72054 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

1See SEC v. Capital Gains Research Bureau, Inc., 

et al., 375 U.S. 180 (1963) (‘‘Capital Gains’’). See 

also Transamerica Mortgage Advisors, Inc., (TAMA)

v. Lewis, 444 U.S. 11 (1979); Santa Fe Industries, 

Inc. v. Green, 430 U.S. 462, 471, n. 11 (1977).

2See Capital Gains, supra note 1, at 191–194.

3See In the Matter of Kidder, Peabody & Co., 

Incorporated, Edward B. Goodnow, Investment 

Advisers Act Release No. 232 (Oct. 16, 1968); In the 

Matter of Mark Bailey & Co., and Mark Bailey, 

Investment Advisers Act Release No. 1105 (Feb. 24, 

1988); In the Matter of Jamison, Eaton & Wood, Inc., 

Investment Advisers Act Release No. 2129 (May 15, 

2003).

4See supra note 3.

5Section 203(b)(3) [15 U.S.C. 80b–3(b)(3)]. The 

Act also provides several other registration 

exemptions, which have much more limited 

application. Registration exemptions are provided 

to advisers that have only intrastate business and 

do not give advice on exchange-listed securities 

(section 203(b)(1) [15 U.S.C. 80b–3(b)(1)]); to 

advisers whose only clients are insurance 

companies (section 203(b)(2) [15 U.S.C. 80b–

3(b)(2)]); to charitable organizations and their 

officials (section 203(b)(4) [15 U.S.C. 80b–3(b)(4)]); 

to church plans (section 203(b)(5) [15 U.S.C. 80b–

3(b)(5)]); and to commodity trading advisors 

registered with the Commodity Futures Trading 

Commission (‘‘CFTC’’) whose business does not 

consist primarily of acting as investment advisers 

(section 203(b)(6) [15 U.S.C. 80b–3(b)(6)]).

6They are also subject to antifraud provisions of 

other federal securities laws, including rule 10b–5 

under the Securities Exchange Act of 1934 [17 CFR 

240.10b–5].

7Section 204 of the Advisers Act [15 U.S.C. 80b–

4] authorizes the Commission to conduct 

examinations of all records of investment advisers. 

Records of advisers exempted from registration 

pursuant to section 203(b) of the Act [15 U.S.C. 

80b–3(b)] are specifically excluded from being 

subject to these examinations.

8See discussion, infra, in Section II.B.8. of this 

Release.

9 Id.; see also infra Section II.C of this Release.

SECURITIES AND EXCHANGE 

COMMISSION 

17 CFR Parts 275 and 279

[Release No. IA–2333; File No. S7–30–04] 

RIN 3235–AJ25

Registration Under the Advisers Act of 

Certain Hedge Fund Advisers

AGENCY: Securities and Exchange 

Commission (the ‘‘Commission’’ or 

‘‘SEC’’).

ACTION: Final rule.

SUMMARY: The Commission is adopting 

a new rule and rule amendments under 

the Investment Advisers Act of 1940. 

The new rule and amendments require 

advisers to certain private investment 

pools (‘‘hedge funds’’) to register with 

the Commission under the Advisers Act. 

The rule and rule amendments are 

designed to provide the protections 

afforded by the Advisers Act to 

investors in hedge funds, and to 

enhance the Commission’s ability to 

protect our nation’s securities markets.

DATES: Effective Dates: February 10, 

2005, except for the amendments to 

§ 275.206(4)–2 [rule 206(4)–2] and 

§ 279.1 [Form ADV], which will become 

effective January 10, 2005. 

Compliance Dates: Advisers that will 

be required to register under the new 

rule and rule amendments must do so 

by February 1, 2006. Advisers must 

respond to the amended items of Form 

ADV in their next ADV filing after 

March 8, 2005. Section III of this 

Release contains more information on 

the effective and compliance dates.

FOR FURTHER INFORMATION CONTACT:

Vivien Liu, Senior Counsel, Jamey 

Basham, Branch Chief, or Jennifer L. 

Sawin, Assistant Director, at 202–942–

0719 or IArules@sec.gov, Office of 

Investment Adviser Regulation, Division 

of Investment Management, Securities 

and Exchange Commission, 450 Fifth 

Street, NW., Washington, DC 20549–

0506.

SUPPLEMENTARY INFORMATION: The 

Commission is adopting new rule 

203(b)(3)–2 [17 CFR 275.203(b)(3)–2], 

amendments to rules 203(b)(3)–1 [17 

CFR 275.203(b)(3)–1], 203A–3 [17 CFR 

275.203A–3], 204–2 [17 CFR 275.204–

2], 205–3 [17 CFR 275.205–3], 206(4)–2 

[17 CFR 275.206(4)–2], and 222–2 [17 

CFR 275.222–2], and Form ADV [17 

CFR 279.1] under the Investment 

Advisers Act of 1940 [15 U.S.C. 80b] 

(the ‘‘Advisers Act’’ or ‘‘Act’’). 

Table of Contents

I. Background 

A. Growth of Hedge Funds 

B. Growth in Hedge Fund Fraud 

C. Broader Exposure to Hedge Funds 

II. Discussion 

A. Need for Commission Action 

B. Matters Considered by the Commission 

C. Our Legal Authority Under the Advisers 

Act 

D. Rule 203(b)(3)–2

E. Definition of ‘‘Private Fund’’

F. Other Amendments to Rule 203(b)(3)–1

G. Amendments to Rule 204–2

H. Amendments to Rule 205–3

I. Amendments to Rule 206(4)–2

J. Amendments to Rule 222–2 and Rule 

203A–3

K. Amendments to Form ADV 

III. Effective and Compliance Dates 

IV. Cost-Benefit Analysis 

V. Effects on Commission Examination 

Resources 

VI. Paperwork Reduction Act 

VII. Effects on Competition, Efficiency and 

Capital Formation 

VIII. Regulatory Flexibility Act 

IX. Statutory Authority 

Text of Rule, Rule Amendments and Form 

Amendments

I. Background 

The Commission regulates investment 

advisers—persons and firms who advise 

others about securities—under the 

Investment Advisers Act of 1940. The 

Act contains a few basic requirements, 

such as registration with the 

Commission, maintenance of certain 

business records, and delivery to clients 

of a disclosure statement (‘‘brochure’’). 

Most significant is a provision of the Act 

that prohibits advisers from defrauding 

their clients, a provision that the 

Supreme Court has construed as 

imposing on advisers a fiduciary 

obligation to their clients.1 This 

fiduciary duty requires advisers to 

manage their clients’ portfolios in the 

best interest of clients, but not in any 

prescribed manner. A number of 

obligations to clients flow from this 

fiduciary duty, including the duty to 

fully disclose any material conflicts the 

adviser has with its clients,2 to seek best 

execution for client transactions,3 and to 

have a reasonable basis for client 

recommendations.4 The Advisers Act 

does not impose a detailed regulatory 

regime.

Not all advisers must register with the 

Commission. The Act exempts an 

adviser from registration if it (i) has had 

fewer than fifteen clients during the 

preceding twelve months, (ii) does not 

hold itself out generally to the public as 

an investment adviser, and (iii) is not an 

adviser to any registered investment 

company.5 Advisers taking advantage of 

this ‘‘private adviser exemption’’ must 

nonetheless comply with the Act’s 

antifraud provisions,6 but do not file 

registration forms with us identifying 

who they are, do not have to maintain 

business records in accordance with our 

rules, do not have to adopt or 

implement compliance programs or 

codes of ethics, and are not subject to 

Commission oversight. We lack 

authority to conduct examinations of 

advisers exempt from the Act’s 

registration requirements.7

The private adviser exemption was 

not intended to exempt advisers to 

wealthy or sophisticated clients.8 It 

appears to reflect Congress’ view that 

there is no federal interest in regulating 

advisers that have only a small number 

of clients and whose activities are 

unlikely to affect national securities 

markets.9 Today, however, a growing 

number of investment advisers take 

advantage of the private adviser 

exemption to operate large investment 

advisory firms without being registered 

with the Commission. Instead of 

managing client money directly, these 

advisers pool client assets by creating 

limited partnerships, business trusts or 

corporations in which clients invest. In 

1985, we adopted a rule that permitted 

advisers to count each partnership, trust 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72055

10See Definition of ‘‘Client’’ of an Investment 

Adviser for Certain Purposes Relating to Limited 

Partnerships, Investment Advisers Act Release No. 

983 (July 12, 1985) [50 FR 29206 (July 18, 1985)] 

(‘‘Rule 203(b)(3)–1 Adopting Release’’). In 1997, we 

expanded the rule to cover other types of legal 

entities that advisers use to pool client assets. See 

Rules Implementing Amendments to the Investment 

Advisers Act of 1940, Investment Advisers Act 

Release No. 1633 (May 15, 1997) [62 FR 28112 (May 

22, 1997)] (‘‘NSMIA Implementing Release’’). Under 

rule 203(b)(3)–1(a)(2)(i)[17 CFR 275.203(b)(3)–

1(a)(2)(i)], an investment adviser may count a legal 

organization as a single client so long as the 

investment advice is provided based on the 

objectives of the legal organization rather than the 

individual investment objectives of any owner(s) of 

the legal organization. Rule 203(b)(3)–1(b)(3)[17 

CFR 275.203(b)(3)–1(b)(3)] states that ‘‘[a] limited 

partnership is a client of any general partner or 

other person acting as investment adviser to the 

partnership.’’ As discussed in more detail below, 

infra note 157, until we adopted this rule there was 

considerable uncertainty whether advisers to 

unregistered investment pools were required to look 

through the pools to count each investor as a client, 

or could count each pool as a single client.

11See William Fung and David A. Hsieh, A 

Primer on Hedge Funds, 6 J. of Empirical Fin. 309–

31(1999), at 310; David W. Frederick, Institute of 

Certified Financial Planners, Hedge Funds: Only the 

Wealthy Need Apply, Jan. 30, 1998, at http://

www.yourretirement.com/fidlquest_22.htm (visited 

on Oct. 24, 2004); Roy Kouwenberg, Erasmus 

University Rotterdam & William T. Ziemba, Sauder 

School of Business, Vancouver and Swiss Banking 

Institute, University of Zurich, Incentives and Risk 

Taking in Hedge Funds, July 17, 2003, at http://

www.few.eur.nl/few /people/kouwenberg/

incentives3.pdf (visited on Oct. 24, 2004). See also

Gregory Zuckerman, Hedge Funds Grab More In 

Fees As Their Popularity Increases, Wall St. J., 

Oct.8, 2004, at A1 (noting that some of the bestperforming hedge fund advisers now receive 

between 30 and 50 percent of their funds’ profits). 

Not all hedge funds, however, are managed by 

legitimate investment professionals. See SEC v. 

Ryan J. Fontaine and Simpleton Holdings 

Corporation a/k/a Signature Investments Hedge 

Fund, Litigation Release No. 18254 (July 28, 2003) 

(22 year-old college student purportedly acted as 

Signature’s portfolio manager and made numerous 

false claims to investors and prospective investors).

12See sections 3(c)(1) and 3(c)(7) of the 

Investment Company Act of 1940 [15 U.S.C. 80a–

3(c)(1) and 3(c)(7)].

13See Carol J. Loomis, Hard Times Come To The 

Hedge Funds, Fortune, Jan. 1970, at 10.

14Bernstein Wealth Management Research, Hedge 

Fund Myths and Realities (Oct. 2002) at 3 (‘‘[H]edge 

funds vary in many ways, including the broad array 

of strategies they employ, the manager’s skill at 

implementing those strategies and the risks they 

take * * *’’). See also Citigroup Asset Management, 

Strategic Thinking: What’s In A Hedge Fund? 

Toward A Better Understanding Of Sources Of 

Returns (Apr. 2004) (examining 12 hedge fund 

strategies and challenging the view that hedge 

funds are all designed to deliver absolute returns).

15Ted Caldwell, Introduction: The Model for 

Superior Performance, in Hedge Funds, Investment 

and Portfolio Strategies for the Institutional 

Investors, (Jess Lederman & Robert A. Klein eds., 

1995); Julie Rohrer, The Red-Hot World of Julian 

Robertson, Institutional Investor, May 1986, at 86.

16See Douglas W. Hawes, Hedge Funds—

Investment Clubs for the Rich, 23 Business Lawyer 

576 (1968).

17Transcripts of the Roundtable participants’

presentations (‘‘Roundtable Transcript’’) and 

comments submitted in connection with the 

Roundtable are available at http://www.sec.gov/

spotlight/hedgefunds.htm. Staff of the Commodity 

Futures Trading Commission (‘‘CFTC’’), the 

Commission des Operations de Bourse of France 

(COB), and the Financial Services Authority of the 

United Kingdom (FSA), participated in our 

Roundtable. In addition, Commission staff met with 

CFTC staff, staff of the Board of Governors of the 

Federal Reserve, staff of the Department of the 

Treasury, state securities officials, and staff of the 

FSA to discuss issues relating to hedge funds, their 

advisers, and their oversight.

18 Implications of the Growth of Hedge Funds, 

Staff Report to the United States Securities and 

Exchange Commission (‘‘2003 Staff Hedge Fund 

Report’’), available at http://www.sec.gov/ spotlight/

hedgefunds.htm.

19See, e.g., Hedge Funds Grab More In Fees As 

Their Popularity Increases, supra note 11; Alistair 

Bair, Pension Funds Seen Boosting Hedge-Fund 

Allocations, CBS MarketWatch, Sept. 13, 2004.

20See Hennessee Group LLC, 10th Annual 

Manager Survey (2004).

21 Id. (Hennessee Group estimates that the 34 

percent growth of hedge funds in 2003 was due to 

both performance (20 percent) and new capital (14 

percent)). See also Sanford C. Bernstein & Co., 

Hedge Fund Industry Update ‘‘One Year Later, The 

Song Remains The Same, Bernstein Research Call 

(July 28, 2004) (hedge fund assets grew globally by 

approximately 31 percent in calendar year 2003 

with aggregate assets reaching $870 billion in 

March 2004) (‘‘Bernstein 2004 Report’’). Hedge fund 

inflows have also continued to set records. See

Chris Clair, Hedge Fund Inflows Set Another 

Record, HedgeWorld/Inside Edge, Aug. 16, 2004 

(second quarter 2004 inflows of $43.3 billion bested 

the record set in the first quarter); Too Much Money 

Chasing Too Few Real Stars, Financial Times, July 

22, 2004 (first quarter 2004 inflows were $38.2 

billion, following record 2003 inflows of $72 

billion).

or corporation as a single client, which 

today permits advisers to avoid 

registration even though they manage 

large amounts of client assets and, 

indirectly, have a large number of 

clients.10

One significant group of these 

advisers provides investment advice 

through a type of pooled investment 

vehicle commonly known as a ‘‘hedge 

fund.’’ There is no statutory or 

regulatory definition of hedge fund, 

although many have several 

characteristics in common. Hedge funds 

are organized by professional 

investment managers who frequently 

have a significant stake in the funds 

they manage and receive a management 

fee that includes a substantial share of 

the performance of the fund.11 Advisers 

organize and operate hedge funds in a 

manner that avoids regulation as 

investment companies under the 

Investment Company Act of 1940, and 

hedge funds do not make public 

offerings of their securities.12

Hedge funds were originally designed 

to invest in equity securities and use 

leverage and short selling to ‘‘hedge’’

the portfolio’s exposure to movements 

of the equity markets.13 Today, 

however, advisers to hedge funds utilize 

a wide variety of investment strategies 

and techniques designed to maximize 

the returns for investors in the hedge 

funds they sponsor.14 Many are very 

active traders of securities.15

In 2002, we requested that our staff 

investigate the activities of hedge funds 

and hedge fund advisers. First, we were 

aware that the number and size of hedge 

funds were rapidly growing and that 

this growth could have broad 

consequences for the securities markets 

for which we are responsible. Second, 

we were bringing a growing number of 

enforcement cases in which hedge fund 

advisers defrauded hedge fund 

investors, who typically were able to 

recover few of their assets. Third, we 

were concerned that the activities of 

hedge funds today might affect a 

broader group of persons than the 

relatively few wealthy individuals and 

families who had historically invested 

in hedge funds.16 We directed the staff 

to develop information for us on a 

number of related topics, and advise us 

whether we should exercise greater 

regulatory authority over the hedge fund 

industry.

In connection with the staff 

investigation, we held a Hedge Fund 

Roundtable on May 14 and 15, 2003, 

and invited a broad spectrum of hedge 

fund industry participants to 

participate. Information developed at 

the Roundtable, and a large number of 

additional submissions that we 

subsequently received from interested 

persons, contributed greatly to the staff’s 

investigation and our understanding of 

hedge funds and hedge fund advisers as 

we developed our proposals.17

In September 2003, the staff 

published a report entitled Implications 

of the Growth of Hedge Funds.18 The 

2003 Staff Hedge Fund Report describes 

the operation of hedge funds and raises 

a number of important public policy 

concerns. The report focused on 

investor protection concerns raised by 

the growth of hedge funds. The 2003 

Staff Hedge Fund Report confirmed and 

further developed several of our 

concerns regarding hedge funds and 

hedge fund advisers.

A. Growth of Hedge Funds

It is difficult to estimate precisely the 

size of the hedge fund industry because 

neither we nor any other governmental 

agency collects data specifically about 

hedge funds. It is estimated that there 

are now approximately $870 billion of 

assets 19 in approximately 7000 funds.20

What is remarkable is the growth of the 

hedge funds. In the last five years alone, 

hedge fund assets have grown 260 

percent, and in the last year, hedge fund 

assets have grown over 30 percent.21

Some predict the amount of hedge fund 

72056 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

22Some estimate that hedge fund assets are 

already at or near $1 trillion. See Boom Or Bust? 

Banks And Hedge Funds, The Economist (Oct. 9, 

2004); Daniel Kadlec, Will Hedge Funds Take A 

Dive?, Time, Oct. 4, 2004; Amey Stone, Hedge 

Funds Are Everyone’s Problem, BUSINESSWEEK, 

Aug. 6, 2004.

23As of the end of August 2004, equity mutual 

funds’ assets were $3.8 trillion. At $870 billion, 

hedge funds’ assets were equal to 22.9 percent of 

this figure. See Investment Company Institute, 

Trends in Mutual Fund Investing: August 2004, 

News Release (available at http://www.ici.org, 

visited on Oct. 13, 2004).

24Sanford C. Bernstein & Co., The Hedge Fund 

Industry—Products, Services, or Capabilities,

Bernstein Research Call (May 19, 2003), at 5 

(‘‘Bernstein 2003 Report’’).

25Marcia Vickers, The Most Powerful Trader on 

Wall Street You’ve Never Heard of, BusinessWeek, 

July 21, 2003, at 66.

26See Henny Sender, Hedge Funds Skid on 

Convertible Bonds, Wall St. J., June 30, 2004, at C4 

(hedge funds account for about 95% of all trading 

in convertible bonds).

27We are not alone in our concerns regarding 

hedge fund frauds. In a recent study, over 50 

percent of respondents identified hedge funds as 

‘‘most likely to be at the centre of an investment 

controversy’’ in the next five years. Bank of New 

York, RESTORING BROKEN TRUST (July 2004).

28This reflects five cases in addition to those we 

cited in Registration Under the Advisers Act of 

Certain Hedge Fund Advisers, Investment Advisers 

Act Release No. 2266 (July 20, 2004) [69 FR 45171 

(July 28, 2004)] (‘‘Proposing Release’’). Some 

commenters have suggested that the cases we cited 

in the Proposing Release did not support the need 

for hedge fund adviser registration because some of 

the hedge funds had less than $30 million in assets 

and advisers with less than $30 million in assets 

under management are not required to register 

under the Act. First, while staff estimates that 

approximately half the advisers in these cases 

managed assets in excess of $30 million or were 

otherwise subject to registration, it was cases 

involving these larger advisers that comprise the 

bulk of the estimated losses, representing more than 

$1 billion of total $1.1 billion of estimated losses. 

Second, regardless of whether any particular 

adviser would be required to register with us, these 

cases demonstrate the increased prevalence of fraud 

associated with hedge funds. We note that whether 

a particular hedge fund adviser will be required to 

register with us will turn not solely on the amount 

of assets of a particular hedge fund it advises, but 

on the total amount of assets the adviser has under 

management, including those of other clients. See 

section 203A(a)(1)(A) of the Advisers Act [15 U.S. 

80b-3a(a)(1)(A)].

29 In the past year, we have sanctioned persons 

charged with late trading of mutual fund shares on 

behalf of groups of hedge funds, and mutual fund 

advisers or principals for permitting hedge funds’

market timing. In the Matter of Invesco Funds 

Group, Inc., AIM Advisors, Inc., and AIM 

Distributors, Inc., Investment Advisers Act Release 

No. 2311 (Oct. 8, 2004) (Commission found that 

mutual fund adviser entered into an undisclosed 

arrangement permitting hedge funds to market time 

the adviser’s mutual funds in a manner inconsistent 

with the mutual funds’ prospectuses); SEC v. 

PIMCO Advisors Fund Management, LLC,

Investment Advisers Act Release No. 2292 (Sept. 

13, 2004) (Commission found that mutual fund 

adviser entered into a market timing arrangement 

permitting over 100 mutual fund market timing 

transactions by hedge funds in exchange for hedge 

funds’ investment in adviser’s other investment 

vehicles; mutual fund adviser also provided hedge 

funds with material nonpublic portfolio 

information concerning four of the adviser’s mutual 

funds); In the Matter of Banc One Investment 

Advisors Corporation and Mark A. Beeson,

Investment Advisers Act Release No. 2254 (June 29, 

2004) (Commission found that investment adviser 

permitted Canary hedge fund manager Edward 

Stern to time the adviser’s mutual funds, contrary 

to the funds’ prospectuses; helped arrange financing 

for the timing trades; failed to disclose the timing 

arrangements; and provided Stern with nonpublic 

portfolio information); In the Matter of Pilgrim 

Baxter & Associates, Ltd., Investment Advisers Act 

Release No. 2251 (June 21, 2004) (Commission 

found that mutual fund adviser permitted a hedge 

fund, in which one of its executives had a 

substantial financial interest, to engage in repeated 

and prolonged short-term trading of several mutual 

funds and that one of its executives provided 

material nonpublic portfolio information to a 

broker-dealer, which passed it on to its hedge fund 

customers); In the Matter of Strong Capital 

Management, Inc., et al., Investment Advisers Act 

Release No. 2239 (May 20, 2004) (Commission 

found that investment adviser disclosed material 

nonpublic information about mutual fund portfolio 

holdings to Canary hedge funds, and permitted 

Canary and the adviser’s own chairman to engage 

in undisclosed market timing of mutual funds 

managed by adviser); SEC v. Security Trust Co., 

N.A., Litigation Release No. 18653 (Apr. 1, 2004) 

(consent to judgment by trust company charged 

with facilitating late trades and market timing by 

affiliated hedge funds over at least a three-year 

period); In the Matter of Stephen B. Markovitz,

Administrative Proceedings Release No. 33–8298 

(Oct. 2, 2003) (Commission found that Markovitz 

engaged in late trading on behalf of hedge funds). 

See also In the Matter of Alliance Capital 

Management, L.P., Investment Advisers Act Release 

No. 2205 (Dec. 18, 2003) (Commission found that 

investment adviser permitted known market timers, 

including Canary hedge funds, to market time its 

mutual funds, in exchange for the timers’

investments in Alliance’s investment vehicles); In 

the Matter of James Patrick Connelly, Jr., Investment 

Advisers Act Release No. 2183 (Oct. 16, 2003) 

(Commission found that vice chairman of mutual 

fund adviser permitted market timing by known 

market timer, including at least one hedge fund). 

We have also sanctioned mutual fund advisers for 

permitting certain investors to engage in 

undisclosed market timing of their funds; hedge 

funds were among the market timers in these cases. 

In the Matter of RS Investment Management,

Investment Advisers Act Release No. 2310 (Oct. 6, 

2004); In the Matter of Janus Capital Management, 

LLC, Investment Advisers Act Release No. 2277 

(Aug. 18, 2004). In addition, we have sanctioned 

insurance companies for facilitating undisclosed 

market timing of mutual funds through variable 

annuity products marketed and sold to market 

timers including hedge funds. In the Matter of 

CIHC, Inc., Conseco Services, LLC, and Conseco 

Equity Sales, Inc., Investment Company Act Release 

No. 26526 (Aug. 9, 2004) and In the Matter of 

Inviva, Inc. and Jefferson National Life Insurance 

Company, Investment Company Act Release No. 

26527 (Aug. 9, 2004). 

We are continuing to pursue several similar cases. 

To date, we have instituted six enforcement actions 

(in addition to the 12 settled actions discussed 

above). See SEC v. Geek Securities, Inc., Litigation 

Release No. 18738 (June 4, 2004) (alleging that 

broker-dealer engaged in late trading of mutual 

funds on behalf of several hedge fund customers, 

and facilitated hedge funds’ market timing 

transactions in numerous mutual funds by evading 

the mutual funds’ attempts to restrict the 

transactions); SEC v. Columbia Management 

Advisors, Inc., Litigation Release No. 18590 (Feb. 

24, 2004) (alleging mutual fund wholesaler entered 

into, and adviser approved, arrangements allowing 

hedge funds to engage in market timing transactions 

in nine mutual funds, including one aimed at young 

investors); SEC v. Mutuals.com, Inc., Litigation 

Release No. 18489 (Dec. 4, 2003) (alleging that 

dually registered broker-dealer and investment 

adviser, three of its executives, and two affiliated 

broker-dealers assisted hedge fund brokerage 

customers in carrying out and concealing thousands 

of market timing trades and illegal late trades in 

shares of hundreds of mutual funds); SEC v. 

Druffner, Litigation Release No. 18444 (Nov. 4, 

2003) (alleging that five brokers, with the assistance 

of their branch office manager, evaded attempts to 

restrict their trading and assisted several hedge 

funds in conducting thousands of market timing 

trades in numerous mutual funds); In the Matter of 

Theodore Charles Sihpol, III, Securities Exchange 

Act Release No. 48493 (Sept. 16, 2003) (charging 

former broker with playing a key role in enabling 

Canary hedge fund to engage in late trading in 

mutual fund shares over a three-year period). See 

also In the Matter of Paul A. Flynn, Securities 

Exchange Act Release No. 49177 (Feb. 3, 2004) 

(alleging Flynn assisted numerous hedge funds in 

obtaining bank financing to fund late trading and 

deceptive market timing of mutual fund shares).

assets will exceed $1 trillion by the end 

of the year.22 Hedge fund assets are 

growing faster than mutual fund assets 

and already equal just over one fifth of 

the assets of mutual funds that invest in 

equity securities.23

As a result, hedge fund advisers have 

become significant participants in the 

securities markets, both as managers of 

assets and traders of securities. One 

report estimates that hedge funds 

represent approximately ten to twenty 

percent of equity trading volume in the 

United States.24 One article portrayed a 

single hedge fund adviser as responsible 

for an average of five percent of the 

daily trading volume of the New York 

Stock Exchange.25 Another reported that 

hedge funds dominate the market for 

convertible bonds.26

B. Growth in Hedge Fund Fraud 

The growth in hedge funds has been 

accompanied by a substantial and 

troubling growth in the number of our 

hedge fund fraud enforcement cases.27

In the last five years, the Commission 

has brought 51 cases in which we have 

asserted that hedge fund advisers have 

defrauded hedge fund investors or used 

the fund to defraud others in amounts 

our staff estimates to exceed $1.1 

billion.28

Although most of our hedge fund 

fraud cases have involved hedge fund 

advisers that defrauded their investors, 

we now too frequently see instances in 

which hedge funds have been used to 

defraud other market participants. Most 

disturbing is that hedge fund advisers 

have been key participants in the recent 

scandals involving late trading and 

inappropriate market timing of mutual 

fund shares.29 Many of our enforcement 

cases involved hedge fund advisers that 

sought to exploit mutual fund investors 

for their funds’ and their own gain. 

Some hedge fund advisers entered into 

arrangements with mutual fund advisers 

under which the mutual fund advisers 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72057

30Our Proposing Release reported only 40 hedge 

funds involved in these cases. Our staff has 

continued its investigation of late trading and 

market timing of mutual fund shares and, at our 

request, conducted a more detailed review. Staff has 

identified 389 different hedge funds, but in light of 

the continuing nature of staff’s investigations, this 

number may be incomplete. Advisers registered 

with the Commission advised some of the 389 

hedge funds.

31See Harriet Johnson Brackey, New Class of 

Hedge Funds Reaches Beyond the Wealthy, San Jose 

Mercury News, Mar. 23, 2003; Pam Black, Going 

Mainstream, Registered Rep., Mar. 1, 2004; Hanna 

Shaw Grove and Russ Alan Prince, Let Us In, 

Registered Rep., Mar. 2004; Jane Bryant Quinn and 

Temma Ehrenfeld, The Street’s Latest Lure: Some 

One Is Going to Mint Money With the New Hedge 

Funds For Smaller Investors, Newsweek, May 26, 

2003. See also two recent articles discussing hedge 

funds in publications for physicians. John J. 

Grande, Alternative Investment Strategies Can Offer 

Significant ROI, Ophthalmology Times, May 15, 

2002; Leslie Kane, Where to Put Your Money: Four 

Experts Tell Whether You Should Expect Happy 

Days for Stocks, and How to Invest Your Money,

Medical Economics, Jan. 9, 2004. See also Jenna 

Gottlieb, Hedge Fund Deal Raises Product’s Bank 

Profile, American Banker, Oct. 14, 2004 (one fund 

of hedge funds adviser stated that hedge funds are 

becoming mainstream and are marketed to the mass 

affluent).

32See 2003 Staff Hedge Fund Report, supra note 

18, at 81.

33Any sales in the United States would, of 

course, be subject to the registration requirements 

of the Securities Act, and the hedge fund itself may 

be subject to the Investment Company Act, unless 

exemptions were available. See, e.g., Robert Murray, 

Vega To Target Smaller Investors, Alternative 

Investment News, Aug 20, 2004 (Spanish hedge 

fund adviser plans to offer a fund of its hedge funds 

to U.S. investors). The UK recently introduced a 

new type of vehicle which will be available only 

to sophisticated investors, but will still be 

authorized by the FSA, as a ‘‘half way house’’

between retail funds (fully regulated) and wholly 

unregulated funds. See Financial Services 

Authority, The CIS Sourcebook—A New Approach, 

Feedback on CP185 and Made Text, Mar. 2004, 

available at http://www.fsa.gov.uk/pubs/policy/

04_07.pdf (visited on Oct. 25, 2004). The media 

recently reported that the FSA was examining 

whether it should lift the ban on letting ordinary 

members of the public invest in hedge funds. See 

FSA May Lift Ban on Hedge Fund Retail Investors, 

Reuters, Sept. 29, 2004, available at http://

www.reuters.co.uk (visited on Sept. 29, 2004). 

Starting Jan. 2004, funds of hedge funds may sell 

their shares to smaller investors in Germany subject 

to certain regulations and procedures. See Silvia 

Ascarelli and David Reilly, Hedge Funds Are 

Coming to the Masses, Wall St. J., Apr. 15, 2004; 

EU Financial Services Group Briefing, Wilmer, 

Cutler & Pickering, Hedge Funds in Germany—

German Parliament Opens the Market for 

Alternative Investment Products, Dec. 5, 2003, 

available at http://www.wilmer.com /pubs/

results.aspx? iPractice (visited on Oct. 25, 2004). 

Since April 2003, funds of hedge funds may sell 

their shares to smaller investors in France, subject 

to certain regulations and procedures. See

Commission des Operations de Bourse (France), 

Regulating Alternative Multi-Management 

Investments, News Release (Apr. 1, 2003) (available 

in File No. S7–30–04); Alain Gauvin and Guillaume 

Eliet, Capital Markets Dept., Coudert Freres, 

Regulating Alternative Multi-Management 

Investments, 2003, available at http://

www.coudert.com (visited on Oct. 25, 2004). In 

Ireland, funds of hedge funds may sell their shares 

to smaller investors subject to certain regulations 

and procedures. See Matheson Ormsby Prentice, 

Establishing a Hedge Fund in Ireland, 2003, 

available at http://www.mop.ie/fileupload/ 

publications (visited on Oct. 25, 2004). In Asia, both 

Hong Kong and Singapore permit authorized hedge 

funds to sell their shares to investors subject to 

certain minimum subscription thresholds and 

regulations. See Donald E. Lacey, Jr., Democratizing 

the Hedge Fund: Considering the Advent of Retail 

Hedge Funds, Apr. 2003, (International Finance 

Seminar at Harvard Law School), available at http:/

/www.law.harvard.edu/programs/pifs/pdfs/

donald_lacey.pdf (visited on Oct. 25, 2004); Mattew 

Harrison, Fund Management in Hong Kong and 

Singapore, CSU Research and Policy, Jan. 6, 2003. 

In South Africa, regulators and trade associations 

recently issued a joint discussion paper to develop 

an acceptable regulated environment in which 

existing and new hedge funds can operate 

(including consideration of whether to permit 

certain hedge fund products to be marketed to the 

public). See The Financial Services Board, 

Association of Collective Investments and 

Alternative Investment Management Association, 

The Regulatory Position of Hedge Funds in South 

Africa—A Joint Discussion Paper (Mar. 9, 2004). 

See also Carla Fiford, South African Hedge Fund 

Industry Grows by Stealth, AIMA Journal, Feb. 

2004. The media recently reported that in 

Luxembourg, changes to regulation have allowed 

offshore hedge funds to list in Luxembourg since 

September 2004. See Phil Davis, Special Report

Luxembourg: Hedge Fund Tide May Be About to 

Turn, Financial Times, Oct. 18, 2004.

34The Street’s Latest Lure: Some One Is Going to 

Mint Money With the New Hedge Funds For Smaller 

Investors, supra note 31; Going Mainstream, supra

note 31; Jessica Toonkel, Firms Take Pause Before 

Launching Hedge Funds of Funds for Mass Affluent; 

Hold Your Horses! Fund Action, Apr. 21, 2003; 

Michael P. Malloy and Jim Strangroom, Registered 

Funds of Hedge Funds, MFA Reporter (2002); Fool’s 

Gold, The Economist, Sept. 1, 2001; Kimberly Hill, 

Investors Need Help With Hedge Funds, Fundfire, 

May 14, 2004.

35An additional 51 funds of hedge funds are 

registered with the Commission as investment 

companies but can be sold only through private 

offerings. The Commission does not have data on 

the number of additional funds of hedge funds that 

exist but are not registered with the Commission.

36Bernstein 2003 Report, supra note 24, at 18.

37Hennessee Group LLC, 10th Annual Manager 

Survey, supra note 20 (‘‘funds of funds continue to 

be the fastest growing source of capital for hedge 

funds, increasing 50 percent since January 1997 

(from 16 percent to 24 percent)’’). See also Pauline 

Skypala, Hedge Funds of Funds Booming, FT.com, 

Sept. 26, 2004 (Morgan Stanley research estimates 

that over two-thirds of hedge fund inflows are 

coming through funds of funds).

38According to Greenwich Associates, about 20 

percent of corporate and public plans in the United 

States were investing in hedge funds in 2002, up 

from 15 percent in 2001. Bernstein Research reports 

that, among the top 200 U.S. defined benefit plans, 

at least 15 percent have allocated a portion of their 

assets to hedge funds. Bernstein 2003 Report, supra

note 24 at 13. Hennessee Group data indicate that 

pensions’ investments in hedge funds increased 

from $13 billion in 1997 to $72 billion in 2004. See

Testimony of Charles J. Gradante, Managing 

Principal, The Hennessee Group LLC, Before the 

Senate Committee on Banking, Housing and Urban 

Affairs, available at http://banking/senate.gov/

_files/gradante.pdf (visited on Oct. 13, 2004); 

Hennessee Group LLC, 10th Annual Manager 

Survey, supra note 20. See also Hedge Funds 

Gaining Acceptance Among Pension Funds,

Morningstar Web Site, June 27, 2003; Chris Clair, 

‘Unprecedented Pressure’: Public Plans Race to 

Embrace Hedge Funds; This Time They Are 

Leading, Not Following, Their Corporate 

Counterparts, Pensions and Investments, July 8, 

2002, at 2; Alaska Pension Allocates to Hedge Fund,

Continued

waived restrictions on market timing in 

return for receipt of the hedge fund 

advisers’ ‘‘sticky assets,’’ i.e., placement 

of other assets in other funds managed 

by the mutual fund adviser. Other hedge 

fund advisers sought ways to avoid 

detection by mutual fund personnel by 

conspiring with intermediaries to 

conceal the identity of their hedge 

funds. While our investigation is 

ongoing, the frequency with which 

hedge funds and their advisers appear 

in these cases and continue to turn up 

in the investigations is alarming. Our 

staff counts almost 400 hedge funds 

(and at least 87 hedge fund advisers) 

involved in these cases and others 

under investigation.30

C. Broader Exposure to Hedge Funds 

The third development of significant 

concern is the growing exposure of 

smaller investors, pensioners, and other 

market participants, directly or 

indirectly, to hedge funds. Hedge fund 

investors are no longer limited to the 

very wealthy. We note three 

developments that we have observed 

that contribute to this concern. 

First, some hedge funds today are 

expanding their marketing activities to 

attract investors who may not 

previously have participated in these 

types of risky investments.31 Many 

hedge funds maintain very high 

minimum requirements, and many of 

the hedge fund participants at our 

Roundtable expressed no interest in 

attracting ‘‘retail investors.’’ Our staff 

observed, however, that some hedge 

funds’’ minimum investment 

requirements have decreased over 

time.32 In developed markets outside 

the United States, hedge funds have 

sought to market themselves to smaller 

investors, and we can expect similar 

market pressures to develop in the 

United States as more hedge funds enter 

our markets.33

Second, the development of ‘‘funds of 

hedge funds’’ has made hedge funds 

more broadly available to investors.34

Today there are 52 registered funds of 

hedge funds that offer or plan to offer 

their shares publicly.35 Most funds of 

hedge funds are today offered only to 

institutional investors, but there are no 

statutory limitations on the public 

offering of these funds. Funds of hedge 

funds today represent approximately 

twenty percent of hedge fund capital,36

and are the fastest growing source of 

capital for hedge funds today.37

Finally, and perhaps most 

significantly, in the last few years, a 

growing number of public and private 

pension funds,38 as well as universities, 

72058 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

Alternative Investment News, July 1, 2004 (the 

Alaska State Pension Investment Board has chosen 

three firms to manage its first $300 million hedge 

fund allocation).

39Median strategic allocation to hedge funds by 

endowments and foundations was 11 percent in 

2001, 10 percent in 2003 and forecast at 12.3 

percent in 2005. See Goldman Sachs International 

and Russell Investment Group, Report on 

Alternative Investing by Tax-Exempt Organizations 

2003, available at http://www.russell.com/II/

Research_and Resources/Informative_Articles 

/Goldman_ Russell_ Survey.asp (visited on Sept. 18, 

2004). Others estimate the average allocation to be 

12 percent, see Bank of New York and Casey, Quirk 

& Acito, Institutional Demand for Hedge Funds: 

New Opportunities and New Standards, (Sept. 

2004) (‘‘BONY Report’’) or as high as 17 percent of 

assets. See Hennessee Group, 2004 Hennessee 

Hedge Fund Survey of Foundations and 

Endowments (reporting that an average 

commitment of 17 percent of assets, and a projected 

commitment of 19 percent by 2005) (‘‘Hennessee 

Foundation and Endowment Survey’’). See also

Lewis Knox, The Hedge Fund: Institutional Money 

is Swelling the Coffers of the World’s Largest Hedge 

Fund Managers, 28 Institutional Investor 

(International Edition) 53 (June 1, 2003); Dan Neel, 

Michigan Preps For Hedge, Real Estate, Investment 

Management Weekly, Apr. 28, 2003; Virginia 

Exposure Soars to 60%, Financial News (Daily), 

Apr. 27, 2003 (University of Virginia has invested 

50 percent of its portfolio in hedge funds, and plans 

to increase its exposure to 60 percent of its total 

portfolio); Chris Clair, Allocation Goal: 25%—

UTIMCO Joins Billion-Dollar Hedge Fund Club,

Pensions and Investments, Apr. 14, 2003, at 3; 

Chidem Kurdas, Hedge Funds Continue to Gain in 

Endowments’ Alternative Investments, HedgeWorld 

Daily News, Apr. 7, 2003; Behind the Money 

Section; University of Wisconsin Searching for 

Hedge Funds, 4 Alternative Investment News, Feb. 

1, 2003, at 20 ($300 million University of Wisconsin 

endowment will allocate up to 10 percent, or $25–

30 million, to a fund of funds manager); Baylor 

University; Inside The Buyside; Increases Hedge 

Fund Activity by $20–25 Million, 4 Alternative 

Investment News, Feb. 1, 2003 at 6; Susan L. 

Barreto, Hedge Funds Become Saving Grace for 

Endowments in Tough Times, HedgeWorld Daily 

News, Apr. 4, 2002.

40Since we issued our Proposing Release, 

industry observers have seen smaller foundations 

expressing growing interest in hedge funds. Family 

Foundations Move Towards Hedge Funds, Fundfire, 

Oct. 11, 2004 (family foundation consultant notes 

many family foundations, run by family members 

with limited investment knowledge, pursuing 

hedge fund investments). Also, in our Proposing 

Release, we identified a large number of pension 

plans that were investing or looking to invest in 

hedge funds. Since then, a number of additional 

pension plans have sought, or are seeking, hedge 

fund investment, according to one trade newsletter. 

Cincy Fund Will Weight Alts, Alternative 

Investment News, Oct. 8, 2004 (Cincinnati 

Retirement System will consider alternative 

investments in 2005); U.S. Pensions Examine Hedge 

Funds, Alternative Investment News, Oct. 8, 2004 

(pension plans sponsored by the General 

Conference of Seventh Day Adventists, Tulare 

County (CA) Employees’ Retirement Association, 

and City of Laredo (TX) Firefighters Retirement 

System are considering investment in hedge funds); 

Colorado Guns & Hoses Makes Overlay Play,

Alternative Investment News, Oct. 1, 2004 

(Colorado fire and police pension fund allocated 

$75 million to two hedge fund of funds managers); 

Service Employees Likely To Seek Hedge Fund of 

Funds, Alternative Investment News, Sept. 10, 2004 

(Service Employees International Union pension 

fund may seek to invest up to 5 percent of its $1.5 

billion in assets to hedge funds of funds); New 

Hampshire Eyes Hedge Funds, Alternative 

Investment News, Sept. 10, 2004 (New Hampshire 

Retirement System is considering allocating up to 

$100 million to one or more hedge fund of funds 

managers); San Bernardino Pension Picks AIG, 

Benchmark Plus, Alternative Investment News, 

Aug. 13, 2004 (San Bernardino County (CA) 

Employees Retirement Association allocated $100 

million to each of two hedge fund of fund 

managers); L.A. Water Dept. To Consider Hedge 

Funds, Alternative Investment News, July 30, 2004 

(defined benefit plan to consider its first allocation 

to hedge funds early in 2005).

41BONY Report, supra note 39, at 1. See also

Lewis Knox, The Hedge Fund: Institutional Money 

is Swelling the Coffers of the World’s Largest Hedge 

Fund Managers, supra note 39.

42Proposing Release, supra note 28.

43 In 1999, the President’s Working Group on 

Financial Markets, in the wake of the near-collapse 

of Long Term Capital Management, Inc., (‘‘LTCM’’), 

published a series of recommendations that did not 

include registration of hedge fund advisers under 

the Advisers Act. See Hedge Funds, Leverage, and 

the Lessons of Long-Term Capital Management—

Report of the President’s Working Group on 

Financial Markets, by representatives from the 

Commission, the Treasury Department, the Board of 

Governors of the Federal Reserve System and the 

Commodity Futures Trading Commission (Apr. 

1999). The principal concerns of the President’s 

Working Group report were the stability of financial 

markets and the exposure of banks and other 

financial institutions to the counterparty risks of 

dealing with highly leveraged entities such as the 

LTCM hedge fund. The focus of the Advisers Act 

is different, and includes such concerns as the 

prevention of frauds on investors. Since the 

issuance of the President’s Working Group report, 

the size of the hedge fund industry has doubled, the 

exposure of investors to hedge funds has 

broadened, and the incidence of fraud we discover 

involving hedge fund advisers has increased. The 

Commission is the only member of the President’s 

Working Group with responsibility for the 

protection of investors and the oversight of our 

nation’s securities markets.

44These letters are available on the Internet at 

http://www.sec.gov/rules/proposed/s73004.shtml.

45See, e.g., Comment Letter of Van Hedge Fund 

Advisors (Sept. 15, 2004) (‘‘Van Hedge Letter’’).

46Hennessee Group also submitted the results of 

a survey of foundations and endowments, 

Hennessee Foundation and Endowment Survey, 

supra note 39. Nearly twice as many respondents 

to the Hennessee Foundation and Endowment 

Survey favored the proposal (59 percent) as 

opposed it (30 percent).

47See, e.g., Comment Letter of Ohio Public 

Employees Retirement System, (Aug. 6, 2004) 

(‘‘Ohio PERS Letter’’); Comment Letter of New 

Jersey State Investment Council (Sept. 17, 2004) 

(‘‘New Jersey State Investment Council Letter’’); 

Comment Letter of Pennsylvania Securities 

Commission (July 26, 2004) (‘‘Pennsylvania 

Securities Commission Letter’’); Comment Letter of 

CFA Institute (Sept. 30, 2004) (‘‘CFA Institute 

Letter’’); Comment Letter of Investment Counsel 

Association of America (Sept. 14, 2004) (‘‘ICAA 

Letter’’); Comment Letter of Alternative Investment 

Group Services, LP (Aug. 20, 2004) (‘‘Alternative 

Investment Group Letter’’); Comment Letter of Lyn 

Batty (July 14, 2004) (‘‘Lyn Batty Letter’’).

48See, e.g., Comment Letter of Investment 

Company Institute (Sept. 15, 2004) (‘‘ICI Letter’’); 

Ohio PERS Letter, supra note 47; Comment Letter 

of Investment Management Consultants Association 

(Sept. 14, 2004) (‘‘IMCA Letter’’); Alternative 

Investment Group Letter, supra note 47; Comment 

Letter of David Patch (July 24, 2004) (‘‘Patch Letter 

A’’).

endowments, foundations, and other 

charitable organizations, have begun to 

invest in hedge funds or have increased 

their allocations to hedge funds.39 More 

of these institutions have also recently 

begun to consider these alternative 

investments.40 Institutional investments 

may increase in the next four years to 

$300 billion.41 Investors that have not 

been traditional hedge fund investors, 

including pension plans that have 

millions of beneficiaries, are thus today 

purchasing hedge funds. As a result of 

the participation by these entities in 

hedge funds, the assets of these entities 

are exposed to the risks of hedge fund 

investing. Losses resulting from hedge 

fund investing and hedge fund frauds 

may affect the entities’ ability to satisfy 

their obligations to their beneficiaries or 

pursue other intended purposes.

