Monthly Archives: October 2008

The Series 7 Exam

The Series 7 exam, also known as the General Securities Representative Examination, is the central exam which brokers need to pass before accepting commissions from clients.  The exam allows brokers to engage in the following trasactions through the broker-dealer firm they are registered with: solicitation, purchase, and/or sale of all securities products, including corporate securities, municipal securities, municipal fund securities, options, direct participation programs, investment company products, and variable contracts.

In order to take the exam a person must be sponsored by a FINRA registered broker-dealer; some states used to sponsor the series 7 but I am not aware of any states which currently sponsor individuals for the exam. In order for a broker-dealer firm to register a person to take the exam, the broker-dealer will need to collect information on the person to fill out the Form U4 which will be submitted to FINRA through the CRD system.  The information that will be requested includes: prior addresses, prior securities industry affiliations, prior work history, among other items.

Overview of the Series 7 Exam

Questions: 260 multiple choice questions (10 questions do not count toward total)

Cost: $250 (usually paid by the sponsoring firm)

Time: 6 hours (two 3 hour sessions – bathroom breaks allowed; manadatory minimum 30 minute break between sessions)

Topic Areas: Prospecting for and Qualifying Customers, Evaluating Customer Needs and Objectives, Providing Customers with Investment Information and Making Suitable Recommendations, Handling Customer Accounts and Account Records, Understanding and Explaining the Securities Markets’ Organization and Participants to Customers, Processing Customer Orders and Transactions, Monitoring Economic and Financial Events, Performing Customer Portfolio Analysis and Making Suitable Recommendations

Passing score: 70%

Testing centers: Pearson or Prometric

Process to register: BD submits U4 through FINRA’s CRD system

Prerequisite: none

After the Series 7 Exam

It is often said that the perfect score on the Series 7 is 70% because that is the score where you studied just enough to pass.  I would not recommend studying just enough because I have heard of people who have not passed the exam.  If you do not pass you will be able to take the exam again.

If you do pass the Series 7 you will also need to pass the Series 63 in order to become a licensed broker in most states.  In addition you will need to submit fingerprint cards to your firm’s compliance officer who will then send them into FINRA for filing.  You should discuss this step with your firm’s compliance officer.  I have also included information on the Series 7 from the SEC below, you can also find the same information on the SEC’s site here.

Series 7 Examination

Individuals who want to enter the securities industry to sell any type of securities must take the Series 7 examination—formally known as the General Securities Representative Examination. Individuals who pass the Series 7 are eligible to register with all self-regulatory organizations to trade.

The Financial Industry Regulatory Authority (FINRA) administers the Series 7 examination. For more information, visit FINRA’s website where you can learn about the Series 7 exam and its qualification and registration process.

Other related HFLB articles include:

Treasury Announces Hedge Fund “Best Practices” to be Issued Soon

Deputy Treasury Secretary Anthony Ryan spoke at the Annual Meeting of the Securities Industry and Financial Markets Association (SIFMA) today.  In his speech he discussed the recent turmoil in the markets and the measures the Treasury Department has taken to help unfreeze the credit markets and stabilize the economy.  He also mentioned hedge funds and other pooled investment vehicles and noted that groups associated with the President’s Working Group on Financial Markets issued hedge fund best practices earlier this year.  He mentioned that finalized versions of these best practices will be forthcoming shortly.  An excerpt from the speech is reprinted here and the full speech is reprinted below and can be found here.

Another PWG effort, which pre-dates the current turmoil, concerns private pools of capital, including hedge funds. Recognizing that private pools of capital bring significant benefits to the financial markets, but also can present challenges for market participants and policymakers, the PWG in February 2007 issued a set of principles and guidelines to address public policy issues associated with the rapid growth of private pools of capital and to serve as a framework for evaluating market developments, including investor protection and systemic risk issues. These principles contained guidelines for all links in the pooled investment chain: pool managers, creditors, counterparties, investors, and supervisors. In September 2007, the PWG facilitated the formation of two private-sector groups to develop voluntary industry best practices: the Asset Managers’ Committee and the Investors’ Committee. In April of this year, the two groups issued draft best practices for hedge fund managers and for investors in pools, and they expect to issue finalized practices very soon.


October 28, 2008

Acting Under Secretary for Domestic Finance Anthony Ryan

Remarks at the SIFMA Annual Meeting

New York – Good morning. I am pleased to represent the Treasury Department at the Annual Meeting of the Securities Industry and Financial Markets Association (SIFMA). I welcome this opportunity to update you on the state of the capital markets and the global economy, and on Treasury’s efforts to implement the Emergency Economic Stabilization Act, the EESA, which was recently passed by Congress and signed into law by President Bush.

Our primary focus at Treasury is to strengthen U.S. financial institutions and restore the flow of financing that is necessary to support and build our economy. This conference presents the ideal venue and is particularly timely given the convergence of financial market events, the critical contributions of private sector participants, the broader policy perspectives that need to be addressed, and the breadth of SIFMA’s reach to the financial community. Moreover, this discussion is also opportune given SIFMA’s mission to enhance the public’s trust and confidence in the markets, to deliver an efficient, enhanced member network of access and forward-looking services, and to be the premier educational resource for professionals in the industry. We at Treasury appreciate SIFMA’s efforts on disclosure, securitization, credit ratings, the restoration of investor and public confidence, and securities fails in the Treasury market. But the work is not complete. SIFMA must continue to address the current challenges as well as provide material and meaningful input to future policy issues.

Financial Markets

The stresses on U.S. and world financial markets are the most serious in recent memory. The disruptions of recent months have their roots in the housing correction. As housing prices have declined and the values of mortgage loans became more opaque, uncertainty spread to the investors and institutions that owned these assets. While some argue that this uncertainty has its roots in the subprime and the Alt-A markets, there are numerous factors to review and to understand before coming to any conclusions. Credit as a whole – not just in the housing sector – has been plentiful over the past decade and we have benefited by being able to finance the spectrum of assets and services, from complex collateralized obligations, to tender option bonds, to student loans, and to household spending with credit cards. Today, we are experiencing the repercussions of this unbridled expansion and access to credit. We needed to strike a balance between strong market discipline and regulatory oversight and we have not. Investor confidence was undermined, illiquidity then compromised our credit markets, and now the housing and financial market turmoil has spilled over into the rest of the U.S. economy.

Equity, credit, and funding markets remain under considerable strain, as banks have been forced to delever aggressively and risk appetite has abated. However, policy measures enacted by the Treasury, the Federal Reserve, the FDIC, other U.S. policymakers and our counterparts around the world have helped relieve some pressures in the funding market.

For example, Treasury implemented the temporary Money Market Mutual Fund Guarantee Program, which has been well received by funds and has helped to relieve large-scale redemption pressure among money market mutual funds–a key buyer of commercial paper. The Federal Reserve also introduced three programs: (i) the Asset-Backed Commercial Paper (ABCP) Money Market Liquidity Facility (AMLF) to provide investors the opportunity to sell ABCP through broker/dealers to the Fed; (ii) the Commercial Paper Funding Facility to enhance the availability of 90-day term funding for issuers of both secured and unsecured paper; and (iii) the Money Market Investor Funding Facility to further restore liquidity to the money market mutual fund industry by purchasing commercial paper, certificates of deposits, and bank notes with maturities of 90 days or less. The first two Fed facilities are already operational, and indications are that they too are helping to stabilize financial institutions’ access to the commercial paper market. Accordingly, commercial paper yields are adjusting, volumes across the maturity spectrum are expanding and maturities have lengthened, although we are still far from what might be called “normal” conditions.

Several other funding market sectors, including London Interbank Offer Rates (LIBOR), have also experienced improvements in response to the passage of the EESA and the announcement of the FDIC’s guarantee of short-term bank debt.

In the longer term credit markets; however, conditions remain quite challenging and U.S. companies are finding it very difficult to issue long-term debt at attractive rates.

Mortgage markets are also continuing to experience strain. While the yield on the current coupon mortgage-backed security issued by Fannie Mae and Freddie Mac has increased, overall consumer mortgage rates have improved, and currently average around 6.04 percent on fixed rate 30-year mortgages according to Freddie Mac’s weekly survey, down from 6.35 percent before the GSEs were placed into conservatorship by their regulator, the Federal Housing Finance Agency (FHFA).

It is important to remember that as part of the Treasury’s actions regarding Fannie Mae and Freddie Mac and in consultation with FHFA, the GSEs entered into a Preferred Stock Purchase Agreement with Treasury that effectively guarantees all debt issued by the GSEs, both existing and to be issued. The U.S. Government stands behind these enterprises, their debt and the mortgage backed securities they guarantee. Their mission is critical to the housing markets in the United States and no one will deny the importance of these institutions in assisting our housing markets in this downturn.

To further address other market issues and offer a comprehensive plan for tackling challenges in the financial system, the President worked with Congress over the past 21 days to move quickly to grant the Treasury Department extraordinary authority to address these unprecedented situations facing Americans. Congress recognized that frozen credit markets pose a significant threat to our economy and to all Americans. With unprecedented speed, Congress enacted a rescue package with a broad set of tools —including authority to purchase or insure troubled assets which in turn assists Americans by permitting the extension of credit, and implementing temporary increases in the FDIC deposit guarantee. These tools are being deployed aggressively to strengthen large and small financial institutions across the country that serve businesses and families and directly impact the well being of Americans.

Treasury is moving rapidly to implement these and other programs and is continuing collaborative efforts with the Federal Reserve, the FDIC, and other financial regulators to address the many challenges we face.
Let me summarize our actions thus far and provide some additional details.

Treasury has moved quickly since the enactment of the EESA to implement programs that will provide stability to the markets and help enable our financial institutions to support consumers and businesses across the country. We are focused on applying the authorities Congress provided in ways that are highly effective and protect the taxpayer to the maximum extent possible. As Interim Assistant Secretary for Financial Stability Neel Kashkari recently testified before the Senate Committee on Banking, Housing and Urban Affairs, we have accomplished a great deal in a short time. A program this large and complex would normally take months or years to establish. We don’t have months or years and so we are moving quickly, and methodically, to facilitate the necessary results. We are also moving with great transparency, communicating with Congress and the oversight authorities at every step.

Capital Purchase Program

Earlier this month we announced a capital purchase program under which Treasury will purchase up to $250 billion of senior preferred shares from qualifying U.S. controlled banks and financial institutions. Last week Treasury and financial regulators outlined a streamlined, systematic process for all banks wishing to voluntarily participate in the capital purchase program. Since that time, we have seen a broad range of interest. We signed final agreements with the initial nine major financial institutions that hold 50 percent of all U.S. deposits over this past weekend, and directed our custodian to deliver the capital to these institutions starting today.  We also granted preliminary approval to several more regional banks over the weekend.  There will be a rolling process for selecting financial institutions for capital injections as we go forward.

