1

             1   UNITED STATES SECURITIES AND EXCHANGE COMMISSION

             2

             3   In the Matter of:           

             4                               

             5   OPEN COMMISSION MEETING     

             6

             7   PAGES:    1 through 129

             8   PLACE:    Securities and Exchange Commission

             9             450 Fifth Street, N.W.

            10             Washington, D.C.  

            11   DATE:     Tuesday, October 26, 2004

            12

            13             The above-entitled matter came on for hearing,

            14   pursuant to notice, at 10:01 a.m.

            15   BEFORE:

            16        WILLIAM H. DONALDSON, Chairman

            17        CYNTHIA A. GLASSMAN, Commissioner

            18        HARVEY J. GOLDSCHMID, Commissioner

            19        PAUL S. ATKINS, Commissioner 

            20        ROEL C. CAMPOS, Commissioner

            21

            22

            23

            24                Diversified Reporting Services, Inc.
            25                           (202) 467-9200                                                                             
            											

             1                          C O N T E N T S

             2

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

             2             CHAIRMAN DONALDSON:  Good morning, everyone.  This

             3   is an open meeting of the United States Securities and

             4   Exchange Commission.  We have two items on our agenda this

             5   morning.

            		   (The discussion of the first item on the agenda, whether to propose new and amended rules and form changes to modify the registration, communications, and offering processes under the Securities Act of 1933, is not included in this transcript.)

				   (Following is the transcript of the Commissions deliberations on whether to adopt rule 203(b)(3)-2 under the Investment Advisers Act of 1940 to require hedge fund advisers to register with the Commission and whether to adopt certain conforming and transitional amendments to rules 203(b)(3)1, 203(A)-3, 204-2, 205-3, 206(4)-2, 222-2 and Form ADV.)

            
       
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        3             CHAIRMAN DONALDSON:  Why don't we get going, ladies

             4   and gentlemen, if we can.

             5             The second and final item on our agenda is a

             6   recommendation from the staff from the Division of Investment

             7   Management that we adopt rules and amendments proposed last

             8   July, to require managers of certain private investment

             9   pools, commonly known as hedge funds, to register with the

            10   Commission as investment advisers.

            11             Most hedge funds are organized in ways that avoid

            12   triggering the registration requirements of the Securities

            13   Act, Securities Exchange Act, and the Investment Company Act,

            14   and many hedge fund managers avoid registration under the

            15   Investment Advisers Act by relying on a safe harbor rule

            16   adopted by the Commission in 1985, that permits an investment

            17   adviser to count a legal organization has a single client, so

            18   long as the investment advice provided is based on the

            19   organization's investment objectives, rather than those of

            20   any owner or owners of the organization.

            21             In recent years, the Commission has been faced with

            22   escalating growth in the hedge fund industry.  The number of

            23   funds, investors, and investment managers participating in

            24   the industry, as well as the assets under management, are all

            25   rising rapidly.


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             1             From what we can tell, the number of hedge funds

             2   has increased at least five-fold over the last ten years. 

             3   The dollar value of funds invested in hedge funds is

             4   reportedly approaching a trillion dollars, up 15-fold in the

             5   last ten years.

             6             Five years ago, the near collapse of the Long-Term

             7   Capital Management vaulted these investment vehicles

             8   into the headlines, bringing into focus the role that they

             9   were playing in the financial markets.  At that time, the

            10   Commission rejected the idea of changing its rules to

            11   preclude hedge fund advisers from relying on the safe harbor.

            12             In the intervening period, there have been major

            13   changes in the hedge fund industry, both in the number and

            14   size of funds, and in the demographics of its investors, that

            15   warrant the Commissions' reconsideration of this position.  

            16             Over two years ago, in June 2002, the Commission

            17   decided to reconsider the hedge fund issue.  The staff, at

            18   the direction of the Commission, commenced a sweeping study

            19   of the hedge fund industry.

            20             The staff's efforts were complemented by a two-day

            21   roundtable held by the Commission in May 2003, and the

            22   results of the staff efforts, along with preliminary

            23   recommendations, were published in September 2003.

            24             The report elicited considerable interest, debate,

            25   and discussion within and outside the Commission, and amongst





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             1   a very broad cross section of interested parties, building on

             2   the observations made in the staff report, and the public

             3   meetings, and the staff investigations that preceded the

             4   report.

             5             One of the recommendations that the staff made in

             6   its 2003 report was that the Commission consider requiring

             7   hedge fund advisers to register as investment advisers,

             8   taking into account whether the benefits outweighed the

             9   burdens of registration.

            10             Last July, the Commission proposed new rules and

            11   amendments that would implement this recommendation.

            12   Recognizing the important policy issues implicated by the

            13   proposal, the Commission included an extensive request for

            14   comment on each aspect of the proposal.  This request was

            15   augmented by a series of additional questions posed by

            16   Commissioners Glassman and Atkins in their dissenting

            17   statement.

            18             Following an extensive review of the comments, the

            19   division is here this morning to recommend that we adopt the

            20   rules substantially as proposed, with revisions that address

            21   specific issues raised by the commenters.

            22             Before turning this over to you, Paul, to present

            23   the division's recommendation, I would like to recognize the

            24   members of the staff of the Investment Management Division

            25   for their tireless efforts in developing the recommendations





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             1   before us today, in particular Bob Plaze, Jennifer Sawin,

             2   Jamey Basham, and Vivien Liu.

             3             They've worked extraordinarily hard through this

             4   process, and they are to be commended and congratulated on

             5   the fine job they've done.

             6             Paul, will you please give us the details of your

             7   recommendation.

             8             MR. ROYE:  Thank you, Chairman Donaldson, and good

             9   morning to you and the other commissioners.

            10             First, I would be remiss that if I didn't also

            11   acknowledge up front the assistance of many people on this

            12   effort, this study, this review of the hedge fund industry. 

            13             As you mentioned, Chairman Donaldson, we commenced

            14   this effort two years ago, with a study of the gathering of

            15   information.  We had extensive help from others in the

            16   division:  Doug Scheidt, Alison Fuller, Elizabeth Osterman,

            17   Barbara Chretien-Dar, Nancy Morris, David Grim, Eric Purple

            18   and Dan Kahl.

            19             We got extensive help from our Office of

            20   Compliance, Inspections, and Examinations, led by Lori

            21   Richards and Gene Gohlke, who heads up the Investment

            22   Management side of OCIE; extensive help from the Division of

            23   Enforcement, Steve Cutler, Nancy Doty, Laurie Stewart; and

            24   Alan Beller, Amy Starr, and Gerry LaPorte in the Division of

            25   Corporation Finance; in our Office of International Affairs,





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             1   Ethiopis Tafara, Elizabeth Jacobs, Stephanie Kim Park, and

             2   Sherman Boone;

             3 	our Office of Economic Analysis, in particular

             4   Harvey Westbrook, Chuck Dale, and Jonathan Sokobin, and

             5   Chester Spatt; also, last but not least, our Office of

             6   General Counsel, Giovanni Prezioso, Arthur Laby, Jill Felker,

             7   and Randy Quinn.  We sincerely appreciate their efforts, and

             8   all the help that they gave us over the course of the last

             9   two years.

            10             I'm pleased this morning, to present to the

            11   Commission our recommendation for a new rule and rule

            12   amendments under the Investment Advisers Act that would

            13   require hedge fund advisers to be registered with the

            14   Commission as investment advisers.  As you indicated, Mr.

            15   Chairman, this past July the Commission proposed the rule and

            16   rule amendments that we're recommending you adopt today.

            17             You received letters from 153 commenters, of which

            18   29 supported the proposal and 82 opposed it, while 42

            19   commenters submitted letters raising questions about

            20   particular issues that they wished the Commission to address.

            21             Of the major trade associations, the Investment

            22   Company Institute, the Investment Counsel Association of

            23   America, both of which have many members who advise hedge

            24   funds, favored the rule proposal, while the Managed Funds

            25   Association, most of whose members manage hedge funds and/or





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             1   commodity pools, opposed the rule.

             2             Most, but not all of the hedge fund managers who

             3   wrote opposed the rule.  Several hedge fund managers who are

             4   registered with us as advisers supported the rule, and

             5   indicated that registration had not interfered with their

             6   operations nor imposed substantial burdens.  The ICI and

             7   ICAA expressed similar views on behalf of their members, who

             8   all are registered advisers.

             9             Individual hedge fund investors were split on the

            10   proposal.

            11             The only two institutional investors who wrote you,

            12   the Ohio Public Employees Retirement System and the New

            13   Jersey State Investment Council, strongly supported the rule.

            14             Interestingly, the Hennessee Group, which is a

            15   hedge fund consulting group, submitted a survey that it had

            16   performed of foundations and endowments, which are

            17   significant investors today in hedge funds, and they reported

            18   that 59 percent favored requiring hedge fund advisers to

            19   register, while 30 percent opposed such a requirement.

            20             But we did not just read the comment letters.  In

            21   the past year, we have had discussions about hedge funds and

            22   our proposals with fellow regulators, including the staff of

            23   the Treasury Department, the Federal Reserve Board, the

            24   Commodity Futures Trading Commission. 

            25             We have also met with our colleagues at foreign





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             1   regulators, including the Financial Services Authority in the

             2   United Kingdom, which requires hedge fund advisers to be

             3   registered with them.

             4             The comments and our conversations with fellow

             5   regulators provided a wealth of information and insight that

             6   has helped us prepare our recommendation for you.

             7             The rule proposal, as I indicated, was the result

             8   of a process that began over two years ago, that included an

             9   extensive staff study of hedge funds and their advisers that

            10   we released last year.  Our study raised a number of concerns

            11   that lead us to recommend that you require registration of

            12   hedge fund advisers under the Advisers Act.

            13             One concern, as you mentioned, Mr. Chairman, is the

            14   tremendous growth in the industry.  While no one knows for

            15   sure, it is estimated that in the last five years, that hedge

            16   fund assets have grown by 260 percent, with assets of

            17   approximately $870 billion in approximately 7,000 funds, and

            18   some predict that hedge fund assets by the end of the year

            19   will reach one trillion dollars.

            20             In the last year alone, hedge fund assets have

            21   grown over 30 percent.  Hedge funds are one-fifth the size of

            22   equity mutual funds, and are growing at a much faster rate

            23   than these funds.

            24             Moreover, hedge funds tend to be active traders. 

            25   One study estimates that hedge funds are responsible for up





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             1   to 20 percent of equity trading volume in the United States. 

             2   It is clear that hedge fund advisers are significant market

             3   participants, both as managers of assets and traders of

             4   securities.  And we think this growth and impact on our

             5   markets simply cannot be ignored.

             6             Now, in spite of the statistics that I just

             7   reviewed for you, neither we nor any government agency has

             8   reliable data on the hedge fund industry, including data on

             9   the number of funds, or the amount of their assets.  We only

            10   have third-party surveys and reports, which often conflict,

            11   and may be unreliable.

            12             Another significant concern is the growing exposure

            13   of smaller investors, pensioners, and other market

            14   participants, directly or indirectly, to the impact of hedge

            15   fund investing.

            16             These vehicles are no longer for the very rich. 

            17   More and more, we see funds pouring in from a new type of

            18   investor who can't afford to absorb the large losses as a

            19   result of a fraud.

            20             Lower minimums and the rise of funds of hedge funds

            21   are permitting smaller, non-traditional investors into hedge

            22   funds.  Moreover, a growing number of public and private

            23   pension plans, as well as universities, endowments, and other

            24   charitable organizations, have begun to invest larger amounts

            25   of money in hedge funds.  It's estimated that these types of





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             1   institutions may soon increase their investments in hedge

             2   funds to over $300 billion.

             3             Investors such as pension plans that have millions

             4   of beneficiaries are now exposed to the risks of hedge fund

             5   investing.  Losses resulting from hedge fund investment

             6   strategies, and possible hedge fund frauds, could affect

             7   these institutions' ability to satisfy their obligations to

             8   their beneficiaries, or to meet other intended goals.

