U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

For sale by the Superintendent of Documents, U.S. Government Printing Office

Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800

Fax: (202) 512–2104 Mail: Stop IDCC, Washington, DC 20402–0001

40–871 PDF 2008

AFTER BLACKSTONE: SHOULD SMALL INVESTORS

BE EXPOSED TO RISKS OF HEDGE FUNDS?

HEARING

BEFORE THE

SUBCOMMITTEE ON DOMESTIC POLICY

OF THE

COMMITTEE ON OVERSIGHT

AND GOVERNMENT REFORM

HOUSE OF REPRESENTATIVES

ONE HUNDRED TENTH CONGRESS

FIRST SESSION

JULY 11, 2007

Serial No. 110–42

Printed for the use of the Committee on Oversight and Government Reform

(

Available via the World Wide Web: http://www.gpoaccess.gov/congress/index.html

http://www.oversight.house.gov

(II)

COMMITTEE ON OVERSISGHT AND GOVERNMENT REFORM

HENRY A. WAXMAN, California, Chairman

TOM LANTOS, California

EDOLPHUS TOWNS, New York

PAUL E. KANJORSKI, Pennsylvania

CAROLYN B. MALONEY, New York

ELIJAH E. CUMMINGS, Maryland

DENNIS J. KUCINICH, Ohio

DANNY K. DAVIS, Illinois

JOHN F. TIERNEY, Massachusetts

WM. LACY CLAY, Missouri

DIANE E. WATSON, California

STEPHEN F. LYNCH, Massachusetts

BRIAN HIGGINS, New York

JOHN A. YARMUTH, Kentucky

BRUCE L. BRALEY, Iowa

ELEANOR HOLMES NORTON, District of

Columbia

BETTY MCCOLLUM, Minnesota

JIM COOPER, Tennessee

CHRIS VAN HOLLEN, Maryland

PAUL W. HODES, New Hampshire

CHRISTOPHER S. MURPHY, Connecticut

JOHN P. SARBANES, Maryland

PETER WELCH, Vermont

TOM DAVIS, Virginia

DAN BURTON, Indiana

CHRISTOPHER SHAYS, Connecticut

JOHN M. MCHUGH, New York

JOHN L. MICA, Florida

MARK E. SOUDER, Indiana

TODD RUSSELL PLATTS, Pennsylvania

CHRIS CANNON, Utah

JOHN J. DUNCAN, JR., Tennessee

MICHAEL R. TURNER, Ohio

DARRELL E. ISSA, California

KENNY MARCHANT, Texas

LYNN A. WESTMORELAND, Georgia

PATRICK T. MCHENRY, North Carolina

VIRGINIA FOXX, North Carolina

BRIAN P. BILBRAY, California

BILL SALI, Idaho

JIM JORDAN, Ohio

PHIL SCHILIRO, Chief of Staff

PHIL BARNETT, Staff Director

EARLEY GREEN, Chief Clerk

DAVID MARIN, Minority Staff Director

SUBCOMMITTEE ON DOMESTIC POLICY

DENNIS J. KUCINICH, Ohio, Chairman

TOM LANTOS, California

ELIJAH E. CUMMINGS, Maryland

DIANE E. WATSON, California

CHRISTOPHER S. MURPHY, Connecticut

DANNY K. DAVIS, Illinois

JOHN F. TIERNEY, Massachusetts

BRIAN HIGGINS, New York

BRUCE L. BRALEY, Iowa

DARRELL E. ISSA, California

DAN BURTON, Indiana

CHRISTOPHER SHAYS, Connecticut

JOHN L. MICA, Florida

MARK E. SOUDER, Indiana

CHRIS CANNON, Utah

BRIAN P. BILBRAY, California

JARON R. BOURKE, Staff Director

(III)

C O N T E N T S

Page

Hearing held on July 11, 2007 ............................................................................... 1

Statement of:

Bullard, Mercer E., University of Mississippi Law School; John C. Coffee,

Jr., Columbia Law School; Joseph P. Borg, president of the Board

of Directors of the North American Securities Administrators Association; and Peter J. Tanous, president and CEO, Lynx Investment Advisory, LLC ....................................................................................................... 40

Borg, Joseph P. .......................................................................................... 100

Bullard, Mercer E. ..................................................................................... 40

Coffee, John C., Jr. .................................................................................... 85

Tanous, Peter J. ........................................................................................ 111

Donahue, Andrew J. ‘‘Buddy’’, Director of the Division of Investment

Management, Securities and Exchange Commission ................................. 19

Letters, statements, etc., submitted for the record by:

Borg, Joseph P., president of the Board of Directors of the North American Securities Administrators Association, prepared statement of ......... 103

Bullard, Mercer E., University of Mississippi Law School, prepared statement of ........................................................................................................... 43

Coffee, John C., Jr., Columbia Law School, prepared statement of ............. 88

Donahue, Andrew J. ‘‘Buddy’’, Director of the Division of Investment

Management, Securities and Exchange Commission, prepared statement of ........................................................................................................... 22

Issa, Hon. Darrell E., a Representative in Congress from the State of

California, prepared statement of ................................................................ 11

Kucinich, Hon. Dennis J., a Representative in Congress from the State

of Ohio, prepared statement of .................................................................... 4

Tanous, Peter J., president and CEO, Lynx Investment Advisory, LLC,

prepared statement of ................................................................................... 113

(1)

AFTER BLACKSTONE: SHOULD SMALL INVESTORS BE EXPOSED TO RISKS OF HEDGE

FUNDS?

WEDNESDAY, JULY 11, 2007

HOUSE OF REPRESENTATIVES,

SUBCOMMITTEE ON DOMESTIC POLICY,

COMMITTEE ON OVERSIGHT AND GOVERNMENT REFORM,

Washington, DC.

The subcommittee met, pursuant to notice, at 1 p.m., in room

2154, Rayburn House Office Building, Hon. Dennis J. Kucinich

(chairman of the subcommittee) presiding.

Present: Representatives Cummings, Kucinich, Davis of Illinois,

Tierney, Watson, Braley, Cannon, Issa, and Bilbray.

Also present: Representative Hodes.

Staff present: Jaron Bourke, staff director; Charles Honig, counsel; Jean Gosa, clerk; Evan Schlom, intern; Natalie Laber, press

secretary, Office of Congressman Dennis J. Kucinich; Leneal Scott,

information systems manager; and David Marin, minority staff director.

Mr. KUCINICH. Good afternoon. The Subcommittee on Domestic

Policy of the Committee of Oversight and Government Reform will

now come to order.

Today’s hearing will take a closer look at loosened initial public

offerings of hedge funds and private equity funds and the risks

they pose to small investors.

Without objection, the Chair and ranking minority member will

have 5 minutes to make opening statements, followed by opening

statements not to exceed 2 minutes by any other Member who

seeks recognition.

Without objection, Members and witnesses may have 5 legislative days to submit a written statement or extraneous materials for

the record.

Without objection, we will be joined on the dias by Members not

on our committee for the purposes of participating in this hearing

and asking questions of our witnesses.

Good afternoon. This hearing’s purpose is to shed light on a serious challenge to America’s decades-long commitment to protecting

small investors, brought to public attention by the recent public offering of Blackstone LP. Hedge funds and private equity funds are

risky, and they operate under exemptions from traditional investor

protections.

Under current law, hedge funds and private equity funds may

not be sold to small investors. They deploy investment strategies

2

that are otherwise prohibited, and they possess the potential for

rich rewards. But at the same time, they are characterized by real

potential risks of callosal failure, illustrated by the collapse of two

Bear Sterns hedge funds just 2 weeks ago, and the collapse of Amaranth Partners and Long Term Capital some years ago.

The public offering of Blackstone LP 2 weeks ago and the offering of the Fortress Investment Group that preceded it marked the

attempt to mainstream a new financial arrangement that effectively presents small investors with the ability to invest in the

management of hedge funds and private equity funds. I am concerned that the effect is to expose small investors to risks that

heretofore have been permitted only for large institutional investors and wealthy individuals.

Blackstone is the latest and by far the largest family of hedge

funds and private equity funds that have devised a way to be traded publicly without compliance with the Investment Company Act

of 1940, but it by no means will be the last. The Kohlberg, Kravis,

Roberts private equity group and the Och-Ziff Capital hedge funds

have already filed with the SEC to make their management companies public following Fortress and Blackstone models, and news reports indicated that other funds, such as the Carlyle Group and

Apollo may not be far behind.

The subject of this hearing is this: has the SEC adequately used

its existing authority to protect small investors with regard to the

initial public offering of these arrangements? Is the existing law

adequate to the task of protecting investors in the face of the desire

and resourcefulness of hedge fund and private equity fund managers to go public? What are the new risks to small investors posed

by these new financial arrangements?

I want to be clear that this hearing is not about the abolition or

even the further regulation of private equity and hedge funds, nor

is this hearing biased toward forbidding future offerings like Blackstone LP. The bias, if there is one, is toward the protection of small

investors and how best regulation may accomplish that goal; in

other words, what steps all actors in the broader regulatory system, including Congress, can and should take to militate against

the risk of these novel investment vehicles.

The backbone of our financial system, one that makes it the envy

of the world and an efficient machine to balance risk and reward,

is our strong system of regulating public offerings. The Securities

and Exchange Commission has attempted to institute some regulation of hedge funds for even sophisticated and wealthy investors.

All of the witnesses that you will hear from today think that when

small investors are allowed access to hedge funds and private equity funds there needs to be regulation. The question is: what type

of regulation is both necessary and reasonable to strengthen our financial system?

Blackstone LP provides the point of departure. This subcommittee wrote the SEC on June 21st out of concern that insufficient

time an opportunity had been allotted to examine those new risks

and the soundness of the new financial arrangements. Chairman

Waxman and I felt that the stakes were high, since a careful reading of Blackstone’s registration statements by our staff revealed

that public investors in the IPO would be assuming risks without

3

the traditional investor protections of corporate governance that

allow investor control and without transparency and the disclosure

of what is being invested in. Those risks include excessive compensation arrangements, management of self-dealing transactions

with affiliates, use of substantial leverage, no diversification requirements, difficult-to-value investments, illiquid investments, no

independent board members, no substantive voting rights, few fiduciary duties on management.

Eagerness by Blackstone to launch this IPO and to stymie Congress’ examination of these questions is unfortunate. It should be

noted that Blackstone moved up its offering date by a week, precisely when we and several other Members of Congress asked the

SEC to scrutinize further the offerings. They could have allowed

the inquiry to take place, and I believe it was unfortunate they

didn’t. But if Blackstone was able to market a black box to ordinary investors by gaming their offering date, others that follow will

not.

The alternative to oversight is not pretty: it is to wait for something bad to happen; for the failure of one or several of these management complaints; and for, as in the Enron debacle, ordinary investors to lose everything, including their retirement income, and

to allow the legal and economic fallout to be resolved through protracted and expensive litigation. You know, this just isn’t acceptable.

So our hearing today is timely and, we hope, helpful to the cause

of protecting ordinary investors. These are individuals and families

who are saving for college or retirement through IRAs and 527s,

mutual funds, and online trading houses. They depend upon the

SEC and Congress to afford them the opportunities of our market

system with protections from excessive risks and dangers which

can otherwise ruin and defeat the American dream.

