Implications of the Growth 

of Hedge Funds 

 Staff Report to the 

 United States Securities and Exchange Commission 

 September 2003 

This is a staff report to the Commission. The Commission has expressed no view regarding the 

analysis, findings or conclusions herein. 
September 29, 2003 

Hedge funds, while representing a relatively small portion of the U.S. financial 

markets, have grown significantly in size and influence in recent years. In June 2002, the staff 

of the Commission’s Division of Investment Management and Office of Compliance 

Inspections and Examinations undertook a fact-finding mission aimed at reviewing the 

operations and practices of hedge funds. 

After last spring’s two-day roundtable on the hedge fund industry, I asked the staff to 

summarize its findings in a report to the Commission. I also asked the staff to include 

recommendations about actions that, in the judgment of the staff, the Commission might 

consider when addressing issues that the staff raised in its report. The substance and the 

language of the report represent the views of the staff. They do not represent the views of the 

Commission or of any individual Commissioner. 

I look forward to reviewing the staff’s report and accompanying recommendations with 

my fellow Commissioners. The staff has raised important issues for the Commission’s 

consideration. I anticipate that we will hear strong views both in support of and in opposition 

to the staff’s recommendations. We intend to consider these comments carefully as we 

continue to deliberate the appropriate extent of Commission oversight of the hedge fund 

industry. 

 William H. Donaldson 

 
ACKNOWLEDGEMENTS

The Division of Investment Management had the able assistance of many members of the 

Commission staff in its study of hedge funds and preparation of this Report, including, in 

particular, the staff of the Office of Compliance Inspections and Examinations. The study and 

preparation of the Report were conducted under the supervision of Paul F. Roye, Director of the 

Division of Investment Management. Much of the study’s field work and document review was 

conducted under the supervision of Lori A. Richards, Director of the Office of Compliance 

Inspections and Examinations. 

The study team from the Division of Investment Management included: 

Cynthia M. Fornelli, Deputy Director; Elizabeth G. Osterman, Assistant Chief Counsel (Team 

Leader); Evan Geldzahler, Special Counsel (Deputy Team Leader); Jennifer B. McHugh, Senior 

Advisor to the Division Director; Lily R. Chiu, Senior Counsel; Wendy F. Friedlander, Senior 

Counsel; Martin Kimel, Senior Counsel; Stephan N. Packs, Senior Counsel; and Rochelle 

Kauffman Plesset, Senior Counsel. 

The study team from the Office of Compliance Inspections and Examinations included: 

Gene A. Gohlke, Associate Director for Investment Company/Investment Adviser Examinations 

and Oversight; Mavis Kelly, Branch Chief; Brian H. Snively, Staff Accountant; Karen A. 

Stevenson, Staff Accountant; Lesley M. Ward, Staff Accountant; Mary Ann Gadziala, Associate 

Director/Broker-Dealer Examinations and Oversight; and Christine M. Sibille, Senior Counsel. 

Many other members of the Division of Investment Management contributed to the 

drafting or editing of various sections of the report, including: Robert E. Plaze, Associate

Director; Barry D. Miller, Associate Director; Jennifer L. Sawin, Assistant Director; Michael A. 

Lainoff, Assistant Director; Brian D. Bullard, Chief Accountant; Paul B. Goldman, Assistant 

Director; Edward J. Rubenstein, Senior Special Counsel; Karen L. Goldstein, Advisor to the 

Division Director; James G. Basham, Special Counsel; John M. Ganley, Senior Counsel; Vivien 

Liu, Senior Counsel; Susan M. Olson, Senior Counsel; Hester M. Peirce, Senior Counsel; Eric S. 

Purple, Senior Counsel; Jacquelyn J. Rivas, Accountant; Ernest J. C’DeBaca, Attorney-Advisor; 

Catherine E. Marshall, Attorney-Advisor; and Robert L. Tuleya, Attorney-Advisor. 

Many members of other Divisions and Offices also made significant contributions in 

drafting, reviewing and commenting on the report, including: Alan L. Beller, Director, Divison 

of Corporation Finance; Mauri L. Osheroff, Associate Director; Amy M. Starr, Senior Special

Counsel; Brian V. Breheny, Office Chief; Gerald J. Laporte, Office Chief; Julia E. Griffith, 

Special Counsel; Nicholas P. Panos, Special Counsel; John J. Mahon, Attorney-Advisor; Annette 

L. Nazareth, Director, Division of Market Regulation; Robert L.D. Colby, Deputy Director; 

Elizabeth K. King, Associate Director; Theodore R. Lazo, Senior Special Counsel; Mark M. 

Attar, Special Counsel; Brian R. Baysinger, Special Counsel; Kevin Campion, Special Counsel; 

Christopher Slogan, Attorney-Advisor; Laurie M. Stegman, Senior Advisor to the Division 

Director, Division of Enforcement; Ethiopis Tafara, Director, Office of International Affairs;

Bridgett M. Neill, Senior Policy Advisor; Elizabeth Jacobs, Assistant Director; Stan Marcel, 

Senior Counsel; Susan F. Wyderko, Director, Office of Investor Education and Assistance; 
Lawrence E. Harris, Chief Economist; Jonathan S. Sokobin, Deputy Chief Economist; Lori S. 

Walsh, Financial Economist; Ira Wein, Financial Economist; Harvey B. Westbrook, Financial 

Economist; Barbara D. Waits, Financial Analyst; and Jill Felker, Senior Counsel, Office of the 

General Counsel. 

Many other Commission staff members provided ideas, energy and input that 

significantly enhanced this Report. While their names are too numerous to list, their

contributions are nonetheless greatly appreciated. 

ii
TABLE OF CONTENTS 

IMPLICATIONS OF THE GROWTH 

OF HEDGE FUNDS 

EXECUTIVE SUMMARY.........................................................................vii 

I. Investigation by the Staff of the Commission............................................................. 1 

II. Legal Structure and Benefits of Hedge Funds ............................................................ 3 

A. What is a Hedge Fund.............................................................................................. 3 

B. Market Benefits of Hedge Funds............................................................................. 4 

C. Pooled Investment Vehicles that Are Not Hedge Funds ......................................... 5 

1. Registered Investment Companies....................................................................... 5

2. Private Equity Funds ............................................................................................ 7

3. Venture Capital Funds.......................................................................................... 8

4. Commodity Pools................................................................................................. 8

D. Domestic and Offshore Hedge Funds...................................................................... 9 

1. Domestic Hedge Funds......................................................................................... 9

2. Offshore Hedge Funds........................................................................................ 10 

III. The Regulation of Hedge Funds and Their Advisers............................................. 11 

A. Hedge Funds and the Investment Company Act of 1940 ...................................... 11 

1. Section 3(c)(1).................................................................................................... 11

2. Section 3(c)(7).................................................................................................... 12
B. Hedge Funds and the Securities Act of 1933......................................................... 13 

1. The Private Offering Exemption of the Securities Act....................................... 14 

2. Regulation D....................................................................................................... 14

C. Hedge Funds and the Securities Exchange Act of 1934........................................ 18 

1. Definition of “Broker” and “Dealer”.................................................................. 18 

2. Exchange Act Registration Under Section 12 .................................................... 18 

3. Beneficial Ownership Reporting under Sections 13 and 16 of the Exchange Act 19 

D. Hedge Fund Advisers and the Investment Advisers Act of 1940.......................... 20 

E. Certain Other Regulatory Requirements................................................................ 23 

1. Regulation under the CEA.................................................................................. 23 

2. NASD Regulation............................................................................................... 25

3. Regulation under ERISA.................................................................................... 28 

4. Treasury Department Regulations...................................................................... 29

5. State Regulation.................................................................................................. 31

IV. Operations of Hedge Funds ................................................................................... 33 

A. Hedge Fund Investment Strategies ........................................................................ 33 

1. Overview ............................................................................................................ 33

2. Hedge Funds Strategies...................................................................................... 34

3. Hedge Fund Investment Activities Compared to those of Registered Investment 

Companies............................................................................................................. 36 

4. Leverage ............................................................................................................. 37

ii
5. Short Selling ....................................................................................................... 39

B. Nature of Hedge Fund Investors............................................................................ 43 

C. Hedge Fund Marketing .......................................................................................... 44

D. Disclosure by Hedge Funds to Investors and Prospective Investors ..................... 46 

1. Private Placement Memoranda........................................................................... 47 

2. Limited Partnership Agreements........................................................................ 49 

3. Transparency ...................................................................................................... 49 

4. Periodic Reporting.............................................................................................. 50

5. Additional Sources of Hedge Fund Information ................................................ 51 

E. Hedge Fund Service Providers............................................................................... 52 

1. Hedge Fund Investment Advisers ...................................................................... 52 

2. Broker-Dealers/Prime Brokers........................................................................... 53 

3. Offshore Administrators..................................................................................... 55

4. Auditors.............................................................................................................. 57

5. Consultants and Other Finders ........................................................................... 59 

F. Hedge Fund Advisory Fees.................................................................................... 61 

G. Hedge Fund Valuation Practices............................................................................ 64 

H. Audit Reports......................................................................................................... 65

I. Risk Management .................................................................................................. 66

J. Funds of Hedge Funds........................................................................................... 67 

iii
1. Background......................................................................................................... 67

2. Registered FOHFs .............................................................................................. 68

3. Repurchases........................................................................................................ 71 

4. Content of Registered FOHF Disclosure............................................................ 71 

V. Hedge Fund Enforcement Actions............................................................................ 72 

A. Commission Actions.............................................................................................. 72

B. State and SRO Enforcement Activities.................................................................. 74 

VI. Concerns ................................................................................................................ 76

A. Lack of Commission Regulatory Oversight .......................................................... 76 

1. Inability to Detect Fraud and Other Misconduct at Early Stages....................... 76 

2. Lack of Meaningful Information about Hedge Funds and Hedge Fund Advisers 77 

B. Valuation of Hedge Fund Portfolio Securities....................................................... 79 

C. Retailization ........................................................................................................... 80

1. Direct Investment in Hedge Funds..................................................................... 80 

2. Registered Funds of Hedge Funds...................................................................... 81 

3. Pension Plan and Other Institutional Investment in Hedge Funds..................... 82 

D. Disclosure .............................................................................................................. 83

E. Conflicts of Interests.............................................................................................. 83

1. Side-by-Side Management of Client Accounts.................................................. 83 

2. Relationships with Prime Brokers...................................................................... 85 

iv
F. Concerns about General Solicitation ..................................................................... 86 

G. Concerns about Whether the Federal Securities Laws and Regulations Are 

Impairing the Investment Activities of Registered Investment Companies .......... 87 

VII. Recommendations.................................................................................................. 88

A. The Commission Should Consider Requiring Hedge Fund Advisers to Register as 

Investment Advisers under the Advisers Act, Taking into Account Whether the 

Benefits Outweigh the Burdens of Registration .................................................... 89 

1. Benefits of Mandatory Registration ................................................................... 92 

2. Concerns about Mandatory Registration ............................................................ 96 

B. The Commission Should Consider Revising its Regulations Under the Advisers 

Act to Require Advisers to Provide a Brochure Specifically Designed for Hedge 

Funds...................................................................................................................... 97 

C. The Commission Should Consider Requiring Certain Registered Investment 

Companies to Follow Board Adopted Valuation Procedures................................ 99 

D. The Commission Should Consider Requiring Additional Disclosure to be 

Provided About Layered Fees of “Funds of Funds”.............................................. 99 

E. Regulators Should Continue to Monitor Whether Suitability Obligations Are 

Being Met............................................................................................................. 100 

F. The Commission Should Consider Permitting General Solicitation in Section 

3(c)(7) Hedge Fund Offerings ............................................................................. 100 

G. Monitor Capital Introduction Services Provided by Prime Brokers.................... 101 

H. Encourage the Hedge Fund Industry to Embrace and Further Develop Best 

Practices............................................................................................................... 101 

I. Investor Education ............................................................................................... 103

VIII. The Commission Should Consider Issuing a Concept Release for Examining

Wider Use of Hedge Fund Investment Strategies in Registered Investment 

Companies........................................................................................................... 103 

v
A. Different Registered Investment Company Structures Provide Various Benefits 

and Challenges in the Deployment of Absolute Return Strategies...................... 104 

B. Registered Investment Companies are Subject to Restrictions on Leverage and 

Short Selling that Hedge Funds Avoid ................................................................ 107 

C. Alignment of the Investment Adviser’s Interests with Investors......................... 109 

D. Absolute Return Strategies May Challenge Traditional Investor Expectations .. 110 

Appendix A -- Summary of the Commission’s Previous Studies or Investigations of 

Hedge funds

 

vi
EXECUTIVE SUMMARY 

I. Background on Report of the Implications of the Growth of Hedge Funds 

At the request of the Commission, the staff has conducted a study of hedge funds, 

including their investment advisers and other service providers and their investors. The 

Commission’s decision to study the hedge fund industry was based, in large part, on the growth 

of hedge fund assets coupled with the Commission’s lack of information about these investment 

pools. The hedge fund industry recently has experienced significant growth in both the number 

of hedge funds and the amount of assets under management. Based on current estimates, 6,000 

to 7,000 hedge funds operate in the United States managing approximately $600 to $650 billion 

in assets. In the next five to ten years, hedge fund assets have been predicted to exceed $1 

trillion. 

The growth in hedge funds has been fueled primarily by the increased interest of 

institutional investors such as pension plans, endowments and foundations seeking to diversify

their portfolios with investments in vehicles that feature absolute return strategies – flexible

investment strategies which hedge fund advisers use to pursue positive returns in both declining

and rising securities markets, while generally attempting to protect investment principal. In

addition, funds of hedge funds (“FOHF”), which invest substantially all of their assets in other 

hedge funds, have also fueled this growth. 

The study focused on a number of key areas of staff concern, including the recent

increase in the number of hedge fund enforcement cases, the role that hedge funds play in our 

financial markets and the implications of the Commission’s limited ability to obtain basic

information about hedge funds. The staff also examined the emergence of registered FOHFs – 

FOHFs that register under the Investment Company Act of 1940 (“Investment Company Act”) 

so that they may offer and sell their securities to a larger number of investors and FOHFs that

register under the Investment Company Act and the Securities Act of 1933 (“Securities Act”) so 

that they may offer and sell their securities in the public market. Finally, the staff reviewed 

hedge fund disclosure and marketing practices, valuation practices and conflicts of interest. 

The study commenced with the staff’s review of 65 hedge fund advisers (both registered 

and unregistered) managing approximately 650 different hedge funds with over $160 billion of 

assets. This phase of the study included a number of on-site visits to hedge fund advisers, which 

were selected to provide a representative cross-section of the industry. The staff also visited 

several broker-dealers offering prime brokerage services to hedge funds and conducted a 

separate series of on-site examinations focused on the operations of registered FOHFs. In

addition, the staff met with hedge fund advisers, investors, regulators and industry observers 

willing to share information about hedge funds. 

Complementing the study, the Commission held a Hedge Fund Roundtable on May 14 

and 15, 2003, and invited a broad spectrum of the hedge fund industry and interested persons to 

participate in a discussion of hedge fund issues. At the close of the Roundtable, Chairman 

vii
William H. Donaldson requested that the staff provide the Commission with a report of its 

findings and recommendations resulting from the hedge fund study. In response, the Division of 

Investment Management, with the assistance of the Divisions of Corporation Finance, 

Enforcement and Market Regulation, and the Offices of Compliance Inspections and 

Examinations, Economic Analysis, International Affairs and Investor Education and Assistance, 

has prepared this Report. The Chairman also requested public comment on the issues discussed 

in the Roundtable. The Commission received approximately 80 comment letters in response and 

those letters have been considered in preparing this Report. 

The Report outlines the staff’s factual findings, identifies concerns and recommends that 

the Commission should consider certain regulatory and other measures to improve the current 

system of hedge fund regulation and oversight. The views expressed in this Report are those of 

the staff and do not necessarily reflect the views of the Commission or the individual 

Commissioners. 

A. Characteristics of Hedge Funds 

Although financial service providers, regulators and the media commonly refer to “hedge

funds,” the term has no precise legal or universally accepted definition. The term generally

identifies an entity that holds a pool of securities and perhaps other assets that does not register 

its securities offerings under the Securities Act and which is not registered as an investment 

company under the Investment Company Act. Hedge funds are also characterized by their fee 

structure, which compensates the adviser based upon a percentage of the hedge fund’s capital 

gains and capital appreciation. Hedge fund advisory personnel often invest significant amounts 

of their own money into the hedge funds that they manage. As discussed in the Report, although 

similar to hedge funds, there are other unregistered pools of investments, including venture 

capital funds, private equity funds and commodity pools that generally are not categorized as 

hedge funds.

The investment goals of hedge funds vary among funds, but many hedge funds seek to 

achieve a positive, absolute return rather than measuring their performance against a securities 

index or other benchmark. Hedge funds utilize a number of different investment styles and 

strategies and invest in a wide variety of financial instruments. Hedge funds invest in equity and 

fixed income securities, currencies, over-the-counter derivatives, futures contracts and other 

assets. Some hedge funds may take on substantial leverage, sell securities short and employ

certain hedging and arbitrage strategies. Hedge funds typically engage one or more brokerdealers to provide a variety of services, including trade clearance and settlement, financing and 

custody services. 

Hedge funds often provide markets and investors with substantial benefits. For example, 

based on our observations, many hedge funds take speculative, value-driven trading positions 

based on extensive research about the value of a security. These positions can enhance liquidity

and contribute to market efficiency. In addition, hedge funds offer investors an important risk 

management tool by providing valuable portfolio diversification because hedge fund returns in 

many cases are not correlated to the broader debt and equity markets. 

viii
B. Hedge Fund Organization and Operations

Hedge funds are typically organized by professional investment advisers that manage a 

hedge fund’s investments. Hedge funds distribute securities in private offerings, traditionally

“marketing” their interests through word of mouth and the personal relationships with the hedge 

fund’s advisory personnel. Broader marketing, including use of the Internet, has become more 

frequent in recent years. Hedge funds generally do not have limited time horizons, although a 

number of factors, including an inability to consistently achieve positive returns, often contribute

to a relatively shorter life span than that of other investment vehicles. Hedge fund advisers 

typically receive, as compensation, a management fee based on the amount of hedge fund assets 

(commonly 1-2 percent), plus a share of the capital gains and capital appreciation (commonly 20 

percent) or some other allocation based on the fund’s investment performance. Hedge funds 

typically agree to repurchase their own interests from investors on a limited, periodic basis, such

as quarterly, often following an initial “lock-up period” during which time investors are not 

permitted to liquidate their investments. 

Because hedge funds are not registered investment companies, they generally are not 

required to meet prescribed disclosure requirements. Hedge fund advisers, however, typically

provide potential hedge fund investors with a private placement memorandum that discloses 

information about the investment strategies the hedge fund is permitted to use and an overview 

of how the hedge fund operates. The private placement memorandum also generally provides 

the adviser with the maximum flexibility in selecting, shifting and modifying its strategies. In

addition, the private placement memorandum often provides the hedge fund adviser with broad 

discretion in valuing the hedge fund’s assets. Hedge fund investors generally receive some 

ongoing performance information, risk analyses and portfolio profiles from their hedge fund 

advisers. Although not required, most hedge funds retain an auditor to conduct an annual 

independent audit, which, if certified, is prepared using generally accepted accounting principles. 

For tax and other considerations, some hedge fund advisers create one or more “offshore” 

hedge funds that are organized in a foreign jurisdiction, in addition to maintaining U.S.-based 

hedge funds. In many cases, an offshore hedge fund is managed using trading strategies that are 

substantially similar to those used to manage an onshore hedge fund managed by the same 

adviser. These hedge funds are offered and sold to certain U.S. investors as well as foreign 

investors. 

C. Principal Exclusions and Exemptions for Hedge Funds and Their Investment

Advisers 

To avoid registration and substantive regulation under the Investment Company Act, 

hedge funds rely on one of two exclusions from the definition of investment company. The first 

exclusion is available to hedge funds that have 100 or fewer investors. The second exclusion 

applies to hedge funds that sell their interests only to highly sophisticated investors. To rely on 

either exclusion, the hedge fund must restrict its offerings so that they meet the requirements for 

non-public offerings. 

ix
Hedge funds do not register the offer and sale of their interests under the Securities Act. 

As such, hedge funds may not offer their securities publicly or engage in a public solicitation. 

Instead, hedge funds generally sell their interests in private offerings. To meet the most 

commonly used regulatory “safe harbor” for conducting private offerings, hedge funds may sell 

their interests to an unlimited number of “accredited investors.” Accredited investors include 

individuals with a minimum annual income of $200,000 ($300,000 with spouse) or $1 million in 

net worth and most institutions with $5 million in assets. Hedge funds that seek to rely on the 

sophisticated investor exclusion from Investment Company Act registration may sell their 

interests only to “qualified purchasers,” a standard with significantly higher financial 

requirements than those necessary for accredited investors. In practice, we understand that most 

hedge funds sell only to investors whose wealth exceeds that required to meet the standard 

established for accredited investor status. 

Although some hedge fund advisers choose to register voluntarily, or are registered for 

another reason, most advisers to hedge funds do not register under the Investment Advisers Act 

of 1940 (“Advisers Act”). They often rely on the “de minimis” exemption from registration for 

investment advisers with 14 or fewer clients. Under Commission rules, each hedge fund counts 

as one client. 

II. Concerns Relating to Hedge Fund Growth 

As noted above, our study was, in large part, the result of the Commission’s recognition 

that it lacks information about hedge fund advisers that are not registered under the Advisers Act 

and the hedge funds that they manage. Although this recognition is not new, the Commission’s 

attention was focused again on the hedge fund industry as a result of the recent growth of the 

industry and the increase of investments in hedge funds by institutions. Although hedge fund 

investment advisers are subject to the antifraud provisions of the federal securities laws, they are

not subject to any reporting or standardized disclosure requirements, nor are they subject to 

Commission examination. Consequently, the Commission has only indirect information about 

these entities and their trading practices and, we believe, is hampered in its ability to develop 

regulatory policy as hedge funds become more important participants in our financial markets. 

We are concerned about our inability to examine hedge fund advisers and evaluate the effect of 

the strategies used in managing hedge funds on our financial markets. We also are concerned 

about the lack of applicable regulatory measures necessary to ensure that material information to 

assist investors in making fully informed investment decisions is available. 

The Commission’s inability to examine hedge fund advisers has the direct effect of 

putting the Commission in a “wait and see” posture vis-à-vis fraud and other misconduct. The 

Commission typically is able to take action with respect to such fraud and other misconduct only

after it receives relevant information from third parties (for example, investors or service 

providers), and frequently only after significant losses have occurred. In contrast, we believe 

that our examination program not only allows the Commission to identify misconduct by

registered investment advisers earlier, but it also assists in identifying and possibly preventing

certain misconduct from developing into fraud. 

x
We also are concerned that some hedge fund investors may not always receive useful 

information about the investment adviser and its management of the fund. In addition, we 

believe that disclosure to some hedge fund investors could be improved to address conflicts of 

interests of hedge fund advisers. 

One of our key concerns relates to the manner by which hedge fund advisers value hedge 

fund assets. The broad discretion that these advisers have to value assets and the lack of 

independent review over that activity gives rise to questions about whether some hedge funds’ 

portfolio holdings are accurately valued. Our concern not only reflects our recognition of the 

incentives that may cause an adviser to inaccurately value hedge fund assets, but it also reflects 

our concern that registered funds that invest their assets in hedge funds may lack access to 

information that enables them to “fair value” their interests in hedge funds and therefore 

accurately calculate their net asset value. 

In addition, we have observed various uses of the Internet by hedge fund advisers to 

communicate with investors. We are taking the opportunity in this Report to reiterate the 

Commission’s statement that the analysis historically applied to determine whether an offering is 

part of a general solicitation or public offering has not changed in the context of offerings made 

through electronic sources. Separately, however, we recommend to the Commission that

additional consideration be given to whether hedge funds that offer and sell their securities solely

to “qualified purchasers,” as defined under the Investment Company Act, should be subject to 

the limitation that such funds only make private offerings of their securities. 

III. Staff Recommendations Relating to Hedge Fund Advisers, Funds of Hedge Funds 

and Hedge Funds

A. The Commission Should Consider Requiring Hedge Fund Advisers To 

Register as Investment Advisers under the Advisers Act, Taking into 

Account Whether the Benefits Outweigh the Burdens of Registration

The staff recommends that the Commission consider revising its rules under the Advisers 

Act to require hedge fund advisers to register as investment advisers. Amending the rules under 

the Advisers Act would require hedge fund advisers to “look through” any hedge funds under 

their management and count each investor in each hedge fund as a separate client of the adviser. 

In practical terms, this would result in the registration of most large hedge fund advisers. The 

staff further recommends that the Commission consider amending its rules to require that 

registered hedge fund advisers file with the Commission, and deliver to investors, a disclosure 

statement specifically designed for hedge fund investors. 

Registration of hedge fund advisers would have several benefits. First, registered hedge 

fund advisers would become subject to the Commission’s regular inspections and examinations 

program. Effective Commission oversight could lead to earlier detection of actual and potential 

misconduct, help to deter fraud and encourage a culture of compliance and controls. Second, the 

Commission would be authorized to collect basic and meaningful information about the activities 

of hedge fund advisers and hedge funds, which are becoming increasingly influential participants 

xi
in the U.S. financial markets. Third, Advisers Act registration would enable the Commission to 

require hedge fund advisers to disclose information about issues important to investors, such as 

conflicts arising from side-by-side management of hedge funds and other client accounts and 

hedge fund advisers’ relationships with prime brokers. Fourth, registration of hedge fund 

advisers under the Advisers Act would effectively increase the minimum investment requirement 

for direct investments in certain hedge funds because registered advisers are generally prohibited 

from charging performance fees unless investors have $750,000 invested with the adviser or 

have a net worth of $1.5 million. 

Importantly, Advisers Act registration would not impede the manner in which a hedge 

fund adviser invests or operates a hedge fund. Registration would not place restrictions on a 

hedge fund adviser’s ability to trade securities, use leverage, sell securities short or enter into 

derivative transactions. Registration would also not require the disclosure of hedge fund 

proprietary trading strategies and portfolio positions, nor would it result in the public 

identification of the hedge fund’s investors. 

B. The Commission and its Staff Should Consider Addressing Certain 

Valuation, Suitability and Fee Disclosure Issues Relating to Registered 

FOHFs 

The Commission should consider requiring, through rulemaking, that all registered 

investment companies that invest their assets in hedge funds, including registered FOHFs, have 

policies and procedures designed to ensure that funds and their boards value their interests in 

hedge funds in a manner consistent with the requirements of the Investment Company Act. To 

address concerns that registered FOHF investors do not understand the impact of multiple layers 

of fees, the Commission should adopt its proposed rulemaking to require all registered 

investment companies, including registered FOHFs, to disclose in their prospectus fee tables the 

estimated expenses of the company’s underlying fund interests. To address concerns about 

registered FOHFs exposing investors to levels and types of risks that are not appropriate for 

those investors, the Commission should continue to encourage the examination staffs of the 

Commission and the NASD to be vigilant in identifying violations of broker-dealer suitability

obligations with respect to the sale of all registered FOHFs. 

C. The Commission Should Consider Permitting General Solicitation in Fund 

Offerings Limited to Qualified Purchasers 

The staff recommends that the Commission consider eliminating the prohibition on 

general solicitation or advertising in offerings by hedge funds that rely on the exclusion from the 

definition of an investment company for hedge funds that permit investments only by highly

sophisticated investors. Permitting pooled investment vehicles, including hedge funds, which 

limit their investors to this higher standard to engage in a general solicitation could facilitate

capital formation, without raising significant investor protection concerns. 

xii
D. The Staffs of the Commission and the NASD Should Monitor Closely Capital 

Introduction Services Provided by Broker-Dealers 

Commission and NASD examiners should continue to monitor prime brokers’ capital 

introduction practices. In addition, the staff should consider whether broker-dealers’ suitability

and other regulatory obligations are being met in connection with the offering of hedge funds 

interests. 

E. The Commission Should Encourage the Hedge Fund Industry To Embrace

and Further Develop Best Practices 

The Commission should encourage those involved in the hedge fund industry to embrace 

existing “best practices” and refine and improve these best practices to supplement current 

conflict management practices. 

F. The Commission Should Continue Its Efforts To Improve Investor 

Education Regarding Hedge Funds 

In light of the publicity surrounding hedge funds, as well as the advent of registered 

FOHFs, there is a greater need to promote investor education regarding hedge funds, their 

investment strategies and their operations. In addition to making investors aware of the potential 

for fraud in hedge funds, we are also concerned that many investors may not realize the 

correlation between risk and return – that higher risk inevitably accompanies potentially higher 

returns. 

IV. The Commission Should Consider Issuing a Concept Release To Examine the Wider 

Use of Hedge Fund Investment Strategies in Registered Funds 

Some commenters have asserted that retail investors could benefit from greater access to

absolute return strategies and hedge fund investment techniques. The Commission should 

consider issuing a concept release requesting comment on this topic generally and focusing on 

issues such as whether: (1) current restrictions placed on registered funds’ use of leverage and 

short selling should be relaxed; (2) an absolute return strategy, especially in connection with a 

performance fee tied to achieving an absolute return, has a positive effect on aligning the

interests of hedge fund advisers and investors; and (3) additional investor education initiatives 

would be necessary to educate investors about absolute return strategies and risks. 

xiii
Staff Report 

I. Investigation by the Staff of the Commission 

Over the past 35 years, the Commission and the staff have periodically conducted or 

participated in a number of studies about hedge funds.1 While some of these studies were 

prompted by particular events, others were part of a program of Commission surveillance to 

review aspects of the securities markets. Previous studies often focused on the impact of hedge

fund operations on the stability of the financial markets. These studies examined, among other 

things, trading and brokerage practices, including the use of short selling and leverage by hedge

funds, the systemic risks posed by hedge funds and the exposure of banks and other 

counterparties to hedge funds and other highly-leveraged institutions. 

The considerable growth of the hedge fund industry in recent years prompted the 

Commission to authorize the staff to examine hedge funds once again.2

 Although hedge funds 

remain a relatively small portion of the U.S. financial markets,3

 the rate of growth of hedge funds 

has been substantially greater than that of other sectors.4

 In addition, hedge funds have a 

growing role in our securities markets as large and frequent traders of securities. 

 

1

 See Appendix A for a chronological discussion of the Commission’s major studies or 

investigations of hedge funds. 

2

 Consistent with previous hedge fund studies, the staff has no reliable data on the number of hedge 

funds in existence or the amount of hedge fund assets under management. Participants at the 

Commission’s May 14-15, 2003 Hedge Fund Roundtable (“Roundtable”) estimated that there are 

approximately 6,000 hedge funds currently operating in the United States, with approximately

$600 billion in assets under management. Other estimates vary greatly. The Commission 

estimated in 1992, based on media reports, that there were approximately 400 hedge funds in 

existence. See Letter from Richard C. Breeden, Chairman, U.S. Securities and Exchange

Commission, to Edward J. Markey, Chairman, Subcommittee on Telecommunications and 

Finance, Committee on Energy and Commerce, U.S. House of Representatives (June 12, 1992) 

(“Breeden Letter”). 

3

 For example, the total market value of corporate equities in the U.S. stock market at the end of 

2002 was $11.8 trillion. Federal Reserve Statistical Release Z.1, Flow of Funds Accounts of the 

United States - Flows and Outstanding, available at 

http://www.federalreserve.gov/releases/Z1/20030605/. 

4

 According to a Roundtable participant, hedge fund assets grew from $50 billion in 1993 to $592 

billion in 2003, an increase of 1084 percent. Comment submitted by Roundtable Panelist Charles 

J. Gradante on behalf of the Hennessee Group LLC at 4-5 (“Hennessee Group Comment Letter”). 

By contrast, over the decade from December 1992 to December 2002, the number of mutual fund 

portfolios increased by 116 percent, from 3,824 to 8,256, and their assets increased by 289 

1
As more fully discussed below, the concerns that prompted the Commission’s current 

examination of hedge funds involve not simply the growth in the number of hedge funds and 

their assets under management, but more importantly, the causes and implications of that growth. 

They also reflect the Commission’s interest in determining whether the recent increase in the 

number of hedge fund frauds is a result of this growth, and whether certain types of offenses are 

endemic to hedge funds. Finally, the Commission was concerned about the potential impact that 

the growth in hedge fund assets and activities may have on our financial markets.5

 

Our examination began in June 2002, and included reviews of both registered and 

unregistered investment advisers that manage hedge funds. The staff also had on-site discussions 

with a number of hedge fund advisers.6

 In addition, the staff met or spoke with a variety of 

experts in their respective fields to get their perspectives on the hedge fund industry. This group 

included legal and accounting experts, chief investment officers, risk managers, prime brokers, 

trade industry representatives, hedge fund consultants and representatives from foreign and 

domestic regulators. 

In May 2003, the Commission hosted a Roundtable to provide a public forum for 

discussion and debate about the implications of hedge fund growth. The Roundtable brought 

together representatives from the hedge fund industry and other interested persons to discuss 

issues relating to hedge funds, and to offer their recommendations.7

 In addition, the Commission 

 

percent from $1.6 trillion to $6.4 trillion. See The Investment Company Institute, 2003 Mutual 

Fund Fact Book: A Guide to Trends and Statistics in the Mutual Fund Industry 63 (43rd ed. 

2003). In that same period, assets of insurance companies increased by 110 percent (from $1.6 

trillion to $3.3 trillion), assets of commercial banks grew by 100 percent (from $3.5 trillion to $7 

trillion), and deposits of commercial banks increased by 79 percent (from $2.5 trillion to $4.5 

trillion). See Federal Reserve Statistical Release Z.1, supra note 3; Federal Reserve Statistical 

Release H.8, Assets and Liabilities of Commercial Banks in the United States, available at 

http://www.federalreserve.gov/releases/Z1/20030605/;

http://www.federalreserve.gov/releases/z1/current/data.htm.

5

 The Commission recognized over 30 years ago that hedge fund trading raises special concerns 

with respect to their impact on the securities markets. See 35th Annual Report, U.S. Securities 

and Exchange Commission 18 (1969) (“[b]ecause hedge funds are so strongly performanceoriented, they may have a greater impact on the securities markets than their asset size would 

indicate”). 

6

 The staff selected hedge fund investment advisers based on their: (1) hedge fund assets under 

management; (2) number of hedge funds under management; (3) hedge fund investment 

objectives; (4) status and length of operations; (5) Commission registration status; and (6) 

additional advisory services provided. 

7

 A wide range of persons involved in the hedge fund industry participated in the Roundtable, 

including hedge fund advisers, consultants, service providers (such as prime brokers, auditors and 

2
invited the public to submit written comments to the Commission relating to the growth and 

investor protection implications of hedge funds. The Commission received approximately 80 

comment letters addressing these topics, which the staff considered in connection with the 

preparation of this Report.8

 

II. Legal Structure and Benefits of Hedge Funds 

A. What is a Hedge Fund 

Although there is no universally accepted definition of the term “hedge fund,”9 the term

generally is used to refer to an entity that holds a pool of securities and perhaps other assets, 

whose interests are not sold in a registered public offering and which is not registered as an 

investment company under the Investment Company Act. Alfred Winslow Jones is credited with 

establishing one of the first hedge funds as a private partnership in 1949. That hedge fund 

invested in equities and used leverage and short selling to “hedge” the portfolio’s exposure to 

movements of the corporate equity markets.10 Over time, hedge funds began to diversify their 

investment portfolios to include other financial instruments and engage in a wider variety of 

investment strategies. Today, in addition to trading equities, hedge funds may trade fixed 

income securities, convertible securities, currencies, exchange-traded futures, over-the-counter 

derivatives, futures contracts, commodity options and other non-securities investments. 

Furthermore, hedge funds today may or may not utilize the hedging and arbitrage strategies that 

 

attorneys), investment bankers and hedge fund investors. Academics and foreign and U.S. 

regulators also participated in the Roundtable. A copy of the webcast and a transcript of the 

Roundtable discussions are available on the Commission’s website. See

http://www.connectlive.com/events/sechedgefunds/; 

http://www.sec.gov/spotlight/hedgefunds/hedge1trans.txt and 

http://www.sec.gov/spotlight/hedgefunds/hedge2trans.txt. 

8

 See Notice of Roundtable Discussions; Request for Comment, Advisers Act Release No. 2117 

(Mar. 26, 2003). All comments received in response to the request are available from SEC public 

reference by calling (202) 942-8090, or by writing to: publicinfo@sec.gov. In addition, 

comments submitted by Roundtable panelists are available at 

http://www.sec.gov/spotlight/hedgefunds/hedge-parts.htm. 

9

 One Roundtable participant submitted a selection of definitions and descriptions of the term

“hedge fund” that illustrates the diversity of views about that term. See Comment submitted by

Roundtable Panelist David A. Vaughan. 

10 Carol Loomis, Hard Times Come to Hedge Funds (“Loomis”), Fortune 100, 101 (Jan. 1970). 

One commenter suggested that the first hedge funds were merely implementing investment 

strategies first used by the proprietary trading desks of investment banks. See Hennessee Group 

Comment Letter, supra note 4, at 2. 

3
hedge funds historically employed, and many engage in relatively traditional, long-only equity

strategies. 

B. Market Benefits of Hedge Funds 

Hedge funds seek to achieve positive investment returns, often with less volatility than 

traditional asset classes such as stocks and bonds. Hedge funds engage in a wide variety of 

investment strategies, such as investing in distressed securities, illiquid securities, securities of

companies in emerging markets and derivatives, as well as pursue arbitrage opportunities, such 

as those arising from possible mergers or acquisitions. They typically are managed by

entrepreneurs who employ more complicated, flexible investment strategies than advisers at 

mutual funds, brokerage firms and bank trust departments. 

Hedge funds can provide benefits to financial markets by contributing to market 

efficiency and enhancing liquidity. Many hedge fund advisers take speculative trading positions 

on behalf of their managed hedge funds based on extensive research about the true value or 

future value of a security. They may also use short-term trading strategies to exploit perceived 

mispricings of securities. Because securities markets are dynamic, the result of such trading is 

that market prices of securities will move toward their true value. Trading on behalf of hedge

funds can thus bring price information to the securities markets, which can translate into market 

price efficiencies.11 Hedge funds also provide liquidity to the capital markets by participating in 

the market. 

