I think.  It would

            22   probably be worthwhile to open it up and take another look at

            23   it.

            24             MR. ROYE:  How about the notion, the restrictions

            25   in terms of general solicitation and no advertising?  I guess





             1   one of the questions I have is whether or not in this new

             2   Internet age, information age where information is free

             3   flowing, there's a lot of information out there about hedge

             4   funds. 

             5             Are we really fooling ourselves when we try to

             6   regulate the offering of a security as opposed to who it's

             7   sold to?  Do we need to step back and rethink the way we

             8   approach these exemptions?  I suppose this may even go

             9   outside the hedge fund area but does anybody have any

            10   reaction?

            11             Paul, do you have any sense of whether or not we

            12   have an antiquated framework in terms of how we regulate

            13   private offerings?

            14             MR. ROTH:  Yes.  I guess my reaction, Paul, would

            15   be that right now it's very difficult for the practitioner

            16   because we are talking about regulating private offerings in

            17   a environment in which the Internet covers an awful lot of

            18   what's going on in the hedge fund world, where you can pick

            19   up Barron's and get a quarterly listing of the performance of

            20   hedge funds that you think you're having a private offering

            21   with respect to, where there is what used to be a cottage

            22   industry and there is now an enormous growth industry in

            23   terms of magazines and other publications that cover it and

            24   where you have reporters for the Wall Street Journal, the New

            25   York Times, the Financial Times, that are assigned to the





             1   hedge fund beat.

             2             And in that context, we find ourselves frequently

             3   dealing with the problem of a manager who's conducting a

             4   continuous offering who is being interviewed and asked a

             5   question about his fund and it's almost a gotcha kind of

             6   situation.  On the one hand, if he answer the question, the

             7   lawyers are sitting there saying well, maybe you really have

             8   to suspend offering for a while because you made the wrong

             9   comment with respect to your fund.

            10             We're very sensitive to this issue because on the

            11   one hand I don't believe that anybody in the hedge fund

            12   industry is looking to advertise and take out advertisements. 

            13   There is some tension between the issue of if you go into

            14   retailization and you have more information out there because

            15   you're not restricting information with respect to offers, is

            16   that conditioning the market with respect to retailization.

            17             That seems to me a legitimate issue.  But all in

            18   all, I think that we would come down at recommending that in

            19   this Internet age where there is an exchange of information

            20   and there is so much literature going on out there, it would

            21   be better -- and we would lose the issue of the press

            22   constantly saying that they couldn't get a reaction to

            23   somebody because he says his lawyer told him he can't answer

            24   the question because of this continuous offering.

            25             It would be better for the freer flow of





             1   information and I don't think it would change the nature of

             2   the risks involved in terms of the investors who can invest

             3   to have the emphasis be on the sale rather than the offering.

             4             MR. ROYE:  Alan, do you have any reaction to

             5   redoing the whole framework along those lines?

             6             MR. BELLER:  Yeah.  I mean, this is a subject which

             7   not just in the hedge fund or the investment fund area but in

             8   terms of offerings generally has been bandied about for kind

             9   of at least a decade at this point.  I think I said yesterday

            10   all the way back at least to the Wohlman commission which I

            11   think is right, we have got lots of suggestions sitting

            12   around both on your floor and on ours about the deregulation

            13   of the offering process as opposed to sales.

            14             We certainly live in an age of publicity and

            15   information where the restrictions that the Securities Act

            16   imposes on publicity are I guess I would say anachronistic

            17   and there probably has to be some recognition of the new

            18   environment with the Internet and with communications

            19   technology and so forth and in investor interest in kind of

            20   unlimited access to information that exists today.

            21             I must say that balanced against that, so long as

            22   you have a Reg D standard that is at the 200, 300,000 level

            23   for income or a million for assets, having unlimited

            24   publicity where that is your offering universe I do think is

            25   a little bit troubling from an investor protection point of





             1   view.

             2             A number of panelists over the last two days have

             3   said I think on both sides of the buy and sell that

             4   ratcheting the accredited investor standard up somewhat -- it

             5   won't change the problem that's been identified, which is

             6   that it's not a good surrogate for sophistication but it

             7   might be a good surrogate for things like liquidity and risk

             8   of loss and so forth.

             9             If you -- I'd be more comfortable in loosening up

            10   the offering process if I thought we -- if we also at the

            11   same time thought about what the accredited investor standard

            12   was.  And I have to say there, one of the questions that

            13   there is is the point that Rick made, which is not just in

            14   the fund area.  I mean, the accredited investor standard and

            15   Reg D have been used -- have been hugely important in the

            16   capital formation process for small business in particular

            17   generally and not just in the hedge fund or unregistered fund

            18   area.  

            19             And I think that has been frankly the principal

            20   obstacle whenever that issue of what the Reg D standards

            21   should be has been revisited, that's always been the

            22   principal obstacle in changing them.  One thought -- one size

            23   doesn't fit all and I'm not sure that you have to have the

            24   same Reg D standard for direct small business investment that

            25   you need to have for other purposes but I think we should be





             1   open-minded about looking at the publicity and offering

             2   issue.

             3             MR. ROYE:  I'd like to move to funds of hedge fund. 

             4   I think we heard from our regulators that there seems to be a

             5   trend in terms of allowing greater offering or the ability to

             6   register and offer various country's funds of hedge funds.

             7             The Investment Company Act restricts the offering

             8   of hedge funds directly, again in terms of private placements

             9   and no public offering, but you have funds of hedge funds

            10   that really allow investors theoretically to access a vehicle

            11   that they could not access directly.  And I guess I just

            12   wanted to throw out to the panel, is this a good development,

            13   a positive development?

            14             Maybe Bob Pozen, you're in the business of

            15   developing products for retail investors.  Is this a good

            16   product, bad product, good development?

            17             MR. POZEN:  Well, I would say that -- are we

            18   talking about the registered fund of funds?

            19             MR. ROYE:  Yes.  Yes.

            20             MR. POZEN:  I think if you look at the way

            21   registered fund of funds are organized, you have a lot of

            22   anomalies between funds that invest -- 3(c)(1) funds and

            23   3(c)(7) funds so I think the Commission probably ought to

            24   clean that all up.  But ultimately you get to the question of

            25   what sorts of fee structures and what's the board of the fund





             1   of funds going to do.

             2             If the board -- I mean, if you justify retail

             3   investors being in a fund of funds, then you have to put a

             4   lot of emphasis on the manager of the fund of funds and the

             5   board of the fund of funds to really take care of the retail

             6   investor.  And if you can get comfortable with that, then you

             7   should be able to be comfortable with fund of funds.

             8             The second thing is what are the fees and how are

             9   the fees going to be layered?  A lot of these fund of funds

            10   really wind up having quite a lot of fees and then if you get

            11   a performance fee for the underlying fund and then you get a

            12   performance fee for the fund of funds, you could do the math

            13   and you could see that a lot of the return gets taken up.

            14             So I think it can be a good product.  It can be a

            15   good product by providing investors good access to non-market

            16   correlated funds but I think that you've got to make sure

            17   that you put some real responsibilities on the managers and

            18   the directors of the fund of funds and that you have some

            19   limitations or a lot of disclosure about what the aggregate,

            20   all the performance fees, all the fees are going to look

            21   like.

            22             MR. ROYE:  Other perspectives on funds of hedge

            23   funds?  Jack?

            24             MR. GAINE:  Yeah.  I think these two days have shed

            25   a lot of light and knowledge about the hedge fund industry





             1   and particularly in the retailization and we've established

             2   that as of today, retailization, as at least I would

             3   understand it, doesn't it but it might well exist at some

             4   point.