We will examine today, with the help of some of the Nation’s

leading experts, if we are living up to that challenge and if we are

responsibly or irresponsibly exposing small investors to excessive

risk and danger.

Thank you very much.

[The prepared statement of Hon. Dennis J. Kucinich follows:]

4

5

6

7

8

9

Mr. KUCINICH. With that I recognize the Honorable ranking minority member, Mr. Issa of California.

Mr. ISSA. Thank you, Mr. Chairman. I think you did a great job

of characterizing the majority opinion on today’s hearing, and Ido

want to thank you very sincerely for holding this. I believe that

there is a need for this Congress to view changes in the market,

and view them with the kind of doubt that, by definition, helps protect investors large and small.

I do believe that we are holding two hearings here today. We are

holding on that seems to be all about Blackstone. This IPO was not

a private equity, in fact, public offering, but rather the management of a private equity. But we are also here today, without a

doubt, dealing with questions of hedge funds and private equity

that are being dealt with in Congress as we speak and that are

being, in some cases, vilified.

So little is known about private equity industry it is easy to

mischaracterize the role they play in our economy. My comments

today are directed primarily at private equity funds. I am concerned that we in Congress are lumping equity and hedge funds together and looking at them as interchangeable. They are different

entities and should be seen differently.

Frequently we have heard individuals such as Steve

Schwartzman of Blackstone or Lew Gerstner of the Carlyle Group

characterized as Masters of the Universe, invoking images of robber barons or captains of industry, to explain the business model.

What is more, in every article concerning Blackstone’s IPO, there

were also descriptions of CEO’s lavish lifestyle. These notions have

led Members of Congress to advocate for increasing taxes associated with the private equity model.

Included today I put some charts up—and I have more—that

specifically make it clear that one of the major recipients of both

hedge funds and private equity are, in fact, both public and private

entities such as union pension funds, public pension funds, and, in

fact, corporate pension funds typically having between 1 and 15

percent of their portfolio in these types of investments. These investments have done well for future retirees throughout the country, running as much as 22, 23 percent return on investment year

over year over year.

So it is very clear that the most sophisticated buyers, the most

sophisticated buyers, these large, multi-billion-dollar pension funds

with all of their professional management, have made a decision

that favors a certain percentage of these investments.

It is also clear that if, not as this chairman, but as chairmen of

some other committees, have been advocating, if, in fact, we choose

to add a level of taxation to this process at any point, we are not

going to take it out of the people and the companies that produce

these profits; we are going to take it out of the pass-along to these

entities. That is one of my concerns here today.

Perhaps as a proud Republican, perhaps simply as a taxpayer, I

find little doubt in my mind that we are taxed sufficiently. I am

not here today to advocate for a tax increase. In fact, my opinion

is that we, as Americans, are fully taxed and need not look for additional tax revenue by adding to a group to vilify in order to raise

their taxes.

10

Also, too often securities legislation has been the product of congressional hothouses. This follows closely on financial scandals or

disasters. It is no coincidence that Congress passed the Security

Exchange Act of 1933 or created the Securities and Exchange Commission in 1934 following the dark days of the 1929 crash and the

Depression that followed.

In recent history, Congress passed during my tenure SarbanesOxley Act on the heels of Enron and WorldCom disasters. Oddly

enough, Sarbanes-Oxley did little to prevent that from happening

again, but has added billions of dollars of legal and accounting

costs to public companies, thus reducing what they can pay in dividends to the small investor that we are here today to talk of.

It is very clear that we are not here today to pass legislation in

a hurry. It is clear that we should not. There has not been a disaster. There has not been some sort of an episode, including this public offering, that should cause us to hastily go to legislation. Just

the opposite. I believe hearing from the Securities and Exchange

Commission and from career investors and other people knowledgeable in this industry today, we will have a better opportunity to see

what is right, what is more right in this country than any other

country on the face of the Earth, and then perhaps what could be

done. Perhaps we could start talking about rolling back some of the

mistakes of Sarbanes-Oxley.

Thankfully, the debate about Blackstone IPO will not result in

a public scandal. It will and has resulted in small investors able

to participate in just a few thousand dollars, a few hundred shares,

if they choose to, in fact, the management team of a company that

has been wildly successful.

Full disclosure, not just by the SEC but also, and I think more

importantly, by the public media has made it very clear that this

is a unique first event and that investors should make sure that

they are not over-weighted in this or any other investment.

Mr. Chairman, not to be overly colorful, but because I am a believer that America’s competitiveness depends on private equity, I

am going to close and put the rest in for the record and just tilt

up one example. I used wine with Chairman Waxman not too long

ago, but Dunkin Donuts, a small public company that went private,

in my opening statement I characterize they have made it very

clear that their success today, in fact, the fact that they are doing

a very good job against their best-known rival, Krispy Kreme—

since I am putting out public names of which I own none—they, in

fact, could not have reorganized and come out a much more successful company if they didn’t have the ability to come out of the

daily quarterly grind, make the kinds of investments that often we

on the dais complain are short-sighted, the I have to make this

quarter, the next quarter that public companies often do. But instead, they were able to put together a long-term plan, come out,

and, in fact—and the odor is absolutely wonderful—produce a product that now is selling dramatically better than it did just a few

years ago.

Mr. Chairman, I will put the rest in for the record and make the

donuts available to all of our guests. [Laughter.]

I will yield back.

[The prepared statement of Hon. Darrell E. Issa follows:]

11

12

13

14

15

16

17

18

Mr. KUCINICH. I want to thank my friend for his presentation

and say that we shall proceed in the spirit of keeping our eye on

the donut and not on the hole. [Laughter.]

I am a vegan. I don’t eat that stuff.

The Chair will recognize the distinguished Member of Congress

from New Hampshire, Mr. Hodes, who is a guest at our committee.

We welcome you.

Mr. HODES. Thank you, Mr. Chairman. I appreciate your allowing me to sit as a guest member of the subcommittee. I am a member of the Oversight and Government Reform Committee and also

a member of the Financial Services Committee, and am especially

interested in the Blackstone matter.

I had a pleasure, as a member of the Financial Services Committee, Mr. Donahue, to question Chairman Cox and the Commissioners of the SEC about the Blackstone IPO because of some particular concerns I had.

Now, I am not here to argue between tempe and tofu or one wine

or the other, and I understand that the SEC has held that the

Blackstone IPO did not have to comply with the Investment Company Act of 1940.

My concern remains, however, and I suppose that reasonable

minds could differ on the SEC’s conclusion, and reasonable minds

do, and the courts could take it up, and they may. But my question

really—and I am hoping you will address this—is that it is a public

policy question. The SEC’s mission is to protect investors; maintain

fair, orderly, and efficient markets; and facilitate capital formation.

We are now in a new world in which a private equity firm,

Blackstone, probably very different than a traditional, if such can

be applied to the word hedge fund, has now gone public. They have

made the transition from the private equity entity into the public

markets.

In that light, according to their S–1 filing and what is generally

recognized in the way they are formed, they have disclaimed fiduciary duties in general to their unit holders, they have limited voting rights to their unit holders, and they have asserted the right

to act with limited disclosure as to important elements of their

strategy and the way they operate which would otherwise, in the

ordinary course of a public offering which did comply with the Investment Company Act of 1940, be available to their shareholders

or unit holders.

I think significant public policy questions are raised, and it is not

too early, given the size and complexity of the Blackstone IPO and

other private equity firms which appear to be coming to the market, to ask the question whether or not, in view of this new entity,

the Investment Company Act of 1940 is up to date, and whether

or not amendments need to be made to respond to the new situation in the markets in order to protect investors, because for the

life of me I cannot see who is protecting the investors in the Blackstone IPO if they are allowed to disclaim their fiduciary duties, and

how and by what mechanism that will happen.

I understand that the SEC is moving on some elements to deal

with fraud provisions that might relate, but it strikes me, as a matter of public policy, that we may have to address the Investment

19

Company Act of 1940, and I look forward to hearing from you your

thoughts on the advisability of doing that.

Thank you very much.

Thank you, Mr. Chairman.

Mr. KUCINICH. I thank the gentleman for joining us.

If there are no additional opening statements, this subcommittee

will now receive testimony from the witnesses before us today.

I want to start by introducing the gentleman who will be making

the first presentation, Mr. Andrew Donahue. Mr. Donahue has

been the Director of the Division of Investment Management at the

Securities and Exchange Commission since May 2006.

Welcome, Mr. Donahue.

As Director, Mr. Donahue is responsible for developing regulatory policy and administering the Federal securities laws applicable to mutual funds, exchange-traded funds, closed-end funds, variable insurance products, unit investment trust, and investment advisors. You can see that we have the right person here to talk to

about this.

Prior to the SEC, Mr. Donahue was global General Counsel for

Merrill Lynch Investment Managers and chairman of the firm’s

Global Risk Oversight Committee. Prior to his time at Merrill

Lynch, Mr. Donahue was a securities lawyer and executive vice

president and general counsel, director, and member of the Executive Committee for Oppenheimer Funds.

Mr. Donahue, it is the policy of the Committee on Oversight and

Government Reform to swear in all witnesses before they testify,

and I would ask if at this time you would kindly rise and raise

your right hand.

[Witness sworn.]

Mr. KUCINICH. The record will reflect that the witness answered

in the affirmative.

I ask the gentleman to give a brief summary of his testimony.

Keep this summary, if you would, under 5 minutes in duration. I

want you to bear in mind that your complete statement and anything you want to attach to it will be included in the hearing

record.

The gentleman is recognized. Again, thank you for your presence

here today.

You may proceed.

STATEMENT OF ANDREW J. ‘‘BUDDY’’ DONAHUE, DIRECTOR OF

THE DIVISION OF INVESTMENT MANAGEMENT, SECURITIES

AND EXCHANGE COMMISSION

Mr. DONAHUE. Chairman Kucinich, Ranking Member Issa, and

members of the subcommittee, I am pleased to be here today to discuss the Securities and Exchange Commission’s perspective with

respect to initial public offerings of investment advisory firms that,

among other things, manage hedge and private equity funds.

As the head of the Commission’s Division of Investment Management, I have responsibilities for overseeing and regulating nearly

1,000 investment company complexes with over $11 trillion in assets, and more than 10,000 investment advisors that manage more

than $37 trillion in assets.

20

A number of issues have been raised about the recent IPOs of

Fortress Investment Group and the Blackstone Group. I am

pleased to be able to offer the committee my knowledge and expertise, especially as it relates to the question of whether Fortress and

Blackstone are investment companies and thus subject to the substantive provisions of the Investment Company Act of 1940.

Congress enacted the Investment Company Act to provide a separate and different regulatory structure for investment companies

as compared to industrial or operating companies. Among Congress’ stated goals was to minimize the risk that an investment

company might be managed in the interest of its managers or certain shareholders rather than for the benefit of all shareholders.

The Investment Company Act provides important protections to

investment company investors. I have great respect for the Investment Company Act and the role that it has had in affording America’s investors an opportunity to invest in our Nation’s securities

markets through a vehicle subject to meaningful oversight and protection. As a result, I believe investment companies’ status to be

a critical determination.

The staff reviewed the Fortress and Blackstone registration

statements in the normal course and consistent with past review

practices and Commission precedent. Applying tests established by

Congress and the Investment Company Act, the staff concluded

that Fortress and Blackstone do not appear to be investment companies.