This program is aimed at healthy banks, and provides attractive terms to encourage lending. The minimum subscription amount available to a participating institution is one percent of risk-weighted assets. The maximum subscription amount is the lesser of $25 billion or three percent of risk-weighted assets. Treasury intends to fund the senior preferred shares purchased under the program by the end of this year. We worked with the four banking regulatory agencies to finalize the application process. Qualified and interested publicly-held financial institutions will use a single application form to submit to their primary regulator – the Federal Reserve, the FDIC, the OCC, or the OTS. These regulators have posted this common application form on their websites.

As Secretary Paulson said last week, this capital purchase program is an investment, not expenditure. This is an investment in Americans, in our community banks, credit unions, and main street banks.

As these banks and institutions are reinforced and supported with taxpayer funds, they must meet their responsibility to lend, and support the American people and the U.S. economy. It is in a strengthened institution’s best financial interest to increase lending once it has received government funding.

Capital Purchase Program Disclosure

Treasury is committed to transparency and disclosure as we implement this program. Once a financial institution is granted preliminary approval, Treasury and the institution will work to complete the final agreement and final authorization of payments. Once the payment is authorized, within two business days Treasury will publicly disclose the name and capital purchase amount for the financial institution. We will disclose the names of financial institutions at the same time every day with postings on our EESA website.

Financing the Financial Rescue Package

Let me now focus on another topic that is just as important – the financing of the Troubled Asset Relief Program (TARP) as well as the various initiatives implemented this past year.

As you know, we make announcements regarding debt management policy at our Quarterly Refunding after consulting with our Treasury Borrowing Advisory Committee as well as after significant internal consultation. This year’s financing needs will be unprecedented. We firmly believe that investors value greatly and pay a premium for Treasury’s predictable actions, the certainty of supply, and the liquidity in the market. To the very best of our ability, we intend to stay the course.

However, specific policy actions or market conditions have recently caused us to take new actions.
For example, two weeks ago I stated that Treasury will continue to increase auction sizes of our bills and coupon securities and continue to issue cash management bills. As has been the case over the past year, some of these cash management bills may be longer-dated. Treasury is also considering its options regarding the frequency and issuance of additional nominal coupons, including a possible reintroduction of the three-year note, beginning in November 2008.

I noted at the time that the announcement was being made, outside the customary Quarterly Refunding announcements, to allow Treasury to adequately respond to the near-term increase in borrowing requirements and to give market participants notice of the potential changes.

Specifically, Treasury may need to address many different policy objectives, including TARP related programs and purchases, FDIC bank resolution measures, liquidity initiatives conducted by the Federal Reserve including the Supplementary Financing Program, the Agency MBS program, student loan program, and the GSE Senior Preferred Stock Agreement. All of these initiatives are not factored into the $482 billion FY 2009 deficit projected by the Office of Management and Budget in July’s Mid-Session review. The potential for deterioration in economic conditions given the contraction in credit may also affect budget conditions this year.

In addition, Acting Assistant Secretary for Financial Markets Karthik Ramanathan recently issued a statement regarding dislocations in the Treasury market. Specifically, Treasury closely monitors conditions in the Treasury securities market as well as financing markets, and realizes that the depth and liquidity of the Treasury market benefits investors both domestically and globally. To address its borrowing needs and further enhance liquidity in the Treasury market, Treasury reopened multiple securities which relieved severe dislocations in the market causing acute, protracted shortages. In addition, Treasury stated that regulators will be monitoring situations in which aged settlement fails are not cleared and will encourage actions by market participants, including the use of netting and bilateral processes, cash settlement, negative rate repo trading, margining of aged settlement fails, and identifying pair-offs.

Once again, we are strongly urging the private sector to lead this effort. We all benefit from a deep, liquid Treasury market, and SIFMA and the Treasury Markets Practices Group have the opportunity to take a leadership role in devising and implementing private sector solutions to current challenges.
Efforts by the private sector to address challenges in the marketplace will go a long way to strengthen market discipline, improve market liquidity and enhance market confidence. It will also help build credibility with market regulators.

Addressing the Challenges and Disequilibrium in the Markets

Our financial market system rests on a balanced tension between private-sector market discipline and public-sector regulatory oversight. However, that balance has been weakened by deficiencies on both sides; market discipline failed and regulatory efforts were compromised. Rules, guidance, and oversight did not mitigate the failures of market discipline. From a public policy perspective, we must restore equilibrium to financial markets, which in this context means market stability. We must strike the optimal balance between market discipline and supervision. Aligning the interests of the private sector and the public sector is critical to the long term success of our economy. When discipline and oversight are balanced, market participants better manage risks, financial institutions operate in a safer and sounder manner, and our economy is served by more competitive, innovative, and efficient capital markets. In March, Treasury released its Blueprint for a Modernized Financial Regulatory Structure. This report outlines a series of steps to improve the U.S.’s antiquated regulatory system. Both market practices and regulatory practices must be reviewed with a critical eye towards improvement and material strengthening. We need to focus on moving forward, with all parties contributing to the collective effort.

President’s Working Group on Financial Markets

In order to address the unprecedented and extraordinary disequilibrium and challenges that our financial markets have experienced, the President’s Working Group on Financial Markets, or “PWG” as it is known, has been taking proactive steps to mitigate systemic risk, restore investor confidence, and facilitate stable economic growth. The PWG issued a policy statement on the financial market turmoil last March, which contained an analysis of underlying factors that contributed to the market turmoil.

The PWG identified weaknesses in global markets, financial institutions, and regulatory policies, and made a set of comprehensive recommendations to address those weaknesses. The analysis focused on six areas: mortgage origination, improving investors’ contributions to market discipline, reforming the ratings process and practices regarding structured credit products, strengthening risk management practices, enhancing prudential regulatory policies, and enhancing the infrastructure for the OTC derivatives market. The PWG’s recommendations cover the practices of a broad array of market participants, as well as supervisors, addressing all links in the securitization chain: mortgage brokers, mortgage originators, mortgage underwriters, securitizers, issuers, credit rating agencies, investors, and regulators.

Since March, the PWG has worked to ensure implementation of its recommendations, and issued an update just over two weeks ago on progress to date. We noted that, while no single measure can be expected to place financial markets on a sound footing, implementation of the recommendations is an important step in addressing weaknesses. Substantial progress has occurred, and more progress has been made in some areas than in others as efforts have been prioritized to address the most immediate problems. The pace of implementation must be balanced with a need to avoid exacerbating strains on markets and institutions. Still, further effort is warranted, and the PWG is continuing to carefully monitor markets and implementation and will not hesitate to make recommendations if necessary.

Another PWG effort, which pre-dates the current turmoil, concerns private pools of capital, including hedge funds. Recognizing that private pools of capital bring significant benefits to the financial markets, but also can present challenges for market participants and policymakers, the PWG in February 2007 issued a set of principles and guidelines to address public policy issues associated with the rapid growth of private pools of capital and to serve as a framework for evaluating market developments, including investor protection and systemic risk issues. These principles contained guidelines for all links in the pooled investment chain: pool managers, creditors, counterparties, investors, and supervisors. In September 2007, the PWG facilitated the formation of two private-sector groups to develop voluntary industry best practices: the Asset Managers’ Committee and the Investors’ Committee. In April of this year, the two groups issued draft best practices for hedge fund managers and for investors in pools, and they expect to issue finalized practices very soon.


We remain vigilant as Americans face strong headwinds in this challenging financial environment. We will focus on addressing or mitigating immediate problems while being mindful that longer term regulatory reform is critical to our continued status as the world’s preeminent capital market. Our Blueprint and the PWG’s reports clearly outlined some of the changes that need to be addressed. Maintaining the balance between regulatory measures and market discipline is critical to highly efficient markets. Most importantly, such a balance fosters market confidence. There is important work for all of us and I appreciate your efforts and dedication. Thank you.

Offshore Hedge Fund Law Firms

Generally speaking, offshore hedge funds utilize both domestic and offshore law firms when launching the hedge fund.  In a recent survey, offshore hedge fund law firms were ranked; please see press release below.

Walkers named Top Offshore Law Firm in 2008 Alpha Awards

Underlining its reputation as the offshore law firm of choice in the hedge fund industry, Walkers is pleased to announce that it has been named as ‘Top Offshore Law Firm’ in the 2008 Alpha Awards for hedge fund service providers, with particular praise in the areas of hedge fund expertise and in the regulatory and compliance field.

Based on the votes of more than 1,000 hedge fund firms which manage more than US$1.5 trillion, Alpha Magazine compiled its rankings based on the quality of service the firms received for the 12 months to March 31 2008. Views on service quality were broken down into a number of broad attributes and respondents were also asked to rate the importance of each attribute, which was used to help calculate the overall winner.

“Receiving any award is always welcome but it is particularly gratifying when the results are based upon the views of our clients in the investment management community,” said Jonathan Tonge, managing partner of Walkers’ hedge fund practice, who is based in the Cayman Islands. “Our success can be attributed to the expertise and hard work of all the members of our hedge funds group and clients can be sure of our continued devoted attention and responsiveness at what is such a crucial time for the industry.”

In addition to offshore law, the Alpha Magazine awards also recognised excellence in service to hedge funds among accountants, fund administrators, prime brokers and onshore law firms.  Other winners included Morgan Stanley, Shartsis Friese, Rothstein Kass & Co., and Goldman, Sachs & Co.

The rankings for the 2008 Alpha awards for hedge fund service providers can be viewed at ––no__catid–4

The recent establishment by Walkers of a specialist Distressed Funds Group was also noted by Alpha Magazine. Formed earlier this year to assist hedge funds affected by the credit crisis and market downturn, the Distressed Funds Group draws on expertise from Walkers corporate, insolvency and litigation departments in its Cayman, British Virgin Islands and Jersey offices. Amid current market uncertainty, clients have welcomed additional specialist services targeted towards a specific market need.

In its overview of this year’s Alpha Awards, the publication noted the brisk growth that the hedge fund industry has experienced in the Cayman Islands, where the number of hedge funds registered with the Cayman Islands Monetary Authority reached 10,291 as of September 30.  Demonstrating resilience in the face of the global financial crisis, there were a net 254 new hedge funds registered in the Cayman Islands in the third quarter of 2008, taking cancellations into account.

“As has been demonstrated by the recent moves to Cayman by offshore law firms from elsewhere in the region, the Cayman Islands remain the clear jurisdiction of choice for offshore hedge funds. If you want to work in the hedge fund space then you need to be here,” said Mark Lewis, senior investment funds partner at Walkers.