             9             The growth in hedge funds has unfortunately been

            10   accompanied by troubling growth in the number of our hedge

            11   fund enforcement cases.

            12             In the last five years, the Commission has brought

            13   51 cases involving hedge fund fraud, resulting in losses of

            14   more than $1.1 billion.  Now, these cases are more than ten

            15   percent of cases against investment advisers over the same

            16   period.  Now, you can slice and dice these cases in a number

            17   of ways, but we think they signal to us that this is an area

            18   where we should have concerns.

            19             In addition, we are seeing hedge funds used to

            20   defraud other market participants.  Hedge fund advisers were

            21   key participants in the recent scandals involving mutual fund

            22   late trading and inappropriate market timing.  We've counted

            23   almost 400 hedge funds and 87 hedge fund advisers involved in

            24   these cases.  They were most of the late traders and market

            25   timers.  They picked the pockets of average mutual fund





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             1   investors.

             2             Registration under the Advisers Act will give us

             3   the tools we need to monitor the activities of hedge fund

             4   advisers without imposing burdens on the legitimate

             5   investment activities of hedge funds, or interfering with the

             6   important role that hedge funds play in our financial

             7   markets.

             8             The Advisers Act does not require an adviser to

             9   follow or avoid any particular investment strategies, nor

            10   does it require or prohibit a specific investment.  It will

            11   not hamper hedge fund operations.

            12             A recent study found that there were no significant

            13   differences between performance of hedge funds managed by

            14   unregistered advisers, and those managed by registered

            15   advisers.  Five of the ten largest, and presumably most

            16   successful hedge fund advisers are today registered with the

            17   Commission.

            18             More than 8,500 advisory firms, that collectively

            19   manage 23 trillion dollars in assets, are registered under

            20   the Advisers Act.  We see no credible evidence that the

            21   Advisers Act has any way impeded their ability to employ

            22   successful investment strategies, or to effectively compete

            23   with other financial institutions that manage securities

            24   portfolios in this country or abroad.

            25             Advisers Act registration will allow the Commission





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             1   to address the various concerns that we identified regarding

             2   the hedge fund industry.

             3             First, registration under the Act will provide the

             4   Commission with the ability to collect important information

             5   that we now lack about this growing component of the U.S.

             6   financial system.

             7             Other approaches suggested would require the staff

             8   to engage in a complicated and time-consuming forensic

             9   exercise to extract an incomplete composite of information

            10   about hedge funds.  And we think this would essentially

            11   require us to put together multiple jigsaw puzzles, without

            12   all the pieces.

            13             Second, registration under the Advisers Act would

            14   give the Commission the ability to conduct examinations of

            15   hedge fund advisers.

            16             Examinations permit us to identify compliance

            17   problems at an early stage, identify practices that may be

            18   harmful to investors, and provide a deterrent to unlawful

            19   conduct.  The prospect of a Commission examination increases

            20   the risk of getting caught violating the law, and thus will

            21   deter wrongdoers.

            22             We are not suggesting that our examination staff

            23   will uncover every fraud, and some critics contend that we

            24   would be unsuccessful in detecting fraud by hedge fund

            25   advisers.





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             1             However, our examination staff uncovered five of

             2   the eight cases that we  brought against registered hedge

             3   fund advisers.  There's nothing unique about hedge fund

             4   advisers, or the type of frauds they have committed.  We

             5   brought the same types of actions against unregistered

             6   advisers that we brought against registered advisers.

             7             Third, registration permits us to screen

             8   individuals associated with an adviser, and to deny

             9   registration if they have been convicted of a felony, or had

            10   a disciplinary record subjecting them to disqualification. 

            11   We would use this authority to help keep fraudsters and scam

            12   artists out of the hedge fund industry.

            13             Fourth, registration would require hedge fund

            14   advisers to adopt policies and procedures designed to prevent

            15   violations of the Advisers Act, and to designate a chief

            16   compliance officer.  So in other words, hedge fund advisers

            17   would have to develop a compliance infrastructure, just like

            18   other advisers of similar size.

            19             Now, we readily acknowledge that compliance

            20   controls cost money, but these are costs all advisers that

            21   register with us must bear, including advisers that are much

            22   smaller, and have substantially fewer resources and cash flow

            23   than many hedge fund advisers.

            24             Given the fee revenue generated by many hedge fund

            25   managers today, the arguments made by some opponents that





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             1   hedge fund advisers could not afford these costs is simply

             2   not credible.

             3             Fifth, registration under the Advisers Act would

             4   have the salutary effect of requiring many direct investors

             5   in most hedge funds to meet wealth standards that are higher

             6   than the current minimums.

             7             Finally, we believe that the adoption of the rule

             8   and rule amendments we recommend today will close a loophole

             9   in our regulations that allows an exception designed for

            10   advisers providing advice only to a small number of clients,

            11   and therefore, not representing a substantial federal

            12   interest, to be used by hedge fund advisers, who in some

            13   cases manage billions of dollars for thousands of investors.

            14             Commenters suggested a variety of alternatives to

            15   Adviser Act registration, but none of them, in our judgment

            16   would accomplish the goals of this rulemaking.

            17             While some of the alternatives would address some

            18   of our policy concerns, each of them lacked what we

            19   considered an essential component of this rulemaking, the

            20   ability to exercise our examination authority, which we view

            21   as vital to deterring and detecting fraud in the hedge fund

            22   sector of the investment management industry.

            23             If we are to maximize our effectiveness, we must

            24   have the ability to use our examination authority to monitor

            25   hedge fund adviser activity, and protect our financial





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             1   markets.

             2             We want to be perfectly clear about the motivations

             3   behind our rulemaking, because there are those who have

             4   characterized this initiative as an attack on the hedge fund

             5   industry, which it is most definitely not.

             6             Most participants in the hedge fund industry are

             7   honest and ethical, and we deeply appreciate the beneficial

             8   role that hedge funds play in our markets.

             9             And we do not want to impede the industry's ability

            10   to flourish and grow.  We simply want to be able to monitor

            11   this fast-growing segment of the investment management

            12   industry, so as to fulfill our mission to protect investors

            13   and the securities markets, and if this rule is adopted, our

            14   sincere hope is that the hedge fund industry would join with

            15   us to make this initiative work for the industry, and

            16   ultimately strengthen hedge funds' role in our securities

            17   markets.

            18             And with that, we'd be pleased to answer any

            19   questions that you may have.

            20             CHAIRMAN DONALDSON:  Thank you, Paul, for that.

            21             Before I ask my colleagues to present their

            22   observations on the proposal before us, I'd like to make just

            23   a few comments.

            24             I think we can agree that by all accounts, the

            25   hedge fund industry is growing explosively.  As you suggest,





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             1   the number of funds, investors and investment managers

             2   participating in the industry, as well as assets under

             3   management, are rising rapidly, particularly in the last five

             4   years.

             5             You acknowledged the benefits of liquidity provided

             6   to the markets in which the funds operate, and cited the

             7   investment flexibility, mobility, and potential for sustained

             8   returns available to hedge fund investors.

             9             Likewise, you provided a detailed catalogue of

            10   concerns regarding the obligations the SEC must face in terms

            11   of investor protection, and enforcement of our security laws,

            12   and most particularly, the prevention and prohibition of

            13   fraud, our central mission.

            14             Your concerns derive not only from the size and

            15   growth of the industry, but also from the evolving

            16   configuration of the investor base.  That ranges from funds

            17   of hedge funds available to relatively small investors to

            18   the increasing investment by institutions, such as pension

            19   funds and endowments and charitable foundations, the

            20   beneficiaries of which include individuals whose

            21   circumstances vary widely.

            22             You cited the increased incidents of fraud

            23   perpetrated by those funds, and noted how difficult it is to

            24   deter this fraud, or to discover this fraud before it

            25   happens, due to our lack of required compliance regime in the





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             1   examination and inspection authority.

             2             You've spoken of others already subject to the

             3   Investment Advisers Act, who register with as little as $25

             4   million under management, when we have not exercised our

             5   jurisdiction over the advisers to the $1 trillion hedge fund

             6   industry.

             7             In short, it would seem that the weight of evidence

             8   is overwhelming, and we accept the staff's recommendation. 

             9   In fact, to not do so would be a major dereliction of the

            10   Commission's responsibility.  And yet, over the course of the

            11   intensive analysis of the past five years, there remain

            12   objections by some.

            13             As part of a fair attempt to evaluate such

            14   objections, I have sought, both personally and

            15   professionally, to see the other side of the arguments,

            16   arguments which go something like this:

            17             The SEC does not have the resources to devote to

            18   this task.

            19             My answer to this is that we do have the resources,

            20   if we are able to apply our manpower and expertise in an

            21   effective, risk-based system designed not only for this

            22   responsibility, but ultimately, as an underpinning for all

            23   examinations and inspections conducted by the Commission.

            24             To bring hedge fund managers under the Investment

            25   Advisers Act will create a false sense of security, some kind





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             1   of a Good Housekeeping seal of approval.

             2             To any student of the role of the SEC, it is clear

             3   that in no sense does our oversight of investment companies

             4   or investment advisers address itself to the merits of the

             5   investments, or the advisers.  In fact, the Investment

             6   Advisers Act anticipated this concern, and explicitly prohibits

             7   registered advisers from making any representation that we

             8   have recommended or approved of them.

             9             We've not done enough study, nor have we allowed

            10   enough time, to receive comments, or entertain alternative

            11   registration schemes.

            12             As the Investment Management Division has indicated

            13   and noted, the intensive review of the issue over the past

            14   two years is self evident.  The extended exchange of views

            15   over that period, the publication of a major study on the

            16   topic, out for almost a year of comment, then a formal

            17   comment period of customary length after the publication of the

            18   proposed rule, and the willingness to review comments, even

            19   after the official deadline passed, all seems to refute this

            20   argument.

            21             I won't catalogue or repeat other areas of

            22   disagreement on our proposal, for to do so would be

            23   redundant, but I do ask just a couple of rhetorical

            24   questions.

            25             If more than 40 percent of all existing hedge fund





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             1   managers have already registered voluntarily, and have

             2   testified to its being a minimal burden, why is it that the

             3   others, or representatives of the others, resist?

             4             Without registration, how can we begin to

             5   understand fully the impact that hedge fund advisers have on

             6   the broad market of individual, institutional, and professional

             7   investors, with which the funds trade every single trading

             8   day.

             9             How can it seriously be argued that our policy

            10   objective, ultimately, is to regulate investment companies'

            11   concentrations or strategies, when we have no authority to do

            12   so under the Investment Advisers Act, and we have never

            13   sought to do so for the past 64 years?

            14             As we proceed this morning, I look forward to any

            15   comments from the staff or my fellow commissioners that might

            16   refute or question the general direction of the thoughts and

            17   analysis I've just presented, but before I ask the commission

            18   colleagues to make their statements, I'd like to ask the

            19   staff two questions.

            20             And my first question I'd like to direct to

            21   Giovanni, as the general counsel of the SEC.

            22             Several of the commenters suggested that the

            23   Commission does not have authority to adopt a rule that

            24   requires hedge fund advisers to look through hedge funds they

            25   manage, for purposes of counting clients.





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             1             I would like the general counsel to address these

             2   arguments, and give us his analysis of the Commission's

             3   authority in this area.

             4             MR. PREZIOSO:  Thank you, Mr. Chairman.

             5             In my view, the Commission does have the authority

             6   to adopt the rule changes presented to you by the division

             7   today.  As you might imagine, we've reflected on this issue

             8   at some length in our office, in consultation with our

             9   colleagues, especially in light of the comments that have

            10   been received that raise this issue.

            11             As you know, the topic's also discussed in the

            12   draft release that's before the Commission.  Let me touch on

            13   just a few points that I think are particularly important on

            14   this issue.