             5             I think there's --

             6             MR. ROYE:  Some are saying that it should exist.

             7             MR. GAINE:  Well, some, yes, and getting to that,

             8   which is what I think we're talking about here, there are a

             9   class of investors who have been pounded for the last 3 or 4

            10   years in long only strategies who want something else.  And

            11   if the something else is a registered fund of funds, I will

            12   maybe throw this back into your court.  I think within the 40

            13   Act context, if you can have that appropriate disclosures of

            14   the risks involved, et cetera, I think it's certainly

            15   something that you should look at.

            16             But I think Commissioner Campos raised that issue

            17   kind of the other day and I've heard it in Europe,

            18   particularly.  There seems like a class warfare that the big

            19   guys can get into something and the little fellow cannot.

            20             I'm not sure all of those disclosures could be done

            21   but I'm sure between you and your staff that you can get

            22   working on it.

            23             MR. POZEN:  And I think the problem really grows

            24   out of the fact that mutual funds are so constricted and

            25   taking non-correlated positions.  I mean, right now, to short





             1   a mutual fund you either have to have a covered position,

             2   which essentially you're not short, or you have to segregate

             3   cash and mark to market daily.  

             4             So it's very difficult for a mutual fund that's a

             5   registered mutual fund to go short.  It's very difficult to

             6   get leverage and I think when I computed the number of mutual

             7   funds that had performance fees, it's less than one percent

             8   of the industry because the rules are so difficult to meet.

             9             So, I mean, you can view this from either way. 

            10   There clearly is an appetite for non-correlated investments,

            11   especially given the last 3 or 4 years.  You can either start

            12   a whole new regime for retail fund of funds or what I would

            13   think would be a useful way to think about it is to think

            14   about why is it that the mutual fund industry has had so few

            15   performance fees and has had so much difficulty in having

            16   non-correlated investments.

            17             And I think the answer is clearly that the

            18   regulations are a significant barrier and I think we ought to

            19   have some more flexibility on those and allow the traditional

            20   mutual fund industry to provide a broader array of products.

            21             MR. ROTH:  Paul, I sort of first want to commend

            22   the Staff in the approach that it's taken with respect to the

            23   registered fund of funds, especially those that -- you got

            24   two classes of them.  One, fund of funds that are registered

            25   under the 40 Act but generally are open only to sophisticated





             1   investors and that can be qualified clients which have a net

             2   worth of a million and a half dollars and up.  Some of them

             3   are offered to accredited investors but that's generally not

             4   the case and they have very, very high minimums.

             5             The new product, so to speak, is the fund of funds

             6   for the retail investor.  And I think there are a couple of

             7   things that are noteworthy about that.  One is this is not a

             8   product really sponsored by the hedge fund industry.  It's

             9   not an outgrowth of what hedge funds want.  It's basically

            10   been a outgrowth of what is perceived to be a demand by Wall

            11   Street institutions in terms of being able to market

            12   something that people think there is a demand for.

            13             The second thing I think is you've done a very good

            14   job of going slow in terms of making sure that the boards of

            15   directors of these funds have adopted procedures with respect

            16   to valuation that are reasonable and that meet the standards

            17   under the 40 Act and that up till now, notwithstanding the

            18   matter in which the registration statements were originally

            19   filed, they have not come out unless the sales are restricted

            20   to either accredited investors or investors who are being

            21   represented by a discretionary -- by an investment advisor

            22   exercising discretion.

            23             And I think that type of rollout of the product, of

            24   seeing how it does, is an intelligent way to proceed.  With

            25   respect to this, I suppose I'm a democrat with a small D and





             1   that is if it's a good product, it should be available and we

             2   ought to be able to figure out how we can describe the risks

             3   to the investing public.

             4             MR. BELLER:  Paul, are there any hedge funds or any

             5   significant number of hedge funds who are saying no to fund

             6   of funds buyers, fund of funds investors, who are saying we

             7   don't want to sell our funds to that?

             8             MR. ROTH:  Yes, there are.  What their reasons are,

             9   I'm not quite sure but I've -- certainly some of them have

            10   done a little bit of betting on whether or not let's say

            11   advisors to hedge funds, underlying hedge funds or leveraged

            12   investment companies to invest in them might someday be

            13   required to be registered investment advisors and some of

            14   them are taking that position.

            15             Others are simply taking it on the basis of we're

            16   not organized to sell to that class of investor and we're not

            17   selling to that class of investor.  For some reason or other,

            18   they're looking at it differently.

            19             I should say that there are some hedge funds that

            20   will not permit funds of funds, private funds of funds to

            21   invest in them as well and others, for ERISA purposes,

            22   because of compliance with ERISA, don't have pension funds

            23   investing with them.

            24             So there's a whole panoply of reasons, business

            25   reasons, that are involved.





             1             MS. MANZKE:  If I can just interject, too, though,

             2   the funds that are out there first of all are still applying

             3   the sophisticated accredited investor attestation but at the

             4   same time there is a little bit of a benefit from these

             5   funds.  Your neighbor could start a fund of funds, as was

             6   said, that he has expertise in this area.

             7             When you're getting into these registered products,

             8   they typically have your outside board of directors and also

             9   the responsibility of those that are offering that is a much

            10   heightened than if I was just taking my neighbor's money. 

            11   There is reputational risk here.  If there is a problem

            12   within these funds, these larger institutions are much better

            13   equipped to pony up any of the mistakes that could occur than

            14   the hedge fund fund of fund purveyor that's out there today.

            15             Also, I should say that there is such a risk in

            16   types of -- this type of offering that some of the issues

            17   that are required -- for example, in the funds that we have,

            18   the manager have to subscribe to Risk Metrics which is a

            19   third party purveyor which gives us this benign transparency

            20   because we won't take that type of risk in this type of

            21   product.

            22             MR. ROYE:  Armando, would you guys sell to a fund

            23   of funds or do you?

            24             MR. BELLY:  Well, the endowment fund is closed so

            25   we don't have to face the issue.





             1             MR. ROYE:  Okay.  Easy.

             2             MS. MANZKE:  But you did before.  Years ago you

             3   did.

             4             MR. BELLY:  I wasn't around, so I wouldn't know.

             5             MR. ROYE:  Okay.  I want to turn to the

             6   registration of the manager question.  I think as was

             7   highlighted, the US is one of the few jurisdictions where the

             8   manager of a hedge fund is not required to be registered in

             9   any manner and again, our registration regime I think as

            10   juxtaposed against some of the other regimes in terms of

            11   requirements and qualifications I believe is fairly -- is

            12   certainly less stringent than a lot of regimes.

            13             Views on whether or not we ought to move to

            14   registration of hedge fund managers.  Sandra?

            15             MS. MANZKE:  Well, I think without moving towards

            16   registration, the industry actually is moving that way. 

            17   There is -- with the institutional investor coming in, they

            18   are requiring that many of these managers have to register so

            19   you're seeing much more of if you want the money, you will

            20   register.  That does mean that there will be managers that

            21   don't register.

            22             If you require, though, all the managers to be

            23   registered, you run the risk that many of them will move to

            24   another jurisdiction and therefore you're also once again

            25   penalizing your US investors or they simply won't take you as





             1   investors into their fund.

             2             But there has to be some middle ground here where

             3   there would be the opportunity to have more disclosures,

             4   maybe you're not subject to the SEC coming in and doing their

             5   audits.  I mean, we are registered as an investment advisor,

             6   have gone through several SEC audits.  The first time it's

             7   painful, the second time less so and it's actually kind of

             8   informative because if you do find you're doing something

             9   that isn't to the proper standards, you have that opportunity

            10   to correct it.  So I don't look at it as a policing function

            11   but actually to keep us in compliance with all the

            12   regulations.