Walkers will host a seminar in New York on November 6 specifically designed to examine issues relating to distressed hedge funds. ‘Fighting the Tape’ will be a unique discussion on protecting and growing a hedge fund business in volatile markets.  Speakers at the event include a number of Walkers hedge fund partners and invited guests, particularly renowned hedge fund manager George Hall, the Founder and President of the Clinton Group Inc.; Yolanda McCoy, Head of the Investments and Securities Division of the Cayman Islands Monetary Authority (CIMA); and Jeffrey Rosensweig, Associate Professor of Finance at Emory University.

A limited number of spaces remain and for more information about the event or to reserve a seat, please contact Walkers’ Marketing Team at [email protected] The ‘Walkers Fundamentals’ series of ‘Thought Leadership’ events will be developed further over the coming months.

Prime Brokerage Survey Results

The following is a press release regarding the results from a prime brokerage survey.

Alpha Magazine Survey Ranks Merlin Securities as the #1 Prime Broker for Small Hedge Funds in 2008
Merlin Securities Receives Top Honors for Second Year Running

SAN FRANCISCO, Oct 28, 2008 — Merlin Securities, a leading prime brokerage services and technology provider for hedge funds, funds of funds and long-only managers, today announced that Alpha magazine has named it #1 prime broker for hedge funds with less than $1 billion in assets under management. This is the second year that Merlin Securities has received top honors as the “Small Firms’ Favorite” in Alpha’s survey of more than 1,000 hedge fund firms.

“We feel very privileged to be voted by so many funds as the top prime broker for the second year running,” said Aaron Vermut, senior partner and chief operating officer of Merlin Securities. “This award recognizes the hard work of our entire team and our continuing commitment to providing quality customer service and leading-edge technology.”

About Merlin Securities

Merlin Securities is a leading prime brokerage services and technology provider for hedge funds, funds of funds and long-only managers. The firm provides single- and multi-primed hedge fund managers with dynamic performance attribution portfolio analytics and reporting. In January 2008, Sequoia Capital, a leading venture capital firm, invested $20 million in Merlin Securities. The firm has offices in New York and San Francisco and is a member of NASD and SIPC.

In 2007, Global Custodian named Merlin Securities the #1 prime broker in North America, the #1 prime broker for single-strategy funds and the #1 prime broker for funds under $100 million. Merlin was also named the #1 prime broker for funds less than $1 billion by Alpha magazine in their 2007 Hedge Fund Service Provider Survey. In the 2008 Global Custodian survey, Merlin achieved the highest overall scores in the single- and multi-primed brokerage categories.

For more information, please visit

Mini-Prime Brokers – Prime Brokerage for Start-up, Small and Mid-Sized Hedge Funds

Historically, prime brokerage was relegated to a few of the very large Wall Street investment houses – the Goldmans, Merrills, Bears and Lehmans.  Many of these firms  provided prime brokerage services to the very large hedge funds.  However, these firms could not provide the comprehensive trading services required by smaller hedge funds because the relationships were not as profitable as the relationships with larger hedge funds.  Eventually the large prime brokers began to neglect the smaller hedge funds (those with less than $50 or $100 million in assets) which made way for the “mini-prime brokers.”

Mini-prime brokers are registered broker-dealers that essentially act as introducing firms to the prime brokers and handle the front end relationship while the trading, execution, clearing and custody are handled through the back end of the large prime brokerage firms.  Mini-prime brokers fill an important niche for smaller hedge funds who desire better support services than the discount or online brokerages provide, but who are not yet big enough to get the very personalized services that bigger funds receive from the large prime brokers.

Types of Instruments

Mini-prime brokers have access to the same investments as the large prime brokerage firms, including stocks, bonds, options, futures and foreign exchange.  Additionally, mini-primes have access to the executing primes short box so that managers can short as well as go long.

Access to Soft Dollars and Trading Platforms

In addition to brokerage and custody, many mini-prime brokers also provide small and start-up managers with many additional services.  Such services may include soft dollar services, operational services, back office services and potentially even capital introduction services.  Many of the mini-prime brokers will also provide their customers with complementary access to many of the most popular trading platforms like REDIPlus, Bloomberg and Neovest.  Each mini-prime will be able to provide different services and execution prices and a hedge fund manager should talk with a few before making a decision.


For a start-up or small hedge fund manager, a mini-prime will be a better choice than the large prime broker.  In general, a mini-prime can provide all the same services that a large prime broker can, and the mini-prime will probably be able to better respond to a small manager’s needs.  Fund investors are also more comfortable with the fact that custody of the hedge fund’s assets will also be maintained at the large brokerage firm.

A hedge fund attorney will be able to provide a start-up manager with referrals for prime and mini-prime brokerage services.  Please contact us if you have any questions or would like recommendations for hedge fund mini-prime brokers. Other HFLB articles:

Third Party Marketers

Raising capital is the most vital part of the hedge fund start-up process.  If the manager cannot raise sufficient capital to cover the cost of starting up and running the fund, the manager will soon be out of business.   Because raising capital is difficult, and because hedge fund managers cannot publicly advertise pursuant to the Regulation D offering rules, third party marketers (3PMs) are an oftentimes invaluable service provider.

Third party marketers are firms which are registered as broker-dealers with the SEC and also registered with the securities commission of the firm’s resident state(s).  These firms have contacts within the hedge fund industry and work to raise money for the hedge fund.  All of the people who raise money for the third party marketing firms are registered as brokers which will generally mean that they have both the Series 7 license (the General Securities Representative Examination) and the Series 63 license (the Uniform Securities Agent State Law Examination).

Third Party Marketing Fees

Third party marketing fees will be different for each 3PM firm.  Most all firms will charge a fee for placing assets which will be calculated as a percentage of the hedge fund manager’s fees – both from the management fee and the performance fee or allocation.  For example, one fee structure might be that the manager pays the third party marketer 20% of all the management and performance fees earned on the assets raised by the third party marketer.  The percentage stated above will be larger (up to 50% or more) for smaller funds because it is easier (and more lucrative to the third party marketer) to raise money for larger funds.

These groups may also require a monthly retainer.  These retainer fees will not typically be paid by the hedge fund but by the management company. In certain circumstances, especially when the fund is very small or just starting out, the third party marketing firm may negotiate for an equity stake in the hedge fund manager.

The Third Party Marketing Agreement

The relationship between a hedge fund manager and the third party marketer is solidified through a third party marketing agreement.  These arrangements are typically initiated by the third party marketing firm and should be reviewed by the manager and the manager’s attorney before signing.  There may be several back and forth iterations of the agreement and the hedge fund lawyer can help a manager with the drafting of certain parts of the agreement based on the business points agreed to with the third party marketer.  A hedge fund manager should never enter into a third party marketing agreement without first having an attorney review the agreement.

Other Asset Raising Considerations

All funds are different and the capital needs of each manager will vary according to a number of factors; however, most all managers are interested in adding assets.  Start-up and emerging hedge fund managers may also want to discuss their strategy with a hedge fund seeder which is basically like a third party marketer except that the seeder will usually provide a large capital contribution to the hedge fund and potentially will take an equity stake in the management company.  Other groups also, such as prime brokers and mini prime brokers, may offer capital introduction services.  While such groups will never commit to raising a certain amount, or any, assets for the fund, it would be worthwhile for the hedge fund manager to discuss this point with the fund’s broker.  Additionally, a hedge fund manager may want to submit its performance results to a hedge fund database.

It goes without saying, but start-up hedge fund managers should not take your eye off the ball when trying to raise assets – attractive returns over time is the best way for the manager to raise money over the long run.

SEC Emphasizes Importance of Hedge Fund Investment Advisor Compliance

The SEC’s Lori Richards, Director, Office of Compliance Inspections and Examinations, spoke last week at an event and emphasized the importance of compliance during these volatile markets.  For chief compliance officers (CCOs) at registered investment advisory firms, the following speech transcript should be required reading.  Hedge fund managers registered as investment advisors must be especially aware of the fiduciary obligation they have to their client.  Specifically Richards noted that examiners will be focusing investment programs to make sure there is no style drift in their portfolios and that valuation is done pursuant to the manager’s stated valuation procedures.

Richards also discussed a number of areas which compliance officers should be focusing on during this time.  Specifically she advocated that a firm’s CCO: make sure following all securities laws and regulations, including the Form SH filings; make sure there is no market manipulation or insider trading; review and update if necessary the following Form ADV, Form ADV Part II, performance advertising, marketing, fund prospectuses and any other information provided to clients; review best execution and any soft dollar programs.  Richards noted that in keeping with the “culture of compliance,” the CCO “should insist on absolute compliance with policies and procedures, there should be no possibility of ‘suspending’ compliance. And it would be timely for you to remind firm employees of your presence and make clear to every employee in the firm that no shortcuts will be allowed.”

Richards also noted that the examiners will be looking for undisclosed payments by and to hedge fund investment advisors.  This is especially interesting in light of the recent case brought by the DOL against a registered investment adviser for failing to disclose payments from a hedge fund manager.  Please see DOL Sues Investment Advisor for ERISA violation.

If a registered hedge fund manager’s CCO has not considered any of the above issues the manager should immediately contact a hedge fund attorney or compliance professional.  It is likely that a hedge fund manager will be audited given the SEC’s “risk-based” model of audits.  I have posted some regular articles below.  The full text of the speach is reprinted below and can also be found here.


Speech by SEC Staff:
Compliance Through Crisis: Focus Areas for SEC Examiners and Compliance Professionals

by Lori A. Richards
Director, Office of Compliance Inspections and Examinations
U.S. Securities and Exchange Commission
National Society of Compliance Professionals
National Meeting
Philadelphia, Pennsylvania

October 21, 2008

Good Morning. I’m very pleased to be with you here today at the National Meeting of the National Society of Compliance Professionals. I believe that this is the largest professional organization of compliance professionals in the securities industry, so you carry a lot of clout!

Before I begin, I am required to state that the views I express today are my own, and do not necessarily represent the views of the Commission or any other member of the staff.

This event and others like it are so important — they provide an opportunity to share information about cutting edge compliance practices, about emerging compliance risks, and about strategies to help establish strong compliance programs and instill a healthy culture of compliance. Your role as compliance professionals is critical in any market environment, but in today’s turbulent times, it is essential. Your job each day is to educate, to guide, to investigate, to test and sometimes to insist on adherence to the law and to the firm’s policies, and sometimes, to just say no! Your job is important in any environment, and it is just as or more important now.

The compliance function within firms is critical in helping to assure operations in compliance with the law, and it must continue to be fully and adequately resourced. While not profit centers, firms must remember that their compliance programs (and related legal functions, as well as the information technology programs that support a well-run compliance program) are essential to their operations — reductions in resources to these programs would be ill-advised. Securities firms cannot now afford to reduce vigilance in compliance.