            15             First, the Commission has broad authority under the

            16   Advisers Act to engage in rulemaking.  And the rules before

            17   you today address an important issue under the Act, namely

            18   how to determine which advisers qualify for an exemption

            19   under Section 203(b)(3).  That exemption, as you know, is

            20   available to an adviser that has fewer than 15 clients, and

            21   that doesn't hold itself out to the public as an investment

            22   adviser.

            23             Questions about when an investor in a pooled vehicle

            24   should be counted as a client, for purpose of this exemption,

            25   date back several decades, and they've been viewed as





                                                                            72

             1   appropriate issues for Commission consideration throughout

             2   that period.  In fact, it's those questions that were one of

             3   the principal reasons the Commission adopted the current safe

             4   harbor that it adopted in 1985.  And at a common sense level,

             5   I think this isn't really surprising.

             6             Take, for example, an investment manager that has

             7   30 clients, with $100 million under management.  Imagine the

             8   adviser says, "I have a clever idea.  I'm going to have all

             9   of my clients invest in a limited partnership, and I'm going

            10   to follow the same strategies in managing that limited

            11   partnerships assets that I follow in managing their accounts

            12   today, and then I won't have to register with the Securities

            13   and Exchange Commission."

            14             Now, if those clients had been managed similarly,

            15   or identically, before, and today, in many cases, they are --

            16   nothing will have changed.  Except that now, the investment

            17   adviser won't be subject to Commission oversight.

            18             And in those circumstances, I think most people

            19   would question whether that's the correct legal result,

            20   particularly under a statute that has an express provision

            21   that prohibits a person from doing indirectly, through

            22   another person, something that they can't do directly.

            23             A second point that I think merits note is that the

            24   Commission has ample evidence from the staff study, from

            25   enforcement actions, from the Hedge Fund Roundtable, and from





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             1   other sources, that the role of hedge fund managers in our

             2   markets has changed very significantly since the Commission

             3   addressed this issue in 1985.  At that time, the Commission

             4   concluded that an exemption for these advisers could be

             5   implemented, consistent with the objectives of Congress when

             6   it adopted Section 203(b)(3) in 1940.

             7             As you know, and as Paul has mentioned, the

             8   exemption originally applied principally to advisers that

             9   offered their services to a small number of friends and

            10   family members.  And today, as you've heard, and as you've

            11   commented, advisers to private funds have a much more

            12   significant impact on our capital markets, and on a much

            13   larger number of investors.

            14             A third point worth noting is that the rule targets

            15   those investment advisers whose activities most directly

            16   implicate the concerns of the Act.  The rule applies only

            17   where a private fund invests primarily in securities, offers

            18   redemption periods of two years or less, and is marketed,

            19   based on the investment skills of the adviser.

            20             In other words, advisers that offer their advisory

            21   services solely to general business corporations, or similar

            22   entities, won't be required to look through to shareholders or

            23   limited partners in counting clients.

            24             Further, the release and the discussion from Paul

            25   today identified extensively how registration of advisers to





                                                                            74

             1   these private funds would advance the goals of the Act. 

             2             Taking all of these considerations into account, I

             3   think that this is a classic and appropriate exercise of

             4   rulemaking authority to implement the statute's objectives,

             5   in light of evolving market conditions.

             6             CHAIRMAN DONALDSON:  Thanks.  I have one other

             7   question.

             8             Commissioners Glassman and Atkins, in their dissent

             9   at the proposing stage, asked commenters to discuss

            10   alternatives to registration that addressed the concerns

            11   raised in the proposal.  Many of the examples of alternatives

            12   described in the dissent were ideas that had been considered

            13   by the staff and the Commissioners, in the evolution of what

            14   ultimately became the Commission's proposal.

            15             Did the commenters offer any fresh insights about

            16   these ideas, or any new alternatives that had not been

            17   previously considered?

            18             And I'll address that to you, Paul.

            19             MR. ROYE:  Yes.  I think one thing that should be

            20   pointed out is that even, you know, prior to the proposal

            21   stage, we spent a lot of time thinking through alternatives. 

            22   Indeed, Mr. Chairman, you, as well as a number of the other

            23   Commissioners, pressed us on different approaches to

            24   addressing the concerns that we had identified in the staff

            25   report.





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             1             Many of the alternatives that were highlighted in

             2   the comments, we had thought about, we reconsidered during

             3   the comment process, when those comments came in.  They range

             4   from different ways for the Commission to access information,

             5   using other regulatory agencies' information.

             6             Using that information, along with information from

             7   brokers, and others, that we regulate, to piece together a

             8   picture of a particular hedge fund adviser's activity, and

             9   the industry as a whole.

            10             You know, we looked at that, we talked to other

            11   regulators about that approach, and again, I think we see

            12   that as a patchwork, a puzzle, that we don't have all the

            13   pieces.  It's going to -- it would be time consuming,

            14   described as a forensic exercise, to try to figure out

            15   exactly what any particular hedge fund adviser is doing.

            16             We think the Advisers Act registration, the

            17   information that we get there is a more direct way to focus

            18   on that issue.

            19             We had commenters suggest we raise the standards

            20   under Regulation D, to get at concerns about small

            21   investors.  That's certainly an alternative that we

            22   considered.  Reg D goes beyond hedge fund investing,

            23   introduces a whole level of complication.  Again, the

            24   Investment Advisers Act regime would effectively address

            25   minimum standards for direct investments in hedge funds.





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             1             There were some new ideas in terms of requiring

             2   hedge fund advisers to go through an annual audit by the

             3   auditors.

             4             But as we pointed out in our hedge fund report, we

             5   have concerns about exactly what the auditors do in

             6   conjunction with those audits, offering to certify that

             7   they're in compliance with particular provisions that we deem

             8   to be appropriate for hedge fund advisers, under the statute.

             9   Again, that kind of approach would not allow us to go in and

            10   check whether or not they're indeed honestly certifying

            11   compliance with various procedures.

            12             So, a number of different approaches.

            13             You know, we thought about a hedge fund adviser

            14   light approach, in thinking through that approach, and

            15   creating a different regime, if you will, for hedge fund

            16   advisers.

            17             We got into issues of how do you administer that,

            18   how is it fair, given the scenario that Giovanni outlined, in

            19   terms of how you structure your business and operations.  You

            20   change clients, you acquire new clients.  What does that do? 

            21   We'd have to administer sort of dueling regimes, here, and we

            22   thought that introduced a level of complexity that was just

            23   not needed.

            24             There's a common theme in all the alternatives. 

            25   All the alternatives would, for the most part, deny us





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             1   two key components of what we view as our objective here. 

             2             First, the Advisers Act would effectively require

             3   the hedge fund advisers to have a compliance program. 

             4   Compliance policies and procedures, and someone designated to

             5   monitor their compliance with the Advisers Act.  We think

             6   that's very important in a program, in terms of heading off

             7   problems, deterring abuses.

             8             The other theme was that it would deny us the

             9   examination authority.  We feel that it's very key, in order

            10   for us to be in a position to understand what's going on and

            11   to test what's going on in the various hedge fund advisers,

            12   and we think it's important to deterring unlawful activity.

            13              So, as we've thought about the alternatives, we

            14   thought about them before we made the proposal.  We've looked

            15   at the alternatives that were proposed or suggested in regard

            16   to the comments.  But we see each of them as deficient in

            17   terms of meeting all the goals and objectives that we set out

            18   for this rulemaking.

            19             CHAIRMAN DONALDSON:  Thanks very much. 

            20             Commissioner Glassman.

            21             COMMISSIONER GLASSMAN:  Thank you, Mr. Chairman. 

            22             In contrast to my enthusiasm for the Securities Act

            23   reform proposal considered by us today, the hedge fund

            24   proposal is a disappointment to me on many levels.

            25             Procedurally, the proposal was rushed through the





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             1   rulemaking process, and appears to have been a fait accompli

             2   from its inception.  The Chairman and other proponents

             3   apparently believe that the commenters already had sufficient

             4   notice, based on the Commission's Hedge Fund Roundtable, as

             5   well as last year's staff study, that a proposal would be

             6   forthcoming.

             7             However, because the Roundtable and the staff study

             8   confirmed that the problems we initially thought would be

             9   found in the hedge fund industry do not appear to be present,

            10   it was not obvious, certainly not to me, that the proposed

            11   rule would be forthcoming.

            12             Further, since regulation of hedge funds has broad

            13   market implications, any regulatory requirement would more

            14   appropriately be addressed as part of a collaborative effort

            15   among the President's Working Group members, all of whom, I

            16   understand, have concerns with our proposal.

            17             I believe it would have been prudent for that

            18   collaborative effort to proceed prior to unilateral

            19   Commission action.

            20             I'm also troubled by the staff's minimization of

            21   commenters' concerns in various drafts of the proposal, as

            22   well as an undertone that the burden of proof is on those

            23   opposed to show that this rule is not warranted.

            24             That's backwards.  In my view, the burden of proof

            25   should be on the Commission to establish that this is the





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             1   least burdensome and most effective way to accomplish our

             2   objective.

             3             The proposal itself is fundamentally the same one

             4   from which I dissented in July.  While I agree, as I have all

             5   along, that we need more information on hedge funds, I

             6   disagree with this solution.

             7             The comment letters in support of this proposal are

             8   not persuasive, and the comment letters against the proposal,

             9   which represent the vast majority of submissions, raise many

            10   of the same concerns that I did.

            11             Accordingly, I am not going to reiterate all of the

            12   concerns that I raised when this went out for comment.  But I

            13   do want to highlight a few issues.

            14             The proposal's supporters assert that the proposal

            15   is justified by the growing number of fraud enforcement cases

            16   involving hedge funds.  The staff repeatedly stresses that

            17   since the rule was proposed in July, the Commission has

            18   brought five new enforcement cases, for a total of 51 cases

            19   over the past five years.  Yet a cursory review of the

            20   litigation release posed on the Commission's Website for each

            21   of these new cases, demonstrates that the proposed rule would

            22   have had no effect on any of them.

            23             Four of the cases involve hedge funds below the $25

            24   million threshold, and the fifth case, while involving a

            25   fraud that ultimately, and a fund that ultimately raised $27





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             1   million, did so over an eight-year period. 

             2             As far as I can tell, none of these cases appears

             3   relevant to the proposed rule.  And, as I noted in my initial

             4   dissent, the total number of enforcement cases that even

             5   tangentially involve hedge funds represents just a small

             6   fraction of Commission enforcement actions over the past five

             7   years.

             8             Regarding the market timing cases, I would point

             9   out that it is not, per se, illegal to market time.  What was

            10   illegal was mutual funds allowing market timing when they

            11   said they did not.  And I would also note that we did not

            12   initially find this problem through our examinations.

            13             The staff also stresses that the threat of an

            14   examination will deter fraudulent activity by hedge fund

            15   advisers, and thus rejects all alternatives to this proposal,

            16   because the alternatives lack an examination component.

            17             The fallacy of this argument is that the Commission

            18   lacks the resources necessary to conduct meaningful hedge

            19   fund adviser exams, and our lack of resources is a matter of

            20   public record.

            21             As the Chairman himself noted when he testified

            22   before Congress this year, the Commission has only 495 staff

            23   conducting examinations of approximately 8,000 mutual funds

            24   managed in over 900 fund complexes, as well as more than

            25   8,000 investment advisers.





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             1             It's no secret that the Commission is rethinking

             2   its inspection model, which historically has focused on site

             3   visits and information requests.  As such, it's difficult to

             4   perceive how hedge fund advisers will be deterred by the

             5   prospect of an examination, when they know that we lack the

             6   resources to audit comprehensively their operations.

             7             Given that we are already stretched as an agency

             8   to examine the mutual fund industry, with about 91 million

             9   investors, I question whether we are justified expending

            10   significant additional resources in an attempt to examine

            11   hedge fund advisers, where the investors are limited to a

            12   small number of wealthy and/or sophisticated individuals and

            13   institutions.