            13             No one wants to have an audit.  If you -- sort of

            14   like nobody wants cancer, but sometimes --

            15             (Laughter.)

            16             MR. ROYE:  Not that bad.

            17             MS. MANZKE:  But nevertheless, they think that --

            18             MR. ROYE:  It's like going to the dentist.

            19             MS. MANZKE:  I really don't see any reason why a

            20   manager would find it that onerous to register and I'd like

            21   to see it to be more voluntary than to be mandatory.  One of

            22   the other reasons that I've also heard that managers are

            23   against registration is while they're in compliance with all

            24   the regulations today, who knows what new rule could come out

            25   that also would be hinging on their ability to make money?





             1             So in that case I can understand that.  But again,

             2   if there was some mandating of disclosure and information so

             3   that the retail investor, so the large investor, we can all

             4   have a standard, I think that would be more appropriate.

             5             MR. ROYE:  I guess I'd ask Paul whether or not

             6   there's anything that you see in the Investment Advisors Act

             7   regime that really is an impediment to running a hedge fund.

             8             MR. ROTH:  Well, maybe I could respond by starting

             9   off by saying for close to 40 years I've been coming to this

            10   building to ask for exemptions or requests or to explain to

            11   the Staff why they've gotten something wrong.  I think you

            12   got it right the way it is right now.  And I'm -- let me talk

            13   about it in a way.

            14             The way I look at it, the question is what's the

            15   purpose served by registration?  Is the purpose served

            16   investor protection?  Well, I think that there are three

            17   different groups that you look at with respect to investor

            18   protection.  You can look at the -- on the retailization and

            19   I think that in connection with retailization, people who

            20   want to go the retail route should expect to have a higher

            21   standard of regulation applied to them because you're going

            22   through the Investment Company Act of 1940.

            23             3(c)(7) investors, I really don't see any purpose

            24   served by regulation of investment advisors with respect to

            25   3(c)(7) investors.  They are perfectly capable of ferreting





             1   out for themselves the information that is necessary.

             2             Now, many people who will become -- who are

             3   advisors to 3(c)(7) investors, as Sandra said, will move in

             4   fact to registration and that's because of business dictates. 

             5   You mentioned before and our office calculated as well that

             6   35 of the top 100 of the institutional investors studied are

             7   registered as investment advisors so that's the top hundred.

             8             And I think that there may be a pressure business-

             9   wise to do it but I see no regulatory purpose in requiring

            10   it.

            11             MR. ROYE:  Let me ask you one question about that. 

            12   When you have a fund of hedge funds that's investing in a

            13   3(c)(7) fund, with the fund of hedge funds potentially having

            14   retail investors and exposed to the risk of the 3(c)(7)

            15   funds, that doesn't change the calculation?

            16             MR. ROTH:  Well, as I said to you earlier, if a

            17   fund wants to accept investors that is going to be a fund of

            18   funds that is registered under the 40 Act, there may be a

            19   difference in calculation that exists there.  I'm not sure

            20   there should be, but I can certainly understand the

            21   Commission taking a very, very cautious approach with respect

            22   to that in terms of -- you know, in some respects, one can

            23   look at the underlying funds in these cases, maybe self-

            24   advisors, to some extent, and require registration the way

            25   you have with self-advisors.





             1             Otherwise, you can look at it in terms of custody

             2   requirements and otherwise.  But I don't think in the absence

             3   of that that there is a reason for registration with respect

             4   to 3(c)(7) funds.  And with respect to 3(c)(1) funds, I think

             5   the issue is sort of less clear.  I mean, in Alan's case,

             6   maybe if you raise the accreditation standards that might be

             7   the way to attack it rather than through registration.

             8             My own view is you have an industry which is

             9   extremely entrepreneurial, which is extremely innovative and

            10   which fortunately thus far has stayed away from a lot of

            11   problems and so the regulatory structure ought to understand

            12   that.

            13             There's a certain risk analysis or risk judgment

            14   that is made with respect to hedge funds that kind of colors

            15   the whole issue but the statistics that we have seen in the

            16   last two days that have come out here, for example, hedge

            17   funds of funds having less than 25 percent of the volatility

            18   of the S&P and hedge funds in general having less than 50

            19   percent of the volatility of the S&P.

            20             I would be cautious only about the value judgment

            21   that is involved with respect to whether or not hedge funds

            22   are somehow riskier than oil and gas funds and real estate

            23   investments that other things have -- that other investments

            24   have had other limited liquidity and frankly are hard to

            25   understand.





             1             And if the requirement is that you can change the

             2   12:00 blinking on your VCR, then there'd be a different

             3   surrogate for investment and I guess I'm out of it then.

             4             MR. ROYE:  Armando, views on advisory registration?

             5             MR. BELLY:  Well, I think the way you have to look

             6   at it is what is the cost and what is the benefit and just

             7   who do you register?

             8             I know that someone had mentioned is it burdensome

             9   to be registered or is it onerous.  I don't really think

            10   that's the question, to put a word like onerous or

            11   burdensome.  Registration has costs.  It costs money, it

            12   costs time.  And the question is whether it's really worth it

            13   and from the point of the SEC -- because we may be

            14   fiduciaries of our clients.  The SEC, in essence, are

            15   fiduciaries for the taxpayers so they have to watch out the

            16   expenditure of what money they have.

            17             If the SEC registers 2,500 or 3,000 hedge funds,

            18   they're going to need auditors to audit these hedge funds. 

            19   Now, this is big building.  Maybe there are 250 or 500

            20   auditors walking around who don't have anything to do, but

            21   I've had friends who work here and they work very hard and I

            22   really doubt it.  I think they're going to have to spend a

            23   lot of money to hire these people.

            24             And then there's going to have to be someplace

            25   where they stay.  They have to have an office.  And I notice





             1   there are a lot of lots around here that are sort of vacant. 

             2   Maybe they can build some buildings.  It's going to be very

             3   expensive.  And the question is is it work it.  Is it worth

             4   it with respect to every unregistered investment advisor?

             5             Take our case.  We're registered with the CFTC. 

             6   Why would we -- why would it make sense for us to be audited

             7   in addition to the National Futures Association and the CFTC

             8   has the ability to audit us as the prime regulator, what

             9   would be gained by having us audited?

            10             Remember, the SEC is a fiduciary for the American

            11   taxpayer.  What would the American taxpayer gain?  And I

            12   would agree with you.  With respect to people, for example,

            13   sophisticated investors, people who are in maybe 3(c)(7)

            14   funds, what actually is gained?  I mean, we're talking about

            15   resources that may be limited.  Maybe those resources should

            16   be focused on where the problem is if there's a problem.

            17             And I have to admit, I've been here, I've tried to

            18   pay attention for two days.  I think I have, and I'm still

            19   trying to identify what it is the problem.  But you all have

            20   more evidence than I do on what the problem -- I mean, I see

            21   our fund, which I haven't seen any problems with.  

            22             So I really would say that whatever we do with the

            23   question of registration should be focused.  It should be --

            24   the taxpayers' money should be spent only if the registration

            25   of the particular investment advisor would serve some





             1   purpose.  And I don't know whether there are cases where that

             2   will be shown.  I really don't have an opinion on that.

             3             But I don't think that if you're already registered

             4   with the CFTC, that it's worth the taxpayers' money to have

             5   you register again and be audited by another federal agency.

             6             MR. ROYE:  Well, do you think the CFTC is looking

             7   for the same things that the SEC examiner is looking for?  I

             8   mean, they're not inspecting for compliance with the

             9   antifraud provisions of the federal securities laws.  Are

            10   they looking at the same things?