In response to these developments, 

and after extensive consultation with 

participants in the hedge fund industry 

in connection with our staff’s 

investigation, we proposed in July of 

2004 a new rule that would require 

hedge fund advisers to count each 

investor in a hedge fund, rather than 

only the hedge fund itself, as a client for 

purposes of the private adviser 

exemption.42 As a result, most hedge 

fund advisers would have to register 

with the Commission and would be 

subject to SEC oversight. The rule and 

rule amendments were designed to 

provide the protections afforded by the 

Advisers Act to investors in hedge 

funds, and to enhance the Commission’s 

ability to protect our nation’s securities 

markets.43

We received letters from 161 

commenters, including investors, hedge 

fund advisers, other investment 

advisers, trade associations, and law 

firms.44 Forty-two commenters did not 

express a view on whether we should or 

should not require hedge fund advisers 

to register, but asked us to consider 

particular issues or concerns if we 

adopted the rule.45 Thirty-six 

commenters supported the rule proposal 

and our efforts to improve our oversight 

of hedge fund advisers.46 Several 

investors and other commenters hailed 

the proposal as an important step 

towards protecting investors and the 

overall securities markets.47 They 

pointed out that while registering hedge 

fund advisers would not eliminate 

fraud, it would allow the Commission to 

address potential opportunities for 

fraud. These commenters also noted that 

registration may help the hedge fund 

industry to the extent it discourages 

persons intent on committing fraud 

from entering the industry and 

damaging the reputation of the 

legitimate managers.48 They also 

cautioned that the Commission should 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72059

49See, e.g., Comment Letter of B. H. Bigg (July 23, 

2004) (‘‘Bigg Letter’’); Comment Letter of Ralph S. 

Saul (Aug. 18, 2004) (‘‘Saul Letter’’).

50See, e.g., Comment Letter of Vantis Capital 

Management LLC (Aug. 6, 2004) (‘‘Vantis August 

Letter’’); Alternative Investment Group Letter, supra

note 47.

51See, e.g., Comment Letter of Managed Funds 

Association (Sept. 15, 2004) (‘‘MFA Letter’’); 

Comment Letter of Madison Capital Management, 

LLC (Sept. 15, 2004)(‘‘Madison Capital Letter’’); 

Comment Letter of Proskauer Rose LLP (Aug. 31, 

2004) (‘‘Proskauer Letter’’); Comment Letter of 

Schulte Roth & Zabel LLP (Sept. 15, 2004) (‘‘Schulte 

Roth Letter’’); Comment Letter of Keith Black (July 

30, 2004) (‘‘Black Letter’’); Comment Letter of Guy 

Lander (Sept. 15, 2004) (‘‘Lander Letter’’); Comment 

Letter of Sidley Austin Brown & Wood, LLP (Sept. 

14, 2004) (‘‘Sidley Austin Letter’’); Comment Letter 

of Joseph LaRocco (Aug. 26, 2004) (‘‘LaRocco 

Letter); Comment Letter of Superior Capital 

Management LLC (Sept. 8, 2004) (‘‘Superior Capital 

Letter’’).

52See, e.g., MFA Letter, supra note 51; Comment 

Letter of Chamber of Commerce of the United States 

of America (Sept. 15, 2004) (‘‘Chamber of 

Commerce Letter’’); Comment Letter of 

International Swaps and Derivatives Association 

(Sept. 15, 2004) (‘‘ISDA Letter’’); Comment Letter of 

David Patch (Sept. 10, 2004) (‘‘Patch Letter B’’); 

Comment Letter of Rodney Pitts (Sept. 15, 2004) 

(‘‘Rodney Pitts Letter’’); Comment Letter of Blanco 

Partners LP (Sept. 13, 2004) (‘‘Blanco Partners 

Letter’’); Comment Letter of Mark Acquino (Aug. 8, 

2004)(‘‘Acquino Letter’’).

53See, e.g., MFA Letter, supra note 51; Chamber 

of Commerce Letter, supra note 52; ISDA Letter, 

supra note 52; Comment Letter of Financial 

Services Roundtable (Sept. 9, 2004) (‘‘Financial 

Services Roundtable Letter’’); Black Letter, supra

note 51; Comment Letter of Tudor Investment 

Corporation (Sept. 15, 2004) (‘‘Tudor Letter’’); 

Comment Letter of David Thayer (Sept. 15, 2004) 

(‘‘David Thayer Letter’’); Lander Letter, supra note 

51.

54See, e.g., Comment Letter of John Waller (July 

31, 2004) (‘‘John Waller Letter’’); Acquino Letter, 

supra note 52; Comment Letter of Melissa Kadiri 

(Sept. 15, 2004) (‘‘Melissa Kadiri Letter’’).

55 During and after the comment period, our staff 

has continued to have discussions in the President’s 

Working Group with other regulators relating to 

hedge fund adviser regulation. See Letter from 

Congressman Richard H. Baker to John W. Snow, 

Secretary, U.S. Department of the Treasury (Oct. 7, 

2004) (available in File S7–30–04).

56As discussed below, we are also adopting 

amendments to rules 203A–3, 204–2, 205–3, 

206(4)–2, and 222–2. Unless otherwise noted, when 

we refer to rules 203(b)(3)–1, 203A–3, 204–2, 205–

3, 206(4)–2, 222–2, or any paragraph of the rules, 

we are referring to 17 CFR 275.203(b)(3)–1, 

275.203A–3, 275.204–2, 275.205–3, 275.206(4)–2, 

and 275.222–2 of the Code of Federal Regulations 

in which the rules are published.

57See Capital Gains, supra note 1.

58See, e.g., AUSA Life Insurance Co. v. Ernst & 

Young, 206 F.3d 202 (2nd Cir. 2000) at 217. ‘‘During 

the Great Depression, Congress enacted the 1933 

and 1934 [Securities] Acts to promote investor 

confidence in the United States securities markets 

and thereby to encourage the investment necessary 

for capital formation, economic growth, and job 

creation.’’ Private Securities Litigation Reform Act 

of 1995, Pub. L. 104–67, S.Rep. No. 104–98 (June 

19, 1995), reprinted in 1995 U.S.C.C.A.N. 679, 683.

59See American Trucking Assns., Inc. v. 

Atchison, Topeka & Santa Fe Ry Co., 387 U.S. 397, 

415 (1967) (‘‘Regulatory agencies do not establish 

rules of conduct to last forever; they are supposed, 

within the limits of the law and of fair and prudent 

administration, to adapt their rules and practices to 

the Nation’s needs in a volatile, changing economy. 

They are neither required nor supposed to regulate 

the present and the future within the inflexible 

limits of yesterday.’’).

60William Fung and David Hsieh, Measuring the 

Market Impact of Hedge Funds, 7 J. of Empirical 

Fin. 1 (2000) (‘‘There are varying estimates of the 

size of the hedge fund industry.’’); Hedg-matics: 

How Many Funds Exist? Wall St. J., May 22, 2003, 

at C5 (‘‘Just how big is the hedge-fund industry? 

This simple question has been debated because the 

data on hedge funds are spotty.’’); Letter from Craig 

S. Tyle, General Counsel of the Investment 

Company Institute, to Jonathan G. Katz, Secretary, 

U.S. Securities and Exchange Commission, July 2, 

2003, available at http://www.ici.org (visited on Oct. 

10, 2004) (‘‘There is currently no universal database 

that contains records of all hedge funds, both those 

currently operating and those that have ceased 

operating.’’); Gaurav S. Amin and Harry M. Kat, 

Hedge Fund Performance 1990–2000: Do the 

‘‘Money Machines’’ Really Add Value?, 38 Journal 

of Financial and Quantitative Analysis 2 (2003) 

(‘‘Due to its private nature, it is difficult to estimate 

the current size of the hedge fund industry.’’). See 

also Bing Liang, Hedge Funds: The Living and the 

Dead, 35 Journal of Financial and Quantitative 

Analysis 309–326 (2000) (study of statistical 

inconsistencies in two major hedge fund databases, 

noting hedge funds ‘‘are basically not regulated. 

They report their fund information only on a 

voluntary basis. Therefore, the reliability of hedge 

fund data is an open question and is critical for 

hedge fund research and the investment 

community.’’); Harry M. Kat, 10 Things That 

Investors Should Know About Hedge Funds,

Institutional Investor (Spring 2003) (noting that 

hedge fund databases are of low quality, that each 

database covers only a subset of the hedge fund 

universe, that all present survivorship bias, and that 

researchers attempting to analyze the hedge fund 

industry or fund performance may perceive matters 

very differently depending on the database or index 

they use).

61CFA Institute agreed that the fact that many 

registered advisers are small firms ‘‘argues strongly 

that such registration is not overly burdensome.’’

CFA Institute Letter, supra note 47.

not wait until the next crisis before 

taking measures of protection against 

potential fraud.49 Some hedge fund 

advisers and other advisers already 

registered with the SEC also welcomed 

the proposal. They used their own 

experiences to illustrate that registration 

would not overburden a firm’s 

operation, and that benefits of being a 

registered adviser more than 

compensated for the costs.50

Eighty-three commenters, including 

many unregistered hedge fund advisers, 

their attorneys, and trade associations, 

however, argued strongly against the 

proposal. They expressed concerns 

about the costs of compliance under the 

new rule,51 and raised questions about 

our effectiveness in preventing hedge 

fund fraud,52 and the potential 

intrusiveness of our oversight of hedge 

fund managers.53 Some hedge fund 

investors were concerned that their 

advisers might pass the costs of 

registration to them and increase 

management fees.54

II. Discussion 

We have carefully considered all of 

the comments we received.55 For the 

reasons discussed below and in the 

Proposing Release, we are adopting rule 

203(b)(3)–2 and related amendments to 

rule 203(b)(3)–1 and Form ADV, which 

would require most hedge fund advisers 

to register with us under the Act.56

A. Need for Commission Action

The Commission is the federal agency 

with principal responsibility for the 

enforcement and administration of the 

federal securities laws and the 

supervision of the securities markets. 

The federal securities laws seek to 

protect investors by providing for the 

transparency of markets, by prohibiting 

fraud, and by imposing fiduciary 

obligations.57 They encourage the 

formation and efficient allocation of 

capital and the participation of investors 

in the capital markets.58 Our obligations 

under these laws as well as our 

commitment to protect investors require 

us to respond to important market 

developments, and the authority 

provided us by those laws permits us to 

adopt rules and interpret the statutes in 

order to preserve fair and honest 

markets.59

We believe that, in light of the growth 

of hedge funds, the broadening exposure 

of investors to hedge fund risk, and the 

growing number of instances of 

malfeasance by hedge fund advisers, our 

current regulatory program for hedge 

fund advisers is inadequate. We do not 

have an effective program that would 

provide us with the ability to deter or 

detect fraud by unregistered hedge fund 

advisers. We currently rely almost 

entirely on enforcement actions brought 

after fraud has occurred and investor 

assets are gone. We lack basic 

information about hedge fund advisers 

and the hedge fund industry, and must 

rely on third-party data that often 

conflict and may be unreliable.60

Requiring hedge fund advisers to 

register under the Advisers Act will give 

us the ability to oversee hedge fund 

advisers without imposing burdens on 

the legitimate investment activities of 

hedge funds. We understand the 

important role that hedge funds play in 

our financial markets, and we 

appreciate that the lack of regulatory 

constraints on hedge funds has been a 

factor in the growth and success of 

hedge funds. But commenters have not 

persuaded us that requiring hedge fund 

advisers to register under the Act, 

requiring them to develop a compliance 

infrastructure, or subjecting them to our 

examination authority will impose 

undue burdens on them or interfere 

significantly with their operations.61

72060 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

62We estimated, in the Proposing Release, that 

40–50 percent of hedge fund advisers are registered 

under the Act. See Section V. of the Proposing 

Release. See also Hennessee Group LLC, 10th 

Annual Manager Survey, supra note 20 (39 percent 

of hedge fund managers surveyed were registered 

under the Advisers Act).

63Moreover, many hedge fund advisers that are 

not registered with us have indicated that they 

conform their operations to those of registered 

advisers. See 2003 Staff Hedge Fund Report, supra 

note 18, at 314.

64See Vantis August Letter, supra note 50 

(‘‘While there are incremental costs associated with 

registration [under the Advisers Act], the burdens 

are not excessive for any serious investment firm, 

which is committed to timely and accurate 

reporting.’’) and Alternative Investment Group 

Letter, supra note 47 (‘‘We believe that the 

compliance costs will be minimal to the wellmanaged advisor.’’).

65The antifraud prohibitions of section 206 [15 

U.S.C. 80b–6], including provisions restricting an 

adviser’s ability to engage in principal trades and 

agency cross-transactions with clients, apply to any 

investment adviser that makes use of the mails or 

any means of interstate commerce. In contrast, 

section 204 [15 U.S.C. 80b–4] (authorizing the 

Commission to require advisers to issue reports and 

maintain books and records) applies to all advisers 

other than those specifically exempted from 

registration by section 203(b) of the Act. Thus, 

although unregistered advisers are subject to the 

antifraud provisions of the Act, our ability to 

enforce those provisions is hampered because in the 

absence of a registration requirement we cannot 

identify and examine these advisers.

66 In the past, hedge fund industry participants 

cited the restrictions on registered advisers charging 

performance-based compensation in section 

205(a)(1) of the Act [15 U.S.C. 80b–5(a)(1)] as being 

incompatible with the operation of hedge funds. 

See Hard Times Come to the Hedge Funds, supra

note 13; Lawrence J. Berkowitz, Regulation of 

Hedge Funds, 2 Rev. of Securities Reg. (1969). In 

1998, however, the Commission eliminated this 

concern by adopting amendments to rule 205–3. 

Exemption to Allow Investment Advisers to Charge 

Fees Based Upon a Share of Capital Gains Upon or 

Capital Appreciation of a Client’s Account,

Investment Advisers Act Release No. 1731 (July 15, 

1998) [63 FR 39022 (July 21, 1998)]. Further, we 

proposed to grandfather hedge fund advisers’

existing investors that would otherwise not qualify 

to pay performance fees. See Section II.G. of the 

Proposing Release. No hedge fund industry 

participant with whom our staff spoke during their 

year-long investigation indicated that section 205 or 

the qualified client criteria in rule 205–3 would 

present any concerns to hedge funds.

67See, e.g., ICI Letter, supra note 48 (‘‘Many of 

our investment adviser members—all of whom are 

registered with the Commission—currently operate 

hedge funds and have found that registration is not 

overly burdensome and does not interfere with their 

investment activities.’’).

68 Id. Nor does the Act restrict the ability of 

advisers to engage in short-selling. Moreover, 

nothing in the Act or our rules requires any 

investment adviser to disclose its securities 

positions. Indeed, we recently declined requests to 

require advisers to publicly disclose how they voted 

client proxies out of a concern that they would 

thereby divulge client securities positions. Proxy 

Voting by Investment Advisers, Investment Advisers 

Act Release No. 2106 (Jan. 31, 2003) [68 FR 6585 

(Feb. 7, 2003)]. The Advisers Act requires us to 

maintain as confidential information obtained by 

our examiners in the course of an examination. See

sections 210(b) and 210A of the Act [15 U.S.C. 80b–

10(b) and 10a].

69Bids and Offers, Wall St. J., July 23, 2004 at C4. 

In the study, Hedge Fund Research, Inc., an 

alternative investments research and consulting 

firm, examined the performance of approximately 

2,200 single-strategy hedge funds. Id. However, the 

extent of cross-sectional variability in hedge fund 

returns makes it difficult to ascertain differences in 

performance statistically.

70See The Hedge Fund 100, Institutional Investor, 

May 2004.

71 In its investigation of hedge funds, see supra

Section I of this Release, our staff conducted 

reviews of registered and unregistered hedge fund 

advisers, had on-site discussions with them, and 

met or spoke with a variety of experts to get their 

perspectives on the hedge fund industry. 2003 Staff 

Hedge Fund Report, supra note 18, at 2.

72See, e.g., Chamber of Commerce Letter, supra

note 52.

73Many of the fears concerning Commission 

oversight expressed by hedge fund advisers today 

are very similar to those expressed in 1940 by 

opponents to enactment of the Advisers Act. See,

e.g., Investment Trusts and Investment Companies: 

Hearings on S.3580 Before the Senate Comm. on 

Banking and Currency, 76th Cong., 3d. Sess. (Apr. 

22–23, 1940) (‘‘1940 Senate Hearings’’) (testimony 

of James N. White, Scudder, Stevens & Clark, (‘‘We 

just feel that registration leads to investigation, and 

that investigation leads to regulation; and it is 

possible for a good deal of controversial theory on 

economics to creep into regulation.’’)), (testimony of 

Dwight C. Rose, President, Investment Counsel 

Association of America, (‘‘* * *all activities and 

recommendations of a cautious investment 

counselor would first have to be subjected to the 

question of whether or not at some time such 

activities or recommendations might involve 

difficulties for him in connection with the statute 

as enacted or with such future rulings as the 

Commission might take.’’)), (testimony of Charles 

M. O’Hearn, Clarke, Sinsabaugh & Co., (‘‘In 

addition, we should like to reaffirm our belief that 

Indeed, the large number of hedge fund 

advisers currently registered under the 

Act—many of whom voluntarily 

register—provides a powerful refutation 

of the assertions made by commenters 

who opposed the rule on these 

grounds.62 We presume these hedge 

fund advisers would take steps to avoid 

registration under the Act if the 

consequences of registration were as 

dire as some commenters have 

asserted.63 Comments we received from 

hedge fund advisers that are registered 

under the Act provide persuasive 

testimonials that confirm our 

conclusion.64

The Act does not require an adviser 

to follow or avoid any particular 

investment strategies, nor does it require 

or prohibit specific investments. Its 

most significant provision, which 

requires full disclosure of conflicts of 

interest and prohibits fraud against 

clients, applies regardless of whether 

the adviser is registered under the Act, 

and will be furthered by the registration 

requirement.65 No commenter identified 

any provision of the Act that would 

provide an impediment to an adviser’s 

successful operation of a hedge fund.66

Arguments by some that registration 

would somehow inhibit hedge fund 

advisers’ willingness to engage in 

complex or innovative strategies 

because they would be second-guessed 

by our examination staff are baseless. 

They are refuted by the experience of 

registered hedge fund advisers.67 One 

commenter familiar with the obligations 

of registered advisers noted that 

registration would not require hedge 

fund advisers to reveal their trading 

strategies or disclose their portfolio 

holdings, and would not interfere with 

their ability to leverage their portfolios, 

and that our proposal would not restrict 

the ability of hedge funds to provide 

liquidity to the markets.68

We are not aware of any evidence that 

suggests that registration under the 

Advisers Act has impeded investment 

advisers’ performance, and commenters 

did not suggest that registration would 

have such an effect. Moreover, a recent 

study, while not conclusive, found that 

there were no significant differences 

between performance of hedge funds 

managed by registered advisers and 

those managed by unregistered 

advisers.69 Five of the ten largest (and 

presumably most successful) hedge fund 

advisers are today registered with us 

under the Advisers Act.70

The bare assertions of adverse 

consequences of registration under the 

Advisers Act offered by many 

commenters opposed to our proposed 

rule, and the anecdotal evidence offered 

by others, simply do not stand up to 

scrutiny. There has been no suggestion 

that hedge funds managed by registered 

advisers play a diminished role in the 

financial markets compared to hedge 

funds managed by unregistered 

advisers. The empirical evidence we 

have seen, and the information collected 

informally by our staff,71 suggests that 

registration under the Advisers Act has 

no adverse effect on the legitimate 

market activities of hedge funds.

More than 8,500 advisory firms that 

collectively manage over $23 trillion 

dollars of assets are today registered 

under the Advisers Act. We have seen 

no credible evidence that the Act has in 

any way impeded their ability to 

employ successful investment strategies, 

or to effectively compete with other 

financial institutions that manage 

securities portfolios here or abroad. 

Some commenters also expressed 

concerns about what the Commission 

might in the future do that could 

adversely affect the operation of hedge 

funds.72 Such inchoate fears, however, 

do not provide reason for our not going 

forward with this important rulemaking. 

Our record of 64 years of administering 

the Advisers Act provides no basis for 

such fears.73 Our regulatory efforts to 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72061

we should be forced to take this position [against 

adviser registration] in the interests of our 

profession, even if we believed some Federal 

regulation was desirable, because of the broad and 

unqualified discretion given to the Securities and 

Exchange Commission to determine conditions 

which are vital not only to the convenience but to 

the very existence of our operations.’’)). 

Registration, however, clearly has not impeded the 

growth of the investment advisory industry—in 

1940, investment advisers managed only $4 billion 

(approximately $50 billion in today’s dollars), but 

assets managed by advisers subject to registration 

under the Advisers Act have grown to over $23 

trillion today.

74See Sections II.F. through II.H. of the Proposing 

Release.

75See Section II.I. of this Release.

76One of these considerations—imposition of 

minimal burdens—is discussed above.

77Collecting information about the nation’s 

investment advisers has been one aim of the 

Advisers Act since it was enacted in 1940. 

Although the primary objective of the Advisers Act 

is the protection of advisory clients, the Act also 

serves as ‘‘a continuing census of the Nation’s 

investment advisers.’’ H.R. Rep. No. 1760, at 2 

(1960). Just as data on all advisers was lacking 

before 1940, there has been no comprehensive data 

on hedge fund advisers available. See supra note 

60.

78Much of this information is currently collected 

from hedge fund advisers that are registered with 

the Commission. A registered adviser that is the 

general partner of a hedge fund must report that it 

advises a ‘‘pooled vehicle’’ in response to Item 5.D 

(6) of Part 1A of Form ADV, list each pooled vehicle 

on Schedule D (Section 7.B.) and disclose the 

amount of assets in the pooled vehicle and the 

minimum amount of capital investment per 

investor.

79See Bernstein 2004 Report, supra note 21, at 2 

(‘‘In general, there are very wide discrepancies in 

market size and performance estimates from 

different sources. As an example, we found that 

among three leading hedge fund data providers only 

approximately 15 percent of funds were included 

in all three databases.’’); see also supra note 60.

80Even commenters that disagreed with our 

proposal to register hedge fund advisers agreed that 

the Commission needs information about them. See, 

e.g., Comment Letter of Kynikos Associates LP 

(Sept. 15, 2004) (‘‘Kynikos Letter’’).

81See, e.g., Chamber of Commerce Letter, supra

note 52; MFA Letter, supra note 51.

82One commenter agreed with our concerns and 

the inadequacy of alternative approaches to 

collecting information about hedge fund managers. 

See Comment Letter of Long Trail Capital, LLC 

(Sept. 14, 2004) (Monitoring prime broker 

information is no substitute for registration of hedge 

fund advisers because (1) funds use multiple prime 

brokers, complicating efforts to monitor a fund; (2) 

the transactional picture is not complete since 

funds may hold private equity, real estate, or 

derivatives not cleared by the prime broker; (3) 

brokers have an incentive to profit from the client 

relationship with the fund, and not to expend 

resources trying to oversee its activities; fund 

advisers should instead be accountable to an 

overseer with a primary mission to protect 

investors.)

83See supra note 7.

84One registered hedge fund adviser commented 

that it benefits from our examination process. See

Vantis August Letter, supra note 50 (‘‘[T]he 

examiner provides an extra set of critical eyes to 

review our systems and identify any deficiencies. 

If we were to have deficiencies, we would want to 

promptly correct them.’’)

85 During an examination, our staff may review 

the advisory firm’s internal controls and 

procedures; they may examine the adequacy of 

procedures for valuing client assets, for placing and 

allocating trades, and for arranging for custody of 

client funds and securities. Examination staff also 

may review the adviser’s performance claims and 

delivery of its client disclosure brochure. Each of 

these operational areas presents a greater 

opportunity for misconduct if it is not open to 

examination.

86Other protections of the Advisers Act would 

also act as deterrents to unlawful conduct by 

serving as a check on the advisers’ control of assets 

in funds they advise and contribute to the 

protection of investors in those funds. Our custody 

rule, for example, requires the adviser to maintain 

fund assets with a qualified custodian. See rule 

206(4)–2 under the Advisers Act.

87The facts of the action against Stevin R. Hoover 

and Hoover Capital Management, Inc. are 

instructive on this question. See SEC v. Hoover and 

Hoover Capital Management, Inc., (Second 

Amended Complaint of the SEC), (available at http:/

/www.sec.gov/litigation/complaints 

/complr17487.htm). Hoover was involved in a 

scheme to defraud clients of his advisory firm by, 

among other things, misappropriating assets and 

Continued

date that relate specifically to hedge 

fund advisers have been to modify our 

rules to accommodate these advisers.74

Indeed, our proposals, and the rules we 

are adopting today, include additional 

regulatory relief to accommodate the 

needs of funds of hedge funds.75

B. Matters Considered by the 

Commission 

In the Proposing Release, we 

identified a series of considerations that 

led us to propose rule 203(b)(3)–2. 

These considerations have now led us to 

adopt the rule. These considerations 

explain what we intended to achieve by 

the proposed rule, why we believed 

some alternative approaches would not 

be effective, and why we believed our 

proposed rule reflected the proper 

administration of the Advisers Act. 

Many of the commenters discussed 

these considerations extensively. Those 

supporting the proposal tended to agree 

with the considerations we set out; 

those opposing the proposal challenged 

them. Below, we discuss each of the 

considerations set out in the Proposing 

Release, as well as others raised by 

commenters. For each, we address our 

considerations, the principal arguments 

commenters made against our adoption 

of the rule, and why we found those 

arguments to be unpersuasive.76

1. Census Information 

Registration under the Advisers Act 

provides the Commission with the 

ability to collect important information 

that we now lack about this growing 

segment of the U.S. financial system.77

Registered advisers must file Form ADV 

with us, the data from which will 

provide us with information we need to 

better understand the operation of hedge 

fund advisers, to plan examinations, to 

better develop regulatory policy, and to 

provide data and information to 

members of Congress and other 

government agencies. This includes 

information about the number of hedge 

funds managed by advisers, the amount 

of assets in hedge funds, the number of 

employees and types of other clients 

these advisers have, other business 

activities they conduct, and the identity 

of persons that control or are affiliated 

with the firm.78

Currently, neither we nor any other 

government agency has any reliable data 

on even the number of hedge funds or 

the amount of their assets. We must rely 

on third-party surveys and reports, 

which often conflict and may be 

unreliable.79 Many commenters 

acknowledged this as a concern, and 

several agreed that the Commission 

needs reliable, current and in-depth 

information about hedge fund 

advisers.80 Some commenters, however, 

urged that, instead of registering 

advisers and obtaining information on 

Form ADV, we rely on a coordinated 

collection of filings and transaction 

reports currently made by hedge funds, 

their advisers, or broker-dealers with 

various government agencies or selfregulatory organizations.81 We have 

considered this alternative, but believe 

that it would lead our staff to engage in 

a time-consuming forensic exercise to 

extract a composite of largely 

transactional information that would 

ultimately result in an incomplete 

picture of each hedge fund adviser and 

an incomplete picture of the hedge fund 

industry.82 We still would not know, for 

example, how many hedge funds, or 

hedge fund advisers, operate in the 

United States or their aggregate assets. 

As we explained in the Proposing 

Release, we need information that is 

reliable, current, and complete, and we 

need it in a format reasonably 

susceptible of analysis by our staff.

2. Deterrence of Fraud 

Registration under the Advisers Act 

enables us to conduct examinations of 

the hedge fund adviser.83 Our 

examinations permit us to identify 

compliance problems at an early stage,84

identify practices that may be harmful 

to investors, and provide a deterrent to 

unlawful conduct.85 They are a key part 

of our investor protection program, and 

a key reason we are adopting rule 

203(b)(3)–2.86

We are not suggesting that registration 

under the Advisers Act will result in 

our eliminating, or even identifying, 

every fraud. The prospect of a 

Commission examination, however, 

increases the risk of getting caught, and 

thus will deter wrongdoers.87 This risk 

72062 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

overbilling expenses. When Hoover became aware 

that the Commission staff was investigating his 

firm, he established a separate, unregistered 

advisory firm and perpetuated his fraud through 

use of a hedge fund he created and controlled.

88Several studies examine the impact of 

deterrence on the decision to commit crimes in 

different contexts. The seminal paper in this area 

is Gary Becker, Crime and Punishment: An 

Economic Approach, 76 J. Political Econ. 169 

(1968). Another influential paper is Isaac Ehrlich, 

Participation in Illegitimate Activities: A 

Theoretical and Empirical Investigation, 81 J. 

Political Econ. 521 (1973). The deterrence 

hypothesis is also discussed in Robert Cooter and 

Thomas Ulen, Law and Economics, ch.11–12 

(1988).

89See, e.g., MFA Letter, supra note 51; ISDA 

Letter, supra note 52; Chamber of Commerce Letter, 

supra note 52; Schulte Roth Letter, supra note 51, 

Black Letter, supra note 51, David Thayer Letter, 

supra note 53; Comment Letter of Sheila C. Bair 

(Sept. 15, 2004) (‘‘Sheila Bair Letter’’).

90 2003 Staff Hedge Fund Report, supra note 18, 

at 72.

91Some of these hedge fund managers may have 

been part of a scheme to defraud mutual fund 

investors and aided and abetted others in 

defrauding them, in violation of federal securities 

laws.

92See, e.g., Comment Letter of Millrace Asset 

Group (Sept. 15, 2004) (‘‘Millrace Letter’’).

93See S. Rep. No. 1760, at 3 (1960) 

(recommending amendments to the Advisers Act 

that gave Commission examination authority, 

explaining that ‘‘[t]he prospect of an unannounced 

visit of a Government inspector is an effective 

stimulus for honesty and bookkeeping veracity.’’).

94Eight of the 51 cases involved registered hedge 

fund advisers, and routine or sweep exams were the 

source of five of those eight cases. In the Matter of 

Alliance Capital Management, L.P., supra note 29 

(Commission found that investment adviser to 

hedge fund and mutual funds permitted market 

timing of the mutual funds in exchange for the 

timers’ agreements to invest in the hedge fund); In 

the Matter of Nevis Capital Management, LLC, 

David R. Wilmerding, III and Jon C. Baker,

Investment Advisers Act Release No. 2214 (Feb. 9, 

2004) (charging hedge fund adviser with 

misallocating favorable investment opportunities); 

In the Matter of Zion Capital Management LLC, and 

Ricky A. Lang, Investment Advisers Act Release No. 

2200 (Dec. 11, 2003) (charging hedge fund adviser 

with misallocating investment opportunities to the 

adviser’s personal account); SEC v. Schwendiman 

Partners, LLC, Gary Schwendiman, and Todd G. 

Schwendiman, Investment Advisers Act Release 

No. 2043 (July 11, 2002) (charging hedge fund 

adviser with usurping favorable investment 

opportunities, for the benefit of the adviser); In the 

Matter of Portfolio Advisory Services, LLC and Cedd 

L. Moses, Investment Advisers Act Release No. 2038 

(June 20, 2002) (Commission found hedge fund 

adviser caused its hedge funds to pay nearly $2 

million in unnecessary and undisclosed 

commission costs, above markups already paid, to 

broker that had no role in executing trades, as 

reward for referring investors to the hedge funds).

95SEC v. KS Advisors, Inc., et al., Litigation 

Release No. 18600 (Feb. 27, 2004) (asserting hedge 

fund advisers misrepresented performance and net 

asset value of two hedge funds to conceal massive 

trading losses); SEC v. James S. Saltzman, Litigation 

Release No. 17158 (Sept. 27, 2001) (asserting hedge 

fund adviser diverted significant amounts of fund 

assets to personal use).

96See, e.g., Schulte Roth Letter, supra note 51; 

Sidley Austin Letter, supra note 51.

97SEC v. Jean Baptiste Jean Pierre, Gabriel Toks 

Pearse and Darius L. Lee, Litigation Release No. 

18216 (July 7, 2003); SEC v. Peter W. Chabot, 

Chabot Investments, Inc., Sirens Synergy and the 

Synergy Fund, LLC, Litigation Release No. 18214 

(July 3, 2003); SEC v. David M. Mobley, Sr., et al., 

Litigation Release No. 18150 (May 20, 2003); SEC

v. Vestron Financial Corp., et al., Litigation Release 

No. 18065 (Apr. 2, 2003); SEC v. Hoover and 

Hoover Capital Management, Inc., Litigation 

Release No. 17487 (Apr. 24, 2002); SEC v. Beacon 

Hill Asset Management LLC, et al., Litigation 

Release No. 18745A (June 16, 2004); SEC v. House 

Asset Management, L.L.C., House Edge, L.P., Paul 

J. House, and Brandon R. Moore, Litigation Release 

No. 17583 (June 24, 2002); SEC v. Edward Thomas 

Jung, et al., Litigation Release No. 17417 (Mar. 15, 

2002); SEC v. Evelyn Litwok & Dalia Eilat, Litigation 

Release No. 16843 (Dec. 27, 2000); SEC v. Ashbury 

Capital Partners, L.P., Ashbury Capital 

should alter hedge fund advisers’

behavior by forcing them to account for 

the consequences of a compliance 

examination that, like a tax audit, may 

not occur with great frequency.88 Hedge 

fund advisers each day make decisions 

based on risk analysis of alternative 

investments, and should be particularly 

sensitive to the consequences of getting 

caught if their conduct is unlawful. The 

consequences may involve paying fines, 

disgorgement and other penalties, 

including industry suspensions or bars, 

as well as loss of reputation. This 

sensitivity, which may be reflected in 

the strength of the opposition among 

some hedge fund advisers to this 

rulemaking, suggests that the benefits of 

our oversight may be substantial.

Economic theories of monitoring and 

deterrence based on principal-agent 

models have been used to examine 

regulatory issues related to tax fraud. 

See Jennifer F. Reinganum and Louis L. 

Wilde, Income Tax Compliance in a 

Principal-Agent Framework, 26 J. Pub. 

Econ. 1 (Feb. 1985); Jennifer F. 

Reinganum and Louis L. Wilde, A Note 

On Enforcement Uncertainty and 

Taxpayer Compliance, 103(4) Quarterly 

J. Econ. 793 (Nov. 1988). These papers 

suggest that randomized monitoring is 

sufficient to generate a deterrent effect. 

If the magnitude of deterrence is 

sufficient, randomized monitoring could 

create a net economic benefit. 

Commenters opposing the rule 

challenged our concerns regarding fraud 

on two grounds. Some asserted that 

there was an inadequate record of fraud 

by hedge fund advisers to support 

requiring hedge fund advisers to 

register. They asserted that the 46 cases 

we cited in the Proposing Release 

represented only two percent of our 

enforcement cases over the applicable 

five-year period.89 We note, however, 

that these cases, which have now grown 

to 51, represented over ten percent of 

our cases against investment advisers 

during the same period.

Some commenters cited to us a 

sentence from the 2003 Staff Hedge 

Fund Report that indicated that there 

was no evidence that hedge fund 

advisers engaged disproportionately in 

fraudulent activity.90 The 2003 Staff 

Hedge Fund Report was issued before 

the discoveries of hedge fund 

involvement in late trading and 

inappropriate market timing of mutual 

fund shares.91 In addition, implicit in 

these commenters’ arguments is that the 

Commission should wait to act until 

hedge fund frauds do comprise a 

disproportionate amount of fraudulent 

activity. We reject such arguments. In 

the face of trends that we now observe, 

including the potential impact of hedge 

fund fraud on a growing and broadening 

number of direct and indirect investors 

in hedge funds, we believe that waiting 

would be irresponsible.

Second, some commenters asserted 

that the Commission would be 

unsuccessful at detecting fraud by hedge 

fund advisers, pointing to frauds that 

have occurred involving mutual 

funds.92 Such an assertion amounts to a 

generalized attack on the Commission’s 

ability to deter and detect fraud in 

general, and on the premise of statutes 

that provide us with authority to 

examine investment advisers.93 This 

assertion is unsupported by any 

empirical data, and is as illogical as an 

assertion that because police officers are 

unable to prevent or detect all crime, 

they should be removed from their 

beats. Our examination staff uncovered, 

during routine or sweep exams, five of 

the eight cases we brought against 

registered hedge fund advisers,94 and 

two of the cases involving unregistered 

advisers originated out of examinations 

of related persons that were registered 

with us.95

Finally, some commenters suggested 

that hedge fund advisers are different 

from other advisers and that our 

examiners would be unable to fully 

understand their trading strategies and 

investments.96 This argument does not 

acknowledge that we are today 

responsible for the oversight of 

significant number of registered hedge 

fund advisers (not all of which are 

engaged in complex trading strategies), 

as well as many other advisers (some of 

which are engaged in complex trading 

strategies). In our experience, there is 

nothing unique about hedge fund 

advisers or the types of frauds they have 

committed that suggests that our 

examination program would not or 

could not play the same effective role. 

The fraud actions we have brought 

against unregistered hedge fund 

advisers have been similar to the types 

of fraud actions we have brought against 

other types of advisers, including 

misappropriation of assets,97 portfolio 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72063

Management, L.L.C., and Mark Yagalla, Litigation 

Release No. 16770 (Oct. 17, 2000).

98SEC v. Michael Lauer, Lancer Management 

Group, LLC, and Lancer Management Group II, LLC,

Litigation Release No. 18247 (July 23, 2003); SEC

v. Burton G. Friedlander, Litigation Rel. No. 18426 

(Oct. 24, 2003).

99 In the Matter of Samer M. El Bizri and Bizri 

Capital Partners, Inc., Admin Proc. File No. 3–

11521 (June 16, 2004); SEC v. Millennium Capital 

Hedge Fund, Litigation Release No. 18362 (Sept. 25, 

2003); SEC v. Peter W. Chabot, Chabot Investments, 

Inc., Sirens Synergy and the Synergy Fund, LLC, 

supra note 97; SEC v. David M. Mobley, Sr., et al., 

supra note 97; SEC v. Hoover and Hoover Capital 

Management, Inc., supra note 97; SEC v. Beacon 

Hill Asset Management LLC, et al., supra note 97; 

SEC v. Edward Thomas Jung, et al., supra note 97; 

SEC v. Michael W. Berger, Manhattan Capital 

Management Inc., Litigation Release No. 17230 

(Nov. 3, 2001); In the Matter of Charles K. Seavey 

and Alexander Lushtak, Investment Advisers Act 

Release No. 1968 (Aug. 15, 2001); In the Matter of 

Michael T. Higgins, Investment Advisers Act 

Release No. 1947 (June 1, 2001); SEC v. Ashbury 

Capital Partners, L.P., Ashbury Capital 

Management, L.L.C., and Mark Yagalla, supra note 

97.

100SEC v. J. Scott Eskind, Litigation Release No. 

18558 (Jan. 29, 2004); SEC v. Jean Baptiste Jean 

Pierre, Gabriel Toks Pearse and Darius L. Lee, supra

note 97; SEC v. Peter W. Chabot, Chabot 

Investments, Inc., Sirens Synergy and the Synergy 

Fund, LLC, supra note 97; SEC v. Vestron Financial 

Corp., et al., supra note 97; SEC v. House Asset 

Management, L.L.C., House Edge, L.P., Paul J. 

House, and Brandon R. Moore, supra note 97; SEC

v. Evelyn Litwok & Dalia Eilat, supra note 97; SEC

v. Ashbury Capital Partners, L.P., Ashbury Capital 

Management, L.L.C., and Mark Yagalla, supra note 

97.

101SEC v. Peter W. Chabot, Chabot Investments, 

Inc., Sirens Synergy and the Synergy Fund, LLC, 

supra note 97; SEC v. David M. Mobley, Sr., et al., 

supra note 97; SEC v. Edward Thomas Jung, et al., 

supra note 97; SEC v. Ashbury Capital Partners, 

L.P., Ashbury Capital Management, L.L.C., and 

Mark Yagalla, supra note 97. 

We have also charged registered hedge fund 

advisers with other types of fraud, including: 

misallocating favorable investment opportunities to 

a hedge fund, to the detriment of the adviser’s other 

clients, In the Matter of Nevis Capital Management, 

LLC, David R. Wilmerding, III and Jon C. Baker, 

supra note 94; misallocating investment 

opportunities to the personal account of a hedge 

fund adviser, to the detriment of the hedge fund, 

In the Matter of Zion Capital Management LLC, and 

Ricky A. Lang, supra note 94; usurping a profitable, 

low-risk investment opportunity available to a 

hedge fund and taking it for the personal benefit of 

a hedge fund adviser, SEC v. Schwendiman 

Partners, LLC, Gary Schwendiman, and Todd G. 

Schwendiman, supra note 94; and causing hedge 

funds to pay commissions to a broker that had no 

role in executing trades, as reward for referring 

investors to the adviser’s hedge funds, In the Matter 

of Portfolio Advisory Services, LLC and Cedd L. 

Moses, supra note 94. We have no reason to believe 

that unregistered advisers may not be perpetrating 

the same types of frauds, beyond our detection.

102SEC v. Global Money Management, L.P.,

Litigation Release No. 18666 (Apr. 12, 2004); SEC

v. Burton G. Friedlander, supra note 98; SEC v. 

Michael Lauer, Lancer Management Group, LLC, 

and Lancer Management Group II, LLC, supra note 

98; SEC v. David M. Mobley, Sr., et al., supra note 

97; SEC v. Beacon Hill Asset Management LLC, et 

al., supra note 97; SEC v. Edward Thomas Jung, et 

al., supra note 97; In the Matter of Charles K. 

Seavey and Alexander Lushtak, supra note 99; In 

the Matter of Michael T. Higgins, supra note 99.

103Section 203(c)(2) of the Advisers Act [15 

U.S.C. 80b–3(c)(2)] permits the Commission, after 

notice and opportunity for a hearing, to deny 

registration to an adviser that is subject to 

disqualification under section 203(e) [15 U.S.C. 

80b–3(e)]. Item 11 of Part 1 of Form ADV requires 

applicants for registration as an investment adviser 

to report felonies and other disciplinary events 

occurring during the last 10 years. The 

Commission’s screening, however, does not rely 

exclusively on an applicant’s self-reporting of 

violations; our staff checks applicants against a 

large database of securities violators to determine 

whether there are any unreported disciplinary 

events.

104See, e.g., SEC v. J. Scott Eskind, supra note 

(Eskind, already barred by the Commission from 

association with any investment adviser, raised 

more than $3 million from investors for a purported 

hedge fund, and simply misappropriated it); SEC v. 

Sanjay Saxena, Litigation Release No. 16206 (July 

8, 1999) (Saxena, already barred by the Commission 

from the securities industry, defrauded hedge fund 

investors of approximately $700,000).

105SEC v. Jean Baptiste Jean Pierre, Gabriel Toks 

Pearse and Darius L. Lee, supra note (defendants 

raised nearly half a million dollars, the majority of 

which were simply misappropriated by Jean Pierre); 

SEC v. Peter W. Chabot, Chabot Investments, Inc., 

Sirens Synergy and the Synergy Fund, LLC, supra

note 97 (Chabot raised over $1.2 million for an 

alleged hedge fund but did not buy any stocks or 

other securities with the funds, instead using the 

money for his personal expenses).

106Comment Letter of Vantis Capital Management 

LLC (July 14, 2004) (‘‘Vantis July Letter’’) (registered 

hedge fund adviser stated that the lack of scrutiny 

of hedge fund advisers has led to the industry 

attracting ‘‘unsavory characters’’).

107We acknowledge that many new sponsors of 

hedge funds may not have $25 million of assets 

under management and thus may not be required 

to register with us. See section 203A(a)(1) of the Act 

[15 U.S. 80b-3a(a)(1)] (prohibiting certain advisers 

having less than $25 million from registering with 

the Commission). It is likely that if we adopt this 

rule, many prospective investors may insist that 

newly-formed hedge fund advisers be registered 

with the Commission. These advisers will apply for 

registration pursuant to our rule 203A–2(d) [17 CFR 

275.203A–2(d)], which permits an adviser with less 

than $25 million of assets under management to 

register with us if the adviser has a reasonable 

expectation that it will be eligible to register within 

120 days.

108Rule 206(4)–7 [17 CFR 275.206(4)–7].

109See Compliance Programs of Investment 

Companies and Investment Advisers, Investment 

Advisers Act Release No. 2204 (Dec. 17, 2003) [68 

FR 74714 (Dec. 24, 2003)].

110See, e.g., MFA Letter, supra note 51; Madison 

Capital Letter, supra note 51; Sidley Austin Letter, 

supra note 51.

111See Comment Letter of Seward & Kissel LLP 

(Sept. 15, 2004) (‘‘Seward & Kissel Letter’’); 

Comment Letter of Bryan Cave LLP (Aug. 16, 2004) 

(‘‘Bryan Cave Letter’’).

112 In the Proposing Release, we estimated that 

the new registrants would need to spend $20,000 

in professional fees and $25,000 in internal costs, 

including staff time, to develop the compliance 

infrastructure required of a registered investment 

adviser. These estimates were based on our 

Continued

pumping,98 misrepresentation of 

portfolio performance,99 falsification of 

experience, credentials and past 

returns,100 misleading disclosure 

regarding claimed trading strategies 101

and improper valuation of assets.102

3. Keeping Unfit Persons From Using 

Hedge Funds To Perpetrate Frauds 

Registration with the Commission 

permits us to screen individuals 

associated with the adviser, and to deny 

registration if they have been convicted 

of a felony or had a disciplinary record 

subjecting them to disqualification.103

We intend to use this authority to help 

keep fraudsters, scam artists and others 

out of the hedge fund industry.104

Several of the frauds we have seen 

appear to have been perpetrated by 

unscrupulous persons using the hedge 

fund as a vehicle to defraud investors. 

These persons appear to never have 

intended to establish a legitimate hedge 

fund, but used the allure of a hedge 

fund to attract their ‘‘marks.’’ 105 We 

have been concerned that these 

individuals may have been attracted to 

hedge funds because they could operate 

without regulatory scrutiny of their past 

activities.106 Our lack of oversight may 

have contributed to the belief that their 

frauds would not be exposed. Our 

ability to screen individuals and, in 

some cases, to block their entrance into 

the advisory profession should serve to 

discourage unscrupulous persons from 

using hedge funds as vehicles for 

fraud.107

4. Adoption of Compliance Controls 

Registration under the Advisers Act 

will require hedge fund advisers to 

adopt policies and procedures designed 

to prevent violation of the Advisers Act, 

and to designate a chief compliance 

officer.108 Hedge fund advisers that have 

not already done so must develop and 

implement a compliance infrastructure. 

We adopted this requirement last year 

for all advisers registered with us in 

recognition that advisers have the 

primary obligation to ensure compliance 

with the securities laws, and to foster 

more effective compliance practices.109

Our examination staff resources are 

limited, and we cannot be at the office 

of every adviser at all times. Compliance 

officers serve as the front line watch for 

violations of securities laws, and 

provide protection against conflicts of 

interests.

Comment letters opposing registration 

of hedge fund advisers did not challenge 

the benefits of compliance programs; 

rather, they complained of the costs of 

developing a compliance infrastructure, 

and of submitting to our compliance 

examinations.110 They asserted that 

these costs would make them less 

competitive, and would impose barriers 

to entry preventing new hedge fund 

advisers from starting their own hedge 

funds.111 We acknowledge that 

development and maintenance of 

compliance controls involves costs,112

72064 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

discussions with industry, including attorneys 

whose practice involved counseling registered and 

unregistered investment advisers. Commenters 

argued that their costs would be higher. We discuss 

the benefits and costs of our rulemaking in Section 

IV. of this Release.

113See ICAA Letter, supra note 47. As of 

September 30, 2004, of the 8,535 advisers registered 

with the Commission, 2,758 reported on their Form 

ADV that they were managing less than $50 million 

in client assets.

114See 2003 Staff Hedge Fund Report, supra note 

18 at section VII.A.1.b.

115BONY Report, supra note 39, at 15–16.

116Rule 206(4)–7. Hedge fund advisers have 

substantial conflicts of interest, both with their 

hedge funds and with their investors. These 

conflicts arise from management strategies, fee 

structures, use of fund brokerage and other aspects 

of hedge fund management.

117One hedge fund adviser agreed: ‘‘Benefits [of 

registration] include * * * the structure it provides 

for advisers’’ policies and procedures, the value of 

having an additional layer of oversight of advisers’

compliance programs.’’ Vantis August Letter, supra

note 50.