            14             There are a number of alternatives that could have

            15   been explored in lieu of registration, but unfortunately,

            16   none of them is on the table.

            17             First, with the growth of hedge funds, I do agree

            18   that we need to know more about them.  I would support a

            19   census, pooling of information from all of the agencies that

            20   collect data on hedge funds, and identifying and requiring

            21   additional periodic and systematic information to be filed

            22   with us, once we determine what would be appropriate.  I've

            23   been supportive of this concept throughout our discussions.

            24             If we really think retailization is a problem, even

            25   though our own staff concluded only last year that this was





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             1   not an issue, we have two very easy options:  raise the

             2   accreditation standards for investors, and/or require

             3   registration for funds that allow relatively small

             4   investment, perhaps $100,000, or another appropriate cutoff.

             5             These conditions would further reduce the number of

             6   high net worth individual investors -- estimated already at

             7   fewer than 200,000 -- to an even smaller universe of

             8   investors.

             9             An additional option would be to require the funds

            10   of funds that are targeted to retail investors, and all of

            11   their component funds, to have registered advisers.  Again, I

            12   have supported these concepts throughout our discussions.

            13             Regarding pension fund and other institutional

            14   investors, who indirectly invest in hedge funds on behalf of

            15   individuals, as part of a risk diversification strategy, this

            16   new requirement will be counterproductive.  Since the trend 

            17   appears to be for such investment

            18   vehicles to limit hedge fund investments to those with

            19   registered advisers, our rule would expand the potential

            20   universe, and encourage even more investment in hedge funds. 

            21             As an aside, my understanding is, we do not have

            22   information on the extent to which institutional investors

            23   actually invest in hedge funds that do not have registered

            24   advisers.  However, we do know that they have a fiduciary

            25   responsibility to their beneficiaries, obligating them to





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             1   conduct appropriate due diligence before making the

             2   investment.

             3             If we are concerned about valuations and fraud, a

             4   notice and filing of appropriate information, including

             5   audited financial statements, would appear to me to be more

             6   useful than the ADV information in the registrations.  We

             7   already have authority, and clearly use it, to investigate

             8   potential fraudulent abuses in hedge funds now.

             9             I continue to be concerned that the registration

            10   and concomitant inspection are the wrong approach.  I do not

            11   think the ADV, even as amended, provides the type of

            12   information that would be helpful in identifying fraud, nor

            13   do we have the resources and expertise to ferret it out in

            14   our examinations.

            15             Thus, as I have said before, the proposed approach

            16   would unrealistically raise expectations about what we are

            17   accomplishing, and would divert significant resources from

            18   other inspection activities that are more focused on retail

            19   investment vehicles.

            20             Regarding the seal of approval, I have heard

            21   anecdotal evidence that registered hedge funds do make that

            22   registration prominent in offering materials.  Why would they

            23   do that?  I understand that we have a task force looking at a

            24   new risk-focused model for investment adviser oversight,

            25   including hedge fund advisers.





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             1             It would have made sense to me to determine the

             2   right model, and then apply it to the hedge funds if that

             3   were -- to the hedge fund advisers, if that were warranted.

             4             Regrettably, the Commission has failed to take an

             5   opportunity to devise a new model of systematic and robust

             6   information gathering, including notice of filing, pooling of

             7   information from all the agencies that collect data on hedge

             8   funds, and identifying and requiring additional information

             9   to be filed with us, once we determine what would be

            10   appropriate, before imposing a new, burdensome, and outdated

            11   requirement.  This would have improved our ability to

            12   perceive market trends, to detect red flags, and to note

            13   industry exceptions.

            14             As I said, I'm disappointed with the approach that

            15   was chosen, and I know that we can and we must do better.  If

            16   this proposal is approved, I hope that as we prepare for its

            17   implementation we develop a workable oversight model.

            18             I want to make perfectly clear that I am not

            19   suggesting that we don't need more information about hedge

            20   funds and their advisers.  However, for all the reasons I

            21   have stated today, at the proposing meeting, and in

            22   Commissioner Atkins' and my dissent, I vote against this

            23   proposal.

            24             I believe it's the wrong solution to an undefined

            25   problem, using an ineffective examination model.  As with the





                                                                            85

             1   proposing release, I plan to file a written dissent to

             2   accompany the adopting release, if this is adopted.  Perhaps

             3   there will be another vote against it.

             4             I do have a few questions.

             5             First, regarding the other agencies, especially the

             6   CFTC request for exemptions, I understand the staff believes

             7   that the concerns of the CFTC have already been addressed in

             8   the proposal, or are specifically provided for in the

             9   Investment Advisers Act.

            10             Given that the CFTC felt compelled to request an

            11   exemption on the eve of this meeting, my question is, what

            12   coordination did we undertake with the CFTC and the other

            13   federal agencies, prior to going forward with this proposal,

            14   and what input did we receive from them?

            15             In this regard, I note that there's a letter from

            16   Congressman Baker, dated October 7th, to Treasury Secretary

            17   Snow, asking the President's Working Group to arrange for the

            18   sharing of data on hedge funds prior to the Commission

            19   undertaking unilateral regulatory action.

            20             Although the Chairman -- our Chairman -- was copied

            21   on this letter, it wasn't posted on the public comment files

            22   of our Website, and I only became aware of its existence

            23   yesterday.

            24             MR. ROYE:  With regard to the CFTC, and the letter

            25   that came in a day or so ago, requesting that in the rule, we





                                                                            86

             1   provide an exemption for hedge fund advisers who are

             2   registered with the CFTC as a commodity trading advisor or a

             3   commodity pool operator, we considered that issue.  I think

             4   it was raised in eight or nine other comment letters as a

             5   possible approach.  We've talked to the CFTC about this

             6   issue, and how we might proceed.

             7             Our conclusion is that we certainly agree that

             8   there should not be regulatory overlap and duplication, and

             9   we should try to work toward minimizing the burdens that we

            10   impose on folks in this sector.

            11             But the CFTC's responsibility is enforcing the

            12   commodity futures laws.  Ours is enforcing the federal

            13   securities laws.  In 2000, the U.S. Congress focused on this

            14   issue of duplication, regulatory overlap.

            15             Any hedge fund adviser, if this rule is approved,

            16   will still have the ability to rely on the statutory

            17   exemption that if their primary business in running hedge

            18   funds and other clients is engaged in futures trading, then

            19   they are exempt, they would be exempt from our jurisdiction. 

            20             If their primary business is managing securities,

            21   where we obviously have an interest, they would not have that

            22   exemption available to them.  So we think that 

            23   this issue has largely been resolved by the Congress, 

            24   with the Commodity Futures Modernization Act, 

            25   but we also think that, on a going-forward basis, if





                                                                            87

             1   this is adopted, that it would be beneficial to work very

             2   closely with the CFTC, in terms of how we target our

             3   resources, how we use our examination authority, how they use

             4   their authority, who they go in to look at.  Information

             5   sharing, we think, is an important component of making this

             6   work going forward, and minimizing burdens.

             7             As far as the other regulatory agencies, in light

             8   of concerns expressed by members of the President's Working

             9   Group, we got together with members of the Fed, to talk about

            10   our concerns about hedge funds, why we're concerned about the

            11   area, and had a dialogue with them.  Same thing with the

            12   Treasury Department.

            13             And Bob, if you want to expand on --

            14             COMMISSIONER GLASSMAN:  Did you listen to anything

            15   they said, or you just had a dialogue?

            16             MR. ROYE:  Well, we certainly listened to what they

            17   had to say.  We listened to, you know, their concerns.

            18             I think that, you know, again, the bottom line is

            19   that we have the responsibility for enforcing the federal

            20   securities laws.  And, you know, they expressed views in

            21   terms of what this approach might mean, what impacts that it

            22   might have.

            23             I think that some of the commenters echoed those

            24   concerns, and, you know, we considered those carefully.  I

            25   mean, we are sensitive to -- you know, we don't want to have





                                                                            88

             1   adverse impacts.  We tried to make that very clear.  

             2             We appreciate the role that hedge funds play in our

             3   markets, the liquidity that they provide, and that's why we

             4   didn't pursue other alternatives, like Investment Company Act

             5   registration, for hedge funds.

             6             We viewed the Advisers Act as a regime that, while

             7   it does impose some costs and some burdens, doesn't interfere

             8   with how the hedge funds are managed or operated, but gives

             9   us a window into what's going on.  And we thought that was

            10   important.

            11             MR. PLAZE:  The real impact it's on is not so much

            12   what we did, but what we didn't do, and we were listening to

            13   all of these agencies, and the Treasury Department, which we

            14   worked on extensively in their hedge fund, by the way, their

            15   hedge fund anti money-laundering rules.

            16             And so, if you look at it from one perspective, we

            17   did not necessarily follow any particular recommendations,

            18   but the release is littered with statements, or footnotes,

            19   that act on their sensitivities.  And so, I think it did have

            20   a significant impact.

            21             COMMISSIONER GLASSMAN:  So, are you suggesting that

            22   the CFTC in particular, and the members of the President's

            23   Working Group would be supportive of this, at this point?

            24             MR. ROYE:  No.

            25             COMMISSIONER GLASSMAN:  No.  I didn't think so. 





                                                                            89

             1             One other question on the cost/benefit analysis,

             2   which unfortunately we only got the first draft of about a

             3   week ago, and have seen a few more drafts in the last week.

             4             There's no, as far as I can tell, there's no

             5   aggregation of costs, no ongoing cost estimate, no compliance

             6   officer cost estimate.  It seems to focus on the qualitative

             7   issues.  It's pretty weak on the quantitative measures.  How

             8   did you include the commenters' cost quantitative estimates

             9   in your estimates?

            10             MR. BASHAM:  I can address that.

            11             We had two primary areas of costs to deal with, and

            12   the first was the cost of converting to registered status,

            13   which we estimated the average cost being at $20,000 in

            14   professional fees, and $25,000 of internal costs, and we got

            15   this estimate by talking to law firms who are in the business

            16   of advising hedge fund advisers as they proceed with their

            17   Commission registration.  And these costs are average costs,

            18   so they might be higher or lower, depending on the firm's

            19   existing compliance infrastructure, or the complexity of its

            20   business.

            21             Some commenters did say that this estimate was too

            22   low, but they didn't provide us with any estimates of their

            23   own and others submitted estimates setting the number much

            24   higher, at around $300,000.  But if you look at the analysis

            25   behind their figures, you see that almost all of this cost





                                                                            90

             1   was attributable to retaining a chief compliance officer. 

             2             Now, if a --

             3             COMMISSIONER GLASSMAN:  Wouldn't retaining a chief

             4   compliance officer be part of the requirement of registering?

             5             MR. BASHAM:  Well, we believe that it would be the

             6   exception, rather than the rule, for a newly-registered hedge

             7   fund firm to add a staff position for a chief compliance

             8   officer.

             9             We don't allow -- we don't have data that will

            10   allow us to quantify this to any reasonable degree of

            11   certainty, but it would be unusual for a firm to require a

            12   full-time chief compliance officer, unless the firm has at

            13   least several hundred thousand dollars of assets under

            14   management.

            15             Excuse me --

            16             COMMISSIONER GLASSMAN:  You mean million.

            17             MR. BASHAM:  -- several hundred million.  Thank

            18   you.

            19             COMMISSIONER GLASSMAN:  Where did you come up with

            20   that thought?

            21             MR. BASHAM:  That's based on our experience with

            22   the compliance rule that went into effect for all registered

            23   advisers this month.

            24             MR. PLAZE:  The compliance rule does not require

            25   the appointment of a new position.  It requires somebody in





                                                                            91

             1   the firm to be designated.  In the hedge fund area, there --

             2             COMMISSIONER GLASSMAN:  There is an opportunity

             3   cost there, for that person.