Hedge funds play an important role in a financial system where various risks are 

distributed across a variety of innovative financial instruments. They often assume risks by

serving as ready counterparties to entities that wish to hedge risk. For example, hedge funds are 

buyers and sellers of certain derivatives, such as securitized financial instruments, that provide a

mechanism for banks and other creditors to un-bundle the risks involved in real economic 

activity. By actively participating in the secondary market for these instruments, hedge funds 

can help such entities to reduce or manage their own risks because a portion of the financial risks 

are shifted to investors in the form of these tradable financial instruments. By reallocating

financial risk, this market activity provides the added benefit of lowering the financing costs 

 

11 “[M]any of the things which [hedge funds] do . . . tend to refine the pricing system in the United 

States and elsewhere. And it is that really exceptionally and increasingly sophisticated pricing

system which is one of the reasons why the use of capital in this country is so efficient . . . there is 

an economic value here which we should not merely dismiss . . . I do think it is important to 

remember that [hedge funds] . . . , by what they do, they do make a contribution to this country.” 

Testimony of Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve, 

Before the House Committee on Banking and Financial Services (Oct. 1, 1998). 

4
shouldered by other sectors of the economy. The absence of hedge funds from these markets 

could lead to fewer risk management choices and a higher cost of capital. 

Hedge funds also can serve as an important risk management tool for investors by

providing valuable portfolio diversification. Hedge fund investment strategies are typically

designed to protect investment principal. Hedge funds frequently use financial instruments (e.g., 

derivatives) and techniques (e.g., short selling) to hedge against market risk and construct a

conservative investment portfolio -- one designed to preserve wealth. In addition, hedge fund 

investment performance can exhibit low correlation to that of traditional investments in the

equity and fixed-income markets.12 Institutional investors have used hedge funds to diversify

their investments based on this historic low correlation with overall market activity. 

C. Pooled Investment Vehicles that Are Not Hedge Funds 

Hedge funds are often compared to registered investment companies. In addition, 

unregistered investment pools, such as venture capital funds, private equity funds and 

commodity pools, are sometimes referred to as hedge funds. Although all of these investment 

vehicles are similar in that they accept investors’ money and generally invest it on a collective 

basis,13 they also have characteristics that distinguish them from hedge funds. 

1. Registered Investment Companies 

As a practical matter, hedge funds are similar to registered investment companies in a 

number of respects. Both are entities that issue securities to investors and hold pools of 

securities and perhaps other assets through which investors can obtain, among other things, 

investment diversification and professional asset management by an investment adviser who 

typically organizes the pool. Hedge funds and registered investment companies may invest in 

similar types of securities and may even share similar investment strategies. 

Registered investment companies, however, also differ from hedge funds in a number of 

significant respects, including the extent to which they are regulated. Registered investment 

companies are registered with the Commission and are subject to the provisions of the 

Investment Company Act. Their securities offerings are almost always registered with the

Commission and they are subject to the disclosure and reporting requirements of the federal 

 

12 See, e.g., Mark J.P. Anson, Handbook of Alternative Assets 37-40 (2002) (“Handbook of 

Alternative Assets”). 

13 But for certain exclusions set forth in the Investment Company Act, all of these vehicles would 

meet the definition of investment company in Section 3(a) of the Investment Company Act. See

infra Part III.A.1. and 2. 

5
securities laws. Finally, investment advisers to registered investment companies are required to

register with the Commission under the Advisers Act. 

Registered investment companies, which register their securities offerings under the 

Securities Act, generally may offer and sell their securities to any investor,

14 including investors 

who are not financially sophisticated. Most registered investment companies have a board of 

directors, a majority of whom are independent of the investment companies’ investment 

adviser.15 The board is responsible for selecting and overseeing the activities of the company’s 

investment adviser and other service providers and for generally overseeing the company’s 

operations. 

In addition, registered investment companies are subject to extensive operational 

restrictions designed to prevent the potential for abuse that exists when an investment adviser has 

control of the assets of other persons who do not actively oversee the management of those 

assets. For example, registered investment companies are subject to regulations concerning the 

computation of the fund's net asset value,16 as well as regulations designed to protect against 

 

14 Recently, a number of hedge funds that invest all or substantially all of their assets in other hedge 

funds have begun registering under the Investment Company Act as closed-end investment 

companies, and many have also registered their securities offerings under the Securities Act. See

infra Part IV.J. (discussing funds of hedge funds). 

15 See Interpretive Matters Concerning Independent Directors of Investment Companies, 

Investment Company Act Release No. 24083 text accompanying n. 4 (Oct. 14, 1999) (“Congress 

intended to place independent directors in the role of ‘independent watchdogs,’ who would 

furnish an independent check upon the management of funds and provide a means for the 

representation of shareholder interests in fund affairs.”)(citations omitted). 

16 Under the Investment Company Act, a registered investment company must value its portfolio 

securities using market quotations or, if market quotations are not readily available, fair value as 

determined in good faith by the company’s board of directors. See Section 2(a)(41) of the 

Investment Company Act and Rule 2a-4 thereunder. See also Accounting Series Release No. 

118, Financial Reporting Codification (CCH) §404.03 (Dec. 23, 1970) (“ASR No. 118”); 

Accounting Series Release No. 113, Financial Reporting Codification (CCH) §404.04 (Oct. 21, 

1969); Letters to Craig S. Tyle, General Counsel, Investment Company Institute, from Douglas 

Scheidt, Associate Director and Chief Counsel, Division of Investment Management (Dec. 8, 

1999; Apr. 30, 2001). Most boards fulfill their obligations by approving and monitoring the 

implementation of valuation procedures and methodologies. Boards of registered investment 

companies are also required to continuously review the appropriateness of their valuation 

methodologies. See ASR No. 118. 

6
conflicts of interest and limit leverage (and consequently certain trading strategies).

17 They also 

are subject to regulations requiring shareholder reports.18 

2. Private Equity Funds 

A private equity fund, like a hedge fund, is an unregistered investment vehicle in which 

investors pool money to invest in securities. Private equity funds concentrate their investments 

in unregistered (and typically illiquid) securities. Both private equity funds and domestic hedge 

funds are typically organized as limited partnerships.19 Because these entities rely on an 

exemption from registration of the offer and sale of their securities, the managers/sponsors of 

both private equity funds and hedge funds solicit investors directly, or through a registered 

broker-dealer, rather than through general solicitation, general advertising or a public offering of 

the securities. The investors in private equity funds and hedge funds typically include high net 

worth individuals and families, pension funds, endowments, banks and insurance companies.20 

Like hedge funds, many private equity funds establish offshore “mirror” funds that are typically

managed by the general partner of the companion U.S. fund and have similar investments. 

Private equity funds, however, differ from hedge funds in a number of significant ways. 

Private equity investors typically commit to invest a certain amount of money with the fund over 

the life of the fund, and make their contributions in response to “capital calls” from the fund’s 

general partner. Because private equity funds typically do not retain a pool of uninvested capital, 

their general partners make a capital call when they have identified or expect to identify a

portfolio company in which the private equity fund will invest.21 Private equity funds are long-

 

17 See Investment Company Act Sections 10(f); 17 (conflicts of interest) and 18 (leverage). 

18 See Investment Company Act Section 30(e) and Rule 30e-1 thereunder. 

19 See George W. Fenn, Nellie Lang and Stephen Prowse, The Economics of the Private Equity 

Market, Staff Study of the Board of Governors of the Federal Reserve System 41 (1995). Like

domestic hedge funds, some private equity funds are organized as limited liability companies and, 

occasionally, corporations. 

20 “[I]ndividuals and families account for less than 10 percent of the assets invested in private equity

funds, pension funds account for about 30 percent, endowments account for about 20 percent, and 

banks and insurance companies account for about 40 percent.” Secretary of the Treasury, Board 

of Governors of the Federal Reserve System, and Securities and Exchange Commission, A Report

to Congress in Accordance with § 356(c) of the Uniting and Strengthening America by Providing 

Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 n. 95 (Dec. 31, 

2002) (“Patriot Act Report”).

21 A hedge fund investor, by contrast, generally can decide when and how much to invest in the 

fund. 

7
term investments, provide for liquidation at the end of the term specified in the fund’s governing

documents, and offer little, if any, opportunity for investors to redeem their investments.22 A 

private equity fund, however, may distribute cash to its investors when it sells its portfolio 

investment, or it may distribute the securities of a portfolio company (assuming the portfolio 

company has complied with the registration requirements of the Securities Act in connection 

with the distribution) to its investors. 

3. Venture Capital Funds 

Venture capital funds are unregistered investment vehicles, which are structurally similar 

to hedge funds and attract similar types of investors.23 Venture capital pools are generally

organized, however, to invest in the start-up or early stages of a company. 

Venture capital funds have the same features that distinguish private equity funds 

generally from hedge funds, such as mandatory capital contributions over the life of the fund and 

the long-term nature of the investment. In addition, unlike hedge fund advisers, general partners 

of venture capital funds often play an active role in the companies in which the funds invest, 

either by sitting on the board of directors or becoming involved in the day-to-day management of 

these companies. In contrast to a hedge fund, which may hold an investment in a portfolio 

security for an indefinite period based on market events and conditions, a venture capital fund 

typically seeks to liquidate its investment once the value of the company increases above the 

value of the investments.

4. Commodity Pools 

Commodity pools are investment trusts, syndicates or similar enterprises that are operated 

for the purpose of trading commodity futures. The investment concentration in commodity

futures distinguishes commodity pools from hedge funds and the other investment vehicles 

 

22 There is typically no formal secondary market for shares in a private equity fund, although there 

may be a small informal secondary market comprised of private equity funds that buy interests in 

other established private equity funds. In 1999, five private equity funds raised $1.6 billion for 

purchases of secondary interests in other private equity funds. See Patriot Act Report, supra note 

20, at n. 99 (citation omitted). See also David M. Toll, Private Equity Primer, in Galante’s 

Venture Capital & Private Equity Directory. 

23 See National Venture Capital Association, 2003 National Venture Capital Association Yearbook 

9 (2003). The National Venture Capital Association estimates that 1,798 venture capital funds 

were in existence in 2002, with $253 billion in capital under management. It also estimates that, 

in 2002, individuals and families accounted for approximately nine percent of the invested assets 

in venture capital funds; pension funds accounted for 42 percent; endowments accounted for 21 

percent; and banks, insurance companies and corporations accounted for 28 percent. Id. at 10. 

8
discussed above.24 Commodity pool operators, which manage commodity pools, are subject to 

oversight by the Commodity Futures Trading Commission (“CFTC”). The CFTC has recently

adopted rules which sharpen the distinction between hedge funds and commodity pools.25 

D. Domestic and Offshore Hedge Funds 

The corporate structure of a hedge fund depends primarily on whether the fund is 

organized under U.S. law (“domestic hedge fund”) or under foreign law and located outside of 

the United States (“offshore hedge fund”). The investment adviser of a domestic hedge fund 

often operates a related offshore hedge fund, either as a separate hedge fund or often by

employing a “master-feeder” structure that allows for the unified management of multiple pools 

of assets for investors in different taxable categories.26 

1. Domestic Hedge Funds 

Domestic hedge funds are usually organized as limited partnerships to accommodate 

investors that are subject to U.S. income taxation.27 The fund’s sponsor typically is the general 

partner and investment adviser. The sponsor also typically handles marketing and investor 

services. Domestic hedge funds typically maintain contractual relationships with one or more 

broker-dealers, which provide clearance and settlement and financing services and may provide a

 

24 Commodity pools also differ from hedge funds, private equity funds and venture capital funds in 

that commodity pools frequently rely on Section 3(b)(1) of the Investment Company Act to 

exclude them from the definition of investment company. Section 3(b)(1) excludes from that 

definition any issuer that is directly or indirectly primarily engaged in a business other than 

investing or trading in securities. 

25 See infra Part III.E.1 (discussing the regulation of commodity pools).

26 The master fund is usually organized as a corporation, such as an international business company,

under non-U.S. law. It offers shares to one or more domestic feeder funds and one or more 

offshore corporate feeder funds, all of which share common investment strategies and objectives. 

See Gerald T. Lins (“Lins”), Hedge Fund Organization, in Hedge Fund Strategies: A Global 

Outlook 98, 100-101 (Brian R. Bruce, ed., 2002).

27 Hedge funds may also take the form of limited liability companies (“LLCs”) or business trusts. 

Limited partnerships, LLCs and business trusts are generally not separately taxed and, as a result, 

income is taxed only at the level of the individual investor. Each of the three forms also limits 

investor liability. LLCs offer the additional benefit of limited liability for fund advisers, but some

states and foreign countries tax LLCs as corporations. See David A.Vaughan and Margaret A. 

Bancroft, Structuring Issues for Hedge Funds, in The Capital Guide to Starting a Hedge Fund – 

A U.S. Perspective 31, 32 (2001). 

9
variety of incidental services.28 A domestic hedge fund also may employ executing brokers, 

accountants, lawyers, custodians, administrators, placement agents, registrars and transfer agents. 

Domestic hedge funds typically do not have a board of directors or any oversight body analogous 

to the board of directors of a registered investment company.

2. Offshore Hedge Funds 

Offshore hedge funds are typically organized as corporations in countries such as the 

Cayman Islands, British Virgin Islands, the Bahamas, Panama, the Netherlands Antilles or

Bermuda. Offshore funds generally attract investment of U.S. tax-exempt entities, such as 

pension funds, charitable trusts, foundations and endowments, as well as non-U.S. residents. 

U.S. tax-exempt investors favor investments in offshore hedge funds because they may be 

subject to taxation if they invest in domestic limited partnership hedge funds.29 Offshore hedge 

funds may be organized by foreign financial institutions or by U.S. financial institutions or their 

affiliates. Sales of interests in the United States in offshore hedge funds are subject to the 

registration and antifraud provisions of the federal securities laws. 

Offshore hedge funds typically contract with an investment adviser, which may employ a 

U.S. entity to serve as subadviser.

30 An offshore hedge fund often has an independent fund 

administrator, also located offshore, that may assist the hedge fund’s adviser to value securities 

and calculate the fund’s net asset value, maintain fund records, process investor transactions, 

handle fund accounting and perform other services.31 An offshore hedge fund sponsor typically

appoints a board of directors to provide oversight activities for the fund. These funds, especially

those formed more recently, may have directors who are independent of the investment adviser. 

 

28 See Roundtable Transcript, May 14 (statement of Richard Lindsey). See infra Part IV.E.2 

(discussing the role of broker-dealers/prime brokers). 

29 Under U.S. income tax laws, a tax-exempt organization (such as an ERISA plan, a foundation or 

an endowment) engaging in an investment strategy that involves borrowing money is liable for a 

tax on “unrelated business taxable income” (“UBTI”), notwithstanding its tax-exempt status. The 

UBTI tax can be avoided by the tax-exempt entity by investing in non-U.S. corporate structures 

(i.e., offshore hedge funds). See

http://www.greencompany.com/HedgeFunds/OffDocOffshore.shtml.

30 Lins, supra note 26 at 100. 

31 According to one Roundtable participant, there is a “trend towards more independent 

administration for domestic [hedge] funds, which traditionally have handled administration 

through fund affiliates.” Roundtable Transcript, May 14 (statement of William Keunen). See

also Roundtable Transcript, May 14 (statement of Joel Press). See infra Part IV.E.3 (discussing

the role of offshore administrators). 

10
III. The Regulation of Hedge Funds and Their Advisers 

A. Hedge Funds and the Investment Company Act of 1940 

Most hedge funds have substantial investments in securities that would cause them to fall 

within the definition of investment company under the Investment Company Act.32 Hedge 

funds, however, typically rely on one of two statutory exclusions from the definition of 

investment company, which enables them to avoid the regulatory provisions of that Act. 

1. Section 3(c)(1) 

Section 3(c)(1) of the Investment Company Act excludes from the definition of 

investment company any issuer whose outstanding securities (other than short-term paper) are

beneficially owned by not more than 100 investors and which is not making and does not 

presently propose to make a public offering of its securities.33 In general, ownership by a 

corporate investor is counted as one investor in testing compliance with the 100-investor 

limitation of Section 3(c)(1).

34 Section 3(c)(1) reflects Congress’s view that privately placed 

 

32 Section 3(a)(1)(A) of the Investment Company Act defines an investment company as an issuer 

which is or holds itself out as being engaged primarily, or proposes to engage primarily, in the 

business of investing, reinvesting or trading in securities. Section 3(a)(1)(C) of that Act defines 

an investment company as an issuer that is engaged or proposes to engage in the business of 

investing, reinvesting, owning, holding or trading in securities, and owns or proposes to acquire 

investment securities having a value exceeding 40 percent of the value of its total assets 

(exclusive of government securities and cash items) on an unconsolidated basis. Many hedge 

funds meet both of these definitions. 

33 Notwithstanding the 100-investor limitation, a hedge fund that is incorporated offshore, but relies 

on Section 3(c)(1) in order to offer its securities privately to U.S. residents, may have more than 

100 investors. The staff of the Division of Investment Management takes the position that an 

offshore hedge fund that relies on Section 3(c)(1) may exclude non-U.S. investors in determining

whether it is in compliance with the 100-investor limitation of Section 3(c)(1). See Touche, 

Remnant & Co. (pub. avail. Aug. 27, 1984); Investment Funds Institute of Canada (pub. avail. 

Mar. 4, 1996) (staff states that it would not recommend enforcement action if an offshore hedge 

fund relying on Section 3(c)(1) exceeds the 100-investor limit because investors who purchased 

securities outside the United States have relocated to the United States). In practice, many

offshore hedge funds relying on Section 3(c)(1) have more than 100 investors. 

34 If a corporate investor that is a registered investment company, or a company relying on Section 

3(c)(1) or Section 3(c)(7), beneficially owns ten percent or more of the outstanding voting

securities of the Section 3(c)(1) fund, the Section 3(c)(1) fund must “look-through” that corporate 

investor and count each of its investors as a beneficial owner of the Section 3(c)(1) fund for 

purposes of the 100-investor limitation. A hedge fund that relies on Section 3(c)(1) and that 

accepts investments from registered investment companies or entities relying on Section 3(c)(1) 

11
investment companies owned by a limited number of investors do not rise to the level of federal 

interest under the Investment Company Act.35

Hedge funds relying on Section 3(c)(1) may not be making or proposing to make a public 

offering. As discussed further below, these hedge funds must comply with Section 4(2) of the 

Securities Act, and frequently do so by relying on the safe harbor available under Regulation D 

under that Act, as discussed below.36 Consequently, hedge funds may offer their securities only

to “accredited investors,” and may not engage in any general solicitation or general advertising

of their shares, as discussed below. 

2. Section 3(c)(7)

Section 3(c)(7) of the Investment Company Act excludes from the definition of 

investment company any issuer whose outstanding securities are owned exclusively by persons 

who, at the time of acquisition of such securities, are “qualified purchasers,”37 and which is not 

 

or Section 3(c)(7), therefore, must ensure that those investors do not acquire more than ten 

percent of the hedge fund’s outstanding voting securities so that the hedge fund may continue to 

rely on Section 3(c)(1). 

35 See Investment Trusts and Investment Companies: Hearings on S. 3580 before a Subcomm. of 

the Senate Comm. on Banking and Currency, 76th Cong., 3d Sess. 179 (1940). 

36 See infra Part III.B.2 (discussing Regulation D). The staff of the Division of Investment 

Management generally interprets the non-public offering requirement of Section 3(c)(1) 

consistently with the non-public offering exemptions under Section 4(2) of the Securities Act and 

the rules thereunder. See, e.g., Santa Barbara Securities (pub. avail. Apr. 8, 1983). See also

Lamp Technologies (pub. avail. May 29, 1997; May 29, 1998) (“Lamp”).

37 Section 2(a)(51) of the Investment Company Act generally defines “qualified purchaser” to be: 

(1) any natural person who owns not less than $5 million in investments; (2) any family-owned 

company (as described in that section) that owns not less than $5 million in investments; (3) any

other trust the trustee and settlor(s) of which are qualified purchasers that was not formed for the 

specific purpose of acquiring the securities of the Section 3(c)(7) fund; and (4) any person acting

for its own account or the accounts of other qualified purchasers, that owns and invests on a 

discretionary basis not less than $25 million in investments. Rule 2a51-1 under the Investment 

Company Act defines the term “investments” for purposes of Section 2(a)(51), and details how 

the value of a qualified purchaser’s investments should be calculated. Rule 2a51-3 under the 

Investment Company Act provides that any company may be deemed to be a qualified purchaser 

if each beneficial owner of the company’s securities is a qualified purchaser. The staff of the 

Division of Investment Management takes the position that a hedge fund that is incorporated 

offshore but relies on Section 3(c)(7) to offer its securities privately in the United States is not 

subject to the qualified purchaser requirements with respect to its investors who are non-U.S. 

residents. See Goodwin Proctor & Hoar (pub. avail. Feb. 28, 1997). 

12
making and does not at that time propose to make a public offering of its securities.38 This 

exclusion reflects Congress’s view that certain highly sophisticated investors do not need the 

protections of the Investment Company Act because those investors are in a position to 

appreciate the risks associated with pooled investment vehicles.39 

A hedge fund relying on Section 3(c)(7) may accept an unlimited number of qualified 

purchasers for investment in the fund. As a practical matter, however, most funds relying on 

Section 3(c)(7) have no more than 499 investors in order to avoid the registration and reporting

requirements of the Securities Exchange Act of 1934 (“Exchange Act”).40 In addition, unlike 

Section 3(c)(1), Section 3(c)(7) does not have a “look-through” provision in the event that a 

registered investment company or a private investment company owns ten percent or more of the 

Section 3(c)(7) fund’s outstanding voting securities. A Section 3(c)(7) fund is only required to 

look through any company (investment company or otherwise) that invests in its shares to 

determine whether that company’s investors are qualified purchasers if the company was 

“formed for the purpose” of investing in the Section 3(c)(7) fund.41 

B. Hedge Funds and the Securities Act of 1933 

One of the Securities Act’s primary objectives is to provide full and fair disclosure in 

securities transactions. To accomplish this objective, Section 5 of the Securities Act mandates 

the registration with the Commission of public securities offerings and the delivery to purchasers 

of a prospectus containing specified categories of information about the issuer and the securities 

being offered, unless there is an available exemption from the registration requirements. Since 

limited partnership, LLC and other interests offered to investors in the case of a typical hedge

fund fall within the definition of the term “securities” for purposes of the federal securities laws, 

the hedge funds must either register the offer and sale of the securities or rely on an exemption 

 

38 As with respect to a Section 3(c)(1) fund, the Commission has stated that the non-public offering

requirement of Section 3(c)(7) should be interpreted consistently with the non-public offering

exemptions under Section 4(2) of the Securities Act and the rules thereunder. Privately Offered 

Investment Companies, Investment Company Act Release No. 22597 n. 5 (Apr. 3, 1997). See

supra note 36. 

39 S. Rep. No. 293, 104th Cong., 2d. Sess. 10 (1996) (“Generally, these investors can evaluate on 

their own behalf matters such as the level of a fund’s management fees, governance provisions, 

transactions with affiliates, investment risk, leverage, and redemption rights.”). 

40 See infra Part III.C.2 (discussing Exchange Act registration under Section 12).

41 Rule 2a51-3 generally provides, in relevant part, that an entity may not be deemed to be a 

qualified purchaser if it was formed for the specific purpose of acquiring the securities offered by

a Section 3(c)(7) fund unless each beneficial owner of an entity’s securities is a qualified 

purchaser. 

13
from registration. Offerings of hedge fund securities in the United States generally rely on the 

private offering exemption in Section 4(2) of the Securities Act or Rule 506 promulgated under 

that Section to avoid the registration and prospectus delivery requirements of Section 5. 

1. The Private Offering Exemption of the Securities Act 

Section 4(2) of the Securities Act exempts from the registration and prospectus delivery

requirements of Section 5 any “transactions by an issuer not involving any public offering.” The 

Section 4(2) exemption, commonly known as the “private offering” or “private placement” 

exemption, requires no notice or other filing or regulatory approval as a prerequisite for its 

availability. 

The procedures appropriate to establish the availability of an exemption under Section 

4(2) have evolved over time based upon judicial decisions, Commission interpretive guidance 

and shared experience. The Supreme Court in Ralston Purina stated that a private offering is an 

“offering to those who are shown to be able to fend for themselves” and that the availability of

the exemption “turns on the knowledge of the offerees” and is limited to situations where the 

offerees have access to the kind of information afforded by registration under Section 5 of the 

Securities Act.42 

2. Regulation D 

a. Rule 506 

Rule 506 of Regulation D under the Securities Act is a set of requirements promulgated 

by the Commission to govern private offerings. Although compliance with the Rule 506 

requirements is not required to establish the availability of a private offering exemption, 

satisfaction of the conditions of the rule entitles an issuer to claim the Section 4(2) exemption. In

this sense, Rule 506 establishes “safe harbor” criteria for the private offering exemption, but is 

not the exclusive means of establishing entitlement to the exemption. Because of a degree of 

uncertainty as to the availability of the Section 4(2) exemption, many hedge funds tailor their 

offering and sale procedures to the criteria specified in Rule 506. 

b. Offerings to “Accredited Investors” 

The safe harbor protection most often relied upon by hedge funds under Rule 506 

exempts offerings that are made exclusively to “accredited investors.”43 Issuers are permitted 

 

42 SEC v. Ralston Purina Co., 346 U.S. 119, 125, 126-27 (1953).

43 While Rule 506(b)(2)(i) limits the number of purchasers in a Rule 506 transaction to 35, this 

numerical limitation becomes irrelevant if the offering is made only to “accredited investors” 

14
under these provisions to sell securities to an unlimited number of “accredited investors.”44 In

addition, if the offering is made only to accredited investors, no specific information is required 

to be provided to prospective investors.

 The term “accredited investors” is defined to include:

Individuals who have a net worth, or joint worth with their spouse, above 

$1,000,000, or have income above $200,000 in the last two years (or joint income 

with their spouse above $300,000) and a reasonable expectation of reaching the 

same income level in the year of investment; or are directors, officers or general 

partners of the hedge fund or its general partner; and 

Certain institutional investors, including: banks; savings and loan associations; 

registered brokers, dealers and investment companies; licensed small business 

investment companies; corporations, partnerships, limited liability companies and 

business trusts with more than $5,000,000 in assets; and many, if not most, 

employee benefit plans and trusts with more than $5,000,000 in assets.45

Although most of these thresholds were initially established in 1982, the Commission has 

modified the definition of accredited investor since then and has had the opportunity to 

reevaluate the thresholds.46 Most recently, the Commission, in December 2001, proposed that 

the term “qualified purchaser” be defined under the Securities Act to mean “accredited investor” 

as defined in Rule 501(a) of Regulation D under the Securities Act.47 At that time, the

 

because Rule 501(e)(1)(iv) provides that “accredited investors” are not counted for purposes of 

determining whether the issuer has exceeded the 35-purchaser limit. 

44 On its face, Rule 506 appears to permit offerings to hundreds of investors, as long as no more 

than 35 purchasers are not accredited investors. In the original proposing release for Regulation 

D, the Commission indicated that it was aware of this potential and issued this warning:

The Commission cautions issuers . . . that depending on the actual circumstances, 

offerings made to such large numbers of purchasers may involve a violation of the 

prohibitions against general solicitation and general advertising.

Proposed Revisions of Certain Exemptions, Securities Act Release No. 6339 n. 30 (Aug. 7, 1981). 

45 See Rule 501 under the Securities Act. 

46 See Defining the Term “Qualified Purchaser” Under the Securities Act of 1933, Securities Act 

Release No. 8041 (Dec. 19, 2001) (history of accredited investor concept). 

47 Id. 

15
Commission stated in the proposing release that the existing “accredited investor” standard 

struck the appropriate balance between investor protection and capital formation needs and did 

not propose changes to the definition. 

c. General Solicitation and General Advertising 

Offers and sales under Rule 506 cannot be made using any form of “general solicitation 

or general advertising.” The current parameters of prohibited and permissible activities are set 

out in Rule 502(c) under the Securities Act, Commission staff no action letters, Commission 

releases and enforcement and private actions. The restrictions on general solicitation and general 

advertising in finding investors for private offerings mean that issuers and persons acting on their 

behalf cannot find investors through, among other things, advertisements, articles, notices or 

other communications published in a newspaper, magazine or similar media, cold mass mailings, 

broadcasts over television or radio, material contained on a web site available to the public or an 

e-mail message sent to a large number of previously unknown persons.48 The restrictions also 

apply to any meeting or seminar where the participants have been invited by general solicitation 

or general advertising.

One central principle in the interpretations is that general solicitation is not present when

there is a pre-existing, substantive relationship between an issuer or its broker-dealer, and the 

offeree. The relationship must be established at a time prior to the commencement of the private

offering or, in the case of a hedge fund, 30 days before the investor can make an investment.49 

The existence of a pre-existing, substantive relationship is not the only way to avoid a general 

solicitation. The presence or absence of a general solicitation depends on the facts and 

circumstances of each particular case. 

 

48 See Rule 506 under the Securities Act; SEC v. Inorganic Recycling Corp., Litigation Release No. 

16322 (Sept. 30, 1999); In the Matter of CGI Capital, Inc., Securities Act Release No. 7904 

(Sept. 29, 2000); In the Matter of Harry Harootunian and Professional Planning & Technologies, 

Inc. and In the Matter of Robert Testa, Exchange Act Release No. 32981 (Sept. 29, 1993); In the 

Matter of Kenman Corp., Exchange Act Release No. 21962 (Apr. 19, 1985); In the Matter of 

PriorityAccess, Inc., Securities Act Release No. 8021 (Oct. 3, 2001); Circle Creek Aquaculture V, 

L.P. (pub. avail. Mar. 26, 1993); H.B. Shaine & Co. (pub. avail. May 1, 1987); Ovation 

Cosmetics, Inc. (pub. avail. Mar. 8, 1976); Woodtrails-Seattle, Ltd. (pub. avail. Aug. 9, 1982).

49 Many of the interpretive letters that the staff of the Division of Corporation Finance has issued 

address the circumstances under which issuers and broker-dealers can establish the pre-existing

substantive relationship without violating the restrictions on general solicitation and advertising. 

See, e.g., Bateman Eichler, Hill Richards, Inc. (pub. avail. Dec. 3, 1985); E.F. Hutton Co. (pub. 

avail. Dec. 3, 1985); IPONET (pub. avail. July 26, 1996) (“IPONET”); Lamp, supra note 36.

16
With respect to online private offerings under Regulation D, the Commission has stated 

that “[b]road use of the Internet for exempt securities offerings under Regulation D is 

problematic because of the requirement that these offerings not involve a general solicitation or 

advertising.”

50 The Commission and staff, on numerous occasions, have made clear how the 

Internet can be used in private offerings of securities without running afoul of the prohibitions on 

general solicitation and general advertising.

51 The staff of the Division of Corporation Finance 

has granted no action relief where a broker-dealer, on behalf of other issuers, solicited, prequalified and made offers to potential investors via the Internet.52 In a letter involving hedge 

funds, the staff of the Division of Corporation Finance determined that there was no general 

solicitation if investors were solicited, pre-qualified and able to access a password protected web 

site containing information on hedge funds to purchase hedge fund interests 30 days after the 

investor was qualified.53

d. Resale Restrictions 

Hedge funds relying on Rule 506 must exercise reasonable care to assure that their 

investors are not investing with a view to distributing their interests in the fund to the public. 

Unrestricted resales of the interests can jeopardize the availability of Rule 506 protection even if 

the original sales qualify for the protection. Rule 506 provides safe harbor protection for issuers 

against the loss of Rule 506 protection because of resales.54 The conditions for the safe harbor 

include “reasonable inquiry to determine if the purchaser is acquiring the securities for himself or 

for other persons” and “written disclosure . . . that the securities . . . cannot be resold unless they

are registered under the [Securities] Act or unless an exemption from registration is available.”55 

 

50 Use of Electronic Media, Securities Act Release No. 7856 (Apr. 28, 2000) (“2000 Electronic 

Release”). 

51 Use of Electronic Media for Delivery Purposes, Securities Act Release No. 7233 (Oct. 6, 1995); 

Statement of the Commission Regarding Use of Internet Web Sites to Offer Securities, Solicit 

Securities Transactions or Advertise Investment Services Offshore, Securities Act Release No. 

7516 (Mar. 23, 1998); 2000 Electronic Release, supra note 50; IPONET, supra note 49; Lamp, 

supra note 36. 

52 IPONET, supra note 49. 

53 Lamp, supra note 36. The staff of the Division of Corporation Finance also has addressed general 

solicitation issues in the context of other privately offered funds. See Royce Exchange Fund, 

Quest Advisory Corp. (pub. avail. Aug. 28, 1996). 

54 Rule 502 under the Securities Act is incorporated into Rule 506 under the Securities Act. 

55 Rule 502(d) under the Securities Act.

17
In addition, the safe harbor is conditioned upon the placement of a legend on the certificate or 

other document that evidences the securities. 

These resale restrictions ordinarily do not present a problem for hedge funds. For a 

variety of business and legal reasons, the principals of hedge funds normally have no interest in 

encouraging resale of interests in their funds. In the usual case, therefore, transfers of the 

interests are prohibited without the written consent of the general partner or other manager, and 

there is limited liquidity of the interests through sales and redemptions by the hedge funds. 

C. Hedge Funds and the Securities Exchange Act of 1934 

1. Definition of “Broker” and “Dealer” 

Some hedge funds may need to register with the Commission as dealers. Section 3(a)(5) 

of the Exchange Act generally defines a dealer as a person that is engaged in the business of 

buying and selling securities for its own account. The Commission historically has distinguished 

“dealers” from “traders.” A trader is a person that buys and sells securities, either individually or

in a trustee capacity, but not as part of a regular business. Entities that buy and sell securities for

investment generally are considered traders, but not dealers. In contrast to dealers, which must 

register with the Commission in accordance with Section 15(b) of the Exchange Act, there is no 

registration requirement for traders.56 

2. Exchange Act Registration Under Section 12 

The Exchange Act contains registration and reporting provisions that may apply to hedge 

funds. Section 12 of the Exchange Act and the rules promulgated thereunder govern the 

registration of classes of equity securities traded on an exchange or meeting the holder of record

and asset tests of Section 12(g) and related rules. Section 12(g) and Rule 12g-1 thereunder 

require that an issuer having 500 holders of record of a class of equity security (other than an 

exempted security) and assets in excess of $10 million at the end of its most recently ended fiscal 

year register the equity security under the Exchange Act. Registration of a class of equity

security subjects domestic registrants to the periodic reporting requirements of Section 13, proxy

requirements of Section 14 and insider reporting and short swing profit provisions of Section 16 

of the Exchange Act. Although hedge fund interests fall within the definition of equity security

 

56 See generally Testimony of Richard R. Lindsey, Director, Division of Market Regulation, U.S. 

Securities and Exchange Commission, Concerning Hedge Fund Activities in the U.S. Financial 

Markets, Before the House Committee on Banking and Financial Services (Oct. 1, 1998); 

Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning 

Hedge Fund Activities in the U.S. Financial Markets, Before the House Committee on Banking,

Finance and Urban Affairs (Apr. 13, 1994). See also Davenport Management, Inc. (pub. avail. 

Apr. 13, 1993); Louis Dreyfus Corp. (pub. avail. July 23, 1987). 

18
under the Exchange Act, most hedge funds seek to avoid Exchange Act registration by having

fewer than 500 holders of record (which in the case of hedge funds are also generally the 

investors). 

3. Beneficial Ownership Reporting under Sections 13 and 16 of the Exchange 

Act 

The beneficial ownership reporting rules under Sections 13(d) and 13(g) of the Exchange

Act generally require that any person who, after acquiring beneficial ownership of any equity

securities registered under Section 12 of the Exchange Act, beneficially owns greater than five 

percent of the class of equity securities, file a beneficial ownership statement containing the

information required by Schedule 13D or Schedule 13G.57 Beneficial ownership is broadly

defined by Rule 13d-3 under the Exchange Act to include the power to vote or dispose of any

equity securities, or the power to direct the voting or disposition of those securities. Due to the

power a hedge fund’s adviser may exercise over the equity securities held by the fund, both the 

hedge fund and its adviser generally will be deemed to beneficially own any equity securities 

owned by the hedge fund.58 In certain specified circumstances, the hedge fund and its advisers 

may file a short form Schedule 13G in lieu of filing a Schedule 13D.59

In addition to the amount of equity securities beneficially owned by the reporting person 

and the percentage of the subject class of equity securities this amount represents, Schedule 13D 

requires disclosure of certain other material information regarding the reporting person (e.g., 

identity and background) and the acquisition of the securities (e.g., source and amount of funds 

or other consideration used or to be used in making the purchase; the purpose of the acquisition; 

contracts, arrangements, understandings or other relationships between the reporting persons 

with respect to any securities of the issuer, etc.). The information required to be disclosed by

Schedule 13G is more limited than the information required to be disclosed by Schedule 13D.60 

Once a hedge fund and its advisers are subject to the reporting obligations of Sections 13(d) or 

 

57 See Rule 13d-1(a) under the Exchange Act. 

58 See Example 11 from Adoption of Beneficial Ownership Disclosure Requirements, Exchange Act 

Release No. 13291 (Feb. 24, 1977) (power over discretionary accounts represents beneficial 

ownership of the shares held in those accounts). 

59 See Rule 13d-1(b) under the Exchange Act. 

60 For example, Schedule 13G does not require as much disclosure on the background of the 

reporting person, does not require any disclosure as to the source of the funds used in the 

transaction, and does not require a statement as to the purpose of the transaction (other than a 

certification that the purpose is not to change or influence control over the issuer). See

Instructions to Schedule 13G. 

19
13(g), previously filed beneficial ownership statements must be amended as a result of certain 

changes in the information disclosed.61

In addition, hedge fund advisers also may be subject to the quarterly reporting obligations 

of Section 13(f) of the Exchange Act, which apply to any “institutional investment manager” 

exercising investment discretion with respect to accounts having an aggregate fair market value 

of at least $100 million in equity securities. An “institutional investment manager” includes any

person (other than a natural person) investing in or buying and selling securities for its own 

account, and any person exercising investment discretion with respect to the account of any other 

person.62

Section 16 applies to every person who is the beneficial owner of more than ten percent 

of any class of equity security registered under Section 12 of the Exchange Act and each officer 

and director of the issuer of the security (collectively, “reporting persons” or “insiders”). Upon 

becoming a reporting person, a person is required by Section 16(a) to file an initial report with 

the Commission disclosing the amount of his or her beneficial ownership of all equity securities 

of the issuer. Section 16(a) also requires reporting persons to keep this information current by

reporting to the Commission changes in ownership of these equity securities, or the purchase or

sale of security-based swap agreements involving these securities.63 Hedge funds are also 

subject to the short swing profit provisions of Section 16(b) of the Exchange Act.