118 In concluding that registration would impose 

substantial burdens on a hedge fund adviser, 

several commenters mistakenly assumed that 

compliance with rule 206(4)–7(c) would require 

them to hire a new chief compliance officer. The 

rule requires all registered advisers to ‘‘designate’’

an individual as chief compliance officer, which 

could be an individual currently employed by the 

adviser who has similar responsibilities.

119Some hedge fund advisers charge up to four 

percent in asset-based fees, and others take between 

30 and 50 percent of their funds’ profits. See Hedge 

Funds Grab More In Fees As Their Popularity 

Increases, supra note 11.

120See Bernstein 2003 Report, supra note 24, at 

4.

121 Id. at 15. See also Vantis July Letter, supra 

note 106 (‘‘there are presently too few barriers to 

entry’’ in the hedge fund industry).

122Bernstein 2003 Report, supra note 24, at 14. 

Regulatory oversight to deter frauds may forestall 

erosion of investor confidence in this growing 

industry. See, e.g., Vantis July Letter, supra note 

106 (mandatory registration will improve the image 

of the hedge fund industry); Hennessee Foundation 

and Endowment Survey, supra note 39 (survey 

participant remark that registration ‘‘lends 

creditability to the field’’); Comment Letter of North 

American Securities Administrators Association, 

Inc. (Oct. 18, 2004) (SEC registration will increase 

investor confidence, thereby benefiting hedge fund 

advisers).

123See supra note 119.

124Hedge funds in the United States are generally 

organized to avoid regulation under the Investment 

Company Act by qualifying for an exclusion, from 

the definition of ‘‘investment company,’’ under 

section 3(c)(1) [15 U.S.C. 80a–3(c)(1)] or 3(c)(7) [15 

U.S.C. 80a–3(c)(7)] of that Act. There are no 

performance fee restrictions on 3(c)(7) funds, but 

each investor in the fund must be a ‘‘qualified 

purchaser,’’ which for natural persons generally 

means having investments of at least $5 million. 

See section 2(a)(51) of the Investment Company Act 

[15 U.S.C. 80a–2(a)(51)]. Rule 205–3 requires 

advisers to 3(c)(1) funds to consider each investor 

in the fund as a client for purposes of charging a 

performance fee.

125See infra Section II.H of this Release.

126Regulation D [17 CFR 230.501 through 508] 

exempts from registration under the Securities Act 

of 1933 offerings and sales of securities that satisfy 

certain conditions, including certain sales to 

‘‘accredited investors.’’ As noted in the 2003 Staff 

Hedge Fund Report, supra note 18, at 313, our 

approach of leaving eligibility requirements for 

accredited investors unchanged also allows small 

businesses to continue to seek capital from 

historical sources.

127Comment Letter of Denali Asset Management 

LLLP (Aug. 27, 2004) (‘‘Denali Letter’’); Comment 

Letter of Willkie Farr & Gallagher LLP (Sept. 13, 

2004) (‘‘Willkie Farr Letter’’); Comment Letter of 

National Futures Association (Sept. 14, 2004) 

(‘‘NFA Letter’’); ICAA Letter, supra note 47; 

Comment Letter of Katten Muchin Zavis Rosenman 

(Sept. 14, 2004) (‘‘Katten Muchin Letter’’); Tudor 

Letter, supra note 53; Financial Services 

Roundtable Letter, supra note 53; Jeffrey R. Neufeld 

(Sept. 15, 2004) (‘‘Neufeld Letter’’); Kynikos Letter, 

supra note 80; Comment Letter of the Association 

of the Bar of the City of New York Committee on 

Futures Regulation (Sept. 15, 2004) (‘‘NYC Bar 

Futures Committee Letter’’); Comment Letter of the 

U.S. Commodity Futures Trading Commission (Oct. 

22, 2004) (‘‘CFTC Letter’’).

but these are costs that today all 

advisers registered with us must bear, 

including advisers that are much 

smaller and have substantially fewer 

resources than many hedge fund 

advisers.113

Our 2003 Staff Hedge Fund Report 

noted that, while many unregistered 

hedge fund managers had strong 

compliance controls, others had very 

informal procedures that appeared to be 

inadequate for the amount of assets 

under their management.114 These lack 

of controls concern not only us, but also 

hedge fund investors. A recent survey of 

institutional investors reported that the 

adequacy of operational controls at 

hedge fund advisory firms was one of 

most frequently mentioned concerns.115

While these investors can request to see 

a hedge fund manager’s compliance 

policies and procedures, we are in a 

position to determine whether the hedge 

fund adviser’s operations seem to be in 

accordance with those policies and 

procedures.

Application of our recent rule 

requiring more formalized compliance 

policies administered by an employee 

designated as a chief compliance officer 

will serve to better protect hedge fund 

investors.116 We also believe it will well 

serve hedge fund advisers that, for 

business reasons alone, should have a 

compliance infrastructure 

commensurate with the nature of their 

operations and the risks involved.117

These costs appear small relative to the 

scale of the industry.118 The typical 

hedge fund fee structure, which 

involves both a management fee of two 

percent or more and a performance fee 

of twenty percent or more provides 

hedge fund advisers with a substantial 

cash flow.119 Today there are many 

investment advisers registered with us 

that manage a comparable amount of 

assets, charge substantially lower fees, 

and bear these same compliance costs. 

One recent study estimated that ‘‘in 

1999, with $450 billion in assets under 

management, hedge funds’’ fee revenues 

were higher than those of the whole 

U.S. equity mutual fund industry.’’ 120

There are today ‘‘[e]xtremely low 

barriers to entry and tremendous 

monetary and non-monetary incentives 

for hedge fund [advisers],’’ 121 and thus 

the cost of compliance with these rules 

should not present significant 

additional barriers to entry for new 

hedge fund advisers. Indeed some have 

suggested that our regulatory initiative 

may ‘‘play a positive role of increasing 

confidence in hedge fund use by further 

demystifying them.’’ 122

5. Limitation on Retailization 

Registration under the Advisers Act 

will have the salutary effect of resulting 

in all direct investors in most hedge 

funds meeting minimum standards of 

rule 205–3 under the Advisers Act, 

because hedge fund advisers typically 

charge performance fees.123 Rule 205–3 

requires that each investor, in a private 

investment company that pays a 

performance fee, generally have a net 

worth of at least $1.5 million or have at 

least $750,000 of assets under 

management with the adviser.124 Many 

hedge fund advisers will rely on rule 

205–3 to continue charging a 

performance fee to the funds they 

manage.

Most commenters did not address this 

effect of registration under the Act, 

except with respect to expressing their 

support for the transitional rule we also 

proposed, and which we discuss later in 

this Release.125 Some argued that we 

should, instead, raise the ‘‘accredited 

investor’’ standards applicable to 

private offerings pursuant to Regulation 

D, which may have a similar effect on 

limiting direct investments in hedge 

funds.126 Raising the accredited investor 

standards would not address the 

broader concerns, discussed above, of 

the indirect exposure to hedge funds by 

an increasingly large number of persons 

who are beneficiaries of pensions plans 

or invest through other intermediaries 

that are likely to meet any higher 

standards.

6. CFTC Regulation 

Several commenters suggested that 

the Commission exempt from 

registration hedge fund advisers that are 

registered with the CFTC as commodity 

pool operators in order to avoid 

duplicative registration.127 In 2000 

Congress addressed this concern by 

adding section 203(b)(6) to the Advisers 

Act, which exempts any CFTCregistered commodity trading advisor 

from investment adviser registration if 

its business does not consist primarily 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72065

128 15 U.S.C. 80b–203(b)(6). Congress enacted 

section 203(b)(6) as part of the Commodity Futures 

Modernization Act of 2000, Pub. L. 106–554, 114 

Stat. 2763 (2000) (codified in scattered sections of 

the United States Code). A parallel provision was 

added simultaneously to the Commodity Exchange 

Act. Section 4m of the Commodity Exchange Act [7 

U.S.C. 6m]. The exemption in section 203(b)(6) is 

not available if the firm acts as an adviser to a 

registered investment company or to a company 

that has elected to be a business development 

company under section 54 of the Investment 

Company Act [15 U.S.C. 80a–53].

129Roundtable Transcript of May 15 at 236–37, 

supra note (statement of Jane Thorpe that ‘‘NFA 

certainly has the ability to go in and inspect 

vehicles that may not directly be trading in futures 

but based on a risk-based approach is going to focus 

on those areas that obviously it has the most and 

we have the most interest in’’).

130We note that the frequency with which hedge 

fund advisers may also be registered with the CFTC 

as commodity pool operators (‘‘CPOs’’) may 

diminish substantially in the future. The CFTC 

recently adopted rules that may permit most hedge 

fund advisers to now avoid registering as CPOs or 

commodity trading advisors (‘‘CTAs’’). See 

Additional Registration and Other Regulatory Relief 

for Commodity Pool Operators and Commodity 

Trading Advisors; Past Performance Issues (Aug. 1, 

2003) [68 FR 47221 (Aug. 8, 2003)] (‘‘CFTC 2003 

Exemptive Release’’) (adopting new rule 4.13(a)(3), 

which exempts CPOs from registration if the pool 

is sold only to accredited investors and engages in 

limited trading of commodity interests, new rule 

4.13(a)(4), which exempts CPOs from registration if 

the pool is offered only to persons reasonably 

believed to be ‘‘qualified eligible persons,’’ and new 

rule 4.14(a)(10), which exempts CTAs who during 

the preceding 12 months provide advice to fewer 

than 15 legal entities). See also Susan Ervin, 

Downsizing Commodity Pool Regulation: The 

CFTC’s New Initiative, Futures Industry, May/June 

2003 (The CFTC has embarked upon a fundamental 

change in its regulatory program, which would free 

very sizable portions of the industry from CFTC 

regulation. Many new entrants would not need to 

register with the CFTC and many currently 

registered persons may elect to withdraw from 

registration.). We expect our staff will consult with 

the staff of the CFTC to discuss a variety of matters 

regarding examinations of hedge fund advisers, 

including the extent to which examinations should 

be coordinated or results shared.

131We note, however, that without the new rule 

requiring registration, a hedge fund adviser can now 

choose to register under the Advisers Act but then 

withdraw its registration, for example, at the 

prospect of an examination. Thus, without the new 

rule, any moral hazard would already exist, but 

without necessarily providing hedge fund investors 

the benefit of our oversight of their advisers.

132See, e.g., 1940 Senate Hearings, supra note 

(testimony of Dwight C. Rose, President, Investment 

Counsel Association of America, (‘‘Many 

incompetents would be permitted to register and 

describe themselves as registered or licensed 

investment counsel. This badge of registration and 

apparent approval by the Federal Government 

might, therefore, in spite of any express provision 

denying such approval in the act itself, give to the 

unsophisticated investor a mistaken and completely 

underserved impression of qualification and 

standing.’’)). Indeed, such an argument could be 

made against Commission regulation of any brokerdealer, transfer agent, or investment company.

133Section 208(a) of the Act [15 U.S.C. 80b–8(a)]. 

A registered adviser may refer to itself as 

‘‘registered’’ so long as the effect of registration is 

not misrepresented. Section 208(b) [15 U.S.C. 80b–

8(b)].

134Practically speaking, a single hedge fund can 

have up to 499 investors; beyond this limit, the 

fund faces potential obligations to register under 

section 12 of the Exchange Act [15 U.S.C. 78h] and 

rule 12g–1 [17 CFR 240.12g–1], generally requiring 

registration of any issue with 500 holders of record 

of a class of equity securities and assets in excess 

of $10 million. Since rule 203(b)(3)–1 has generally 

allowed an adviser to count each hedge fund as one 

client, a hedge fund adviser could have 14 funds 

with 499 investors in each, or a total of 6,986 

investors.

135See, e.g., Chamber of Commerce Letter, supra

note 52; MFA Letter, supra note 51. Opponents of 

the Advisers Act made this same argument to 

Congress in 1940 without success. See, e.g., 1940 

Senate Hearings, supra note (testimony of Charles 

O’Hearn, Clarke, Sinsabaugh & Co., (‘‘Regulation of 

this profession by the Securities and Exchange 

Commission is not necessary for the protection of 

small, uninformed investors, since they do not use 

investment counsel service. There is a marked 

difference between the owners of investment trust 

securities and our clients. While investment trusts 

sell securities in amounts sufficiently small so that 

even the poorest may buy, our services are designed 

for and limited to a group of persons who are a 

minority in the community. We do not deal with 

the general public. Our clients represent substantial 

amounts of capital and have adequate means to 

inform themselves about us through their banking 

and legal affiliations.’’)).

136The Commission’s 1939 Investment Trust 

Study to Congress, which preceded enactment of 

the Advisers Act, found that the average size of 

individual clients’ accounts managed by advisers 

surveyed in 1936 was $281,000, which equals $3.8 

million in today’s value. Individual clients 

represented about 83 percent of these advisers’

client base. See SEC, Investment Trusts and 

Investment Companies, H.R. Doc. No. 279, 76th 

Cong., 1st Sess., pt. 2 at 8–9 (1940).

of acting as an investment adviser.128 A 

hedge fund adviser that qualifies for this 

statutory exemption is not required to 

register with us.

We disagree that our oversight of 

hedge fund advisers that are also 

commodity pool operators would be 

duplicative. Most hedge fund portfolios 

consist primarily of securities, and the 

CFTC’s oversight necessarily focuses 

more on the area of futures trading, 

which is the activity of most concern to 

the CFTC.129 It would be inconsistent 

with principles of functional regulation 

and contrary to the design and purpose 

of the 2000 amendments to the Advisers 

Act for the Commission not to oversee 

hedge fund advisers whose primary 

business is acting as an investment 

adviser.130

7. Moral Hazard Implications 

Some commenters urged us not to 

adopt the rule because Commission 

oversight of hedge fund advisers might 

tend to cause hedge fund investors to 

rely on that oversight instead of 

performing appropriate due diligence 

before making an investment in a hedge 

fund.131 Such an argument, if accepted, 

would support withdrawal of the 

Commission’s oversight of all advisers, 

particularly of those advisers whose 

clients are less sophisticated and who 

might be less likely to appreciate the 

limitations of regulatory oversight.132

Congress addressed such arguments in 

1940 when it passed the Advisers Act 

by including a provision in the Act that 

makes it unlawful for any investment 

adviser to ‘‘represent or imply in any 

manner whatsoever that [the adviser] 

has been sponsored, recommended, or 

approved, or that his abilities or 

qualifications have in any respect been 

passed upon by the United States or any 

agency or officer thereof.’’ 133

8. Proper Administration of the 

Advisers Act 

In adopting rule 203(b)(3)–2, an 

important consideration for us has been 

our dissatisfaction with the operation of 

the existing safe harbor because it 

permits advisers, without registering 

under the Act, to manage large amounts 

of securities indirectly through hedge 

funds that may have, collectively, 

hundreds of investors.134 We believe 

that the safe harbor has become 

inconsistent with the underlying 

purpose of the registration exemption in 

Section 203(b)(3), which was designed 

to exempt advisers whose business 

activities are too limited to warrant 

federal attention. Commenters have not 

persuaded us otherwise. Our actions 

today withdraw that safe harbor and 

require advisers to ‘‘private funds’’—

which will include most hedge funds—

to ‘‘look through’’ the funds to count the 

number of investors as ‘‘clients’’ for 

purposes of the private adviser 

exemption.

Many commenters who opposed the 

rule urged us to maintain the safe harbor 

because it operated to exempt advisers 

to hedge funds in which only wealthy 

and sophisticated investors 

participated.135 This argument 

implicitly concedes that the 

Commission should look to the 

investors in the hedge fund (rather than 

the hedge fund itself) to determine 

whether the adviser should be required 

to register, but concludes that we should 

continue to exempt the adviser from 

registration because the ultimate 

advisory clients are wealthy or 

sophisticated.

Section 203(b)(3) was not intended to 

exempt advisers to wealthy or 

sophisticated clients. First, they were 

the primary clients of many advisers in 

1940 when the provision was included 

in the Act.136 Second, it would make no 

sense for Congress to have imposed a 

limit on the number of wealthy or 

sophisticated clients an adviser could 

have before it had to register under the 

Act. Surely, the fifteenth wealthy or 

sophisticated client would not trigger 

the need for registration. Other 

72066 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

137See, e.g., section 3(c)(7) [15 U.S.C. 80a–3(c)(7)] 

of the Investment Company Act.

138See section 201 of the Act [15 U.S. 80b–1] 

(activities of investment advisers are of national 

concern because they substantially affect national 

securities exchanges and the national economy).

139The legislative history of section 3(c)(1) of the 

Investment Company Act of 1940 [15 U.S.C. 80a–

3(c)(1)], a parallel section to section 203(b)(3) that 

was enacted at the same time, reflects Congress’

view that privately placed investment companies, 

owned by a limited number of investors likely to 

be drawn from persons with personal, familial, or 

similar ties, do not rise to the level of federal 

interest. See 1940 Senate Hearings, supra note 73.

140See section 201 of the Act.

141See, e.g., sections 4(2) and 4(6) of the 

Securities Act of 1933 [15 U.S.C. 77d(2) and 77d(6)] 

and Regulation D and rule 144A [17 CFR 230.144A]; 

SEC v. Ralston Purina Co., 346 U.S. 119 (1953).

142See, e.g., Comment Letter of Wilmer Cutler 

Pickering Hale and Dorr LLP (Sept. 8, 2004) 

(‘‘Wilmer Cutler Letter’’).

143Pub L. No. 104–290, 110 Stat. 3416 (1996) 

(codified in scattered sections of the United States 

Code).

144S.Rep. No. 104–293, at 10 (1996).

145Title III of NSMIA amended the Advisers Act 

to allocate regulatory responsibility over advisers 

between the Commission and state securities 

authorities. It gave the Commission responsibility 

for advisers with more than $25 million of assets 

under management, and preempted state 

registration and other requirements for advisers 

registered with the Commission. These are firms 

that Congress concluded were ‘‘[l]arger advisers, 

with national businesses [that] should be registered 

with the Commission and be subject to national 

rules.’’ S. Rep. No. 293, 104th Cong., 2d Sess. (1996) 

at 3–4.

146See, e.g., Financial Services Roundtable Letter, 

supra note 53; Tudor Letter, supra note 53. Another 

commenter suggested that the investments of the 

hedge fund adviser’s insiders be excluded in 

applying the registration requirements. Comment 

Letter of Alex M. Paul (July 21, 2004). We are 

adopting a provision that allows an adviser to 

exclude certain knowledgeable insiders when 

counting its clients. See infra Section II.D.2 of this 

Release. 147See, e.g., Chamber of Commerce Letter, supra

note 52; Neufeld Letter, supra note 127 (increase 

accreditation standards, with exemptions for family 

members of advisory firms’ employees). See also

MFA Letter, supra note 51 (suggesting creation of 

investor accreditation standards under the Advisers 

Act for hedge fund investors). 148Other commenters suggested variations with 

special rules for funds of funds or pension plans. 

Regardless of the extent to which these alternatives 

might limit indirect participation in hedge funds 

advised by unregistered advisers, these alternatives 

would not permit us to examine unregistered hedge 

fund advisers. See, e.g., Bryan Cave Letter, supra

note 111 (apply investor accreditation standards to 

funds of funds on a look-through basis); Comment 

Letter of Leon M. Metzger (Sept. 15, 2004) 

(‘‘Metzger Letter’’) (require fund of funds whose 

investors do not meet accreditation standards to 

invest only in funds with registered advisers; 

coordinate with Department of Labor to prohibit 

pension fund investments in hedge funds with 

unregistered advisers); Madison Capital Letter, 

supra note 51 (apply the look-through for purposes 

of counting up to 15 clients, but the only investors 

that would be counted towards the limit would be 

(i) investors that did not meet 3(c)(7) ‘‘qualified 

purchaser’’ standards, (ii) pension funds, and (iii) 

registered investment companies).

149See supra Section II.B.8 of this Release.

provisions in the federal securities laws 

designed to exempt transactions or 

relationships with wealthy or 

sophisticated investors contain no such 

limitations.137

The intent of Congress in enacting 

section 203(b)(3) appears to have been 

to create a limited exemption for 

advisers whose activities were not 

national in scope 138 and who provided 

advice to only a small number of clients, 

many of whom are likely to be friends 

and family members.139 These advisers 

are unlikely to significantly affect 

investors and the securities markets 

generally.140 While provisions of the 

Securities Act (and its rules) provide 

exemptions from registration under that 

Act for securities transactions with 

persons, including institutions, that 

have such knowledge and experience 

that they are considered capable of 

fending for themselves and thus do not 

need the protections of the applicable 

registration provisions,141 the Advisers 

Act does not. When a client—even one 

who is highly sophisticated in financial 

matters—seeks the services of an 

investment adviser, he acknowledges he 

needs the assistance of an expert. The 

client may be unfamiliar with investing 

or the type of strategy employed by the 

adviser, or may simply not have the 

time to manage his financial affairs. The 

Advisers Act is intended to protect all 

types of investors who have entrusted 

their assets to a professional investment 

adviser.

Several commenters opposing the rule 

pointed to legislation enacted in 1996 

that created a new exclusion from the 

definition of ‘‘investment company’’

under the Investment Company Act for 

pools of securities offered exclusively to 

‘‘qualified purchasers’’ as evidence that 

Congress intended that hedge fund 

advisers be left unregulated by the 

Advisers Act as well as the Investment 

Company Act.142 These commenters 

offered no support for this proposition.

The 1996 National Securities Markets 

Improvement Act (NSMIA) exempted 

these qualified purchaser funds from 

only the Investment Company Act.143 Its 

legislative history explains only that 

Congress believed the protections 

afforded by the Investment Company 

Act were unnecessary for financially 

sophisticated investors.144 Moreover, 

the current safe harbor, which can result 

in hedge fund advisers with hundreds of 

millions of dollars of assets being 

registered with one or more state 

regulators, is inconsistent with the 

policy and purposes of NSMIA, which 

allocated oversight responsibility for 

larger advisers to the Commission.145

The legislative record of NSMIA, in 

fact, suggests that Congress may have 

expected the Commission to regulate the 

activities of advisers to hedge funds 

eligible for the new Investment 

Company Act exclusion. NSMIA 

amended section 205 of the Advisers 

Act to exempt qualified purchaser funds 

from restrictions on performance fees. 

Section 205 of the Act does not apply 

to advisers ‘‘exempt from registration 

pursuant to Section 203(b),’’ and thus 

affects only funds advised by 

investment advisers registered with the 

Commission. Thus, Congress 

understood that at least some of these 

qualified purchaser pools would be 

advised by registered advisers, and 

chose to exempt these advisers only 

from the restrictions on performance 

fees.

9. Alternatives Submitted 

Several commenters submitted 

alternative approaches for our 

consideration. These alternatives 

included provisions aimed at addressing 

several of the considerations that led us 

to propose rule 203(b)(3)–2, such as the 

need for information about hedge fund 

advisers and the broadening exposure of 

investors to hedge funds. We have 

considered these alternatives. However, 

as discussed below, the alternatives 

each involve partial responses to our 

concerns, and all would deny us the 

ability to examine the activities of hedge 

fund advisers, and would not, in our 

judgment, accomplish the goals of this 

rulemaking. 

Some commenters suggested we 

except hedge fund advisers from the 

adviser registration requirement if all 

investors in their hedge funds meet 

‘‘qualified purchaser’’ standards under 

section 3(c)(7) of the Investment 

Company Act.146 Others suggested that 

in lieu of requiring hedge fund adviser 

registration, we should increase the 

current ‘‘accredited investor’’ standards 

for private securities offerings under 

Regulation D.147 These alternatives 

would address one aspect of our 

concern about the prospect of direct 

ownership of hedge funds by investors 

who may not previously have 

participated in these types of risky 

investments, but would not permit us to 

protect the interests of those whose 

exposure is through intermediaries such 

as funds of funds and pension funds.148

Moreover, as discussed earlier, the 

Advisers Act does not exempt an 

adviser from registration merely because 

its clients may be wealthy or 

sophisticated.149

Other commenters offered alternatives 

based on amending our Form D to 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72067

150Form D [17 CFR 239.500] is the form filed 

with the Commission by issuers (including many 

hedge funds) that make private securities offerings 

in reliance on Regulation D. Other commenters 

suggested informational filing requirements but did 

not focus on Form D in particular. See, e.g., 

Comment Letter of the American Bar Association 

Section of Business Law (Sept. 28, 2004) (‘‘ABA 

Letter’’); MFA Letter, supra note 51 (informational 

filing coupled with certification that insiders of the 

adviser or its funds did not have disciplinary 

history that would be reportable under Form ADV, 

and adviser’s agreement to provide certain 

additional information to the Commission on 

‘‘special call’’ in limited circumstances).

151These commenters suggested registration 

carve-outs apply to hedge fund advisers whose 

funds submitted the expanded Form D information 

and accepted investments only from persons 

meeting ‘‘accredited investor’’ or ‘‘qualified client’’

criteria. See, e.g., Bryan Cave Letter, supra note 111; 

Seward & Kissel Letter, supra note 111. Bryan Cave 

also suggested that hedge funds be covered under 

revised and expanded Suspicious Activity Reports 

(‘‘SARs’’), and any information reported be shared 

with the Commission to aid enforcement efforts. 

The Financial Crimes Enforcement Network 

requires banks, brokers, and other financial 

institutions to file SARs if the institution observes 

suspected or potential financial crimes. We believe 

this kind of monitoring of hedge funds’ financial 

transactions with third parties would provide us 

only with partial information about hedge fund 

advisers’ activities.

152See, e.g., Comment Letter of Coudert Brothers 

LLP (Sept. 15, 2004) (‘‘Coudert Letter’’); Katten 

Muchin Letter, supra note 127.

153See, e.g., Bryan Cave Letter, supra note 111; 

MFA Letter, supra note 51; Kynikos Letter, supra

note 80. Kynikos suggested that each adviser certify 

its compliance with the custody, compliance, and 

code of ethics rules and its adherence to investor 

qualification standards, as well as provide investors 

with special disclosures of key valuation and 

allocation standards, and distribute quarterly 

unaudited and annual audited financial statements 

to investors. Other commenters similarly included 

audit requirements as part of their alternatives. See, 

e.g., Madison Capital Letter, supra note 51 

(suggesting annual audit requirement (with results 

delivered to investors and the Commission) and 

expanded Form D information reporting); Willkie 

Farr Letter, supra note 127 (suggesting selfexecuting exemptive application procedure for 

advisers whose funds distribute audited financials 

and special valuation disclosures to investors). We 

have previously requested comment on alternatives 

that would incorporate private audits into our 

oversight of investment advisers. Compliance 

Programs of Investment Companies and Investment 

Advisers, Investment Advisers Act Release No. 2017 

(Feb. 5, 2003) [68 FR 7038 (Feb. 11, 2003)]. 

However, as commenters in that inquiry noted, 

reliance on auditors can be problematic, since their 

reviews are not necessarily designed to address all 

the issues addressed by our oversight program, and 

audit personnel do not necessarily have an in-depth 

knowledge of the Advisers Act. See, e.g., Comment 

Letter of the Council of Institutional Investors 

(April 10, 2003), available at http://www.sec.gov/

rules/proposed/s70303/cii041003.htm.

154Further, under this alternative, hedge fund 

advisers could not use Investment Adviser 

Registration Depository system (‘‘IARD’’), the 

electronic filing system that investment advisers 

use to make filings with us. Thus, information 

about investment advisers to hedge funds would 

not be integrated with information about other 

investment advisers, it would not be included in 

the data reports available to our staff, and 

disciplinary and other important information about 

hedge fund advisers would not be available to the 

public through the Investment Adviser Public 

Disclosure system, which draws data from the 

IARD.

155See, e.g., MFA Letter, supra note 51; Tudor 

Letter, supra note 53.

156See also supra notes 138–140 and 

accompanying text.

157Before the Commission adopted the safe 

harbor in 1985, the staff issued numerous no-action 

letters that required an investment adviser to look 

through an entity and count each individual 

advisee or member as a separate client. See Ruth 

Levine, SEC Staff No-Action Letter (Dec. 15, 1976); 

David Shilling, SEC Staff No-Action Letter (Apr. 3, 

1976); B.J. Smith, SEC Staff No-Action Letter (Dec. 

25, 1975); S.S. Program Limited, SEC Staff NoAction Letter (Oct. 17, 1974); Wofsey, Rosen, 

Kweskin & Kuriansky, SEC Staff No-Action Letter 

(Apr. 25, 1974); Hawkeye Bancorporation, SEC Staff 

No-Action Letter (June 11, 1971). Ambiguity with 

respect to this issue was fueled in part by 

Abrahamson v. Fleschner, 568 F.2d 862 (2d Cir. 

1977), cert. denied, 436 U.S. 913 (1978), overruled 

on other grounds by TransAmerica Mortgage 

Advisors, Inc. v. Lewis, 444 U.S. 11 (1979), in which 

the Second Circuit held that general partners of 

limited partnerships investing in securities were 

investment advisers. The Second Circuit originally 

characterized the individual limited partners as the 

‘‘clients’’ of the general partner, (1976–77) 

Fed.Sec.L.Rep. (CCH) ¶ 95,889, at 91,282 n. 16, but 

later withdrew this characterization, 568 F. 2d at 

872 n. 16, leaving unanswered the issue of whether 

the partnership, or each of the partners, should be 

‘‘counted’’ as a client. For a discussion, see Robert 

Hacker and Ronald Rotunda, SEC Registration of 

Private Investment Partnerships after Abrahamson

v. Fleschner, 78 Colum. L. Rev. 1471, 1477 (1978).

require hedge funds to provide certain 

information about their advisers.150

Some suggested that hedge fund 

advisers whose funds submitted this 

information be excepted from adviser 

registration requirements,151 while 

others suggested it be an alternative to 

registration.152 Some commenters 

further suggested that these information 

requirements be combined with limited 

application of specific rules that apply 

only to registered advisers, such as the 

custody rule or the compliance rule.153

None of these alternatives, however, 

would provide us with examination 

authority.154

Finally, some commenters suggested 

that, instead of registering hedge fund 

advisers, we gather information about 

them from a variety of regulatory filings 

currently made by hedge funds, their 

advisers, and broker-dealers.155 We have 

considered this alternative, but the 

reports and information currently 

available would provide at best a 

partial, inadequate view of the activities 

of hedge fund advisers. While some of 

the reports emphasized by these 

commenters might provide us with 

basic identifying information about 

hedge funds advisers that are registered 

as broker-dealers or commodity pool 

operators, many are not registered in 

either capacity. These commenters also 

focus on several existing transactional 

reporting requirements, arguing they 

contain a wealth of information about 

hedge funds. However, as discussed 

above, making use of this information 

would require substantial effort on the 

part of our staff to extract a composite 

of information about any particular 

hedge fund, yielding limited 

information about its assets instead of 

any useful information about whether 

its adviser is fulfilling its fiduciary 

duties. As we stated in the Proposing 

Release, we need information that is 

reliable, current, and complete, and we 

need it in a format reasonably 

susceptible to analysis by our staff.

C. Our Legal Authority Under the 

Advisers Act 

A few commenters challenged our 

legal authority to adopt rule 203(b)(3)–

2, asserting that the approach of the 

rule, which requires an adviser to ‘‘look 

through’’ a hedge fund to determine 

whether it is eligible for the private 

adviser exemption, is contrary to the 

Act. For the reasons discussed below, 

we believe we have broad authority to 

adopt the rule. We start our discussion 

with the statutory language. 

Section 203(b)(3) of the Act provides 

an exemption from registration for 

certain investment advisers. To qualify 

for the exemption, Congress provided 

two specific tests, each of which an 

adviser must satisfy. First, the adviser 

must not advise fifteen or more clients 

and, second, the adviser must not hold 

itself out to the public as an investment 

adviser. In enacting this provision, 

Congress exempted from the registration 

requirements a category of advisers 

whose activities were not sufficiently 

large or national in scope, e.g., advisers 

to family or friends, to implicate the 

policy objectives identified in section 

201 of the Act.156

Congress did not appear to have 

addressed or considered whether an 

adviser must count an investor in a 

pooled investment vehicle as a client for 

purposes of section 203(b)(3). 

Nevertheless, it has long been 

recognized that determining whether 

the exemption applies could not be 

limited to a formalistic assessment of 

whether the adviser provided 

investment advice to a single legal 

entity, but instead requires 

consideration of the surrounding 

circumstances of the advisory 

arrangement, which, in appropriate 

cases, might call for ‘‘looking through’’

the advised entity.157

For purposes of counting clients, 

‘‘looking through’’ the advised entity in 

appropriate circumstances is fully 

consistent with the broad remedial 

purposes of the Advisers Act and the 

exemptive provisions of section 

72068 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

158 In other circumstances, we look through pools 

to the investors themselves in specifying advisers’

obligations under the Advisers Act. See, e.g., rule 

205–3(b) (requiring each investor in a private 

investment company to meet qualified client 

criteria if the adviser charges the private investment 

company a performance fee); rule 206(4)–2(a)(3)(iii) 

(requiring that custody account statements for funds 

and securities of limited partnerships for which the 

adviser acts as general partner be delivered to each 

limited partner). We note, also, that other regulators 

have required a look-through approach in similar 

circumstances. Various states look through 

investment vehicles to count the investors as 

‘‘clients’’ of the adviser. See Comment Letter of 

North American Securities Administrators 

Association (Oct. 18, 2004) (‘‘NASAA Letter’’). In 

addition, section 4m(1) of the Commodity Exchange 

Act [7 U.S.C. 6m(1)] provides an exemption from 

CTA registration that parallels the exemption in 

section 203(b)(3) of the Advisers Act, and until 

recently, the CFTC looked through legal 

organizations to count owners for purposes of 

determining whether a person had provided 

commodity trading advice to more than 15 persons 

in the preceding 12 months. See Additional 

Registration and Other Regulatory Relief for 

Commodity Pool Operators and Commodity 

Trading Advisors, (Mar. 10, 2003) [68 FR 12622 

(Mar. 17, 2003)] (proposing new rule 4.14(a)(10) to 

treat legal organizations as single clients).

159See supra note 157.

160See H.R. Rep. No. 96–1341, at 62–63 (1980) 

(‘‘with respect to persons or firms which do not 

advise business development companies, [this 

amendment] is not intended to suggest that each 

shareholder, partner or beneficial owner of a 

company advised by such a person or firm should 

or should not be regarded as a client of that person 

or firm’’), and S.Rep. No. 96–958 at 41.

161Rule 203(b)(3)–1 Adopting Release, supra note 

10 (by providing a safe harbor, rule 203(b)(3)–1 will 

provide greater certainty regarding when advisers 

can rely on section 203(b)(3)). Commenters did not 

challenge our authority to withdraw the safe harbor 

of rule 203(b)(3)–1(a)(2)(i) with respect to private 

funds.

162 Definition of ‘‘Client’’ for Purposes Relating to 

Limited Partnerships, Investment Advisers Act 

Release No. 956 (Feb. 25, 1985) [50 FR 8740 (Mar. 

5, 1985)] (proposed rule [203(b)(3)–1] is intended to 

provide investment advisers to limited partnerships 

with greater certainty in determining the 

circumstances under which they may rely on 

section 203(b)(3)).

163 15 U.S.C. 80b–11(a). See also section 

202(a)(17) of the Act [15 U.S.C. 80(b)–2(a)(17)] 

(‘‘The Commission may by rules and regulations 

classify, for the purposes of any portion or portions 

of this title, persons, including employees 

controlled by an investment adviser.’’).

164 15 U.S.C. 80b–6(4). The Supreme Court has 

upheld, in a similar context, our broad authority to 

prohibit acts not themselves fraudulent in order to 

prevent fraudulent or manipulative conduct. See 

U.S. v. O’Hagan, 521 U.S. 642, 672–73 (1997).

165See section 204 of the Act [15 U.S.C. 80b–4] 

(inspection and examination authority).

166See infra Section II.E of this Release.

203(b)(3).158 The Act’s objectives would 

be substantially undermined if an 

adviser with more than fifteen clients 

could evade its registration obligation 

through the simple expedient of having 

those clients invest in a limited 

partnership or similar fund vehicle—

which the adviser would thereafter 

count as a single client. This concern is 

amplified where the adviser solicits 

investments directly in the fund vehicle 

based on the adviser’s investment 

management skills, and offers investors 

the ability to redeem their assets on a 

short-term basis, as they would be 

permitted to do if they opened an 

account directly with the adviser.

The legislative and regulatory history 

of the Advisers Act since its enactment 

in 1940 is consistent with the 

understanding that the statute in 

appropriate cases may require ‘‘looking 

through’’ the entity for purposes of 

counting clients. Congressional action 

involving section 203(b)(3), the 

Commission’s rulemaking under the 

provision, and staff no-action letters 159

evidence the longstanding recognition 

that the exemption does not require a 

rigid approach to counting clients 

without consideration of the 

surrounding circumstances.

First, the amendment to section 

203(b)(3) in 1980 confirmed that the 

exemption could be read to require an 

adviser to ‘‘look through’’ a legal entity 

and count its investors. In 1980, 

Congress amended the section to 

provide that, in the case of a business 

development company, ‘‘no 

shareholder, partner, or beneficial 

owner * * * shall be deemed to be a 

client of such investment adviser unless 

such person is a client of such 

investment adviser separate and apart 

from his status as a shareholder, partner 

or beneficial owner.’’ The language of 

this provision would have been 

superfluous absent a recognition that, in 

some cases, a shareholder, partner, or 

beneficial owner, could be counted for 

purposes of the exemption. Further, the 

legislative history indicates that 

Congress deliberately left open the 

question of how to count clients for 

entities other than business 

development companies.160

Second, the Commission’s creation of 

the existing safe harbor in current rule 

203(b)(3)–1 would have been entirely 

unnecessary if there had not been a 

substantial concern, at that time, that an 

adviser to a hedge fund might, in some 

cases, either be required to ‘‘look 

through’’ the fund for counting purposes 

or to view itself as having violated the 

‘‘holding out’’ limitation set out in the 

statutory exemption. 

When adopting the safe harbor in 

1985, we determined to resolve the 

uncertainty regarding when advisers to 

hedge funds must register by expressly 

exempting them from registration.161 At 

that time, when advisers to hedge funds 

played a far less significant role in the 

national markets than they do today, we 

did not consider it inconsistent with the 

legislative objectives embedded in the 

statutory exemption to exempt those 

advisers from registration. However, as 

we stated when we proposed the safe 

harbor, ‘‘a different approach could be 

followed in counting clients.’’ 162 In 

light of the developments regarding 

hedge funds and their advisers, we are 

now taking a different approach.

As discussed above, in the 

intervening two decades and 

particularly in recent years, much has 

changed in our capital markets. The 

growth of hedge funds, their market 

activity and their trading volume has 

been dramatic, and as a result they now 

have a substantial effect on national 

securities markets and on the national 

economy. This growth, together with the 

increase in fraud involving hedge fund 

advisers, fully justifies a reexamination 

of whether it is consistent with the Act 

to continue to provide an across-theboard registration exemption for all 

advisers to hedge funds. The 

amendments adopted by the 

Commission today recognize those 

changed circumstances and constitute 

an appropriate use of the Commission’s 

rulemaking authority under the Act. 

The Commission has broad 

rulemaking authority under section 

211(a) of the Act, which states that the 

Commission may adopt rules ‘‘necessary 

or appropriate to the exercise of the 

functions and powers conferred upon 

the Commission elsewhere in this title 

***’’ and ‘‘may classify persons and 

matters within its jurisdiction and 

prescribe different requirements for 

different classes of persons or 

matters.’’ 163 Section 206(4) of the Act 

provides us with authority to adopt 

rules ‘‘that define, and prescribe means 

reasonably designed to prevent such 

acts, practices, and courses of business 

as are fraudulent, deceptive or 

manipulative.’’ 164 Once these advisers 

are registered, the Commission will be 

able to carry out its regulatory function 

with respect to them, such as 

conducting inspections and 

examinations,165 and implementing 

other provisions, discussed elsewhere in 

this Release, to further investor 

protection.

The amendments we adopt today 

implement our rulemaking authority in 

a manner specifically targeted to those 

advisers whose activities involving 

‘‘private funds’’ most directly suggest 

the need for registration. As discussed 

in more detail below,166 first, a private 

fund will be one that is excepted from 

the definition of investment company 

under section 3(c)(1) or 3(c)(7) of the 

Investment Company Act of 1940. By 

definition, these funds engage in 

significant securities related activities in 

a context where they deal privately with 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72069

167See sections 3(a) and 3(b) of the Investment 

Company Act [15 U.S.C. 80a–3(a) and 80a–3(b)].

168Although rule 203(b)(3)–1(c) provides that an 

adviser will not be deemed to be holding itself out 

generally to the public as an investment adviser 

solely as a result of participating in a non-public 

offering of limited partnership interests, there may 

be circumstances where the marketing activities of 

a hedge fund adviser go beyond the scope of this 

safe harbor.

169See, e.g., Wilmer Cutler Letter, supra note 142. 

See also Comment Letter of Managed Funds 

Association (Oct. 12, 2004).

170See Hard Times Come To The Hedge Funds, 

supra note 13 at 10.

171The original version of section 203(b) in 1940 

also exempted from registration any adviser ‘‘whose 

only clients are investment companies.’’ Investment 

Advisers Act, Section 203(b), Pub. L. No. 76–768, 

54 Stat. 847, 850 (1940). This language does not, as 

some commenters have asserted, undermine the 

Commission’s interpretation of section 203(b)(3) 

with respect to counting the number of clients in 

a hedge fund. See, e.g., Wilmer Cutler Letter, supra

note 142. Even if Congress in 1940 clearly intended, 

with respect to investment companies, that a legal 

entity be the client, that does not mean that 

Congress must have intended the same result with 

respect to entities—such as hedge funds—that are 

not investment companies. Moreover, Congress may 

have included this provision because it believed 

that, absent an express exemption for investment 

companies, individual investors might be counted 

as clients, or may have simply concluded that 

advisers to entities subject to Title I of the statute 

they were considering (the Investment Company 

Act) would not be subject to Title II (the Advisers 

Act). Title I of the legislation established a new 

comprehensive scheme for the regulation of 

investment companies, and Congress may have 

determined that the investment advisory 

relationship between an adviser and an investment 

company would be governed by the new Investment 

Company Act. See 1940 Senate Hearings, supra

note 73, (statement of Senator Boren (‘‘there is a 

distinct separation of investment advisers under the 

two different sections of the bill’’)).

172Although commenters argue, citing certain 

dictionaries, that ‘‘client’’ has a plain meaning that 

cannot include passive investors in an entity who 

are not being advised individually, resort to 

dictionary definitions is inconclusive. See

Webster’s Unabridged Dictionary (2nd ed. 1934) 

(‘‘client’’ means ‘‘one who consults a legal adviser 

in order to obtain his professional advice or 

assistance, or submits his cause to his 

management’’ (emphasis added.)).

173Chevron U.S.A. v. NRDC, 467 U.S. 837, 843–

44 (1984). Because the Commission has the inherent 

authority to interpret the ambiguous language used 

in section 203(b)(3), the absence of a specific grant 

of authority in the Advisers Act to define terms 

(such as is found in the Investment Company Act 

and other securities statutes) does not limit the 

scope of our authority. Nor is our authority 

undermined by the fact that, as explained in the 

Proposing Release, we are changing our 

interpretation of the statutory exemption from 

registration created by section 203(b)(3), as it 

applies to hedge funds, in light of changed 

circumstances resulting from the growth of hedge 

funds. Courts have recognized that agencies have 

clear authority to change a prior position in light 

of changed circumstances. See, e.g., American 

Trucking Assns., Inc. v. Atchison, Topeka & Santa 

Fe Ry Co., supra note 59; United Video Inc. v. FCC,

890 F.2d 1173, 1181–82 (D.C. Cir. 1989).

174Some commenters assert that the method for 

counting clients of a private fund set forth in rule 

203(b)(3)–2 would be inconsistent with the 

Supreme Court’s view of the scope of the Advisers 

Act expressed in Lowe v. SEC, 472 U.S. 181 (1985). 

However, Lowe involved a different issue and a 

different statutory provision—the meaning of the 

exclusion from the definition of investment adviser 

in section 202(a)(11)(D) for ‘‘the publisher of any 

bona fide newspaper, news magazine or business of 

financial publication of general and regular 

circulation.’’ 15 U.S.C. 80b–2(11)(d).

175See supra note 158.

176 15 U.S.C. 80b–8d. Congress added section 

208(d) to the Advisers Act in 1960, Investment 

Advisers Act of 1940, Amendment, Pub. L. 86–750, 

54 Stat. 847 (1960).

177See, e.g., SEC v. Gary A Smith, 1995 Lexis 

22352 (S.D. Mich. 1995) (adviser persuaded client 

to place accounts in trusts to try to avoid Advisers 

Act regulation).

178See Status of Investment Advisory Programs 

Under the Investment Company Act of 1940,

Investment Company Act Release No. 22579 (Mar. 

24, 1997) [62 FR 15098 (Mar. 31, 1997)] (adopting 

rule providing safe harbor from investment 

company registration for similarly managed 

accounts).

179Similar factors led the Second Circuit to 

conclude that limited partners of an investment 

partnership were clients of the general partner/

investment adviser for purposes of section 206 of 

the Act. See Abrahamson v. Fleschner, supra note 

157, at 869–70.

180See, e.g., Roundtable Transcript of May 14 at 

171, supra note (statement of Robert Bernard, Chief 

Continued

each of their investors (since under 

sections 3(c)(1) and 3(c)(7) they may not 

engage in a public offering).167 Second, 

the term ‘‘private funds’’ is limited to 

investment pools with redemption 

features that offer investors a short-term 

right to withdraw their assets from 

management, based on their individual 

liquidity needs and other preferences, in 

a manner similar to clients that directly 

open an account with an adviser. This 

condition will ensure that the definition 

does not inadvertently include private 

equity funds, venture capital funds, or 

other funds that require long-term 

commitment of capital. Third, the term 

is limited to those funds that are 

marketed based on the skills, ability, 

and expertise of the adviser to the fund, 

thereby confirming the direct link 

between the adviser’s management 

services and the investors. These 

investors thus not only expect to 

receive, but are solicited explicitly on 

the basis of, the investment management 

ability of the adviser. Under the 

definition of private fund, an adviser 

will only need to look through for 

purposes of counting clients where 

some affirmative steps have been taken 

to make fifteen or more potential clients 

aware of the ability to obtain the 

adviser’s services through the fund 

vehicle.168 Based on this definition of 

private fund, we believe registration of 

these advisers will advance the 

objectives of the Advisers Act.

Some commenters argued that the 

Commission lacks authority because the 

new rule and rule amendments 

contradict the ‘‘unambiguous’’ intent of 

Congress expressed in section 

203(b)(3).169 However, as discussed 

above, the intent of Congress appears to 

have been to create a limited exemption 

for advisers whose activities were not 

national in scope and who provided 

advice to family members or friends. 