             4             MR. PLAZE:  Obviously.  But there's also current

             5   compliance obligations, which firms have.

             6             Remember, all of these firms are subject to the

             7   anti-fraud provisions of the Advisers Act, are subject to a

             8   number of other obligations under the securities laws and

             9   other statutes, so you have to have somebody at the firm

            10   concerned about this.  Our concern, of course, is that there is

            11   nobody concerned about this, and this winds up in our

            12   enforcement cases, sometimes.  So, you're going to have a

            13   firm --

            14             COMMISSIONER GLASSMAN:  Not too often.

            15             MR. PLAZE:  -- yeah, you're going to have firms

            16   dealing with this in various ways.  The largest firms already

            17   have compliance.  They have significant reputational risk

            18   -- value at risk, and they have these.  You have the smallest

            19   firms --

            20             COMMISSIONER GLASSMAN:  So what is our deterrent

            21   effect for those?

            22             MR. PLAZE:  The smallest firms.

            23             COMMISSIONER GLASSMAN:  I'm sorry.  For the large

            24   firms --

            25             MR. PLAZE:  The deterrent effect for those firms is





                                                                            92

             1   that that chief compliance officer suddenly says "I'll never

             2   be able to explain what you want to do when the guys from the

             3   SEC come in here."

             4             We suddenly strengthen that person's position

             5   within the firm considerably, and if you disagree with me,

             6   you need to find out what's going on right now, in the

             7   registered firms, where the compliance rule that you voted on

             8   last year is having a tremendous effect in terms of the

             9   position that person holds within the firm and their

            10   ability -- the principal ability, not only their personal

            11   reputation, their personal career position, but they're going

            12   to have to deal, that chief compliance officer has to deal

            13   with our examiners when we come in, and that's the stick that

            14   chief compliance officer wields.

            15             Now, without that stick, he has his own -- he or

            16   she has their own personality, and their own relationship,

            17   hopefully, with the executives that they can deal with.  But

            18   the strongest stick is when the guys from the SEC come in,

            19   "I'll never be able to explain what you want to do."

            20             And I think that's considerable for the larger

            21   firms.  The smaller firms -- what Jamey is saying is that there

            22   is somebody that may provide these services right now,

            23   that'll be designated.

            24             At the margin, it's somewhere between the various

            25   small firms and the medium-size firms.  There are people that





                                                                            93

             1   are going to make a big decision to hire an entirely new

             2   position.  And we factored that into the cost.

             3             The problem here is we have so little information

             4   about hedge fund advisers, other than the ones that are

             5   registered with us.  And we can't even distinguish those from

             6   other advisers under our current regime.  Very difficult to

             7   try to figure out what hedge fund advisers put into what

             8   category.  

             9             For the smaller ones, they typically start business

            10   in a turn-key operation from a prime broker.  They set them

            11   up in the office.  They set them up with their electronic

            12   equipment.  They give them desk space, they provide them with

            13   back-office services.

            14             Our best guess is that that kind of a turn-key

            15   operation in the future will include a chief compliance

            16   officer that will not be dedicated full-time to a hedge fund

            17   consisting of two or three traders, will be a marginal cost,

            18   but it will not be the $300,000 cost, because that chief

            19   compliance officer will have similar responsibilities for a

            20   number of people set up at the prime broker, so that they

            21   will act to minimize those costs.

            22             The comment letters that we got that suggested

            23   these very high costs assumed a stand-alone operation with a

            24   fully-loaded chief compliance officer, and that is going to

            25   occur, at some percentage of the firms, the trouble is, we





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             1   just don't know at what percentage that will occur.

             2             But we think that there are other business models

             3   available, both at the upper end of the spectrum, which

             4   suggests costs already effected, and the smaller end of the

             5   spectrum, which would go to mitigate that larger cost.

             6             But unfortunately, we simply don't have the data to

             7   classify hedge fund advisers where they would fall.  And that

             8   explains, I think, the lack of real good quantitative data.

             9             COMMISSIONER GLASSMAN:  Did we have the economists

            10   do any kind of statistical estimations to try to figure this

            11   out?

            12             MR. SPATT:  We have not.  We've reviewed, and we've

            13   commented upon the cost benefit that's been done by IM.

            14             COMMISSIONER GLASSMAN:  Okay.  Thank you.  

            15             CHAIRMAN DONALDSON:  Commissioner Goldschmid.

            16             COMMISSIONER GOLDSCHMID:  Thank you, Mr. Chairman.

            17             In case anyone hasn't noticed it, there may not be

            18   unanimity on these hedge fund issues.  I do share the

            19   Chairman's views.  As Chairman Donaldson and Paul Roye have

            20   indicated, the new hedge fund adviser rules and amendments

            21   result from extensive examinations and reviews by the SEC

            22   staff, and by the Commission itself.

            23             In my time on the Commission, we have had two days

            24   of Hedge Fund Roundtables, testimony at several Congressional

            25   hearings, a review and publication of the excellent staff





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             1   report in September of 2003, the proposed rulemaking in July

             2   2004, and numerous discussions at public forums, with the

             3   staff, and with various commenters.

             4             Today's rulemaking, in short, is the culmination of

             5   a long and very serious process.  We have weighed carefully

             6   concerns of parts of the hedge fund community, and others

             7   worried about counterproductive effects.

             8             We have looked at suggestions for alternatives, but

             9   they've been inadequate and wanting, compared to what I

            10   believe is our modest, pragmatic, balanced regulatory

            11   approach.

            12             I have tried to think through the hedge fund issues

            13   by asking myself the following key questions:

            14             Why alter what has been the SEC's largely hands-off

            15   approach?  We have always gone after fraud.

            16             What are the public policy concerns that now compel

            17   the Commission to act?  My answers have largely been heard

            18   before, but given the controversy, they ought to be heard

            19   again.

            20             First, we know too little about this dramatically

            21   growing industry, and what little we know, has, at least for

            22   me, had alarm bells ringing.

            23             In terms of growth, eight or ten years ago there

            24   was roughly a billion dollars in hedge funds.  The staff's

            25   September 2003 report used the $600 billion figure.  Our





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             1   proposed rulemaking in July 2004, used an $850 billion

             2   figure.  Today, we're talking about $870 billion, and the

             3   Chairman correctly indicated that most estimates are towards

             4   a trillion, as early as the end of the year.

             5             Moreover, as Paul Roye indicated, all of these

             6   figures are unreliable and soft.  And that is part of the

             7   basic problem, and as Commissioner Glassman indicated, that

             8   may be common ground among the five of us here.

             9             Our information is inadequate, and this is a

            10   growing, powerful part of the financial community.  We need

            11   accurate information about the aggregate size of the hedge

            12   fund industry -- how leveraged it is at any given time; their

            13   trading patterns, and the management and size of any given

            14   fund.

            15             Second is the reasons to think about the regulation

            16   of investment advisers.  There has been a recent increase in

            17   fraud cases involving hedge funds.

            18             Now, that's true, with the qualification about

            19   slicing and dicing that Paul Roye used, of fund clients, or

            20   shareholders themselves.  But it's particularly true about

            21   the corrupting influence that unregistered hedge funds have

            22   had on mutual funds.  It was true in the Canary context, and

            23   in too many other instances that have been public, and that

            24   could become public in the future.  That corrupting influence

            25   has led to scandals about late reporting, and abusive timing. 





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             1             Finally, on the so-called retailization issue, it's

             2   not just the funds of the wealthy anymore, but more and more

             3   the general public's savings and charitable funds are being

             4   put at risk, as indicated in large and sharply increasing

             5   amounts from public and private pension funds, from funds of

             6   hedge funds, and from endowments and other charitable

             7   institutions that are being invested.

             8             The next question I suppose is what are the

             9   advantages or benefits of hedge fund investment adviser

            10   registration?  They've already been discussed, and I'll give

            11   you shorthand.

            12             First, it's accurate information for public policy

            13   purposes.  Second, disclosure about advisers will be very

            14   useful.  Some investors -- many investors appear to use due

            15   diligence to find out about advisers, but that's an

            16   expensive, costly process.  Why require each one to repeat

            17   what others have done, and what if some are not doing?  Getting

            18   information out about advisers will save costs, and be useful

            19   to all concerned.

            20             The recordkeeping requirements are important.  The

            21   chief compliance officer and compliance programs are

            22   important.  Now, that may add cost, but who in their right

            23   mind wants these institutions, and particularly the large

            24   ones, operating without effective compliance programs?

            25             OCIE inspections have to be thought about, too. 





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             1   They should bring about important accountability and

             2   deterrence.  And I'm not suggesting that every fraudster will

             3   be stopped, or deterred.  But whether one analogizes the tax

             4   audits, or police patrols, one knows that the risk of getting

             5   caught and punished has significant deterrent effect, and

             6   particularly on potential white-collar wrongdoers.

             7             As Paul Roye indicated earlier, where hedge fund

             8   advisers were registered, five of eight of recent cases in

             9   the last five years have been uncovered by OCIE inspections. 

            10   I have, of course, discussed with the staff whether we have

            11   the ability and resources to inspect hedge fund advisers. 

            12   Registration would increase the present number of advisers

            13   registered by roughly 12 percent, but all numbers here are

            14   soft, again, because of the inadequacy of our information. 

            15             We used a range of 8 to 15 percent in our original

            16   proposing release in July.  I am satisfied that better

            17   investment adviser compliance programs required as of October

            18   2004, are growing efficiency, and our risk-based assessment

            19   programs and tools, and the ability, if necessary, to increase 

            20   the current $25 million threshold for SEC registration, 

            21   in combination, provide adequate assurance that we will be 

            22   able to do the job effectively, and the risk-based ability 

            23   to inspect gives an important deterrence effect, knowing 

            24   we can come in will have a meaningful effect on real people.

            25             In terms of deterrence, or in terms of





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             1   disadvantages, rather, let me make absolutely clear my view,

             2   which the Chairman has stated, too, and I think we all

             3   believe.

             4             There will be no interference with investment

             5   strategies of hedge funds, with their operations, with their

             6   creativity, with their liquidity, with their flexibility. 

             7   We've demonstrated that with the 40 or 50 percent of advisers

             8   that are already registered.

             9             And the costs here are relatively low, in terms of

            10   both dollar costs and burdens.  If there's more money added

            11   to the cost of compliance programs, which appears to be the

            12   only item of any significant expense, that will be very

            13   useful to anyone who's invested in that fund.  A cost/benefit

            14   analysis -- the benefits here are overwhelming.

            15             Let me close on -- and I just have a statement, I

            16   have no questions.

            17             A rational regulatory system responds to warning

            18   signals and substantial and growing risk.  This is the context

            19   in which we address hedge funds today.  Given the

            20   substantial and growing risks for millions of investors, in

            21   pension funds, and funds of funds, and other investment

            22   vehicles, the SEC can no longer turn a blind eye.  Our

            23   fundamental mandate is protection of investors in the public

            24   interest.  Paul Roye, Bob Plaze, and their staff have done

            25   wonderful work.





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             1             But I'd like to stop a second and pay a particular

             2   tribute to the Chairman.  His leadership, his strength, his

             3   wisdom, the decency he brings to the job is enormously 

             4   helpful to the public, and very much in the great traditions

             5   of the SEC.  Thank you.

             6             CHAIRMAN DONALDSON:  Commissioner Atkins.

             7             COMMISSIONER ATKINS:  Thank you, Mr. Chairman. 

             8             Well, I find it very telling that we are gathered

             9   here to consider this rulemaking on the 26th of October,

            10   because today is just two days before the comment period on

            11   this proposal would have ended, had we granted the requests

            12   of several commenters, including the National Venture Capital

            13   Association, to extend the comment period.  They had asked

            14   for a 90-day period, instead of the 48 days, which was the

            15   effective length of the comment period after the proposal was

            16   published in the Federal Register.