            11             MR. BELLY:  Well, you know, I have never gone

            12   through an SEC audit and frankly I hope I never do but we

            13   just completed an NFA audit and I have to say it was very,

            14   very thorough.  They examined our books and records, they

            15   interviewed people, they examined our practices.  I don't

            16   know if -- we don't have any fraud, I assume.  They didn't

            17   discover any.  I don't know what -- we don't sell to anybody

            18   at this point.  I don't know what type of fraud your auditors

            19   would be looking for that the NFA auditors would have missed,

            20   or that you would have caught that the NFA auditors would

            21   have missed.

            22             MR. ROYE:  Did they look at vehicles for which

            23   there was no futures trading?

            24             MR. BELLY:  Well, we have our hedge fund -- there's

            25   one hedge fund.  I mean, I think really when you talk about





             1   hedge funds, we're talking about -- so they looked at the

             2   Quantum Endowment Fund and there are really two parts to

             3   that, Quantum Partners and Quantum Emerging Growth.

             4             MR. ROYE:  So you may be a case where because of

             5   your activity, they come in and maybe they look at the same

             6   things we would look at but there can be other advisors where

             7   it's futures trading or not futures trading, there are

             8   different types of accounts and they have no reason to look

             9   at those.

            10             MR. BELLY:  Well, as I said, I really don't have

            11   the answer.  I mean, I don't know -- maybe there really is a

            12   problem with CFTC registrants who don't engage in fraud

            13   relating to futures but engage in fraud in securities.  I

            14   don't know that one way or the other.

            15             If there is a big problem on that and you come to

            16   the conclusion that's the only way to deal with it, then I

            17   could --

            18             MR. ROYE:  I mean, my only point is that we

            19   shouldn't be falling all over each other in terms of our

            20   examinations but there very well may be legitimate reasons

            21   given the nature of the operations why we come in and look at

            22   different things and look at different vehicles, different

            23   clients.

            24             MR. BELLY:  But I'm glad that you agree that we

            25   don't need another examination so any rule that you apply





             1   we're happy with.

             2             (Laughter.)

             3             MR. ROYE:  Well, let me reserve on that point.

             4             MR. GAINE:  Quickly, I agree with what Paul and

             5   Armando said but this cost benefit analysis is not -- I think

             6   coming from us it might seem self-serving but I've heard it

             7   from Chairman Donaldson, I've heard it from your deputy, Ms.

             8   Fornelli, Professor Liang and Bob Steel actually referenced

             9   it as well, that there could well be a movement offshore.

            10             And I don't think per se -- I think you probably do

            11   a very well audit and it's well done and it might produce

            12   results but I think you have to establish the problem first. 

            13   This may not be popular as it was four or five years ago and

            14   I guess I have to agree with Armando.  

            15             I tried to pay attention, probably with my advanced

            16   age not nearly as well as he has, and I haven't seen the case

            17   here on either the incidence of fraud and then some of Pat

            18   McCarty's statistics, assuming they're accurate, that he

            19   brought over with him.  It's underwhelming, to put it mildly,

            20   if that's the -- you know, if it's somehow to identify fraud

            21   and given the host of problems that you all are facing -- and

            22   I have not seen the 250 or 500 auditors wandering through

            23   here; in fact, I think you're all probably very much

            24   overworked.

            25             If the industry drives people into it, if Mark





             1   ANSON and Mark Yusko and Charles Swensen say if you register

             2   we might invest with you, then maybe a hedge fund will listen

             3   to that or if an ERISA for purposes -- register, but if it's

             4   an industry-driven thing, that's fine but federally mandated

             5   here, I don't know that the case is there to be made.  In

             6   fact, I don't think it's made here but then, again, as the

             7   chairman pointed out on the opening day, we're only in the

             8   middle of a fact-finding mission.

             9             MR. ROYE:  Doug?

            10             MR. SCHEIDT:  I think a case could be made.  I

            11   think that you've seen a large amount of money flow into the

            12   industry which also attracts a large number of people who

            13   want to provide services in the industry.  So you have a big

            14   change factually.  You have an increase in the number of

            15   enforcement actions and we only see the problems after they

            16   occur.

            17             I bet you that there wouldn't be that many

            18   enforcement actions against registered investment advisors if

            19   we didn't examine them.  I think the exam program is a big

            20   source of enforcement referrals and enforcement cases.  If we

            21   didn't conduct examinations, we wouldn't learn of many of the

            22   fraudulent activities that occur until long after the fact,

            23   if at all.

            24             I think that you also, Armando, have to give us a

            25   little bit of credit and I think the UK approach is part of





             1   that.  We have been operating under limited resources for a

             2   long, long time.  At one time, not too long ago, we had

             3   30,000 registered investment advisors with us and we had far

             4   fewer examiners than we do today.  But we made intelligent

             5   cuts on where to develop those resources.

             6             We didn't and we couldn't hire additional resources

             7   to do the job so we devoted our resources and directed them

             8   at the areas that we thought presented the highest risk. 

             9   Now, we may have missed some problems but there was always

            10   the threat that the SEC might come knocking on a registered

            11   advisor's door.  That deterrent effect that that has is a

            12   positive one whether or not the exam ever happens.

            13             And here with the larger amount of money in recent

            14   years, the larger number of players, the apparent larger

            15   number of enforcement cases involving frauds, I think that

            16   really cries out for at a minimum giving the SEC authority to

            17   examine advisors over a certain level or under certain

            18   circumstances which we don't have right now.

            19             I think the case has been made or the facts to make

            20   that case are present and you've got to give us some credit

            21   for -- give us some leeway that we aren't -- Congress isn't

            22   going to give us the kind of money that would enable us to

            23   conduct exams of advisors on a monthly basis or to put

            24   someone in the manager's office like the bank regulators do. 

            25   It's just not going to happen.  You've got to give us some





             1   credit for using our limited resources in an intelligent way.

             2             MS. THORPE:  Paul, can I comment on the futures

             3   side?

             4             MR. ROYE:  Sure.

             5             MS. THORPE:  Let me just go back and comment on

             6   something Armando said and Jack said as well that when the

             7   CFTC regulates the pool operator but not the underlying fund,

             8   you cannot have a situation where the entity is out there

             9   regulated by you, you're up at the plate responsible for its

            10   propriety and the manner in which it acts and have it

            11   engaging in completely fraudulent activities and other

            12   similar types of pools that may not directly be trading in

            13   futures.

            14             As a consequence of that, NFA certainly has the

            15   ability to go in and inspect vehicles that may not directly

            16   be trading in futures but based on a risk-based approach is

            17   going to focus on those areas that obviously it has the most

            18   and we have the most interest in.  I think there's a little

            19   bit of concern with one of the suggestions that I heard at

            20   the table, well, maybe you don't have to do inspections as

            21   the SEC but you should at least register them.

            22             And I think that's the most difficult for the

            23   regulator that you actually have registered somebody and yet

            24   you're not going in to do inspections.  I think that that

            25   creates certain problems and you can't say registration is





             1   not expensive.  It's not the registration that's the

             2   burdensome part of supervising somebody.  It's the actual

             3   inspections and the compliance supervision that actually is

             4   the cost that the industry has to bear.

             5             MR. ROYE:  I think that's an important point.  I

             6   mean, certainly you don't want to be in a position where you

             7   create a false sense of security or you don't have the

             8   resources to go in and do what you want to do in order to do

             9   appropriate oversight.

            10             I did want to return to the point that Bob Pozen

            11   made about the mutual fund area and again I think what we've

            12   heard is that you don't see mutual funds engaging in a lot of

            13   the strategies that hedge funds engage in.  Short selling,

            14   use of leverage, there are constraints on performance fees

            15   and I do want to see the panel react to whether or not those

            16   are constraints that we ought to consider removing.