First, under the orthodox investment company test, Fortress and

Blackstone are primarily engaged and hold themselves out as being

primarily engaged in the business of managing money for others,

not themselves. Their assets, sources of income, officer and employee activities, historical development, and public statements are

consistent with those of an operating company, not an investment

company.

Second, in applying the inadvertent investment company test,

Fortress and Blackstone did not appear to have 40 percent of their

assets in investment securities.

In addition to other assets, the primary assets of Fortress and

Blackstone are their general partnership interests and the underlying funds they manage. These general partnership interests raise

two questions relevant to the investment company status determinations. First, are they securities or investment securities? Second, what is their value?

Under existing law, general partnership interests are not securities if the profits relating to those interests generally come from

the efforts of the general partners, as opposed to the efforts of others. In the case of Fortress and Blackstone, the issue is maintained

control over the day-to-day management of the underlying funds,

with senior employees exercising such management through wholly

owned subsidiaries.

The profits to the general partnership interest result from the efforts of the general partnership managers, not others; thus, the

general partnership interest would not constitute securities or investment securities.

With respect to valuation, the Investment Company Act requires

an issuer to assign a fair value to general partnership interests like

21

those at issue in Fortress and Blackstone filings. In determining a

fair value, the right to carried interest in underlying funds may be

considered, because such rights are inexorably linked to the general partnership interest.

Applying these principles, neither Fortress nor Blackstone appears to hold investment securities with a value exceeding 40 percent of total assets.

Put another way, in the context of both Fortress and Blackstone,

the value of the assets that are not investment securities—the general partnership interests, including the right to receive carried interest in the underlying funds—is more than 60 percent of total assets.

This asset composition is indicative of an operating company

business rather than an investment company business.

When conducting an investment company status analysis, the

staff considers the status to the relevant entity prior to the offering, as well as giving effect to the offering. They also monitor the

investment company status of certain companies on an ongoing

basis. In some cases, the staff may disagree with the investment

company’s status analysis and request that it either register as an

investment company or restructure its business or securities holdings so as to no longer be an investment company. The Commission

will bring an enforcement action against a company in appropriate

circumstances.

Our staff did not object to the investment company status conclusion in the Fortress and Blackstone registration statements. As

noted in the required legends on all registered public offerings, the

Commission does not approve or disapprove of the securities offered, nor does it pass upon the adequacy or accuracy of the disclosures. Fortress and Blackstone remain liable for the statements

contained in their registration statements.

Finally, it is important to consider that the public investors in

Fortress and Blackstone are buying an interest in an ongoing business which, among other things, manages some underlying funds.

While the value of their investment in Fortress or Blackstone may

be related to how well Fortress or Blackstone do at managing those

underlying funds, as well as how well Fortress and Blackstone are

operating their business, investors are not acquiring a share in any

underlying fund.

Thank you for this opportunity to appear before the committee.

I would be happy to answer any questions you may have.

[The prepared statement of Mr. Donahue follows:]

22

23

24

25

26

27

28

Mr. KUCINICH. I thank the gentleman.

I would like to start out by asking you, sir, can you tell the committee what are some of the investor protections that follow if an

offering is determined by the SEC to be an investment company?

Mr. DONAHUE. There is a broad array of investor protection built

into the 1940 act. There are limits on the composition of the board

of directors, there are certain approvals that must be made by the

board of directors of the investment company. There are provisions

that cover the valuation of the assets that are owned by the investment company. There are limits on borrowing, senior securities,

and leverage. There are limits on what the capital structure can be.

There are limits on affiliate transactions. There are limits on where

assets can be custodied. And there are very specific requirements

with respect to who the advisor and who the officers and employees

can be for the investment company.

Mr. KUCINICH. Thank you. Now, in view of the Securities and Exchange Commission determination that Blackstone LP was not an

investment company, what investor protections exist now?

Mr. DONAHUE. The investor protections that exist now for investors investing in Blackstone and in Fortress are those that are

available to investors in securities that are registered with the Securities and Exchange Commission that are not investment companies.

Mr. KUCINICH. Let me be more specific, if I may. Under this determination that Blackstone LP was not an investment company,

do investors have a right to an independent board of directors?

Mr. DONAHUE. The composition of the board of directors for that

entity, same as for other 1933 Act companies, would be determined

by a combination of State law and the listing requirements of the

exchange that they are traded on.

Mr. KUCINICH. So you can’t answer yes or no? Is that what you

are saying?

Mr. DONAHUE. I believe in the case of Blackstone that three of

their seven directors will be independent. That is my understanding.

Mr. KUCINICH. OK. Three of seven. Do they have guaranteed voting rights under this?

Mr. DONAHUE. They have the voting rights that are afforded to

them under their governing documents and State law and Exchange rules, same voting rights as any other 1933 Act company,

same limitations.

Mr. KUCINICH. Do they have protections against self-interested

transactions with affiliates?

Mr. DONAHUE. Not under the Investment Company Act, but they

would have the same protections that might be afforded to other

registered companies.

Mr. KUCINICH. Do they have the guarantee of protections of the

traditional range of fiduciary duties owed by management to shareholders in a corporation such as a duty of loyalty?

Mr. DONAHUE. They would have the duty that is determined

under State law.

Mr. KUCINICH. Now, may I ask you, are hedge funds and private

funds sold today to ordinary investors? If not, why not?

29

Mr. DONAHUE. The hedge funds and private pools of capital, private funds, can be sold currently to investors, provided that they

are done in accordance with the—generally they use Regulation D,

and in order to avoid registration under the Investment Company

Act they generally comply with the exception under either 3(c)(1),

where there are under 100 investors, or 3(c)(7), where there is unlimited number of investors that all meet the $5 million or higher

test for investments.

Mr. KUCINICH. Does the case law in applying the Securities and

Investment Company Act generally support the principle that function trumps form, or the converse?

Mr. DONAHUE. As I look at our responsibilities in administering

the securities laws, we are mindful of the statutory framework

within which we have been charged to operate by Congress, and

determinations that have been made by courts with respect to interpretations. If there is anybody that felt that this was an investment company in our area, the protection of investors, we would

have sought to see whether or not there was a way. If we felt that

this had been constructed in a way to evade the Investment Company Act, we certainly would have taken, I wouldn’t say a different

look at it, but you can’t evade the Investment Company Act. We

did not feel that was the case here.

Mr. KUCINICH. I am going to ask one more question and then we

will probably need to go another round. Will a significant portion

of the value of the units of shares offered to the public in the Fortress or Blackstone LP deals ultimately be determined by the returns garnered under the underlying hedge fund and private equity

fund portfolios and move in unison with the fund portfolios?

Mr. DONAHUE. I would start off by saying I believe in the case

of Blackstone that they have over 100 underlying investment funds

that it is managing. I would think that the stock price of Blackstone is going to be driven by a variety of forces. One certainly I

would hope would be how well they would manage their businesses

and how well they are managing their underlying funds.

It is true that, as currently constituted, a fair amount of their

earnings are derived from how well they manage those underlying

funds, but they are not parting company. They can go into other

businesses. They can create new funds. So going forward, a lot is

dependent not just on their current investments, the funds that

they are managing, but also on how well they run their management, how well they manage their company.

Mr. KUCINICH. OK. Thank you very much, Mr. Donahue.

The Chair recognizes Mr. Issa. Thank you.

Mr. ISSA. Thank you. I want to continue along the line the chairman was doing. I find this very interesting.

If for a moment, instead of the IPO being about Blackstone

Group, LP, if you were, in fact, investing in Dunkin Donuts, Hilton

Hotels, Linens and Things, as typically people have, they are investing as limited partners, normally, correct?

Mr. DONAHUE. I am not familiar with——

Mr. ISSA. Their underlying funds are, in fact, typically

Blackstone’s——

Mr. DONAHUE. The underlying funds are typically set up as limited partnerships.

30

Mr. ISSA. Right.

Mr. DONAHUE. Yes.

Mr. ISSA. And these are sophisticated buyers, usually, if there

are more than 100 of them, and they go in with a portion of their

otherwise high net worth. Many of them, of course, are public entities and pension funds. And they go in knowing that they will have

absolutely no control; isn’t that true? That limited partners are just

what it says, they are limited, they are in for the ride and for the

most part are delineated with relatively little control, virtually

none of the protections that the chairman talked about?

Mr. DONAHUE. I would hope they appreciate that.

Mr. ISSA. OK. So that wasn’t what was offered by the SEC or reviewed by the SEC. You were reviewing something that had comparatively a little more protection; would that be fair to say?

Mr. DONAHUE. I would say it had considerable disclosure with respect to the entity that was being——

Mr. ISSA. Thank you. I stand corrected. That really is more accurate, better disclosure. However, in the public disclosure it was

made clear that 78 percent of the interest in this entity belongs to

the partners of Blackstone, the managers, the people who have

made this a successful entity, and only 22 percent was being offered to the public, and of that, half was going to one investor,

China. The other half, 11 percent of this interest, was going to the

public. Is that roughly right, as you recall?

Mr. DONAHUE. As I understand it, yes, sir.

Mr. ISSA. So there is inherently a, ‘‘We are going to give you 11

percent of what we get, and the 78 percent is going to go to us, the

managers, and we are going to be in it with what they like to call

in the industry our skin, because we are going to try to maximize

our profits.’’ Is that essentially what this offering was all about?

Mr. DONAHUE. I don’t want to characterize what the offering was

all about, but certainly the sale of the units to public investors was

enabling the public investors to share in the success of the operating company that they had.

Mr. ISSA. Now I am going to call your attention to those things

that you can’t possibly read over there, even though we made them

as large as possible.

Mr. KUCINICH. Would the gentleman yield? Is there a way, if you

have those on a transparency, maybe we could put them up.

Mr. ISSA. We will make it available. I will just characterize it

until they get it up on the slide.

Public entities such as the Ohio Teachers Retirement, California’s PERS and STERS, both the teachers and the public employees, they are typically running from 5 to 15 percent of their portfolio in private equity. For purposes of, I think, the public and

Members here today, those percentages show that, in fact, private

equity is something that you might want to have some of, but you

wouldn’t want to necessarily have only that. Is that fair to say,

from your experience, because I am calling on your private life in

addition to your current job.

Mr. DONAHUE. If I could answer from my prior life and not my

current responsibility——

Mr. ISSA. Your prior life would be fine. You are an expert in that

area.

31

Mr. DONAHUE. Well, I don’t know that I would characterize myself as an expert, but certainly certain asset classes—and I think

private equity is in there—for purposes of diversification, having a

portion of your investments in those types of investments may be

appropriate for you, depending on your circumstances.

Mr. ISSA. And I am going to need a second round, too, but I will

just do one more on this round and then we will come back to some

of the other details.

When Goldman Sachs went public, Senator Corzine, now Governor Corzine, or, as we call him Seatbelt Corzine around here—

he is going to be an advocate for seatbelt safety, I am sure—made

at least $233 million on that public offering. Would you, for our edification, characterize why Goldman Sachs was one type of entity,

why Blackstone is another type, and how, if you are familiar with

both of these, how you would deal with it. I realize that you were

a Merrill Lynch guy, but you may have looked over your shoulder

at Goldman Sachs at some point. I think that will help us in understanding what an investment company is, etc.