Further, since hedge funds did not exist 

until 1949,170 it is unclear whether 

Congress would have viewed a hedge 

fund or the hedge fund’s investors as the 

client.171 Moreover, the term ‘‘client’’ is 

not defined in the Act, nor does the 

word have one clear meaning.172 To the 

extent section 203 is unclear, the 

Commission has authority to interpret 

an exemption and to adopt a rule that 

is reasonably related to the statutory 

purpose.173 As we have explained 

above, rule 203(b)(3)–2 is such a rule.174

Although Congress in 1940 may not 

have anticipated the client counting 

questions that arose from the 

development of hedge funds and other 

pooled investment vehicles, by 1960 it 

clearly anticipated that, in certain cases, 

enforcement of the Act may require the 

Commission or courts to ‘‘look through’’

legal artifices to address the substance 

of a transaction or relationship.175

Section 208(d), added in 1960, made it 

unlawful for any person ‘‘to indirectly, 

through or by any other person to do 

any act or thing which it would be 

unlawful for such person to do directly 

under the provisions of this [Act], or 

any rule or regulation thereunder.’’ 176

Today, an adviser with, for example, 

15 clients and $100 million in assets 

under management can take those client 

assets, move them into a hedge fund it 

advises and, because the adviser now 

has but one client, withdraw its 

Advisers Act registration.177 If those 

clients’ assets had been managed 

similarly or identically (and today in 

many cases they are),178 nothing will 

have changed, except that the clients 

will have lost the protection of our 

oversight. Advisers to hedge funds 

market their services based on the skills, 

ability and expertise of the persons who 

will make the fund’s investment 

decisions. Thus, the clients will still 

rely exclusively on the efforts and skill 

of the investment adviser, and any new 

investors will be attracted to the hedge 

fund as a means to obtain the asset 

management services of the adviser. The 

clients will periodically receive reports 

from the adviser about the hedge fund, 

and their decisions whether or not to 

withdraw their assets from the fund will 

necessarily rely heavily on those 

reports.179

A hedge fund adviser may not treat all 

of its hedge fund investors the same. 

Some investors may have greater access 

to risk and portfolio information,180

72070 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

of Administration and Finance, RiskMetrics Group) 

(some investors have the market power to receive 

full portfolio position disclosure); id. at 177–78 

(statement of Robert Bernard). See also Roundtable 

Transcript of May 15 at 108–09, supra note 17, 

(statement of Patrick McCarty) (an investor with $25 

or $30 million in a fund will have more access than 

someone investing a small amount).

181Ron S. Geffner, Deals on the Side,

HEDGEFUNDMANAGER, (US East Coast 2005).

182See, e.g., Roundtable Transcript of May 14 at 

167, supra note (statement of David Swensen, Chief 

Investment Officer, Yale University) (Yale 

sometimes negotiates ‘‘deal structures’’ that differ 

from the terms set forth in the offering documents); 

id. at 211–12 (same).

183See id. at 68 (statement of Joel Press, Senior 

Partner, Ernst & Young). See also id. at 56 

(statement of Joel Press) (hedge funds may establish 

separate share classes by type of investor in order 

to track each investor’s return separately). We also 

note that on June 13, 2002, the Commission issued 

a Formal Order of Private Investigation in the 

matter of Investor Protection Implications of Private 

Investment Fund Growth. In the course of their 

investigation, our staff reviewed materials that 

appear to indicate that different investors in a hedge 

fund may have different investment experiences or 

may receive different disclosure. Under one limited 

partnership agreement, for example, limited 

partners can elect not to participate in the fund’s 

purchase of illiquid assets, which are kept apart 

from the majority of the fund’s assets. Under 

another limited partnership agreement, as much as 

20 percent of the fund’s yearly profits, including 

profits from ‘‘hot issue’’ accounts, could be 

reallocated to certain limited partners. Marketing 

material for a third hedge fund stated that investors 

investing over a certain amount in the fund are 

provided with additional information about the 

fund’s portfolio holdings.

184For convenience, we will use the terms 

‘‘adviser to a private fund’’ and ‘‘hedge fund 

adviser’’ interchangeably. As proposed, rule 

203(b)(3)–2 was titled ‘‘definition of client for 

certain private funds.’’ The rule is now titled 

‘‘methods for counting clients in certain private 

funds.’’ This change does not alter the substance of 

the rule but is meant to clarify the rule’s scope.

185As discussed in Section III of this Release, we 

are implementing a special transition period for the 

new rule so that advisers to private funds need not 

look back for the 12-month period when 

determining their registration obligations as of the 

compliance date of the new rule.

186Commenters asked us to provide further 

clarification on how hedge fund advisers should 

count investors when looking through private 

funds. Comment Letter of Tannenbaum Helpern 

Syracuse & Hirschtritt LLP (Sept. 14, 2004) 

(‘‘Tannenbaum Helpern Letter’’). If an adviser 

manages private funds that have, in the aggregate, 

more than 14 investors, it must register. Thus, an 

adviser to two private funds, each of which has 

eight investors, will need to register. Similarly, an 

adviser must register if it advises a private fund that 

has 10 investors, and also manages five other 

portfolios that are not private funds. For counting 

purposes, an adviser that is required to count the 

investors in a private fund need not also count the 

private fund itself.

187We remind advisers, however, that, 

independent of this new rule, the antifraud 

provisions of the Advisers Act apply to the 

adviser’s relationship with the fund’s limited 

partners. See Abrahamson v. Fleschner, supra note 

157.

188See section 203A(a)(1)(A) [15 U.S.C. 80b–

3a(a)(1)(A)]. The National Securities Markets 

Improvement Act of 1996 amended the Advisers 

Act to divide the responsibility for regulating 

investment advisers between the Commission and 

the state securities authorities. Section 203A of the 

Advisers Act [15 U.S.C. 80b–3a] effects this division 

by generally prohibiting investment advisers from 

registering with us unless they have at least $25 

million of assets under management or advise a 

registered investment company, and preempting 

most state regulatory requirements with respect to 

SEC-registered advisers. See Pub. L. 104–290, 110 

Stat. 3416 (1996) (codified in scattered sections of 

the United States Code).

189See Seward & Kissel Letter, supra note 111, 

Comment Letter of the European Commission (Sept. 

15, 2004) (‘‘European Commission Letter’’); 

Comment Letter of the Alternative Investment 

Management Association Limited (Sept. 15, 2004) 

(‘‘AIMA Letter’’); ABA Letter, supra note 150. 

Seward & Kissel suggested we apply a $100 million 

threshold to offshore advisers.

190Any adviser whose principal office and place 

of business is in a state that has enacted an 

investment adviser statute is subject to this 

statutory minimum. Any investment adviser whose 

principal office and place of business is outside the 

United States, or in Wyoming (the only U.S. state 

that does not have an adviser statute), is not subject 

to this minimum and must register with us 

regardless of the amount of assets it manages. See 

NSMIA Implementing Release, supra note 10 at 

Section II.E.

191 Instruction 5(b) to Part 1 of Form ADV [17 CFR 

279.1]

192Rule 203(b)(3)–2(a).

193 Id.

different lock-up periods may be 

provided,181 and some investors may be 

able to negotiate lower fees.182 ‘‘Side 

pockets,’’ in which assets are segregated, 

may operate to provide different 

investors with different investment 

experiences.183 Thus, today each 

account of a hedge fund investor may 

bear many of the characteristics of 

separate investment accounts, which, of 

course, must be counted as separate 

clients for purposes of section 203(b)(3). 

Our rule closes this loophole.

D. Rule 203(b)(3)–2

Rule 203(b)(3)–2 requires investment 

advisers to count each owner of a 

‘‘private fund’’ towards the threshold of 

14 clients for purposes of determining 

the availability of the private adviser 

exemption of section 203(b)(3) of the 

Act.184 As a result, an adviser to a 

‘‘private fund,’’ which is defined in rule 

203(b)(3)–1 and discussed below, can no 

longer rely on the private adviser 

exemption if the adviser, during the 

course of the preceding twelve months, 

has advised private funds that had more 

than fourteen investors.185 Furthermore, 

an adviser that advises individual 

clients directly must count those clients 

together with the investors in any 

private fund it advises in determining 

its total number of clients for purposes 

of section 203(b)(3).186 If the total 

number of individual clients and 

investors in private funds exceeds 

fourteen, the adviser is not eligible for 

the private adviser exemption and must 

register with us, assuming it meets our 

minimum requirements for assets under 

management.

The new rule is designed to amend 

the method of counting that hedge fund 

advisers use for purposes of applying 

the private adviser exemption. It is not 

intended to alter the duties or 

obligations owed by an investment 

adviser to its clients.187

1. Minimum Assets Under Management

Rule 203(b)(3)–2 does not alter the 

minimum amount of assets under 

management that an investment adviser 

generally must have in order to register 

with the Commission. A hedge fund 

adviser whose principal office and place 

of business is in the United States 

cannot (subject to certain exceptions) 

register with the Commission unless it 

manages at least $25 million.188 A hedge 

fund adviser whose principal office and 

place of business is outside the United 

States (an ‘‘offshore adviser’’) must 

register with the Commission if it has 

more than fourteen clients who are 

resident in the United States regardless 

of the amount of assets the adviser has 

under management. We are not applying 

the $25 million threshold to offshore 

advisers, as urged by some 

commenters,189 because that threshold 

is premised on regulation of the 

unregistered adviser by one or more 

states in which the adviser has its 

principal office and place of 

business.190

In determining the amount of assets it 

has under management, a hedge fund 

adviser whose principal office and place 

of business is in the United States must 

include the total value of securities 

portfolios in its assets under 

management. That is, it may not reduce 

the value of those assets by amounts 

borrowed to acquire them. An adviser 

may exclude proprietary assets invested 

in the fund, and need not include the 

value of assets attributable to non-U.S. 

investors.191

2. Counting ‘‘Owners’’

Rule 203(b)(3)–2 requires investment 

advisers to count each owner of a 

private fund towards the threshold of 

fourteen clients, that is, each 

shareholder, limited partner, member, 

or beneficiary of the private fund.192 In 

response to suggestions by several 

commenters we have revised the rule. 

First, we have added a provision 

clarifying that an adviser does not have 

to count itself as a client regardless of 

the form its ownership in the pool 

takes.193 Second, we permit a hedge 

fund adviser to exclude certain 

knowledgeable advisory personnel who 

are ‘‘qualified clients’’ (i.e., who are 

‘‘insiders’’) that may be charged a 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72071

194Rule 203(b)(3)–2(a). Rule 205–3(d)(1)(iii) 

under the Advisers Act permits certain 

knowledgeable personnel of an investment adviser 

to pay a performance or incentive fee to the adviser 

without meeting the net worth or invested assets 

requirements that would otherwise apply. 

Similarly, rule 3c–5 under the Investment Company 

Act [17 CFR 270.3c–5] provides that 

‘‘knowledgeable employees’’ of a private investment 

pool or of its adviser need not be counted in 

determining the number of beneficial owners of the 

pool (for 3(c)(1) pools) or in determining whether 

all investors in the pool are ‘‘qualified purchasers’’

(for 3(c)(7) pools). An adviser could not, however, 

make a private fund investor a partner in the 

advisory firm to avoid counting the investor for 

purposes of the private adviser exemption. See

section 208(d) of the Advisers Act.

195An adviser is permitted, but not required, to 

include the value of its family and proprietary 

securities portfolios in calculating its assets under 

management under Instruction 5.b(1)(a) to Part 1A 

of Form ADV. A hedge fund adviser may construe 

the investments of these inside personnel and their 

families as proprietary or family assets for purposes 

of calculating its assets under management. This 

does not, however, alter the fiduciary obligations of 

the adviser with respect to those accounts.

196The new rule does not require the adviser to 

the underlying fund to receive information as to the 

identities of the top tier investors, and does not 

specify when or how often the underlying hedge 

fund adviser must assess whether the number of 

investors in the top tier funds exceeds 14. The 

underlying adviser need not necessarily receive 

information as to the precise number of the top tier 

investors, so long as the underlying adviser can 

determine, on a periodic ongoing basis, its own 

registration obligations. Although some commenters 

expressed concern that advisers to funds of funds 

would face uncertainty as to their registration 

obligations, we believe it would be exceedingly rare 

for the top tier funds to have 14 or fewer investors. 

Most advisers to underlying hedge funds will not 

be eligible to rely on the private adviser exemption, 

absent facts and circumstances that provide 

assurances to the underlying adviser that no more 

than 14 investors, in the aggregate, are being served.

197Commenters suggested that the adviser to an 

underlying hedge fund be required to look through 

its top tier funds only under limited circumstances, 

such as when the top tier fund holds more than ten 

percent of the underlying fund. See, e.g., Comment 

Letter of Dechert LLP (Sept. 15, 2004) (‘‘Dechert 

Letter’’), Comment Letter of Davis Polk & Wardwell 

(Sept. 15, 2004) (‘‘Davis Polk Letter’’); ABA Letter, 

supra note 150. Such an approach would, however, 

permit hedge fund managers to avoid registration 

simply by providing their services to a multitude 

of investors through, for example, 12 funds of 

funds, each of which owned eight percent of the 

underlying fund.

198Whether an adviser is ‘‘offshore’’ depends on 

the location of the adviser’s principal office and 

place of business. See rule 203(b)(3)–1(b)(5).

199See, e.g., Financial Services Roundtable Letter, 

supra note 53; Tannenbaum Helpern Letter, supra

note 186. Some commenters raised concerns that 

regulation under the Advisers Act would conflict 

with regulations in offshore advisers’ home 

jurisdictions. See Financial Services Roundtable 

Letter, supra note 53. According to one law firm’s 

analysis, however, registration under the Advisers 

Act will have little impact on most non-U.S. hedge 

fund managers: ‘‘For unregistered non-U.S. 

investment managers, it is likely that the impact 

will be less significant because in most jurisdictions 

where hedge fund managers are concentrated, 

including, for example, London, Paris and Frankfurt 

and other European Union jurisdictions, 

management of third party assets is generally an 

activity which requires registration with local 

regulators and ongoing compliance with minimum 

operational standards, regardless of the number of 

‘‘clients’’ for whom these services are provided. It 

is likely therefore that most major non-U.S. hedge 

fund managers that will be affected by the SEC’s 

recommendations will already be complying in 

their home jurisdictions with broadly similar 

requirements to those the Staff now seeks to 

impose.’’ See Shearman & Sterling, SEC Report: 

Implications of the Growth of Hedge Funds, Jan. 

2004, available in File No. S7–30–04.

200So that our oversight of offshore advisers can 

be conducted effectively and efficiently in light of 

potential overlap with foreign regimes, we have 

asked our Division of Investment Management, our 

Office of Compliance Inspections and 

Examinations, and our Office of International 

Affairs to explore ways to obtain and share 

information with foreign authorities with oversight 

of hedge advisers that may register with the SEC.

201As discussed in Section II.F. of this Release, 

new rule 203(b)(3)–2 and rule 203(b)(3)–1 are 

designed to work together. Once the offshore 

adviser looks through the private fund as required 

under rule 203(b)(3)–2, rule 203(b)(3)–1(b)(5) 

provides that only U.S. clients must be counted 

towards the private adviser exemption. 

Commenters asked that, because rule 203(b)(3)–

1 speaks only to residents, we provide further 

guidance on when a client, particularly a client that 

is not a natural person, should be considered a U.S. 

client. Several commenters suggested that the 

Advisers Act should look to the definition of ‘‘U.S. 

person’’ in Regulation S under the Securities Act of 

1933. See 17 CFR 230.902. Regulation S is designed 

for use in transactions, not ongoing advisory 

relationships, and its use in this context raises 

larger issues that we cannot address in this 

rulemaking. Until the Commission reconsiders this 

question, however, we would not object if advisers 

looked (i) in the case of individuals to their 

residence, (ii) in the case of corporations and other 

business entities to their principal office and place 

of business, (iii) in the case of personal trusts and 

estates to the rules set out in Regulation S, and (iv) 

in the case of discretionary or non-discretionary 

accounts managed by another investment adviser to 

the location of the person for whose benefit the 

account is held.

performance fee.194 An adviser to a 

private fund may also exclude the value 

of these insiders’ interests in the private 

fund when calculating the firm’s assets 

under management for purposes of the 

$25 million registration threshold.195

3. Funds of Hedge Funds 

Under rule 203(b)(3)–2, a hedge fund 

adviser whose investors include a fund 

of funds that is itself a ‘‘private fund’’

must apply the general provisions of the 

new rule, which compel looking 

through that ‘‘top tier’’ private fund and 

counting its investors as clients for 

purposes of the private adviser 

exemption.196 If the fund of funds is a 

registered investment company, rule 

203(b)(3)–2(b) requires the adviser to an 

underlying private fund to look through 

the investment company and to count 

its investors as clients for purposes of 

the exemption. Without the lookthrough requirement, an adviser could 

provide its services through fourteen or 

fewer top tier funds and continue to 

indirectly manage the assets of 

hundreds or, in the case of registered 

funds of hedge funds, thousands of 

investors, without registering or being 

subject to the Commission’s 

oversight.197

4. Offshore Advisers 

Some commenters suggested that 

advisers located offshore 198 be 

exempted from regulation under the 

Advisers Act if they are subject to 

regulation in their home jurisdiction.199

The Commission has not chosen to take 

such an approach. The Commission’s 

primary concern when developing 

regulatory policy that has implications 

for foreign participants in our markets is 

to ensure that U.S. investors are 

protected and that there is a level 

playing field for all market participants. 

In this regard, a single set of rules 

provides greater transparency to 

investors, who can be confident that 

they will receive the same level of 

protection with respect to their 

investments regardless of the country of 

origin of their investment adviser. 

Similarly, a single set of rules assures a 

level playing field for both U.S. and 

foreign participants in our markets. Our 

approach to offshore advisers to offshore 

funds with U.S. investors, discussed 

below, represents an accommodation 

and not a fundamental change of policy 

in this regard.

Acceptance of home jurisdictional 

regulatory protections or ‘‘mutual 

recognition’’ may be a compelling 

alternative for participants in a common 

regulatory and statutory framework, 

such as the European Union. However, 

the absence of such a framework would 

require us to determine regulatory 

equivalence of hundreds of potential 

home jurisdictions. Such an effort 

would tax our resources. Moreover, 

regulatory systems that may be 

equivalent today may diverge in a 

matter of a few years, thus the 

evaluation would have to occur on an 

ongoing basis.200

a. Counting Clients of Offshore Advisers 

The final rules impose the same 

counting requirements on offshore 

advisers to hedge funds as offshore 

advisers providing advice directly to 

U.S. clients. Thus, for purposes of 

eligibility for the private adviser 

exemption, an offshore hedge fund 

adviser must look through each private 

fund it advises, whether or not those 

funds are also located offshore, and 

count each investor that is a U.S. 

resident as a client.201 An offshore 

adviser to any hedge fund that, in the 

course of the preceding twelve months, 

has more than fourteen investors (or 

other advisory clients) that are U.S. 

72072 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

202The offshore adviser would not have to 

register, however, if it were eligible for some other 

exemption from registration.

203Rule 203(b)(3)–1(b)(7). If, however, a non-U.S. 

investor transfers his interest to a U.S. investor, the 

adviser should count the transferee as a U.S. client.

204Comment Letter of International Bar 

Association (Sept. 14, 2004) (‘‘International Bar 

Letter’’), ABA Letter, supra note 150, AIMA Letter, 

supra note 189.

205Commenters pointed out that, because of 

provisions in the U.S. tax laws, U.S. investors in 

offshore hedge funds are likely to be tax-exempt 

investors such as pension and benefit plans subject 

to the Employee Retirement Income Security Act of 

1974 (‘‘ERISA’’) [29 U.S.C. 1001 et seq.]. Many 

hedge funds permit no more than 25 percent of the 

fund’s assets to be held by pension plans subject to 

ERISA in order to prevent the assets of the fund 

from being deemed ‘‘plan assets’’ under ERISA. See

29 CFR 2510.3–101 (Department of Labor regulation 

deems participation by plan investors of 25 percent 

or more in the unregistered securities of an entity 

to be significant which would then trigger certain 

ERISA limitations on the hedge fund). Accordingly, 

it may be unusual for these funds to have more than 

25 percent U.S. ownership.

206Rule 203(b)(3)–1(d)(3). Commenters supported 

this exception.

207Section 7(d) of the Investment Company Act 

[15 U.S.C. 80a–7(d)] generally prohibits a foreign 

investment company from publicly offering its 

securities in the United States unless registered 

with us. That provision does not preclude these 

foreign investment companies from making private 

offerings in the United States. Resale of Restricted 

Securities, Investment Company Act Release No. 

17452 (Apr. 23, 1990) [55 FR 17933 (Apr. 30, 

1990)]. See also Touche Remnant & Co., SEC Staff 

No-Action Letter (Aug. 27, 1984); Goodwin, Procter 

& Hoar, SEC Staff No-Action Letter (Feb. 28, 1997). 

Our staff has also provided no-action relief to 

address circumstances where U.S. persons are 

shareholders of foreign investment companies as a 

result of, for example, relocating to the United 

States. See, e.g., Investment Funds Institute of 

Canada, SEC Staff No-Action Letter (Mar. 4, 1996). 208This clarification responds to an issue raised 

by the European Commission. See European 

Commission Letter, supra note 189. Some 

commenters asked whether all funds listed on an 

offshore securities exchange were offshore public 

funds. See AIMA Letter, supra note 189; Coudert 

Letter, supra note 152. We note that listing criteria 

in some jurisdictions may be distinct from criteria 

for public offerings, and we cannot provide 

guidance in this area at this time. The European 

Commission also pointed out that some offshore 

public funds may be authorized for public sale in 

multiple countries pursuant to harmonized 

regulations, while others may be sold publicly only 

in individual countries. A fund would qualify for 

this exception so long as it is regulated as a public 

investment company in at least one of the 

jurisdictions in which it may be offered to the 

public. 209We are aware that, in some jurisdictions, 

hedge funds may be publicly offered. Such funds 

would not be public investment companies for 

purposes of this rule. Whether a particular fund is 

a public investment company will turn on, among 

other things, how it is known in those other 

jurisdictions. 210Rule 203(b)(3)–2(c). This provision applies in 

the case of an adviser whose principal office and 

place of business is outside the United States, if the 

fund is organized under the laws of a country other 

than the United States. The proposal looked instead 

to the principal office and place of business of the 

fund, but as one commenter noted, a fund as a 

passive vehicle typically has no offices. ABA Letter, 

supra note 150. 211This policy was first set forth in a staff letter 

from our Division of Investment Management, in 

which Division staff stated that they would not 

recommend to the Commission enforcement action 

against an offshore fund adviser under such 

circumstances. See Uniao de Banco de Brasileiros 

S.A., SEC Staff No-Action Letter (July 28, 1992) 

(‘‘Unibanco letter’’).

212 It has been estimated that 70 percent of hedge 

funds are organized offshore. See Bernstein 2003 

Report, supra note at 11.

213 It is not uncommon for U.S. investors to 

acquire interests in an offshore hedge fund that has 

few connections to the United States other than the 

investors (or the securities in which they invest). 

The laws governing such a fund would likely be 

those of the country in which it is organized or 

those of the country in which the adviser has its 

principal place of business. U.S. investors in such 

a fund generally would not have reasons to expect 

the full protection of the U.S. securities laws. See 

Offshore Offers and Sales, Securities Act Release 

No. 6863 (Apr. 24, 1990) [55 FR 18306 (May 2, 

1990)]. Moreover, as a practical matter, U.S. 

investors may be precluded from an investment 

opportunity in offshore funds if their participation 

resulted in the full application of the Advisers Act 

and our rules.

214 Dechert Letter, supra note 197, Comment 

Letter of White & Case LLP (Aug. 31, 2004) (‘‘White 

& Case Letter’’); Comment Letter of Jonathan Baird 

(Aug. 11, 2004) (‘‘Baird Letter’’); ICI Letter, supra

note 48; Tannenbaum Helpern Letter, supra note 

186, European Commission Letter, supra note 189, 

Davis Polk Letter, supra note 197, AIMA Letter, 

supra note 189; Comment Letter of the Association 

of the Bar of the City of New York Committee on 

Private Investment Funds (Sept. 15, 2004) (‘‘NYC 

Bar Private Funds Letter’’); ABA Letter, supra note 

150.

215One commenter asked whether we would 

view it as misleading for an offshore adviser to 

represent itself as registered with the Commission 

under the Advisers Act, given that it is not required 

under the rule to comply with many provisions of 

the Act with respect to its offshore clients. NYC Bar 

Private Funds Letter, supra note 214. We note that 

offshore advisers seeking no-action relief from our 

staff have undertaken not to represent themselves 

to offshore clients as registered with us. E.g., Royal 

Bank of Canada, SEC Staff No-Action Letter (June 

3, 1998). We are not, at this time, prohibiting 

offshore advisers from representing themselves as 

SEC-registered advisers, but we remind them that 

they remain subject to the Act’s antifraud 

provisions and that substantial clarification and 

disclosure may be necessary to make the 

representation not misleading.

216Our staff has provided guidance, in a series of 

no-action letters, regarding the recordkeeping 

obligations of registered advisers that are located 

offshore. Under that analysis, the registered adviser 

must, in order to rely on the no-action relief, 

comply with our recordkeeping rules, other than (1) 

rules 204–2(a)(3) and (7) with respect to 

transactions involving offshore clients that do not 

relate to advisory services performed by the 

registered adviser on behalf of United States clients 

or related securities transactions; and (2) rules 204–

2(a)(8), (9), (10), (11), (14), (15) and (16) and 204–

2(b) with respect to transactions involving, or 

representations or disclosures made to, offshore 

clients. See, e.g., Royal Bank of Canada, supra note 

215. In the context of rule 203(b)(3)–2, an offshore 

residents generally must register under 

the Advisers Act.202

At the suggestion of commenters, we 

are adopting a provision that allows an 

adviser to a private fund to determine 

whether an investor is a U.S. client or 

a non-U.S. client at the time of the 

investment in the private fund.203 If an 

investor is a non-U.S. client at the time 

of that investment, the adviser may 

continue to count the investor as a nonU.S. client even if the investor 

subsequently relocates to the United 

States.

Several commenters suggested that 

offshore advisers be required to look 

through their private funds only if more 

than 25 percent of the fund was held by 

U.S. investors.204 We believe that this 

suggestion would result in most offshore 

advisers that serve U.S. investors being 

exempt from registration, and we are not 

adopting it.205

b. Advisers to Offshore Publicly Offered 

Funds 

The final rule includes an exception 

to the definition of ‘‘private fund’’ for a 

company that has its principal office 

and place of business outside the United 

States, makes a public offering of its 

securities in a country outside the 

United States, and is regulated as a 

public investment company under the 

laws of the country other than the 

United States.206 Absent this provision, 

advisers to offshore publicly offered 

mutual funds or closed-end funds might 

be required to register with us simply 

because more than fourteen of their 

investors are now residents in the 

United States.207 The exception applies 

to any type of publicly offered fund, 

whether in corporate, trust, contractual 

or other form,208 so long as the fund is 

authorized for sale in the same 

jurisdiction in which it is regulated as 

a public investment company.209

c. Advisers to Offshore Privately Offered 

Funds 

Rule 203(b)(3)–2 limits the 

extraterritorial application of the 

Advisers Act that would otherwise 

occur as a result of the new rule, by 

providing that an offshore adviser to an 

offshore private fund may treat the fund 

(and not the investors) as its client for 

most purposes under the Act.210

Because we do not apply most of the 

substantive provisions of the Act to the 

non-U.S. clients of an offshore 

adviser,211 and because the offshore 

fund would be a non-U.S. client,212 the 

substantive provisions of the Act 

generally would not apply to the 

offshore adviser’s dealings with the 

offshore fund.213

Commenters supported this aspect of 

the rule, but also requested that we 

clarify how we would apply the 

Advisers Act to offshore advisers relying 

on it.214 The offshore adviser will be 

required (unless eligible for an 

exemption) to register under the Act 215

and to keep certain books and records 

as required by our rules,216 and will 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72073

adviser to an offshore private fund would treat the 

fund as its offshore client for purposes of its 

recordkeeping requirements.

217 During an examination, the registered offshore 

adviser must provide to our staff any and all records 

required to be kept under our rules as well as any 

records the adviser keeps under foreign law. Id.

Section 204 of the Act [15 U.S.C. 80b–4] authorizes 

us to examine all records of any registered adviser.

218 17 CFR 275.206(4)–7.

219 17 CFR 275.206(4)–2.

220 17 CFR 275.206(4)–6.

221 In addition, we would not require an offshore 

adviser to deliver a written disclosure brochure to 

its offshore clients (or to any investors in an 

offshore private fund it advises) under rule 204–3 

[17 CFR 275.204–3], although the adviser does have 

a fiduciary duty to provide those clients with full 

and fair disclosure of conflicts of interest. We 

would not require an offshore adviser’s contracts 

with its offshore clients, including an offshore 

private fund, to include certain provisions that 

would otherwise be required by section 205. 

Moreover, with respect to an offshore fund, an 

adviser, whether located within or without the 

United States, is not subject to the prohibition on 

performance fees contained in section 205; section 

205(b)(5) makes that prohibition inapplicable to an 

advisory contract with a person that is not a 

resident of the United States. [15 U.S.C. 80b–5]. 

Thus, a registered adviser can charge performance 

fees to an offshore fund regardless of whether the 

fund has U.S. investors. We would not apply 

section 206(3)’s restrictions to an offshore adviser’s 

principal transactions with offshore clients. [15 

U.S.C. 80b–6(3)]. We would also not subject an 

offshore adviser to our rules governing adviser 

advertising [17 CFR 275.206(4)–1], or cash 

solicitations [17 CFR 275.206(4)–3] with respect to 

offshore clients. 

A registered offshore adviser must, of course, 

comply with all of the Advisers Act and our rules 

with respect to any U.S. clients it may have.

222 17 CFR 275.204A–1.

223Our approach to defining the scope of rule 

203(b)(3)–2 is similar to that taken recently by the 

Department of Treasury in defining the scope of its 

proposed rule requiring ‘‘private investment 

companies’’ to adopt anti-money laundering 

programs. See Financial Crimes Enforcement 

Network; Anti-Money Laundering Programs for 

Unregistered Investment Companies, Department of 

the Treasury Release [67 FR 60617 (Sept. 26, 2002)]. 

Like the Treasury Department, we have tried to 

keep the definition simple, and provide a ‘‘bright 

line’’ indicator of when an adviser must look 

through a client that is a legal organization.

224Private equity funds concentrate their 

investments in unregistered (and typically illiquid) 

securities. They typically are long-term investments 

providing for liquidation at the end of a term 

specified in the fund’s governing documents. 

Private equity investors typically commit to invest 

a certain amount of money with the fund over the 

life of the fund, and make their contributions in 

response to ‘‘capital calls’’ from the fund’s general 

partner. Private equity funds offer little, if any, 

opportunity for investors to redeem their 

investments.

225 Venture capital funds are generally organized 

to invest in the start-up or early stages of a 

company. Venture capital funds have the same 

features that distinguish private equity funds 

generally from hedge funds, such as capital 

contributions over the life of the fund and the longterm nature of the investment. A venture capital 

fund typically seeks to liquidate its investment once 

the value of the company increases above the value 

of the investment. 

A few commenters suggested that the rule 

distinguish hedge funds from other privately 

offered investment pools on the basis of their 

investment strategies or portfolio composition. See, 

e.g., Madison Capital Letter, supra note 51. We have 

not adopted such an approach because we are 

concerned that it could serve to chill advisers’ use 

of certain investment strategies solely in order to 

avoid registration under the Advisers Act, and 

might possibly negatively affect the markets.

226Rule 203(b)(3)–1(d)(1)(i). Section 3(c)(1) 

excepts from the definition of investment company, 

an issuer the securities (other than short-term 

paper) of which are beneficially owned by not more 

than 100 persons and that is not making or 

proposing to make a public offering of its securities. 

An issuer that is organized in a country other than 

the United States is not subject to the 100-investor 

limitation of section 3(c)(1) with respect to its 

beneficial owners who are non-U.S. persons. 

Section 3(c)(7) excepts from the definition of 

investment company, an issuer the outstanding 

securities of which are owned exclusively by 

persons who, at the time of acquisition of such 

securities, are qualified purchasers and that is not 

making or proposing to make a public offering of 

its securities. An issuer that is organized in a 

country other than the United States is not subject 

to the qualified purchaser limitation of section 

3(c)(7) with respect to its owners who are non-U.S. 

persons. Under certain conditions, an issuer 

organized in a country other than the United States 

may make a private placement in the U.S. in 

accordance with Regulation D concurrently with an 

offering in another country in accordance with 

Regulation S under the Securities Act of 1933 

without integrating the two offerings for purposes 

of determining whether the issuer complies with 

section 3(c)(1) or 3(c)(7) or has made a public 

offering in contravention of section 7(d) of the 

Investment Company Act (prohibiting investment 

companies organized outside of the United States 

from making a public offering). Statement of the 

Commission Regarding Use of Internet Web Sites to 

Offer Securities, Solicit Securities Transactions or 

Advertise Investment Services Offshore, Securities 

Act Release No. 7516 (Mar. 23, 1998); See also 

Touche Remnant & Co., SEC Staff No-Action Letter 

(Aug. 27, 1984) and Goodwin, Proctor & Hoar, SEC 

Staff No-Action Letter (Feb. 28, 1997) (addressing 

public offerings for purposes of section 7(d)). Cf. 

Resale of Restricted Securities; Changes to Method 

of Determining Holding Period of Restricted 

Securities Under Rules 144 and 145, Securities Act 

Release No. 33–6862 (Apr. 30, 1990), at Section II.F. 

Our staff’s no-action letter, The France Growth 

Fund, Inc., SEC Staff No-Action Letter (July 15, 

2003), is superseded to the extent that it is 

inconsistent with this Release. 

An offshore hedge fund in which U.S. persons 

invest will ordinarily be a section 3(c)(1) or 3(c)(7) 

issuer because it makes a private offering (if any) 

in the U.S., and has 100 or fewer beneficial owners 

that are U.S. persons or requires all of its owners 

who are U.S. persons to be qualified purchasers, 

respectively.

227These companies, as opposed to other entities, 

by definition, engage in significant securities 

related activities. See sections 3(a) and 3(b) of the 

Investment Company Act. Moreover, 3(c)(1) and 

3(c)(7) funds invest in the context in which they 

deal privately with investors because both 

provisions require that the fund not engage in a 

public offering. 

Commenters asked whether the rule would 

require a U.S. adviser to look through an offshore 

pooled investment vehicle whose investors are all 

non-U.S. persons. If interests in the pool are offered 

only to non-U.S. investors, it is unlikely that the 

pool would be relying on the exceptions in either 

section 3(c)(1) or section 3(c)(7). If the pool does not 

rely on one of those exceptions, the pool is not a 

private fund under the rule, and thus only the pool 

itself would count as a single client. 

Many offshore hedge funds are organized as 

master-feeder structures in which an offshore 

adviser organizes a ‘‘master’’ fund interests in 

which are purchased by multiple ‘‘feeder funds.’’

The feeder funds seek to achieve their investment 

objectives solely by investing in the master fund 

and thus the feeder is a conduit that provides 

different investors access to the master fund. One 

feeder fund may be organized as a corporation and 

offered solely to non-U.S. investors, while another 

may be organized as a limited partnership in a 

foreign jurisdiction offering its shares exclusively to 

more than 14 U.S. investors. See Thomas P. Lemke 

et al, Hedge Funds and Other Private Funds: 

Regulation and Compliance (2004–05) at 19. The 

Continued

remain subject to examinations by our 

staff.217 Other requirements, including 

the Act’s compliance rule,218 custody 

rule,219 and proxy voting rule,220 would 

not apply to the registered offshore 

adviser, assuming it has no U.S. clients 

other than for counting purposes under 

the private adviser exemption.221 The 

registered offshore adviser without U.S. 

clients (other than for counting 

purposes) will not be required to adopt 

a code of ethics but must retain its 

access persons’ personal securities 

reports that would otherwise be 

required under such a code.222

E. Definition of ‘‘Private Fund’’

Because our concern is focused on 

hedge fund advisers and their oversight, 

we did not propose to require advisers 

to ‘‘look through’’ every business or 

other legal organization they advised for 

purposes of determining the availability 

of the ‘‘private adviser’’ exemption. Our 

proposal included a definition of 

‘‘private fund’’ in order to identify those 

legal organizations that advisers would 

be required to look through.223 We 

proposed to define a ‘‘private fund’’ by 

reference to three characteristics shared 

by virtually all hedge funds, and that 

differentiate hedge funds from other 

pooled investment vehicles such as 

private equity funds 224 or venture 

capital funds.225 In our amendments to 

rule 203(b)(3)–1, we are adopting the 

definition substantially as proposed, 

and we discuss each of the 

characteristics of a private fund below.

1. Section 3(c)(1) and 3(c)(7) 

First, a fund will not be a ‘‘private 

fund’’ unless it is a company that would 

be subject to regulation under the 

Investment Company Act but for the 

exception, from the definition of 

‘‘investment company,’’ provided in 

either section 3(c)(1) (a ‘‘3(c)(1) fund’’) 

or section 3(c)(7) (a ‘‘3(c)(7) fund’’) of 

such Act.226 Thus, advisers are not 

required to ‘‘look through’’ most clients 

that are business organizations, 

including insurance companies, brokerdealers, and banks, but are required to 

look through many types of pooled 

investment vehicles investing in 

securities, including hedge funds.227

72074 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

feeder fund is a private fund under rule 203(b)(3)–

1(d); interests in the feeder are sold directly to U.S. 

investors, and thus the feeder must rely on either 

section 3(c)(1) or 3(c)(7) to avoid being subject to 

the Investment Company Act. The adviser to the 

master fund must look through the master fund as 

well as the feeder in order to count U.S. investors 

as clients, so that it is not violating section 208(d) 

of the Act by doing indirectly through the master 

what it could not do if it provided its advice 

directly to the feeder fund. See discussion supra

note 176.

228Comment Letter of David Schroll (July 27, 

2004) (‘‘Schroll Letter’’); Proskauer Letter, supra

note 51; Comment Letter of Guy Judkowski (July 27, 

2004) (‘‘Judkowski Letter’’); Seward & Kissel Letter, 

supra note 111; Madison Capital Letter, supra note 

51; Tudor Letter, supra note 53; Davis Polk Letter, 

supra note 197; Financial Services Roundtable 

Letter, supra note 53; Comment Letter of Kleinberg, 

Kaplan, Wolff & Cohen, P.C. (Sept. 15, 2004) 

(‘‘Kleinberg Letter’’).

229See supra Section II.B.8 of this Release. 

Further, Congress chose to not to exempt 3(c)(7) 

fund advisers from the Advisers Act. An adviser 

that manages more than fourteen 3(c)(7) funds is 

required to register and is subject to all provisions 

of the Advisers Act, yet the investors in those funds 

are no less sophisticated than other 3(c)(7) fund 

investors. Also, Congress excepted 3(c)(7) fund 

advisers from performance fee restrictions under 

section 205 of the Act, which applies only to 

advisers who are not otherwise exempt from 

registration under section 203(b). See section 

205(b)(4) [15 U.S.C. 80b–5(b)(4)].

230Rule 203(b)(3)–1(d)(1)(ii). Two commenters 

suggested we shorten the period while another 

suggested it be longer. See AIMA Letter, supra note 

189; Seward & Kissel Letter, supra note 111; 

Comment Letter of UnFarallon Coalition (Sept. 14, 

2004) (‘‘UnFarallon Letter’’). Research has shown 

that hedge funds’ average lock-up period is 12 

months. Bernstein 2003 Report, supra note 24, at 5. 

We believe a two-year period, therefore, would 

include most hedge funds as private funds, and we 

are adopting a redemption test of two years as 

proposed.

231Funds could use a ‘‘first in, first out’’ for 

determining the age of purchases and capital 

contributions.

232Private funds operate in this respect similarly 

to an account an investor maintains with an 

adviser.

233Hedge funds generally offer semi-annual, 

quarterly, or monthly liquidity terms to their 

investors. Because liquidity is important to hedge 

fund investors, some hedge fund advisers offer 

certain investors ‘‘side letter agreements’’ to provide 

shorter liquidity terms than other investors in the 

same fund may receive. See Alexander M. Ineichen, 

Funds of Hedge Funds: Industry Overview, 4 J. 

Wealth Mgmt. 47 (Mar. 22, 2002); Ron S. Geffner, 

Deals on the Side, HEDGEFUNDMANAGER, U.S. 

East Coast 2005, at 22–23. An investment pool 

cannot use side letters to bypass the two-year 

redemption test. That is, if the pool uses side letters 

to provide some, but not all, investors the 

opportunity to redeem shares within two years, the 

pool would meet the definition of a private fund.

234This provision is also designed to prevent 

certain structured finance vehicles from being 

included as ‘‘private funds.’’ See, e.g., rule 3a–7(a) 

under the Investment Company Act [17 CFR 

270.3a–7(a)] (exemption from Investment Company 

Act is not available to structured finance vehicle 

issuing redeemable securities); see also Comment 

Letter of Chapman and Cutler LLP (Sept. 15, 2004) 

(expressing concerns that some structured finance 

vehicles would inappropriately be deemed to be 

private funds).

235See, e.g., SEC v. Jean Baptiste Jean Pierre, 

Gabriel Toks Pearse and Darius L. Lee, Litigation 

Release No. 17303 (Jan. 10, 2002) and supra note 

97; In the Matter of Michael T. Higgins, supra note 

99; SEC v. David M. Mobley, Sr., et al., supra note 

99; SEC v. Michael W. Berger, Manhattan Capital 

Management Inc., supra note 99; SEC v. Todd 

Hansen and Nicholas Lobue, Litigation Release No. 

17299 (Jan. 9, 2002).

236We are currently pursuing actions in which 

we allege hedge fund advisers lulled investors into 

keeping their assets in the hedge fund. See, e.g., 

SEC v Anthony P. Postiglione, Jr., et al., Litigation 

Release No. 18824 (Aug. 9, 2004).

237Moreover, periodic redemption rights offered 

by hedge funds provide the hedge fund investors 

with a level of liquidity that allows the investor to 

withdraw a portion of his or her assets, controlled 

by the adviser, or to terminate the relationship with 

the hedge fund adviser and choose a new adviser. 

The ability to terminate the relationship with an 

adviser and choose a new one, or to withdraw a 

portion of one’s investment after a relatively short 

time period, is consistent with the notion that 

hedge fund advisers are effectively providing 

advisory services to the fund’s investors. As a 

result, the redeemability feature of the definition of 

private fund will promote the purposes of the Act 

by applying the rule to those relationships that the 

Act was designed to address.

238E.g., NYC Bar Private Funds Letter, supra note 

214. Some commenters expressed concern that 

hedge fund advisers would extend their lock-up 

periods beyond two years in order to avoid 

registration. E.g., Comment Letter of the Greenwich 

Roundtable (Sept. 15, 2004). Others felt that the 

two-year test drew an appropriate line between 

hedge funds and private equity or venture capital 

funds. See Comment Letter of National Venture 

Capital Association (Sept. 15, 2004) (‘‘NVCA 

Letter’’) (‘‘As a practical means of exempting 

venture capital from the proposed rule’s definition 

of ‘private fund,’ two years is appropriate.’’). We 

will continue to monitor developments regarding 

this aspect of the new rule and whether it continues 

effectively to distinguish hedge funds from private 

equity and venture capital funds.

239Rule 203(b)(3)–1(d)(2)(i).

240See Davis Polk Letter, supra note 214, NYC 

Bar Private Funds Letter, supra note 150, ABA 

Letter, supra note 150. Many partnership 

agreements provide the investor the opportunity to 

redeem part or all of its investment, for example, 

in the event continuing to hold the investment 

became impractical or illegal, in the event of an 

owner’s death or total disability, in the event key 

personnel at the fund adviser die, become 

incapacitated, or cease to be involved in the 

management of the fund for an extended period of 

time, in the event of a merger or reorganization of 

the fund, or in order to avoid a materially adverse 

tax or regulatory outcome. Similarly, some 

investment pools may offer redemption rights that 

can be exercised only in order to keep the pool’s 

assets from being considered ‘‘plan assets’’ under 

ERISA. Offering redemption rights that apply only 

in these types of circumstances will not make the 

fund a ‘‘private fund’’ under the new rule.

Several commenters suggested that 

the definition of private fund exclude 

3(c)(7) funds because investors in a 

3(c)(7) fund must all be qualified 

purchasers and can be presumed to have 

a certain level of financial 

sophistication.228 We have considered 

these comments but believe such an 

exclusion would not be consistent with 

the purpose and scope of the private 

adviser exemption. As we discussed 

above, the Advisers Act does not 

exempt from registration advisers whose 

clients are all financially sophisticated, 

and indeed a client’s decision to engage 

a professional adviser acknowledges 

that the client needs an expert’s 

assistance.229

2. Redemption Within Two Years 

Second, a company will be a private 

fund only if it permits investors to 

redeem their interests in the fund 

within two years of purchasing them.230

The provision applies to each interest 

purchased or amount of capital 

contributed to the fund.231 Hedge funds 

typically offer their investors liquidity 

access 232 following an initial ‘‘lock-up’’

period, which is typically for less than 

two years.233 Thus, this provision will 

include most hedge fund advisers, but 

will exclude advisers that manage only 

private equity funds, venture capital 

funds, and similar funds that require 

investors to make long-term 

commitments of capital.234 These other 

funds are similar to hedge funds in 

some respects, but the Commission has 

not encountered significant enforcement 

problems with advisers with respect to 

their management of private equity or 

venture capital funds. In contrast, the 

Commission has developed a substantial 

record of frauds associated with hedge 

funds. A key element of hedge fund 

advisers’ fraud in most of our recent 

enforcement cases has been the 

advisers’ misrepresentation of their 

funds’ performance to current 

investors,235 which in some cases was 

used to induce a false sense of security 

for investors when they might otherwise 

have exercised their redemption 

rights.236 Because hedge funds are 

where we have seen a recent growth in 

fraud enforcement actions, we will 

focus our examination resources on 

their advisers, rather than on advisers to 

private equity or venture capital funds, 

at this time.237 Most commenters who 

spoke to the issue supported drawing 

this distinction between hedge funds, 

on the one hand, and private equity and 

venture capital funds, on the other.238

The rule permits a fund to offer 

redemption rights under extraordinary 

circumstances without being considered 

a private fund under the rule.239 Private 

equity and venture capital funds may 

offer redemption rights under 

extraordinary circumstances, and these 

extraordinary redemptions do not 

change the basic character of the 

investment pool into a hedge fund. We 

are omitting the proposed requirement 

that such circumstances be 

‘‘unforeseeable.’’ Commenters suggested 

that to the extent an investor negotiated 

for the right to redeem its interest in 

extraordinary circumstances, the 

circumstances could be viewed as 

‘‘foreseeable.’’ 240 The redemption test 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72075

241These are distributions, as distinguished from 

redemptions initiated by the investor. Similarly, an 

investor’s transfer of his interest to, for example, a 

new limited partner in a secondary market 

transaction will not be considered a redemption.

242Proposed rule 203(b)(3)–1(d)(2)(ii). Though we 

proposed this exception only for interests acquired 

with reinvested dividends, commenters noted that 

venture capital and private equity funds are more 

likely to distribute capital gains than declare 

dividends.

243 If interests in an investment pool are offered 

based on the investment advisory skills, ability or 

expertise of the pool’s investment adviser, then the 

pool is a private fund and all advisers to the pool, 

including subadvisers, must look through it to 

count owners as clients for purposes of the private 

adviser exemption. Advisers may not circumvent 

the rule by delegating the advisory function to 

subadvisers, including subadvisers that might not 

be identified in the fund’s offering materials, or by 

establishing a ‘‘manager of managers’’ structure.

244See also Roundtable Transcript of May 14 at 

167–68, supra note 17 (statement of David 

Swensen, Chief Investment Officer, Yale University) 

(investor looks for ‘‘the character, the intelligence, 

the integrity, the creativity, and market savvy’’ of 

the fund adviser, and the most important criterion 

when making an investment decision is the 

character and quality of the investment adviser).

