Hedge funds typically are organized as limited partnerships or limited liability companies, and are structured and operated in a manner that enables the fund and its advisers to qualify for exemptions from certain federal securities laws and regulations that apply to other investment pools, such as mutual funds. In addition, hedge funds operate to qualify for exemptions from certain registration and disclosure requirements of federal securities laws (including the Securities Act of 1933 and the Securities Exchange Act of 1934). For example, hedge funds must refrain from advertising to the general public and can solicit participation in the fund from only certain large institutions and wealthy individuals. Although certain advisers may be exempt from registration requirements, they remain subject to anti-fraud (including insider trading), anti- manipulation, and large trading position reporting rules. For example, upon acquiring a significant ownership position in a particular publicly traded security or holding a certain level of futures or options positions, a hedge fund adviser may be required to file a report disclosing the adviser’s or hedge fund’s holdings with SEC or positions with CFTC, as applicable. Hedge funds have significant business relationships with the largest regulated commercial and investment banks. Hedge funds act as trading counterparties for a wide range of over-the-counter (OTC) derivatives and other financing transactions. They also act as clients through their purchase of clearing and other services and as borrowers through their use of margin loans from prime brokers. Hedge funds generally are not restricted by regulation in their choice of investment strategies, as are mutual funds. They may invest in a wide variety of financial instruments, including stocks and bonds, currencies, OTC derivatives, futures contracts, and other assets. Most hedge fund trading strategies are dynamic, often changing rapidly to adjust to fluid market conditions. To seek to generate “absolute returns” (performance that exceeds and has low correlation with stock and bond markets returns), advisers may use leverage, short selling, and a variety of sophisticated investment strategies and techniques. However, while hedge funds frequently borrow or trade in products with leverage to magnify their returns, leverage also can increase their losses. Appendix III provides examples of investment strategies used by hedge funds. Advisers of hedge funds commonly receive a fixed compensation of 2 percent of assets under management plus 20 percent of the fund’s annual profits. Some fund advisers can command higher fees. Since this compensation scheme rewards hedge fund advisers for exceptional performance, but does not directly penalize them for inferior performance, advisers could be tempted to pursue excessively risky investment strategies that might produce exceptional returns. To discourage excessive risk taking, investors generally insist that the advisers and principals also personally invest in their funds to more closely align principals’ interests with those of fund investors. SEC’s ability to directly oversee hedge fund advisers is limited to those that are required to register or voluntarily register with SEC as investment advisers. Recent examinations of registered advisers raised concerns in areas such as disclosure, reporting and filing, personal trading, and asset valuation. Also, under a program established in 2004, SEC oversees, on a consolidated basis, some of the largest internationally active securities firms that engage in significant hedge fund-related activities. CFTC directly oversees registered CPOs and CTAs (some of which may be hedge fund advisers) through market surveillance, regulatory compliance surveillance, an examination program delegated to NFA, and enforcement actions. The banking regulators also monitor hedge fund-related activities at the institutions under their jurisdiction. For instance, in recent years regulators conducted targeted examinations and horizontal reviews that have focused on areas such as stress testing, leverage, liquidity, due diligence, and margining practices as well as overall credit risk management. Registered hedge fund advisers are subject to the same disclosure requirements as all other registered investment advisers. These advisers must provide current information to both SEC and investors about their business practices and disciplinary history. Advisers also must maintain required books and records, and are subject to periodic examinations by SEC staff. Meanwhile, hedge funds, like other investors in publicly traded securities, are subject to various regulatory reporting requirements. For example, upon acquiring a 5 percent beneficial ownership position of a particular publicly traded security, a hedge fund may be required to file a report disclosing its holdings with SEC. Also, any institutional investment adviser with investment discretion over accounts holding certain publicly traded equity securities valued at $100 million or more must file on a quarterly a report with SEC. SEC also plans to propose new rule making that would require a registered adviser sponsoring a hedge fund to identify and provide some basic information to SEC about the hedge fund’s gatekeepers, i.e., auditor, prime broker, custodian, and administrator. In December 2004, SEC adopted an amendment to Rule 203(b)(3)-1, which had the effect of requiring certain hedge fund advisers that previously enjoyed the private adviser exemption from registration to register with SEC as investment advisers. In June 2006, a federal court vacated the 2004 amendment to Rule 203(b)(3)-1. According to SEC, when the rule was in effect (from February 1, 2006, through August 21, 2006), SEC was better able to identify hedge fund advisers. In August 2006, SEC estimated that 2,534 advisers that sponsored at least one hedge fund were registered with the agency. Since August 2006, SEC’s ability to identify an adviser that manages a hedge fund has been further limited due to changes in filing requirements and to advisers that chose to retain registered status. As of April 2007, 488, or about 19 percent of the 2,534 advisers, had withdrawn their registrations. At the same time, 76 new registrants were added and some others changed their filing status, leaving an estimated 1,991 hedge fund advisers registered. While the list of registered hedge fund advisers is not all-inclusive, many of the largest hedge fund advisers—including 49 of the largest 78 U.S. hedge fund advisers—are registered. These 49 hedge fund advisers account for approximately $492 billion of assets under management, or about 33 percent of the estimated $1.5 trillion in hedge fund assets under management in the United States. In fiscal year 2006, SEC took additional steps to oversee hedge fund advisers by creating an examination module specifically for hedge fund advisers and providing training for examiners in hedge fund-related topics. The new examination module outlines how the examination of a hedge fund adviser generally begins with an analysis of the adviser’s compliance program and the work of its chief compliance officer and uses a control scorecard as a guide. As part of this review of compliance programs, examiners inspect the typical activities of advisers and are expected to obtain a clear understanding of all activities of affiliates and how these activities may affect or conflict with those of the hedge fund adviser being examined. Examiners are to focus primarily on the following activities during their examinations of hedge fund advisers: brokerage arrangements and trading; personal trading by access persons; valuation of positions and calculations of net asset value; safety of clients’ and funds’ assets; fund investors and capital introduction; violations of domestic or foreign laws that may directly harm fund investors or other market participants, or cause harm to prime brokers; books and records, fund financial statements, and investor reporting; chief compliance officer, compliance culture, and program; and boards of directors for offshore funds (fiduciary duties to shareholders of the hedge funds and consistent disclosure to its investors). In preparation for the registration of hedge fund advisers and because SEC does not have a dedicated group of examiners that focus on hedge funds, SEC and hedge fund industry officials noted the need for more experience and ongoing training of examiners on hedge funds’ investment strategies and complex financial instruments. SEC developed a specialized training program to better familiarize its examiners with the operation of hedge funds to improve effectiveness of examinations of hedge fund advisers. In that regard, from October 2005 through October 2006, SEC held about 20 examiner training sessions on hedge fund-related topics. Industry participants were instructors in many of these sessions. These sessions covered topics such as hedge fund structure, hedge fund investment vehicles, identification and examination of conflicts of interests at hedge fund advisers, risk management, prime brokerage, valuation, current and future regulation, examination issues, and investment risk. SEC continues to offer hedge fund training to examiners and other staff on an ongoing voluntary basis. SEC uses a risk-based examination approach to select investment advisers for inspections. Under this approach, higher-risk investment advisers are examined every 3 years. One of the variables in determining risk level is the amount of assets under management. SEC officials told us that most hedge funds, even the larger ones, do not meet the dollar threshold to be automatically considered higher-risk. As part of the overall risk-based approach for conducting oversight of investment advisers, SEC uses a database application called Risk Assessment Database for Analysis and Reporting (RADAR), to identify the highest-risk areas designated by examiners and to develop and recommend regulatory responses to address these higher-risk areas.