Mr. DONAHUE. This is based on imperfect knowledge. I would

first say that many indeed would have loved to have been at Goldman Sachs when they went public, but the businesses of Goldman

Sachs—investment banking, global market trading, asset management, and brokerage—are businesses that are traditional investment banking brokerage type businesses. A portion of what they do

would be in the realm of what Blackstone and Fortress do, so they

would have units that would do similar things, but it wouldn’t be,

obviously, as much of the particular entity as exists in a Blackstone

case, the way I would characterize the differences there.

Mr. ISSA. OK. And that was where the 40 percent threshold and

these other considerations makes it black and white as to how you

would deal with an entity like Goldman Sachs, even if they were

not a corporation, but Goldman Sachs versus Blackstone.

Mr. DONAHUE. With respect to Goldman Sachs, I truly believe

that the status determination would have been simpler, obviously,

than Blackstone or Fortress.

Mr. ISSA. OK. Thank you.

Mr. Chairman, I look forward to a second round.

Mr. KUCINICH. Thank you very much.

The Chair recognizes Mr. Hodes.

Mr. HODES. Thank you, Mr. Chairman.

Mr. Donahue, thank you for that testimony. I marvel at your

skill and the careful distinctions you made when answering Chairman Kucinich’s question in referring to the rights that Blackstone

would have under, say, the law of Delaware under which they are

organized.

It is my understanding that in significant instances the law of

Delaware also allows those registered under its laws to, by contract, essentially disclaim various of their obligations.

For instance, in this case Blackstone has limited voting rights

and giving its investors no rights to elect board members, according

to its S–1 filing with the SEC. This is a restriction and all of these

are restrictions of rights generally available to shareholders of

what we will call normal publicly traded companies. They have disclaimed their fiduciary duty to investors and limited the remedies

32

available. They have required a super majority vote to remove general partners. They prohibit shareholders who own more than 20

percent of outstanding common units from voting on any matter.

They limit the unit holders rights of appraisal if Blackstone is reorganized. And approval from Blackstone’s Conflicts Committee will

be conclusive, despite Delaware law stating that this approval will

simply shift the burden to a plaintiff to show a conflict of interest.

They go on. There are other disclaimers. I have just listed a partial listing of the disclaimers that Blackstone makes. So they have

disclosed the multitude of ways in which they limit the rights of

those who are investing in their company.

I would like you to change baseball caps for a moment to your

far-sighted view as a regulator with vast experience and far better

than I to look forward.

Do you agree or disagree that when a company such as Blackstone or any company sells its shares to the public, that there is

a public policy implication that kicks in to provide or that should

provide protection for the investors who are now no longer limited

to those millionaires and multi-millionaires who are qualified investors, whether at a $1 million or $5 million level, but are not Ma

and Pa, my constituents in New Hampshire investing in various

ways who do not read SEC disclosure statements, who do not know

what Blackstone is, and who are now trying to invest? Do you

think the public policy kicks in and that we need to protect those

investors?

Mr. DONAHUE. Protection of investors is certainly key to the responsibilities that the Securities and Exchange Commission has.

Traditionally, for non-investment companies and 33 Act registered

companies, those types of issues have been left to State law and

left to the listing exchanges for their determinations. And the 1933

Act is a disclosure statute. It is, for the very reason that you could

state all of those what you might characterize as non-protections,

is what the 1933 Act is about, which is to make those material disclosures to investors so that investors can make an informed judgment about whether or not to make those investments.

We are not in the 1933 Act context; we are in the 1940 Act context, really merit regulators or disclosure regulators. That is the

context within which we review and allow registration statements

to go to the light.

Now, whether I have concerns about investor issues within certain companies and about remedies that might be to investors, of

course I do.

Mr. HODES. Understanding your role as the SEC regulator on the

disclosure requirements, do you have concerns on behalf of the investors in the Blackstone offering?

Mr. DONAHUE. In the Blackstone context, I believe that the review that was done by my brethren in the Corporate Finance Division, that they felt that all the material disclosures were made.

They had no reason to believe that the information was not out

there for investors and their advisors to make a choice of whether

or not this is an investment that they should want to make.

Mr. HODES. Thank you. I see my time is up. Thank you, Mr.

Chairman.

Mr. KUCINICH. The Chair will recognize Mr. Braley.

33

Mr. BRALEY. Thank you, Mr. Chairman.

Mr. Donahue, I want to talk to you a little bit about the SEC’s

mandating of Blackstone’s disclosure questions. Does the SEC’s

judgment about whether Blackstone LP is an investment company

make that determination binding upon courts who are interpreting

the legal implications of such a determination?

Mr. DONAHUE. My answer to that would be no, that courts have

at times disagreed with determinations that we have made.

Mr. BRALEY. And, in fact, isn’t it true that just last year the 7th

Circuit Court of Appeals disagreed with the SEC’s interpretation of

the Investment Company Act determination?

Mr. DONAHUE. I assume you are referring to the National Presto

case?

Mr. BRALEY. Yes.

Mr. DONAHUE. The SEC believed that National Presto was an investment company under both the traditional test, the orthodox

test, and the inadvertent test, and the court did disagree with us.

Mr. BRALEY. Could you share with us the practical impact of the

ability of Blackstone LP to conduct its business and the value of

the units offered to the public if a court determined that Blackstone was an investment company?

Mr. DONAHUE. It is a difficult question for me to answer in my

current role, but the structure they have, the way that they operate

would not be, in my judgment, practical under the 1940 Act.

Mr. BRALEY. Would it be possible that it would impose a substantial obstacle to the ability of the company to conduct its business?

Mr. DONAHUE. In my judgment it most likely would.

Mr. BRALEY. Could cause the value to fall precipitously?

Mr. DONAHUE. I am sorry?

Mr. BRALEY. Could it cause the value to fall precipitously?

Mr. DONAHUE. That is beyond my expertise.

Mr. BRALEY. All right. Did SEC staff request further explanations from Blackstone regarding its finances, including the partnership asset composition, in order to make a determination

whether Blackstone LP was an investment company?

Mr. DONAHUE. If you don’t mind, I will expand a little bit on it,

because this is really an important determination. We didn’t take

the registration statement, the information contained on it, and

from that just say, OK, the company says they are not an investment company. There was much back and forth between us trying

to get more information about exactly what the various components

were, really how the assets were being determined, and how they

reached their determination that they did not believe they were investment companies.

It is difficult to, picking up a registration statement, on its face,

to be able to tell that without getting more of the detailed information from the company about the valuations and a number of other

things that go into that determination.

Mr. BRALEY. Did the SEC view the information as being material

in making its decision on the Investment Company Act?

Mr. DONAHUE. The information supplied to us by the companies

was critical for us to be able to determine that their determination

of the status was not accurate, yes.

34

Mr. BRALEY. And was this further information about its asset

composition disclosed to the public before the IPO became effective?

Mr. DONAHUE. There were some aspects of that information that

was in the registration statement, and there was a certain amount

of that was sent to us with a request to keep it confidential, so it

was not in the registration statement.

Mr. BRALEY. Well, can you quantify for us, in terms of the volume of information that was supplied that was actually made public?

Mr. DONAHUE. Well, the first thing I would like to point out is

we have a registration statement that is available, but the correspondence that goes back and forth between the registrant and

the SEC are made public unless there is an appropriate request for

confidential treatment.

Mr. BRALEY. When you say they are made public, in what format

are those made available to potential investors?

Mr. DONAHUE. The actual letters are available on the EDGAR

Web site, which is the official Web site for the SEC.

Mr. BRALEY. So is that something that a potential investor could

easily access as part of their own due diligence?

Mr. DONAHUE. That would not work well for the due diligence

that an investor might do in participating in the initial public offering, because the initial public offering will have already concluded

by the time that correspondence is up.

Mr. BRALEY. Thank you. Those are all the questions I have.

Mr. KUCINICH. I thank the gentleman.

The Chair recognizes Ms. Watson.

Ms. WATSON. Mr. Chairman, I missed the first part of the testimony, so I am going to kind of work backward to inform myself,

but, Mr. Donahue, in the Senate Finance hearing this morning,

Congressional Budget Director Peter Orszag testified directly before your testimony and said that he viewed carried interest as

partly compensation for return on capital and partly compensation

for services rendered.

In his testimony, he also referred to a large body of academic literature discussing the issue, and other witnesses testified that carried interest differed from earnings based on service.

Do you agree with this conclusion, with Mr. Orszag’s conclusion?

Mr. DONAHUE. I haven’t had an opportunity to look at the academic studies that he was referring to. I would note that his testimony was being given, I believe, in the context of a hearing relative to the appropriate tax treatment of carried interest, so I don’t

have a view toward that.

Ms. WATSON. Well, the SEC, as I understand, has determined

that Blackstone is a carried investment or carried interest and

doesn’t come under the Investment Company Act. Can you comment on that?

Mr. DONAHUE. I think the carried interest winds up to be an element in our determination of whether or not the nature of its investments, whether it meets the definition of an investment company. The carried interest analysis goes into the carried interest

being part of the general partnership interest. Whether the carried

interest entitles the general partner to receive income or whether

it entitles the general partner to receive it in another form, it is

35

tied in to the general partnership interest, I don’t believe our analysis would differ, and particularly not based on the appropriate tax

treatment of it.

Ms. WATSON. Well, if Blackstone is selling publicly, there are

some things that are of concern to me, and this is an area that I

don’t have a lot of expertise, but looking at it from afar, at least

if it conformed to the Investment Company Act it would have to

keep the investors well informed, it would have to compensate or

have returns on their dollars a little differently, and also what

would the protection of the investors be like without coming under

the act.

That is a concern to me. The investors cannot vote. I guess there

are no public meetings once a year. Therefore, they can do whatever they want with management, they can raise their salaries,

they can give them huge bonuses, and they don’t have to give them

full reimbursement for their investments.

So I am wondering what your view is, having them determined

as being a direct investment group and not under the act.

Mr. DONAHUE. I would like to start my response by saying that

I am a great fan of the Investment Company Act. I think it provides great investments for investors. Our analysis that we start

off with recognizing those great benefits, the key question that we

first have is: is this an investment company? If it is not, then we

don’t move to push it into the investment company framework in

order to get those benefits.

The threshold question is, and the charge we have gotten from

Congress, is to determine whether or not these are investment

companies. If they are, they are in the investment company structure, for better or worse with respect to what it is going to do with

respect to how their business operates. And if they are not, then

they are not investment companies and are not entitled to the protections of the Investment Company Act.

Ms. WATSON. Well, what are you going to determine on your way

to making a decision? Can you give us a heads-up?

Mr. DONAHUE. On the two determinations——

Ms. WATSON. Yes.

Mr. DONAHUE [continuing]. With respect to Fortress? We will

look at what their real business is, how they characterize their

business, what the nature of their assets are, where the five factors

that are really set up and are extraordinarily old paced, and these

are asset management companies. They happen to be managing alternative type investments, but these are asset management companies.

If you look at Blackstone, I believe Blackstone has over 100 different investment vehicles that they are managing. I believe if you

look at Fortress, has over 20 different investment vehicles that it

is managing. They are in the business of managing other peoples’

money, not in the business of managing their own money. Now,

their success may very well be related to how well they do at their

business of managing other peoples’ money.

Ms. WATSON. Well, if you walk like a duck and you quack like

a duck, most people think you are a duck, so I would be

interested——

Mr. DONAHUE. Am I a duck?

36

Ms. WATSON. I would be interested in your determination. I will

look forward to a hearing about that.