            17             I mean, I would point out that there are mutual

            18   funds out there that do use short selling strategies, use

            19   leverage, particularly on the short sale and we don't see

            20   very many funds that embrace those strategies.  They have the

            21   ability to do it and maybe some of the constraints that you

            22   alluded to --

            23             MR. POZEN:  I don't think I'm suggesting that there

            24   ought not to be any restrictions on registered funds but the

            25   restrictions that exist are pretty daunting.  I mean, if you





             1   sell short and you have to cover it with a security, then

             2   you're not selling short, you're just doing a covered call or

             3   something like that.  And if you have to sell short and have 

             4   segregated cash -- and mark to market, so again, I don't

             5   think we know whether -- if there is this -- I mean, what I

             6   think -- what's the fund of funds all about?  It's about an

             7   appetite for less volatile investments.

             8             And if you -- you have two approaches and concepts. 

             9   You can either open up the fund of funds more or you can let

            10   mutual funds have a class of funds which you could identify

            11   in some way as being somewhat different for which you would

            12   have much more flexible rules on short selling and on

            13   leverage but you don't have to have no rules.

            14             And right now the rules are daunting and the rules

            15   on performance fees -- I mean, if we have only 140 funds out

            16   of 8,000 that have performance fees, that suggests that

            17   regulation is preventing a lot of people who might otherwise

            18   have performance fees which should generally be a good thing

            19   because they align the interest of investors with managers. 

            20   So we should be encouraging performance fees.

            21             If I may, there are two issues -- two big broad

            22   issues to discuss in terms of mutual funds that do use

            23   hedging strategies.  One is what's gone on to date and the

            24   other bigger issue is what is the public policy issue at

            25   stake.  And the public policy issue at stake is that the





             1   country is about to face its largest generation of retirees

             2   ever and they have 5 to $7 trillion of mutual funds,

             3   depending how you calculate the size of the mutual fund

             4   universe.

             5             In the last year alone, mutual funds lost $600

             6   billion of investor money. In the year before that, they lost

             7   $500 billion of investor money.  In they year before that,

             8   they lost $400 billion of investor money.  So if we were the

             9   board of trustees of a retirement pool of $5 trillion and we

            10   had to tell our colleagues we just lost one and a half

            11   trillion because of the investment restrictions, I think we'd

            12   start looking for other ways to try to incorporate

            13   opportunities for return, opportunities for diversification

            14   and tools for risk control.

            15             So from a public policy point of view, maybe we

            16   should be talking about the democratization of hedge funds

            17   rather than the retailization of hedge funds as a commercial

            18   objective.

            19             In terms of mutual funds that do use hedging, there

            20   is a small universe of them which began to grow after

            21   Congress repealed the short short rule in '97, which was a

            22   restriction that limited the amount of income a mutual fund

            23   can derive from short selling or short term trading.  And as

            24   soon as that one tiny regulation which was a bit archaic was

            25   released, a small group of hedge mutual funds began to





             1   develop.  And they did quite well during the bull and bear

             2   market, outperforming the S&P when the markets were going up

             3   and protecting investors really well when the market was

             4   going down.

             5             It was not Lake Woebegone as Doug Scheidt warned us

             6   yesterday with all these hedge mutual funds doing well.  They

             7   did have to drink from the bitter brew of the bear market but

             8   they were able to handle the bear market reasonably well.

             9             So the next question becomes if we try to

            10   incorporate alternative investments into the open end mutual

            11   fund world, we would have to make a catalog of the

            12   restrictions that impair them and then go through that

            13   catalog and say what should be loosened up and what would be

            14   appropriate in light of investor protection.  So I think that

            15   would be the issue in terms of hedging strategies within

            16   mutual funds.

            17             It would also have the dual effect of regulating

            18   the hedge fund industry if the hedge fund private industry

            19   had to compete with the public hedge fund industry.  So I

            20   think it would be interesting to explore that in more detail

            21   at some future date.

            22             MR. ROYE:  Do you -- I mean, in a mutual fund,

            23   money is flowing in and out on a daily basis.  In the hedge

            24   fund area, the money is locked up for at least a quarter.  I

            25   mean, you don't have to worry about meeting withdrawals, you





             1   know, their intervals.  Bob, do you see --

             2             MR. POZEN:  What's interesting is one of the -- I

             3   think Doug will notice it -- how many interval funds are --

             4   the Commission put out a rule a few years ago for interval

             5   funds which were geared to be sort of periodic redemptions

             6   rather than daily redemptions.  To the best of my knowledge,

             7   there are either none or very few interval funds.

             8             So the 40 Act actually does have a mechanism and

             9   one could think of a regulation where you said that if you

            10   went short more than 10 percent of your fund, then you had to

            11   go into the interval fund sort of regime but if you did just

            12   a modest amount of shorting or hedging, it's different.  And

            13   I think we all know that hedge fund is a misnomer. 

            14             There are lots of hedge funds that don't hedge and

            15   they have lots of different strategies but I think that

            16   clearly rather than us sort of searching for how we can sort

            17   of fit the fund of hedge funds into -- you know, a circle

            18   into a square sort of a mold, we might think of sort of -- we

            19   could think of two diff -- we could think of modest mutual

            20   funds hedging, we could think of more -- and the interval

            21   fund is a sort of concept that we really haven't used very

            22   well.  Maybe that's an appropriate concept to think about.

            23             MR. ROYE:  Would this also be an answer to

            24   something that I know you've spoken about before?  You

            25   hijacked our roundtable on fund governance to talk about





             1   hedge fund managers, mutual fund managers leaving to go start

             2   hedge funds.  If we were to revamp the compensation

             3   structure, allow performance fees in a mutual fund framework,

             4   would it solve this sort of what you view as a brain drain?

             5             MR. POZEN:  Well, there always will be managers of

             6   mutual funds who will go off and want to do their own thing

             7   and have their own shops but I do think that the huge

             8   differential in compensation between hedge fund managers

             9   who're getting 20 percent of the upside and then the downside

            10   only limited to a high watermark is used.  

            11             So I think it would help mutual fund managers if

            12   there could be more flexibility in their compensation

            13   structures, and clearly this very strict symmetrical

            14   requirement has led most mutual funds not to have performance

            15   fees.  In fact, I think if you -- I mean, you have Fidelity,

            16   you have IDS and you have Vanguard only for its external

            17   managers, not for its internal managers.  Those are the only

            18   three groups that have any performance fees of any

            19   significance.

            20             So I think it would help.  It wouldn't solve the

            21   problem but it surely would sort of move us to the situation

            22   where managers could be compensated better in the mutual fund

            23   context, which would be a positive thing.

            24             MS. MANZKE:  But so far that hasn't worked because

            25   every good hedge fund manager that was part of a larger





             1   institution, Lazard being the latest example, those managers,

             2   once they have good numbers and maybe they're getting 60

             3   percent of the upside, they're going to want a hundred, so

             4   then they walk out the door.

             5             And I think the other thing that on the mutual fund

             6   side is this is not an un -- you can have trillions of

             7   dollars in these types of strategies.  There's only so many

             8   convertibles that are out there.  There's only so much stock

             9   that you can lend in your portfolio and it really isn't --

            10   you're talking about revamping the entire mutual fund world

            11   if you started having performance fees and all these to

            12   alternative strategies.

            13             It's a relative gain where the hedge funds is an

            14   absolute return.  Your investors are going to turn around and

            15   say well, if you really don't have that good view of the

            16   market and you started shorting and you started raising cash,

            17   why didn't you call me and tell me to get out of your long

            18   fund? 