245This is particularly true when this attribute is 

combined with the redeemability feature discussed 

earlier, such that an investment in a hedge fund 

more closely resembles an advisory account. It is 

also worth noting in this regard that section 

203(b)(3) of the Advisers Act [15 U.S.C. 80b–3(b)(3)] 

specifically excludes an adviser from relying on the 

exemption, even if it has fewer than 15 clients, if 

it holds itself out generally to the public as an 

investment adviser.

246Rule 203(b)(3)–1(b)(6). We are also adopting, 

as proposed, non-substantive changes to the 

wording of several other paragraphs of rule 

203(b)(3)–1 to clarify those sections. 247Rule 203(b)(3)–1(a)(2)(i). 248For example, particularly paragraph (a)(1) of 

rule 203(b)(3)–1 allows a ‘‘single client’’ to 

encompass (i) a natural person, (ii) his or her minor 

children, (iii) his or her relatives, spouse, and 

relatives of spouse who share the same principal 

residence, as well as (iv) any accounts or trusts of 

which the only primary beneficiaries are the 

foregoing persons. In addition, if a given individual 

invests in two private funds advised by the same 

adviser, that individual need be counted only once 

towards the 14-client threshold.

249Several commenters suggested that new rule 

203(b)(3)–2 contain a special provision for limited 

partnerships owned or controlled primarily by 

members of a single family. See Comment Letter of 

Paul, Hastings, Janofsky & Walker LLP (Sept. 10, 

2004) (‘‘Paul Hastings Letter’’); Comment Letter of 

Skadden, Arps (Sept. 14, 2004) (‘‘Skadden Letter’’), 

Kynikos Letter, supra note 80, ABA Letter, supra

note 150. Others suggested we adopt a provision 

declaring that interests in family limited 

partnerships are not offered based on the expertise 

of the adviser. See Davis Polk Letter, supra note 

197, Comment Letter of William S. McGinness, Jr. 

(July 26, 2004). This latter suggestion may be true 

in some circumstances, but there may be other cases 

in which, for example, a family group has engaged 

an outside adviser and interests in the family 

vehicle are offered to family members based on the 

expertise of the adviser. We believe that rule 

203(b)(3)–1(a)(1) already affords family office 

advisers considerable flexibility before they reach 

fifteen clients. We also note that we have granted 

exemptive relief, on application, to a number of 

family office advisers. E.g., Bear Creek Inc., 

Investment Advisers Act Release No. 1931 (Mar. 9, 

2001) [66 FR 15150 (Mar. 15, 2001)] (notice); 

Moreland Management Co., Investment Advisers 

Act Release No. 1700 (Feb. 12, 1998) [63 FR 8710 

(Feb. 20, 1998)] (notice). A further exception for 

family limited partnerships is outside the scope of 

this rulemaking.

250An adviser to a hedge fund underlying a fund 

of funds must, as discussed earlier, apply new rule 

203(b)(3)–2 to look through the top tier fund and 

count that fund’s investors as clients for purposes 

of the private adviser exemption. Once the 

underlying adviser has looked through the layers of 

private funds, however, it may then apply the 

provisions of rule 203(b)(3)–1(a)(1) to those 

investors for counting purposes.

251Under rule 204–2(a)(16), a registered 

investment adviser that makes claims concerning its 

performance track record must keep ‘‘[a]ll accounts, 

books, internal working papers, and any other 

records or documents that are necessary to form the 

basis for or demonstrate the calculation of the 

performance or rate of return of any or all managed 

accounts or securities recommendations in any 

notice, circular, advertisement, newspaper article, 

investment letter, bulletin or other communication 

that the investment adviser circulates or distributes, 

directly or indirectly, to 10 or more persons (other 

than persons connected with such investment 

adviser); provided, however, that, with respect to 

the performance of managed accounts, the retention 

of all account statements, if they reflect all debits, 

credits, and other transactions in a client’s account 

for the period of the statement, and all worksheets 

necessary to demonstrate the calculation of the 

performance or rate of return of all managed 

accounts shall be deemed to satisfy the 

requirements of this paragraph.’’ The supporting 

records must be retained for a period of five years 

after the performance information is last used. Rule 

204–2(e)(3). Thus, if a registered adviser promotes 

its 20-year performance record in 2004, it must 

continue to keep its supporting records for its 1984 

performance through 2009—five years after the last 

time that 1984 performance is included.

252Rule 204–2(e)(3)(ii). Commenters pointed out 

that hedge fund advisers may manage other clients’

assets.

253Commenters generally supported this 

transitional exemption for hedge fund advisers’ past 

performance records, in order to avoid placing these 

new registrants at a competitive disadvantage in 

promoting the returns they have earned, in some 

cases over many years. See Comment Letter of 

Cumberland Associates LLC (Sept. 9, 2004) 

(‘‘Cumberland Letter’’), Comment Letter of James E. 

Mitchell (Sept. 1, 2004) (‘‘Mitchell Letter’’), ICAA 

Letter, supra note 47, Davis Polk Letter, supra note 

197; ABA Letter, supra note 150. Three commenters 

suggested that we require hedge fund advisers to 

place a legend on any marketing materials that 

contained performance claims for which the adviser 

did not maintain all required records. CFA Institute 

Letter, supra note 47; ICAA Letter, supra note 47, 

Continued

also does not restrict the general partner 

or investment adviser from initiating 

distributions payable to all owners, or a 

class of owners, in accordance with the 

fund’s governing documents.241 The 

rule also provides an exception to the 

two-year redemption test for interests 

acquired through reinvestment of 

distributed capital gains or income.242

3. Advisory Skills, Ability, or Expertise 

Third, a company will be a private 

fund only if interests in it are offered 

based on the investment advisory skills, 

ability or expertise of the investment 

adviser.243 As we discussed in the 

Proposing Release, a hedge fund 

adviser’s history, experience, past 

performance, strategies, and 

disciplinary record are likely important 

to investors, who rely on the adviser for 

their investment’s success, in deciding 

whether to invest in a particular hedge 

fund.244 Accordingly, hedge fund 

advisers often emphasize the portfolio 

manager’s record when marketing their 

fund, and provide prospective investors 

with information about the adviser and 

individual manager. This reliance by 

hedge fund investors implicates the 

need for the protections that Advisers 

Act registration offers.245

F. Other Amendments to Rule 203(b)(3)–

1

We are amending rule 203(b)(3)–1 to 

clarify that investment advisers may not 

count hedge funds as single clients 

under that safe harbor.246 As discussed 

earlier, many hedge fund advisers have 

avoided Advisers Act registration in the 

past by relying on paragraph (a)(2)(i) of 

this rule, which we adopted in 1985 in 

order to permit advisers to count a legal 

organization, rather than its owners, as 

a single client.247 Advisers to private 

funds may, however, continue to rely on 

the other paragraphs of rule 203(b)(3)–

1 when determining the number of their 

clients for purposes of the private client 

exemption.248 We have designed new 

rule 203(b)(3)–2 to be used in 

conjunction with rule 203(b)(3)–1.249

The adviser to a private fund must, 

under rule 203(b)(3)–2, look through the 

fund to its investors, but may rely on the 

safe harbor of rule 203(b)(3)–1 to 

determine whether each investor must 

count as a separate client or whether a 

‘‘single client’’ may include more than 

one investor.250

G. Amendments to Rule 204–2

We are adopting two amendments to 

the adviser recordkeeping rule. The first 

of these amendments permits hedge 

fund advisers that are required to 

register with us under new rule 

203(b)(3)–2 to market their performance 

from periods prior to their registration 

with us, even if they have not kept 

documentation that our rules would 

otherwise require.251 This exception 

applies not only to the adviser’s private 

funds (as proposed), but also to other 

accounts.252 Hedge fund advisers are 

required to retain whatever records they 

do have that support the performance 

they earned prior to their registration 

with us, but are excused from our 

recordkeeping rule to the extent that 

those records are incomplete or 

otherwise do not meet the requirements 

of rule 204–2.253

72076 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

UnFarallon Letter, supra note 230. The final rule 

does not impose such a requirement, but we caution 

hedge fund advisers that they remain, as they were 

prior to their registration, subject to the Advisers 

Act’s antifraud provisions with respect to their 

marketing materials. One commenter opposed the 

exemption.

254Rule 204–2(e)(3)(ii).

255Section 204 of the Act [15 U.S.C. 80b–4] 

generally subjects records of registered investment 

advisers to examination by the Commission.

256We include private funds for which the 

adviser’s related person (as defined in Form ADV) 

acts as general partner, managing member, or in a 

similar capacity, because many hedge fund advisers 

establish a separate special purpose vehicle to be 

named as the fund’s general partner.

257Rule 204–2(l). One commenter described this 

amendment as a ‘‘necessary requirement.’’ CFA 

Institute Letter, supra note 47. The rule does not 

require that the adviser maintain duplicate books 

and records for the funds, nor that a registered 

private fund adviser be the party to keep the books 

and records of the private funds in question. 

Because the private funds’ records will be deemed 

to be records of the adviser, however, our 

examination staff will have access to them when 

they examine the adviser.

258The rule applies to related person general 

partners only when the adviser has an advisory 

relationship with the fund in question. It does not, 

as one commenter was concerned, apply to every 

related general partnership in a large financial 

complex.

259Rule 205–3 permits registered advisers to 

charge performance fees that would otherwise be 

prohibited by section 205(a) [15 U.S.C. 80b–5(a)]. 

Registered advisers are not prohibited from 

charging performance fees to 3(c)(7) funds, 

investors in which must all be ‘‘qualified 

purchasers.’’ Section 205(b)(4) [15 U.S.C. 80b–

5(b)(4)].

260Rule 205–3(a). The adviser to a 3(c)(1) fund 

must look through the fund to determine whether 

all investors are qualified clients. See rule 205–3(b). 

A ‘‘qualified client’’ under rule 205–3 is: (i) A 

natural person who or a company that immediately 

after entering into the contract has at least $750,000 

under the management of the investment adviser; 

(ii) A natural person who or a company that the 

investment adviser entering into the contract (and 

any person acting on his behalf) reasonably 

believes, immediately prior to entering into the 

contract, either: (A) Has a net worth (together, in the 

case of a natural person, with assets held jointly 

with a spouse) of more than $1,500,000 at the time 

the contract is entered into; or (B) Is a qualified 

purchaser as defined in section 2(a)(51)(A) of the 

Investment Company Act of 1940 [15 U.S.C. 80a–

2(a)(51)(A)] at the time the contract is entered into; 

or (iii) A natural person who immediately prior to 

entering into the contract is: (A) An executive 

officer, director, trustee, general partner, or person 

serving in a similar capacity, of the investment 

adviser; or (B) An employee of the investment 

adviser (other than an employee performing solely 

clerical, secretarial or administrative functions with 

regard to the investment adviser) who, in 

connection with his or her regular functions or 

duties, participates in the investment activities of 

such investment adviser, provided that such 

employee has been performing such functions and 

duties for or on behalf of the investment adviser, 

or substantially similar functions or duties for or on 

behalf of another company for at least 12 months. 

Rule 205–3(d)(1).

261 In the absence of relief, the newly-registered 

adviser would have to either force the non-qualified 

client out of the 3(c)(1) fund or restructure its fee 

so that the non-qualified client is not paying the 

performance-based component of the fee.

262Proposed rule 205–(3)(c)(2) (grandfathering 

investors in ‘‘private funds’’).

263NYC Bar Private Funds Letter, supra note 214.

264One hedge fund adviser suggested that we also 

allow grandfathered investors to open new accounts 

in the hedge fund in which they were invested, and 

two other commenters suggested we also allow 

grandfathered investors to invest in new funds 

advised by the same hedge fund adviser. Davis Polk 

Letter, supra note 197, ABA Letter, supra note 150. 

These suggestions go significantly beyond our 

oxbjective in proposing the grandfathering 

provision, which was to avoid disrupting existing 

business arrangements.

265An adviser acting as general partner to a 

pooled investment vehicle it manages, including a 

hedge fund, has custody of the pool’s assets. Rule 

206(4)–2(c)(1)(iii). The adviser may satisfy its 

obligation to deliver custody account information to 

investors by distributing the pool’s audited 

financial statements to investors. Rule 206(4)–

2(b)(3). The current rule gives advisers 120 days 

from the pool’s fiscal year-end to distribute the 

financial statements. Id.

266A ‘‘fund of funds’’ under the amended rule is 

any limited partnership (or limited liability 

company or other type of pooled investment 

vehicle) that invests at least 10 percent of its total 

assets in other pooled investment vehicles that are 

not related persons of the fund of funds, or related 

persons of the adviser or general partner of the fund 

of funds. Rule 206(4)–2(c)(4). Where the underlying 

funds are related to the fund of funds, the fund of 

funds should have ample opportunity to coordinate 

its audit with that of the underlying funds.

267 Dechert Letter, supra note 197; Renaissance, 

Alternative Investment Group Letter, supra note 47; 

Comment Letter of Stroock/Credit Suisse Union 

Bancaire (Sept. 2, 2004) (‘‘Stroock Letter’’); Katten 

Muchin Letter, supra note 127; Van Hedge Letter, 

supra note 45; Coudert Letter, supra note 152; 

Comment Letter of Price Meadows (Sept. 15, 2004) 

(‘‘Price Meadows Letter’’); Comment Letter of Silver 

Creek (Sept. 15, 2004) (‘‘Silver Creek Letter’’).

As proposed, the exemption would 

have covered only the records 

supporting the performance of the 

adviser’s private funds. Commenters 

pointed out that a hedge fund adviser 

may also manage other pools, such as 

private equity funds. The amendment as 

we are adopting it applies to records 

supporting any accounts managed by 

the hedge fund adviser.254

Our second amendment to the 

recordkeeping rule clarifies that, for 

purposes of section 204 of the Advisers 

Act,255 the books and records of a 

registered hedge fund adviser include 

records of the private funds for which 

the adviser acts as investment adviser 

and the adviser or a related person 256

acts as general partner, managing 

member, or in a similar capacity.257 Our 

examiners require access to these 

records to determine whether a hedge 

fund adviser is meeting its fiduciary 

obligations to a private fund under the 

Advisers Act and rules.258

H. Amendments to Rule 205–3

We are adding grandfathering 

provisions to rule 205–3 under the 

Advisers Act, the performance fee rule, 

to avoid disrupting existing 

arrangements between newly-registered 

hedge fund advisers and their current 

pool investors or separate account 

clients.259 Most hedge fund advisers 

charge a ‘‘performance fee’’ based on 

their fund’s capital gains or 

appreciation. Our rules, however, 

permit registered investment advisers to 

charge performance fees only to 

‘‘qualified clients.’’ 260 Unregistered 

hedge fund advisers have not 

necessarily required all of their 

investors to meet this standard.261 We 

proposed (and commenters supported) 

an amendment to rule 205–3 

grandfathering the existing equity 

accounts of hedge fund investors, and 

allowing these investors to add to their 

accounts.262 Commenters noted, 

however, that our proposal would 

disrupt performance fee agreements 

with other types of investment pools or 

separate accounts sometimes managed 

by hedge fund advisers.263 We have 

revised the coverage of the amendment 

to permit existing owners in any 3(c)(1) 

fund to retain their investment and to 

add to it,264 and to permit the newlyregistered advisers to continue in effect 

advisory contracts they may have with 

other clients that are not 3(c)(1) funds.

I. Amendments to Rule 206(4)–2

We are amending rule 206(4)–2, the 

adviser custody rule, to allow additional 

time for completion of audit work on 

behalf of advisers to funds of hedge 

funds that choose to distribute audited 

fund financial statements to investors 

under the custody rule.265 The 

amendments extend from 120 to 180 

days the time within which an adviser 

to a fund of funds may distribute the 

fund’s audited financial statements. 

Some advisers to funds of funds are not 

able to comply with the current 120-day 

deadline because they cannot obtain 

completion of their fund audits prior to 

completion of the audits for the 

underlying funds in which they invest. 

To be eligible for the extended deadline, 

a fund of funds must invest at least ten 

percent of it assets in other, unrelated, 

pooled investment vehicles.266

Commenters strongly supported the 

amendment, but persuaded us that our 

proposal to extend the period for all 

pooled investment vehicles (instead of 

just funds of funds) would lead to the 

underlying funds taking advantage of 

the extension themselves, leaving funds 

of funds in no better position to comply 

than they were previously.267

J. Amendments to Rule 222–2 and Rule 

203A–3

This rulemaking is designed to alter 

the method of counting clients that 

hedge fund advisers use for purposes of 

determining their registration 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72077

268The ABA Letter, supra note 150, and NYC Bar 

Private Funds Letter, supra note 214, both raised 

this specific concern. Section 222(d) of the Advisers 

Act [15 U.S.C. 80b–18a(d)] provides that a state may 

not require an adviser to register with its state 

securities authority unless the adviser has a place 

of business located within the state or has had, 

during the preceding 12-month period, at least 6 

clients who are residents of that state. Rule 222–2 

[17 CFR 275.222–2] provides that an adviser may 

rely on rule 203(b)(3)–1 when counting clients for 

purposes of the de minimis standard.

269 17 CFR 275.203a–3. See NYC Bar Private 

Funds Letter, supra note 214.

270The amendment makes new rule 203(b)(3)–

1(a)(6) inapplicable in the context of rules 203A–

3 and 222–2. Because new rule 203(b)(3)–1(a)(6) 

does not apply, advisers are free to look to rule 

203(b)(3)–1(a)(2)(i) with respect to private funds.

271CFA Institute Letter, supra note 47. Because 

advisers’ responses to Form ADV are made 

available to the investing public on the Internet 

through the Investment Adviser Public Disclosure 

system, one commenter asked that we confirm that 

hedge fund advisers would not be disqualified from 

relying on section 4(2) of the Securities Act of 1933 

[15 U.S.C. 77d(2)] or on rule 506 [17 CFR 230.506] 

thereunder, both of which are unavailable in the 

event of a public offering, solely as a result of the 

private fund being identified through the IAPD. See

ABA letter, supra note 150. The mere identification 

of a private fund through the IAPD does not render 

section 4(2) or rule 506 unavailable. We note that 

Form ADV already calls for registered advisers to 

identify the private investment pools they manage; 

this information appears on the IAPD for the 

estimated 40 to 50 percent of hedge fund advisers 

that are already registered with us.

272Commenters expressing a view on the 

compliance period generally suggested hedge fund 

advisers would require one year to begin complying 

as registered advisers under the Advisers Act and 

its rules. Dechert Letter, supra note 197, Seward & 

Kissel Letter, supra note 111, Davis Polk Letter, 

supra note 197, AIMA Letter, supra note 189, 

Coudert Letter, supra note 152; NYC Bar Private 

Funds Letter, supra note 214, NYC Bar Futures 

Committee Letter, supra note 127, ABA Letter, 

supra note 150.

273The private adviser exemption requires that 

the adviser count all persons who have been clients 

at any time during the preceding 12 months. At the 

suggestion of a commenter, we will apply the new 

counting rule only prospectively, without regard to 

this ‘‘look back’’ provision for the period leading up 

to the compliance date. Coudert Letter, supra note 

152.

274Under the Advisers Act and our rules, 

registered investment advisers must, for example, 

have policies in place to ensure compliance with 

the Act and its rules (rule 206(4)–7), including 

policies to prevent misuse of material nonpublic 

information (section 204A [15 U.S.C. 80b–4a]) and 

policies to ensure that (if they vote client securities) 

client securities are voted in the best interest of the 

client (rule 206(4)–6). Registered advisers must also 

have in place a code of ethics applicable to their 

supervised persons, which code must require access 

persons to submit reports of personal securities 

transactions and holdings (rule 204A–1). We 

understand that, in many advisory firms, access 

persons use their year-end brokerage statements to 

compile their securities holding reports; 

accordingly, we have set the compliance date for 

the new rules so as to allow sufficient time for 

hedge fund advisers’ access persons to receive their 

brokerage statements for the period ended 

December 31, 2005 and to submit their securities 

holdings reports before the compliance date. For 

this reason, we are hereby extending the 

compliance date for rule 204A–1 from January 7, 

2005 to February 1, 2005. See Investment Adviser 

Codes of Ethics, Investment Advisers Act Release 

No. 2256 (July 2, 2004) [69 FR 41695 (July 9, 2004)] 

at Section III.

275Rule 206(4)–7. Several commenters seemed to 

believe our rule would require them to hire a new 

executive to serve as chief compliance officer. As 

we have explained previously, the rule does not 

require an adviser to hire new staff, only to 

designate the person within the firm that is 

primarily responsible for compliance.

276Rule 206(4)–2.

277Section 205(a)(1) and rule 205–3.

278Rule 204–2.

279Rule 206(4)–1.

280Rule 206(4)–3.

281Similarly, advisers applying for registration 

with the Commission after the form has 

incorporated the amendments must respond to Item 

7.B of Part 1A as amended.

obligations with us. It is not our 

intention to amend advisers’ method of 

counting clients for other purposes. Two 

commenters raised concerns about 

whether private fund investors must be 

counted as clients for purposes of 

applying the national ‘‘de minimis’’

standard for state adviser registration.268

One commenter also questioned 

whether advisers’ supervised persons 

must count private fund investors as 

clients for purposes of the definition of 

‘‘investment adviser representative’’ in 

rule 203A–3.269

To respond to commenters’ concerns, 

we are amending both rules 222–2 and 

203A–3 to clarify that advisers and 

supervised persons may, for purposes of 

those rules, count clients as provided in 

rule 203(b)(3)–1 without giving regard to 

the look through requirements in rule 

203(b)(3)–2.270

K. Amendments to Form ADV 

We proposed to amend Form ADV to 

require advisers to ‘‘private funds’’ as 

defined in the proposed rule to identify 

themselves as hedge fund advisers, and 

we are adopting this provision as 

proposed. One commenter spoke to 

these changes to say they were 

essential.271

III. Effective and Compliance Dates 

The effective date of the amendments 

to rule 206(4)–2 and Form ADV is 

January 10, 2005. The effective date of 

new rule 203(b)(3)–2 and amendments 

to rules 203(b)(3)–1, 203A–3, 204–2, 

205–3, and 222–2 is February 10, 2005. 

Hedge fund advisers may elect to begin 

complying with the new rule and the 

rule amendments as of their effective 

date, but have until February 1, 2006 to 

come into compliance with rule 

203(b)(3)–2 and the amendments to 

rules 203(b)(3)–1, 203A–3, 204–2, 205–

3, 206(4)–2, and 222–2.272 We are 

providing hedge fund advisers with this 

long transition period so that they have 

time to work through any technical 

issues as they prepare for registration. 

Our staff will be available to work with 

these new registrants on resolving 

technical questions.

By the compliance date, February 1, 

2006, each adviser required to register 

under the new rule273 must have its 

registration effective, and must have in 

place all policies and procedures 

required under our rules.274 Each 

adviser must also have designated a 

chief compliance officer.275 Also by 

February 1, 2006, advisers must ensure 

that they are in compliance with our 

rule for custody of client funds and 

securities.276 We expect that most 

private funds are already subject to an 

annual audit and that advisers will elect 

to have the audit results distributed to 

investors within the appropriate time 

period under the custody rule. Some 

advisers, however, may need to either 

arrange for their private funds to be 

audited or for quarterly transaction 

statements to be distributed to the 

investors in lieu of audit results.

Once their registrations are effective, 

the new registrants must, of course, 

comply with the Advisers Act and all of 

our rules, including provisions applying 

to registered advisers such as the 

limitations on performance fees,277 our 

books and records requirements,278 and 

our rules governing advertising 279 and 

cash solicitations.280

Several commenters asked whether 

the two-year redemption test under the 

definition of private fund would apply 

to investments made prior to the 

effectiveness of the new rules. Advisers 

must apply the two-year redemption test 

to any investments made on or after 

February 1, 2006, whether those 

investments are made by new or 

existing investors, but need not apply 

this test to investments made prior to 

the compliance date. 

The IARD filing system will 

incorporate the amendments made to 

Form ADV on March 8, 2005. Registered 

advisers amending their Form ADV after 

the form has incorporated the 

amendments must respond to Item 7.B 

of Part 1A as amended 281 and must in 

any event amend their Form ADV to 

respond to the revised item by February 

1, 2006. By implementing these changes 

to the IARD system in March of 2005, 

we will allow most registered advisers 

to respond to the revised item in 

conjunction with their regular annual 

updating amendment, rather than 

requiring them to file an additional 

amendment. Implementing this change 

to the IARD system promptly will also 

ensure that our staff, as well as members 

of the investing public, can begin to 

72078 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

282See supra notes 46–50 and accompanying text.

283See supra note 51 and accompanying text.

284See Section II.B.2 of this Release. We received 

comments specifically focusing on these benefits 

under the rule. See, e.g., ICAA Letter, supra note 

47. One commenter asserted it may be impossible 

for the Commission to identify potentially harmful 

compliance problems at an early stage absent the 

ability to examine hedge fund advisers. ICI Letter, 

supra note 48.

285See Section II.B.3 of this Release. Commenters 

also viewed this screening function as an important 

benefit for investors. See, e.g., Vantis July Letter, 

supra note 106 (registered hedge fund adviser stated 

that lack of scrutiny of hedge fund advisers has led 

to the industry attracting ‘‘unsavory characters’’); 

Ohio PERS Letter, supra note 47; ICI Letter, supra

note 48; IMCA Letter, supra note 48.

286SEC v. EPG Global Private Equity Fund, 

Litigation Release No. 18577 (Feb. 17, 2004); SEC

v. Millennium Capital Hedge Fund, L.P., 

Millennium Capital Group, LLC, and Andreas F. 

Zybell, supra note 99; In the Matter of John 

Christopher McCamey and Sierra Equity Partners, 

LP, Securities Exchange Act Release No. 48917 

(June 18, 2003).

287SEC v. Haligiannis, et al, Litigation Release 

No. 18853 (Aug. 25, 2004); SEC v. Scott B. Kaye, 

et al., Litigation Release No. 18845 (Aug. 24, 2004); 

SEC v. Gary M. Kornman, Litigation Release No. 

18836 (Aug. 18, 2004); SEC v. Anthony P. 

Postiglione, Jr., et al., supra note 236; In the Matter 

of Samer M. El Bizri and Bizri Capital Partners, Inc., 

supra note 99, SEC v. Daniel D. Dyer and Oxbow 

Capital Partners, LLC, Litigation Release No. 18719 

(May 19, 2004); SEC v. J. Robert Dobbins, Dobbins 

Capital Corp., Dobbins Offshore Capital LLC, 

Dobbins Partners, L.P., and Dobbins Offshore, Ltd., 

Litigation Release No. 18634 (Mar. 23, 2004); SEC

v. Patrollers Capital Fund and Franklin S. Marone, 

Litigation Release No. 18601 (Feb. 27, 2004); SEC

v. Darren Silverman and Matthew Brenner, 

Litigation Release No. 18597 (Feb. 25, 2004); In the 

Matter of Nevis Capital Management, LLC, David R. 

Wilmerding, III and Jon C. Baker, supra note 94; In 

the Matter of Robert T. Littell and Wilfred Meckel, 

Investment Advisers Act Release No. 2203 (Dec. 15, 

2003); SEC v. Adam G. Kruger and Kruger, Miller, 

and Tummillo, Inc., Litigation Release No. 18473 

(Nov. 20, 2003); SEC v. Koji Goto, Litigation Release 

No. 18456 (Nov. 14, 2003); SEC v. John F. Turant, 

Jr., Russ R. Luciano, JTI Group Fund, LP, J.T. 

Investment Group, Inc., Evergreen Investment 

Group, LP, and New Resource Investment Group, 

Inc., Litigation Release No. 18351 (Sept. 15, 2003); 

SEC v. Michael Batterman, Randall B. Batterman 

III, and Dynasty Fund, Ltd., et al., Litigation Release 

No. 18299 (Aug. 20, 2003); SEC v. Ryan J. Fontaine 

and Simpleton Holdings Corporation a/k/a 

Signature Investments Hedge Fund, supra note 11; 

In the Matter of Ascend Capital, LLC, Malcolm P. 

Fairbairn, and Emily Wang Fairbairn, Investment 

Advisers Act Release No. 2150 (July 17, 2003); SEC

v. Beacon Hill Asset Management LLC, et al., supra

note 97; SEC v. J. Scott Eskind, Lorus Investments, 

Inc., and Capital Management Fund, Limited 

Partnership, supra note 100; SEC v. Michael L. 

Smirlock and LASER Advisers, Inc., Litigation 

Release No. 17630 (July 24, 2002); SEC v.

Schwendiman Partners, LLC, Gary Schwendiman, 

and Todd G. Schwendiman, supra note 94; SEC v.

Von Christopher Cummings, Paramount Financial 

Partners, L.P., Paramount Capital Management, 

LLC, John A. Ryan, Kevin L. Grandy and James 

Curtis Conley, Litigation Release No. 17598 (July 3, 

2002); SEC v. House Asset Management, L.L.C., 

House Edge, L.P., Paul J. House, and Brandon R. 

Moore, supra note 97; In the Matter of Portfolio 

Advisory Services, LLC and Cedd L. Moses, supra

note 94; SEC v. Jean Baptiste Jean Pierre, Gabriel 

Toks Pearse and Darius L. Lee, supra note 97; In 

the Matter of Zion Capital Management LLC, and 

Ricky A. Lang, supra note 101; SEC v. Peter W. 

Chabot, Chabot Investments, Inc., Sirens Synergy 

and the Synergy Fund, supra note 97; SEC v.

Vestron Financial Corp., et al., supra note 97; SEC

v. Edward Thomas Jung, et al., supra note 97; SEC

v. Burton G. Friedlander, supra note 98; SEC v.

Hoover and Hoover Capital Management, Inc., 

supra note 97; SEC v. Evelyn Litwok & Dalia Eilat, 

supra note 97; SEC v. Ashbury Capital Partners, 

L.P., Ashbury Capital Management, L.L.C., and 

Mark Yagalla, supra note 97; SEC v. James S. 

Saltzman, supra note 95; In the Matter of Stephen 

V. Burns, Investment Advisers Act Release No. 1910 

(Nov. 17, 2002); In the Matter of Michael T. Higgins, 

supra note 99; SEC v. David M. Mobley, Sr., et al., 

supra note 97; SEC v. Michael W. Berger, 

Manhattan Capital Management Inc., supra note 99; 

In the Matter of Charles K. Seavey and Alexander 

Lushtak, supra note 99; SEC v. Todd Hansen and 

Nicholas Lobue, supra note 235. 288SEC v. Global Money Management, LP, LF 

Global Investments, LLC, and Marvin I. Friedman, 

supra note 102; SEC v. KS Advisors, Inc. et al., 

supra note 95; In the Matter of Alliance Capital 

Management, L.P., supra note 29; SEC v. Edward J. 

Strafaci, Litigation Release No. 18432 (Oct. 29, 

2003); In the Matter of Stephen B. Markovitz, supra

note 29; Michael Lauer, Lancer Management Group, 

LLC, and Lancer Management Group II, LLC, supra

note 98; In the Matter of Martin W. Smith and 

World Securities, Inc., Investment Advisers Act 

Release No. 2124 (Apr. 18, 2003); SEC v. Platinum 

Investment Corp. et al., Litigation Release No. 

17643 (July 31, 2002). 289 In the Matter of Alliance Capital Management, 

L.P., supra note 29; SEC v. Michael L. Smirlock, 

supra note 287; SEC v. Edward J. Strafaci, supra

note 288; In the Matter of Nevis Capital 

Management, supra note 94; In the Matter of Martin 

W. Smith and World Securities, Inc., supra note 

288; SEC v. Schwendiman Partners, LLC, Gary 

Schwendiman, and Todd G. Schwendiman, supra

note 94; In the Matter of Portfolio Advisory Services, 

LLC and Cedd L. Moses, supra note 94; In the 

Matter of Zion Capital Management LLC, and Ricky 

A. Lang, supra note 101. Staff cannot estimate the 

amount of losses in 3 of these cases at this time. 290Staff cannot estimate the amount of losses in 

5 of these cases at this time. 291As substantial inflows chase absolute returns, 

there may be pressure for hedge fund advisers to 

engage in strategies that may not be consistent with 

the funds’ disclosure or may be unlawful. See David 

Reilly, Hot Hedge Fund Vega Grapples With 

Growth: Global/Macro Style of Investing May 

Provide Room to Maneuver, But a Door Is Closed 

to New Cash, The Wall St. J., June 4, 2004, at C1 

(as hedge funds’ assets explode, difficulties in 

finding winning strategies raises the specter of 

diminished returns and concentrations of 

investment risk that are difficult to unwind in a 

crisis); Mara Der Hovanesian, Will Hedge Funds Be 

Overrun By All The Traffic?, BusinessWeek, Mar. 

11, 2002 (some hedge fund strategies are becoming 

less effective as the capacity of managers to generate 

high absolute returns diminishes when investment 

portfolios are too large). See also Alexander M. 

Ineichen, Absolute Returns (2003) at 47 (falling 

barriers to entry for new hedge fund advisers are 

causing a dilution of the talent pool, making adviser 

selection more difficult). In the absence of 

Commission oversight as a deterrent, these 

incentives may tempt hedge fund advisers to engage 

in fraud.

access information about advisers to 

private funds.

IV. Cost-Benefit Analysis 

We are sensitive to the costs and 

benefits that result from our rules. Rule 

203(b)(3)–2 requires certain hedge fund 

advisers to register with us under the 

Investment Advisers Act of 1940. We 

are also adopting related rule 

amendments to facilitate a smooth 

transition for hedge fund advisers. In 

the Proposing Release, we identified 

possible costs and benefits of the rule 

and rule amendments and requested 

comment on our analysis. Many 

commenters supported the new rule,282

although many commenters, chiefly 

hedge fund advisers and a trade 

association, expressed reservations at 

the potential costs of the new rule.283

A. Benefits

As discussed above in this Release, 

we expect that hedge fund investors, 

advisory clients and advisers will 

benefit from the rule and rule 

amendments, although these benefits 

are difficult to quantify. 

1. Benefits to Hedge Fund Investors 

(a) Deter fraud and curtail losses. Our 

oversight may prevent or diminish 

losses that hedge fund investors would 

otherwise experience as a result of 

hedge fund advisers’ fraud. Registration 

allows us to conduct examinations of 

hedge fund advisers, and our 

examinations provide a strong deterrent 

to advisers’ fraud, identify practices that 

may harm investors, and lead to earlier 

discovery of fraud that does occur.284

Registration also permits us to screen 

individuals seeking to advise hedge 

funds, and to deny entry to those with 

a history of disciplinary problems.285

In the last five years, the Commission 

has brought or authorized 51 

enforcement cases in which we assert 

hedge fund advisers have defrauded 

hedge fund investors or used the hedge 

fund to defraud others. While three of 

these frauds were detected in time to 

prevent investor losses, this was the 

exception rather than the rule.286 In 40 

of these cases, our staff estimates 

potential investor losses aggregate 

approximately $1.1 billion.287 Staff 

cannot at this time estimate the amount 

of losses in the remaining eight cases.288

We are concerned that individuals have 

targeted hedge fund investors and 

chosen hedge funds as a vehicle for 

fraud because these individuals could 

operate their funds without regulatory 

scrutiny of their activities. Only eight of 

the 51 cases involve investment advisers 

registered with the Commission, with 

over $75.7 million in estimated 

aggregate investor losses.289 The 

remaining 43 cases involve advisers that 

were not registered with us, with over 

$1 billion in estimated aggregate 

investor losses.290

While our regulatory oversight cannot 

guarantee hedge fund investors will 

never be defrauded, we expect our 

oversight will reduce investor losses.291

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72079

292See, e.g., MFA Letter, supra note 51; LaRocco 

Letter, supra note 51; Chamber of Commerce Letter, 

supra note 52; ISDA Letter, supra note 52.

293 In addition, in two of the 43 cases against 

unregistered advisers, our examiners uncovered the 

fraud as a result of examining registered advisers 

who employed the principals of the hedge fund. See 

supra notes 94 and 95.

294Cf. Alternative Investment Group Letter, supra

note 47 (hedge fund managers will realize they are 

more likely to receive SEC scrutiny and will tighten 

their procedures toward a greater culture of 

compliance); Vantis August Letter, supra note 50 

(possibility of SEC exams on short notice creates an 

extra incentive for firm professionals to remain 

disciplined and keep files updated on a timely 

basis). In addition, as discussed above, examination 

of regulatory issues relating to the deterrent effect 

of unannounced government inspections, under 

economic theories of monitoring and deterrence 

based on principal-agent models, suggest that 

randomized monitoring is sufficient to generate a 

deterrent effect. See supra note 88.

295UnFarallon Letter, supra note 230; Comment 

Letter of Gregg D. Caplitz (Aug. 9, 2004) (‘‘Caplitz 

Letter’’); Comment Letter of Rosalind D. Herman 

(August 10, 2004) (‘‘Rosalind Herman Letter’’).

296The difficulty many institutional investors 

have in obtaining information about hedge fund 

advisers is reflected in the Hennessee Group’s 

survey clarifying the involvement of foundations 

and endowments in the hedge fund market. Among 

foundations and endowments responding to the 

survey, those supporting hedge fund adviser 

registration outnumbered its opponents by nearly 2 

to 1. See Hennessee Foundation and Endowment 

Survey, supra note 39. Participants at our Hedge 

Fund Roundtable last year similarly spoke of the 

difficulty and costs that investors face in obtaining 

information from hedge fund advisers. Roundtable 

Transcript, May 15 (statement of Sandra Manzke) 

(‘‘[I]t’s very difficult to get answers out of managers, 

and they hold all the keys right now. If you want 

to get into a good fund, and you ask some difficult 

questions, you may not get that answer. Sure, there 

is a lot of access, to get online and do background 

checks, and hire firms * * *. But that’s expensive. 

And can the retail investor do it? No. Firms like 

ours, we spend a lot of money, we have a lot more 

people working for us now to uncover these types 

of situations.’’).

297See, e.g., ICAA Letter, supra note 47, 

Alternative Investment Group Letter, supra note 47, 

Caplitz Letter, supra note 295.

298Rule 206(4)–7.

299Rule 206(4)–6.

300Rule 204A–1.

301Some registered hedge fund advisers used 

their own experiences to support this conclusion. 

See, e.g., Vantis August Letter, supra note 50, 

Alternative Investment Group Letter, supra note 47.

302See supra note 29.

303 Id.

304 Id.

305See, e.g., ICAA Letter, supra note 47; Rosalind 

Herman Letter, supra note 295; Patch Letter A, 

supra note 48; Comment Letter of Joe Allebaugh 

(July 14, 2004) (‘‘Allebaugh Letter’’); Vantis August 

Letter, supra note 50; Saul Letter, supra note 49.

Some commenters argued that 

registration of hedge fund advisers 

would not address the frauds evidenced 

by these enforcement cases, arguing the 

majority of the advisers in these fraud 

cases were too small to meet the $30 

million threshold for registration under 

the Advisers Act or were registered 

already.292 We disagree with these 

commenters. Half of the advisers in 

these 51 cases appear to have managed 

more than $30 million or otherwise 

been eligible for registration with us, 

and it was these larger advisers who 

caused nearly all the investor losses, 

representing over $1 billion of the 

estimated total losses of $1.1 billion. 

This strongly suggests that the 

Commission’s registration requirement 

will affect an appropriate group of 

hedge fund advisers and serve as an 

effective response to combat hedge fund 

fraud.

In addition, these commenters argued 

that examination programs are unable to 

detect fraud, and that regulatory 

authorities must instead rely on ‘‘tips’’

to uncover misconduct. However, in 5 

of the 8 cases against registered 

advisers, it was our examiners who 

uncovered the fraudulent conduct.293

These cases show that registered hedge 

fund advisers contemplating their 

chances of ‘‘getting away’’ with a breach 

of their fiduciary duty to their clients 

would be well advised to fear detection. 

We believe this has a genuine deterrent 

effect.294

(b) Provide basic information about 

hedge fund advisers.

Form ADV information that hedge 

fund advisers will file in registering will 

aid hedge fund investors in evaluating 

potential managers. Filing Form ADV 

will require hedge fund advisers to 

disclose information about their 

business, affiliates and owners, and 

disciplinary history. As commenters 

pointed out, many investors currently 

lack good access to this information 

about their hedge fund managers.295

Although the information hedge fund 

advisers will be required to provide on 

their Form ADV filings and to comply 

with our rules cannot substitute for an 

investor’s due diligence, it should aid 

investors by providing a publicly 

accessible foundation of basic 

information.296

(c) Improve compliance controls. 

Hedge fund investors should benefit 

from their advisers’ improved 

compliance controls. Several 

commenters confirmed this assessment 

in their comment letters.297 Once 

registered, hedge fund advisers will be 

required to have comprehensive 

compliance procedures and to designate 

a chief compliance officer.298 Specific 

procedures governing proxy voting 299

and a code of ethics including 

requirements for personal securities 

reporting will also be required.300 In 

addition, the obligation to commit to a 

program of compliance controls 

combined with our examinations foster 

adherence to a culture of compliance by 

advisers.301 These compliance measures 

are the first line of defense in protecting 

investors against an adviser’s 

misconduct.

2. Benefits to Mutual Fund Investors 

Mutual fund investors will benefit 

from hedge fund adviser registration to 

the extent that Commission oversight 

deters hedge funds and their advisers 

from illegal conduct that exploits 

mutual funds. Many of the market 

timers and illegal late traders involved 

in recent mutual fund scandals have 

been hedge fund advisers.302 The 51 

enforcement cases discussed earlier do 

not include 18 other actions we have 

brought to date against persons charged 

with late trading of mutual fund shares 

on behalf of hedge fund groups, and 

against mutual fund advisers or 

principals for permitting hedge fund 

advisers to market time mutual funds 

contrary to the mutual funds’

prospectus disclosure.303 Hedge fund 

advisers reaped huge profits for their 

funds over an extended period while 

costing our nation’s retail mutual fund 

investors hundreds of millions of 

dollars.304

3. Benefits to Other Investors and 

Markets 

The registration of hedge fund 

advisers will benefit not only hedge 

fund investors but also other investors 

and the securities markets, to the extent 

that the Commission’s oversight 

eliminates opportunities for hedge fund 

advisers to engage in other types of 

unlawful conduct in the securities 

markets. Commenters also saw this as a 

benefit to adviser registration.305 The 

mutual fund scandals have shown us 

that hedge fund advisers’ improper or 

illegal activities can cause harm beyond 

the hedge funds’ own investors. There 

may be other fraudulent activities by 

hedge fund advisers of which we are 

unaware because we cannot examine 

these advisers regularly. Adviser 

registration, as discussed above, should 

lead to earlier discovery of fraudulent 

activities and thus enhance protections 

to all investors in the securities markets.

4. Benefits to Regulatory Policy 

Registration of hedge fund advisers 

will benefit all investors and market 

participants by providing us and other 

policy makers with better data. We have 

limited information about hedge fund 

advisers and the hedge fund industry, 

and much of what we do have is 

indirect information extrapolated from 

other data. This hampers our ability to 

develop regulatory policy for the 

protection of hedge fund investors and 

72080 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

306See Section II.B.1 of this Release.

307See, e.g., Ohio PERS Letter, supra note 47, 

ICAA Letter, supra note 47, ICI Letter, supra note 

48, IMCA Letter, supra note 48.

308See, e.g., MFA Letter, supra note 51, Tudor 

Letter, supra note 53.

309See Section II.B.9 of this Release.

310Many advisers to hedge funds are required to 

register with us because of other advisory business 

they have. Still others have chosen to register with 

us because their investor clients require it. 

Registered hedge fund advisers commented on the 

benefits of registration. See Vantis August Letter, 

supra note 50.

311See Section VII.A.1.b. of the 2003 Staff Hedge 

Fund Report, supra note 18.

312See, e.g., Saul Letter, supra note 49, Rosalind 

Herman Letter, supra note 295, Caplitz Letter, supra

note 295.

313See Section I.A. of this Release.

314See, e.g., Vantis July Letter, supra note 106 

(mandatory registration will improve the image of 

the hedge fund industry); Hennessee Foundation 

and Endowment Survey, supra note 39 (survey 

participant remark that registration ‘‘lends 

creditability to the field’’); Comment Letter of North 

American Securities Administrators Association, 

Inc. (Oct. 18, 2004) (SEC registration will increase 

investor confidence, thereby benefiting hedge fund 

advisers).

315See, e.g., MFA Letter, supra note 51, Chamber 

of Commerce Letter, supra note 52, ISDA Letter, 

supra note 52, David Thayer Letter, supra note 52.

316Furthermore, section 208(a) of the Act [15 

U.S.C. 80b–8(a)] expressly forbids registered 

advisers from implying that their services bear the 

imprimatur of the government. Section 208(b) of the 

Act permits a registered adviser to state that it is 

registered, but only if the effect of registration is not 

misrepresented.

317 Vantis August Letter, supra note 50, 

Alternative Investment Group Letter, supra note 47.

318See Hedge Funds, Leverage, and the Lessons 

of Long-Term Capital Management—Report of the 

President’s Working Group on Financial Markets, 

supra note 43, at 2. The 2003 Staff Hedge Fund 

Report also noted that hedge funds’ trading brings 

price information to our securities markets, thus 

improving market efficiency, and hedge funds also 

provide liquidity to our capital markets. See 2003 

Staff Hedge Fund Report, supra note 18, at 4.

319See, e.g., Madison Capital Letter, supra note 

51; Chamber of Commerce Letter, supra note 52; 

ISDA Letter, supra note 52; Blanco Partners, supra

note 52; Millrace Letter, supra note 92.

320 Vantis August Letter, supra note 50, 

Alternative Investment Group Letter, supra note 47, 

ICI Letter, supra note 48, ICAA Letter, supra note 

47, CFA Institute Letter, supra note 47.

321See Vantis August Letter, supra note 50, 

Alternative Investment Group Letter, supra note 47.

322The MFA stated that one of its members 

expended $75,000 of internal staff time in preparing 

its Form ADV filing. See MFA Letter, supra note 51. 

MFA’s comments are also not reflective of other 

feedback we have received on revised Form ADV 

and the IARD electronic filing system, which were 

launched in 2001. See Letter from Karen Barr, 

General Counsel, Investment Counsel Association 

of America, to Paul F. Roye, Director, Division of 

investors in general.306 Hedge fund 

adviser registration would provide the 

Congress, the Commission and other 

government agencies with important 

information about this rapidly growing 

segment of the U.S. financial system. 

While some commenters agreed with 

our assessment of this benefit,307 others 

suggested that, instead of registering 

hedge fund advisers, we compile 

information about them from a variety 

of scattered regulatory filings currently 

made by hedge funds, their advisers, 

and broker-dealers.308 We have 

considered this alternative, but the 

reports and information currently 

available would provide at best a partial 

and inadequate view of the activities of 

hedge fund advisers.309

5. Benefits to Hedge Fund Advisers 

Mandatory registration will provide a 

level playing field for hedge fund 

advisers. Many hedge fund advisers 

have already registered with us, and 

have organized their compliance 

procedures under the Advisers Act. 310

Unregistered hedge fund advisers, 

however, vary substantially in their 

compliance practices.311 While many of 

them have adopted sound compliance 

practices, many others, against whom 

they and the registered advisers 

compete, have not allocated resources to 

implement an effective compliance 

infrastructure. We received comments 

noting that mandatory registration 

would ensure that all hedge fund 

advisers compete on the same basis in 

this regard.312

Registering hedge fund advisers may 

enhance investor confidence in a 

growing and maturing industry. As 

discussed above, the hedge fund 

industry has been growing at an 

extraordinary pace in the past 

decade.313 Registration under the 

Advisers Act will bring hedge fund 

advisers to the same compliance level as 

other SEC-registered advisers, thus 

providing hedge fund investors with 

additional protections with respect to 

conflicts of interest addressed by the 

funds’ advisers.314

Some commenters, however, argued 

that registration would create a ‘‘moral 

hazard’’ by providing hedge fund 

investors with a false sense of enhanced 

investor protection that might cause 

them to be less diligent in their own 

investigations.315 We disagree. Such 

argument could have been used against 

registration of any kind of investment 

adviser and against any regulation of the 

securities industry.316 In addition, 

without the new rule requiring 

registration, a hedge fund adviser can 

now choose to register under the 

Advisers Act but then withdraw its 

registration, for example, at the prospect 

of an examination. Thus, without a 

registration requirement, any ‘‘moral 

hazard’’ would already exist, but 

without necessarily providing hedge 

fund investors the benefit of our 

oversight of their advisers.