            17             But why should we extend the comment period for a

            18   rule that was essentially written in stone when it was

            19   proposed?  Despite the constricted comment period, we

            20   received over, as you hear, 150 comment letters, only about

            21   30 of which supported the proposal.  Many commenters raised

            22   complex technical concerns about how the registration

            23   requirement would work in practice.  I am disappointed that

            24   in the rush to get a rule adopted we took so little time to

            25   consider these comment letters.





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             1             It's also hard to hit the Trifecta of having the

             2   "Wall Street Journal," the "New York Times," and the

             3   "Washington Post" editorial pages being against our action. 

             4   I think we are rightfully viewed as being dismissive of the

             5   concerns that commenters raised.  Unfortunately, we have also

             6   refrained from hashing out the issues with, among others, our

             7   colleagues in the President's Working Group, the Treasury,

             8   the CFTC, and the Federal Reserve, as well as others, such as

             9   the Department of Labor.

            10             Earlier this month, as you heard Commissioner

            11   Glassman say, Chairman Baker wrote to the President's Working

            12   Group to ask it to intervene before we acted.  I saw that

            13   letter at the same time that Commissioner Glassman did, just

            14   yesterday.

            15             Chairman Greenspan has warned us that "[t]he

            16   initiative cannot accomplish what it seeks to accomplish." 

            17   With due deference to Chairman Greenspan and the tough job

            18   that he has, I cannot think of a time when he has been so

            19   clear.

            20             I am befuddled as to why we are charging ahead in

            21   the face of such a groundswell of principled opposition to

            22   this action.  Comity and cooperation is more than just

            23   talking to someone.  It means listening and responding, and

            24   working together.

            25             I sometimes feel that we are in a Moby Dick-like





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             1   pertinacious pursuit of one particular whale, as Herman

             2   Melville described in his colorful prose.

             3             The Commission would do better to keep its eye

             4   trained on the mutual funds and broker dealers to whom

             5   average Americans entrust so much of their money, rather than

             6   hedge fund advisers, who manage the money of, at most,

             7   200,000 well-heeled individuals and institutions.  Average

             8   investors expect the Commission to monitor the entities

             9   handling their money, whereas hedge fund investors do not

            10   rely on Commission oversight.

            11             No one is forcing them to put their money into

            12   unregistered hedge funds.  They have a choice, the ability to

            13   get advice, and the market power to do otherwise.  They

            14   perform, or can hire someone else to perform for them, due

            15   diligence to lower their risk of investing in hedge funds.

            16              Risk averse investors could insist, for example,

            17   on getting audit reports, or a third-party internal control

            18   review.  If they suspect fraud or malfeasance, they can

            19   figure out where to turn for help.

            20             But now, we are upsetting this private/public

            21   balance, and taking on a task that we might not have the

            22   resources to perform as well as the private sector does.

            23             In response to the argument that hedge fund

            24   investors are fully capable of taking care of themselves,

            25   proponents of registration raise cries of retailization. 





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             1   They say that hedge funds are surreptitiously reaching into

             2   the pockets of unsuspecting retail investors, including

             3   investors and funds of hedge funds, and vulnerable retirees.

             4             In addition, they charge that pension, endowment,

             5   and charitable institution money is pouring into hedge funds

             6   at great threat to the welfare of their beneficiaries.

             7             First, the 2003 staff hedge fund report found no

             8   retailization.  Second, for each of these fiduciary entities,

             9   an investment professional stands between the hedge fund and

            10   the retail investor.  The investment professional is not only

            11   paid, but is legally obligated under federal and state law,

            12   to look out for the best interests of the entity.

            13             A pension plan administrator has a fiduciary

            14   obligation to the plan's participants.  Because these

            15   entities tend to be large, the investment professionals

            16   representing them generally are in a better position than the

            17   SEC would be, through its registration process, to obtain

            18   information about hedge funds in which they invest, to ensure

            19   that their investment choices are prudent, and that the

            20   fiduciaries have all the information that they need to make

            21   their investment determination.

            22             Third, we can take actions to ensure that investors

            23   in the funds of hedge funds satisfy investment minimums. 

            24             Finally, as for the pension funds, we need to put

            25   the issue in perspective.  The $72 billion invested by





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             1   pension funds is only 8 percent of the total hedge fund

             2   investments, and more importantly, just 1 percent of the U.S.

             3   pension fund assets.

             4             Maybe we ought to be more concerned about the 99

             5   percent of the other pension fund investments.  Maybe we

             6   ought to let the Department of Labor, which is charged by

             7   Congress to look after pension funds under the ERISA act,

             8   weigh in on pension funds, and on whether they perceive this

             9   as an issue.

            10             As I noted at the proposal stage, it would be

            11   useful for us to have more information about hedge fund

            12   advisers. 

            13             Commenters showed a commendable willingness to work

            14   with us, to get us the information that we need.  They

            15   suggested a number of alternatives for achieving this,

            16   including requiring unregistered investment advisers to file,

            17   and to annually update information statements with the

            18   Commission.

            19             This approach would have enabled us to develop a

            20   complete picture of the advisory industry, without imposing

            21   undue costs on advisers who choose not to register.

            22             In addition, we could have worked with other

            23   regulators to standardize, formalize information sharing. 

            24   We could have worked with entities that are already

            25   regulated, such as prime brokers.  Through these avenues, we





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             1   would have been able to obtain exactly the information that

             2   we need to monitor the industry, and root out fraud.

             3             By contrast, requiring hedge fund advisers to fill

             4   out a Form ADV will yield only snippets of useful

             5   information.

             6             We missed all of these opportunities that could

             7   have produced a less costly, more streamlined approach that

             8   likely would have found unanimous support on the Commission,

             9   and perhaps even among the affected investors and advisers.

            10             Proponents of registration insist that filling the

            11   information void is only one of the objectives of

            12   registration.  They insist that the Commission, which already

            13   has the authority to conduct for-cause examinations of

            14   unregistered advisers, also needs routine inspection

            15   authority, which only registration could afford.

            16             I do not dispute that we need to be ever vigilant

            17   for hedge fund fraud, and that undoubtedly there is fraud

            18   occurring.  But subjecting hedge fund advisers to routine

            19   examinations is unlikely to be an effective deterrent.

            20             Certainly, a perfectly-timed examination could turn

            21   up wrongdoing, but with so many registrants, and so few

            22   examiners, perfect timing is a lot to ask.

            23             We've been in the process of augmenting our

            24   examination team in order to address the overextension of our

            25   examination program for current registrants.  Our budget has





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             1   doubled over the past two years.  So it seems unwise to shift

             2   resources away from traditional areas of oversight, so soon

             3   after we made the case that those areas are understaffed.

             4             Hedge fund advisers tend to employ more complex

             5   investment strategies than the typical registered adviser,

             6   especially those who advise mutual funds.  If hedge funds

             7   become a primary focus for us, we will need to train all of

             8   our examiners, most of whom have no background in this area,

             9   so that they are able to recognize unique issues that arise

            10   in the hedge fund context.  Otherwise, we are simply setting

            11   them up to fail.

            12             Market surveillance is a far more effective,

            13   targeted way of finding fraud, and would allow us to leverage

            14   the knowledge and expertise of the self regulatory

            15   organizations.  In addition to being costly for us, the new

            16   registration requirement will be costly to affected advisers,

            17   and these costs will be passed on to investors.

            18             Registration is more than filling out a simple

            19   form, filing it, and forgetting about it.  A Form ADV, which

            20   is a public disclosure form, is a potential litigation

            21   document, and therefore, cannot be filed without a lawyer's

            22   blessing.  Lawyers' blessings, as most people in this room

            23   know, never come cheap.

            24             Registered advisers face numerous requirements,

            25   including record-keeping, custody, and compliance





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             1   requirements.  All of these impose costs.

             2             We are told to take comfort in the fact that

             3   advisers to hedge funds are handsomely paid for their work,

             4   especially as compared to the so-called run-of-the-mill

             5   registered advisers.  So, the argument goes, they can afford

             6   the extra cost of regulation in a marketplace that has seen

             7   the trend of hedge fund management fees increase from a low

             8   of one and 20, up towards two and 25 these days.

             9             I do not take comfort in seeing resources diverted

            10   from other uses, such as hiring new employees, or purchasing

            11   outside research, to cover the costs of compliance with our

            12   regulatory mandates.  These management fees, which investors

            13   have agreed out of self interest to pay, presumably reflect

            14   the risky nature of establishing a hedge fund, and the high

            15   costs for extracting expensive top talent.

            16             Proponents also argue that, to the extent there are

            17   costs, we are just leveling the playing field between those

            18   hedge fund advisers who have already registered voluntarily,

            19   and the ones who remain in the so-called shadows.

            20             As an initial matter, I reject the insinuations

            21   underlying this initiative, that hedge fund advisers who have

            22   chosen not to register have done something wrong, or have

            23   something to hide.  We should not be so hasty to assume the

            24   worst about anyone who is not registered with us.

            25             Moreover, we can all come up with a long list of





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             1   enforcement actions against registered advisers to shatter

             2   the myth that all registrants are pure as the driven snow.

             3             Hedge fund advisers, like other businesses,

             4   register if it is cost-effective for them to do so.  If the

             5   benefits of registration, such as wider appeal to pension

             6   funds and other investors, do not outweigh the costs, then

             7   hedge fund advisers do not register.

             8             We cannot assume that the cost/benefit balance will

             9   be the same for every hedge fund adviser.  Mandating across-

            10   the-board registration only serves to eliminate any benefit

            11   registered advisers enjoyed in being able to distinguish

            12   themselves from unregistered advisers.

            13             But, if we are intent on leveling the playing

            14   field, we should focus on the line that we have drawn between

            15   hedge fund advisers and advisers to other types of private

            16   pools.  Why have we not applied the registration requirement

            17   to advisers of private equity and venture capital funds? 

            18   Valuation issues are critically important in these funds, as

            19   well.

            20             Our argument for excluding advisers to other types

            21   of unregistered investment companies looks particularly weak

            22   when we see that the only real line of demarcation employed

            23   in the rulemaking is the length of the redemption period.

            24             A hedge fund adviser can avoid application of the

            25   rule by simply extending its redemption period beyond two





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             1   years.  Instead of the so-called 529 plans named after the

             2   tax section that middle class investors use to save tax-free

             3   money for college, wealthy investors will now have what I

             4   would like to be the first to dub 735 plans, which will stand

             5   for the 735-day lock-up period necessary to avoid the rule,

             6   and take into account any leap year with a day or two to

             7   spare.

             8             This two-year distinction does not capture a

             9   legitimate regulatory distinction among funds.  If this trend

            10   towards longer lock-up periods takes hold because of our

            11   rule -- longer lock-up periods are already becoming more

            12   standard, after all, in the marketplace today -- it actually

            13   harms investors, who will now have less freedom to vote with

            14   their feet by pulling their money out of a hedge fund that

            15   is mismanaged.  We are simply encouraging an industry trend

            16   towards longer lock-ups.

            17             Proponents argue that the recent spate of hedge

            18   fund enforcement actions justifies our preoccupation with

            19   hedge funds.

            20             As I discussed at the open meeting on this rule

            21   when we proposed it, this approach would not have done much

            22   to stop the fraud underlying the 46 cases cited in the

            23   proposal.  The additional five cases cited in the adopting

            24   release do not strengthen the case, as Commissioner Glassman

            25   said.  Most of the advisers at issue in the cases were either





                                                                           110

             1   too small to be registered, or already registered, or should

             2   have been registered.

             3             We will not protect unsophisticated investors from

             4   fraudsters by requiring legitimate advisers to hedge funds

             5   open only to sophisticated investors, to register.

             6             Finally, there are serious questions about the

             7   Commission's statutory authority to proceed without specific

             8   Congressional authorization to do so.  Rather than

             9   recommending statutory amendments, it seems that we have

            10   chosen to make a tortured end run around the statute, by

            11   redefining who a client is for certain types of investment

            12   advisers.