D. Hedge Fund Advisers and the Investment Advisers Act of 1940 

Virtually all hedge fund advisers meet the definition of “investment adviser” under the 

Advisers Act.64 Under the Advisers Act, investment advisers must register with the Commission 

and comply with the provisions of that Act and Commission rules. Registered investment 

advisers must keep current a Form ADV that is filed with the Commission and provide a 

 

61 See Rule 13d-2 under the Exchange Act. 

62 See Section 13(f)(5)(A) of the Exchange Act. 

63 See Section 16(a)(3)(B) of the Exchange Act.

64 Section 202(a)(11) of the Advisers Act generally defines an investment adviser as “any person 

who, for compensation, engages in the business of advising others, either directly or through 

publications or writings, as to the value of securities or as to the advisability of investing in, 

purchasing, or selling securities, or who, for compensation and as part of a regular business, 

issues or promulgates analyses or reports concerning securities.” The Advisers Act contains 

certain limited exceptions from this definition for banks, certain professionals, including lawyers 

and accountants, broker-dealers, publishers and persons giving advice only about U.S. 

government securities. 

20
disclosure statement that includes the information disclosed on Part II of Form ADV to clients.65 

These disclosures provide both the Commission and investors with current information about the 

adviser’s business practices and disciplinary history, among other things. Registered advisers 

must maintain required books and records66 and submit to periodic examinations by the

Commission’s staff. Advisers registered with the Commission also must comply with other

requirements, including those relating to safeguarding client assets that are in the adviser’s

custody67 and requiring that clients be told of an adviser’s adverse financial condition.68 

Registered investment advisers must also inform clients of the adviser’s proxy voting practices.69 

The Advisers Act also prohibits them from defrauding their clients.70 

Many hedge fund advisers, however, avoid registering with the Commission by relying

on the Advisers Act’s de minimis exemption under Section 203(b) of that Act. That section 

excludes from registration investment advisers that have had fewer than 15 clients during the 

preceding 12 months, do not hold themselves out generally to the public as an investment adviser 

and are not an investment adviser to a registered investment company.

71 For purposes of Section 

203(b), current Commission rules provide that investment advisers may count a “legal 

organization,” such as a hedge fund, as a single client.72 Thus, an adviser may manage up to 14 

hedge funds before being required to register with the Commission as an investment adviser, so 

long as it satisfies the “no holding out” condition. Investment advisers that are exempt from 

registration nevertheless are subject to the antifraud provisions of the Advisers Act. 

 

65 See Rule 204-3 under the Advisers Act. 

66 See Rule 204-2 under the Advisers Act. 

67 See Rule 206(4)-2 under the Advisers Act. 

68 See Rule 206(4)-4 under the Advisers Act. 

69 See Rule 206(4)-6 under the Advisers Act. 

70 Section 206(1) of the Advisers Act prohibits investment advisers from employing “any device, 

scheme or artifice to defraud any client or prospective client.” Section 206(2) of the Advisers Act 

prohibits and investment adviser from engaging “in any transaction, practice or course of business 

which operates as a fraud or deceit upon any client or prospective client.” 

71 Section 203(b)(3) of the Advisers Act. 

72 Rule 203(b)(3)-1 under the Advisers Act provides that an adviser may count a legal organization 

as a single client if the legal organization receives investment advice based on its investment 

objectives rather than on the individual investment objectives of its owners. 

21
Registered investment advisers are not required to indicate whether they manage hedge 

funds. They are also not required to state the amount of hedge fund assets under their 

management. A recent survey identifying the largest hedge fund firms accounts for slightly

under half of the estimated $600 billion in U.S. hedge fund assets.73 Approximately 52 percent 

of the domestic advisers in this survey, managing some $158 billion of hedge fund assets, are not 

registered with the Commission as investment advisers.74 There is no comprehensive database or 

survey of the smaller firms managing the other half of U.S. hedge fund assets – approximately

another $300 billion. We expect that relatively fewer of these smaller advisers would be 

registered with the Commission, and that the proportion of hedge fund advisers not registered 

with us industry-wide may be approximately two-thirds.75 

A number of hedge fund advisers, however, do register as investment advisers under the 

Advisers Act. Some are required to register because they have 15 or more advisory clients, or 

they advise one or more registered investment companies, and therefore are ineligible for the de 

minimis exemption. Others have registered with the Commission voluntarily because their 

investors demand it or for competitive reasons.76 

 

73 See Institutional Investor, The Hedge Fund 100 (June 2002) (“The Hedge Fund 100”) (The 

survey lists 86 U.S.-based and U.S.-registered firms managing $298 billion in hedge fund assets. 

It also covered 14 internationally based firms managing approximately $42 billion in hedge fund 

assets.). 

74 Forty-eight percent of the domestic hedge fund advisers listed in The Hedge Fund 100 are 

registered with the Commission and manage a total of $140 billion in hedge funds. 

75 This expectation is based on our assumption that smaller hedge fund advisers who are not named 

in The Hedge Fund 100 are more likely to operate without registering with the Commission than 

larger hedge fund advisers. Larger hedge fund advisers are more likely to serve investors who 

demand registration, such as pension plans and many endowments, or to engage in other advisory

activities such that the adviser is no longer eligible for the exception under Section 203(b)(3). 

76 Hennessee Group Comment Letter, supra note 4, at 14 (“Due to market forces predominantly

driven by trust and ERISA fiduciaries, hedge funds are finding it necessary to become Registered 

Investment Advisers in order to attract capital from that market.”); Roundtable Transcript, May

15 (statement of Sandra Manzke) (institutional investors are requiring that hedge fund advisers 

register). See also U.S. Hedge Fund Regulations Might Help Industry in Long Run, Reuters 

English News Service (May 24, 2002) (“We registered with the SEC because it was simply easier 

to say that we were registered. A few fraud cases have gotten attention and when someone writes 

a $10 million check, they want some assurances.” (Quoting Jerry Paul of Quixote Capital 

Management LLC)). 

22
E. Certain Other Regulatory Requirements 

Depending upon their activities, in addition to complying with the federal securities laws, 

hedge funds and their advisers may have to comply with other laws including the Commodity

Exchange Act (“CEA”), rules promulgated by the National Association of Securities Dealers 

(“NASD”) and/or provisions of the Employment Retirement Income Security Act (“ERISA”). In

addition, hedge funds may be subject to certain regulations promulgated by the Department of 

the Treasury, including rules relating to the prevention of money laundering. Moreover, hedge 

fund advisers are subject to certain state laws. 

1. Regulation under the CEA 

Generally, a hedge fund that engages in even a single commodity futures transaction will 

be deemed to be a “commodity pool” by the CFTC.77 Similarly, the person that organizes and 

provides futures advice to such a hedge fund will typically fall within the statutory definitions of 

“Commodity Pool Operator” (“CPO”) and “Commodity Trading Advisor” (“CTA”), 

respectively.

78 An adviser to a hedge fund that uses commodity futures typically acts as both a 

CPO and a CTA to that hedge fund. However, as noted below, most hedge fund advisers can 

now claim an exemption from registration as a CPO and CTA pursuant to exemptions that were 

recently adopted by the CFTC. 

Once an adviser falls within the definition of CPO or CTA, it generally must register as 

such with the CFTC.79 Registered CPOs and CTAs must comply with CFTC rules that impose 

disclosure, record keeping and periodic reporting requirements.80 In addition, registered CPOs 

and CTAs must complete an annual self-audit and must submit to periodic audits conducted by

 

77 See CFTC Interpretive Letter 98-18 (Mar. 12, 1998). 

78 See Section 1a(5) of the CEA (defining CPO); Section 1a(6)(A) of the CEA (defining CTA). A 

hedge fund adviser generally will not fall within the definition of CPO or CTA if it invests only in 

swaps, forward contracts or synthetic futures. These investments provide the same investment 

exposure as futures, but generally are not subject to regulation under the CEA. 

79 See Section 4m(1) of the CEA. A person generally registers with the CFTC as a CPO or a CTA

by filing a completed Form 7-R and certain supporting materials with the National Futures 

Association (“NFA”), the self-regulatory organization governing the commodities markets. 17 

C.F.R. Section 3.10. 

80 See Rules 4.21 through 4.26 under the CEA (rules applicable to CPOs), and Rules 4.31 through 

4.36 under the CEA (rules applicable to CTAs). 

23
the NFA.81 All registered CPOs and CTAs are subject to the CEA’s general antifraud rules,82 as 

well as specific client protection, advertising and position reporting rules.83 

As a result of recent CFTC rule adoptions, many hedge fund advisers can now qualify for 

exemptions from CPO and CTA registration. Regulations under the CEA provide an exemption 

from registration to CPOs operating pools that engage in limited commodity futures activities 

and sell interests solely to certain qualified individuals.84 Regulations under the CEA also 

provide an exemption from registration to CPOs that operate pools that sell interests to certain 

highly sophisticated pool participants.85 Investment advisers to hedge funds that operate in 

reliance upon Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act may be able to 

rely upon one of these CFTC exemptions.86 In addition, the CEA provides a de minimis

 

81 See Interpretive Notice, NFA Compliance Rule 2-9 (July 4, 2000). Audits conducted by the NFA 

are designed to determine whether a firm is maintaining records in accordance with applicable 

CFTC and NFA rules, and to ensure that the firm is being operated in a manner that protects 

investors in the commodity futures markets. Although the NFA’s audits may include a review of 

non-commodities, the emphasis of these audits is on reviewing commodities futures issues. See, 

e.g., Roundtable Transcript, May 15 (statement of Jane Thorpe) (stating that the NFA conducts its 

audits using “a risk-based approach [and] is going to focus on those areas that obviously it has the 

most and we have the most interest in.”). 

82 See Section 4o of the CEA (general antifraud provision similar to Section 206(1) and Section 

206(2) of the Advisers Act) and CFTC Rule 32.9 (prohibiting fraud in connection with 

commodity option transactions). See also Section 4b of the CEA (prohibiting fraudulent or 

misleading contracts) and CFTC Rule 4.15 (stating that Section 4o continues to apply to persons 

that are exempt from registration as a CTA or CPO). 

83 See Rules 4.20 and 4.30 under the CEA (governing segregation of pool assets and prohibited 

CTA activities, respectively); Rule 4.41 under the CEA (governing advertising by CPOs, CTAs

and the principals thereof); Rule 18.04 under the CEA (requiring traders who hold or control 

reportable positions in futures, or options on futures, to file a “Statement of Reporting Trader” on 

Form 40 with the CFTC upon receipt of a special call by the CFTC). 

84 See CFTC Rule 4.13(a)(3) (exempting pools that privately place ownership interests to 

“accredited investors” as defined in Rule 501 of Regulation D of the Securities Act, and to certain 

other special groups of purchasers, provided that the pool, among other things, complies with 

certain limits on margin and notional value of the fund’s commodity interests). This rule 

amendment took effect on August 8, 2003. 

85 See CFTC Rule 4.13(a)(4) (exempting pools that privately place ownership interests to certain 

highly sophisticated persons, including natural persons that are “qualified purchasers,” as defined 

in Section 2(a)(51) of the Investment Company Act). This rule was recently adopted by the 

CFTC and became effective on August 8, 2003. 

86 Approximately 50 percent of the roughly 1,800 registered CPOs are eligible to deregister with the 

CFTC in reliance upon CFTC Rules 4.13(a)(3)-(4). See Roundtable Transcript, May 15 

24
exemption from CTA registration that is similar to the Investment Advisers Act’s de minimis

exemption from investment adviser registration.87 Consequently, hedge fund advisers that are 

exempt from registration as an investment adviser also are usually exempt from registration as a 

CTA.

88 Hedge fund advisers that meet the definition of CPO or CTA, but that are exempt from 

registration as such, are required to keep books and records, but are not subject to disclosure, 

periodic reporting or audit requirements that apply to a registered CPO or a registered CTA.89 

2. NASD Regulation 

a. Suitability Determinations 

Broker-dealers that sell interests in hedge funds are subject to the requirements of NASD 

rules, which regulates sales practices of its members, including certain suitability matters. The

NASD recently issued a Notice to Members to remind them of their obligations when selling

hedge funds and funds of hedge funds.90 The Notice to Members was issued in response to the 

NASD’s recent review of its broker-dealer members when recommending an investment in

 

(statement of Jane Thorpe). As of May 2003, the CFTC had received 290 notices claiming the 

CFTC no action relief that was subsequently codified as CFTC Rule 4.13(a)(3). See id. It is 

difficult to ascertain whether these CPOs are new participants in the commodity markets or 

whether they are existing, registered CPOs that deregistered after claiming this relief. 

87 See Section 4m(1) of the CEA (providing exemption from registration for CTAs with 15 or fewer 

clients). See also CFTC Rule 4.14(a)(10) (counting certain business organizations as a single 

client for the purposes of the calculation required by Section 4m(1)). This rule amendment took

effect on August 8, 2003. 

88 CPOs that are registered, or exempt from registration, as CPOs are specifically exempted from

registration as CTAs. See CFTC Rules 4.14(a)(4) and 4.14(a)(5). As a result, only hedge fund 

advisers that are not CPOs, such as hedge fund sub-advisers, will typically need to rely upon the 

Section 4m(1) exemption. 

89 Certain CPOs and CTAs, although not exempt from registration, nevertheless enjoy relief from

many of the requirements applicable to registered entities. See CFTC Rule 4.7 (exempting

certain registered CPOs and CTAs from portions of the CEA’s operational requirements). In

order to obtain this relief, a CPO must sell interests in its commodity pool, and a CTA must 

provide advice, only to “qualified eligible persons,” as defined in the rule (e.g., qualified 

purchasers, as defined by Section 2(a)(51) of the Investment Company Act), or individual 

accredited investors who meet a specific commodity portfolio requirement set forth in CFTC

Rule 4.7(a)(1)(v). 

90 NASD Notice to Members 03-07, NASD Reminds Members of Obligations When Selling Hedge 

Funds (Feb. 2003). 

25
hedge funds or FOHFs.91 The NASD found that some broker-dealers may not be fulfilling their 

sales practice obligations under the NASD Rules, particularly when selling hedge funds and 

FOHFs to investors. 

The Notice to Members reminded broker-dealers of their obligations in the following five

areas:

• Promotion of Hedge Funds. Broker-dealers must balance sales material and 

oral presentations that promote hedge fund investing with disclosure of the 

risks and potential disadvantages that investing in these products may

present.

92 Broker-dealers must give potential investors any prospectus or 

disclosure document, but providing such a document does not by itself satisfy

the member’s duty to provide balanced sales materials and oral presentations.

• Reasonable-Basis Suitability. A broker-dealer that recommends a hedge fund, 

directly or indirectly, must believe that the hedge fund is suitable for any

investor. To satisfy this obligation broker-dealers must conduct due diligence 

regarding any hedge fund that they recommend to potential investors.93 

• Customer-Specific Suitability. A broker-dealer must believe that its 

recommendation to invest in a hedge fund product is suitable for that 

particular investor. To reach this determination, a broker-dealer must, in 

accordance with NASD Rule 2310, examine the investor’s financial status, tax

status and investment objectives, as well as any other pertinent information.94 

 

91 The NASD censured and fined a broker-dealer for failing to disclose the risks associated with 

hedge funds when marketing them to investors. See infra note 262 (discussing disciplinary action 

taken against Altegris Investments, Inc.). 

92 The NASD specifically stated, among other things, that broker-dealers “may not claim that hedge 

funds offer superior professional management with more investment flexibility [and] protection 

against declining markets . . . unless these statements are fair, accurate, and without 

exaggeration.” In addition, when disclosing the risks of hedge fund investing, the NASD stated 

that broker-dealers should specifically disclose (where applicable) that hedge funds can be 

illiquid, engage in leverage and other speculative practices, are not required to provide valuation 

information to investors, are not regulated like open-end investment companies, may raise 

complex tax issues and often charge high fees. 

93 This due diligence includes, but is not limited to, investigating the background of the hedge fund 

adviser, reviewing the offering memorandum and subscription agreements, examining references, 

and examining the relative performance of the fund. 

94 NASD Rule 2310. 

26
Whether an investor is an accredited investor for purposes of Regulation D 

under the Securities Act does not, by itself, satisfy the NASD’s suitability

requirements. 

• Internal Controls. A broker-dealer’s internal controls, including those relating

to compliance and supervision of associated persons, must ensure that the sale 

of hedge fund products comply with all NASD and Commission rules. 

• Training. Broker-dealers must train all associated persons about the features, 

risks and suitability of hedge funds products before such persons may

recommend investment in them. 

b. NASD Hot Issues Rule 

The NASD’s Free-Riding and Withholding Interpretation, IM-2110-1, governs the 

allocation of so-called “hot issues.”95 IM-2110-1 does not directly restrict a hedge fund’s ability

to acquire shares of a hot issue. However, it does prohibit an investment adviser to a hedge fund 

from acquiring shares of a hot issue through a personal account. Hedge fund advisers often have 

significant interests in the funds that they manage and the investment adviser’s interest in the 

hedge fund does not disqualify the fund itself from acquiring shares of a hot issue, provided that 

such acquisitions are part of the fund’s “normal investment practice,” and the notional pro rata

amount of hot issues acquired by the investment adviser through the fund is “insubstantial and 

not disproportionate in amount as compared to sales to members of the public.”96 

 

95 NASD IM-2110-1 defines “hot issue” as a public offering that trades at a premium in the 

secondary market whenever such secondary market trading begins. 

96 NASD IM-2110-1(b)(5). The NASD has filed a proposed rule change with the Commission that 

would amend the Interpretation in several respects. Under the proposal, all portfolio managers, 

including investment advisers to hedge funds, would be “restricted persons.” An account in 

which a restricted person had a beneficial interest generally would be prohibited from purchasing

hot issues. Thus, a hedge fund adviser would be prohibited from purchasing a hot issue through a 

personal account as well as for the account of the hedge fund because the beneficial interest in the 

hedge fund of even a single restricted person might disqualify the entire fund from purchasing hot 

issues. The NASD is proposing a de minimis exemption whereby a collective investment vehicle 

(such as a hedge fund) would be permitted to purchase shares of a hot issue, provided that the 

participation of restricted persons in the fund (the adviser, plus any other restricted persons) does 

not, among other things, exceed ten percent. Notice of Filing of Amendment Nos. 3 and 4 to a 

Proposed Rule Change by the National Association of Securities Dealers, Inc. Regarding 

Restrictions on the Purchase and Sale of Initial Public Offerings of Equity Securities, Exchange

Act Release No. 46942 (Dec. 4, 2002). The Commission has received comments from the hedge 

27
3. Regulation under ERISA 

An investment adviser to a hedge fund is an ERISA plan fiduciary if it exercises 

discretionary authority over the management of “plan assets.”97 The assets of a hedge fund are 

deemed to be “plan assets” if an ERISA plan’s investment in that hedge fund is “significant.” 

An ERISA plan’s investment is deemed to be significant if, immediately after the most recent 

acquisition of any equity interest in the hedge fund, more than 25 percent of the value of any

class of equity interests in the hedge fund is held collectively by the employee benefit plan 

investors.98 Many hedge fund advisers take measures to ensure that employee benefit plan 

investments in hedge funds do not exceed this 25 percent threshold in order to avoid being

subject to regulation as an ERISA fiduciary.

99 

Some hedge fund advisers, however, accept regulation under ERISA because they view 

ERISA plans as attractive investors for the hedge funds they advise. As a result, they permit the 

investment of significant amounts of employee plan assets in the hedge funds. Before investing

plan assets in such a hedge fund, however, the non-adviser ERISA plan fiduciary typically will 

require assurances from the hedge fund adviser that it will not be liable under ERISA for any

misconduct on the part of the hedge fund adviser in managing the plan assets. Generally, a 

hedge fund adviser can shield ERISA plan fiduciaries from liability for its misconduct by

registering as an investment adviser under the Advisers Act, and by qualifying as an “investment 

manager” under ERISA.100 

 

fund industry strongly opposing this approach. It has not yet taken final action on the NASD’s 

proposal. 

97 See Section 3(21)(A) of ERISA. Once an investment adviser is deemed to be an ERISA 

fiduciary, it is subject to ERISA’s provisions governing, among other things, prohibited 

transactions, fiduciary obligations and liability for the acts of co-fiduciaries. 

98 See Rule 3-101 under ERISA. 

99 The fund adviser will monitor the percentage of equity held by employee benefit plan investors 

on every purchase, redemption or transfer. Among other things, hedge funds may disclose in the 

private placement memorandum delivered to investors that they may deny a subscription, forcibly

redeem shares owned by benefit plan investors or refuse to recognize transfers that would cause 

the fund to reach the 25 percent limitation. 

100 An ERISA trustee generally will be insulated from co-trustee liability for actions taken by an 

“investment manager” that meets certain criteria established by the statute. See Section 405(d) of 

ERISA. In order to qualify as an “investment manager” for the purposes of ERISA, a hedge fund 

adviser generally must: (1) have the power to manage, acquire or dispose of plan assets; (2) be 

registered as an investment adviser under the Advisers Act; and (3) acknowledge in writing that it 

is a plan fiduciary. See Section 3(38) of ERISA. In lieu of being a federally registered 

28
4. Treasury Department Regulations 

a. Treasury Securities Position Reports 

Pursuant to authority granted by the Exchange Act, the Treasury Department has adopted 

rules that govern the reporting of large positions in U.S. Treasury securities by persons who 

participate in the government securities market, including registered investment advisers and 

hedge funds.101 Pursuant to these rules, the Treasury Department periodically provides notices 

of Treasury security issues for which large position information must be reported (“reportable 

position”) and the applicable large position threshold for that issue.102 Hedge funds that have a 

reportable position in a noticed government securities issue that is equal to or greater than the

large position threshold must file a report with the Federal Reserve Bank of New York 

(“FRBNY”) containing certain prescribed information relating to that issue of securities.103 

Hedge funds may also be required to make and keep certain records related to their large position 

reports.104

b. Foreign Currency Position Reports

The Treasury Department also requires weekly, monthly or quarterly reports from hedge 

fund advisers and other institutions (e.g., U.S. banks, brokers, dealers and registered investment 

company advisers) that hold more than a designated dollar equivalent threshold of foreign 

exchange contracts.105 Specifically, hedge funds that had more than the equivalent of $50 billion 

 

investment adviser, a person also generally may qualify as an “investment manager” under 

ERISA if it is a bank, insurance company or state registered investment adviser that files a copy

of its Form ADV with the Secretary of Labor each time it updates that document. Id. 

101 See Section 15C(f) of the Exchange Act (grant of rulemaking authority) and 17 C.F.R. pt. 420 

(2003) (rules adopted pursuant to grant of authority). 

102 See 17 C.F.R. § 420.3(a) (2003). To date, the Treasury has only issued test notices. See, e.g., 

Government Securities Act Regulations: Large Position Rules, 67 Fed. Reg. 77411 (Dec. 18, 

2002) (stating “[s]ince the rules became effective in 1997, we have conducted annual calls for 

reports to test the accuracy and reliability of large position reporting systems.”). The large 

position threshold is a dollar amount set by Treasury that is no less than $2 billion. See 17 C.F.R. 

§ 420.2(d) (2003).

103 See 17 C.F.R. § 420.3 (2003). 

104 See 17 C.F.R. § 420.4 (2003). 

105 See 31 U.S.C. § 5315 (reports on foreign currency transactions); 31 C.F.R. § 128 (reporting of 

international capital and foreign currency transactions and positions). The value of the contracts 

29
in foreign exchange contracts on the last business day of any calendar quarter during the 

previous year must file Form FC-1 on a weekly basis and Form FC-2 on a monthly basis with the 

FRBNY.106 The foreign currency reporting provisions provide information on the nature and 

source of flows of mobile capital with respect to six “specified currencies” (i.e., U.S. dollars, 

Euros, Swiss francs, U.K. pounds, Japanese yen and Canadian dollars). The reports collect 

consolidated data of foreign exchange contracts and positions and include, among other things, 

all foreign exchange contracts involving specified currencies that are used for hedging. The 

reported data is not publicly disclosed in a manner that will reveal the information reported by

any individual entity.

107

c. Recent Anti-Money Laundering Regulations 

Section 352 of the USA Patriot Act requires every “financial institution” to establish an 

anti-money laundering program that meets certain minimum requirements.108 In connection with 

Section 352, the Treasury has proposed a rule that would require hedge funds, among other 

entities, to adopt anti-money laundering procedures.109 In addition to adopting an anti-money

 

is calculated using the prevailing exchange rates at the end of each quarter. See, e.g., Treasury

Foreign Currency Form FC-1, General Instructions Section B (Who Must Report). 

106 Hedge funds that have more than the equivalent of $5 billion in foreign exchange contracts on the 

last business day of any calendar quarter during the previous year and that do not file Form FC-2

must file Form FC-3 on a quarterly basis with the FRBNY.

107 See 31 C.F.R. § 128.3 (permitting only the publishing or disclosure of aggregate data). 

108 See Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept 

and Obstruct Terrorism Act of 2001, Pub. L. No. 107-56 (Oct. 26, 2001) (“USA Patriot Act”). 

These requirements include: (1) the development of internal policies, procedures and controls; (2) 

the designation of a compliance officer; (3) an ongoing employee training program; and (4) an 

independent audit function to test the program. 

109 See Financial Crimes Enforcement Network; Anti-Money Laundering Programs for Unregistered 

Investment Companies, 67 Fed. Reg. 60617 (Sept. 26, 2002) (“Treasury Anti-Money Laundering

Proposal”). The term “financial institution” includes “investment companies.” The Treasury rule 

would define “investment company” to include entities operating in reliance on Sections 3(c)(1) 

and 3(c)(7) of the Investment Company Act, commodity pools and companies investing primarily

in real estate or interests in real estate. These entities would be included in the definition of 

“investment company,” provided that they: permit owners to redeem ownership interests within 

two years of purchase; have total assets, as of the most recently completed calendar quarter, of 

$1 million or more; and are organized under the laws of a state or the United States, are 

organized, operated or sponsored by a U.S. person or sell their ownership interests to U.S. 

persons. The rule excludes from its requirements family companies, employee benefit plans, 

employees’ securities companies (as defined in Section 2(a)(13) of the Investment Company Act) 

or persons that are otherwise required to have anti-money laundering plans. Id. 

30
laundering program, these entities would be required to provide a written notice to the Treasury

within 90 days of becoming subject to the rule.110 

5. State Regulation 

a. State Regulation of Hedge Funds 

Unlike the Investment Company Act, state securities laws do not regulate the operations 

of pooled investment vehicles such as investment companies or hedge funds. Although states do 

not regulate hedge funds directly, they may regulate them indirectly through the fund’s 

investment adviser or by regulating the offer and sale of interests in the hedge fund. Because of 

federal preemption and the availability of exemptions from adviser registration, only some states 

exercise regulatory authority over some hedge fund advisers, and most do not regulate the offer 

and sale of interests in hedge funds. 

b. State Regulation of Offers and Sales of Hedge Fund Securities 

The adoption of the National Securities Markets Improvements Act of 1996 

(“NSMIA”)111 also greatly reduced state regulation of offers and sales of hedge fund securities. 

Most hedge funds issue securities in offerings that are exempt from registration under the 

Securities Act in reliance upon Rule 506 of Regulation D, and are therefore deemed to be 

“covered securities” under Section 18 of the Securities Act.112 Under Section 18, covered 

securities are exempt from state regulations that: (1) require the registration or qualification of

securities or securities transactions; (2) impose any requirements related to disclosure documents 

used in an offering; or (3) impose any merit regulation of such offerings. The states, however, 

 

110 The form of the proposed notice would require the filing entity to provide identifying

information, a statement of the assets held by the “investment company” at the end of the 

preceding fiscal year and a disclosure of the number of participants, interest holders or securities 

holders of the “investment companies.” See id. If adopted, the form of notice filed by a hedge 

fund would be a partial source of information about that hedge fund. 

111 Pub. L. No. 104-290, 110 Stat. 3416 (1996) (codified in scattered sections of the United States 

Code).

112 See Section 18(b)(4)(D) of the Securities Act. 

31
retain their antifraud jurisdiction.113 They may also impose notice filing requirements and 

notice filing fees.

114 

c. State Regulation of Hedge Fund Advisers 

Hedge fund advisers registered with the Commission under the Advisers Act are not 

required to register with the state securities authorities and are exempt from most substantive

provisions of state investment adviser laws. Moreover, hedge fund advisers not registered with 

the Commission may also be eligible for exemptions from state registration and regulatory

requirements.115 State exemptions can be found in a number of states where hedge fund advisers 

are concentrated, including California, Connecticut and New York.116 As a result, it is not 

uncommon for a hedge fund adviser to be exempt from registration under both state and federal 

investment adviser laws. 

A hedge fund adviser that is subject to state investment adviser laws is likely to face 

regulations similar to the Commission’s, as state regulation of investment advisers is generally

similar to the Advisers Act. Broadly speaking, the investment adviser must register with 

authorities and must provide certain disclosures to clients. The adviser is also subject to rules 

designed to protect investors and prevent fraud, and may be subject to periodic examination by

regulators.

117

 

113 See Section 18(c)(1) of the Securities Act. See also, e.g., In the Matter of James Pangione, 

Timothy Rassias, Hercules Capital Management, LLC, Hercules Hedgehog Fund, LP No. E2003-56 (Mass. Sec. Div. filed Aug. 13, 2003). 

114 See Section 18(c)(2) of the Securities Act. 

115 The preemption of state investment adviser laws applies only to those investment advisers that are 

registered with the Commission. Advisers that rely on an exemption from registration with the 

Commission may therefore be subject to state investment adviser laws. See Section 203A(b)(1) 

of the Advisers Act. 

116 See California Code of Regulations Title 10, Section 260.204.9; Order Governing Certain 

Federally Exempt Investment Advisers, Connecticut Department of Banking Order (Oct. 14, 

1997) (each, in pertinent part, granting an exemption from state registration to any investment 

adviser that relies on the exemption from Commission registration in Section 203(b)(3) of the 

Advisers Act). See also NY Gen. Bus. Law Section 359-eee(a)(5) and Codes, Rules and 

Regulations of the State of New York Part 11.12(a) (respectively, providing an exclusion from

the definition of adviser if an adviser has fewer than six clients, and counting limited 

partnerships, and other legal organizations, as single clients). 

117 Both the Commission and states retain antifraud jurisdiction to bring enforcement actions against 

all investment advisers, whether registered or not. 

32
IV. Operations of Hedge Funds 

A. Hedge Fund Investment Strategies 

1. Overview

Hedge funds generally employ an absolute return approach to investing through which 

they seek to make money in a variety of market environments. Registered investment 

companies, in contrast, tend to favor a relative return approach. These funds attempt to duplicate 

or exceed the performance of a selected asset class or securities index.

Because an absolute return approach places a premium on flexibility (a successful bull 

market strategy is unlikely to produce positive returns during bear markets), many hedge funds 

tend to be opportunistic in seeking positive returns while avoiding loss of principal. The 

organizational documents of most hedge funds establish broad objectives and authorize multiple 

strategies in order to provide flexibility to take advantage of changing market conditions.118 

Some hedge funds use traditional tools of fundamental or technical analysis to purchase 

or sell short individual stocks and bonds. Others take a directional view on a particular stock, 

bond or currency market. Still others engage in arbitrage in order to exploit perceived 

inefficiencies in the markets or to make money from particular expected events, such as mergers 

or bankruptcies. Certain hedge funds take large, concentrated positions in securities. Others 

invest across diverse asset classes and types of securities. When market conditions turn negative, 

many hedge funds sell short, utilize derivatives that increase in value as security values fall or 

take positions that are less dependent on the price movements of broad market averages. Many

hedge funds use some or all of these strategies from time to time, based on their view of what 

strategy is most favored by current market conditions.119 Finally, a number of hedge funds 

eschew all of these techniques and adopt traditional, long-only strategies similar to those used by

most registered investment companies. 

 

118 See Roundtable Transcript, May 14 (statement of Robert Schulman) (“The hedge fund industry

has avoided, in large measure, the catastrophic impacts of the market by having enough flexibility

in the [private placement] document and using it to react to what you would call changing market 

conditions.”). 

The flexibility of some hedge fund advisers appears to be restricted only by the presence of 

investors who have invested in a hedge fund because of its use of a particular investment strategy

and their expectation, communicated to the hedge fund adviser, that the fund will only invest in 

accordance with that strategy. See Alexander M. Ineichen, Absolute Returns: The Risk and 

Opportunities of Hedge Fund Investing 123 (2003) (“Ineichen”). 

119 See Hedge Funds: A Guide, The Economist 82 (Oct. 3, 1998).

33
2. Hedge Funds Strategies 

Hedge funds use a wide variety of investment styles and strategies.120 Even among hedge 

funds that purport to use the same investment strategy or invest within the same asset class, there 

is a wide range of investment activities, performance and risk levels.121 Because the investment

activities of hedge funds are so diverse, the hedge funds assigned to a particular investment 

category are likely to exhibit less similarity than more traditional investment vehicles, such as

registered investment companies. 

Although classification systems vary, hedge funds may generally be classified according

to broad style and strategy categories, including: 

• Market Trend (Directional/Tactical) Strategies 

(These strategies exploit broad market trends in equities, interest rates or commodity

prices.) 

− 

− 

 

Macro: These funds may take positions in currencies (often unhedged) based on 

their opinion of various countries' macroeconomic fundamentals. For example, if a 

country's economic policies look inconsistent and its ability to sustain its exchange

rate appears questionable, macro funds may take positions designed to profit from 

devaluation, usually by selling the currency short. 

Long/Short: (includes sector and market neutral/relative value funds): These funds 

try to exploit perceived anomalies in the prices of securities. For example, a hedge

fund may buy bonds that it believes to be underpriced and sell short bonds that it 

believes to be overpriced. No matter what happens to overall interest rates, as long as 

the spread between the two narrows, the fund profits. Conversely, if spreads widen, 

120 One commenter classifies hedge fund investment strategies into more than 25 categories. 

Comment submitted by Roundtable Panelist John G. Gaine on behalf of the Managed Funds 

Association, at 2 (“Managed Funds Association Comment Letter”). 

121 See Roundtable Transcript, May 14 (statement of Michael Neus) (“When speaking about hedge 

funds [whether] the average hedge fund is less risky or more risky, I think that misses the point. 

It's not a monolithic institution. Hedge funds, by and large, are incredibly entrepreneurial; are 

constantly innovating and mutating.”). 

34
gains can turn quickly into losses. Long/short equity is the most frequently used

strategy among hedge funds.122 

• Event-Driven Strategies 

(These strategies attempt to exploit discrete events such as bankruptcies, mergers, and 

takeovers.) 

− 

− 

− 

 

Distressed Securities: These funds may take long and/or short positions to attempt 

to profit from pricing anomalies among securities issued by companies going through 

bankruptcy or reorganization. 

Risk/Merger Arbitrage: These funds attempt to profit from pending merger 

transactions by, for example, taking a long position in the stock of the company to be 

acquired in a merger, leverage buyout or takeover and simultaneously taking a short 

position in the stock of the acquiring company.

• Arbitrage Strategies123

(These strategies, which exploit pricing discrepancies between closely related securities, 

are designed to be among the less risky hedge fund strategies. Arbitrage also may be a 

significant strategy component for funds in the event-driven and long/short categories.) 

Convertible Arbitrage: This strategy involves taking long positions in a company's 

convertible bonds, preferred stock, or warrants that are deemed to be undervalued 

while taking short positions in the company's common stock. 

122 The actual percentage varies according to different commenters, probably because commenters 

often define investment strategies differently. One commenter claimed that over 60 percent of 

hedge fund assets were managed using this strategy. Hennessee Group Comment Letter, supra

note 4 at 3. Another commenter stated that, as of the third quarter of 2001, approximately 45 

percent of hedge fund assets were managed using this strategy. Ineichen, supra note 118 at 42-

43.

123 Many arbitrage strategies contribute substantial benefits to the U.S. financial markets by

exploiting mispricings and inefficiencies. These efforts often result in enhanced liquidity and 

improved market efficiency. As was recently demonstrated, however, some abusive strategies 

used by hedge fund advisers such as mutual fund “market timing” activities provide no benefits to 

the securities markets. See State of New York v. Canary Capital Partners, LLC, (N.Y. Sup. Ct., 

complaint filed Sept. 3, 2003), available at: 

http://www.oag.state.ny.us/press/2003/sep/canary_complaint.pdf (“Canary Capital Partners”). 

35
Fixed Income Arbitrage: Hedge funds in this category seek to provide stable, 

positive returns by exploiting the relatively small pricing inefficiencies of fixed 

income instruments. For example, a newly issued (“on the run”) 10-year Treasury

bond may trade at a slightly higher price than a similar previously issued (“off-therun”) 10-year Treasury bond. A hedge fund may seek to profit from this disparity by

purchasing off-the-run Treasuries and selling on-the-run Treasuries short. 

− 

− Statistical Arbitrage: Funds in this category attempt to profit from pricing

inefficiencies identified through the use of mathematical models. Statistical arbitrage

attempts to profit from the likelihood that prices will trend toward a historical norm. 

3. Hedge Fund Investment Activities Compared to those of Registered 

Investment Companies 

As discussed above, registered investment companies typically seek positive returns 

compared to the performance of a particular asset class or index (“benchmark”). Thus, in a 

declining market, a registered investment company may be considered successful even if it loses 

money, so long as the company outperforms its benchmark (i.e., its relative return is positive). 

In a rising market the registered investment company may be considered unsuccessful if the 

company, though profitable, underperforms the benchmark (i.e., its relative return is negative). 

In brief, in the relative return paradigm, downside risk means the risk of failing to perform as

well as the benchmark. In contrast, a hedge fund that utilizes an absolute return strategy may be 

considered successful only if it is profitable in both rising and declining markets.124 In the 

absolute return paradigm, downside risk means the risk of failing to make money. 

Registered investment companies generally have less flexibility to change their

investment objectives than do most hedge funds. As a result, these funds provide investors with 

greater certainty of the risks their advisers will take, but provide their advisers with a diminished 

ability to take alternative investment approaches when market conditions change. Most of the 

restrictions on registered investment companies are self imposed, and are designed to assure 

investors that the fund will be managed in a manner consistent with their expectations.125

 

124 As discussed in Part IV.F. infra, compensation arrangements for hedge fund advisers are typically

structured to reinforce the incentive to produce positive returns, irrespective of the direction of 

the market. 