B. Costs 

As we discussed in the Proposing 

Release, registration of hedge fund 

advisers under the Advisers Act would 

not impede hedge funds’ operations. 

Comments from registered hedge fund 

advisers agreed.317 The Act does not 

prohibit any particular investment 

strategies, nor does it require or prohibit 

specific investments. Instead of 

imposing specific procedures on 

registrants, the Advisers Act is 

principally a disclosure statute that 

requires registrants to fully inform 

clients of conflicts so that those clients 

can determine whether to give their 

consent. For the same reasons, 

registering hedge fund advisers should 

not impair the ability of hedge funds to 

continue their important roles of 

providing price information and 

liquidity to our markets.318

Nevertheless, registration imposes 

certain costs. In the Proposing Release, 

we analyzed various costs that hedge 

fund advisers would incur in 

connection with registration. 

Commenters representing the views of 

unregistered hedge fund advisers 

generally challenged our cost estimates 

and predicted the costs of compliance 

would be burdensome.319 Comments 

from registered advisers generally 

characterized the costs as being 

significant, but reasonable in light of the 

nature of the advisory business.320 As 

we discussed in the Proposing Release, 

the costs of compliance for a new 

registrant can vary widely among firms 

depending on size, activities, and the 

sophistication of the existing 

compliance infrastructure. Investment 

advisers, whether registered with us or 

not, place the future of their business at 

peril if they do not establish a sound 

compliance infrastructure to fulfill their 

fiduciary duties towards their clients 

under the Act. Registered hedge fund 

advisers estimated that advisers with 

good compliance infrastructures in 

place would incur much less 

incremental cost than those that did not 

have good compliance 

infrastructures.321

1. Registration Costs 

In our Proposing Release, we 

estimated that the costs of preparing 

adviser registration submissions, 

including preparation and submission 

of Part 1A of Form ADV, would not be 

high. Although one commenter 

suggested the costs of preparing a Part 

1A submission can be quite high, we 

believe the commenter’s example does 

not reflect the experience of other 

advisers, none of whom made similar 

comments.322 Part 1A requires advisers 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72081

Investment Management, U.S. Securities and 

Exchange Commission (May 16, 2001) (noting that 

ICAA members found the filing system easy to use 

and found the form instructions and staff responses 

to frequently-asked questions to provide useful 

guidance).

323 In fact, our new rule makes only one small 

change to Part 1A, to better identify which advisers’

pooled investment vehicles are hedge funds. See

Section II.K. of this Release.

324See rule 204–3, the brochure delivery rule.

325Rule 204–2.

326Rule 206(4)–2.

327Rule 206(4)–6.

328Rule 206(4)–7.

329Rule 204A–1.

330See, e.g., Schulte Roth Letter, supra note 51; 

ICAA Letter, supra note 47.

331One private attorney commenting on the rule 

noted he knows of few hedge fund managers which 

do not already comply with the substantive 

provisions of the Advisers Act as a matter of best 

practice. Sidley Austin Letter, supra note 51.

332Alternative Investment Group Letter, supra

note 47; Vantis August Letter, supra note 50.

333Our staff has estimated that between 690 and 

1,260 hedge fund advisers would be new Advisers 

Act registrants under the new rule and rule 

amendments. See infra Section V of this Release; 

Section V of the Proposing Release. Aggregate startup costs to establish required compliance 

infrastructure for all new registrants are therefore 

estimated to range from $31 to $57 million.

334Schulte Roth Letter, supra note 51; Bryan Cave 

Letter, supra note 111; Davis Polk Letter, supra note 

197.

335Lander Letter, supra note 51, Madison Capital 

Letter, supra note 51, MFA Letter, supra note 51 

(recounting the estimates of members, and noting 

larger firms’ cost for a chief compliance officer can 

approach $500,000). Data from the SIA Report on 

Management and Professional Earnings in the 

Securities Industry 2003, modified by the SEC staff 

for an 1800-hour work-year and with a 35 percent 

markup for overhead, however, suggest that the 

total cost for hiring a full-time chief compliance 

officer in New York City would be approximately 

$234,000.

to answer basic questions about their 

business, their affiliates and their 

owners, and Part 1A can be completed 

using information readily available to 

hedge fund advisers. Numerous hedge 

fund advisers have already registered 

with the Commission using Part 1A, and 

none has reported to us that its business 

model presents any difficulty in using 

the form.323 Advisers must also 

complete Part II of Form ADV and 

deliver a copy of Part II or a disclosure 

brochure containing the same 

information to clients.324 Part II requires 

disclosure of certain conflicts of 

interest, which even unregistered 

advisers have a fiduciary duty to 

disclose to their clients. We expect that 

hedge fund advisers will face relatively 

small internal costs in preparing a Part 

II, and will be likely to include their 

Part II disclosure as part of their private 

placement memoranda for their hedge 

funds, reducing their overall costs even 

further. We received no comments to 

the contrary.

2. Cost of Establishing a Compliance 

Infrastructure 

New hedge fund adviser registrants 

will also face costs to bring their 

operations into conformity with the 

Advisers Act and the rules under the 

Act. In the Proposing Release, we 

estimated the cost of establishing a 

compliance infrastructure would 

primarily consist of establishing 

procedures and systems that address 

rules under the Advisers Act such as the 

books and records rule,325 the custody 

rule,326 the proxy voting rule,327 the 

compliance rule,328 and the code of 

ethics rule.329 While some commenters 

also focused on these factors,330 others 

identified additional cost 

considerations, as we discuss below.

Many unregistered hedge fund 

advisers have already built sound 

compliance infrastructures because their 

business compels it. These firms already 

have procedures designed to keep good 

records of all transactions, to keep their 

clients’ assets safe, to provide fair and 

full disclosure of conflicts of interest, 

and to prevent their supervised persons 

from breaching fiduciary duties.331 In 

the Proposing Release, we estimated 

these advisory firms should face little 

cost to modify their current compliance 

practices to comply with the Advisers 

Act rules. Comments from registered 

hedge fund advisers agreed.332 For other 

hedge fund advisers that have not yet 

established sound compliance 

programs, however, the costs will be 

higher.

In the Proposing Release, we 

estimated the cost for hedge fund 

advisers to establish the required 

compliance infrastructure will be, on 

average, $20,000 in professional fees 

and $25,000 in internal costs including 

staff time.333 These estimates were 

prepared in consultation with private 

attorneys who, as part of their practice, 

counsel hedge fund advisers 

establishing their registrations with the 

SEC. The estimates are averages, 

premised on the understanding that the 

costs will likely be less for new 

registrants that have already established 

sound compliance practices and more 

for new registrants that do not yet have 

good compliance procedures. Several 

law firms and attorneys representing 

hedge fund advisers challenged these 

estimates as being too low, but these 

firms did not provide any estimates of 

their own.334 The ICAA, based on the 

experience of its adviser members 

generally, commented that the costs of 

a compliance infrastructure are 

considerable, but that they are justified, 

especially considering the relative risks 

of hedge fund activities as compared to 

many other investment advisory 

activities.

Several hedge fund advisers estimated 

the costs to be in the range of $300,000, 

but most or all of the cost was 

attributable to compensation costs for 

hiring a dedicated chief compliance 

officer (CCO).335 Our compliance rule 

does not require firms to hire a new 

individual to serve as a full-time CCO, 

and the question of whether an advisory 

firm can look to existing staff to fulfill 

the CCO requirement internally is firmspecific. Firms may consider factors 

such as the size of the firm, the 

complexity of its compliance 

environment, and the qualifications of 

current staff.

While we recognize some hedge fund 

advisers will need to designate someone 

to serve as CCO on a full-time basis, we 

expect these will be larger firms—those 

with many employees and a sizeable 

amount of investor assets under 

management. Because there is no 

currently-available comprehensive 

database of hedge fund advisers, we 

cannot determine the number of these 

larger hedge fund firms in operation, but 

our staff estimates it is relatively few. 

Staff estimates approximately half of 

these hedge fund advisers are already 

registered with us, and have already 

designated a CCO. While the remaining, 

unregistered, larger hedge fund advisers 

may not have designated a CCO as such, 

many of these firms likely already have 

personnel who perform similar 

functions to a CCO, in order to address 

the firm’s liability exposure and protect 

its reputation.

In smaller hedge fund advisers, the 

designated CCO will likely also fill 

another function in the firm, and 

perform additional duties alongside 

compliance matters. Firms designating a 

CCO from existing staff may experience 

costs to the extent the individual is 

taking on additional compliance 

responsibilities or giving up other noncompliance responsibilities. These costs 

may include costs of shifting 

responsibilities among employees, and 

might in some cases include additional 

compensation costs. Some of these firms 

may need to add compliance capacity to 

their staffs. Costs will vary from firm to 

firm, depending on the extent to which 

firm staff is already performing some or 

all of the requisite compliance 

functions, the extent to which the CCO’s 

non-compliance responsibilities need to 

be lessened to permit allocation of more 

time to compliance responsibilities, and 

the value to the firm of the CCO’s noncompliance responsibilities. We do not 

have access to information that would 

72082 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

336One law firm commented that it knew of few 

hedge fund advisers that are not already complying 

with the substantive provisions of the Advisers Act 

as a matter of best practices. Sidley Austin Letter, 

supra note 51. See also Superior Capital Letter, 

supra note 51 (noting that the Advisers Act 

compliance regulations would be ‘‘redundant’’ for 

this firm).

337These underlying uncertainties surrounding 

these internal costs would introduce the same level 

of uncertainty to various alternatives that we might 

pursue in determining these costs. For example, 

advisory firms themselves are not likely to be able 

to provide reliable estimates for several reasons. 

First, experiences will vary across firms; second, 

few firms are likely to have allocated the internal 

resources necessary to assess which costs are a 

direct result of legal requirements and which arise 

from other factors; and third, firms’ experience with 

some newer requirements (such as the adviser 

compliance rule and the adviser code of ethics rule) 

is still limited. Attempting to estimate the number 

of staff hours involved (and applying industry 

standard wage and benefit costs for the 

corresponding types of personnel) would entail the 

same uncertainties.

338Comment Letter of Joseph L. Vidich (Aug. 7, 

2004) (‘‘Vidich Letter’’) (currently managing $10 

million hedge fund); Comment Letter of Venkat 

Swarna (Sept. 14, 2004) (‘‘Swarna Letter’’) 

(anticipates managing $2 million hedge fund). 

Although these commenters would not be covered 

by our registration requirement, we have taken their 

cost estimates into consideration, because other 

small firms that will be covered did not provide us 

with quantified estimates. 339See Vidich Letter, supra note 338; Superior 

Capital Letter, supra note 51; LaRocco Letter, supra

note 51; see also ISDA Letter, supra note 52. 340See, e.g., Millrace Letter, supra note 92; see 

also Seward & Kissel Letter, supra note 111; Blanco 

Partners Letter, supra note 52. 341 ICAA Letter, supra note 47, CFA Institute 

Letter, supra note 47. 342Some commenters suggested the threshold for 

hedge fund adviser registration should be $50 

million, to address their concerns that the cost 

burden of adviser registration might be 

disproportionate for advisers managing lesser 

amounts of assets. See, e.g., LaRocco Letter, supra

note 51. However, many currently-registered firms, 

which presently comply with these same 

registration obligations, manage less than $50 

million. As of September 30, 2004, 2,758 advisers 

registered with us reported that they were managing 

less than $50 million in client assets. These 

advisers represent 32 percent of our registrant pool. 

We also note that establishing a higher assets under 

management registration threshold for advisers to 

private funds would allow these other advisers to 

avoid registration merely by pooling some of their 

clients’ assets into a private fund. 343 In addition to asset-based investment 

management fees that are comparable to advisory 

fees charged by non-hedge fund advisory firms, 

hedge fund advisers also typically earn incentive 

compensation equaling 20 percent of the fund’s net 

investment income. See supra note 11. 344MFA Letter, supra note 51 (reporting 

experience of one registered hedge fund adviser). 345As we discuss elsewhere, the absence of a 

comprehensive database of hedge fund advisers 

makes it difficult to estimate the number or size of 

hedge fund advisory firms that will be affected by 

the new rule. However, staff estimates half or more 

of the larger hedge fund advisers are likely already 

registered with us. See also The Hedge Fund 100, 

supra note 70 (estimating that even the top 100 

hedge fund advisers manage in the range of $2 

billion to $11.5 billion). 346Sidley Austin Letter, supra note 51. 347 Vantis August Letter, supra note 50 (review 

provides additional assurance that any deficiencies 

not already identified by internal or external audit 

are identified; exam staff offers helpful instruction 

in regulatory issues and assistance in developing 

policies and procedures).

348See, e.g., Schulte Roth Letter, supra note 51, 

Davis Polk Letter, supra note 197, Rodney Pitts 

Letter, supra note 52, Sheila Bair Letter, supra note 

89, Comment Letter of Alex Cook (Aug. 26, 2004) 

(‘‘Alex Cook Letter), Tudor Investment Letter, supra

note 53.

allow us to determine these costs, and 

commenters did not provide estimates. 

3. Ongoing Costs of Compliance and 

Examination 

Several comments on our Proposing 

Release identified additional cost 

considerations related to hedge fund 

advisers’ ongoing, annual costs of 

compliance and the costs of undergoing 

examination by the Commission. There 

may be a number of unregistered hedge 

fund firms whose operations are already 

substantially in compliance with the 

Advisers Act and that would therefore 

experience only minimal incremental 

ongoing costs as a result of 

registration.336 There are other 

unregistered hedge fund advisers, 

however, who will face additional 

ongoing costs to conduct their 

operations in compliance with the 

Advisers Act. These costs may be 

significant for some hedge fund 

advisers.

We do not have access to information 

that would enable us to determine these 

additional ongoing costs, which are 

predominantly internal to the firms 

themselves. Incremental ongoing 

compliance costs will vary from firm to 

firm depending on factors such as the 

complexity of each firm’s activities, the 

business decisions it makes in 

structuring its response to its 

compliance obligations, and the extent 

to which it is already conducting its 

operations in compliance with the 

Advisers Act.337 We received comments 

from small hedge fund advisers 

estimating that their annual compliance 

costs would be approximately $25,000 

and could be as high as $50,000.338

These commenters and other small 

hedge fund advisers expressed concerns 

that compliance costs would be 

prohibitive in comparison to their 

management fee revenues.339 Other 

small hedge fund advisers commented 

that their existing staff could not 

accommodate the compliance 

responsibilities they would face as a 

result of registration.340 We also, 

however, received comments from 

investment advisory trade associations 

noting that thousands of small 

investment advisers currently operate 

under the same compliance burden.341

We note that more than 2,500 smaller 

advisory firms are currently registered 

with us.342 These firms have absorbed 

these compliance costs, notwithstanding 

the fact that their revenues are likely to 

be smaller than those of a typical hedge 

fund adviser.343

Some commenters asserted that there 

would be substantial costs associated 

with hedge fund advisers’ responses to 

our examinations. One hedge fund 

adviser reportedly estimated spending 

160 hours of internal staff time during 

an SEC examination.344 We believe this 

does not reflect the typical experience of 

our registrants, with the possible 

exception of the very largest advisers, 

and few of the firms affected by the new 

rule are likely to be of this size.345 A law 

firm commented that two registered 

hedge fund advisers reportedly spent an 

estimated $300,000 to $500,000 in outof-pocket costs preparing for and 

undergoing SEC examinations.346 We 

believe this also is not representative of 

our registrants’ experiences, who do not 

typically find it necessary to involve 

private counsel in extensive preexamination review of their activities 

and records. Also, we note that one 

registered hedge fund adviser 

commented that the firm itself derived 

benefit from the examination process.347

V. Effects on Commission Examination 

Resources 

The new registration requirement will 

increase the number of investment 

adviser firms subject to Commission 

examinations. The examination program 

is operated by our Office of Compliance 

Inspections and Examinations (‘‘OCIE’’). 

OCIE’s examination program already 

covers a number of advisers to hedge 

funds. These advisers have registered 

with the Commission, either because 

they advise non-hedge fund clients for 

whom registration is required, or 

because they perceive registration with 

the Commission to be necessary to their 

business model. Implementation of rule 

203(b)(3)–2 will increase the number of 

SEC-registered advisers by some 

amount. 

Several commenters expressed 

concerns about this increase.348 As 

stated in the Proposing Release, there 

are various options we could pursue to 

lessen the effect of this increase. Though 

OCIE’s resources will be spread over an 

expanded pool of investment adviser 

registrants, we are developing risk 

assessment tools to enhance the 

efficiency of our examination program 

by allowing our staff to focus 

examination resources on the areas of 

greatest risk to investors. In addition, we 

have recently adopted measures that 

require advisory personnel to be more 

accountable for the efficacy of 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72083

349Rule 206(4)–7. See Compliance Programs of 

Investment Companies and Investment Advisers, 

supra note 109.

350See Section V. of the Proposing Release.

351Staff estimated that between 690 and 1,260 

hedge fund advisers will be new Advisers Act 

registrants under the new rule and rule 

amendments. See Section V. of the Proposing 

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

353 975 filings of the complete form at 22.25 hours 

each, plus 975 amendments at 0.75 hours each, plus 

6.7 hours for each of the 975 hedge fund advisers 

to deliver copies of their codes of ethics to 10 

percent of their 670 clients annually who request 

it, at 0.1 hours per response. (975 × 22.25) + (975 

× 0.75) + (975 × (670 × 0.1) × 0.1).

compliance programs. As of October of 

this year, registered advisers have begun 

complying with our new compliance 

rule, which requires them to implement 

comprehensive policies and procedures 

for compliance with the Advisers Act, 

under the administration of a chief 

compliance officer.349 As advisers 

improve their own compliance regimes, 

we expect this will facilitate our 

examination of advisory firms. As 

discussed in the Proposing Release,350

another option would be to increase the 

current threshold for SEC registration 

from $25 million of assets under 

management to a slightly higher 

amount, thereby reducing the number of 

smaller advisers overseen by the 

Commission (instead of state securities 

administrators). Or we could seek 

additional resources from Congress, if 

necessary. We are continuing to develop 

techniques to assess risk.

Our ability to estimate the size of the 

increase in our workload has been 

hampered by the absence of any reliable 

and comprehensive database of hedge 

funds or advisers to hedge funds. In the 

Proposing Release, we described our 

staff’s tentative estimates that the 

addition of new hedge fund advisers to 

our current registrant pool could 

increase the total size of this pool by 8 

to 15 percent.351 We received no 

comment on these estimates.

VI. Paperwork Reduction Act 

As we discussed in the Proposing 

Release, rule 203(b)(3)–2 contains no 

new ‘‘collection of information’’

requirements within the meaning of the 

Paperwork Reduction Act of 1995 (44 

U.S.C. 3501 to 3520). The rule 

amendments contain several collections 

of information requirements, but the 

amendments do not change the burden 

per response from that under the current 

rules. Rule 203(b)(3)–2 will have the 

effect of requiring most advisers to 

hedge funds to register with the 

Commission under the Advisers Act and 

will therefore increase the number of 

respondents under several existing 

collections of information, and, 

correspondingly, increase the annual 

aggregate burden under those existing 

collections of information. The 

Commission has submitted, to the Office 

of Management and Budget (‘‘OMB’’) in 

accordance with 44 U.S.C. 3507(d) and 

5 CFR 1320.11, the existing collections 

of information for which the annual 

aggregate burden will likely increase as 

a result of rule 203(b)(3)–2. The titles of 

the affected collections of information 

are: ‘‘Form ADV,’’ ‘‘Form ADV–W and 

Rule 203–2,’’ ‘‘Rule 203–3 and Form 

ADV–H,’’ ‘‘Form ADV–NR,’’ ‘‘Rule 204–

2,’’ ‘‘Rule 204–3,’’ ‘‘Rule 204A–1,’’

‘‘Rule 206(4)–2, Custody of Funds or 

Securities of Clients by Investment 

Advisers,’’ ‘‘Rule 206(4)–3,’’ ‘‘Rule 

206(4)–4,’’ ‘‘Rule 206(4)–6,’’ and ‘‘Rule 

206(4)–7,’’ all under the Advisers Act. 

The existing rules affected by rule 

203(b)(3)–2 contain currently approved 

collection of information numbers 

under OMB control numbers 3235–

0049, 3235–0313, 3235–0538, 3235–

0240, 3235–0278, 3235–0047, 3235–

0596, 3235–0241, 3253–0242, 3235–

0345, 3235–0571 and 3235–0585, 

respectively. An agency may not 

conduct or sponsor, and a person is not 

required to respond to, a collection of 

information unless it displays a 

currently valid OMB control number. 

All of these collections of information 

are mandatory, and respondents in each 

case are investment advisers registered 

with us, except that (i) respondents to 

Form ADV are also investment advisers 

applying for registration with us; (ii) 

respondents to Form ADV–NR are nonresident general partners or managing 

agents of registered advisers; (iii) 

respondents to Rule 204A–1 include 

‘‘access persons’’ of an adviser 

registered with us, who must submit 

reports of their personal trading to their 

advisory firms; (iv) respondents to Rule 

206(4)–2 are only those SEC-registered 

advisers that have custody of clients’

funds or securities; (v) respondents to 

Rule 206(4)–3 are advisers who pay cash 

fees to persons who solicit clients for 

the adviser; (vi) respondents to Rule 

206(4)–4 are advisers with certain 

disciplinary histories or a financial 

condition that is reasonably likely to 

affect contractual commitments; and 

(vii) respondents to Rule 206(4)–6 are 

only those SEC-registered advisers that 

vote their clients’ securities. Unless 

otherwise noted below, responses are 

not kept confidential.

We cannot estimate with precision the 

number of hedge fund advisers that will 

be new registrants with the Commission 

under the Advisers Act after rule 

203(b)(3)–2 is adopted. As discussed 

earlier, our staff has estimated that 

between 690 and 1,260 hedge fund 

advisers will be new Advisers Act 

registrants under the new rule and rule 

amendments.352 For purposes of 

estimating the increases in respondents 

to the existing collections of 

information, we have used the midpoint 

of this estimated range, or 975 new 

respondents. We received no comments 

on these estimates.

A. Form ADV 

Form ADV is the investment adviser 

registration form. The collection of 

information under Form ADV is 

necessary to provide advisory clients, 

prospective clients, and the Commission 

with information about the adviser, its 

business, and its conflicts of interest. 

Rule 203–1 requires every person 

applying for investment adviser 

registration with the Commission to file 

Form ADV. Rule 204–1 requires each 

registered adviser to file amendments to 

Form ADV at least annually, and 

requires advisers to submit electronic 

filings through the IARD. This 

collection of information is found at 17 

CFR 275.203–1, 275.204–1, and 279.1. 

The currently approved collection of 

information in Form ADV is 102,653 

hours. We estimate that 975 new 

respondents will file one complete Form 

ADV and one amendment annually, and 

comply with Form ADV requirements 

relating to delivery of the code of ethics. 

Accordingly, we estimate the new rule 

will increase the annual aggregate 

information collection burden under 

Form ADV by 28,958 hours 353 for a total 

of 131,611 hours.

B. Form ADV–W and Rule 203–2

Rule 203–2 requires every person 

withdrawing from investment adviser 

registration with the Commission to file 

Form ADV–W. The collection of 

information is necessary to apprise the 

Commission of advisers who are no 

longer operating as registered advisers. 

This collection of information is found 

at 17 CFR 275.203–2 and 17 CFR 279.2. 

The currently approved collection of 

information in Form ADV–W is 500 

hours. We estimate that the 975 hedge 

fund advisers that will be new 

registrants will withdraw from SEC 

registration at a rate of approximately 16 

percent per year, the same rate as other 

registered advisers, and will file for 

partial and full withdrawals at the same 

rates as other registered advisers, with 

approximately half of the filings being 

full withdrawals and half being partial 

withdrawals. Accordingly, we estimate 

the new rule will increase the annual 

aggregate information collection burden 

72084 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

354 156 filings (975 × 0.16), consisting of 78 full 

withdrawals at 0.75 hours each and 78 partial 

withdrawals at 0.25 hours each.

355We expect that no hedge fund advisers would 

be small advisers that would be eligible to file for 

a continuing hardship exemption.

356 1 filing (975 × 0.001) at 1 hour each.

357 2 filings (975 × 0.002) at 1 hour each. 358See section 210(b) of the Advisers Act [15 

U.S.C. 80b–10(b)]. 359See rule 204–2(e). 360 975 hedge fund advisers x 191.78 hours per 

adviser = 186,985.5 hours.

361 975 hedge fund advisers times 694 hours per 

adviser.

362 975 hedge fund advisers at 117.95 hours per 

adviser annually.

under Form ADV–W and rule 203–2 by 

78 hours 354 for a total of 578 hours.

C. Rule 203–3 and Form ADV–H 

Rule 203–3 requires that advisers 

requesting either a temporary or 

continuing hardship exemption submit 

the request on Form ADV–H. An adviser 

requesting a temporary hardship 

exemption is required to file Form 

ADV–H, providing a brief explanation of 

the nature and extent of the temporary 

technical difficulties preventing it from 

submitting a required filing 

electronically. Form ADV–H requires an 

adviser requesting a continuing 

hardship exemption to indicate the 

reasons the adviser is unable to submit 

electronic filings without undue burden 

and expense. Continuing hardship 

exemptions are available only to 

advisers that are small entities. The 

collection of information is necessary to 

provide the Commission with 

information about the basis of the 

adviser’s hardship. This collection of 

information is found at 17 CFR 275.203–

3, and 279.3. The currently approved 

collection of information in Form ADV–

H is 10 hours. We estimate that the 

approximately 975 hedge fund advisers 

that will be new registrants will file for 

temporary hardship exemptions at 

approximately 0.1 percent per year, the 

same rate as other registered advisers.355

Accordingly, we estimate the new rule 

will increase the annual aggregate 

information collection burden under 

Form ADV–H and rule 203–3 by 1 

hour 356 for a total of 11 hours.

D. Form ADV–NR 

Non-resident general partners or 

managing agents of SEC-registered 

investment advisers must make a onetime filing of Form ADV–NR with the 

Commission. Form ADV–NR requires 

these non-resident general partners or 

managing agents to furnish us with a 

written irrevocable consent and power 

of attorney that designates the 

Commission as an agent for service of 

process, and that stipulates and agrees 

that any civil suit or action against such 

person may be commenced by service of 

process on the Commission. The 

collection of information is necessary 

for us to obtain appropriate consent to 

permit the Commission and other 

parties to bring actions against nonresident partners or agents for violations 

of the federal securities laws. This 

collection of information is found at 17 

CFR 279.4. The currently approved 

collection of information in Form ADV–

NR is 15 hours. We estimate that the 

approximately 975 hedge fund advisers 

that will be new registrants will make 

these filings at the same rate (0.2 

percent) as other registered advisers. 

Accordingly, we estimate the new rule 

will increase the annual aggregate 

information collection burden under 

Form ADV–NR by 2 hours 357 for a total 

of 17 hours.

E. Rule 204–2

Rule 204–2 requires SEC-registered 

investment advisers to maintain copies 

of certain books and records relating to 

their advisory business. The collection 

of information under rule 204–2 is 

necessary for the Commission staff to 

use in its examination and oversight 

program. Responses provided to the 

Commission in the context of its 

examination and oversight program are 

generally kept confidential.358 The 

records that an adviser must keep in 

accordance with rule 204–2 must 

generally be retained for not less than 

five years.359 This collection of 

information is found at 17 CFR 275.204–

2. The currently approved collection of 

information for rule 204–2 is 1,537,884 

hours, or 191.78 hours per registered 

adviser. We estimate that all 975 

advisers that will be new registrants will 

maintain copies of records under the 

requirements of rule 204–2. 

Accordingly, we estimate the new rule 

will increase the annual aggregate 

information collection burden under 

rule 204–2 by 186,985.5 hours 360 for a 

total of 1,724,869.5 hours.

F. Rule 204–3

Rule 204–3, the ‘‘brochure rule,’’

requires an investment adviser to 

deliver or offer to prospective clients a 

disclosure statement containing 

specified information as to the business 

practices and background of the adviser. 

Rule 204–3 also requires that an 

investment adviser deliver, or offer, its 

brochure on an annual basis to existing 

clients in order to provide them with 

current information about the adviser. 

The collection of information is 

necessary to assist clients in 

determining whether to retain, or 

continue employing, the adviser. This 

collection of information is found at 17 

CFR 275.204–3. The currently approved 

collection of information for rule 204–

3 is 5,412,643 hours, or 694 hours per 

registered adviser, assuming each 

adviser has on average 670 clients. We 

estimate that all 975 advisers that will 

be new registrants will provide 

brochures as required by rule 204–3. 

Accordingly, we estimate the new rule 

will increase the annual aggregate 

information collection burden under 

rule 204–3 by 676,650 hours 361 for a 

total of 6,089,293 hours. We note that 

the average number of clients per 

adviser reflects a small number of 

advisers who have thousands of clients, 

while the typical SEC-registered adviser 

has approximately 76 clients. We 

requested, but did not receive, 

comments on the number of clients of 

the average hedge fund adviser.

G. Rule 204A–1

Rule 204A–1 requires SEC-registered 

investment advisers to adopt codes of 

ethics setting forth standards of conduct 

expected of their advisory personnel 

and addressing conflicts that arise from 

personal securities trading by their 

personnel, and requiring advisers’

‘‘access persons’’ to report their 

personal securities transactions. The 

collection of information under rule 

204A–1 is necessary to establish 

standards of business conduct for 

supervised persons of investment 

advisers and to facilitate investment 

advisers’ efforts to prevent fraudulent 

personal trading by their supervised 

persons. This collection of information 

is found at 17 CFR 275.204A–1. The 

currently approved collection of 

information for rule 204A–1 is 945,841 

hours, or 117.95 hours per registered 

adviser. We estimate that all 975 

advisers that will be new registrants will 

adopt codes of ethics under the 

requirements of rule 204A–1 and 

require personal securities transaction 

reporting by their ‘‘access persons.’’

Accordingly, we estimate the new rule 

will increase the annual aggregate 

information collection burden under 

rule 204A–1 by 115,001 hours 362 for a 

total of 1,060,842 hours.

H. Rule 206(4)–2

Rule 206(4)–2 requires advisers with 

custody of their clients’ funds and 

securities to maintain controls designed 

to protect those assets from being lost, 

misused, misappropriated, or subjected 

to financial reverses of the adviser. The 

collection of information under rule 

206(4)–2 is necessary to ensure that 

clients’ funds and securities in the 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72085

363 975 hedge fund advisers times 670 clients 

times 0.5 hours per annual financial statement 

distribution. 364 195 respondents (975 × 0.2) at 7.04 hours 

annually per respondent.

365 169 respondents (975 × 0.173) at 7.5 hours 

annually per respondent.

366We estimate that 975 hedge fund advisers will 

spend 10 hours each annually documenting their 

voting policies and procedures, and will provide 

copies of those policies and procedures to 10 

percent of their 670 clients annually at 0.1 hours 

per response.

367 975 hedge fund advisers at 80 hours per 

adviser annually.

368 15 U.S.C. 80b–2(c).

custody of advisers are safeguarded, and 

staff of the Commission uses 

information contained in the collections 

in its enforcement, regulatory, and 

examination programs. This collection 

of information is found at 17 CFR 

275.206(4)–2. The currently approved 

collection of information for rule 

206(4)–2 is 72,113 hours. We estimate 

that all 975 hedge fund advisers that 

will be new registrants will have 

custody. Advisers to pooled investment 

vehicles such as hedge funds may 

distribute audited financial statements 

to their investors annually in lieu of 

quarterly account statements sent by 

either the adviser or a qualified 

custodian. We are amending rule 

206(4)–2 to make it easier for advisers 

to funds of hedge funds to use this 

approach. We estimate that all 975 new 

respondents will use this approach and 

will not be required to undergo an 

annual surprise examination. 

Accordingly, we estimate the new rule 

will increase the annual aggregate 

information collection burden under 

rule 206(4)–2 by 326,625 hours 363 for a 

total of 398,738 hours.

I. Rule 206(4)–3

Rule 206(4)–3 requires advisers who 

pay cash fees to persons who solicit 

clients for the adviser to observe certain 

procedures in connection with 

solicitation activity. The collection of 

information under rule 206(4)–3 is 

necessary to inform advisory clients 

about the nature of a solicitor’s financial 

interest in the recommendation of an 

investment adviser, so the client may 

consider the solicitor’s potential bias, 

and to protect investors against 

solicitation activities being carried out 

in a manner inconsistent with the 

adviser’s fiduciary duties. This 

collection of information is found at 17 

CFR 275.206(4)–3. The currently 

approved collection of information for 

rule 206(4)–3 is 10,982 hours. We 

estimate that approximately 20 percent 

of the 975 hedge fund advisers that will 

be new registrants will be subject to the 

cash solicitation rule, the same rate as 

other registered advisers. Accordingly, 

we estimate the new rule will increase 

the annual aggregate information 

collection burden under rule 206(4)–3 

by 1,373 hours 364 for a total of 12,355 

hours.

J. Rule 206(4)–4

Rule 206(4)–4 requires registered 

investment advisers to disclose to 

clients and prospective clients certain 

disciplinary history or a financial 

condition that is reasonably likely to 

affect contractual commitments. This 

collection of information is necessary 

for clients and prospective clients in 

choosing an adviser or continuing to 

employ an adviser. This collection of 

information is found at 17 CFR 

275.206(4)–4. The currently approved 

collection of information for rule 

206(4)–4 is 10,118 hours. We estimate 

that approximately 17.3 percent of the 

975 hedge fund advisers that will be 

new registrants will be subject to rule 

206(4)–4, the same rate as other 

registered advisers. Accordingly, we 

estimate the new rule will increase the 

annual aggregate information collection 

burden under rule 206(4)–4 by 1,265 

hours 365 for a total of 11,383 hours.

K. Rule 206(4)–6

Rule 206(4)–6 requires an investment 

adviser that votes client securities to 

adopt written policies reasonably 

designed to ensure that the adviser votes 

in the best interests of clients, and 

requires the adviser to disclose to 

clients information about those policies 

and procedures. This collection of 

information is necessary to permit 

advisory clients to assess their adviser’s 

voting policies and procedures and to 

monitor the adviser’s performance of its 

voting responsibilities. This collection 

of information is found at 17 CFR 

275.206(4)–6. The currently approved 

collection of information for rule 

206(4)–6 is 103,590 hours. We estimate 

that all 975 hedge fund advisers that 

will be new registrants will vote their 

clients’ securities. Accordingly, we 

estimate the new rule will increase the 

annual aggregate information collection 

burden under rule 206(4)–6 by 16,283 

hours 366 for a total of 119,873 hours.

L. Rule 206(4)–7

Rule 206(4)–7 requires each registered 

investment adviser to adopt and 

implement written policies and 

procedures reasonably designed to 

prevent violations of the Advisers Act, 

review those policies and procedures 

annually, and designate an individual to 

serve as chief compliance officer. This 

collection of information under rule 

206(4)–7 is necessary to ensure that 

investment advisers maintain 

comprehensive internal programs that 

promote the advisers’ compliance with 

the Advisers Act. This collection of 

information is found at 17 CFR 

275.206(4)–7. The currently approved 

collection of information for rule 

206(4)–7 is 623,200 hours, or 80 hours 

annually per registered adviser. We 

estimate all 975 advisers that will be 

new registrants will be required to 

maintain compliance programs under 

rule 206(4)–7. Accordingly, we estimate 

the new rule will increase the annual 

aggregate information collection burden 

under rule 206(4)–7 by 78,000 hours 367

for a total of 701,200 hours.

VII. Effects on Competition, Efficiency 

and Capital Formation 

Section 202(c) of the Advisers Act 

mandates that the Commission, when 

engaging in rulemaking that requires it 

to consider or determine whether an 

action is necessary or appropriate in the 

public interest, to consider, in addition 

to the protection of investors, whether 

the action will promote efficiency, 

competition, and capital formation.368

As discussed above, rule 203(b)(3)–2 

will, in effect, require most hedge fund 

advisers to register with the 

Commission under the Advisers Act. 

The new rule is designed to provide the 

protection afforded by the Advisers Act 

to investors in hedge funds, and to 

enhance the Commission’s ability to 

protect our nation’s securities markets. 

We are also adopting rule amendments 

that will facilitate hedge fund advisers’

transition to registration and improve 

the Commission’s ability to identify 

hedge fund advisers from information 

filed on their Form ADV. The new rule 

and rule amendments may indirectly 

increase efficiency for hedge fund 

investors. Hedge fund adviser 

registration will provide hedge fund 

investors and industry participants with 

better access to important basic 

information about hedge fund advisers 

and the hedge fund industry. This 

improved access may allow investors to 

investigate and select their advisers 

more efficiently. 

We do not anticipate that the new rule 

will introduce any competitive 

disadvantages. The new rule may 

provide a level playing field with 

respect to advisers’ compliance 

infrastructures. Many hedge fund 

advisers are already registered with us, 

either because their investors demand it 

or because they have other advisory 

business that requires them to register. 

These registered advisers must adopt 

compliance procedures under the 

72086 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

369 5 U.S.C. 605(b)

370Rule 0–7(a) [17 CFR 275.0–7(a)].

371 15 U.S.C. 80b–3A.

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

373Rule 206(4)–2.

374Rule 206(4)–2(b)(3).

375We initially proposed to extend the period for 

all investment advisers. Commenters pointed out 

that such extension would leave the advisers to 

funds of funds in the same situation, i.e., the 

underlying hedge funds would use the entire 180-

day period, and the advisers to the funds of funds 

would have no time to prepare financial statements 

for the funds of funds after they receive the 

financial statements from underlying hedge funds.

376This estimate is based on the information 

provided by SEC-registered advisers in Form ADV, 

Part 1A.

377See Section VIII.A. of this Release for the 

definition of a small entity. Unlike the other rules 

and amendments the Commission is proposing 

today, the scope of the amendment to rule 206(4)–

2 is not limited to hedge fund advisers that would 

be subject to registration requirements under rule 

203(b)(3)–2.

Advisers Act and must provide certain 

safeguards to their clients, including 

their hedge fund investors. While some 

unregistered hedge fund advisers have 

adopted sound comparable compliance 

procedures, others have not. Mandatory 

registration will require that all hedge 

fund advisers compete with each other 

and with other investment advisers on 

the same basis in this regard. The 

amendment to rule 204–2 is designed to 

prevent newly-registered hedge fund 

advisers from being at a competitive 

disadvantage with respect to the 

promotion of their previous 

performance records, and the 

amendment to rule 206(4)–2 is designed 

to allow advisers to funds of hedge 

funds to use the same approach under 

the adviser custody rule as do advisers 

to other pooled investment vehicles. 

Some hedge fund advisers may elect 

to limit the number of investors in their 

funds, or limit their total assets under 

management in order to avoid 

registration under the Advisers Act. To 

the extent that certain hedge fund 

advisers choose not to expand their 

business, some investors may not be 

able to place their assets with particular 

advisers; on the other hand, a hedge 

fund adviser’s decision not to expand its 

business may make it easier for other 

advisers to enter the market. 

The new rule is unlikely to have a 

substantial effect on capital formation. 

To the extent that registration and the 

prospect of Commission examinations 

improves the compliance culture at 

hedge fund advisory firms, it may 

bolster investor confidence and 

investors may be more likely to entrust 

hedge fund advisers with their assets for 

investment. However, these assets may 

be diverted from other investments in 

the capital markets.

VIII. Regulatory Flexibility Act 

A. Certification 

Pursuant to section 605(b) of the 

Regulatory Flexibility Act,369 the 

Commission hereby certifies that rule 

203(b)(3)–2 and the amendments to 

rules 203(b)(3)–1, 203A–3, 204–2, 205–

3, 222–2 and Form ADV will not have 

a significant economic impact on a 

substantial number of small entities. 

Under Commission rules, for the 

purposes of the Advisers Act and the 

Regulatory Flexibility Act, an 

investment adviser generally is a small 

entity if it: (i) Has assets under 

management having a total value of less 

than $25 million; (ii) did not have total 

assets of $5 million or more on the last 

day of its most recent fiscal year; and 

(iii) does not control, is not controlled 

by, and is not under common control 

with another investment adviser that 

has assets under management of $25 

million or more, or any person (other 

than a natural person) that had $5 

million or more on the last day of its 

most recent fiscal year.370

Rule 203(b)(3)–2 and the amendment 

to rule 203(b)(3)–1 will remove a safe 

harbor and require certain advisers to 

private funds to register with the 

Commission under the Advisers Act by 

requiring them to count investors in the 

fund as clients for purposes of the 

Advisers Act ‘‘de minimis’’ exemption 

from registration. Notwithstanding the 

new rule, investment advisers with 

assets under management of less than 

$25 million will remain generally 

ineligible for registration with the 

Commission under section 203A of the 

Advisers Act.371 The amendments to 

rule 203A–3 and 222–2 clarify that 

advisers may continue to rely on rule 

203(b)(3)–1’s safe harbor when counting 

clients for purposes of rules that affect 

state licensing and registration. The 

amendments to rules 204–2 and 205–3 

will allow advisers affected by the new 

rule to continue certain marketing 

practices and performance fees they 

now have in place. The amendment to 

Form ADV will require advisers to 

private funds to identify themselves as 

such. No other entities will incur 

obligations from the new rule and 

amendments. Accordingly, the 

Commission certifies that rule 

203(b)(3)–2 and the amendments to 

rules 203(b)(3)–1, 203A–3, 204–2, 205–

3, 222–2, and Form ADV will not have 

a significant economic impact on a 

substantial number of small entities.

B. Amendment to Rule 206(4)–2

The Commission has prepared the 

following Final Regulatory Flexibility 

Analysis (‘‘FRFA’’) regarding the 

amendment to rule 206(4)–2 in 

accordance with section 3(a) of the 

Regulatory Flexibility Act.372

1. Reasons for Action 

We are amending rule 206(4)–2, the 

adviser custody rule, to accommodate 

advisers to private funds of funds, 

including funds of hedge funds.373

Under the rule, advisers to pooled 

investment vehicles may satisfy their 

obligation to deliver custody account 

information to investors by distributing 

the pool’s audited financial statements 

to investors within 120 days of the 

pool’s fiscal year-end.374 Some advisers 

to private funds of funds (including 

funds of hedge funds) have encountered 

difficulty in obtaining completion of 

their fund audits prior to completion of 

the audits for the underlying funds in 

which they invest, and as a practical 

matter will be prevented from 

complying with the 120-day deadline. 

We amended the rule to extend the 

period for funds of funds to distribute 

their audited financial statements to 

their investors from 120 days to 180 

days, so that advisers to funds of hedge 

funds may comply with the rule.375

2. Objectives and Legal Basis 

The objective of the amendment to 

rule 206(4)–2 is to make the rule 

requirements easier to comply with for 

advisers to private funds of funds such 

as funds of hedge funds. Section IX of 

this Release lists the statutory authority 

for the amendment. 

3. Small Entities Subject to Rule 

The Commission estimates that as of 

June 30, 2004,376 approximately 490 

SEC-registered investment advisers that 

would be affected by the amendment to 

the rule were small entities for purposes 

of the Advisers Act and the Regulatory 

Flexibility Act.377

4. Reporting, Record-keeping, and Other 

Compliance Requirements 

The amendment will impose no new 

reporting, record-keeping or other 

compliance requirements. To the 

contrary, the amendment will provide 

all advisers, big or small, that advise 

funds of funds with the opportunity to 

reduce the burdens they incur 

complying with the present rule’s 

requirements to send pools’ audited 

financial statements to their investors 

within 120 days. 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72087

378 15 U.S.C. 77s(a).

379 15 U.S.C. 78w(a) and 78bb(e)(2).

380 15 U.S.C. 77sss(a).

381 15 U.S.C. 80a–37(a).

382 15 U.S.C. 80b–2(a)(17), 80b–3, 80b–4, 80b–6(4) 

and 80b–11(a).

383Section 211(a) also provides that ‘‘the 

Commission shall have authority from time to time 

to make, issue, amend, and rescind such rules and 

regulations and such orders as are necessary or 

appropriate to the exercise of the functions and 

powers conferred upon the Commission * * *.’’

5. Duplicative, Overlapping, or 

Conflicting Federal Rules 

The Commission believes that there 

are no rules that duplicate, overlap, or 

conflict with the amendment.

6. Significant Alternatives 

The Regulatory Flexibility Act directs 

the Commission to consider significant 

alternatives that will accomplish the 

stated objective, while minimizing any 

significant adverse impact on small 

entities. In connection with the new 

rule, the Commission considered the 

following alternatives: (a) The 

establishment of differing compliance or 

reporting requirements or timetables 

that take into account the resources 

available to small entities; (b) the 

clarification, consolidation, or 

simplification of compliance and 

reporting requirements under the rule 

for such small entities; (c) the use of 

performance rather than design 

standards; and (d) an exemption from 

coverage of the amendment for such 

small entities. 

The overall impact of the amendment 

is to decrease regulatory burdens on 

advisers; small advisers, as well as large 

ones, will benefit from the new rule. 

Moreover, the amendment achieves the 

rule’s objectives through alternatives 

that are already consistent in large part 

with advisers’ current custodial 

practices. For these reasons, alternatives 

to the amendment are unlikely to 

minimize any impact that the new rule 

may have on small entities. The 180-day 

rule cannot be further clarified, or 

improved by the use of a performance 

standard. Regarding exemption from 

coverage of the rule amendment, or any 

part thereof, for small entities, such an 

exemption will deprive small entities of 

the burden relief provided by the 

amendment. 

IX. Statutory Authority 

We are adopting new rule 203(b)(3)–

2 and amendments to rule 203(b)(3)–1, 

rule 203A–3, rule 204–2, rule 205–3, 

rule 206(4)–2, rule 222–2 and Form 

ADV pursuant to our authority under 

section 19(a) of the Securities Act of 

1933,378 sections 23(a) and 28(e)(2) of 

the Securities Exchange Act of 1934,379

section 319(a) of the Trust Indenture Act 

of 1939,380 section 38(a) of the 

Investment Company Act of 1940,381

and sections 202(a)(17), 203, 204, 

205(e), 206(4), 206A, 208(d) and 211(a) 

of the Advisers Act.382 Section 211(a) 

gives us authority to classify, by rule, 

persons and matters within our 

jurisdiction and to prescribe different 

requirements for different classes of 

persons, as necessary or appropriate to 

the exercise of our authority under the 

Act.383 Our authority is described in 

more detail in Section II.C of this 

Release.

Text of Rule, Rule Amendments and 

Form Amendments

List of Subjects in 17 CFR Parts 275 and 

279

Investment Advisers, Reporting and 

recordkeeping requirements, Securities.

■ For reasons set forth in the preamble, 

Title 17, Chapter II of the Code of Federal 

Regulations is amended as follows:

PART 275—RULES AND 

REGULATIONS, INVESTMENT 

ADVISERS ACT OF 1940

■ 1. The general authority citation for 

Part 275 continues to read as follows:

Authority: 15 U.S.C. 80b–2(a)(11)(F), 80b–

2(a)(17), 80b–3, 80b–4, 80b–4a, 80b–6(4), 

80b–6a, and 80b–11, unless otherwise noted.