            13             So, I, to add a little bit of levity, and so not to

            14   disappoint, I thought that I hope that ultimately, we do not

            15   wind up looking like the gunslinger in this Gary Larson "Far

            16   Side" cartoon, where he shot the guy dead, and only then

            17   realized that there were some questions that he should have

            18   asked, and in light of all our discussion today, responses

            19   that he might have heeded.

            20             So, from the outset, I've been open about my

            21   disappointment and distaste for this idea that is presented

            22   before us today.  So accordingly, I plan to vote "No" here in

            23   a few minutes, and then, if the rule is approved, then I

            24   intend to join again with Commissioner Glassman, and file a

            25   written dissent.





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             1             So that being said, and notwithstanding everything

             2   else, I recognize that behind this incredibly quick timetable

             3   is an incredibly overworked staff, so I appreciate your hard

             4   work, and wish you Godspeed.  Thank you.

             5             CHAIRMAN DONALDSON:  Thank you.

             6             Commissioner Campos?

             7             COMMISSIONER CAMPOS:  Thank you, Chairman

             8   Donaldson.

             9             Well, Commissioner, I can tell you, I appreciated

            10   that cartoon.  That was the -- today, it's clear that we have

            11   different rationales and we have different views of

            12   this particular proposal, and this particular finalization of

            13   the rule.  I think it's pretty clear that the case and

            14   rationale for the final rule has been made fairly well by the

            15   staff, and has been presented in great detail in the release.

            16             Not to repeat some of the arguments that have

            17   already occurred, essentially, hedge funds have grown

            18   dramatically.  There's about a trillion dollars invested in

            19   hedge funds today.  At the rate of current growth, the

            20   amounts managed by hedge funds could be several trillion

            21   dollars in short order.  The amounts keep growing, and there

            22   is much troubling evidence of fraudulent activity.

            23             It is clear that hedge funds are not doing business

            24   in a vacuum, and it is not the case, in my view, of a few

            25   rich people playing by themselves in a corner.  No one can





                                                                           112

             1   seriously argue that hedge funds do not impact, directly, or

             2   indirectly, public funds -- mutual funds, as demonstrated by

             3   the timing and the late trading cases and through -- pension

             4   funds have been affected, and may be affected in the future

             5   by the activities of hedge fund managers.

             6             Clearly, there is smoke, and there is danger, and

             7   light needs to be shed on a dark corner.  To ignore this

             8   situation, it seems to me, would be irresponsible in my view,

             9   both to investors, and to the industry.

            10             Essentially, the industry and many commenters have

            11   proposed one simple idea, with several variations.  The idea

            12   seems to be create a registry of some sort, and require

            13   annual audited reports.

            14             So to put it in the simplest context, what we have

            15   had, in terms of alternatives, when one filters out all the

            16   different comments, and the different commentary that we

            17   received, we have a registry versus registration under the

            18   Investment Advisers Act.

            19             I certainly respect the views of the practitioners,

            20   and their associations and counsel.  However, I do not

            21   believe that the registry idea and its variations would be

            22   sufficient, given the problems that we have discerned. 

            23   Obtaining information is an important part of our objective,

            24   but its not the exclusive goal.

            25             Again, I have a hard time seeing the argument that





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             1   having examination and compliance procedures in place doesn't

             2   offer deterrence.  It's simply the wrong paradigm.

             3             Would anyone suggest that registration under the

             4   '34 Act should be abolished because we can't foresee, or we

             5   can't detect every item of fraud?  Would anyone argue that

             6   cops on the beat make a difference, or that tax audits keep

             7   individuals who are tempted to cheat from doing so?

             8              Registration under the Advisers Act provides,

             9   among other things, for clear standards under developed case

            10   law of fiduciary to its investors.  Books and records

            11   requirements.  A compliance system to be established by the

            12   fund manager, and the right of our agency to conduct

            13   examinations.

            14             Now, having said that, a very important part of our

            15   agency's obligation, in my view, is to discuss fully with the

            16   regulated community, and with commenters.  The agency

            17   historically has always sought to have the regulated industry

            18   help design the right regulation and oversight.

            19             During this process, I've tried to be a part of

            20   that.  I have sought to keep an open mind, and to listen, and

            21   to discuss with all who had opinions on this matter.  Late

            22   last week I promoted, I arranged and participated in meetings

            23   with industry representatives of the Managed Funds

            24   Association, and our senior staff.  I listened, the staff

            25   listened, and our Chairman and his staff listened.





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             1             Although so many quibble or argue that the agency

             2   did not listen enough or read enough of the commentary, I

             3   believe that this final rule has significant accommodations

             4   to the industry, and these particular accommodations have

             5   helped me to support it.

             6             First of all, I want to point out that the

             7   effective date of this particular final rule is over a year

             8   away, in 2006.  This allows great flexibility to the

             9   industry.

            10             There are technical rules that allow

            11   grandfathering, so certain individual investors who may not

            12   qualify after the effectiveness, can qualify.  Planning can

            13   occur.  Significantly, the industry and their advisers will

            14   have more time to point out problems to our staff.

            15             Items that are unclear in the rulemaking can be

            16   brought to light, and I am confident, and I know that our

            17   staff will welcome those kind of inputs, and will work with

            18   the industry and their advisers.  I can't emphasize how

            19   important I think that is.

            20             One of the areas that concerned me greatly was the

            21   so-called barrier-to-entry problem.  I believe, again, that

            22   much has been done in the final rule to help with that

            23   particular problem.

            24             Essentially -- and I think it's important to

            25   emphasize this -- insiders and executives, and significantly,





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             1   partners, including passive partners, will not have their

             2   contributions counted against the $25 million limit.  As I

             3   understand the way it will work, a passive partner to a hedge

             4   fund adviser would not have his or her investment count

             5   against the limit, so this would allow managing substantially

             6   above the $25 million limit, and not be registered.

             7             I've also asked many questions, and I am confident

             8   that the marketplace will adjust and mitigate the cost of

             9   compliance.  As has been said, there does not need to be

            10   hired an individual to separately take on the position of

            11   compliance officer.  There are business models, there are

            12   prime brokers who are sponsoring hedge fund advisers, and I

            13   believe that that and other arrangements will work out, and

            14   will mitigate those costs.

            15             Now, I would like to take a moment to address one

            16   of the most controversial aspects of the proposal, and that

            17   is the compliance oversight by the Commission.  Even those

            18   opponents who support some type of information exchange

            19   consistently have argued against the examination requirement. 

            20   They contend that the Commission staff lacks resources,

            21   experience, and structure -- essentially, a justifiable and

            22   well-modeled plan.

            23             Although I believe some of these concerns stem from

            24   our own, or from their own prior experiences with our OCIE,

            25   which, by the way, the Commission and the OCIE are working





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             1   hard to rectify, some of these concerns seem to be rhetoric

             2   that miss the point.  The heart of the argument, the heart of

             3   this particular argument, nonetheless, does resonate with me.

             4             Accordingly, I took this problem to the Chairman,

             5   and I mentioned to him that I was concerned that our

             6   particular oversight was not sufficiently developed, and that

             7   I was concerned, also, about our ability within the

             8   resources.  I am pleased to report that he also had similar

             9   reservations, and that he also has given this much thought. 

            10             In response to these concerns, I'm pleased to say

            11   that Chairman Donaldson has directed the formation of a task

            12   force of SEC staff members, to be responsible for the

            13   development of processes by which Commission examinations of

            14   registered investment advisers will become truly risk-

            15   filtered and risk-based.

            16             Headed by Charles Fishkin, our director of the

            17   Commission's Office of Risk Assessment, this task force is

            18   comprised of staff members from the Office of Compliance,

            19   Inspection and Examinations, OCIE; the Division of Investment

            20   Management; the General -- or, I'm sorry, the Office of

            21   General Counsel; the Office of Economic Analysis; and the

            22   Office of Information Technology.

            23             The staff group will begin meeting immediately,

            24   following the Commission's approval of final rules, should

            25   they be approved, requiring the registration of hedge fund





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             1   advisers.  Their goal is to have a risk-based inspection

             2   program operational by February 1, 2006.

             3             Although we anticipate that the group's initial

             4   deliberations will be internal to the Commission staff, it is

             5   our expectation -- my expectation -- that the group will seek

             6   input from investment advisers that are currently registered

             7   with the Commission, as well as those investment advisers who

             8   will be required to become registered as a result of the

             9   hedge fund initiative.

            10             We anticipate that by the time this new compliance

            11   inspection regime has been fully developed, it will reflect

            12   significant input, and further comment from the regulated

            13   community.  Again, this is one of the reasons I'm so pleased

            14   to see a long period before the effective date for today's

            15   rules.

            16             So on two tracks, consultation with the industry

            17   and their advisers will continue.  Our staff will continue to

            18   receive comments, and meet as they customarily do, with the

            19   industry, with respect to the rules that are being finalized

            20   today.  At the same time, the new task force will study very

            21   carefully what it is that our agency can do, given our

            22   resources, and given what we can do with respect to our

            23   examination procedures.

            24             Again, we are now studying, and our particular

            25   agency is interested in looking at risk-based examinations,





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             1   and studying particular problems that may be discerned.  I

             2   support the adoption of the proposal, and now I'd like to ask

             3   a few questions, if I might. 

             4             As we all know, Paul and Bob, the Commission has

             5   received a good deal of comment on aspects of the rule that

             6   will affect the operation of hedge funds, and I know that the

             7   staff has made a number of changes and clarifications that

             8   address some of these comments, and produce a much clearer

             9   definition and set of rules.

            10             As I've said before, the changes have, in my mind,

            11   significantly reduced barriers to entry, and I want to explore

            12   that a little bit, or I also believe, address some of the

            13   limits on innovation that others have been concerned about.

            14             So, let me ask a few questions in that area.

            15             One of the concerns is that we do not disrupt the

            16   relationship between the hedge fund manager and the pool, so

            17   as to raise questions about whether hedge fund investors are

            18   clients for other purposes, and if there are special duties to 

            19   them that would be inconsistent with managing a pooled vehicle.  

            20   How have we dealt with that?

            21             MR. PLAZE:  Well, we've included a sentence in the

            22   draft release, making it absolutely clear that the rulemaking

            23   is solely limited to the method of counting clients for

            24   purposes of Section 203(b)(3), and doesn't alter the duties

            25   or obligations owed by hedge fund advisers to clients, or





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             1   investors in any respect.  

             2             COMMISSIONER CAMPOS:  As far as counting clients,

             3   under the rule, or actually the current rule, off-shore

             4   advisers only have to count clients that are U.S. persons. 

             5   Commenters were concerned about the definition of U.S.

             6   person, and whether it works for hedge funds.  Could you

             7   explain how that is addressed in the rule?  

             8             MR. PLAZE:  Yes.  The issue arises with respect to

             9   an offshore adviser.  Since an offshore adviser only has to

            10   count U.S. clients in order to determine whether they have a

            11   registration obligation -- whether they have more than 14

            12   clients, the question is how do you determine whether

            13   somebody is a U.S. client?  The Advisers Act rule looks --

            14   the Advisers Act looks consistently to the residence of a --

            15   of a U.S. person.  

            16             But the commenters raised the question, well what

            17   if the client is -- is under this rule, and the investor and

            18   the hedge fund is a corporation, or a trust, or a managed

            19   account, what -- what are we going to use -- they don't have

            20   residences, and so, we've clarified that in the case of a --

            21   a corporation or a business entity -- it's the place of

            22   organization.  A trust, it's the location of the trustee. 

            23   And so, we've made -- we've made those issues -- we've

            24   answered those questions.  They've never been asked before,

            25   which was surprising to us when we got the comment letters





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             1   before, because these rules have been on the books for quite

             2   a number of year now.  