In today’s environment, perhaps the most important thing you can do as a compliance professional is to remind firm employees of their obligations to investors — for an adviser, the fiduciary obligation to clients, and for a broker, the obligation to follow just and equitable principles of trade. These obligations must continue to motivate and inform the way that the firm interacts with clients, customers, and investors. In addition to this reminder, however, there are areas where you will want to pay particular attention to compliance obligations. I will describe some of those this morning. Finally, you cannot let slip the other ongoing compliance responsibilities that the firm has, I will describe some of these priority areas as well.

As I speak to you today, our markets are undergoing unprecedented change. Once large firms no longer exist, and others have been acquired or merged. Securities firms that once stood alone are now parts of large banks. A money market fund has broken a dollar, and the Treasury has implemented a new program to guarantee certain money market funds from loss and the government has taken unprecedented steps to buy troubled assets and shore up credit markets. These are sudden and significant changes, and while we won’t see their full impact for some time, today, in the securities compliance world, our work could not be more important.

It’s worth remembering, for all of us who work administering compliance programs under the securities laws, that the underlying tenets of the securities laws are quite simple and provide meaningful protections to every investor every day:

  • Companies publicly offering securities to investors must tell the public the truth about their businesses, the securities they are selling, and the risks involved in investing — enabling investors to make informed investment decisions.
  • People who sell and trade securities and provide investment advice — brokers, dealers, advisers and exchanges — must treat investors fairly and honestly, putting investors’ interests first.

In the current credit crisis, the SEC has been aggressively working to police the markets, and to ensure that the “rules of the road” for public companies and market participants include full disclosure to investors and promote healthy capital markets. While a small agency (only 3,800 staff), the SEC packs clout through its experienced and dedicated staff. Addressing the extraordinary challenges facing our markets, the SEC has issued new regulations to strengthen capital markets and protections for investors, taken enforcement measures against market manipulation (including a landmark enforcement action against a trader who spread false rumors designed to drive down the price of stock), initiated examination sweeps, communicated with investors, and collaborated with domestic and foreign regulators around the world.

The SEC is an aggressive police force too — we bring hundreds of enforcement actions each year to protect public investors from fraud.  Indeed in just this last year, we brought more than 650 enforcement actions, more than the year before, involving all types of fraud that harm investors — corporate non-disclosure, ponzi schemes, insider trading, failures to value assets correctly, and other types of frauds. The protections of the securities laws are meaningful and have real consequences for investors. In just the last year alone, we returned over one billion dollars to harmed investors — making the protections of the federal securities laws mean something to those investors who have been defrauded.

And, in the Office of Compliance Inspections and Examinations, we are keenly focused on issues that present risk to investors. I wanted to highlight some of the areas that SEC examiners will be focusing on in the months ahead in our examinations of registered investment advisers, investment companies, and broker-dealers — and suggest that these are areas that you might focus attention on as well.

Let me start with the “landscape” because the sheer number of registered firms subject to our examinations impacts our actions quite directly. At the start of FY 2009:

  • There are approximately 11,300 registered investment advisers and 950 fund complexes with over 8,000 mutual fund portfolios (this is a highly transient population: approximately 1,200 advisers became registered and 750 de-registered in FY 2008).
  • There are approximately 5,600 broker-dealers, 174,000 branch offices, and 676,000 registered representatives (as more firms have consolidated, the broker-dealer registrant pool has declined slightly in recent years, while the number of branch offices has increased dramatically). And, there are approximately 410 SEC-registered transfer agents.

Our program is risk-based, which means that we seek to accord resources to those firms and issues that present the greatest risk to investors. Our overall examination plan consists of numerous complementary components: routine and periodic examinations of those advisers (about 1,000) that are considered “higher risk;” routine examinations of large broker-dealer firms to evaluate their internal controls; “oversight” examinations of broker-dealers to evaluate the SROs’ regulatory programs; cause exams based on indications of violations; “sweep” exams focused on particular risk areas; random examinations of lower risk advisers; and visits to newly-registered advisers. In addition to these types of examinations, we will also closely monitor the compliance activities and controls of certain large advisers and broker-dealers.

We’ve also sought to leverage compliance results from firms’ own compliance programs by encouraging firms’ own compliance professionals to be aggressive in assuring compliance with the securities laws. In the coming year, we will continue this work as well — we will continue our CCOutreach programs for chief compliance officers. Our National Seminar for adviser and fund CCOs is November 13, and we just announced that our National Seminar for broker-dealer CCOs, in coordination with FINRA, will be held on March 10, 2009. We will also continue to issue ComplianceAlerts that summarize results of recent examinations so that all firms can benefit from our insights into both what can go wrong, and also, what particular practices seem to help make things go right.

Our examination program includes focus areas and exam initiatives that are particularly critical in today’s market environment. While these are not new areas, they are timely now and examiners will be paying special attention to compliance in these areas. These areas include:

  • Portfolio management: recent losses may provide an impetus for portfolio managers to trade more aggressively than they should or to deviate from investment objectives in order to make up losses, and perhaps also to catch-up on performance-based fees. This is an area where compliance personnel should be active.
  • Financial controls, including compliance with net capital and customer control requirements by broker-dealers, as well as these firms’ risk management and internal control procedures. While the Division of Trading and Markets will no longer be supervising the holding companies of large broker-dealer firms — OCIE examiners will continue to focus attention on controls within the registered broker-dealer, which are intended to protect investors’ accounts with a broker-dealer. And, if you’re an adviser in precarious financial condition — you must disclose this fact to clients. This is an area where your focus is warranted.
  • Valuation, at all types of registrants, including controls and procedures for valuation of illiquid and difficult-to-price securities at all registrants. Reluctance to fair value or mark down prices cannot take precedence over the firm’s pricing procedures — investors and fund shareholders have a right to know the current value of their holdings. If you work for a broker-dealer that provides quotes or for an investment adviser or other user of broker quotes — be particularly alert to and look for the possibility of “accommodation quotes” — which don’t reflect prices at which the security could actually be sold. At its worst, this could be fraudulent conduct. A reminder too — under accounting rules (FAS 157), issuers must classify their assets within a hierarchy. For those assets valued by using a broker’s quote or a price from a pricing service — you should be sure that you understand whether the quote or price is based on actual transactions, reflects the willingness of the broker to trade at that price, or is based on a model or another methodology.  Among strong practices in this area are to require multiple sources of pricing information, and also to regularly go back and compare the actual prices realized on any sale to the fair values used: then, determine the reasons for any wide gaps and implement improvements in pricing processes. This is an area where your focus is needed now — be sure that your firm is implementing its controls and its oversight over pricing.
  • Sales of structured products by broker-dealers and advisers. Of special note — given that investors may be particularly looking for lower-risk investment products, examiners will focus on products marketed as being relatively “safe,” such as principal protected notes and other products, and will review the adequacy of disclosures concerning credit risk, liquidity, and investment risk. Conversely, investors may be looking to recoup losses, and may be more vulnerable to sales of high-risk, high-return products. You will want to focus on both types of products and make sure that representations are accurate and that your firm is treating investors fairly.
  • Controls and processes at recently merged or acquired firms, both advisers and broker-dealers. This is an area where compliance staff must be active — to help make sure that controls and processes do not fall through the cracks in a merged organization.
  • Money market funds, including, at a minimum, compliance with Rule 2a-7 regarding the creditworthiness of portfolio securities, shadow pricing, and compliance oversight — and more broadly, whether funds’ are stretching for yield and subjecting the fund to excessive undisclosed risk. We have examinations underway. The problems experienced by money market funds should be seen as cautionary for all managers and CCOs of money market funds.
  • Short selling and compliance with Regulation SHO and filings of Form SH. Examiners are also focusing on firms’ policies and procedures to prevent employees from knowingly creating, spreading, or using of false or misleading information with the intent to manipulate securities prices, and will be concluding a sweep of broker-dealers and hedge fund advisers in this area.

Beyond these specific compliance risk issues, in times of financial strain, people may act in uncharacteristic ways — in order to conceal losses, inflate revenues or profits, to stay in business or just to avoid delivering bad news. Examiners will be alert for indications of fraud and “acts of desperation” by individuals and firms that are under financial duress. As compliance personnel, however, you are much closer to the scene than we are — and you should be aware of and alert to the increased possibility that individuals under stress may take fraudulent or deceptive actions. Checks and balances are critical in this environment. You should insist on absolute compliance with policies and procedures, there should be no possibility of “suspending” compliance. And it would be timely for you to remind firm employees of your presence and make clear to every employee in the firm that no shortcuts will be allowed.

In addition to these focus areas, OCIE examiners will also be focusing on other compliance risks, and so too must you. We cannot afford to pay less attention to any of these issues. Let me describe several of these areas:

  • Suitability and appropriateness of investments for clients: Examiners will focus on whether securities recommended and investments made for clients and funds are consistent with disclosures, the client’s investment objectives and any investment restrictions, and with the broker or adviser’s obligations to clients to only recommend securities that are suitable or appropriate. We’ll focus in particular, on how firms are interacting with their senior customers and clients. We’ll also focus on structured products and other complex derivative instruments, variable annuities, niche ETFs, managed pay-out funds, and 130/30 funds.
  • Disclosure: Examiners will focus on ADVs, performance advertising, marketing, fund prospectuses and any other information provided to clients. This is a good time for you to review your firm’s disclosures to investors and shareholders. Make sure that any steps the firm has taken in recent days or weeks to deal with the credit crisis are consistent with the firm’s disclosures. Examiners will be specifically looking at how the firm represents its participation in Treasury’s money market guarantee program, the existence of SIPC coverage, and at advertised performance figures. Consider your disclosures as your “Constitution” — even in a crisis, it’s your governing document, and it must match your practices.
  • Controls to prevent insider trading: We’re focusing on the adequacy of policies and procedures, information barriers, and controls to prevent insider trading and leakage of information including the identification of sources of material non-public information, surveillance, physical separation, and written procedures. Controls to prevent insider trading should be strong in any environment.
  • Trading, brokerage arrangements and best execution: We’ll be looking at whether brokerage arrangements are consistent with disclosures, whether the firm seeks best execution, and whether soft dollars are used appropriately (consistent with disclosures), Reg NMS and direct market access arrangements. We will particularly scrutinize the use of an affiliated broker-dealer or any undisclosed relationships with a broker-dealer for excessive commissions, kick-backs and other conflicted relationships. Your best execution committees will want to particularly review execution quality in current markets.
  • Proprietary and employees’ personal trading: This is a basic part of any compliance program — when we find weaknesses in this area, it makes us wonder about the firm’s commitment to addressing other conflicts of interest. This is not an area to be overlooked.
  • Undisclosed payments: Examiners are looking for compensation or payment arrangements that may be part of revenue-sharing, or other undisclosed arrangements with third parties. These payments may be made to increase fund sales or assets under management (such as fund networking fees and payments by advisers to broker-dealers for obtaining space on the firms’ recommended adviser list). Undisclosed payments may also involve misappropriation of adviser/fund/broker-dealer assets by, for example, creating fictitious bills and expense items, or receiving kick-backs from a service provider.
  • Safety of customer assets: Examiners will look at whether brokers, funds and advisers have effective policies and procedures for safeguarding their clients’ assets from theft, loss, and misuse. This is a good time for you too to assess controls in this area. Make sure that advisory clients’ money is with a qualified custodian and review prime brokerage relationships. You may want to ensure that the process for sending account statements to clients has controls to ensure that the account statements cannot be intercepted or falsified. Examiners will also continue to focus on controls for compliance with Regulation S-P with respect to customer information.
  • Anti-money laundering: Examiners will look at whether funds and broker-dealers are complying with obligations under the securities laws, the Patriot Act and Bank Secrecy Act to have effective policies and procedures to detect and deter money-laundering activities, whether these policies and procedures are regularly tested for continued effectiveness, and whether actual practices are consistent with the policies and procedures.
  • Compliance, supervision, and corporate governance: While this is the last item I’ll list, it’s the most important — because it underpins all the other compliance responsibilities that firms have. In the coming year, examiners will focus in particular on supervisory procedures and practices at large branch offices of broker-dealers and at advisory branch offices, on supervision and controls over traders, whether funds have appropriately-constituted boards and have considered required matters (e.g., fair value procedures), and whether firms have implemented effective internal disciplinary processes. Also, we’ll examine: firms that advertise themselves as allowing maximum independence to registered representatives; for abuses in transferring customer accounts as registered representatives move to new firms; supervision of producing branch managers; bank broker-dealer branches; and the adequacy of firms’ testing to detect unsuitable or aberrant trades.

For advisers and mutual funds, in that this is the fifth year of both the Compliance Rule and our CCOutreach efforts for adviser and fund CCOs, we hope to see improvements in firms’ compliance programs, and in particular, that significant deficiencies were identified promptly and corrected appropriately by firms.

* * *

These are challenging times, no doubt. The SEC has been and will continue to guard the interests of investors. Industry compliance professionals too play an indispensable role in fostering and assuring investor protection and the integrity of our markets. As I said at the outset, I think that the first thing that you might do in the current environment is to is to remind firm employees of their obligations to investors — for an adviser, the fiduciary obligation to clients, and for a broker, the obligation to follow just and equitable principles of trade. These obligations must continue to motivate and inform the way that the firm interacts with investors.

I have shared with you today some of the issues that SEC examiners will be focusing on in the coming months — and these are areas where I hope you too will focus your attention. Finally, you cannot let slip the other ongoing compliance responsibilities that the firm has, and I have described some of these priority areas as well.

I hope this information will be helpful to you in your work, and I look forward to continuing to work with you to help improve and assure strong compliance practices in the securities industry.

Thank you.

Hedge Fund Databases

As hedge fund managers are limited in their ability to advertise their performance results because of the Regulation D rules, one of the ways which managers have found to market their hedge fund and distribute the performance results is through hedge fund databases.

What is a hedge fund database?

Hedge fund databases are websites which collect information and performance results from a hedge fund and then publish the information for the use of their subscribers.  Subscribes to hedge fund databases are typically either high net worth investors or institutional investors like hedge fund of funds.  Other service providers such as administration firms may be subscribers as well as students/academics.  Subscribers will usually go through a vetting process to ensure that they meet the eligibility requirements for investing in hedge funds.

What information is included in a hedge fund database?

Hedge fund databases will include all of the basic identifying information on the hedge fund (name, manager, addresses, phone numbers, etc) as well as the structure of the hedge fund (i.e. domicile, fees, lock-up, withdrawal provisions) and any pertinent investment strategy information.  In addition to these items the database will also post the performance results of the hedge fund.  Depending on the database, the reports will be more or less comprehensive – that is, some databases will include information on the fund’s underlying positions and other metrics (alpha, beta, VaR, etc) while some databases will only include the fund’s most recent returns. This helps an institutional investor with some of the initial parts of the hedge fund due diligence process.

How does a hedge fund manager submit information to the databases?

Each database requires different information in order to establish listing.  In addition to much of the basic factual information on the hedge fund, some databases may request a copy of the offering documents or evidence that the performance returns have been reviewed by a hedge fund auditor.  Once a manager has gathered this information and completed any other items required for listing, the database will include the fund’s most recent information and performance.   After the listing is initially established, the hedge fund managers will typically need to upload their performance reports on a monthly or quarterly basis.  This process can usually be done by an administrative person within the hedge fund management company.

What are the costs?

Generally there are no costs associated with initiating a listing with a hedge fund database.  However, many of these databases require investors to pay an initial or periodic fee in order to continue to receive the information within the database.  Those databases with the highest fees tend to have the most fund listings and also tend to provide greater searching abilities which provide institutional investors with the metrics used to select potential hedge fund investments.

What are the best databases?

I have not seen any studies on which databases actually place the most assets.  Obviously the best database for any individual hedge fund is the database which places the most assets in such fund.  With that being said there is no reason why any particular hedge fund should not submit to multiple databases.  The only issue with this is the time and costs it takes a hedge fund manager to submit the periodic information to these databases.  This would be a cost normally borne by the management company (instead of the hedge fund itself) unless the offering documents specifically allowed for this expense to be incurred at the fund level.

Other related HFLB articles include:

Overview of Issues Related to ERISA Hedge Fund Investments

This article outlines the issues which are central to ERISA plans when such plans invest in hedge funds. The information comes from a report prepared by the Government Accountability Office and provides hedge fund managers with a good informational foundation of the issues which matter to ERISA plans. As ERISA is a very important set of federal laws a hedge fund manager should be especially diligent about making sure all proposed transactions are lawful. In a recent ERISA article we discussed how a hedge fund’s assets were frozen because of an unlawful transaction between the hedge fund manager and an ERISA fiduciary .

Please also note that with regard to the article below, HFLB has not prepared any of the items in here but we have added titles and brackets.  A complete copy of the GAO report can be found here.  If a manager has a specific ERISA question the manager should talk to an attorney to discuss the specific facts of the ERISA matter.

ERISA Prudent Man Standard

Private sector pension plan investment decisions must comply with the provisions of ERISA, which stipulates fiduciary standards based on the principle of a prudent man standard. Under ERISA, plan sponsors and other fiduciaries must (1) act solely in the interest of the plan participants and beneficiaries and in accordance with plan documents; (2) invest with the care, skill, and diligence of a prudent person with knowledge of such matters; and (3) diversify plan investments to minimize the risk of large losses. Under ERISA, the prudence of any individual investment is considered in the context of the total plan portfolio, rather than in isolation.*

Hence, a relatively risky investment may be considered prudent, if it is part of a broader strategy to balance the risk and expected return to the portfolio. In addition to plan sponsors, under the ERISA definition of a fiduciary, any other person that has discretionary authority or control over a plan asset is subject to ERISA’s fiduciary standards.** The Employee Benefit Security Administration (EBSA) at Labor [the U.S. Department of Labor] is responsible for enforcing these provisions of ERISA, as well as educating and assisting retired workers and plan sponsors. Another federal agency, the Pension Benefit Guaranty Corporation (PBGC), collects premiums from federally insured plans in order to insure the benefits of retirees if a plan terminates without sufficient assets to pay promised benefits.

* ERISA’s prudent man standard is satisfied if the fiduciary has given appropriate consideration to the following factors (1) the composition of the plan portfolio with regard to diversification of risk; (2) the volatility of the plan investment portfolio with regard to general movements of investment prices; (3) the liquidity of the plan investment portfolio relative to the funding objectives of the plan; (4) the projected return of the plan investment portfolio relative to the funding objectives of the plan; and (5) the prevailing and projected economic conditions of the entities in which the plan has invested and proposes to invest. 29 C.F.R. § 2550.404a-1(b) (2007).

** Under ERISA, a fiduciary is a person who (1) exercises discretionary authority or control over plan management or any authority or control over plan assets; (2) renders investment advice regarding plan moneys or property for direct or indirect compensation; or (3) has discretionary authority or responsibility for plan administration. 29 U.S.C. §1002(21).

Discussion of State Sponsored Plans

In the public sector, governments have established pension plans at state, county, and municipal levels, as well as for particular categories of employees, such as police officers, fire fighters, and teachers. The structure of public pension plan systems can differ considerably from state to state. In some states, most or all public employees are covered by a single consolidated DB [defined benefit] retirement plan, while in other states many retirement plans exist for various units of government and employee groups. Public sector DB plans are not subject to funding, vesting and most other requirements applicable to private sector DB plans under ERISA, but must follow requirements established for them under applicable state law. While states generally have adopted standards essentially identical to the ERISA prudent man standard, specific provisions of law and regulation vary from state to state. Public plans are also not insured by the PBGC, but could call upon state or local taxpayers in the event of a funding shortfall.

Hedge Fund Investments Allowed under ERISA; Due Diligence Required; 25% Threshold

Although ERISA governs the investment practices of private sector pension plans, neither federal law nor regulation specifically limit pension investment in hedge funds or private equity. Instead, ERISA requires that plan fiduciaries apply a prudent man standard, including diversifying assets and minimizing the risk of large losses. The prudent man standard does not explicitly prohibit investment in any specific category of investment.* Further, an unsuccessful individual investment is not considered a per se violation of the prudent man standard, as it is the plan fiduciary’s overall management of the plan’s portfolio that is evaluated under the standard.** In addition, the standard focuses on the process for making investment decisions, requiring documentation of the investment decisions, due diligence, and ongoing monitoring of any managers hired to invest plan assets.