Thank you so much, Mr. Chairman. I yield back my time.

Mr. KUCINICH. I thank the gentlelady.

The Chair recognizes Mr. Cannon.

Mr. CANNON. I thank you, Mr. Chairman. I apologize. We have

another hearing going on in Judiciary next door and I am a member of that panel, so I apologize for not having been here for your

testimony prior to this.

Pursuing this investment question, how many comments did the

SEC receive regarding the classification of Blackstone as an investment company? And how did the SEC respond to the views of these

comments?

Mr. DONAHUE. I am aware of two letters we received from one

entity raising questions regarding the status determination, and

also aware of a letter or two that we actually received from Congress asking us questions relating to those determinations. I took

those seriously. If we get correspondence coming in to us that

raises questions about whether or not we are analyzing something

appropriately, whether or not we are taking into account the right

circumstances, whether or not we might have it wrong, I take those

seriously. I want to get it right, and so we do take them seriously.

Mr. CANNON. So did you evaluate those letters and the claims in

light of the statute and, I take it, determined that it is not an investment company?

Mr. DONAHUE. When we got those, one of the first things that

I did with them was to send those letters to my professional staff,

the senior staff that actually were the main people that were looking into the appropriate treatment of the status of these two entities, Blackstone in particular, so that they were aware, and told

them that I, you know, want them to take it into account and to

be in a position to discuss with me why our analysis might differ,

and, if so, why we are correct.

Mr. CANNON. So you have a statutory decision about what an investment company is, with some exemptions. I take it these letters

didn’t lead you to believe or your staff to believe that the exemption should qualify and that this should not be an investment company?

Mr. DONAHUE. It didn’t lead us to believe that Blackstone or Fortress, although I don’t believe we got comments on Fortress, that

either one would require an exemption from the SEC to qualify as

not being an investment company.

Mr. CANNON. Let me just see if I understand it right. Even if

your analysis had determined that Blackstone was an investment

company, it would still likely have fallen under the statutory exemptions to an investing company? Have I gotten that correct?

Mr. DONAHUE. If the determination had been that Blackstone

met either the orthodox investment company test or the inadvertent investment company, then they would have had to search for

a reason why those analyses wind up being overridden. There is an

analysis that they could do under a different section that their primary business is not that and is else, or they could apply for an

exemption from the SEC from or determination that they are not

37

an exempted. They did not seek a determination that they were

not.

Mr. CANNON. And they didn’t need to because you had already

made the determination that they are not?

Mr. DONAHUE. We concluded that they were not an investment

company.

Mr. CANNON. Could you explain the key distinguishing characteristics between a mutual fund and an organization like Blackstone

LP?

Mr. DONAHUE. Well, simply I would start off by saying that an

investment company is in the business of managing its money,

money that comes from individual investors, and in the investment

company framework their capital structure is very simple. You

wind up generally with one class of shares, similar rights, and the

assets are valued under net asset value, and that determines what

you get for your shares if you buy them or sell them, if it is an

open-end fund. And there are a lot of controls built around how

that money can be managed, what affiliated transactions can take

place, and a lot of things.

In the case of Blackstone and in the case of Fortress, they were

not investing their money. They were managing other peoples’

money. They were more akin to the investment advisor to a mutual

fund than they were to a mutual fund. In fact, Blackstone I believe

was the investment advisor to two closed-end funds as part of its

business.

Mr. CANNON. Thank you.

Mr. Chairman, may I ask how much time I have remaining? It

seems like the clock is running very long.

Mr. KUCINICH. Take another minute. Go ahead.

Mr. CANNON. Thanks. I would be happy to yield.

Mr. KUCINICH. Go ahead.

Mr. CANNON. I yield that minute to Mr. Issa.

Mr. ISSA. Perhaps I can bring some clarity through a question.

If we look at an architectural firm and they take on huge jobs like

building the new center here, the new visitors’ center at the Capitol, and they derive revenue from it, and maybe even a bonus if

they do a good job and it comes in under time and under budget,

which is not true of our visitors’ center, as you know—there will

be no bonus earned there—but, in fact, if that partnership chose

to go public, it would be akin to Blackstone. It drives its revenues

by its management or activities of its team, and you are investing

in that team, in the revenue stream that team earns.

Is that a fair similarity, so that we get off of the model of are

you a mutual fund or are you this other? Isn’t that really akin to,

if you were evaluating that architectural firm with all kinds of activities, including land acquisition on behalf of clients and lots of

stuff, it makes it look complex, but ultimately you are investing in

the management team; isn’t that right?

Mr. DONAHUE. I think that is a correct analysis. From your description, it sounds like an operating company. I would need to

know, to make that determination—and this is, you know, the process that we wind up going through—I would need to know what

degree of investments they might have. By way of example, if they

had considerable amount of investments that were in investment

38

securities, even though they are also in this other business they

may be treated as an investment company.

Mr. ISSA. Right. And I will yield back, but the reason I asked

that question is you seem to have the tools to make this evaluation

of Blackstone like other companies, and these tools have served the

SEC well for many, many years, and Blackstone is no exception;

is that right?

Mr. DONAHUE. That is correct.

Mr. ISSA. Thank you.

I yield back.

Mr. KUCINICH. The Chair recognizes Mr. Tierney.

Mr. TIERNEY. Thank you, Mr. Chairman. I would like to just

claim my time for the purposes of yielding to Mr. Kucinich.

Mr. KUCINICH. I thank the gentleman.

Mr. Donahue, in his written testimony Professor Coffee recommends that, in light of the Blackstone LP offering, the Securities

and Exchange Commission used its influence to pressure the New

York Stock Exchange and NASDAQ to change its listing requirement to require that publicly traded partnerships provide the same

basic corporate governance protections for public investors that are

demanded of public corporations. Do you support this recommendation?

Mr. DONAHUE. I thought it was a very thoughtful analysis and

appreciation for the position that the SEC is in. I have not had an

opportunity to discuss Professor Coffee’s recommendation with the

chairman or with any of the Commissioners.

Mr. KUCINICH. Thank you. Now, with your broad jurisdiction in

investor protection, as a matter of policy does the SEC have a problem that investors in these funds are denied basic corporate governance protection, such as being owed fiduciary duties, an independent board, and meaningful voting rights?

Mr. DONAHUE. First I would like to note that the investors are

the investors in the operating company, and I think I am not aware

of any particular problems that have arisen yet with respect to

this, and I will discuss the issue with my brethren over in corporate finance that oversee public companies and see whether or

not there have been issues in similar companies.

Mr. KUCINICH. Doesn’t the Securities and Exchange Commission

have a regulatory role beyond that of simply enforcing the Securities Act and the Investment Company Act?

Mr. DONAHUE. Well, our primary role is in enforcing the securities laws.

Mr. KUCINICH. Do you want to elaborate on that a little bit?

Mr. DONAHUE. We, as an agency, you know, should be enforcing

the Federal securities laws to the best of our ability to protect investors. With respect to other issues, and some issues that might

arise under State laws, some remedies that people may have contractually, that is not necessarily in our mandate unless there is

fraud taking place. We have broad authority, but, once again, that

is pursuant to the Federal securities laws.

Mr. KUCINICH. The reason why I ask that, of course, is, I am

sure you remember Chairman Levitt, who believed that it was a

proper role when he, you know, created the discussion about the

39

exchanges on corporate governance requirements. I am just trying

to see how the SEC currently——

Mr. DONAHUE. That is a distinction there, I think, and I wasn’t

at the SEC when the event being referred to taking place occurred,

but, having heard the characterization of it, I would look at that

as the SEC taking a leadership role with respect to going to others

that had responsibility and could, you know, implement changes,

and suggesting that, for the protection of investors, change might

be necessary.

Mr. KUCINICH. Would you agree that it is a significant question,

though, whether or not the Securities and Exchange Commission

sees itself as having a regulatory role in addition to enforcing the

Securities Act and Investment Company Act?

Mr. DONAHUE. I view us as protecting investors, among other

things. We have a mandate. Part of it is protecting investors. Others is to promote capital formation and provide for orderly markets,

so we have a broad mandate and we do exercise it.

Mr. KUCINICH. Thank you.

First of all, I want to thank you for your participation. It is very

helpful, a little bit more of a discussion. I know we are going to

get into some of these issues even more in depth in the next panel,

but it is important to have you here and we want to thank you for

the service that you give to our country. Thank you very much.

Mr. DONAHUE. Thank you for inviting me.

Mr. KUCINICH. You bet.

We are going to go to the next panel.

Mr. ISSA. As the next panel is coming up, please give our best

to our former colleague, Mr. Cox, when you see him.

Mr. DONAHUE. I certainly will.

Mr. KUCINICH. We are going to begin the second panel. I want

to welcome all of the witnesses.

It is the policy of our subcommittee and the full committee to

swear in all witnesses.

[Witnesses sworn.]

Mr. KUCINICH. Let the record show that the witnesses individually answered in the affirmative.

I would like to make the introduction of the first witness. We will

go from my left to right.

Professor Mercer Bullard is assistant professor of law at the University of Mississippi School of Law, where he has been since 2002.

He specializes in the areas of securities and banking regulation,

corporate finance, and contracts, and he is recognized as one of the

Nation’s leading advocates for mutual fund shareholders.

In January 2000, Professor Bullard founded Fund Democracy, a

nonprofit membership organization that serves as an advocate and

information source for mutual fund shareholders and their advisors. Fund Democracy publishes articles that address mutual fund

practices, policies and rules that may be harmful to fund shareholders, and by lobbying legislators and regulators on mutual fund

reform issues.

Prior to founding Fund Democracy, Professor Bullard was Assistant Chief Counsel in the Securities and Exchange Commission’s Division of Investment Management for 4 years, where he was reVerDate 11-MAY-2000 13:22 Apr 07, 2008 Jkt 000000 PO 00000 Frm 00043 Fmt 6633 Sfmt 6633 C:\DOCS\40871.TXT HGOVREF1 PsN: HGOVREF1
40

sponsible for a wide range of matters involving mutual funds and

investment advisors.

Professor John Coffee is Adolph A. Berle professor of law at Columbia Law School, where he has been a member of the faculty

since 1980. As one of the Nation’s preeminent security and corporate law experts, Professor Coffee has served as a member of

many influential financial advisory boards and commissions, including the New York Stock Exchange, NASDAQ, and the Securities and Exchange Commission. He has testified numerous times

before congressional committees. He has co-authored a number of

textbooks on securities and corporate law, and the National Law

Journal has named him 1 of the 100 most influential lawyers in

the United States.

Next, Mr. Joseph Borg is president of the North American Security Administrators Association, which represents 67 State, provincial, and territorial securities administrators. He has been a Director of the Alabama Securities Commission since 1994.

The NASAA member agencies work to protect consumers who

purchase securities or investment advice, and regulate a wide variety of issuers and intermediaries who sell securities to the public.

Prior to his career in public service, Mr. Borg was in-house corporate counsel to First Alabama Bank, practiced in law firms in

Montgomery, AL, and New York City. He also served as an adjunct

professor of law at Faulkner University Jones School of Law.

Finally on the panel, Mr. Peter J. Tanous. Mr. Tanous is president and CEO of Lynx Investment Advisory, LLC, which he founded in 1992. Lynx Investment Advisory is an independent investment consulting firm specializing in asset allocation, risk management, and customized portfolio design. Lynx has over $1.4 billion

under advisement, and on behalf of both nonprofit and for-profit institutions and affluent individuals worldwide.