125 The Investment Company Act does not require registered investment companies to restrict the 

flexibility of fund advisers. Section 13(a)(3) of the Investment Company Act requires registered 

investment companies to obtain the consent of their shareholders before deviating from their 

fundamental policies, including concentration in certain industries, but does not require registered 

investment companies to have policies restricting investments. Similarly, Section 13(a)(2) of the 

Investment Company Act requires registered investment companies to seek the approval of their 

36
4. Leverage 

a. Background 

Leverage is an important component of many hedge fund investment strategies. 

Leverage can be defined in numerous ways. As a general matter, however, leverage, can be 

viewed as a means of potentially increasing an investment’s value or return without increasing

the amount invested. Although leverage historically was obtained primarily by purchasing

securities with borrowed money, today futures, options and other derivative contracts may be a

major source of leverage. The use of leverage may have a significant impact on investment 

results because, while it may enhance investment gains, it may also magnify investment losses. 

Leverage also may increase the risk caused by holding assets that are illiquid or whose full value

cannot be realized in a quick sale. 126

b. Use of Leverage by Hedge Funds 

The degree to which a hedge fund uses leverage depends largely on its investment 

strategy. Macro funds and funds that attempt to capitalize on small inefficiencies in relative 

values (e.g., fixed income arbitrage and statistical arbitrage) are more likely to engage in

leverage and to take more highly leveraged positions127 than are hedge funds that use other 

investment strategies, such as investing in distressed securities situations.128 

 

shareholders before they deviate from their policies regarding borrowing money, issuing senior 

securities, underwriting certain securities, purchasing or selling real estate or commodities or 

making loans, but does not preclude registered investment companies from having policies 

permitting all such activities to the extent permitted by law.

126 Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management - Report of The 

President's Working Group on Financial Markets 5 (Apr. 1999) (“LTCM Report”). 

127 For example, according to hedge fund data consultants, approximately 89 percent of macro funds 

use leverage. Of those macro funds, 52 percent have leverage ratios greater than 2 to 1. (Here, a 

leverage ratio is defined as the ratio of total absolute dollars invested to total dollars of equity. A

leverage ratio of greater than 2 to 1 is considered high; while a ratio of less than or equal to 2 to 1 

is considered low.) This information is based on a sample of funds and may not be representative 

of all hedge funds. See Van Hedge Fund Advisors International, Inc., Global Hedge Funds - Use 

of Leverage As of December 2002 (2003). 

128 Slightly over half (52 percent) of hedge funds that employ a distressed securities strategy use 

leverage. Of hedge funds using distressed securities strategies that use leverage, only six percent 

have leverage ratios greater than 2 to 1. Id. 

37
A hedge fund’s limitation on its use of leverage is often dictated by any margin or 

collateral requirements imposed on lenders or on others (e.g., broker-dealers), and the 

willingness of lenders or other counterparties to provide it with credit. For example, a brokerdealer extending credit to a hedge fund in connection with a short sale would have to comply

with Regulation T issued by the Board of Governors of the Federal Reserve System.

129 The 

hedge fund could also be required to provide additional “maintenance margin” for transactions in 

short sales under margin requirements imposed by self-regulatory organizations.130

c. Use of Leverage by Registered Investment Companies 

Although registered investment companies may use leverage and sell short, their ability

to use these tools is more limited than is the case with hedge funds. For example, the Investment 

Company Act generally allows open-end investment companies to leverage themselves only by

borrowing from a bank, and provided that the borrowing is subject to 300 percent asset 

coverage.

131 Closed-end investment companies are subject to less restrictive limits.132 The 

Commission and staff have applied the Investment Company Act provisions governing use of 

leverage to permit registered investment companies to engage in certain transactions involving

leverage (“senior security transactions”), generally, however, only if the registered fund “covers” 

the transaction by setting aside liquid assets in an amount equal to the potential liability or 

exposure created by the transaction.133 A registered investment company’s board of directors has 

 

129 12 C.F.R.§ 220.12. This could require the hedge fund to provide margin for a short sale of a 

“nonexempted security,” such as a security registered on a national securities exchange, of 150 

percent of the current market value of the security. 12 C.F.R.§ 220.12(c)(1). 

130 See NASD Rule 2520(c) and NYSE Rule 431(c). See also NASD Rule 2520(d) and NYSE Rule 

431(d), which permit broker-dealers to institute higher short-sale margin requirements than those 

imposed by self-regulatory organizations rules. 

131 Section 18(f)(1) of the Investment Company Act. The Investment Company Act also allows

registered investment companies to engage in certain private and temporary borrowings without 

300 percent asset coverage, and from non-bank lenders. See Section 18(g) of the Investment 

Company Act. 

132 See Sections 18(a) - (e) of the Investment Company Act. 

133 See, e.g., Securities Trading Practices of Registered Investment Companies, Investment 

Company Act Release No. 10666 (Apr. 18, 1979) (“Release 10666”) (discussing Section 18 

regulation of reverse repurchase agreements, firm commitment agreements, standby agreements 

and other transactions having similar effects on the capital structure of an investment company). 

See also, e.g., Dreyfus Strategic Investing & Dreyfus Strategic Income (pub. avail. June 22, 1987) 

(“Dreyfus”) (short selling transactions and certain derivatives transactions such as: purchasing

and selling futures contracts; purchasing and selling options on specific securities, stock indexes, 

38
certain responsibilities in connection with the company’s use of leverage,

134 and information 

about the characteristics and risks of permitted leverage transactions must be disclosed to 

investors in fund prospectuses.135

5. Short Selling 

a. Background 

A short sale is the sale of a security that the seller does not own or a sale that is 

consummated by the delivery of a security borrowed by, or for the account of, the seller.136 In

order to deliver the security to the purchaser, the short seller borrows the security, typically from 

a broker-dealer or an institutional investor. The short seller later closes out the position by

returning the security to the lender, typically by purchasing equivalent securities on the open 

market, or by using an equivalent security that it already owns. In general, short selling is 

 

or interest rate futures contacts; and purchasing and selling forward contracts on currencies 

“involve potential leveraging.”). 

The requirement that registered investment companies set aside liquid assets to cover senior 

security transactions is also referred to as the “segregated account” obligation. The purpose of 

this requirement is to limit the amount of leverage in which a registered investment company may

engage, and to ensure the availability of adequate funds to meet the obligations arising under the 

senior security transactions. See, e.g., Release 10666, as modified by Dreyfus and Merrill Lynch 

Asset Management, L.P. (pub. avail. July 2, 1996) (“MLAM”). This requirement applies in 

addition to any margin requirements, which apply to investment companies just as they do to 

hedge funds and other brokerage customers engaging in margin transactions. The assets set aside 

to cover the senior security transactions are considered frozen and unavailable for sale or any

other purpose. See, e.g., Release 10666; MLAM. 

134 Specifically, the board must conclude that senior security transactions are consistent with the 

policies recited in its registration statement pursuant to Section 8(b) of the Investment Company

Act, and must also make sure that the level of senior security transactions will not impair the 

investment company's ability: to meet current obligations; to honor requests for redemption (for 

open-end investment companies); and to manage properly the investment portfolio in a manner 

consistent with the investment company's stated investment objectives. See Release 10666, supra

note 133. 

135 See Form N-1A , Items 4(b)(1) (requiring a description of the fund's principal investment 

strategies) and 4(c) (requiring a description of the principal risks of investing in the fund, 

including circumstances reasonably likely to affect adversely the fund's net asset value, yield or 

total return). See also Release 10666, supra note 133. 

136 See Rule 3b-3 under the Exchange Act. 

39
utilized to profit from an expected downward price movement, to provide liquidity in response to 

unanticipated demand or to hedge the risk of a long position in the same or a related security. 

Short selling can provide the market with important benefits, including market liquidity

and pricing efficiency. Market liquidity is provided through short selling by market

professionals, such as market makers (including specialists) and block positioners, who offset 

temporary imbalances in the supply and demand for securities. Short sales effected in the market 

by securities professionals add to the trading supply of stock available to purchasers and thus 

may reduce the risk that the price paid by investors is artificially high. 

Short selling also can contribute to the pricing efficiency of the markets. Efficient 

markets require that prices fully reflect all buy and sell interest. When a short seller speculates 

on or hedges against a downward movement in a security, the transaction is a mirror image of the

person’s who purchases the security based upon speculation that the security’s price will rise or 

in order to hedge against such an increase. The strategies primarily differ in the sequence of 

transactions. Market participants who believe a stock is overvalued may engage in short sales in 

an attempt to profit from a perceived divergence of prices from true economic values. Such 

short sellers add to stock pricing efficiency because their transactions inform the market of their 

evaluation of future stock price performance. This evaluation is reflected in the resulting market

price of the security.

137

Although short selling serves useful market purposes, it also may be used to manipulate 

stock prices. One example is the “bear raid” where an equity security is sold short in an effort to 

drive down the price of the security by creating an imbalance of sell-side interest.138 

Unrestricted short selling can also exacerbate a declining market in a security by eliminating bids 

and causing a further reduction in the price of a security by creating an appearance that the price 

is falling for fundamental reasons. 

 

137 Arbitrageurs also contribute to pricing efficiency by utilizing short sales to profit from price 

disparities between a stock and a related security, such as a convertible security or an option on 

that stock. For example, an arbitrageur may purchase a convertible security and sell the 

underlying stock short to profit from a current price differential between two economically

similar positions. 

138 Many people blamed “bear raids” for the 1929 stock market crash and the market's prolonged 

inability to recover from the crash. See 7 Louis Loss and Joel Seligman, Securities Regulation

3203-04, n. 213 (3d ed. 1989). 

40
b. Regulatory Restrictions on Short Selling 

The Commission has traditionally held the belief that protections against abusive short 

selling are important for issuer and investor confidence, and has enacted prophylactic rules 

designed to curb manipulative behavior. Rule 10a-1 under the Exchange Act was adopted in 

1938 after several years of considering the effects of short selling in a declining market.139 The 

core requirement of Rule 10a-1 is commonly referred to as the “tick test.” The tick test provides 

that, subject to certain exceptions, an exchange-listed security may only be sold short: (1) at a

price above the immediately preceding reported price (“plus tick”); or (2) at the last sale price if 

it is higher than the last different reported price (“zero-plus tick”). Subsection (c) and (d) of Rule 

10a-1 also require broker-dealers effecting sell orders for exchange-listed securities to mark such

orders “long” or “short.” The Commission has also approved a price test for certain Nasdaq 

securities.140

There are other requirements that apply to short selling. For example, the self-regulatory

organizations (“SROs”) have adopted rules generally requiring that, prior to effecting short sales, 

member firms must “locate” stock available for borrowing, so that the short seller may effect

delivery to the purchaser.141 In addition, short sale transactions are subject to margin 

requirements,142 and may impact a broker-dealer's net capital.

143 Other securities market

 

139 By adopting Rule 10a-1, the Commission sought to achieve three objectives: (1) allow relatively

unrestricted short selling in an advancing market; (2) prevent short selling at successively lower 

prices, thus eliminating short selling as a tool for driving the market down; and (3) prevent short 

sellers from accelerating a declining market by exhausting all remaining bids at one price level, 

causing successively lower prices to be established by long sellers. See Short Sales of Securities, 

Exchange Act Release No. 13091 (Dec. 21, 1976). 

140 NASD Rule 3350 uses a “bid test” that prohibits NASD members from effecting short sales in 

NASDAQ National Market System Securities at or below the best bid when the best bid 

displayed is below the preceding best bid in a security. 

141 See, e.g., NASD Rule 3370; NYSE Rule 440C. 

142 See, e.g., Section 220.12(c)(1) of Regulation T of the Board of Governors of the Federal Reserve 

System, which requires margin for a short sale of a nonexempted equity security of 150 percent 

of the current market value of the security. An investor may be required to deposit additional 

“maintenance margin” for transactions in short sales under margin requirements imposed by

SROs. See, e.g., NASD Rule 2520(c) and NYSE 431(c). Further, broker-dealers may institute 

higher short sale margin requirements than those imposed by self-regulatory organization rules. 

See, e.g., NASD Rule 2520(d); NYSE Rule 431(d). 

143 For example, a broker-dealer with a proprietary short position in an equity security may be 

required to deduct a percentage of the market value of the position when computing net capital 

under Exchange Act Rule 15c3-1. See Rule 15c3-1(c)(2)(vi)(J) under the Exchange Act. There 

may also be net capital implications for a broker-dealer executing short sale transactions for 

41
participants, such as registered clearing agencies, may also establish requirements for firms 

engaging in short sale transactions.144 

The SROs also have rules requiring members to report monthly aggregate short positions 

in all customer and proprietary accounts in securities listed on such exchanges or traded on 

NASDAQ.145 This information is publicly available from a number of different sources, 

including Barrons, the Wall Street Journal and some financial websites. 

c. Short Selling by Hedge Funds 

Many hedge funds regularly engage in short selling as a major component of their 

investment strategy. For example, hedge funds may engage in long/short strategies that consist 

of buying higher-expected-return securities and selling short lower-expected-return securities. 

Hedge funds also may sell short in connection with arbitrage activities. A risk arbitrage position 

would consist of buying the target company securities coupled with simultaneous shorting of the 

securities of the acquiring company. Convertible arbitrage involves taking long positions in 

convertible securities while shorting the underlying securities, thereby taking advantage of a 

difference between the prices. Statistical arbitrage involves attempting to profit from pricing

differentials between statistically related securities identified through the use of mathematical

models. 

The use of short selling by hedge funds has led to allegations that some hedge funds may

be engaging in short selling as part of a manipulative scheme. Issuers have alleged that the

hedge funds accumulated bearish positions in their stocks (i.e., sold securities short or purchased

put options and credit-default swaps) and subsequently issued critical reports regarding the

issuers in an attempt to drive down their security prices.

146

 

customers. For example, a broker-dealer may be required to deduct the amount of cash required 

in a customer's account to meet maintenance margin requirements arising from the customer's

short sale transactions. See Rule 15c3-1(c)(2)(xii) under the Exchange Act. 

144 There are capital and risk management standards established by the National Securities Clearing

Corporation, which generally acts as the guarantor of trades between broker-dealers. See

National Securities Clearing Corporation Rules of Procedures, Addendum K (effective Aug. 11, 

2003). 

145 See, e.g., NASD Rule 3360; NYSE Rule 421.10. 

146 See, e.g., Randall Smith, Regulators Review Complaints About Hedge Funds, Wall Street Journal, 

(Jan. 22, 2003). 

42
d. Short Selling by Registered Investment Companies 

Registered investment companies have less flexibility than hedge funds to engage in short 

selling. While there are registered investment companies that actively sell short, registered

investment companies are constrained by requirements of the Investment Company Act. 

Registered investment companies that sell short need to ensure that their prospectuses and other 

disclosure documents adequately inform shareholders about the risks associated with short 

selling.

147 Registered investment advisers and directors of registered investment companies 

should consider the consistency of such risks with the companies’ disclosures and (for open-end 

investment companies) with the duty to have sufficient liquid assets to meet redemption requests 

in a timely manner.

148

B. Nature of Hedge Fund Investors 

Historically, hedge funds were sold primarily to high net worth individuals and families. 

Individual investors and families continue to represent a large portion of the hedge fund investor 

population today.

149 Much of the recent growth in the hedge fund industry, however, can be 

attributed to the investments of institutional investors.150 Institutional investors such as pension 

 

147 See Form N-1A, Items 4, 12. Registered investment companies are required to disclose their 

short sale activity in their financial statements that accompany their annual reports and semiannual reports. For example, open- and closed-end investment companies must provide a 

Schedule of Securities Sold Short along with their financial statements, which schedule 

specifically lists the securities sold short during the relevant reporting period. See Regulation SX, Rules 6-10 and 12-12A. In addition, all registered investment companies must disclose: (1) 

the amount held by others in connection with short sales in the asset section of the balance sheet; 

(2) the amount payable for securities sold short in the liability section of the balance sheet; and 

(3) the gain or loss on closed short positions in securities in the statement of operations. See

Regulation S-X, Rules 6-04, 6-07. 

148 See, e.g., Release 10666, supra note 133; MLAM, supra note 133. 

149 According to one commenter, as of January 1, 2003, individuals and families invested $249 

billion in hedge funds, representing approximately 42 percent of industry assets. Over the past 

several years, however, these investments, as a percentage of all hedge fund assets, have been 

declining. Hennessee Group Comment Letter, supra note 4 at 7-9.

150 See e.g., Roundtable Transcript, May 14 (statement of Robert Schulman) (“[T]he vast majority of 

. . . [the] growth [in the hedge fund industry] is coming institutionally. So although there’s been 

a lot of talk about the retailization of the business . . . the reality is it is large commitments from

big public plans . . . , like CALPERS and Texas Teachers, that is leading the way towards the 

growth in this asset.”). 

43
plans, endowments and foundations are increasingly considering investments in hedge funds, and 

those who are already investing are devoting a larger portion of their portfolios to these funds.151 

These institutional investors are shifting portions of their portfolios away from more traditional 

investments to investment vehicles employing absolute return strategies.

152 According to one 

commenter, the catalyst for this shift was the performance of these vehicles during the recent 3-

year bear market.

153 These investors are also increasingly investing in FOHFs.154 

C. Hedge Fund Marketing 

Typically, hedge fund advisers market and distribute hedge funds to investors directly,

 155

as compared to registered investment companies, which often are sold through broker-dealers.156 

Hedge funds rely heavily on investors’ pre-existing relationships with the hedge fund’s advisory

personnel (either on a personal basis or through a prior advisory relationship) and existing

investors’ recommendations. In addition, some hedge fund advisers have staff dedicated to 

 

According to one commenter, institutional investors in the aggregate invested $175 billion in 

hedge funds in 2002, compared to $53 billion four years earlier. Hennessee Group Comment 

Letter, supra note 4, at 14.

151 See, e.g., Chris Clair, A Growing Role: Institutional Investors Jumping Big into the Hedge Fund 

Market, Pensions and Investments 3 (Feb.18, 2002); Gregory Zuckerman, Hedge Funds May 

Give Colleges Painful Lesson, WSJ.com (Oct. 7, 2002); Andy Serwer, Where the Money’s Really 

Made, Fortune 106 (Mar. 31, 2003).

152 Hedge funds are only one of the alternative investments that institutional investors are exploring

as part of an overall diversification strategy. Other alternative investments include real estate, 

timberland and oil and gas. See Foundations, Endowments Try Real Assets, Fundfire (Aug. 25, 

2003). 

153 See Roundtable Transcript, May 14 (statement of Charles Gradante). 

154 According to one commenter, as of January 1, 2003, FOHFs represented approximately 27 

percent of hedge fund assets, compared to 20 percent the year before. Hennessee Group 

Comment Letter, supra note 4, at 8-9. 

155 One commenter stated that, as of January 1, 2003, hedge funds raised approximately 88 percent 

of their capital as a result of in-house marketing efforts. Id., at 10. Close to half (43 percent) of 

this capital, however, came from the hedge fund’s general partners and employees. Id. 

156 Some hedge funds, however, use the services of a broker-dealer as a placement agent for their 

securities. Broker-dealers often may place hedge fund shares with wealthy clients through 

divisions of broker-dealers dedicated to providing services to “high net worth” customers. We 

note, however, that for most broker-dealers that sell hedge funds, these sales account for a 

minimum amount of total revenue. 

44
marketing the fund, which may include identifying new investors, holding seminars for potential 

investors and assisting potential investors in understanding the products and completing the 

subscription documents. 

Many hedge fund advisers also operate Internet websites through which they

communicate with investors. As sponsors of securities offerings by hedge funds, the advisers are 

required to limit both the content of their websites and the persons who may access them in order 

to avoid general solicitation and general advertising concerns in connection with the hedge fund 

securities offering.

157 Many hedge fund advisers provide information about themselves, but 

typically do not mention to the general public that they manage hedge funds. Some hedge fund 

advisers follow the staff and the Commission’s guidance on using password protected websites 

to communicate with existing investors and investors with whom they or persons acting on their 

behalf have substantive, pre-existing relationships. 

Hedge fund advisers using the Internet and other medium of electronic communications 

are subject to the constraints of the exemptions from the applicable registration requirements that

they are relying on in selling the hedge fund securities or engaging in advisory activities. 

Moreover, if advisers and hedge funds do not follow the Commission’s guidance on the use of 

the Internet in engaging in private offerings, they run a risk of not being able to rely on an 

exemption from the registration requirements of the Securities and Investment Company Acts. 

Purchasers of securities sold in violation of these registration requirements have the right to 

rescind their purchase and obtain the amount of their investment plus interest. 

In addition to obtaining marketing information directly from hedge fund advisers, 

prospective investors and financial professionals also may receive information about potential 

investment opportunities in hedge funds through third-party intermediaries. Many potential 

investors are introduced to hedge funds through capital introduction services that are provided by

 

157 See supra Part III.B.2.c. (discussing permissible and prohibited solicitation activities in 

connection with securities offerings). 

45
broker-dealers.158 Also, many investors hire consultants to advise them about investing in hedge 

funds.159 Hedge funds also hire consultants as “marketers” to introduce investors to the fund.160

D. Disclosure by Hedge Funds to Investors and Prospective Investors 

Hedge fund advisers typically provide information to investors during an investor’s initial 

due diligence review of the fund, although some, more proprietary, information may not be 

provided until after the investor has made a capital commitment to the fund, if at all. Most hedge 

funds provide written information to their investors in the form of a private offering

memorandum or private placement memorandum (“PPM”).161 This reflects market practice and 

the expectations of the sophisticated investors who typically invest in hedge funds. It also 

reflects the realization of the sponsors and their attorneys that the exemptions from the 

registration and prospectus delivery provisions of Section 5 of the Securities Act available under 

Section 4(2) of the Securities Act and Rule 506 thereunder do not extend to the antifraud 

provisions of the federal securities laws. The disclosures furnished to investors serve as

protection to the principals against liability under the antifraud provisions. Some of the 

information may be disclosed less formally in one-on-one conversations between investors and 

the hedge fund adviser. 

Hedge fund advisers may also provide information to hedge fund investors in the form of 

letters, conference calls and financial statements. In addition, some hedge fund advisers may

provide prospective investors with access to their prime brokers and other service providers, such 

 

158 See infra Part IV.E.2. (discussing broker-dealers/prime brokers). According to one survey, 

capital introduction services sponsored by broker-dealers are the second most popular method by

which investors are introduced to hedge fund advisers, following networking. Deutsche Bank, 

Equity Prime Services Alternative Investment Survey Results Part 2: Inside the Mind of the 

Hedge Fund Investor 22 (Mar. 2003) (the “Deutsche Bank Survey”). 

159 See infra Part IV.E.5. (discussing consultants and other finders). See also Investors Jump LongOnly Ship for Hedge Funds, Fundfire (Jan. 30, 2003); Plans Seek Sound Advice on Hedge Funds, 

Fundfire (May 29, 2002). 

160 See infra Part IV.E.5. (discussing consultants and other finders).

161 Rule 506 does not require that issuers provide any specific written information to accredited 

investors. This reflects the Commission’s view that accredited investors are sophisticated enough 

and have enough bargaining power to obtain any information they need from an issuer in making

an investment decision. If the offering is extended to anyone who is not an accredited investor, 

the issuer must provide extensive written information to the investors who are not accredited. See

Rule 502(b) under the Securities Act. 

46
as administrators, both during the investor’s initial due diligence of the hedge fund and 

subsequently. 

Hedge fund investors must often spend significant resources, frequently hiring a 

consultant or a private investigation firm, to discover or verify information about the background 

and reputation of a hedge fund adviser.162 In practice, even very large and sophisticated 

investors often have little leverage in setting terms of their investment and accessing information 

about hedge funds and their advisers.163 

1. Private Placement Memoranda 

As a matter of practice, hedge funds generally provide investors with a PPM before an 

investment is made. As with any other offering solely to accredited investors, there are no 

specific disclosure requirements that pertain to the PPM under Section 4(2) or Rule 506.164 

While we are not passing on the adequacy and content of PPM disclosure generally, we note that 

certain basic information about the hedge fund’s adviser and the hedge fund is typically

disclosed. The information disclosed in PPMs varies from adviser to adviser, however, and often 

is general in scope. PPMs generally discuss in broad terms the fund’s investment strategies and 

practices. They also typically disclose that the hedge fund’s investment adviser may invest fund 

assets in illiquid, difficult-to-value securities and that the adviser reserves the discretion to value

 

162 Roundtable Transcript, May 14 (statement of Michael Neus) (“Whether they do it internally or 

whether they hire a consultant, they do more than kick the tires. They audit. Sometimes they

audit results, they do background checks, they do a huge amount of legal work internally, as well 

as externally -- talking to other investors.”); Roundtable Transcript, May 15 (statement of Sandra 

Manzke) (“[I]t’s very difficult to get answers out of managers, and they hold all the keys right 

now. If you want to get into a good fund, and you ask some difficult questions, you may not get 

that answer. Sure, there is a lot of access, to get online and do background checks, and hire firms 

. . . . But that's expensive. And can the retail investor do it? No. Firms like ours, we spend a lot 

of money, we have a lot more people working for us now to uncover these types of situations.”). 

163 Roundtable Transcript, May 15 (statement of Mark Anson) (“[t]he power remains with the hedge 

fund managers . . . .[T]here are far more attorneys out there representing hedge fund managers 

than representing investors in hedge funds. So when you get down to negotiating the nitty gritty, 

generally you're sitting across the table from a hedge fund manager who has better legal 

representation than you do as an investor. . . .The best hedge fund managers close their hedge 

funds. Or, if they open them for a small period of time, . . . it’s basically a take it or leave it. 

‘You want into my fund? Here are the terms that you get.’ The bargaining and leverage remains 

with the best hedge fund managers.”). 

164 Hedge fund advisers that are registered investment advisers, however, are required to provide 

investors with a disclosure statement that includes information required under Part II of Form

ADV. See supra Part III.D. (discussing hedge fund advisers and the Advisers Act). This may be 

satisfied by providing a copy of the PPM that includes the appropriate disclosure to an investor.

47
such securities as it believes appropriate under the circumstances.165 The PPM also may disclose 

that the adviser may exercise its discretion to invest fund assets outside the stated strategy or 

strategies. 

PPMs also generally discuss qualifications and procedures for a prospective investor to 

become a limited partner, as well as provide information about the hedge fund’s operations.166 

For example, PPMs generally discuss fund expenses, allocations of gains and losses, tax aspects 

of investing in the fund and may incorporate the hedge fund’s financial statements. PPMs 

disclose any lock-up period that new investors must observe, as well as laying out the specifics 

for when investors will be able to redeem some or all of their investments out of the hedge fund. 

PPMs also may name frequently used service providers to the fund. 

PPMs may generally disclose potential conflicts of interest to investors, frequently under 

the heading of “risk factors.” A hedge fund’s PPM may note that the fund’s valuation practices 

give rise to an inherent conflict of interest because the level of fees that the investment adviser 

earns is based on the value of the fund’s portfolio holdings as determined by the fund’s adviser. 

PPMs also may discuss potential conflicts arising from the adviser’s “side-by-side management”

of multiple accounts, including the hedge fund, private accounts, proprietary accounts and 

registered investment companies.167 A hedge fund’s PPM may also disclose the investment 

adviser’s conflicts in allocating its time and certain investment opportunities among its clients. 

Some PPMs spell out allocation policies with respect to limited investment opportunities in great 

detail, while others may list, and only briefly discuss, the factors on which such allocations will 

be decided. 

PPMs also often provide information concerning the use of affiliated services providers, 

including affiliated broker-dealers. Some PPMs also may note that the hedge fund may direct 

brokerage business to, and use other services of, firms that introduce investors to the fund. 

PPMs may disclose that the adviser may use soft dollars to pay for research and other services 

used by the adviser to benefit other accounts that it manages, and may further disclose that soft 

 

165 See infra Part IV.B. (discussing concerns relating to valuation practices of hedge funds). 

166 Alternatively, the information may be detailed in the fund’s limited partnership and/or 

subscription agreement. 

167 A registered investment adviser, including a registered adviser managing a hedge fund, is 

generally required to provide this disclosure. See infra Part VI.E. (discussing conflicts of 

interest). 

48
dollar arrangements could give the adviser an incentive to place trades more actively than it

might otherwise in order to generate additional credits with executing broker-dealers.168 

2. Limited Partnership Agreements 

Investors in a hedge fund structured as a limited partnership enter into a limited 

partnership agreement. These agreements specify the respective rights and responsibilities of the 

limited partners and the general partner (usually the investment adviser). For example, these

documents frequently list any restrictions on the percentage of an investor’s assets invested in the 

hedge fund that a hedge fund will repurchase at any one time. 

3. Transparency 

Hedge fund advisers may provide investors with a list of hedge fund securities positions 

and holdings (position transparency) or information about the risks associated with the hedge 

fund’s market positions (risk transparency).169 The information may be provided in full or in 

part and on a current or delayed basis. 

Position transparency may help investors monitor whether a hedge fund adviser is 

following the fund’s stated strategies. For example, an investor who receives a month-end 

aggregated position report by industry can see whether the hedge fund adviser is drifting away

from earlier statements about the fund’s industry concentrations.170 Many hedge funds, however, 

decline to share specific position transparency citing, among other reasons, the need to keep such

 

168 The Commission has defined soft dollar practices as arrangements under which an adviser obtains 

products or services other than execution of securities transactions from or through a brokerdealer in exchange for the direction by the adviser of client brokerage transactions to the brokerdealer. See Disclosure by Investment Advisers Regarding Soft Dollar Practices, Advisers Act

Release No. 1469 (Feb. 14, 1995) (proposing amendments to Form ADV). 

169 There are divergent views as to the utility of position transparency. See, e.g., Consultants 

Demand Hedge Fund Transparency, Fundfire (Mar. 27, 2003). Many experts believe that 

position transparency is of little value to most investors because hedge fund advisers tend to 

engage in complex strategies beyond the understanding of those investors. See, e.g., Roundtable 

Transcript, May 14 (statement of George Hall) (“position level transparency is basically

meaningless . . . to most investors.”). 

170 In one survey, 75 percent of institutional investors named monitoring strategy drift as one of their 

primary reasons for requiring additional transparency and 57 percent of those polled said that 

monitoring sector concentration was important to them. Deutsche Bank Survey, supra note 158,

at 15. 

49
proprietary information confidential.171 For example, many worry that such disclosure might 

permit other market participants to take advantage of short positions that the hedge fund might 

hold, to the detriment of the fund and its investors. Moreover, position transparency with respect 

to a hedge fund implementing a merger arbitrage strategy, for example, will reveal little about 

the risks involved because it reveals nothing about the likelihood of certain events occurring and 

it does not disclose what leverage, if any, the investment adviser is using.

172 

The financial press has reported increased investor interest in risk transparency, and has 

ascribed this trend primarily to institutional investor demand as hedge funds become a 

component of mainstream investing programs for pension plans, endowments, foundations and 

other non-private institutional investors.173 Proponents of increased risk transparency assert that 

it provides a more meaningful measure of the risks associated with an ongoing hedge fund 

investment than position transparency.

174 

4. Periodic Reporting 

Many hedge fund advisers provide periodic reports to their investors, although they are 

not specifically required under the federal securities laws.175 The information in such reports 

varies widely among hedge fund advisers in terms of the types of information shared and the 

quality of the disclosure. Some hedge fund advisers report only the hedge fund’s overall 

performance during the most recent period, while other reports disclose each individual 

 

171 See Roundtable Transcript, May 15 (statement of Mark Anson) (“If there is a public disclosure of 

the hedge fund manager's trading positions, well, that may reveal that hedge fund manager's 

competitive advantage. And as an investor, that doesn't help me, that's just going to erode my

returns.”). 

172 Roundtable Transcript, May 14 (statement of George Hall) (“[I]f you look at most of the wellknown blowups and problems that have happened, . . .[position] transparency wouldn’t have

made investors get out of those investments.”). 

173 See Alison Bisbey Colter, Hedge-Fund Investors Seek Detailed Data, Survey Finds, Wall Street 

Journal (Apr. 1, 2003); Hedge Funds Seen Upping Risk Transparency, Fundfire (Mar. 10, 2003). 

174 Leslie Rahl, Hedge Fund Transparency: Unraveling the Complex and Controversial Debate 31-

32 (2003); Comment submitted by Price Meadows Inc. at 3. 

175 Hedge fund advisers are not required to provide investors with semiannual or any other reports 

containing information about their investments under the federal securities laws. In contrast, a 

registered investment company is required to provide shareholders with semiannual reports 

containing, among other information, a balance sheet and income statement within 60 days after 

the close of the reporting period. These reports also typically include a discussion of 

management’s explanation of the investment company’s performance. See Section 30(e) of the 

Investment Company Act and Rule 30e-1 thereunder. 

50
investor’s performance. Periodic reports may include detailed information about the fund, its 

investments, including whether the adviser has diverged from the fund’s primary investment 

strategies, its performance history and relevant market commentary. Hedge fund advisers also 

may provide investors with account statements reporting their capital account balances with 

these periodic reports. 

5. Additional Sources of Hedge Fund Information 

Hedge fund databases and indices are an additional source of information about hedge 

funds. 176 Hedge fund indices are statistical composites that measure and report value changes in 

hedge fund groupings based on information contained in various databases. Various 

commenters, however, have questioned the accuracy and utility of these sources of 

information.177 Among the complaints is the concern that, because there is no known universe of 

hedge funds, it is impossible to determine if all hedge funds that meet the qualifications of a 

particular index or database are actually represented in that index or database. In addition, there 

is no requirement for hedge funds to report their performance, and those that do may choose to 

stop providing the information at any time.

178 Studies also suggest that databases reflect a 

survivorship bias in that they may include only hedge funds currently in operation, and may

exclude funds that close down as a result of poor performance and for other reasons.179 Finally, 

the accuracy of hedge fund performance data provided by hedge fund advisers cannot be verified 

because of the lack of independent oversight of a hedge fund adviser’s valuation of a hedge 

fund’s portfolio securities and the fact that hedge fund performance results are not required to be 

reported using a uniform or standardized performance measure. 

Information about hedge funds is also available through third-party websites (i.e., 

websites sponsored by persons not connected to any hedge fund). Generally these websites 

provide in one central location descriptive and performance-related information about a number 

 

176 Bloomberg posts the results of over 100 hedge fund indices. The data for the indices is compiled 

by several database repositories/consultants, including: Credit Suisse First Boston/Tremont 

Partners; Evaluation Associates Capital Markets; Lehman Brothers; Hedge Fund Research, Inc.; 

Hennessee Hedge Fund Group; and Standard & Poor’s. 

177 See, e.g., Comment submitted by Craig S. Tyle on behalf of the Investment Company Institute; 

Bing Liang, Hedge Funds: The Living and the Dead, 35 Journal of Financial and Quantitative 

Analysis 309 (Sept. 2000); Harry M. Kat, 10 Things That Investors Should Know About Hedge 

Funds, The Journal of Wealth Management 72 (Spring 2003). 

178 For example, a successful hedge fund that has reached its capacity limits may close the fund to 

new investors and stop reporting altogether. 

179 See, e.g., Liang, supra note 177 at 309; Kat, supra note 177 at 72, 73. 

51
of hedge funds. Subscribers who are pre-qualified as accredited investors may, for a fee, receive 

a password permitting them access to this information. 180 

Finally, some information about hedge funds can be obtained from institutional reporting

services such as Bloomberg and from financial newsletters. In addition, consistent with the 

growth of hedge funds, members of the press and other forms of media actively cover the hedge 

fund industry.

181 

E. Hedge Fund Service Providers

1. Hedge Fund Investment Advisers 

A hedge fund typically is sponsored, organized and managed by its investment adviser. 

Many hedge fund investment advisers were founded by former traders, analysts or portfolio 

managers who left investment banks, investment management firms and other large financial

institutions to establish their own hedge funds. Many of these individuals were attracted by the 

entrepreneurial aspects of starting their own business and managing assets using investment 

strategies in which they may have a particular expertise.182 They also often are lured to establish 

their firms by the potential compensation that can be earned by managing hedge funds.

A hedge fund’s investment adviser usually is responsible for establishing the hedge fund 

and overseeing the preparation of the hedge fund’s PPM and subscription agreement, as well as 

the applicable limited partnership or limited liability company agreements (for domestic

funds).183 The investment adviser negotiates the hedge fund’s arrangements with various service 

 

180 See Lamp, supra note 36. 

181 As discussed below, some of these practices lead to questions regarding the sources of hedge fund 

information and more importantly, whether hedge fund advisory personnel that provide 

information through these sources or that respond to inquiries from the media are engaged in a 

general solicitation or in a general advertising for purposes of the federal securities laws. See

infra Part VI.F. (discussing concerns relating to general solicitation).

182 See Roundtable Transcript, May 14 (statement of Joel Press) (“It really is a business of people 

wanting to create their own culture, their own environment, . . . creating their way of earning

dollars in a way that’s unique to them, in their own strategy, their own people, their own 

compensation environment, and allowing them to exist in today’s technology wherever they

choose to set up their organization and just work and trade and do their research. It’s a very

unique entrepreneur.”). 

183 If the fund is a limited partnership, the investment adviser typically serves as the fund’s general 

partner. If the fund is a limited liability company, the investment adviser typically serves as the 

52
providers, including broker-dealers providing prime brokerage services. The investment adviser 

also generally is responsible, at least in the early stages of the hedge fund’s existence, for 

marketing and distributing the fund’s securities to investors. Finally, the investment adviser 

often is responsible for investor relations, including providing periodic reports to investors about 

fund performance. 

The nature and capabilities of hedge fund investment advisers vary greatly. Some hedge 

fund advisers are exceedingly sophisticated entities that manage billions of dollars in investment 

assets. These advisers employ multiple portfolio managers, analysts, brokers and compliance,

risk management, legal and other operational personnel. These advisers also have the ability to 

install sophisticated systems and procedures to assist in complying with the advisers’ fiduciary

duties. At the opposite end of the spectrum are smaller, typically recently established investment 

advisers where one individual serves as marketer, portfolio manager, trader, operations officer 

and risk manager. Many of these types of advisers have few, if any, formal procedures. 

2. Broker-Dealers/Prime Brokers 

Full service broker-dealers frequently offer prime brokerage services, in addition to 

typical brokerage services, to hedge fund advisers. Prime brokerage is a system developed by

full-service broker-dealers to facilitate the clearance and settlement of securities trades and to 

provide other services for substantial retail and institutional customers, including hedge funds.184 

Hedge fund advisers often select prime brokers by matching the hedge fund’s strategies with the 

specific services and areas of expertise offered by one or more different full-service brokerdealers.185 Among the key services that may be offered by broker-dealers are: 

• Streamlined Trading. Prime brokers clear and settle hedge funds’ trades executed by

other broker-dealers (“executing brokers”) upon instructions from hedge fund 

advisers.186 The hedge fund maintains its funds and securities in an account with the 

 

fund’s managing member. Terrance J. O’Malley, The Regulation of Hedge Fund Managers by 

the SEC 2 (2003). 