*However, ERISA may indirectly limit a pension plan’s ability to invest in specific hedge funds or private equity funds. Under Labor’s plan asset regulation, if the aggregate investment by benefit plan investors in the equity interest of a particular entity is “significant,” and that equity interest is not (i) a publicly-offered security, (ii) issued by a registered investment company, such as a mutual fund, nor (iii) issued by an operating company, then the assets of that entity are deemed assets of each benefit plan investor (i.e., plan assets). See 29 C.F.R. § 2510.3-101 (2007). As a result, any person who exercises management authority over the entity now deemed to hold plan assets will become subject to ERISA’s fiduciary standards. The equity investments by benefit plan investors are considered “significant” if at any time the aggregate investment of the benefit plan investors represents 25 percent or more of the value of any class of equity in the entity. According to one industry expert, in order to avoid being deemed a plan fiduciary (and assuming all of the liabilities that accompany that status), many managers of hedge funds, which generally are not publicly-traded, not registered investment companies, nor operating companies, carefully monitor the level of investments in the hedge fund by benefit plan investors to ensure that their aggregate investment remains below the 25 percent threshold. Prior to the Pension Protection Act of 2006 (PPA), the calculation of the 25 percent threshold pertained to investments by ERISA plans and certain non-ERISA covered plans, such as public sector and foreign retirement plans. However, in accordance with section 611(f) of the PPA, investments by certain plans, including public sector and foreign retirement plans, are now excluded from the calculation. Pub. L. No.109-280, § 611(f), 120 Stat. 780, 972 (codified at 29 U.S.C. § 1002(42)). This modification may facilitate an increase in the level of investments by pension plans in hedge funds and private equity funds.

**With some exceptions, ERISA does prohibit plans from investing more than 10 percent of plan assets in the sponsoring company’s stock. See 29 U.S.C. § 1107. In addition to requiring plan fiduciaries to adhere to certain standards of conduct, ERISA also prohibits plan fiduciaries from engaging in specified transactions. See 29 U.S.C. § 1106.

Best Practices in Hedge Fund Investing

Although there are no specific federal limitations on pension plan investments in hedge funds, two federal advisory committees have, in recent years, highlighted the importance of developing best practices in hedge fund investing. In November 2006, the ERISA Advisory Council recommended that Labor publish guidance describing the unique features of hedge funds, and matters for consideration in their adoption for use by qualified pension plans.* To date, Labor has not acted on this recommendation. According to Labor officials, an effort to address these recommendations was postponed while Labor focused on implementing various aspects of the Pension Protection Act of 2006.**

However, in April 2008, the Investors’ Committee established by the President’s Working Group on Financial Markets, composed of representatives of public and private pension plans, endowments and foundations, organized labor, non-U.S. institutions, funds of hedge funds, and the consulting community, released draft best practices for investors in hedge funds.*** These best practices discuss the major challenges of hedge fund investing, and provide an in-depth discussion of specific considerations and practices that investors in hedge funds should take. While this guidance should serve as an additional tool for pension plan fiduciaries and investors to use when assessing whether and to what degree hedge funds would be a wise investment, it may not fully address the investing challenges unique to pension plans leaving some vulnerable to inappropriate investments in hedge funds.

*The ERISA Advisory Council was created by ERISA to provide advice to the Secretary of Labor. 29 U.S.C. § 1142.

**The PPA is the most recent comprehensive reform of federal pension laws since the enactment of ERISA. It establishes new funding requirements for DB pensions and includes reforms that will affect cash balance pension plans, defined contribution plans, and deferred compensation plans for executives and highly compensated employees.

***Principles and Best Practices for Hedge Fund Investors: Report of the Investors’ Committee to the President’s Working Group on Financial Markets, April 15, 2008. The President’s Working Group on Financial Markets includes the heads of the U.S. Treasury Department, the Federal Reserve, the SEC, and the Commodity Futures Trading Commission.

How Hedge Funds Report Investments to Labor

Labor does not specifically monitor pension investment in hedge funds or private equity. Labor annually collects information on private sector pension plan investments via the Form 5500, on which plan sponsors report information such as the plan’s operation, funding, assets, and investments. However, the Form 5500 includes no category for hedge funds or private equity funds, and plan sponsors may record these investments in various categories on the form’s Schedule H. In addition, because there is no universal definition of hedge funds or private equity and their strategies vary, their holdings can fall within many asset classes. While EBSA officials analyze Form 5500 data for reporting compliance issues—including looking for assets that are “hard to value”—they have not focused on hedge fund or private equity investments specifically.* According to EBSA officials, there have been several investigations and enforcement actions in recent years that involved investments in hedge funds and private equity, but these investments have not raised significant concerns.

*“Hard to value” assets are those that are not traded on an exchange. “Hard to value” assets may include hedge funds, private equity funds, and real estate. It is difficult to distinguish the type of investment with the information provided. Federal agency officials use the Form 5500 report data to enforce ERISA pension requirements, monitor plan compliance, develop aggregate pension statistics, and conduct policy and economic research.

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SEC Chairman Cox Asks Congress for More Financial Regulation

Discussion of the new world of U.S. financial regulation that will be developing over the coming months continued last Thursday as the Congressional Committee on Oversight and Government Reform received testimony on oversight of the financial markets from the SEC Chairman Christopher Cox, among others.  Chairman Cox’s testimony can be characterized as advocating a stronger SEC and more oversight of the financial institutions.  At many times during his testimony he spoke of Congress increasing the regulation in the industry, especially with regard to the unregulated Credit Default Swap markets.

Below I’ve identified some of the more interesting quotes from his speech:

… what happened in the mortgage meltdown and the ensuing credit crisis demonstrates that where SEC regulation is strong and backed by statute, it is effective — and that where it relies on voluntary compliance or simply has no jurisdiction at all, it is not.

There is another reason that a new, overarching statutory scheme is necessary. The current regulatory system is a hodge-podge of divided responsibility and regulatory seams. Coordination among regulators is enormously difficult in this fragmented arrangement, where each of them implements different statutes that treat various financial products and services differently. Today’s balkanized regulatory system undermines the objectives of getting results and ensuring accountability.

Across the board, other regulatory anomalies cry out for rationalization: outdated laws that treat broker-dealers dramatically differently from investment advisers, futures differently from economically equivalent securities, and derivatives as something other than investment vehicles or insurance. Now is the time to make sense of this confusing landscape. But doing so will require enormous leadership from the Congress.

The first is that our laws are relatively ancient, at least from the standpoint of today’s modern markets. They were crafted mainly in the 1930s and 40s. The speed of change in the financial marketplace has only accelerated the divergence of the legal framework and reality. Regulation has embroidered a semblance of modernity onto this outdated framework, but it has not been enough to keep up.

The full text of his speech, reprinted below, can be found here.

Testimony Concerning the Role of Federal Regulators: Lessons from the Credit Crisis for the Future of Regulation

by Chairman Christopher Cox
U.S. Securities and Exchange Commission
Before the Committee on Oversight and Government Reform
United States House of Representatives

Thursday, October 23, 2008

Chairman Waxman, Ranking Member Davis, and Members of the Committee, thank you for inviting me to discuss the lessons from the credit crisis and how what we have learned can help the Congress shape the future of federal regulation. I am pleased to appear here today with the distinguished former Chairman of the Federal Reserve and the distinguished former Secretary of the Treasury, who together have given more than 25 years of service to our country. I should say at the outset that my testimony is on my own behalf as Chairman of the SEC, and does not necessarily represent the views of the Commission or individual Commissioners.


To begin with, it will be helpful to describe the SEC’s function in the current regulatory system, to better explain our role in the events we are discussing.

The SEC requires public companies to disclose to the public their financial statements and other information that investors can use to judge for themselves whether to buy, sell, or hold a particular security. Companies do this through annual and quarterly reports, as well as real-time announcements of unusual events. Administering this periodic reporting system has been a fundamental role of the SEC since its founding 74 years ago.

The SEC regulates the securities exchanges on which stocks, bonds, and other securities are traded. The SEC makes rules that govern trading on the exchanges, and also oversees the exchanges’ own rules. The primary purpose of this regulation is to maintain fair dealing for the exchanges’ customers and to protect against fraud.

The SEC also regulates the securities brokers and dealers who trade on the exchanges. Our authority to do this comes from the Securities Exchange Act, written in 1934. Although the law has been amended several times in the intervening 74 years, it lays out today essentially the same role for the SEC that the agency has always had in this area.

The agency’s Investment Management Division regulates investment advisers, and also investment companies such as mutual funds, under statutes written in 1940. Here, too, the SEC is concerned primarily with promoting the disclosure of important information, and protecting against fraud.

The Office of the Chief Accountant oversees the independent standard setting activities of the Financial Accounting Standards Board, to which the SEC has looked for accounting standards setting since 1973. It also serves as the principal liaison with the Public Company Accounting Oversight Board, established by the Sarbanes-Oxley Act to oversee the auditing profession.

Above all, the SEC is a law enforcement agency. Each year the SEC brings hundreds of civil enforcement actions for violation of the securities laws involving insider trading, accounting fraud, and providing false or misleading information about securities and the companies that issue them.

Some have tried to use the current credit crisis as an argument for replacing the SEC in a new system that relies more on supervision than on regulation and enforcement. That same recommendation was made before the credit crisis a year ago for a very different, and inconsistent, reason: that the U.S. was at risk of losing business to less-regulated markets. But what happened in the mortgage meltdown and the ensuing credit crisis demonstrates that where SEC regulation is strong and backed by statute, it is effective — and that where it relies on voluntary compliance or simply has no jurisdiction at all, it is not.

The lessons of the credit crisis all point to the need for strong and effective regulation, but without major holes and gaps. They also highlight the need for a strong SEC, which is unique in its arm’s-length independence from the institutions and persons it regulates.

If the SEC did not exist, Congress would have to create it. The SEC’s mission is more important now than ever.

Genesis of the Current Crisis

That brings us to the issue of how the credit crisis came about. The answers are increasingly coming into sharper relief, and this Committee has been looking at several of the contributing causes.

Because the current credit market crisis began with the deterioration of mortgage origination standards, it could have been contained to banking and real estate, were our markets not so interconnected. But the seamlessness which characterizes today’s markets saw financial institutions in every regulated sector suffer significant damage — from investment banks such as Bear Stearns and Lehman Brothers, to commercial banks and thrifts such as Wachovia, Washington Mutual, and IndyMac, to the government-sponsored enterprises Fannie Mae and Freddie Mac, as well as the nation’s largest insurance company, AIG. Every sector of the financial services industry has been vulnerable to the effects of this toxic mortgage contagion. And as the bank failures in Europe and Asia have made clear, regulated enterprises around the world are susceptible as well.

It is abundantly clear, as the SEC’s former Chief Accountant testified at this Committee’s recent hearing on the failure of AIG, that “if honest lending practices had been followed, much of this crisis quite simply would not have occurred.” The nearly complete collapse of lending standards by banks and other mortgage originators led to the creation of so much worthless or near-worthless mortgage paper that as of last month, banks had reported over one-half trillion dollars in losses on U.S. subprime mortgages and related exposure. This was typified by the notorious no down payment loans, and “no-doc” loans in which borrowers not only didn’t have to disclose income or assets, but even employment wasn’t verified.