Previously Mr. Tanous was executive vice president of Bank Audi

in New York City, Chairman of Petra Capital Corp., and first vice

president and international regional director with Smith Barney.

Mr. Tanous is the author of Investment Gurus: the Wealth Equation, and his latest book, Investment Visionaries.

I want to thank all the members of this panel for their presence,

their participation.

Let us proceed with Professor Bullard.

I also want to welcome Mr. Danny Davis and also Mr. Bilbray

to our committee. Thank you.

Let us proceed. Thank you. You may proceed.

STATEMENTS OF MERCER E. BULLARD, UNIVERSITY OF MISSISSIPPI LAW SCHOOL; JOHN C. COFFEE, JR., COLUMBIA

LAW SCHOOL; JOSEPH P. BORG, PRESIDENT OF THE BOARD

OF DIRECTORS OF THE NORTH AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION; AND PETER J. TANOUS,

PRESIDENT AND CEO, LYNX INVESTMENT ADVISORY, LLC

STATEMENT OF MERCER E. BULLARD

Mr. BULLARD. Chairman Kucinich, members of the subcommittee, thank you for the opportunity to appear today before you to

discuss the public offering of interest and hedge fund managers. It

41

is an honor and a privilege to appear before this subcommittee

today.

The question for today’s hearing, Should investors be exposed to

the risks of hedge funds, is answered by current law in the negative. Only sophisticated persons are permitted to invest in hedge

funds. I believe that the answer should be the same for hedge fund

managers that are the functional equivalent of hedge funds. There

appears to be substantial agreement on this point. Virtually every

commentator on the Blackstone IPO had described the firm’s future

prospects as depending directly on the performance of its funds.

The financial press has suggested that the Blackstone offering, for

example, provides a way for small investors to access the previously forbidden world of hedge funds.

It is worth noting that no one views the future prospects of pure

asset managers such as T. Rowe Price as depending directly on the

performance of their funds, and firms such as T. Rowe Price accordingly have traded at a tiny fraction of their assets under management, whereas hedge fund managers have traded at 20 or 30

times that fraction.

The markets recognize that hedge fund managers are the economic equivalent of hedge funds, and we should respect the market’s judgment. The market’s judgment is confirmed by the structure of hedge fund managers, as illustrated by Blackstone.

A majority of Blackstone’s assets are investment securities. Of its $7.2 billion in assets on its March 31st balance sheet, $5.2 billion

are investments in its funds and funds portfolio companies, another

$4.1 billion are carried interest, which substantially exceeds 50

percent of its total assets. I note that includes a denominator that

includes assets that have virtually nothing to do with any business

activity, such as its goodwill, deferred tax assets, and cash. If you

eliminate those assets, virtually all of the meaningful assets held

by Blackstone are investment securities.

There is disagreement as to whether Blackstone’s carried interest or investment securities under the Investment Company Act. I

am not aware of any disagreement that carried interest are the

economic equivalent of a leveraged bet on Blackstone’s funds.

Someone suggested that carried interest should be viewed as compensation. Professor Coffee, for example, suggests that carried interest are more like compensation on the ground that investors and

hedge fund manager do not share the funds’ ‘‘downside’’ because

they will ‘‘simply not receive their share of the nonexistent profits

from that fund.’’

I must respectfully disagree. Blackstone’s $4.1 billion in carried

interest are exactly what investors in Blackstone are buying, and

that figure is based on the current value of those carried interests.

If Blackstone’s funds take a turn for the worse, Blackstone’s investors will lose billions of dollars. The severity of those losses will actually exceed proportionately the decline in the funds because a

carried interest skims profits off the top of a fund’s performance.

A slight decline in a fund’s annualized performance has a multiplier effect on the value of a carried interest.

I would refer you to this morning’s hearing on the Senate side,

during which this point was made repeatedly by every one of the

persons testifying at that hearing.

42

Professor Coffee’s position is correct as to the Blackstone manager who sees a carried interest that started as a zero value and

goes up and returns to zero, but it is incorrect as to the purchaser

of a carried interest in the middle of a fund’s life. When a Blackstone manager sells his carried interest at that point, he is effectively cashing out his part of the carried interest before its value

has been realized and leaving public investors holding the bag in

the event of the fund’s performance declining.

Professor Coffee further suggests that reading the ICA to include

carried interest in the definition of investment security reads the

definition too broadly because it would mean that every business’

‘‘actively managed subsidiary would thus become an investment security. At this point, the ICA applies to everything.’’

That would be a fair observation but for the fact that the securities issued by subsidiaries would be investment securities under

the Investment Company Act if Congress had not specifically excluded from the definition. The ICA defines investment security to

exclude all securities, to include all securities except securities

issued by majority-owned subsidiaries.

I mentioned Professor Coffee’s comments not only out of my high

regard for his opinions on securities law issues, but also because

I believe that we are substantially in agreement on the critical policy question for this subcommittee. Although I have stated that

public investors should not be allowed to assume the risk of hedge

funds and Professor Coffee argues that they should, he uses risk

in an economic sense and I use it in a broader functional sense. If

risk were to include the risk of inadequate corporate governance,

which I include in the concept of risk, Professor Coffee and many

others would agree that public investors should not be exposed to

such risk.

Professor Coffee describes Blackstone’s corporate governance as

pathological and recommends reforms notably that would apply if

Blackstone were treated as an investment company under the Investment Company Act.

In conclusion, the ICA’s regulatory framework and exemptive

provisions are ideally suited to address the regulatory shortcomings

that have been exposed by the Blackstone offering. It is unfortunate that the SEC has decided not to take advantage of this efficient, proven approach to regulation, and I strongly recommend

that Congress, assuming continued SEC inaction, take steps to ensure the appropriate regulation of hedge fund managers.

Thank you very much.

[The prepared statement of Mr. Bullard follows:]

43

44

45

46

47

48

49

50

51

52

53

54

55

56

57

58

59

60

61

62

63

64

65

66

67

68

69

70

71

72

73

74

75

76

77

78

79

80

81

82

83

84

85

Mr. KUCINICH. I thank the gentleman.

Professor Coffee, you may proceed.

STATEMENT OF JOHN C. COFFEE, JR.

Mr. COFFEE. Thank you, Chairman and members of the committee, for inviting me to be here.

My message is simple. This is the Oversight Committee, and the

Blackstone approach to going public needs a great deal of oversight. I am not recommending legislation, and I, in my comments,

urge the committee and regulators to always use the least drastic

means available to realize the regulatory objective. I also happen

to be a supporter. I believe that private equity funds and hedge

funds are among the most successful, dynamic performers in our financial services industry, but I do think there is a problem. The

Blackstone offering has established a template for future offerings

by managers of private equity funds and hedge funds. Already others are lining up and there is a race to rush to the window before

it closes.

Unfortunately, that template has three elements that represent

the worst imaginable corporate governance. As has already been

pointed out, there are no meaningful voting rights. Beyond that,

the founders of the firm have the right to remove any of the directors at any time if they act together jointly.

Second, there is no independent board. Indeed, there is neither

a nominating committee nor a compensation committee that has

any independence. That to me is totally against the trend which

the business community, itself, has come to and accepted that independent directors are necessary for publicly held investments because that is where the ultimate protection and the legitimacy enterprise comes from, oversight by independent directors.

Finally, there is no meaningful fiduciary duties owed to the investors because the partnership agreement has exploited all the potential under Delaware law to cancel the normal fiduciary duties.

That is because Delaware law regards a partnership agreement as

really a private contract among a small, limited number of people,

not a mechanism by which thousands of investors are asked to

trust other people’s money, in effect, to financial managers who do

face significant conflicts of interest.

Thus, voiceless, voteless, and stripped of legal remedies, Blackstone’s investors must remain passive. There is not even the usual

possibility of a control contest, because no one can vote more than

20 percent.

Now, how did this unique and I have said pathological governance structure arise? You can attribute it to one of two things: one,

that the company is deemed to be exempt from the Investment

Company Act. I would like to get this committee’s attention beyond

the Investment Company Act. I think we are a little too obsessed

with just the Investment Company Act. The problem here is basically one of corporate governance. There is little transparency and

no accountability under the governance structure that Blackstone

has put in place and that others are rushing to copy.

The other reason why there is this pathological structure is that

Blackstone was not subject to the usual corporate governance

standards required by the New York Stock Exchange and NASDAQ

86

because it went public as a limited partnership, not as a corporation. While the critics have all focused on the Investment Company

Act, I think the Investment Company Act, frankly, is a remedy that

can sometimes be worse than the disease when it is applied to

those entities that are at least at the margin of its possible coverage.

You could make this an investment company and then exempt

Blackstone from most of the rules under the Investment Company

Act. That would work. But I think it is much simpler and more direct to focus on what we want to achieve. I believe what we want

to achieve is greater accountability, greater transparency, and that

can be done by simpler ways than imposing the investment company straightjacket on this particular entity.

Now, how do we get to this goal of greater accountability and

greater transparency? I think the simple problem here is that partnerships are never subjected to normal corporate governance standards because in the past partnerships very seldom went public.

When we have seen publicly held partnerships, they were used basically to hold passive pools of investments—real estate, oil and

gas, timber. There aren’t serious corporate governance problems

there. But Blackstone is an operating company that is basically restructuring companies, not holding a passive pool of investments;

therefore, what should we do?

Well, besides State law the other mechanism by which corporate

governance standards are imposed on publicly listed companies are

the rules of the stock exchanges, both New York and NASDAQ

today. The New York Stock Exchange since its inception has had

minimum corporate governance standards, but it has had no reason

to apply them to partnerships because they were a tiny aspect,

probably no more than 1 or 2 percent of all listed companies.

The New York Stock Exchange, under influence of Congress,

under the oversight of Congress, did move to adopt strong independence standards requiring an independent board, and it is a

majority independent board; entirely independent nominating,

audit, and compensation committees; and a lead director and a

process for annual evaluation of the chief executive officer. All of

that is in the interest of investigators. The business community

does not resist this.

The typical American public corporation today has 10.4 directors

and over 8 of them are independent. That is not the law; that is

the norms established by the business community and respected by

them. But a partnership is exempt from that.

This didn’t arise by any conscious decision to exempt partnerships; it arose by the unconscious design, the unconscious fact that

there was no need to develop governance rules for partnerships.

Today there is. I think this is a process that needs oversight.

I think in the past we have seen the SEC, under Chairman Arthur Levitt, go to the exchanges and ask them to upgrade their

governance standards. He did that with respect to the one-share/

one-vote rules, where the court struck down the mandatory rule

but Chairman Levitt was able, through diplomacy, to convince the

exchanges to adopt minimum rules to protect shareholders’ voting

rights.

87

I think the exchanges should be invited before this committee to

explain whether they are satisfied with the idea that shareholders

would have no independent voting rights; no right to a majority of

independent directors; no compensation, audit, or nominating committee that was independent; and no other rights that are traditionally associated with publicly held companies.

I think that is in the long-term national interest because the

market works best when we have the oversight of independent directors. That is the least drastic means, and I think we should

move in the direction of trying to implement that particular remedy.

Thank you.