184 See Testimony of William H. Donaldson, Chairman, U.S. Securities and Exchange Commission,

Before the House Financial Services Subcommittee on Capital Markets, Insurance and 

Government Sponsored Enterprises (May 22, 2003) (“Chairman Donaldson Testimony”). 

185 Less established hedge funds tend to have arrangements with a single prime broker, which is 

often the firm that assisted in the hedge fund’s start-up. More established hedge funds and those 

with more complex investment strategies are more likely to use multiple prime brokers. Hedge 

fund advisers may also use multiple broker-dealers in order to ensure only limited exposure of 

their investment strategies and portfolio holdings to any one broker-dealer. 

186 See Prime Broker Committee (pub. avail. Jan. 25, 1994). 

53
prime broker. Transactions placed with executing brokers are effected through 

accounts with those brokers in the name of the prime broker for the benefit of the 

hedge fund. After executing a trade, the executing broker and the hedge fund adviser 

report the details to the prime broker, who clears the trade and provides custody of the 

securities. 

• Securities Lending. Many hedge funds’ investment strategies involve short selling. 

A broker-dealer’s securities loan capability plays a critical role in this process. Prime

brokers use their relationships in the banking and brokerage communities to locate

and acquire securities to lend to their customers for short selling purposes. Hedge

funds often choose prime brokers who have the largest inventories of securities 

available for loans, or those who are able, through relationships and market clout, to 

easily acquire the securities. 

• Margin Lending. Broker-dealers maintain margin accounts and provide loans and 

other services in connection with facilitating transactions for their customers. Prime

brokers are generally required to maintain collateral to secure margin loans to hedge

funds as a result of regulatory requirements and internal limits on risk exposure, 

which are constantly monitored for changes. 

• Capital Introduction. These services are designed to introduce hedge fund advisers to 

potential hedge fund investors. Prime brokers may sponsor seminars for consultants 

and institutional investors seeking exposure to hedge funds. Prime brokers may also 

set up one-on-one meetings and prepare marketing materials to introduce potential 

investors to hedge fund advisers. 

• Hedge Fund Start-up Services. Broker-dealers may offer new hedge fund advisers 

with the means of operating a hedge fund through introductions or referrals to 

lawyers, accountants and other service providers. In addition to assisting these hedge 

fund advisers with back office support, the broker-dealer may provide the hedge fund 

adviser with office space. 

• Customized Reporting. Some broker-dealers offer to provide hedge fund advisers 

with customized periodic reports, including: (1) reports that reflect end of day pricing

of securities; (2) reports that provide risk management to investment advisers, such as

value-at-risk, liquidity and stress testing; and (3) reports that allow fund advisers to 

provide investors with some limited transparency information. 

• Research. Most broker-dealers offer to provide proprietary and third-party research 

and other soft dollar arrangements related to individual securities and particular

market sectors of interest to the hedge fund’s investment adviser. 

• Valuation. Some broker-dealers may function as a source of prices for certain types 

of (or individual) securities. 

54
• Technology. Some broker-dealers facilitate the start-up of new hedge funds by

offering technology services, including reporting systems, software, trading systems, 

connections to ECNs, fixed connectivity and risk management systems. Other 

broker-dealer firms offer advice in these areas and may arrange for these services to

be provided by a third-party.

• Operations Services. Broker-dealers may offer to provide persons seeking to start a 

hedge fund with: (1) advice regarding minimum and maximum amounts of investor 

subscriptions required to be raised and rates of returns expected by investors; (2) 

services such as the preparation of offering materials and reports to investors; (3) 

information on strategies to assist in obtaining investments; (4) advice as to

appropriate investment alternatives for excess cash; and (5) referrals of requests for 

information from potential investors. 

Compensation for prime brokers varies based on the nature of the services that they

provide to their customers. While some broker-dealer firms have guidelines for fees, most will 

negotiate final fees on a case-by-case basis.187 To determine fees, prime brokers evaluate each 

hedge fund adviser on an overall risk/return basis and on the business done at the broker-dealer 

firm. Prime brokers generate revenue on hedge fund business from commissions, spreads, 

administrative fees, ticket charges, stock loans and credit interest earned from providing position 

financing and arranging securities loans.188 The prime broker will generally assess the package

of services required by the hedge fund and suggest a price on that basis. 

3. Offshore Administrators 

Investment advisers of offshore hedge funds typically rely on offshore administrators to 

provide various types of operational support.189 These administrators provide offshore hedge 

funds with a number of services, many of which were initially offered to assist offshore hedge 

 

187 Fee arrangements for prime brokerage services generally take the form of undocumented, verbal 

agreements. 

188 For example, prime brokers that finance margin transactions receive income based on the spread 

between the prime broker’s cost of borrowing and the rate charged to the hedge fund for the loan. 

In short sale arrangements handled by the prime broker, the prime broker generally retains the 

spread between the interest earned on collateral (i.e., cash) posted by the borrower and the rebate 

paid to the borrower. In addition, prime brokers may receive income by charging a “ticket 

charge” for each transaction processed through the prime broker. 

189 Outsourcing the Administration of Alternative Investment and Hedge Funds – Presentation by

Dermot S.L. Butler to the Mastering Investments and Offshore Funds Conference in Dublin, 

Ireland (Nov. 28, 2001), available at www.customhousegroup.com/outsourcing.htm. 

55
funds in addressing certain U.S. tax provisions.190 Notwithstanding the repeal of these 

provisions, many offshore funds continue to maintain their relationships with offshore 

administrators as a matter of convenience and investor preference. 

Hedge fund advisers contract with offshore administrators for specific services that the 

administrator will provide their offshore hedge funds.191 Offshore administrators may assist a

hedge fund adviser to set up an offshore hedge fund in accordance with applicable foreign laws 

and also may assist the fund in complying with such laws on an ongoing basis. Offshore 

administrators also may assist hedge fund advisers by organizing meetings of investors and 

directors. They also may provide accounting, record keeping and reporting services, as well as 

assist in calculating fees and accruals. Offshore administrators may provide offshore hedge fund 

advisers with some oversight of their activities, particularly with respect to hedge fund 

finances.192 

One of the more important tasks an offshore administrator may provide to an offshore 

hedge fund adviser is to assist it in pricing the fund’s portfolio securities. The scope of this 

service frequently depends on the nature of the agreement with the offshore administrator, as 

well as the investment strategies used by a particular fund and whether prices are easily

obtainable for the securities in which the hedge fund invests. In some cases, the administrator 

will not provide independent prices of specific securities, but may generally defer to the

valuations provided to it by the hedge fund adviser and calculate the offshore hedge fund’s net 

asset value based on that information.193 

Certain offshore jurisdictions regulate offshore hedge fund administrators operating

within their borders. Such regulation may subject the administrators to licensing, auditing and 

record keeping requirements. For example, many offshore hedge funds are domiciled in The 

 

190 Prior to 1998, if an offshore hedge fund performed a set of specific services (called the “Ten 

Commandments”) from offices outside of the United States, the IRS would not consider the fund 

to have its principal office in the United States, and generally would not subject the hedge fund to 

U.S. taxation. The Taxpayer Relief Act of 1997 eliminated the need for offshore hedge funds to 

comply with the Ten Commandments. Pub. L. No. 105-34, 111 Stat. 788 (1997). 

191 For a discussion of the range of possible services provided by an offshore third-party hedge fund 

administrator, see Roundtable Transcript, May 14 (statement of William Keunen). 

192 See Ready to Take Advantage, International Fund Services Review Dublin 40 (2001). See also

Roundtable Transcript, May 14 (statement of William Keunen). 

193 Hedge fund PPMs typically state that the general partner/managing member has ultimate authority

in the valuation of securities. 

56
Bahamas, Bermuda, the British Virgin Islands and the Cayman Islands.194 These jurisdictions 

generally apply certain laws regulating the operations and conduct of investment pools and 

investment pool administrators to hedge funds and hedge fund administrators. These laws 

generally require fund administrators to be licensed, and three of the four jurisdictions require 

licensed fund administrators to have their accounts audited by an auditor approved by the 

regulator.

195 With respect to record keeping, each of these jurisdictions also subjects licensed 

fund administrators to anti-money laundering provisions. These provisions set forth client 

identification and record keeping requirements in addition to obligations to report any suspicious 

activity with respect to the funds they administer to the relevant authority in that jurisdiction.196 

4. Auditors 

Unlike registered investment companies, there is no statutory or regulatory requirement 

that a hedge fund have its financial statements audited.197 Whether a hedge fund undergoes an 

annual audit of its financial statements is a contractual matter between the hedge fund and its 

investors. The auditors of hedge funds that provide audited financial statements to their 

investors generally conduct independent audits of hedge funds pursuant to Generally Accepted 

Auditing Standards in the United States (“GAAS”),198 and generally render an opinion on 

 

194 See generally The Bahamas Mutual Funds Act, 1995 (June 2001 Revision); Bermuda Monetary

Authority Act 1969; Bermuda Companies Act 1981, Part XIIA (Mutual Fund Companies); 

Bermuda Monetary Authority (Collective Investment Scheme Classification) Regulations 1998; 

British Virgin Islands Mutual Funds Act, 1996 (as amended 1997); and Cayman Islands Mutual 

Funds Law (2003 Revision). 

195 We understand that the fourth jurisdiction, Bermuda, has legislation pending that would require 

such audits. 

196 See generally Bermuda Proceeds of Crime (Money Laundering) Regulations Sections 4-6 

(1998); British Virgin Islands Anti-Money Laundering Code of Practice (1999); Cayman Islands 

Proceeds of Criminal Conduct Law (Money Laundering Regulations) (2000); The Bahamas 

Financial Transactions Reporting Act (2001 Revision). 

197 Generally, the federal securities laws effectively prohibit any issuer, including registered 

investment companies, from offering or selling its securities publicly unless the issuer has filed a 

registration statement with the Commission which is required to include the issuer’s financial 

statements and an opinion from an independent accountant. This prohibition, however, does not 

apply to hedge funds because they do not publicly offer or sell their securities. See Sections 5 

and 7 of the Securities Act. 

198 GAAS is generally comprised of the professional standards established by the American Institute 

of Certified Public Accountants (“AICPA”), including the industry audit and accounting guides. 

See Implementation of Section 10A of the Securities Exchange Act of 1934, Exchange Act 

Release No. 38387 (Mar. 12, 1997) (citing AU Section 150.02, AICPA Codification of 

Statements on Auditing Standards). 

57
whether a hedge fund’s financial statements are materially consistent with Generally Accepted 

Accounting Principles in the United States (“GAAP”)199 Depending on its agreement with its 

investors, the investment adviser may forward the independent accountant’s report and the hedge 

fund’s financial statements to investors upon the completion of the audit.200

A domestic hedge fund’s engagement of an independent accountant to audit its financial 

statements is normally the responsibility of the fund’s investment adviser. The selection of an 

independent accountant by domestic hedge funds, because they are typically organized as limited 

partnerships, is not subject to ratification or approval by a board of directors or other 

representative body of the investors in the hedge fund.201 

The qualifications of an independent accountant that may be used by a hedge fund are not 

as stringent as those used for registered investment companies. A hedge fund’s independent 

accountant must comply with the general independence standards of the AICPA or of the 

individual State Boards of Accountancy where the independent accountant practices. In contrast, 

a registered investment company independent accountant must comply with the requirements of 

the Investment Company Act of 1940 and is required to follow certain regulations established 

under the Sarbanes-Oxley Act of 2002 and various Commission rules to ensure the independence 

 

199 A minority of domestic hedge funds and many offshore hedge funds prepare financial statements 

on a different comprehensive basis of accounting (e.g., tax accounting standards, international 

accounting standards (IAS) or local country generally accepted accounting principles (foreign 

GAAP)). If the financial statements are prepared in accordance with another comprehensive 

basis of accounting instead of GAAP, an audit may still be conducted under GAAS. 

200 There are no time constraints on delivering the hedge fund’s audited financial statements to 

investors unless specifically stated in the PPM or partnership agreement. But see Rule 206(4)-2

of the Advisers Act (registered investment adviser with custody of client assets is required to 

provide all limited partners or beneficial owners of the hedge fund with audited financial 

statements within 120 days in certain circumstances). In contrast, registered investment 

companies must transmit to shareholders audited financial statements within 60 days of their 

fiscal year end. See Rule 30e-1(c) under the Investment Company Act. 

201 The selection process used by domestic hedge funds contrasts with the selection of an 

independent accountant by a registered investment company. The Investment Company Act 

regulates both the selection process of the fund’s accountant and the continuing oversight of a 

registered investment company’s auditing processes by requiring an independent accountant to be 

approved by either a majority vote of the disinterested board members or the approval by the 

board’s audit committee. See Section 32(a) of the Investment Company Act and Rule 32a-4

thereunder. There may be some oversight of the selection of the independent accountants by

offshore hedge funds, because they are typically organized as corporations.

58
of auditors.202 In addition, a hedge fund’s independent accountant is not required to register with 

the Public Company Accounting Oversight Board (“PCAOB”) unless if it also serves as the 

independent auditor for a public company.

203 A hedge fund’s independent auditor is not 

otherwise required to register with PCAOB, nor are its audits with respect to private issuers 

subject to PCAOB examination. As a result, the audits of hedge fund financial statements will 

not be subject to the examination process of the PCAOB in its oversight of registered accounting

firms.204 

5. Consultants and Other Finders 

Hedge fund consultants are generally third parties who perform services for hedge fund 

investors and the hedge funds. Consultants offer investors educational and due diligence 

services to assist them in navigating the complexities of hedge fund investing.

205 They also may

provide hedge fund advisers with services, such as assisting those advisers to determine the 

eligibility of new investors. Many consultants manage their own proprietary hedge fund 

products for sale to investors. 

Hedge fund consultants educate investors with respect to the type of information that

should be sought in connection with any hedge fund investment.206 They may assess the 

 

202 Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002) (“Sarbanes-Oxley Act”). 

See also Article 2 of Regulation S-X (qualifications and reports of accountants). 

203 PCAOB has jurisdiction over entities that are issuers pursuant to Section 3(a)(8) of the Exchange

Act. PCAOB oversees the audits of financial statements of such public companies through 

registration, standard setting, inspection and disciplinary programs. See Sarbanes-Oxley Act, 

Sections 102-105, 108. 

204 The independent audits of public companies, including registered investment companies, will be 

subject to PCAOB examination. PCAOB is in the process of establishing auditing, quality

control and ethics standards to be used by registered public accounting firms in the preparation 

and issuance of audit reports. The implementation of these standards may indirectly benefit 

audits of hedge funds to the extent that PCAOB-registered firms also perform audits of hedge 

funds and draw on the standards applicable with respect to public companies. 

205 Hedge fund investors also frequently hire private investigator services to assist them in verifying

the information provided by the investment adviser and its personnel. For example, these 

services may be called upon to verify a portfolio manager’s educational or employment 

background as well as to confirm reported investment performance assertions. See Roundtable 

Transcript, May 15 (statement of Sandra Manzke), supra note 162. 

206 Most hedge fund investors perform extensive due diligence prior to making initial and subsequent 

investments. According to a survey of institutional investors, 60 percent of institutional investors 

take between two to six months to complete due diligence on a hedge fund. Deutsche Bank

Survey, supra note 158, at 7. 

59
suitability of a hedge fund investment in light of the investor’s investment objectives and risk 

tolerance and may assist with asset allocation decisions.207 

Consultants often provide investors with due diligence services relating to specific hedge

fund investments, such as analyzing the hedge fund’s offering and partnership documents, 

compiling historic return information and checking background information about the hedge 

fund adviser. Consultants may also make an assessment of the operational capabilities of a 

particular hedge fund by visiting the adviser. After an investment is made, consultants assist 

investors’ monitoring of hedge fund investments and management through regular 

communications with the hedge fund adviser and tracking of the fund’s performance against 

other funds that utilize the same investment strategy. 

The intermediary role of hedge fund consultants may present certain conflicts of interest. 

A conflict of interest may exist when a hedge fund consultant provides an advisory service to 

investors, but also offers or recommends its own proprietary hedge fund products. A conflict of 

interest may also arise when the consultant essentially acts as a “marketer” for the hedge fund 

and receives a “rebate” or fee (e.g., a percentage of the hedge fund’s management and 

performance fees) from the hedge fund.208 This contrasts with other arrangements where the 

 

207 See, e.g., Hennessee Group Comment Letter, supra note 4, at 18-19. Consultants who, for 

compensation, recommend specific hedge funds to investors generally are serving as investment 

advisers under Section 202(a)(11) of the Advisers Act. A consultant that merely engages in 

solicitation activities for a registered investment adviser is deemed to be an associated person of 

that investment adviser. See Requirements Governing Payments of Cash Referral Fees by 

Investment Advisers, Advisers Act Release No. 688 (July 12, 1979). 

208 Generally, the obligation to disclose conflicts arises from the consultant’s status as an investment 

adviser. Consultants that market hedge fund interests, however, may be acting as a broker and be 

required to register with the Commission as such under Section 15(b) of the Exchange Act. 

Section 3(a)(4) of the Exchange Act generally defines a “broker” as a person who is “engaged in 

the business of effecting transactions in securities for the account of others.” “Regularity of 

participation” in securities transactions is primary indicia of being engaged in the business of 

effecting securities transactions. SEC v. Kenton Capital, Ltd., 69 F. Supp. 2d 1, 12-13 (D.D.C. 

1998). A person may be found to be acting as a broker if he participates in securities transactions 

“at key points in the chain of distribution.” Massachusetts Financial Services, Inc. v. Securities 

Investor Protection Corp., 411 F. Supp. 411, 415 (D. Mass.), aff’d, 545 F.2d 754 (1st Cir. 1976), 

cert. denied, 431 U.S. 904 (1977). Key factors indicating that a person may be acting as a broker 

-- and, thus would need to register with the Commission -- are solicitation of investors to 

purchase securities, involvement in negotiations between the issuer and the investor, and receipt 

of transaction-related compensation. See, e.g., SEC v. Hansen, [1984 Transfer Binder] Fed. Sec. 

L. Rep. (CCH) 91,426 (S.D.N.Y. 1984). It is not necessary to prove scienter to establish a 

violation of Section 15(a)(1). SEC v. National Executive Planners, Ltd.,503 F. Supp. 1066, 1073 

(M.D.N.C. 1980).

60
consultant receives a fee from the investor, in the form of either a retainer, or a flat or asset-based 

fee.209 

F. Hedge Fund Advisory Fees 

An investment adviser to a hedge fund generally receives compensation composed of an 

investment management fee and an incentive allocation.210 The investment management fee is 

an asset-based fee that is similar to the advisory fee charged by advisers to registered investment 

companies and is designed to provide the investment adviser with current cash flow to maintain 

operations. The investment management fee is generally one to two percent of net assets.211 

The incentive allocation is not a fee paid to the investment adviser, but instead, is an 

allocation of partnership earnings and profits to the general partner of the partnership. Unlike the 

management fee, the incentive allocation is usually calculated as a percentage of the hedge

fund’s net investment income, realized capital gains and unrealized capital appreciation. 

Incentive allocations for hedge funds tend to be 20 percent of realized and unrealized gains.212 

 

209 Hedge fund advisers that are registered investment advisers that have referral/solicitation 

arrangements with various consultants or broker-dealers are specifically required to disclose, 

among other things, the compensation that they pay to solicitors. See Rule 206(4)-3 under the 

Investment Advisers Act and Form ADV, Part II, Item 13. Any conflicts of interest surrounding

the referral arrangement (e.g., when the solicitor is also an investor in the hedge fund) must also 

be disclosed. 

210 The nature of a hedge fund’s fees and the tax implications are intertwined with the fund’s 

domicile and organizational structure. 

211 According to Van Hedge Fund Advisers (“VHFA”), as of the first quarter of 2003, the median 

hedge fund had a management fee of one percent. VHFA tracks over 4,000 hedge funds. See

Van Hedge Fund Advisors International, Inc., Global Hedge Funds, characteristics as of the first 

quarter of 2003 (“Global Hedge Funds Characteristics”). See also Clinton Group Hikes Fees on 

Macro Fund, Alternative Investment News (July 1, 2003) (noting that the fund increased its 

management fee to three percent).

212 Section 205 of the Advisers Act and Rule 205-3 thereunder address the assessment of fees based 

upon a share of capital gains and capital appreciation. These provisions generally prohibit 

registered investment advisers from charging performance-based fees to most clients that are not 

“qualified clients,” as defined in Rule 205-3. This prohibition does not apply to advisory

relationships with hedge funds that rely on Section 3(c)(7). See Section 205(b)(4) of the Advisers 

Act. 

Rule 205-3 generally defines a qualified client as one of the following: (1) a natural person or 

company that has $750,000 under the management of the adviser; or (2) a natural person or 

company whom the adviser believes has (a) a net worth of $1.5 million or (b) is a qualified 

61
In comparison with the asset-based fees typically charged by registered investment companies, 

the incentive allocations, or performance fees typically charged by hedge fund advisers, are often 

perceived as creating incentives for investment advisers to take greater risks with client assets.213

Hedge fund advisers often agree to certain conditions that are designed to align the 

adviser’s interests with those of the hedge fund investors. For example, investors often require 

the investment adviser to have a significant financial investment in the hedge fund. Investors 

rely on this requirement to serve a number of purposes, including curbing any temptation for the

adviser to take undue risks. 

The partnership agreement may also contain other provisions that protect investors from 

paying incentive allocations for poor performance, such as high water marks and hurdle rates. 

High water marks are thresholds that the investment adviser must achieve before an incentive 

allocation can be assessed.214 Generally, a high water mark varies for each limited partner based 

on the maximum value of the limited partner’s interest in the partnership since its initial 

investment in the fund. The investment adviser must generate investment returns beyond the 

“high water mark” before the investment adviser can assess an incentive allocation. In essence, 

the hedge fund’s performance must surpass its previous high point before additional incentive 

allocations can be assessed. This prohibits an adviser from collecting an incentive allocation 

twice for the same performance.215 

 

purchaser as defined in Section 2(a)(51)(A) of the Investment Company Act. Rule 205-3(b) 

requires a registered investment adviser intending to charge a hedge fund relying on Section 

3(c)(1) a performance fee to look through the hedge fund to ensure that each of its equity owners 

is also a qualified client. See Exemption to Allow Investment Advisers to Charge Fees Based 

Upon a Share of Capital Gains Upon or Capital Appreciation of a Client's Account, Advisers Act

Release No. 1731 at text accompanying nn.28-32 (July 15, 1998).

213 See H.R. Rep. No. 2639, 76th Cong., 3d Sess. 29 (1940). Performance fees have been 

characterized as “heads I win, tails you lose” arrangements in which the adviser had everything to 

gain if successful and little, if anything, to lose if not. S. Rep. No. 1775, 76th Cong., 3d Sess. 22 

(1940). See also Investment Trusts and Investment Companies, H.R. Doc. No. 477, 76th Cong., 

3d Sess. 30 (1939); Exemption To Allow Registered Investment Advisers to Charge Fees Based 

Upon a Share of Capital Gains Upon or Capital Appreciation of a Client's Account. Advisers Act

Release No. 996 (Nov. 26, 1985); Exemption To Allow Investment Advisers To Charge Fees 

Based Upon a Share of Capital Gains Upon or Capital Appreciation of a Client's 

Account, Advisers Act Release No. 1682 (Nov. 13, 1997). 

214 According to VHFA, of those funds with performance fee arrangements, 89 percent have a high

water mark. See Global Hedge Funds Characteristics, supra note 211. 

215 For example, assuming an initial investment of $10,000, a 20 percent performance fee, and a first 

year return of ten percent, the first year’s performance fee would be $200: [($10,000 * 1.10 = 

62
Hurdle rates are also used to guarantee that the hedge fund achieves a minimum 

investment performance before the fund’s adviser may receive any incentive allocation.216 A 

hurdle rate establishes a performance floor that the investment adviser must exceed in order to

obtain the incentive allocation.217

Hedge funds that cannot consistently achieve positive performance are likely to exit the 

business. Because the incentive allocation provides the majority of an investment adviser’s 

income from its hedge fund, failure to produce positive returns will prevent a hedge fund from 

collecting the performance fee. If an adviser’s performance allocation is subject to a high water 

mark, the hedge fund must surpass its previous high point before a performance allocation is 

paid. The failure to produce positive returns has other effects beyond denying the fund’s adviser 

of profits. These may include the departure of the fund’s key employees, as well as the 

redemption of investments. Of course, these factors are key determinants into whether the hedge 

fund will survive.218

When hedge funds do close, certain liquidation issues may be present. Hedge fund 

management contracts typically have provisions designed to protect the adviser and the 

remaining limited partners in the event of liquidation. “Holdback provisions” permit hedge 

funds to withhold specified fractions of redeeming limited partner’s capital. These provisions 

 

$11,000) and ($11,000 - $10,000) * 0.20 = $200]. If the second year’s return is -20 percent 

[$11,000 * 0.80 = $8,800], the adviser receives no performance fee since the $8,800 is less than 

the high water mark of $11,000. If in the third year the fund has a 30 percent return [$8,800 * 

1.30 = $11,440], the adviser receives a performance fee of $88 [$11,440 - $11,000 = $440 * 0.20 

= $88]. 

216 According to VHFA, of those funds with performance fee arrangements, 18 percent have a hurdle 

rate. See Global Hedge Funds Characteristics, supra note 211. 

217 If a hedge fund investment adviser performance compensation plan is subject to a 10 percent 

hurdle rate provision, then the investment adviser must exceed a 10 percent return on the fund 

before an incentive allocation can be assessed. For example, assuming an initial investment of 

$10,000, a hurdle rate of ten percent, a 20 percent performance fee and first year actual fund 

performance of 25 percent, then the adviser would earn $300 in incentive allocation: 

[{10,000*(1.25-1.10)}*.20=300]. In other variations, a hurdle rate can be applied to all profits, 

but only after the net return has exceeded the hurdle rate (i.e., the investment return after 

consideration of the incentive allocation is greater than the hurdle rate). 

218 The President’s Working Group on Financial Markets report estimated that, based on a sample of 

397 hedge funds from 1994 to 1998, the survival rate was less than 60 percent. LTCM Report, 

supra note 126, at A-4. VFHF reports that the median hedge fund age is only 5.5 years. See

Global Hedge Funds Characteristics, supra note 211. 

63
guard against the possibility that investors should have received less money than they received 

on the redemption dates. 

G. Hedge Fund Valuation Practices

Hedge funds that invest in liquid securities normally value their portfolio securities using

market values for those securities when available. Hedge fund advisers generally “fair value” 

portfolio securities when market prices for those securities are not readily available.

219 Some 

hedge fund advisers fair value their portfolio securities by reference to an accounting industry

standard, which standard generally equates fair value to the price that the fund might reasonably

expect to receive for a security or other asset upon its current sale.220 

The key difference between the valuation of a registered investment company’s portfolio 

securities and those of a hedge fund’s portfolio securities, is that a hedge fund investment adviser 

generally has complete discretion with respect to the valuations used to price the fund’s 

securities, whereas the board of directors of a registered investment company provides 

independent oversight of the adviser’s valuation activities.221 For example, some hedge funds 

may value the securities of non-publicly traded companies at cost and may not revalue them until 

a public trading market for the securities develops or the issuer engages in a subsequent round of 

equity financing. 

Third parties also may assist hedge funds in the valuation process. Many hedge funds 

obtain pricing information from independent pricing services to either ascertain the market

values or assist the investment adviser in establishing fair values of the securities. Prime

brokers, as well as third-party administrators to offshore hedge funds, often perform fund 

valuation services as part of the package of services they provide to hedge funds.222 Whether 

 

219 Illiquid securities, certain debt instruments and securities issued in private placements and other 

difficult-to-price securities are the types of securities a hedge fund would be expected to fair 

value. 

220 See Statement of Financial Accounting Standards No. 107, Financial Accounting Standards Bd. 

(1991); Statement of Financial Accounting Standards No. 115, Financial Accounting Standards 

Bd. (1993); and Statement of Financial Accounting Standards No 133, Financial Accounting

Standards Bd. (1998). 

221 See supra note 16. 

222 See supra Part IV.E.2. (discussing role of broker-dealers/prime brokers) and Part IV.E.3.

(discussing offshore administrators). Prime brokers and administrators may review the valuation 

of portfolio securities, provide independent prices and reconciliation of portfolios and calculate 

and report NAVs. 

64
interposing a third-party into the fund’s valuation process increases the accuracy of the reported 

NAV largely will depend on the relationship of the third party to the hedge fund adviser and on 

what responsibilities the third-party is required to perform under the service contract.223 To 

assist in valuing particularly difficult securities, some hedge funds segregate these securities into 

“side pockets,” and postpone including the value of those securities in the hedge fund’s NAV 

calculation until the investment is liquidated.224 

H. Audit Reports 

When conducting an audit of a hedge fund in accordance with GAAS, auditors are 

required to follow the AICPA’s Investment Company Audit and Accounting Guide. Similar to 

an audit of a registered investment company, the auditor designs a series of tests, based upon an 

assessment of the hedge fund’s internal control environment, that verify the validity of the assets, 

liabilities, income, expenses and capital transactions of the hedge fund. In addition, this audit 

testing typically verifies the accuracy of partner capital balances, management and incentive fee 

calculations and of NAV calculations at intervals when significant contributions and withdrawals 

are permitted by the fund. 

A hedge fund audit, however, is not required to be identical to an audit of a registered 

investment company.

225 Unlike an audit of a registered investment company, a hedge fund audit 

generally utilizes a substantive test approach and does not rely on a strong, established internal

control system.226 The audit testing typically includes a sample confirmation of assets and 

 

223 For example, the service contract may require a third party to simply transmit prices or check

computations based on valuations provided by the hedge fund or its prime broker, without inquiry

into the reasonableness of those prices.

224 “Side pockets” protect investors against adverse timing of withdrawals. Since investment 

advisers tend to redeem more liquid assets first, as limited partners withdraw their money, the 

portion of the fund that is illiquid may increase significantly, leaving the remaining limited 

partners with an illiquid investment. The use of “side pocket” accounting effectively reduces the 

risk of illiquidity issues for limited partners that remain in the fund. 

225 The AICPA is in the process of revising its guidance to clarify the differences in accounting and 

auditing by registered investment companies and non-registered investment partnerships, such as 

hedge funds. See, e.g., AICPA Accounting Standards Executive Committee, Exposure Draft of a 

Proposed Statement of Position (SOP), Reporting Financial Highlights and Schedule of 

Investments by Nonregistered Investment Partnerships: An Amendment to the Audit and 

Accounting Guide Audits of Investment Companies and AICPA Statement of Position 95-2, 

Financial Reporting by Nonpublic Investment Partnership (July 15, 2003).

226 A hedge fund auditor is not required to render a separate opinion on whether the internal control 

system contains any material weaknesses. See Form N-SAR, Item 77B.

65
liabilities with independent third-party service providers to the hedge fund. In addition, a hedge 

fund audit generally permits the use of sampling techniques (i.e., less than 100 percent) in audit 

areas where the statutory provisions or regulatory rules applicable to registered investment 

companies require 100 percent verification, such as with respect to the existence and valuation of 

portfolio securities.227 

When conducting an audit of a hedge fund in accordance with GAAS, auditors are 

required to review a hedge fund’s fair valuation procedures for consistency with the fund’s PPM 

or partnership agreement, as applicable, to determine the reasonableness of the procedures.228 

Although the audit procedures with respect to valuation also are similar to those used for 

registered investment companies, a hedge fund audit provides less assurance about the valuation 

process for two reasons.229 First, a hedge fund audit evaluates a valuation determination that is 

made by the hedge fund’s investment adviser, who both makes investment decisions for the 

hedge fund and typically has ultimate discretion for assigning a value to its portfolio securities. 

This valuation process contrasts with the delegation of duties in the registered investment 

company context, where the investment company’s board of directors establishes valuation 

procedures and provides independent review of valuation determinations. Second, hedge fund 

auditors perform sample valuation tests of the hedge fund’s portfolio securities that are less 

comprehensive than the 100 percent verification standard applicable to registered investment 

companies.230 

I. Risk Management 

Hedge fund advisers are expected to achieve performance returns for investors by using

strategies that are designed to assume or eliminate calculated risks consistent with the hedge

fund’s investment objective. The observation that some hedge funds are riskier than others 

 

227 See Section 30(g) of the Investment Company Act (100 percent custody verification) and 

Accounting Series Release No. 118, Financial Reporting Codification (CCH) Section 404.03 

(Dec. 23, 1970) (100 percent verification of pricing). 

228 Hedge fund auditors typically conduct substantive tests on the application of the procedures in 

pricing portfolio securities to ensure that the process is being consistently applied. 

229 See infra Part VI.B. (discussing concerns about valuation of hedge fund portfolio securities). 

230 Many hedge funds obtain pricing information from pricing/valuation services such as Bloomberg, 

Reuters and FT Interactive Data to either ascertain market values or assist the investment adviser 

in establishing fair values. As with registered investment companies, auditors of hedge funds 

confirm the accuracy of market-priced security valuations with an independent third party by

comparing the portfolio values obtained from a pricing service to the valuations used in a hedge 

fund’s financial statements. 

66
reflects the wide latitude hedge fund advisers have to operate their funds and the potential that 

exists for some hedge funds to suffer significant losses. An effective risk management system, 

therefore, is important to a hedge fund’s operations.

The risk management systems used by hedge funds vary by firm. Larger and more 

seasoned hedge funds often establish an internal risk management structure using their own 

resources and personnel. It is common for less established hedge fund advisers that usually have 

fewer financial and personnel resources to outsource the risk management function to their prime 

brokers or to other service providers. Some of the less established hedge fund advisers have 

little or no risk management controls. 

Generally, risk management is a monitoring function that quantifies and tracks the risks 

involved after investments are acquired. Effective risk management systems require hedge fund 

advisers to identify, measure, monitor and manage the various dimensions of risk. These 

processes generally differ by firm because they are based on the resources and investment

strategies of the hedge fund adviser. The risks that are associated with hedge funds generally

may be divided into three broad areas of concern: portfolio risks; the effect of leverage on 

portfolio risks; and operational risks. Portfolio risks may be further divided into market risk, 

liquidity risk and credit risk. 

As a general industry standard, hedge fund advisers uniformly review information about 

positions, transactions, orders and margin to identify and monitor exposures at the individual 

portfolio level and on an aggregate basis for portfolios with the same adviser and/or using the 

same strategy. This information is then used to identify any excessive concentration of holdings 

in any one market and any concentration of holdings with potential converging correlations. 

J. Funds of Hedge Funds 

1. Background 

A FOHF is a hedge fund that utilizes a multi-manager, multi-strategy approach by

investing all, or a significant portion, of its assets in hedge funds.231 Although FOHFs can invest 

in as many underlying hedge funds as they choose, they typically invest in 15 to 25 funds. 

Institutional investors often choose to invest in FOHFs, rather than in single-manager hedge 

funds, in order to diversify against the risks associated with a particular hedge fund adviser. One 

 

231 The Investment Company Act generally does not limit the investment in hedge funds by

registered investment companies, including registered FOHFs. But see supra note 34 (lookthrough provision of Section 3(c)(1)) and supra note 41 (companies formed for the specific 

purpose of investing in a Section 3(c)(7) fund may not be a qualified purchaser). 

67
article reports that during the first three quarters of 2002, the number of FOHFs grew from an 

estimated 510 to 675, an increase of 32 percent, and FOHF assets increased by 84 percent.232 

Most FOHFs are not registered as investment companies under the Investment Company

Act and privately place their securities generally with accredited investors or qualified 

purchasers. FOHFs employ a compensation structure similar to that of other hedge funds. 

FOHFs typically charge asset-based investment management fees that range from about one-half 

to two percent and a performance allocation that ranges up to 20 percent. These fees are levied 

in addition to the asset-based fees and performance allocations assessed by the underlying hedge 

funds. 

2. Registered FOHFs 

An increasing number of FOHFs are registering as investment companies with the

Commission; as of early September 2003, 82 FOHFs had registered as closed-end investment 

companies under the Investment Company Act.233 At the same time that a FOHF registers as an

investment company under the Investment Company Act, it may also choose to register the offer 

and sale of its securities under the Securities Act (“Dual Registered FOHF”). Registration under 

the Securities Act allows a registered FOHF to, among other things publicly offer its securities. 

Dual Registered FOHFs must comply with the prospectus requirements of the Securities Act. 

In contrast to Dual Registered FOHFs, registered FOHFs that do not register their 

offerings under the Securities Act must privately place their securities in reliance on an 

exemption from registration (“40 Act only Registered FOHF”).234 More than two-thirds of the 

82 registered FOHFs are Dual Registered FOHFs.235 Registered FOHFs collectively have 

 

232 Justin Dini, The Fund of Hedge Fund, Institutional Investor 50, 51 (Dec. 2002) (citing

information from HFR, an organization that collects hedge fund data). 

233 In 1998, the first FOHF registered as an investment company under the Investment Company Act. 

See PW After Tax Equity Partners (SEC File No. 811-08803). 

234 See supra Part III.B.2 (discussing Regulation D). 

235 In October 2001, Oppenheimer Tremont Market Neutral Fund (SEC File No. 811-10537) and 

Oppenheimer Tremont Opportunity Fund (SEC File No. 811-10541) became the first FOHFs to 

register as investment companies under the Investment Company Act and to register the offering

of their securities under the Securities Act. 

68
approximately $3.7 billion of assets under management. Investment advisers to registered 

FOHFs must register under the Advisers Act.236

To date, all operating registered FOHFs have imposed a minimum initial investment 

requirement on their investors ranging from $25,000 up to $1 million.237 With respect to 

eligibility standards, registered FOHFs, including Dual Registered FOHFs, have restricted sales 

to investors that, at a minimum, satisfy the accredited investor standard.238 Registered FOHFs, 

however, may lower or eliminate the investment minimum at any time because this investment 

qualification is not required by law.239 

Importantly, other net worth-related, eligibility criteria may apply to investors in a

registered FOHF, depending, in large part, on whether the fund intends to charge a performance 

fee. If the investment adviser wishes to charge a performance fee to the registered FOHF, all of 

the fund’s investors must satisfy the definition of a “qualified client” under the Investment 

Advisers Act.240 

Investors in a registered FOHF are directly subject to the fees and expenses charged at

the registered FOHF level. They are also indirectly subject to the fees and expenses charged by

the underlying hedge funds in which the registered FOHF invests.241 Typically, a registered 

FOHF pays its investment adviser an asset-based management fee, generally equal to one to two 

percent of assets under management and, again provided that the fund’s investors are all 

qualified clients, a performance allocation based on the capital gains and capital appreciation of 

 

236 See Rule 203A-1 of the Advisers Act (requiring registration of advisers to registered investment 

companies). 