            19             MR. POZEN:  I think probably this wouldn't be a

            20   situation which the whole mutual fund complex would go that

            21   way.  What you would have is a subset of funds that might be

            22   offered to your higher net worth investors in mutual funds

            23   and most mutual fund complexes have a difficulty satisfying

            24   the needs of their higher net worth investors within the

            25   mutual fund context.  Some of them have done explicitly hedge





             1   funds.  So I think you wouldn't have -- in most big complexes

             2   you wouldn't have this as the main theme.  This would be a

             3   small set of funds just like funds -- complexes now have a

             4   small set of sector funds that are higher risk and higher

             5   return funds.

             6             MR. ROTH:  I think there are -- for many of the

             7   mutual fund companies there are cultural issues involved and

             8   putting in whether the tail is going to wag the dog in terms

             9   of compensation of a small number of their managers based on

            10   a percentage of their profits as they would do in the hedge

            11   fund world as contrasted to the way in which the vast

            12   majority of the managers are compensated, certainly that has

            13   been the major concern that we have heard as we have talked

            14   to institutions that sponsor mutual funds, that they have a

            15   grave concern as to the manner in which it will affect the

            16   culture of the organization.

            17             MR. POZEN:  I think that is a valid concern.  On

            18   the other hand, we do have mutual fund complexes that have

            19   hedge funds that run in a related trust company or something

            20   like that some complexes have overcome the --

            21             MR. ROTH:  Absolutely, but it has been a very big

            22   sticking point for a lot of them.

            23             MR. POZEN:  I don't think what we're talking about

            24   is requiring mutual funds to have this sort of hedge funds. 

            25   I think all we're saying is if we had some more flexibility





             1   we would have some percentage of complexes in some probably

             2   modest percentage of their funds that would do it.

             3             MR. SCHEIDT:  Aren't mutual fund managers making an

             4   obscene amount of money as it is and why can't they just

             5   divvy up some of those profits to their star managers --

             6             MR. POZEN:  Well, everything is relative as

             7   Einstein said and I think if you compare the -- what hedge

             8   fund managers are making in an up market, there's nothing

             9   that beats 1 or 2 percent base or 20 percent of the upside,

            10   even if you are --

            11             MR. SCHEIDT:  Well, I'll put it another way. 

            12   Aren't mutual fund investors already paying too much for

            13   basically getting closet indexes that their managers are

            14   trying to perform against an index rather than doing what

            15   they could do which is trying to achieve absolute returns,

            16   yet they closet index the funds and the performance, they

            17   take in an awful lot of money and the mutual fund investors

            18   are paying managed account fees for index funds?

            19             MR. POZEN:  Well, I would strongly disagree with

            20   that characterization of what most maul fund managers do.  I

            21   think that you would find that most mutual fund managers are

            22   actively managing their portfolio, they're researching their

            23   stocks.  If you have a very large fund, then it's maybe

            24   constrained in terms of how much it can trade in or out but,

            25   you know, I think that the fees of most mutual funds reflect





             1   the active management and that all the index funds are, I

             2   think in some sense, free riding off all that research that's

             3   being done.  So it's the relative efficiency of the market

             4   that's produced by the active research that makes the index

             5   funds able to exist.

             6             MR. SCHEIDT:  I don't understand how index funds

             7   free ride off of the research of the managers.  The index

             8   funds are --

             9             MR. POZEN:  Because index funds depend on an

            10   efficient pricing of the market.  The only way the market is

            11   efficiently priced is because there are lots of analysts from

            12   lots of active managers who are out there researching the

            13   stocks and trading them all the time.

            14             MR. SCHEIDT:  Okay.  Well, they're free riding on

            15   more than just the fund manager.

            16             MR. POZEN:  If you had a universe in which you

            17   prohibited in the theoretical sense active research, then the

            18   pricing of index funds would be way off.  So the only reason

            19   why an index fund can exist is because it's taking advantage

            20   of the efficient market which is being produced by all those

            21   active analysts, not only in mutual fund complex but

            22   throughout the securities industry.

            23             MR. ROYE:  Okay.  To wrap this up, I thought we

            24   would give each of our panelists the opportunity to give

            25   their view on hedge funds and whether or not there are





             1   things, issues the SEC ought to be focusing on, concerns,

             2   approaches we ought to take, cautions, whatever, and I'll

             3   start with Mark Anson.

             4             MR. ANSON:  I think I would make one final comment. 

             5   As we were talking about the registration of hedge funds,

             6   whether it's Form ADV or some other format that the SEC would

             7   design, from my perspective as an investor, that's just a

             8   starting point for due diligence.

             9             If a hedge fund manager is registered with the SEC

            10   and does have a form ADV, great, but that's not where I'm

            11   going to end my due diligence.  That's really only a starting

            12   point for me.  There's much more work and analysis that's

            13   going to go into my selection about a hedge fund manager.

            14             The flip side of that is it does provide a starting

            15   point for every investor in the market.  We have some piece

            16   of paper, some platform from which every person can begin. 

            17   But from there you have to rely on your own wits.  You have

            18   to know which questions to have.  Paul, you have to have the

            19   right legal representation.

            20             MR. ROTH:  It's available, Mark.

            21             (Laughter.)

            22             MR. ANSON:  Well said.  Well done.

            23             MR. DELESPAUL:  At a cost.

            24             MR. ANSON:  So registration of hedge fund managers,

            25   yes, it gives you a starting point but that's all it is.  A





             1   lot of the work remains with the investor and we can never

             2   forget that.  Thank you.

             3             MR. ROYE:  Alan, I'll give you a pass.  Jean-

             4   Claude, any wisdom from abroad for us?

             5             MR. DELESPAUL:  Well, I don't know if it would be

             6   wisdom.  I suppose that through all these, the major question

             7   is the willingness to protect the investors in the best

             8   manner.  I must say I was quite surprised with the

             9   discussions I heard about registration or non-registration on

            10   the managers.  I come from a country where managing somebody

            11   else's money requires necessarily that you be known by the

            12   regulator and that you be registered in a way.  At least you

            13   are under surveillance.

            14             Everything is possible.  I mean, it's possible not

            15   to contemplate any retailization of the hedge funds or any

            16   change in the sector.  What is important is to make sure that

            17   whatever invests or easy to invest because information as we

            18   said in this Internet age becomes very open, money in a

            19   financial product be completely protected in terms of risk,

            20   in terms of information and that the regulator make sure that

            21   he is in a position to take good positions.

            22             MR. ROYE:  Bob?

            23             MR. POZEN:  I think that the reason we're all here

            24   is because retail investors now have an appetite for downside

            25   protection.  That's what this is all about.  That's why we're





             1   here.  Otherwise we wouldn't be here.  And I think the

             2   Commission has two choices.  One is it can try to regulate

             3   more hedge funds and hedge fund of hedge funds and I think it

             4   will be limited both because it's not sensible to regulate

             5   them more in certain ways and because if you push too hard,

             6   they'll go offshore.

             7             So again, I'd suggest that the Commission consider

             8   another approach which is to loosen a little, not do away

             9   with, some of the regulations you now have on short selling

            10   and performance fees for your registered mutual funds as a

            11   way to respond to what I think is basically what we're

            12   hearing from investors.

            13             MR. ROYE:  Rick?

            14             MR. LAKE:  Well, I want to thank Professor Pozen

            15   for saying what I wanted to say.  But what's happening --

            16             MR. POZEN:  You're welcome.  I did it with my mike

            17   on, though.

            18             MR. LAKE:  Well, technically you're a sophisticated

            19   investor.  I don't know how to use a microphone.

            20             (Laughter.)

            21             MR. LAKE:  But all levity aside, we're all here

            22   also because hedge funds have become part of the landscape. 

            23   Alternative investments are a key part of any portfolio so

            24   once we know that, moving forward, the question is how do we

            25   make sure alternative strategies can be available to everyone





             1   and operate effectively for everyone within the context of

             2   investor protection.