             3             COMMISSIONER CAMPOS:  It just seems to me there was

             4   a lot of concern about that, and -- and this is -- these are

             5   very helpful.  Just on another technical item, when -- when a

             6   non-U.S. person is -- invests in a hedge fund, and later

             7   moves to the United States, does that person then become a

             8   U.S. person, thus forcing the hedge fund manager to register?

             9             MR. PLAZE:  That's -- that was a new issue, too,

            10   because in a normal advisory relationship, when someone moves

            11   to the United States, you would expect them to be a U.S.

            12   person, and we would not change that.  Commenters

            13   persuasively argued that with a pooled investment vehicle, it's

            14   a different -- one needs to take a different approach.  And

            15   we were persuaded, and under the rules, as we recommend that

            16   you adopt today, you would look to the -- the residency, or

            17   the place of organization of the person at the time he or she

            18   invests in the pool.

            19             COMMISSIONER CAMPOS:  I mentioned this in my

            20   statement, but have you clarified -- or maybe you can make

            21   sure that I'm correct, here -- regarding a hedge fund manager

            22   himself as a client, and what about the family of the advisers,

            23   and other key employees?

            24             MR. PLAZE:  Well, this is actually one of the most

            25   significant changes from the proposal, and an idea that came





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             1   about by commenters, again, persuading us.  And so, there are

             2   some significant changes, particularly for small hedge funds. 

             3   Under the -- under the rules we recommend you adopt today,

             4   you would exclude in counting employees to the 14 -- key

             5   executives, partners, key employees of the advisory firm. 

             6   And this is important for your small firms, because

             7   typically, you start with a group of -- of partners, or

             8   insiders, who put together the capital.  

             9             And you'd only -- you would exclude those people

            10   who -- who would be typically involved in the start-up of a

            11   small hedge fund.  Members of the family, your partners --

            12   even passive partners in the advisory firm itself.  Those are

            13   people you're going into business with.  The Advisers Act is

            14   not about protecting people you're in business with.  The

            15   Advisers Act is about protecting people whose professional

            16   services you are offering, and those would be the outside

            17   investors, when they eventually come into the pool.  

            18             And you would be able to exclude many of those, also,

            19   from -- from the assets -- the proprietary assets of the firm

            20   would not be counted, in terms of the $25 million threshold. 

            21   And the practical effect of that is that firms are going to

            22   be able to conduct business for a longer period of time than

            23   you might have thought, given the 14 client and the $30

            24   million threshold before they come into registration with the

            25   SEC. 





                                                                           122

             1             COMMISSIONER CAMPOS:  Again, I mentioned, and I'm

             2   drawing a lot of comfort form the fact that there's a year

             3   period before the effective date.  Can you comment about how

             4   that will work?

             5             MR. PLAZE:  Well, that -- that's an important

             6   period, because we understand that some firms are going to

             7   have to examine their business operations, and are going to

             8   have to hire advisers, and we have given plenty of time for

             9   new firms to come into compliance with our compliance rule,

            10   and we've given similar time for firms.  Let me give you some

            11   transition areas during this period that's very important.

            12             One is that we have statements in the release that

            13   the staff stands prepared to deal and assist with technical

            14   issues that came up.  About seven or eight years ago, we

            15   adopted a set of rules under 3(c)(7) of the Investment

            16   Company Act that dealt with hedge funds.  And during the

            17   implementation period, the staff issued quite a lengthy

            18   interpretive letter, issuing -- explaining issues that we

            19   hadn't fully seen, and ones that Congress left open when it

            20   did its statute.  It stands ready to provide similar guidance

            21   here.  

            22             But in addition, the transition period contains a

            23   number of -- of -- of transitional rules that are important. 

            24   Would you like me to go through those transition rules, also?

            25             COMMISSIONER CAMPOS:  I think that'd be useful. 





                                                                           123

             1   Sure.

             2             MR. PLAZE:  One is that all current investors in

             3   hedge funds are grandfathered, as are other clients of hedge

             4   fund advisers.  Therefore, no one is going to have to leave

             5   the hedge fund who perhaps wouldn't be eligible to be in the

             6   hedge fund in the future, as a result of the effect of the

             7   performance fee rules.  Under the performance fee rules, a

             8   client -- you look through the fund, and you require clients

             9   to have a certain amount of wealth or sophistication in order

            10   to be in that fund.  Those are essentially waived for all

            11   clients in the fund -- already in the fund, as of the day of

            12   the compliance date, which is -- we mentioned is in February

            13   of 2006.  

            14             And secondly, in measuring 14 clients, under the

            15   statute, you look back 12 months.  So let's say if you only

            16   have one client today, but indeed, if cumulatively you had 14

            17   clients over the past 12 months, you might have a

            18   registration obligation.  And indeed, you could certainly see

            19   a situation with the hedge fund, that it had a number of

            20   investors six months ago, but it doesn't today.  Some have

            21   left for whatever reason.  

            22             Now, what we would do is, we would modify the

            23   measure of -- of look-backs, so that the look-back begins on

            24   the compliance date in February 2006, so that you wouldn't

            25   have retroactive registration obligations on hedge funds who





                                                                           124

             1   would perhaps have gotten smaller -- hedge fund advisers have

             2   gotten smaller, or because they've rearranged their business

             3   arrangements to avoid registration.  So, we avoid the -- the

             4   I gotcha application of that statutory provision.  

             5             And secondly, the two-year redemption limitation. 

             6   That is, if you have redemption -- if the fund offers

             7   redemption rights of more than -- two years, if it offers

             8   redemption rights for investments that have been in the fund

             9   less than two years, it's going to have to register.  It's

            10   going to be a private fund.  We would not make that

            11   retroactive.  We'd only apply that to securities that are

            12   offered -- interests in the hedge fund that are offered after

            13   the compliance date.  So, funds that have entered into

            14   business arrangements with a certain expected set of rules,

            15   are not going to be -- have those retroactively applied.  

            16             And finally, we have our

            17   recordkeeping requirements dealing with performance

            18   information, which have to be substantiated

            19   back from the first day of that performance period.  We would

            20   relax those for these hedge fund advisers of course, they would

            21   still be subject to the anti-fraud provisions, which really

            22   weren't on notice that they were required to keep those --

            23   those records, having not had a registration obligation.  So

            24   these are important, I think, transition provisions that will

            25   really alleviate the impact of these rules on -- on hedge





                                                                           125

             1   fund managers that have heretofore been operating under a

             2   separate set of rules.  

             3             COMMISSIONER CAMPOS:  Thank you, that -- that is at

             4   least reassuring to me.  Mr. Chairman, I hope that it is

             5   clear from this statement, and from our particular release

             6   that the industry understands that the agency is seeking to

             7   work with it, to make these rules realistic and not overly

             8   burdensome, and that we will continue to do so.  We certainly

             9   -- the door is open, and the invitation is there, and I know

            10   that you are supportive of that -- of that particular

            11   approach.  And I -- and I do hope that -- that those out

            12   there will not let themselves get into this tailspin of -- of

            13   a toxic environment, and instead, come in, work with us, have

            14   these rules be effective, and -- and appropriately designed,

            15   as we have already.  But again, we -- we have the structure

            16   now, and -- and I think it's something that can be very --

            17   very palatable to the industry. 

            18             At the end of the day, I believe that the industry

            19   can win with this situation.  This should provide deterrence,

            20   and when one thinks about the reputational capital, and the 

            21   -- and the loss that could occur to the industry with -- with

            22   a small hiccup -- with a small scandal, I think this kind of

            23   system is worth having in place, and is worth the cost. 

            24   Thank you.

            25             CHAIRMAN DONALDSON:  Thank you.  Do you -- any of the





                                                                           126

             1   Commissioners have any comments?  We're getting close to the

             2   conclusion, here.

             3             COMMISSIONER GLASSMAN:  I do.  It will be short. 

             4   I'm glad Commissioner Campos mentioned the task force.  As I

             5   said in my remarks, I -- I think it will be useful to have

             6   the task force.  I would have preferred that the task force

             7   do its work first, to determine the right model, and apply it

             8   to the hedge funds.  And I would point out that I asked the

             9   Chairman to do such a thing over a year ago, to look at the

            10   kind of information that we need from hedge funds, and the

            11   best way to get it.  And unfortunately, that hasn't been

            12   done.  Had it been done, we'd be in a very different place

            13   today.

            14             CHAIRMAN DONALDSON:  Commissioner Atkins?

            15             COMMISSIONER ATKINS:  I think I've said my piece. 

            16   Thank you.  

            17             CHAIRMAN DONALDSON:  I'm sorry.  Took you out of

            18   order.  Commissioner Campos.

            19             COMMISSIONER CAMPOS:  I've said my piece, as well.

            20             CHAIRMAN DONALDSON:  Let me just make two remarks,

            21   because I -- I believe that there have been -- I don't want

            22   to rehash all that's been said.  I think we've been over it,

            23   and over it.  There are two remarks that were made here that

            24   I want to clarify.  The first is the reference to the

            25   President's Working Group.  And I want to make sure that my





                                                                           127

             1   colleagues on that organization understand, and the people

             2   sitting at this table in this room understand that the

             3   President's Working Group does not -- I think the statement

             4   was, we were proceeding without the concurrence of the

             5   President's Working Group, and the President's Working Group

             6   is not an organization that -- that has a concurrence to it. 

             7   It's an advisory group.  Comments made by members of that

             8   group are made in their own individual capacity, just as the

             9   comments that I make are made in my capacity as Chairman of

            10   this regulatory agency.  The other gentlemen on that group

            11   have different roles.  I think that needs to be made clear.

            12             I also want to just comment one moment on the issue

            13   of -- of the task force, and the formation of the task force. 

            14   As all of us at this table know, we've been working since the

            15   day I got here as Chairman of the Commission, to -- to put

            16   together a risk-based approach to our entire method of

            17   operation.  And we've had to bring in the structure to do

            18   that.  We've had to bring in the people to chair the office. 

            19   We have now advanced to the point where we have a risk-based

            20   approach throughout the entire agency, and we've now got a

            21   special sub-group of something that's already going, that's

            22   going to focus, and thank goodness they are, as Commissioner

            23   Campos stated.  

            24             So, I just want to say that, you know, I've of

            25   course given consideration to the discussion -- arguments pro





                                                                           128

             1   and con, and I fully support the staff's recommendation.  In

             2   connection with what Commissioner Campos said, I want to note

             3   that a number of important issues were discussed this

             4   morning, particularly in response to the questions of those

             5   of other Commissioners, and I'd like to ask the Commission to

             6   authorize the staff to make appropriate revisions to the

             7   final release, to reflect the key points we've covered. 

             8   Subject, of course, to the approval of each of the

             9   Commissioners who favor the rule.  

            10             However, before I officially call the question, I

            11   just want to say a few words.  I appreciate and welcome the

            12   insights and observations that have been offered by all of my

            13   colleagues this morning, and throughout this process.  I've

            14   said before, if all of the decisions we were asked to make were

            15   easy, and self-evident, there'd be no need to have five

            16   people sitting on this panel.  And while we may not always

            17   have agreed, disagreements are driven by the bedrock respect

            18   we share for this institution that we serve.  They provide

            19   valuable evidence that the process works, and it works well.

            20             To each of my colleagues, I extend my thanks and

            21   congratulations.  These are difficult decisions.  The

            22   rigorous debates that we've had have been crucial to the

            23   development of this initiative.  And with that, I will call

            24   the question, do the Commissioners vote to approve the

            25   staff's recommendation?





                                                                           129

             1             (Voice vote.)

             2             CHAIRMAN DONALDSON:  Okay.  That -- that, then, is

             3   an approval by a vote of three to two.  Thank you all.  And

             4   that's the end of the meeting.  Thanks.  

             5             (Whereupon, at 1:09 p.m., the meeting was

             6   concluded.)

             7                             * * * * *

             8

             9

            10

            11

            12