237 Notwithstanding the stated investment minimum, the offering documents of a registered FOHF 

(like those of hedge funds or unregistered FOHFs) may provide that the fund may reduce or 

waive the required minimum investment in limited circumstances, such as when the investor 

already is an existing client of the investment adviser with substantial assets under management, 

or when the investor is an officer or employee of the investment adviser. 

238 See supra Part III.B. (discussing accredited investor standard). 

239 But see infra note 250 (pending registration statement of FOHF that will offer and sell its 

securities without investor eligibility limitations). 

240 See supra note 212.

241 The underlying hedge funds could also be FOHFs, which would further compound fees and affect 

the performance of an investor’s investment in a registered FOHF. 

69
the fund’s portfolio.242 The underlying hedge funds, in turn, pay similarly structured investment 

advisory fees to their investment advisers. In addition, operational expenses, including

brokerage commissions, custody fees and transfer agent fees, may be incurred at both levels of a 

registered FOHF. 

Registered FOHFs are structured as closed-end management investment companies. As a 

general matter, closed-end investment companies offer a fixed number of shares to investors 

during the initial offering period. Investors purchase registered FOHF shares either in the fund’s 

initial offering or in any subsequent offerings.243 Many registered FOHFs provide for 

subsequent offerings on a semi-annual or quarterly basis, but other registered FOHFs allow 

investors to purchase shares on a more frequent basis. The number and dates of any subsequent 

offerings are determined by the fund. 

A registered FOHF uses the Form N-2 to register as a closed-end investment company

under the Investment Company Act.244 The prospectus portion of the registration statement

discloses information about, among other things, the FOHF’s investment objectives and 

strategies, risks, expenses and performance. Additional or more detailed information regarding

the FOHF and its operations, such as: fund history and policies; officers, directors, and persons 

controlling the fund; advisory and other services; brokerage commissions; and tax and other 

matters are contained in the Statement of Additional Information portion of the registration 

statement.

245 

A 40 Act only Registered FOHF may commence offering and selling its shares

immediately upon filing a registration statement with the Commission because such registration 

statements are deemed effective upon filing.

246 Because 40 Act only Registered FOHFs do not

register their securities offerings under the Securities Act, the prospectus delivery requirements 

under the Securities Act do not apply. Accordingly, these funds typically provide a PPM to 

interested investors that may not necessarily provide all the information required to be included 

in the N-2 registration statement. 

 

242 See supra note 212. See also supra Part IV.F. (discussing hedge fund advisory fees). 

243 Unlike open-end registered investment companies, closed-end funds do not continuously offer to 

sell and redeem fund shares. 

244 The Form N-2 is used by FOHFs that choose also to register their shares under the Securities Act. 

245 Registration statements on Form N-2 are available to the public on the Commission’s website. 

246 See Section 8(a) of the Investment Company Act. The FOHF also would file a notice on Form D 

with the Commission no later than 15 days after the first sale of securities. 

70
Under the Investment Company Act, shareholders in Dual Registered FOHFs and 40 Act 

only Registered FOHFs receive semiannual shareholder reports that are required to disclose, 

among other information, the fund’s financial statements and portfolio holdings, during the 

relevant period.247 Registered FOHFs may fulfill this disclosure obligation by listing the hedge

funds in which the registered FOHF has invested, but they are not required to identify the 

securities in which the underlying hedge funds have invested. 

3. Repurchases 

Registered FOHFs generally provide limited liquidity to their shareholders by offering to 

repurchase their securities pursuant to tender offers structured to comply with Section 23(c)(2) of

the Investment Company Act and Rule 13e-4 of the Exchange Act.248 Many registered FOHFs 

provide for repurchases twice a year, but other registered FOHFs provide for repurchases on a 

quarterly or more frequent basis. The registered FOHF’s adviser sets the terms of repurchase, 

which are disclosed to investors in the fund’s offering documents.249 Unlike most closed-end 

registered investment companies, shares of registered FOHFs have not been, to date, listed for 

trading in the United States on an exchange or NASDAQ.250 

4. Content of Registered FOHF Disclosure. 

Registered FOHFs provide in their registration statements on Form N-2 information that 

is required to be disclosed by all closed-end investment companies. In addition, they disclose 

information about the fund’s unique strategies, operations and risks. Registration statements also 

provide information about the valuation of portfolio securities, certain risks involved in the 

investment and fees and expenses. 

 

247 See Section 30(e) of the Investment Company Act and Rule 30e-1 thereunder.

248 Under Section 23(c)(2) of the Investment Company Act, registered closed-end investment 

companies may repurchase their shares in tender offers. Generally, Rule 13e-4 under the 

Exchange Act governs issuer tender offers and prohibits fraudulent, deceptive and manipulative 

acts by an issuer or an affiliate in connection with an issuer tender offer, and prescribes filing,

timing, disclosure, anti-discrimination provisions and other requirements. 

249 Registered FOHF prospectuses typically state that the fund “expects” to repurchase shares on a 

semi-annual, quarterly, or other basis. However, these funds do not qualify as “interval funds” for 

purposes of the Investment Company Act because they do not comply with all of the 

requirements of Rule 23c-3 under that Act. For example, registered FOHFs have not, to date, 

designated periodic repurchases as a fundamental policy. 

250 One Dual Registered FOHF that seeks to list its shares on the New York Stock Exchange has 

filed a registration statement with the Commission. That registration statement is currently under 

review. See CINTRA Select Fund (SEC File Nos. 811-21165 and 333-96821). 

71
• Valuation. Many registered FOHFs disclose that, prior to investing in a hedge 

fund, the registered FOHF’s adviser conducts due diligence reviews of the 

valuation methodologies used by each potential hedge fund investment. Most 

registered FOHFs disclose that one of the factors that they rely on to value their

interests in hedge funds is valuation information provided to them by the advisers 

to the underlying hedge funds. They also typically disclose that they generally

lack access to the information that would be needed to confirm independently the 

accuracy of valuation information provided by the underlying hedge funds. 

• Risks. Registered FOHFs typically disclose that only those investors who can 

tolerate a high degree of risk, e.g., the loss of all or a portion of the investment, 

should invest in such funds. Some registered FOHFs also disclose that a potential 

investor should consider various factors (such as the investor’s net worth, income, 

age, risk tolerance and liquidity needs) before deciding whether the particular 

registered FOHF is a suitable investment. 

• Fees and Expenses. The fact that investors pay fees and expenses at both the 

registered FOHF and underlying hedge fund level is disclosed prominently to 

investors, as are the types of fees charged at the hedge fund level. Registered 

FOHFs generally do not, however, disclose the actual or estimated amount of fees 

indirectly incurred by the FOHF through its investment in the underlying hedge 

funds.251

• Investment Strategies. Registered FOHFs typically disclose the various 

investment strategies that the underlying hedge funds may employ, including, in 

some cases, the impact of style shifts in underlying hedge funds on the registered 

FOHF’s ability to achieve its stated investment objective.

V. Hedge Fund Enforcement Actions 

A. Commission Actions 

Although hedge funds are not registered under the Investment Company Act, they and 

their advisers (regardless of whether the advisers are registered under the Advisers Act) are 

subject to the antifraud provisions of the federal securities laws. In recent years, the Commission 

 

251 Form N-2 requires disclosure of the fees and expenses incurred by the registered FOHF, but does 

not encompass disclosure of fees and expenses incurred by the underlying hedge funds. See infra

note 322.

72
has instituted a significant number of actions alleging hedge fund fraud.252 Since 1999, the 

Commission has brought approximately 38 enforcement actions relating to hedge fund advisers 

and hedge funds, and, in the last few years, the Commission has seen a steady increase in 

actions. The Commission staff is currently investigating a number of additional matters

involving possible fraud or other violations by hedge fund advisers and hedge funds. 

There is no evidence indicating that hedge funds or their advisers engage

disproportionately in fraudulent activity. However, the growth in the number of hedge fund 

fraud cases is likely attributable to a number of factors, including: the popularity of hedge fund 

investments and the large amounts of money they involve (and thus their attractiveness to 

perpetrators of fraud); the entrance to the industry of inexperienced, untested and, in some cases, 

unqualified individuals; and lack of adequate controls on the operations of some hedge fund 

advisers. 

The fraud charged in Commission enforcement actions against hedge fund advisers has 

been similar to the types of fraud charged against other types of investment advisers. Examples

include: misappropriation of assets;253 misrepresentation of portfolio performance;254

falsification of experience, credentials and past returns;255 misleading disclosure regarding

 

252 In most cases involving hedge funds, the Commission institutes enforcement actions against the 

hedge fund adviser and/or the adviser’s principals. 

253 See, e.g., SEC v. Jean Baptiste Jean Pierre, Gabriel Toks Pearse and Darius L. Lee, Litigation 

Release No. 18216 (July 7, 2003); SEC v. Peter W. Chabot, Chabot Investments, Inc. Sirens 

Investments, Inc., Sirens Synergy and the Synergy Fund, LLC, Litigation Release No. 18214 (July

3, 2003); SEC v. David M. Mobley, Sr., Litigation Release No. 18150 (May 20, 2003); SEC v. 

Vestron Financial Corp., Litigation Release No. 18065 (Apr. 2, 2003); SEC v. Hoover and 

Hoover Capital Management, Inc., Litigation Release No. 17981 (Feb. 11, 2003). 

254 See, e.g., SEC v. Michael Lauer, Lancer Management Group, LLC, and Lancer Management 

Group II, LLC, Litigation Release No. 18247 (July 23, 2003); SEC v. Peter W. Chabot, Chabot 

Investments, Inc., Sirens Investments, Inc., Sirens Synergy and the Synergy Fund, LLC, Litigation 

Release No. 18214 (July 3, 2003); SEC v. David M. Mobley, Sr., Litigation Release No. 18150 

(May 20, 2003); In the Matter of Charles K. Seavey, Advisers Act Release No. 2119 (Mar. 27, 

2003); SEC v. Hoover and Hoover Capital Management, Inc., Litigation Release No. 17981 (Feb. 

11, 2003); SEC v. Beacon Hill Asset Management LLC, Litigation Release No. 17831 (Nov. 7, 

2002); SEC v. Edward Thomas Jung, Litigation Release No. 17417 (Mar. 15, 2002); SEC v. Jerry 

A. Womack, Litigation Release No. 17293 (Jan. 2, 2002); SEC v. Michael W. Berger, Manhattan 

Investment Fund, Ltd., Manhattan Capital Management Inc., Litigation Release No. 17193 (Oct. 

16, 2001). 

255 See, e.g., SEC v. Jean Baptiste Jean Pierre, Gabriel Toks Pearse and Darius L. Lee, Litigation 

Release No. 18216 (July 7, 2003); SEC v. Peter W. Chabot, Chabot Investments, Inc., Sirens 

Investments Inc., Sirens Synergy and the Synergy Fund, LLC, Litigation Release No. 18214 (July

3, 2003); SEC v. Vestron Financial Corp., Litigation Release No. 18065 (Apr. 2, 2003); SEC v. 

73
claimed trading strategies;

256 and improper valuation of assets.257 The overwhelming majority of

the cases the Commission has instituted involve charges under each of the Securities Act, the 

Exchange Act and the Investment Advisers Act. 

There are a number of observations that can be made regarding hedge fund enforcement 

actions brought since 1999. Nearly a third of the hedge fund cases brought in the last four years 

involved criminal charges. Another characteristic, which appears common to hedge fund cases, 

is the lengths to which the violators go to conceal their fraud. In almost half of the enforcement 

actions brought since 1999, the defendants or respondents created false documentation in an 

effort to hide their fraud. These documents included account statements and other types of 

reports to customers, confirmations and pricing sheets. The third characteristic that is perhaps 

more common to hedge fund cases than the typical investment adviser’s case is the greater 

frequency of outright theft, or misappropriation, of investor funds that occurs. Finally, based on 

the Commission’s recent cases, both registered and unregistered investment advisers have 

engaged in hedge fund fraud. We have also found the same individual operating both registered 

and unregistered investment advisers while engaging in hedge fund fraud.258 

B. State and SRO Enforcement Activities 

State attorneys general are using state antifraud statutes to pursue enforcement actions 

against hedge funds. For example, New York Attorney General Eliot Spitzer used a 1921 New 

York business statute, the Martin Act, in asserting fraudulent trading arrangements between a 

 

House Asset Management, L.L.C., House Edge, L.P., Paul J. House, and Brandon R. Moore, 

Litigation Release No. 17583 (June 24, 2002); In the Matter of the Application of Brian 

Prendergast, Exchange Act Release No. 44632 (Aug. 1, 2001). 

256 See, e.g., SEC v. Peter W. Chabot, Chabot Investments, Inc., Sirens Investments Inc., Sirens 

Synergy and the Synergy Fund, LLC, Litigation Release No. 18214 (July 3, 2003); SEC v. David 

M. Mobley, Sr., Litigation Release No. 18150 (May 20, 2003); SEC v. Edward Thomas Jung,

Litigation Release No. 17417 (Mar. 15, 2002); SEC v. Jerry A. Womack, Litigation Release No. 

17293 (Jan. 2, 2002); In the Matter of the Application of Brian Prendergast, Exchange Act 

Release No. 44632 (Aug. 1, 2001). 

257 See, e.g., SEC v. Michael Lauer, Lancer Management Group, LLC, and Lancer Management 

Group II, LLC, Litigation Release No. 18247 (July 23, 2003); SEC v. Beacon Hill Asset 

Management LLC, Litigation Release No. 17831 (Nov. 7, 2002); SEC v. Michael L. Smirlock and 

LASER Advisers, Inc, Litigation Release No. 17630 (July 24, 2002). 

258 SEC v. Stevin R. Hoover and Hoover Capital Management, Inc., Litigation Release No. 17981 

(Feb. 11, 2003). 

74
hedge fund and four mutual fund companies.259 Other state securities regulators are also 

investigating state securities law violations involving hedge funds.260 

These state enforcement actions underscore the fact that the activities of hedge funds can 

have a material effect on both the securities markets and investors at large. The opaqueness of

hedge funds, however, presents a significant obstacle in regulatory efforts to monitor hedge fund 

activities. For example, the fact that most hedge fund advisers are not registered with the 

Commission as investment advisers conceals not only the existence of advisers but also of hedge 

funds themselves. The states’ efforts against hedge fund frauds assist the Commission in 

promoting fairness in the securities markets. 

Self-regulatory organizations have also been active in instituting hedge fund related 

enforcement actions. The NASD recently censured and fined a firm for failing to disclose the 

risks associated with hedge funds when marketing them to investors, and for exaggerated and 

unwarranted statements made in sale literature.

261 The NASD also censured and fined the firm’s 

 

259 See Canary Capital Partners, supra note 123. See also Spitzer Alleges Mutual Funds Allowed 

Fraudulent Trading, Wall Street Journal (Sept. 4, 2003) 

260 For example, the Illinois Secretary of State's Office has launched an investigation in connection 

with the New York Attorney General's investigation of hedge fund trading in mutual fund shares. 

See, e.g., Illinois Probing Hedge Fund Samaritan, Reuters English News Service (Sept. 10, 

2003). In August, Massachusetts securities regulators filed three complaints against hedge funds 

and their advisers for a variety of state securities law violations. See In the Matter of Rahul V. 

Singh, No. E-2003-55 (Mass. Sec. Div. filed Aug. 13, 2003) (alleging sales of hedge fund 

interests to non-accredited investors); In the Matter of Michael F. Payne, Futronix Trading, LTD, 

No. E-2003-55 (Mass. Sec. Div. filed Aug. 13, 2003) (alleging use of misleading performance 

claims and sales to non-accredited investors); In the Matter of James Pangione, Timothy Rassias, 

Hercules Capital Management, LLC, Hercules Hedgehog Fund, LP, No. E-2003-56 (Mass. Sec. 

Div. filed Aug. 13, 2003) (alleging use of misleading statements on adviser qualifications and 

experience, investment strategy and risk levels); In re Stonehouse, No. E-2003-52 (Mass. Sec. 

Div. filed Sept. 22, 2003) (alleging, among other things, fraud in the offering of hedge fund 

securities). 

261 See NASD Notice to Members 03-07 (June 16, 2003) (announcing disciplinary action taken 

against Altegris Investments, Inc.); see also In the Matter of the Application of Brian 

Prendergast, Exchange Act Release No. 44632 (Aug. 1, 2001) (Commission sustaining NASD 

bar and censure of hedge fund co-adviser for, among other things, using materially misleading

PPM and sales literature). 

75
Chief Compliance Officer for failing to adequately supervise the firm’s advertising practices in 

this area.262

VI. Concerns 

We have identified below a number of significant concerns in connection with the growth 

of hedge funds. 

A. Lack of Commission Regulatory Oversight 

1. Inability to Detect Fraud and Other Misconduct at Early Stages 

As noted above, in the last five years, the Commission has instituted 38 enforcement 

actions involving hedge fund fraud, involving significant losses to investors. The Commission 

typically identifies frauds and other misconduct involving hedge funds only after fund investors 

or service providers suspect fraudulent activity and contact the Commission. Thus, the 

Commission often finds itself instituting enforcement action against an unregistered hedge fund 

adviser only after significant losses have occurred.263 In contrast, the Commission has an 

advantage in identifying the misconduct of registered investment advisers because they are 

subject to periodic examinations by Commission staff. When fraudulent or other unlawful 

activity does occur, examinations can lead to earlier discovery – often before significant losses 

have resulted. Further, the Commission uses the potential for a surprise examination and 

 

262 See id. Specifically, the NASD found that between October 2002 and February 2003, Altegris 

distributed 26 different pieces of hedge fund sales literature to its customers. Each of these 

marketing pieces failed to include important disclosures regarding specific risks of investing in 

hedge funds and made unbalanced presentations about the particular hedge funds that failed to 

provide investors with a sound basis for evaluating whether to invest in these hedge fund 

products. 

263 Roundtable Transcript, May 15 (statement of Stephen M. Cutler) (“[I]n the case of unregistered 

advisers, [the Commission’s Enforcement Division is] not going to be the beneficiar[y] of an 

examination that is going to have identified a problem, brought it to our attention in the form of 

an enforcement referral. So a lot of what we end up seeing in the hedge fund area is after the 

train wreck has already happened. We will get a complaint from an investor that finds that he’s 

been wiped out.”); Roundtable Transcript, May 15 (statement of Mark Anson) (“[W]hile the 

antifraud provisions can deter fraud, they really can't prevent it. [W]here hedge fund managers 

don't disclose their losses immediately . . . once the fraud is uncovered, and the antifraud 

provisions kick in, and action can be taken, well, by that time, the losses have already occurred. 

And it's difficult for investors to get their money back.”). See also Robert Lenzner and Michael 

Maiello, The Money Vanishes, Forbes 70 (Aug. 6, 2001) (“[I]f there is mischief [in unregulated 

hedge funds], the [Commission] will find out about it too late.”). 

76
deficiency letters to encourage a culture of compliance at regulated entities. We believe that the

prospect of Commission examination serves as a deterrent to fraud and other misconduct. 

2. Lack of Meaningful Information about Hedge Funds and Hedge Fund 

Advisers 

The Commission has long been concerned about the lack of information available about 

hedge funds and their investment advisers.264 Despite the growth of the hedge fund industry in 

the last decade, we do not have accurate information about how many hedge funds operate in the 

United States, their assets or who controls them.265 Instead, we must rely on information 

provided by private organizations, the accuracy of which information remains unclear.266

 

264 See Hugh F. Owens, A Regulator Looks at Some Unregulated Investment Companies The Exotic 

Funds, Address before the North American Securities Administrators Ass’n (Oct. 21, 1969) (“I

am limited to relying on conventional wisdom because the Commission does not presently have

sufficient information on which to base unqualified statements on the nature of hedge funds’ 

investment techniques. . . . The lack of information on hedge funds is explained in part, of 

course, by the fact that we have no registration data to refer to because of claimed exemptions or 

exceptions by the funds from the registration requirements of the various federal securities 

laws.”). See also Breeden Letter, supra note 2 (attaching staff memorandum stating that the 

Commission is unable to provide the House Subcommittee with statistics on the number of hedge 

funds, their managed assets, their investors, rates of return, leverage or investments in various 

classes of financial assets). 

265 For example, the Commission was unable to provide the Treasury Department with accurate 

information about the number of hedge funds for use in connection with its proposals to require 

hedge funds to adopt anti-money laundering programs. Treasury Anti-Money Laundering

Proposal, see supra note 109. Because there is no government source of information to identify

or locate hedge funds, the Treasury Department has proposed a rule under the USA Patriot Act 

that will require hedge funds, among others, to file a notice with the Department with certain 

information about their operations. Id. at p. 60622. See also supra Part III.E.4.c. (discussing

Treasury Department Regulations). As noted, the proposed notice will only be a partial source of 

information about hedge funds and their advisers. 

Chairman Donaldson Testimony, supra note 184 (“[T]here are no precise figures available 

regarding the number, size and assets of hedge funds. This is due, in part, to the fact that there is 

no industry-wide definition of hedge fund; in part, because those that track hedge fund data rely

on self-reporting by hedge funds; and in part because hedge funds generally do not register with 

the SEC, so we cannot independently track the data.”). See also The President's Working Group 

Study on Hedge Funds: Hearing Before the House Comm. on Banking and Financial Services, 

106th Cong. 5 (1999) (statement of Representative John LaFalce, Member, House Comm. on 

Banking and Financial Services) (“The message of LTCM is. . . that we can no longer doubt that 

we have a new powerful kind of financial institution in our midst, the hedge fund, and that we

77
The nature of hedge fund investors is changing. Although we did not observe an existing

retail market for hedge funds, the potential for that market is clearly at hand. Investment 

advisers already have proposed to offer registered FOHFs to retail investors without 

sophistication or other wealth requirements.267 Moreover, the amount of retirement assets 

directly invested in hedge funds is growing.

268 In our view, the Commission is impeded in its 

ability to formulate public policy that appropriately protects the interests of the U.S. investing

public unless it also has access to accurate and current information about hedge funds and their 

advisers. 

Also, hedge funds are becoming a significant participant in our financial markets. We are 

concerned about the incomplete nature of information we are able to compile about the trading

practices of hedge fund advisers on behalf of hedge funds. Hedge funds are active and important 

participants in our securities markets. Among other things, hedge fund advisers can invest hedge 

 

know very little about them.”); LTCM Report, supra note 126, at 1 (“[I]t is difficult to estimate 

precisely the size of the [hedge fund] industry . . . .”).

266 See Liang, supra note 177, at 310 (study of statistical inconsistencies in two major hedge fund 

databases, noting that “the reliability of hedge fund data is an open question critical to hedge fund 

research and the investment community”). William Fung and David A. Hsieh, 

Measuring the Market Impact of Hedge Funds, 7 Journal of Empirical Finance 1, 3 (2000) 

(“There are varying estimates of the size of the hedge fund industry.”); and Hedge-matics: How 

Many Funds Exist?, Wall Street Journal C5 (May 22, 2003) (“Just how big is the hedge-fund 

industry? This simple question has been debated because the data on hedge funds are spotty.”). 

See also

267 See supra note 250.

268 See, e.g., US Pension Plan Looks to Hedge Funds, Financial Times (London), Global Investing

21 (June 26, 2003) (Virginia retirement system plans to invest $1 billion in hedge funds); Michael 

P. Norton, Changes to State Pension Sought; Hedge Funds Top Treasurer's Plan to Reduce Risks, 

The Patriot Ledger (Quincy, MA), Business 24 (June 5, 2003) (proposal to invest up to five

percent of pension fund assets in hedge funds); and NYC Fund Eyes Maiden Hedge Fund of 

Funds Investment, 4 Alternative Investment News 19 (June 1, 2003) (Manhattan & Bronx Surface 

Transit Operating Authority Retirement Fund considers investment in hedge funds). See also

Chris Clair, ‘Unprecedented Pressure’: Public Plans Race to Embrace Hedge Funds; This Time

They Are Leading, Not Following, Their Corporate Counterparts, Pensions and Investments 2 

(July 8, 2002); Susan L. Barreto, Hedge Funds Become Saving Grace for Endowments in Tough 

Times, HedgeWorld Daily News (Apr. 4, 2002); Virginia Exposure Soars to 60%, Financial 

News (Daily) (Apr. 27, 2003) (University of Virginia has invested 50 percent of its portfolio in 

hedge funds, and plans to increase its exposure to 60 percent of its total portfolio); University of 

Wisconsin Searching for Hedge Funds, 4 Alternative Investment News 20 (Feb. 1, 2003) ($300 

million University of Wisconsin endowment will allocate up to ten percent, or $25-30 million, to 

a fund of funds adviser); and Baylor University; Inside The Buyside; Increases Hedge Fund 

Activity by $20-25 Million, 4 Alternative Investment News 6 (Feb. 1, 2003). 

78
fund assets in innovative, and sometimes aggressive, ways in order to effectuate their investment 

strategies.269 The Commission’s inability to examine unregistered investment advisers, however, 

inhibits its ability to familiarize itself with the types of trading and other investment activities 

taking place in hedge funds. 

Moreover, because of the close relationships between hedge funds and broker-dealers, the 

failure of a large hedge fund could also impact those firms. Interactions between broker-dealers 

and hedge funds have long been a Commission concern and one that has been addressed in 

particular as part of the Commission’s supervision of broker-dealers. Our concern is based both 

on the possible loss of customer assets held by broker-dealers, which the Commission has a 

mandate to protect in conjunction with the Securities Investors Protection Corporation, and the 

systemic risk implications for the broader financial system, should a large broker-dealer fail due 

to exposure to a hedge fund. The Commission may indirectly view certain limited aspects of 

hedge fund trading activities through its supervision of other market participants, i.e., brokerdealers, SROs, etc. These avenues, however, present a fragmented view of the overall trading

activity of hedge funds. 

B. Valuation of Hedge Fund Portfolio Securities

The lack of independent checks on a hedge fund adviser’s valuation of a hedge fund’s 

portfolio securities is among the most serious concerns we have identified in the course of our

investigation of hedge funds. Hedge fund advisers have powerful incentives to achieve superior 

(and positive) performance. The requirement to achieve positive performance in order to receive

a performance allocation (and to remain in business) is just one such incentive. The adviser’s 

own investment in the hedge fund is another. Hedge fund advisers that perform well find it 

easier to retain investors and raise additional capital. 

 

269 Among the most common trading practices used by hedge fund advisers is short selling. The 

staff makes no recommendations to the Commission regarding short selling at this time, but notes 

that it is currently considering recommending that the Commission propose rule amendments that 

would modernize short sale regulation designed to target areas of abuse, including naked short 

selling. (“Naked” short selling generally refers to a sale of securities when the seller does not 

own the securities sold and makes no arrangements to borrow the securities in order to make

delivery on the sale.) The amendments would also be designed to ease regulatory restrictions 

where they are unnecessary or inhibit beneficial short selling. 

Business Week recently reported that trading of a single hedge fund adviser routinely accounts 

for “as much as 3% of the New York Stock Exchange’s average daily trading, plus up to 1% of 

the NASDAQ’s -- a total of at least 20 million shares a day.” See Marcia Vickers, The Most

Powerful Trader on Wall Street You’ve Never Heard Of, Business Week 66 (July 21, 2003). 

79
A hedge fund adviser has broad discretion to value these securities; hedge funds need 

only value its portfolio securities in a manner consistent with the valuation policies and 

guidelines they disclose to their investors.270 Moreover, even when hedge fund advisers use an 

outside service provider such as an administrator or pricing service to assist in valuing securities, 

advisers may exercise their discretion to override such prices. 

The absence of any form of independent oversight over hedge fund pricing raises 

significant questions about the quality and fairness of the prices at which investors buy or 

redeem interests in some hedge funds. Because many hedge funds invest in highly illiquid 

securities, these concerns are heightened. In addition, smaller hedge fund advisers often lack the 

resources to establish and install adequate pricing systems. Moreover, the Commission lacks the

authority to examine many hedge fund advisers’ books and records or conduct on-site 

inspections of hedge fund adviser operations, which could reveal instances of mispricing.

C. Retailization 

One of the primary objectives of the staff’s investigation was to determine whether, as a 

result of the growth of hedge funds, or otherwise, significant numbers of less sophisticated 

investors were investing in hedge funds. 

1. Direct Investment in Hedge Funds 

Inflation, along with the sustained growth in wealth and income of the 1990s, has boosted 

a substantial number of investors past the “accredited investor” standard.271 To date, however, 

the staff has not uncovered evidence of significant numbers of retail investors investing directly

in hedge funds. A number of factors may account for this, including that most hedge funds 

maintain investment minimums that effectively limit the entry of minimally qualified investors 

into the funds.272 Hedge fund sponsors also assert that they do not seek retail investors because 

such investors may not be suitable for the inherent risks that accompany some hedge funds and 

 

270 See supra Part IV.G. (discussing hedge fund valuation practices). 

271 See supra Part III.B.2. (discussing Regulation D). 

272 The investment minimum for hedge funds typically ranges from $50,000 to $10 million. The 

staff, however, found that hedge funds may waive these minimums for pre-qualified investors and 

that these minimums have dropped in recent years. 

80
that the effort required to ensure such suitability often outweighs the benefit of any investments 

that they might make.

273 

Nevertheless, the increased number of retail investors qualifying as accredited investors 

raises our concern that hedge funds and broker-dealers might begin to seek out these investors as 

a new source of capital for hedge funds. We have observed that the minimum qualifications 

required to invest in some hedge funds has decreased as newer entrants into the alternative 

investments market compete for investors. We remain concerned that less sophisticated 

investors, even those meeting the accredited investor standard, may not possess the 

understanding or market power to engage a hedge fund adviser to provide the necessary

information to make an informed investment decision. 

2. Registered Funds of Hedge Funds 

The staff’s concerns about registered FOHFs mirror our concerns expressed in this 

Report about hedge funds generally. Our concerns are amplified, however, by the possibility

that the retail public may be offered access to some of these investment opportunities without 

restriction in the future. 

We are concerned about the reliability of registered FOHFs’ calculations of net asset 

value (“NAV”). There are no readily available market prices for hedge fund securities. In

addition, as discussed above, an adviser of a FOHF may find it difficult to independently verify

the accuracy of the valuation provided by the underlying hedge funds because it does not have 

access to portfolio holdings of those hedge funds.274 Despite disclosure that advisers to 

registered FOHFs will look to a variety of factors in valuing hedge fund securities, some advisers 

may still rely almost completely on a hedge fund adviser to provide it with the value of the hedge 

fund’s securities. 

The lack of hedge fund transparency presents other problems as well, including with 

respect to fees and expenses of the underlying hedge funds and evaluating overall investment 

diversification or risk exposures. Although a registered FOHF generally is required to disclose 

its fees and expenses in its registration statement, it is not required to disclose, and investors do 

not have specific information about, the fees and expenses of the hedge funds in which the 

 

273 See Roundtable Transcript, May 14 (statement of James R. Hedges) (“[I]t is my sense that the 

lion’s share of the hedge fund industry is actually not interested in the retail investor. More hedge 

fund managers that I talk to than not have no interest whatsoever in selling their product in a retail 

channel. They like being privately placed to accredited or qualified purchasers. They like the 

freedom that that enables them to have. And they are not interested in getting into a different 

type of construct in order to target the retail investor.”). 

274 See supra Part IV.G. (discussing hedge fund valuation practices). 

81
FOHF invests. In addition, the lack of transparency limits the ability of the registered FOHF

adviser to ascertain the diversification of the registered FOHF’s portfolio. Consequently, a 

registered FOHF adviser following a particular strategy may invest in a number of hedge funds 

executing similar strategies. Each of the underlying hedge funds could be taking similar 

positions in its portfolio. The potential for this to occur is particularly a concern for registered 

FOHFs executing convertible or merger arbitrage strategies. The registered FOHF adviser may

have no way of knowing if it is, in fact, making duplicate investments, and possibly magnifying

its risk. Significantly, retail investors seeking diversification by investing in a Dual Registered

FOHF are also unable to ascertain this information, and may take on more risk than desired as a 

part of their overall portfolio. 

3. Pension Plan and Other Institutional Investment in Hedge Funds 

Perhaps the greatest change in terms of indirect exposure of individual investments in 

hedge funds has been the frequency with which pension plans, universities, endowments, 

foundations and other charitable organizations are investing in hedge funds. Pension plans were 

among the earliest hedge fund investors.275 The pace of these investments, however, has 

increased over the past few years.276

The staff is concerned that recent infusions of funds from public and private pension 

plans, universities, endowments, foundations and other charitable organizations into hedge funds 

may raise public policy considerations that heretofore have not been examined. These concerns 

do not relate to the ability or propriety of pension plan sponsors or trustees making investment 

decisions to place plan assets into hedge funds. Indeed, many trustees may believe that hedge 

fund investments are critical parts of a prudent investment strategy. 

Instead, our immediate concern stems from the increasing presence of these investors in 

hedge funds over which neither the Commission nor any other regulatory authority exercises 

meaningful oversight. Although these institutions typically qualify as “accredited investors” or 

“qualified purchasers,” these institutions, by investing in hedge funds, expose their participants 

or other beneficiaries to hedge funds. Thus, for example, a pension plan that experiences 

substantial losses as a result of hedge fund fraud may be unable to meet its obligations to 

pensioners. The collective indirect investment of the assets of less sophisticated individuals into 

vehicles that are managed by entities that are not examined by the Commission leaves open the

 

275 See, e.g., Loomis, supra note 10, at 103.

 g ; Hedge Funds Gaining Acceptance Among 

Pension Funds, note 268; Lewis Knox, The Hedge Fund: Institutional Money is Swelling 

the Coffers of the World's Largest Hedge Fund Managers, 28 Institutional Investor (International 

Edition) 53 (June 1, 2003); and Dan Neel, Michigan Preps For Hedge, Real Estate, Investment 

Management Weekly (Apr. 28, 2003). note 268. 

276 See enerally http://www.iialternatives.com/home.asp

supra

See also supra

82
possibility that the Commission will be unable to anticipate problems involving hedge funds that 

may invest on behalf of these institutions. 

D. Disclosure 

As discussed above, hedge funds are not subject to any minimum disclosure 

requirements.277 Although hedge fund advisers generally provide investors with a PPM, and 

while we acknowledge that there are often a range of other communications between hedge fund 

advisers and hedge fund investors, we are concerned that investors may not always receive 

disclosure about certain fundamental information relating to the investment adviser and its 

management of a hedge fund. We are also concerned that investors may not receive information 

about material changes to an adviser’s management of a hedge fund on an ongoing and regular 

basis. 

E. Conflicts of Interests 

An investment adviser must act solely in the best interests of its clients consistent with its 

fiduciary obligations owed to clients. Hedge fund advisers often have substantial conflicts of 

interest, both with the hedge fund and with other non-hedge fund investors. In recognition that 

certain conflicts may be unavoidable, an investment adviser may discharge its fiduciary

obligation only by disclosing conflicts of interest to its client.278 We are concerned, however, 

that disclosure currently being provided to some hedge fund investors could be improved to 

address the level of the conflict. 

1. Side-by-Side Management of Client Accounts 

Conflicts of interest between investment advisers and their clients are not new. As one 

commenter at the Hedge Fund Roundtable noted, “conflicts exist any time a manager has two 

clients.”279 Unique facts, however, including the nature of the fees paid, the interests of the 

 

277 See supra Part IV.D (discussing disclosure by hedge funds). 

278 See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191-92 (1963) (“Capital Gains”) 

(“The Investment Advisers Act of 1940 thus reflects a congressional recognition ‘of the delicate 

fiduciary nature of an investment advisory relationship,’ as well as a Congressional intent to 

eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser 

-- consciously or unconsciously -- to render advice which was not disinterested” (citations 

omitted)). Undisclosed, such conflicts may constitute fraud by an investment adviser. 

279 Roundtable Transcript, May 14 (statement of Richard Phillips). See also Institutional Investor 

Study Report of the Securities and Exchange Commission, H.R. Rep. 92-64, Vol. 2, pt. 2, at 348 

(1971) (noting that advisers might give preferential treatment to accounts in which they have a 

83
adviser and the nature of hedge fund investment strategies themselves, distinguish hedge funds 

from other pooled investment vehicles offered by investment advisers, and bring these conflicts 

into even sharper focus. 

The relationship between a hedge fund and its investment adviser incorporates a 

number of significant incentives that have the potential to motivate an adviser to favor its hedge

fund client over other clients. Performance fees, which often are 20 percent or more of the 

realized capital gains and capital appreciation of the hedge fund, are significantly higher than the 

asset-based fees paid on traditional accounts, including registered investment companies. In

addition, many investment advisers have significant investments in hedge funds that they

manage.

280 As a result, the investment adviser has additional incentives to favor the hedge fund 

client over other clients by allocating investment opportunities to the hedge fund.281 

The very nature of the investment strategies used by hedge funds may put them at odds 

with other, more traditional investment products and thus, may raise additional conflicts of 

interest for the adviser. For example, an investment adviser that manages a mutual fund using a 

long-only strategy may, at the same time, manage a hedge fund using a different strategy. The 

investment adviser may determine that an equity security that the mutual fund holds long is 

appropriate for the hedge fund to sell short.282 The short sale may have a negative effect on the 

price of the security and therefore also have a negative effect on the mutual fund’s performance. 

Similarly, a model-driven statistical arbitrage fund may be engaging in short-term buying while 

 

greater self-interest) and Report of Special Study of Securities Markets of the Securities and 

Exchange Commission, H.R. Doc. No. 95, pt. 1, at 373 (1963). 

280 Hedge fund investors generally insist on hedge fund advisers and their principals investing a 

significant percentage of their net worth alongside the limited partners’ investments to ensure that 

a hedge fund adviser’s interests are aligned with theirs. See, e.g., Roundtable Transcript, May 14 

(statement of David Swensen). 

281 See In the Matter of Nevis Capital Management, LLC, David R. Wilmerding, III and Jon C. 

Baker, Advisers Act Release No. 2154 (July 31, 2003) (alleged unfair allocations of “hot issues” 

to two clients, including a hedge fund). See also In the Matter of F.W. Thompson Co. and 

Frederick W. Thompson, Advisers Act Release No. 1895 (Sept. 7, 2000) (undisclosed preferential 

allocation of hot issues to certain clients); and In the Matter of McKenzie Walker Investment 

Management, Inc. and Richard C. McKenzie Jr., Advisers Act Release No. 1571 (July 16, 1996) 

(undisclosed favoritism of performance-fee paying clients). 