Securitization of these bad loans was advertised as a way to diversify and thus reduce the risk. But in reality it spread the problem to the broader markets. When mortgage lending changed from originate-to-hold to originate-to-securitize, an important market discipline was lost. The lenders no longer had to worry about the future losses on the loans, because they had already cashed out. Fannie Mae and Freddie Mac, which got affordable housing credit for buying subprime securitized loans, became a magnet for the creation of enormous volumes of increasingly complex securities that repackaged these mortgages. (Fannie and Freddie together now hold more than half of the approximately $1 trillion in Alt-A mortgages outstanding.)

The credit rating agencies, which until late September 2007 were not regulated by statute, notoriously gave AAA ratings to these structured mortgage-backed securities. But that was not all: the ratings agencies sometimes helped to design these securities so they could qualify for higher ratings. These ratings not only gave false comfort to investors, but also skewed the computer risk models and regulatory capital computations. Both the risk models used by financial institutions and the capital standards used by banking and securities regulators had the credit ratings hard-wired into them.

All of this made financial institutions and the broader economy seriously vulnerable to a decline in housing prices. But the economy has been through real estate boom and bust cycles before. What amplified this crisis, and made it far more virulent and globally contagious, was the parallel market in credit derivatives. If the original cause of the mortgage crisis was too-easy credit and bad lending, the fuel for what has become a global credit crisis was credit default swaps.

Credit default swaps resemble insurance contracts on bonds and other assets that are meant to pay off if those assets default. Lenders who did not sell all of the loans they originated were able to buy relatively inexpensive protection against credit risks through credit default swaps. That further encouraged unsound lending practices and encouraged greater risk-taking. At the same time, credit default swaps became a way for banks, financial firms, hedge funds, and even Fannie Mae and Freddie Mac to hedge their risk — but in the process, to expose themselves to new risk from their often unknown counterparties.

By multiplying the risk from the failure of bad mortgages by orders of magnitude, credit default swaps ensured that when the housing market collapsed the effects would be felt throughout the financial system.

For example, as this Committee heard during your hearing on AIG, when mortgage-related securities fell in value, issuers of credit default swaps around the world were forced to post collateral against their positions. This led to increasingly large losses. Credit rating downgrades for such firms would then lead to further requirements for additional collateral, accelerating the downward spiral. Investors concerned about these firms’ deepening problems fled from their stocks. In the case of financial institutions, the slumping stock price led to a loss of customer confidence, often precipitating customer withdrawals and “runs on the bank” that have been averted only with central bank guarantees and liquidity.

Lessons for the Future of Financial Services Regulation

There are important lessons to be learned from this experience — for the SEC, and for the Congress. Like each of you, I have asked myself what I would have wanted to do differently, knowing what we all know now. There are several things.

First, I think every regulator wishes that he or she would have been able to predict before March of this year what we have recently seen not just in investment banks and commercial banks but the broader economy: the meltdown of the entire U.S. mortgage market, which was the fundamental cause of this crisis. I would want the agency’s economists and experts to have seen in the gathering evidence what we now know was there, but what virtually no one saw clearly. Looking back, it is evident that even as the stock market reached its all-time high in October 2007, the deterioration in housing prices and the rise of credit spreads on mortgage backed securities were early signals of a trend that grew so quickly and so powerfully it would within months wipe out both Fannie Mae and Freddie Mac. But none of the investment banks, commercial banks, or their regulators in the U.S. or around the world in March 2008 used a risk scenario based on a total meltdown of the mortgage market. It clearly would have been prescient for the SEC to have done so.

Second, I would have wanted to question every one of the assumptions behind the Consolidated Supervised Entities program for investment bank holding companies. Although I was not at the SEC when the Commission unanimously approved the program in 2004, when I arrived at the SEC a year later this new program represented the best thinking of the agency’s professional staff. Nonetheless, I would have wanted the Division of Trading and Markets to challenge its reliance on the Basel standards and the Federal Reserve’s 10% well-capitalized test, for reasons including the fact that unlike commercial banks, investment banks didn’t have access to Fed lending. That, as we have seen, can be a crucial distinction.

When the Commission wrote the rules establishing the CSE program in 2004, they chose to rely upon the internationally-accepted Basel standards for computing bank capital. They also adopted the Federal Reserve’s standard of what constitutes a “well-capitalized” bank, and required the CSE firms to maintain capital in excess of this 10% ratio. Indeed, the CSE program went beyond the Fed’s requirements in several respects, including adding a liquidity requirement, and requiring firms to compute their Basel capital 12 times a year, instead of the four times a year that the Fed requires.

Nonetheless, the rapid collapse of Bear Stearns during the week of March 10, 2008 challenged the fundamental assumptions behind the Basel standards and the other program metrics. At the time of its near-failure, Bear Stearns had a capital cushion well above what is required to meet supervisory standards calculated using the Basel framework and the Federal Reserve’s “well-capitalized” standard for bank holding companies.

The fact that these standards did not provide adequate warning of the near-collapse of Bear Stearns, and indeed the fact that the Basel standards did not prevent the failure of many other banks and financial institutions, is now obvious. It was not so apparent before March of this year. Prior to that time, neither the CSE program nor any regulatory approach used by commercial or investment bank regulators in the U.S., or anywhere in the world, was based on the assumption that secured funding, even when backed by high-quality collateral, could become completely unavailable. Nor did regulators or firms use risk scenarios based on a total meltdown of the U.S. mortgage market. That is why, in March of this year, I formally requested that the Basel Committee address the inadequacy of the capital and liquidity standards in light of this experience. The SEC is helping to lead this revision of international standards through our work with the Basel Committee on Banking Supervision, the Senior Supervisors Group, the Financial Stability Forum, and the International Organization of Securities Commissions.

Third, both as SEC Chairman and as a Member of Congress, knowing what I know now, I would have wanted to work even more energetically with all of you to close the most dangerous regulatory gaps. I would have urged Congress to repeal the swaps loophole in the 2000 Commodity Futures Modernization Act. As you know, in this bipartisan law passed by a Republican Congress and signed by President Clinton, Congress specifically prohibited the Commission from regulating swaps in very precise language. Indeed, enacting this loophole eight years ago was a course urged upon us in Congress by no less than the SEC Chairman and the President’s Working Group at the time. We now know full well the damage that this regulatory black hole has caused.

The unprecedented $85 billion government rescue of AIG, necessitated in substantial part by others’ exposure to risk on its credit default swaps, is but one of several recent alarms. As significant as AIG’s $440 billion in credit default swaps were, they represented only 0.8% of the $55 trillion in credit default swap exposure outstanding. That amount of unregulated financial transactions is more than the GDP of every nation on earth, combined. Last month, I formally asked the Congress to fill this regulatory gap, and I urge this Committee to join in that effort.

Fourth, I would have worked even more aggressively than I have over the last two years for legislation requiring stronger disclosure to investors in municipal securities. Now that the credit crisis has reached the state and local level, investors need to know what they own.

This multi-trillion dollar market entails many of the same risks and is subject to the same abuses as other parts of the capital markets. Individual investors own nearly two-thirds of municipal securities, directly or through funds, and yet neither the SEC nor any federal regulator has the authority to protect investors by insisting on full disclosure. The problems in Jefferson County, Alabama are only the most recent reminder of what can go wrong. The multi-billion dollar fraud in the City of San Diego, in which we charged five former City employees this past year, has injured investors and taxpayers alike. The economic slowdown will now make it even harder for many states and localities to meet their obligations. Many municipalities continue to use interest rate swaps in ways that expose them to the risk that the financial institution on the other side of the derivatives contract may fail.

That is why, repeatedly over the last two years, I have asked Congress to give the SEC the authority to bring municipal finance disclosure at least up to par with corporate disclosure. Knowing what we now know, I would have begun this campaign on my first day on the job.

Even more important than what I would have wanted to do differently in the past is what we can do together in the future to make sure that this astonishing harm to the economy is not repeated. The work that you are doing in this hearing and others like it this month is helping to build the foundation for the modernization of financial services regulation. What was formerly viewed as an opportunity for improvement sometime in the future has become absolutely essential now.

We have learned that voluntary regulation does not work. Whereas in 1999 the Chairman of the SEC could testify before the House on Gramm-Leach-Bliley that he “strongly supports the ability of U.S. broker-dealers to voluntarily subject their activities to supervision on a holding company basis,” experience has taught that regulation must be mandatory, and it must be backed by statutory authority. It was a fateful mistake in the Gramm-Leach-Bliley Act that neither the SEC nor any regulator was given the statutory authority to regulate investment bank holding companies other than on a voluntary basis.

To fully understand why this is so begins with an appreciation for the enormous difference between an investment bank and an investment bank holding company. The holding company in the case of Lehman Brothers, for example, consisted of over 200 significant subsidiaries. The SEC was not the statutory regulator for 193 of them. There were over-the-counter derivatives businesses, trust companies, mortgage companies, and offshore banks, broker-dealers, and reinsurance companies. Each of these examples I have just described falls far outside of the SEC’s regulatory jurisdiction. What Congress did give the SEC authority to regulate was the broker-dealers, investment companies, and investment adviser subsidiaries within these conglomerates.

When I ended the Consolidated Supervised Entities program earlier this year, it was in recognition of the fact that this short-lived experiment in reviewing the consolidated information for these vast global businesses that could opt in and out of the program did not work. Throughout its 74-year history, the SEC has done an outstanding job of regulating registered broker-dealers, and protecting their customers. The SEC’s investor protection role has consistently been vindicated when financial institutions fail: for example, following the bankruptcies of Drexel Burnham Lambert and more recently Lehman Brothers, customers’ cash and securities have been protected because they were segregated from the firms’ other business. They have also been covered by insurance from the Securities Investor Protection Corporation.

But prior to the Federal Reserve’s unprecedented decision to provide funding for the acquisition of Bear Stearns, neither the Fed, the SEC, nor any agency had as its mission the protection of the viability or profitability of a particular investment bank holding company. Indeed, it has been a fact of life in Wall Street’s history that investment banks can and will fail. Wall Street is littered with the names of distinguished institutions — E.F. Hutton, Drexel Burnham Lambert, Kidder Peabody, Salomon Brothers, Bankers Trust, to name just a few — which placed big bets and lost, and as a result ended up either in bankruptcy or being sold to save themselves. Not only is it not a traditional mission of the SEC to regulate the safety and soundness of diversified financial conglomerates whose activities range far beyond the securities realm, but Congress has given this mission to no agency of government.

The lesson in this for legislators is threefold.

First, eliminate the current regulatory gap in which there is no statutory regulator for investment bank holding companies. This problem has been temporarily addressed by changes in the market, with the largest investment banks converting to bank holding companies, but it still needs to be addressed in the law.