* * * * *

■ 2. Section 275.203(b)(3)–1 is revised to 

read as follows:

§ 275.203(b)(3)–1 Definition of ‘‘client’’ of 

an investment adviser.

Preliminary Note to § 275.203(b)(3)–1.

This section is a safe harbor and is not 

intended to specify the exclusive 

method for determining who may be 

deemed a single client for purposes of 

section 203(b)(3) of the Act. Under 

paragraph (b)(6) of this section, the safe 

harbor is not available with respect to 

private funds. 

(a) General. You may deem the 

following to be a single client for 

purposes of section 203(b)(3) of the Act 

(15 U.S.C. 80b–3(b)(3)): 

(1) A natural person, and: 

(i) Any minor child of the natural 

person; 

(ii) Any relative, spouse, or relative of 

the spouse of the natural person who 

has the same principal residence; 

(iii) All accounts of which the natural 

person and/or the persons referred to in 

this paragraph (a)(1) are the only 

primary beneficiaries; and 

(iv) All trusts of which the natural 

person and/or the persons referred to in 

this paragraph (a)(1) are the only 

primary beneficiaries; 

(2)(i) A corporation, general 

partnership, limited partnership, 

limited liability company, trust (other 

than a trust referred to in paragraph 

(a)(1)(iv) of this section), or other legal 

organization (any of which are referred 

to hereinafter as a ‘‘legal organization’’) 

to which you provide investment advice 

based on its investment objectives rather 

than the individual investment 

objectives of its shareholders, partners, 

limited partners, members, or 

beneficiaries (any of which are referred 

to hereinafter as an ‘‘owner’’); and 

(ii) Two or more legal organizations 

referred to in paragraph (a)(2)(i) of this 

section that have identical owners. 

(b) Special rules. For purposes of this 

section: 

(1) You must count an owner as a 

client if you provide investment 

advisory services to the owner separate 

and apart from the investment advisory 

services you provide to the legal 

organization, provided, however, that 

the determination that an owner is a 

client will not affect the applicability of 

this section with regard to any other 

owner; 

(2) You are not required to count an 

owner as a client solely because you, on 

behalf of the legal organization, offer, 

promote, or sell interests in the legal 

organization to the owner, or report 

periodically to the owners as a group 

solely with respect to the performance 

of or plans for the legal organization’s 

assets or similar matters; 

(3) A limited partnership or limited 

liability company is a client of any 

general partner, managing member or 

other person acting as investment 

adviser to the partnership or limited 

liability company; 

(4) You are not required to count as 

a client any person for whom you 

provide investment advisory services 

without compensation; 

(5) If you have your principal office 

and place of business outside the United 

States, you are not required to count 

clients that are not United States 

residents, but if your principal office 

and place of business is in the United 

States, you must count all clients; 

(6) You may not rely on paragraph 

(a)(2)(i) of this section with respect to 

any private fund as defined in 

paragraph (d) of this section; and 

(7) For purposes of paragraph (b)(5) of 

this section, a client who is an owner of 

a private fund is a resident of the place 

at which the client resides at the time 

of the client’s investment in the fund. 

(c) Holding out. If you are relying on 

this section, you shall not be deemed to 

be holding yourself out generally to the 

72088 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

public as an investment adviser, within 

the meaning of section 203(b)(3) of the 

Act (15 U.S.C. 80b–3(b)(3)), solely 

because you participate in a non-public 

offering of interests in a limited 

partnership under the Securities Act of 

1933. 

(d) Private fund. (1) A private fund is 

a company: 

(i) That would be an investment 

company under section 3(a) of the 

Investment Company Act of 1940 (15 

U.S.C. 80a–3(a)) but for the exception 

provided from that definition by either 

section 3(c)(1) or section 3(c)(7) of such 

Act (15 U.S.C. 80a–3(c)(1) or (7)); 

(ii) That permits its owners to redeem 

any portion of their ownership interests 

within two years of the purchase of such 

interests; and 

(iii) Interests in which are or have 

been offered based on the investment 

advisory skills, ability or expertise of 

the investment adviser. 

(2) Notwithstanding paragraph (d)(1) 

of this section, a company is not a 

private fund if it permits its owners to 

redeem their ownership interests within 

two years of the purchase of such 

interests only in the case of: 

(i) Events you find after reasonable 

inquiry to be extraordinary; and 

(ii) Interests acquired through 

reinvestment of distributed capital gains 

or income. 

(3) Notwithstanding paragraph (d)(1) 

of this section, a company is not a 

private fund if it has its principal office 

and place of business outside the United 

States, makes a public offering of its 

securities in a country other than the 

United States, and is regulated as a 

public investment company under the 

laws of the country other than the 

United States.

■ 3. Section 275.203(b)(3)–2 is added to 

read as follows:

§ 275.203(b)(3)–2 Methods for counting 

clients in certain private funds. 

(a) For purposes of section 203(b)(3) 

of the Act (15 U.S.C. 80b–3(b)(3)), you 

must count as clients the shareholders, 

limited partners, members, or 

beneficiaries (any of which are referred 

to hereinafter as an ‘‘owner’’) of a 

private fund as defined in paragraph (d) 

of section 275.203(b)(3)–1, unless such 

owner is your advisory firm or a person 

described in paragraph (d)(1)(iii) of 

section 275.205–3. 

(b) If you provide investment advisory 

services to a private fund in which an 

investment company registered under 

the Investment Company Act of 1940 

(15 U.S.C. 80a–1 to 80a–64) is, directly 

or indirectly, an owner, you must count 

the owners of that investment company 

as clients for purposes of section 

203(b)(3) of the Act (15 U.S.C. 80b–

3(b)(3)). 

(c) If you have your principal office 

and place of business outside the United 

States, you may treat a private fund that 

is organized or incorporated under the 

laws of a country other than the United 

States as your client for all purposes 

under the Act, other than sections 203, 

204, 206(1) and 206(2) (15 U.S.C.

80b–3, 80b–4, 80b–6(1) and (2)).

■ 4. Section 275.203A–3 is amended by 

revising paragraph (a)(4) to read as 

follows:

§ 275.203A–3 Definitions. 

(a) * * *

(4) Supervised persons may rely on 

the definition of ‘‘client’’ in 

§ 275.203(b)(3)–1, without giving regard 

to paragraph (b)(6) of that section, to 

identify clients for purposes of 

paragraph (a)(1) of this section, except 

that supervised persons need not count 

clients that are not residents of the 

United States.

* * * * *

■ 5. Section 275.204–2 is amended by:

■ (a) Redesignating paragraph (e)(3) as 

(e)(3)(i); and

■ (b) Adding paragraphs (e)(3)(ii) and (l).

The additions read as follows:

§ 275.204–2 Books and records to be 

maintained by investment advisers.

* * * * *

(e) * * *

(3)(i) * * *

(ii) Transition rule. If you are an 

investment adviser to a private fund as 

that term is defined in § 275.203(b)(3)–

1, and you were exempt from 

registration under section 203(b)(3) of 

the Act (15 U.S.C. 80b–3(b)(3)) prior to 

February 10, 2005, paragraph (e)(3)(i) of 

this section does not require you to 

maintain or preserve books and records 

that would otherwise be required to be 

maintained or preserved under the 

provisions of paragraph (a)(16) of this 

section to the extent those books and 

records pertain to the performance or 

rate of return of such private fund or 

other account you advise for any period 

ended prior to February 10, 2005, 

provided that you were not registered 

with the Commission as an investment 

adviser during such period, and 

provided further that you continue to 

preserve any books and records in your 

possession that pertain to the 

performance or rate of return of such 

private fund or other account for such 

period.

* * * * *

(1) Records of private funds. If an 

investment adviser subject to paragraph 

(a) of this section advises a private fund 

(as defined in § 275.203(b)(3)–1), and 

the adviser or any related person (as 

defined in Form ADV (17 CFR 279.1)) of 

the adviser acts as the private fund’s 

general partner, managing member, or in 

a comparable capacity, the books and 

records of the private fund are records 

of the adviser for purposes of section 

204 of the Act (15 U.S.C. 80b–4).

6. Section 275.205–3 is amended by 

redesignating paragraph (c) as (c)(1) and 

adding paragraph (c)(2) to read as 

follows:

§ 275.205–3 Exemption from the 

compensation prohibition of section 

205(a)(1) for investment advisers.

* * * * *

(c)(1) * * *

(2) Advisers to private funds with 

non-qualified investors. If you are an 

investment adviser to a private 

investment company that is a private 

fund as that term is defined in 

§ 275.203(b)(3)–1, and you were exempt 

from registration under section 203(b)(3) 

of the Act (15 U.S.C. 80b–3(b)(3)) prior 

to February 10, 2005, paragraph (b) of 

this section will not apply to the 

existing account of any equity owner of 

a private investment company who was 

an equity owner of that company prior 

to February 10, 2005. 

(3) Advisers to private funds with 

non-qualified clients. If you are an 

investment adviser to a private 

investment company that is a private 

fund as that term is defined in 

§ 275.203(b)(3)–1, and you were exempt 

from registration under section 203(b)(3) 

of the Act (15 U.S.C. 80b–3(b)(3)) prior 

to February 10, 2005, section 205(a)(1) 

of the Act (15 U.S.C. 80b–5(a)(1)) will 

not apply to any investment advisory 

contract you entered into prior to 

February 10, 2005, provided, however, 

that this paragraph will not apply with 

respect to any contract to which a 

private investment company is a party, 

and provided further that section 

205(a)(1) of the Act will apply with 

respect to any natural person or 

company who is not a party to the 

contract prior to and becomes a party to 

the contract on or after February 10, 

2005.

* * * * *

■ 7. Section 275.206(4)–2 is amended by 

revising paragraph (b)(3) and adding 

paragraph (c)(4) to read as follows:

§ 275.206(4)–2 Custody of funds or 

securities of clients by investment advisers.

* * * * *

(b) * * *

(3) Limited partnerships subject to 

annual audit. You are not required to 

comply with paragraph (a)(3) of this 

section with respect to the account of a 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72089

1Registration Under the Advisers Act of Certain 

Hedge Fund Advisers, Investment Advisers Act 

Release No. 2266 (July 20, 2004) [69 FR 45172 (July 

28, 2004)] (‘‘Proposing Release’’).

2 In addition to the many comments the 

Commission received, the diversity of voices is 

illustrated by the appearance of editorials opposing 

the rulemaking in the New York Times, Wall Street 

Journal, and Washington Post. See Hands off Hedge 

Funds, Wash. Post, B6, July 18, 2004; Reforming 

Hedge Funds, N.Y. Times, D12, June 27, 2004; The 

SEC’s Expanding Empire, Wall St. J., A14, July 13, 

2004.

3Registration Under the Advisers Act of Certain 

Hedge Fund Advisers, Investment Advisers Act 

Release No. 2333 (Dec. 2, 2004) (‘‘Adopting 

Release’’).

limited partnership (or limited liability 

company, or another type of pooled 

investment vehicle) that is subject to 

audit (as defined in section 2(d) of 

Article 1 of Regulation S–X (17 CFR 

210.1–02(d)) at least annually and 

distributes its audited financial 

statements prepared in accordance with 

generally accepted accounting 

principles to all limited partners (or 

members or other beneficial owners) 

within 120 days of the end of its fiscal 

year, or in the case of a fund of funds 

within 180 days of the end of its fiscal 

year; and

* * * * *

(c) * * *

(4) Fund of funds means a limited 

partnership (or limited liability 

company, or another type of pooled 

investment vehicle) that invests 10 

percent or more of its total assets in 

other pooled investment vehicles that 

are not, and are not advised by, a related 

person (as defined in Form ADV (17 

CFR 279.1)), of the limited partnership, 

its general partner, or its adviser.

■ 8. Section 275.222–2 is revised to read 

as follows:

§ 275.222–2 Definition of ‘‘client’’ for 

purposes of the national de minimis 

standard. 

For purposes of section 222(d)(2) of 

the Act (15 U.S.C. 80b–18a(d)(2)), an 

investment adviser may rely upon the 

definition of ‘‘client’’ provided by 

section 275.203(b)(3)–1 without giving 

regard to paragraph (b)(6) of that 

section.

PART 279—FORMS PRESCRIBED 

UNDER THE INVESTMENT ADVISERS 

ACT OF 1940

■ 9. The authority citation for Part 279 

continues to read as follows:

Authority: The Investment Advisers Act of 

1940, 15 U.S.C. 80b–1, et seq.

■ 10. Form ADV (referenced in § 279.1) 

is amended by:

■ a. In Part 1A, Item 7, revising Item 7B; 

and

■ b. In Schedule D, revising Section 7.B.

The revisions read as follows:

Note: The text of Form ADV does not and 

this amendment will not appear in the Code 

of Federal Regulations.

Form ADV

* * * * *

Part 1A

* * * * *

Item 7 Financial Industry Affiliations

* * * * *

B. Are you or any related person a 

general partner in an investment-related 

limited partnership or manager of an 

investment-related limited liability 

company, or do you advise any other 

‘‘private fund,’’ as defined under SEC 

rule 203(b)(3)–1? b Yes b No 

If ‘‘yes,’’ for each limited partnership, 

limited liability company, or (if 

applicable) private fund, complete 

Section 7.B. of Schedule D. If, however, 

you are an SEC-registered adviser and

you have related persons that are SECregistered advisers who are the general 

partners of limited partnerships or the 

managers of limited liability companies, 

you do not have to complete Section 

7.B. of Schedule D with respect to those 

related advisers’ limited partnerships or 

limited liability companies.

To use this alternative procedure, you 

must state in the Miscellaneous Section 

of Schedule D: (1) that you have related 

SEC-registered investment advisers that 

manage limited partnerships or limited 

liability companies that are not listed in 

Section 7.B. of your Schedule D; (2) that 

complete and accurate information 

about those limited partnerships or 

limited liability companies is available 

in Section 7.B. of Schedule D of the 

Form ADVs of your related SECregistered advisers; and (3) whether 

your clients are solicited to invest in 

any of those limited partnerships or 

limited liability companies.

* * * * *

Schedule D

* * * * *

SECTION 7.B. Limited Partnership or 

Other Private Fund Participation 

You must complete a separate 

Schedule D Page 4 for each limited 

partnership in which you or a related 

person is a general partner, each limited 

liability company for which you or a 

related person is a manager, and each 

other private fund that you advise. 

Check only one box: 

b Add b Delete b Amend lllllllllllllllllllll

Name of Limited Partnership, Limited 

Liability Company, or other Private 

Fund:

lllllllllllllllllllll

Name of General Partner or Manager: 

If you are registered or registering 

with the SEC, is this a ‘‘private fund’’ as 

defined under SEC rule 203(b)(3)–1? 

b Yes b No 

Are your clients solicited to invest in 

the limited partnership, limited liability 

company or other private fund? 

b Yes b No 

Approximately what percentage of 

your clients have invested in this 

limited partnership, limited liability 

company, or other private fund? 

llllllll%

Minimum investment commitment 

required of a limited partner, member, 

or other investor: 

$llllllllllll

Current value of the total assets of the 

limited partnership, limited liability 

company, or other private fund: 

$llllllllllll

Dated: December 2, 2004.

By the Commission. 

Margaret H. McFarland, 

Deputy Secretary.

Dissent of Commissioners Cynthia A. 

Glassman and Paul S. Atkins to the 

Registration Under the Advisers Act of 

Certain Hedge Fund Advisers

Four months ago, the majority proposed to 

regulate hedge fund advisers over our 

dissent.1 We were nevertheless hopeful that 

a careful review of commentary on the 

proposal would convince the majority, 

instead of taking further action on this 

proposal, to consider better alternatives. Our 

hope was fueled by the fact that many 

commenters offered excellent insights and 

recommendations to the Commission. We are 

disappointed that the majority, unmoved by 

the chorus of credible concerns from diverse 

voices,2 has determined to adopt the hedge 

fund registration rules largely as proposed.3

As discussed below, we continue to agree 

that we need more information on hedge 

funds, but we disagree with the majority’s 

solution.

Our main concerns with this rulemaking 

can be broadly divided into the following 

categories: 

• There are many viable alternatives to this 

rulemaking that should have been 

considered. 

The needed information about hedge funds 

can be obtained from other sources, 

including other regulators and market 

participants, as well as through a notice and 

filing requirement. The Commission should 

have collected and analyzed the existing 

information and determined what new 

information would be useful before imposing 

mandatory registration. Further, the 

Commission has failed to demonstrate that 

this is the least burdensome and most 

effective way to accomplish its objective. 

• The pretext for the rule does not 

withstand scrutiny. 

Just last year, the staff found that fraud was 

not rampant in the hedge fund industry, and 

that retailization was not a concern. 

Nonetheless, the majority repeatedly asserts 

72090 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

4See Robert Schmidt, Hedge Fund Rule May 

Cause SEC to Drop Smaller Firms, Roye Says,

Bloomberg (Oct. 28, 2004).

5Such a major shift in the Commission’s 

regulatory approach warranted a significantly 

longer comment and comment review period than 

we afforded it. The proposal appeared in the 

Federal Register on July 28, 2004, and comments 

were due by September 15, 2004. Concerned about 

the brevity of the comment period and its 

inopportune timing during the vacation month of 

August, ten commenters requested a reasonable 

extension, but no extension was granted. 

Moreover, once the comment period closed, the 

staff did not prepare a formal summary analyzing 

the issues raised by the more than 160 comment 

letters, most of which opposed the rule. Such 

summaries are standard procedure for rulemakings 

of this significance, because the summaries help 

ensure that the comments are considered by the 

commissioners and staff. The abbreviated 

discussion of the comment letters in the adopting 

release is not a sufficient substitute for a comment 

summary that is prepared before drafting the release 

to assist the Commission in deciding whether to 

adopt a proposed rulemaking and, if so, whether to 

make any changes. 

The majority seems to have concluded that it had 

already heard all perspectives at the Commission’s 

roundtable on hedge funds in May of 2003 and 

through the subsequent staff study. See Securities 

and Exchange Commission, Hedge Fund 

Roundtable (May 14–15, 2003) (transcript and 

webcast available at: http://www.sec.gov/spotlight/

hedgefunds.htm) (‘‘Roundtable’’); Implications of 

the Growth of Hedge Funds, Staff Report to the 

United States Securities and Exchange Commission 

(Sept. 2003) (available at: http://www.sec.gov/news/

studies/hedgefunds0903.pdf) (‘‘2003 Staff Hedge 

Fund Report’’). However, the roundtable and staff 

study disproved the existence of the problems that 

some thought might be found in the hedge fund 

industry. Consequently, the public did not have 

sufficient notice that a rulemaking would be 

forthcoming, much less of the specifics of the 

proposed rulemaking.

6The Commodity Futures Trading Commission 

(‘‘CFTC’’), for example, has offered to enter into an 

information-sharing arrangement with the 

Commission and other relevant agencies. See

Comment Letter of the CFTC (Oct. 22, 2004). The 

National Futures Association, which is a selfregulatory organization for the futures industry, 

likewise offered to share the information that it 

collects about hedge funds. See Comment Letter of 

the National Futures Association (Sept. 14, 2004).

7Financial Crimes Enforcement Network; AntiMoney Laundering Programs for Investment 

Advisers, 68 FR 23646 (May 5, 2003). The proposed 

rule would apply to, among others, any adviser that 

has at least $30 million in assets under management 

and is exempt from registration under section 

203(b)(3) of the Investment Advisers Act [15 U.S.C. 

80b–3(b)(3)], unless it is otherwise required to have 

an anti-money laundering program and is subject to 

examination by a federal regulator. See section 

103.50(a)(2) of the proposed rule. [31 CFR 

103.50(a)(2)]. As proposed, the form is intended to 

identify unregistered advisers, but the Commission 

could work with the Department of Treasury to 

tailor the form to elicit the information that the 

Commission determines that it needs.

8The President’s Working Group is made up the 

heads of the Treasury, the Federal Reserve Board, 

the CFTC, and the SEC.

9See Letter from Congressman Richard H. Baker 

to John Snow, Chairman of the President’s Working 

Group on Financial Markets (Oct. 7, 2004). Oddly, 

the majority cites this letter, the existence of which 

we learned about the day before the Open Meeting 

for this rulemaking, in support of the proposition 

that ‘‘During and after the comment period, our staff 

has continued to have discussions with other 

regulators relating to hedge fund adviser 

regulation.’’ Adopting Release at n. 55.

10See, e.g., Alan Greenspan, Chairman, Federal 

Reserve Board, Testimony before the Senate 

Banking, Housing and Urban Affairs Committee 

(July 20, 2004) (‘‘My problem with the SEC’s 

current initiative is that the initiative cannot 

accomplish what it seeks to accomplish. Fraud and 

market manipulation will be very difficult to detect 

from the information provided by registration under 

the 1940 Act.’’); Comment Letter of the CFTC (Oct. 

22, 2004) (requesting exemption for CFTCregistered advisers that ‘‘would be complemented 

by a formal information sharing agreement between 

the CFTC and SEC related to CFTC-registered CPOs 

and CTAs’’); Judith Burns, Split SEC Set to Vote on 

Tighter Hedge Fund Oversight, Dow Jones News 

Service, Oct. 25, 2004 (‘‘Federal Reserve Chairman 

Alan Greenspan and Treasury Secretary John Snow 

worry that more regulation won’t prevent fraud and 

could reduce benefits that hedge funds bring to 

markets.’’).

11Hedge Funds, Leverage, and the Lessons of 

Long-Term Capital Management—Report of the 

President’s Working Group on Financial Markets, at 

B–16 (Apr. 1999) (available at: http://

www.treas.gov/press/releases/reports/hedgfund.pdf) 

(the Council of Economic Advisers, the Federal 

Deposit Insurance Corporation, the National 

Economic Council, the Federal Reserve Bank of 

New York, the Office of the Comptroller of the 

Currency, and the Office of Thrift Supervision also 

participated in the study and supported its 

conclusions and recommendations). The majority 

contends that the report did not focus on issues 

relevant to the Commission’s administration of the 

Advisers Act, but rather on ‘‘the stability of 

financial markets and the exposure of banks and 

other financial institutions to the counterparty risks 

of dealing with highly leveraged entities.’’ Adopting 

Release at n. 43. The Commission cannot protect 

the nation’s securities markets without considering 

the effect of its rules on the stability of the financial 

markets.

12See Alan Greenspan, Chairman, Federal 

Reserve Board, Written Responses to Questions 

from Chairman Shelby in Connection with 

Testimony before the Senate Banking, Housing and 

Urban Affairs Committee, at 3 (July 20, 2004).

that these issues justify imposition of the 

rulemaking. The fallacy of the majority’s 

approach is apparent when one notes that 

registration of hedge fund advisers would not 

have prevented the enforcement cases cited 

by the majority, and the rulemaking will have 

the perverse effect of promoting, rather than 

inhibiting, retailization. 

• The Commission’s limited resources will 

be diverted. 

At the open meeting, Chairman Donaldson 

stated that a task force had been constituted 

to identify hedge fund risks and implied that 

the task force would develop a targeted 

examination model. However, the task force 

should have completed its work prior to the 

promulgation of this rulemaking, so that it 

could be specifically tailored to address 

actual, as opposed to hypothetical, concerns. 

Under this rulemaking, the Commission will 

have to allocate its limited resources to 

inspect more than 1,000 additional advisers. 

Our concerns about the misuse of resources 

were validated when, just two days after the 

open meeting, the staff stated that, if the 

Commission cannot undertake its new 

examination responsibilities, it has in its 

‘‘back pocket’’ the ability to shift resources 

from oversight of small advisers.4 This 

possible shift should have been raised during 

the open meeting and weighed by the 

Commission in deciding whether to adopt 

the rule.

Our concerns are addressed in detail 

below.

I. The Information That the Commission 

Needs can be Obtained From Other Sources 

We share the majority’s objective of getting 

better information about hedge funds and 

would support alternative measures such as 

pooling of information from Commission 

registrants and other government agencies 

and self-regulatory organizations that collect 

data on hedge funds, enhanced oversight of 

existing registrants, a census of all hedge 

funds, and requiring additional periodic and 

systematic information to be filed with us. 

Although the majority anticipates without 

specificity that ‘‘registration would provide 

the Congress, the Commission and other 

government agencies with important 

information,’’ Form ADV is unlikely to 

provide the information that the Commission 

needs. Before taking an action of the 

magnitude of this final rule, the Commission 

should have determined the information that 

it needs and worked with its fellow 

regulators and affected parties to obtain this 

information. Instead, the process by which 

the rule was proposed and adopted 

discouraged a true exchange of ideas about 

the proposed approach and alternatives.5

A. Coordination With Other Regulators 

Should Have Been a Prerequisite to 

Unilateral Commission Action 

Before adopting this rulemaking, the 

Commission should have coordinated with 

other government entities to aggregate the 

information that is available. The majority 

correctly notes that such information is not 

gathered in one convenient place, but we 

could work with other regulators to improve 

our and other agencies’ access to 

information.6 The Commission also could 

explore ways of expanding the form that the 

Department of Treasury has proposed to 

require all unregistered advisers to file as 

part of its anti-money laundering program for 

investment advisers.7

The majority approved the rulemaking 

three weeks after Congressman Baker, 

Chairman of the House Subcommittee on 

Capital Markets, Insurance and Government 

Sponsored Enterprises, asked the President’s 

Working Group on Financial Markets 

(‘‘PWG’’) 8 to work out a data sharing 

agreement before the Commission proceeded 

with its rule.9 Because the regulation of 

hedge funds has broad market implications, 

any regulatory requirement would be more 

appropriately addressed as part of a 

collaborative effort among the members of 

the PWG, all of whom apparently have 

concerns with our proposal.10 In 1999 after 

the near collapse of Long Term Capital 

Management, the PWG issued a report that 

concluded that ‘‘requiring hedge fund 

managers to register as investment advisers 

would not seem to be an appropriate method 

to monitor hedge fund activity.’’ 11 We agree 

with Chairman Greenspan that nothing has 

changed since then to warrant a different 

conclusion.12

The majority justifies going forward in the 

face of such opposition by arguing that the 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72091

13Adopting Release at n. 43.

14As the Commission has explained elsewhere, 

the Commission’s interest in a particular area does 

not preclude its working with other regulators. See, 

e.g., SEC, 2002 Annual Report 1 (available at:

http://www.sec.gov/pdf/annrep02/ar02fm.pdf) 

(‘‘Though it is the primary overseer and regulator 

of the U.S. securities markets, the SEC works 

closely with many other institutions * * *’’). The 

Adopting Release notes that the staff met with staff 

of various fellow regulators, but because these 

meetings were not documented in the comment file, 

it is difficult to discern what occurred at those 

meetings. See Adopting Release at n. 17.

15See Comment Letter of the CFTC (Oct. 22, 

2004) (‘‘in the interest of good government and in 

order to avoid duplicative regulation, the CFTC 

respectfully requests that the SEC provide a 

registration exemption for these CFTC registrants 

that do not hold themselves out to the general 

public as investment advisers.’’). Many other 

commenters also recommended an exemption for 

CFTC-registered entities. The majority dismisses 

requests to exempt CFTC-registered commodity 

pool operators by arguing that Congress already 

addressed this concern by adding section 203(b)(6) 

to the Advisers Act in 2000 [15 U.S.C. 80b–3(b)(6)], 

but that section covers only commodity trading 

advisers, not commodity pool operators. See

Adopting Release at text accompanying n. 128. We 

share the majority’s hope that the staff will consult 

with the CFTC staff regarding examinations, but 

staff discussions at the implementation stage cannot 

substitute for discussions about the Commission’s 

proposal prior to adoption. See Adopting Release at 

n. 130.

16Many commenters recommended that the 

Commission should not require the registration of 

certain advisers that are subject to oversight by 

foreign authorities. See, e.g., Comment Letter of the 

European Commission (Sept. 15, 2004); Comment 

Letter of the Fe ́de ́ration Europe ́enne des Fonds et 

Socie ́te ́s d’Investissement (Sept. 15, 2004); 

Comment Letter of the Financial Services 

Roundtable (Sept. 15, 2004); the International Bar 

Association (Sept. 14, 2004).

17See, e.g., Alan Greenspan, Chairman, Federal 

Reserve Board, Written Responses to Questions 

from Chairman Shelby in Connection with 

Testimony before the Senate Banking, Housing and 

Urban Affairs Committee, (July 20, 2004) (‘‘If there 

was a public policy reason to monitor hedge fund 

activity, the best method of doing so without raising 

liquidity concerns would be indirectly through 

oversight of those broker-dealers (so-called prime 

brokers) that clear, settle, and finance trades for 

hedge funds. Although the use of multiple prime 

brokers by the largest funds would complicate the 

monitoring of individual funds by this method, 

such monitoring could provide much useful 

information on the hedge funds sector as a 

whole.’’).

18See, e.g., Alan Greenspan, Chairman, Federal 

Reserve Board, Written Responses to Questions 

from Chairman Shelby in Connection with 

Testimony before the Senate Banking, Housing and 

Urban Affairs Committee (July 20, 2004) (‘‘Concerns 

about market manipulation, whether by hedge 

funds or others, can best be addressed by enhanced 

market surveillance.’’).

19 15 U.S.C. 80a–3(c)(1) and 15 U.S.C. 80a–3(c)(7).

20 17 CFR 275.203(b)(3)–1.

21A number of commenters suggested this 

approach or a similar annual census form for hedge 

fund advisers. See, e.g., Comment Letter of the 

American Bar Association, Section of Business Law 

(Sept. 28, 2004); Comment Letter of Sheila C. Bair, 

Professor of Financial Regulatory Policy, University 

of Massachusetts—Amherst (Sept. 15, 2004); 

Comment Letter of the U.S. Chamber of Commerce 

(Sept. 15, 2004); Comment Letter of Kynikos 

Associates (Sept. 15, 2004); Comment Letter of the 

Managed Funds Association (Sept. 15, 2004); 

Comment Letter of Seward & Kissell LLP (Sept. 15, 

2004); Comment Letter of Schulte Roth & Zabel, 

LLP (Sept. 15, 2004); Comment Letter of Tudor 

Investment Corp. (Sept. 15, 2004). Other 

commenters suggested requiring hedge fund 

advisers to file audited financial statements. See, 

e.g., Comment Letter of Madison Capital 

Management LLC (Sept. 15, 2004); Comment Letter 

of James E. Mitchell (Sept. 1, 2004); Comment Letter 

of Joseph L. Vidich (Aug. 7, 2004); Comment Letter 

of Willkie, Farr & Gallagher (Sept. 13, 2004) 

(recommending self-executing exemptive 

application procedure for advisers that provide 

investors with audited financials and valuation 

disclosures).

22See Adopting Release at n. 150.

23See Adopting Release at text accompanying n. 

154. The majority also concluded that it was not 

worthwhile for the staff to try to make use of the 

information generated by existing transactional 

reporting requirements. See Adopting Release at 

text following n. 155. This seems to be a premature 

conclusion, particularly in light of commenters’

suggestion to tailor current forms so that they meet 

the Commission’s information needs. See, e.g., 

Comment Letter of Bryan Cave LLP (Aug. 16, 2004) 

(recommending extensive amendments to 

Regulation D and Form D and Suspicious Activity 

Reports); Comment Letter of Madison Capital 

Management LLC (Sept. 15, 2004); Comment Letter 

of Proskauer Rose LLP (Aug. 31, 2004); Comment 

Letter of Tudor Investment Corp. (Sept. 15, 2004).

24The majority estimates the hedge fund industry 

to be $870 billion, which is dwarfed by the 

approximately $23 trillion under management by 

registered advisers. See Adopting Release at text 

accompanying n. 19 and following n. 71.

25Proposing Release, supra n. 1, at text following 

n. 183.

26This belief manifests itself in the perfunctory 

manner in which the majority dismisses legitimate 

concerns from opposing commenters by challenging 

the commenters’ integrity. See, e.g., Adopting 

Release at text accompanying n. 87 (noting, that 

hedge fund advisers ‘‘should be particularly 

sensitive to the consequences of getting caught if 

Continued

Commission alone among the PWG members 

bears the ‘‘responsibility for the protection of 

investors and the oversight of our nation’s 

securities markets,’’ 13 but other regulators 

may be better suited to address some of the 

majority’s specific areas of concern.14 The 

majority, for example, did not consult the 

Department of Labor, which has primary 

jurisdiction over private pension plan 

advisers, about this rulemaking even though 

one of its justifications for the rulemaking is 

pension fund investment in hedge funds. The 

CFTC, with which many hedge fund advisers 

or sponsors are already registered, expressed 

serious concerns about duplicative regulation 

by the SEC and recommended an exemption 

for CFTC registrants.15 Similarly, although 

the majority addressed a number of concerns 

raised with respect to offshore funds, they 

did not adequately address, through 

discussions with foreign regulators, 

commenters’ concerns about potentially 

duplicative regulation.16

B. Before Proceeding With Registration, the 

Commission Should Have Enhanced Its 

Oversight of Existing Registrants 

Rather than adding to its stable of 

registrants, the Commission could have 

obtained useful information by monitoring 

transactions through its existing registrants. 

The Commission, for example, could 

enhance its oversight of prime brokers to 

detect and deter fraud by their hedge fund 

clients and obtain more information about 

hedge fund advisers.17 More generally, 

market surveillance is an effective, targeted 

way of finding fraud, and would allow us to 

leverage the knowledge and expertise of 

other self-regulatory organizations.18

C. Commenters Showed a Commendable 

Willingness To Help the Commission Obtain 

the Information We Need Through Mining 

Existing Information Resources or Developing 

New Ones 

The commenters, the vast majority of 

which opposed mandatory registration, 

suggested a number of alternatives for 

ensuring that the Commission has ample 

information about hedge funds. Among the 

suggestions was requiring investment 

advisers that are exempt under sections 

(3)(c)(1) or (3)(c)(7) of the Investment 

Company Act of 1940 19 or rely on the safe 

harbor in rule 203(b)(3)–1 under the Advisers 

Act 20 to file and annually update 

information statements with the 

Commission.21 These information statements 

could include information such as the names 

of all unregistered funds advised, the names 

and qualifications of the key owners and 

employees of the adviser, assets under 

management, other types of accounts 

managed, a list of the prime brokers used by 

the adviser, and performance data. The 

majority’s footnote addressing this approach 

dismisses this as a variant of another 

suggested approach—expanded Form D 

reporting.22 The majority refused to consider 

either approach because both lack an 

examination component.23 For the reasons 

stated below, we do not believe that the 

examination aspect of hedge fund regulation 

will deliver the benefits that the majority 

believes it will and we are concerned with 

the diversion of resources that examination 

will entail.

II. Mandatory Registration Does Not Address 

the Concerns Underlying the Rulemaking 

The majority cites three main bases for its 

action: the growth of hedge fund assets, the 

growth in hedge fund fraud, and the broader 

exposure to hedge funds. None of these 

justifies the majority’s action. 

A. The Commission Should Not Necessarily 

Increase Its Regulatory Requirements on an 

Industry Simply Because It Has Grown 

The majority points to the growth of the 

hedge fund industry as a concern underlying 

the action being taken. Given the industry’s 

size,24 the Commission has a basis for 

wanting more information about it, but the 

Commission should not assume that a greater 

level of regulation is needed in a flourishing 

industry with a wealthy and sophisticated 

investor base.

In the Proposing Release, the majority 

argued that registration would ‘‘legitimiz[e] a 

growing and maturing industry that is 

currently perceived as operating in the 

shadows.’’25 The Adopting Release does not 

repeat this dramatic language, but the 

underlying belief that there is something 

improper about not registering voluntarily is 

evident.26 The Commission should not 

72092 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

their conduct is unlawful. * * * This sensitivity, 

which may be reflected in the strength of the 

opposition among some hedge fund advisers to this 

rulemaking, suggests that the marginal benefits of 

our oversight may be substantial.’’). See also

William H. Donaldson, Chairman, SEC, Testimony 

before the Senate Banking Committee (July 15, 

2004) (video testimony available at: http://

banking.senate.gov/index.cfm?Fuseaction= 

Hearings.Detail&HearingID=122) (‘‘I don’t get much 

push back from people that are operating good 

funds. I don’t get much push back from people who 

have nothing to hide.’’).

27See, e.g., Comment Letter of Amaranth 

Advisors LLC (Sept. 15, 2004) (hedge fund adviser 

explains that it does not operate in the shadows, but 

under the scrutiny of a number of regulators); 

Comment Letter of the Greenwich Roundtable 

(Sept. 15, 2004) (‘‘The hedge fund industry is 

already a highly legitimate and professional 

industry. Sophisticated investors in the hedge fund 

community make significant allocation decisions 

based in large part on the rigorous due diligence 

examinations that they personally perform prior to 

making an investment.’’); Comment Letter of the 

Managed Funds Association (Sept. 15, 2004) 

(detailing regulatory obligations to which hedge 

fund advisers are subject). The perception that 

hedge funds operate in the shadows might be 

attributable partially to the limitations to which 

hedge fund advisers are subject. See, e.g., 

Testimony of Michael Neus, Principal and Chief 

General Counsel, Andor Capital Management, LLC, 

at the Hedge Fund Roundtable, supra n. 5 (May 14, 

2004) (‘‘it’s a highly professional, highly organized 

industry which, because of restrictions on 

advertising or holding yourself out to the public, we 

are not capable of sharing with the general public 

***’’).

28See 2003 Staff Hedge Fund Report, supra n. 5, 

at 73. The majority notes that it is ‘‘not alone in [its] 

concerns regarding hedge fund frauds’’ and cites the 

results of interviews with managers of European 

financial institutions about the state of the 

European Financial Market. See Adopting Release 

at n. 27 (citing Bank of New York, Restoring Broken 

Trust: A Pan European Study of the Causes of 

Declining Trust in the European Financial Services 

Industry and Analysis of the Actions Needed to 

Rebuild Investor Trust (July 2004). While 

interesting, the opinions expressed by these 

European managers are largely immaterial in the 

context of the U.S. industry, and it is not clear how 

today’s rulemaking will address these concerns.

29See Testimony of Patrick J. McCarty, General 

Counsel of the CFTC, before the U.S. Senate 

Committee on Banking, Housing and Urban Affairs 

1 (July 15, 2004). See also Comment Letter of the 

National Futures Association (Sept. 14, 2004) 

(NFA’s experience with the hedge funds it oversees 

is ‘‘consistent with the comparatively small number 

of CFTC and SEC enforcement actions involving 

commodity pool and hedge fund activities.’’).

30Hedge fund advisers, like other advisers, 

generally will be required to register only if they 

have assets under management of $30 million or 

more and advisers with between $25 million and 

$30 million will be permitted to register. See

Investment Advisers Act section 203A(a)(1) [15 U.S. 

80b–3a(a)(1)] and rule 203A–1 [17 CFR 275.203A–

1] thereunder.

31The majority states that ‘‘[o]ur examination 

staff uncovered, during routine or sweep exams, 

five of the eight cases we brought against registered 

hedge fund advisers * * *.’’ Adopting Release at n. 

94 and accompanying text. One of those cases was 

uncovered during a sweep examination that was 

prompted by a civil complaint filed by the New 

York Attorney General. See In the Matter of 

Alliance Capital Management, L.P., Investment 

Advisers Act Release No. 2205 (Dec. 18, 2003). In 

another, the problem was not discovered until 

seven years after it began. See In the Matter of 

Portfolio Advisory Services, LLC and Cedd L. 

Moses, Investment Advisers Act Release No. 2038 

(June 20, 2002). The Commission cannot rely on 

registration to unearth violations in a prompt and 

predictable manner.

32 In our dissent to the Proposing Release, we 

discussed these 46 cases in detail. See Proposing 

Release, supra n. 1, at 45197–98. The advisers 

implicated in the five newly-identified cases likely 

would fall outside the scope of the rulemaking. See

SEC v. Haligiannis, et al, Litigation Release No. 

18853 (Aug. 25, 2004) (having raised $27 million 

over eight years, the hedge fund’s president and 

general partners likely would not have been 

required to register); SEC v. Scott B. Kaye, et al., 

Litigation Release No. 18845 (Aug. 24, 2004) 

(having raised only $1.9 million, the adviser likely 

would not have been required to register); SEC v. 

Gary M. Kornman, Litigation Release No. 18836 

(Aug. 18, 2004) (individual that used inside 

information to make trades on behalf of hedge funds 

was owner of broker-dealer registered with the 

Commission); SEC v. Anthony P. Postiglione, Jr., et 

al., Litigation Release No. 18824 (Aug. 9, 2004) 

(having raised approximately $5 million, the 

adviser likely would not have been required to 

register); SEC v. Adam G. Kruger and Kruger, 

Miller, and Tummillo, Inc., Investment Advisers 

Act Release No. 2297 (Sept. 15, 2004) (having raised 

approximately $1 million, the adviser likely would 

not have been required to register).

33The majority anticipates that hedge fund 

investors will demand that even new hedge fund 

advisers register. These advisers will be able to 

register even before they have $25 million under 

management if they have a reasonable expectation 

of meeting the $25 million threshold within 120 

days. See rule 203A–2(d) [17 CFR 275.203A–2(d)]. 

It is not realistic to assume that all new advisers 

would register. Reaching $25 million in assets 

under management within four months is likely to 

be an unrealistic goal for many.

34See also SEC v. Sanjay Saxena, Litigation 

Release No. 16641 (Aug. 2, 2000) (having already 

been barred by the Commission from acting as an 

investment adviser, the defendant used his wife as 

a front for his advisory activity).

35The Commission, for example, employed its 

subpoena power in order to impose a broad 

document request on unregistered hedge fund 

advisers to enable the staff to gather information for 

the 2003 Staff Hedge Fund Report. See supra n. 5.

36See, e.g., Comment Letter of W. Hardy Callcott, 

Bingham McCutchen LLP (Sept. 15, 2004) 

(anticipating that addition of hedge fund advisers 

to examination pool could disproportionately slow 

the examination cycle for all advisers because ‘‘it 

is likely to take a substantial amount of time and 

effort for [] examiners to understand what they are 

seeing—hedge fund trading strategies and 

operations are often far more complex than those 

at mutual funds and retail-oriented investment 

advisers’’).

encourage an adviser’s registration status to 

be viewed as a proxy for the adviser’s 

honesty. There are many legitimate reasons 

for a hedge fund adviser not to register.27

B. Registration Would Not Have Prevented 

the Violations in the Enforcement Cases 

Cited by the Majority 

While we acknowledge that hedge fund 

fraud exists and should be taken seriously, it 

appears, based on our knowledge, that the 

majority overstates its relative significance. 

The 2003 Staff Hedge Fund Report did not 

find disproportionate involvement of hedge 

funds or their advisers in fraud.28 We 

estimate that the cases cited by the majority 

during the past five years comprise less than 

two percent of total SEC cases in the same 

period. The CFTC similarly found that only 

three percent of all SEC and CFTC 

enforcement actions were against hedge 

funds or their advisers.29

Citing to forty-six cases in the Proposing 

Release and five additional cases in the 

Adopting Release, the majority is requiring 

advisers to the most sophisticated investors 

to register based on fraud cases, most of 

which were directed at the least 

sophisticated investors. These cases do not 

provide a justification for mandatory 

registration because, in most, the hedge fund 

advisers would have been too small to be 

registered under the new requirement,30 were 

already registered,31 or should have been 

registered.32 Many were garden-variety 

fraudsters who could as easily have called 

their schemes something other than ‘‘hedge 

funds.’’ The majority argues that registration 

with the Commission permits it to screen 

registrants and deny registration to anyone 

who has been convicted of a felony or 

otherwise has a disciplinary history that 

warrants disqualification. Many of those 

implicated in our cases would not even have 

sufficient assets to be eligible for 

registration.33 Others, whose sole objective 

was to defraud investors, likely would not 

even attempt to register, but would 

nevertheless perpetrate their frauds.34

The majority also points to the 

involvement of hedge funds in the recent 

market timing scandals as evidence of a need 

for registration. The illegal conduct occurred 

when advisers to mutual funds contravened 

their fund prospectuses by allowing hedge 

funds and others to engage in market timing. 

While the Commission also should pursue 

any securities law violations by hedge funds 

(and is doing so), it should not necessarily 

impugn hedge fund advisers for the legally 

permissible actions they took to enhance the 

performance of the hedge funds. Finally, to 

the extent hedge fund advisers committed 

illegal actions, it is difficult to believe that 

this rulemaking would have stopped them. 

Despite the Commission’s examination 

authority over mutual fund advisers, all of 

whom must be registered under the Advisers 

Act, routine examinations did not uncover 

the illegal conduct. In addition, of the 

approximately 70 hedge fund advisers 

involved in these cases, at least 20 were 

registered.

In the hedge fund context, routine 

examinations will not be an effective tool for 

the Commission. The Commission already 

can invoke its subpoena power to investigate 

potential fraudulent abuses in hedge funds.35

Certainly a perfectly-timed routine 

examination could expose fraud, but with so 

many registrants and so few examiners, it is 

unrealistic to anticipate that this will happen 

very often. Moreover, because hedge fund 

advisers tend to employ more complex 

investment strategies than the typical 

registered adviser, the Commission will have 

to incur substantial training costs in order to 

understand and oversee the newly registered 

hedge fund advisers.36 Chairman Donaldson 

envisions being able ‘‘to apply our manpower 

and expertise in an effective, risk-based 

system designed not only for this 

responsibility but ultimately as an 

underpinning for all examinations and 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72093

37Chairman William H. Donaldson, Remarks at 

Open Meeting: Registration of Hedge Fund Advisers 

(Oct. 26, 2004).

38See Comment Letter of W. Hardy Callcott, 

Bingham McCutchen LLP (Sept. 15, 2004) (‘‘The 

Commission should not rely on a risk assessment 

model to replace regular cycle examinations—

certainly not until such a model has been rigorously 

tested and has a track record of effective 

implementation.’’).

39As Chairman Greenspan noted: Even should 

SEC’s proposed risk evaluation surveillance of 

hedge funds detect possible trading irregularities, 

which I doubt frankly, those irregularities will 

likely be idiosyncratic and of mainly historic 

interest, because by the time of detection, hedge 

funds would have long since moved on to different 

strategies. 

Alan Greenspan, Chairman, Federal Reserve 

Board, Testimony before the Senate Banking, 

Housing and Urban Affairs Committee (July 20, 

2004).

40See Adopting Release at text accompanying nn. 

87–88. Because examinations take place so 

infrequently, the marginal increase in the chance of 

getting caught will not change the fraudster’s 

calculus significantly. Further, the majority, to be 

consistent in its deterrence analysis, should take 

into account the shift of resources away from other 

types of advisers and hence the resulting decrease 

in deterrence for those advisers, particularly 

because they see the Commission’s focus on hedge 

fund advisers as an area of emerging risk.

41As Chairman Donaldson noted when testifying 

before Congress this year, the Commission has only 

495 staff conducting examinations of approximately 

8,000 mutual funds, managed in over 900 fund 

complexes, as well as more than 8,000 investment 

advisers. See Testimony of William H. Donaldson, 

Chairman, Securities and Exchange Commission, 

before the House Subcommittee on Commerce, 

Justice, State, and the Judiciary, Committee on 

Appropriations (Mar. 31, 2004) (‘‘During most of the 

period from 1998 to early 2003, the SEC’s 

examination program for funds and advisers had 

approximately 370 members on its staff (including 

examiners, supervisors, and support staff). Routine 

examinations were conducted every five years. In 

the last two years, program staffing was increased 

by one-third, to approximately 495 employees. With 

this staffing increase, the SEC has increased the 

frequency of examinations of funds and advisers 

posing the greatest compliance risks, and is 

conducting more examinations targeted to areas of 

emerging compliance risk.’’).