[The prepared statement of Mr. Coffee, Jr., follows:]

88

89

90

91

92

93

94

95

96

97

98

99

100

Mr. KUCINICH. I want to say to Professor Coffee I think that you

have made a worthwhile suggestion here to the committee with respect to asking the New York Stock Exchange and NASDAQ questions such as the ones that you have raised. Thank you, sir.

Mr. Borg.

STATEMENT OF JOSEPH P. BORG

Mr. BORG. Thank you. Chairman Kucinich, members of the subcommittee, I appreciate the opportunity to testify today on an issue

of importance to retail investors.

State securities regulators have a special appreciation for the

plight of everyday investors who are confronted with a bewildering

array of new and complex investment products. We are the only securities regulators who interact with and advocate for individual

investors on a personal basis each and every day. In short, we are

uniquely qualified to address the potential impact of making alternative investments such as hedge funds widely available to the average individual investor.

My remarks should not suggest to you that I believe the retail

investing public is unable to properly evaluate investments, nor am

I suggesting that regulators should adopt a paternalistic approach

and withhold alternative investments from the average retail investor.

What I do suggest to you today is the following: new investments

with highly complex structures, opaque investment strategies, and

dubious profitability have arrived on Main Street. Precisely because of this trend, the investigator protections afforded by statutes

like the Investment Company Act are more important than ever.

Due to a nearly complete lack of transparency, the level of individual and systemic risk attached to these instruments remains

unknown to the individual investor. Their fee structures and lack

of full disclosures obscure real returns.

The structure of these new instruments places investors in a vulnerable position subject to the whims of controlling persons and literally without recourse. In light of the complexity and uncertainty

surrounding these instruments, allowing them to be offered to the

public without appropriate regulatory protections poses serious

risks to the investors.

As a threshold matter, we believe that public offerings by private

equity firms or hedge funds must provide full transparency and investor rights and protections. More particularly, we believe that

private equity firms engaging in public offerings, when structured

as Blackstone is, should be subject to the requirements of the Investment Company Act of 1940.

While the Securities Acts of 1933 and the Securities and Exchange Commission Act of 1934 protected investors from potential

abuse by corporate managers and financial intermediaries, they

could not adequately protect investors from abuses by organizers of

pooled instrument vehicles. Congress enacted the ICA to impose

additional layers of protection for investors, including independent

boards, fiduciary duties, shareholder rights, heightened disclosures,

restrictions on permissible investments, and even limits on fees

and loads.

101

Offerings such as the Blackstone IPO circumvent the governance

protections that the ICA mandates, even though it is no longer a

private investment company. For example, under the ICA a fund

must have independent directors who represent the interests of

public investors. Additionally, investors are protected by the fiduciary duty that attaches to officers and directors. Neither is the

case with Blackstone.

We must remember that the securities laws favor substance over

form and disdain structures whose only purpose is to evade their

reach. In reality, both pre-and post-IPO, Blackstone functions as an

investment company that earns its income through investments.

From an investor protection standpoint, we are puzzled by the exclusion Blackstone enjoys from the safeguards mandated under the

ICA.

The SEC has viewed this type of structure broadly and flexibly

since the enactment of ICA. My written testimony cites a number

of legal opinions where the SEC recognized that even funds engaged to a significant degree in ‘‘special situations,’’ as is Blackstone, qualify as investment companies. For decades, the SEC has

been guided by ‘‘In re: Tonopah Mining Company,’’ which set forth

five factors to determine whether a company was operating as an

investment company: the company’s history, its public representations, the activities of its officers and directors, the nature of its assets, and the sources of its income, all of which serve as a proxy

for what a reasonable investor would believe to be an investment

company.

Tonopah identified the most important factor as whether the nature of the assets and income of the company was such as to lead

investors to believe that the principle activity of the company was

trading and investing in securities. We believe that Blackstone

meets this test. The Blackstone structure, now being copied by others seeking to ‘‘go retail’’ appeals to mask the nature of the assets

and income of the company in order to avoid the strictures of the

ICA and to allow its continued operation as a de facto private company. Neither goal serves the interest of investors or marketplace.

The new entities attempted to escape the conclusion that they

are investing companies through a purely structural maneuver:

adding a new layer in its corporate form, Blackstone LP, and then

selling units in Blackstone LP to the public. But measured by the

true nature of its activities and its investment holdings, the Blackstone structured entities should be regulated as investment companies.

The prospectus makes it clear to investors that they will share

in the rewards and bear the risks of Blackstone’s investment activities. The point is further reinforced through the identification of

the carried interest as a significant source of potential gain for investors.

Presumably, Blackstone would suggest that their offering poses

no undue threat to investors because, while it may be risky, those

risks are disclosed. The public policy issue is: how much risk, even

when disclosed, should be transferred to the general public? In a

perfect world a careful financial advisor will say Blackstone type

entities are too risky, too opaque, too conflicted, so we won’t invest.

However, the real world operates much differently. Securities salesVerDate 11-MAY-2000 13:22 Apr 07, 2008 Jkt 000000 PO 00000 Frm 00105 Fmt 6633 Sfmt 6633 C:\DOCS\40871.TXT HGOVREF1 PsN: HGOVREF1
102

persons sell whatever their firms tell them to sell. They are not

likely to delve deeply into disclosed risks with the customer sitting

across the kitchen table.

The IPO disclosures come dangerously close to an affirmative

statement by Blackstone that it will conduct its business in whatever way it chooses, and that the investors must waive any rights

or remedies for such conduct. It is precisely for these reasons that

Congress enacted the ICA, not just to ensure disclosure, but to impose affirmative duties on such companies and to delineate boundaries in the operation of these inherently risky enterprises.

In the Blackstone IPO, which apparently now will be followed by

KKR, Och-Ziff Capital, and others, a fundamental purpose of the

ICA is imperiled. That purpose is the protection of the investing

public from the potential risks of investment pools. When private

speculators turn to the public markets for capital, what Justice

Brandeis called ‘‘other people’s money,’’ they cannot continue to operate as if they were still a private concern.

In conclusion, I want to emphasize that NASAA does not object

to access to alternative investigations by retail investors so long as

they are accompanied by all appropriate and necessary investor

protections, rights, and remedies. This can only be accomplished by

ensuring such investments are offered pursuant to the appropriate

act.

Your constituents, America’s retail investors, are not accustomed

to the realities of alternative investments, portfolios of illiquid securities, the use of substantial leverage, concentration of investments, and excessive compensation arrangements detrimental to

their interest. Congress sought to eliminate these elements of alternative investments from the public marketplace. Surely, your and

our constituents are still deserving of the protections so wisely provided to them.

Thank you, Mr. Chairman.

[The prepared statement of Mr. Borg follows:]

103

104

105

106

107

108

109

110

111

Mr. KUCINICH. Thank you very much, Mr. Borg.

Mr. Tanous.

STATEMENT OF PETER J. TANOUS

Mr. TANOUS. Thank you, Chairman Kucinich and Ranking Member Issa, for allowing me to appear before you today.

Let me make several points relative to the discussion today. The

first was made by Congressman Issa earlier, which is the difference

between private equity firms and hedge funds. They are in very different businesses, and I won’t belabor that point. They have two

things in common. One is that they both charge very high fees, and

the other is that their liquidity is very limited. In the case of private equity firms, you are basically investing for a number of years.

Now, what are the risks in owning shares of Blackstone, because

that is on the table today? We shouldn’t confuse the risk of owning

the Blackstone management company, we should call it, with the

risk of investing in Blackstone funds. They are very different. The

people who bought the Blackstone shares are basically buying into

a stream of income from the fees that Blackstone earns. That is arguably not very different from the risk any investor takes when an

investor buys a company that is competing in the marketplace and

is subject to whatever the competitive factors are.

Now, it also has been pointed out that the unit shareholders of

Blackstone do not have the same rights as most stockholders do.

I don’t particularly like that, but the fact is that when an investor

decides to invest in it, the investor knows or should know what

those limitations are.

I might also point out that there are other examples, such as in

the newspaper industry where you have two classes of stocks, and

most of the investors have very limited rights with respect to electing the board and other rights.

Are hedge funds safe for the average investor? There is a wide

gamut of hedge fund activities and philosophies, and, frankly, they

run from very safe to very risky. In our business, though, because

they are not at all transparent, we do not want our investors, even

very wealthy ones, to take the risk of buying a single hedge fund.

We all remember last year the case of Amaranth. This is a case of

a hedge fund that was very highly regarded, a lot of very smart

people had money with them, and they bragged about how good

their controls were, and yet a 32-year-old trader made a big bet on

natural gas and lost $5 billion in 1 week and the fund subsequently

folded.

For those who are interested in hedge funds, small or large investors, we think they should use funds of funds where the risk is

spread out over 20, 30, or 50 separate hedge funds.

Finally, should private equity firms and hedge funds be regulated by the SEC, which seems to be the major topic today? The

SEC was created to protect investors, and the American capital

systems are the envy of the world as a result of the honesty and

integrity of our systems. My firm is registered with the SEC. We

file a form ADV once a year, sometimes even more frequently, and

we have to disclose lots of things in that form. We have to disclose

our board of directors, our shareholders, the nature of our clients,

and what not.

112

Now, I heard—forgive me for characterizing it this way—the

legal mumbo-jumbo about why Blackstone is not subject to SEC

rules, and I would rather apply a simpler test that was alluded to

earlier in this hearing. If it looks like a duck and acts like a duck

and quacks like a duck, it is a duck. I suggest that, to me, Fortress

and Blackstone are investment ducks, and if my firm is regulated

by the SEC I can think of a lot of reasons why they should be, as

well.

Thank you, Mr. Chairman.

[The prepared statement of Mr. Tanous follows:]

113

114

115

116

117

118

119

Mr. KUCINICH. I thank the gentleman.

We are going to go to questions from members of the panel. Mr.

Tierney, would you like to go first?

Mr. TIERNEY. Well, I think I fall in line with most of the public

here. I am not sure that I understand all that I ought to understand about what seems to be a complex issue, but I look at it more

from the standard of somebody that has worked all their life and

put money into a pension fund, to have those pension fund managers turn around and invest in something like a Blackstone on

that. So I guess my question would be: what protections do we have

under the current system for those individuals? And what protections ought we have for them?

Professor, we will start with you and just go left to right.

Mr. COFFEE. I think right now the only protection that a pension

fund manager investing in Blackstone, the hedge fund manager,

not the Blackstone funds, have would be rule 10(b)(5) in the law

of fraud. I am not alleging in any way that there is any fraud, but

you don’t have the usual mechanisms. You don’t get to vote. You

don’t get your right to information. You don’t have independent directors owing you fiduciary duties. And there is no prospect that

if this management is poor some other management will come in

and buy them out and have a control fight. None of that can happen under the way this has been designed, and I think that is a

very poor precedent for the future.

My focus is not on Blackstone, but we are opening up a possibility of a whole new asset class, which could be over $100 billion in

a few months or years, composed of entities that are in a business

that is full of conflicts of interest and there is not any of the traditional mechanisms of corporate accountability applicable to them.

Mr. BULLARD. I would add to that I see your question in the context of it being publicly offered. My view is that if the pension fund

were investing in a Blackstone, that by itself Blackstone should be

able to do anything it wants and I wouldn’t object to any of the provisions that Professor Coffee has mentioned.

I think he is meaning in the context of a public offering, because

no one questions it in today’s context. A pension fund can invest.