Second, recognize each agency’s core competencies. The mission of the SEC is investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation. In strengthening the role of the SEC, build on these traditional strengths — law enforcement, public company disclosure, accounting and auditing, and the regulation of exchanges, broker-dealers, investment advisers, and other securities entities and products. The vitally important function of securities regulation is best executed by specialists with decades of tradition and experience.

Third, ensure that securities regulation and enforcement remain fiercely independent. This point bears emphasis. Strong securities regulation and enforcement requires an arm’s-length relationship, and the SEC’s sturdy independence from the firms and persons it regulates is unique. For example, banks regulated by the Federal Reserve Bank of New York elect six of the nine seats on the Board of the New York Fed; both the CEOs of J.P. Morgan Chase and Lehman Brothers served on the New York Fed board at the beginning of the credit crisis. In contrast, the SEC’s regulation and enforcement is completely institutionally independent. Not only the current crisis, but the significant corporate scandals such as Enron and WorldCom earlier this decade, have amply demonstrated the need for such independent, strong securities regulation and enforcement. That is why an independent SEC will remain as important in the future as ever it has been before.

Communication and coordination among regulators serving distinct but equally important purposes must also be a priority for regulatory reform. During my Chairmanship, the SEC has initiated Memoranda of Understanding with the CFTC, the Federal Reserve, and the Department of Labor, and we are working on an agreement with the Department of the Treasury. The fact that these agreements are necessary highlights the importance of better information flows among regulators, to communicate meaningful information sooner. But instead of ad hoc arrangements, an overarching statutory scheme that anticipates and addresses these needs would represent fundamental improvement. Through the sharing of market surveillance information, position reporting, and current economic data, federal regulators could get a more comprehensive picture of capital flows, liquidity, and risk throughout the system.

There is another reason that a new, overarching statutory scheme is necessary. The current regulatory system is a hodge-podge of divided responsibility and regulatory seams. Coordination among regulators is enormously difficult in this fragmented arrangement, where each of them implements different statutes that treat various financial products and services differently. Today’s balkanized regulatory system undermines the objectives of getting results and ensuring accountability.

The remarkably rapid pace of change in the global capital markets has also placed new importance on international coordination. American investors simply cannot be protected any longer without help from fellow regulators in other jurisdictions, because so much of the fraud directed at investors today is international in scope. In recent years the Commission has entered into law enforcement and regulatory cooperation agreements with securities regulators in Europe (including London, Paris, and Brussels), Ottawa, Hong Kong, Tokyo, Beijing, New Delhi, Mexico City, and elsewhere that promote collaboration, information sharing, and cross-border enforcement.

We have all witnessed over the past weeks the connections between financial markets around the world. The same phenomena affecting our markets are roiling markets abroad. Regulators in other countries are also under many of the same pressures as those of us here. While our existing cooperation agreements are helping to protect investors in the current circumstances, the new administration must open negotiations on a new global framework for regulations and standards.

Perhaps the most important change to the marketplace in recent years, from the standpoint of investor protection, is the enormous growth in financial products that exist wholly outside the regulatory system. We simply cannot leave unregulated such products as credit default swaps, which can be used as synthetic substitutes for regulated securities, and which can have profound and even manipulative effects on regulated markets. The risk is too great.

Across the board, other regulatory anomalies cry out for rationalization: outdated laws that treat broker-dealers dramatically differently from investment advisers, futures differently from economically equivalent securities, and derivatives as something other than investment vehicles or insurance. Now is the time to make sense of this confusing landscape. But doing so will require enormous leadership from the Congress.

There are two main reasons that our regulatory system has grown into the current dysfunctional patchwork, and one of them is traceable to the organization of Congress itself.

The first is that our laws are relatively ancient, at least from the standpoint of today’s modern markets. They were crafted mainly in the 1930s and 40s. The speed of change in the financial marketplace has only accelerated the divergence of the legal framework and reality. Regulation has embroidered a semblance of modernity onto this outdated framework, but it has not been enough to keep up.

The second is that legislative jurisdiction in both the House and the Senate is split so that banking, insurance, and securities fall within the province of the Financial Services and Banking Committees, while futures fall within the domain of the Agriculture Committees in each chamber. This jurisdictional split threatens to forever stand in the way of rationalizing the regulation of these products and markets.

I know from experience how difficult it will be to challenge the jurisdictional status quo. But the Congress has overcome jurisdictional divides in urgent circumstances before. Appointing a Select Committee, with representation from each of the existing standing committees with responsibility for financial services regulation, is a model that has worked well. As you know, I chaired such a Committee for two years after 9-11, following which the House created the permanent Homeland Security Committee with oversight jurisdiction over the new Department of Homeland Security. A Select Committee on Financial Services Regulatory Reform could cut across the existing jurisdictional boundaries and address these urgent questions from a comprehensive standpoint.

As the Congress undertakes a top-to-bottom review and reassessment of the federal framework for regulation of our financial markets, we must not fall prey to the age-old response of fighting the last war. If we continue to do what we were doing, and just do more of it, we will undoubtedly repeat history. I remember working in the White House in 1987, helping to determine how to respond to a 25% drop in the markets in one day. I see the very real similarities to current events — institutions borrowing short and lending long, housing bubbles in California and Florida, pressure to change accounting rules to give savings and loans time to right their balance sheets. The nation subsequently spent upwards of $150 billion to clean up the wreckage.

While the nation learned much in 1987, and Congress made some constructive changes in regulation, people and institutions too quickly fell back into old habits in old ways. We read now with disappointment the history of regulatory turf battles and missed opportunities, of old-fashioned greed and misguided economic incentives, of regulations that either failed or had unintended consequences.

It is time to think anew. We should begin with a clear-eyed view of the purpose of our capital markets. The financial system administered by Wall Street institutions exists to raise money for productive enterprise and millions of jobs throughout our economy, and to help put the savings of millions of Americans to work in our economy. It should not be an end in itself — a baroque cathedral of complexity dedicated to limitless compensation for itself in the short-term, paid for with long-term risk capable of threatening the entire nation’s sustenance and growth. Transparency has been sorely lacking from enormous swaths of our market. It should by now be abundantly clear that risk in the system which cannot be clearly identified can neither be priced nor effectively disciplined by the market. And it can no longer be tolerated.

In redesigning the regulatory structure, we should also bear in mind the advantages of market forces over government decision-making in allocating scarce resources — including capital — throughout an economy as vast as America’s, as well as what we can and cannot leave to the market alone. Government intervention, taxpayer assumption of risk, and short-term forestalling of failure must not be a permanent fixture of our financial system.

Addressing the Current Crisis

These are some of the regulatory lessons learned during this crisis, and some of the future opportunities. But just as important as reflecting on what could have been done in the past and what should be done in the future is actually dealing with the current emergency. While other federal and state agencies are legally responsible for regulating mortgage lending and the credit markets, the SEC has taken the following decisive actions to address the extraordinary challenges caused by the current credit crisis:

We have worked on a number of fronts to improve transparency, including using our new authority under the Credit Rating Agency Reform Act to expose weaknesses in the ratings process and to develop strong new rules.

We gave guidance on how financial institutions can give fuller disclosure to investors, particularly with respect to hard-to-value assets.

We have worked closely with the Financial Accounting Standards Board to deal with such issues as consolidation of off-balance sheet liabilities, the application of fair value standards to inactive markets, and the accounting treatment of bank support for money market funds.

We are in the midst of conducting a Congressionally-mandated 90-day study of the impacts of fair value accounting on financial firms in the current crisis.

We have initiated examinations of the effectiveness of broker-dealers’ controls on preventing the spread of false information.

We have required disclosures of short positions to the SEC, complementing the existing requirements for reporting of long positions.

We have adopted a package of measures to strengthen investor protections against naked short selling, including rules requiring a hard T+3 close-out, eliminating the options market maker exception of Regulation SHO and expressly targeting fraud in short selling transactions.

We are working with firms in the private sector to speed the development of one or more central counterparties, clearance and settlement systems, and trading platforms for credit default swaps, as an operational step toward bringing this unregulated finance into the sunlight. This work is being closely coordinated with the CFTC and the Federal Reserve.

Beyond all of this, the SEC is first and foremost a law enforcement agency. During the market turmoil of the last several months, the professional men and women of the SEC have been working around the clock, seven days a week, to bring accountability to the marketplace and to see to it that the rules against fraud and unfair dealing are rigorously enforced.

In the fiscal year just ended, the SEC’s Enforcement Division brought the second-highest number of cases in the agency’s history. For the second year in a row, the Commission returned over $1 billion to injured investors. In the last few months, our Enforcement Division successfully negotiated agreements in principle to obtain $50 billion in immediate relief for investors in auction rate securities after these markets seized up. Every one of these cases, when finalized, will set a record for the largest settlements in the history of the SEC, by far.

The agency has been especially aggressive at combating fraud that has contributed to the subprime crisis and the loss of confidence in our markets. We have over 50 pending law enforcement investigations in the subprime area. Most recently, the Commission charged five California stockbrokers with securities fraud for pushing homeowners into risky and unsustainable subprime mortgages, and then fraudulently selling them securities that were paid for with the mortgage proceeds. We have brought fraud charges against the managers of two Bear Stearns hedge funds in connection with last year’s collapse of those funds. And we have brought the first-ever case against a trader for spreading knowingly false information designed to drive down the price of stock.

The Division of Enforcement is currently in the midst of a nationwide investigation of potential fraud and manipulation of securities in some of the nation’s largest financial institutions through means including abusive short selling and the intentional spreading of false information.

As part of this aggressive law enforcement, the Commission approved orders requiring hedge funds, broker-dealers and institutional investors to file statements under oath regarding trading and market activity in the securities of financial firms. The orders cover not only equities but also credit default swaps. To assist in analyzing this information, the SEC’s Office of Information Technology is working with the Enforcement Division to create a common database of trading information, of audit trail data, and of credit default swaps clearing data. Our Office of Economic Analysis is also supporting this effort by helping to analyze the data across markets for possible manipulative patterns in both equity securities and derivatives.

In the days ahead we will continue to work to bring to justice those who have violated the law, and to help mitigate the effects of the credit crisis on investors and our markets.

Mr. Chairman, the role of the SEC has never been more important. The several thousand men and women who have devoted themselves to law enforcement and the protection of investors, markets, and capital formation represent this nation’s finest. The last several months have been difficult for the country and for our markets, but this adversity has brought out the best in the people with whom I work. Every day, the staff of the SEC devote themselves with passion to protecting America’s investors and ensuring that our capital markets remain strong. I am humbled to work side-by-side with them.

Thank you for the opportunity to discuss the role of the SEC in our financial system, and the lessons from the current crisis for fundamental regulatory reform in the future. I am happy to answer any questions you may have.