42Testimony of William H. Donaldson, Chairman, 

SEC, before the Senate Committee on Banking, 

Housing and Urban Affairs (July 15, 2004) (‘‘I have 

asked the staff to develop an enhanced risk-based 

approach to oversight and examination of our 

investment adviser registrants, including hedge 

fund advisers.’’).

43Periodic examinations would likely have no 

deterrent effect on scam artists, who, under the 

guise of operating a hedge fund set out to steal 

money from unwitting investors, because these 

types of individuals will simply not register.

44 2003 Staff Hedge Fund Report, supra n. 5, at 

80 (‘‘To date, however, the staff has not uncovered 

evidence of significant numbers of retail investors 

in hedge funds.’’).

45See, e.g., Testimony of Robert Schulman, 

Chairman and CEO, Tremont Asset Management, at 

the Roundtable, supra n. 5 (May 14, 2004) (‘‘It is 

not a massive flow of money from retail or high net 

worth investors using registered products. That’s 

not what’s fueled the growth here to date. It may 

come to be that, but that’s not what it’s been 

today.’’).

46See, e.g., Comment Letter of the Managed Fund 

Association (Sept. 15, 2004) (noting the validity of 

the Commission’s concern about the increased 

number of persons qualifying as individual 

investors and recommending an adjustment of the 

accredited investor standard); Comment Letter of 

Porter, Felleman, Inc. (Aug. 16, 2004); Comment 

Letter of Tudor Investment Corp. (Sept. 15, 2004). 

And if, as the majority notes, hedge fund inflows 

already are so rapid that hedge fund advisers have 

more to invest than they can handle, then they will 

not need to look to retail investors. See Adopting 

Release at n. 21 and accompanying text.

47See Greenwich Associates, Press Release, 

Alternative Investments May Disappoint Dabblers

(Jan. 21, 2004) (available at: http://

www.greenwich.com).

48This assumes that $72 billion of pension money 

is invested in hedge funds, which are estimated to 

have total assets of $870 billion. See Adopting 

Release at n. 38 and text accompanying n. 19. The 

majority does not tell us what proportion of pension 

fund investments are invested in hedge funds 

without registered advisers.

49See Hewitt Investment Group, In Brief: 

Immunization—Theory and Practice 5 (July 2004) 

(available at: http://www.hewittinvest.com/pdf/

InBrief_Immunization.pdf) (citing Greenwich 

Associates Market Characteristics 2003 Report) 

(based on asset allocation of private pension funds). 

See also Comment Letter of the National Venture 

Capital Association (Sept. 15, 2004) (noting that 

pension funds, foundations and university 

endowments have long invested in venture capital 

funds).

50The Department of Labor oversees the conduct 

of private pension plan advisers. In the public 

pension fund context, state law requires that the 

pension fund adviser, often an elected official, act 

for the benefit of the pensioners.

51See, e.g., Transcript of Chronicle of Higher 

Education Colloquy with John S. Griswold of the 

Commonfund Group, (May 27, 2004) (available at: 

http://chronicle.com/colloquylive/2004/05/

endowments/) (noting the role alternative 

investments, including hedge funds, play in 

diversifying endowment portfolios, reducing 

portfolio risk, and boosting returns).

52See 2003 Hedge Fund Report, supra n. 5, at 69.

inspections conducted by the 

Commission.’’37 However, the Commission 

has not yet demonstrated the effectiveness of 

this new approach.38 More specifically, the 

move towards risk-based oversight will not 

be effective if we have not identified relevant 

risk factors.39

The majority contends that, even if 

examinations do not routinely detect fraud, 

the threat of an examination will deter

fraudulent activity by hedge fund advisers.40

Any deterrent effect, however, is muted by 

the fact that the Commission lacks the 

resources necessary to conduct frequent, 

comprehensive hedge fund adviser 

examinations, and our lack of resources is a 

matter of public record.41 The Chairman has 

publicly announced that the Commission is 

rethinking its inspection model, which 

historically has focused on site visits and 

information requests.42 The new approach 

will not be centered around routine 

inspections. Heavy sanctions for fraudulent 

behavior are a more effective and cheaper 

deterrent than the specter of an examination 

every several years.43 In making these 

observations, we are not questioning the need 

for a Commission examination program. 

Rather, we are suggesting that the 

Commission should not assume a task that is 

now handled by the market, particularly 

since it is a task the Commission is not 

equipped to perform.

C. Retail Investors’ Exposure to Hedge Funds 

Is Limited and They Can Be Protected 

Through More Effective Means Than 

Registration 

The majority speaks ominously of the 

‘‘retailization’’ of hedge funds, i.e., their 

increasing accessibility through pension 

funds and funds of funds to unsophisticated 

investors of moderate means. The 2003 Staff 

Hedge Fund Report, however, found no 

retailization.44 Moreover, the Report’s 

conclusion is consistent with the views 

expressed at the Commission’s May 2003 

Roundtable, at which 60 panelists, including 

representatives of federal, state and foreign 

government regulators, securities industry 

professionals, and academics testified.45

Hedge fund advisers appear willing to take 

steps to preclude retailization.46 Raising the 

accreditation standards for hedge fund 

investors, for example, would reduce the 

number of high net worth individual 

investors, which is estimated already at fewer 

than 200,000, to an even smaller universe of 

investors. Alternatively, we could require 

registration for funds that allow relatively 

small investments.

Concern about the exposure of retirees 

through their pension funds, a cornerstone of 

the majority’s retailization argument, is 

unwarranted. Although pension fund 

investment in hedge funds has grown in 

recent years, just one percent of the more 

than $6.4 trillion invested in U.S. pension 

funds is currently invested in hedge funds.47

Pension fund investments are only eight 

percent of total hedge fund investments.48

For every pension fund dollar invested in 

hedge funds, approximately three pension 

fund dollars are invested in other private 

investment funds,49 yet the rulemaking 

carefully seeks to avoid reaching them. More 

generally, pension funds, as part of a risk 

diversification strategy, invest in hedge funds 

and other investments in which retirees 

might not be able to invest directly. Some of 

these investment vehicles, such as off-shore 

investment vehicles, venture capital funds, 

and real estate investment trusts, are not 

advised by advisers registered with the 

Commission.

Pension funds, along with the universities 

and charitable organizations that the majority 

cites as contributors to the trend towards 

retailization, are managed by fiduciaries, who 

typically are highly-skilled.50 These 

fiduciaries are responsible for determining 

whether to invest in hedge funds, the types 

of hedge funds in which to invest, and how 

to weigh risk and transparency issues in 

making these determinations.51 Neither the 

information available on Form ADV nor the 

possibility that a particular hedge fund 

adviser will be subject to an inspection 

would substantially reduce these fiduciaries’

due diligence obligations.

The majority also worries about retail 

investors’ exposure to hedge funds through 

funds of hedge funds. Advisers so far have 

set investment minimums between $25,000 

and $1 million.52 There are a number of ways 

aside from universal registration to address 

concerns about retail exposure to these 

funds. The Commission could require the 

funds of funds that are targeted to retail 

72094 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

53See, e.g., Comment Letter of Leon M. Metzger 

(Sept. 15, 2004).

54See supra n. 1. Another option discussed in the 

Adopting Release is asking Congress for more 

funding, a request Congress might be loathe to 

fulfill absent assurances the new funds would not 

again be applied to expand our regulatory reach. 

See Adopting Release at Section V.

55Although both the Proposing and Adopting 

Releases mentioned raising the threshold for 

registration ‘‘to a slightly higher amount’’ as a 

possible way of compensating for the increase in 

registered advisers resulting from the rulemaking, 

the Proposing Release did not solicit comment on 

whether this was an appropriate reallocation of 

resources. See Proposing Release, supra n. 1, at 

section V and Adopting Release at section V.

56S.R. 104–293, at 10 (June 26, 1996).

57See, e.g., Comment Letter of the Greenwich 

Roundtable (Sept. 15, 2004) (nonprofit organization 

made up of private and institutional investors 

opposed the rulemaking), Comment Letter of 

Rodney C. Pitts (Sept. 15, 2004) (hedge fund 

investor suggesting that Commission resources 

should not be diverted to protect the relatively 

small number of hedge fund investors), Comment 

Letter of Myra Tatum, Pointer Management Co. 

(Aug. 26, 2004) (manager of fund of funds noting 

that mandatory registration will not benefit 

investors; fund of funds manager already conducts 

extensive due diligence and ongoing monitoring of 

hedge fund managers). The majority cites a survey 

conducted by the Hennessee Group in support of 

its rulemaking. See Hennessee Group, 2004 

Hennessee Hedge Fund Survey of Foundations and 

Endowments (submitted as a comment letter for this 

rulemaking). While 59 percent of the 46 

respondents supported the rulemaking, foundations 

and endowments opposing the rulemaking were 

larger, more heavily invested in hedge funds, and 

had more years of experience in hedge fund 

investment than entities that favored the 

rulemaking. See id.

58As one commenter pointed out, ‘‘the 

‘‘institutionalization’’ of the hedge fund market has 

had many salutary effects on the industry [because] 

[m]ost such institutions require funds to complete 

voluminous questionnaires about management, 

investment procedures, and operational and risk 

controls.’’ Comment Letter of Schulte, Roth & Zabel 

LLP (Sept. 15, 2004). Moreover, reports by auditors 

are a commonly-used method of demonstrating the 

integrity of internal controls. See, e.g., Codification 

of Accounting Standards and Procedures, Statement 

on Auditing Standards No. 70, Service 

Organizations. See also Comment Letter of Blanco 

Partners LP (Sept. 13, 2004) (‘‘We feel that having 

the highest quality attorneys, auditors and prime[] 

brokers is a selling point for our fund.’’). In other 

contexts, the Commission views favorably the use 

of outside control reports. See, e.g., Fair 

Administration and Governance of Self-Regulatory 

Organizations; Disclosure and Regulatory Reporting 

by Self-Regulatory Organizations; Recordkeeping 

Requirements for Self-Regulatory Organizations; 

Ownership and Voting Limitations for Members of 

Self-Regulatory Organizations; Ownership 

Reporting Requirements for Members of SelfRegulatory Organizations; Listing and Trading of 

Affiliated Securities by a Self-Regulatory 

Organization, Securities Exchange Act Release No. 

50699 (Nov. 18, 2004).

59See, e.g., Comment Letter of Sheila C. Bair, 

Dean’s Professor of Financial Regulatory Policy, 

University of Massachusetts-Amherst (Sept. 15, 

2004) (‘‘By promising a ‘culture of compliance’

through registration, the SEC may be encouraging 

investors to take a ‘free ride’, reducing the amount 

of due diligence they would otherwise conduct on 

their own. The first line of defense for sophisticated 

investors should be their own due diligence, not 

SEC compliance measures, which are already 

seriously strained.’’); Comment Letter of W. Hardy 

Callcott, Bingham McCutchen LLP (Sept. 15, 2004) 

(‘‘When not promised that the SEC will oversee the 

adviser, hedge fund investors have been able 

through private ordering to negotiate adequate 

protections for themselves—protections apparently 

at least as effective as those provided by SEC 

registration and oversight.’’), Comment Letter of the 

U.S. Chamber of Commerce (‘‘[C]ounterparty 

surveillance (e.g., extended pre-investment due 

diligence by investors and discipline imposed by 

lenders) is today pervasive among institutions and 

other sophisticated [private investment fund] 

investors.’’); Comment Letter of Price Meadows Inc. 

(Sept. 15, 2004) (noting that market pressures are 

enhancing investor protection as reflected in the 

increasing percentage of hedge funds that are 

audited or rely on third-party administration).

60See, e.g., Adopting Release at text 

accompanying n. 61 (‘‘But commenters have not 

persuaded us that requiring hedge fund advisers to 

register under the Act, requiring them to develop 

a compliance infrastructure, or subjecting them to 

our examination authority will impose undue 

burdens on them or interfere significantly with their 

operations.’’). The majority bolstered the costbenefit analysis and the discussion of alternatives 

in the final release three weeks after the vote to 

approve the rulemaking. Such issues should have 

been thoroughly explored prior to the vote.

61Compare Adopting Release at n. 64 and 

accompanying text (relying on the ‘‘persuasive 

testimonials’’ of two commenters who did not 

provide empirical data to conclude that registration 

is not overly burdensome) with Adopting Release at 

text following n. 70 (‘‘The bare assertions of adverse 

consequences of registration under the Advisers Act 

offered by many commenters opposed to our 

proposed rule, and the anecdotal evidence offered 

by others, simply do not stand up to scrutiny.’’).

62See, e.g., Adopting Release at nn. 344–46 and 

accompanying text.

63 In fact, the only cost estimates offered by the 

majority in its cost-benefit analysis are per-firm 

costs of $20,000 for professional fees and $25,000 

for internal costs that firms would incur in 

establishing the required compliance infrastructure 

and aggregate costs of $31 to $57 million. See

Adopting Release at n. 333 and accompanying text.

64See Adopting Release at text accompanying n. 

320.

65See, e.g., Comment Letter of Proskauer Rose 

LLP (Aug. 31, 2004) (‘‘[F]or certain advisers the 

benefits of registration exceed the costs and for 

others the reverse is true, and [] the gulf can be 

substantial.’’). If the majority is correct in its cost 

estimates, it should be satisfied in simply letting the 

trend of voluntary registration continue.

66Mandating across-the-board registration only 

serves to eliminate any benefit registered advisers 

enjoyed in being able to distinguish themselves 

from unregistered advisers.

investors, and all of their component funds, 

to have registered advisers.53 Alternatively, 

the Commission could prohibit these funds 

from being publicly offered or place 

heightened restrictions on investors.

III. The Majority’s Approach Will Have 

Detrimental Effects on Investors, Advisers, 

and the Markets 

A. The New Rule Will Necessitate a 

Dangerous Diversion of Resources 

In order to administer the new 

requirement, the Commission will have to 

divert resources from the protection of 

unsophisticated investors, including more 

than 90 million mutual fund investors, to an 

estimated 200,000 individual and 

institutional hedge fund investors. This 

seems unwise so soon after we made the case 

that we did not have enough staff to oversee 

the existing pool of registered advisers and 

funds. In fact, just two days after the majority 

adopted this rulemaking, the Director of the 

Division of Investment Management 

reportedly said that an option that the 

Commission has in its ‘‘back pocket’’ is 

raising the threshold registration level to $40 

million.54 If the majority was seriously 

contemplating raising the registration 

threshold in connection with the rulemaking, 

it should have sought specific comment on 

the implications of such a change.55

The majority argues that all investors, 

sophisticated and not, are entitled to 

protection under the Advisers Act. Indeed, 

all investors do enjoy the protection of the 

Act’s antifraud provisions. But, as Congress 

recognized in 1996 in connection with the 

adoption of Investment Company Act section 

3(c)(7), ‘‘[financially sophisticated] investors 

can evaluate on their own behalf matters 

such as the level of a fund’s management 

fees, governance provisions, transactions 

with affiliates, investment risk, leverage, and 

redemption rights.’’56 In contrast to mutual 

fund investors, hedge fund investors have not 

been conditioned to rely on Commission 

oversight.57 They can perform due diligence 

(or hire someone else to do so for them), 

review audit reports or third-party internal 

control reports, and enlist help if they 

suspect fraud or malfeasance.58 By adopting 

the registration requirement, the Commission 

has upset the private-public balance and 

taken on a task that it might not have 

adequate resources to perform.59

B. The Commission Has Failed To 

Demonstrate That This Is the Least 

Burdensome and Most Effective Way To 

Accomplish Its Objective 

In addition to being costly to the 

Commission, the new registration 

requirement will be costly to affected 

advisers, and these costs will be passed on 

to investors. The majority approaches the 

costs of its action with a remarkable 

casualness and tries to shift responsibility for 

the cost-benefit analysis to commenters.60

The majority accepts anecdotal evidence 

from those in support of the rulemaking, but 

rejects as complaints equivalent statements 

by those opposed.61 The majority treats cost 

estimates provided by commenters as 

overestimates.62 The majority failed to 

aggregate the initial costs associated with 

registration and did not estimate ongoing 

costs of compliance.63

The majority points to the fact that advisers 

that are already registered, including hedge 

fund advisers, are able to bear the costs 

associated with registration.64 Yet the 

majority also argues that its action will level 

the playing field between hedge fund 

advisers by imposing the costs on currently 

unregistered advisers that are borne now only 

by voluntary registrants. Costs of registration 

vary across firms.65 Currently, if the benefits 

of registration, such as wider appeal to 

pension funds and other investors, do not 

outweigh the costs, then hedge fund advisers 

do not register.66 Costs are likely to be 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72095

67See, e.g., Comment Letters of Blanco Partners 

LP (Sept. 13, 2004) (small advisers will be 

disproportionately burdened); Venkat Swarna (Sept. 

14, 2004) (‘‘We estimate the annual compliance 

costs of a state or federal registration to be in the 

range of 20,000 to 25,000. These compliance costs 

would be prohibitive to a small advisor like ours, 

as these costs alone constitute a sizeable percentage 

of the portfolio of the fund we would be managing 

in our case more than 1[%]’’); Joseph L. Vidich 

(Aug. 7, 2004) (‘‘In a one or two person firm, with 

10 million under management, the annual cost of 

compliance could easily fall between 25,000 and 

50,000, which represents twenty five to fifty percent 

of the firms asset management fee.’’). See also 

Hedge Fund Regulation May Force Consolidation,

PipeLine 3 (June 15, 2003) (reporting study findings 

that registration would impose significant burdens 

on small hedge funds in the range of $50,000 to 

$100,000 annually) (citing Sanford C. Bernstein & 

Co., The Hedge Fund Industry—Products, Services, 

or Capabilities? (May 19, 2003); Arden Dale, Small 

Mutual-Fund Firms Cry Uncle—New Rules Protect 

Investors, but They Can be a Burden; Cost of a 

Compliance Cop, Wall St. J., C15, Sept. 13, 2004 

(reporting difficulty of mutual fund advisers that 

have less than a few billion dollars under 

management to bear the costs of regulatory 

requirements, including the Commission’s 

compliance requirement). 68See, e.g., Comment Letter of Blanco Partners LP 

(Sept. 13, 2004) (contending that registration will 

burden small hedge fund advisers more heavily 

than the average small adviser); Comment Letters of 

the International Swaps and Derivatives 

Association (Sept. 15, 2004) and Guy Judkowski, 

Hedgehog Capital (explaining that, in contrast to 

many other small advisers, some small hedge fund 

advisers deliberately remain small in order to 

effectively pursue a particular strategy).

69Even proponents of registration acknowledge 

that its costs will be significant enough to deter 

some advisers from entering the business. See, e.g., 

Ron Orol, Regulation? Bring it on, TheDeal.com, 

Oct. 11, 2004 (interview of Steven Holzman, the 

managing partner of Vantis Capital Management 

LLC, who wrote two comment letters cited 

repeatedly in support of registration) (Mr. Holzman 

predicted that registration would help his business 

by raising barriers to entry and anticipated that 

‘‘[w]ith registration, we will have half as many new 

funds starting up next year * * *.’’ ). Nonetheless, 

the majority cites Mr. Holzman for the proposition 

that barriers to entry are low and concludes that 

‘‘thus the cost of compliance with these rules 

should not present significant additional barriers to 

entry for new hedge fund advisers.’’ Adopting 

Release at nn. 121–22 and accompanying text.

70See Comment Letter of the ICAA (Sept. 14, 

2004) (‘‘The fact is that investment adviser 

regulation and compliance have become 

increasingly complex and costly.’’). See also

Comment Letter of Davis, Polk & Wardwell (Sept. 

15, 2004) (noting that the costs of registration and 

compliance are ‘‘substantial and increasing’’ and 

will be passed on to investors).

71See, e.g., Comment Letter of the Managed 

Funds Association (Sept. 15, 2004) (reporting that 

one MFA member incurred over $75,000 in staff 

time in connection with the preparation of Form 

ADV).

72See, e.g., Comment Letter of Guy P. Lander 

(Sept. 15, 2004) (reporting that client anticipates 

spending more than $300,000 in the first year to 

come into compliance with the rulemaking); 

Comment Letter of the Managed Funds Association 

(Sept. 15, 2004) (MFA members report incurring 

more than $300,000 in outside legal and other 

expenses associated with registration and 

compliance requirements); Comment Letter of C. 

Peter Marin, Superior Capital Management LLC 

(Sept. 8, 2004) (estimating that compliance costs 

will be 15–20% of revenues of adviser to small 

hedge fund); Comment Letter of Millrace Asset 

Group (Sept. 15, 2004) (hedge fund adviser 

anticipates having to increase staff from four to five 

to handle compliance under the rulemaking); 

Comment Letter of Seward & Kissel LLP (Sept. 15, 

2004) (‘‘To properly fulfill the breadth of 

compliance requirements under the Advisers Act, 

many advisers would be required to hire at least 

one additional professional at a cost far greater than 

the estimate provided.’’). The majority did not 

attempt to estimate ongoing compliance and 

examination costs because of the difficulty of doing 

so, dismisses the estimates it received as ‘‘not 

representative,’’ and instead offers the observation 

that ‘‘one registered hedge fund adviser commented 

that the firm itself derived benefit from the 

examination process.’’ Adopting Release at IV.B.3.

73The majority explains this failure and its 

rejection of commenters’ estimates by noting that 

advisers are not required to hire someone to fill the 

role and the chief compliance officer can have 

responsibilities. See Adopting Release at text 

following n. 335. The majority did not attempt to 

estimate the real, quantifiable cost of the 

requirement on firms, which must allocate at least 

a portion of an employee’s time to handling the 

increased compliance functions. See Adopting 

Release at Section IV.B.2.

74See, e.g., David R. Sawyer (Sidley, Austin, 

Brown and Wood) (Sept. 14, 2004) (reporting that 

two clients, hedge fund advisers, spent between 

$300,000 and $500,000 preparing for and hosting 

examiners, without including opportunity costs).

75Adopting Release at n. 116. The staff, in its 

hedge fund report, noted: ‘‘We are concerned about 

our inability to examine hedge fund advisers and 

evaluate the effect of the strategies used in 

managing hedge funds on our financial markets.’’

2003 Staff Hedge Fund Report, supra n., at 11. 

Certainly, then, hedge fund advisers can anticipate 

that the staff will be looking into, and perhaps 

regulating, such strategies.

76Comment Letter of Guy P. Lander (Sept. 15, 

2004). See also Comment Letter of the U.S. Chamber 

of Commerce (Sept. 15, 2004) (advisers might avoid 

innovative strategies in order to avoid Commission 

scrutiny).

77See, e.g., Alan Greenspan, Chairman, Federal 

Reserve Board, Testimony before the Senate 

Banking, Housing and Urban Affairs Committee 

(July 20, 2004) (‘‘Should the existing proposal fail 

in achieving its goal, pressure will become 

irresistible to expand SEC’s regulatory reach in an 

endeavor to accomplish what it set out to do. Hedge 

fund arbitrageurs are required to move flexibly and 

expeditiously if they are to succeed. If placed under 

increasing restrictions, many will leave the 

industry, to the significant detriment of our 

economy.’’). See also Comment Letter of the 

International Swaps and Derivatives Association 

(Sept. 15, 2004) (registration will reduce the 

number of entrants into the hedge fund industry 

and force others offshore, which will harm the 

derivatives industry and the market as a whole); 

Comment Letter of the Financial Services 

Roundtable (Sept. 15, 2004) (rulemaking might 

deter ‘‘the types of innovative and active trading 

that serve the marketplace as a whole’’); Comment 

Letter of the Managed Funds Association (Sept. 15, 

2004) (the rulemaking ‘‘has the potential to create 

inefficiency and instability in our capital markets 

by stifling the willingness of hedge funds to act as 

shock absorbers and provide risk capital in times 

of market instability’’); Comment Letter of Seward 

& Kissel LLP (Sept. 15, 2004) (rulemaking could 

raise barriers to entry for new advisers); Comment 

Letter of Tudor Investment Corp. (Sept. 15, 2004). 

The majority, in faulting commenters opposing the 

rule for failing to demonstrate ‘‘that hedge funds 

managed by registered advisers play a diminished 

role in the financial markets compared to hedge 

funds managed by unregistered advisers,’’ fails to 

recognize that the effects of registration might be 

different for different advisers. Adopting Release at 

text accompanying n. 71.

78The majority’s attempt to characterize this as a 

positive potential effect of the rulemaking is not 

persuasive. See Adopting Release at Section VII 

(acknowledging that investors might not be able to 

select the adviser of their choice, but noting that ‘‘a 

hedge fund adviser’s decision not to expand its 

business may make it easier for other advisers to 

enter the market.’’).

79Adopting Release at text accompanying n. 118. 

It is difficult to discern how the majority made such 

a determination without making an estimate of the 

costs. The majority also argues that, absent 

registration, hedge fund advisers might not 

understand how beneficial a strong compliance 

program is to their business. See Adopting Release 

at text accompanying n. 117. Our intervention is 

unnecessary to solve this problem; the market will 

punish advisers who provide less compliance 

controls than investors want. See, e.g., Comment 

Letter of Leon M. Metzger (Sept. 15, 2004) (‘‘the 

Commission may want to consider whether the 

growing movement toward voluntary registration 

will accomplish the goals of mandatory 

registration.’’).

particularly onerous for small advisers.67

According to some, registration costs will be 

even more burdensome for small hedge fund 

advisers than they are for other small 

advisers.68

The majority’s cost-benefit analysis does 

not provide a realistic assessment of the 

direct costs associated with registration.69

Even the Investment Counsel Association of 

America (‘‘ICAA’’), which supports the 

majority’s action, took issue with the 

majority’s minimization of costs.70 Advisers 

must file Form ADV, and are likely to seek 

the assistance of an attorney because it is a 

public disclosure form.71 Once registered, 

advisers face numerous substantive 

requirements, including recordkeeping, 

custody, and compliance requirements, all of 

which impose costs.72 The majority failed to 

offer any quantitative estimate for the costs 

associated with the requirement to have a 

chief compliance officer.73 Hosting a 

Commission examination team can be very 

costly, particularly in terms of the 

opportunity cost of those who must comply 

with increasingly burdensome document 

requests and stand ready to answer 

questions.74

In addition to the direct costs of complying 

with Commission rules, there are likely to be 

indirect costs as hedge funds advisers are 

dissuaded from employing complex 

investment strategies that they cannot 

explain to Commission examiners. Questions 

about those strategies are likely since the 

majority believes there to be substantial 

conflicts related to ‘‘management strategies, 

fee structures, use of fund brokerage and 

other aspects of hedge fund management.’’ 75

As one commenter explained, ‘‘there is no 

doubt that hedge fund managers would 

abandon a lawful strategy that the 

Commission takes exception with rather than 

face the controversy and the associated 

distractions generated by the Commission’s 

position.’’ 76 The effects might be felt by the 

market as a whole.77 Advisers might even 

limit their businesses in order to avoid 

registering.78

The majority reasons that the ‘‘costs appear 

small relative to the scale of the industry.’’ 79

Further, the majority argues, hedge fund 

advisers’ fees provide them with ‘‘a 

72096 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

80Adopting Release at text accompanying n. 119.

81See, e.g., Comment Letter of Madison Capital 

Management LLC (Sept. 15, 2004) (predicting that 

the rulemaking will have the effect of inducing 

hedge funds to admit retail investors).

82 15 U.S.C. 80b–8(a).

83See amended rule 203(b)(3)–1(d).

84See, e.g., Comment Letter of the CFA Institute 

Center for Financial Market Integrity (Sept. 30, 

2004) (noting that the two year redemption criterion 

‘‘would seem to us to be somewhat arbitrary’’); 

Comment Letter of Madison Capital Management 

LLC (Sept. 15, 2004) (‘‘the majority’s ‘private fund’

centered regulatory scheme creates an arbitrary 

distinction among funds’’); Comment Letter of the 

North American Securities Administrators 

Association (‘‘NASAA feels that the definition of 

‘Private Fund’ is ineffective at distinguishing hedge 

funds from private equity, venture capital and 

commodity pools.’’).

85See, e.g., Comment Letter of Gibson, Dunn & 

Crutcher LLP (Sept. 13, 2004) (‘‘this component is 

the only factor in the Rule itself that can be relied 

upon to exempt traditional private equity and 

venture capital funds’’).

86Comment Letter of the Financial Services 

Roundtable (Sept. 15, 2004) (rule will reach some 

private equity and real estate fund advisers); 

Commenter Letter of Gunderson Dettmer Stough 

Villeneuve Franklin & Hachigian, LLP. (Sept. 15, 

2004) (requesting narrower definition of ‘‘Private 

fund’’ to avoid including other types of investment 

vehicles).

87See, e.g., Comment Letter of Ellington 

Management Group LLC (Sept. 15, 2004) (‘‘The 

industry ‘buzz’; is that, in fact, many hedge fund 

managers wishing to avoid registration will be 

trying to institute two-year lockups exactly for this 

purpose.’’); Comment Letter of the Greenwich 

Roundtable (Sept. 15, 2004); Comment Letter of 

Jeffrey R. Neufeld (Sept. 15, 2004).

88The majority inappropriately looks to ease of 

redeemability as evidence that ‘‘hedge fund 

advisers are effectively providing advisory services 

to the fund’s investors.’’ See Adopting Release at n. 

237.

89See, e.g., Comment Letter of the Greenwich 

Roundtable (Sept. 15, 2004) (‘‘If the intention of the 

Rule is to specifically exclude venture capital and 

private equity funds, then those funds can more 

easily be excluded without harming genuine hedge 

fund investors. We would suggest instead that the 

Rule apply a test that focuses on the marketability 

of a fund’s holdings, rather than on an investor’s 

willingness to lock-up an investment.’’); Comment 

Letter of Kynikos Associates (Sept. 15, 2004) 

(recommending distinguishing funds on the basis of 

‘‘investment characteristics’’); Comment Letter of 

the North American Securities Administrators 

Association (recommending a test based on 

frequency with which securities in fund are traded). 

See also Comment Letter of Ellington Management 

Group LLC (Sept. 15, 2004) (recommending 

distinguishing hedge funds from other types of 

private investment funds by looking at how the 

fund employs net asset value in determining 

management fees and setting purchase price and 

redemption fees). The majority explains that it 

rejected this approach in order to prevent advisers 

from altering their investment strategies to avoid 

registration. See Adopting Release at n. 225. It is 

much easier for advisers to alter their redemption 

period in order to avoid registration.

90See, e.g., Comment Letter of Kynikos 

Associates (Sept. 15, 2004) (noting that while 

venture capital and private equity funds are 

‘‘somewhat different’’ from hedge funds, the 

Commission’s concerns, including particularly 

valuation, are nevertheless applicable); Comment 

Letter of Leon M. Metzger (Sept. 15, 2004) (interim 

valuations matter for other types of private funds, 

e.g., for purposes of the valuation of a deceased 

investor’s estate ); Comment Letter of the 

Committee on Private Investment Funds, The 

Association of the Bar of The City of New York 

(Sept. 15, 2004) (although of ‘‘more limited 

relevance,’’ in the venture capital and private equity 

context, valuation is important for purposes such as 

investor reporting, and marketing follow-on funds).

91Comment Letter of the National Venture Capital 

Association (Sept. 15, 2004) (‘‘NVCA believes that 

the [proposing] Release and the proposed rule 

create a risk of future burdensome regulation on 

venture capital that outweighs any investor 

protection benefit that would come from the 

proposed rule.’’).

92The majority also argues that the third prong 

of the definition, which limits ‘‘private funds’’ to 

those that are marketed based on the skills, ability, 

and expertise of the adviser, ‘‘confirm[] the direct 

link between the adviser’s management services 

and the investors.’’ Adopting Release at text 

preceding n. 168. If this reasoning is sound with 

respect to hedge funds, the same link exists 

between investors in venture capital and private 

equity funds and the advisers of those funds.

substantial cash flow.’’ 80 It is not the 

Commission’s job to make value judgments 

regarding the propriety of hedge fund 

advisers’ management fees, which investors 

have agreed to pay and which presumably 

reflect the risks of establishing a hedge fund 

and the high costs of attracting talented 

managers. Resources used to pay for 

compliance with new regulatory mandates 

cannot be used for other purposes, such as 

hiring new employees or purchasing outside 

research. Thus, unless the Commission 

determines that the benefits of imposing the 

requirements justify the costs, the 

Commission should not impose the costs.

C. The Rulemaking May Encourage 

Retailization 

The majority’s proposal ironically may 

stimulate retailization. First, pension funds 

and other institutional investors, who 

indirectly invest in hedge funds on behalf of 

individuals, might invest more money in 

hedge funds as a result of the rulemaking. 

Because such investment vehicles tend to 

limit hedge fund investments to those with 

registered advisers, the mandatory 

registration would expand the potential 

universe and encourage even more 

investment in hedge funds, which the 

majority suggests puts retail investors at risk. 

Second, if all hedge fund advisers are 

registered, there is likely to be grassroots 

demand for access to hedge funds by retail 

investors.81 Section 208(a) of the Advisers 

Act prohibits advisers from representing or 

implying that they are ‘‘sponsored, 

recommended, or approved, or that their 

abilities or qualifications have in any respect 

been passed upon’’ by the government.82

Registered advisers, however, may advertise 

themselves as SEC-registered (and anecdotal 

evidence suggests that they do). Those who 

are not familiar with the Commission’s role 

likely will not understand how little this 

means, particularly because the majority has 

argued that registration will ‘‘legitimize’’

hedge funds.

IV. The Majority’s Approach Makes 

Arbitrary Distinctions Between Funds 

A. The Definition of ‘‘private funds’’ Covered 

by the Rule Is Unsuitable 

‘‘Private funds’’ are defined in the new rule 

on the basis of three characteristics. A 

‘‘private fund’’ is a company: (1) That would 

be subject to regulation under the Investment 

Company Act but for the exception, from the 

definition of ‘‘investment company’’

provided in either section 3(c)(1) or 3(c)(7) of 

the Investment Company Act; (2) that permits 

investors to redeem their interests in the fund 

within two years of purchasing them; and (3) 

the interests of which are offered based on 

the investment advisory skills, ability or 

expertise of the investment adviser.83 This 

definition is arbitrary and not reflective of a 

relevant difference among different types of 

private investment companies.84

The redemption period is the only criterion 

that would distinguish most hedge funds 

from most other types of private funds.85

Even this criterion will pull into the rule 

other types of private investment funds, 

which the majority does not deem at this 

time to be in need of regulation.86 More 

generally, at a time when there is already a 

trend towards longer lock-ups, this criterion 

will encourage advisers to extend their 

redemption periods beyond two years in 

order to avoid registration.87 Therefore, it 

will be more difficult for investors, once they 

have made the decision to invest in a hedge 

fund, to ‘‘vote’’ on the quality and integrity 

of the hedge fund manager by leaving the 

fund.88 A definition that looked, for example, 

to portfolio content or frequency of trading 

rather than redemption period would likely 

be more precise.89

B. If the Majority’s Rationale for Regulation 

of Hedge Fund Advisers Is Sound, Then It 

Applies Equally to Advisers to Private Equity 

and Venture Capital Funds 

We asked in our dissent to the proposal 

whether there was a basis for excluding 

advisers to venture capital and private equity 

funds. Valuation issues, for example, arise in 

the private equity and venture capital funds, 

just as they do in hedge funds.90 The 

National Venture Capital Association 

(‘‘NVCA’’) filed a comment letter that 

explained that, while there are meaningful 

bases upon which to distinguish venture 

capital funds from hedge funds, the grounds 

on which the majority distinguished them are 

not meaningful. Fearing that these same 

justifications could be used in the future to 

require venture capital advisers to register, 

the NVCA opposed the proposal.91 The 

majority continues to maintain that advisers 

to venture capital and private equity funds 

should remain beyond the scope of this 

rulemaking because they have not been 

implicated in as many enforcement actions as 

advisers to hedge funds have been.92 We 

share the NVCA’s concern that the majority 

has not meaningfully differentiated between 

hedge funds and other private investment 

funds. Just as the majority’s justifications do 

not support the registration of hedge funds, 

they do not compel registration of any other 

type of private investment fund.

V. In Taking This Action, the Majority Has 

Departed From Regulatory and Statutory 

Precedent 

In order to carve out hedge fund advisers 

as a subset of advisers to private investment 

Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 72097

93 15 U.S.C. 80b–3(b)(3). When Congress amended 

section 203(b)(3) in 1980 to preclude looking 

through business development companies in 

counting clients for purposes of that section, 

Congress did not ‘‘intend to affect adversely the 

status of investment advisers which are not 

registered under the Act.’’ H.R. Rep. No. 96–1341, 

at 62 (1980).

94The Commission explained that this safe harbor 

was ‘‘not intended to specify the exclusive method 

for a limited partnership, rather than each limited 

partner, to be counted as a ‘client’ for purposes of 

section 203(b)(3) of the Act.’’ Definition of ‘‘Client’’

of an Investment Adviser for Certain Purposes 

Relating to Limited Partnerships, Investment 

Advisers Act Release No. 983 (July 12, 1985) [50 FR 

29206 (July 18, 1985)].

95See, e.g., Definition of ‘‘Client’’ for Certain 

Purposes Relating to Limited Partnerships, 

Investment Advisers Act Release No. 956 (Feb. 25, 

1985) [50 FR 8740 (Mar. 5, 1985)] (‘‘Where an 

adviser to an investment pool manages the assets 

of the pool on the basis of the investment objectives 

of participants as a group, it appears appropriate to 

view the pool—rather than each participant—as a 

client of the adviser.’’).

96See Status of Investment Advisory Programs 

under the Investment Company Act of 1940, 

Investment Company Act Release No. 22579 (Mar. 

24, 1997) [62 FR 15098 (Mar. 31, 1997)] (adopting 

rule 3a–4 under the Investment Company Act [17 

CFR 270.3a–4(a)] to provide a nonexclusive safe 

harbor from the definition of investment company 

for certain programs under which investment 

advisory services are provided on a discretionary 

basis to a large number of advisory clients having 

relatively small amounts to invest). Among the 

safeguards in the rule is a requirement that the 

sponsor of the program must obtain sufficient 

information from each client to be able to provide 

individualized investment advice to the client and 

periodically update the information. See rule 3a–

4(a)(2). The majority, in support of its approach, 

posits a situation in which a group of individual 

clients of an adviser is combined into a hedge fund 

in order to avoid application of the Advisers Act. 

The majority’s hypothetical example does not tell 

us whether the investors continue to receive 

personalized advice. See Adopting Release at text 

accompanying nn. 177–78. If they do not, there is 

nothing inappropriate about the adviser’s 

characterizing the group as an unregistered 

investment company; they should be characterized 

as such, so long as they meet the applicable criteria 

to be classified as a private investment company.

97Status of Investment Advisory Programs under 

the Investment Company Act of 1940, Investment 

Company Act Release No. 22579 (Mar. 24, 1997) [62 

FR 15098 (Mar. 31, 1997)].

98 In instances in which an entity is merely a legal 

artifice, advisers, of course, are prohibited from 

counting it, rather than its investors, as clients in 

order to avoid registration. See section 208(d) of the 

Advisers Act [15 U.S.C. 80b–8d] (making it 

‘‘unlawful for any person indirectly * * * to do any 

act or thing which it would be unlawful for such 

person to do directly.’’). This does not describe the 

hedge funds the advisers of which are the intended 

targets of the new rulemaking.

99See, e.g., Comment Letters of Schulte Roth & 

Zabel LLP (Sept. 15, 2004); U.S. Chamber of 

Commerce (Sept. 15, 2004); Willkie, Farr & 

Gallagher (Sept. 13, 2004), Wilmer Cutler Pickering 

Hale and Dorr, LLP (Sept. 8, 2004).

100The majority speculates that Congress might 

not have intended for the legal entity to be treated 

as the client in the hedge fund context as it is in 

the investment company context. See Adopting 

Release at n. 171. But for their ability to rely on 

statutory exemptions from the definition of 

‘‘investment company’’ under the Investment 

Company Act, hedge funds generally would fit 

within the definition. The approach of treating the 

entity, not the investors, as the client is equally 

appropriate in both cases.

101 Investment Advisers Act, Section 203(b), Pub. 

L. 76–768, 54 Stat. 847, 850 (1940).

102See Investment Company Act Amendments of 

1970, H.R. Rep. No. 91–1382, at 39 (1970).

103See Adopting Release at n. 139.

104 Investment Trusts and Investment Companies: 

Hearings on S. 3580 before a Subcommitteee of the 

Senate Committee on Banking and Currency, 76th 

Cong., 3d Sess. 179 (1940) (David Schenker, Chief 

Counsel of the Investment Trust Study, explained: 

‘‘The total assets play no part in the determination 

as to whether a company is a public investment 

company or a private investment company 

* * *.’’).

105S. Rep. 104–293, at 10 (1996).

companies for registration, the majority has 

redefined ‘‘client’’ solely for this particular 

subset of advisers and then only to determine 

their eligibility to rely on section 203(b)(3). 

That section exempts from registration any 

adviser who during the past year has had 

fewer than fifteen clients and who does not 

hold himself out to the public as an 

investment adviser and does not act as an 

adviser to investment companies or business 

development companies.93 Traditionally, for 

purposes of section 203(b)(3), advisers 

counted the funds, not the investors in those 

funds, as clients. The safe harbor in rule 

203(b)(3)–1, which deems ‘‘the legal 

organization * * * that receives investment 

advice based on its investment objectives 

rather than the individual investment 

objectives of its [owners],’’ confirms the 

propriety of this approach.94 The majority, 

however, has now (i) amended rule 

203(b)(3)–1 to deprive advisers to ‘‘private 

funds’’ of the safe harbor for counting clients 

afforded by that rule and (ii) added new rule 

203(b)(3)–2 to require advisers to count each 

owner of a ‘‘private fund’’ towards the 

threshold of 14 clients for purposes of 

determining the availability of the private 

adviser exemption of section 203(b)(3) of the 

Act.

The majority’s action marks a departure 

from the Commission’s established approach 

of determining who an adviser’s client is, 

namely by looking at whether or not the 

adviser is tailoring the advice to the financial 

situation and objectives of the individual 

investors or is simply providing advice to an 

entity in which individuals share the 

profits.95 The core of the advisory 

relationship is the provision of 

individualized advice tailored to the needs 

and financial situation of the client. Thus, in 

1997, when the Commission created a safe 

harbor to enable investment advisers to group 

clients together, it included safeguards to 

ensure that the adviser continued to treat 

each investor, not the group, as a client.96 As 

the Commission explained:

A client of an investment adviser typically is 

provided with individualized advice that is 

based on the client’s financial situation and 

investment objectives. In contrast, the 

investment adviser of an investment 

company need not consider the individual 

needs of the company’s shareholders when 

making investment decisions, and thus has 

no obligation to ensure that each security 

purchased for the company’s portfolio is an 

appropriate investment for each 

shareholder.97

An adviser to a hedge fund is not 

expected to tailor its advice to the needs 

of individual owners of the fund, who 

do not necessarily have identical 

financial situations or objectives.98

Not only does the majority’s action 

awkwardly depart from the established 

approach for identifying an adviser’s 

clients, but the majority rejected 

compelling challenges to the 

Commission’s statutory authority for 

this action.99 When Congress first 

adopted the Investment Advisers Act in 

1940, it did not look through investment 

companies and treat the underlying 

shareholders as the client. Rather, the 

Advisers Act treated the company itself 

as the client.100 In this vein, section 

203(b) of the Act as originally enacted 

exempted from registration ‘‘any 

investment adviser whose only clients 

are investment companies and 

insurance companies.’’101 In 1970, when 

Congress, acting on the Commission’s 

recommendation, amended the Act to 

require advisers to investment 

companies to register, it determined that 

‘‘the shareholders of investment 

companies should have the same 

protections now provided for clients of 

investment advisers who obtain 

investment advice on an individual 

basis.’’102 Advisers to privately placed

investment companies, however, were 

not affected by the change. These 

advisers could still rely on the 

exemption from registration in section 

203(b)(3) for advisers who do not hold 

themselves out generally to the public 

as advisers and have fewer than 15 

clients.

The Commission assumes that 

removing the exemption would simply 

effect Congress’s unspoken intent that 

any adviser who manages a significantly 

large asset pool must register. The 

majority points for support to the 

legislative history of Investment 

Company Act section 3(c)(1), which 

exempts investment companies with 

fewer than 100 owners.103 But the 

legislative history of that section 

suggests that Congress understood that 

there would be asset pools, some of 

them large, that were not reached by the 

statute.104 Congress has not amended 

section 203(b)(3) to require hedge fund 

advisers to register despite being aware 

that many hedge fund advisers are 

advising large pools of money without 

being registered. In fact, just eight years 

ago, Congress, recognizing ‘‘the 

important role that these pools can play 

in facilitating capital formation for U.S. 

companies,’’ made the formation of 

large private pools easier.105 Congress 

72098 Federal Register / Vol. 69, No. 237 / Friday, December 10, 2004 / Rules and Regulations 

106 15 U.S.C. 80a–3(c)(7).

107S. Rep. 104–293, at 10 (1996).

added section 3(c)(7) to the Investment 

Company Act to permit the formation of 

unregistered pools of an unlimited 

number of highly sophisticated 

investors.106 The Committee report 

faulted ‘‘regulatory restrictions on these 

private pools’’ for driving American 

investors offshore.107 The fact that many 

advisers to such pools were not 

registered under the Advisers Act was 

certainly known to Congress and 

allowing them to continue in their 

unregistered state was entirely 

consistent with Congress’s objective of 

minimizing regulatory restrictions on 

such pools of assets.

VI. Conclusion 

When we dissented from this 

rulemaking at the proposal stage, we 

asked for comment on a wide range of 

issues. We were interested in exploring 

different ways of getting more 

information about hedge funds, 

including working with other regulators 

and enhancing Commission oversight of 

existing registrants. Commenters 

responded with legitimate concerns 

about the costs and unintended 

consequences and offered their 

cooperation and a number of more 

feasible alternatives for addressing the 

Commission’s concerns. 

As the commenters pointed out, 

mandatory registration is an 

inappropriate response to the concerns 

underlying this rulemaking. The growth 

of the industry might support our call 

for more information, but it is not a 

valid justification for regulation. 

Registration is not likely to deter or 

lessen substantially the harm of 

fraudulent activities of the type cited by 

the majority. The majority has failed to 

demonstrate that retailization is a 

problem, let alone that mandatory, 

universal registration would be the 

appropriate solution. Not only is the 

majority’s rulemaking a poor solution 

for the problems that the majority cites, 

but it gives rise to unintended 

consequences. Among these are the 

imposition of substantial direct and 

opportunity costs on hedge fund 

advisers and their investors, and 

increased retailization. Moreover, 

implementing the rulemaking diverts 

Commission resources from the 

protection of retail investors. The 

Commission, in carrying out its mission, 

should apply its limited resources 

towards their highest and best use. 

The majority also has failed to draw 

legitimate distinctions between hedge 

funds and other types of private 

investment pools that would justify 

different regulatory schemes. Questions 

about the wisdom of the majority’s 

approach are compounded by questions 

about the propriety of this approach in 

light of legislative and regulatory 

precedent. 

We hoped that the Commission would 

accord serious consideration to 

objections to their proposal. Today’s 

rulemaking, which is the wrong solution 

to an undefined problem, disappoints 

those hopes and leaves better solutions 

unexplored. 

For all of the foregoing reasons, we 

respectfully dissent.

Dated: December 2, 2004. 

Cynthia A. Glassman, 

Commissioner. 

Paul S. Atkins, 

Commissioner.

[FR Doc. 04–26879 Filed 12–9–04; 8:45 am]

BILLING CODE 8010–01–P