282 For example, a registered investment company may have a focus on a particular industry or sector 

and must choose (and remain fully invested in) those securities that the adviser believes represent 

the best opportunities within that universe. Nonetheless, that adviser may simultaneously be 

quite bearish on the same industry and may choose to short sell certain representative securities, 

including those held long in the registered investment company. 

84
the investment adviser is selling the same securities in another account that follows a different 

strategy. Both strategies may be used for legitimate business reasons, but the conflicting nature

of the strategies may affect certain clients negatively.

2. Relationships with Prime Brokers 

Services provided by prime brokers can be very important to a hedge fund’s operations. 

The nature of the services provided by a prime broker to a hedge fund adviser varies, depending

upon its stage of development, organization and structure and investment strategy. 

Notwithstanding the importance of these services to the hedge funds, we found that the quality of 

disclosure typically provided to hedge fund investors about advisers’ relationships with their 

prime broker(s) is minimal. Hedge fund advisers rarely disclose the nature of the services that 

they receive from a prime broker, nor is there clear disclosure regarding how they compensate

the prime broker for these services. 

We are concerned that hedge fund advisers may not be disclosing that fees paid to prime 

brokers may include amounts for services that do not benefit investors. For example, the 

provision of, and payment for, capital introduction services to a hedge fund’s adviser presents a 

conflict of interest in that the introduction of new investors to the hedge fund may occur because 

the adviser used (and used fund assets to pay for) certain of the prime broker’s services.283 The 

provision of office space to the hedge fund adviser as part of the package of services provided to 

the adviser and paid for by the hedge fund creates a similar conflict of interest. 

There are other potential conflicts of interest that may raise disclosure issues. For

example, accepting “seed capital” investments by prime brokers without disclosing the potential 

conflicts inherent in such arrangements may raise concerns. The acceptance of such capital may,

for example, negate any flexibility that the hedge fund adviser would have to freely choose its 

prime broker, or negotiate more attractive fees. As another example, there may be a quid pro 

quo for the inclusion of a hedge fund on a prime broker’s “preferred” list of hedge funds, or its 

inclusion in a proprietary fund of hedge funds, which would essentially wed the hedge fund to 

the prime broker. These conflicts of interest also raise a concern that a hedge fund may pay

more than is usual for core services (such as fees relating to securities borrowing) provided by

the prime broker, or may satisfy pre-determined minimum targets for services, such as margin or

brokerage, that are established prior to the delivery of services. 

 

283 Broker-dealer firms typically do not charge separately for capital introduction services. 

Moreover, they assert that this service, like others, is provided “gratis” as an accommodation to 

the hedge fund. We are not persuaded that these services are free. Although they do not receive

separate compensation, broker-dealers are compensated for such services, albeit indirectly, 

through the fees that they negotiate and receive for the entire package of services provided to the 

hedge fund. 

85
F. Concerns about General Solicitation 

We also have concerns about the proliferation of public information about hedge funds 

that has accompanied the growth of the hedge fund industry. We believe that questions exist 

whether some participants in the hedge fund industry may not be complying with the prohibition 

on general solicitation and general advertising in privately offering and selling the hedge fund 

securities. As discussed above, as a condition to the availability of the safe harbor of Rule 506, 

hedge funds may not engage in any form of general solicitation or general advertising in finding

investors.284 The hedge fund has the burden of proving the availability of the exemption from 

registration. If the hedge fund, its adviser or other persons acting on its behalf uses general 

solicitation or general advertising to sell the hedge fund interests, the hedge fund will not be able 

to rely on the safe harbor. 

 Current marketing practices by some hedge fund advisers raise questions as to whether 

the hedge fund is engaging in a general solicitation or general advertising. For example, 

information contained in newsletters, press articles and even institutional reporting services

about a specific hedge fund raises concerns about whether the hedge fund is engaged in a general 

solicitation or general advertising if that information is provided by the hedge fund’s adviser or 

at their behest.285 The extensive use of the Internet by hedge fund advisers has exacerbated this 

concern. Given the public nature of the Internet, issues arise as to how to sufficiently target

information to eligible investors without running afoul of the general solicitation or advertising

prohibition.286 Although the Commission has been clear in its interpretive releases about the 

ways in which the Internet can be used in private offerings, questions exist as to whether some 

hedge fund advisers and sponsors have not followed the Commission’s and staff’s guidance. In

fact, the Commission, in its 2000 Interpretive Release on the Use of Electronic Media, 

recognized that parties are not following staff guidance on when web sites may constitute general 

 

284 See supra Part III.B. (discussing hedge funds and the Securities Act). See also Roundtable 

Transcript, May 14 (statement of Alan Beller) (“You can’t put up a billboard on Times Square 

and say, ‘We have a new hedge fund but please understand that unless you are an accredited 

investor, don’t call.’ ”). 

285 The staff has found numerous media reports quoting hedge fund advisory personnel discussing

the “rollout” of new hedge funds. 

286 See supra Part III.B. See also Roundtable Transcript, May 14 (statement of Alan Beller) (“Even 

targeted means of publicity to offer to persons to whom or with whom the adviser or the other 

intermediary seller does not have a pre-existing relationship can also raise general solicitation 

questions, especially as that targeting becomes less targeted, if you will. You send out an e-mail 

or make a website generally available and say, ‘You can buy this but only if you are an accredited 

investor, and people with whom you don’t have a preexisting relationship have access to that 

page, that itself can be problematic under our current rules.’ ”). 

86
solicitation for particular offerings and again reminded market participants of the permissible

types of activities. 

Although the restrictions on general solicitation and general advertising apply only to 

activities that are used to offer and sell securities, for hedge fund advisers using the Internet, 

questions arise as to whether information about their services and their activities would be 

outside the scope of the restriction on general solicitation and general advertising. In addition to 

the implications of the use of the Internet for the hedge fund offering itself, the Commission has 

also made clear that if an unregistered adviser uses a publicly available web site to provide 

information about its services, it would not qualify for the exemption from registration in Section 

203(b)(3) of the Advisers Act because it would be considered to be holding itself out generally to 

the public as an investment adviser.287 

The use of the Internet by hedge fund advisers in marketing their products has sharpened 

the question as to whether, at least with respect to a certain category of sophisticated investors, 

the prohibition on general advertising and general solicitation continues to be necessary. While 

it may not be appropriate to revisit the limitations on general solicitation, including those 

resulting from the use of electronic media, in the context of private offerings generally or even

hedge funds specifically, it may be worthwhile to consider the need for such limitations for funds 

whose owners are limited to investors that clearly meet a higher standard or may be presumed to 

be able to “fend for themselves” such as, for example, the “qualified purchaser” standard of 

Section 3(c)(7). 

G. Concerns about Whether the Federal Securities Laws and Regulations Are 

Impairing the Investment Activities of Registered Investment Companies 

The staff’s investigation of hedge funds revealed the broad investment flexibility that 

most hedge fund advisers find necessary in order to effectuate their absolute return strategies. 

The staff believes that this flexibility may have contributed to hedge funds avoiding some of the 

losses sustained by investors in registered investment companies during the 2000-2002 bear 

market.

288 One investor advocate for individual investors who participated in the Roundtable 

 

287 Use of Electronic Media by Broker-Dealers, Transfer Agents, and Investment Advisers for 

Delivery of Information; Additional Examples Under the Securities Act of 1933, Securities 

Exchange Act of 1934, and Investment Company Act of 1940, Exchange Act Release No. 37182 

(May 9, 1996). 

288 One Roundtable participant cited data that registered open-end investment companies lost 

approximately $1.4 trillion from 2000-2002. See Comment submitted by Roundtable Panelist 

Frederick C. “Rick” Lake.

87
expressed the view that these types of investment vehicles should be made available to a broader 

array of investors.289

A very small percentage of registered investment companies currently use certain hedge 

fund investment strategies, including long/short, market neutral and merger arbitrage. The 

registered investment companies that pursue such investment strategies represent, in our 

estimation, less than one half of one percent of the investment company industry’s assets under 

management as of June 30, 2003.290 It is unclear why so few registered investment companies 

pursue these types of strategies, although the restrictions placed on investment companies and 

investment advisers to such companies may be at least partially responsible. 

VII. Recommendations 

We recommend that the Commission consider making several changes to the regulatory

framework relating to hedge funds and their investment advisers. We believe that these changes 

will address the concerns that we have identified above. The adoption of our recommendations 

would result in a shift in the federal securities laws’ approach to the regulation of the hedge fund 

industry, but would add a greater level of investor protection to investors in hedge funds and 

FOHFs. It would also provide greater insight into this growing segment of the investment 

management industry without constraining the legitimate investment activities of hedge funds 

and their advisers. 

Our recommendations are intended to address, on a going forward basis, existing and 

emerging issues that flow from the growth in the number of hedge funds and the assets under 

management at those funds. The adoption of our primary recommendation, that the Commission 

consider mandating federal registration of hedge fund investment advisers under the Advisers 

Act, would mean that hedge fund investors would receive important information regarding the 

funds and their advisers. We believe that these measures will also foster stronger compliance 

programs and provide the Commission with the ability to: identify important participants in the

U.S. financial markets; examine the activities of investment advisers to assist in evaluating issues

relating to market movements; and deter fraud and wrongdoing. 

We have recommended changes to the regulatory framework with a view toward

minimizing any impediments that these changes may have on the manner in which advisers

 

289 See Roundtable Transcript, May 15 (statement of John Markese) (expressing the view that with 

registration and appropriate information, hedge fund-type products may be useful in assisting

investors in diversifying their investment portfolios). 

290 According to the staff’s estimate, companies with a market neutral or merger arbitrage investment 

style had approximately $2.1 billion under management at the end of June 2003. 

88
manage hedge funds to achieve their investment goals. Indeed, in making these 

recommendations we recognize the beneficial role that hedge funds play in our financial markets. 

We also suggest that the hedge fund industry observe and continue to develop best practices 

guidelines that will result in better investor protection and healthier financial markets. 

Finally, we ask the Commission to consider a number of recommendations that apply to 

registered investment companies. Some of these recommendations are designed to provide 

additional protections to investors in registered FOHFs. Other recommendations suggest that the 

Commission reconsider certain of the restrictions generally applicable to registered investment 

companies and their investment advisers. For example, we recommend that the Commission 

take steps to determine if hedge fund-type strategies can be made available to less sophisticated 

investors in a manner that both achieves investment goals and protects investors. 

A. The Commission Should Consider Requiring Hedge Fund Advisers to

Register as Investment Advisers under the Advisers Act, Taking into 

Account Whether the Benefits Outweigh the Burdens of Registration 

We recommend that the Commission consider amending Rule 203(b)(3)-1 under the 

Advisers Act to require hedge fund advisers to “look through” any hedge funds that they manage

and count each separate investor as a client.291 By amending Rule 203(b)(3)-1 to redefine 

“client,” the Commission would shift the regulatory emphasis away from counting the number of 

hedge funds advised by the investment adviser and refocus it so that it reflects a determination of 

whether an investment adviser is of a size to merit federal regulation. In our view, the result of 

the recommendation to amend Rule 203(b)(3)-1 would be consistent with the underlying purpose 

of Section 203(b)(3), which was designed to exempt advisers whose advisory business is so 

limited that it does not warrant federal attention.292 We also recommend that the Commission 

 

291 See supra Part III.D. (discussing hedge fund advisers and the Advisers Act). 

292 There is no legislative history explaining the de minimis exception of Section 203(b)(3). That 

provision appears to reflect Congress’s view that investment advisers with only a handful of 

clients that do not hold themselves out to the public are presumably “private” and therefore do not 

raise issues of federal interest and need not register. Yet an investment adviser that manages 

client assets through hedge funds could have thousands of clients. For example, one hedge fund 

that relies on Section 3(c)(7) of the Investment Company Act could have 499 investors, one short 

of the threshold number at which an issuer must register its securities and comply with certain 

reporting requirements of the Exchange Act. An adviser that managed 14 such hedge funds 

would then manage the assets of 6,986 clients. In addition, if any of those clients were also hedge 

funds that the adviser managed, the number of clients would increase by the number of investors 

in those hedge funds. 

89
consider incorporating into any such amendment a threshold for Commission registration based 

upon the aggregate amount of assets managed by the hedge fund adviser.293 

In the course of the staff’s investigation of hedge funds, we frequently raised, with 

industry participants and others, the question of whether the Commission should require all 

hedge fund advisers to register as investment advisers. Some supported required registration as a 

means of obtaining needed oversight of the hedge fund industry and providing appropriate 

transparency294 and background information about the adviser for investors,295 without impeding

the functioning of hedge funds.296 Some felt that required registration would benefit a maturing

hedge fund industry by helping reduce fraudulent activities that diminish all members’ 

reputations. One thought that it would provide a basis for permitting greater retail participation 

in hedge funds.297 

Many of those opposing required registration expressed a strong preference for leaving

the hedge fund industry “unregulated.” They argued that the incidence of fraud among hedge 

fund advisers is low, and that hedge funds are adequately supervised by prime brokers, auditors 

and lenders.298 Some asserted that there would be no purpose in requiring registration, arguing

that the types of clients investing in hedge funds are able to take steps to protect themselves 

without the assistance of the Commission.299 

 

293 Such a threshold would maintain the registration exemption for advisers to very small hedge 

funds whose investors are likely to have personal relationships with the hedge fund adviser. It

would also be consistent with the approach taken by Congress when it amended the Advisers Act 

in NSMIA to divide oversight of advisers between the states (for advisers with less than $25 

million in assets under management) and the Commission (for advisers with assets under 

management of $25 million or more). We note, however, that even with such a threshold, our 

recommendation would require most hedge fund advisers to register under the Advisers Act. 

294 Roundtable Transcript, May 15 (statement of Mark Anson). 

295 Roundtable Transcript, May 15 (statement of Sandra Manzke). 

296 Roundtable Transcript, May 14 (statement of Richard Phillips). 

297 Roundtable Transcript, May 15 (statement of John Markese). 

298 Roundtable Transcript, May 15 (statement of Paul Roth). See also, Managed Funds Association 

Comment Letter, supra note 120. 

299 Roundtable Transcript, May 15 (statement of Paul Roth). See also Gibson, Is Hedge Fund 

Regulation Necessary?, 73 Temple Law Review 713-14 (Summer 2000) (hedge fund investors’ 

ability to privately assert rights under antifraud provisions of federal securities laws obviates need 

for SEC regulation). We note, however, that there are limited private rights of action under the 

90
During the course of the staff’s investigation of hedge funds, we also questioned whether 

mandating registration of investment advisers to hedge funds would impede the operations or 

investment activities of hedge fund advisers. No one identified any provision of the Advisers 

Act or Commission rules that, if applied to hedge fund advisers, would have this result.300 

Although industry participants had mixed reactions to mandatory registration of hedge fund 

advisers,301 many hedge fund advisers register voluntarily. This belies any notion that 

 

Advisers Act. Hedge fund investors would be unable to bring a private action against a hedge 

fund adviser for monetary relief based on violations of the Advisers Act antifraud provisions. 

Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11 (1979). 

300 Indeed, hedge fund lawyers indicated to us that the U.S. approach to excluding hedge fund 

advisers (or making registration optional, depending upon the other advisory activities of the 

adviser) appeared to be unique among countries with developed markets and regulatory systems, 

most of which regulate the activities of hedge fund advisers (and in some cases hedge funds 

themselves), or are in the process of changing their laws to add hedge funds and hedge fund 

advisers to the country’s existing system of investment management regulation. See, e.g.,

Japanese Securities Investment Adviser Association website, About the Industry in Japan at 

http://jsiaa.mediagalaxy.ne.jp/komon_e/index.html; Securities and Futures Commission (Hong

Kong), Securities and Futures Ordinance (Cap. 571, Sec. 114 and Sch. 5), at 

http://www.hksfc.org.hk/eng/bills/html/index/index0.html; Securities and Futures Commission 

(Hong Kong), Fund Managers Code of Conduct (April 2003), at 

http://www.hksfc.org.hk/eng/bills/html/index/index0.html. One author has suggested that the 

European approach to regulating hedge fund advisers has benefited the industry by establishing

minimum standards of practice in which investors can have some confidence. Neil Wilson, Why

Regulation Can Be Good, Absolute Return (Apr. 2003) (U.K. regulation of hedge fund advisers 

has not impeded growth, and encourages advisers to build professional operations before 

launching funds; many of the firms deterred by regulation probably should not be managing

hedge funds). 

301 A few Roundtable panelists suggested that if the Commission requires mandatory registration for 

most hedge funds advisers, some of those advisers would move their operations to jurisdictions 

that did not have such a requirement. We believe that such concerns are unwarranted. A hedge 

fund adviser could not avoid application of the Advisers Act simply by moving its office to a 

non-U.S. location. In fact, an adviser moving offshore would be required to register if more than 

14 U.S. investors owned interests in the hedge fund. See Rule 203(b)(3)-1(b)(5) under the 

Advisers Act. At least one hedge fund consultant has suggested that advisers foregoing U.S. 

investors is unlikely to occur. Ron Orol, Firmly Rooted, Daily Deal (July 14, 2003) (citing

Arthur Bell of Arthur Bell & Associates as stating that U.S. investors would be “virtually

impossible to replace.”) 

Several Roundtable panelists asserted that registration under the Advisers Act was unnecessary

because hedge fund advisers are already registered with the CFTC as CPOs or CTAs and 

examined by the NFA. Roundtable Transcript, May 14 (statement of Anthony Artabane); 

Roundtable Transcript, May 15 (statements of Patrick McCarty and Armando Belly). As 

discussed above, however, the CFTC and the NFA necessarily focus their examinations more 

91
registration of hedge fund advisers is detrimental to a hedge fund’s legitimate investment 

activities. 

Registration under the Advisers Act represents the least intrusive form of regulation 

available to address many of the concerns identified in this Report. Our recommendation that 

hedge fund advisers register with the Commission under the Advisers Act would not result in 

any changes with respect to those advisers' ability to effectuate their investment strategies. 

Registration would not place any restrictions on hedge fund advisers’ ability to trade securities, 

use leverage, sell securities short or enter into derivatives transactions. Nor would registration 

under the Act require the disclosure of any proprietary trading strategy. In addition, registration 

would not result in hedge funds and hedge fund advisers being subject to any additional portfolio 

disclosure requirements. 

Our recommendation would not result in hedge funds having to register the offerings of 

their interests with the Commission, nor would it require that they modify their organizational 

structures. Advisers would be able to maintain their existing lock-up and repurchase schedules. 

Adviser registration would not result in public disclosure of the identities of advisers’ clients. 

Finally, registration would not restrict the amount of fees that hedge fund advisers may charge

hedge funds, although an adviser to a hedge fund relying on Section 3(c)(1) of the Investment 

Company Act would be permitted to charge that fund a performance fee only if each of the 

investors in the fund are qualified clients under Rule 205-3 under the Advisers Act.302 

1. Benefits of Mandatory Registration 

a. Registration of Hedge Fund Advisers Would Serve as a Deterrent to 

Fraud 

Our examination experience with registered investment advisers demonstrates that 

examinations can lead to earlier discovery of actual and potential misconduct and frequently

reduces the possibility that such misconduct will occur.303 Periodic examination of hedge fund 

advisers can be expected to have the same result. We concede, however, that Commission 

examinations cannot assure that frauds do not occur. Indeed, a number of our enforcement 

actions involving hedge fund frauds have been against hedge fund advisers that are registered 

 

closely on futures trading. Moreover, the CFTC recently adopted rules that may permit most 

hedge fund advisers, including those currently able to avoid investment adviser registration, to 

avoid registering as CPOs or CTAs. 

302 See supra note 212. Hedge fund advisers to funds relying on Section 3(c)(7) under the 

Investment Company Act would not be subject to any such limitation. 

303 See supra Part VI.A. (discussing concerns about lack of Commission oversight).

92
with us.304 Nevertheless, the prospect of Commission examination may discourage persons from 

using hedge funds to engage in fraud. Moreover, we believe that the lack of regulatory oversight 

of hedge funds may contribute to the belief on the part of hedge fund advisers that fraud will not 

be exposed. 

b. Registration of Hedge Fund Advisers Would Provide the Commission with 

Examination Authority and Foster Strong Compliance Practices 

Advisers, including hedge fund advisers, are fiduciaries that must avoid conflicts of 

interest with their clients, or fully disclose those conflicts.305 To protect against the adverse 

consequences of these conflicts, hedge fund advisers should adopt a “culture of compliance,” 

which involves making compliance considerations a part of an adviser’s business plan. 

Our investigation revealed that many unregistered hedge fund advisers already have 

adopted sound compliance practices, which would need little modification to address registration 

requirements. Those unregistered advisers, however, tended to be larger firms that have 

substantial reputational risk at stake. Several participants in the hedge fund industry with whom 

we met during the course of our investigation, however, expressed concern that newer industry

participants had not adopted compliance controls adequate for the amount of assets under their 

control. 

While some new entrants to the hedge fund industry brought with them – from their 

previous employment with a money management or brokerage firm – an understanding of their 

obligations to fund investors, other new entrants may have little such experience. Our 

examinations confirmed that in many cases controls at some hedge fund advisers are very

informal. We believe that the prospect of a compliance examination by the Commission staff

will result in the adoption of procedures and controls designed to fulfill the hedge fund adviser’s 

fiduciary responsibilities to the hedge fund and its investors.306 

 

304 See, e.g., Hoover and Hoover Capital Management, Inc., Litigation Release No. 17981 (Feb. 11, 

2003); SEC v. Michael L. Smirlock and LASER Advisers, Inc., Litigation Release No. 17630 (July

24, 2002); In the Matter of William F. Branston, Advisers Act Release No. 2040 (June 26, 2002); 

In the Matter of Abraham and Sons Capital, Inc. and Brett G. Brubaker, Advisers Act Release 

No. 1956 (July 31, 2001). 

305 Capital Gains, supra note 278, at 191, 194. 

306 See Neil Wilson, Why Regulation Can Be Good, Absolute Return (Apr. 2003) (U.K. regulation of 

hedge fund advisers establishes minimum standards of practice; the process of registration 

encourages advisers to build professional operations before launching a fund “rather than 

scrambling to put them together after launch.”). 

93
Earlier this year, the Commission proposed a new rule that, if adopted, would require all 

registered investment advisers to adopt written compliance procedures, review them at least 

annually and appoint a chief compliance officer.307 Application of this rule to hedge fund 

advisers would, in our view, be particularly useful. 

As registered investment advisers, hedge fund advisers would be required to make certain 

prescribed disclosures to the Commission and investors, including disclosure regarding the 

advisers’ business practices and disciplinary history, and to maintain required books and records 

and safeguard client assets. The Commission could conduct periodic compliance examinations 

of these advisers and monitor whether they conduct their operations (as well as those of hedge 

funds that they manage) so as to avoid the concerns identified in this report. We anticipate that 

the prospect of a staff compliance examination will serve to support business decisions to 

allocate resources necessary to ensure the implementation of strong compliance controls and the 

satisfaction of hedge fund advisers’ fiduciary responsibilities to their clients. 

c. Registration Would Provide the Commission with Important Information 

about a Segment of the U.S. Financial System that Is Growing in 

Significance

Hedge fund adviser registration under the Advisers Act would permit the Commission to 

collect basic information about virtually all hedge fund advisers, including the number of hedge 

funds that they manage, the amount of assets of those hedge funds and the identity of persons 

controlling the hedge fund advisers.308 This requirement also would enable the Commission to 

more comprehensively and effectively observe the trading activities of the funds managed by

such advisers. Currently, the Commission generally has access to records of trading on behalf of 

hedge funds through the books and records maintained by the brokers that the hedge fund 

advisers use and the markets on which they trade. These records, however, are dispersed and it

could be difficult to detect improper trading activities conducted by a particular hedge fund if 

such activities were effected through orders placed with multiple brokers and traded on multiple 

markets. The ability to directly examine the trading activities of hedge fund advisers would 

 

307 Compliance Programs of Investment Companies and Investment Advisers, Advisers Act Release 

No. 2107 (Feb. 5, 2003). 

308 Roundtable panelists suggested that it would be valuable for the Commission to gather 

information about hedge funds. Roundtable Transcript, May 15 (statement of Thomas Fedorek) 

(“[T]here's a real opportunity here for the SEC to be not just a cop but to be what it is, actually, to 

a large extent already, an information provider. [N]ot a day that goes by that I don't dial into one 

of the SEC's databases to get information to help me in the research that I do in my

investigations.”); Roundtable Transcript, May 15 (statement of Andrew Lo) (suggesting that the 

Commission is in a unique position to gather hedge fund data that are not generally and publicly

available, and noting that an understanding of risks involved in hedge funds begins with data.). 

94
provide a more complete picture of their trading activities and make it easier to detect improper

or illegal trading practices. 

Much of this information currently can be collected from hedge fund advisers that are 

registered with the Commission.309 Using the Commission’s existing authority under the 

Advisers Act to obtain information about hedge fund advisers is particularly appropriate because, 

as originally enacted, the Advisers Act was designed to be “a continuing census of the Nation’s 

investment advisers.”310

d. Mandatory Registration Would Effectively Raise the Standards for Direct 

Investments in Hedge Funds 

Our investigation of hedge funds was driven, in part, by the Commission’s concern that 

the growth in hedge funds was being fueled by the direct investments of less sophisticated 

investors in hedge funds. Although our investigation did not uncover significant direct 

investment in hedge funds by less sophisticated investors, we continue to believe that the rise in 

investor wealth and incomes could ultimately result in retail investors investing directly in hedge

funds relying on Section 3(c)(1) of the Investment Company Act. A number of commenters 

expressed their views that this concern could be remedied by raising the wealth standards, 

primarily the accredited investor standard under Regulation D.311 Registration of hedge fund 

advisers, however, would effectively address our concerns. 

In general, the Advisers Act prohibits registered investment advisers from charging

performance fees to hedge funds relying on Section 3(c)(1) of the Investment Company Act 

unless all of the fund’s clients are “qualified clients.”312 The wealth standards for qualified 

 

309 A registered adviser that is the general partner of a hedge fund must report that it advises a 

“pooled vehicle” in response to Item 5.D.4. of Part 1A of Form ADV, list each pooled vehicle on 

Schedule D (Section 7B) and disclose the amount of assets in the fund and the minimum amount 

of capital investment per investor. 

310 H.R. Rep. No. 1760, 86th Cong., 2d Sess. 2 (1960). 

311 See, e.g., Managed Funds Association Comment Letter, supra note 120 (proposing increases to 

the accredited investor thresholds to $2 million in net worth, $400,000 in annual income and 

$500,000 in annual income jointly with one’s spouse); Comments submitted by the Ad Hoc 

Hedge Fund Committee of the Securities Industry Association (supporting suggestions to tighten 

the accredited investor standard built into Regulation D under the Securities Act of 1933); 

Comments submitted by David G. Tittsworth on behalf of the Investment Counsel Association of 

America (urging the Commission to consider revising the current definition of “accredited 

investor”). 

312 See Section 205(a)(1) of the Advisers Act and Rule 205-3(d)(1) thereunder. See supra note 212. 

95
clients are appreciably higher than those for “accredited investors,” requiring that the investor 

have $750,000 invested with that adviser, or generally have a net worth of $1.5 million.313 Our 

recommendation also has the salutary effect of permitting the Commission to reevaluate any

future concerns about the nature of hedge fund investors and address any such concerns through 

regulation under the Advisers Act. 

2. Concerns about Mandatory Registration 

We recognize that adviser registration will impose additional costs on hedge fund 

advisers that are not already registered with the Commission. Nevertheless, we believe that the 

benefits of adviser registration outlined in this Report outweigh the additional costs that would 

be imposed on unregistered hedge fund advisers.314 There are three types of costs associated 

with registering: (1) electronic filing, which costs $1100 the first year and $550 each year 

thereafter; (2) recordkeeping systems meeting the requirements of the Advisers Act, which are 

typically provided by the hedge fund’s prime broker and thus, in many cases, would involve no 

additional costs; and (3) ongoing costs related to regulatory compliance. Most of these latter

costs are attributable to compliance with the Act’s antifraud provisions to which unregistered 

advisers already are subject and thus should be incurred regardless of whether the adviser is 

registered under the Act. In connection with any rulemaking, the staff would prepare a more 

complete analysis of the costs and benefits of requiring hedge fund advisers to register under the 

Advisers Act. 

We are also mindful that the Commission’s resources available to examine advisers are 

limited. Thus, we recommend that any rule the Commission adopts requiring advisers to count 

clients by “looking through” the hedge fund limit the number of new registrants by

distinguishing between hedge funds and other investment vehicles that do not register under the 

Investment Company Act in reliance on Sections 3(c)(1) or 3(c)(7). These other investment 

vehicles include venture capital funds, private equity funds and structured financing vehicles.315 

 

313 Our recommendation also is attentive to the Commission’s interest in maintaining existing

regulations that support its mission to assist small business development. See Chairman 

Donaldson Testimony, supra note 184. By leaving eligibility requirements for “accredited 

investors” under Regulation D unchanged, small businesses may continue to seek capital from

historical sources. 

314 In addition, some advisers to hedge funds that are already registered with the Commission have

indicated that the burdens of adviser registration do not impose significant additional costs on 

their operations. Further, many advisers of hedge funds that are not registered have indicated that 

they conform their operations to those of registered advisers. 

315 The President’s Working Group cited the difficulty of limiting registration to advisers to hedge 

funds as one reason for not requiring hedge fund managers to register under the Advisers Act. 

LTCM Report, supra note 126, at B-16. In developing anti-money laundering rules under the 

USA Patriot Act, the Treasury Department was, however, able to craft such a limitation by

96
In addition, we recommend that the Commission consider its available resources when 

establishing the amount of assets under management threshold for registration with the 

Commission. 

The Commission should carefully evaluate its resources and capabilities to seek to ensure 

that any rulemaking would not affect the efficacy of the Commission’s examination program 

before taking action on our recommendations. Moreover, the Commission would have to devote 

the resources necessary to modify its existing investment adviser examination program so that it 

recognizes the unique nature of hedge fund advisers and identifies deficiencies and possible 

violations.316 We also believe that our recommendations would require that additional resources 

be dedicated to the Division of Investment Management so that it may consider and evaluate 

regulatory policy regarding hedge fund investment advisers. 

B. The Commission Should Consider Revising its Regulations Under the

Advisers Act to Require Advisers to Provide a Brochure Specifically 

Designed for Hedge Funds 

We recommend that the Commission consider revising its rules to require that hedge fund 

advisers file with the Commission, and deliver to investors, a disclosure statement tailored to 

meet the needs of hedge fund investors.317 Disclosure could be in the form of a brochure and 

 

proposing to apply its rule only to funds that offered certain redemption rights. See Treasury

Anti-Money Laundering Proposal, supra note 265; see also supra Part III.E.4.c. 

316 Requiring hedge fund advisers to register with the Commission would not impose any additional 

burdens on state securities authorities. Hedge fund advisers registered under state law would, 

upon registering with the Commission, be eligible to withdraw their state registrations. See

Section 203A(b)(1) of the Advisers Act. The rulemaking that we recommend that the 

Commission consider may thus be expected to relieve some state regulators of their regulatory

obligations with respect to some hedge fund advisers that are registered with state securities 

authorities. See supra Part III.E.5.c. (discussing state regulation of hedge fund advisers). 

317 Investment advisers register with the Commission or state securities administrators on Form

ADV. See http://www.sec.gov/divisions/investment/iard.shtml. Part I of Form ADV requires 

general disclosure about the adviser’s business and certain disciplinary information. Part I of an 

adviser’s Form ADV is available on the Commission’s web site. Part II of Form ADV requires 

disclosure of certain information, including conflicts of interest, assets under management and 

whether the adviser manages any pooled assets. Part II of Form ADV (or a brochure 

incorporating the information required in Part II) must be delivered to clients and prospective 

clients under Rule 204-3 under the Advisers Act. Advisers to hedge funds must deliver their 

brochures to the hedge fund investors, rather than the hedge fund itself. Electronic Filing by 

Investment Advisers; Proposed Amendments to Form ADV, Advisers Act Release No. 1862 n.117 

(Apr. 5, 2000). The Commission has under consideration a proposal to make Part II of Form

ADV available on the Commission’s website. 

97
would prescribe minimum requirements for basic disclosure information provided to investors 

and prospective investors. The Commission could require, for example, disclosure about various 

conflicts of interest, what risk management measures the adviser performs,318 how the adviser 

values securities held by hedge funds (and the extent to which that valuation will be determined 

independently) and what lock-up periods may apply to an investor’s investment in hedge funds 

managed by the adviser. Although hedge fund investors may already receive some of the 

information in the fund’s PPM, we would propose that the Commission require that this 

information be disclosed in the “hedge fund brochure” – the brochure having the added benefit 

of requiring the adviser to update its disclosures periodically and make that information available 

to investors on an ongoing basis.319 Moreover, these disclosures could be useful to other clients 

of the adviser in identifying conflicts of interests on the part of the adviser. 

The information contained in Form ADV would not, we recognize, give investors in 

hedge funds all the information that they may need or want. Because that form is designed to 

provide information about investment advisers, there would be limitations on information about 

specific hedge funds. In addition, Form ADV cannot provide investors with sufficient 

information to evaluate the character of the hedge fund adviser or its employees.320 But Form 

 

318 The Commission also could consider exploring the possibility of developing appropriate risk

measures that hedge fund advisers could use to provide investors with ongoing risk information. 

Hedge fund advisers, institutional investors and knowledgeable groups such as the Investor Risk

Committee of the International Association of Financial Engineers could be contacted to assist 

the Commission in developing risk measures that would be meaningful to, and meet the needs of, 

hedge fund investors. 

We note that our recommendation would implement one of the recommendations in the LTCM 

Report, supra note 126, at 32-33. The Working Group recommended the enactment of legislation 

granting any necessary authority to require disclosure by hedge funds that were not registered 

with the CFTC as commodity pools. Legislation was introduced into Congress but was never 

enacted. Legislation would be unnecessary to effect the Working Group’s recommendation once 

hedge fund advisers registered with the Commission.

319 See Roundtable Transcript of May 14 (statement of George Hall) (the private placement 

memorandum does not provide for ongoing information – ongoing information is provided more 

informally, “more outside of the documents”). 

320 Roundtable Transcript of May 14 (statement of David Swensen) (“[W]hat we really care about 

when we're making investment decisions is, first and foremost, the quality of the people, and 

there's no way that you can look at somebody's disclosure document and figure out if the people 

that you're invested with have the character, the intelligence, the integrity, the creativity, and 

market savvy that you want to have in a partner in this arena or any other investment arena, for

that matter.”); Roundtable Transcript of May 15 (statement of Pamela Parizek) (“While there is a 

great deal of information that's available in the public domain, . . . things like reputation and 

integrity [are] not generally going to be available and frequently we are called upon to get that 

type of information for many of our investors.”). 

98
ADV disclosure would, we believe, make the due diligence process in which many hedge fund 

investors engage substantially more efficient and provide investors with more current 

information about the operations of hedge fund advisers and the strategies, policies, management 

and operations of the hedge funds that they operate. 

C. The Commission Should Consider Requiring Certain Registered Investment

Companies to Follow Board Adopted Valuation Procedures

We recommend that the Commission consider rulemaking to address our concerns about 

how registered investment companies, including registered FOHFs, that invest their assets in

hedge funds value their portfolio holdings. As noted above, the Investment Company Act 

requires boards of directors to fair value in good faith any securities for which there are no 

readily available market quotations. Best practices would suggest that all registered investment 

companies adopt procedures under which they may satisfy this requirement. Because of our 

heightened concerns relating to registered FOHFs, however, we recommend that the 

Commission consider a rule that would prohibit registered investment companies from investing

in the securities of hedge funds unless their boards of directors have adopted procedures 

designed to ensure that the funds value those assets consistently with the requirements of Section 

2(a)(41) of the Investment Company Act. In making this recommendation, however, we note 

that the requirement under Section 2(a)(41) that a board of directors determine, in good faith, the 

fair value of securities for which there is no readily available market quotation reflects 

Congress’s recognition that a board of directors must exercise its best business judgment in 

valuing these types of securities. We do not recommend, therefore, that the Commission 

consider mandating the specific procedures that a fund must follow in valuing its assets.321

D. The Commission Should Consider Requiring Additional Disclosure to be

Provided About Layered Fees of “Funds of Funds” 

We recommend that the Commission consider adopting its recently proposed rule that 

would expressly require all registered investment companies, including registered FOHFs, that 

invest all or substantially all of their assets in hedge funds (collectively “funds of funds”) to 

disclose in the fee table the estimated fees (both asset based and performance based) and 

expenses of the underlying funds.322 The staff believes that disclosure of the expenses of both 

the fund in which an investor invests and the funds in which a fund of funds invests is important 

to provide meaningful information to investors. 

 

321 We believe that this recommendation could ultimately address our concerns about a registered 

FOHFs diversification and risk exposure. See supra Part VI.C.2. (discussing concerns relating to 

registered FOHFs). 

322 See Fund of Funds Investments, Investment Company Act Release (to be released). 

99
We believe our recommendation is particularly germane to registered FOHFs. Neither 

the Investment Company Act nor the Advisers Act limits the amount of fees that may be charged 

by hedge fund advisers. Moreover, to the extent that performance fees may be charged at the 

hedge fund level, a registered FOHF investor may indirectly pay performance fees to some 

hedge fund advisers regardless of how poorly the investor’s registered FOHF performed overall. 

Because an investor in a registered FOHF has access only to the fee disclosure in that fund’s 

prospectus, the investor cannot accurately evaluate his or her investment goals and expectations 

against the costs of the investment, without additional disclosure that would be required under 

the recommended rule. 

E. Regulators Should Continue to Monitor Whether Suitability Obligations Are

Being Met 

We do not recommend specific measures to be taken with respect to suitability

determinations at this time. We believe that the staffs of the NASD and the Commission are

carefully focusing their examinations of broker-dealers to, among other things, ensure that they

are meeting their obligation to evaluate and disclose to investors the general suitability of hedge

funds and FOHFs (both registered and not registered with the Commission), as well as their 

suitability for specific investors. Although we believe that the examination of broker-dealers has 

been effective in deterring abusive sales practices relating to these securities, we also urge the

examination staffs of the NASD and Commission to continue to be vigilant in identifying any

violations of broker-dealer suitability obligations. 