             3             MS. MANZKE:  Well, in the ideal world, not only

             4   would you register in my opinion but you would also have

             5   qualification standards to meet in order to become an

             6   investment advisor.  However, this isn't a perfect world and

             7   I don't certainly want to kill the golden goose.  Hedge funds

             8   have been quite kind to me and we've been quite to all the

             9   hedge fund industry because they've all made a lot of money.

            10             I'd like to see this move to a voluntary

            11   registration, which I think one day it will.  If you want to

            12   get money, your investors will someday say well, why aren't

            13   you registered and if you're not registered, that will add

            14   another question mark.

            15             I don't think many of the -- if you regulate the

            16   hedge fund managers requiring them to register, I don't think

            17   that many will move offshore.  I mean, it's not the greatest

            18   place to live if you have to live in St. Croix the rest of

            19   your life so if you live in the United States you still would

            20   be subject to some of these industry demands.

            21             In the meantime, before the industry moves into

            22   this perfect direction, I think that disclosure and mandatory

            23   disclosures about historical performance and some of the

            24   industry -- their practices, how they allocate trades, et

            25   cetera, all these important factors should be at some point





             1   on a quarterly basis filed somewhere.

             2             MR. ROYE:  Iain?

             3             MR. CULLEN:  I think the one thing that I would ask

             4   you to bear in mind in relation to whether or not to regulate

             5   hedge fund managers is the offshore industry.  

             6             I think you will find that if the way you regulate

             7   hedge fund managers is such that it causes non-U.S. hedge

             8   fund managers or indeed non-U.S. investment advisors of any

             9   sort without any presence in the U.S. to have to register

            10   whilst already being regulated in their own jurisdiction in

            11   order to offer a product to U.S. investors, then to cite a

            12   comment I saw recently in relation to the proposed anti-

            13   monitoring rules, you could find that there are a large

            14   number of products and a large number of PPMs that come out

            15   with a sticker on them saying something along the lines of

            16   American investors not welcome.

            17             MR. ROYE:  Jane?  Fellow regulator?  Advice for us?

            18             MS. THORPE:  Well, we actually have it quite easy. 

            19   The Commodities Futures Modernization Act gave the CFTC a

            20   blueprint for how we should regulate and that blueprint says

            21   that one size does not fit all and don't cast a broad net to

            22   address a one-all situation.

            23             And so essentially it's the way we've been

            24   proceeding in our new rule proposal which is identify the

            25   risks that you believe the activity is presenting and second,





             1   look at who the customers are and what level of protection

             2   they need.

             3             MR. ROYE:  John, our individual investor

             4   representative?

             5             MR. MARKESE:  The individual investor.  You know,

             6   if it's a viable product, which I think it is, it will help

             7   diversification which we all support.  I think we should make

             8   it available and before we make it available, I think we

             9   should have information.

            10             Right now we have an information vacuum and the way

            11   we've solved this information vacuum indirectly or obliquely

            12   is to keep raising the bar and say we're going to have high

            13   minimums and high income and net worth.

            14             I'd like to essentially have registration, have

            15   information, allow individual investors, even the smaller

            16   individual investors who want to partake of this industry to

            17   do so, but we obviously have to have registration

            18   information, historic information, risk information so they

            19   can make intelligent decisions independently on their own.

            20             MR. ROYE:  Armando.

            21             MR. BELLY:  I really just wanted to make sure that

            22   everyone understood that I wasn't saying that there shouldn't

            23   be registration.  I was simply saying --

            24             MR. ROTH:  For other people.

            25             (Laughter.)





             1             MR. BELLY:  Right.  Well, that's a very good point. 

             2   But if we have regulation or additional registration, that it

             3   should be focused on the particular problem and be cost-

             4   effective.

             5             MS. SINCLAIR:  I just want to make one sort of

             6   final statement that I guess we didn't have too much time to

             7   talk about here but with respect to short sales which we

             8   talked about in the trading strategies panel, I think it is

             9   important to reiterate that it seems that short selling and

            10   hedge funds are often said in the same breath.  It's

            11   important to reiterate that certainly short selling is a

            12   legitimate trading strategy.

            13             I think there was a lot of conversation that went

            14   to the point that it has actually helped to reduce volatility

            15   with respect to these portfolios and certainly also

            16   contributed to market efficiency.

            17             I think another point to emphasize is that short

            18   selling is not exclusively a tool used by hedge funds by any

            19   means and finally to the extent that there has been talk of

            20   manipulation, manipulation also is not exclusive to short

            21   selling but it is something that we look at very closely and

            22   put all of our enforcement tools to work to address and we

            23   would continue to do that.

            24             And I think that my own view is that that would be

            25   the way to address the problems rather than to be overly





             1   restrictive in the activity itself.

             2             MR. ROYE:  Paul?

             3             MR. ROTH:  Well, I think that the Commission and

             4   the Staff have done an admirable job in recognizing that

             5   there's been a huge growth in the assets in the hedge fund

             6   area and therefore a study with respect to the industry which

             7   is educational for the Commission as well as the participants

             8   in the industry and those who want to invest is something

             9   that is very, very worthwhile.  So I think this is a helpful

            10   process.

            11             From my standpoint, I look at regulation as saying

            12   it should cure some problem and I don't see thus far the

            13   problem to be cured in connection with the hedge fund

            14   industry as we've discussed it.  The number of fraud cases,

            15   while they have increased, are relatively small in terms of

            16   the Commission's load and with respect to the CFTC and

            17   certainly as a percentage of the number of hedge funds that

            18   are out there.

            19             It seems to me that there is a full panoply of

            20   antifraud rules and regulations that the Commission has at

            21   its beck and call to deal with fraud and fraud should be

            22   dealt with, I think we all agree, in an intelligent manner

            23   and by the enforcement division.

            24             So I think that this is a good exercise but the net

            25   result is that I think the industry is doing pretty well. 





             1   And one of the things that people say, well, what's the cost

             2   of imposing regulation?  I think in some sense that is

             3   turning the question upside down by the cost potentially is

             4   homogenization.  

             5             What people in the industry are concerned with is

             6   that their investment techniques which are constantly on the

             7   cutting edge and the innovative edge and dealing with

             8   products that haven't been dealt with before, I'm not sure

             9   your costs in terms of educating your examiners are going to

            10   be just limited to how many you're going to have and where

            11   you're going to house them, but the question of learning how

            12   to evaluate those techniques is something that is a problem

            13   as people move into new and different instruments.  And

            14   that's one of the concerns with respect to examination.

            15             MR. ROYE:  Christina?

            16             MS. SINCLAIR:  Yes.  I'll make just a couple of

            17   points.  To pick up again on what Jean-Claude said, in our

            18   jurisdiction it's already our law that you need to be

            19   registered if you are going to manage other peoples'

            20   investments and other people's money so registration is not a

            21   big issue for us.

            22             What is a much bigger issue for us is whether or

            23   not these funds should be made available for retail and there

            24   we come into very difficult issues and there's a tension

            25   between allowing the freedom and the flexibility which we've





             1   heard as being so important to some of the hedge funds there

             2   balanced against the safeguards that are necessary for a

             3   group of consumers for whom credit cards and mortgages can be

             4   complicated products.  Very difficult judgments there.

             5             MR. SCHEIDT:  I have four thoughts which for me may

             6   be an all-time personal best.

             7             MR. POZEN:  On the high or the low side?

             8             MR. SCHEIDT:  On the high.

             9             (Laughter.)

            10             MR. SCHEIDT:  You heard my views on hedge fund

            11   manager registration but I'll add that I don't think the SEC

            12   is qualified nor do I think it's an appropriate part of the

            13   SEC's scope to evaluate the qualifications of hedge fund

            14   managers or advisors in general.