It can agree contractually to all of those onerous pathological provisions and I don’t think anyone on this table objects to that. What

is objectionable is when that vehicle becomes available in the public market.

Mr. COFFEE. I misunderstood your question. He has corrected

me. I thought you were asking about investment in the public.

Mr. TIERNEY. I probably wasn’t as clear as I should be. As I said,

I don’t think I understand it as fully as I should. What is the harm

to Blackstone if they go out and are treated as an investment company? What is the deal to them? I am telling you, from somebody

on the other side that doesn’t completely understand all of it, this

thing just smells to high heaven. I am looking out there and saying, you know what, this is distasteful. This reminds me of a lot

of things that have happened in our history where the small guy

gets tucked and somebody else walks away with all the dough.

They are taking care of themselves, as the gentleman at the end

said, with a lot of mumbo-jumbo, and they are off and running.

120

So why don’t we just regulate them and make them do the things

we reasonably make other people do? What is the harm?

Mr. COFFEE. If you were to subject Blackstone to the Investment

Company Act, much of what they currently do could not be done

without a new form of exemption. For example, that would include

that there is a prohibition on incentive fees and that you right now

are receiving very high incentive fees based on percentage of profits. That is regulated by a series of rules that treat mutual funds

very differently than hedge funds, and they are very different animals. They are not that similar at all in terms of their behavior.

There are restrictions on leverage, and it is the case that a true

investment company can’t have more than approximately 15 percent of its assets in illiquid investments. All of what Blackstone

owns is illiquid investments, so that they would have to have a

very different portfolio. There could be exemptions given. I fully

agree the SEC could call it an investment company and take 80

percent of it back, but that seems to me going up the hill and back

down the hill and accomplishing very little along the way.

My colleague here differs.

Mr. BULLARD. Well, I agree that they simply would not be able

to function if they were subject to all the requirements of the Investment Company Act. That being said, I think I would go further

than Professor Coffee in pointing out that the exemptive process is

a longstanding tradition of the SEC. It has created numerous entities and allowed them to be publicly offered, subject to carefully

tailored exemptions. For example, asset-backed securities have a

virtually complete exemption from the act. Exchange traded funds

exist only because of an exemption from the act. Even more, the

multi-class funds with their A, B, and C shares are prohibited by

the act. They exist because of an exemption. The 12(b)(1) fees are

prohibited by the act. They exist only because of an exemption.

Money market funds are prohibited by the act. The only reason

that we have only $2 trillion in money market funds is the SEC

exemptive authority, and that is a much more efficient way to regulate them than to go to the exchanges to obtain some kind of limited governance reform.

Mr. TIERNEY. Mr. Tanous, I sympathize with what you were saying. If your firm has to register, why don’t they? Would you put

them under the Investment Act, or would you do some of the other

more novel approaches of Professor Coffee?

Mr. TANOUS. Mr. Tierney, I would put them under the Investment Act, but make the exceptions that were enunciated here. That

seems to be the best way to do it. The idea of putting them under

the Investment Act and saying that now they are going to have to

comply with all of the provisions that were written in 1940 obviously doesn’t make much sense. But there is a simpler way and

more practical way to do this, but they should be regulated.

Mr. TIERNEY. Absolutely.

Thank you all very, very much.

Mr. KUCINICH. Mr. Cannon.

Mr. CANNON. Thank you again, Mr. Chairman. I apologize for

going back and forth. We have a high level panel on clemency going

on in the Judiciary Committee, which is just next door, and so Mr.

121

Issa and I are both on both of these committees and are going back

and forth. So, again, I apologize for the erratic presence.

I do actually have some questions that I would like to go into

with this panel.

Mr. Tanous, could you explain for the committee the concept of

investing in funds of hedge funds and what this type of investing

does to insulate—I am sorry, we don’t want to ask that question.

Mr. TANOUS. I would be happy to answer.

Mr. CANNON. What I would rather ask is this: would you agree

that organizations like Blackstone are nothing like Long-Term

Capital Management, and therefore comparisons between the two

are flawed?

Mr. TANOUS. Yes. I don’t think they are anything like Long-Term

Capital Management. The Long-Term Capital Management blowup was largely an issue of very high leverage, and that, to my

knowledge, is not at all the case with respect to Blackstone and the

activities that they do.

Mr. CANNON. And would you describe their activities, just in

comparison?

Mr. TANOUS. Say that again?

Mr. CANNON. Would you describe Blackstone’s activities?

Mr. TANOUS. I am not an expert on Blackstone, but basically

they have a number of different activities. The one that they are

best known for is private equity. Essentially, they will buy a company out, improve it, sell it back on the market at a higher price,

and make money for their fundholders and themselves.

Mr. CANNON. Thank you.

Now if I can shift to Mr. Borg—and maybe you can come back

on this Mr. Tanous—the idea that you have private equity and that

there is some risk involved—of course, with any investment you

have some risk, but you also have these large investment funds, retirement funds. Those are run, Mr. Borg, by professionals, and, in

fact, CALPERS has, like, $21 billion that is invested just in their

investment portfolio in private equity, the California State Teachers Retirement System has $10 billion in private equity, and apparently the Ohio Public Employees Retirement System has $600 million invested in private equity. These are among the most sophisticated managers of money on earth. No private individual could

spend the kind of time and focus. Do we need to be worried about

those people making decisions that are inappropriate, where the

risk would be inconsistent with the return?

Mr. BORG. As with any pension fund, as an institutional investor

certainly they are different than the retail market that I was addressing. We are talking about the Mom and Pops in the kitchen

trading stocks on the kitchen table. The pension funds, with their

managerial experience, would qualify for even having Blackstonelike entities come and talk to them on a one-to-one basis and talk

about details that a retail investor will never hear about. That is

the first thing.

Are there dangers with respect to the pension funds? Sure. There

are a lot of pension funds that are under water because of changes

in the market conditions, especially since the crash of 2000–2001.

The bottom line, though, is retail investors who won’t even know

what an illiquid pool of investment is, the pension funds, with their

122

expertise, can make a more informed judgment as to what their

risk factors are. Plus, most pension funds—and I can speak for the

pension fund that I am familiar with, which of course would be the

State of Alabama—there are certain criteria where they cannot go

over a certain amount of risk, as well.

That is vastly different than asking somebody to take their retirement fund from their job and all of the sudden they have

$30,000 or $50,000 in Blackstone with very little protections at all.

In fact, even the big pension funds, the bigger they are the more

they are going to be listened to, even if they don’t have protections,

to some extent, because they are a force to be reckoned with, not

the retail investors.

Mr. CANNON. Professor Coffee, would you like to comment on

that?

Mr. COFFEE. I think I agree very much with what Joe Borg has

just said. In the world of the private pension fund, the governance

is really by contract. The pension fund sits down and contracts

with the hedge fund manager and maybe will agree that you have

the right to redeem after 6 months, 1 year. You have all kinds of

provisions that you put in by contract. That is not feasible when

we move into the world of public markets where little investors

can’t contract with the manager and where the small retail investor doesn’t know to diversify.

Intelligent pension funds are going to be diversified among a variety of different hedge fund and similar investments. The retail investor unfortunately chronically under-diversifies.

Mr. CANNON. I might point out that is probably less the case

since Enron collapsed and people are aware of the possibility, but

over time it is probably clearly the case.

Thank you, Mr. Chairman. I yield back. Do we have a vote?

Mr. KUCINICH. We do. I am going to try to get my questions. How

much time is left on that vote? We are going to try to do this.

I would like the members of the panel, in particular starting

with Mr. Bullard and then Professor Coffee, assuming that Blackstone were regulated under the Investment Company Act, from

what provisions would you grant or not grant exemptive relief?

Mr. BULLARD. I would probably subject them to virtually all of

the corporate governance provisions. They would have an independent board. They would have to get shareholder approval for various

fee issues, which would in this context be essentially executive

compensation. I think on that point I would probably agree with

Professor Coffee.

Where I would disagree is I think that one thing the Investment

Company Act provides that the exchanges cannot do, which is to

limit affiliated transactions and provide that they only occur under

certain circumstances, and the SEC has a long history of granting

exemptions to business development companies where they have

managed the problem of co-investments and other affiliated transactions for that purpose.

Other than those two major categories, I think that virtually all

of the other requirements of the Investment Company Act would be

handled through better disclosure and some standardizing of the

disclosure regarding volatility and risk.

Mr. KUCINICH. Professor Coffee.

123

Mr. COFFEE. To the extent that there is a debate or a dialog between Professor Bullard and I, it is really a debate about whether

you apply the statute and then grant exemptions for 80 or 85 percent of it, because that is the order of magnitude we are talking

about in terms of exemptions, or, alternatively, we say the simpler,

more direct approach is to focus on that 15 percent of the statute

that we think is relevant today and not make it applicable and

then repeal it, but rather say what we want is better independent

boards, we want better voting rights, we want fiduciary duties to

apply, and I agree we want related party transaction to be restricted. But I do think that the SEC using its disclosure options

can put a very strong oversight over affiliated transactions, and I

don’t think that really is the problem with Blackstone.

Mr. KUCINICH. Mr. Borg, did you want to weigh in on that?

Mr. BORG. Very quickly. I think that there is a 1990 case—and

I am going to defer to the professors—that says the SEC cannot

apply those listing standards. I may be wrong on that.

Mr. COFFEE. You are talking about the Business Roundtable

case——

Mr. BORG. Yes.

Mr. COFFEE [continuing]. Which I do discuss. And I think this

has to be done by diplomacy, but that is the least drastic means.

Mr. BORG. I think this actually opens up the SEC to a possible

lawsuit if they try and do that, even by a separate agreement, if

there is a case law that says you can’t do that. But I agree in general with the idea that those are the protections that need to be

imposed. I only see at this point the existing law as the ICA as the

one method available at this time.

Mr. KUCINICH. Mr. Tanous, did you want to add anything?

Mr. TANOUS. My only concern, Mr. Chairman, and perhaps one

of the other panelists could address it if you want them to, but I

worry about the slippery slope aspect of mandating or even legislating how the voting is going to take place in some of these firms,

because the issue of the two classes of stocks in a number of corporations comes to mind where you have class A stock with one

vote and class B stock with ten. Where do you draw the line in

terms of voters’ rights and prerogatives?

Mr. KUCINICH. Thank you. I just have one quick question. I

would ask Professor Coffee to respond. If the exchanges were to

adopt new rules for hedge fund managers, what should those rules

be?

Mr. COFFEE. I think the first thing would be that there would be

a majority independent board, or perhaps it could even be as high

as the Investment Company Act may require in the future, and I

think that there should be independent nominating, audit, and

compensation committees.

As to affiliated party transactions, both the exchanges and the

SEC could require periodic disclosure that I think would focus on

the danger of affiliated party transactions.

Mr. KUCINICH. I want to thank the panel. We have a vote on

right now that I am going to have to go to, but I think we have

covered the territory substantively in a relatively short amount of

time.

124

This has been a hearing of the Domestic Policy Subcommittee of

the Oversight and Government Reform Committee. The topic of today’s hearings has been: After Blackstone, Should small Investors

Be Exposed to Risks of Hedge Funds? We have had a representative of the Securities and Exchange Commission testify, as well as

experts in securities issues that relate to this pertinent matter.

I want to thank very much all of the people who testified today.

This committee stands adjourned.

[Whereupon, at 3:07 p.m., the subcommittee was adjourned.]

Æ