F. The Commission Should Consider Permitting General Solicitation in Section 

3(c)(7) Hedge Fund Offerings 

We question whether the restrictions on general solicitation for private placement

offerings of interests in funds relying on Section 3(c)(7) of the Investment Company Act should 

be retained. Unlike a Section 3(c)(1) fund, a Section 3(c)(7) fund can be sold to an unlimited 

number of investors, so long as they are “qualified purchasers.” There seems to be little

compelling policy justification for prohibiting general solicitation or general advertising in 

private placement offerings of Section 3(c)(7) funds that are sold only to qualified purchasers.323

 

323 The Commission has requested comment in various rulemakings as to whether the restrictions on 

general solicitation should be relaxed as to certain types of offerings or certain types of investors. 

See, e.g., The Regulation of Securities Offerings, Securities Act Release No. 7606A (Nov. 13, 

1998); Securities Act Concepts and their Effects on Capital Formation, Securities Act Release 

No. 7314 (July 25, 1996); Exception for Certain California Limited Issues, Securities Act Release 

No. 7285 (May 1, 1996); Exemption for Certain California Limited Issues, Securities Act Release 

No. 7185 (June 27, 1995). To date, the Commission has not adopted proposals to relax general 

solicitation or general advertising restrictions. The Commission and the staff have, however, 

100
The staff would be reluctant to ease or eliminate the prohibition on general solicitation 

for hedge funds or other funds that use the accredited investor standard as their minimum 

investor criteria. We believe that such an arrangement could increase the level of risk of 

investment interest by less wealthy investors. On the other hand, permitting funds, including

hedge funds, that limit their investors to a higher standard (e.g., “qualified purchasers”) to 

engage in a general solicitation could facilitate capital formation without raising significant 

investor protection concerns. 

G. Monitor Capital Introduction Services Provided by Prime Brokers 

Prime brokers frequently provide certain investors with information about hedge funds. 

In particular, prime brokers who provide capital introduction services to hedge fund advisers 

often invite these investors to attend capital introduction conferences and seminars. Prime 

brokers have asserted that these “dating service” activities do not rise to the level of acting as a 

broker or investment adviser. We question whether this conclusion is accurate in all

circumstances. Accordingly, we encourage examiners to be vigilant in examining capital

introduction services to determine whether prime brokers are complying with all applicable 

regulatory requirements. 

H. Encourage the Hedge Fund Industry to Embrace and Further Develop Best

Practices 

The Commission should encourage the hedge fund industry and others involved with the 

industry to embrace existing “best practices” and expand and develop additional best practice 

guidelines in areas that further investor protections and enhance the ability of hedge funds to 

manage their operations. Generally, best practice guidelines allow firms to benchmark their 

activities relative to their peers and can produce a self-regulatory solution to issues arising within 

an industry. At least three industry groups and associations have issued best practice 

recommendations for hedge fund advisers.324 

 

recognized that a shorter time frame, 30 days, between the end of activities that may be 

considered general solicitation or general advertising and the commencement of an offering may

be sufficient to eliminate a concern that investors in the subsequently commenced private offering

were found by means of general solicitation or general advertising. See e.g., Integration of 

Abandoned Offerings, Securities Act Release No. 7943 (Jan. 26, 2001). 

324 See The Managed Funds Association, 2003 Sound Practices for Hedge Fund Managers (Aug. 

2003) (“MFA 2003 Sound Practices”); The Alternative Investment Management Association 

Ltd., Guide to Sound Practices for European Hedge Fund Managers (Aug. 30, 2002) (“AIMA 

Guide to Sound Practices”); and The International Association of Financial Engineers, Investor 

Risk Committee, Hedge Fund Disclosure for Institutional Investors (July 27, 2001). 

101
Some best practice recommendations were developed in response to issues arising out of 

LTCM, and therefore focus largely on risk management techniques, addressing investor 

protection issues in the context of market, leverage, and operational risks. The Managed Funds 

Association recently revised its sound practices.325 These sound practices include 

recommendations concerning the type of information that should be disclosed to a hedge fund’s 

investors, such as the fund’s investment objectives and strategies, performance information, and 

range of permissible investments as well as valuation policies and business continuity and 

disaster recovery. These recommendations also acknowledge that hedge fund operations may

generally present conflicts of interest and that these conflicts, if material, should be appropriately

disclosed. The Alternative Investment Management Association sound practices guide covers 

topics such as: creating and managing a hedge fund business; hedge fund structures and 

organizations; the investment process and portfolio risk management; portfolio administration 

and operation controls; as well as capital raising and investor relations. AIMA guidelines, for

example, address among the most critical conflicts of interest confronted by investment advisers: 

side-by-side management of hedge funds and other clients. The AIMA guidelines emphasize

that addressing side-by-side management issues in managing various portfolios should be an 

“overriding principle of business.”326

The use of best practices can be an effective means of addressing issues that arise in the 

hedge fund industry. For example, based on its examination of major brokerage houses, the 

Commission staff discovered that many firms responded favorably to recommendations made in 

the President's Working Group on Financial Markets’ report to address the risk management and 

transparency issues raised in LTCM. The Managed Funds Association has also indicated that the 

best practices it issued was “widely recognized by members of the hedge fund industry as a 

highly useful resource for hedge fund managers.”327 Best practices may thus be a useful tool to 

improve how firms address issues, such as conflicts of interest, beyond regulatory and legal 

mandates. 

While we are encouraged by the best practice guidelines that currently exist, we believe 

that the industry should be encouraged to continue to refine and expand their scope, especially in 

light of evolving industry developments. For example, we believe that certain of these 

recommendations are general in nature and may be more meaningful if they provide specific 

policies and procedures that hedge fund advisers may follow or consider to improve their 

operations and to prevent conflicts from harming their clients. 

 

325 See MFA 2003 Sound Practices, supra note 324. 

326 See AIMA Guide to Sound Practices, supra note 324. 

327 See MFA 2003 Sound Practices, supra note 324 (referring to sound practices recommendations 

that the MFA previously issued in 2000). 

102
I. Investor Education 

As this Report notes, improvements in disclosure practices of hedge fund advisers is 

desirable to help investors make more informed investment decisions regarding hedge fund 

securities. Even if the Commission follows our recommendations, there may be practical limits 

on the extent to which investor education can assist retail investors to make informed decisions 

about hedge funds and FOHFs. It also may be that some investors overlook the correlation 

between risk and reward. 

The Commission’s website provides a partial list of questions that investors should ask, 

and most importantly, understand the answers to before making any investments in hedge funds 

or registered FOHFs. These issues run the gamut from understanding the costs associated with 

investing in hedge fund or registered FOHF securities, to understanding any limitations on an 

investor’s ability to liquidate the investment to understanding how the lack of transparency

affects the investor’s personal investment needs (e.g., diversification). We recommend that the 

Commission continue to provide and enhance investor education relating to hedge funds and 

registered FOHFs. 

In February 2003, in response to increasing publicity about hedge funds and registered 

FOHFs, the Commission developed a website advertising a simulated hedge fund, Guaranteed 

Returns Diversified, Inc. (“GRDI” for short, pronounced “greedy”).328 This website 

demonstrates how easy it is to be taken in by false statements and seeks to sensitize investors to 

their vulnerability. Although the Commission's website provides a link to the fake scam, many

investors appear to be finding it by surfing the Internet looking for quick and easy hedge fund 

returns. Several hedge fund websites, and bulletin boards frequented by hedge fund investors, 

also steer investors to the site. Since the Commission launched the website on February 13, 

2003, there have been over 80,000 hits on it.329

VIII. The Commission Should Consider Issuing a Concept Release for Examining Wider 

Use of Hedge Fund Investment Strategies in Registered Investment Companies 

We recommend that the Commission consider issuing a Concept Release exploring the 

wider use of hedge fund-type/absolute return strategies. Many hedge funds use absolute return 

strategies that are designed to produce positive returns irrespective of the performance of other

securities markets. These investments typically have lower correlations to the broader debt and 

equity markets and thus, may provide benefits to investors under a wider variety of market 

 

328 See http://www.growthventure.com/grdi. 

329 The agency has received telephone calls and a handful of e-mailed comments from investors who 

have visited the GRDI site. Nearly half of these calls and comments came from investors who, 

upon reading the website’s description of unbelievably high returns, wished to invest. 

103
conditions. The staff believes that these investments may have benefits that could assist other 

investors, including retail investors, in diversifying their overall portfolios. The staff is not 

recommending that hedge funds be made more readily available and does not believe that direct 

investment into hedge funds by retail investors is appropriate.330 Instead, we believe it may be

the case that retail investors interested in absolute return strategies should be able to pursue those 

investments through the registered investment company structure. 

We recommend that the Commission consider issuing a Concept Release assessing the 

steps that should be taken to encourage the wider use of absolute return strategies in registered 

investment companies. This release would seek information including, but not limited to, the

following: what, if any, statutory or regulatory changes would enable more effective deployment 

of absolute return strategies in registered investment companies; and what is the ability of retail 

investors to understand absolute return strategies. 

A. Different Registered Investment Company Structures Provide Various 

Benefits and Challenges in the Deployment of Absolute Return Strategies 

Several registered investment companies currently offered to the public utilize absolute

return strategies. Although still quite small, this group appears to have grown markedly since 

1997 when Congress repealed the “short-short” rule, a tax regulation that limited the amount of 

profits that an open-end investment company could derive from short-term trading or short 

selling. Many of the strategies currently being used in registered investment companies attempt 

to use offsetting long and short positions in an attempt to mitigate market risk and generate

positive returns. Among the types of funds currently being offered are market neutral, long/short 

equity and even merger arbitrage investment strategies.331 The growth of these funds suggests 

that the Investment Company Act presents manageable impediments to the retail offering of

hedge fund (or hedge fund-like) investment funds. 

Some of the registered investment companies using hedge fund strategies are organized 

as open-end management companies, and thus must make payment on redemption requests no 

 

330 A few jurisdictions, such as Hong Kong, Singapore and Switzerland, permit individual hedge 

funds to be marketed and sold directly to retail investors. See Hedge Funds and the FSA, 

Financial Services Authority Discussion Paper No. 16, at 21-22 (Aug. 2002) at 

http://www.fsa.gov.uk/pubs/discussion/16. 

331 Registered investment companies with market neutral, merger arbitrage and other absolute return 

strategies represent a very small niche of the approximately $6.8 trillion investment company

industry. One estimate is that there are approximately 50 such registered investment companies 

with about $8 billion under management. See Hedging Trims Some Fund Gains, Wall Street 

Journal (Aug. 4, 2003). 

104
more than seven days after receipt of those requests.332 As a result, these funds are unable to 

impose “lock-ups” or notice requirements, both of which are common among hedge funds. 

Moreover, the need to manage cash flows as a result of purchases and redemptions (aggravated 

by market timers) may make the open-end management company structure less attractive or may

negatively affect returns of the fund.333 However, for those many hedge fund strategies 

involving investments in highly liquid securities, redemption requirements of the Investment 

Company Act do not present a significant obstacle. 

Those advisers using strategies involving illiquid securities or who wish to avoid cash 

flow management obligations, may register their funds as closed-end investment companies. 

The closed-end investment company offers several significant advantages over the mutual fund 

structure in the utilization of absolute return strategies. Closed-end funds do not issue 

redeemable securities and are therefore not required to liquidate securities in order to meet

redemption requests. This more stable asset base permits advisers to remain fully invested. 

Closed-end funds are also not required to hold any specified percentage of their assets in liquid 

securities and may engage in strategies that require large portions of illiquid securities as a

percentage of their total assets.334 Closed-end funds, of course, may offer less liquidity to their 

shareholders.335 As discussed below, closed-end funds can engage in leveraging transactions 

 

332 See Section 22(e) of the Investment Company Act (prohibiting registered investment companies 

issuing redeemable securities from suspending the right of redemption for more that seven days

following tender of security). 

333 Open-end funds may hold no more that 15 percent of their assets in illiquid securities. A security

is considered “illiquid” if a fund is unable to promptly sell or dispose of the security in the 

ordinary course of business at its current value within seven days. See Acquisition and Valuation 

of Certain Portfolio Instruments by Registered Investment Companies, Investment Company Act

Release No. 14983 (Mar. 21, 1986) (adopting amendments to Rule 2a-7). The Commission has 

historically recommended the 15 percent ceiling in order to maintain and enhance a registered 

investment company’s liquidity. See Revisions of Guidelines to Form N-1A, Investment 

Company Act Release No. 18612 (Mar. 12, 1992). While the Guidelines were not republished 

when Form N-1A was amended in 1998, they continue to set forth the staff’s views on issues not 

addressed in the 1998 amendments to Form N-1A. See Registration Form Used by Open-End 

Management Investment Companies, Investment Company Act Release No. 23064 (Mar. 13, 

1998). 

334 Because of the ability to hold illiquid securities, closed-end investment companies tend to 

specialize in less liquid bonds, foreign securities, small/microcap securities and securities issued 

by companies that are not publicly traded. 

335 Most closed-end funds provide liquidity to their shareholders by listing their securities for trading

on an exchange or on the over-the-counter markets. However, there is no requirement that 

closed-end fund shares be publicly traded and many funds provide their shareholders with 

liquidity solely through periodic purchases of their own shares or through tender offers. 

105
beyond those of open-end investment companies. Unlike open-end investment companies, 

however, closed-end investment companies cannot engage in continuous offerings and often 

have difficulty raising additional assets.336

Closed-end investment companies that elect to operate as “interval” funds under Rule 

23c-3 under the Investment Company Act may be well suited for use of absolute return 

strategies.337 Interval funds are registered closed-end investment companies that adopt as a 

fundamental investment policy that they will engage in periodic repurchases of their own shares 

at net asset value.

338 There are few interval funds currently in operation.339 One reason for the 

reluctance to use the interval fund structure may be the requirement that the fund maintain liquid 

assets equal to at least 100 percent of the amount of the mandatory repurchase offer. Complying

with this provision may require selling securities in anticipation of the periodic repurchases. 

Interval funds also lack the same flexibility of other closed-end funds with respect to the use of 

leverage.

340 

We recommend that the Commission consider seeking comment through a Concept 

Release to learn the extent to which hedge fund investment strategies might be effectively

deployed in the open-end investment company structure. The release should request comment 

on what measures could assist these companies in offering absolute return strategies consistent 

with the issuance of redeemable securities, including whether there should be flexibility with 

respect to the limitation on illiquid securities. The release should also seek comment on how 

closed-end investment companies could be made to be more conducive for the use of absolute 

return strategies. Similarly, the Concept Release should seek comment on what steps could be 

taken to increase the utility of Rule 23c-3 under the Investment Company Act, including whether 

raising the maximum permitted redemption amount above 25 percent would be helpful. 

 

336 Section 23 of the Investment Company Act generally prohibits closed-end funds from issuing

shares below NAV, and since closed-end fund shares often trade at discounts to NAV, the 

presence of a trading discount limits the issuance of additional shares to rights offerings, for 

practical purposes. 

337 See Repurchase Offers by Closed-End Management Investment Companies, Investment Company 

Act Release No. 19399 (Apr. 7, 1993). 

338 The periodic repurchase provisions are intended to allow closed-end investment companies to 

offer their investors a limited ability to resell shares—a benefit traditionally available only to 

shareholders of registered open-end investment companies. Id. 

339 Commission records indicate that 43 investment companies or portfolios operate pursuant to Rule 

23c-3 under the Investment Company Act. 

340 Rule 23c-3 under the Investment Company Act requires that leveraged positions either mature or 

be callable in advance of the periodic repurchases. 

106
B. Registered Investment Companies are Subject to Restrictions on Leverage 

and Short Selling that Hedge Funds Avoid 

While hedge funds may no longer engage solely in strategies that involve hedging and 

leverage, the majority of hedge funds still use these techniques to varying degrees. The ability to 

borrow money to engage in securities transactions and to sell securities short are of critical

importance to most hedge fund advisers. 

Congress chose to limit, but not to prohibit, the ability of investment companies to 

engage in leverage.

341 Section 18 of the Investment Company Act addresses leverage concerns 

by limiting the ability of investment companies to borrow and incur indebtedness.342 Under the 

Investment Company Act, securities and related transactions in which the registered investment 

company is a borrower, or that involve indebtedness on the part of the registered investment 

company, are generally known as “senior securities.” Congress limited the ability of investment 

companies to engage in leverage by limiting their ability to issue “senior securities.”343 In

 

341 See, e.g., Mutual Fund Use of Derivatives, Letter from Arthur Levitt, Chairman of the SEC, to 

Hon. Edward J. Markey and Hon. Jack Fields, U.S. House of Representatives, attaching Division 

of Investment Management Memorandum, at n. 83 (Sept. 26, 1994) (“The legislative history of 

the Investment Company Act indicates that the Act was not intended to eliminate all leverage

from fund investments.”) See also id. at n. 82 (“The framers of the Investment Company Act 

specifically disavowed any attempt to prohibit speculative mutual fund investments.”). The 

Commission has stated that “[l]everage exists when an investor achieves the right to a return on a 

capital base that exceeds the investment which he has personally contributed to the entity or 

instrument achieving a return.” See Release 10666, supra note 133. 

342 See, e.g., Sections 18(a) - (e) of the Investment Company Act (restrictions on closed-end 

investment companies); Section 18(f) of the Investment Company Act (restrictions on open-end 

investment companies); Section 18(g) of the Investment Company Act (definition of “senior 

security”); and Section 18(h) of the Investment Company Act (asset coverage formula). 

343 Because securities issued by open-end investment company securities are redeemable, and 

securities issued by closed-end investment companies are not, Sections 18(a) and (f) of the Act 

limit the use of leverage by these different types of investment companies in different ways. A 

closed-end company may issue a senior security representing indebtedness if it maintains asset 

coverage of at least 300 percent. See Sections 18(a)(1)(A) and (h) of the Investment Company

Act. A closed-end company may issue a senior security that is a stock, e.g., preferred stock, if it 

maintains asset coverage of at least 200 percent. See Section 18(a)(2)(A) of the Investment 

Company Act. The Investment Company Act generally limits a closed-end company to issuing

one class of senior securities representing indebtedness and one class of senior stock, but the class 

of indebtedness or stock may be issued in one or more series. See Section 18(c) of the 

Investment Company Act. Under the Investment Company Act, open-end companies generally

may not issue senior securities, except that they may borrow from banks provided that the 

borrowing is subject to 300 percent asset coverage. See Section 18(f) of the Investment Company

Act. The Investment Company Act also permits open-end investment companies to engage in 

107
practice, these restrictions limit the amount of leverage in which registered investment 

companies may engage. Hedge funds are not subject to these limitations. 

The Investment Company Act does not prohibit a registered investment company from 

engaging in short selling.

344 Registered investment companies are permitted to short sell 

provided that they cover any open short positions by setting aside or “segregating” cash or other

liquid securities.345 Assets set aside to cover a short position are generally frozen and 

unavailable to the fund for any other purpose, including other short selling or leveraged 

transactions.346 By taking these assets “out of circulation,” the asset set-aside (segregation) 

requirement serves as a de facto limit on the amount of short selling in which an investment 

company may engage.

347 Nonetheless, even with these limits, registered investment companies 

still have the ability to engage in high levels of short selling. 

The Concept Release should seek comment on whether the Investment Company Act’s 

restrictions on the use of leverage and short selling are discouraging the use of absolute return

strategies in registered investment companies, as well as impairing the ability of registered

investment companies to effectively employ such strategies. The release should also consider 

whether certain types of derivatives may be useful to registered investment companies seeking to 

use absolute return strategies. The release should also invite comment on what additional steps, 

 

certain private and temporary borrowings, from banks and non-banks, without 300 percent asset 

coverage, because such borrowings are not “senior securities.” See Section 18(g) of the 

Investment Company Act.

344 According to Commission records, for the six-month period ended April 30, 2003, approximately

3,900 mutual funds, out of a universe of approximately 9,000 mutual funds, disclosed that they

were authorized to short sell. During this period, 236 mutual funds engaged in short selling. 

345 Registered investment companies must set aside or segregate an amount equal to the daily price 

of the shorted securities less any non-proceeds margin posted under applicable margin rules. 

See, e.g., Release 10666, supra note 133; MLAM, supra note 133; Robertson Stephens Investment 

Trust (pub. avail. Aug. 24, 1995); Dreyfus, supra note 133. Instead of setting aside assets, the 

staff has permitted a fund to cover its short positions by owning the security or holding a call 

option on the security with a strike price no higher than the price at which the security was sold. 

See id. 

346 See, e.g., Release 10666, supra note 133. 

347 All mutual funds, irrespective of whether they are engaging in short selling, must ensure their 

ability to satisfy their redemption requirements under Section 22(e) of the Investment Company

Act. A fund’s board of directors must ensure that short selling will not interfere with the fund’s 

ability to: meet current obligations; honor requests for redemptions (in the case of a mutual 

fund); and manage properly its investment portfolio in a manner consistent with the fund's stated 

investment objectives, especially as short selling approaches high levels. Id. 

108
including clarifying existing guidance, may be taken to enhance the ability of all registered

investment companies to utilize these tools. 

C. Alignment of the Investment Adviser’s Interests with Investors 

Hedge funds advisers argue that two factors are critical to aligning their interests with 

those of their investors. First, they assert that a properly configured performance fee 

arrangement providing compensation based on capital gains and capital appreciation provides a 

greater incentive for the adviser to produce absolute returns. The requirement that an absolute

return be achieved before the performance fee is paid, in their view, insures diligence in 

managing the fund.348

Second, investment of the adviser’s own assets alongside the investors’ helps assure that 

the adviser acts responsibly.

349 Hedge fund investors rely on having the adviser’s assets in the 

fund to serve as a curb on any adviser who may seek to engage in high-risk investment strategies. 

If the adviser stands to lose as much as the fund’s investors by engaging in unduly risky

investment activities, that adviser may be deterred from such activities.350 Not surprisingly, a 

number of private placement memoranda include provisions requiring that the general partner 

disclose significant withdrawals from their capital account. 

Performance fees based on capital gains and capital appreciation have an interesting

history under the federal securities laws. 351 Congress originally limited the receipt of these types 

 

348 “Hedge fund managers seek out and exploit mispricings of securities using a variety of financial 

instruments. They produce superior performance, and they are not judged by their ability to track

a passive benchmark. As a result, the compensation structure within the industry is based largely

on performance.” See Steven J. Brown et al., Offshore Hedge Funds: Survival and Performance, 

1989-95, 72 Journal of Finance 91 (1999). 

349 Hedge fund investors also look to the adviser’s own investment in the fund as a measure of 

prudence to ensure that the manger acts responsibly in others areas, e.g., brokerage fees, soft 

dollars, etc. 

350 The Commission has recognized that where advisers have their own substantial investment in 

certain accounts, it reduces their incentive to take undue risks. See, e.g., Foster Management 

Company, Advisers Act Release Nos. 646 (Nov. 1, 1978) and 651 (Nov. 28, 1978); Weiss, Peck 

& Greer, Advisers Act Release Nos. 623 (Mar. 28, 1978) and 625 (Apr. 25, 1978). 

351 Section 205(a) of the Advisers Act, in general, prohibits registered investment advisers from

entering into a contract to provide investment advisory services that, among other things, 

“provides for compensation to the investment adviser on the basis of a share of capital gains upon 

or capital appreciation of the funds or any portion of the funds of the client.” See Section 

205(a)(1) of the Investment Advisers Act. For a discussion of the history of performance fees in 

109
of fees out of a concern that they encouraged managers to take inappropriate risks.352 

Notwithstanding this history, the Investment Advisers Act did not originally prohibit registered 

investment advisers from charging a performance fee to registered investment companies.353 In

1970, however, Congress extended the performance fee prohibition to cover advisory contracts 

with registered investment companies in response to information demonstrating that performance 

fee arrangements that were included in such contracts were unfair to the registered investment 

companies’ shareholders.354 

The staff believes that it is appropriate to re-examine whether fee arrangements that are 

based on a share of the capital gains and capital appreciation may be appropriate for agreements

between investment advisers and registered investment companies. The staff also believes that it 

is worth exploring whether encouraging investment advisers to invest in the funds that they

manage may help to ensure responsible management of registered investment companies using

absolute return strategies.

355 

D. Absolute Return Strategies May Challenge Traditional Investor Expectations 

Perhaps the most formidable obstacle to further use of absolute return strategies may lie

in whether investors can understand and feel comfortable with these products. Absolute return 

investment vehicles operate differently from traditional, long-only/relative return products. 

Thus, it would be useful for the Concept Release to explore some of these differences, as 

highlighted below. 

 

investment advisory contracts, see Protecting Investors: A Half Century of Investment Company 

Regulation, Division of Investment Management 237-249 (May 1992) (“Protecting Investors”). 

352 H.R. Rep. No. 2639, 76th Cong., 2d Sess. 29 (1940). 

353 The investment company industry persuaded Congress that performance fees closely linked the 

interests of investors and management and that the basis for management’s compensation should 

not be specified by statute as long as the basis for such compensation was adequately disclosed to 

shareholders. See Protecting Investors, supra note 351, at 242. 

354 More than two-thirds of the performance fees in existence at that time either permitted the 

registered investment company’s adviser to earn a bonus for good performance without suffering

a penalty for poor performance, or had fee arrangements in which the potential rewards were 

substantially greater than the potential penalties. See id., at 242. 

355 The Investment Company Act requires that the sponsors of registered investment companies 

make initial investments in those companies. See Automation Shares, 37 S.E.C. 771 (1957) 

(Section 14(a) of the Investment Company Act requires that seed capital be provided by

“shareholders with a bona fide investment purpose without any present intention to dispose of the 

security.”). 

110
Registered investment companies generally engage in long-only/relative return strategies

whose performance is highly correlated to specific benchmarks or indexes.356 One benefit of 

relative-return strategies is the ease with which investors may compare their investment’s

performance with that of the relevant benchmark, as well as against similar funds using the same 

benchmark. These characteristics help shape many of the expectations that retail investors have 

today. For example, an investor in a long-only/relative return product will generally be able to 

assume that if the major equity markets are rising, the performance of the investment will rise as

well. Index funds and exchange-traded funds, which are designed to replicate entire markets or 

segments of markets, further attune investors to performance results that track the broader 

markets. 

In contrast, absolute return strategies generally seek to achieve a high level of return for 

their funds in a variety of market environments, rather than attempting to duplicate or exceed the 

performance of a particular benchmark or index. Absolute return strategies are designed to move 

independently of the underlying markets and thus, have lower correlations to the broader 

markets. During falling markets the performance of the fund should stay independent from that 

of broader market movements, thus providing some protection from those downward 

movements. In rising markets, however, it is not uncommon for funds employing absolute return 

strategies to lag behind more traditional, long-only investments.357 Indeed, some proponents of 

hedge funds admit that during periods of strong equity performance, hedge fund performance 

may suffer.358 

Broader use of absolute return strategies might also require investors to modify their 

expectations with respect to the investment flexibility accorded to investment advisers. Perhaps 

the most critical aspect of an adviser’s ability to seek absolute returns is the often unfettered 

discretion to manage the fund in light of changing market conditions. Many hedge funds have 

broad investment objectives and are authorized to use multiple strategies in order to take

advantage of changing market conditions.359 In adverse markets, a hedge fund adviser will 

 

356 See supra Part IV.A. (discussion of hedge fund investment strategies). 

357 This is because the hedging portions of the portfolio will act as a drag on the long portions. One 

Roundtable participant explains that “[b]y definition, hedge funds are not going to outperform a 

broad index in a strongly rising market, like the one we saw in the second quarter [April-June 

2003].” See Neil Martin, Bull in the Hedges, Barron’s (July 28, 2003) (quoting Greg Newton). 

358 “Hedge funds under perform the stock market only when the latter is strong, that is, when the 

stock market yields a positive annual return.” See Absolute Returns, supra note 118, at 105. 

359 See Roundtable Transcript, May 14 (statement of Robert Schulman) (“The hedge fund industry

has avoided, in large measure, the catastrophic impacts of the market by having enough flexibility

in the [private placement ] document and using it to react to what you would call changing market 

conditions.”).

111
generally have the flexibility to hedge against market declines, engage in short-selling or take

positions that are less dependent on the price movements of broad market averages to make 

profits or limit losses.360 Most traditional relative-return products, including registered 

investment companies, are either limited in their flexibility or forego engaging in these

strategies. 

More flexible investment mandates permit the adviser to manage the fund according to 

his or her best judgment. Poor choices, of course, are a continual possibility for absolute return

advisers, as they are for all investment advisers. For example, if an absolute return adviser

redeploys assets incorrectly, the performance of the fund may suffer. This may contrast with 

instances where an adviser with less flexibility must adhere to a particular investment mandate, 

which, in the end, prevents the adviser from exercising more discretion, and possibly, making a 

mistake. 

The flexibility that absolute return advisers require often makes it more difficult for

investors to categorize the precise nature of their investments. For example, investors in longonly/relative return strategies often associate their investment with the type of portfolio securities 

that their mutual fund or closed-end fund typically holds. Retail investors often rely on the 

structure and nature of the particular fund’s investments to provide continuity to their portfolio. 

In contrast, absolute return investments may lack that continuity or assurance. In one sense, 

investors in funds utilizing absolute return strategies must rely more heavily, and may associate 

their investment more closely, with an adviser, rather than with a fund itself.361 

The Concept Release should explore whether investor education would be helpful in 

connection with absolute return investments. The Concept Release should also examine whether 

any particular absolute return strategies raise especially difficult issues with respect to investor

expectations. The Concept Release should explore whether more education is necessary to 

familiarize retail investors with the risks of engaging in short selling and leveraging

transactions.362 Moreover, the Concept Release should seek comment on what, if any, additional 

 

360 Because these strategies often necessitate a steady turnover in the nature and character of the 

underlying investments, investors should recognize that they may have little ongoing insight into 

how a hedge fund is invested. This may differ from traditional long-only relative return products 

that permit investors to remain focused on sectors or sub-sectors of the broader markets. 

361 “[T]he most interesting feature of hedge funds is that they are thought of as nearly pure ‘bets’ on 

manager skill.” See Brown, supra note 348. 

362 The primary market risk from short selling is the fact that losses “can be infinite, depending on 

how high the stock price moves after the [short] sale.” Comment submitted by Roundtable 

Panelist James Chanos. 

112
disclosure is necessary to ensure that absolute return investments are fully understood by

investors.363

 

363 In the Concept Release, the Commission may also wish to explore whether there are other 

alternatives that will expand the accessibility of absolute return strategies to a broader group of 

suitable investors. It could explore, for example, whether certain hedge funds relying on Section 

3(c)(7) of the Investment Company Act may be permitted to accept investors below the qualified 

purchaser standard, so long as that hedge fund provides fundamental Investment Company Act 

protections commensurate with the level of investors permitted to invest. 

113
Appendix A 

Summary of the Commission’s Previous Studies 

or Investigations of Hedge Funds 

In January 1969, the Commission commenced an investigative study of hedge funds in 

response to the rapid increase in the number of hedge funds and their assets under management. 

At that time, the Commission estimated that there were almost 200 hedge funds in existence with 

estimated total assets of $1.5 billion. The Commission's study, however, was not limited to 

unregistered funds. It also examined the activities of registered investment companies that 

engaged in hedge fund trading techniques such as leveraging and short selling. The Commission 

sent questionnaires to registered and unregistered funds in an effort to obtain basic background 

information, information about trading and brokerage practices, affiliations of hedge fund 

principals, borrowing practices and sources of credit. 

Twenty three years later, the Commission, in collaboration with representatives of the 

Treasury Department and the Board of Governors of the Federal Reserve System (“Federal

Reserve”) issued a report focusing on abuses in the market for United States government 

securities (i.e., Treasury bills, notes and bonds) following admissions by Salomon Brothers Inc. 

of violations of Treasury auction rules.1

 The report did not make any legislative proposals with 

respect to hedge funds, but did recommend reforms for administrative and regulatory changes 

regarding Treasury auction participation, policies and enforcement as well as the means for 

detecting and combating short squeezes in the U.S. government securities market.

2

 

 

1

 See Joint Report on the Government Securities Market (Jan. 1992) (“Joint Report”). 

2

 Id., at xiii-xv. The report also made related legislative recommendations. However, in an 

appendix discussing hedge funds, the report recognized the potential dangers of the use of 

leverage by hedge funds, stating: 

Events in the government securities market have shown that their capacity for 

leverage allows hedge funds to take large trading positions disproportionate to their 

capital base. Thus far, [hedge] fund managers have proved very adept at controlling

their market risk, and their lending counterparties appear to consider them

creditworthy. However, the sheer size of the positions taken by hedge funds raises 

concerns about systemic risk that these funds may introduce into the financial 

markets.

Appendix B to Joint Report. 
In 1992, the Commission’s Division of Investment Management looked at hedge funds in 

connection with its study of the Investment Company Act and recommended that the 

Commission propose a new private investment company exception for qualified purchasers.3

 

Later that year, in response to a Congressional inquiry, the Commission provided detailed 

information about both the nature and regulatory treatment of hedge funds to Congress.4 That 

staff report focused on the systemic risk posed by hedge funds and analyzed how various 

provisions of the federal securities laws affect hedge funds. The staff made clear at that time that 

it had no direct source of information regarding hedge fund activities, and that a limited amount 

of information about hedge funds was publicly available.5

 The report concluded that the relevant 

regulatory issues did not involve the protection of hedge fund investors, but instead, the potential 

of hedge funds to affect the equity markets due to their size and active market presence. At that 

time, the Commission believed that its proposed large trader reporting system would enhance its 

ability to examine the activities of hedge funds in the event of large movements in the equity

markets.6

 

 

3

 See Protecting Investors: A Half Century of Investment Company Regulation, Division of 

Investment Management, May 1992, p. 103-105. The Division’s recommendation was 

subsequently adopted as Section 3(c)(7) as part of the National Securities Markets Improvement 

Act of 1996. See Privately Offered Investment Companies, Investment Company Act Release 

No. 22597 (Apr. 3, 1997). 

4

 See Letter from Richard C. Breeden, Chairman, U.S. Securities and Exchange Commission, to 

Edward J. Markey, Chairman, Subcommittee on Telecommunications and Finance, Committee on 

Energy and Commerce, U.S. House of Representatives (June 12, 1992). 

5

 Press reports estimate that approximately 400 hedge funds existed at that time. With respect to 

the asset base of the hedge fund industry, the staff was able to identify publicly available 

information for only 17 hedge funds with approximately $13 billion in assets under management 

as of December 31, 1991. 

6 The Commission’s authority to implement the large trader reporting system is provided in Section 

13(h) of the Exchange Act, which was added to the statute by the Market Reform Act of 1990 to 

remedy difficulties that the Commission encountered during its attempts to reconstruct and 

analyze trading activity following the stock market breaks of October 1987 and October 1989. 

The Commission, however, never adopted implementing regulations due, in part, to the 

availability of other mechanisms for monitoring stock market activity (e.g., the electronic blue 

sheet system). See also Electronic Submission of Securities Trading Data by Exchange Members, 

Brokers and Dealers, Exchange Act Release No. 42741 (May 2, 2000) (proposing rule 17a-25 

under the Exchange Act and stating that public comments raised concerns that, among other 

things, the comprehensive system envisioned by Section 13(h) could prove difficult to implement 

and maintain, and most likely would not expedite trading reconstructions to the extent 

contemplated in 1990). 

 2
The President’s Working Group on Financial Markets (“Working Group”)7

 issued a 

report in April 1999 in the wake of the near-collapse of Long Term Capital Management 

(“LTCM”).8

 The report examined hedge funds in general as well as LTCM, analyzed the public 

policy issues presented to the markets by leverage, risk and bankruptcy, and recommended a 

number of measures designed to constrain excessive leverage in the financial system. 

The report focused on the risk management and transparency issues raised by LTCM as 

well as “highly leveraged institutions” in general. It also focused on the exposure of banks and 

others to the counterparty risks of highly leveraged entities such as hedge funds. The Working

Group looked at such issues as these entities’ use of leverage and whether that use was 

excessive, counterparty adherence to stated policies, margin and collateral requirements and how 

well risk models functioned. The Working Group also recommended in its report that no 

changes be made to the exemptions for hedge funds and hedge fund advisers under the 

Investment Company Act and the Advisers Act.9

 The report took the position that registration of 

hedge funds and their advisers at that time did not appear to be a useful method of monitoring

hedge fund activity. 

In addition to the examination of risk management and transparency issues by the 

Working Group, the Commission staff actively supported the work of the Multidisciplinary

Working Group on Enhanced Disclosure (“MWGED”), which was established by the 

international regulatory and central banking community to assess the feasibility and utility of

enhanced public disclosure by financial intermediaries (i.e., banks, securities firms, insurance

companies and hedge funds). The MWGED issued a report in April 2001 that recommended that 

all regulated financial intermediaries move promptly to make routine, periodic disclosures of 

certain quantitative risk measurements to their shareholders, creditors and counterparties. It also 

recommended that hedge funds be encouraged to make such disclosures, when material, to their 

 

7

 The President’s Working Group, which continues to examine market leverage and counterparty

risks, includes representatives from the Commission, the Treasury Department, the Federal 

Reserve and the Commodity Futures Trading Commission.

8

 See Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management - Report of The 

President's Working Group on Financial Markets (Apr. 1999) (“LTCM Report”). LTCM was a 

prominent and successful hedge fund in the 1990s that was distinguished by its size, leverage and 

trading strategies (e.g., convergence trading and dynamic hedging). These characteristics made 

LTCM vulnerable to the market conditions that followed Russia’s devaluation of the ruble, and 

caused it to suffer approximately $1.8 billion in losses in August 1998. At that time, LTCM’s 

simple balance sheet leverage ratio had reportedly climbed to in excess of 25 to 1, and the hedge 

fund had difficulty meeting its margin call requirements. Because, among other things, many

Wall Street firms were creditors and counterparties to LTCM, there was a general concern that 

the fund’s collapse would have an impact on the financial markets, and the Federal Reserve 

intervened by facilitating a private-sector recapitalization of the fund. 

9

 See Appendix B to LTCM Report.

 3
investors, creditors and counterparties. The MWGED’s successor, the Joint Forum Working

Group on Enhanced Disclosure (“JFWGED”), which the Commission chairs, also addresses 

issues of enhanced disclosure for financial intermediaries. The work of the JFWGED is ongoing, 

and the Commission believes that many in the hedge fund industry are considering the 

recommendations of these two groups and continuing to explore ways to improve some of their 

practices.10 

 

10 The Commission has also been involved in other reviews of market stability and counterparty risk

issues posed by hedge funds in the wake of LTCM’s near collapse conducted by foreign financial 

regulators. See, e.g., Review of issues relating to Highly Leveraged Institutions (HLIs), Basel 

Committee on Banking Supervision and International Organization of Securities Commissions 

(Mar. 2001). 

 4