            15             It's more in my view a matter for the individual

            16   investor to make a decision whether that person has the

            17   experience and qualifications necessary to manage that

            18   person's money and we shouldn't be in the -- stand in the way

            19   of perhaps allowing a 16-year-old whiz kid to open up his own

            20   business and manage money in a way that no one ever has

            21   before just because he hasn't served an apprenticeship with

            22   one of the big shops.  It's not the American way.

            23             I definitely think that we should change the

            24   accredited investor standards.  The current ones are not

            25   representative of the sophistication whatsoever.  I can't





             1   think of another proxy other than net worth and income but

             2   they should probably be doubled.

             3             Two other thoughts.  If you permit retail investors

             4   to invest directly in hedge funds without requiring the hedge

             5   funds to register, all of the abuses that the 40 Act is

             6   addressed against are possible.  You have principal trades

             7   with the manager, you have joint arrangements, you have all

             8   of the other abuses that were present before the 1940 Act was

             9   adopted in a pooled vehicle and that makes investing in a

            10   hedge fund a different thing from investing in an individual

            11   risky security.  Those additional elements of pooled

            12   management and the abuses that the manager can engage in with

            13   respect to the pool are elements that make retail investors

            14   investing in a hedge fund different from a retail investor

            15   investing in a risky instrument.

            16             The fourth thing is that we should consider

            17   allowing public offers by restricting sales to sophisticated

            18   investors.  I think currently -- the current system increases

            19   the cost of capital formation.  It decreases the amount of

            20   information that's out there to investors to make intelligent

            21   decisions and, for that matter, the financial press and the

            22   financial advisory press, the more information that they can

            23   distill and provide to investors, the better off we all will

            24   be.  And the current regulations have had the perverse effect

            25   of limiting the amount of information available to people.





             1             But I would also suggest that perhaps we get more

             2   creative about this and perhaps if hedge funds themselves

             3   were allowed, apart from any other kind of issuer to make

             4   this kind of public offers but restricted to sophisticated

             5   investors, we might want to attach some conditions that would

             6   not change the nature of the hedge fund and how they operate

             7   but that might attach some conditions in the sense that a

             8   hedge fund might be permitted to make public offers but only

             9   sophisticated sales on the condition that they have an annual

            10   audit, that they get third party valuations and they provide

            11   standardized returns and perhaps that they provide a minimum

            12   amount of mandatory disclosure.

            13             Think about -- just be creative in the process of

            14   give here and take away a little bit here and give here but

            15   add some investor protection aspects to it that might satisfy

            16   the individual investor and might even satisfy the

            17   sophisticated investor and might provide some additional

            18   protections.  

            19             And, you know, for that matter, requiring an annual

            20   audit probably just would codify what most funds do but it

            21   might encourage those that don't have an audit who may have a

            22   greater need to raise money in an easier less expensive way

            23   to allow them to do that but with an additional investor

            24   protection cost added to it.

            25             MR. ROYE:  Jack, last word.





             1             MR. GAINE:  You told me that the concession stands

             2   would still be open when I finished and I don't think that's

             3   true.

             4             On a serious note and on a positive note I think

             5   for the whole meeting, Annette, unless Rich Lindsay took the

             6   only copy of that '99 concept release on short selling with

             7   him, I would love to think that the discussions over the last

             8   couple of days have resurrected that.  We can get rid of the

             9   uptick rule and put the U.S. markets on a level playing field

            10   with other markets.

            11             Secondly, on the merits of what we're talking about

            12   today, I'll just agree with what Paul Roye had to say and

            13   thirdly and finally, Bob Pozen, for your former colleagues, I

            14   support a pay parity bill for the mutual fund manager.  I

            15   thank these four guys and Doug, I think you got a good

            16   night's sleep because I loved 90 percent of what you just

            17   said.

            18             And thank you all very much.

            19             MR. ROYE:  We're going to turn it over to Chairman

            20   Donaldson for some closing remarks, but on behalf of the

            21   Staff, I'd like to thank all our panelists over the past two

            22   days.  I think we've learned a lot.  We appreciate the time. 

            23   Many of you came great distances to be here and adjusted

            24   schedules to be here and I think we're better off for it and

            25   better informed.





             1             Chairman Donaldson?

             2             (Applause.)

             3             CHAIRMAN DONALDSON:  Thanks very much, Paul.  This

             4   brings to a close what I think we all can agree has been a

             5   very informative and helpful and provocative two days of

             6   discussion regarding all aspects of the mutual funds, how

             7   they're structured, how they operate, how they're managed and

             8   how they're currently regulated.  We also I think identified

             9   some areas of concern.  As I believe the roundtable has

            10   demonstrated, hedge funds play an important role in our

            11   markets and offer investors legitimate and oftentimes

            12   lucrative investment opportunities.

            13             I believe that our discussions have also

            14   demonstrated that it is an appropriate time to review hedge

            15   funds and our regulation of them.

            16             The next phase for the Commission and the staff is

            17   to analyze what we've learned over the past two days at this

            18   roundtable and through our previous fact-finding.  Therefore,

            19   I encourage all of you to submit comments to us as you

            20   reflect on the past two days.

            21             As I stated yesterday, I want to emphasize again,

            22   the discussion does not end with the close of this

            23   roundtable.  This is perhaps the most critical phase yet

            24   because it allows us to review the input from various experts

            25   as well as the data we've collected so far.





             1             Therefore I'm asking the staff to prepare a report

             2   that will summarize our findings and include the

             3   recommendations for any actions that should be taken, whether

             4   legislative or regulatory, to ensure that the hedge fund

             5   investors are adequately protected.

             6             I look forward to the staff's report, which the

             7   Commission will make public.

             8             Before you go, I want to thank the group of

             9   panelists.  We've all benefitted from their participation

            10   yesterday and today and I thank them for taking the time out

            11   of their schedules to help us focus on the important issues

            12   surrounding hedge funds.  I think this is the way the SEC

            13   should operate, in an open manner to bring all sorts of

            14   points of view together, for the Commissioners to sit here

            15   and listen, for the staff to sit here and listen.

            16             I do want to thank the staff who put this together. 

            17   Though the list is long, I want to mention by name the staff

            18   members who played the most significant roles.  Paul,

            19   beginning with you as our master of ceremonies --

            20             (Applause.)

            21             CHAIRMAN DONALDSON:  Will you hold your applause

            22   until the end?

            23             Cindy Fornelli, Jennifer McHugh, Bob Platz, Doug

            24   Scheidt, Liz Osterman, Evan Gelzar, Rochelle Plessett, Martin

            25   Kimmell, Steve Pax, Lily Chu, Wendy Friedlander and Jennifer





             1   Berman, all of them from the division of investment

             2   management.

             3             From the office of compliance, inspections and

             4   examinations, I'd like to thank Lori Richards, Jean Hogey,

             5   Maryann Godzilla, Marvis Kelly, Brian Snively, Karen

             6   Stevenson, Leslie Ward and all of the staff who worked on the

             7   fact-finding stage of this endeavor.  And of course, Alan

             8   Beller, Steve Cutler, Annette Nazareth, our division

             9   directors from corporation finance, enforcement and market

            10   regulation, respectively.

            11             I'm sure, absolutely sure that I left somebody out

            12   and I know this group has played an instrumental role in

            13   assisting the Commission in this important endeavor.

            14             I close by thanking all of you again for coming

            15   here, wishing you all a nice evening and safe travel to those

            16   of you who are going to be dispersed in the winds.

            17             Thanks for joining us.

            18             (Applause.)

            19             (Whereupon, at 5:19 p.m., the roundtable was

            20   concluded.)

            21                             * * * * *

            22

            23

            24

            25